Archive for the Category Monetary Policy


We need a commission on stabilization policy

I know, you are gagging on the title of the post.  I hate commissions too.  But there’s already a lot of discussion about a commission to re-evaluate the Fed’s goals and tactics.  And the current proposals are both too much and too little.  Too much because there are some tactical questions that the Fed itself can resolve better than any commission.  But there are also some questions that the Fed currently cannot answer, and where a commission could be very useful to the Fed. I believe the biggest issue now is what to do about stabilization policy in a world that frequently hits the zero bound during recessions. That’s not the world of the past 50 years, but I believe it’s quite likely to be the world of the next 50 years.

Although I don’t recall doing so, it’s quite possible that at some point in the past 6 years I insinuated that Paul Krugman favors fiscal policy because he likes big government.  Perhaps there’s even a grain of truth in that statement.  But there’s also one really big problem with that claim.  Consider:

1.  Paul Krugman strongly supports raising the inflation target to 4%

2.  There is only one justification for raising the inflation target to 4%; it makes it possible for the Fed to handle 100% of the responsibility for stabilization policy.

And it’s not just Krugman; lots of other liberal economists have also favored raising the inflation target to 4%.  Why do I bring this up now?  Because I can just hear commenters saying how naive I am; “liberals will never agree to a plan that eliminates the need for fiscal policy.”  Then why do so many favor 4% inflation target?  And why does Paul Krugman say fiscal policy is pointless when nominal interest rates are positive?

Now I don’t happen to favor a 4% inflation target, and I doubt that this would be the outcome of the commission.  But I do believe the commission’s output would be very useful, even if I don’t “get my way” on fiscal policy.

Both liberal and conservative economists agree on these basic facts:

1.  When trend NGDP growth rates are lower, the economy will hit the zero bound more often.  One option is to raise the inflation target.  The Paul Krugman solution.

2.  Another option is to do something like NGDPLT.  My preferred solution.

3.  Another option is to keep the Fed’s current policy framework, 2% PCE inflation, growth rate targeting, and unemployment near the natural rate.

Economists also agree that option three may require some hard choices.  These include:

a.  Pursuing QE to the limit in a liquidity trap.  Allowing the Fed to buy whatever it takes, even if they have to move beyond Treasury debt.  Telling the Fed not to worry about capital risk, the Treasury has them covered.  My second preference.

b.  Constraining the Fed to buy securities of no more than a specific amount, say 50% of GDP, to avoid excessive risk.  Other options are also possible here, such as more aggressive cuts in IOR, perhaps to negative levels.  Then just live with a slow recovery.  Similar to current policy.

c.  Same as option b, but have an implicit agreement that once the Fed hits its QE limit, fiscal stimulus will take over.  The Larry Summers solution, Krugman’s second preference.

Policy is currently hindered by the fact that the Fed doesn’t know exactly how aggressive it should be, partly because Congress is not even aware of these “hard choices.”  So we don’t have any sort of clear policy regime, rather we drift in a sort of limbo, where the Fed doesn’t really know how much others want it to do.  Or whether it would be scolded for large capital losses on its balance sheet if rates rose sharply.  Or whether Congress would support the Fed if it shifted its target higher in order to keep interest rates above zero.  The Fed knows that politicians are concerned that rates are low for savers, but doesn’t know if that concern implies they’d favor higher interest rates that are caused by higher inflation.

I don’t think this commission is politically feasible until January 2017, but at that time it just might work. I’m assuming the Dems will again win the presidency and the GOP will retain the House.  Gridlock will make fiscal policy impossible unless an agreement can be reached.  If you put sensible conservatives like Taylor, Mankiw and Hubbard on the committee, with sensible Keynesians, they are all going to understand the trade-offs I discussed above.  The GOP economists can explain to GOP politicians “look, it’s inflation or socialism, take your choice.  If we don’t have a bit more inflation then interest rates will fall to zero, and the Fed will keep expanding its balance sheet, bigger and bigger.”  Or we’d get fiscal stimulus, another option the GOP doesn’t like.  The liberal members of the commission can explain to Democrats “look, it’s better if the Fed handles stabilization policy, and fiscal resources are utilized for pressing social needs, not economic stabilization. And in any case, the GOP will never let us do the amount of fiscal stimulus we need, or they’ll insist on tax cuts that ‘starve the beast’.”

Krugman and I may not get our way.  Maybe the commission will compromise on a monetary/fiscal mix, where the Fed takes the lead, but the fiscal authorities act if the Fed ‘s balance sheet hits X% of GDP.  If I lose the battle I’ll stop objecting to fiscal stimulus.  I’ll stop claiming the multiplier is zero.  I’ll stop claiming there is monetary offset.  If that’s clearly the regime, and it’s all spelled out, then so be it. At that point I’ll argue that payroll tax changes are the best form of stimulus.

But right now there is great uncertainty about who is in charge, and what is expected of the Fed.  This stuff really needs to be clarified for the zero bound environment.  Or at least discussed.  I’ll bet the Fed would be thrilled if Congress told them exactly what their responsibilities were in terms of capital losses, instead of leaving it quite vague.

What would Congress decide in the end?  One possibility is keeping the 2% inflation target, and a continual role for fiscal policy.  That’s very possible.  Or Congress might ask the Fed to study options for preventing the zero rate bound from hamstringing monetary policy, and they might buy into a technical fix like level targeting and/or NGDP targeting. I don’t know.  But politics goes in cycles.  After so many years of gridlock, 2017 might be a good time for a compromise.  To make this happen we all have to starting talking up the idea right now—assuming anyone agrees with me.

Monetary offset and the time inconsistency problem

I recently ran across a very revealing article from April 24, 2012:

NEW YORK, April 24 (Reuters) – Federal Reserve policymakers are sounding the alarm over a “fiscal cliff” at the end of this year, when scheduled U.S. tax hikes and spending cuts could pose a big threat to the fragile economic recovery.

Along with its official mandate of watching unemployment and inflation, the U.S. central bank is keeping a close eye on a potentially debilitating political fight over how to fix the budget deficit.

If lawmakers in Washington do not get rid of the tax hikes and spending cuts due to take effect in early 2013, the country could easily careen into another recession. Any moves by Congress, however, aren’t expected until after the Nov. 6 presidential election.

The Fed is worried that individuals and companies could hunker down and curb spending, making markets antsy as the country awaits the outcome of an election that could pave the way for new tax and spending policies.

Though few expect Washington to do nothing while fiscal policies push the economy into another downturn, partisan politics could undermine the Fed’s unprecedented actions to revive the economy.

“I have been disappointed that the president and Congress are not taking action until after the election,” St. Louis Fed President James Bullard told reporters in Utah last week.

“I’m also worried that markets will react badly to the fiscal cliff at the end of this year. Markets might start to speculate about what might or might not happen … after the election,” he said.

Asked what the Fed can do, however, Bullard seemed to dismiss the possibility of resorting to new bond buying to counter the effects of political gridlock over the budget deficit and economic policy.

“It’s up to the Congress,” he said.

By the end of 2012, it was pretty clear that fiscal policy would sharply tighten in 2013. The Fed responded with QE3 and some additional forward guidance.  Bullard was so confident that these steps would offset the fiscal guidance that he forecast an acceleration of RGDP growth in 2013, to around 3% to 3.5%.  Actual RGDP growth (Q4 to Q4) turned out to be about 3.1%. So we have a nice example of monetary offset, with a happy ending.

But notice something strange at the end of the long quote; Bullard seems to be warning Congress not to expect the Fed to bail them out if the send the economy into a recession with reckless fiscal austerity.

When I was young I got a nice job offer from the New York Fed, at a salary 75% higher than my Bentley salary.  My department chair took the offer to the Dean, who responded, “Tell him I hope he likes New York.”  In the end I stayed at Bentley. (Feel free to insert dog retreating, tail between legs metaphor here.)  I learned a lesson, and indeed not once have I ever told my daughter “If I catch you smoking pot you can forget about me paying for your college education.”  My threats aren’t credible, due to the time inconsistency problem.

Matt Yglesias once wrote a post pointing out that the Fed denies that it engages in monetary offset:

A curious issue that in my opinion he and other proponents of the full monetary offset thesis haven’t fully grappled with is that Federal Reserve officials keep saying it’s not true. I heard John Williams of the San Francisco Fed say it’s not true at the Brookings event this morning. I heard Ben Bernanke say it’s not true at the American Economics Association meeting in Philadelphia earlier this month. I separately heard William Dudley of the New York Fed say it’s not true in Philadelphia. Janet Yellen has repeatedly said it’s not true. And since full monetary offset isn’t just an abstract economic thesis, it’s specifically a thesis about the actual behavior of the Federal Reserve, the fact that nobody in a position of authority at the Fed believes in it seems like a big problem worthy of a more substantive response.

You find lots of counterarguments in this post, written in response to Matt’s post. That post is my best counterargument. But I’d add this post as a footnote, as it shows how statements by Fed officials regarding their intentions may not accurately describe the Fed’s actual future policy response, but rather may reflect a desire to get Congress to do more of the heavy lifting.

That’s not to say that Matt’s completely wrong, indeed his views are actually about halfway between my view and the views of more traditional Keynesians.  Here’s the very next paragraph of the Yglesias post:

What I think clearly is true is that partial monetary offset is very real. The people who thought the tight fiscal policy of 2013 would crush the economy were wrong, and they were proven wrong precisely because of monetary offset.

That’s a reasonable argument, and if my version of monetary offset were proved wrong at some later date, Yglesias’s view would be the alternative that I’d find most plausible.  But thus far the data seem to support something close to full offset—both the 2013 case of austerity in the US, and the cross sectional study by Mark Sadowski.  Of course “further research is needed.”

PS.  Here’s a perceptive observation from the April 2012 article:

“We’re naive if we think that [fiscal cliff] doesn’t play into the Fed’s thinking about monetary policy,” said Tom Porcelli, chief U.S. economist at RBC Capital Markets in New York.

“But the way that the Fed would want to present it is a minor consideration at best, because they don’t want to be supplementing fiscal policy,” Porcelli said.

Porcelli clearly gets it, although the term ‘supplementing’ doesn’t really capture the idea he’s trying to express.  He should have said, “offsetting.”

PPS.  I have a new post on the euro over at Econlog.

AD shocks aren’t so mysterious

Marcus Nunes pointed me to a Stephen Williamson post.

On the other hand, suppose I am an empirical macroeconomist, and I’m trying to understand the Great Recession. I have coffee with Paul Krugman, and he tells me not to worry. This looks pretty much like other recessions – just an insufficiency of demand. As an empirical macroeconomist, I may not know what Paul is talking about, as there now exist practicing macroeconomists who have never seen AD/AS, IS/LM. But, for example, Christiano, Eichenbaum, and Trabandt know AD/AS, IS/LM (at least I’m pretty sure the first two do). They’re well-known empirical macroeconomists, and they’re not coming out and saying the Great Recession is about aggregate demand deficiency. They have a model, and the model has stochastic shocks which they give names to, and none of those shocks appear to have the name “aggregate demand.” They have taken the time to write a whole paper in which they try to figure out how the shocks account for the Great Recession, and what the propagation mechanism is. Conclusion:

We argue that the vast bulk of movements in aggregate real economic activity during the Great Recession were due to financial frictions interacting with the zero lower bound.

Sorry, but that’s not in AD/AS, IS/LM.

So I took a look at the abstract to their paper:

We argue that the vast bulk of movements in aggregate real economic activity during the Great Recession were due to financial frictions interacting with the zero lower bound. We reach this conclusion looking through the lens of a New Keynesian model in which firms face moderate degrees of price rigidities and no nominal rigidities in the wage setting process. Our model does a good job of accounting for the joint behavior of labor and goods markets, as well as inflation, during the Great Recession. According to the model the observed fall in total factor productivity and the rise in the cost of working capital played critical roles in accounting for the small size of the drop in inflation that occurred during the Great Recession.

That sounds an awful lot like an AD paper to me.  But I’ve only read the abstract. Perhaps someone else can read the paper, and tell me why they used a NK model with liquidity traps and sticky prices, if it’s not an AD-oriented model.

Returning to the Williamson post:

Now, consider another person. This one is older than the average undergraduate – old enough to actually care about the Great Recession, and not think of this as ancient history. This person is, say, 30, and worked on Wall Street during the financial crisis. She saw a lot of stuff. Volatile financial market activity, unemployed people, large financial institutions in trouble, etc. Now she’s motivated to go back to school and take some economics so she can understand all that stuff. She takes an intro-to-macro course, learns AS/AD, and is told that the Great Recession is just like all the other recessions – AD shifts left. Given her experience in the world does this get her excited? Does this information somehow put all her practical experience into perspective? I don’t think so.

I can’t speak for her, but it would sure get me excited.  If I’d run up huge debts and then found myself unable to pay them off, I’d double down and work harder. The fact that Americans, on average, decided to take lots of vacations in late 2008 is a big puzzle.  Especially in industries that had nothing to do with subprime mortgage debt, like autos and services.  Why did so many autoworkers stop working when the mortgage crisis occurred in 2008? Why didn’t creative destruction work, with labor moving from overbuilt housing to other areas? Why did output fall in almost all industries? I’d want to take a course in macro to find out.

And suppose I was told that there are competing theories:

1.  Technological regress in autos, people forgot how to make them.

2.  An earthquake destroyed most of America’s auto-making facilities.

3.  Autoworkers were tired of working, and decided it was time for a long vacation.

4.  The government raised the minimum wage to $30/hour, making the industry uncompetitive

5.  AD fell, and Americans cut back on spending on cars.

Which of those theories, or any other you’d like to mention, might that hypothetical stock trader find plausible?  If she was really smart she might ask why a decline in spending would reduce real output.  And you’d answer that prices are sticky.  And then she’d ask why AD fell, and you’d mention the financial crisis.  And then she’d ask why the Fed didn’t offset the effect of the financial crisis on AD by easing monetary policy.  And you’d mention the zero bound, and their reluctance to pursue unconventional techniques to the max.

Hmmm, sticky prices, financial crisis, the zero bound problem, isn’t that the abstract to the paper Williamson said was not AS/AD?

I actually enjoyed reading Williamson’s post.  Lots of good observations about Krugman and Meltzer.  A nice critique of Phillips curve thinking.  But I’m far less impressed by modern modeling techniques than he is.  For me the proof is in the pudding.  If modern macro really is making progress, then we ought to hear its practitioners make useful observations during a major crisis.  Or at least make observations as astute as someone like Milton Friedman would have made in 1997:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

.   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

Instead we’ve regressed, and most of what I’ve read since 2008 has been utter nonsense, starting with claims that the Fed has been conducting an “easy money” policy.  In fairness to Williamson, he and David Andolfatto are among the extremely tiny number of macroeconomists who don’t equate low interest rates with easy money.

PS.  I have a new post on Iceland over at Econlog.

Are Aussie housing regulations the dumbest rules on Earth?

Commenter Colin Docherty sent me an article on the Reserve Bank of Australia’s counterproductive attempt to hold down house prices with tight money:

The Reserve Bank of Australia’s surprise decision to defer its widely anticipated April rate cut for at least another month might have been influenced by the increasingly pricey housing market, which it regards as posing a real “dilemma”.

According to UBS, in March the ratio of Australian dwelling prices-to-disposable household incomes equalled – and is presently surpassing – the previous record of 5.3 times set back in September 2003. And they predict it will climb further.

As a result, Aussie inflation is now sliding far below the 2.5% target, and unemployment has been climbing. This is the same policy the Fed tried in 1929. This is the same policy the Riksbank tried in 2010.  Do central bankers ever learn?

Back in 2009 I ridiculed the idea of bubbles by pointing out that while all the English speaking countries had seen huge house price surges in the early 2000s, only the US and Ireland saw a crash.  Australian prices were particularly robust. But despite the bubblemongers being wrong about these countries, they continued to insist it was all a bubble.  OK, I can sort of understand how people could make that mistake in 2009. But now, six years later, Australian house prices are still up at the same lofty levels.  Is the term “bubble” now so elastic that it can fit a house price boom that’s occupied virtually the entire 21st century?  How about if prices are still high in 2020—will it still be a bubble?  How about 2030?  How about 2050? Of course the bubblemongers will refuse to answer these questions because like soothsayers they always want an “out” if their predictions fail.  They always want to be able to say; “You just wait and see.”

And how about those people who said Bitcoin was a bubble at $25?  I’m will to buy coins from you guys at twice the price you said was a bubble back then.

I still haven’t gotten to the dumbest policy on Earth.  Australia is the size of the continental US, with a population smaller than Texas.  Like Texans, Aussies should be able to afford comfortable single-family homes.  But in the right column of the article linked to above, I see links for these articles:

I can visualize microapartments in Hong Kong, but Australia? Are the zoning regulators there sadists?  What would cause an otherwise sensible country to have such insane housing rules that Sydney would end up with some of the highest land prices on Earth?

Milton Friedman said:

If you put the federal government in charge of the Sahara Desert, in 5 years there’d be a shortage of sand.

Well the Australian government was put in charge of land use in a country the size of the Sahara, and now they have microapartments.

I’m begging regulators there to make me look like a fool.  Pop that nonexistent housing bubble by changing the fundamentals.  Give landowners the freedom to build, like they have in Germany.  Please, make me look like a fool.

Update:  Lorenzo has a much better post today on housing, interest rates and monetary policy.

The second step

A few weeks ago, I published a post discussing the minimum acceptable level of Fed accountability.  At a minimum, any institution needs to establish some procedure to evaluate how they are doing their job.  The Fed’s main job is to use its policy instruments to nudge AD up or down in a way that they think is most likely to hit their inflation and employment targets.  That’s monetary policy.

Because of policy lags it’s not always clear what current instrument setting is most likely to lead to an increase in AD that is compatible with on-target inflation and employment.  Thus the Fed needs to periodically evaluate past FOMC meetings, and tell the public whether, in retrospect, the policy stance set at the earlier meeting was too expansionary, too contractionary, or about right.  They can use any criteria they wish, it’s up to them.  Just tell us how well they are hitting they AD goals. Who could object to that?

It’s rather shocking the Fed doesn’t currently meet even that extremely minimal level of accountability.  Of course more would be better.  Ken Duda sent me some ideas that form a useful second step, still falling well short of NGDP targeting (an idea rapidly gaining popularity among the elite.)  Here’s Ken’s still extremely modest second set of steps:

1) publishing an NGDP forecast

2) publishing a forecast of how policy instrument settings would affect NGDP (“if we were to raise interest rates, we’d expect the NGDP level to be X% lower than if we hold interest rates at zero”).

3) forecasting what are desirable levels of NGDP, i.e., what NGDP level-path would be most consistent with the dual mandate, or what NGDP level-path would be consistent with what level of unemployment or inflation

4) operating a prediction market for any of the three above

I can’t even imagine how anyone could oppose any of those 4 steps, even if they were 100% opposed to NGDP targeting.  How would that information not be useful? Of course it would be useful, it would help markets to better understand what the Fed is doing.  Instead we see statements from Fed officials implying that the economy is currently skating on the edge of recession (my words not hers) and also that the Fed may well increase interest rates in the near future. No wonder markets are confused.

PS.  The first quarter was negative for both real and nominal GDP, and Cleveland Fed president Federal Reserve Governor Lael Brainard sees no bounce back in Q2.  Obviously I meant “recession”, not actual recession, which won’t happen even if we have 2 negative quarters.

PPS.  Over at Econlog I have an update on Summers’ NGDP targeting comments.