Archive for the Category Monetary Policy


Obama’s horrible advice to Germany

This caught my eye:

Greece’s pleas to stop the “fiscal waterboarding” of its devastated economy are substantively no different from President Obama’s repeated warnings to Germany to stop bleeding the euro area economy with excessive fiscal austerity. Sadly, the president’s reportedly more than a dozen phone calls to the German Chancellor Merkel in 2011 and 2012 urging supportive economic policies in the euro area fell on deaf ears.

These calls were not just brushed aside; they were plainly ridiculed as Chancellor Merkel kept telling the media that “it made no sense to be adding new debt to old debt.”

This advice would have merely added to the eurozone debt woes, without doing anything to promote recovery,  Even worse, most of the countries lacked the ability to spend more, as the markets were worried they might default on their debts.  Germany could have spent more, but any extra demand in Germany would have been offset by even less growth in the other countries, leaving total eurozone AD unchanged.  That’s the real “beggar-thy-neighbor” policy.

People reading this will probably assume I’m making wacky market monetarist claims again.  But unless I’m mistaken Paul Krugman agrees with me.  After all, he has repeatedly said that when not at the zero bound, central banks determine the path of inflation.  The eurozone was not at the zero bound in 2011, and indeed the ECB was repeatedly raising rates to slow inflation.  Had there been more fiscal stimulus, the ECB would have raised rates even more, offsetting the effect.  That’s what an inflation target means.  If you don’t like it, then don’t target inflation.

There is one type of fiscal stimulus that would have been effective, employer-side payroll tax cuts.  Oddly, in the past Krugman has been relatively skeptical of this approach, and I’ve been more supportive.  So you could argue that I’m more supportive than Krugman of the argument that fiscal stimulus might have helped the eurozone in 2011, but only a very specific type of stimulus.

PS.  I love the way the press acts as if the fiscal austerity was forced onto Greece, with the metaphor “fiscal waterboarding.”  Greece could have said “we don’t want your emergency assistance with strings attached”, and left the eurozone.  Maybe they should have done so.

PPS.  Over at Econlog I catch Robert Shiller reasoning from a price change.


Making life easier for central bankers

This is from an excellent article at Free Exchange:

THE Bank of England released its quarterly inflation report this morning. It also published the letter from Mark Carney, governor of the bank, to George Osborne, Britain’s chancellor of the exchequer, that was required to explain why inflation—currently 0.5%—had deviated more than a percentage point below the bank’s target of 2%.

According to the report’s forecasts, inflation will turn negative in the coming months as a result of the huge fall in oil prices. However, the letter emphasises the short-term, one-off nature of the oil-price shock, which will fall out of the numbers relatively quickly and so requires no offsetting action. Mr Carney noted that in 68% of the categories which make up the CPI, prices are rising. In any case, the bank thinks it takes 18-24 months for monetary policy to have an impact on the economy; the oil-price fall came on much more quickly.

When asked whether the bank was overlooking the oil-price decline because it was unanticipated or because it was external to the economy, Mr Carney said it was the former. Were the bank able to forecast supply shocks in time to offset them, it would have to do so under its inflation-targeting mandate (“If we knew it, and could lean against it, we would”). Mr Carney hinted that in such a situation, it might be worth reconsidering the mandate.

It was interesting to listen to Carney’s comments in the second link—you can see why the Free Exchange writer saw Carney hinting that another mandate might be more appropriate.  At the same time, Carney sort of backed off before saying what you expected him to say—perhaps uneasily aware that he wasn’t really free to speak his mind on this issue; the mandate is up to the government.

On the other hand, when people are able to speak their minds it seems as though increasing numbers see the obvious virtues of NGDP targeting, including academics, bloggers, and indeed Mr Carney himself when he spoke in Toronto a few months before taking the BoE job.  Here’s Free Exchange:

That’s one of the problems with inflation-targeting regimes. The central bank uses its interest rate to steer demand. Demand shocks cause output and inflation to move in the same direction; if demand rises, both output and inflation tend to go up too. But a positive supply shock—like the recent fall in oil prices—increases output while suppressing inflation. To offset the deflationary effect of a “good” supply shock, the bank would have to lower interest rates to stimulate the domestic economy. That is, the bank would have to let the economy overheat. In the event of a negative supply-shock, such as an oil-price rise, the bank would have to slow down the domestic economy—potentially causing unemployment—in order to generate domestic deflationary pressure. The overall effect is to increase the volatility of domestic output, rather than promote macroeconomic stability, one of the intentions behind inflation targeting.

As has been frequently pointed out in the blogosphere, if the bank targeted nominal GDP (NGDP) rather than inflation, there would be no such problem. Under a such a regime, the bank would concern itself only with nominal spending in the economy, which can rise due to inflation or due to output growth (the supply-side of the economy determines the split between the two). The bank could therefore tolerate supply-side shocks which boosted growth and reduced inflation, as they would have an offsetting effect on NGDP. There would be no need to manipulate domestic output to offset forces from abroad.

Carney would have a much easier time at press conferences if he wasn’t constantly having to explain BoE policy that on the surface seemed inconsistent with inflation running much too high or much too low relative to the 2% mandate.  He could simply announce the NGDP growth rate, and explain in a very simple and transparent way why the BoE responded to that information with their current policy stance.

Carney also announced that the current policy rate (0.5%) was no longer viewed as the lower bound.  Here’s Britmouse:

The Governor of the Bank of England announced yesterday that interest rates are no longer at the Zero Lower Bound.  This was a rather under-the-breath “Oh, and by the way” announcement, which is kind of funny given how much some economists have staked on the significance of the ZLB.

.  .  .

In choosing to hold rates at 0.5%, the MPC is choosing to set rates above the new, lower, actual ZLB.  The Bank of England is no longer at the ZLB.

The good news is that now the Bank is off the ZLB, reality-based Keynesians will return to talking about UK macro policy in terms of conventional monetary policy and will go quiet about the need to use fiscal policy to control AD.  Right?

The other thing I find amusing is that Keynesians kept insisting that if only central banks could have cut rates further they would have.  That may have been the case at one time, but obviously is no longer true.  The BoE could cut them right now, but chooses not to.

PS.  Yichuan Wang has a good post criticizing my posts on the musical chairs model:

I have no disagreement on the policy advice. But I do have an issue with the way that Scott justifies his “musical chairs” model of employment. In particular, the key stylized fact — the countercyclicality ratio of wages divided by nominal GDP — is not unique to his model. As such, it does not provide any smoking gun for the market monetarist claim that fluctuations in nominal GDP are key to understanding the business cycle.

.  .  .

Now, I still believe that a model of nominal GDP + sticky wages is a powerful framework. Wages are indeed sticky, as evidenced by a spike in the wage change distribution at 0. And if wages are sticky, monetary tightness and declining nominal GDP mean that people are paid high real wages and as such there are fewer jobs. Alternatively, you can view it as a liquidity issue as companies just don’t have enough nominal cash flows to pay those persistently elevated wages. So I don’t think there are too many issues with the underlying framework. I would just advise more caution on the way that statistical evidence is used.

I should be more careful in my discussion.  Yichuan is right that the correlations by themselves don’t provide much support for the musical chairs model, as they are also consistent with other models.  You might think of them as a necessary condition.  You actually need several assumptions:

1.  The fact that W/NGDP is highly correlated with unemployment.

2.  The fact than nominal wages are very sticky in the presence of high frequency NGDP shocks (lasting one, two or three years.)

Reducing Fed discretion (dedicated to John Taylor)

John Taylor has written a number of articles that are critical of the Fed’s current discretionary regime.  It’s difficult to know what the Fed is trying to achieve, and how they intend to get there.  This creates uncertainty in the marketplace, and greater macroeconomic instability stability.  Naturally Taylor focuses on the need for something like the Taylor Rule.  In contrast, I’ve advocated NGDPLT, with the same goal—reducing discretion and making the Fed more accountable.

In this post I plan to talk about a policy that I don’t favor, in the sense that it’s not my first choice.  On the other hand it’s a policy I do favor, in the sense that I’d vastly prefer it to current Fed policy.  I’m hoping that if Taylor Rule supporters read this post they’ll have a better idea as to where I’m coming from.

My proposed rule is CPCELT, that’s “core PCE level targeting.”  Why this target?

I see two big sources of discretion and ambiguity in the current target, which is PCE inflation targeting:

1.  One problem is supply shocks.  It’s widely known that pragmatic central banks may want to allow some price level variation when there is a supply shock.  For instance, if oil prices suddenly change, then keeping overall inflation on target would require moving “all other prices” in the opposite direction.  But those other prices are often stickier than oil prices, and trying to move them suddenly can create business cycles. Thus central banks often allow some inflation variation when there are supply shocks, especially to food and energy, and in some cases they point to core inflation as being more meaningful, at least in the short run.

And yet central banks also insist that they are targeting headline inflation in the long run.  This is supposed to reassure the public, because the public cares about headline inflation.  There are two problems with catering to public opinion in this case.  First you are pandering to ignorance.  Even if the Fed prevents supply shocks from increasing the price level in the long run, they will not be able to prevent the associated loss of real income, which is why the public cares about inflation in the first place.  Economists know that the public misunderstands the effect of inflation on living standards, but we pander to that ignorance when we insist we’ll stabilize headline inflation in the long run.  The second problem is that the public thinks of inflation in terms of the CPI, but the Fed targets the PCE.  So we aren’t really targeting what the public thinks of as “inflation,” even with a headline PCE inflation target.  PCE inflation runs about 0.35% below CPI inflation.

So I propose the Fed target what they actually care about, core PCE inflation.  That increases accountability, as the Fed can no longer point to temporary oil and food price changes as excuses.

2.  The second problem is growth rate targeting.  Under growth rate targeting we have no idea where the price level will be in 10 or 20 years, making long term planning more difficult.  Suppose prices fall, as in 2009.  Is the Fed trying to make up some of that fall, or shoot for 2% inflation from that point forward?  It’s hard to say.  Perhaps errors are a sort of random walk, and the price level gradually drifts further and further from that trend line. Even worse, a central bank that pays lip service to inflation targeting, but doesn’t seriously try to get there (say the Pre-Abe BOJ) can let the price level gradually drift lower for 20 years, each year claiming they just missed by 1% or so.  At the other extreme, the dovish Bank of England can consistently run slightly above target.

Level targeting is a way of forcing central banks to do what they claim they are trying to do.  Under level targeting you always have a precise point estimate of where PCE core price level is supposed to be in 2 or 3 or 5 years.  It’s a way of holding central banks accountable.  You still allow some variation in the very short run, assuming there is the dual mandate.  But they can no longer act like magicians, directing your attention somewhere else when they persistently fail to hit their goals.  “Look at oil.”  “Look at unemployment.”  “Don’t worry, we’ll get there eventually, despite the TIPS market saying we won’t.”  Those excuses won’t work; they’ll eventually be exposed if they persistently miss.

If there is to be a dual target (which is something I don’t like, and why I favor NGDPLT instead) then central banks must also be held accountable on the unemployment front. In recent years, inflation has run below target when unemployment is high, and vice versa. The Fed should be instructed to do the opposite, and its effectiveness should be judged on that basis.  They should have to explain to Congress why inflation is below target when unemployment is high, as that’s even worse that a rigid single mandate for inflation.

To summarize, with CPCELT central banks will no longer be able to offer the following excuses:

1.  We missed because of temporary factors like food and energy prices.

2.  We keep missing by 1/2% on the low or high side, year after year, but in the future we promise to do better.

But there are other advantages as well.  When prices fall, as in 2009, inflation expectations automatically rise (they actually fell under the current regime) and this reduces real interest rates, boosting the economy. During the housing boom the market would have understood that core inflation was overshooting, and that awareness would have led to more bearish expectations—reducing speculation.  In addition, some macro models suggest that you want to target the stickiest price, which might be wages.  Core inflation is more closely correlated with wage inflation than is headline inflation.

Everyone knows that a NGDP target would have called for a more expansionary monetary policy in recent years.  But the same is true for core PCE.  Core PCE inflation averaged 2.03% between December 1990 and December 2007, then the inflation rate fell to 1.4% between December 2007 and December 2014.  Under the dual mandate you’d prefer slightly lower inflation during the booming 1990-2007 period, and slightly above 2% inflation during the depressed 2007-14 period.  Even under a single inflation mandate this sort of variation is unacceptable, as it creates macroeconomic instability. Under a dual mandate it’s even more unacceptable.

To conclude, my critique of the Fed goes far beyond the fact that they are targeting inflation and I’d prefer NGDP.  Even under inflation/price level targeting there could be vast improvements, which would reduce discretion, increase accountability, and make the economy more stable.

Of course there’d still have to be a conversation about the instrument rules needed to hit this target.  But I firmly believe this sort of regime would vastly reduce the discretion/accountability/ambiguity problems that John Taylor worries about, even before we moved on to the policy instrument issue.

PS.  This post is a response to commenter SG.

Do central banks worry more about the bond market or the labor market?

Commenter Nick directed me to this FT story:

Mr Williams spoke amid speculation about when the Fed will pull the trigger following more than six years of rates at near-zero levels. Economists including Lawrence Summers, a former US Treasury secretary, have urged the Fed to leave rates unchanged until there is clear evidence that inflation, and inflation expectations, are set to breach its 2 per cent target.

However Mr Williams dismissed such calls, warning of the risk that the Fed gets behind the curve on inflation and that it could end up being forced to hike rates “much more dramatically” to rein in inflation, provoking market turmoil. Given the trails with which monetary policy operates it was better to start raising interest rates “gradually, thoughtfully”, he said.

When I hear Wall Street types talk about the danger of a sudden and dramatic tightening of interest rates, they often refer to the awful 1994 “bloodbath” in the bond market, triggered by the Fed’s decision to tighten monetary policy after a period of low rates during the 1991 recession and weak recovery.  Here’s a graph showing the rise in 10-year bond yields, which sharply depressed bond prices in 1994.

Screen Shot 2015-02-13 at 10.42.56 AM

Fortunately, there was no “bloodbath” in the labor market, which is the market I care about:

Screen Shot 2015-02-13 at 10.48.17 AM

Nor was there a bloodbath in the stock market.  The 1994 move was an example of highly effective stabilization policy by the Fed, despite all the gnashing of teeth in the bond market.  I wonder if the Fed is overly concerned about the impact of its policies on the bond market, and insufficiently concerned about the impact on the labor market.

In contrast, during April to September 2008 the labor market was deteriorating rapidly—clearly headed into a recession—while the Fed twiddled its thumbs.  Unemployment rose from 5.0% in April to 6.1% in August, which was 1.7% above the low point reached at the cyclical peak (4.4%.)  In the past, a recession has occurred 100% of the time when unemployment rose by more than 0.8% above the cyclical low, so the 1.7% rise was a completely unambiguous signal.  How did the Fed respond?  They did nothing at their September 2008 meeting, 2 days after Lehman failed.

The Phillips Curve and interest rate targeting are dead. What next?

Larry Summers has an article in the FT where he admits that the Phillips curve hasn’t worked very well recently, and then advocates keeping interest rates near zero until inflation rises significantly.  Summers likes discretionary monetary policy, whereas I believe that’s how we got into this mess.  Stephen Williamson is also not a fan.  Here he comments on Summers:

If the Phillips curve doesn’t explain what’s going on, how do we get more inflation with continued ZIRP except through a Phillips curve mechanism? Further, Summers seems worried about the “next recession.” Presumably if the Fed still has ZIRP at that point, it’s powerless (except perhaps with unconventional tools) to do anything about it.

Next, we enter the realm of the bad analogy:

…a plane that accelerates too rapidly as it takes off may cause passengers discomfort while a plane that accelerates too slowly may crash at the end of the runway. Historical experience is that inflation accelerates only slowly so the costs of an overshoot on inflation are small and reversible with standard tightening policies. In contrast, aborting recovery and risking a further slowing of inflation is potentially catastrophic — as Japan’s experience demonstrates. So in a world where economic forecasts are highly uncertain, prudence in avoiding the largest risks counsels in favour of Fed restraint in raising rates.

His assumption, again, is that continued ZIRP will make the inflation rate go up. But “as Japan’s experience demonstrates,” 20 years of ZIRP just serves to produce low inflation.

Of course I think that neo-Fisherians like Williamson get the causation exactly backwards—20 years of low inflation “serves to produce” the zero interest rates.  But Williamson is right to sense something is wrong with the standard Keynesian remedies.  Actually two things:

1.  The inflation targeting approach favored by new Keynesians doesn’t work well today because inflation is no longer closely correlated with output gaps.  In contrast, NGDP is closely correlated with output gaps, and hence central banks should target NGDP, not inflation.

2.  Interest rates are not a good policy instrument, as they can get stuck at zero for years, even decades.  We need a policy instrument with no zero bound (the base, forex rates, or my favorite, NGDP futures prices.)

The Fed thinks that monetary policy can go back to normal in the near future, and that they can return to something like a Taylor Rule approach.  Here’s who disagrees with the Fed:

1.  Me

2.  The 30-year bond market

3.  Stephen Williamson

4.  Paul Krugman and Larry Summers

I’d like to see NGDPLT, Krugman wants fiscal stimulus or a 4% inflation target, and Summers wants fiscal stimulus.

Perhaps it’s inevitable that big institutions like the Fed are reactive rather than creative.  It’s really hard to believe that they don’t see that interest rate targeting just won’t work in the future—that rates will go right back to zero in the next recession (assuming they rise above zero before it occurs.)  Or that IT is far inferior to NGDP targeting.

PS.  I have a piece in the Telegraph, and there’s also another Telegraph article that quotes Lars Christensen and me.

PPS.  Check out my new Econlog post.

PPPS.  Eggs are fine!

HT:  Michael Byrnes, TravisV