Archive for the Category Monetary Theory

 
 

Will it matter when the Fed has “traction?”

People have made all sorts of arguments against “monetary offset,” but there’s only one that actually makes much sense.  The argument is that the Fed does not like doing “unconventional policies” like QE, because they feel “uncomfortable” with a large balance sheet.  (Put aside the fact that QE is perfectly conventional monetary policy–open market operations—and that there is no reason at all to feel uncomfortable with a large balance sheet.  The Fed is effectively part of the Federal government.)

Nonetheless, there is a sort of plausibility to the theory; Fed officials will occasionally say they would cut interest rates further if they could.  But what is the implication of this theory?  It seems to me that this theory implies that Fed policy should become much more aggressive when the Fed is no longer hamstrung by the zero bound.  When they can stimulate without adding to the balance sheet.  But this raises an interesting paradox—the Fed is conventionally viewed as being “stimulative” when they cut rates.  Thus the Fed should want to cut rates as soon as they can do so, which means right after they raise them!

Of course I’m half-kidding.  More realistically the implication is that once the Fed stops doing the “uncomfortable” QE, there will be a long period of zero rates before they raise them.  And perhaps there will be, but right now the Fed suggests it will be raising interest rates in less than a year.

Here’s a graph from a Marcus Nunes post:

Screen Shot 2014-10-30 at 6.15.21 PMNGDP had been rising at about 5% per year in the 17 years before the recession, and it’s been rising about 4% per year in the “recovery.”  Because wages and prices are flexible in the long run, the real economy has been recovering despite the lack of any demand stimulus.  We have fallen from 10% to 5.9% unemployment.  But most people think the economy is still in the doldrums, and needs more stimulus.  President Obama just instructed the Department of Labor to increase unemployment compensation benefits (without any authorization from Congress of course–why do you think would Congress be involved in spending decisions?) This was done because unemployment is at emergency levels, requiring extra-legal remedies.

Fortunately the Fed is no longer doing the “uncomfortable” QE policy, which adds to the balance sheet.  So if you believe the fiscal policy advocates, the Fed should be raring to go with stimulus. How do they do that?  By promising to hold rates near zero for a really long time, or until the labor market is really strong.  But instead, they are suggesting that they will probably raise interest rates soon.  There will be no attempt to get back to the old trend line; the new one seems just fine.

Let’s consider an analogy.  A bicycle rider has a “policy” of maintaining a steady speed of 15 miles per hour.  Then he hits a long patch of ice, and slows to 10 miles per hour, perhaps due to a lack of traction, perhaps because he decided to go slower.  How can we tell the reason?  How about this, let’s put a strong headwind in his face, and see if the speed slows even more.  But now he petals harder and keeps maintaining the 10 miles per hour speed.  That suggests it’s not a lack of traction. But the pessimists insist it must be a lack of traction, why else would he have slowed right when he hit the ice?  Then the bicycle final comes to the end of the ice.  The lack of traction proponents expect him to suddenly speed up, exhilarated by the sudden traction of rubber on asphalt.  Oddly, however, the bike keeps plodding along at 10 miles an hour.  Nothing seems to have changed even though the ice patch is long past.

[In case it's not clear, the headwinds were the 2013 austerity, and the end of the asphalt was the end of the liquidity trap.]

Here’s my claim.  The Fed promise to raise rates soon is not the sort of statement you’d expect from a central bank that for the past 5 years had been frustrated by an inability to cut rates.  (Nor is their other behavior consistent—such as the on and off QE.)  Rather it’s the behavior of a central bank that has resigned itself to pedaling along at a slower speed.  Ten miles per hour is the new normal.

I don’t want to sound dogmatic here.  Obviously monetary offset is not “true” in the sense that Newton’s laws of mechanics are true; the concept only applies in certain times and places.  Oh wait, that’s true of Newton’s laws too .  .  .

Opponents of monetary offset face two big problems.  In theory, the central bank should target some sort of nominal aggregate, and offset changes in demand shocks caused by fiscal stimulus. And in practice it seems like they do, as we saw in 2013, even at the zero bound.  So if monetary offset is not precisely true, surely it should be the default baseline assumption.  Instead, as far as I can tell 90% of economists have never even considered the idea.

PS. Totally off topic, I love this sentence from an article on why a million dollars no longer makes you rich:

Although it sounds like a lot of cash, $1 million of today’s money is only worth $42,011.33 of 1914 dollars, which is less than today’s median household income.

Someone should collect all these amusing claims in the media.  They could have added that today’s median income of $42,011 is only equal to $1764 in 1914 dollars, roughly equal to the per capita GDP (PPP) of Haiti.  I guess I was wrong, the American middle class really is struggling.

Question for David Glasner

Here’s David Glasner:

I can envision a pure barter economy with incorrect price expectations in which individual plans are in a state of discoordination. Or consider a Fisherian debt-deflation economy in which debts are denominated in terms of gold and gold is appreciating. Debtors restrict consumption not because they are trying to accumulate more cash but because their debt burden is so great, any income they earn is being transferred to their creditors. In a monetary economy suffering from debt deflation, one would certainly want to use monetary policy to alleviate the debt burden, but using monetary policy to alleviate the debt burden is different from using monetary policy to eliminate an excess demand for money. Where is the excess demand for money?

Why is it different from alleviating an excess demand for money?

As far as I know the demand for money is usually defined as either M/P or the Cambridge K.  In either case, a debt crisis might raise the demand for money, and cause a recession if the supply of money is fixed.  Or the Fed could adjust the supply of money to offset the change in the demand for money, and this would prevent any change in AD, P, and NGDP.

Perhaps David sees the debt crisis working through supply-side channels—causing a recession despite no change in NGDP.  That’s possible, but it’s not at all clear to me that this is what David has in mind.

Williamson on monetary policy and interest rates

In the past, Stephen Williamson has attracted some fierce criticism for his views on the relationship between money and interest rates, specifically some posts that seemed to deny the importance of the “liquidity effect.”  Nick Rowe and others criticized Williamson for seeming to suggest that a Fed policy of lowering interest rates would actually lower the rate of inflation–via the Fisher effect. Williamson has a new post that seems to have somewhat more conventional views of the liquidity effect, but still emphasizes the longer term importance of the Fisher effect:

If the central bank experiments with random open market operations, it will observe the nominal interest rate and the inflation rate moving in opposite directions. This is the liquidity effect at work – open market purchases tend to reduce the nominal interest rate and increase the inflation rate. So, the central banker gets the idea that, if he or she wants to control inflation, then to push inflation up (down), he or she should move the nominal interest rate down (up).

But, suppose the nominal interest rate is constant at a low level for a long time, and then increases to a higher level, and stays at that higher level for a long time. All of this is perfectly anticipated. Then, there are many equilibria, all of which converge in the long run to an allocation in which the real interest rate is independent of monetary policy, and the Fisher relation holds.

Before discussing Williamson, let me point out that back in 2008-09, 99.9% of economists thought the Fed had eased policy, and that the deflation of 2009 occurred in spite of those heroic easing attempts.  That 99.9% included the older monetarists.  Only the market monetarists and the ghost of Milton Friedman insisted that money was tight and that interest rates were falling due to the income and Fisher effects.  I’d like to think that Williamson agrees with us, but of course he’d be horrified by the specifics on the MM model, indeed he wouldn’t even recognize it as a “model.”

Williamson continues:

A natural equilibrium to look at is one that starts out in the steady state that would be achieved if the central bank kept the nominal interest rate at the low value forever. Then, in my notes, I show that the equilibrium path of the real interest rate and the inflation rate look like this:

Screen Shot 2014-09-13 at 10.41.23 AM

Is that really monetary tightening?  After all, inflation rises.  Here’s the very next paragraph by Williamson:

There is no impact effect of the monetary “tightening” on the inflation rate, but the inflation rate subsequently increases over time to the steady state value – in the long run the increase in the inflation rate is equal to the increase in the nominal rate. The real interest rate increases initially, then falls, and in the long run there is no effect on the real rate – the liquidity effect disappears in the long run. But note that the inflation rate never went down.

The scare quotes around “tightening” suggest that Williamson is also skeptical of the notion that tightening has actually occurred.  Indeed inflation increased, then policy must have eased. However to his credit he recognizes that “conventional wisdom” would have viewed this as a tightening.  Nonetheless the final part of the paragraph has me concerned.  Williamson refers to the disappearance of the liquidity effect, but in the example he graphed there is no liquidity effect, as the rise in interest rates was not caused by a tightening of monetary policy.  If it had been caused by tighter money, inflation would have fallen.

So how can the graph be explained?  As far as I can tell the most likely explanation is that at the decisive moment (call it t=0) the equilibrium Wicksellian interest rate jumps much higher, and then gradually returns to a lower level over the next few years.  And the central bank moves the policy rate to keep the price level well behaved.  I suppose you might see this as being roughly the opposite of the shock that hit the developed economies in 2008, except of course it was more gradual.

Suppose there had been no change in the Wicksellian equilibrium rate, and the central bank simply increased the policy rate by 100 basis points, and kept it at the higher level.  In that case, the economy would have fallen into hyperdeflation. When you peg interest rates in an unconditional fashion, the price level becomes undefined.

Is there any other way that one could get a path like the one shown by Williamson? Could the central bank initiate this new path? Maybe, at least if you don’t assume a discontinuous change in the interest rate, followed by absolute stability.  To explain how you could get roughly this sort of path lets look at the reverse case.

Suppose the Fed had been increasing the monetary base at about 5% a year for many years, and the markets expected this to continue.  This led to roughly 5% NGDP growth.  The markets assumed the Fed was implicitly targeting NGDP growth at about 5%.  But the Fed actually also cared about headline inflation, which suddenly rose higher than desired (due to an oil shock.)  The Fed responded by holding the base constant for a period of 9 months.  (For those who don’t know, so far I’ve described events up to May 2008.)

This unexpectedly tight money turned market expectations more bearish.  As expectations for NGDP growth became more bearish, the asset markets fell and the Fed responded by cutting interest rates.  And since inflation did not immediately decline, real short term rates also fell (still the mirror image of the Williamson graph.)  BTW, we know that even 3 month T-bill yields FELL on the news of policy tightening at the December 2007 FOMC meeting.  Williamson would have approved of that market reaction!!

Normally the Fed would have realized its mistake at some point, and monetary policy would have nudged us back onto the old path.  In this case, however, market rates had fallen to zero by the time the Fed realized its mistake.  And the Fed was reluctant to do unconventional stimulus.  There was a permanent reduction in the trend rate of NGDP growth, as well as nominal interest rates. This showed up in lower than normal 30-year bond yields.  The process played out even more dramatically in Europe (and earlier in Japan.)

I do have one quibble with the Williamson post.  He seems too skeptical of the claim that the ECB recently eased policy.  But before I criticize him let me say that I find his error much more forgivable than the conventional wisdom, which views low interest rates as easy money.

Williamson points out that the ECB recently cut rates, and that if the ECB leaves rates near zero for an extended period of time, then inflation is likely to stay very low, as in Japan.  All of this is correct.  But I think he overlooks the fact that while the overall policy regime in Europe is relatively “tight”; the specific recent actions taken by the ECB most definitely were “easing.”  We know that because the euro clearly fell in the forex markets in response to that action.

I think this puzzles a lot of pundits.  It’s very possible for central banks to take relative weak actions that are by themselves expansionary, even while leaving the overall policy stance contractionary, albeit a few percent less so than before. That’s the story of the various QE programs in America.

I encourage all bloggers to never reason from a price change.  Do not draw out a path of interest rates and ask what sort of policy it is.  First ask what caused the interest rates to change—the liquidity effect, or the income/Fisher effects?

PS.  Of course I agree with most of the Williamson post, such as his criticism of “overheating” theories of inflation.

HT:  TravisV

Don’t show this St. Louis Fed article to Nick Rowe

A commenter sent me a paper from the St. Louis Fed:

This view can also be represented by the so-called “quantity theory of money,” which relates the general price level, the total goods and services produced in a given period, the total money supply and the speed (velocity) at which money circulates in the economy in facilitating transactions in the following equation:

MV = PQ

In this equation:

  • M stands for money.

  • V stands for the velocity of money (or the rate at which people spend money).

  • P stands for the general price level.

  • Q stands for the quantity of goods and services produced.

Oh, so that’s the quantity theory of money.  In fairness, they do mention stable velocity later on. But stable velocity is the QTM, it’s where you start the explanation.  They continue:

And why then would people suddenly decide to hoard money instead of spend it? A possible answer lies in the combination of two issues:

  • A glooming economy after the financial crisis
  • The dramatic decrease in interest rates that has forced investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds

In this regard, the unconventional monetary policy has reinforced the recession by stimulating the private sector’s money demand through pursuing an excessively low interest rate policy (i.e., the zero-interest rate policy).

If only the Fed had joined the ECB in raising interest rates back in 2011.  Then we would have had a much faster recovery.

Base money is just as special as it ever was

Here’s Frances Coppola:

Technology changes and post-crisis monetary policy are making financial assets and money indistinguishable. Central banks now need to work in partnership with fiscal authorities.

Several economists at the Lindau meeting were severely critical of central banks’ conduct of monetary policy in the light of continuing depression in the US, Japan and much of Europe, and called for greater use of fiscal policy to bring about recovery. Among the most critical was Christopher Sims, who gave a trenchant presentation on “Inflation, Fear of Inflation and Public Debt”.

He started by announcing the death of the quantity theory of money, MV=PY. Due to interest on reserves and near-zero interest rates, “money” can no longer be clearly distinguished from other financial assets. This is a fundamental point which requires some explanation.

These days, nearly all forms of money bear interest, which makes them indistinguishable from interest-bearing assets. For Sims, the paying of interest on bank reserves, coupled with the decline of physical currency, all but eliminates the distinction between interest-bearing safe assets such as Treasury bills and what we traditionally call “money”. All assets can be regarded as “money” to a greater or lesser extent: the extent to which assets have “moneyness” is really a matter of liquidity.

Sometimes words can get in the way of meaning.  There is no point in arguing about what the term “money” really means, it obviously means different things to different people.  But the term “base money” still has a pretty clear meaning; currency in circulation and bank deposits at the Fed.  The Fed happens to have a complete monopoly on the (US$) monetary base.  Prior to 2008 it could determine the supply of base money through OMOs and discount loans, and it could influence the demand for base money through changes in reserve requirements.  After 2008, a 4th tool was added—interest on reserves, which also impacts the demand for base money.  With these four tools the Fed can push the value of the dollar (in terms of euros) to anywhere between zero and infinity.  That’s a lot of power.  Nothing fundamental has changed, at least nothing relating to the validity of the quantity theory of money.

A few other points:

1.  The quantity theory of money has NOTHING to do with the equation of exchange.  That equation is best viewed as a definition of velocity, nothing more.  Definitions are not theories.

2.  Currency is not “declining.” The currency stock is growing faster than GDP.  It is also becoming a steadily larger share of the monetary aggregates.

HT:  Marcus Nunes