I was reading a new book by Tim Congdon and came across this interesting quotation, discussing the flaw at the heart of New Keynesian economics:
In the New Keynesian schema, it [the interest rate] became in effect the only policy instrument, the factotum of macroeconomics.
Why did we have to end up with the worst possible policy instrument? The only instrument that has a zero lower bound. We could have chosen the monetary base, or the trade-weighted exchange rate, or the price on NGDP futures, or the TIPS spread, or the price of zinc. But no, we had to pick nominal interest rates.
We ended up with a steering mechanism that locks up just when you most need it to work. Even worse, central banks have so fallen in love with the mechanism that they can’t seem to shift to a different target. Instead we end up with never-ending attempts to manipulate interest rates, even when short term rates have hit zero. Promise to hold rates at zero for X number of years. Or attempts to lower longer term rates. Or to reduce interest rate risk spreads.
These proposals have a slightly pathetic quality, because (as Nick Rowe reminds us in this recent post) a policy that is expected to be successful will actually raise nominal rates. So you have the Fed announcing that the goal of QE2 was to lower long term rates, and then when they start rising the Fed announces that the policy must be working. It’s a wonder the Fed still has any credibility. How’s this for communication?
WASHINGTON — The Federal Reserve made a rare promise on Tuesday to hold short-term interest rates near zero through at least the middle of 2013, in a sign that it has all but written off the chances of an expansion strong enough to drive up wages and prices. . . .
By its action, the Fed is declaring that it, too, sees little prospect of rapid growth and little risk of inflation. Its hope is that the showman’s gesture will spur investment and risk-taking by convincing markets that the cost of borrowing will not rise for at least two years.
The Fed’s statement, with its mix of grim tidings and welcome aid, contributed to wild market oscillations as investors struggled to make sense of the economy and the path ahead. (emphasis added)
Well that will certainly whip up those animal spirits!
The zero rate bound doesn’t occur for variables like the monetary base. Some Keynesians argue that this doesn’t matter; open market purchases become ineffective when rates hit zero, as one is merely swapping one asset for another. But that’s not true, as a permanent increase in the base is inflationary. And if the Fed had already been using the base, it would have been able to continue signaling future policy intentions as if nothing had happened. In contrast, once rates hit zero the Fed can’t signal anything with changes in interest rates, because it can’t change interest rates.
Of course the New Keynesians also insist that interest rates are the transmission mechanism. Not so. When there’s a big apple crop, NGDP in apple terms soars. No need to invoke interest rates. Ditto for a big crop of Federal Reserve Notes. And the mechanism that causes nominal shocks to have real effects is sticky wages and prices, not interest rates. When I point out that rates hardly budged during the most expansionary monetary policy in US history, Keynesians start talking about rates falling relative to their Wicksellian equilibrium value. Yes, but that’s pretty much true by definition, and true for any price. If the Wicksellian equilibrium zinc price is the one consistent with 2% inflation, then the Fed can boost inflation above 2% if and only if it can raise zinc prices above their Wicksellian equilibrium.
The next meeting will be a big test for the Fed. I don’t expect miracles, but I’d hope for at least some sign that they understand there’s nothing more they can do to generate recovery by fiddling with interest rates. They need to indicate that they are at least attempting to communicate in some other language.
Most people seem to assume nothing major will be done until the three hawks leave in January. In fact, Fed stimulus would be more credible if they could get at least one of the three to vote for it. It seems to me that Kocherlakota offers the best hope. At times he seems to indicate that he’s aware of the unemployment problem, but doesn’t like the lack of a nominal anchor in open-ended promises, such as two years of near-zero interest rates. He might be willing to support stimulus, as long as there is an explicit promise to maintain prices or NGDP along a particular trajectory. If I’m right, it’s quite possible that the fate of 100,000s of unemployed people might depend on what he decides.
It’s no way to run monetary policy. We should have an explicit 5% NGDP target, and let the market set the money supply and interest rates. But you go into recession-fighting with the Fed you have, not the Fed you wish you had.