Right before I got into blogging I started reading James Hamilton. He was a sort of inspiration to me; he kept his head as the world around him seemed to be losing its mind. My favorites were his posts mocking the idea of a “liquidity trap” the idea that a fiat money central bank would somehow be unable to “debase it’s currency” when rates hit zero. Now he seems to have gone over to the other side, as his new post is very skeptical of whether the Fed could hit a higher inflation or NGDP target. And yet the reasons provided seem based on macro theory that was discredited long ago. More specifically, he seems to have become one of what Nick Rowe calls “the people of the concrete steppes.”
These academic critics would like to see the Fed announce more aggressive targets in the form of either higher rates of inflation or faster growth of nominal GDP. I will get to the issue of these targets in a moment, but first would like to discuss the mechanical details of what, exactly, the Fed is supposed to do in the way of concrete actions in order to ensure that any such announced target is achieved.
Recall that current Fed actions that are mechanical in nature have almost no impact on prices, output, or any other macro aggregate. The effect of monetary policy, if it is effective at all, comes mostly from signaling future policy intentions. In the comment section Nick raises this very point:
If a (say) 5% NGDP level path target (with a catch-up step) were credibly communicated, all those “mechanical” and “concrete” “logistics” would have to be implemented very quickly, only in the exact reverse direction. The Fed’s balance sheet is far larger than it would need to be if people expected 5% NGDP level path. The more ambitious the target, the easier the logistics.
And here’s how Hamilton responds:
Nick Rowe: Not sure I’m following your argument. I gather your claim is that the announcement itself would solve the problem. If so, I’m skeptical about that assumption. I am just looking at the mechanics of what the Fed would do right now, with numbers and the situation such as we have, in order to boost nominal GDP growth. And my answer is, it would have to do more buying of securities, leaving bigger concerns than those we have right now as to how later the Fed is going to go about undoing those positions.
Hamilton has it exactly backwards. Countries with lower expected NGDP growth than the US (like Japan) have higher base to GDP ratios. Countries like Australia which have faster expected NGDP growth (and thus avoided the zero rate bound) have lower base to GDP ratios (indeed only about 1/4th US levels.) Nick’s right that a policy of faster NGDP growth would require the Fed to reduce the monetary base. I’m surprised that Hamilton finds this a novel argument. He’s one of the best scholars of the Great Depression, and is well aware of what happens to base demand in a depressed economy with near zero interest rates.
In the comment section a number of commenters confronted him with his earlier quotations mocking the idea that the Fed would be unable to boost inflation. (Read comments by Anon1, and Andy Harless.) And his response was as follows:
Anon1: Not sure I understand your point, either. I claimed then and still claim today that the Fed has the power to prevent deflation.
But the quotation provided by Anon1 doesn’t just say the Fed has the power to prevent deflation, he also claims it has the power to create inflation. If Hamilton is right that there is no contradiction, then I humbly suggest that almost everyone must be completely misinterpreting his current message. (It would be interesting to know how Tyler Cowen interprets the post, which he calls “superb.”)
Let me first acknowledge that it is very possible I have misinterpreted either Hamilton’s earlier posts or his current post. And yet I can’t help thinking about the large number of elite monetary theorists who seem to have changed their views since before the recession, while strongly denying any change. The most famous example is of course Ben Bernanke. The most amusing example is Frederic Mishkin, who keeps changing his textbook in ways that make current Fed policy look less bad. Why the changes? What scares me is that I fear some economists think that recent events in the US cast doubt on the effectiveness of monetary stimulus, whereas in fact they confirm that effectiveness.
Hamilton also makes this odd claim:
And the way I see current U.S. monetary policy is exactly as Bernanke defended it at a recent press conference. I believe the Fed has effectively and credibly communicated that it is not going to allow the U.S. to repeat Japan’s experience of deflation or extremely low inflation. Deflation is the exact opposite of the potentially chaotic flight from dollars that I described above, and deflation would unquestionably be counterproductive for the U.S. By drawing a line at keeping inflation above 2%, I think the Fed can use its limited available mechanical tools in a credible way to achieve an appropriate goal.
This seems to imply that Bernanke is promising to keep inflation above 2%, but the reverse is more nearly correct. Headline inflation has averaged well below 2% since mid-2008, the slowest rate since the mid-1950s. This tight money policy has of course made the debt crisis much worse. By mid-2010 the core inflation rate had fallen to 0.6%. Their current forecast calls for 1.9% inflation over the next few years, suggesting 2% is more like a ceiling than a floor. If we’d had a 2% floor the recession would have been much milder. But it’s actually much worse than that. Both core and headline inflation are dominated by housing costs. The BLS numbers show housing up by about 8% since early 2006, whereas the Case-Shiller index shows prices down 32%. Obviously the actual fall in all housing costs (including rental units) is far less than the Case-Shiller number, but nonetheless the actual CPI number is hugely distorted by mis-measured housing prices
Based on his late 2008 writings that helped inspire me to get into blogging, I’d expect Hamilton to be outraged by Bernanke’s recent statements. The US clearly has a nominal spending shortfall. Bernanke says the Fed can fix it, but that it doesn’t need fixing because they are close to their 2% inflation target. What about the dual mandate? I’m confused and somewhat dismayed by Hamilton’s support for Bernanke, and can’t find anything in this new post that would justify it.