In the late 1990s Paul Krugman did some clever work on the role of expectations in monetary policy. At one point he provocatively argued that centrals banks needed to “promise to be irresponsible” when stuck at the zero rate bound. I certainly understand the logic of his argument—it can help to boost inflation expectations—but it turns out that this phrase did more harm than good. Central banks are never going to adopt a policy that seems irresponsible, and hence it becomes easy for central bankers to dismiss all proposals for monetary stimulus, including the sorts of responsible proposals put forward by market monetarists (and later endorsed by many Keynesians.) It so happens that 5% NGDP targeting is both the right policy and the responsible policy. It’s pro-growth, but also has a nominal anchor. It fulfills the Fed’s dual mandate, which they are legally obligated to adhere to.
This provides one more reason why inflation targeting should be abandoned and replaced with NGDPLT. If inflation targeting can only work at the zero bound if austere conservative central banks promise to behave like drunken teenagers with the keys to their dad’s Porsche, then it can never work.
This post was motivated by a Brad DeLong post that CA sent me:
Brad quotes his commenter Daniel Kuehn:
We have the confidence fairy. We need to start talking more about the “expectations fairy” in reference to market monetarists like Scott Sumner. Of course in the best of all possible worlds the expectations channel works great and we can talk about monetary policy with confidence even with a non-existent interest rate channel. But we don’t live in that world and we can advocate monetary policy while still having reservations about its effectiveness. Sumner seems to interpret that as opposition. So let’s talk more about the “expectations fairy”.
Actually I don’t interpret it as opposition, I interpret it as ineffective advocacy. There’s something very wrong when 99.99% of Paul Krugman’s readers in late 2008 and early 2009 thought he was claiming that monetary policy was ineffective at the zero bound, partly because he frequently did claim that monetary policy was ineffective at the zero bound (before putting an asterisk about possible but unlikely expectations channels in a footnote.) Just to review the evidence for DeLong and Kuehn:
1. No evidence of a determined central bank failing to inflate at the zero bound, while there is evidence of success.
2. Bernanke insists the Fed can do more. Bernanke (and Cameron in Britain) are not taking steps that they could take.
3. All the asset markets react to hints of monetary easing as if it’s a massively important issue. By late 2010 when rumors of QE2 were pushing up TIPS spreads, Krugman was forced to admit that yes it was working in practice, but gosh darn it, it couldn’t possibly work in theory.
I’m actually not as stubborn as I look. I’ve been wrong about plenty of things before, and I change my mind when new evidence comes in. But until the Fed sets a higher NGDP target, or does level targeting, and buys up another $10 trillion in debt and eliminates IOR (not one of those actions, but all of them) then there’s no point in even talking about running out of ammunition. And since they obviously won’t do those things, I won’t have to admit I was wrong on this issue.
Matt Yglesias has it exactly right in the title of this post:
And no sooner do I find this post, than I see Matt has a new one that basically anticipates my argument:
One area in which I think some prominent left-of-center voices have gone badly awry is in suggesting that the Federal Reserve faces some serious credibility problem in attempting to reflate a depressed economy. Paul Krugman’s famous line about trying to credibly promise to be irresponsible is funny, but I think makes the issue sound more paradoxical than it is.
And while I’m quoting progressives that “get it,” how about a couple Tim Duy gems sent me by “dwb”:
In some sense, this is right – market participants expect that economic conditions will be such that the Fed will need to keep interest rate low for a long time. But the Fed should not be content with low rates. If policy was effective, longer term interest rates would rise in expectation of eventual Fed tightening. The collapse of rates – again – is an indication that the Fed needs to be doing much, much more. And Yellen is a dove!
The Federal Reserve would have been better off to buy a set quantity of assets every week, adjusting that number as they might the interest rate, until certain macroeconomic objectives are met. This would let the expectations channel shoulder some of the work by laying out a clear path for monetary policy. Moreover, they would probably need to buy fewer assets overall. Instead, now we have policy scheduled to end discretely in the absence of the consideration of the macroeconomic backdrop, thus disrupting the expectations channel because market participants don’t know what will trigger continuation of the policy. It simply isn’t the way to manage the monetary affairs of the nation.
I love that stuff. Easy money can raise rates by boosting growth. That’s Milton Friedman. Switching to a money supply form of communication because interest rates go “mute” at the zero bound—that’s Nick Rowe. And the Fed won’t have to buy as much stuff if they get serious about a credible policy of reflation—that’s all of us market monetarists. Interestingly, Ben Bernanke discussed this idea in a 1995 JMCB article, and called it “multiple monetary equilibria.”
BTW. I’m not trying to embarrass Duy by dragging him into the market monetarist camp—I don’t doubt that we disagree on many issues. But it is surprising how many bridges are being built across the ideological divide on the issue of monetary policy. (Now if we could only convince our fellow conservatives.)
And finally, Saturos sent me a Justin Wolfers tweet indicating that Bernanke’s recent statements somehow undercut the “monetary offset” argument for the zero fiscal multiplier. Just to be clear, even I think the fiscal cliff would slow GDP growth, if only for supply-side reasons. But in terms of demand-side policy, this is what it would take to convince me. Suppose Ben Bernanke said the following:
My fellow Americans, the Fed recently announced a 2% inflation objective. We are now changing that policy. We have decided that we will only aim for 2% inflation if Congress does our preferred fiscal policy. If they do more than we want, we will shoot for more than 2% inflation, even though that violates our dual mandate. And if they do less than we want we will shoot for less than 2% inflation, even though that also violates our dual mandate.
I’m not too worried about Bernanke saying anything like that—so until further notice the “Sumner critique” remains operative.