The Fed doesn’t have the luxury of waiting for the perfect DSGE model; they must do policy right now
OGT sent me a recent Stephen Williamson post on Christina Romer’s call for NGDP targeting. Williamson is highly critical, but doesn’t seem to fully understand the distinction between policy instruments and policy goals:
NGDP targeting does not do anything other than specify the Fed’s ultimate goals.
Goals are macroeconomic outcomes that the central banks would like to see. Instruments are actions or statements by the central bank that change the current supply or demand for base money. Adoption of NGDPLT is not just a policy goal, it is an act that changes the current demand for base money. And it’s not just a policy tool; it’s by far the Fed’s most powerful tool. The Fed steers the nominal economy by sending out signals regarding the future path of the supply and demand for base money. Even changes in the fed funds target work this way—no one seriously believes the huge stock market responses to the January 2001, September 2007 and December 2007 Fed announcements occurred because the target was set 1/8% away from market expectations. Rather they changed expectations of the future policy trajectory. It’s always about the expected future path of policy.
But Williamson is right about his main point; Romer doesn’t present a rigorous model that would justify NGDPLT. Perhaps such a model doesn’t exist. But here’s the problem, no one else has a rigorous model that would justify any monetary policy, at least not a model that passes the laugh test. Just imagine if Steve Williamson walked into the FOMC with his favorite GE model and said; “Here’s the correct model of the economy; this tells you how you should conduct monetary policy.” People would literally fall on the floor laughing.
In the comment section someone mentioned Evan Soltas’s recent defense of NGDPLT, and Williamson responded:
You realize that was written by a high school student?
“Perhaps not all of these arguments are wrapped up in one tight analytical model, but these general concepts should not be difficult to model in chunks.”
How do I model in chunks?
Charming. I’d recommend Williamson read Milton Friedman, if he wants to see partial equilibrium analysis that blows away 99.9% of the GE stuff churned out by our grad schools today.
The hard truth is that the Fed must do monetary policy. We will never find an even half way decent DSGE model of the economy, so they need to rely on pragmatic arguments. If you read the minutes of the Fed meetings, you’ll see exactly the same sort of non-technical pragmatic arguments that Evan used. The debate at the Fed almost never rises above the sort of simple, natural rate AS/AD model used in intro econ classes.
Here’s the type of argument that economists find persuasive:
This may not be news to you, but it was to me. In this speech, Narayana Kocherlakota shows us how the labor market behavior in Sweden, following the early-1990s financial crisis that occurred there, looks much like what has been happening recently in the United States. This is consistent with this post, where I looked at some Canadian labor market data. Canada sailed through the financial crisis with essentially no problems in its banking sector, and the recent behavior of the labor market (or rather, labour market) in Canada looks quite different from the US. Sweden had a financial crisis in the early 1990s, and it’s labor market behaved subsequently like the US labor market is behaving now.
You may or may not be persuaded by that particular argument (I’m not), but the point is that it represents exactly the sort of argument that every macroeconomist from Krugman to Cochrane uses. And they use them because they know other macroeconomists are far more persuaded by this sort of reasoning, then if they say “let me show you my newest mathematical GE model; it tells us what the Fed should be doing.” And I’m pretty sure that Williamson knows this, as I pulled the argument from his latest blog post.
PS. I was puzzled by this statement:
Romer and the FOMC are on the same page on this one, but I don’t think QE does anything at all (again, see the last link above). At best, QE can signal future intentions of the Fed with regard to the policy rate (and thus move asset prices), but the Fed can do the same thing with “forward guidance,” i.e. announcements about the future path for the policy rate.
Oh really? What if the Fed announces zero interest rates for the next 20 years? Is that easy money or tight money? Williamson calls himself a “new monetarist,” but I can’t help wondering what Friedman would think of an economist claiming that the future path of nominal interest rates describes the stance of monetary policy.