Market monetarism vs. new monetarism

Here’s Stephen Williamson:

That seems to be what Kocherlakota is attempting here, and he goes even further than you might expect. His conclusion is:

“…monetary policy is, if anything, too tight, not too easy.”If you have not fainted and fallen on the floor, take a couple of deep breaths, and we’ll figure out what Narayana has on his mind.

If you did faint and fall on the floor, you are probably someone who thinks money was “easy” in 1932, when the base was soaring under an aggressive QE program, and rates were near zero.  Or perhaps you are a follower of Joan Robinson, who thought easy money couldn’t have caused the German hyperinflation, because interest rates were not low.  So I hope all my readers are still conscious.

Monetary policy should respond to forecast inflation, not actual inflation. You would think Kocheralakota would know better. Does a forecast give us any more information than what is in the currently available data? Of course not.

This one had me scratching my head.  When it was announced that the Bank of England would become independent the TIPS spreads in the UK fell on the news.  What sort of “currently available data” was that in response to?  You target the ratex forecast, not some sort of crude adaptive expectation equation using past inflation.

So let’s do a test. When the Fed met on September 16, 2008, the trailing 12 month inflation data was quite high, in contrast the TIPS spreads were showing only 1.23% annual inflation over the next 5 years, well below the Fed’s target. One can’t imagine a better test of market monetarism against new monetarism. Should we have a forward-looking monetary policy and target the forecast (preferably the level of NGDP, BTW, not inflation), or a backward-looking monetary policy as Stephen Williamson seems to favor.  Should we drive the car while looking down the road, or in the rear view mirror?

The Fed opted for new monetarism. Citing an equal risk of recession and HIGH inflation (yes, you read that right, high inflation), they refrained from easing two days after Lehman failed, keeping the fed funds target at 2%. In mid-2009 NGDP fell 9% below trend. And that’s why we are in a little depression. Bad demand-side policies lead to bad supply-side policies (just as in the 1930s), making the contraction longer than necessary.

I can’t imagine someone advocating a policy that doesn’t target the forecast.  Why adopt a policy stance that is expected to fail?  Right now, Fed policy is set at a position that will likely deliver less NGDP growth than would be optimal, given the Fed’s dual mandate.  Money is tight in the only sense of the term ‘tight’ that is meaningful, relative to what’s necessary in order that policy be expected to hit the policy goal.

I remember in late 2008 all sorts of conservatives mocking the fear of deflation, mocking the claim that we needed demand stimulus.  Then we got deflation in 2009, and the biggest fall in NGDP since 1938.  They were wrong in late 2008, 2009, 2010, 2011, and they are still wrong.  High inflation is not just around the corner. Just as the doves were wrong in 1965, 1966, 1967, 1968, 1969, 1970, 1971, 1972, 1973, 1974, 1975, 1976, 1977, 1978, 1978, 1979, 1980, and 1981.  Both hawks and doves were about right between 1985 and 2007.

HT:  Lars Christensen

PS.  Commenter Declan sent me an interview of Warwick McKibbin, who is a former central banker in Australia.  I haven’t had time to hear the entire interview, but in the 37:00 minute to 40:00 minute area he confirms that Bernanke abandoned the advice he gave the Japanese and speculates that there were political constraints involved.  A bit after the 40:00 minute mark he endorsed NGDP targeting.


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22 Responses to “Market monetarism vs. new monetarism”

  1. Gravatar of Greg Ransom Greg Ransom
    4. November 2012 at 18:42

    I remember mocking and attacking the repeated expressions of fear of deflation voiced by Greenspan & Bernanke in *2003* and *2004* ….I don’t remember anyone doing this in 2008. Do you have any documented examples?

    Scott writes,

    “remember in late 2008 all sorts of conservatives mocking the fear of deflation, mocking the claim that we needed demand stimulus”

  2. Gravatar of Benjamin Cole Benjamin Cole
    4. November 2012 at 19:00

    Williamson has been tying himself into knots for a couple of years now, to what purpose I cannot discern. He hates Market Monetarism, although it does not seem that different from he espouses. Maybe it is the old “not invented here” problem.

    I see no clear path forward with Williamson ideas. I do with Market Monetarism.

    Add on, MM gets us closer to the democratic ideals of transparency and accountability in government.

  3. Gravatar of ssumner ssumner
    4. November 2012 at 19:14

    Greg, Greenspan and Bernanke said their easy money policy would prevent deflation–and they were right! They should be lauded as heroes for preventing the deflation of 2002-03, which Japan, China, and Hong Kong experienced.

    Ben, I thinks we are the real “new monetarists”. Pity the name was already taken.

  4. Gravatar of Philo Philo
    4. November 2012 at 19:43

    “I can’t imagine someone [who understands monetary policy] advocating a policy that doesn’t target the forecast.” You need to add the qualifier in brackets here, for it is easy to imagine people who lack understanding (and even if one’s imagination is deficient he can *observe* them—they are all around us, especially in government and in the media ).

  5. Gravatar of Greg Ransom Greg Ransom
    4. November 2012 at 19:59

    You are right, Scott, it was 2002.

    November of 2002:

    http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm

    And I was slamming Bernanke for the same reasons William White & BIS economists were slamming Bernanke — and White and I were proven right.

  6. Gravatar of Major_Freedom Major_Freedom
    4. November 2012 at 20:51

    ssumner:

    When the Fed met on September 16, 2008, the trailing 12 month inflation data was quite high, in contrast the TIPS spreads were showing only 1.23% annual inflation over the next 5 years, well below the Fed’s target

    This is not a correct inference from TIPS spreads. One cannot infer from a TIPS spread of 1.23% that expected inflation is 1.23%. This is because TIPS bonds have an embedded option in it that rises in value when future inflation expectations on the part of some investors goes up.

    A declining TIPS spread MAY be associated with increasing inflation expectations, as investors are willing to trade off low yield in the near term so as to gain from inflation when they expect it rise in the future.

  7. Gravatar of Major_Freedom Major_Freedom
    4. November 2012 at 20:53

    ssumner:

    Right now, Fed policy is set at a position that will likely deliver less NGDP growth than would be optimal, given the Fed’s dual mandate. Money is tight in the only sense of the term ‘tight’ that is meaningful, relative to what’s necessary in order that policy be expected to hit the policy goal.

    The Fed’s policy goal is solely to benefit the banks. Any benefit to employment or price stability is derivative.

  8. Gravatar of Major_Freedom Major_Freedom
    4. November 2012 at 20:56

    ssumner:

    They should be lauded as heroes for preventing the deflation of 2002-03, which Japan, China, and Hong Kong experienced.

    That’s rather myopic. The COST of Greenspan’s easy money after 2001 was an economic bubble, and subsequent crash, along with high unemployment.

    They should not be lauded, they should be scorned.

  9. Gravatar of Rajat Rajat
    4. November 2012 at 22:39

    McKibbin supports nominal income targeting – that was news to me. But he still thinks the Fed left rates too low in 2003 and he currently supports higher policy rates in Australia at the same time as supporting forex intervention to bring the AUD down. Too confusing for me.

  10. Gravatar of Saturos Saturos
    4. November 2012 at 22:52

    The doves were wrong twice in 1978? That’s really terrible.

  11. Gravatar of Saturos Saturos
    4. November 2012 at 22:54

    Scott, you see, I was right! It is all political!

    Good stuff Declan.

    Rajat, maybe he means something like Kocherlakota said a while back, he wants rates to rise because of looser money?

  12. Gravatar of Kevin Donoghue Kevin Donoghue
    5. November 2012 at 01:53

    “Or perhaps you are a follower of Joan Robinson, who thought easy money couldn’t have caused the German hyperinflation, because interest rates were not low.”

    Never let the facts spoil a good story.

  13. Gravatar of Saturos Saturos
    5. November 2012 at 02:24

    Sorry, but as far as I’m concerned this is big news. I’m going to repost it:

    I personally spoke to Ben Bernanke about Scott Sumner’s work a couple of months ago. He was familiar with it.

    https://twitter.com/BruceBartlett/status/264703018472185857

  14. Gravatar of Bill Woolsey Bill Woolsey
    5. November 2012 at 03:55

    Scott:

    I think Williamson’s point is closer to “rational expectation of t+1 conditional on information at t.” I don’t think he is making any strong claim that monetary rules should be solely based on inflation rates and unemployment rates from the recent past.

    What information at time t does Kocherlakota see that shows monetary policy is too tight (rather than people are choosing to take vacations now?)

    Don’t you realize that if the target nominal interest rate is too high, the price level (including nominal wages) immediately falls enough so that its future rate of increase generates a real interest rate appropriate for otimal intertemporal market clearing?

    It shows up that way with any model you can write down. Unless, of course, you can specify some frictions that interfere with optimization.

    I do think that there was a time (and maybe even today) where Williamson shared your single minded focus on currency. And that is about all of your common ground.

    He has no use for our rather naive notion that textbook AS-AD is pretty insightful and instead counts it as completely wrong.

    Some of your recent talk about the price level is equal to nominal currency divided by real currency comes closer to Williamson’s approach where the only world that counts is the models that are written down.

  15. Gravatar of Rajat Rajat
    5. November 2012 at 04:45

    Saturos, I don’t think so. He argued the rate cuts earlier this year should have been reversed after Europe didn’t implode: http://www-1.eurekareport.com.au/bs.nsf/Article/RBA-should-raise-interest-rates-McKibbin-pd20120702-VTPZD?OpenDocument.
    He also argued subsequently that the RBA should sell AUD to offset the ‘shock’ of foreigners’ increased desire to hold Aussie bonds, and suggested this position didn’t contradict his rate call.

  16. Gravatar of ssumner ssumner
    5. November 2012 at 04:49

    Kevin, Markets are forward looking. The fact that the exchange rate fell before prices rose tells us NOTHING about causation. The hyperinflation of prices was caused by the hyperinflation of the money supply. Period, end of story.

    Bill, I’m confused. He’s saying we should target the forecast? Then why criticize Kocherlakota for making that sensible argument?

    Saturos. They were doubly wrong in 1978–a very bad year for monetary policy.

  17. Gravatar of Rajat Rajat
    5. November 2012 at 04:49

    He said: “The question of whether the RBA should intervene in the foreign exchange market is completely independent of the question of whether the RBA should change interest rates at its next meeting.”
    http://afr.com/p/opinion/how_the_rba_should_clip_the_dollar_tX2MLmZQjY69g6kP1lCbtO
    Make sense of that!

  18. Gravatar of Kevin Donoghue Kevin Donoghue
    5. November 2012 at 06:09

    Scott, your claim was that Joan Robinson “thought easy money couldn’t have caused the German hyperinflation, because interest rates were not low.”

    She didn’t think that. “Period, end of story.”

  19. Gravatar of Market monetarism vs. new monetarism « Economics Info Market monetarism vs. new monetarism « Economics Info
    6. November 2012 at 07:01

    [...] Source [...]

  20. Gravatar of Scott Sumner Scott Sumner
    6. November 2012 at 08:14

    Kevin, When someone doesn’t respond to my counterargument, but simply repeats their unsupported claim, there’s not much for me to say. Except perhaps that I’m quite certain that most people would read it exactly as I did.

    Rajat, I suppose a central bank could have some impact on the long term real rate, if they did a lot of saving. But in this case I’d guess you are right.

  21. Gravatar of Kevin Donoghue Kevin Donoghue
    6. November 2012 at 09:45

    Scott, you made an inaccurate statement which you won’t retract. That’s all there is to it. You have no counterargument. Maybe you have a whole new argument you now want to present; if so fire away. I might even agree. But you won’t rescue your original claim. It’s beyond repair.

    “The fact that the exchange rate fell before prices rose tells us NOTHING about causation” is an interesting proposition, but it’s not the same proposition as “Joan Robinson thought easy money couldn’t have caused the German hyperinflation, because interest rates were not low.” The latter is just plain wrong.

  22. Gravatar of Saturos Saturos
    11. November 2012 at 03:51

    Finally took a look at the McKibbin clip. Scott, he sounds exactly like you in the 42nd minute. You have to get together with this guy.

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