Focus on NGDP expectations, not interest rates

I was asked to comment on a Paul Krugman column that discusses a speech by Larry Summers. Summers made two important points:

1.  In the future we may repeatedly bump up against the zero rate boundary.

2.  Monetary policy has not been expansionary in recent decades, despite a downward trend in interest rates.  We know this because an expansionary policy would raise inflation, but inflation has actually been trending downwards.

Readers of this blog know that market monetarists have been emphasizing these points for quite some time.  Good to see Keynesians saying the same thing.

Krugman comments:

2. An economy that needs bubbles?

We now know that the economic expansion of 2003-2007 was driven by a bubble. You can say the same about the latter part of the 90s expansion; and you can in fact say the same about the later years of the Reagan expansion, which was driven at that point by runaway thrift institutions and a large bubble in commercial real estate.

So you might be tempted to say that monetary policy has consistently been too loose. After all, haven’t low interest rates been encouraging repeated bubbles?

But as Larry emphasizes, there’s a big problem with the claim that monetary policy has been too loose: where’s the inflation? Where has the overheated economy been visible?

So how can you reconcile repeated bubbles with an economy showing no sign of inflationary pressures? Summers’s answer is that we may be an economy that needs bubbles just to achieve something near full employment – that in the absence of bubbles the economy has a negative natural rate of interest. And this hasn’t just been true since the 2008 financial crisis; it has arguably been true, although perhaps with increasing severity, since the 1980s.

I strongly disagree with this.  Bubbles have nothing to do with recent macro history; indeed I doubt that the concept is even useful in macroeconomics.  And we need to stop obsessing about low interest rates.  Instead we should adopt a stabilization policy that is not inhibited by the zero bound.  The best solution is to end the Keynesian policy of targeting interest rates, and shift to a variable that doesn’t have a zero bound.  I’d prefer NGDP futures prices, but there are lots of other possible intermediate targets with no zero bound. McCallum has suggested the monetary base.  Others have mentioned exchange rates.  We could target the price of zinc–keep actual zinc prices close to the Wicksellian equilibrium zinc price.

One objection is that a policy of NGDP targeting, level targeting, might require the Fed to buy up the entire stock of government debt, and then some additional assets as well.  I doubt that, although it’s obviously possible, especially if the NGDP growth target was set too low.  But Keynesians draw the wrong conclusion from the zero bound.  They suggest that the choice is between fiscal stimulus and economic stagnation at zero interest rates.  In fact, the actual debate should be whether we are better off with a higher NGDP target, or a bloated monetary base with the current NGDP target, or economic stagnation as we fall short of the NGDP target.  Discussion of interest rates is simply a distraction; NGDP targeting is the real issue.  With a 5% NGDP growth target, level targeting, we will be fine.  Unemployment will be at the natural rate.  If NGDP grows at 5% it doesn’t matter whether interest rates on T-bills are stuck at 0%.  We don’t need fiscal stimulus.  And we don’t need private sector bubbles.

Summers is certainly moving in the right direction.  He recognizes that the downward trend in real rates over the past 30 years is not easy money.  He recognizes that this trend creates problems for traditional New Keynesian policies such as the Taylor Rule.  But he still doesn’t understand where we need to go. Market monetarists still have a lot of work to do.

HT:  Erik and Martin


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36 Responses to “Focus on NGDP expectations, not interest rates”

  1. Gravatar of dtoh dtoh
    17. November 2013 at 20:27

    Scott,
    This is a perfect example of why the HPE is defective as a model of the transmission mechanism. The primary argument against market monetarism and QTM is that HPE is only effective when money is held as medium of exchange. When there is no price differential between money and financial assets (i.e. at the ZLB), then money is increasingly held as a store of value (i.e. a financial asset) and HPE ceases to be effective because increases in M are simply offset by drops in V. Faced with this argument, you and other market monetarists have to resort to convoluted arguments about expectations of future interest rates and the permanence of monetary injections. These arguments may well be accurate, but they are not convincing. (If they were convincing, there would no longer be any debate about the effectiveness of monetary policy and you could retire from blogging.)

    The financial asset price mechanism suffers no such defect. The price differential between money and financial assets is irrelevant. The only price differential that is important is the differential between financial assets and goods/services. It does not matter whether the financial assets are Treasuries, auto loans or money being held as a store of value.

    Using the asset price mechanism as model, monetary policy is effective as long at the Fed can raise the real price of financial assets relative to real goods and services. And, since there is no limit on inflation, there is no limit to the real price of financial assets.

    The ZLB is only a problem, when the explanation of the transmission mechanism relies on the existence of a price differential between financial assets and money.

    (And for the sake of clarity, think of asset prices as 1/(1 – the real expected risk adjusted IRR).

  2. Gravatar of Tom M. Tom M.
    17. November 2013 at 20:41

    dtoh,

    Are you saying that Krugman and Summers are correct? That we do need asset bubbles to return to full employment?

  3. Gravatar of dtoh dtoh
    17. November 2013 at 20:57

    Tom M.
    No. When the economy is at less then full employment and you want a faster return to full employment than you need either a) higher asset prices (not necessarily bubbles) and/or b) the expectation of higher NGDP. (The latter generally being the result of market expectations that higher asset prices will result in higher NGDP.)

    Slightly OT, but IMHO asset bubbles are primarily caused by the implicit TBTF guarantee provided to financial institutions which causes those institutions to buy assets at prices above what would be justified by the risk of those assets absent the TBTF guarantee.

  4. Gravatar of Geoff Geoff
    17. November 2013 at 20:59

    “Monetary policy has not been expansionary in recent decades, despite a downward trend in interest rates. We know this because an expansionary policy would raise inflation, but inflation has actually been trending downwards.”

    “Readers of this blog know that market monetarists have been emphasizing these points for quite some time.”

    Never reason from a price change.

    Monetary policy has almost certainly been expansionary, because the rate of dollar creation has almost certainly exceeded the rate of money that would have otherwise been created in a free market.

    The only correct foundation of “reasoning” in economics is reasoning from individual preferences. Reasoning from individual preferences in the context of money production, is necessarily reasoning from money production constrained to individual property rights, i.e. a free market in money.

    Inflation defined as an increase in money created by the Federal Reserve System has indeed trended upwards since the 1970s. The fact that productivity throughout the world has kept prices down in absolute terms, doesn’t mean inflation can be argued as subdued. In a free market, productivity since the 1970s might have resulted in a healthy production based price deflation of -5% or -10%, in which case the present 2% price inflation represents significant inflation defined in terms of prices.

    The reason why Monetarists and Keynesians agree to so much is because they are both based on the same erroneous foundation.

    The differences are due to personal preferences being introduced into their arguments, presented of course as objective reasoning and science.

    To keep NGDP growing at 5% ad infinitum, would have the cost of perpetually increasing malinvestment, volatility, and thus rising continuously accelerating cash balances, and eventual hyperinflation.

    For 20 years Australia had stable NGDP but unstable money supply inflation. It couldn’t last.

  5. Gravatar of Tom M. Tom M.
    17. November 2013 at 21:16

    dtoh,

    How do you distinguish higher asset prices from asset bubbles? Living through the Bush years, I remember how much the housing bubble affected the economy. Especially here in AZ, there were people getting jobs as appraisers, mortgage processors, loan officers, etc. Those who didn’t get a job in these fields, still benefited from the home equity loans. I personally used a home equity loan to refinance credit card debt and knew many others who bought boats and the like. I remember thinking, this is ridiculous. This isn’t real…my house isn’t really worth double what it was 5 years ago. It really felt like a fake economy that you knew was going to end one day.

  6. Gravatar of Zachary Bartsch Zachary Bartsch
    17. November 2013 at 21:39

    How would too LOW of an NGDP target cause a higher risk of the Fed buying all of the debt and then some? Wouldn’t a higher target provide the impetus to increase M by issuing more money by way of security purchases? Unless you’re presuming something about velocity or real output…

    (Sorry if this is basic. I’ve only recently started following this blog. Is it a typo? “I doubt that, although it’s obviously possible, especially if the NGDP growth target was set too low.”)

  7. Gravatar of JP Koning JP Koning
    17. November 2013 at 22:10

    In general I agree with this post, but…

    “The best solution is to end the Keynesian policy of targeting interest rates, and shift to a variable that doesn’t have a zero bound.”

    You don’t have to throw interest rates out the window if you’re willing to introduce a variable conversion rate between cash and central bank deposits, thereby allowing a central banker to push rates below zero without mass paper conversion.

    “The financial asset price mechanism suffers no such defect.”

    What the heck is the “financial asset price mechanism”?

  8. Gravatar of Peter Peter
    17. November 2013 at 22:43

    How about this idea for OMOs?

    Central banks keep no assets to sell. To increase the base they create money and either send it to the government or to every citizen (or use it to pay their own costs). To decrease the base they create government debt and sell it to the market. It would obviously take changes in the law to make this possible.

  9. Gravatar of Are real rates of return negative? Is the “natural” real rate of return negative? Are real rates of return negative? Is the “natural” real rate of return negative?
    18. November 2013 at 00:50

    […] There is also this older Krugman post, and here is Gavyn Davies, and also Ryan Avent.  And Scott Sumner.  Do read and listen to these, there is much in there to ponder.  I do very much agree with the […]

  10. Gravatar of Philippe Philippe
    18. November 2013 at 01:30

    “What the heck is the “financial asset price mechanism”?”

    http://en.wikipedia.org/wiki/Trickle-down_economics

  11. Gravatar of Benjamin Cole Benjamin Cole
    18. November 2013 at 03:22

    What Summers is looking at, and he doesn’t seem to quite nail it, is Japan, all the time, everywhere. We are Japan-lite, and so is Europe (although they may do the full Japan, minus Japan’s better culture and governance).

    The current fix has something to do with the global glut of capital too.

    Summers is right that conventional responses will be lacking. We saw that in Japan.

    I hope for a Fed that targets NGDP. But maybe targeting 3-4 percent inflation, ala the People’s Bank of China is a close enough proximation.

    Targeting 1.5 percent (or 0.9 percent, the current rate of inflation) will suffocate America.

    Of course Market Monetarist have a lot of work to do, like that guy at Sisyphus.

  12. Gravatar of lxdr1f7 lxdr1f7
    18. November 2013 at 06:10

    “One objection is that a policy of NGDP targeting, level targeting, might require the Fed to buy up the entire stock of government debt, and then some additional assets as well. I doubt that, although it’s obviously possible, especially if the NGDP growth target was set too low. ”

    Can anyone explain how this would occur?

  13. Gravatar of Steven Kopits Steven Kopits
    18. November 2013 at 06:18

    US oil consumption is up 6% is the last three weeks. If I take an oil view of GDP, we should expect a very strong Q4 or Q1, maybe over 4%.

  14. Gravatar of libertaer libertaer
    18. November 2013 at 06:36

    dtoh said:

    “Using the asset price mechanism as model, monetary policy is effective as long at the Fed can raise the real price of financial assets relative to real goods and services.”

    But how can they raise the price of financial assets without the hot potatoe effect?

    They can raise the price of treasuries by buying them, but after having bought them all up, they can affect other asset prices only through inflation expectations by committing to permanent money injections even when interest rates rise again.

    If future interest rates are expected to be forever below zero, how can central banks raise asset prices (after they bought all treasuries)?

  15. Gravatar of ssumner ssumner
    18. November 2013 at 06:40

    dtoh, I have to use the explanation that I think is right, and assume that in the long run it will be the most convincing explanation.

    Zachary, Not a typo, but it is a confusing topic. Velocity is positively related to NGDP growth. Thus very tight money leads to slow NGDP growth which leads to lower velocity and a higher ratio of M/NGDP.

    JP, That sounds like Miles Kimball’s plan, which would work. But it’s far too cumbersome in my view. Remind me, which one is the medium of account?

    Peter, Helicopter drops are a bad idea. They lead to much higher taxes in the long run. Don’t give away the new money, sell it.

    Steve, How strongly does past oil variability predict quarterly GDP? I suspect not very well, and I expect modest GDP growth in Q4.

  16. Gravatar of Dtoh Dtoh
    18. November 2013 at 06:57

    Libertaer
    1. Theoretically the Fed can buy any assets

    2. Unlikely to run out of Treasuries

    3. Remember we’re talking real prices 1/(1- real IRR). You increase real prices by lowering nominal yields or increasing expected inflation. After nominal yields drop to zero, the real price is increased primarily through inflation expectations.

    4. Keep in mind asset prices are only one part of the equation. Expected NGDP also impacts the amount of financial assets exchanged for goods/services so its entirely possible that this effect will overwhelm the asset price effect so you actually end up with OMP causing a fall in the real price of assets.

  17. Gravatar of Dtoh Dtoh
    18. November 2013 at 07:01

    Scott,
    It would seem to me that if your explanation is not convincing it would make sense to re-examine whether or not your explanation is right.

  18. Gravatar of lxdr1f7 lxdr1f7
    18. November 2013 at 07:13

    ssumner
    “Peter, Helicopter drops are a bad idea. They lead to much higher taxes in the long run. Don’t give away the new money, sell it.”

    how do heli drops lead to higher taxes?

  19. Gravatar of Peter Peter
    18. November 2013 at 07:15

    “Peter, Helicopter drops are a bad idea. They lead to much higher taxes in the long run. Don’t give away the new money, sell it.”

    I agree Scott. I would prefer to give the new money to the government instead. But you can do that directly instead of by buying debt.

  20. Gravatar of JP Koning JP Koning
    18. November 2013 at 07:16

    “Remind me, which one is the medium of account?”

    Yes, that’s Miles Kimball’s plan (although the idea is older than Miles). The medium of account would be Fed deposits/reserves, cash being “demonetized” though still usable in payments. You could twin it with an NGDP target (maybe even an NGDP futures market? Rather than have NGDP futures purchases & sales drive the quantity of money, it drives the rate.)

  21. Gravatar of ssumner ssumner
    18. November 2013 at 07:29

    lxdr, You need taxes to hoover the money back when it’s not needed (velocity rises), or you get hyperinflation.

    JP, Yes, the plan was kicked around by Gesell in the 1930s. My first blog post after the intro discussed negative IOR. I don’t like reserves as a MOA because it’s really cumbersome if people go shopping with currency that doesn’t trade at par. Not saying it wouldn’t work, but NGDPLT is a much simpler option.

    dtoh, I’m playing the long game. And I don’t feel I could defend your view in a debate without relying on the expected HPE in any case.

  22. Gravatar of Philippe Philippe
    18. November 2013 at 07:42

    David Beckworth:

    “Helicopter drops along these lines also need not imply large distortionary taxation in the future. The stable nominal income expectations that they would create and the relative ease of implementing this kind of helicopter drop would prevent the buildup of excess money demand in the first place. But even if the Fed did need to reverse itself in the future, one could always allow the Fed to start issuing it’s own bills and notes. They could be funded by current and future seigniorage and would not be that different than its current practice of paying interest on excess reserves.”

    http://macromarketmusings.blogspot.co.uk/2013/08/helicopter-drops-as-insurance-against.html

  23. Gravatar of Cory Cory
    18. November 2013 at 07:57

    Scott,

    Assuming you don’t get your ideal of a NGDP futures market, what would you think about a policy wherein Congress granted the Federal Reserve Board, in conjunction with something like the FOMC, the power to raise or lower marginal income tax rates? (supposing of course that we’re going to remain saddled with the income tax).

    Let’s call it the Federal Taxation Committee. They don’t have the power to change the rate structure but can raise or lower all rates by X basis points w/ no zero bound to get a Friedman style negative income tax if need be.

    So for example, the current marginal rates are:

    39.6%
    35%
    33%
    28%
    25%
    15%
    10%

    The Federal Taxation Committee reduces them to

    24.6%
    20%
    18%
    13%
    10%
    0%
    -5%

    until some target of ngdp or inflation/unemployment is reached.

    The Catholics and Protestants slaughtered one another until they settled on Separation of Church and State as a compromise.

    Maybe this could be a peace offering between fiscal-minded Keynesians and monetary-minded market monetarists? (Supposing of course that Keynesians don’t really just want to increase the size and scope of government when they call for “fiscal stimulus”).

  24. Gravatar of Tommy Dorsett Tommy Dorsett
    18. November 2013 at 08:12

    Scott – Doesn’t this Krugman post and his column today http://nyti.ms/I0oEw2 confuse supply side (the composition of spending) with demand side (the volume of spending) by arguing that population growth (to lack there of) and slowing innovation has created the ZLB predicament?

    He’s practically endorcing Bob Gordon’s productivity slump hypothesis. Yet, he’s spent the last four years raging for fiscal stimulus precisely because the slump was a demand side phenomenon. The focus on interest rates and RGDP has really led the keynesians into a clu de sac.

  25. Gravatar of Floccina Floccina
    18. November 2013 at 08:14

    I have this idea in my head that production in China and India has grown very fast making the cost of manufactured goods cost fall fast enough that other stuff needs to go up pretty fast to keep NGDP up. So these may look like “bubbles” and some might be “bubbles” but they are needed to absorb the new labor coming into the world market in India and China. People need to learn to ride the “bubbles” rather than trying to get the fed to burst them. In time China and India wages will rise to a point where relative values will not change to so fast. IMO Bubbles are relative values changing so fast that speculators start to buy things not because they are good values but because they have gone up a lot recently and a simple projection forward make them look like good investments. The thinking is that x went up 20% per year for the last five years so let’s buy some so I cam make 20% next year.

  26. Gravatar of Jim Glass Jim Glass
    18. November 2013 at 09:51

    Slightly OT, but IMHO asset bubbles are primarily caused by the implicit TBTF guarantee provided to financial institutions which causes…

    Bubbles did not begin in the 1980s.

    There was a huge tech stock bubble in the 1920s for anything related to radio or electronics. In five years RCA went from an IPO of $1.40 to $397 to $10. No TBTF guarantees were around to cause that. Nor were there with tulips.

    Summers and Krugman should look back before 1980 and think, maybe bubbles just happen. I mean, there are lots and lots and lots of pre-1980 examples.

    Economists should pay more attention to history. (I said this once to an economist professor friend at a high-ranked university department and he told me: “Isn’t going to happen. We eliminated our history requirement and replaced it with tougher math requirements and our national ranking shot way up”.)

    People look at “bubbles”, think “bad”, then “I don’t like X”, and then conclude “X causes bubbles, we have to get rid of X”. We can’t help it, it is in our genes (the reason why witches used to get burned after crop failures) but we really should try to control it.

    We can’t even *identify* bubbles prospectively, without hindsight, much less explain their cause in any convincing manner. Until we can we should just accept that they are going to happen just as they always have and find the best ways to deal with them. And take them as being not particularly critical to anything else in the economy any more (or less) than they ever were before … until someone comes up with *solid* analysis to the contrary.

  27. Gravatar of Mark A. Sadowski Mark A. Sadowski
    18. November 2013 at 10:26

    Scott,
    “Steve, How strongly does past oil variability predict quarterly GDP? I suspect not very well, and I expect modest GDP growth in Q4.”

    The percent change in US weekly oil consumption has a standard deviation of about 4% since 1990 so a 6% increase isn’t statistically significant.

  28. Gravatar of dtoh dtoh
    18. November 2013 at 14:57

    Scott,
    “I’m playing the long game. And I don’t feel I could defend your view in a debate without relying on the expected HPE in any case.”

    I think we agree

    1) Asset prices do a play a role (but we disagree on their importance).

    2. Expectations are important.

    3. Expectations have to be about something.

    4. Expectations are about the HPE and/or asset price effect (APE). (You would say both HPE and APE. I would say just APE.)

    So my questions are these.

    5. Are there any cases where the APE will not raise AD directly or through expectations? (If the APE is always sufficient then it’s just a question of doing enough OMP to get the right level of NGDP, and…the argument for efficacy of monetary policy does not need to rely on HPE.)

    6. If there are cases where APE will not be effective but HPE will be effective, what are they?

    7. I think you have said that HPE may not be effective in the short term, but will be effective in the long term. What is the length of time required for HPE to be effective? Why is it different in the long term and the short term? What triggers the change in the temporal effectiveness of the HPE?

  29. Gravatar of dtoh dtoh
    18. November 2013 at 15:04

    Jim Glass,
    Agree with everything you said. Also note, I was somewhat careful in saying “are” and “primarily” specifically because of the examples you raise. However, most recent “bubbles” do seem to be the result of government induced distortions.

  30. Gravatar of lxdr1f7 lxdr1f7
    18. November 2013 at 20:23

    ssumner

    “lxdr, You need taxes to hoover the money back when it’s not needed (velocity rises), or you get hyperinflation.”

    You dont expand money through heli drops at an excessive pace in the first place and that solves the inflation problem. Your not going to get hyperinflation if money supply is static because like you said MP doesn’t affect velocity in long run only short.

  31. Gravatar of Peter Peter
    19. November 2013 at 09:51

    lxdr1f7:

    I was thinking of a different effect. You can either use the seignorage (as we do today) and keep the taxes the same, or send it as ‘helicopter drops’ and increase the taxes to compensate. But I believe the seignorage is usually very small.

  32. Gravatar of ssumner ssumner
    19. November 2013 at 09:54

    Philippe, I don’t agree with that–there is no free lunch. If you give cash to people, someone has to pay.

    Cory, If I don’t get NGDP futures, I’d just use ordinary monetary policy.

    I don’t think it’s a good idea to give the Fed control over fiscal policy, and in my view there is no chance it would happen in ay case.

    I’m not completely opposed to fiscal policy, I just don’t want it used to try to influence AD.

    Tommy, Tyler made the same point, with some justification. In fairness to Krugman, the productivity slowdown does not explain the high unemployment.

    dtoh, You asked:

    “Are there any cases where the APE will not raise AD directly”

    I’m not sure, but suppose bonds were the only asset. Suppose more M caused bond prices to rise. That would cause lower velocity, which might prevent AD from rising. Or if it rose, it would be only because M rose, offsetting the fall in V.

    I think the HPE works even in the short run, although the channel may be expectations.

    lxdr, I don’t follow that. The helicopter drop usually refers to a large increase in the money supply. If it’s small, why would it be expected to work?

  33. Gravatar of lxdr1f7 lxdr1f7
    19. November 2013 at 10:06

    “lxdr, I don’t follow that. The helicopter drop usually refers to a large increase in the money supply. If it’s small, why would it be expected to work?”

    You dont make the heli drops too small or too large. You heli drop at a measured pace in accordance to what you want to achieve in terms of NGDP targeting or inflation targeting. If its too small the effect will be insignificant and if its too big it will be inflationary.

  34. Gravatar of dtoh dtoh
    19. November 2013 at 10:38

    Scott, you said;

    “I think the HPE works even in the short run, although the channel may be expectations.”

    1. Expectations have to be about something.

    2. If HPE only works in the short term through expectations, then that implies the market believes in the long term HPE but not short term HPE.

    So same questions:

    Why does the market believe HPE works in the long term but not the short term?

    At what point and why does the shift occur from HPE being ineffective (except through expectations) to being effective?

  35. Gravatar of dtoh dtoh
    19. November 2013 at 10:52

    Scott, you said;

    “I’m not sure, but suppose bonds were the only asset. Suppose more M caused bond prices to rise. That would cause lower velocity, which might prevent AD from rising. Or if it rose, it would be only because M rose, offsetting the fall in V.”

    1. Bonds are not the only asset… but that actually doesn’t matter. If you think about asset prices as (1/1 – risk adjusted after tax real expected IRR), then there is only one price for all financial assets.

    2. I think theoretically your example could exist, but the drop in V caused by the rise in asset prices (drop in real rates) is likely to be small unless the change in i was quite large, and even then it would have to offset a) the higher expected NGDP caused by the OMP and b) the increased exchange of financial assets into goods and services caused by higher bond prices. So…. the pushback against MM because of this small theoretical example is not likely to be significant. To reiterate therefore, relying solely on the APE as the model to explain the transmission mechanism becomes essentially irrefutable. Unlike HPE which generates a lot of pushback because of the ZLB problem.

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