Nick Rowe explains how to avoid reasoning from a price change
Here’s Nick Rowe, from a post responding to David Andolfatto:
It makes no sense for economists to talk about the effects of nominal interest rates on inflation (or anything else) without talking about how agents will interpret those changes in nominal interest rates. What is the Bank trying to do when it changes nominal interest rates? What does it mean? Is the Bank trying to change the inflation target? Or trying to defend the existing inflation target? Central banks know this, of course. That’s why they have communications strategies, and announce monetary policy targets.
Exactly.
Andolfatto has an interesting discussion of the recent post by Steve Williamson that triggered a storm of criticism:
So my interpretation of the criticisms I am hearing of Williamson’s paper is that his critics are claiming that he is wrong because his results are inconsistent with the type of models these people are used to working with. It seems to me that the critics should have instead attacked his results and interpretations with empirical facts (or am I too old-fashioned in this regard?). After all, Williamson at least motivated his post with some data (the diagram at the top of this post). And he makes what is potentially a testable prediction (notice the if-then structure of the statement):
In general, if we think that inflation is being driven by the liquidity premium on government debt at the zero lower bound, then if the Fed keeps the interest rate on reserves where it is for an extended period of time, we should expect less inflation rather than more.
Let’s work backwards from the Williamson quote, where the ambiguity of language might cause confusion. If I was told by Nostradamus that the Fed kept the interest rate on reserves at 0.25% for the next 20 years, I’d certainly revise downward my inflation forecast. But that’s because I would assume the causation runs from a lower rate of inflation to a lower policy rate. And that’s because I assume the Fed has a model in its head where raising the policy rate is contractionary.
Regarding empirical evidence, as far as I know all the empirical evidence is that QE has boosted inflation. And yet Andolfatto’s post is entitled:
Is QE lowering the rate of inflation?
And the very first line of the post is:
The answer may be “yes,” according to a new paper by Steve Williamson.
This confuses me, as I had thought it was widely understood that QE has been modestly expansionary for nominal spending and inflation. Recall that markets have responded to QE announcements by changing asset prices in a way that implied higher inflation expectations.
So what is the “data” that Andolfatto refers to when he says that Williamson’s post is motivated by “data?” It’s a simple time series graph showing that the inflation rate has been fairly low since 2009—rising after QE1, and then falling after QE3. But why would that graph have any bearing on the inflationary impact of QE? Surely you’d want to look at market responses to QE announcements, not the actual path of inflation.
As far as I know everyone who seriously follows QE knows that the program is inflationary. The only serious debate is whether it has only a tiny inflationary effect, or whether it has a modest inflationary effect. I can’t imagine anyone claiming it’s been deflationary. For God’s sake the dollar fell by 6 cents against the euro on the day QE1 was announced! Does anyone seriously think a 6 cent depreciation in the dollar is deflationary? So why develop models to explain empirical results that don’t exist? I don’t get it.
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1. December 2013 at 20:09
The argument that QE may be deflationary is based on the idea that QE makes treasury bonds more attractive. If the Fed is a market buyer of bonds, then it doesn’t matter if more money from the Fed will at some point in the future increase consumer goods prices. Bond investors who know there is a guaranteed Fed buyer will find bonds more attractive. It is not true that bond prices always fall with QE. Not when the Fed is a bond purchaser itself.
You can disagree with the above if you want, but the theoretical implication is that if investors are putting their money into bonds, then they are not putting their money into commodities, capital goods, and other assets. As a result, production costs do not increase as much as they otherwise would have increased, and this puts downward pressure on output prices from a cost plus mark-up perspective. This is the deflationary force being referred to. This is of course temporary, as the reduction in investment leads to reduced output, and thus higher prices, ceteris paribus.
Of course, if you asked me, QE has been significantly inflationary, as the stock and bond market indexes rapidly rose and are at record levels. The S&P 500 for example has almost tripled since a local minimum in 2009!
1. December 2013 at 20:18
Inflation does not affect all prices equally. The transmission mechanism of inflation tends to raise stock market indexes prior to raising consumer prices.
This cycle can take many years. If the Fed continues to target consumer prices, then they could be inflating like gangbusters for years on end, blowing up stock market and bond market bubbles in the process, until finally market actors bring about an increase in consumer spending specifically, after which the Fed finally reduces its inflation, thus bringing about a stock market collapse. This cycle has happened many times over the last 100 years.
1. December 2013 at 20:39
Scott,
“Recall that markets have responded to QE announcements by changing asset prices in a way that implied higher inflation expectations.”
I’m not sure you can conclude that definitively. Nominal asset prices are effected by both inflation expectations and by expected RGDP growth (i.e. an increase in the WNR). Further, FX changes are heavily influenced by equity prices which are very sensitive to expected changes in NGDP, for which it is difficult to distinguish the real and nominal components.
Maybe you’re looking at TIPS spreads to draw your conclusions?
“So why develop models to explain empirical results that don’t exist? I don’t get it.”
I don’t agree with Williamson, but isn’t there a theoretical possibility that the empirical results are caused by something else is going on. If not, it should be easy to mathematically disprove his results.
2. December 2013 at 01:06
Also, it’s great that Andolfatto is focussing on testable predictions, but then I hope he’s not following that up by committing the fallacy of affirming the consequent…
2. December 2013 at 01:09
Also see Noah Smith’s comment: http://noahpinionblog.blogspot.com.au/2013/12/does-qe-cause-deflation.html
2. December 2013 at 04:43
There have been a rash of studies (St. Louis and NY Feds) and economists who say QE is not inflationary, and perhaps even contractionary, or deflationary.
I cannot fathom the reasoning, and when I do torture myself into understanding what they mean, I find their explanations depend upon a number of conditions and premises that may be squishy.
And I come back to it: If we really believe that QE is not inflationary then fine, let’s give our grandchildren a huge gift: Let’s pay off, say, three-quarters of the national debt.
There will be gigantic reserves in the banks, but so what? As long as they collect their 0.25 percent interest, the banks will be happy, and the banks can be paid from interest income gathered on the bonds the Fed bought.
2. December 2013 at 05:40
Here’s part of Williamson’s post from last week:
“p(t+1)/p(t) = B/(1-L),
so, the larger the liquidity premium, the higher is the inflation rate at the zero lower bound.
…What I hope the discussion above makes clear is that this is a trap for the Fed. There is not much that the Fed can do on its own about the short supply of liquid assets. They can get some action from QE, but the matter is mostly out of their hands, and more QE actually pushes the Fed further from its inflation goal. If the Fed actually wants more inflation, the nominal interest rate on reserves will have to go up. Of course that will lead to some short-term negative effects because of money nonneutralities.”
The biggest problem for Williamson’s “empirical evidence” is what happened in the fall of 2008 when the liquidity premium surged and inflation plunged. According to his theory, the financial crisis should have caused inflation to surge higher. But it didn’t.
And if more QE pushes inflation lower, imagine low inflation must have been in France immediately after WWI when they monetized more than half of their war debt. Also, it’s amazing that he completely ignores what happened to TIPS spreads after QE1, QE2, twist and QE3. I guess market reactions are meaningless to “smart macroeconomists”.
2. December 2013 at 06:23
Noah Smith:
“Williamson’s model, if I’m not mistaken, predicts that QE will cause a short burst of slightly higher inflation, followed by a long period of lower inflation.”
http://noahpinionblog.blogspot.com/2013/12/does-qe-cause-deflation.html
Alas, I believe Noah Smith is mistaken.
On page 14 of Stephen Williamson’s paper, equation 40 states that the gross inflation rate is given by:
Mu=Beta*u'(x1)
Where Mu is the gross inflation rate, Beta is the discount factor bound between 0 and 1, x1 is the amount of currency and u is a a strictly increasing, strictly concave, and twice continuously differentiable function.
http://www.artsci.wustl.edu/~swilliam/papers/qe2.pdf
Thus an increase in the amount of currency strictly decreases the inflation rate. In my reading of his paper this appears to be true regardless of whether the central bank is operating a channel or a floor system, regardless of the maturity of the debt it purchases, and whether it is at or away from the zero lower bound.
On page 16, in the section on conventional open market operations in short-maturity debt, he notes:
“Some of the effects here are unconventional. While the decline in nominal bond yields looks like the “monetary easing” associated with an open market purchase, the reduction in real bond yields that comes with this is permanent, and the infl‡ation rate declines permanently. Conventionally-studied channels for monetary easing typically work through temporary declines in real interest rates and increases in the in‡flation rate. What is going on here? The change in monetary policy that occurs here is a permanent increase in the size of the central bank’s holdings of short-maturity government debt – in real terms – which must be …financed by an increase in the real quantity of currency held by the public. To induce people to hold more currency, its return must rise, so the in‡flation rate must fall…”
2. December 2013 at 07:18
Because academia, and media, reward novelty more than accuracy… Look how many hits/citations he’s getting for saying something stupid.
On a more serious note, you can get away with a lot by making strong assumptions that certain variables are purely a function of other variables. For example, the liquidity premium is a function of collateral supply – this is a purely financial perspective.
There’s no conception of liquidity premium being a function of perceived macroeconomic risk, or of a fear of lack of demand. What is this thing, ‘Demand’, you ask? Pshaw! That would imply an ‘exogenous’ increase in the real interest rate, and we’re holding ‘exogenous’ factors constant! Everyone knows that the mechanism for money supply affecting demand is through the real rate! What other mechanism could there be?
2. December 2013 at 07:57
dtoh, For QE to raise NGDP without raising P, you’d have to assume the SRAS curve was flat. Pretty sure Williamson isn’t a naive Keynesian.
Gregor, Yes, I also wondered about late 2008 and early 2009.
Mark, If Noah is right then the solution is to do so much QE in the short run that you don’t have to do any QE in the long run.
It seems to me that Williamson is being criticized for assuming that since low inflation equilibria involve low rates ands lots of QE (true), then low rates and lots of QE cause low inflation (not true). The same issue that appeared earlier with Kocherlakota. Is that right?
2. December 2013 at 08:02
Saturos, That Noah Smith post is excellent.
2. December 2013 at 08:34
[…] 3. Noah nails the Stephen Williamson debate, many others got it wrong, badly wrong. By the way, here is Williamson’s response. Here is a good post by Scott on the debate. […]
2. December 2013 at 12:37
Scott,
“If Noah is right then the solution is to do so much QE in the short run that you don’t have to do any QE in the long run.”
Noah is mistaken. He seems to think Williamson’s model predicts an initial jump in the price level (apparently so does Brad Delong if you read the comments) and this is quite simply wrong.
“It seems to me that Williamson is being criticized for assuming that since low inflation equilibria involve low rates ands lots of QE (true), then low rates and lots of QE cause low inflation (not true). The same issue that appeared earlier with Kocherlakota. Is that right?”
It seems to me Williamson is being criticized for a long list of things, and there is little consensus as to which one thing is the most important, or is even true. It is gradually dawning on me that this is probably the result of the fact that very few people have taken the time to really understand Williamson’s model.
The bottom line is that Williamson’s model predicts QE lowers nominal long-term rates and lowers the rate of inflation and yet there is empirical evidence that neither of these things is true.
By the way take a look at David Beckworth’s post if you haven’t already, as well as my comment there:
http://macromarketmusings.blogspot.com/2013/12/taking-model-to-data.html
2. December 2013 at 14:28
Krugman has a post that cuts through a lot of the BS concerning Williamson’s model:
“…OK, so “agents require” a fall in the inflation rate to induce them to hold more currency. How does this requirement translate into an incentive for producers of goods and services “” remember, we’re talking about stuff going on in the real economy “” to raise prices less or cut them? Don’t retreat behind a screen of math “” tell me a story.
I don’t think either Andolfatto or Williamson have any such story in mind; they are, in some form, invoking the doctrine of immaculate inflation. And I don’t even think they realize that they have a problem…”
http://krugman.blogs.nytimes.com/2013/12/02/immaculate-stability-wonkish/
And you know, I don’t even really mind that there isn’t a coherent story (unless you honestly think “agents require a fall in the inflation rate to induce them to hold more currency” is coherent). What I object to is the fact that nobody defending Williamson’s model both realizes that this is what the model actually claims, and can simultaneously point to clear empirical evidence of this actually happening in real life.
2. December 2013 at 14:55
Williamson has a response to Krugman:
http://newmonetarism.blogspot.com/2013/12/stories.html
P.S. Noah Smith finally crossed out the passage I quoted above so I guess my comment in response to it at his post had an effect.
P.P.S. This has been a good year for me in terms of getting blog hosts to cross out things. (I guess I should get the award for most annoying nitpicker of the year.) In fact I managed to get poor old Steve Randy Waldman to cross out practically an entire post this fall for which I am almost a little sorry.
2. December 2013 at 15:51
If fed balance sheet growth correlates weakly with the implicit deflator then something is stepping in to offset QE. There is no reason large equity brokers cannot adjust share returns and cash holdings to offer investors the QE offseting service for a fee.
2. December 2013 at 18:31
Geoff wrote:
“The argument that QE may be deflationary is based on the idea that QE makes treasury bonds more attractive. If the Fed is a market buyer of bonds, then it doesn’t matter if more money from the Fed will at some point in the future increase consumer goods prices. Bond investors who know there is a guaranteed Fed buyer will find bonds more attractive. It is not true that bond prices always fall with QE. Not when the Fed is a bond purchaser itself.
You can disagree with the above if you want, but the theoretical implication is that if investors are putting their money into bonds, then they are not putting their money into commodities, capital goods, and other assets.”
This argument almost makes sense… but not quite.
An investor can only “put his money into bonds” if, somewhere, another investor is “putting his bonds into money”. If your assumption (holding treasuries is more attractive due to Fed buying) is correct, then why does anyone want to move from bonds into cash in order to hold more cash (rather than using that cash to buy commodities, capital goods, or other assets? Bonds are about as safe as cash, pay higher rates of interest than cash, and can be easily sold at any time cash is needed.
2. December 2013 at 20:06
Michael:
“An investor can only “put his money into bonds” if, somewhere, another investor is “putting his bonds into money”. If your assumption (holding treasuries is more attractive due to Fed buying) is correct, then why does anyone want to move from bonds into cash in order to hold more cash (rather than using that cash to buy commodities, capital goods, or other assets?”
I believe the stock answer to that question, from what I can recall, is that you would be incorrectly assuming that rational expectations to be a correct theory of markets. If housing suddenly became attractive, or if the Nasdaq market suddenly became attractive, then, like all other exchanges, there is a requirement of disagreement in valuations, not agreement as rational expectations assumes.
Just think of an individual exchange between two people. If A trades away money for a bond, and B trades away a bond for money, then clearly A and B disagree as to the value of the bond and money, namely, they have unequal, offsetting valuations. A values the bond more than the money, while B values the money more than the bond. Exchanges cannot occur unless there is a difference, i.e. a disagreement, in valuations.
Thus, bringing this back to the bond market bubble argument, if investors pile into bond, what this means is that current bond buyers are putting a higher valuation on bonds than previous bond buyers, and the current bond sellers are in disagreement with the current crop of bond buyers as to the value of the bonds vis a vis money.
Did I just blow your mind?
2. December 2013 at 20:12
I read that discussion from MR. It’s insanity — your take makes so much more sense.
Let’s imagine the Fed decides it wants 10% inflation and starts buying up assets like mad — QE on steroids. Given that they can buy every asset in existence, who thinks they couldn’t achieve the target? Surely no one believes that!
2. December 2013 at 20:12
Michael:
Forgot to explicitly re-emphasize the connection to deflation for this view: The current crop of treasury bond buyers, who are pouring money into treasury bonds instead of capital and labor, are bringing about a downward pressure on aggregate business costs throughout the economy, which then puts downward pressure on prices based on costs plus profit.
3. December 2013 at 12:06
There’s a very simple way to see what’s going on here, but let me warn you – up to now I’ve agreed with Krugman on almost everything, and I’ve been a staunch Pro-QE advocate.
Here it is: Gresham’s Law. In swapping cash for long-term treasuries, the FED has done a bit of price-setting. Long-term bonds should be worth less than short-term bonds or cash, so the long-term bonds are the under-valued asset in this price-setting case. Therefore, agents will hoard the more valuable asset: cash. Hoarding cash is disinflationary.
What Williamson’s graph is showing is that the market currently BELIEVES QE is inflationary, so essentially performs “puts” that inflation will increase post-QE. But then inflation falls – as if seeking an equilibrium with 0% (or 0.25%, etc – we could quibble on the exact equilibrium and I don’t think Williamson has it 100% right). The graph shows two almost symmetrical negative growth curves in the inflation rate as QE proceeds.
As you can see, I’ve been swayed to Williamson on this one. I think this shows QE doesn’t work the way we hoped – and the lesson isn’t to just give up, but to consider something else that will inject inflationary cash at the consumer-level in some way that will actually, finally, boost demand. The only issue is finding a way to do that in a way that is considered “fair.” One way that isn’t fair – but I would support – is if the FED swapped consumer debt, instead.
But Williamson’s is a testable hypothesis – just turn off QE again and see what the inflation rate does. If he’s right, inflation will jump (within the first quarter or two) up a percentage point or so. This won’t cure the economy – but slightly more inflation might be enough to get us moving inflation in the right direction. Right now, it’s continuing to fall.
By the way, there are other ways to see why QE is disinflationary. Gresham’s Law is just one.
3. December 2013 at 15:57
Mark, Thanks for all the tips. We’ll move this discussion to newer posts.
J Hansen, If the market thinks QE is inflationary, then it’s inflationary. The market test is the ONLY reliable test.
4. December 2013 at 10:45
[…] corporations, investment trends, measured profits, asset prices, and so on. I also fully endorse Scott Sumner’s point that short-term asset price and exchange rate reactions to QE pretty clearly show it is […]