Nick Rowe on Cochrane and Williamson
Here’s Nick Rowe:
I have been arguing with John Cochrane and Steve Williamson over whether central banks announcing higher nominal interest rates is inflationary or deflationary. The very fact that economists are arguing about that very basic question tells us something important about central banks’ using nominal interest rates as a communications strategy: it sucks. This is a point that economists like Scott Sumner and I have been making for some time. Do low nominal interest rates mean monetary policy is loose or tight? It depends.
Obviously I agree, but I want to be careful that we don’t overstate its suckiness (is that a word?) There is no question what central banks mean by higher interest rates, ceteris paribus. They are signaling contractionary intent. And there is no question that markets interpret it that way. So what is the problem? Ceteris is rarely paribus. Suppose the economy is weakening and the markets believe the Wicksellian equilibrium interest rate has fallen by more than 50 basis points. For instance, December 2007. The Fed announces a 25 basis point rate cut. The stock market crashes. Why? Because policy became more contractionary (if you are a MM or a thoughtful NK), or policy became expansionary at a slower rate than needed (if you are a normal person or a sloppy NK.)
That is the ambiguity that Nick refers to. Of course Williamson was postulating something much more counterintuitive, that even a larger than expected fed funds (or IOR?) rate cut could have a contractionary impact on expected inflation (relative to a smaller rate cut.)
In fairness to the Keynesians, the monetary base has the same problem as interest rates. A huge increase in the base could be expansionary (Zimbabwe) or it could reflect a lower NGDP trend growth rate (Japan.)
Nonetheless, the base is better that interest rates because interest rates also have the zero bound problem, which makes policymakers mute when nominal interest rates are zero. That’s why they turn to QE as their communication strategy.
Of course NGDP futures targeting is better than either option. To summarize:
1. Interest rates:
Lousy at communicating policy stance, zero bound problem in communication.
2. The monetary base:
Lousy and at communicating policy stance, no zero bound problem in communication.
3. NGDP futures prices:
Good at communicating policy stance, no zero bound problem in communication.
Can you guess which policy instrument I favor?
PS. In this post Arnold Kling argues that monetary policy is endogenous. Actually it’s both exogenous and endogenous. The “partly exogenous” is an implication of the strong disputes that break out within central banks, the differing reaction function between central banks, the differing reaction functions within a central bank over time, and the market response to unexpected central bank actions.
Markets react strongly to monetary shocks—for good reason.
Kling also makes this comment:
Perhaps a few key Wall Street gurus interpreted the announcement as good news, because of (1) or because they are devoted followers of Scott Sumner or because of the meds they were on or whatever.
The easiest explanation is that markets aggregate information better than any individual, including me. That’s why I look to markets for interpretation, and why market monetarism keeps outperforming alternative models of the economy, such as those that predicted QE would be highly inflationary, or that the austerity of 2013 would sharply slow growth in the US.
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22. December 2013 at 09:43
“There is no question what central banks mean by higher interest rates, ceteris paribus. They are signaling contractionary intent. And there is no question that markets interpret it that way. So what is the problem? Ceteris is rarely paribus. Suppose the economy is weakening and the markets believe the Wicksellian equilibrium interest rate has fallen by more than 50 basis points. For instance, December 2007. The Fed announces a 25 basis point rate cut. The stock market crashes. Why? Because policy became more contractionary (if you are a MM or a thoughtful NK), or policy became expansionary at a slower rate than needed (if you are a normal person or a sloppy NK.)”
It’s interesting to see the definitions for tight and loose money on this blog continually fluctuate. Sometimes they’re defined in terms of NGDP. This time they’re being defined in terms of the difference between prevailing interest rates (controlled by the Fed) and the Wicksellian interest rate.
Consistency would require that contractions in NGDP to be the definition of “monetary contraction”, such that “MMs and thoughtful NKs” conclude that the stock market crash was due to that fact, not differences between prevailing and Wicksellian interest rates.
“In fairness to the Keynesians, the monetary base has the same problem as interest rates. A huge increase in the base could be expansionary (Zimbabwe) or it could reflect a lower NGDP trend growth rate (Japan.)”
This seems to be comparing apples and oranges. The increase in the monetary base in Zimbabwe is “huge” because of the absolute increase. On the other hand, the increase in the monetary base in Japan is “huge” because of the relative increase as compared to NGDP. The monetary base increase in Japan was not “huge” in absolute terms. Therefore, using the monetary base as the metric to define monetary tightness or looseness, does not actually suffer from the above problem. We can say that money was much looser in Zimbabwe than in Japan based on what happened to the monetary base, with no problems.
Of course, a more useful metric is the aggregate money supply. This is what money producers would be producing in a free market. The more (less) investment in the production of money in a free market, the more (less) money is desired to be owned. Money producers in a free market would not have control over aggregate spending, not should they have control. They would have control over how much money they produce given their means (invested capital).
Given that an unnatural requirement of creating unlimited quantities of money would be needed to keep aggregate spending on an arbitrary trend, it makes little sense to use NGDP as a metric.
22. December 2013 at 13:11
I, for one, interpreted the Fed announcement as good news because of the meds I’m on.
22. December 2013 at 13:45
I suspect an ‘at’ has become an ‘and’ in the description of QE.
(I find the way over-enthusiastic automatic spell checking changes what you type into what you didn’t mean a touch annoying.)
22. December 2013 at 14:13
Thanks Lorenzo.
22. December 2013 at 16:52
Sumner:
“Of course NGDP futures targeting is better than either option.”
NGDP futures prices won’t communicate any information regarding present NGDP or expected NGDP.
Investors invest in a security to earn a return. The return on one of these contracts would be, according to you, the discretionary interest rate the Fed would pay to entice investors to buy the contracts. As such, an NGDP futures contract would be a fixed income security.
I would recommend that to save yourself from further embarrassment, you should cease mentioning them. They’re cringe inducing.
23. December 2013 at 01:40
Paul Krugman: “I’m not a nice guy (but freshwater economists are worse)”
http://krugman.blogs.nytimes.com/2013/12/20/microfoundations-and-the-parting-of-the-waters/
23. December 2013 at 04:31
I for one welcome our new Chinese overlords: http://www.businessinsider.com.au/chinese-train-doesnt-stop-at-stations-2013-12
23. December 2013 at 06:26
Saturos, It would be a very good idea for Krugman to NEVER write a paper on the history of economic thought.
23. December 2013 at 07:31
An elementary question on the topic of interest rates that I’ve been unable to resolve via google:
Regarding Fed actions, I understand that reduced interest rates are thought to be expansionary because the resulting decrease in cost of capital induces greater investment. But I also understand that reduced interest rates are thought to be contractionary because the resulting decrease in opportunity cost of holding money increases demand for money.
One? Neither? Both? Little of each? Depends?
My Christmas cheer would benefit from some clarity…
23. December 2013 at 08:56
One has to be rather bold to assert a counter-intuitive position that contradicts everything that Wall Street believes.