Archive for the Category Market monetarism

 
 

Market monetarism is gaining ground

I recently did a post over at Econlog, discussing how Jerome Powell has adopted some ideas that sound vaguely market monetarist.  Marcus Nunes sent me another example, this time from St. Louis Fed President James Bullard:

In his talk, Bullard laid out a possible strategy for extending the U.S. economic expansion—one that relies on placing more weight on financial market signals, such as the slope of the yield curve and market-based inflation expectations, than has been customary in past U.S. monetary policy strategy. He explained that the empirical relationship between inflation and unemployment has largely broken down over the last two decades and that many current approaches to monetary policy strategy continue to overemphasize the now-defunct empirics of the Phillips curve.

“U.S. monetary policymakers should put more weight than usual on financial market signals in the current macroeconomic environment due to the breakdown of the empirical Phillips curve,” he said. “Handled properly, current financial market information can provide the basis for a better forward-looking monetary policy strategy.”

Market monetarists have long argued that financial market indicators are superior to the Phillips Curve as a forecasting tool for inflation.

On another topic, Karl Rhodes directed me to some Richmond Fed research on the zero bound.  Here’s the abstract of the paper, written by Thomas A. Lubik, Christian Matthes and David A. Price:

The likelihood of returning to near-zero interest rates is relevant to policymakers in considering the path of future interest rates. At the zero lower bound, the Fed can no longer lower rates and thus can respond to a contraction only through alternative policy measures, such as quantitative easing. Recent research at the Richmond Fed has used repeated simulations of the U.S. economy to estimate the probability of such an occurrence over the next ten years. The estimated probability of returning to the zero lower bound one or more times during this period is approximately one chance in four.

I certainly don’t have any reason to contest their finding, but I do have doubts about the method they used:

Lubik and Matthes began by estimating the TVP-VAR model over the full sample from 1961 to 2018 for quarterly data on real GDP, inflation (personal consumption expenditures inflation), and the federal funds rate. They then used the model’s estimated coefficients to produce forecasts over a ten-year horizon. The researchers generated multiple simulations of the shocks hitting the economy over the ten-year period and recorded their effects on macroeconomic variables for each quarter. The result of this process was a distribution of likely outcomes for each quarter.

In my view, the US is extremely likely to hit the zero bound in the next recession.  Thus for me, the chance of hitting the zero bound over the next 10 years is almost identical to the chance that there will be a recession during the next ten years.

If they agreed with my intuition, and used a VAR model to predict the chance of recession during the next 10 years, they might have come up with a figure higher than 25%. So does that mean that the risk of hitting the zero bound is greater than 25%?  I’m actually not sure, because I’m also skeptical of whether past performance is the best way to predict the timing of the next recession.  Yes this is true:

1. The US has never gone more than 10 years without a recession.

But these claims are also true:

2.  The US business cycle has recently been “stretching out”, getting longer.

3.  Other similar economies such as the UK and Australia have recently experienced extremely long expansions—about 15 years for the UK, and 27 years (so far) for Australia.

Is fact #1 more relevant for forecasting the risk of recession in the US over the next 10 years?  Or facts #2 and #3?

Forecasting is more an art than a science.

Teaching money/macro in 90 minutes

A few weeks ago I gave a 90-minute talk to some high school and college students in a summer internship program at UC Irvine.  Most (but not all) had taken basic intro to economics.  I need to boil everything down to 90 minutes, including money, prices, business cycles, interest rates, the Great Recession, how the Fed screwed up in 2008, and why the Fed screwed up in 2008.  Not sure if that’s possible, but here’s the outline I prepared:

1.  The value of money (15 minutes)

2.  Money and prices  (20 minutes)

3.  Money and business cycles (25 minutes)

4.  Money and interest rates (15 minutes)

5.  Q&A (15 minutes)

Intro

Inflation is currently running at about 2%.  It’s averaged 2% since 1990.  That’s not a coincidence, the Fed targets inflation at 2%.  But it’s also not normal.  Inflation was much higher in the 1980s, and still higher in the 1970s.  In the 1800s, inflation averaged zero and there were years like 1921 and 1930-32 where it was more like negative 10%!

We need to figure out how the Fed has succeeded in targeting inflation at 2%, then why this was the wrong target, and finally how this mistake (as well as a couple freshman-level errors) led to the Great Recession.

1. Value of Money  

Like any other product, the real value of money changes over time.

But . . . the nominal price of money stays constant, a dollar always costs $1

Value of money = 1/P (where P is price level (CPI, etc.))

Thus if price level doubles, value of a dollar falls in half.

Analogy:

Year      Height    Unit of measure   Real height

1980      1 yard           1.0                1 yard

2018      6 feet            1/3               2 yards

Switching from yards to feet makes the average size of things look three times larger.  This is “size inflation”.  But this boy’s measured height increased 6-fold, which means he even grew (2 times) taller in real terms.

Year      Income    Price level  Value of money   Real Income

1980     $30,000        1.0               1.0               $30,000

2018    $180,000       3.0               1/3               $60,000

The dollar lost 2/3rds of its purchasing power between 1980 and 2018, as the average thing costs three times as much.  This is “price inflation”.  But some nominal values increase by more than three times, such as this person’s income, which means the income doubled in real terms, or in purchasing power.

Punch line:  Don’t try to explain inflation by picking out items that increased in price especially fast, say rents or gas prices, rather think of inflation as a change in the value of money.  Focus on what determines the value of money . . .

2.  Money and the Price Level

. . . which, in a competitive market is supply and demand:

Screen Shot 2018-08-02 at 7.11.51 PM

Demand for Money: How much cash people prefer to hold.

Who determines how much money you carry in your wallet?  You?  Are you sure?  Is that true for everyone?

Who determines the average cash holding of everyone in the economy?  The Fed.

How can we reconcile these two perceptions?  They are both correct, in a sense.

Helicopter drop example:  Double money supply from $200 to $400/capita

==> Excess cash balances

==>attempts to get rid of cash => spending rises => AD rises => P rises

==>eventually prices double.  Back in equilibrium.

Now it takes $400 to buy what $200 used to buy.  You determine real cash holdings (the purchasing power in your wallet), while the Fed determines average nominal cash holdings (number of dollars).

Punch line:  Fed can control the price level (value of money), by controlling the money supply.

What if money demand changes?  No problem, adjust money supply to offset the change.

Fed has used this power to keep inflation close to 2% since 1991.  Before they tried, inflation was all over the map.  After they tried, they succeeded in keeping the average rate close to 2%.  That success would have been impossible if Fed did not control price level.

But, inflation targeting is not optimal:

3.  Money and business cycles

Suppose I do a study and find that on average, 40 people go to the movies when prices are $8, and 120 people attend on average when prices are $12.  Is this consistent with the laws of supply and demand?  Yes, completely consistent. But many students have trouble seeing this.

Explanation:  When the demand for movies rises, theaters respond with higher prices.  The two data points lie along a single upward-sloping supply curve.

Implication:  Never reason from a price change.  A rise in prices doesn’t tell us what’s happening in a market.  It could be more demand or less supply.  The same is true of the overall price level.  Higher inflation might indicate an overheating economy (too much AD), or a negative supply shock:

Screen Shot 2018-08-02 at 7.26.42 PM

In mid-2008, the Fed saw inflation rise sharply and worried the economy was overheating.  It was reasoning from a price change. In fact, prices rose rapidly because aggregate supply was declining.  It should have focused on total spending, aka “aggregate demand”, for evidence of overheating:

M*V = P*Y = AD = NGDP

This represents total spending on goods and services.  Unstable NGDP causes business cycles.

Example: mid-2008 to mid-2009, when NGDP fell 3%:Screen Shot 2018-08-02 at 7.43.04 PM

Here we assume that nominal GDP was $20 trillion in 2008, and then fell in 2009, causing a deep recession and high unemployment.

Musical chairs model:  NGDP is the total revenue available to businesses to pay wages and salaries.  Because wages are “sticky”, or slow to adjust, a fall in NGDP leads to fewer jobs, at least until wages can adjust.  This is a recession.

It’s like the game of musical chairs.  If you take away a couple chairs, then when the music stops several contestants will end up sitting on the floor.

The Fed needs to keep NGDP growing about 4%/year, by adjusting M to offset any changes in V (velocity of circulation).

Punch line:  Don’t focus in inflation, NGDP growth is the key to the business cycle

Why did the Fed mess up in 2008? Two episodes of reasoning from a price change:

1.  The 2008 supply shock inflation was wrongly viewed as an overheating economy.

2.  Low interest rates were wrongly viewed as easy money.

4.  Money and Interest Rates

Below is the short and long run effects of an increase in the money supply, and then a decrease in the money supply.  Notice that easy money causes rates to initially fall, then rise much higher.  Vice versa for a tight money policy.

Screen Shot 2018-08-02 at 7.26.56 PMWhen the money supply increases, rates initially decline due to the liquidity effect. The opposite occurs when the money supply is reduced.

Screen Shot 2018-08-02 at 7.43.15 PMHowever, in the long run, interest rates go the opposite way due to the income and Fisher effects:

Income effect: Expansionary monetary policy leads to higher growth in the economy, more demand for credit, and higher interest rates.

Fisher effect:  Expansionary monetary policy leads to higher inflation, which causes lenders to demand higher interest rates.

In 2008, the Fed thought lower rates represented the liquidity effect from an easy money policy.

Actually, during 2008 we were seeing the income and Fisher effects from a previous tight money policy.

Don’t assume that short run means “right now” and long run means “later”.  What’s happening right now is usually the long run effect of monetary policies adopted earlier.

Punchline:  Don’t assume low rates are easy money and vice versa.  Focus on NGDP growth to determine stance of monetary policy.  That’s what matters.

(I actually ended up covering about 90% of what I intended to cover, skipping the yardstick metaphor.)

Lars Christensen’s new market monetarist newsletter

Lars Christensen has a new newsletter called the Global Monetary Conditions Monitor, which I highly recommend for people interested in international monetary policy.  It is by subscription at this link, but Lars is allowing me to quote from the newsletter.  (There is a discount for academic users and think tanks.)

Lars has constructed a monetary conditions index for a wide range of currencies. This basically measures whether the current stance of monetary policy is too easy or too tight to hit the target.  (A value of zero means right on target.)

On pages 8 and 9 of the May issue there is a discussion of policy credibility:

The approach here is to evaluate a central bank’s credibility based on our monetary conditions indicators.

We consider a central bank to be credible if it succeeds over time in keeping the monetary indicator close to zero. This can be measured by how long each central bank keeps the indicator within a range between -0.25 and 0.25 over a rolling five year period. This also means a central bank’s credibility can and will change over time.

By this criterion, the central bank of New Zealand has the highest credibility:

This can be illustrated by looking at developments in New Zealand over the past five years.

If monetary policy is (highly) credible, we would expect monetary conditions to be ‘mean-reverting’ – meaning that if the monetary conditions indicator is above (below) zero, we should expect it to decline (increase) in the subsequent period.

This is precisely the case for New Zealand. The graph below shows monetary conditions in New Zealand six months ago and how they changed over the following six months.

The line should go through zero, with most of the points being in the upper left and lower right quadrants.  To give you a sense of what a lack of credibility looks like—consider Turkey, one of the least credible central banks:

Maybe Lars will eventually incorporate the Hypermind NGDP forecast into his analysis.

Lars Christensen has a new website

One of the founding members of market monetarism (and the guy who provided the name) has a new website, called Markets and Money Advisory.

Each MM has their own special area of expertise, and I see Lars as the leading figure on the implications for MM for various European countries.  He had a career at a top Danish investment bank and is very knowledgeable about what’s going on across the Atlantic.

He’s also our most stylish presenter:

Screen Shot 2017-03-31 at 10.36.29 AMLars also informed me:

We are also launching a new – for pay – publication: Global Monetary Conditions Monitor (12 months for 2,000 euros).

Basil Halperin’s critique of NGDP targeting

Lots of people have tried to find flaws in NGDP targeting, but most of these posts are written by people who have not done their homework.  Basil Halperin is an exception.  Back in January 2015 he wrote a very long and thoughtful critique of NGDP targeting.  A commenter recently reminded me that I had planned to address his arguments.  Here’s Basil:

Remember that nominal GDP growth (in the limit) is equal to inflation plus real GDP growth. Consider a hypothetical economy where market monetarism has triumphed, and the Fed maintains a target path for NGDP growing annually at 5% (perhaps even with the help of a NGDP futures market). The economy has been humming along at 3% RGDP growth, which is the potential growth rate, and 2% inflation for (say) a decade or two. Everything is hunky dory.

But then – the potential growth rate of the economy drops to 2% due to structural (i.e., supply side) factors, and potential growth will be at this rate for the foreseeable future.

Perhaps there has been a large drop in the birth rate, shrinking the labor force. Perhaps a newly elected government has just pushed through a smorgasbord of measures that reduce the incentive to work and to invest in capital. Perhaps, most plausibly (and worrisomely!) of all, the rate of innovation has simply dropped significantly.

In this market monetarist fantasy world, the Fed maintains the 5% NGDP path. But maintaining 5% NGDP growth with potential real GDP growth at 2% means 3% steady state inflation! Not good. And we can imagine even more dramatic cases.

Actually it is good.  Market monetarists believe that inflation doesn’t matter, and that NGDP growth is “the real thing”.  Our textbooks are full of explanations of why higher and unstable inflation (or deflation) is a bad thing, but in almost every case the problem is more closely associated with high and unstable NGDP growth (or falling NGDP).  In most cases it would be entirely appropriate if trend inflation rose 1% because trend growth fell by 1%.  That’s because what you really want is stability in the labor market.  If productivity growth slows then real wage growth must also slow.  But nominal wages are sticky, so it’s easier to get the required adjustment via higher inflation (and steady nominal wage growth) as compared to slower nominal wage growth.

I said “most cases” because there is one exception to this argument.  Suppose trend growth slows because labor force growth slows.  In that case then in order to keep nominal wages growing at a steady rate, you’d want NGDP growth to slow at the same rate that labor force growth slows.  As a practical matter it would be very easy to gradually adjust the NGDP growth target for changes in labor force growth. I’d have the Fed estimate the growth rate every few years, and nudge the NGDP target path up or down slightly in response to those changes.  Yes, that introduces a tiny bit of discretion.  But when you compare it to the actual fluctuations in NGDP growth, the problem would be trivial.  I’d guess that every three years or so the expected growth rate of the labor force would be adjusted a few tenths of a percent.  Even if the Fed got it wrong, the mistake would be far to small to create a business cycle.

Say a time machine transports Scott Sumner back to 1980 Tokyo: a chance to prevent Japan’s Lost Decade! Bank of Japan officials are quickly convinced to adopt an NGDP target of 9.5%, the rationale behind this specific number being that the average real growth in the 1960s and 70s was 7.5%, plus a 2% implicit inflation target.

Thirty years later, trend real GDP in Japan is around 0.0%, by Sumner’s (offhand) estimation and I don’t doubt it. Had the BOJ maintained the 9.5% NGDP target in this alternate timeline, Japan would be seeing something like 9.5% inflation today.

Counterfactuals are hard: of course much else would have changed had the BOJ been implementing NGDPLT for over 30 years, perhaps including the trend rate of growth. But to a first approximation, the inflation rate would certainly be approaching 10%.

[Basil then discusses similar scenarios for China and France.]

Basil’s mistake here is assuming that there is a 2% inflation target.  As George Selgin showed in his book ‘Less than Zero”, deflation is appropriate when there is very fast productivity growth.  Isn’t deflation contractionary?  No, that’s reasoning from a price change.  Deflation is contractionary if caused by falling NGDP.  But if NGDP (or NGDP/person) is growing at an adequate rate, then deflation is an appropriate response to fast productivity growth.  Indeed if you kept inflation at 2% when productivity growth was high, then the labor market could overheat. (See the U.S., 1999-2000).

Let’s suppose that the Japanese decide to target NGDP growth at 3% plus or minus changes in the working age population.  In that case, the target might have been 5% in the booming 1960s, and 2% today (assuming labor force growth fell from 2% to minus 1%.  Or they might have chosen 4% per person, in which case NGDP growth would have slowed from 6% to 3%.  In the first scenario, Japan would have gone from minus 2.5% inflation to about 1%, whereas in the second scenario inflation would have risen from minus 1.5% to about 2%.  Either of those outcomes would be perfectly fine.

As an aside, I recommend that countries pick an NGDP growth target higher enough so that their interest rates are not at the zero bound.  But that’s not essential; it just saves on borrowing costs for the government.

Basil does correctly note that New Keynesian advocates of NGDP targeting don’t agree with market monetarists (or with George Selgin):

Indeed, Woodford writes in his Jackson Hole paper, “It is surely true – and not just in the special model of Eggertsson and Woodford – that if consensus could be reached about the path of potential output, it would be desirable in principle to adjust the target path for nominal GDP to account for variations over time in the growth of potential.” (p. 46-7) Miles Kimball notes the same argument: in the New Keynesian framework, an NGDP target rate should be adjusted for changes in potential.

Basil points out that this would require a structural model:

For the Fed to be able to change its NGDP target to match the changing structural growth rate of the economy, it needs a structural model that describes how the economy behaves. This is the practical issue facing NGDP targeting (level or rate). However, the quest for an accurate structural model of the macroeconomy is an impossible pipe dream: the economy is simply too complex. There is no reason to think that the Fed’s structural model could do a good job predicting technological progress. And under NGDP targeting, the Fed would be entirely dependent on that structural model.

Ironically, two of Scott Sumner’s big papers on futures market targeting are titled, “Velocity Futures Markets: Does the Fed Need a Structural Model?” with Aaron Jackson (their answer: no), and “Let a Thousand Models Bloom: The Advantages of Making the FOMC a Truly ‘Open Market’”.

In these, Sumner makes the case for tying monetary policy to a prediction market, and in this way having the Fed adopt the market consensus model of the economy as its model of the economy, instead of using an internal structural model. Since the price mechanism is, in general, extremely good at aggregating disperse information, this model would outperform anything internally developed by our friends at the Federal Reserve Board.

If the Fed had to rely on an internal structural model adjust the NGDP target to match structural shifts in potential growth, this elegance would be completely lost! But it’s more than just a loss in elegance: it’s a huge roadblock to effective monetary policymaking, since the accuracy of said model would be highly questionable.

I’ve already indicated that I don’t think the NGDP target needs to be adjusted, or if it does only in response to working age population changes, which are pretty easy to forecast.  But I’d go even further.  I’d argue that the Woodford/Eggertsson/Kimball approach is quite feasible, and would work almost as well as my preferred system.  The reason is simple; business cycles represent a far great challenge than shifts in the trend rate of output.  Because NGDP growth is what matters for cyclical stability, it doesn’t matter if inflation is somewhat unstable at cyclical frequencies.  That’s a feature, not a bug.  And longer-term changes in trend growth tend to be pretty gradual.  In the US, trend growth was about 3% during the entire 20th century.  Since 2000, trend growth has been gradually slowing, for two reasons:

1.  The growth in the working age population is slowing.

2.  Productivity growth is also slowing.

Experts now believe the new trend is 2%, or slightly lower.  I think it’s more like 1.5%.  But I fail to see how this would add lots of discretion to the system. Imagine if the Fed targets NGDP growth at 5% throughout the entire 20th century, using my 4% to 6% NGDP futures guardrails.  No Great Depression, no Great Inflation, no Great Recession.  Then we go into the 21st century, and the Fed gradually reduces the target to 4.5%, then to 4.0%.  And let’s use the worst case, where the Fed is slow to recognize that trend growth has slowed.  So you have slightly higher than desired inflation during that recognition lag.  But also recall that only NKs like Woodfood, Eggertsson and Kimball think that’s a problem.  Market monetarists and George Selgin thin inflation should vary as growth rates vary.

Who’s opinion are you going to trust?  (Don’t answer that.)

Seriously, even in the worst case, this system produces macro instability that is utterly trivial compared to what we’ve actually experienced.  Or at least if we hit our targets it’s highly successful.  And Basil is questioning the target, not the Fed’s ability to hit the target.  You would have had 117 years with only one significant alteration in the target path.  Yes, for almost any other country, the results would be far worse.  But that’s why you don’t want to adjust the NGDP target for changes in trend RGDP growth.

Further, level targeting exacerbates this entire issue. . . . For instance, say the Fed had adopted a 5% NGDP level target in 2005, which it maintained successfully in 2006 and 2007. Then, say, a massive crisis hits in 2008, and the Fed misses its target for say three years running. By 2011, it looks like the structural growth rate of the economy has also slowed. Now, agents in the economy have to wonder: is the Fed going to try to return to its 5% NGDP path? Or is it going to shift down to a 4.5% path and not go back all the way? And will that new path have as a base year 2011? Or will it be 2008?

Under level targeting there is no base drift.  So you try to come up to the previous trend line.  In 2011 you set a new 4.5% line going forward, but until you change that trend line, the existing 5% trend line still holds.  If you drop the growth path to 4.5% in 2011, then by 2013 the target for NGDP will be 1% less than people would have expected in 2008, and by 2015 it will be 2% less.  In fact, NGDP was more like 10% less than people expected.  So even if a gradually adjusting path is not ideal, it’s a compromise worth making to satisfy the NKs who are far more influential than I am, but have yet to read Less Than Zero.  (George may not agree with the compromise, he’s less wimpy than I am.)

Before I close this out, let me anticipate four possible responses.

1. NGDP variability is more important than inflation variability

Nick Rowe makes this argument here and Sumner also does sort of here. Ultimately, I think this is a good point, because of the problem of incomplete financial markets described by Koenig (2013) and Sheedy (2014): debt is priced in fixed nominal terms, and thus ability to repay is dependent on nominal incomes.

Nevertheless, just because NGDP targeting has other good things going for it does not resolve the fact that if the potential growth rate changes, the long run inflation rate would be higher. This is welfare-reducing for all the standard reasons.

The “standard reasons” are wrong.  The biggest cost of inflation, by far, is excess taxation of capital income.  That’s better proxied by NGDP growth than inflation. Things like “menu costs” are essentially unrelated to inflation as measured by the government.  The PCE doesn’t measure the average amount that the price of “stuff” changes; it measures the average amount by which the price of “quality-adjusted stuff” changes.  Hedonics.  If the government were serious about targeting inflation, they’d need to come up with an inflation measure that actually matches the supposed welfare costs of inflation in the textbooks.  We don’t have that.  We have nonsense like “rental equivalent”. The standard welfare costs also ignore the massive costs of nominal wage stickiness.  And Basil mentions the incomplete financial markets problem.  Please, can macroeconomists stop talking about inflation, and use NGDP growth as their nominal indicator?  It would make life much simpler.

2. Target NGDP per capita instead!

You might argue that if the most significant reason that the structural growth rate could fluctuate is changing population growth, then the Fed should just target NGDP per capita. Indeed, Scott Sumner has often mentioned that he actually would prefer an NGDP per capita target. To be frank, I think this is an even worse idea! This would require the Fed to have a long term structural model of demographics, which is just a terrible prospect to imagine.

Actually, it’s pretty easy to predict changes in working age population, because we know how many 64 year olds will turn 65, and we know how many 17 year olds will turn 18.  And immigration doesn’t vary much from year to year.  The Fed doesn’t need long range forecasts; three years out would be plenty.  As long as the market understands that the NGDP target path will be gradually adjusted for population growth, they can form their own forecasts when making decisions like buying 30-year bonds.

I want to support NGDPLT: it is probably superior to price level or inflation targeting anyway, because of the incomplete markets issue. But unless there is a solution to this critique that I am missing, I am not sure that NGDP targeting is a sustainable policy for the long term, let alone the end of monetary history.

I still think that NGDPLT, combined with guardrails is the end of macroeconomics as we know it.  All that would be left is discussions of supply-side policies to boost long-term growth. The freshman econ sequence could be reduced to one semester. Or better yet a full year, with a more in depth discussion of micro.

PS.  In this new Econlog post I make some forecasts.