Archive for the Category Monetary Theory

 
 

Was NeoFisherism vindicated?

Rajat directed me to a new post by Stephen Williamson, which suggests that recent events provide support for the NeoFisherian view.  The Fed has been gradually raising their interest rate target since late 2015, and inflation has gradually risen from near zero up to roughly 2%.  In addition, nominal interest rates are positively correlated with inflation rates at the international level.

Here are three ways of interpreting that evidence:

1. Higher interest rates cause higher inflation.  (NeoFisherism)

2. Low unemployment led the Fed to fear inflation (Phillips Curve), and they tightened monetary policy to prevent inflation from overshooting. (Keynesian)

3. The Fed did not tighten at all.  Contra NeoFisherism, raising the interest rate target is usually contractionary, ceteris paribus.  But the Fed often raises rates during periods when the natural rate is rising, and in most cases they raise rates more slowly that the natural rate is rising.  This means that while it is true that raising rates is usually contractionary, ceteris paribus, in the majority of cases a period of rising interest rates is also a period of increasingly expansionary monetary policy. I would argue that 2017 was no different. So I also reject the Keynesian view.

I prefer the second and third explanation to the first because the NeoFisherian view is inconsistent with the response of asset prices to unexpected changes in the central bank’s nominal interest rate target.  And I prefer the third explanation to the second because the Phillips Curve is not a reliable way of forecasting inflation, and changes in the nominal interest rate are not a reliable indicator of changes in the stance of monetary policy.

Off topic, I just returned from a monetary conference at the Hoover Institution, which was attended by no fewer than 4 Fed presidents.  I was delighted to see both John Williams (who was recently appointed to the New York Fed), and Robert Kaplan (Dallas Fed) mention both price level and NGDP level targeting as promising options to think about.  While neither endorsed these policy options, I had the impression that if the Fed were not already committed to inflation targeting, these two Fed presidents would probably be favorably inclined to one of these two approaches.  Kaplan seemed especially interested in NGDP targeting.  However, I don’t expect the Fed to change its policy target as long as things are going well.  Instead, I’d expect some consideration of level targeting the next time we go into a recession, and hit the zero bound.

 

What is demand stimulus?

This is a sort of follow-up to my previous post.  One can think of demand stimulus as policies that boost NGDP.  (There are of course other policies that boost RGDP, such as supply side reforms, which work even if NGDP doesn’t rise.  But demand stimulus boosts NGDP.)

We know from long run money neutrality that the long run trend rate of growth doesn’t matter, except for second order effects like hysteresis and menu costs and taxation of capital income—and these second order effects might be positive or negative.  If someone argues that a certain policy may be able to significantly raise the trend line for RGDP, they may be right, but they are almost certainly NOT talking about demand-side stimulus.

The upshot of all of this is that there is only one coherent way to think about demand-side policies.  When should AD be more expansionary than average and when should it be less expansionary than average? It’s incoherent to say, “I think demand side polices should always be stimulative.”  That doesn’t even mean anything.  It’s like saying, “I believe all Americans should earn above average incomes.”  Any demand-side strategy should either call for stable AD growth, or else specify when aggregate demand should be more expansionary than average and when it should be more contractionary than average.

If you are advocating demand stimulus during a period of low unemployment, then (whether you know this or not) you are implicitly suggesting that demand-side policy should be more contractionary than average during a recession.  Not good.

A corollary of this is that terms like ‘hawks’ and ‘doves’ don’t have the meaning that almost everyone thinks they have.  If you have a 2% inflation target, exactly how do you implement a “dovish” policy?  A “hawkish” policy?

What if we turn to fiscal policy; does that change things?  Not at all.  The government’s national debt is constrained by the fact that the debt must be serviced in the long run.  This budget constraint means that budget deficits that are larger than average during certain periods must be offset by deficits that are smaller than average during other periods–to keep the debt manageable.  It makes no sense for someone to say, “I generally favor a more expansionary fiscal policy than what is favored by Sumner.”  It’s not even a coherent statement.  If you say that you favor a more expansionary fiscal policy that what I currently favor, you are implicitly saying, “and at some future date I prefer a more contractionary fiscal policy than what Sumner will favor at that point in time.”  I worry that the insights of Robert Lucas are being forgotten.

How many punches should Chuck Norris be allowed to throw?

A number of market monetarist bloggers use the “Chuck Norris” metaphor for monetary policy credibility.  The basic idea is that if the central bank credibly promises to do whatever it takes to hit its target, then NGDP growth expectations won’t fall very far, nominal interest rates will stay above zero, and the central bank won’t have to actually take many “concrete steppes” to hit its target.  Exhibit A is the Reserve Bank of Australia, which never had to cut rates to zero or do QE during the global recession of 2008-09.  And yet the Aussie outcome was better than in other advanced economies.  The Chuck Norris metaphor refers to the fact that he can clear a room without throwing a punch, just due to his reputation.

Chuck Norris is a good metaphor, but (as far as I know) other bloggers have not fully fleshed out this line of reasoning.  The focus has been on what central banks need to do, but perhaps the real focus should be on what governments need to authorize.

Consider two countries with central bank balance sheets equal to 5% of GDP, both on the eve of the Great Recession.  In each case, the balance sheet balloons to 25% of GDP during the Great Recession.  In which case is policy more expansionary?

Case A:  The central bank is legally limited to a balance sheet of no more than 25% of GDP.

Case B:  There is no legal limit on the central bank balance sheet.

In case B, the expansionary impact of the QE will probably be much greater than in case A.  While the “concrete steppes” are identical, in case B there will probably be expectations of a more expansionary future policy than in case A.  Nick Rowe often points out that the current concrete steps taken by central banks are far less important than changes in the future path of policy.  That’s implicit in the Chuck Norris metaphor, and also an implication of state-of-the-art New Keynesian models developed by Michael Woodford and others.

At this point you might assume that the implication of my post is clear—don’t have legal limits on central bank balance sheets.  But a decade of reading deep thinkers like Tyler Cowen and Robin Hanson (or petty much any of the George Mason bloggers) has convinced me that when it comes to human institutions, things are always more complicated than they seem, certainly more complicated than they seemed to me a decade ago.  For instance, let’s add another case:

Case C:  The central bank’s balance sheet is legally limited to 250% of GDP.

Now let’s think about Fed policy during the recovery from the Great Recession.  We know that the Fed did three QE programs, and stopped when its balance sheet was just under 25% of GDP.  We know that Bernanke cited vague “costs and risks” of doing even more QE.  (Although we also now know from the FOMC transcripts that Bernanke himself was less concerned about these risks than other members of the committee.)  And we know that some in Congress were complaining about all the money printing, and almost no one on Congress were complaining that they did not print enough money.

To summarize, while the Fed was in Case B, with no legal limit on their balance sheet, the institution behaved as if there was a sort of implicit limit, probably much lower than 250% of GDP.  In that case, moving to case C might have actually been expansionary.  The Fed would have thought, “Congress has our back, they authorize us to do truly massive QE if necessary to achieve our mandate.”  Think of Russian highway speed limits changing from “no explicit limit but at the discretion of what the police officer views as unsafe” to “150 kilometers per hour”.  Do speeds rise or fall?

In a perfect world, I’d want Congress to tell Chuck Norris that he’s authorized to throw as many punches as required to clear the room.  Or perhaps to authorize a specific number that is clearly more than he would need (say 10,000 punches.)  But I’m not sure about the idea of actually having Congress set a limit.  If they had done so back in 2008, the limit on the central bank balance sheet would likely have been set too low.

Because Congress is so dysfunctional, and likely to remain so, one could argue that the Fed can pretty much do whatever they want.  Who will stop them?  The Fed is about 100 times more respected than Congress, and any Congressional attempt to control the Fed would almost certainly fail to get 51 votes in the Senate (which actually has a few grown-ups).  There are plenty of pragmatic GOP senators (say among people like Lindsey, McCain, Flake, Collins, etc.), some of which would not support a right wing attempt to rein in the Fed.  Heck I doubt even Trump would support it, as he knows he might need monetary stimulus if we again go into a recession.  So perhaps the Fed could simply put on its Superman costume (sorry for mixing metaphors) and unilaterally announce that it views itself as being authorized to lower IOR to as much as negative 0.75%, and boost the balance sheet to as much as 250% of GDP, and then dare Congress to stop them.

That won’t happen (Larry Summers was not picked to be chair), but it’s the sort of issue we should be thinking about.  Instead we think about question like “does QE work?”  Which is such a dumb question it makes my hair hurt every time someone asks it.

Update:  People keep asking me how I enjoy California:

Further thoughts on NeoFisherism

David Beckworth recently interviewed Stephen Williamson, who is an advocate of the NeoFisherian approach to thinking about monetary policy and interest rates.  Williamson argues that a policy of permanently reducing interest rates is disinflationary.  Others think this idea is crazy.  I’m not in either camp, and I keep looking for ways to explain why.  Here are some facts about monetary policy, which seem related to this issue:

1. In the short run, nominal interest rates can be reduced with a tight money policy.

2. In the short run, nominal interest rates are usually reduced with an easy money policy.

3. Because money is neutral in the long run, any monetary policy that permanently reduces nominal interest rates must be disinflationary.

4. A tight money policy reduces the natural rate of interest.

All of these claims are pretty easy to justify, and none seem particularly controversial.  But they raise an interesting puzzle.  Points #1, #3 and #4 all seem sort of NeoFisherian in spirit, consistent with the claims made by Stephen Williamson and John Cochrane.  So why are so many mainstream economists horrified by NeoFisherism?  I think the sticking point is #2.

The vast majority of the time, a reduction in interest rates on any given day represents an easier monetary policy than a counterfactual policy where the central bank doesn’t reduce interest rates.  Not always (in which case #1 and #3 would no longer be true), but the vast majority of the time.  But the NeoFisherian thought experiment requires that the lower rates be achieved via tighter monetary policy.

I think that people are confused about what NeoFisherians are talking about when they discuss policy option number three.  In the minds of most economists, switching to a permanently lower interest rate seems like an expansionary monetary policy, because on any given day cutting interest rates usually is an expansionary monetary policy.  Here’s why they are wrong:

1. If you don’t want the price level to blow up, then any permanent switch to a lower interest rate must be done with a tighter monetary policy.  If the central bank tried to do it with an easier money policy then they’d have to inject larger and larger amounts of liquidity, eventually causing hyperinflation and then complete collapse of the system.  So any sustainable policy of low interest rates must be contractionary.

2.  A contractionary monetary policy lowers the natural rate of interest.  I think many economists picture a world where the natural rate of interest is not affected by monetary policy.  In that world, lowering the policy rate makes policy more expansionary, because the stance of monetary policy is the gap between the policy rate and the natural rate (assumed to be stable).  In fact, any sustainable policy of low rates must be caused by tight money, and any tight money policy will reduce the natural rate of interest so much that monetary policy does not get easier, despite the lower fed funds target.  This is Japan since 1995.

So far I’ve presented a picture that is somewhat sympathetic to the NeoFisherians.  Let me conclude with a discussion of what I don’t like about the way NeoFisherians present their theory.

1.  The listener is led to believe that if you want lower inflation, you need to cut interest rates.  I’d say if you want lower inflation you need to cut interest rates via a tight money policy.  Any attempt to achieve lower inflation via a cut in interest rates achieved through an easier money policy will end in disaster.

2.  Because the vast majority of rate cuts represent easier money than the counterfactual of not cutting rates on that given day, it is not accurate to imply that the first step to lowering inflation is for the central bank to do the sort of rate cut that it often does do–i.e., liquidity injections.  Instead, the NeoFisherians should argue that the first step to lower inflation is for central banks to do the sort of rate cut that the Swiss National Bank did in January 2015, when they simultaneously appreciated their currency and created a credible policy of further currency appreciation going forward.  That credible promise led to lower nominal interest rates via the interest parity condition, and lower inflation expectations via the currency appreciation (combined with PPP.)

PS.  Has anyone commented on the similarity between the NeoFisherian puzzle identified in points #1 – #4 above, and the puzzle that led to the Dornbusch overshooting model?  The overshooting model was an attempt to resolved the following puzzle in a conventional Keynesian fashion:

Puzzle:  Easy money seems to lead to both actual currency depreciation and expected currency appreciation.

Rudi Dornbusch wanted to show how easier money could lead to expected currency appreciation (which is an implication of lower nominal interest rates combined with the interest parity condition.)  His solution was overshooting.

The NeoFisherian model assumes a permanent change in the interest rate, which rules out Dornbusch’s resolution to this puzzle. If you make the rate cut permanent than his solution no longer works; you take overshooting off the table.  In that case, the NeoFisherian result is the only explanation left standing.  Now it is a tighter money policy that reduces interest rates, and that tighter money also makes the currency become expected to appreciate forever, lowering inflation.

El-Erian at the Fed?

The Wall Street Journal has a new piece discussing rumors that Mohamed El-Erian might be chosen for the position of vice chair of the Board of Governors:

In recent years, Mr. El-Erian has voiced somewhat hawkish critiques of the Fed’s policy stance, including decisions to hold interest rates at ultralow levels despite signaling plans to raise them. In recent months, he has suggested that the Fed’s inflation target of 2% might be too high given structural forces holding down consumer prices.

A few comments:

1.  We now know that those who offered hawkish critiques of Fed policy a few years ago were wrong.  Inflation has continued to undershoot the Fed’s target.

2.  When “structural forces” hold down inflation, they do so by boosting RGDP growth.  There is no other way by which structural forces can hold down (GDP deflator) inflation.  None.  RGDP growth has actually been at unusually low levels over the past decade.  Thus we now know that structural forces are not holding down inflation.  It was slow NGDP growth.  Those who think otherwise are confusing microeconomic factors (Amazon, China, etc.) with macroeconomic factors.  Yes, Amazon and China hold down specific prices, but only by boosting GDP growth.  And this mistake cannot be excused by pointing to mismeasurement of inflation.  Maybe tech is causing actual inflation to be lower than measured inflation, but the puzzle being discussed is why measured inflation is so low.

Confusion over these sorts of basic macro issues is exactly why we need to appoint world class experts on monetary economics to the Fed.  People like El-Erian tend to assume that a tighter monetary policy would allow the Fed to have a higher path of interest rates going forward.  In truth a tighter monetary policy would result in slower growth and a lower path of the natural rate of interest over time.  (See Trichet, ECB.)  If the Fed didn’t realize this and persevered with their plan to raise rates, they would create a depression.  I’m not predicting a depression because I don’t expect the Fed to do this, just pointing to the logical consequence of this sort of mistaken reasoning.

Higher interest rates should not be a goal of monetary policy, but if it is a goal then you get there by making monetary policy more expansionary, and boosting the trend rate of NGDP growth.

PS.  I have a cameo role in a new MRU video.

PPS.  I was interviewed for this piece in the Commercial Observer.

HT:  Patrick Horan, Vaidas Urba