Archive for the Category Monetary Theory


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

The things that you think CAUSE inflation are merely the symptoms of price stickiness

Some people liked my previous post, while some missed the point.  So let’s take another stab at it.

My island economy with 100,000 people and $1 billion dollars in Monopoly money does just fine for 273 years, with NGDP fluctuating above and below $8 billion as velocity moves around due to random minor shocks.  Then another crate of Monopoly money unexpectedly washes up on the beach, doubling the money supply to $2 billion.  The public is not stupid; they understand the implications of this monetary shock.  They know that prices will double in equilibrium, so they immediately start charging twice as much for the commodities they sell.

Is this “rational expectations” assumption realistic?  I think so.  I’m pretty sure than when the Mexican government does a 100 to 1 currency reform, an uneducated woman in Oaxaca selling strawberries to tourists will immediately cut the peso price of her strawberries by 99%, even though the Mexican government has no law requiring that lady to charge any particular price for strawberries.  (Someone correct me if I’m wrong.)

Now let’s say I am wrong about rational expectations and flexible prices.  Then what?  Let’s say the people who live in my island economy are a bit “slow” and don’t understand that the extra $1 billion in Monopoly money that washed up on the beach will soon cause the price level to double.  What then?  In that case you get an overheated economy, with excess demand.  The price level does not immediately double; rather it doubles over a period of weeks or months, as people eagerly spend their new wealth on goods and services.

Only an idiot (or a brilliant saltwater economist) would think that this excess demand is causing the inflation.  Indeed if there were no excess demand we’d be back in the currency reform case, where prices immediately double.  The excess demand resulting from sticky prices is actually slowing the upward adjustment in prices.  The inflation is clearly caused by a doubling of the money supply in both the rational expectations and the sticky price case, it’s just that with sticky prices it takes a bit longer to occur, and excess demand for goods is a side effect.  But it would be idiotic to claim that this excess demand causes the inflation.  It’s a symptom of price stickiness.

Now let’s add wage earners and sticky wages to our island economy.  After the crate washes up on the beach, firms eagerly produce more as demand for their goods rises and wages are temporarily fixed.  Hours worked increase.  But only an idiot (or a brilliant saltwater economist) would claim the tight labor market is causing the inflation.  If wages were not sticky and the labor market cleared then the inflation would actually happen even more rapidly, indeed it would happen immediately if both wages and prices were flexible and people had rational expectations.  Sticky wages slow the inflation process and lead to labor shortages.  Labor shortages are a symptom of sticky wages.

Now let’s add a financial market to the island economy.  After the crate of money washes up on the beach, the lucky islanders who first discover the crate have more money than they wish to hold.  They exchange this money for other assets, which depresses interest rates.  Of course eventually prices will double and then they really will be happy to hold twice as much cash as before.  Interest rates will return to normal.  But during the transition period the interest rate will fall, which depresses the velocity of circulation.  The reduced velocity slows inflation.  So money is not neutral in the short run.  But only an idiot (or a brilliant saltwater economist) would claim that the lower interest rates cause the inflation.  Indeed if interest rates did not decline and velocity stayed the same, then prices would rise much faster.  The tendency for interest rates and velocity to initially decline due to sticky prices actually slows the upward adjustment in prices.  It’s merely a symptom of price stickiness, not an underlying cause of inflation.  The inflation is caused by a doubling of the money supply. Lower interest rates are a symptom of sticky prices.

Look, I’m a market monetarist, not a new classical economist.  So obviously I think sticky wages and nominal debt contracts are really important.  But they are not important because they explain how money causes inflation—the flex-price classical model does just fine in that regard—they are important because they help us to understand all the nasty side effects from unstable money.  Those real world side effects are extremely important, far more important than the inflation itself.  (Hitler was a side effect of German tight money.)  But they are not the underlying cause of the inflation (or the NGDP growth), they are symptoms.  This makes excess demand/Phillips curve/interest rate theories of inflation doubly wrong.  Not only do these factors not cause inflation, to the extent they are important they actually slow the inflation process resulting from monetary shocks (shocks to the money supply or money demand).

PS.  People please read what I wrote, not what you think I wrote.  I never said saltwater economists were idiots, I said “idiot or a brilliant saltwater economist.”  These guys really are brilliant.  The word “or” has a very well defined meaning, please use the correct definition.

PPS.  Why did brilliant saltwater economists fall into the trap of confusing symptoms and causes?  First, because these symptoms often result from inflationary monetary shocks.  (Confusing correlation with causation).  And second, they are confusing demand shifts with “excess demand”.  Think about a microeconomic analogy.  If there is a shortage of bottled water in Florida after a hurricane, and water prices are gradually rising to equilibrium, the rising water prices are not caused by the shortage of water; indeed prices would be even higher if there were no excess demand.  The rising water prices are caused by more demand for water.

Similarly, inflation is caused by either more supply of money or less demand for money.  All the rest is symptoms.

Money/macro needs to go back to basics

Imagine an island with 100,000 people who are all self-employed. They produce 43 commodities, such as food, clothing and shelter, and exchange the commodities with each other. There is no financial system and obviously there is 0% unemployment—how could a self-employed person be unemployed? To avoid the inconvenience of barter, they adopt some form of money—it might be silver coins or it might be a crate of Monopoly money that washed up on the beach.

How do we model the price level? Certainly not with interest rates or a Phillips curve!  There are no interest rates and there is no unemployment.

It’s easiest to start with NGDP, and then work backwards to prices. Suppose people prefer to hold 12.5% of their annual output/income in the form of money balances. That 12.5% represents the inverse of velocity (i.e. 1/V). In that case, V will be 8 and NGDP will be 8 times the money supply. Thus if the money supply is $1 billion, then NGDP will be $8 billion, or $80,000 per person. Now let’s model the rate of inflation:

Inflation equals NGDP growth minus RGDP growth

NGDP growth will be growth in the money supply plus growth in velocity. RGDP growth is determined by non-monetary factors. There’s your basic model of inflation in the simple island economy.

Now let me immediately acknowledge that the real world is very complicated, and this makes it hard to model V. Workers are usually not self-employed–they work for companies and have sticky wages. Labor markets don’t always clear. There are also financial markets, and the nominal interest rate can have a big impact on velocity (especially at the zero bound). But no matter how important these extra factors, they are still basically epiphenomena—the core of monetary economics is all about shifts in the supply and demand for money—it has nothing to do with the Phillips Curve or the liquidity effect from interest rate changes. Call the supply and demand transmission mechanism in my simple model, “Mechanism X”. That’s still the core transmission mechanism in our modern economy; it doesn’t go away just because you add sticky wages and interest rates. It’s just harder to see.

Where did modern macro go wrong? Perhaps when they made these liquidity effect/Phillips curve epiphenomena into the center of their models of the transmission mechanism. We don’t need Phillips curves or interest rates to explain why more supply of peaches and/or less demand for peaches reduces the relative value of peaches, nor do we need Phillips Curves or interest rates to explain why more money supply and/or less money demand reduces the relative value of money. We need to go back to basics.

Matthew Klein has a good article in the FT, pointing to the fact that modern macroeconomists are floundering around, unable to explain recent trends in inflation. He begins by quoting Olivier Blanchard, who states the conventional New Keynesian view:

I have absolutely no doubt that if you keep interest rates very low for long enough the unemployment rate will go to 3.5, then 3, then 2.5, and I promise you at some point that you will have the rate of inflation that you want.

-Former International Monetary Fund Chief Economist Olivier Blanchard

Japan has kept rates very low for a very long time, and still has low inflation. Their unemployment rate is only 2.8%. Sorry, but interest rates and the Phillips curve are not reliable models of inflation.

Now of course these elite NKs are very smart guys, and they did not develop these models for no reason at all. In the short run an easy money policy often (not always) leads to lower short-term interest rates. But over longer periods of time it often leads to higher nominal interest rates. The point here is that it’s the easy money policy that matters, not the interest rates. An easy money policy will lead to higher inflation regardless of when whether it causes lower or higher interest rates. The easy money policy of 1965-81 led to both higher interest rates and higher inflation. Switzerland’s tight money policy of January 2015 led to lower inflation and lower interest rates–even in the short run. (Yes, the NeoFisherians are occasionally correct.)

The same is true of the Phillips curve. It worked OK for many years, especially under the gold standard.  The Phillips curve still “works” in places like Hong Kong. A low rate of unemployment is indeed often associated with higher inflation. But it did not work during the 1970s in America, when unemployment and inflation rose at the same time, or in the last few years when inflation has stayed low despite unemployment falling to 4.2%. And that’s because it’s not the core transmission mechanism for inflation, the core mechanism is the supply and demand for money. Changes in inflation may or may not be related to interest rates or unemployment, but they are always related to what’s going on with the supply and demand for money.

Unfortunately, this confusion has led Blanchard’s opponents to go even further off base:

Blanchard was prompted to recite his faith in the power of the Phillips Curve by former Fed governor Jeremy Stein, who wondered how central banks were supposed to raise their inflation target to 4 per cent when they are still undershooting the current target of 2 per cent. Blanchard seemed to think the answer was easy: keep rates low, unemployment will fall, and inflation will necessarily accelerate.

Larry Summers — Blanchard’s co-host at the conference and co-author of one of the papers — found this hopelessly inadequate. He pointed to Japan’s long experience with full employment, large government budget deficits, aggressive monetary expansion…and total price stability. If they haven’t managed to get inflation, how could anyone? Blanchard had no answer but to repeat his catechism.

This literally makes me want to pull my hair out. Indeed Stein’s argument is not even logical. Suppose someone were halfway between Baltimore and DC, driving south, and the passenger said “What makes you think you’d be capable of driving this car to New York, when you haven’t even reached Baltimore”. My response would be “Umm, I’m not trying to reach Baltimore. If I wanted to reach New York I’d turn around and drive north. I’m driving south.” My response to Stein would be to point out that if the Fed wanted higher inflation it would not be raising interest rates with the publicly expressed purpose of holding inflation down. Rightly or wrongly, the Fed believes that if it raises interest rates it will achieve 2% inflation, and if it does not raise them then inflation will overshoot 2%. They may be wrong, but this has nothing to do with monetary policy being impotent. It’s a question of whether they are steering in the right direction.

I could have also responded, “I have decades of experience driving cars, I’m pretty sure I’m capable of driving this car to New York.”

I’m not sure if people realize just how radical 2% trend inflation is. If you had told Keynes that central banks could target inflation at 2% in the long run he would have laughed—he would have regard you as a fool. Throughout almost all of human history the long-term trend rate of inflation was either near-zero (commodity money) or wildly gyrating (German hyperinflation, post-Bretton Woods “Great Inflation”, etc.) Then around 1990 the Fed started trying to stabilize inflation at about 2%. Since that time, inflation has averaged about 1.9%, amazingly close to 2%. This isn’t some sort of weird miracle; it’s happened because the Fed controls the long-term trend rate of inflation.

If the Fed wants 4% trend inflation, they’d go back to Volcker’s policy from 1982-90, when inflation averaged 4%. This is not rocket science; other countries have also been able to target inflation.

Japan can’t create inflation? Really? What if they devalued the yen from 112 to the dollar to 600 to the dollar? No inflation? Then what about 6000 yen to the dollar?

Inflation is always and everywhere a money supply and demand phenomenon.  (I prefer that to Friedman’s, “Persistent inflation is always and everywhere a money supply phenomenon.”  Which is basically what he meant in the quote often attributed to him)

HT:  Caroline Baum