Archive for October 2010


Why a little bit of inflation is good for savers

Will be in Dallas for a few more days.  Just so you don’t think I disappeared, I dug up an old post I wrote but never posted.  I saw the 3rd quarter NGDP was about 4%–surprised by the high deflator (something I can’t explain.)  Looks like final sales (Woolsey’s target) were much lower than GDP growth.  I will try to catch up on comments early next week.  Here’s something to look at until then:

We are taught in basic economics that an unexpected increase in inflation hurt savers.  But I’m a very heavy saver, and I think a bit more inflation would help me.  Partly that’s because I have lots of equities, but I’d still feel this way if I had to live the next 30 years as a retiree surviving on T-bill interest.

You might argue that I am confusing real and nominal interest rates.  Yes, inflation would raise nominal rates, but surely it wouldn’t raise the real yield on T-bills?  In fact, I think a little bit more inflation would raise real T-bill yields.  Maybe not right away, but within two or three more years.

To make this argument we have to remember a few important macro concepts, and also empirical regularities:

1.  Near zero rate traps are associated with very low inflation and a depressed real economy.  The depressed real economy often leads to low real interest rates, even if the economy is growing.  The best example occurred in 1933-40, when real interest rates remained low despite fast RGDP growth.  The explanation was that although RGDP growth was high, the level of RGDP remained low throughout the 1930s—and this led to low levels of real investment, and hence not much demand for credit.  Japan is another example.

2. The economy should be able to fully adjust to an adverse demand shock within a few years, as wages and prices adjust.  However, the adjustment may take longer if various real factors delay the recovery:

a.  A higher real minimum wage, caused by legislation or disinflation.

b.  Extended unemployment insurance, which reduces downward wage flexibility.

c.  Protectionism.

d.  Higher taxes, which discourage investment.

e.  Increased regulations that discourage small firms from adding employees.

These factors cannot, by themselves, explain the current high unemployment.  But they can slow the adjustment to lower unemployment in an economy where the central bank is not providing enough money for the usual recovery–which is normally associated with fast NGDP growth. 

3.  AD shocks can amplify AS problems, and vice versa.  Just as the tight money of 2008 caused Congress to extend UI for 99 weeks, an easier money policy that boosts nominal growth and inflation will cause Congress to reduce the benefits much sooner.  And the real minimum wage would fall.   Some economists say the problem is almost entirely a deficiency of AD.  Other RBC-types say labor market distortions are a big problem.  But since the labor market distortions are mostly a response to the falling AD, the policy implications of each view are the same—we need more AD.

Here’s what people forget.  Monetary policy was far more inflationary in 1990-2007, but savers were also far better off.  The recent disinflation has hurt savers badly because it has lowered the real rate of return on their investments.   Why is the textbook view wrong?  Because it assumes money neutrality, i.e. it assumes inflation is a zero sum game.  In fact, unexpected inflation could cause the economy to recover, after which real returns on investment like T-bills would return to their normal level.  Yes, there may be a “new normal” because of high savings rates in Asia, but it’s hard for me to believe that the current minus 0.50% yield on 5 years TIPS is the new normal.  I think it at least partly reflects the weak economy.  If we get stuck in a long period of economic weakness (as debt markets are now forecasting), then savers will do very poorly, even as they experience the lowest inflation rates of their lives.

So no, I’m not trying to stick it to savers; I’m trying to help them.  And I’m trying to help borrowers as well.  Economics is not a zero sum game.  Right now an extra trillion dollars in NGDP would be more than 50% real, and that’s a lot of extra income to make everyone better off.

Don’t say I didn’t warn you

So here’s what I read when I woke up this morning:

The dollar has been hit by expectations the Fed will announce new stimulus measures next month, diluting the dollar’s value.

But it gained strength Wednesday after a report in the Wall Street Journal suggested the Fed could take a more gradual approach to the stimulus and after an upbeat report on U.S. consumer confidence.

And this:

NEW YORK (AP) — Stocks slid Wednesday as concerns grew over whether the Federal Reserve’s plans to buy Treasury bonds might be smaller and slower than anticipated.

And here’s what I wrote a  month ago:

Here is a recent story from

“NEW YORK (Reuters) – Stocks rose on Tuesday after opening lower on weak economic data, with investors saying the data bolsters expectations the Fed will pump more money into the economy, which would support equities.”

And what sort of economic data was weak?

“September data showed U.S. consumer confidence fell to its lowest level since February, underscoring lingering worries about the strength of the economic recovery, while home prices dipped in July.”

Let’s suppose consumers react with a lag to economic data, or suppose the survey was done early in the month.  In that case the survey might have reflected the very weak economic data coming out in August (revised GDP at 1.6%, etc) and also a weak stock market, which was partly a response to the weak data.

So let me get this straight:

1.  The markets were weak in August, causing a low consumer confidence number in September

2.  This leads investors to expect more easing by the Fed

3.  This leads to a stronger stock market

4.  This will lead to a better consumer confidence number in October

5.  Which will lead investors to fear the Fed won’t ease

6. Which will cause stock prices to fall in October

7.  Which will lead to a weaker consumer confidence number in November.

8.  And so on

Are you getting dizzy yet?  This is the so-called “circularity problem,” which occurs when the Fed tries to target market expectations.  It was discussed in 1997 in a pair of JMCB papers by Garrison and White, and also Bernanke and Woodford.

The Fed needs to be careful here.  It’s easy to say the Fed doesn’t respond to the stock market; but let’s face it, they do.  They cut rates after the 1987 crash, even though there was no sign of recession or deflation, and they announced a bond purchase program in March 2009, right after a sickening plunge in equity prices.  Make all the jokes about the stock market you want, people do see it as an important indicator of which way the economy is headed.  Even if only subconsciously.

So if the Fed were to meet in November and decide not to do QE because the market was looking up, and if the market was looking up because they expected QE in response to weak economic data, then the Fed could end up with a nasty surprise.  Something like what occurred in December 2007 and January 2008, or again in September 2008 and October 2008.  Using Wall Street lingo, they could “fall behind the curve.”

I guess markets aren’t efficient after all.  My blog is “public information” and any investors who bought S&P puts right before the Fed response to the consumer confidence number could have made a killing.  I think I’ll take private, and start charging a fee.

Seriously, this has all happened before.  Here’s how I described the events of late 1933:

The distinction between flexible (commodity) prices and a sticky overall price level is crucial to any understanding of Roosevelt’s policy.  For instance, when Roosevelt decided to formally devalue the dollar in January 1934 [and stop the gradual depreciation], many prominent economists such as E.W. Kemmerer predicted runaway inflation.  Prices did rise modestly, but remained well below pre-depression levels throughout the 1930s.  Pearson, Myers, and Gans quote Warren’s notes to the effect that when the summer of 1934 arrived without substantial increases in commodity prices:

“The President (a) wanted more inflation and (b) assumed or had been led to believe that there was a long lag in the effect of depreciation.  He did not understand–as many others did not then and do not now–the principle that commodity prices respond immediately to changes in the price of gold”.  (1957, p. 5664.)

Warren understood that commodity prices in late January 1934 had already incorporated the anticipated impact of the devaluation, and that commodity price indices were signaling that a gold price of $35/oz. was not nearly sufficient to produce the desired reflation.

One of the most important monetary economics papers of the 20th century was published in 1957 in Farm Economics.  I wonder how many famous economists have even heard of it.

PS.  Please, no angry comments; I was just kidding about predicting the market and going private.  Does anyone really think I’d ever abandon the EMH?

PPS.  I’m going to a conference in Dallas tomorrow (on Karl Brunner.)  Depending on whether the hotel has a computer, the blog may slow down for a few days.  But I’ll be blogging furiously on November 3rd–you can count on that.

Mr. Bernanke: You are playing Wii, not mini golf

Ben Bernanke recently used a golf metaphor to describe monetary policy:

In remarks simply titled “Gradualism,” then-Governor Bernanke explained the case for policymakers “to move slowly and cautiously” when they can’t be sure about the consequences. He cited a classic 1967 article by Brainard, a Yale economist, who “showed that when policymakers are unsure of the impact that their policy actions will have on the economy, it may be appropriate for them to adjust policy more cautiously and in smaller steps than they would if they had precise knowledge of the effects of their actions.”

Then he gets into miniature golf:

“Imagine that you are playing in a miniature golf tournament and are leading on the final hole. You expect to win the tournament so long as you can finish the hole in a moderate number of strokes. However, for reasons I won’t try to explain, you find yourself playing with an unfamiliar putter and hence are uncertain about how far a stroke of given force will send the ball. How should you play to maximize your chances of winning the tournament?

“Some reflection should convince you that the best strategy in this situation is to be conservative. In particular, your uncertainty about the response of the ball to your putter implies that you should strike the ball less firmly than you would if you knew precisely how the ball would react to the unfamiliar putter. This conservative approach may well lead your first shot to lie short of the hole. However, this cost is offset by the important benefit of guarding against the risk that the putter is livelier than you expect, so lively that your normal stroke could send the ball well past the cup. Since you expect to win the tournament if you avoid a disastrously bad shot, you approach the hole in a series of short putts (what golf aficionados tell me are called lagged putts). Gradualism in action!”

That’s way too gradual.  Bernanke is playing something closer to electronic golf.  After each practice swing in Wii, the likely distance the ball will travel is shown on the computer screen.  The practice swings are the recent policy statements by Fed officials.  The reactions of markets (everything from stocks to TIPS spreads) show us the likely effects.  Yes, there is a circularity problem here–but at least it gives us a ballpark estimate.  And the Fed’s still not swinging hard enough.

Target the forecast!  Set monetary policy at a level expected to produce desired growth in AD.  We’re still far from that level.  I hope Bernanke doesn’t choke under the pressure.  I hope he remembers what he told the Japanese a few years back:

Needed: Rooseveltian Resolve

Franklin D. Roosevelt was elected President of the United States in 1932 with the mandate to get the country out of the Depression. In the end, the most effective actions he took were the same that Japan needs to take””-namely, rehabilitation of the banking system and devaluation of the currency to promote monetary easing. But Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and to experiment””-in short, to do whatever was necessary to get the country moving again. Many of his policies did not work as intended, but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done.

Japan is not in a Great Depression by any means, but its economy has operated below potential for nearly a decade. Nor is it by any means clear that recovery is imminent. Policy options exist that could greatly reduce these losses. Why isn’t more happening? To this outsider, at least, Japanese monetary policy seems paralyzed, with a paralysis that is largely self-induced. Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work. Perhaps it’s time for some Rooseveltian resolve in Japan.

The reason I could never be a government official

Daniel Sherry sent me this video of William Dudley responding to his question during Dudley’s talk at Cornell.

“If we could guarantee 5% NGDP growth for several years, it would be great.”

Frequent commenter Derrill Watson sent me a recent post from his own blog:

Mr. Dudley, President of the NY Federal Reserve Bank, is speaking at Cornell today. One of the economics faculty got him to make a presentation in his class. He could speak a little more freely in exchange for no audio or video recording. I eagerly attended and took copious notes.

.   .   .

I had communicated with Sumner about Dudley’s arrival and asked what question I should ask if I got the chance. I got the chance. Given that the Fed’s purpose right now is to lower the cost curve, it seems to me that there is a political economy question of how to sell it. If stimulating aggregate demand is your goal, why not tell people you are targeting a proxy for aggregate demand, like NGDP growth, and announce you are working on raising people’s average incomes rather than trying to raise inflation? His response:

[Dudley:] That is the right point. We would like to see something like 1.75% inflation. It’s too low right now. We are worried about NGDP because people can’t leverage. [He made several statements about why low NGDP growth is bad.] We could try targeting NGDP, but would it be credible? Could we actually hit our targets? There’s also a communication problem. People hear “nominal income” and don’t know what to do with it. But this is a key issue. If we could guarantee 5% NGDP growth per year for several years, it would be great.
[Me:] Personally, I score a big win here for Sumner et al. I’ll do another post tomorrow about his comments on the recession itself and the steps Congress, the Fed, and international policy makers are doing to prevent this all from happening again.

I do understand that the underlined statement is ambiguous.  I recall Krugman once said something similar, and was expressing skepticism about whether the Fed could actually hit that NGDP target.  Nonetheless, I think the most likely interpretation is that Dudley thinks a 5% NGDP target would actually be a good idea, as long as some practical communication issues could be overcome.  I think this bodes well for the future.  The appeal of NGDP growth (and 5% no less!) is becoming better understood.  Of course I’d actually like to see above 5% growth for a couple years, and then 5% thereafter.

However this comment worried me:

When is the time to exit? At one point, he tossed a couple numbers into the air. Until aggregate demand has grown enough that unemployment is back down to below 8% or if inflation got above 2%, they really aren’t looking at exit.

I hope something was lost in translation.  It should be “and,” not “or.”  If Dudley actually said or, and meant it, he would be violating the Fed’s dual mandate.  There would be no justification for the Fed to tighten policy if inflation was 1% and unemployment was 7.5%.  And that scenario might well occur in 2012 or 2013.

This is also slightly worrisome:

[Back to me:] Paying interests on reserves (IOR) has been fingered by Sumner, Beckworth, and others as a cause of much of the monetary contraction since 2008. Yes, the Fed sent out $800 billion, but all of it went straight back into Fed deposits instead of into the economy. It shored up banks and kept more of them from failing, but didn’t produce growth. The big take away for me was understanding what the Fed thinks it’s doing, keeping up a contractionary policy while claiming it’s trying to ease more.

[Back to Dudley:] The answer is that IOR is a major new tool to reduce the costs of quantitative easing. It allows the Fed to convince investors and other people that they can and will mop up excess reserves later. By shifting the cost curve down, it allows them to do more easing. “We can control the demand for credit” by changing the costs of credit directly. The combination of reserves which cost them 25 basis points (0.25%) and the long term assets they purchase at about 4% return means that the Fed is currently bringing in an $80 billion annual profit, so they are very popular on the Hill right now. If, in order to mop up excess liquidity, they have to raise the IOR to more than 4%, however, they start losing money. So the risk of QE2 is that it becomes a major liability later.

If the Fed was forced to raise IOR to 4%, that would mean we got a very robust recovery.  In that case the gains to the Treasury would far outweigh any losses to the Fed from QE2.  The Fed is part of the US government’s consolidated balance sheet.  I hope misguided fears of capital losses are not holding back the Fed.

Off topic, Tyler Cowen raised this interesting question today:

Question: When the measured expected real return is below zero, how well can any recovery program work?

Recovery programs can work quite well.  Let’s break this down into two parts:

1.  Can the monetary authority raise NGDP when real rates are negative?

2.  Does higher NGDP boost RGDP when the economy has slack and real rates are negative?

The answer to both questions is clearly yes.  If on a gold standard, just raise the price of gold.  Svensson correctly called that a “foolproof”; method of inflation.  If on a fiat money standard, peg the price of NGDP or CPI futures at the desired level, or at the very least raise your inflation target and do level targeting.

Once NGDP rises, output will rise if there is slack.  This is because nominal wages are sticky when unemployment is high, so the higher NGDP will induce firms to produce more.

I think it’s a mistake to see interest rates (nominal or real) as an important part of the monetary policy transmission mechanism.  They mostly reflect the state of the economy—whether output is expected to be high or low relative to trend.  Of course if the economy did recover, real rates would rise back above zero.