Dustin asks an interesting question:

An elementary question on the topic of interest rates that I’ve been unable to resolve via google:

Regarding Fed actions, I understand that reduced interest rates are thought to be expansionary because the resulting decrease in cost of capital induces greater investment. But I also understand that reduced interest rates are thought to be contractionary because the resulting decrease in opportunity cost of holding money increases demand for money.

One? Neither? Both? Little of each? Depends?

It’s not at all clear that lower interest rates boost investment (never reason from a price change.)  And even if they did boost investment it is not at all clear that they would boost GDP.

But two things are very clear:

1.  Open market purchases reduce short term nominal rates.

2.  Open market purchases boost NGDP.

However it’s surprisingly hard to explain why OMPs boost NGDP using the mechanism of interest rates. Dustin is right that lower interest rates increase the demand for money.  They also reduce velocity. Higher money demand and lower velocity will, ceteris paribus, reduce NGDP.  So why does everyone think that a cut in interest rates increases NGDP?  Is it possible that Steve Williamson is right after all?

Here’s what people forget.  The Fed doesn’t wave a magic wand and reduce interest rates.  They do so via a boost in the monetary base.  Now let’s think about the effect of a sudden and instantaneous 1% boost in the monetary base. Contrary to most macro models, there is an immediate impact on NGDP, although almost certainly less than 1%.  The instantaneous impact on NGDP comes from the fact that the OMP immediately boosts commodity prices, and hence the gold and oil flowing out of the ground in America has a higher nominal value.  But that’s nowhere near enough to instantly boost NGDP by 1%.  Instead interest rates must fall by enough so that Americans are willing to hold extra non-interest bearing base money.  The lower interest rates reduce velocity in the short run.  So NGDP might rise by 0.2%, and V might fall by 0.8%, within seconds.

In the very long run money is neutral, V is unchanged, and NGDP rises by 1%.

The medium term is the most complicated.  There may well be a period when velocity goes up, especially if inflation rises and real growth is strong.

So the correct answer is that the lower interest rates tend to reduce NGDP, but the thing that causes lower interest rates may increase NGDP by more than the reduction caused by lower V.  At least if that “thing” is OMPs.

Yes, easy money often makes rates fall in the short run, but it’s the larger money supply that does the “heavy lifting” of boosting NGDP.

And here’s my claim, if a student asked Dustin’s question in a typical American econ class, the professor would struggle to answer the question.  What do you think?  Note that to answer the question you must address the specific concern raised by the student (lower rates causing rising demand for money in this case.) It’s not enough to wave off that concern and answer it using an unrelated model, say New Keynesianism.

Now suppose interest rates were cut via lower interest on reserves. How would the answer be different? Lower IOR would reduce the demand for money, which would boost NGDP.  No increase in the monetary base would be necessary.  No wonder that many anti-monetarists are so anxious to move to a world of IOR. They are embarrassed by some inconvenient facts about the impact of lower interest rates in a world of OMOs involving zero interest base money.

PS.  Some have claimed that in the brave new world of IOR we won’t need OMPs to target NGDP.  Perhaps with a zero growth rate target path that would work. But if you want 5% NGDP growth, then IOR would have to fall fast enough to lead to 5% velocity growth.  Eventually you would blow right through the zero bound, and need negative IOR.  Even on currency.  Velocity would rise faster and faster. After being paid workers would run to the store to spend their money.  Then they’d start using jetpacks.  Eventually the speed of light might put an upper limit on V, and hence NGDP.

I’d rather stick to good old OMPs.

Here’s Nick Rowe:

I have been arguing with John Cochrane and Steve Williamson over whether central banks announcing higher nominal interest rates is inflationary or deflationary. The very fact that economists are arguing about that very basic question tells us something important about central banks’ using nominal interest rates as a communications strategy: it sucks. This is a point that economists like Scott Sumner and I have been making for some time. Do low nominal interest rates mean monetary policy is loose or tight? It depends.

Obviously I agree, but I want to be careful that we don’t overstate its suckiness (is that a word?)  There is no question what central banks mean by higher interest rates, ceteris paribus.  They are signaling contractionary intent.  And there is no question that markets interpret it that way. So what is the problem? Ceteris is rarely paribus.  Suppose the economy is weakening and the markets believe the Wicksellian equilibrium interest rate has fallen by more than 50 basis points.  For instance, December 2007.  The Fed announces a 25 basis point rate cut.  The stock market crashes.  Why?  Because policy became more contractionary (if you are a MM or a thoughtful NK), or policy became expansionary at a slower rate than needed (if you are a normal person or a sloppy NK.)

That is the ambiguity that Nick refers to.  Of course Williamson was postulating something much more counterintuitive, that even a larger than expected fed funds (or IOR?) rate cut could have a contractionary impact on expected inflation (relative to a smaller rate cut.)

In fairness to the Keynesians, the monetary base has the same problem as interest rates.  A huge increase in the base could be expansionary (Zimbabwe) or it could reflect a lower NGDP trend growth rate (Japan.)

Nonetheless, the base is better that interest rates because interest rates also have the zero bound problem, which makes policymakers mute when nominal interest rates are zero.  That’s why they turn to QE as their communication strategy.

Of course NGDP futures targeting is better than either option.  To summarize:

1.  Interest rates:

Lousy at communicating policy stance, zero bound problem in communication.

2.  The monetary base:

Lousy and at communicating policy stance, no zero bound problem in communication.

3.  NGDP futures prices:

Good at communicating policy stance, no zero bound problem in communication.

Can you guess which policy instrument I favor?

PS.  In this post Arnold Kling argues that monetary policy is endogenous.  Actually it’s both exogenous and endogenous.  The “partly exogenous” is an implication of the strong disputes that break out within central banks, the differing reaction function between central banks, the differing reaction functions within a central bank over time, and the market response to unexpected central bank actions.

Markets react strongly to monetary shocks—for good reason.

Kling also makes this comment:

Perhaps a few key Wall Street gurus interpreted the announcement as good news, because of (1) or because they are devoted followers of Scott Sumner or because of the meds they were on or whatever.

The easiest explanation is that markets aggregate information better than any individual, including me. That’s why I look to markets for interpretation, and why market monetarism keeps outperforming alternative models of the economy, such as those that predicted QE would be highly inflationary, or that the austerity of 2013 would sharply slow growth in the US.

Here’s Paul Krugman discussing Britain:

A couple of weeks ago I tried to get at what’s wrong with the latest tactic of the austerians in terms of a classic Three Stooges scene. Curly is seen banging his head against the wall; when Moe asks why, he replies, “Because it feels so good when I stop.”

And here’s a typical news story describing an American economy that is growing faster in 2013 than 2012:

Friday’s report of third-quarter GDP was the latest positive piece of economic news. Growth was revised up to 4.1 percent, the first above 4 percent and best-performing quarter since fourth- quarter 2011.

“There’s such good news on the economy, and I’m really encouraged about the 2014 outlook,” said Knapp, who now expects companies to show better revenue growth than they’ve been reporting in recent periods.

Joseph LaVorgna, chief U.S. economist at Deutsche Bank, said the third-quarter number could mean that fourth-quarter growth will be even better than the 3 percent he expects-a forecast that’s already more bullish than average.

“The numbers are looking really good,” he said. “On the GDP, the upward revision was all in demand.”

.  .  .

The third-quarter growth forecast was for it to remain at 3.6 percent, but gains in consumer and business spending pushed it up.There had been a lot of skepticism about the third quarter, as it was inflated by a big inventory number, and the concern was that there would be a giveback for that in the fourth quarter.

“Now that you have better sales, it makes the inventory numbers look even better because producers are building the inventories in anticipation,” LaVorgna said.

Thanks to Ben Bernanke for proving the cushion for America’s head.  Of course Ben is much too modest to take credit, and indeed late last year denied the Fed could provide an adequate cushion.

But he did.  🙂

I’ve been trying to work my way through John Cochrane’s recent post on money, inflation, and interest rates.  I don’t like the intro:

I’ve been following with interest the rumblings of economists playing with an amazing idea — what if we have the sign wrong on monetary policy? Could it be that raising the interest rate raises inflation, and not the other way around?

Most recently, Steve Williamson plays with this idea towards the end of a recent provocative blog post.

Cochrane implies that, according to conventional monetary economics, raising interest rates is deflationary, and that Williamson is one of the first to suggest otherwise.  But here’s Milton Friedman, discussing Japanese deflation:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

So it seems like Friedman agrees with Williamson.  A monetary policy that produces low interest rates also produces deflation.  And of course this is true.   And yet Friedman would have obviously been horrified by Williamson’s recent post.  Friedman’s views of the liquidity effect were fairly conventional.  At a minimum, Cochrane should have been more specific—how does the central bank raise interest rates? Cutting the money supply?  Or raising the inflation target to 40% per year?

Now in fairness Cochrane certainly does understand the liquidity effect/Fisher effect distinction I am making:

The first standard story was money. In the past, when the Fed wanted to raise rates, it sold bonds, cutting down on the $50 billion of non-interest-paying reserves. The standard story was, with less “money” in the economy and somewhat sticky prices, nominal interest rates would rise temporarily.  The less money would eventually mean less inflation, and then and only then would nominal rates decline. In this  view, running the Fed was a tricky job, like driving 68 Volkswagen bus in a crosswind, since the steering was connected to the wheels in the wrong direction in the short run.

An automobile metaphor.  No wonder Nick Rowe thought it was a good post!   But I don’t like the next paragraph:

However, we are likely to stay with huge excess reserves and interest on reserves. When the Fed wants to raise interest rates now, it will simply pay more on reserves and bingo, interest rates rise. We will remain as awash in interest-paying reserves as before. So this 1960s monetary mechanism just won’t apply. Is it possible that in the interest-on-reserves world, raising interest rates translates right away into larger inflation?

I think Cochrane is confusing “money supply model” with “monetarist model.”  The monetarist model is completely symmetrical vis-a-vis (permanent) changes in the supply or demand for base money.  Start with the basic graph:

The standard monetarist model uses basic price theory (aka hot potato effect) to argue that printing more money will reduce the value of money.  A lower value of money means a higher price level.  But the basic model is symmetrical.  If the Fed lowers the demand for base money, say via lower reserve requirements, that will shift the demand for base money to the left, which is just as inflationary as a increase in the money supply.  More supply or less demand for any asset will reduce the value of that asset, unless it is exchanged for a perfect substitute.

Of course interest on reserves (IOR) is just like reserve requirements, a Fed policy tool that can increase the demand for base money.

Now consider the impact on interest rates.  Monetarists assume that prices are not perfectly flexible in the short run.  Thus a decrease in the money supply will initially lead to “disequilibrium.”  I use scare quotes because the nominal interest rate will rise to equate supply and demand for base money in the very short run.  There is a disagreement between me and the other market monetarists as to whether it makes sense to refer to this situation as “disequilibrium” (they say yes, I say no) but that’s merely a semantic debate, no policy implications are at stake.

The tendency of a decrease in the supply of money to raise interest rates in the short run is called the “liquidity effect.”  For the exact same reason an increase in IOR raises market interest rates.  Higher IOR shifts the demand for money to the right.  Because the price level does not immediately decline, there is a short run excess demand for money, and interest rates will rise until the price level adjusts. Once prices adjust, interest rates will return to their original level.  Money is neutral in the long run.  You can also do the same exercise with rates of change, and get superneutrality in the long run (apart from some second order effects.)

So unless I am mistaken, Cochrane errs in assuming that the world of IOR cannot be smoothly handled by the conventional monetarist model.  Here’s the next paragraph:

More recent economic thinking has (rightly, I think) left the money vs. bonds distinction in the dust. The “Paleo-Keynesian” (credit to Paul Krugman for inventing this nice word) models in policy circles state that the Fed raises rates, this lowers “demand,” and through the Phillips curve, lower demand means less inflation. No money in sight here, but yes a negative effect. The first half of Steve’s blog post tearing apart the Phillips curve at least should question one’s utter confidence in that mechanism.

Here I disagree with both Cochrane and the NKs.  I like money in my models, and think it is no more similar to bonds than it is to a microwave oven.  But I’ll say this in partial defense of Cochrane.  Any (NK) economist who has jettisoned money from their model, and describes policy solely in terms of interest rates, has lost any right to get indignant about Cochrane and Williamson.  Without money it’s impossible to show that Williamson is saying anything different from what Friedman said about the Japanese back in 1998.  And Friedman was right.

PS.  Nick Rowe has an excellent post.  Nick keeps emphasizing that statements like “The Fed raises interest rates” make no sense unless embedded in a much more detailed and complete policy regime. What else changes between now and the end of time?

PPS.  Tyler Cowen’s link says the following:

6. John Cochrane defends Williamson on interest rates and inflation.

Yes, but just to be clear, Cochrane does not endorse Williamson’s claims.  He defends Williamson’s right to ask interesting and provocative questions.

PPPS.  Ed Dolan has a new post discussing market monetarism.

Matt Yglesias has a post on land taxes:

Last we turn to noncorporate business, which owns $9.704 trillion in real estate and has a replacement cost of structures of $4.786 trillion, giving us $4.918 trillion in land.

Add it all up and you get $14.488 trillion in land value.*

.  .  . 

So who cares? Well, you should care. This number is high enough that it tends to confirm that view that taxation of land and other natural resources, supplemented by pollution fees and things like congestion charges could replace all taxes on labor and investment and still fund an ample welfare state and public sector.

Here’s Greg Mankiw:

This NY Times story on the middle class’s struggle with the new healthcare law is generally pretty good, but this sentence struck me as comically meaningless:

Experts consider health insurance unaffordable once it exceeds 10 percent of annual income.

What the heck does this mean?  The typical American spends more than a third of income on housing.  Does that make housing unaffordable?  Presumably not.

I agree with Mankiw, but see an additional implication as well.  Health care is 18% of GDP in America.  I believe that’s about 22% of national income, perhaps a bit more.  So the sort of single-payer tax system supported by liberals would require taxes of about 22% of income on average, just for health care!  This makes a single-payer system completely unaffordable, according to the NYT.