Steve Williamson has a very good post on the Phillips curve and the Fisher effect.  Because I have been encouraging macroeconomists to stop paying attention to inflation and start focusing on NGDP, I’m all for any and all attempts to mock inflation-oriented models like the Phillips curve.

Towards the end he suggests that if we want to avoid Japanese-style nominal stagnation we will have to raise interest rates.  Yes, but how?  The ECB tried that strategy in 2011 and the eurozone went right back into a double-dip recession. Then they had to cut rates to prevent the eurozone from collapsing.  So I think we can all agree that the ECB’s way of getting to higher interest rates is far from optimal.  And yet there is some truth to Williamson’s claim that a higher inflation equilibrium will involve higher steady-state interest rates than would a lower inflation equilibrium.  But how do we get there?

The explanation is a bit complicated, so first I have to make sure that all readers accept the proposition that the reason we have 2% inflation in recent decades is not luck, and not fiscal policy, but rather monetary policy.  Other long run inflation rates are feasible. We had zero inflation on average in the gold standard period. We had 8% inflation in the 1970s. In recent decades we have 2% trend inflation and not 0% or 6% or 16% because the central banks of the world decided 2% was the right number. God knows it wasn’t fiscal policy, Reagan greatly expanded the deficit in the early 1980s just as Volcker was bringing inflation down.  Can you imagine Congress trying to target inflation at 2%?  I believe the technical term is “ROFL.”

Why the emphasis on inflation?  Because I’m going to talk from here on out like central banks control inflation, and by implication NGDP growth, at least in the long run when interest rates are positive.  If that is true, then I define an easy money policy as a policy that will lead to higher expected price levels and NGDP ten years out, and a tight money policy as policies that will lead to lower expected price levels and NGDP ten years out, as compared to before the new policy is announced.  And this brings us back to the ECB policy failure of 2011.  The reason their policy failed is that they tried to raise interest rates with a tight money policy, whereas they should have tried to raise interest rates with an easy money policy.  How do we know it was a tight money policy? Two reasons:

1.  They said so.

2.  They adjusted their policy instruments in a way that modern central bankers and asset markets recognize as having “contractionary intent.”

You might think “contractionary intent” sounds a bit metaphysical, but it is actually pretty important, as Michael Woodford showed that what really matters is not the current setting of the policy instrument, but rather changes in the expected future path of that instrument.  Markets know that central banks determine the long run path of inflation or NGDP growth, and they care a lot about just where that path is set.

I still haven’t answered the question of how you raise rates the right way.  Clearly it makes more sense to raise rates via the expected inflation and income effects (expansionary) as compared to the liquidity effect (contractionary.)  Yes, but how do you do that, and how quickly can it be done?

Unfortunately the liquidity effect is quicker, indeed essentially instantaneous.  The other effects take longer, at least at the short term end of the yield curve.  I’ve often seen monetary shocks immediately affect long rates via the income and Fisher effects, but rarely short rates.  The shortest term I ever recall being dominated by the Fisher and income effects was the 3 month T-bill yield, which fell on a tighter than expected monetary policy announcement in December 2007.  But that was unusual.

As far as the how to raise interest rates question, that’s pretty easy.  You simply target the price of NGDP futures along the desired growth path, and let markets determine the monetary base and interest rates.  I believe interest rates would rise in a fairly short time with a 5% NGDP (level) target, perhaps a year or so. But it’s not really important how long it takes, because just as inflation doesn’t matter, nominal interest rates also don’t matter.  Only NGDP growth matters.

PS.  There is nothing unusual about the ECB’s failed attempt to raise rates in 2011. The exact same thing happened in Japan in 2000, and again in 2006.  The same thing happened in the US in 1937.  It’s what central bankers do; premature ejection from the zero rate bound.  They are as anxious to tighten as a 16 year old boy.  The markets need a lot of sweet talk first.  Some forward guidance.  Easing. You know what I mean.

PPS.  Tyler Cowen recently made the following comment about money neutrality:

Milton Friedman, some time ago, wrote that money was for the most part neutral, and that the new money rapidly mixes in with the old.  That made sense to me at the time, and it nudged me away from Austrian views, yet we have seen decidedly non-neutral effects from the various QEs and the periodic taper talk. –

This puzzles me.  Friedman and Schwartz’s famous Monetary History was devoted to showing that monetary policy has non-neutral effects on output and asset prices.  The Great Depression was one example they cited.  Friedman favored QE in Japan precisely because he believed its effects would be non-neutral.  So unless I have misunderstood Tyler, I think he misinterpreted Friedman.  Perhaps he was thinking of long run neutrality, which I think almost everyone accepts.

Over the years my critics, and even some of my supporters, have said; “Sumner is basically proposing higher inflation as a solution.”  That was never really true, I was proposing 5% NGDP, level targeting.  And even though inflation would have been above 2% in the 2008-11 period, a stable NGDP policy would have prevented that inflation from having the sort of negative effects that economists see as resulting from high inflation.  My plan would not have hurt savers, in aggregate.

Even so, there was a grain of truth in the claim.  The inflation rate would have run above 2% for a number of years under my proposal.  But now even that is no longer true.  There have been enough wage/price adjustments to the lower NGDP growth rate that the SRAS has been shifting to the right.  This means that today even a 2% inflation rate would produce a robust recovery.  But we aren’t even getting that inflation rate, indeed Bloomberg reports that the rate has fallen to 1%:

Bond investors are signaling they expect the Federal Reserve to lose its battle against disinflation, even after inundating the U.S. economy with more than $3 trillion in the past five years.

While central banks around the world are trying to spur demand and boost prices, signs are emerging that a slowdown in inflation is becoming entrenched. Treasury Inflation-Protected Securities are suffering unprecedented losses after inflation in the U.S. rose 1 percent last month, the smallest increase since 2009. Known as TIPS, the bonds have plunged 8.8 percent this year, the most since they were introduced in 1997, according to Bank of America Merrill Lynch indexes.

“The idea that central banks can always get the inflation rate they want is something that’s going to pass away,” Peter Fisher, the former Fed official and undersecretary for domestic finance at the U.S. Treasury, who now serves as senior managing director at BlackRock Inc., said in an interview on Dec. 9. “We could be at a 1 percent inflation rate for a long time.”

In a recent post Andy Harless suggested that it was obvious that nominal interest rates were lower than expected NGDP growth.  I’m not sure why he makes that claim.  NGDP has been growing at 4% during a period when the unemployment rate is falling at 0.7% per year.  Once unemployment stops falling (around 2016) the growth rate of NGDP will likely slow even further, to below 3.5%.  And 30 year bonds are currently yielding about 3.85%.  Yes, the inflation rate may rise a bit at that point, but it’s not at all clear to me that 30 year bond yields exceed 30 year NGDP growth expectations.  The markets seem to have read The Great Stagnation.

PS. That doesn’t mean Andy is wrong.  It’s quite possible that countries would benefit from issuing more safe assets and using the funds to buy global stock index funds.  Or subsidizing low wage jobs.  I’m agnostic on that question.

HT:  James

Here is Free Exchange:

SLOVENIA’s banking bail-out announced on December 12th followed a familiar pattern. Having driven over the edge thanks to reckless lending, the country’s three big banks are being hauled back onto the road by taxpayers.

Now this is certainly an interesting coincidence.  At the same time that Atlanta and Phoenix banksters were engaging in Reckless Lending in America, the same thing was occurring in small far-away formerly communist country, with a very different economic system.

And in an even more shocking coincidence, the same thing was going on in Greece.

And in Latvia.

And in Spain.

And in Britain.

And in Iceland.

And in Cyprus.

And in Ireland.

.  .  .

.  .  .

etc, etc.

Or perhaps this is a lazy explanation.  Could there be some sort of common external shock that economic theory predicts would cause Reckless Lending in a large group of countries?  Yes, the biggest fall in NGDP since the Great Depression.

“So are you saying . . .”

Here’s precisely what I’m saying:

1.  There was some reckless lending (no caps) in America and a few other places.  Nothing catastrophic.

2. When oil prices soared in 2007-08, central banks responding to rising headline CPI inflation with tight money, which slowed NGDP growth sharply in the first 9 months of 2008.

3.  The sharply falling NGDP growth made the banking crisis much worse, driving the Wicksellian real equilibrium rate so low that even with a 2% inflation target equilibrium nominal rates fell to zero.

4.  Central bank error #2, they cut rates far too slowly during this period.  Especially in Europe.  Now NGDP plunged sharply in late 2008 and the financial crisis became much more intense.  Suddenly even more Reckless Lending was exposed.

5.  When rates finally hit zero at the end of 2008 in the US (but not in Europe), the Fed had no backup plan to maintain NGDP growth.  They did not do what Bernanke had told the Japanese they must do. Now NGDP fell even further, the financial crisis got even worse.  More Reckless Lending was exposed.

6.  Because the eurozone budget deficits got much worse, fiscal strains appeared in places like Greece, which really had done some (sovereign) reckless borrowing.  Or should we call that reckless lending by the Germans, in order to be consistent?

7.  Time to raise those VATs, so that the sovereign debt crisis doesn’t get even worse.

8.  Higher VATs raise inflation in the eurozone.  The ECB must focus like a laser on keeping inflation around 1.9%, unless of course it is lower than 1.9%, in which case inflation should be ignored and attention should switch to stopping “bubbles,” which are of course easy for government bureaucrats to spot.  But I’m getting ahead of myself.

9.  The higher VATs raise headline inflation, and the ECB in its infinite wisdom decides to target inflation inclusive of VAT at a time of fiscal austerity.  They raise interest rates twice in 2011, and a double-dip recession ensues.  Right out of the 1937 playbook—tight fiscal and tight money.

10.  Now the debt crisis gets even worse, as it always does when NGDP growth plunges.  Even more Reckless Lending by the Germans.  And they didn’t just Recklessly Lend to Greece, they Recklessly Lent to Spain and Italy and Portugal and Ireland.  No bailouts for governments (that creates moral hazard) but Irish banks that borrowed from the Germans must of course be bailed out.

10.  And now Slovenia.  And we are asked to believe the explanation is simply Reckless Lending.  A bizarre epidemic of Reckless Lending suddenly appeared all over the world at roughly the same time.  Wildcat banks in the American sunbelt.  Sober German banks.  British banks.  Irish banks.  Spanish banks.  Cypriot banks.

And now Slovenian banks.  And all this at a time when NGDP plunged.  And economic theory predicts that plunging NGDP would cause a big increase in debt defaults.  And economic theory suggests that central banks are supposed to prevent NGDP from plunging.

Especially when not at the zero bound.

And the ECB has been above the zero bound for more than 95% of the time over the past 5 years.

So how do you prevent reckless lending from occurring?  It’s impossible, but a reduction in regulations generating moral hazard would help.  How do you prevent an epidemic of Reckless Lending?  Simple, a 5% trend growth target for NGDP, level targeting.

PS.  The snark is not aimed at P.W., who is only expressing the conventional wisdom.

PPS.  Just to be clear, when I say tight money causes “Reckless Lending,” I mean tight money causes NGDP to fall, which causes defaults, which causes loans that were not reckless at the time to later be perceived as reckless.

I’ve been reviewing the editor’s proofs of my Depression manuscript (don’t ask) and I suddenly felt a sense of deja vu.  Britain left the gold standard on September 20, 1931 (the crises are always September or October—1929, 1931, 1937, 1987, 1992, 2008, etc).  And then everything started falling apart.

But not right away.  Stocks in the US did fall on September 18-19 as rumors of the devaluation leaked out, but then stocks actually rose modestly over the next few days.  And then the US stock market crashed.

Why?  And why the delay?

Now flash forward to the Lehman failure.  Stocks fall in September 2008 due to Lehman, but nothing disastrous.  Then the stock market collapses in the first 10 days of October, and zig zags much lower up until March 2009.

Why?  And why the delay?

It turns out that the dynamic was very similar on each occasion.  The initial shock in 1931 was worrisome, but not by itself a major factor.  Then a few days after the British left gold a run on the dollar began (fear of devaluation), and massive gold and currency hoarding commenced.  Gold and currency were the dual media of account.  Massive hoarding means a massive increase in demand for gold and cash.  Econ 101 says an increase in the demand for any asset makes that asset more valuable.  But the nominal price of the media of account cannot rise.  So the only way for them to increase in value (in real terms) is for the price level to fall.  And commodity prices did plunge during this period.

In 2008 the Lehman event was worrisome, but not catastrophic.  Then it gradually became apparent in early October that demand for liquidity was soaring.  Even worse it became clear that the world’s major central banks were not willing to cut interest rates sharply enough and/or supply enough liquidity to prevent NGDP expectations from plunging. And despite Bernanke’s insistence that the Fed should never let the US fall into a Japanese-style liquidity trap, we did.  Even worse, the Fed adopted IOR in early October and stock prices crashed.  Then they raised IOR a few weeks later and stock prices crashed again.  Then they raised IOR a few weeks later and stock prices crashed again.

In both cases the delayed stock crashes and severe output declines and severe financial distress all had the same cause—falling AD caused by bad monetary policy.  The 1931 event was actually slightly more excusable—the gold standard was a constraint on policymakers.  Fiat money banks have no excuse at all. Especially fiat money central banks that continued to raise and lower interest rates over the next few years, and hence were able to avoid the zero bound trap.  I.e. the ECB.

The press tends to treat foreign countries as a sort of “freak show.”  “Look at all the bizarre things going on in China!”  Or Japan, or Saudi Arabia, or Zimbabwe, or Turkmenistan.

But they have a blind spot for bizarre activities closer to home.  Imagine a country where:

1.  Gambling is illegal in many states, because it’s harmful, and yet the government of most of those states run enormous numbers rackets.

2.  Prostitution is illegal, allegedly because it exploits women.  But the police then imprison the victim and let the villains go scot-free.

3.  The public is so horrified by the thought of people getting high that they imprison hundreds of thousands of drug users, but then turn around and elect three consecutive former dope-smokers as president.

4.  A 20 year old soldier who has returned from Afghanistan cannot legally walk into a bar and drink a 3% alcohol beer.  A couple of 20 year olds can’t legally drink a glass of champaign at their wedding.  But a 16 year old boy can legally drive a 2 ton SUV down the highway at 110 kilometers per hour.

5.  Many people have to pay stiff penalties for being married, sometimes as much as $10,000 per year.  But the penalties don’t apply to people “living in sin.”  Or gay married people in 2010, 2011, 2012.

6.  Landlords face severe penalties for renting apartments with lead paint to families with children, yet neighbors in single family homes face no penalty for raising their own kids in a high lead environment.

7.  Farmers are paid to not grow food.

8.  Unlicensed economists are allowed to run the central bank, and yet you need a license to be an interior designer or a hair dresser.

9.  One of the two major parties thinks monetary policy is wildly inflationary, despite the fact that inflation is running at the lowest level in decades.

10.  And it’s a country where most economists don’t know how to debase a fiat currency.

Americans should take heart from the fact that all countries are freak shows.  But people generally can only see the freakishness of other places, not their own.

PS.  Of course no one can compete with this country.