Tim Duy has a good post explaining why the Fed is unlikely to opt for “overshooting.”

I was re-reading some of the recent overshooting debate and it occurred to me that it is comical that we are even having this discussion.  The Fed is not going to deliberately overshoot inflation, period. That train left the station long ago. So long ago that you can’t even here the rumble on the tracks.

The train left the station on January 25, 2012, with this statement by the Federal Reserve:

The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.

On that day, the Federal Reserve locked in the definition of price stability.  They locked it in specifically to prevent even the appearance they might deliberately overshoot as a result of extraordinary monetary policy.  They locked it in as a commitment device to tie the hands of future policymakers as they would need to justify changing the definition of price stability, presumably a very high bar for any central banker to cross.

That’s probably correct.  But it does point to some confusion at the Fed.  The Fed seems pretty committed to their dual mandate, but doesn’t seem to understand what it implies.  Let’s start with a simple policy rule.  Suppose the Fed never aimed for above target inflation.  Also suppose they aim for 2% inflation, on average.  In that case it would be a logical necessity for the Fed to never aim for below 2% inflation.  Which means that they would always have to aim for exactly 2% inflation going forward.

Now that is a defensible policy (although I would oppose it.)  But it certainly is not a policy consistent with a dual mandate.  It would be a single mandate inflation target (IT), pure and simple.  Fed officials often seem confused on that point. They talk about the need to aim for 2% inflation, even when unemployment is high.  But that means they are behaving exactly as they would behave if Congress had given them an IT single mandate.  In other words, they are behaving exactly as they would if their mandate was set by the right wing of the Republican Party. Even now, under Janet Yellen, the tapering and prospective interest rate hikes are aimed at boosting inflation back up to 2%.  The policy is exactly the same as it would be if the Fed did not care about unemployment at all.

I suppose 99% of people would look at this picture and see all sorts of grand conspiracies.  The Fed is in the back pocket of the bankers, the bondholders, the creditors, the coupon clippers.  But I’m different, I’m a hopelessly naive fool who actually thinks the Fed is trying to do a good job, but just lost its way.  And why do I believe the Fed is actually not corrupt, despite all the evidence pointing to their violation of the dual mandate over the past 5 years?  Two reasons:

1.  The top Fed officials tend to be economists.  Both actual voters like Bernanke and Yellen, and also the all important staff people who set the agenda.

2.  As far as I can tell the vast majority (not all) of economists who are not at the Fed, who have no financial interest at all in helping bankers, even economists who favor increased welfare spending, a higher minimum wage, help for the unemployed, and all sorts of other left wing causes, seem equally confused about monetary policy as the economists who are at the Fed.

So one possibility is that clueless economists join the Fed, and instantly become both highly intelligent and corrupt at the same moment.  That’s what the critics who call me naive seem to think.  However I think it much more likely that when they join the Fed their competence and honesty don’t change very much. They are trying their best, and making the same mistakes as their private sector counterparts make when asked about monetary policy.  They think it’s “natural” that we have deflation in a deep slump like 2009, whereas their mandate actually implies that inflation should be countercyclical; above target when unemployment is high, and vice versa.

If this interpretation seems naive, then I plead guilty.

PS. Tim Duy has another good post on this subject:

If the most dovish member of the FOMC can tolerate no more than a 25bp upside miss on inflation, what does it say about the other FOMC members?  Regardless of whether this is Kocherlakota’s max or the best he thinks he can get, it tells you that 2% is really a ceiling, not a target.  Now, generously, it maybe that the FOMC believes that they cannot exceed 2% politically given the amount of extraordinary stimulus already in place.  But that still leaves 2% as a ceiling.

PPS.  I do realize there are lots of other interpretations (none good.)  For instance, the bubbleheads may have gained influence, and the worry about bubbles may be roughly offsetting worry about unemployment, leaving us with a 2% inflation target (which we will likely fall short of.)

HT:  Travis V

I was teaching the money multiplier the other day, and showing how lower interest rates tend to reduce the multiplier, and hence M1.  A student asked for clarification—they’d been told that lower interest rates were expansionary.  I knew how I was going to answer the question, but I sort of wondered how other (less heterodox) money and banking professors would respond to the question.  (Let me know in the comments.)  In any case here’s my answer.  First let’s see why low rates are contractionary:

A fall in interest rates will increase the demand for base money (here I assume no IOR, or at least a fixed IOR.)  As money demand increases the value (or purchasing power) of a dollar bill increases. Here I use the standard 1/price level as the value of money, although I actually prefer 1/NGDP.

So that’s the answer.  But of course that’s not a sufficient answer for a student; you also need to explain to students why they had the false belief that low interest rates are expansionary.  So I draw another graph, this time showing the case where lower interest rates are caused by a fall rise in the monetary base.

In this case the supply curve moves first.  In the very short run we assume prices are sticky, so the interest rate must fall to equilibrate Ms and Md. In the long run expectations of higher future NGDP cause an increase in current AD. When all wages and prices have fully adjusted to the increased money supply, interest rates return to their original level, and the demand for money shifts back.  The value of money falls to point C, which means prices have risen.  So the myth that low interest rates are expansionary comes from the fact that in some cases low interest rates are caused by an increase in the base.  In that case the base is the expansionary impulse, and the accompanying fall in interest rates actually delays the inflationary impact of the higher money supply (point b).

What would be an example of the first case?  That’s easy.  Between August 2007 and May 2008 there was no change in the monetary base, and yet interest rates fell sharply.  Not surprisingly NGDP growth slowed and we tipped into recession.

Nick Rowe has a new post that argues the money supply is fully exogenous, even when the central bank is targeting interest rates.  I’m not sure I fully understand the post, but I’ll attempt to translate his argument into Ms/Md graphs, and then see if he corrects me.

Most students are used to a Ms/Md graph with interest rates on the vertical axis, not 1/P.  Suppose there was an increase in the demand for credit, Md shifted to the right on the interest rate graph, and the Fed had to raise the quantity of money (“money supply”) enough to keep interest rates from rising.  That’s what most people think of as “endogenous money.”  Here’s Nick:

P and Y will (eventually) adjust until the quantity of money demanded equals the quantity of money created by the supply (function) for money and the demand for loans. The supply (function) of money, and the demand for loans, together determine the quantity of money created, and that quantity created (eventually) determines the quantity of money demanded.

I believe Nick is saying that if the central bank increases the quantity of money to accommodate the loan demand (and hence keep interest rates from rising) that will boost AD, which will raise P and Y.  If you use my graph above, he seems to be saying that just because Md shifts right on an interest rate graph, doesn’t mean it shifts right on a Ms/Md graph with 1/P (or 1/NGDP) on the vertical axis. Instead on that graph only the Ms line shifts right, causing you to slide down to the right on the stable Md curve (point C on my graph.)  That’s what he means by more quantity of money demanded.

In other words, interest rate targeting creates a money supply function that causes quantity of money changes that are exogenous on a “1/P” graph, and hence the normal monetarist assumptions about money still hold.  I think that’s a good way to think about the whole “endogenous money” issue (which has spawned more nonsense than almost another other topic in economics.)

PS. I’m never too sure what the MMTers are trying to say, but in comments to my blog they seem to claim that if for some weird reason the Fed were to do an exogenous increase in M, interest rates would fall, we’d go to point b, and just stay there.

Over at Econlog I have a post discussing why most highly educated people have never heard of policy proposals that would provide clear benefits to humanity, but are very aware of policy proposals with dubious merits.  That is because only the latter group of policies gets debated in the media.  If everyone agrees then there is nothing to debate, and hence people don’t know about the ideas.

There is also another group of policies that get ignored, those where both the right and the left find the proposal to be completely beyond the pale.  In the US those proposals tend to be related to our puritanical approach to drugs, alcohol, sex, etc. One example is heroin legalization, combined with public treatment facilities for addicts.  Here is a British publication that is willing to “defend the indefensible.”

THE death of Philip Seymour Hoffman from a heroin overdose on February 2nd left the extraordinary actor’s fans distraught. Artists have always been prone to self-destruction, and no one knows how to change that. Drug-abuse experts do, however, have a good idea of how to stop more people from destroying themselves by injecting heroin.

Over the past two decades many have come to favour tackling heroin abuse through “harm reduction” policies, rather than tougher policing. Many governments have decriminalised personal use and provided free therapy programmes, using drugs such as methadone and buprenorphine that block heroin’s high. Two other proven ways to reduce harm, however, are more politically controversial: setting up safe sites where users can inject while monitored by health-care staff, and””for registered addicts who cannot or will not comply with treatment regimes””providing heroin itself free.

Switzerland and the Netherlands pioneered this “Heroin Assisted Treatment” (HAT) approach in the 1990s, and both countries later adopted it as national policy. HAT trials have also been run in Spain, Britain, Germany and Canada. The evidence suggests that HAT slashes heroin-related deaths and HIV infection, since users are shooting up under medical supervision. It also drastically reduces heroin-related crime, since addicts have no need to steal or sell their bodies to get money for their fix. Some studies find that HAT actually works better than methadone or buprenorphine. Heroin use is falling steadily in both Switzerland and the Netherlands; by the late 2000s the Dutch incidence of new heroin users had fallen close to zero, and the ageing population of addicts from the 1970s and 1980s continues to shrink.

Decriminalisation of marijuana use has also played a role in limiting Dutch heroin use, since it separates the use of cannabis from the use of harder drugs. More interestingly, harm reduction including HAT appears to lead to lower illicit heroin consumption, in part because free government heroin drives out private-sector providers. When addicts shoot up in safe rooms monitored by public-health staff, where they are recruited into treatment programmes or (if they fail or refuse) simply receive free heroin, it gradually erodes the market for dealing the drug. As they say in the tech world, you can’t compete with free.

PS.  I realize that ‘legalization’ is not quite the right term here, but neither is “decriminalization,” which implies a non-prison penalty such as a monetary fine. These countries have no penalty at all for heroin use, just a requirement that the drug be used in safe (actually “less dangerous”) conditions.

PPS.  “Harm reduction” is a nice utilitarian concept.  Unfortunately the countries in northern Europe are well ahead of the US in utilitarianism, which I regard as the most important difference between civilization and barbarism.

Changes in aggregate demand impact housing, retail sales, industrial production, business investment and exports.  Those are all components of RGDP.  Aggregate demand also affects prices.  Both RGDP and prices are components of NGDP.  So in a sense NGDP is the most comprehensive measure of AD.  It’s the total dollar value of all spending on all domestically produced final goods and services.  Today the Fed moved away from using unemployment as a policy benchmark, and towards … well you decide what they are moving towards:

The Fed on Wednesday reaffirmed its plan to keep short-term rates low to help support the economy. But it no longer mentions a specific unemployment rate that might lead it eventually to raise short-term rates. The Fed says instead it will monitor “a wide range of information” on the job market, inflation and the economy before approving any rate increase.

Hmm, what single variable contains the widest range of information?

By the way, both the Fed and the BoE have come under criticism for abandoning their unemployment rate thresholds.  I half agree and half disagree.  I certainly believe that the unemployment rate is something that central banks should NOT be targeting.  However I’m also bemused by the specific criticism—that the Fed and BoE had to abandon the thresholds because right after the thresholds were adopted the unemployment rate fell much faster than anyone expected.  Wasn’t the purpose of forward guidance to make the unemployment rate fall much faster than it had been falling?  So if it does exactly that, and they are able to shift to new and more ambitious goals, is that really a policy failure?  Especially if this faster than expected fall in unemployment is associated with an acceleration in RGDP growth during a period of fiscal austerity?

With failure like that who needs success?

PS.  Obviously I would have preferred they adopt more explicit guidance, and hence agree with Narayana Kocherlakota’s dissent.

PPS.  Did Yellen say anything to cause the secondary dip in stock prices?

Over at Econlog I have a new post discussing the legacy of my favorite economist—Milton Friedman.  Here I’d like to discuss how my view of macro has been shaped by Robert Lucas and Eugene Fama, two other famous Chicago economists.  In some ways these are odd choices. I focus on demand-side models of the business circle, and Fama seems to think AD doesn’t matter.  And I never even took a class from Fama. I did take several classes from Lucas, and he was my PhD advisor.  But I never really bought into his “microfoundations” approach to macro.  My “musical chairs” model of unemployment is about as far from Lucas as you can get.  He’d be horrified.  But great ideas can show up in all sorts of surprising and unexpected places.  And even though I think that Lucas and Fama overestimate the flexibility of labor markets, I believe they are right on the mark in some other important areas.  Here’s what I learned from Lucas:

1.  The long run is now:  I used to have a lazy belief that the term “in the long run” meant something like “in the future,” and short run meant the present, or very near future.  Lucas taught me that the long run is (also) right now.  The term ‘long run’ refers to situations where factor X effects factor Y with a long delay.  It has nothing to do with present and future.  And yet I often hear even professional economists talk as if the term “in the long run” meant in the future.

Here’s one example.  The short run effect of monetary policy is called the liquidity effect.  A change in the money supply causes interest rates to move in the opposite direction, in the short run.  The long run effects of monetary policy are called the income effect, the price level effect and the expected inflation (Fisher) effect.  These three effects all cause interest rates to move in the same direction as the money supply.   If you erroneously thought that “short run” meant “now” you would interpret any current change in interest rates through the lens of the liquidity effect.  That is, you’d assume falling interest rates reflect an easier monetary policy, and vice versa.  Lucas taught me that what’s going on right now is equally likely to be the long run effect of policies that happened earlier.  Thus falling interest rates might just as well be the long run effect of an earlier tight money policy.  How can you tell which is which?  Ben Bernanke says you look at NGDP growth and inflation.  And what happened to those two indicators in 2008-09?

2.  Think regimes, not discretionary policy choices:  It’s tempting to debate monetary policy without reference to a policy regime. People debate “what should the Fed do now,” as if the question makes sense in the absence of a clear policy framework.  Now in fairness there are some policies that are so obviously bad, under such a wide range of plausible policy regimes, that it’s tempting to just come out and say “money is too tight” (i.e. 1931) or “money is too easy (i.e. 1979).  But in most cases the discussion pits one plausible policy against another, with no agreed upon destination.  Unfortunately people play lip service to the need for clear policy rules, but in practice they don’t buy into this approach because they don’t trust policymakers to have the right policy rule.  Thus the Fed minutes show a confusing debate over how best to get to the right destination, among policymakers who don’t even agree on the correct destination.

And people may have good reason for not trusting the policymakers to adopt the correct rule, look at the BOJ in the 1993-2012 period, and the ECB in recent years, both clearly aiming at the wrong policy target.

3.  Rational expectations:  It makes no sense to have a model of the economy that assumes X, but which is filled with people who believe “not X.”  As Bennett McCallum pointed out this idea is better called “consistent expectations,” as the term “rational” has all sorts of connotations that have nothing to do with the public’s expectations being consistent with the model of the public’s behavior.  Rational expectations also underlies the “Lucas Critique,” the idea that a statistical relationship that is true under one policy regime, may not hold up if the policy regime is altered to take advantage of that statistical relationship.

4.  The “voluntarily unemployed” might still be miserable:  If someone loses a job as an accountant and turns down an open position at McDonalds, they might be considered “voluntarily unemployed.”  That makes me agree with Lucas that the term is pretty much useless.  I’d add that I don’t find either side of the “deserving/undeserving poor” debate to be making useful arguments, for similar reasons. I focus on how policy affects outcomes, and leave to God the question of who is or isn’t deserving of more out of life.

Fama is famous for the efficient market hypothesis, which underlies several important pieces of market monetarism, or at least my peculiar version of MM:

1.  No wait and see:  When a new policy initiative aimed at boosting AD is announced, it makes no sense to “wait and see” if it will work. The market reaction immediately tells us the expected impact of the policy, and anything different that occurs will reflect unexpected shocks that violate the “ceteris paribus” assumption.  If the Fed was expected to cut rates by either a 1/4% or 1/2%, and the fed funds futures market assigns probabilities to each outcome, then the actual response of TIPS spreads and stock prices to the policy announcement tells us almost all we will ever learn about the policy.  If we had a NGDP futures market we could even do better, but the markets we do have give us a pretty good idea of the impact of unexpected policy announcements.

2.  Target the futures price of the policy goal:  It’s silly to have intermediate targets such as the fed funds rate, or the exchange rate. Simply adjust the monetary base as necessary to keep the futures price of the policy goal variable on target.  But of course first you need to create a futures market for the policy goal variable (preferably NGDP.)

3.  Bubbles?  No such thing:  Or more precisely the bubble theory is completely vacuous–it doesn’t help us to better understand the world around us.  When house prices soared in the early 2000s in Canada, the US, Australia, New Zealand and Britain, people cried bubble. That did not help me to understand why in Australia they later soared even higher, in the US they plunged lower, and in the other three they mostly moved sideways.  When Bitcoin soared from $1 to $30, people cried bubble.  That told me nothing useful about why prices later rose to $1000 and then fell to $600.  When Robert Shiller said stocks were a bubble in 1996, it told me nothing useful about the future path of stock prices.  And I could go on and on.

4.  Ignore the financial system:  I know what you are thinking.  “Wait a minute—surely Fama never said to ignore the financial system, that’s what he spent his whole life studying.”  But he did understand that money (MOA) and credit are completely different entities.  He suggested that the Fed could stabilize the price level (and by implication NGDP) simply by controlling the currency stock.  In a sense he was talking about control of the monetary base, but in those days the base was almost entirely currency and required reserves, and he thought reserve requirements were a silly regulatory policy that could be dispensed with.  So control of the stock of currency was all you need in order to control the value of currency.  And since the value of currency is (by definition) the inverse of the price level, that’s all you needed to control the price level, or any other nominal aggregate.  Monetary theory without banking and finance—the 2008 financial crisis shows us how important it is to divorce these concepts.  Economists who see them as being linked got 2008 all wrong.  They thought the real problem was banking distress, when in fact the real problem was nominal (GDP.)

MMTers should not read Fama’s currency paper; it would give them a heart attack.