Archive for June 2019


Believe whatever you like

Lindsey Graham has certainly raised some eyebrows since the death of his friend John McCain, by radically shifting his approach to politics. But give Graham credit for being honest about what’s going on, in this remark from 2018:

“I would imagine in a Democratic administration, I would be all over them for being in the pocket of Saudi Arabia,” Graham said of Mattis and Pompeo. “But since I have such respect for them, I’m going to assume they are being good soldiers.

In politics, people obviously believe what they wish to believe. Some Trump supporters would like to believe that Trump shares their opposition to the Fed’s recent “lowflation” policies. But does Trump actually oppose tight money? Or is he a secret NeoFisherian, who favors low interest rates because they are associated with low inflation?

The best way to answer this question is NOT to look at the statements of Trump himself, which are entirely incoherent. But I know that some of you disagree, and so I provide this recent quote for those of you that hang on his every word:

He followed up with a separate tweet, saying: “The United States has VERY LOW INFLATION, a beautiful thing!”

(Yes, I’m just joking around here, so don’t get on your high horse in the comment section. I have a more serious post on the same topic over at Econlog, which I recommend that you read.)

Don’t ease monetary policy; cut rates instead

David Beckworth directed me to a new piece by Jeffrey Frankel:

A Trade War is No Reason to Ease Monetary Policy

A trade war is a negative supply shock, and central banks cannot counteract the negative effects of current policies on real incomes in the United States, the United Kingdom, and many other countries. Only voters can do that

He’s right.  A supply shock does not provide a reason to ease monetary policy, as it’s an adverse supply shock.  The Fed should not boost AD to offset a supply shock.  Rather, it should prevent AD growth from changing by keeping interest rates at the Wicksellian equilibrium rate.  Because a trade war will generally reduce the equilibrium interest rate, the Fed should cut rates to avoid changing monetary policy.

PS.  Some (most?) economists believe that cutting interest rates is equivalent to easing monetary policy.  I find that horrifying.

PPS.  I was not able to read the entire Frankel piece, as it’s limited to subscribers.  But the opening bit is 100% correct.

The risks for Trump

I’m on record predicting that Trump will be re-elected. But the events of the last month give me a bit of pause. Here I’d like to present some of the risks facing Trump. In my view, there’s a likelihood that Trump will fail to achieve six of his primary objectives, to a greater extent than recognized by even his critics. Indeed, some of his critics say, “I hate the guy, but you’ve got to admit he’s doing what he promised.” But is he? Here are 6 key promises:

1. Raise trend RGDP growth (his biggest win, so far.)

2. Bring back manufacturing

3. Cut the trade deficit

4. Build a wall and reduce illegal immigration.

5. Build infrastructure

6. Repeal Obamacare

Some would add conservative judges (a Trump win), but here I’m focusing on the so-called “Obama/Trump voters” in Pennsylvania, Michigan and Wisconsin, who have never even heard of the Federalist Society. We don’t live in a democracy where 250 million eligible voters get to pick the president. The president is picked by a handful of relatively uneducated white voters in those three states, who voted for Obama and who voted for Trump. I’d prefer to call them “Biden/Trump” voters (they voted for Biden as VP), as I think the Dems would be foolish not to nominate someone who is acceptable to those voters. They will pick the next president.

As far as tax cuts, for average voters the tariffs may raise taxes almost as much as the 2018 tax bill cut them.

Trump has completely failed on Obamacare, infrastructure and the wall. He’s done nothing to reduce the trade deficit. Illegal immigration is soaring higher at an amazing rate. Indeed it’s rising so fast that total immigration to the US is now rising sharply despite a modest cut in legal immigration of high skilled workers caused by Trump making it harder for those people to get visas to study in America, or keep working here after graduation. So low skilled illegal immigration is soaring while skilled immigration is down modestly. Is that an alt-right success? The silver lining for Trump is that this will boost the monthly payroll jobs numbers (above what I anticipated) and even RGDP growth.

There was a modest boomlet in manufacturing during 2017-18, although nothing special. Since January, that growth has ended and I anticipate that manufacturing will remain weak through 2020. If I’m right then Trump will lose a big issue in those Rust Belt states. Trade wars are hurting manufacturing.

The bond market seems to expect RGDP growth to slow going forward, and I agree. I predict that trend RGDP growth will be back to Obama levels (i.e. 2%) by late this year and throughout 2020.

If I’m right, then by 2020 Trump will have completely failed on all 6 of the key Rustbelt issues. In fairness, the growth we have achieved so far has led to a very strong job market, and even with slower growth going forward I expect the jobs market to remain strong, with low unemployment. So that helps Trump sell his message, and he’s especially good at convincing his supporters that he’s getting wins when he is actually losing. (Let’s see if his supporters believe he won the recent Mexican standoff.) Plus, there’s a good chance the Dems will pick someone as annoying as Hillary, not a reassuring figure like Biden. I sometimes think the entire Democratic Party should be renamed “The Committee to Re-Elect the President.”.

So for the moment I continue to predict a Trump win. But this has been a bad month, especially the May surge in illegal immigration and lower yields in the bond market signaling slower growth ahead. This anticipated slowdown is partly, but only partly, due to Trump’s foolish trade war. Monetary policy is the bigger problem.


I am currently at a Fed conference called “FedListens”, which is evaluating options for improving monetary policy. One focus of the conference is the question of how best to address the zero bound problem. Here I’ll present a few initial impressions, based on the first paper (by Janice Eberly, James Stock and Jonathan Wright) and the following discussion. I should warn you that I may be misinterpreting the paper, but FWIW I’ll give you my impression of where I think it goes off course.

The authors argue that a negative 5% nominal interest rate would have been appropriate during the Great Recession, and then look at various counterfactual strategies for improving monetary policy, given the zero bound constraint. These counterfactuals include asset purchases, forward guidance, and a higher inflation target (3% or 4%), among others. The goal is to get the stance of policy closer to the negative 5% fed funds that would have been appropriate, if not constrained by the zero bound.

In my view, the basic mistake is to (implicitly?) assume that the need for a negative 5% fed funds rate was caused by an exogenous negative shock (something like the financial crisis, for instance), rather than excessively tight money during 2008, which sharply depressed NGDP growth expectations. If I’m right, then they underestimate the benefits of structural changes in monetary policy that lead to faster NGDP growth, and hence a milder recession. One of these benefits is that the real Wicksellian equilibrium rate would have fallen much, much less sharply.

Thus consider the counterfactual of a 6% inflation target. In a simple model where this policy counterfactual had no impact on the exogenous shock that reduced the Wicksellian equilibrium real rate, the Fed would still have had to reduce interest rates to negative 1% to achieve an appropriate real rate during the Great Recession. I find that assumption to be exceedingly implausible. In my view, even a 4% inflation target, and certainly a 6% target, would have prevented the Fed from ever hitting the zero bound. The extra NGDP growth expectations (both inflation and RGDP) caused by a higher inflation target would have prevented the equilibrium rate from falling anywhere near zero (see Australia), and thus none of the unconventional policy options would have been needed.

I believe this critique is related to John Taylor’s criticism of the paper, which was that they had not based their policy counterfactuals on a structural model.

The profession as a whole tends to have a Keynesian approach to these issues. The economy is inherently unstable due to “shocks”, and the Fed is a sort of fireman that comes to the rescue, by trying to depress rates to as close to the equilibrium rate as possible. In the monetarist framework (which is best explained in the work of Robert Hetzel), the Fed is more like an arsonist, creating nominal instability through monetary policy errors. Because wages and prices are sticky, this nominal instability creates labor market instability, which depresses investment and hence the equilibrium interest rate. A more effective monetary policy helps mostly by avoiding causing nominal shocks, not by reacting to instability in the private economy.

I don’t favor a 4% or 6% inflation target, but I believe a 4% or 5% NGDPLT would have had a similar stabilizing effect, which is not picked up in the paper presented.

Another way of putting things is that while most economists want to reduce interest rates to the Wicksellian equilibrium rate during a recession, I want to use asset purchases to raise the equilibrium interest rate.

Alternatively, this conference needs to take NeoFisherism more seriously. Although NeoFisherism as a stand alone theory is wrong, it’s a very useful critique of conventional macro. It reminds us that the ultimate goal should not be to get the policy rate as low as possible, but to create conditions where the equilibrium interest rate is much higher than it was in 2009. We need a regime that reduces the need to cut rates to below zero.

What would Japan have to do to achieve a 10% inflation target?

I do not expect Japan to adopt a 10% inflation target, nor do I think it’s a good idea. Nonetheless, it’s a useful thought experiment, which helps to illuminate some difficult to grasp ideas.

Let’s think about what Japanese interest rates and base money demand would look like with a 10% inflation target, assuming no IOR. Here are some plausible guesses:

1. Japanese interest rates would be roughly 10%, plus or minus 2%.

2. The Japanese monetary base would be roughly 5% to 10% of GDP.

I base the first estimate on the fact that real interest rates in Japan are currently close to zero, or perhaps slightly negative. With 10% inflation, real rates might fall slightly (due to the zero bound being lifted), or rise slightly (due to the taxation of nominal interest.) But history suggests that higher inflation expectations are mostly passed along as higher nominal interest rates.

One the second point, 5% is roughly the figure I’d expect, but given the unusually large Japanese demand for currency I put in 10% as an upper bound.

Now let’s think about where Japan is today:

1. Interest rates are roughly 0%.
2. The monetary base is roughly 100% of GDP.

Thus, to achieve a 10% inflation target the BOJ would have to raise interest rates to 10% and then cut the monetary base by 90% or 95%. After that initial cut, the base would rise by roughly 11% per year, assuming 1% trend RGDP growth and 10% inflation.

Now here is where things get confusing. Just raising interest rates to 10% and cutting the base by 90% will not magically produce 10% inflation; just as having millions of New Yorkers leave their house with umbrellas will not magically produce rain. It’s more the other way around. If you seed the clouds over New York to produce rain, then millions of New Yorkers will leave their house with umbrellas.  NeoFisherian meteorologists claim that you create rain by ordering New Yorkers to carry umbrellas, citing “equilibrium conditions”.  Market monetarist meteorologists claim you create rain by creating conditions where millions of New Yorkers choose to carry umbrellas.

Do you see the subtle distinction? It’s true that a non-coercive policy that indirectly causes millions of New Yorkers to choose to carry umbrellas will also cause rain, but a coercive policy of umbrella carrying will not work. Thus seeding clouds will cause rain, but having a crazy dictator say he will execute New Yorkers for not carrying umbrellas will not cause rain.

With monetary policy, you cause 10% inflation expectations with a credible policy to buy as many assets as needed to move market inflation expectations up to 10%. When is a policy credible? When the government actually intends to carry it out, whatever it takes.  In that case, you probably don’t have to buy anything. Indeed just the opposite—you reduce the monetary base.

A few years ago, the Japanese government adopted a 2% inflation target, but markets correctly understood that the Japanese government had no intention of doing whatever it takes to carry out the policy. And they were right. If the Japanese government had intended to do whatever it takes, then markets would almost certainly have seen that. Markets are not stupid; they can pretty easily see whether governments are serious or not. Or if they can’t, it doesn’t take long to figure it out.

Governments are like 3-year old toddlers.  They don’t have a poker face.  Their emotions are clearly written in their facial expression.

To summarize, asking whether QE “works” is like asking whether umbrellas imply rain.  It’s a meaningless question, unless put into some sort of context.

PS.  Try this:

1. Do umbrellas keep people dry?

2. On average, are umbrella carriers wetter than those not carrying umbrellas?

I don’t know about you, but on average my pants get wetter on days that I carry an umbrella (due to wind) than on days I don’t carry an umbrella (and it’s usually not raining).  So do umbrellas “work”?

QE is aimed at leading to faster NGDP growth.  But, on average, countries doing QE have slower NGDP growth than countries not doing QE.

Hospitals are aimed at keeping people healthy.  On average, however, people in hospitals are less healthy than people outside of hospitals.

Unfortunately, all these metaphors fall short by ignoring the role of expectations.  But it’s the best I can do.