Archive for November 2019


Two views of the Phillips Curve

The standard (Keynesian) view of the Phillips Curve is that a strong economy leads to higher inflation. If I’m not mistaken, Milton Friedman reversed the causation, arguing that higher than expected inflation led to a stronger economy:

There is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off. The temporary trade-off comes not from inflation per se, but from unanticipated inflation, which generally means, from a rising rate of inflation. The widespread
belief that there is a permanent trade-off is a sophisticated version of the confusion between ‘high’ and ‘rising’ that we all recognize in simpler forms. A rising rate of inflation may reduce unemployment, a high rate will not.

That’s also my view of causality, although I think inflation is the wrong variable.  The model should use the rate of growth in NGDP, not prices.

Here’s Nick Rowe:

Andy Harless’ tweet (about the US economy) got me thinking.

There’s a frog-boiling aspect to this economy. The consistent lack of *rapid* improvement throughout the recovery is enabling us to reach levels of employment that might not otherwise have been attainable.

It reminds me of my old post “Short Run ‘Speed Limits’ on recovery“.  The basic idea is simple: actual inflation (relative to expected inflation) might depend not just on the level of employment (relative to some unknown level of “full employment”), but also on the speed at which employment increases.

I’ve added an epicycle to the Phillips Curve that I think makes it fit the facts better. But I added that epicycle 10 years before the facts that Andy’s tweet asks us to explain. And it’s based on an idea that make sense, and goes back further still:

It’s difficult and costly to increase employment quickly, and easier and cheaper to increase employment more slowly, even for the same cumulative increase in employment. So if demand for output suddenly increases by (say) 10%, individual firms will raise prices and wages relative to the prices and wages they expect at other firms, or raise them more than they would otherwise have done if demand for output had slowly increased by that same 10%. Even with no underlying trend growth in productivity. Even with the same average level of demand for output.

There’s another way of thinking about this question.  Inflation is not determined by economic slack, rather it’s determined by monetary policy.  When monetary policy is highly expansionary and prices rise much faster than expected, then output tends to rise rapidly.  That’s Friedman’s view.  Thus it’s no surprise that a subdued rate of inflation is associated with a slow recovery.  Phillips curve models that predicted otherwise, i.e., mainstream Keynesian models, are simply wrong.

I do believe that Andy and Nick are making valuable observations here, albeit not because they provide a useful tweak to Phillips curve theory.  It’s better to simply drop the Phillips curve and focus on other models, such as the relationship between unexpected NGDP growth and changes in employment.

Instead, Andy and Nick are showing that the natural rate of unemployment is a slippery concept.  If inflation is stable (or better yet if NGDP growth is stable), then the economy will gradually move toward its natural rate.  Because of costs of adjustment, however, the fact that unemployment is currently above (or below) the long run natural rate does not mean that monetary policy is off course, even if inflation (or NGDP growth) is exactly on target, and even if the Fed has a dual mandate.  Monetary policy is off course if expected future inflation/employment outcomes are not consistent with the Fed’s dual mandate, as was the case during 2008-16

During 1933, both prices and NGDP rose rapidly, and yet unemployment was roughly 25%.  Now you could certainly argue that even faster nominal growth would have been desirable.  But even with appropriate monetary policy, unemployment in 1933 would have been well above any reasonable estimate of the natural rate.

Some people argue that the current 3.6% unemployment rate shows that money was too tight a couple years ago, when unemployment was 4.1%.  That’s not the case.  Money might have been slightly too tight in 2017, but only because inflation was also running a bit below target.  The optimal unemployment rate might well have been 4.1% in October 2017 (due to costs of rapid adjustment) and 3.6% today.  But it certainly was not 10% in October 2009.

Even when monetary policy is producing appropriate nominal stability, it would not be unusual to see the unemployment rate gradually falling (or rising) toward its long run natural rate.

Don’t boycott artists

The NYT has an article discussing a London exhibition of paintings by Paul Gauguin:

Is It Time Gauguin Got Canceled?

LONDON — “Is it time to stop looking at Gauguin altogether?”

That’s the startling question visitors hear on the audio guide as they walk through the “Gauguin Portraits” exhibition at the National Gallery in London. . . .

 . . . The artist “repeatedly entered into sexual relations with young girls, ‘marrying’ two of them and fathering children,” reads the wall text. “Gauguin undoubtedly exploited his position as a privileged Westerner to make the most of the sexual freedoms available to him.”

How should we judge people who lived in an earlier era?  By our standards?  By their standards?  Indeed, should we make any judgments about their personal life?

I am a utilitarian, so I like to think about the practical value of cultural practices such as “shaming”.  How does it make society better off?  Does it discourage bad behavior?

When artists are long dead, it’s harder to make a utilitarian argument for boycotting their work.  I suppose one could argue that shaming discourages bad behavior, and that even the prospect of future shaming (after death) could encourage artists to behave better, to insure they have a good reputation in posterity.

That seems like a bit of a stretch, especially if the behavior was not seen in the same way when the artist was alive.  A French/Peruvian artist living in the 19th century might not have realized that by 2019 the NYT would regard certain types of sexual practices as being more evil when engaged in by  “privileged Westerners” than when similar practices were engaged in by native born men.  So I’m dubious that the prospect of a future boycott would have deterred Gauguin.

There are also significant costs associated with boycotting artists.  Gauguin was an extremely productive artist, producing (in aggregate) paintings worth hundreds of millions, if not billions of dollars.  There would be large costs if viewers were deprived of the pleasures associated with viewing this art.  Some viewers might find that Gauguin’s personal life in some way tainted the art, which prevented them from enjoying the paintings.  But that’s an argument for individuals to avoid viewing the art, not a societal boycott.  Where’s the “externality” argument calling for collective action?

Ironically, when I was young, Gauguin’s personal life was considered a plus by people (men?) in the artistic community—he was viewed as a sort of “hippie”, rejecting staid bourgeois values.  In the 19th century, his life was seen as scandalous for reasons entirely different from those discussed in the NYT.

There’s also the slippery slope argument against boycotts.  Should D.W. Griffith’s films be boycotted because he glorified racism?  Should Leni Riefenstahl be boycotted for glorifying Hitler?  Should Frida Kahlo be boycotted for glorifying Stalin?  Does your answer depend on whether you are on the left or the right?  When it comes to politics, even highly intelligent people often hold appallingly ill-founded opinions.  Should we cut people some slack because it’s apparently so difficult to think clearly about political issues?

And what about unproven allegations?  Many in Hollywood are boycotting Woody Allen due to allegations that were investigated by the authorities and found to be unsubstantiated.  Why not let the criminal justice system do its job?

In the end, we might end up not punishing the worst people.  Many, many, many famous artists who produced art and literature of incredible beauty and sensitivity were basically cruel jerks in their personal life.  But being a mean person doesn’t get you blacklisted, rather you get blacklisted for violating some sort of taboo.  In the 17th century, it might have been atheism, then later it might have been homosexuality, then (in the 20th century) the advocacy of fascism and communism.  Today it might be racism or sexism.  But this is self-indulgence; society is boycotting people based on our current ideological obsessions, not the eternal moral truth that cruelty is the worst thing that humans do.

“The person, I can totally abhor and loathe, but the work is the work,” said Vicente Todolí, who was Tate Modern’s director when it staged a major Gauguin exhibition in 2010, and is now the artistic director of the Pirelli HangarBicocca art foundation in Milan.

“Once an artist creates something, it doesn’t belong to the artist anymore: It belongs to the world,” he said. Otherwise, he cautioned, we would stop reading the anti-Semitic author Louis-Ferdinand Céline, or shun Cervantes and Shakespeare if we found something unsavory about them.

As I utilitarian, I have a hard time justifying that claim.  Shaming can deter bad behavior.  But so can prisons.  And what is the marginal value of shaming in a culture that already has prisons?  So perhaps Vicente Todolí is right for the wrong reason.  Some artists are deserving of being boycotted, but from a “rules utilitarian” perspective we’d be better off agreeing to a blanket rule analogous to the First Amendment to the US Constitution.  No boycotts of artists.

Gauguin may or may not have been evil, but his art is among the few things that make life worth living:

Ramin Toloui on QE

David Beckworth directed me to a new paper by Ramin Toloui, which examines the various transmission mechanisms for quantitative easing. This might be the single best paper I’ve read on the effects of Fed policy during the Great Recession and its aftermath.

In the past, I’ve often criticized people who judge the effectiveness of QE by looking at the impact on interest rates. Toloui does a nice job explaining why macroeconomists should avoid reasoning from a price change:

First, evaluating the effectiveness of quantitative easing by focusing solely on realized bond yields is inherently flawed. The conventional narrative for QE’s transmission mechanism to the broader economy focuses on the causal chain whereby central bank purchases boost bond prices, thus stimulating investment and consumption via the intermediate channel of lower bond yields. But this ignores the powerful expectations channel through which central bank policy operates. If central bank actions positively shock expectations for future economic prospects, that may directly shift the willingness of businesses and households to invest and consume. Success in breaking deflationary expectations can catalyze increased consumption and investment.

But such a shift toward reflationary expectations—higher growth, higher inflation—also tends to increase bond yields! In theory, therefore, the impact of “successful” central bank balance sheet policy on realized risk-free yields is ambiguous. At minimum, any central bank success in generating reflationary expectations would mitigate observed downward effects on yields, understate the full impact of QE policies, and help account for why bond yields increased during some implementation periods cited by QE skeptics.

Then Toloui develops a very clever way to address the identification problem:

First, this study explicitly models how changes in Fed balance sheet policy shifted market expectations for the Fed’s future policy reaction function. It achieves this by using a Taylor Rule-based framework to model the market’s future expected policy rate as a function of the market’s expectations for future inflation and output. Controlling for these variables makes it possible to identify periods when the market perceives there to be outright shifts in the central bank’s future policy reaction function—that is, when the market expects that the central bank will select a different policy rate in the future than it would have previously given the identical expectations for inflation and output.

It is useful to illustrate this concept with an example. Assume that the month before a Federal Open Market Committee (FOMC) meeting, the market expects that the policy rate three years in the future will be 2 percent, expected inflation will be 1½ percent, and the expected output gap will be zero. The FOMC then meets, leaving the policy rate unchanged but taking other actions. In the month after the FOMC meeting, the market shifts its expected policy rate to 1¼ percent while the market’s expectation for inflation and the output gap remain unchanged at 1½ percent and zero, respectively. This indicates that the market anticipates that there has been an accommodative shift in the central bank’s future policy reaction function—i.e., the market expects the Fed to choose a policy rate that is ¾ percentage points lower than before, despite identical inflation and output gap expectations.

This is indirectly related to a point I’ve made about “forecast targeting”.  The point is not to get the market forecast of inflation, or the market forecast of future levels of the fed funds rate; rather you want the market forecast of the fed funds rate that is likely to lead to on-target inflation.

Toloui also understands that any evaluation of interest rates should be conditional on the state of the economy.  Instead of using this approach to identify the optimal policy rate, he uses it to identify the impact of monetary policy.  He finds that the effect of QE on interest rates is even greater than estimated in previous studies, when conditioned on the state of the economy.

He also has some very interesting things to say about the impact of Fed policy on riskier assets:

But that is where the future Fed reaction function becomes important. To the extent that the market believes that the Fed will be more quiescent in face of future inflationary pressures, the risk that the punch bowl will be removed diminishes and prospects for a boisterous party increase. The market’s expectation for the Fed’s future policy reaction thus affects the attractiveness of a wide range of financial assets, not just U.S. Treasury bonds.

It is worth emphasizing this point, since investment committees around the world were focusing intensively on Federal Reserve policy during the post-crisis period. The interest of investors in new policy announcements was not limited to the technical dimensions of particular initiative. Rather, market participants were looking for what these announcements revealed about the character of the central bank. Was the Federal Reserve willing to do “whatever it takes” to secure a recovery and clip the tail risk of a deflation scenario? If so, portfolio managers would have a “green light” for investing in riskier assets that would benefit from a reflationary scenario. Each additional policy innovation provided more information about the Fed’s attitudes.

Lots of people have in mind a model where monetary stimulus inflates asset prices by lowering interest rates.  But that’s not actually what’s going on.  Asset prices plunged during 2008-09 even as interest rates were cut to zero.

Toloui has a much better explanation.  Monetary stimulus creates a macroeconomic environment (basically “prosperity”) where risk assets do well.  It has nothing to do with creating bubbles; it’s all about the fact that what’s good for America (in a macroeconomic sense) is more often than not also good for the stock market and credit spreads.

I strongly encourage younger academics to take a look at this paper, it provides lots of ideas that point the way toward future research opportunities.

Could’ve fooled me

Here’s the NYT:

The cumulative impact of a decade of austerity measures and Labour shifting the political center of gravity leftward on economic policy means that Mr. Johnson has been forced to promise more public spending if he wins the election. But make no mistake: In the long term his administration remains committed, as one Conservative-aligned think tank put it recently, to “rampant individualism” and “a small state.”

I was fooled by the fact that Trump, Johnson and other modern conservatives all over the world are both promising and delivering more public spending.  I thought that meant they no longer favored “a small state”.  My “mistake”.

Bartleby the central banker

The Reserve Bank of Australia has delivered 28 years of solid growth in NGDP. Unfortunately, its recent performance has been subpar. Even more worrying is the fact that its communication has been borderline incoherent:

In its quarterly monetary policy review earlier this month, the RBA downgraded a series of economic forecasts, including growth, wages, consumption and inflation, and warned “further easing could unintentionally convey an overly negative view of the economic outlook”.

It said it was prepared to cut rates again, if required, to stimulate growth but flagged the possible use of unconventional monetary policies. Philip Lowe, RBA governor, is due to deliver a speech later this month outlining options, which are likely to include negative interest rates and large-scale buying of government bonds.

Actually, it would be more accurate to say that making the statement, “further easing could unintentionally convey an overly negative view of the economic outlook” is itself likely to unintentionally create an overly negative view of the economic outlook.  Markets will look at that sort of statement and assume the RBA doesn’t know what it is doing.

This statement is just one more indication that the problem in central banking is not the zero lower bound, it’s a much deeper failure.  Central banks seem paralyzed for some reason that I don’t fully understand.  Ben Bernanke noticed this phenomenon way back in 1999.

As an analogy, we’ve all known someone who stayed in a dysfunctional relationship that they should have left.  To an outsider, it’s hard to understand why they stay in a relationship where they are subjected to continual abuse.

Similarly, people like Bernanke and I have trouble understanding why so many central banks clearly need to do something and yet hold back for some unknown reason.  Why?  It’s one of life’s great mysteries.

As a result of their paralysis, there are now calls for fiscal stimulus in Australia:

The Liberal-National government is now under increasing pressure to abandon its election pledge to return the budget to surplus for the first time in more than a decade and instead to unleash fiscal stimulus via tax cuts and infrastructure spending.

After all, it worked great in Japan: