Archive for February 2020


Interest rate cuts may not be enough

The Fed should certainly cut their target interest rate. But if the coronavirus problem continues to get worse, that may not be enough to keep monetary policy on tract.

A much more effective policy would be to commit to average inflation targeting of 2%/year over the next 5 years. The Fed should indicate that if the coronavirus causes near-term inflation to fall below their 2% target (which is likely), then they’ll go all out to obtain higher inflation in future years, so that 5 years from today the inflation rate will have averaged about 2%.

The goal is to raise the equilibrium interest rate on 5-year Treasuries. Doing so will make monetary policy more expansionary today, for any given setting of the policy rate.

Another advantage of this approach is that the Fed won’t have to backtrack if the coronavirus quickly fades. In contrast, a big cut in interest rates might have to be quickly reversed. There’s actually nothing wrong with quickly reversing an interest rate move as new facts come in, but pundits think it’s embarrassing and hence the Fed is reluctant to “reverse course”. (Of course they aren’t actually reversing course when they cut and then raise rates, as interest rates are not monetary policy.)

PS. Over at Econlog, Steve Fritzinger had a good comment:

My driving policy is to stay 2 to 2.5 seconds behind the car a front of me at all times. To do that speed up and slow down as needed to stay in that window.

If I’m accelerating and decelerating, it doesn’t mean I’ve changed my policy.  It means I’m implementing it.

Here’s another example. My driving policy is to maintain a speed of 65mph. Moving the accelerator pedal as I go up and down hill doesn’t mean I’m changing my policy.

Demand vs. aggregate demand

The Black Death killed 1/3 of all the people in Europe. The demand for almost every single commodity probably fell, in the sense that demand curves shifted to the left. Supply curves also shifted to the left, and hence relative prices stayed about the same, on average. (In a supply and demand diagram, the “price” on the vertical axis is the relative price, the price relative to the overall CPI.)

And yet the Black Death probably had little or no impact on aggregate demand. How can that be? There were far fewer people, and the demand for virtually every single commodity fell. Why wouldn’t aggregate demand also fall?

Aggregate demand is a horrible term for the concept that economists use in macro 101. It has absolutely nothing to do with “demand” in the ordinary sense of the term. I wish it were called “nominal expenditure”.  The “price” on the AS/AD diagram is the nominal price level, not the relative price of a single commodity.

The Black Death did not kill money, so the (commodity) money supply was presumably unchanged. If might have reduced AD by reducing velocity, but I doubt it had much impact. We know that the Black Death increased the price level in Europe, and it’s likely that it reduced real GDP. The AD curve probably didn’t shift very much in response to this plague.  Here’s what happened:

When average people think about macro, they tend to conflate “aggregate demand” and “quantity of goods and services purchased”. Even if there is no change in aggregate demand, the quantity of stuff that people buy at stores will tend to fall when AS falls (as in the figure above). But that’s a decline in equilibrium quantity; it’s not a decline in AD.

Monetary policy determines AD.  The Economist recently had this to say:

In practice, the distinction between shocks to demand and those to supply is fuzzy. In a paper published in 2013 that revisited the era of stagflation, Alan Blinder of Princeton University and Jeremy Rudd of the Federal Reserve argue that supply alone cannot explain the soaring unemployment of the 1970s. In fact, they say, price increases had demand effects that mattered more. They raised uncertainty, reduced households’ disposable income and eroded the value of their savings.

Actually, aggregate demand (NGDP) in the US rose at about 11%/year from 1971-1981, due to easy money (despite 15% interest rates!)  People were spending money like crazy.  So the high unemployment was not primarily caused by a demand shortfall.  In my view, the natural rate of unemployment rose during the 1970s.  Spikes in unemployment in late 1974 and the spring of 1980 were caused by brief declines in AD (NGDP growth).

PS.  Narayana Kocherlakota may not be right, but his recommendation is probably “less wrong” than doing nothing:

My benchmark forecast is that the U.S. economy will remain resilient to these forces. But there is a substantial risk that such a forecast could be wrong. One possible strategy is to wait until there actually is a slide in the economy before easing interest rates. But rates are still only a little above zero and so the Fed has few tools available to offset adverse shocks. In this situation, a basic precept of monetary policy is to keep the economy as healthy as possible in advance of downturns. As New York Federal Reserve Bank President John Williams explained in a speech last year, that means cutting interest rates in a pre-emptive fashion when threats to growth become more pronounced. Of course, it was exactly in response to the increase in global downside risks that the Fed cut interest rates by 75 basis points, or three-quarters of a percentage point, in 2019.

The Fed’s rate-setting Federal Open Market Committee holds its next meeting on March 17-18. I don’t think that the FOMC should wait that long to deal with this clear and pressing danger. I would urge an immediate cut of at least 25 basis points and arguably 50 basis points. That’s a cheap insurance policy for the economy that the Fed shouldn’t pass up.

A question for cold warriors

We now live in a country where the Director of National Intelligence is fired for doing his duty, for going to Congress and truthfully reporting intelligence information about our adversaries.

We now live in a country where top intelligence officials must lie about foreign threats in order to keep their jobs.

Here’s my question: For how much longer should we believe our intelligence community when they report on “threats” from China that happen to mesh with the propaganda coming out of the Trump administration?

PS. The new acting DNI is a Trump hack and a purveyor of right wing fake news. Still don’t think we are a banana republic?

Interview with Erik Torenberg

I was interviewed by Erik Torenberg while at the AEA meeting in San Diego. Here’s the (50 minute) podcast.

I had trouble finding a quiet place, as I’d already checked out of my hotel. So I may sound distracted by background noise a few times.

Why supply shocks look like demand shocks

Over at Econlog I have a new post that I wrote last night, before the recent market crash. It occurred to me that it might be useful to present a graph explaining the argument I’m making.

[The original post had a graph with a typo]

You’d expect a negative supply shock to be inflationary.  But lots of recent supply shocks in the global economy have reduced the equilibrium interest rate, and central banks have inadvertently tightened policy by not cutting their policy rate fast enough.  Markets clearly fear another example of this in response to the Covid-19 outbreak, especially as it spreads to other countries such as Italy and South Korea.

Adverse supply shocks are inflationary.  But a bad monetary policy response can be even more deflationary.  That’s what the markets currently fear.

To be sure, markets are often wrong, indeed in a sense they are always wrong—events are almost never exactly as they predicted.  A few weeks ago, markets were too complacent about Covid-19 becoming a global pandemic.  Who knows, perhaps today they are too fearful.  But markets do provide the best guess as to what’s likely to happen, and today the best guess is that the odds of recession just increased, albeit still remain below 50%.

The Fed would prefer not to cut rates.  But they also need to understand that the longer they wait, the deeper they will have to cut them.  Don’t slowly wade into that cold lake—jump in!

PS.  Americans are increasingly “risk averse” (i.e. scaredy cats).  I worry that an outbreak in the US could lead to panic.

PPS.  If I don’t respond to comments immediately, that’s because I’m at the store stocking up on toilet paper.

PPPS.  I’m 28 days into one of those colds where you can’t stop from coughing.  I developed it the day after returning on a long flight from the Eastern hemisphere.

PPPPS.  Fortunately, it was a flight from New Zealand!