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What if monetary policymakers lack credibility?

Trevor Chow sent me the following questions, as a follow up to my recent post:

I was wondering what your thoughts are regarding the following:

1. I agree that the thought experiment shows monetary policy can set nominal aggregates as high as they would like. But I’m not entirely sure this solves the machete-scalpel problem.

2. What I mean is the following. Suppose we start in a world where we’re on some nGDP growth path. Suddenly, there’s a recession (V falls/k rises) and expected nGDP falls. The central bank tells everyone about this helicopter thought experiment and persuades them that it can credibly maintain the nGDP growth path. Consequently, it needs to do very little actual money creation in order to keep nGDP futures on the nGDP growth path. And so expected nGDP doesn’t actually fall. This is basically what you were saying.

3. However, suppose instead that for some reason it screws up. And for some reason, people no longer believe that the thought experiment is enough i.e. they believe in the machete-scalpel problem. Perhaps this is because they mess up for a period of time or because everyone misdiagnoses what tight and loose policy are. Regardless, it is no longer credible. Then it can’t just say it wants an nGDP path and hope that people will respond accordingly, and in fact might have to do a lot just to get close.

4. This may be particularly difficult because people’s belief in a central bank depends on whether they think other people find the central bank to be credible. And in that sense, it would seem likely that while what you’re saying is true most of the time, it is possible to get stuck in bad equilibria where you need a lot more than the usual show of force to even begin regaining control of the scalpel?

5. What I’m trying to say, albeit somewhat poorly, is that the machete-scalpel problem seems to be true if everyone believes it to be true, and to be false if everyone believes it to be false.

I’m going to disagree with this:

This may be particularly difficult because people’s belief in a central bank depends on whether they think other people find the central bank to be credible.

In my view, people tend to doubt central bank commitments mostly when central banks are not in fact committed to doing whatever it takes. Yes, you can imagine a hypothetical case where a central bank was committed to do whatever it takes to boost inflation, but the public for some reason still did not believe the central bank. But I suspect that that’s pretty rare. It is most likely to happen in a case where a central bank had previously made a commitment that was not sincere, reneged on its promise, and then subsequently made a commitment that was sincere, but not credible.

For instance, Volcker backed off on his first attempt to reduce inflation in late 1980, and then in late 1981 adopted a “whatever it takes” approach that was ultimately successful. Note, however, that it didn’t take all that long to convince people that the Fed was serious, and NGDP growth rates plunged sharply in late 1981 and 1982. And when it comes to stimulus, the central bank’s job is actually much easier in a political sense. Volcker faced doubts because a contractionary monetary policy hurts workers, businesses and borrowers. There was intense pressure on him to back off on the tight money policy. In contrast, a policy aimed at raising inflation from zero to 2% tends to make the economy better in the short run, and thus is less politically controversial.

Central banks are not completely transparent, but they are also not particularly secretive. Top Fed officials frequently describe their policy preferences to people in the media. Thus I doubt that a sincere and publicly announced policy to do whatever it takes to hit an NGDP level target (or price level target) would be non-credible. On the other hand, I could easily imagine such a policy not being sincere.

Consider the following example. Suppose that in 2003, BOJ policymakers announced that they were going to adopt Lars Svensson’s “foolproof” plan to escape from a liquidity trap. They say that they will do “whatever it takes” to hit the target amount of yen depreciation. But privately, BOJ officials decide that if the US complains too strongly about a weak yen, and threatens trade sanctions, they will back off. That’s not a sincere “whatever it takes” policy decision, and the markets would (correctly) find the promise non-credible. They’d see right through it.

In the vast majority of cases, promises are seen as non-credible because they are not in fact sincere, and when sincere they are seen as credible. For that reason, I’m not very worried about the hypothetical raised by Trevor. Nonetheless, let’s consider the outcome of a sincere promise that was seen as being non-credible, no matter how remote that possibility. Suppose the BOJ made the sincere decision to implement Svensson’s recommendation regardless of how much flack they received from the US, but the decision was not credible. What then?

I’d still say the policy was a scalpel, not a machete. Yes, the BOJ would probably have to increase the monetary base dramatically, as speculators would anticipate big profits if and when the BOJ caved in and let the yen appreciate. But in the longer term, the central bank that abandons its stimulus is actually forced to do more money creation than the sincere central bank.

Thus in early 2015, both the Swiss and Danish central banks were under pressure from speculators who anticipated a break in their currency’s euro exchange rate peg. The Swiss did cave in, a decision that in retrospect was clearly a mistake, whereas the Danish central bank refused to give in to speculators. Indeed I’d even go further. I suspect that speculators attacked the Swiss franc in early 2015 partly because they anticipated that the SNB was not sincere, and would soon let the franc appreciate as a result of the false belief that Switzerland was threatened with spillover inflation from the eurozone. Speculators didn’t so much force the SNB’s hand as they anticipated a bad decision that was already in the works.

Denmark got the last laugh, however, as once speculators saw the Danes would not let the krone appreciate, they stopped speculating in their currency. Thus, in the long run, the SNB had to increase their monetary base far more than the Danish central bank, as speculators assumed that the Swiss franc would continue to appreciate over time.

Given the fact that a non-credible central bank might have to dramatically boost the monetary base, why do I insist that this policy is a scalpel and not a machete? Because in this case it is more useful to think of the policy instrument as the exchange rate, not the base. The monetary base might change dramatically, but only in service of a central bank policy aimed at targeting the exchange rate (the scalpel) at a precise level.

Here’s an analogy. Consider a Taylor Rule-type policy in 1991, which sets the fed funds rate at 3%. Then assume a sudden collapse of the Soviet bloc, which leads to massive hoarding of US currency. To keep the fed funds rate at 3%, the Fed must accommodate that demand by printing enough base money to meet the growing demand for US currency in the former Soviet Union. From the perspective of the rapidly growing monetary base, policy looks like a blunt instrument, a machete. But from the perspective of the fed funds target, policy looks like a scalpel, a very precise instrument that keeps the fed funds rate exactly where the Fed wants it.

I favor a policy where the Fed adjusts the base as much as needed to keep its policy indicator right on target. That indicator might be an exchange rate, an NGDP futures price, or a TIPS spread. More likely it would be a hybrid market/internal forecast of something like NGDP or core inflation. But I don’t want the Fed to actually target the monetary base, or to use it as an indicator of the stance of policy.

The base is like the steering wheel for the nominal economy. A steering wheel controls the path of the car, but I don’t “target” the position of the steering wheel. Rather I move it as needed so that my GPS says I’m moving to the place I’d like to reach in the most efficient way possible.

When monetary policymakers are sincere but not believed by the public, the central bank may have to move the base by more than otherwise, until the public becomes convinced that it is sincere. But, in general, when a central bank is truly sincere it won’t take the public long to figure that out. They are like 5-year old children, whose intentions can easily be read in their face. Speculators that are slow to realize the central bank’s sincerity will lose money on their investments.

The key is that the central bank must be sincere. Everything works so much better if you tell the truth.

A simple model of monetary policy and interest rates

This comment caught my eye:

I think it’s easier for most people (especially laymen) to understand how central banks affect interest rates than it is to understand the mechanics of the money supply and other aspects of monetary policy.

You could probably count on one hand the number of laymen who understand how monetary policy affects interest rates. Suppose you asked an average person how the Fed affects interest rates. What might they say?

Most people would have no idea how to answer this question. Better educated people would attempt an answer, but they would almost certainly be wrong. Consider some plausible explanations:

1. Changing the discount rate? Nope.

2. Changing the interest rate on reserves? OK, but how does that affect market rates? They might cite some sort of arbitrage condition. But from 1913 to 2008 the IOR in America was set at zero, and yet market rates were often well above zero. So that can’t be the entire explanation.

3. Pumping money into the economy? OK, but why would that affect interest rates? They might point to supply and demand. More supply of money means a lower price of money, with the implicit assumption being that interest rates are the price of money. But interest rates are not the price of money; they are the price of credit, and (throughout most of US history) interest rates tend to be higher when money growth rates are higher. Thus money growth sped up in the 1960s and 1970s and interest rates rose sharply. Indeed interest rates rose sharply because money growth sped up (leading to higher inflation.)

Here’s a simple model of money and interest rates:

i = IRG + NRI

That is, market interest rates = interest rate gap + natural rate of interest

The natural rate of interest can be defined in multiple ways, but is usually assumed to represent the risk free short-term interest rate that is consistent with some sort of macroeconomic equilibrium. For simplicity, let’s assume macroeconomic equilibrium occurs when NGDP is consistent with the public’s previous expectations. Even that’s a bit vague, as it raises the question, “Expectations formed at what time?” But it’s a reasonable approximation of what we mean by the concept.

In this model, monetary policy affects interest rates in two ways. Policy affects the natural rate of interest (NRI) and it affects the interest rate gap (IRG). Thus in the long run, a monetary policy that raises the trend rate of NGDP growth from 4%/year to 14%/year will tend to boost the NRI by 10 percentage points. You can call this aspect of policy the “NeoFisherian effect” although it includes both the (real) income and inflation effects.

The other part of policy is the liquidity effect. Because NGDP is slow to respond to changes in the supply and demand for money, policy shocks move the market interest rate away from the natural rate in the short run, producing an interest rate gap.

I cannot emphasize enough that every single monetary policy action influences both the IRG and the NRI; it’s just a question of how much. Furthermore, most actions (not all) push these two rates in the opposite direction. And the liquidity effect has more of an impact on short-term rates, whereas the NeoFisherian effect usually has more impact on medium and longer-term rates.

Imagine asking a layman to explain all this.

Open market purchases raise the supply of base money, creating disequilibrium (excess money supply) at the previous level of interest rates and NGDP. Because NGDP is slow to adjust, short-term interest rates immediately decline to induce the public and banks to hold larger cash balances.

A reduction in IOR reduces the demand for base money, creating disequilibrium (excess money supply) at the previous level of interest rates and NGDP. Because NGDP is slow to adjust, short-term interest rates immediately decline to induce banks to hold existing cash (i.e. reserve) balances.

It is less clear how these actions affect future expected short-term rates; the answer depends on how they influence the future expected path of NGDP, which in turn depends on the impact on the future expected path of policy.

Imagine asking a layman to explain all this!

In general, interest rate gaps move the natural interest rate in the opposite direction. Creating a positive IRG nudges the NRI downward. And in the medium to longer-term, the natural interest rate has more impact on market interest rates than does the interest rate gap. This is what Nick Rowe means when he uses the analogy that monetary policy is like riding a bike where you turn the wheel to the left when you want to go right, and vice versa. If you want lower rates in the long run, you nudge short-term rates higher, and vice versa. Usually.

Imagine asking a layman (or MMTer) to explain all this!!

In some cases (such as Switzerland in January 2015), a cut in the policy rate is associated with the natural interest rate falling, because it is associated with other signals that lead people to expect a more contractionary policy stance going forward. (Signals such as allowing a large upward appreciation in the franc’s exchange rate.)

Imagine asking a layman to explain all this!!!

Before trying to teach students how monetary policy affects interest rates, we should start with something easier, like quantum mechanics.

Treat CPTPP as an opportunity

This caught my eye:

China has applied to join an Asia-Pacific trade pact once pushed by the U.S. as a way to isolate Beijing and solidify American dominance in the region.

The country submitted a formal application letter to join the deal, known officially as the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, according to a statement late Thursday in Beijing.

This is great news. China should be welcomed into the CPTPP if it agrees to adhere to all of their rules (currently it does not.) There should be a provision that no CPTPPP member is allowed to impose economic sanctions on another member in response to any sort of “free speech” in any member country. Today, China retaliates against speech that it opposes in other countries. If China wants to join under those conditions, then let it in. We should encourage any agreement that makes China less nationalistic, less of a rogue nation. (Ditto for the US.)

A number of members of Congress have been calling for the U.S. to either rejoin the CPTPP or to be more active on trade diplomacy in the region. However, the Biden administration hasn’t announced any concrete trade policies for the region, although there are reports it’s discussing a digital trade deal covering Asia-Pacific economies. 

“The future of technology, trade and defense is either going to be led by the Chinese Communist Party or by the United States and our allies,” U.S. Senator Ben Sasse said in response to the news. “If China sees the value in building alliances across the Pacific, why can’t the United States? Let’s get back into a position of leadership instead of retreat.”

Ben Sasse is correct. (He’s one of the few members of the GOP who has not entirely caved in to Trumpism.) And yet I’m not optimistic. I predicted that Biden would be a lousy president, and so far I’ve been right. (Although he’s still 100 times better than Trump.)

BTW, the WaPo has a good article on how our misguided cold war with China is leading to the arrest of lots of Chinese-American scientists on trumped up charges of “spying”.

Did Covid originate in Laos?

Here’s Bloomberg:

Bats dwelling in limestone caves in northern Laos were found to carry coronaviruses that share a key feature with SARS-CoV-2, moving scientists closer to pinpointing the cause of Covid-19.

Researchers at France’s Pasteur Institute and the University of Laos looked for viruses similar to the one that causes Covid among hundreds of horseshoe bats. They found three with closely matched receptor binding domains — the part of the coronavirus’s spike protein used to bind to human ACE-2, the enzyme it targets to cause an infection.

The finding, reported in a paper released Friday that’s under consideration for publication by a Nature journal, shows that viruses closely related to SARS-CoV-2 exist in nature, including in several Rhinolophus, or horseshoe bat, species. The research supports the hypothesis that the pandemic began from a spillover of a bat-borne virus. . . .

The three viruses found in Laos, dubbed BANAL-52, BANAL-103, and BANAL-236, are “the closest ancestors of SARS-CoV-2 known to date,” said Marc Eloit, head of pathogen discovery at the Pasteur Institute in Paris, and co-authors. “These viruses may have contributed to SARS-CoV-2’s origin and may intrinsically pose a future risk of direct transmission to humans.” 

Note that this newly discovered virus is still significantly different from SARS-CoV-2. But the finding is still important, as the receptor binding domains (RBDs) are pretty similar, and some lab leak proponents had argued that the SARS-CoV-2 RBD was suspicious and likely a product of “gain of function” research.

Discount code for my new book

I received this information:

Customers can get a 20% discount (bringing the price to $28 before shipping) when they purchase the book from press.uchicago.edu and enter the code SUMNER20 at checkout. I have that set to run through the end of the year.

Not sure if that’s the best deal, but I thought I’d put it out there.

Also, I did a podcast with Larry White where I discussed the book. It was just released.

I also have a new column at The Hill.