Be careful what you wish for

Suppose that in early February a crystal ball told you that the US economy was about to be locked down for a month to prevent a big outbreak of Covid-19. That time would be used to implement an aggressive policy of test/trace/isolate plus widespread mask wearing. With just a few dozen cases, it would be possible to isolate all the infected, as in places like New Zealand. You might think the one month lockdown was good news.

Now suppose instead that your crystal ball suggested that there would be a 5-year lockdown. Now your reaction might be fear. “Wow, that would only happen if the epidemic really got out of control.”

Now let’s switch to monetary policy. Suppose the Covid epidemic causes the Fed to temporarily slash rates to zero. You might think this was good news, monetary stimulus to offset the decline in nominal spending.

Now suppose instead that you saw this Bloomberg headline:

Fed Seen Holding Rates at Zero for Five Years in New Policy

The new approach could be unveiled as soon as next month.

How do you react? I worry that this means the economy is likely to be very weak for the next 5 years—not at all what I hoped for.

Now suppose you have been calling for level targeting and the Fed instead opts for “average inflation targeting”. Also assume the market reacts to the Fed’s announcement with market inflation forecasts of well below 2% for as far as the eye can see. Does that make you optimistic?

I do think that average inflation targeting would be a tiny step forward. But it’s also far more discretionary than level targeting, and hence it depends much more on implementation. Unlike with price level targeting, we don’t know how it will work.

Unfortunately, if the policy lacks credibility it’s not of much use. So I expect any gains from the policy to be small. The good news is that it’s one step toward price level targeting, and price level targeting would be a step toward NGDP level targeting.



13 Responses to “Be careful what you wish for”

  1. Gravatar of P Burgos P Burgos
    26. August 2020 at 09:56

    Does the Fed need to do more than wipe out one investor betting on low inflation? It seems to me it should be pretty easy to convince the markets, if it wanted to.

  2. Gravatar of ssumner ssumner
    26. August 2020 at 10:36

    Burgos, I wish it were only one.

    And does the Fed really want to? If they do, they’ll chose price level targeting over average inflation targeting.

  3. Gravatar of Garrett Garrett
    26. August 2020 at 11:51

    I think the Fed likes discretion because it makes them more important. If the policy is “automated” then insiders dislike it for the same reason why people in finance dislike index funds.

  4. Gravatar of Postkey Postkey
    26. August 2020 at 13:12

    “In the 70s, U.S. prices soared with little money growth, while since 2009, base money rose six fold while inflation remained minuscule.”

  5. Gravatar of Benjamin Cole Benjamin Cole
    26. August 2020 at 15:27

    The real problem is not monetary policy, but rather the lockdowns.

    No major Western democracy has had much success with lockdowns. One might say Western democracies don’t “do government.”

    Obviously lockdowns maintain a fragile and crumbling status quo of a naive population and a novel virus, but at ruinous expense.

    Lockdowns, whether perpetuated in Germany, or by state and local governments in the US, are the public health care sector’s Vietnam.

    Even more amazing, the same economists who once railed against FDA clunkiness now appear to abide by the extremely slow FDA process of approving a C19 vaccine.

    Good luck everybody.

  6. Gravatar of cbu cbu
    27. August 2020 at 12:16

    Important account about COVID-19 outbreak:

  7. Gravatar of Tacticus Tacticus
    28. August 2020 at 01:19

    Professor, didn’t you see the giant spike in TIPS spreads following the announcement? Yeah, me neither…

    My crystal ball did actually tell me in January that rates would be slashed to zero this year, but it did not say for how long. It was certainly not predicting five years.

    Benjamin Cole, You do realise that economic activity crashed before lockdowns were introduced and that Sweden, who did not lock down, had a larger economic drop that Denmark, Finland, or Norway?

    Gresham’s Law of Commentators, indeed.

  8. Gravatar of ssumner ssumner
    28. August 2020 at 07:51

    cbu, I already posted on that story. It’s excellent.

    Tacticus, Given that fact that the markets already knew AIT was coming, the 5 basis point spike was huge–much more than I expected. I should have shorted T-bonds, as I knew what Powell was going to do.

    Sometimes my belief in the EMH costs me dollars.

  9. Gravatar of ssumner ssumner
    28. August 2020 at 07:52

    Tacticus, Respond to Ben is like talking to a wall. He pays zero attention to facts, living in his own dream world.

  10. Gravatar of Tacticus Tacticus
    28. August 2020 at 12:16

    Your belief in the EMH definitely costs you dollars. This has, personally, been the best year of my investing life. The second was 2009. When there’s blood in the streets… Unfortunately my professional colleagues are never as keen to bet the farm on my feelings as I am. Alas.

    Yes, I realised Cole was not worth reasoning with after he disclosed he had no factual basis whatsoever for stating that coronavirus in the US was only a problem because of some 3,000 per day illegal immigrants crossing the border. I did enjoy your use of Gresham’s Law, however. A Law applicable to more situations than one might assume, I think.

  11. Gravatar of ssumner ssumner
    30. August 2020 at 09:47

    Tacticus, You said:

    “Your belief in the EMH definitely costs you dollars.”

    Yes, but I also probably did better than 98% of 401k investors–albeit partly because I maxed out my contributions. I suspect my 401k is in the top 2% of people with my lifetime wage income. Recall the tortoise and the hare.

    I’m incredulous when I read that the typical 401K for someone in their 60s has just a few hundred thousand. I had colleagues who put half their contributions into bonds when they were young.

  12. Gravatar of Is the Fed Getting Warmer? – Alt-M Is the Fed Getting Warmer? - Alt-M
    10. September 2020 at 11:07

    […] albeit only a tenuous one, toward their own (and my) preferred policy of NGDP level targeting.  Scott calls "average inflation targeting…a tiny step forward," though one that will allow the Fed […]

  13. Gravatar of Is the Fed Getting Warmer? | GOVfeasance Is the Fed Getting Warmer? | GOVfeasance
    11. September 2020 at 10:54

    […] albeit only a tenuous one, toward their own (and my) preferred policy of NGDP level targeting. Scott calls “average inflation targeting…a tiny step forward,” though one that will allow […]

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