Matt Yglesias on Kocherlakota’s strange logic

Paul Krugman does a very good post that is slightly different, but analogous, to something I wrote yesterday and will post shortly.

Nick Rowe does a very good post on rules vs. discretion.  He zeros in on a key quotation from a recent Bullard interview:

[Update: This interview (H/T Mark Thoma) with James Bullard, President of the St Louis Fed, is an example of what I mean. I used to think that the Fed had an implicit inflation target of around 2%-2.5%. Now I learn that one man who votes on Fed decisions has a lower bound of somewhere just below 1% on his personal inflation target.

‘He also suggested a renewed vigilance on a threshold that, if crossed, would cause the Fed to act. Referring to the annualized gains in core consumer prices of around 1%, Bullard said, “That’s not extremely low. But if it would start to go down from there, to 50 basis points or down to zero, then I would start to get concerned we’d be in a Japanese style scenario, so I think we want to defend our inflation target on the low side, and take aggressive action if necessary.”‘

Though the analogy is imperfect (and the fact that it is imperfect says a lot), we do not interview deputy governors of the Bank of Canada to find out their personal inflation targets. They would all give exactly the same 2% answer, and think you were silly for asking. Which is not to say that some of them don’t think the target should be changed; but until it is changed, and the new target is announced, it’s 2% for all of them. Period. Rule of law vs rule of men.]

Exactly.  And I can’t resist quoting the first two lines from my review of Bernanke’s Jackson Hole speech, which raised a few eyebrows in the blogosphere:

Pretty disappointing, but with one silver lining.  We pretty much know where the “Bernanke put” is, he drew a line at roughly 1% core inflation.

It’s unlikely we”ll get deflation, but 1% inflation won’t produce a robust recovery.

Pretty disappointing, but with one silver lining.  We pretty much know where the “Bernanke put” is, he drew a line at roughly 1% core inflation.  That means no more “depression economics.”  Let’s get costs down and we can get a faster economic recovery:

1.  Payroll tax cuts (at the margin, employer only.)

2.  Replace unemployment extended benefits with large lump sum payments to the unemployed.

3.  Temporary (two year) minimum wage cuts to $6.50.

Of course this won’t happen, but it would promote faster growth if it did.  They are things Obama could try.  Now for the speech:

Maintaining price stability is also a central concern of policy. Recently, inflation has declined to a level that is slightly below that which FOMC participants view as most conducive to a healthy economy in the long run. With inflation expectations reasonably stable and the economy growing, inflation should remain near current readings for some time before rising slowly toward levels more consistent with the Committee’s objectives.

Translation:  The Fed defines price stability as about 2% inflation, and it’s running around 1% (core inflation.)  Bernanke thinks that’s a bit lower than desirable.  But then there is also this:

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC. Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.

However, such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability.

Aaaargh!!  So which is it?  Is inflation too low, or not?

I wish those prominent economists calling for 4% inflation had followed my advice.  Call for level targeting.  Draw a 2% trend line for core inflation from September 2008.  We are now 1.4% below that trend line.  Shoot for getting back to trend.  I know that doesn’t sound like much stimulus, but given the slack in the economy it would actually take pretty fast NGDP growth to get 3.4% core inflation over 12 months.  Or 2.7% over 24 months.  You’ll never convince the Fed to change its inflation target to 4%, and there is no need to try.

But Bernanke definitely does understand the logic of the argument I have been making in recent posts:

First, the FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.

Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.  (italics added.)

Translation:  “Listen you inflation hawks, if things get even a tiny bit worse we will need more stimulus not just to boost growth, but to prevent further disinflation.”

I think we are already there, where more nominal growth is a win/win, and my hunch is that (to a lesser extent) Bernanke agrees.  After all, he basically said that in the first quotation I gave you, which I take to be his true feelings.  The hawks would never have said inflation is too low.  Bernanke is a patient man, but he is running out of patience.  Let’s hope the three new Board members push him hard this fall.

So if Bernanke wants to do more, why doesn’t he say so?  He explained why, if you read between the lines:

Central banks around the world have used a variety of methods to provide future guidance on rates. For example, in April 2009, the Bank of Canada committed to maintain a low policy rate until a specific time, namely, the end of the second quarter of 2010, conditional on the inflation outlook.4 Although this approach seemed to work well in Canada, committing to keep the policy rate fixed for a specific period carries the risk that market participants may not fully appreciate that any such commitment must ultimately be conditional on how the economy evolves (as the Bank of Canada was careful to state). An alternative communication strategy is for the central bank to explicitly tie its future actions to specific developments in the economy. For example, in March 2001, the Bank of Japan committed to maintaining its policy rate at zero until Japanese consumer prices stabilized or exhibited a year-on-year increase. A potential drawback of using the FOMC’s post-meeting statement to influence market expectations is that, at least without a more comprehensive framework in place, it may be difficult to convey the Committee’s policy intentions with sufficient precision and conditionality. The Committee will continue to actively review its communication strategy, with the goal of communicating its outlook and policy intentions as clearly as possible.

Translation:  We can’t communicate a clear objective because unlike in Canada and Japan, I can’t get those hawks to agree with my view of the appropriate “comprehensive framework.”  We will try to make our intentions as clear as possible, if we can ever agree on what they are.

[BTW, notice how in 2001 the BOJ promised to tighten policy as soon as inflation reached zero?  If you have deflation for years, and tighten the moment you hit zero (which was 2006) won’t you go right back into deflation?  The answer is yes.  So much for Paul Krugman’s theory that the BOJ is valiantly struggling to avoid deflation.]

What if more stimulus is needed, does the Fed have more ammo?

The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.

So Congress and the President are desperately looking for ways to boost demand, w/o ballooning the deficit.  The Fed has such tools, but sees no need to use them.  And what is the most likely tool?

A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve’s holdings of longer-term securities. As I noted earlier, the evidence suggests that the Fed’s earlier program of purchases was effective in bringing down term premiums and lowering the costs of borrowing in a number of private credit markets. I regard the program (which was significantly expanded in March 2009) as having made an important contribution to the economic stabilization and recovery that began in the spring of 2009. Likewise, the FOMC’s recent decision to stabilize the Federal Reserve’s securities holdings should promote financial conditions supportive of recovery.

I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed’s balance sheet would have to be weighed against potential risks and costs. One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions. In particular, the impact of securities purchases may depend to some extent on the state of financial markets and the economy; for example, such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high. The possibility that securities purchases would be most effective at times when they are most needed can be viewed as a positive feature of this tool. However, uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses.

Another concern associated with additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to execute a smooth exit from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might lead to an undesired increase in inflation expectations. (Of course, if inflation expectations were too low, or even negative, an increase in inflation expectations could become a benefit.) To mitigate this concern, the Federal Reserve has expended considerable effort in developing a suite of tools to ensure that the exit from highly accommodative policies can be smoothly accomplished when appropriate, and FOMC participants have spoken publicly about these tools on numerous occasions. Indeed, by providing maximum clarity to the public about the methods by which the FOMC will exit its highly accommodative policy stance–and thereby helping to anchor inflation expectations–the Committee increases its own flexibility to use securities purchases to provide additional accommodation, should conditions warrant.

Translation:  It worked last time (March 2009), there are a few minor problems, but we have addressed those problems.  He mentions other ideas like better communication and lower IOR, but you get the impression that he is much less enthusiastic about those ideas.  My guess is that he would only do a comprehensive stimulus with all three tools if things got really bad.  Actually things are really bad; I mean  if things got really, really bad.  If 3rd quarter NGDP growth comes in around 3% or lower, look for more QE in the fall (when the three new members are seated.)  BTW, I am less confident than Bernanke that QE worked last time.  But it is definitely better than nothing.

After my recent trip I was appalled to discover the number of leading conservative voices opposing monetary easing.  Even worse, many seemed to assume the Fed was already engaged in monetary stimulus.  Before considering their views, let’s examine the thoughts of the greatest conservative monetary economist of all time, Milton Friedman.  Here he discusses the zero rate problem in Japan:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

.   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

Friedman was absolutely right, near-zero interest rates are an almost foolproof indicator that money has been too tight.  Were he still alive, I can’t even imagine what he would think of the views being expressed by his fellow conservatives.  Here is Minneapolis Fed president Narayana Kocherlakota:

Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.

Actually money has been tight.  And those construction jobs were mostly lost in 2007 and early 2008, when employment was still high.  The serious unemployment problem developed in late 2008 and early 2009, and reflected a generalized drop in AD across the entire economy.  And manufacturing has also shed lots of jobs.

Update:  Regarding 2007-08, I should have specified construction jobs associated with the housing bubble.  The subsequent sharp fall in NGDP obviously cost construction jobs in commercial and industrial building.  But those were cyclical losses due to tight money, not misallocation problems.

The right seemed to have latched onto the view that since tight money can’t be the problem, it must be some mysterious “structural problem.”  Obviously there may be some structural problems, indeed I have argued that some government labor market policies are counterproductive.  But there is nothing structural that could explain the sudden dramatic jump in unemployment between 2008 and 2009.

Even worse, we already have a perfectly good explanation for that rise in unemployment; in 2009 NGDP fell at the fastest rate since 1938.  You’d expect a massive rise in unemployment from this sort of nominal shock, even if there were no structural problems.  Now of course there is a respectable argument that the US currently faces both problems.  But economists who make that argument (e.g. Tyler Cowen) correctly note that this means we need more monetary stimulus.  They simply warn us not to expect miracles.  But unless you are an extreme RBC-type who doesn’t believe monetary shocks matter at all (and most conservatives are not) then how can one not favor monetary stimulus?

I suppose one argument is that we are “recovering,” and hence that no more stimulus is needed.  People seem to have forgotten that deep recessions are generally followed by fast growth.  Both NGDP and RGDP growth was very fast in the first 6 quarters of recovery from the 1982 recession.  But now we are getting only 4% NGDP growth, not the 11% of the earlier recovery, so how can we expect the 7.7% RGDP growth of the recovery from 1982?  Even worse, David Beckworth presents data (from Macroeconomic Advisers) that NGDP peaked in April, and actually declined in May and June.  We may see the already anemic 2nd quarter numbers revised downward this week.  Goldman Sachs expects less than 2% growth in 2011.  And a rise in unemployment.  That’s no recovery.

If we really were facing structural problems, then on-target NGDP growth would lead to stagflation, as in the 1970s.  Conservatives keep insisting that high inflation is just around the corner, and Paul Krugman keeps making them look like fools.  This pains me because I like most conservative economists more than I like Krugman.

Friedman and Schwartz noted that in the 1930s the low interest rates and high levels of liquidity (cash and reserves hoarding) lulled people into thinking money was easy.  Thus pundits during that era pointed to all sorts of structural problems, which were actually symptoms of the Depression, not causes.  So I have been disappointed to read statements like this one from Edmund Phelps:

THE steps being taken by government officials to help the economy are based on a faulty premise. The diagnosis is that the economy is “constrained” by a deficiency of aggregate demand, the total demand for American goods and services. The officials’ prescription is to stimulate that demand, for as long as it takes, to facilitate the recovery of an otherwise undamaged economy “” as if the task were to help an uninjured skater get up after a bad fall.

The prescription will fail because the diagnosis is wrong. There are no symptoms of deficient demand, like deflation, and no signs of anything like a huge liquidity shortage that could cause a deficiency. Rather, our economy is damaged by deep structural faults that no stimulus package will address “” our skater has broken some bones and needs real attention.

Or William Poole:

More bond buying from the Federal Reserve won’t help the U.S. economy, because purchases can’t remedy the main problem plaguing the U.S., which is fiscal and regulatory uncertainty, former St. Louis Federal Reserve President William Poole said.

While the Fed buying more debt will bring rates down, it won’t inspire spending and lending given uncertainties in the U.S. ranging from tax cuts to health care reforms.

Or Gerald O’Driscoll:

A policy of low interest rates is a textbook response of monetary authorities to the economic weakness brought on by deficient aggregate demand. The policy is justified by pointing to various ways in which money can promote economic activity””including by stimulating investment, discouraging savings, encouraging consumption spending, and allowing individuals to lower their debt burdens by refinancing existing debt. While these effects are theoretically plausible, this textbook policy does not apply to our present situation.

First, our lingering crisis and economic weakness was brought on not by a Keynesian failure of effective demand, but by a Hayekian asset boom and bust. Second, the textbook case for low interest rates treats the policy as one of benefits without costs. No such policy exists.

Yes, Hayek did briefly oppose monetary stimulus in the early 1930s.  But in the 1970s he admitted that he had been wrong, as the problem was not simply “misallocation” resulting from an asset boom, but also insufficient nominal spending.

Or the Wall Street Journal:

As the Bible says, we know that our redeemer liveth. And on Wall Street and Washington these days, the economic redeemer of choice is the Federal Reserve. When the Fed’s Open Market Committee meets again today, markets are expecting a move toward easier money that is supposed to prevent deflation, re-ignite a lackluster recovery, revive the jobs market, and turn water into Chateau Petrus.

It’s a tempting religion, this faith in the magical powers of Ben Bernanke and monetary policy, but it’s also dangerous. It puts far too much hope in a single policy lever, ignores the significant risks of perpetually easy money, and above all lets the political class dodge responsibility for its fiscal and regulatory policies that have become the real barrier to more robust economic growth.  .  .  .

As for the current moment, the Fed has maintained its nearly zero interest rate target for 20 months, while expanding its balance sheet by some $2 trillion. By any definition this is historically easy monetary policy, and not without costs of its own.

Not by Milton Friedman’s definition.  And then it gets worse:

This is the real root of our current economic malaise””the conceit of Congress and the White House that more government spending, taxing and rule-making can force-feed economic expansion. Now that this great government experiment is so obviously failing, the politicians and the Wall Street Keynesians who cheered the stimulus are asking the Federal Reserve to save the day. Mr. Bernanke should tell them politely but firmly that his job is to maintain a stable price level, not to turn bad policy into wine.

So that’s what it’s really all about.  I agree that Obama’s economic policies are highly counterproductive.  But unlike some conservatives I am not willing to unemploy millions of workers to win a policy argument.  I guess that’s the difference between hard core conservatives and pragmatic classical liberals like Friedman and I.  We should do the right thing and then put our trust in the democratic system.

Update:  I should clarify that my attack here was not directed at all conservatives–most are well intentioned, but rather the sentiments in the WSJ editorial.  On many policy issues I agree with the other conservatives mentioned here.

BTW, when I researched the Great Depression, I was shocked at how the conservative Wall Street establishment hated dollar devaluation, despite the fact that the stock market obviously loved it.  I noted (to myself) that “at least the modern WSJ is much better; they often use the market reaction to policy announcements as a way of establishing their likely effects.”  I guess the WSJ has reverted back to the primitive pattern of the 1930s.  “Yes, the markets are screaming for easier money, probably because it will boost the economy.  But we can’t have that because it might make Obamanomics look successful.”  Plus ca change . . .

HT:  Marcus Nunes, JimP, 123, Ryan Avent.

CNBC discusses the views of Dallas Fed President Fisher:

Signs are rife that the U.S. economic recovery is slowing, with retail and housing sales down, manufacturing slowing, and unemployment at a stubbornly high 9.5 percent. Some Fed officials, including Fed Chairman Ben Bernanke, have recently raised the possibility that the Fed may need to ease monetary policy further if the economy worsens.

Fisher said such a move would be ineffective, and could even make matters worse.

Businesses are distressed and dispirited by uncertainty over upcoming rule changes and are unable to conduct long-term planning, he said.

“They are calling time-outs and heading to the sidelines while they wait for the referees to settle on the rules of the game,” Fisher said. “If this is so, no amount of further monetary policy accommodation can offset the retarding effect of heightened uncertainty over the fiscal and regulatory direction of the country.”

I don’t get this at all.  There was lots of governmental activism during the Lyndon Johnson years, and yet rapid NGDP growth led to rapid RGDP growth.  During FDR’s first term there was far more activism and far more uncertainty than right now, but fast NGDP growth led to fast RGDP growth.  I’m no fan of Obama’s policies; I think they have modestly increased the structural rate of unemployment.  But monetary stimulus remains the key to recovery.  It will also eventually lead to fewer policies that reduce aggregate supply, such as extended UI benefits.

Fisher sought to assure his audience that the Fed will not allow itself to be pushed into printing money to resolve the deficit and signaled he would would oppose any further easing on that basis.

Of course he has things exactly backward.  Many of the spending programs that he doesn’t like were undertaken precisely because monetary policy reduced NGDP nearly 8% below trend between mid-2008 and mid-2009.  And the current recovery is anemic, with NGDP growing at less than 40% of the rate it grew during the 1983-84 recovery.

Calling price stability the Fed’s “ultimate goal,” he said the U.S. central bank will not tolerate either inflation or deflation.

“The Federal Reserve is absolutely committed to its goal of achieving price stability,” he said. “This entails keeping inflation extremely low and stable.”

I’ve already said enough about “opportunistic disinflation.”

Ben Bernanke doesn’t think the economy needs any more monetary stimulus, even though many types of monetary stimulus are essentially costless.  Oddly, however, Bernanke does seem to think we need fiscal stimulus, even though fiscal stimulus is extremely costly, imposing huge dead-weight costs on the economy from future tax increases:

Federal Reserve chief Ben Bernanke told Congress on Thursday that the economy needs continued government stimulus spending to strengthen the recovery and reduce unemployment. But more stimulus spending would be a tough sell with congressional Republicans, who say the first round hasn’t helped enough.

This has never made any sense to me.  In the comment section of a recent post, Andy Harless provided the most plausible explanation that I have seen thus far:

Under today’s circumstances, fiscal policy is more precise than monetary policy. (It’s easy to get a vaguely reasonable estimate of the effect of a fiscal policy move, e.g. extending unemployment benefits, on AD. Much harder to estimate the effect of, say, a $200 billion purchase of 5-year T-notes by the Fed.) I think this is somehow related to the conception that most people seem to have that fiscal policy affects real output and monetary policy affects the price level. I’m not sure exactly how.

The term ‘today’s circumstances’ refers to the current monetary base setting and near-zero interest rates.  Harless is arguing that this fulfills the “other things equal” assumption required to get relatively accurate fiscal stimulus multiplier estimates.  Elsewhere I have criticized that view, noting that Fed signals about future policy intentions (exit strategies, etc) are its most powerful tool.  But as this is a minority view, I’d like to focus on some other issues.

1.  The first thing I’d say is that if the Fed believes it doesn’t have any precise tools to use, then it has no one but itself to blame.  In 1988 or 1989 I presented a paper at the New York Fed advocating the targeting of NGDP futures.  The audience assured me that the Fed already had all the tools it needed to target NGDP, and didn’t need any help from futures markets.  So how’s their interest rate targeting working out now?  Even worse, if you run out of interest rate “ammunition,” you’d presumably want to turn to QE.  Unfortunately the Fed began paying interest on reserves in October 2008, which essentially sterilized the effects of QE.  The Fed is like someone who puts on boxing gloves, and then complains that they are having trouble sewing on a button.  Take off your gloves!

2.  The Fed definitely needs to move toward level targeting, and give up on the inflation targeting approach, which has obviously failed.  Under level targeting the economy is much less likely to overshoot toward high inflation, because commodity speculators will know that if inflation rises above target, tight money will later bring it back down to the target.  Even better, since markets are forward-looking, the mere expectation of future corrective action will make overshooting much less likely (as with a credible currency peg.)

3.  But even if the Fed sticks with inflation targeting, they ought to be able to prevent overshooting.  I think many economists are still over-reacting to a very painful episode in American monetary history, 1965-1981.  As you may recall (if you are an old guy like me), the economics profession was continually surprised by unexpected increases in inflation during that period, as the trend rate rose from about 1% to over 10%.  But there are two very good reasons why that won’t happen today.  Unlike during 1965-81, we have TIPS markets which allow us to measure inflation expectations in real time.  And second, the Fed has a much greater understanding of the risks associated with letting inflation expectations drift to higher levels.

You may ask why I focus on inflation expectations, and not inflation.  After all, market expectations can be wrong.  It turns out that it isn’t just me; the Fed also focuses on inflation expectations.  The reason is that transitory movements in actual inflation, which don’t get embedded into expectations, are not very harmful to the economy.  For instance, inflation might rise temporarily because of an oil shock.  But if inflation expectations don’t rise then the temporary rise in actual inflation won’t become embedded in core inflation and wages (which respond to inflation expectations.)

If inflation starts to creep up to unacceptable levels the Fed can raise rates.  There is nothing equivalent to the zero rate bound on the high side.  And the mere fact that markets know the Fed can do this will tend to keep inflation expectations well anchored.  Of course all of this would be much easier if the Fed came up with an explicit price level, or better yet, an NGDP target.

Since I’ve responded to Harless’s comment, I’ll give him the last word.  In a different post’s comment section he expressed skepticism about whether TIPS spreads can be counted on to accurately measure inflation expectations:

Also, it risks getting whipsawed by changes in risk/liquidity premia associated with TIPS vs. nominal bonds. (I’m guessing this might be an even bigger problem with long-horizon NGDP futures, since my impression is that futures with distant settlement dates usually have low liquidity, and I can’t see a way to do NGDP futures with a settlement date before the actual horizon date.)