Rajat directed me to a new post by Stephen Williamson, which suggests that recent events provide support for the NeoFisherian view.  The Fed has been gradually raising their interest rate target since late 2015, and inflation has gradually risen from near zero up to roughly 2%.  In addition, nominal interest rates are positively correlated with inflation rates at the international level.

Here are three ways of interpreting that evidence:

1. Higher interest rates cause higher inflation.  (NeoFisherism)

2. Low unemployment led the Fed to fear inflation (Phillips Curve), and they tightened monetary policy to prevent inflation from overshooting. (Keynesian)

3. The Fed did not tighten at all.  Contra NeoFisherism, raising the interest rate target is usually contractionary, ceteris paribus.  But the Fed often raises rates during periods when the natural rate is rising, and in most cases they raise rates more slowly that the natural rate is rising.  This means that while it is true that raising rates is usually contractionary, ceteris paribus, in the majority of cases a period of rising interest rates is also a period of increasingly expansionary monetary policy. I would argue that 2017 was no different. So I also reject the Keynesian view.

I prefer the second and third explanation to the first because the NeoFisherian view is inconsistent with the response of asset prices to unexpected changes in the central bank’s nominal interest rate target.  And I prefer the third explanation to the second because the Phillips Curve is not a reliable way of forecasting inflation, and changes in the nominal interest rate are not a reliable indicator of changes in the stance of monetary policy.

Off topic, I just returned from a monetary conference at the Hoover Institution, which was attended by no fewer than 4 Fed presidents.  I was delighted to see both John Williams (who was recently appointed to the New York Fed), and Robert Kaplan (Dallas Fed) mention both price level and NGDP level targeting as promising options to think about.  While neither endorsed these policy options, I had the impression that if the Fed were not already committed to inflation targeting, these two Fed presidents would probably be favorably inclined to one of these two approaches.  Kaplan seemed especially interested in NGDP targeting.  However, I don’t expect the Fed to change its policy target as long as things are going well.  Instead, I’d expect some consideration of level targeting the next time we go into a recession, and hit the zero bound.

Nick Rowe likes to teach PPP with a thought experiment, asking students to imagine how they might guess an exchange rate between the dollar and a foreign currency.  Thus if you went to Japan and noticed that most prices seem to be about 100 times higher than in the US, you might guess that 100 yen equals one dollar.  Of course PPP often does not hold true, but it’s still probably the best first guess for the exchange rate, if you had absolutely nothing else to go on.

In that case, it is more useful to think of the exchange rate being caused by the Japanese price level being 100 times higher than in the US?  Or should we think about the price level difference being caused by the exchange rate?  Is this even a meaningful question?

I like to think about the two price levels as being in some sense more fundamental, as I could imagine a case with no contract between the two countries.  Then once contact is made by Commodore Perry, the exchange rate conforms to the pre-existing price levels.  But you can also imagine a new country being settled by England, and choosing to use the dollar rather than the pound.  In that case the two price levels would be determined by the choice of the exchange rate.  The adoption of the euro is an obvious recent example, which caused Italian prices to plummet dramatically.

In a recent comment section I’ve discussed the fact that the 30-year forward dollar trades at roughly 50 yen (actually 49.332).  Is that exchange rate caused by the interest rate differential, or is the interest rate differential caused by the forward exchange rate?  People in the financial markets may focus on interest rate differentials as the primary factor, as the 30-year forward exchange rate is not very liquid and seems to be roughly 50Y/$ merely to prevent easy arbitrage opportunities, given the interest rate differential.

[I tried to see if interest parity held, but I don’t know the interest rate on 30-year zero coupon bonds.  So I took the yields on actual 30-year bonds as a proxy.  The US 30-year bond yields 3.17% and the Japanese bond yields 0.747%.  The differential is 2.423%.  Then I took 1.02423, and raised it to the 30th power, which equals 2.0508.  Then I took the actual exchange rate of 106.17, and divided by 2.0508, and got 51.77 as the implied 30-year forward yen. Is that right?]

In my view, it makes more sense to think of the expected 30-year forward exchange rate of 50 as the fundamental factor, and the interest rate differential as contingent on that expected future exchange rate.  Conversely, consider what would happen if we were to start with the interest rate differential as fundamental.  Then thinking in terms of interest rates, what would the BOJ have to do to prevent the yen from getting so strong in 30 years?  Obviously they need to make monetary policy more expansionary.  That’s how you weaken a currency.  But how do you do that in terms of the interest rate differential?  Obviously you need to get rid of the interest rate differential if you want the yen to be worth roughly 106 out in the year 2048.  But how do you get rid of the interest rate differential, while making monetary policy much more expansionary?

Let’s assume the BOJ cannot do anything about the level of interest rates in the US.  If they want the yen to be worth 106Y/$ in the year 2048, they need to get Japanese interest rates up to 3.17% on 30-year Japanese government bonds.  Even more daunting, they must do so with a highly expansionary monetary policy.  (Cochrane and Williamson are smiling at this point.)

So how do you do that?  Normally, a decision to raise interest rates is treated by the financial markets as a tight money policy, which causes the currency to appreciate.  So the BOJ needs to get interest rates up to 3.17% on 30-year bonds, and keep the exchange rate close to 106Y/$.  So how do they do that?  The simplest solution is to go back to Bretton Woods, and peg the yen to the dollar at 106.  If credible, that will cause Japanese 30-year bond yields to rise to 3.17%, and after 30 years the exchange rate will still be 106.  Because of PPP, Japan’s inflation rate over the next 30 years probably won’t be much different from the US inflation rate.  More importantly, the current expected inflation rate will rise to roughly 2%, just as in the US.

The fact that investors now expect the yen to be trading at about 50Y/$ in 2048 tells you just how far away from success the BOJ remains.  This is why I say that any talk of exiting from monetary stimulus is crazy.  Monetary policy in Japan remains extremely tight, expected to produce very low inflation over the next 30 years.  They need more than tinkering; they need a dramatic regime change.  I don’t advocate a fixed exchange rate system, but that’s one example of a radical regime change that would “work”.  A better option might be level targeting, combined with a “do whatever it takes” approach to monetary policy implementation.  I.e. buy as many assets as needed to get prices or NGDP rising along the desired level targeting path.

We don’t have that regime today, which makes the 30-year forward yen a useful proxy for policy credibility.  Only when the 30-year forward yen rises far above the current level of 50 can the BOJ start relaxing.  The BOJ has had some success in boosting prices and NGDP, but very little success in convincing the markets that this policy will continue in the very long run.  It seems like markets believe that once Abe is gone the BOJ will revert to its old habits.

PS.  If the regime change is credible they won’t have to buy very many assets.

Tyler Cowen linked to a Binyamin Appelbaum interview of Boston Fed President Eric Rosengren:

Q. A number of the academics at this conference said they don’t think you should be trying to raise rates. What do you make of their hesitations?

A. We haven’t hit 2 percent inflation for a while. Some of them have argued that we should in effect be price-level targeting, which is to say that the misses that we’ve had in the past ought to be made up in the future. So they have a different model than we actually are using for monetary policy. We have an inflation target right now. If we wanted to move to price-level targeting, as was advocated by a number of the academics at the conference, we should have that discussion. We should announce it publicly. I don’t think we should do it without telling the public.

I think also the inability of so many central banks to hit their 2 percent inflation target has caused some people to say, “I want to actually see evidence that you can hit 2 percent, and since we’ve just seen the consequences of hitting the zero lower bound, I want to take out some insurance against hitting the zero lower bound more quickly.” I think both concerns are credible. My concern with those arguments would be that the very scenario that causes the next recession might be that we overshoot.

Rosengren currently favors an increase in the Fed’s target rate, whereas I’m a bit more skeptical.  But I do applaud the way he analyzes these issues.  Level targeting makes a lot of sense, but only if you’ve announced that you are going to do level targeting.  Otherwise it may end up destabilizing the economy.  Monetary policy would react in ways that the markets did not anticipate.

The next recession is likely to have the same cause as the previous one—Fed tightening triggered by inflationary concerns.  If you run 3% inflation for a while because you are doing level targeting of prices, that’s fine.  But if you run 3% inflation, and then tighten because inflation is over your 2% target, then the high inflation could trigger another recession.

That’s why I keep insisting that the Fed needs a completely new strategy (NGDPLT), and that we focus far too much on minor tactical issues, such as the question of whether the Fed will raise rates in December.

In contrast, when the economics profession should have been screaming tight money from the rooftops (say in 2008) they were almost completely silent (except a few MMs, and people like Bob Hetzel.)

PS.  Here’s another quote I like:

So you don’t see instances where we go from 4.2 percent to 4.7 or 5 percent and level off. What you actually see is when we start tightening we end up with a recession.

I’ve done a number of posts pointing to the fact that the US does not have any mini-recessions, whereas our macro models predict that mini-recessions should be more plentiful than actual recessions.  That is, when unemployment start rising, you don’t see it rise 1.0% or 1.5%, and then stop.  It either rises by only a tiny bit, or by a lot.  The Fed needs to prevent those cases where it rises by a lot. (Oddly, other countries do have mini-recessions.)  If we switched to any sort of level targeting (P or NGDP), then I predict the US would start having mini-recessions instead of normal recessions.

I find that when things go bad with the economy, the level of discourse seems to suffer.  Here are a few items I keep bumping up against:

1.  Why not do a helicopter drop?  Because there are no free lunches in economics, and any fiscal stimulus will have to be paid for with future distortionary taxes.  What if they promise to never remove the money injected in the helicopter drop? Then we either get hyperinflation or perma-deflation, neither of which is appealing.  Won’t it help to achieve the Fed’s inflation target?  The Fed already thinks it’s achieved its target, in the sense that expected future inflation is 2%, in the Fed’s view.  That’s why they raised rates in December.  You and I may not agree, but helicopter drops are a solution for a problem that the Fed doesn’t think exists.  If we can convince the Fed that market forecasts are superior to Philips curve forecasts, then the solution is not helicopter drops, it’s a more expansionary monetary policy.

2.  Are negative interest rates good for the economy?  That’s not even a question.  I don’t even know what that means.  For any given monetary base, lower levels of IOR are expansionary (for NGDP), and lower levels of long term bond yields are contractionary. So there is no point in even talking about whether negative rates are good or bad, unless you are clear as to what sort of interest rate you are discussing.

People often debate whether the problem is that interest rates are too high, or whether the problem is that interest rates are too low.  Neither.  The problem is that we are discussing interest rates, which means we are talking nonsense.  We need to talk about whether NGDP growth expectations are too high or too low.  We need to create a NGDP futures market (which I’m trying to do, but not getting much support) and focus on getting that variable right.

Tyler Cowen’s recent post on negative rates is not helpful, because it fails to distinguish between the fact that negative bond yields are bad and negative IOR is mildly helpful.  The eurozone has negative bond yields because it raised IOR in 2011.  That was a really bad move.

3.  If market monetarism is so smart, how come you guys can’t predict recessions?  The point of economics is not to predict recessions (which is impossible, at least for demand-side recessions) the point is to prevent recessions.

4.  What’s the optimal rate of NGDP growth, or the optimal rate of inflation?  It depends.  If the central bank plans to hit the target you can get by with a lower growth rate than if they plan to miss the target.  If they use level targeting then the optimal growth rate is lower than if they target the growth rate.  If capital income taxes are abolished then the optimal rate of inflation/NGDP growth is higher than otherwise. So I can’t give you a specific number, except to say “it depends.”

5.  What do we make of the fact that the yen depreciated when negative IOR was announced, and later appreciated?  The depreciation that occurred immediately after the announcement was caused by the negative IOR.  The later appreciation was caused by other factors.  The EMH says the market responds immediately to new information.  BTW, talk about a new headline not matching the accompanying article, check out this bizarre story from Bloomberg.

6.  Thomas Piketty recently claimed:

Whatever the case, however, the failures to make such [structural] reforms are not enough to explain the sudden plunge in GDP in the eurozone from 2011 to 2013, even as the US economy was in recovery. There can be no question now that the recovery in Europe was throttled by the attempt to cut deficits too quickly between 2011 and 2013—and particularly by tax hikes that were far too sharp in France. Such application of tight budgetary rules ensured that the eurozone’s GDP still, in 2015, hasn’t recovered to its 2007 levels.

No question?  Anyone making that claim has clearly paid no attention to the recent debate over fiscal and monetary policy. His claim is not just wrong, it’s patently absurd.  I question the claim.  Hence there is a question.  QED.

Seriously, Piketty himself points out that the US kept growing during 2011-13.  And the US did even more austerity than Europe.  And the only significant policy difference was that the US monetary policy was much more expansionary than the eurozone monetary policy.  The logical inference is that the eurozone recession was caused by tighter money in Europe. I’m tempted to say that there is “no question” that tight money in Europe caused the double-dip recession, as eurozone fiscal policy was more expansionary than in the US.  But I won’t, because Piketty clearly questions this claim.

Are there any Keynesians out there who are willing to debate me on this point?  I’d love to see the argument as to how fiscal austerity clearly caused a double dip recession in Europe, even though the US did even more austerity and kept growing. It seems to me as if Keynesians live in some sort of intellectual bubble, where they aren’t even aware of the arguments made by people on the other side.  That’s not helpful if you have to debate the other side.

John Taylor has a new post criticizing NGDP targeting:

One change is that, in comparison with earlier proposals, the recent proposals tend to focus more on the level of NGDP rather than its growth rate. This removes some of the instability of NGDP growth rate targeting caused by the fact that NGDP growth should be higher than its long run target during the catch up period following a recession. But it introduces another problem: if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targeting and most likely result in abandoning the NGDP target.

I see lots of problems here, but in fairness this may reflect my particular vision of NGDP targeting, which is the “target the forecast” approach.  Under my plan, the Fed would constantly adjust policy so that expected future NGDP (12 or 24 months forward) remained right on target.  Ideally this would involve NGDP futures markets, more likely it would involve an internal Fed NGDP forecast, which also incorporated the consensus private NGDP forecast as well as various asset prices such as TIPS spreads.

Taylor is right that there might be inflation shocks under NGDP targeting, just like there are under inflation targeting.  For instance, the rise in oil prices in 2007-08 caused CPI inflation to rise far above the Fed’s implicit target.  But he’s wrong in assuming these inflation shocks would raise NGDP, indeed NGDP growth slowed to well under 5% during the 2007-08 oil shock.

The deeper problem with this criticism is that wages are not set on the basis of expected inflation, but rather the expected rate of NGDP growth.  That’s why wages in a country like China have been rising at double digit rates for years, despite much lower inflation rates.  It is why wages in the US remained well behaved in 2007-08, even as headline inflation rose to over 5% (as NGDP growth was slowing.)  As long as the Fed keeps targeting NGDP expectations, wage growth will remain anchored.  Workers and employers understand that wages cannot compensate for every spurt in prices at the gas pump.  If actual NGDP does change suddenly, it will be easy to reverse as long as expected future NGDP (and hence wages) remain on track.  (Note; this argument applies best if the Fed targets NGDP per capita, or per working age adult.)

If the Fed had been targeting inflation in 2008 the crisis would have been far worse, as monetary policy in mid-2008 would have been much tighter.  The Fed actually takes both inflation and real growth into account.  But an NGDP target would allow them to do so in a much more explicit fashion, and would have allowed them to ease much more aggressively in late 2008.

Taylor continues:

A more fundamental problem is that, as I said in 1985, “The actual instrument adjustments necessary to make a nominal GNP rule operational are not usually specified in the various proposals for nominal GNP targeting. This lack of specification makes the policies difficult to evaluate because the instrument adjustments affect the dynamics and thereby the influence of a nominal GNP rule on business-cycle fluctuations.” The same lack of specificity is found in recent proposals.

That may be true of Romer and Krugman, but they were basically endorsing the proposals of others.  And certainly no one can claim that my proposal lacks specificity—it is just as rule-based as Taylor’s famous policy rule.  It also has the advantage of being forward-looking, which is a huge plus in a fast moving financial crisis like 2008.  The Fed used Taylor Rule-like reasoning in deciding not to cut rates below 2% in their September 16, meeting, which occurred right after Lehman failed.  They cited a roughly equal risk of recession and inflation.  Incredibly, the risk they saw was excessively high inflation, not excessively low inflation.  How could the Fed have made such a bone-headed mistake?  They were looking in the rear view mirror, at nearly 5% headline inflation over the previous 12 months.  They should have looked down the road as Svensson suggests, as the TIPS spreads that day showed 1.23% inflation over the next 5 years.  Taylor Rule-type thinking caused the Fed to unintentionally leave money way too tight to hit their implicit inflation and employment targets.

I’m sure that today even Ben Bernanke would agree that they erred in not sharply cutting rates at the September 2008 meeting.  During the fall of 2008 the Fed needed to do enough stimulus so that forecasts of 2010 NGDP remained roughly 10% above actual 2008 levels.  They didn’t even come close, which is why the recession was so much worse than it needed to be.  The sub-prime fiasco made a mild recession almost inevitable, but the fall in NGDP (the biggest since the 1930s), made it far worse than it needed to be.  Sharply falling NGDP expectations in late 2008 led to sharply lower asset prices, which dramatically worsened bank balance sheets.  IMF estimates of expected US banking system losses nearly tripled in late 2008 and early 2009, even though the sub-prime fiasco was already well-understood by mid-2008.  What wasn’t predicted in mid-2008 was the catastrophic fall in NGDP over the next 12 months.

At first glance Taylor’s piece looks like a critique of NGDP targeting.  But on close inspection it is something different.  It is a discussion of tactics; level versus growth rate targeting.  Rules versus discretion.  I’ve added the issue of forward-looking versus backward-looking rules.  These are all interesting issues, and I actually agree with Taylor on the importance of policy rules.  He is well aware that some of the most distinguished proponents of NGDP targeting (such as Bennett McCallum) have proposed explicit NGDP policy rules.  He also knows that the dual mandate embedded in NGDP targeting is not that different from the dual mandate embedded in the Taylor Rule.  Readers of critiques by Taylor and Shlaes need to keep in mind that their real target isn’t NGDP targeting, it’s discretion.  I hope John Taylor will consider jumping on board and writing an explicit “Taylor Rule” for NGDP targeting, so that if the Fed does move in that direction they do so in a responsible way.

BTW,  What’s the non-discretionary Taylor Rule suggestion for Fed policy if rates fall to zero and further stimulus is needed?

HT:  Marcus Nunes