Archive for the Category Level targeting


What I said on August 21st

See how this looks today:

So both Hamilton and Greg Mankiw have suggested a price level target with a 2% trend growth rate.  These are both highly respected moderates who don’t shoot from the hip like I do.  They both praise Bernanke.  I see this as a real test for Bernanke and the FOMC.  If the Fed won’t even do this little amount . . .   Something that would not require tearing up the (implicit) 2% inflation target and replacing with another number.  Something that would anchor the price level and remove any lingering fears of high inflation.  A policy that could be defended even if the Fed didn’t give a damn about unemployment at all, if the Fed lacked a dual mandate.  If they won’t even do that much, then the Fed will have abdicated all responsibility.

Even the Hamilton/Mankiw proposal would represent failure, relative to what the Fed would be expected to do if rates weren’t stuck at zero.  But at least it would be something (unlike Operation Twist, which seems like nothing to me.)

The TIPS markets show very clearly that investors have given up on the Fed.  There will be no level targeting (of prices or NGDP.)

Memo to Krugman: Quasi-monetarism isn’t monetarism

Here’s Paul Krugman criticizing what he calls “quasi-monetarism”:

Now, in principle you can get traction by making money a less attractive store of value. In particular, if you can credibly promise future inflation, that will make the real return on money negative. But getting that kind of credibility is tricky, especially given the normal prejudices of central bankers. And in any case it’s very different from the kind of thinking we normally associate with monetarism, which focuses on the current money supply.

That’s a good description of the problem with old-style monetarism, but has no bearing on the quasi-monetarist model.  Quasi-monetarists are generally in favor of level targeting, having the monetary authority make up for shortfalls or overshoots.  That means we don’t focus on the current money supply, we focus on the future expected path of policy as a way of controlling NGDP.  The expectations traps that appear in Krugman’s models result from a memory-less inflation rate targeting regime.  Even Michael Woodford argues that level targeting is a good way of addressing expectations traps.  It’s infuriating to see Krugman treating us like a bunch of dummies, especially as at least one of us described why temporary currency injections had little or no effect long before Krugman himself did.

Krugman is surely right about the “prejudices of central bankers” being an impediment to appropriate policy, just as the prejudices of Congressmen are an impediment to appropriate fiscal policy.  That’s the whole point of the quasi-monetarist movement—we are trying to change those prejudices.  But from a purely technical perspective there is nothing in quasi-monetarism that conflicts with Krugman’s basic expectations trap model.  A credible regime of level targeting is far more politically acceptable than suddenly raising the inflation target to 4% during recessions, and just as effective.

HT:  Dilip

Why we are losing (A shockingly uninformed statement by Alan Blinder)

In a recent post I argued that the opponents of having the Fed promote faster NGDP growth are full of “passionate intensity” while the supporters are strangely silent.  There is no better example of this weak passivity than this shockingly uninformed statement by Alan Blinder:

Creating jobs costs money””whether it’s via tax cuts or more spending. (The Federal Reserve normally can create jobs without budgetary costs, but with interest rates already near zero it says it’s out of ammunition.)

This is what Paul Krugman would call a “lie.”  (I think Blinder’s just uninformed.)  Alan Blinder (who used to be vice chair of the Fed!!), seems completely ignorant of the fact that the Fed repeatedly insists it is not out of ammunition, that it has many tools that it hasn’t even used.  Blinder’s statement isn’t even close to being true.  Here’s Ben Bernanke in 2010:

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.

Perhaps Blinder got confused by statements made by some of the Fed hawks, who expressed skepticism that additional stimulus would help.  But these hawks are worried about more inflation.  They don’t deny that the Fed can inflate, but worry that more NGDP would not raise real output, just prices.  If the zero bound was a problem, they couldn’t even inflate.

The Fed has studies showing QE2 had a positive impact.  Bernanke insists that there are even more powerful tools that the Fed is still reluctant to use–lower IOR, higher inflation targets, or level targeting.  Or they could do a much bigger QE3.

It would be one thing if our Fed made phony claims about being unable to boost AD, as the BOJ sometimes does.  But the Fed actually insists it can do much more, it simply doesn’t think the economy needs more AD.

And much of the liberal establishment covers its ears and pretends not to hear.  Pathetic.

PS.  By the way, not only would aggressive monetary stimulus cost nothing, it would actually have negative budget costs, as it would sharply reduce our budget deficit.

HT Marcus Nunes

Charles Calomiris explains why QE2 is needed

A few months back a great deal was made of a letter signed by 24 mostly conservative intellectuals.  Some people drew the conclusion that conservative economists were opposed to QE2.  Undoubtedly many are, including some that did not sign the letter.  But the letter itself shows almost nothing.  Many of the signers were not economists.  A grand total of 5 had jobs at American universities.  One more taught at a college.  Four were at Stanford, meaning a total of one American economist teaching at a university not named Stanford signed the letter.  Let’s take a look at that one, the distinguished monetary economist Charles Calomiris, who teaches at Columbia University.

Noah Kristula-Green emailed Calomiris to ask him why he opposed QE2:

Charles W. Calomiris of the Columbia University Graduate School of Business told FrumForum in an email that he favored keeping interest rates were they currently were:

“There are many reasonable alternative views on how to target monetary policy. I favor Ben McCallum’s proposal to target nominal GDP growth at about 5%. Since we were on track with that target before QE II, at least for the moment, I would neither be raising or lowering interest rates.”

Though he also stated that he would be in favor of a looser monetary policy if the evidence could convince him the circumstances warranted it:

“If there were evidence of a need for further loosening to raise the growth of nominal GDP to that target rate, then some quantitative easing might be a reasonable proposal.”

This puzzled me on several levels.  First, I also support 5% NGDP growth targeting, and I thought QE2 was far too weak.  The easiest way to explain this discrepancy is that I favor level targeting, which requires us to make up for at least some of the previous NGDP shortfall, whereas Calomiris may support a sort of “memory-less” growth rate targeting.  Let bygones be bygones.  I feel pretty strongly that level targeting is better after a serious slump, and also when monetary policy is up against the zero bound, but let’s put that issue aside.

What I find most perplexing about Calomiris’s statement is that even if you accept growth rate targeting, and even if you buy his argument that QE2 should only be adopted if there were signs that NGDP growth was likely to be inadequate, there is no logical reason why Charles Calomiris should have opposed QE2.

A few weeks ago I suggested that the early indications are that QE2 had raised NGDP growth expectations up from about 3.5% to 4.0% in late summer, to around 5.0% to 5.5% today.  Isn’t that what Calomiris wants?  But those were just my hunches, from reading various news stories.  So I looked for a table that averages the various forecasts.  The Economist  magazine provides monthly estimates of the consensus forecasts for RGDP and inflation.  They don’t provide separate NGDP forecasts, but NGDP growth is usually similar to the sum of RGDP growth plus CPI inflation, if not slightly lower (as the GDP accounts use a more conservative technique for estimating inflation.)

Here are the numbers for the last 8 months of The Economist:

Issue date     RGDP growth        CPI inflation    Sum of growth plus inflation

June 3                   3.0%                   1.8%                              4.8%

July 8                    2.9%                   1.5%                              4.4%

Aug. 5                   2.8%                    1.5%                             4.3%

Sept. 9                  2.4%                    1.5%                             3.9%

Oct.  7                  2.4%                     1.5%                             3.9%

Nov.  4                 2.3%                     1.5%                             3.8%

Dec.  9                  2.6%                     1.5%                             4.1%

Jan. 6                   3.0%                     1.5%                             4.5%

A few comments on the numbers.  The date refers to the issue of the Economist magazine.  Because these changes lag a couple months behind changes in many market indicators, my hunch is that the actual forecasts were made somewhat earlier.  The Economist may have surveyed forecasts that had already been published elsewhere by professional forecasters.  But either way, whether you think NGDP growth forecast hit bottom at the time QE2 was announced, or whether you believe (as I d0) that they hit bottom right before the intense flurry of QE2 rumors in September and October, it is clear that NGDP growth expectations were falling well below 5%, and QE2 seems to have raised them back up closer to Calomiris’s target.

I don’t know about you, but even if these numbers are slightly off, I don’t see any reason for someone who favors 5% NGDP targeting to write a highly public letter complaining about Fed policy on the basis of this sort of pattern.  Perhaps Calomiris looked at actual NGDP growth.  But NGDP growth had only averaged about 4% during the recovery, and if anything was slowing slightly in the summer of 2010.

Now it may be that actual NGDP growth in 2011 will come in at a tad more than 5%.  Perhaps we’ll get 4% RGDP growth and 1.8% inflation.  And Calomiris can claim that vindicates his opposition.  But even in that case I don’t think I’d write a letter complaining about Fed policy being too easy, particularly if I had not signed any letters complaining it was too tight from mid-2008 to mid-2009, when growth was 8% below trend, or mid-2009 to mid-2010 when it was 1% below trend.  Indeed I don’t recall any letters from conservatives complaining about tight money, unless you count us quasi-monetarists as “conservatives.”

My hunch is that Calomiris was asked to sign the letter, had recalled reading someone forecast roughly 3% growth, added on an assumption of 2% inflation, and thought “things are fine, we don’t need that.”  I think if he had looked closely at the data, and noticed that the recent increases in forecasts for 2011 occurred precisely when QE2 rumors began swirling around, and precisely because of QE2 rumors, he might not have signed the letter.  I hope he provides more clarifying remarks.

PS.  I notice Ben McCallum did not sign the letter.

Why I don’t believe in liquidity traps

I’ve been asked to summarize my views on liquidity traps in one place, so brace yourself for a long post.  (Longtime readers will definitely want to skip this one.)

For simplicity, I’ll define the term ‘liquidity trap’ as a situation where a fiat money central bank with a freely floating currency is unable to boost nominal spending because nominal interest rates have fallen to zero.  There may be some cases where central banks are limited by laws regulating the sorts of assets they are allowed to purchase, but I know of no real world cases where that was a determining factor.  Indeed I know of no case where a central bank that wished to boost inflation and/or NGDP was unable to do so.  Nor do I think we need ever worry about that scenario actually occurring.

On the other hand, I do think the zero rate bound is a real problem for real world central banks.  Because central banks are used to using short term rates as their primary policy tool, policy may well become sub-optimal once rates hit zero.  But that would not be because an economy is “trapped” at a zero bound, rather it is because central banks are reluctant to aggressively use alternative policy tools, including tools that would be much superior to fed funds targeting even if the economy were not up against the zero bound.

Part 1.  Basic monetary framework

Unlike most economists, I don’t believe that changes in short term interest rates play an important role in the monetary transmission mechanism.  The liquidity effect is an epiphenomenon, having little impact on investment.  Woodford argues that what really matters is changes in the expected future path of interest rates.  I agree that policy expectations are a key, but find it more useful to think in terms of changes in the expected path of the supply and demand for base money.  Simply put, I believe that current and expected future increases in base supply relative demand cause expected future NGDP to increase.  This is because even if we are at the zero bound, and cash and T-bills are perfect substitutes, we are not expected to be there forever.

Increases in expected future NGDP (my preferred policy indicator) raise current asset prices (foreign exchange, stocks, commodities, commercial real estate, etc.)  Because wages are sticky in the short run, production of corporate fixed assets, exports, commercial and residential real estate, commodities, etc, increase as their prices increase.  The resulting higher real incomes also boost consumption.  The reverse is true during tight money, as in late 2008.

I don’t like the interest rate transmission mechanism because interest rates often move in the “wrong” direction in response to monetary surprises.  An unexpectedly small cut in the fed funds target in December 2007 sharply depressed equity prices at 2:15pm.  The fed funds futures market confirmed that the decrease was smaller than expected.  Keynesian theory says T-bond yields should have risen on the news.  Instead, yields fell from 3 months to 30 years, as investors (correctly) understood that the Fed’s pathetic response to the sub-prime crisis would slow economic growth, and hence future fed funds rates would have to be cut sharply.  (And they were in January 2008.)  The action slowed the economy, but not because interest rates rose.

The powerful monetary stimulus of 1933 (dollar depreciation) had little effect on interest rates or the current money supply, but sharply raised future expected NGDP.  This sharply raised current asset prices, and led to rapid growth in output.

If you buy my argument that changes in expected future NGDP (what Keynes probably meant by “business confidence”) is driving current asset prices and aggregate demand, then the next question is whether monetary policy can influence future expected NGDP at the zero bound.

Part 2.  Unconventional policy tools.

My favorite example of an unconventional policy tool is the 1933 dollar devaluation.  In 1932 the Fed had tried open market purchases to boost the money supply, but the policy failed as fears the US would be forced to devalue led to gold outflows, which negated most of the effect of the asset purchases.  This is the only example of a liquidity trap cited in the General Theory.  Unfortunately, Keynes confused two closely related problems.  A liquidity trap is where an increase in the money supply fails to boost NGDP.  In 1932 the constraints of the international gold standard meant that purchases of assets failed to substantially increase the money supply.  That’s gold standard economics 101, having nothing to do with liquidity traps.  As soon as we left the gold standard in March-April 1933, FDR was able to easily create rapid inflation despite 25% unemployment, near zero T-bill yields, and much of the banking system shutdown for many months.

FDR’s policy of raising the price of gold can be seen in one of two ways.  In one sense it was a devaluation of the dollar in the forex markets, as most countries did not follow his action by raising their purchase price of gold.  But even if the US had been a closed economy the Fed could have depreciated our currency by reducing the weight of gold in one dollar.  In ancient times this was called “debasing coinage” and no one worried about the zero rate bound preventing central banks from inflating.  As far back as 1694 John Locke used a reductio ad absurdum argument to criticize monetary ineffectiveness claims.

Another approach is to do quantitative easing.  But printing money (even under a fiat money regime) will not be very effective unless the currency injections are expected to be permanent.  Why would people bid up asset prices if the central bank was expected to pull the money out of circulation in the near future?  This is why the QE done in Japan around 2003 did not do much, and it is why Paul Krugman is skeptical about QE.  The other problem is that it is hard to make a credible promise to permanently increase the money supply by X%, because once you exit the zero rate bound the velocity of base money will rise sharply, and unless the base is reduced you will get hyperinflation.  Markets know this, and hence don’t expect QE to be permanent.

The solution is to adopt an explicit nominal target such as the price level, or better yet NGDP, and then do level targeting.  This is essentially a promise by the central bank to leave enough base money in circulation long term to allow for a modestly higher price level of NGDP.  For instance, they might want to target 5% NGDP growth.  Even if we are at the zero bound and monetary policy appears to be spinning its wheels, a commitment to higher future NGDP will tend to raise current AD.

The Fed made two mistakes.  First, they did not engage in level targeting.  It has long been understood that once nominal rates hit zero the central bank must adopt a level target.  Indeed Bernanke lectured the Japanese on exactly this point back in 2003.  So in September 2008 the Fed should have switched to level targeting, indicating that they wanted core inflation to grow along a 2% path until we were out of the recession, promising to later make up for any near-term shortfalls.  Instead they allowed core inflation to fall well below 2%, and then (implicitly) indicated that they were going to continue inflation targeting, allowing bygones to be bygones.  There was to be no above 2% inflation to catch up for the shortfall.  This actually made their job much more difficult, as it resulted in a more severe recession than necessary in 2009, and then plunging investment pushed the Wicksellian equilibrium nominal rate below zero.  They could no longer use their traditional policy instrument and they were reluctant to aggressively employ alternative measures, because they didn’t know how strong the effect would be.  For instance, when banks needed more liquidity in late 2008 the Fed neutralized the effects of the large monetary base injections by paying interest on reserves at a rate higher than T-bill yields.  Only when the recession drove stock prices to extremely low levels in March 2009, and deflation appeared on the horizon, was the Fed willing to do QE1.  And only when the recovery faltered during mid-2010 (as European troubles increased the value of the dollar) was the Fed willing to do QE2.

The best way to avoid the zero rate bound is to create and subsidize trading in a price level or NGDP futures market, target the futures price, and let the money supply and interest rates respond endogenously.  The Fed should be willing to supply an unlimited amount of reserves in order to keep NGDP futures prices rising along a 5% growth trajectory.   Because there is no zero bound for NGDP futures prices, the Fed will always be able to keep NGDP expectations on target.

The flaw in the Keynesian model is that it assumes sticky wage and prices, whereas only T-bond prices are flexible.  But there are lots of other asset prices that are also flexible, and that don’t have a zero lower bound.  These include commodities like gold and silver, stocks, and foreign exchange.  Unfortunately, all of those asset prices have drawbacks as targets for a major central bank like the Fed.  And the asset price that would work best (NGDP futures prices) doesn’t yet exist.

[BTW, it’s a disgrace that the government has not yet set up and subsidized trading in a NGDP futures market.  Contrary to popular impression the Fed isn’t trying to create more inflation; they are trying to create more NGDP.  For any given increase in NGDP, the Fed would actually prefer less inflation and more RGDP growth.  We desperately need a real time measure of market NGDP growth expectations in order to know whether AD is likely to exceed or fall short of the target.]

In this imperfect world the best the Fed can do is to focus on TIPS spreads as a crude measure of expected inflation, and a whole range of indicators for expected RGDP growth, such as the relative prices of stocks and commodities, as well as other indicators or real output trends.  The Fed needs to do enough QE to increase expected NGDP growth (using all these imperfect indicators) up to the desired level.  Since we are below trend, they should probably target slightly above 5% NGDP growth for a few years, then 5% thereafter.

Part 3.  Fallacious arguments in favor of the liquidity trap

There are so many, I hardly know where to begin.  One common argument is that swapping cash for zero interest T-bills is useless, because they are perfect substitutes.  I don’t view them as perfect substitutes at all.  When I get in the car to go shopping at Walmart I don’t think “Hmmm, should I take cash or T-bills.”  At this point people will say “Yes, but zero interest bank reserves and T-bills are near perfect substitutes.  And all the recent base injections are going into excess reserves.”  Yes, but there is no zero lower bound on interest paid on reserves (and yes I’m including vault cash in “reserves.”)

But let’s suppose cash and T-bills were perfect substitutes.  Even in that case a permanent injection of new base money would still be expected to raise the future level of NGDP, as liquidity traps don’t last forever.  (If they did we should legalize counterfeiting.)   Yes, a temporary currency injection wouldn’t do anything, but that’s almost equally true when rates on T-bills are positive.  Temporary currency injections don’t matter, permanent ones do.  It makes little difference whether rates are at zero or not.

The second fallacious argument is that monetary policy was ineffective in the Great Depression.  Actually, when the government got serious about inflating they left the gold standard, and then they had no difficulty in raising prices sharply.

The third fallacious argument is that monetary stimulus would not be effective at the zero bound because central banks are conservative and no one would believe their promises to inflate.  In fact, no one can provide an example of a central bank that tried to inflate but failed because they were stuck in a liquidity trap.  Some cite Japan, but that example doesn’t meet any of the criteria for a liquidity trap:

1.  The Bank of Japan has frequently expressed opposition to a positive inflation target.  Because they are not trying to produce inflation, it’s no surprise they have failed to produce inflation.

2.  It’s true that they pay lip service to avoiding deflation, but every time the inflation rate rises above zero percent they tighten monetary policy and go right back into deflation.

3.  Some point to the large QE the BOJ did around 2003.  But their promise to keep prices stable meant the QE was going to be temporary.  The public knew this and quite rationally refused to bid up prices.  Sure enough, when 1% inflation threatened to rear its ugly head in 2006, they promptly reduced the monetary base by 20%.

4.  They passively sat by and allowed the yen to appreciate strongly, even as deflation was accelerating in recent years.

5.  If it walks like a duck . . .

Some point to the alleged failure of the Fed to inflate, despite trying hard.  Yet a few months back when Brad DeLong asked Bernanke why the Fed didn’t adopt a 3% inflation target, Bernanke said that would be a horrible idea.  The Fed had worked so hard to bring inflation down to low levels.  If you heard an answer like that, would you expect the Fed to produce higher inflation?  It’s no surprise inflation expectations have remained low.  Admittedly the Fed doesn’t want deflation either.  My view is that when core inflation falls to about 1%, warning bells go off and the Fed grudgingly does some QE to boost inflation a bit closer to 2%.  If that’s not what they are trying to do, I’d love to know their policy goal.

There’s another problem with the view that QE is ineffective at the zero bound.  Even if the Fed couldn’t reduce nominal rates, they could always reduce real rates.  Indeed Mishkin’s textbook suggests about 10 different transmission mechanisms other than nominal rates.  Yet liquidity trap proponents ignore them all.  Even worse, when the mechanisms are shown to work they go into denial, asserting that it just can’t be true because their theory says it’s impossible.  So for instance during September and October there were more and more rumors of aggressive QE (and possibly even level targeting) emanating from various Fed officials.  Mishkin’s text says this should boost stock prices, it should depreciate the dollar, it should raise commodity prices, it should raise inflation expectations in the TIPS markets, and it should lower real interest rates.  And all of those things happened.  For years Paul Krugman has been arguing that what the Fed really needed to do was to raise inflation expectation.  Well they did it.  And his response seemed to be incredulity, as if the markets were nuts in thinking QE could actually raise inflation expectations.

Although Krugman and Robert Barro are poles apart ideologically, they both suffer from one weakness–relying too much on what their models tell them.  Both expressed skepticism about whether QE would do very much, because they looked at QE from a mechanistic perspective.  But QE is much more than that;  it is an implicit commitment by the Fed to seek (slightly) higher inflation.  Of course they need to do much more, but they did succeed in terms of their very conservative goals.  They did generate about 0.5% higher inflation expectations over 5 years.  The reason QE worked was not the operation itself (which I agree does little or nothing) but rather because it tells the market that the Fed is now more serious about boosting long term prices and NGDP.  In other words they are now willing to leave that base money out there long enough to get closer to their implicit inflation target.  The Fed was afraid to directly call for higher inflation (something Krugman thinks could work) so they spoke in code, hoping the markets would understand them but Sarah Palin would not.  Unfortunately for Bernanke, Sarah Palin has advisers who know exactly what the Fed was up to.

Part 4.  Reductio ad absurdum arguments

I can’t take anyone serious who actually believes in a complete liquidity trap–i.e. that no amount of monetary base injections would be inflationary.  Taken literally, that would imply the Fed could buy up all of Planet Earth without creating any inflation.  Among serious economists the debate is over magnitudes.  The skeptics will say that the amount of QE required would be unacceptable, it would expose the Fed to excessive risks if they later had to resell assets in order to prevent runaway inflation.

In fact, there are all sorts of reasons why this “risk” argument is bogus.  First of all, the high base demand is itself a product of the Fed’s contractionary policies, which allowed NGDP to fall in 2009 at the sharpest rate since 1938.  That’s why banks hoard reserves.  A much more aggressive monetary policy would mean less real demand for base money.  Second, the demand for base money has been artificially bloated by the IOR policy; the public is not hoarding much cash and they certainly would not do so if the Fed set a much higher inflation or NGDP target path.  Most importantly, any capital losses suffered by the Fed would be tiny compared to the gains the Treasury would get from much faster NGDP growth.  Remember that the big drop in NGDP is the number one reason the deficit ballooned in 2009—more important than even the fiscal stimulus.  Furthermore, many of the Fed’s purchases have been medium term T-notes, for which price risk is not that significant.  If people are actually worried about this issue, the Fed could buy equities and foreign bonds, which would appreciate with an expansionary monetary policy.  But in my view those (controversial) steps would not be necessary, as the risks are greatly overblown.

Maybe I should stop there—I feel like I am beating a dead horse.  Does anyone still believe in liquidity traps?  Is there even anyone still reading this post?