Archive for the Category Monetary Theory

 
 

What does it mean to “have control”

There’s a lot of confusion over my previous post, where I agreed with Jeffrey Hummel’s claim that the Fed has relatively little control over interest rates, at least in the way that most people envision the concept.  (Of course they can create high nominal interest rates through persistent inflation, but that’s another issue.)

Let’s return to the road analogy.  A bus driver in the Alps can turn the wheel to the left and right, as he wishes.  However given the additional constraint that he prefers to avoid a fiery death, he actually has relatively little discretion—for all practical purposes he must follow the road.  In contrast, a hippie driving a VW minivan across the Bonneville Salt Flats can wander to the left and right according to his drug-fueled whims.  He has true freedom, true discretion.

So let’s go beyond pointless debates over the meaning of “control” and focus on the substantive issue here.  I claim that monetary policy is like the bus driver in the Alps, and I also claim that most people, and even many economists, view it as being at least somewhat more like the Bonneville Salt Flats.  Use whatever definition of ‘control’ that you prefer, but that is the substantive difference.

I claim that if Bernanke had adopted the sort of interest rate policy advocated by conservatives then we would have gone into a Great Depression, he would have been quickly replaced, and the Fed would have changed course.  Just as Trichet was replaced in 2011 after his small interest rate increase pushed the eurozone into a double dip recession (plus debt crisis), and just as Miller was replaced in 1979 when his low interest rate policy pushed the US into double-digit inflation.  In both cases their replacement quickly reversed course on interest rates.

Now I may be wrong on these points; some people claim the Fed has little or no control over the economy.  In that case they could set rates where ever they wished, and life would go on as usual.  I take almost the opposite view.  I believe they have very little room to adjust rates without creating a spiral toward hyperinflation or hyperdeflation.  Why don’t we see those disasters more often?  For the same reason we rarely see buses plunge off 100 foot cliffs–the Fed usually follows the road.

So yes, I understand the Fed controls interest rates in the same sense that a bus driver in the Alps controls steering.  To understand what I am trying to say, think about the two driving analogies above.  Then think about how conservatives advocated higher interest rates under Bernanke.  If you thought that was a plausible policy proposal, then you don’t agree with me on the substantive economic issues.  I believe it would have led to disaster, and been quickly reversed.  (Again, unless the higher rates were generated by higher inflation expectations, which is not what those conservatives had in mind.)

Off topic, Trump seems to now view the Obama record on jobs as “excellent” not “terrible”.  Why the sudden change in the characterization of jobs reports averaging 200,000/month?  Could it be because we have a different president?

PS.  My wife now spends most of each day on the phone dealing with bureaucracies (government, insurance, banks, etc.)  What an annoying Kafkaesque society we’ve created.

Monetary policy and interest rates

There is a new interview available in David Beckworth’s series of money/macro podcasts.  This time it’s with me.

I’m also happy to announce a new Mercatus working paper by Jeffrey Hummel, on a topic that’s dear to my heart—the myth of central bank control over interest rates.

Before discussing this idea, I need to reassure readers that both Jeffrey and I acknowledge that on any given day the Fed is able to raise or lower the fed funds rate, through suitable adjustments in monetary policy.  But that true fact leads many non-economists, and unfortunately even many economists, to wildly excessive views on the extent to which the Fed “controls” interest rates.  The deeper mistake is to confuse the path of interest rates over time with “monetary policy”. Here is the abstract to Jeffrey’s paper:

Many believe that central banks, such as the Federal Reserve (Fed), have almost total control over some critical interest rates. Serious monetary economists are more sophisticated. They realize that central bank control over interest rates is very far from complete. Nonetheless, central bank officials and many economists are largely responsible for the popular misapprehension. This is because they persistently and misleadingly describe central bank policy as if it determined interest rates. Their focus on interest rates as both the target and indicator of monetary policy stems from the fact that even those holding the sophisticated view of how monetary policy works tend to overestimate the strength and significance of a central bank’s limited effect on real interest rates. There is no denying that central banks have some impacts on interest rates, in both the short run and the long run. However, this working paper argues that not only is the popular belief in precise central bank management of interest rates simply wrong, but also even the sophisticated view of central bankers and mainstream monetary economists turns out to be overstated. In fact, continued targeting of interest rates by central banks has even led to some confusion and policy errors.

The entire paper is well worth reading.

I’d also like to add my own perspective.  One way to think about Fed control is with the concept of policy discretion–freedom to move rates at the whim of the FOMC.  Just how much freedom does the Fed actually have?

1. Let’s start with Wicksell’s concept of the natural or equilibrium rate.  He defined the natural rate as the interest rate that led to price stability. If the Fed pegs the expected future value of the CPI at a constant level, then it would have zero freedom to control interest rates.  In that case the market would set interest rates at the level expected to lead to price stability.  The same argument applies to a 2% inflation target, an NGDP target, or any other similar policy regime.  Let’s call this “perfect policy” and it implies zero central bank control over interest rates.  The Fed simply follows the market.

2.  Of course in the real world, policy is not always perfect.  But this doesn’t have the implications for policy discretion that many people assume.  Suppose the Fed sets the interest rate target at a level 1/2% below the Wicksellian equilibrium rate, and then leaves it there. Thus they peg the rate at 1.5% when the Wicksellian equilibrium rate is 2.0%. What happens next?  The simple answer is that the system blows up.  The expansionary monetary policy causes inflation expectations to steadily rise.  If the central bank stubbornly continues to peg the fed funds rate at 1.5%, then the actual (nominal) interest rate falls further and further below the (nominal) Wicksellian rate, which is rising sharply with higher inflation expectations.  Thus setting the policy rate below the Wicksellian rate causes policy to become increasingly expansionary over time, ultimately leading to hyperinflation.  At that time the system blows up, and people stop using the now worthless currency produced by the central bank.  Let’s call this the “disastrous policy”.

3.  If “perfect policy” is an unrealistic assumption for actual real world monetary policy, then “disastrous policy” is even more unrealistic.  The roughly 1.95% average inflation experienced since 1990 is closer to the Fed’s notion of “price stability” than it is to hyperinflation.  So let’s now consider the only case that really matters–imperfect policy that roughly but not perfectly adheres to the Fed’s dual mandate, while also making occasional errors.  In order to better understand the role of errors in creating central bank control over interest rates, it will be helpful to distinguish between small errors (1922-29, 1983-2007) and large errors (1929-33, 1966-82 and 2008-13).

A.  When there are large errors the macroeconomy will move far off course.  Does this give the Fed a lot of control over interest rates?  Actually it doesn’t, unless the Fed wants the system to blow up.  Thus LBJ and Nixon wanted a low interest rate policy to spur growth.  And for a brief period the Fed delivered.  But very quickly the Fed had to reverse course and raise rates to restrain inflation (caused by the earlier error).  The much more important moves in interest rates during the late 1960s and 1970s were higher not lower, despite a brief dip in rates associated with the Fed’s expansionary policy.  Many people wrongly attributed the higher interest rates to a discretionary Fed “tight money” policy, when they were in fact a product of a sharply rising Wicksellian interest rate, which was caused by higher inflation (or more specifically NGDP growth) expectations.

The same applies in the reverse direction.  The ECB used its “control” over interest rates to raise then 1/4% in July 2008, but the effect was so negative that the ECB had to cut them sharply over the next few years.  Those cuts were not “monetary policy”, they reflected a weakening economy depressing interest rates, and the ECB following along. (Interest rates used to fall during recessions even before the US had a central bank.) The ECB made the same mistake in the spring of 2011, raising rates by 1/2%.  Once again, the eurozone economy tanked and the ECB had to dramatically reduce rates over the next few years.

The bottom line is that during periods of policy failure, the big swings in interest rates do not reflect discretionary decisions of central banks, but rather are moves that are forced on central banks by their desire to prevent hyperinflation or hyperdeflation.  So when there are big policy errors, the big moves in market interest rates mostly do not reflect central bank “control” over rates—indeed just the opposite, rates moving in the opposite direction from the original policy error that created the disturbance.

B.  What about small policy errors?  Yes, the central bank has some control over rates in the short run, and can use that control to create small policy errors.  But the irony here is that the closer policy approaches perfection, the less discretionary control is available to the central bank.  In contrast, when errors are larger, the absolute level of control over rates is larger, but macroeconomy produces proportionally larger swings in inflation and NGDP growth, so the share of interest rate movements that reflect “monetary policy” remains quite small.  Most moves in interest rates reflect shifts in GDP growth and/or inflation, which were in turn created by previous policy errors.

There are powerful cognitive illusions here.  The day-to-day Fed “control” over rates creates the illusion of much more control than actually exists.  Monetary policy is much more than a series of short run decisions on where to set the fed funds target.  By analogy, a bus driver going through the Alps has very good short term “control” over the direction of the bus.  He can nudge the bus left or right by turning the steering wheel.  But over longer stretches of time the direction of the bus is “controlled” by a combination of the direction of the road (i.e. economy) combined with the bus driver’s strong desire than he and his passengers don’t hurl over the edge to a terrifying death (i.e. hyperinflation/hyperdeflation).

Hong Kong is a good example of a country with almost no control over interest rates. Why is that?  Perhaps because monetary policy in Hong Kong is nearly “perfect”.  Their monetary authority decided to target the exchange rate rather than inflation. More specifically, the HK$ has been pegged at roughly 7.8 per US$ since 1983.  That’s pretty close to perfect, given their policy goal (which may or may not be a wise goal.) That success creates credibility, and thus the exchange rate is expected to stay at this level.  As a result, interest rates in the Hong Kong move in tandem with rates in the US.

A common mistake is to assert that while the income effect and the Fisher effect are important “in the long run”, current interest rate changes reflect Fed control.  Wrong! The long run is right now.  “Current” is not the opposite of “long-run”, rather short run is the opposite of long run.  Perhaps 10 percent of current moves in interest rates reflect Fed “control”, while 90 percent reflect the long run income and Fisher effects of actions taken earlier.

Although I don’t count myself as a NeoFisherian, their view is in some ways less inaccurate than the conventional view.  It’s not always the case that higher interest rates reflect an easy money policy, but it’s much more likely to reflect the long run effects of an easy money policy, than it is to reflect the short run effect of a tight money policy.  So if someone put a gun to my head and forced me to believe that the Fed controls interest rates, I’d become a NeoFisherian and argue that they control them by controlling inflation and NGDP growth, not via the liquidity effect.

PS.  Moving has recently pre-occupied my time.  An hour ago I learned that I won’t get my furniture (including computer) for at least another week, much longer than they promised.  So we’ll continue to camp out in our home for quite some time.

Bob Murphy on the deflationary effects of devaluation fears

In a recent post, I quoted from a Josh Hendrickson review of The Midas Paradox, particularly the discussion of the deflationary impact of devaluation fears during the 1930s.  I viewed this as a bit of a puzzle.  It’s no surprise that devaluation expectations would raise the demand for gold, and hence the value of gold.  And since gold was a medium of account, that would be deflationary.  But it would also reduce the demand for currency, which was also a medium of account. So why didn’t it reduce the value of currency?  After all, an actual devaluation would reduce the value of currency.

Bob Murphy has a very interesting explanation in the comment section:

Scott,

Forgive me if I’m just saying the same thing you did, in different vocabulary, but, wouldn’t the following make sense? I don’t see what the mystery here is.

(1) Right now the US government will trade gold for dollars at $20.67 / ounce.

(2) Investors are worried that next year, they will charge people $35 to give them an ounce of gold.

(3) So investors naturally shift out of dollars and into gold. (Just like if you suddenly thought Acme stock would go from $20.67 today to $35 next year, at a time of very low interest rates, you would rebalance your portfolio to buy more Acme stock than you were holding 5 minutes ago.)

(4) Yet since right now the US is still on the gold standard at $20.67, as people try to get rid of dollars and hold more gold, the only way to maintain that rate is for the US Treasury to absorb dollars and release gold from its vaults.

(5) As the total amount of dollars held by the public shrinks, prices in general (quoted in dollars) fall.

Am I missing something?

That may indeed be the solution.  If so, what did I overlook?

1. Perhaps I focused too much on the actual currency stock, which did not tend to fall during these episodes.  But that may be because devaluation fears were associated with banking crises.

2.  So let’s assume that Bob is correct that devaluation fears are deflationary because they reduce the currency stock, ceteris paribus.  In that case, the banking panics that increased currency demand could be viewed as a second deflationary shock, and perhaps the central bank increased the currency stock enough to partially offset this increase in currency demand, but not the initial shock of more demand for gold.

3.  Suppose there had been no banking panics.  And suppose that the central bank responded to fears of devaluation by preventing the money stock from falling. What then?  In that case, the shock might not have been deflationary.  But that’s not because devaluation fears are not deflationary, but rather because the central bank would have taken an expansionary monetary action to offset the private gold hoarding.  Under a gold standard, an outflow of gold into private hoards should normally result in a smaller currency stock, keeping the ratio of gold to currency stable.  So if the central bank refuses to let the currency stock fall, that’s an expansionary monetary policy.  It wouldn’t mean the devaluation fears were not deflationary, ceteris paribus, but rather that the deflationary impact of one shock was being offset by an expansionary policy elsewhere.

4.  Bob mentions that the M1 money supply did fall during the banking panics, which simplifies things, but I prefer to do all the analysis through the currency stock (or monetary base), which in this case made things more complicated for me.

5.  How about from a finance perspective?  At first glance it seems weird that people would hold both gold and currency, even though the expected return on gold was higher during a period of devaluation fears.  But gold and currency may not be perfect substitutes, and as the stock of currency declines the marginal liquidity services it provides increase relative to gold.  Or perhaps those who feared devaluation correctly anticipated that the government would confiscate domestic gold hoards.

I am still a bit confused by the evidence that markets respond differently when devaluation (or revaluation) seems imminent.  The markets were not adversely affected by the gold crisis in early March 1933, anticipating that FDR would soon do something dramatic.  And they were adversely affected by fears of revaluation during the “gold panic” of 1937.  So there are still some unresolved puzzles in my mind.  But Bob’s explanation for the basic pattern of the early 1930s seems better than anything else I’ve seen.

PS.  I am currently in San Diego, at the Western Economic Association conference. Blogging will be sporadic for most of the summer.

Counterfactuals are tricky

A commenter named “tpeach” recently asked the following:

My question is, what would have happened if the Fed hadn’t cut rates between Dec 07 and Apr 08? What would have happened to the base and velocity if the fed kept the rate stable while the Wicksellian or market rate plummetted during that time? Would the base shrink? If so, what are the mechanics behind that process? Also, how can the fed adjust the rate without changing the base? And why didn’t velocity drop when they cut rates during this time?

I wasn’t able to provide much of an answer.  Here I’d like to explain why.

At first glance, the obvious counterfactual would seem to be a smaller monetary base and a higher path of interest rates.  But that is a very fragile equilibrium, which could easily spiral off in one direction or another.  For instance, suppose the Fed had reduced the monetary base in late 2007 in order to prevent any fall in the fed funds rate.  What might have happened next?  One possibility is that the economy would have gone into a deep depression in early 2008.  Most likely, the Fed would have responded to that deep depression with a big rate cut and a big increase in the monetary base.  Thus in this case the counterfactual path of the base would have been a bit lower in late 2007, and much higher in early 2008. Indeed what I just described is roughly what did happen between early and late 2008—I am simply contemplating that scenario playing out 6 months earlier.

Monetary equilibrium often has “knife edge” qualities.  Imagine climbing along a mountain ridge with steep drop-offs on both sides.  If you are not at the peak of the ridge, you have the option of walking a bit further up the slope.  But if you go too far, you risk plunging down the other side.  Monetary economics is kind of like that.  Small changes are often “Keynesian” in character, meaning slightly tighter money means slightly higher nominal interest rates.  But larger changes can easily be “Neo-Fisherian” in character, meaning tighter money leads to lower nominal interest rates.  And it’s not just a question of more or less tight money, it’s more about expectations regarding the future path of policy.

Screen Shot 2017-05-12 at 12.04.59 PM

Yip Cloud recently pointed me to the latest in his excellent series of interviews of macroeconomists, this one of Atif Mian:

Some people have the 5-year adjustable rate mortgages (ARMs), others have the 7-year ARMs. Let’s say that the mortgages started in 2005. When 2010 comes, in the middle of the slowdown, those with the 5-year ARMs would get the interest rate reduction because the mortgages reset to a lower rate automatically. They get this reduction in the interest rate that the Fed was trying to pass through to the individual households. But those individuals who have a 7-year ARMs still have to wait for 2 additional years before they get a lower interest rate.

By taking advantage of this kind of variation in the cross-section, they can actually show the impact of the reduction in interest rate for the 5-year ARMs owners, by comparing them to the 7-years ARMs owners who didn’t receive the same reduction in interest rate just because they have a different kind of financial contract. What they’ve shown with this kind of analysis is that a reduction interest rate is actually beneficial. It actually allows the lenders to boost their spending and improves local economic outcome, in term of employment and aggregate demand. That’s just one example that actually shows monetary policy can be effective.

At the same time, that same work also shows why the monetary policy was ineffective. If you think about it, you need to be able to pass through the action of the Fed to the ultimate households. However, if people are struck in the 30-year fixed rate mortgages, they would not be able to take advantage of this lower interest rate environment. As a result, monetary policy is not able to pass through to the ultimate households. It is going to be constrained in the effectiveness. That’s a very important insight that has come about because of this kind of work that I emphasized. That’s a very interesting and useful development.

If people have borrowing capacity and willing to borrow, the same monetary policy shock can have more impact on the real economy. When you lower interest rate, for people who are prone to borrow more, they can borrow aggressively against a lower interest rate and that boosts the economy.

But if the same individuals have already borrowed a lot in the down-cycle, you can lower the interest rate but those individuals are underwater. They can’t borrow any more. Then the same reduction in interest rate is not going to have much of an impact on the macroeconomy. This kind of logic also suggests that monetary policy itself is going to be insufficient in dealing with the downturn. You need to focus on something that Sufi and I have to try to emphasize in our book.

I can’t emphasize enough that (as Friedman, Bernanke and Mishkin pointed out) changes in interest rates are not the same as changes in the stance of monetary policy, for standard “never reason from a price change” reasons.  Thus it’s not possible to draw any conclusions about the effectiveness of monetary policy by looking at the impact of changes in interest rates.  To take the most obvious reductio ad absurdum example, a Mexican currency reform exchanging 100 old pesos for one new peso will immediately reduce the price level by 99%, without any significant change in interest rates.

My vision of macro

The following Venn diagram helps to explain how I visualize macro:

Screen Shot 2017-03-26 at 3.17.11 PMThere are three basic fields within macro:

1.  Equilibrium nominal

2.  Equilibrium real

3.  Disequilibrium sticky wage/price (interaction)

I’ll take these one at a time.

1. Within equilibrium nominal there are important concepts:

A.  The quantity theory of money

B.  The Fisher effect

C.  Purchasing power parity

The first suggests that a change in M will cause a proportionate change in P.  The second suggests that a change in inflation will cause an equal change in nominal interest rates.  The third suggests that a change in the inflation differential between two countries will cause an equal change in the rate of appreciation of the nominal exchange rate.

All three concepts implicitly hold something constant; either the real demand for money, the real interest rate, or the real exchange rate.  In all three cases the concept is most useful when the money supply and price level are changing very rapidly, especially if those changes persist for long periods of time.

2.  Equilibrium real macro can be thought of as looking at economic shocks that do not rely on wage/price stickiness.  These include changes in population, technology, capital, preferences, government policies, weather conditions, taxes, etc.  These can cause changes in the real demand for money, the real interest rate, the real exchange rate, the unemployment rate, real GDP, and many other real variables.

3.  Disequilibrium macro looks at nominal shocks that cause changes in real variables, but only because of wage/price stickiness.  Thus because prices are sticky, an increase in the money supply will temporarily cause higher real money demand, a lower real interest rate, and a lower real exchange rate.  These changes occur even if there is no fundamental real shock hitting the economy.  The effects are temporary, and go away once wages and prices have adjusted.

If wages and prices are sticky then an increase in the money supply will also cause a temporary rise in employment and real output.

And that’s basically all of macro.  (This is how I’d try to explain macro to a really bright person, if I were given only 15 minutes.)

I also believe that understanding the implications of this three part schema makes one a better macroeconomist. Talented macroeconomists like Paul Krugman tend to have good instincts as to which real world issues belong in each category. Here’s my own view on a few examples. For simplicity, I’ll denote these three areas: nominal, real, and interaction:

1.  Most business cycles in ancient times were real, with some interaction.  The 1500 to 1650 inflation was nominal.

2.  Recessions such as 1893, 1908, 1921 and 1982 were mostly interaction.

3.  The Great Depression was all three.

4.  The Great Inflation was mostly nominal, especially in high inflation countries.

5. The 1974 recession was more “real” than usual.  Ditto for the WWII output boom.

6.  The real approach works best for short run shocks to specific industries such as housing and oil, plus long run growth.  The nominal approach works best for high inflation rates and long run inflation.  The interaction approach works best for real GDP fluctuations in large diversified economies.

7.  If one set of economists say the Japanese yen is too strong, and another set say it’s too weak, they are probably using different frameworks.  Those who say its too strong are using a nominal framework, and are likely worried about deflation.  A weaker yen would boost inflation.  Those who think the yen is too weak are using a real framework.  Rather than worry about deflation, they worry that Japan has a current account surplus.  These views seem to contradict, but it’s theoretically possible for both to be right.  Perhaps the nominal exchange rate for the yen is too strong, and the real exchange rate is too weak.  You would then weaken the nominal exchange rate by printing money, and strengthen the real exchange rate by reducing Japanese saving rates.  (I don’t favor the latter, just saying that’s the proper implication of the misguided worry about Japanese CA surpluses.)

8.  Don’t let your policy preferences drive your analysis.  Throughout all of my life, it’s been assumed that monetary shocks drive real output by causing changes in the unemployment rate.  Not changes in trend productivity growth or population growth or labor force participation or any number of other variables.  Money matters because it affects unemployment.  If the unemployment rate is telling you that monetary policy is no longer holding back growth, the proper response is not to double down on your belief that we need easier money and then look for new theories to justify it, but rather to conclude that whatever problems we still have are now “real”, not “interaction.”

A good macroeconomist knows that all three fields of macro are very important, and which models apply to each of the three fields, and which field is most applicable to each real world macro issue.