W. Peden directed me to this article:

Andy Haldane said low rates kept some “zombie” firms alive, but the trade off was far more people stayed in work.

A Bank modelling scenario found that years of 0.25% rates probably kept 1.5 million in jobs, he said in a speech.

He would not have sacrificed those jobs for an extra 1% or 2% productivity.

This sort of thing makes me want to pull my hair out.  Start with the fact that he’s reasoning from a price change.  I suppose his defenders would claim he meant “an easy money policy that caused low interest rates also tended to hurt productivity”. But of course that’s not what happened.  In fact, UK interest rates fell to very low levels because of extremely low NGDP growth after 2008, which was in turn caused by tight money.  In a counterfactual where the BoE adopted ECB style policy, NGDP growth would have been even slower, and interest rates would have been ever lower (indeed negative.)

Although BoE policy was far better than ECB policy, it was still too contractionary. But for simplicity let’s assume it was about right—that will make it easier to explain what’s wrong with Haldane’s comments.

Suppose NGDP growth in the UK were appropriate.  And suppose you saw falling interest rates and falling productivity growth in that environment.  How would you interpret those facts?  I’d make the following claims:

1.  The UK was probably hit by an adverse supply shock.  I can think of at least three components; falling North Sea oil output, a big decline in banking jobs in “The City” after the crash of 2008, and a drop in manufacturing jobs because of the collapse in world trade in 2008-09.  Of course the 2008-09 shock is a demand shock at the global level, but at the UK level it shows up as a supply shock.

2.  In oil, banking, and manufacturing, worker productivity is much higher than for the economy as a whole.  So when those sectors suddenly decline, overall productivity will take a hit. This has nothing to do with monetary policy.

3.  If monetary policy is sound (reasonable NGDP growth), then the workers losing jobs in those three sectors will initially re-allocate into less productive sectors, mostly in the service sector.  Again, overall productivity will suffer.

4.  I also suspect that the UK is suffering from some of the same “Great Stagnation” problems that are affecting the US and other developed countries.

If the BoE had adopted a very tight money policy, causing a big drop in NGDP, then the re-allocation of workers from declining sectors to growing sectors would have been less complete.  This might have actually raised productivity slightly, as the least productive workers often are the ones who have the hardest time getting re-employed.

To summarize, neither a low interest rate policy nor monetary policy more generally reduced UK productivity.  Rather productivity fell as part of the natural adjustment process in a free market economy, as workers get re-allocated out of high productivity sectors into lower productivity sectors.  To its credit, the BoE refrained from the sort of tight money policy adopted by the ECB, which would have led to much more unemployment, but which also might have led to slightly higher productivity in the short run.

The BoE is not a fireman that rescued the UK labor market at the cost of lower productivity; rather the ECB is an arsonist who trashed the eurozone labor market.

Over at Econlog, I have a new post discussing Ricardo Reis’s proposal for a market-based price level target, which relies on shifts in money demand.  (In contrast, my NGDP futures targeting paper contemplates using markets to adjust the money supply until NGDP expectations are on target.)

When thinking about these two approaches, it might be useful to compare a money demand shock with a money supply shock.  We all know from EC101 that a shift in supply has the opposite impact (on value) from a shift in demand.  Money is no different.  Those who are used to taking a quantity theoretic approach to money might consider the following three examples:

1. Suppose there is a huge spike in the demand for US currency in foreign countries.  That will increase the demand for US base money and, other things equal, will reduce the US price level.  But you can also think of this sort of demand shock as reducing the supply of currency within the US.  With less currency circulating in the US, the price level falls for standard “quantity theory” reasons.

2. Now let’s consider an economy whose currency is of no interest to outsiders—say Canada.  If Canada imposes draconian taxes then the Canadian public might hoard currency as a way of hiding income from the government.  That would result in a huge spike in Canadian currency demand.  But you can also view that as a money supply shock.  The supply of currency actively being used as a medium exchange, aka Canadian “transactions balances”, would decline as hoarding balances increase. The quantity theory of money applies better to transactions balances than to all money balances.

3. With the advent of interest on reserves (IOR), and enormously bloated levels of excess reserves, the Fed has shifted somewhat away from a supply of money approach and towards a demand for money approach.  On the other hand, the original monetarist model treated “high-powered money” as being equivalent to the monetary base.  With IOR, the entire monetary base is no longer high-powered money.  Instead, the currency stock is the new high powered money.  So a change in IOR that impacts the demand for base money can also be thought of as impacting the supply of high-powered money.   Thus if the Fed suddenly cut IOR to zero, banks would try to get rid of some of their excess reserves, which would flow out into circulation, boosting the supply of currency, and hence the price level.

[Some people who understand accounting but not macroeconomics will tell you that banks as a whole cannot get rid of reserves—that reserves withdrawn from one bank will be deposited into another.  Don’t believe them.  A monopoly bank could easily get rid of unwanted ERs by buying assets, then making bank deposits unattractive enough so that all the base money doesn’t get redeposited into the banking system.  The entire banking system is no different.  People who treat macro as a branch of accounting will only confuse you—stay away from them.]

There’s nothing new in this post, even more than a quarter millennium ago David Hume knew that an increase in money demand is equivalent to a decrease in the money supply:

“If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.” David Hume — Of Money

PS.  The thought experiments in this paper were merely to illustrate basic concepts. In the real world, the Fed would accommodate a shift in currency demand from overseas hoarding, or domestic tax evaders.  Hence there would be no significant macroeconomic impact.

Caroline Baum has an interesting article on a new book written by DiMartino Booth, who worked at the Fed from 2006 to (I think) 2015:

The Fed regularly publishes a summary of economic conditions in the 12 federal reserve districts, but when real-world information contradicts the Fed’s econometric model, the model wins. DiMartino Booth provided Fisher with real-time information — not seasonally adjusted, to the consternation of the staff — gleaned from an array of market sources and data sets.

Fisher, with his background in business, finance and government, earned a reputation as a maverick inside the Fed. He dissented from the FOMC statement five times in 2008, twice in 2011 and twice again in 2014, in all cases favoring less monetary accommodation or earlier rate hikes than the consensus view.

Fisher retired at the end of 2014; DiMartino Booth followed shortly after, once she realized her real “mission” is to educate the public about the inner workings of the Fed. “Fed Up” succeeds in doing just that. . . .

One of her suggestions made me laugh out loud. The Fed should ship the Ph.D. economists back to academia and use the money saved to hire some crack bank supervisors at competitive salaries for the Fed’s “Sup & Reg departments,” traditionally a second-tier job at the Fed.

A few comments:

1.  In retrospect, it’s clear that all of the Fisher votes cited above were in error. Indeed in my view that’s not even debatable.  The fact that it is debated tells us that we need to reform Fed policy is such a way that clearly mistaken votes are no longer debatable.  Chad Reese and I have a letter just published in The Hill that discusses this issue.

2.  You generally don’t want to rely on non-seasonally adjusted data, which might signal a huge “boom” in December.

3.  Over the past three decades, the Fed has relied far more heavily on academic economists than in the past.  During this period, Fed policy has become vastly more stable than in the prior 70 years, whether you rely on inflation or NGDP growth as your indicator.

The author advocates greater diversity at the Fed: specifically, more staffers with actual business experience and fewer ivory-tower types. She would like to see an increased focus on systemic risk. And she wants Congress to release the Fed from its dual mandate — stable prices and maximum employment — so it can focus solely on price stability. . . .

Where I [Caroline Baum] would challenge DiMartino Booth is on her recommendation that the Fed normalize the overnight rate and pledge never to breach the 2% floor again so as not to punish savers.

I have not read her book and I may be misinterpreting the comment about a 2% floor.  But if the floor refers to interest rates, then I’d say the proposal is either absolutely horrible or mindbogglingly insane.  Let’s start with the best case, absolutely horrible:

1.  One way to make sure interest rates never again fell below 2% is to raise the inflation target to 10%.  That’s a horrible idea, and since it would probably punish savers I don’t think that’s what the quote refers to.

2.  If the inflation target is kept at 2%, then a 2% interest rate floor would be non-credible, because it would be impossible for the Fed to achieve.  But trying to achieve it could easily cause another Great Depression.  A mindbogglingly bad idea. This is why you don’t want non-PhDs making monetary policy.  Indeed, even the brief April to October 2008 2% interest rate floor proved to be disastrous.

PS.  Vaidas Urba sent me another post that comments on the same book.  Looks like a very good blog.

PPS.  The case for the Fed increasing its interest rate target is growing stronger by the day.  Some of the new data looks quite strong for both prices and output. Continued talk of fiscal stimulus is starting to look kind of silly.  For the first time since I started blogging, I see the monetary policy risks as being balanced, instead of skewed to the downside.

PPPS.   Many commenters are unaware of my current views on NGDP targeting.  I currently favor the “guardrails” approach, which is not susceptible to the market manipulation problem.  Nor would lack of trading be a problem.  My attempt to create a small NGDP prediction market is not to be confused with this policy proposal.  I have a new article in the Journal of Macroeconomics that explains my current views on a wide range of monetary policy rule issues.

PPPPS.  A zero percent interest rate floor would be less bad than 2%, as the Fed has the option of QE.

PPPPPS.  For those who don’t have access to the JM article, the basic idea is as follows.  The Fed sets a 4% NGDP target path, level targeting.  If the economy is currently on target, the Fed commits to take a short position against any NGDP futures trader going long at 5% NGDP growth, and the Fed takes a long position on any NGDP futures traders who go short at 3% NGDP growth.  Thus the Fed might be exposed to loses if the actual NGDP growth rate is outside the 3% to 5% guardrails.  The losses could be large if, ex ante, it’s clear to traders that NGDP growth will be far too high, or too low.

The Fed monitors the trades.  It still has 100% discretion over monetary policy, with the proviso that it be willing to commit to the NGDP positions described above. This is much like Bretton Woods or a gold standard (where they committed to exchange money for gold, instead of NGDP contracts), and no more susceptible to market manipulation than those regimes.  Indeed less so, as the “band” is (effectively) wider than under the gold standard. The Fed can and should ignore a single large trader, who might be engaged in market manipulation.  If it sees lots of traders all going long or short, and if the Fed’s potential losses become too large, it may want to take corrective action.

Even if I were wrong about manipulation, competition among potential manipulators would keep expected NGDP growth in the 3% to 5% range (as the second manipulator could offset the first, and earn larger profits by going the opposite direction).

Here’s another metaphor.  The 3% and 5% guardrails serve the same purpose as the beeping sound when trucks are backing up, and get too close to hitting something.

The basic idea here is to allow me, Scott Sumner, to get filthy rich if the Fed screws up the way they did in 2008.  Since I’m a fatalist who never expects to get filthy rich, I would not expect the Fed to screw up under my proposed guardrails regime. I hope I’m wrong!!

James Alexander directed me to a recent post by Basil Halperin, which is one of the best blog posts that I have read in years.  (I was actually sent this material before Christmas, but it sort of fell between the cracks.)

Basil starts off discussing a program for distributing excess food production from manufacturers to food banks.

The problem was one of distributed versus centralized knowledge. While Feeding America had very good knowledge of poverty rates around the country, and thus could measure need in different areas, it was not as good at dealing with idiosyncratic local issues.

Food banks in Idaho don’t need a truckload of potatoes, for example, and Feeding America might fail to take this into account. Or maybe the Chicago regional food bank just this week received a large direct donation of peanut butter from a local food drive, and then Feeding America comes along and says that it has two tons of peanut butter that it is sending to Chicago.

To an economist, this problem screams of the Hayekian knowledge problem. Even a benevolent central planner will be hard-pressed to efficiently allocate resources in a society since it is simply too difficult for a centralized system to collect information on all local variation in needs, preferences, and abilities.

One option would simply be to arbitrarily distribute the food according to some sort of central planning criterion.  But there is a better way:

This knowledge problem leads to option two: market capitalism. Unlike poorly informed central planners, the decentralized price system – i.e., the free market – can (often but not always) do an extremely good job of aggregating local information to efficiently allocate scarce resources. This result is known as the First Welfare Theorem.

Such a system was created for Feeding America with the help of four Chicago Booth economists in 2005. Instead of centralized allocation, food banks were given fake money – with needier food banks being given more – and allowed to bid for different types of food in online auctions. Prices are thus determined by supply and demand. . . .

By all accounts, the system has worked brilliantly. Food banks are happier with their allocations; donations have gone up as donors have more confidence that their donations will actually be used. Chalk one up for economic theory.

Basil points out that while that solves one problem, there is still the issue of determining “monetary policy”, i.e. how much fake money should be distributed each day?

Here’s the problem for Feeding America when thinking about optimal monetary policy. Feeding America wants to ensure that changes in prices are informative for food banks when they bid. In the words of one of the Booth economists who helped design the system:

“Suppose I am a small food bank; I really want a truckload of cereal. I haven’t bid on cereal for, like, a year and a half, so I’m not really sure I should be paying for it. But what you can do on the website, you basically click a link and when you click that link it says: This is what the history of prices is for cereal over the last 5 years. And what we wanted to do is set up a system whereby by observing that history of prices, it gave you a reasonable instinct for what you should be bidding.”

That is, food banks face information frictions: individual food banks are not completely aware of economic conditions and only occasionally update their knowledge of the state of the world. This is because obtaining such information is time-consuming and costly.

Relating this to our question of optimal monetary policy for the food bank economy: How should the fake money supply be set, taking into consideration this friction?

Obviously, if Feeding America were to randomly double the supply of (fake) money, then all prices would double, and this would be confusing for food banks. A food bank might go online to bid for peanut butter, see that the price has doubled, and mistakenly think that demand specifically for peanut butter has surged.

This “monetary misperception” would distort decision making: the food bank wants peanut butter, but might bid for a cheaper good like chicken noodle soup, thinking that peanut butter is really scarce at the moment.

Clearly, random variation in the money supply is not a good idea. More generally, how should Feeding America set the money supply?

One natural idea is to copy what real-world central banks do: target inflation.

Basil then explains why NGDP targeting is likely to be superior to inflation targeting, using a Lucas-type monetary misperceptions model.

III. Monetary misperceptions
I demonstrate the following argument rigorously in a formal mathematical model in a paper, “Monetary Misperceptions: Optimal Monetary Policy under Incomplete Information,” using a microfounded Lucas Islands model. The intuition for why inflation targeting is problematic is as follows.

Suppose the total quantity of all donations doubles.

You’re a food bank and go to bid on cheerios, and find that there are twice as many boxes of cheerios available today as yesterday. You’re going to want to bid at a price something like half as much as yesterday.

Every other food bank looking at every other item will have the same thought. Aggregate inflation thus would be something like -50%, as all prices would drop by half.

As a result, under inflation targeting, the money supply would simultaneously have to double to keep inflation at zero. But this would be confusing: Seeing the quantity of cheerios double but the price remain the same, you won’t be able to tell if the price has remained the same because
(a) The central bank has doubled the money supply
or
(b) Demand specifically for cheerios has jumped up quite a bit

It’s a signal extraction problem, and rationally you’re going to put some weight on both of these possibilities. However, only the first possibility actually occurred.

This problem leads to all sorts of monetary misperceptions, as money supply growth creates confusions, hence the title of my paper.

Inflation targeting, in this case, is very suboptimal. Price level variation provides useful information to agents.

IV. Optimal monetary policy
As I work out formally in the paper, optimal policy is instead something close to a nominal income (NGDP) target. Under log utility, it is exactly a nominal income target. (I’ve written about nominal income targeting before more critically here.)

. . .  Feeding America, by the way, does not target constant inflation. They instead target “zero inflation for a given good if demand and supply conditions are unchanged.” This alternative is a move in the direction of a nominal income target.

V. Real-world macroeconomic implications
I want to claim that the information frictions facing food banks also apply to the real economy, and as a result, the Federal Reserve and other central banks should consider adopting a nominal income target. Let me tell a story to illustrate the point.

Consider the owner of an isolated bakery. Suppose one day, all of the customers seen by the baker spend twice as much money as the customers from the day before.

The baker has two options. She can interpret this increased demand as customers having come to appreciate the superior quality of her baked goods, and thus increase her production to match the new demand. Alternatively, she could interpret this increased spending as evidence that there is simply more money in the economy as a whole, and that she should merely increase her prices proportionally to account for inflation.

Economic agents confounding these two effects is the source of economic booms and busts, according to this model. This is exactly analogous to the problem faced by food banks trying to decide how much to bid at auction.

To the extent that these frictions are quantitatively important in the real world, central banks like the Fed and ECB should consider moving away from their inflation targeting regimes and toward something like a nominal income target, as Feeding America has.

The paper he links to contains a rigorous mathematical model that shows the advantages of NGDP targeting. He doesn’t claim NGDP targeting is always optimal, but any paper that did would actually be less persuasive, as it would mean the model was explicitly constructed to generate that result. Instead the result flows naturally from the Lucas-style archipelago model, where each trader is on their own little island observing local demand conditions before aggregate (NGDP conditions). This is the sort of approach I used in my first NGDP futures targeting paper, where futures markets aggregated all of this local demand (i.e. velocity) information. However Basil’s paper is light years ahead of where I was in 1989.

I can’t recommend him highly enough.  I’m told he recently got a BA from Chicago, which suggests he may be another Soltas, Wang or Rognlie, one of those people who makes a mark at a very young age.  He seems to combine George Selgin-type economic intuition (even citing a lovely Selgin metaphor at the end of his post) with the sort of highly technical skills required in modern macroeconomics.

Commenters often ask (taunt?) me with the question, “Where is the rigorous model for market monetarism”.  I don’t believe any single model can incorporate all of the insights from any half decent school of thought, but Basil’s model certainly provides the sort of rigorous explanation of NGDP targeting that people seem to demand.

Basil has lots of other excellent posts, and over the next few weeks and months I will have more posts responding to some of the points he makes (which to his credit, include criticism of NGDP targeting–he’s no ideologue.)

I have pretty similar views on monetary policy as Ryan Avent, but I’m going to quibble slightly with this:

At the same time, a period of inflation above the Fed’s 2% target would give the central bank more headroom to raise its benchmark interest rate. The higher the level of long-run nominal rates, the less likely rates are to fall back to zero the next time trouble strikes.

Back in 2009, 2010, 0r 2011, it would have made sense to try to overshoot the 2% inflation target.  But not today, with unemployment at 4.6%.  If we pushed inflation above 2% when the economy is strong, then we’d have to shoot for under 2% inflation when the economy is weak.  We’d be more likely to fall back to zero next time.

Indeed this is basically what went wrong in 2008.  Inflation exceeded 2% during the housing boom.  Thus when the Fed needed to move aggressively to ease policy in 2008, they held back in fear of inflation (which ran above 2% during 2008).  It would make more sense to shoot for below 2% inflation during booms, and above 2% inflation during recessions.

Ryan does have some forceful arguments for higher inflation, but I think they’d be more effective if couched in terms of a change in the inflation target.  Thus instead of calling for an overshoot of the 2% target by 1/2%, it would make more sense to call for undershooting a new and higher 3% inflation target, by 1/2%.  Increasing the inflation target to 3% would indeed give the Fed more room to cut rates in the next recession, in a way that overshooting the 2% target would not.  In addition, undershooting the target during a boom is more consistent with the spirit of NGDP targeting, which Ryan has previously endorsed.

This all might seem like a meaningless quibble; “What difference does it make what we do to the target, as long as we get 2.5% inflation.”  In the very short run it may make no difference.  But if you don’t make monetary policy decisions in the context of a clearly defined policy regime, then the economy is likely to be less stable, especially when we reach a turning point in the business cycle.

As always, this 3% inflation target is not my preferred option (I prefer NGDPLT). I’m just trying to illustrate what I think is the most fruitful approach for people with current views on policy that might be described as “dovish.”