Here’s Janet Yellen:

The Federal Reserve may need to run a “high-pressure economy” to reverse damage from the 2008-2009 crisis that depressed output, sidelined workers, and risks becoming a permanent scar, Fed Chair Janet Yellen said on Friday in a broad review of where the recovery may still fall short.

Though not addressing interest rates or immediate policy concerns directly, Yellen laid out the deepening concern at the Fed that U.S. economic potential is slipping and aggressive steps may be needed to rebuild it.

I see this as a big mistake. The Fed needs to focus on smoothing out the path of nominal spending.  There’s not much they can do about the economy’s “potential”, and trying to boost it would end up destabilizing the economy.  Back in the 1960s, the Fed also believed there was a permanent trade-off between inflation and unemployment—it did not end well.

Yellen’s comments, while posed as questions that need more research, still add an important voice to an intensifying debate within the Fed over whether economic growth is close enough to normal to need steady interest rate increases, or whether it remains subpar and scarred, a theory pressed by Harvard economist and former U.S. Treasury Secretary, Lawrence Summers, among others.

Her remarks jarred the U.S. bond market on Friday afternoon, where they were interpreted as perhaps a willingness to allow inflation to run beyond the Fed’s 2.0 percent target. Prices on longer dated U.S. Treasuries, which are most sensitive to inflation expectations, fell sharply and their yields shot higher.

Yellen’s statement was not an indication of Fed policy, but merely the musings of one person.  It’s very unlikely to be put into action.  And yet bond prices plunged. Now imagine if all 12 members of the FOMC got on a stage and said they were raising the inflation target from 2% to 3%.  The impact on the bond market would have been at least 10 times greater than what occurred yesterday.  There’s no question that the Fed can move inflation expectations, the question is what should they be doing?  Credibility has never been the Fed’s problem.  In late 2008, the Fed’s contractionary policy was highly credible—markets saw where the Fed was pushing NGDP.  In 2009-10 their explicit decision not to return NGDP to the old trend line was highly credible.

Jeffrey Gundlach, chief executive of DoubleLine Capital, said he read Yellen as saying, “‘You don’t have to tighten policy just because inflation goes to over 2 percent.’

“Inflation can go to 3 percent, if the Fed thinks this is temporary,” said Gundlach, who agreed Yellen was striking a chord similar to Summer’s “secular stagnation” thesis. “Yellen is thinking independently and willing to act on what she thinks.”

It would be destabilizing to let inflation go to 3% while unemployment is low.  It would bring the recovery to a premature end, triggering another recession as soon as the economy was hit by another oil shock.  Instead, the Fed should shoot for 3% inflation during the next recession—not during this expansion.  But they currently lack a policy regime capable of achieving that (countercyclical) outcome.  Yellen’s policy remains resolutely procyclical.  NGDPLT anyone?

“If strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand,” Yellen said. It would “make it even more important for policymakers to act quickly and aggressively in response to a recession, because doing so would help to reduce the depth and persistence of the downturn.”

That’s a really big “if”, which goes against 50 years of macroeconomic research.  That doesn’t mean it’s wrong, we learn new things all the time.  But this theory is not even close to being ready to implement.  At a minimum, we’d need many years of research and testing of the idea, before using the US economy as a test tube for Yellen’s latest theory.

PS.  Commenters invariably tell me that easier money leads to more investment, and hence more growth.  Do you really believe that macroeconomists haven’t been aware of that?  The problem is that it doesn’t boost the economy’s long-term growth rate, and hence creates more cyclical instability.  It might be helpful to consider “investment” as “home building”—one of its biggest components.  It’s true that even today the flow of housing services from homes is larger than it might have been without all those homes built during the 2003-06 boom.  Does the mean the 2003-06 housing boom boosted the long term growth rate of the US?  Did it help to stabilize the US economy?

PPS.  Don’t take this post as a criticism of Yellen’s current policy stance within the Fed.  I don’t have a problem with her recent votes (not to raise rates.)

PPPS.  I have a related post at Econlog, which discusses the issue of credibility and inflation expectations.

HT:  TravisV

An important idea in macroeconomics is that you need at least as many tools as targets.  Over at Econlog, I have a long post discussing Roger Farmer’s views on monetary policy.  Here I’ll do a short post, giving you the Cliff’s Notes version.

In a better world, economists wouldn’t focus on interest rates.  But they do.  So how do we make sure that a change in interest rates has the desired effect?  After, all, higher rates could represent tight money (liquidity effect) or easier money (income and Fisher effects.)  How do we pin it down?

With two tools.  If you want interest rates to rise, you can raise the IOR.  If you want to make sure that this increase reflects the income/Fisher effects, you need to also use one of the following tools:

1.  A huge increase in the quantity of money (old monetarist)

2.  Target a higher commodity price index (1980s supply-side econ)

3.  Target a higher price of foreign exchange–i.e. depreciate your currency.  (Mundellian economics)

4.  Target higher stock prices.  (Roger Farmer)

5.  Target a higher NGDP futures price (market monetarist)

In each case, you use a “whatever it takes” approach to open market operations, to get your second policy tool moving in an unambiguously expansionary direction.

Recently, the Swiss did this in reverse.  In January 2015 they lowered interest rates and simultaneously appreciated the Swiss franc.  This assured that the lower interest rates were contractionary (income/Fisher effect.)  Singapore also uses exchange rates as a policy tool.  The BOJ has dabbled in Farmer’s approach, buying ETFs.  But not enough to make it effective.

PS.  Nick Rowe has a related post on Roger Farmer’s proposal.

Off topic:  In January 2014, I argued that “IndoAsia” would be the next big growth story.  This article says it’s beginning to happen.  And remember that 60 Minutes story about the ghost cities in China?  The ghost neighborhood in Zhengzhou that they highlighted seems to be doing fine:

Home prices in at least one district in Zhengzhou, which became a symbol of China’s property excesses because of rows of empty housing developments, have risen two-thirds this year to 25,000 yuan ($3,747.56) per square metre on average, a sales manager told Reuters on a recent visit to the city.

The average new home price in 70 major cities climbed an annual 9.2 percent in August, up from 7.9 percent in July, according to data from China’s National Bureau of Statistics.

After a period of modestly slower growth, the China boom is picking up speed again.  Looks like the naysayers will have to wait a few more years for the most widely predicted crash in history.

It’s hard not to be super optimistic about the world right now.  Asia is booming, and most people are Asians.

LK Beland directed me to a paper by Paul Romer, which I’ve only had time to skim.  But the abstract is great:

For more than three decades, macroeconomics has gone backwards. The treatment of identification now is no more credible than in the early 1970s but escapes challenge because it is so much more opaque. Macroeconomic theorists dismiss mere facts by feigning an obtuse ignorance about such simple assertions as “tight monetary policy can cause a recession.” Their models attribute fluctuations in aggregate variables to imaginary causal forces that are not influenced by the action that any person takes. A parallel with string theory from physics hints at a general failure mode of science that is triggered when respect for highly regarded leaders evolves into a deference to authority that displaces objective fact from its position as the ultimate determinant of scientific truth.

He focuses on RBC theory, but the problems go far deeper.  New Keynesian models also fail at identification.  Nick Rowe has an excellent recent post on this problem:

Suppose we model monetary policy as M(t) = bX(t) + e(t), where M is the money supply, X is some vector of macroeconomic variables, and e is some random shock. Or, if you prefer, as i(t) = bX(t) + e(t), where i is a nominal interest rate. We estimate (somehow) that monetary policy reaction function, and call our estimate of e(t) the “monetary shock”.

Let us suppose, heroically, that our estimate of the monetary policy reaction function is correct. The econometrician, by sheer luck, gets it exactly right. Whatever that means. And then we use that estimate of monetary shocks to see what percentage of macroeconomic fluctuations (somehow defined) was caused by those “monetary shocks”, and what percentage was caused by other shocks. And suppose, again heroically, we get it right.

This is nonsense. We are making exactly the same mistake that the people were making in my Gold Standard examples above. If the central bank had been following the monetary policy reaction function exactly (or if the econometrician had a complete data set and correct model of the central bank’s behaviour so the estimated reaction function fitted exactly) then by definition there would have been no “monetary shocks”. And so “monetary shocks” would explain 0% of anything, because there weren’t any. 100% of macroeconomic fluctuations were caused by other, non-monetary shocks. Any deterministic monetary policy will have zero “monetary shocks”, by that definition, and any organisation’s behaviour is deterministic, if we understand it fully enough. That is not a useful definition of “monetary shocks”.

Monetary shocks are not the e(t). Monetary shocks mean the central bank chose the wrong monetary policy reaction function. It’s the choice of parameter b, and the choice of which variables belong in the vector X.

People get sick of me always talking about “the stance of monetary policy”.  But the misidentification of easy and tight money is THE central problem in macroeconomics.  Everything else is a footnote.

On a related topic, check out my new post at Econlog—I’m interested in feedback on my graph.

Paul Krugman has an excellent post discussing why stock prices are relatively high.  Apart from the opening paragraph, where he (implicitly) dismisses the EMH and rational expectations, I almost entirely agree with his interpretation.  (OK, the last bit defending Obama is also a bit questionable.)  I have expressed similar views, although of course Krugman expresses his ideas in a much more elegant fashion.  David Glasner was critical of this observation by Krugman:

But why are long-term interest rates so low? As I argued in my last column, the answer is basically weakness in investment spending, despite low short-term interest rates, which suggests that those rates will have to stay low for a long time.

Here’s how David responded:

Again, this seems inexactly worded. Weakness in investment spending is a symptom not a cause, so we are back to where we started from. At the margin, there are no attractive investment opportunities.

First let’s be clear about what Krugman means by “investment spending” in the quote above.  He clearly does not mean the dollar volume of investment spending, in equilibrium, because equilibrium quantities cannot “cause” anything, including low interest rates.  Instead he means the investment schedule has shifted to the left, and that this decline in the investment schedule (on a savings/investment diagram) has caused the lower interest rates.  And that seems correct.

Unfortunately, Krugman adds the phrase “despite low short-term interest rates”, which only serves to confuse things. Changes in interest rates have no impact on the investment schedule.  There is nothing at all surprising about low investment during a time of low interest rates, that’s normally the relationship we see.  (Recall 1932, 1938, and 2009).

David is certainly right that Krugman’s statement is “inexactly worded”, but I’m also a bit confused by his criticism. Certainly “weakness in investment spending” is not a “symptom” of low interest rates, which is how his comment reads in context.  Rather I think David meant that the shift in the investment schedule is a symptom of a low level of AD, which is a very reasonable argument, and one he develops later in the post.  But that’s just a quibble about wording.  More substantively, I’m persuaded by Krugman’s argument that weak investment is about more than just AD; the modern information economy (with, I would add, a slow growing working age population) just doesn’t generate as much investment spending as before, even at full employment.

I’d also like to respond to David’s criticism of the EMH:

The efficient market hypothesis (EMH) is at best misleading in positing that market prices are determined by solid fundamentals. What does it mean for fundamentals to be solid? It means that the fundamentals remain what they are independent of what people think they are. But if fundamentals themselves depend on opinions, the idea that values are determined by fundamentals is a snare and a delusion.

I don’t think it’s correct to say the EMH is based on “solid fundamentals”.  Rather, AFAIK, the EMH says that asset prices are based on rational expectations of future fundamentals, what David calls “opinions”.  Thus when David tries to replace the EMH view of fundamentals with something more reasonable, he ends up with the actual EMH, as envisioned by people like Eugene Fama.  Or am I missing something?

In fairness, David also rejects rational expectations, so he would not accept even my version of the EMH, but I think he’s too quick to dismiss the EMH as being obviously wrong. Lots of people who are much smarter than me believe in the EMH, and if there was an obvious flaw I think it would have been discovered by now.

David concludes his post as follows:

Thus, an increasing share of total investment has become capital-deepening and a declining share capital-widening. But for the economy as a whole, this self-fulfilling pessimism implies that total investment declines. The question is whether monetary (or fiscal) policy could now do anything to increase expectations of future demand sufficiently to induce an self-fulfilling increase in optimism and in capital-widening investment.

I would add that the answer to the question that David poses is clearly “yes”, as the Zimbabweans have so clearly demonstrated.  I would rather avoid terms like “self-fulfilling pessimism”, as AD depends on monetary policy, or combined monetary/fiscal policy is you are a Keynesian.  Either way it don’t think it’s useful to view AD as depending on the expectations of investors, pessimistic or not.  Those expectations merely respond to what the policymakers are doing, or not doing, with NGDP.

PS.  Yes, I do understand that under certain monetary policy stances, such as a money supply or interest rate peg, exogenous expectations impact AD.  I just don’t think it’s useful to view those pegs as a baseline policy.

PPS.  Let me repeat what I said earlier, we are going to have an interesting test of the impact of uncertainty on (British) GDP, over the next few months.  Not a definitive test (which would require observations with and without NGDP targeting, to tease out AD vs. AS channels), but certainly a suggestive test.  I have an open mind at this point, and am eager to learn.

Matt O’Brien has a good article on low bond yields, in the Washington Post:

Bond yields aren’t always the most exciting thing in the world, but they are right now.

In fact, you’ll probably be telling your grandkids about them one day. That’s because the yield on the benchmark 10-year U.S. Treasury bond plunged to an all-time low of 1.37 percent on Tuesday. Not only that, but it’s done so at a time when unemployment is a relatively normal 4.7 percent. This isn’t, to say the least, what’s supposed to happen. But it is what’s happening, here and everywhere else, because the world economy is turning Japanese. Which, as we’ll get to in a minute, means that future generations might have a harder time believing that rates were ever this high rather than this low.

Let’s compare bond yields to a previous period when unemployment was this low, the first quarter of 2006 (which was the peak of the housing boom).  In February 2006, 10-year bond yields were about 4.55%, more than 300 basis points above the current level.  So why are bond yields now so low?

Everything is relative.  Most of us were taught that nominal variables don’t matter; you need to look at real variables.  With interest rates you need to normalize by subtracting NGDP growth.  Back in the first quarter of 2006, NGDP had grown at a 6.51% over the previous 4 quarters.  The most recent data shows a 3.29% growth over the past 4 quarters.  So NGDP growth has slowed by over 300 basis points.  Hmm, does that sound familiar?

To be fair, by 2006 interest rates were already pretty low by historical standards.  In the distant past the 10-year bond yield was often closer to the NGDP growth rate.  By the early 2000s, however, we were already in the new world of low interest rates.  The declines since then reflect slower NGDP growth, nothing more.  If you want higher interest rates, ask the Fed to give us higher NGDP growth.  It’s that simple.

The rest of the world has only made this more true. That’s because zero interest rates in one country exert a kind of gravitational pull on interest rates in another. They’re “contagious,” as economists Gauti Eggertsson, Neil Mehrotra, Sanjay Singh and Larry Summers put it. Here’s why: if you have zero interest rates and are expected to for a while, then capital will flow into my economy every time I even consider raising my own. Money, after all, moves to where it thinks it can get the best return. But on a less happy note, this will push my currency up so much that my exports will start to lose competitiveness. And that, in turn, will slow my economy down enough that I won’t actually have to raise rates. Instead, I’ll keep them around zero — just like yours. The same kind of thing happens any time there’s any financial turbulence in the world. Investors stampede into the safe haven that is U.S. government debt, pushing down yields and pushing out expectations of rate hikes.

If you try to raise rates with a tight money policy, it will fail for the reasons outlined in Eggertsson, et al.  If you try to raise interest rates with an easy money policy that raises NGDP growth up to 5%, then you will succeed.

The yield on the 10-year U.S. Treasury bond has fallen 0.3 percentage points since Britain voted to leave the European Union two weeks ago, and almost a full percentage point since the Fed raised rates last December.

Last December, there was a vigorous debate between those who wanted the Fed to raise rates because low rates could lead to asset price bubbles, and those of us who said that argument was wrong.  Can we now all agree that those who favored raising rates because a low rate environment could lead to excessive risk taking were wrong?  Put aside the question of whether low rates lead to asset price bubbles, the entire premise of the argument was that the Fed’s action would lead to higher rates over time.  We now know that this was false, longer term rates are far lower than in December, as are expected future short-term rates.

The paradox is that the economy can only handle higher rates if the Fed says it won’t raise them. Anything else will create so much turmoil that the Fed won’t even be able to pretend it’s going to increase interest rates as much as it was before. That’s why long-term rates actually fell after the Fed raised short-term rates at the end of last year.

If you want peace, prepare for war.

If you want to be happy, don’t try to be happy.

If you want higher interest rates, tell the Fed to cut interest rates.

When Janet Yellen retires, how about appointing a Zen Master to chair the Fed?  (I propose Nick Rowe.)

PS.  I was recently interviewed by the French magazine Atlantico.

PPS.  I also have a new Econlog post.