This caught my eye:

Unlike these past five major rate hike cycles, today’s Fed will not be moving to fight inflation or cool economic growth. Inflation is running below their target and current U.S. GDP readings are not exactly red hot. What the Fed wants (or needs) to do is raise the target rate in order to have ammunition for the next time our economy stumbles. A well-telegraphed series of small rate increases could allow the Fed to “reload” while having only a minimal to modest impact on overall economic activity. It would be another spectacular tight rope act for the Fed to pull off, but their recent track record suggests it is something possible. One certainty that exists is the fact that the Fed will do no harm to the market or the economy, especially with the next presidential election cycle beginning already.

I guess once people start reasoning from an interest rate change there’s no telling where it will lead.  Of course he has things exactly backwards; if the Fed wants more (conventional) ammunition, it needs to delay raising interest rates to speed up NGDP growth.

The mistake here is that the author assumes the ability to cut rates represents “ammunition.”  In fact, if you insist on thinking in Keynesian terms, then ammunition is represented by a higher Wicksellian equilibrium nominal interest rate, not a higher actual rate.  The farther above zero is the Wicksellian rate, the more ability the Fed has to stimulate using conventional interest rate cuts.  But here’s the problem.  If the Fed raises rates today with a tight money policy then they will be reducing NGDP growth, and hence reducing the Wicksellian equilibrium rate.  They’ll have less ammo.

Now it’s conceivable that the author was suggesting that the Fed could get more ammunition by raising interest rates via a Neo-Fisherian channel (easier money), say by raising the inflation target to 4%.  Sure, that would work, but I sort of doubt that’s what the author had in mind.  Again, a tighter monetary policy gives the Fed less ammo, not more.

PS.  Russ Roberts has a new podcast interviewing me on interest rates.

Update:  The Washington Examiner has a list of 28 “New Voices.”  I was pleased to see my name, and even more pleased to see Matthew Rognlie.  Matt always left extremely thoughtful comments, and I considered him to be one of the rising young stars even before his famous post on the Piketty data issue.  It’s great to see how the internet can give a voice to talented students like Matt (as well as Evan Soltas, Yichuan Wang, etc.)

Update#2:  Ramesh Ponnuru has a very good article on Bernanke’s discussion of NGDP targeting.

Paul Krugman has weighed in on my “never reason from a price change” argument.

[And of course NRFPC it isn’t my idea; it’s a part of EC101 that many economists never learned, or forget on occasion.  Over at Econlog I cited a great Krugman essay where he claimed that one reason he became successful is that he took the stance of a rebel, while using arguments out of standard econ textbooks.  I suggested someone else who had modest success doing exactly that.]

Here’s Krugman:

Sumner says that you can’t reason from a price change; the dollar doesn’t just move for no reason, so you have to go back to the underlying cause and ask what effect it has. Actually, asset price moves often have no clear cause “” they’re bubbles, or driven by changes in long-term expectations, so you really do want to ask about the effects of price changes you can’t explain very well.

Obviously I don’t agree about the existence of bubbles–Fama shoots that idea down in his Nobel lecture.  But even if I’m wrong about bubbles, Krugman is wrong about the relevance of never reason from a price change to bubbles.  It matters very much why prices change, even if those reasons are irrational.  For instance, stock prices may be driven to irrational heights because:

A.  People are irrationally pessimistic about NGDP growth, and this depresses bond yields to unreasonably low levels, and this discounts a given flow of earnings at a higher valuation.

B.  People are unreasonably optimistic about the economy, and expect a highly implausible rate of growth in NGDP and profits.

Surely you can’t argue that it doesn’t matter which of those two types of irrationality cause the stock price “bubble”?  And surely you can’t have confidence that something is a bubble without having some sort of view as to what market thinking is leading to the excessive price movements?

Krugman continues:

More specifically, Sumner is right that if the euro’s fall is being driven by expansionary monetary policy, this affects the U.S. through the demand channel as well as competitiveness, so it may be a wash. But I’ve already argued that the fall in the euro is much bigger than you can explain with monetary policy; it seems to reflect the perception that Europe is going to be depressed for the long term. And if that’s what drives the weak euro/strong dollar, it will hurt US growth.

I agree with the reasoning process in the last sentence.  But I don’t think it applies to the current case, as it seems very unlikely that lower growth expectations are what is depressing the euro.  Here’s what we do know:

1.  Eurozone growth expectations have been in the toilet for years.

2.  The euro was valued at about $1.35 for years, and then gradually fell to about $1.05 over the past few months.

3.  During the past few months the growth forecasts of the eurozone have been revised upward, as the euro has been falling.

You don’t need to be an EMH fanatic like me to see a problem with Krugman’s argument. Kudos to him for not reasoning from a price change, for not lazily assuming that a weaker euro meant more growth.  But I think’s he’s gone too far in the other direction, in assuming that the cause of the weaker euro was lower growth expectations.

Having said that, I’ll admit I’m a bit puzzled by the timing of the euro’s fairly steady decline.  Some of that was associated with easy money statements coming out of the ECB, but not all. So there may be some other factor depressing the euro that I don’t see. I just don’t see any evidence that slower growth in the eurozone is that mysterious X factor.  It’s not new information.  On the other hand Krugman’s right that weaker growth might be the cause, so I’m willing to revise my views as new information comes in, such as another growth pause in Europe.  There is no theoretical issue at stake here, separating our two views.

Off topic, don’t read too much into my statements on Fed policy over the next few years.  Unlike in past years, when the Fed was clearly much too tight, I don’t think they are far off course.  Some of my statements might suggest I think policy is not far off course, others might suggest I think policy is a bit too tight to hit the Fed’s dual mandate.  There is no contradiction between those statements.  It’s hard to evaluate current policy without knowing where the Fed wants to go, and they refuse to tell us where they want to be in 10 years, either in terms of the price level or NGDP.  If they would tell us, I’d recommend they go there in the straightest path possible.

Also, I see people talking like it’s perfectly obvious that Fed policy is now much tighter than ECB policy.  That’s not at all obvious.  What causes that perception?

1.  The ECB has recently loosened, and the Fed may have slightly tightened.

2.  Rates are lower in Europe, and they are doing QE.

Neither of those are good reasons.  During 2011-14 ECB was far tighter than in the US. So even though they have loosened, it doesn’t mean that ECB policy is looser in absolute terms. The deeper into a liquidity trap you fall, the more “concrete steppes” you need to achieve a given policy stance.  And the eurozone has fallen very, very deeply into their liquidity “trap.”  Of course neither interest rates nor the monetary base are good indicators of the stance of policy, unless you want to argue that the Fed’s highly deflationary policy of 1932 was actually easy money because rates were near zero and the Fed was doing QE. That claim would have been viewed as wacky 10 years ago, although I admit that many economists now seem hopelessly confused about how to define the stance of monetary policy.

As always, NGDP futures markets in the two regions would best establish the relative stances of monetary policy.  TIPS markets suggest the ECB is still effectively tighter.

HT:  Foosion, Edward

I did a post a while back that responded to John Taylor’s criticism of NGDP targeting.  In the comment section Statsguy pointed out that Taylor’s argument was even more flawed than I assumed.  And now George Selgin shows that it was even more flawed than Statsguy assumed:

Thus Professor Taylor complains that, “if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targetting.” Now, first of all, while it is apparently sound “Economics One” to begin a chain of reasoning by imagining an “inflation shock,” it is crappy Economics 101 (or pick your own preferred intro class number), because a (positive) P or inflation “shock” must itself be the consequence of an underlying “shock” to either the demand for or the supply of goods. The implications of the “inflation shock” will differ, moreover, according to its underlying cause. If an adverse supply shock is to blame, then the positive “inflation shock” has as its counterpart a negative output shock. If, on the other hand, the “inflation shock” is caused by an increase in aggregate demand, then it will tend to involve an increase in real output. Try it by sketching AS and AD schedules on a cocktail napkin, and you will see what I mean.

Good. Now ask yourself, in light of the possibilities displayed on the napkin, what sense can we make of Taylor’s complaint? The answer is, no sense at all, for if the “inflation shock” is really an adverse supply shock, then there’s no reason to assume that it involves any change in NGDP. On the contrary: if you are inclined, as I am (and as Scott Sumner seems to be also) to draw your AD curve as a rectangular hyperbola, representing a particular level of Py (call it, if you are a stickler, a “Hicks-compensated” AD schedule), it follows logically that an exogenous AS shift by itself entails no change at all in Py, and hence no departure of Py from its targeted level. In this case, although real GDP must in fact decline, it will not decline “much more than with inflation targetting,” for the latter policy must involve a reduction in aggregate spending sufficient to keep prices from rising despite the collapse of aggregate supply. A smaller decline in real output could, on the other hand, be achieved only by expanding spending enough to lure the economy upwards along a sloping short-run AS schedule, that is, by forcing real GDP temporarily above its long-run or natural rate–something, I strongly suspect, Professor Taylor would not wish to do.

If, on the other hand, “inflation shock” is intended to refer to the consequence of a positive shock to aggregate demand, then the “shock” can only happen because the central bank has departed from its NGDP target. Obviously this possibility can’t be regarded as an argument against having such a target in the first place! (Alternatively, if it could be so regarded, one could with equal justice complain that similar “inflation shocks” would serve equally to undermine inflation targeting itself.)

Another good reason to “never reason from a price change.”  However it wasn’t all good news for me, as George also took me to task for sloppy reasoning about the dual mandate:

But lurking below the surface of Professor Taylor’s nonsensical critique is, I sense, a more fundamental problem, consisting of his implicit treatment of stabilization of aggregate demand or spending, not as a desirable end in itself, but as a rough-and-ready (if not seriously flawed) means by which the Fed might attempt to fulfill its so-called dual mandate–a mandate calling for it to concern itself with both the control of inflation and the stability of employment and real output. And this deeper misunderstanding is, I fear, one of which even some proponents of NGDP targeting occasionally appear guilty. Thus Scott Sumner himself, in responding to Taylor, observes that “the dual mandate embedded in NGDP targeting is not that different from the dual mandate embedded in the Taylor Rule,” while Ben McCallum, in his own recent defense of NGDP targeting, treats it merely as “one way of taking into account both inflation and real output considerations.”

To which the sorely needed response is: no; No; and NO.

We should not wish to see spending stabilized as a rough-and-ready means for “getting at” stability of P or stability of y or stability of some weighted average of P and y: we should wish to see it stabilized because such stability is itself the very desideratum of responsible monetary policy. The belief, on the other hand, that stability of either P or y is a desirable objective in itself is perhaps the most mischievous of all the false beliefs that infect modern macroeconomics. Some y fluctuations are “natural,” in the sense meaning that even the most perfect of perfect-information economies would be wise to tolerate them rather than attempt to employ monetary policy to smooth them over. Nature may not leap; but it most certainly bounces. Likewise, some movements in P, where “P” is in practice heavily weighted in favor, if not comprised fully, of prices of final goods, themselves constitute the most efficient of conceivable ways to convey information concerning changes in general economic productivity, that is, in the relative values of inputs and outputs. A central bank that stabilizes the CPI in the face of aggregate productivity innovations is one that destabilizes an index of factor prices.

We shall have no real progress in monetary policy until monetary economists realize that, although it is true that unsound monetary policy tends to contribute to undesirable and unnecessary fluctuations in prices and output, it does not follow that the soundest conceivable policy is one that eliminates such fluctuations altogether. The goal of monetary policy ought, rather, to be that of avoiding unnatural fluctuations in output–that is, departures of output from its full-information level–while refraining from interfering with fluctuations that are “natural.” That means having a single mandate only, where that mandate calls for the central bank to keep spending stable, and then tolerate as optimal, if it does not actually welcome, those changes in P and y that occur despite that stability.

I mostly agree with this, but I also think there is some ambiguity as to the meaning of “mandate.”  Some view it as similar to “target,” but I don’t.  Consider this from Congress’s perspective.  They don’t understand the fine points of money/macro, but notice that it sure looks like there are suboptimal employment fluctuations and that at times inflation is excessively high and/or erratic.  Now of course George might very reasonably argue I am being far too kind.  They simply want MORE JOBS, and know nothing about “suboptimal employment fluctuations.”  Nevertheless, inflation and unemployment can be viewed as two distinct problems.  A monetary policy that produces optimal employment fluctuations with an average inflation rate of minus 1%, could probably have done the same with an average inflation rate of plus 1%.  I.e., money is approximately super-neutral, and hence decisions about the average inflation rate (or preferably average NGDP growth rate) are logically distinct from how we vary the inflation (or NGDP growth) rate to avoid suboptimal employment fluctuations.

Of course we shouldn’t target inflation at all, but Congress doesn’t understand that.  Nonetheless their intuition about “inflation” being bad is roughly correct; an average NGDP growth rate of 10% is also bad, even if employment is always at its Walrasian equilibrium level.

So let’s suppose that Congress tells the monetary authority to address those two vague goals.  Is that reasonable?  I think it is.  But that doesn’t mean the Fed should actually target inflation and unemployment, or inflation and output gaps.  They should address the dual mandate with something like an NGDP target (or productivity norm, or nominal wage target.)  They should address the dual mandate with a single target.

The super-neutrality of money allows us to maintain optimal employment with either a high or low average inflation rate.  Since inflation is costly, we might as well pick a low rate, and hence a fairly low NGDP target.  But money may not be precisely super-neutral at very low inflation rates, as there is a sharp discontinuity in nominal wage gains at just below zero percent (which implies money illusion.)

To summarize, George Selgin is right that the goal should not be zero employment fluctuations; it should be to reproduce the employment levels of an economy with wage/price flexibility (or perfect-information, to use George’s characterization.)  But that still doesn’t pin down the average inflation rate, or the average NGDP growth rate.  So I do think that the concept of “dual mandate” makes some sense, at least as a sort of political aspiration.  What we need to avoid is dual monetary policy targets.

PS.  Elsewhere I’ve argued that the welfare costs assumed to flow from inflation are actually caused by high and unstable NGDP growth.  I’ve used inflation in this post to avoid needlessly complicating the issues discussed by George Selgin.

Here’s Macroeconomics Advisers:

In principle, FOMC communications can be very powerful. If the FOMC could encourage the market to shift out its expectation of the time of the first rate hike by six months, the impact on the ten-year Treasury yield would be comparable to that of $760 billion of QE! Our analysis suggests that a six-month shift in the expected time of the first rate hike would have a significant impact on the yield curve.

But recall that the larger the monetary stimulus, the more quickly interest rates are likely to rise.  This creates a problem.  It very much matters whether the Fed’s decision to hold down rates is seen as an expansionary move, reflecting greater than anticipated monetary stimulus, or a contractionary move—the Fed throwing in the towel and adopting the Japanese monetary model of ultra-slow NGDP growth.  Never reason from a price change.

It might be argued that the Fed has only a single policy, and hence there is only one way that they can affect the path of short term rates—buying bonds.  But in fact the Fed has many tools, the most important of which are not current purchases of bonds in the open market.  If the Fed promise to lower rates is tied to communication hinting at much more aggressive stimulus in the future, it is likely to be expansionary.  If the low rate promise is accompanied by a disappointing refusal to commit to QE3, level targeting, or any other robust stimulus, it will may interpreted as a contractionary move (as in Japan.)

In the first half hour after the recent Fed promise to hold rates near zero, the move was interpreted as being highly contractionary.  Later in the day markets (presumably) focused on other aspects of the statement, hinting at more expansionary policy to come.  When they did so stock prices rose sharply, but so did interest rates!

New Keynesian models incorporate all these expectations channels, but I rarely see mainstream economists, even elite economists, talk about Fed policy moves using this sort of sophisticated model.  Are there any recent analyses I am missing?  I’d like to link to other economists who use the expectations channel of NK models (and financial markets reactions) in their analysis.  Any links would be appreciated.

PS.  Interested readers might want to look at Andy Harless’s different interpretation of Tuesday’s event in the comment section of the previous post.  Both of our interpretations are consistent with NK models, although in my eyes his interpretation implies a greater degree of market inefficiency than mine.  Other’s may disagree.

HT:  Alex Tabarrok

I have great respect for the work of Justin Wolfers, so it pains me to write this post.  But if you read the following, I think you’ll see why I couldn’t let it pass:

Typically, the Fed does this by reducing the Federal Funds Rate, which is an interest rate on overnight loans. Unfortunately, that short-term interest rate is now pretty much at zero, and can’t go any lower. The thing is, no-one actually cares about the Fed Funds Rate. You and I and the businesses we work for don’t borrow using short-term interest rates.  Instead, we finance our investments with longer-term loans.  The Fed Funds Rate only matters to the extent that it reduces long-term interest rates.

So the key is for the Fed to reduce long-term rates.

Recently, the Fed has been doing this by “Quantitative Easing.”  It’s a terrible name for a simple solution. Just as the Fed adjusts short-term interest rates by buying and selling overnight government securities, it can adjust long-term interest rates by buying and selling long-term government securities. That’s what QE2 did.

Many market commentators are disappointed that the Fed didn’t announce “QE3″””a renewed round of quantitative easing. But they shouldn’t be. The Fed still chose to reduce long-term interest rates, they just decided to do it with a different tool. They figured that if you can’t reduce short-term interest rates further, you should reduce ’em for longer. That’s what the Fed was promising, when they said they expect to keep their short-term rate at “exceptionally low levels for the federal funds rate at least through mid-2013.”  What does this do? Keeping short-term interest rates lower for longer will also reduce long-term interest rates. And that’s the main game. It has already worked””perhaps even more reliably than following QE2. The interest rate on two-year bonds is down to virtually zero, and the 10-year interest rate is down to 2.2 percent.

So yes, we got lower long-term interest rates.  That’s what matters. And it doesn’t really matter how we got there.

I certainly agree that the fed funds rate is unimportant.  But I’m afraid Wolfers has violated one of my favorite maxims: Never reason from a price change.

It does matter why rates fall.  In December 2007 the cautious Fed announcement so discouraged investors that the stock market crashed and long term interest rates fell (on expectations of recession–which turned out correct.)  Obviously I can’t say for sure that this explains the current movement in the long term bond market.  But consider the following:

1.  When AD is severely depressed, stocks react very positively to monetary stimulus.

2.  When AD is severely depressed, stocks tend to move in the same direction as bond yields.

3.  QE2 rumors seemed to clearly boost stock prices in the fall of 2010.

4.  In recently weeks both stock prices and bond yields have fallen sharply, and the falls have been highly correlated.

Put all those facts together and it seems much more likely that the recent decline in yields is due to fears that the Fed will allow NGDP to plunge, rather than the belief the Fed has adopted a truly stimulative policy.

Wolfers’ mistake is to forget that interest rates can change for many reasons.  It might be more demand for T-bonds from the Fed (expansionary) or more demand for T-bonds from people frightened that the Fed will do nothing to prevent a double dip (contractionary.)

HT:  JTapp

Update:  JTapp told me that Justin Wolfers made the following comment in Twitter:  “Scott Sumner failed to read my piece closely: themoneyillusion.com/?p=10422. I didn’t reason from a price change but from a Fed demand shock.”

I understand that Wolfers was assuming the fall in interest rates was in response to a Fed demand shock, but I’m arguing he had no basis for drawing that inference.  The Fed did not announce a policy of increasing its purchases of bonds by more than the market expected—if anything, just the reverse.  All we really know is that markets are responding to the Fed.  We don’t know exactly why.   Indeed the Fed’s action was so confusing that the markets initially didn’t even seem to know how to react, gyrating wildly up and down several times in the hours after the 2:15 announcement.  And recall that in December 2007 a contractionary surprise caused bond yields to plunge–why is this different?     So I’m afraid my criticism stands.

We really, really need a NGDP futures  market, which would eliminate all these debates about whether Fed actions are expansionary and contractionary.  And who is one of the two most famous proponents of prediction markets?  Justin Wolfers.  I’m sure Justin and I agree on that issue.

Update#2:  I just got an email from Justin Wolfers.  Perhaps I created the wrong impression in my “never reason from a price change” comment.  Justin certainly understands the distinction between supply and demand shocks, and I didn’t mean to suggest otherwise.  But monetary economics adds another degree of complexity.  The same action (buying bonds) can raise or lower bond yields, depending on expectations.  A one time open market purchase may well lower bond yields.  But an announcement that the Fed will buy enough bonds to create Zimbabwe-style inflation will raise bond yields.  So even if one knows it’s a demand for bonds shock (and we don’t know in this case) it’s still dangerous to draw inferences from interest rate changes.