Archive for the Category Price Level Targeting


Bernanke and Mishkin on helicopter drops

There are two serious approaches to dealing with the zero bound, and one deeply unserious approach.  The two serious proposals are:

1.  Unconventional policy tools (quantitative easing, qualitative easing, negative IOR)

2.  A new policy target (price level targeting, NGDPLT, 4% inflation, etc.)

And one deeply unserious proposal:

1.  Helicopter drops

In this video, Frederic Mishkin points out that the Fed is not even authorized to do helicopter drops.  And the idea that the GOP Congress would go along with this sort of scheme is ludicrous.  (And people somehow think I’m unrealistic for talking about NGDP futures markets.)

And yet helicopter drops seem to be all the rage at the WSJ, the Economist, and Bloomberg.

Back in 2004, Ben Bernanke (in a paper with Vincent Reinhart and Brian Sack) discussed the real issue:

The greater the confidence of central bankers that tools exist to help the economy escape the ZLB, the less need there is to maintain an inflation “buffer,” and hence the lower the inflation objective can be.

Helicopter drops are not even an option.  Either you use unconventional tools aggressively enough to hit your target (and there is no limit to how aggressively they can be used) or you set a policy target where the zero bound does not occur (or does not create problems if it does occur, as with level targeting).

It’s a sad commentary on the media that they are buying into this notion that central banks are out of ammo, even as central bankers insist they are not out of ammo, and the Fed is raising interest rates despite inflation being below 2%, and expected to remain below 2%.

Also note this suggestion from the same paper:

Despite our relatively encouraging findings concerning the potential efficacy of nonstandard policies at the ZLB, we remain cautious about making policy prescriptions. Although it appears that nonstandard policy measures may affect asset yields and thus potentially the economy, considerable uncertainty remains about the size and reliability of these effects under the circumstances prevailing near the ZLB. Thus we still believe that the best policy approach is one of avoidance, achieved by maintaining a sufficient inflation buffer and easing preemptively as necessary to minimize the risk of hitting the ZLB. [emphasis added]

The Fed obviously ignored that advice in 2008, and they are ignoring it today.  The question is why?

HT:  Ben Klutsey, Patrick Horan


Gavyn Davies on the Fed meeting

Here’s Gavin Davies of the FT:

The startling recovery in risk assets in October – global equities rose by 11 per cent during the month – was triggered mainly by reduced pessimism on the eurozone’s debt crisis, but was probably also helped by easier monetary policy from several of the major central banks. As usual, the Federal Reserve has been in the vanguard of this action, and further measures are expected from the FOMC when it meets on  Tuesday and Wednesday.

There have been calls for major innovations, such as the introduction of a target for the level of nominal GDP, but the Fed has given little indication that it is ready for anything quite so drastic. Much more likely are some further modest steps to improve the communication of the Fed’s thinking on the future path of short rates, with the aim of keeping long rates as low as possible. And there might also be some more purchases of mortgage backed securities.

This certainly caught my attention, as there were three high profile endorsements of NGDP targeting recently; Romer, Krugman and Goldman-Sachs.  And there is only one person who was cited or linked to in all three statements.  I’m tempted to resurrect my connecting the dots post, but can’t really do so in good faith.  Davies is right; NGDP targeting is not going to be adopted at this meeting.  Indeed something that important ought to be widely debated first.  And that hasn’t yet occurred.  Still, I’d hope to see a mention that they are at least discussing the merits.

I do think Davies might be right about monetary stimulus chatter having some effect on equity prices recently, but I don’t see any firm evidence that would make that more than a conjecture.  In any case, any influence I have on that debate is an order of magnitude lower than the specific topic on NGDP targeting.

Davies continues:

Although the idea has merit, and may well be discussed by the FOMC in future, it is not likely to emerge from this week’s meetings.  Ben Bernanke has discussed many radical actions for monetary policy in the past, notably relating to Japan a decade ago, but I do not recall him ever giving much attention to a nominal GDP target.  He has consistently focused on the advantages of adopting a clear and consistent target for the rate of inflation (note, not the level of prices, but their rate of change, so past shortfalls would not need to be restored), and in a recent speech on 18 October he said the following:

“As a practical matter, the Federal Reserve’s  policy framework has many of the elements of flexible inflation targeting…The FOMC is committed to stabilising inflation over the medium term while retaining the flexibility to help offset cyclical fluctuations in economic activity and employment.”

A couple points.  Davies is right about Bernanke’s focus on inflation, but Bernanke actually has recommended the level targeting of prices.  Of course it was for Japan, not the US.  It’s too bad Bernanke has no interest in NGDP targeting, as it would achieve the objective laid out in that quotation far better than inflation targeting.  Indeed that Bernanke quotation is a textbook argument for NGDP targets.

He went on to argue that inflation targeting had proven its worth in stabilising inflation expectations in both directions in recent years, and he concluded as follows:

“My guess is that the current framework for monetary policy – with innovations, no doubt, to further improve the ability of central banks to communicate with the public – will remain the standard approach, as its benefits in terms of macroeconomic stabilisation have been demonstrated.”

If a 9% fall in NGDP below trend from mid-2008 to mid-2009, which led to massive and costly fiscal stimulus in the desperate hope it would prop up the very same aggregate demand that the Fed is supposed to be controlling is “benefits . . . demonstrated,” I’d hate to see a failed monetary policy.  And then there’s the sub-5% NGDP growth during the 27 month “recovery.”

Janet Yellen is particularly important here, since she is in charge of a Fed committee examining the matter. In her speech, she said:

“We have been discussing potential approaches for providing more information “” perhaps through the SEP “” regarding our longer-run objectives, the factors that influence our policy decisions, and our views on the likely evolution of monetary policy.”

The SEP is the Summary of Economic Projections, in which FOMC members give their outlooks for the main economic variables in the years ahead. It seems from Janet Yellen’s guidance that the Fed might decide to beef up this document so that it becomes more explicit about the nature of its long run inflation and unemployment objectives, and about the conditions underpinning its commitment to hold interest rates close to zero until mid 2013.

It is even possible that FOMC members might start to publish their entire expected path for short rates over future years, conditional on their economic forecasts. (Read my lips: no new rate hikes!”) The Chairman has explicitly pointed out that other central banks publish such projections of policy rates, which help influence market expectations of central bank policy.

The idea here would be to increase the confidence of the markets that short rates are intended to remain at zero for a very long time to come, which might in turn reduce long bond yields even further.  That would be useful in easing monetary policy slightly, but it cannot be expected to have very much effect when short rate expectations are already so low. More drastic options, like a target for the level of nominal GDP, will have to wait a while.

That doesn’t do much for me.  I’d say lower long term rates are more likely to be “evidence that monetary policy remains ineffective,” rather than “useful in easing monetary policy slightly.”  The Fed is still a long way from the point where it comes to grips with what actually needs to be done.  But at least they are searching for answers.

HT:  Richard W.

PS.  Joshua Lehner just sent me some interesting graphs comparing actual NGDP growth with Fed forecasts at different time horizons.  They obviously envision roughly 5% NGDP growth, and just as obviously aren’t doing level targeting.  Interestingly, he said the Fed stopped doing explicit NGDP forecasts in 2005, now it’s just RGDP and P.  That’s a bad sign.

Update:  Josh Lehner send me this post from his blog.

When legend becomes fact, print the legend

I view the 1920s as a sort of golden age of macroeconomics, before Keynes ushered in the long dark night.  The standard model was similar to the AS/AD model we teach in intro textbooks.  Nominal shocks have real effects in the short run, but merely lead to higher prices in the long run.  Irving Fisher argued the business cycle was “a dance of the dollar.”  He discovered the Phillips curve.  Most economists pointed to wage and price rigidity as the cause of short run non-neutrality, the same explanation that we see in modern textbooks.  People like Fisher, Pigou, Wicksell, Cassel, Hawtrey, etc, did great work in the 1910s and 1920s.  And last but not least, there was the Keynes of the Tract on Monetary Reform (1924) and the Treatise on Money (1930.)

Hicks (1937) argued that the only thing in the General Theory that was really new was the zero rate trap.  Otherwise it was all known to the economists of the 1920s.  But Keynes had a big ego, and wanted to claim he had revolutionized macroeconomics, rather than just dress up well known ideas in a different language.  So he grossly distorted the actual macro of the 1920s, by creating a fictional “classical” economics where the economy is always at the long run run equilibrium.  His contemporaries were outraged, but since Keynesian economics won out in the long run, modern textbook writers accepted his version of events.  Now we teach all our students a bunch of falsehoods, such as the myth that the pre-Keynesian economists had no explanation for high unemployment.  Or that MV=PY is the quantity theory of money.

Brad DeLong is quite knowledgeable about economic history, so I was surprised to see him buy into the myth of interwar “classical” economics.  He quotes this passage from the GT with approval:

The General Theory of Employment, Interest and Money: The idea that we can safely neglect the aggregate demand function is fundamental to the Ricardian economics, which underlie what we have been taught for more than a century. Malthus, indeed, had vehemently opposed Ricardo’s doctrine that it was impossible for effective demand to be deficient; but vainly. For, since Malthus was unable to explain clearly (apart from an appeal to the facts of common observation) how and why effective demand could be deficient or excessive, he failed to furnish an alternative construction; and Ricardo conquered England as completely as the Holy Inquisition conquered Spain. Not only was his theory accepted by the city, by statesmen and by the academic world. But controversy ceased; the other point of view completely disappeared; it ceased to be discussed. The great puzzle of Effective Demand with which Malthus had wrestled vanished from economic literature. You will not find it mentioned even once in the whole works of Marshall, Edgeworth and Professor Pigou, from whose hands the classical theory has received its most mature embodiment. It could only live on furtively, below the surface, in the underworlds of Karl Marx, Silvio Gesell or Major Douglas. . . .

The celebrated optimism of traditional economic theory, which has led to economists being looked upon as Candides, who, having left this world for the cultivation of their gardens, teach that all is for the best in the best of all possible worlds provided we will let well alone, is also to be traced, I think, to their having neglected to take account of the drag on prosperity which can be exercised by an insufficiency of effective demand. For there would obviously be a natural tendency towards the optimum employment of resources in a Society which was functioning after the manner of the classical postulates. It may well be that the classical theory represents the way in which we should like our Economy to behave. But to assume that it actually does so is to assume our difficulties away.

Ah, the old “let well enough alone” myth.  A poll in the late 1920s of 282 economists showed that 251 favored a monetary policy aimed at price level stabilization.  Isn’t that sort of like New Keynesian inflation targeting?  And of course the University of Chicago economists of the 1930s favored a combination of fiscal and monetary stimulus.

What Keynes did was move the profession away from the idea of monetary cures for business cycles–which actually can be effective, toward the idea of fiscal cures, which (short of WWII) are almost never effective.   It would take many decades for money to be rediscovered.  Indeed the influence of Keynes was so powerful that even in 2009 there were many Keynesian economists who should have known better who suddenly announced that monetary policy couldn’t work at the zero bound, and that fiscal stimulus was needed.  Fortunately those Keynesians rediscovered money much more quickly this time, indeed within 2 years.

The End of History: Why the Fed will fail

In 1989 Francis Fukuyama made a bold prediction.  The world would become increasing democratic and market-oriented.  Other political models would gradually wither away.  He called this “The End of History.”  Here are a couple facts about his prediction:

1.  It would be difficult to find any other prediction in the humanities or social sciences that has proved more accurate.  There are many more democratic countries than in 1989, and policy has become much more market-oriented in most countries.

2.  When intellectuals discuss his prediction today, 99% assume it failed to come true.  Indeed most utter the phrase “the end of history” with undisguised contempt.

The juxtaposition of these two realities has made a deep impression on me.  How can we explain why so many brilliant people have failed to acknowledge Fukuyama’s prescience?  In some cases people were too lazy to even inquire as to exactly what the term ‘end of history’ meant.  In other cases they were too mesmerized by what they saw on the evening news. After all, doesn’t it look like “history is being made tonight in Libya”?  In fact, history is probably (knock on wood) ending in Libya.  For the rest of my life it is unlikely that I’ll ever know the name of another Libyan leader.  At least I hope not.

My theory is that it looks very much like history is not ending, if you rely on impressions, not facts.  After all, the cable networks are increasing able to bring political strife into our living rooms, which would have been invisible in past years.  I’m old enough to remember major strife in various parts of the world receiving zero coverage on TV.  Massacres in Africa.  The Cultural Revolution in China.  Pol Pot.  The 1982 massacres in Hama.  The list could go on and on.  The world seems increasing violent, even as it becomes increasing peaceful and democratic and market-oriented.

How does this relate to the Fed?  Here are two facts about monetary policy.

1.  Economic theory strongly suggests that NGDP falling 11% below trend in the last three years has severely depressed real output (regardless of what other factors might have also depressed output.)

2.  Economic theory strongly suggests that the Fed could have prevented this sharp slowdown in NGDP growth.  Interestingly, the Fed agrees.

The implication is that Fed errors of omission caused much of the Great Recession.  Yet very few economists believe that.  No matter how powerfully theory and empirical evidence point in one direction (the end of history, the Fed’s at fault) if it doesn’t SEEM THAT WAY, even very bright intellectuals will go with the gut, and then invent whatever theoretical rationales they need to make their prejudices plausible.  Policy impotence.  A Fed capable of unlimited money creation is somehow incapable of debasing the dollar.  Structural problems.  Even though unemployment didn’t rise significantly during the big housing crash of January 2006 to April 2008, gosh darn it that housing crash must be to blame for 9% unemployment, because it seems like it’s to blame.

Imagine the FOMC were composed of 12 Spock-like characters, brutal logicians devoid of any biases.  Ruthless in their reasoning.  Then they might have been able to devise an effective response.  But FOMC members are not Vulcans; they are flesh and blood humans, subject to all the usual biases.

I’m not asking the Fed to do any more than it’s technically capable of doing.  But alas, I am asking it to do more than it’s humanly capable of doing.

That’s why the Fed will fail.  Oh, they might do something useful, make things somewhat better.  But there is no chance that they will do what Spock would do.

Part 2.  What is the minimum acceptable action?

I don’t want to end this post on such a downbeat note.  Here’s Jim Hamilton:

I would suggest that the more important and achievable goal for the Fed should be to keep the long-run inflation rate from falling below 2%. The reason I say this is an important goal is that I believe the lesson from the U.S. in the 1930s and Japan in the 1990s is that exceptionally low or negative inflation rates can make economic problems like the ones we’re currently experiencing significantly worse. By announcing QE3, the Fed would be sending a clear signal that it’s not going to tolerate deflation, and I expect that would be the primary mechanism by which it could have an effect. Perhaps we’d see the effort framed as part of a broader strategy of price level targeting.  .  .  .

And while I’m offering predictions, I might as well make it a triple. If events do take this turn and Bernanke does act again, he’ll be the subject of personal political attacks even more vicious than we’ve seen so far. But I expect the Fed chair to go ahead with the policy in those circumstances anyway, because he knows it’s the right thing to do. I could even imagine the Texas Governor delivering a rousing speech, praising in his appealing drawl those who have the courage to make a personal sacrifice for the larger good.

But I don’t expect the Governor to include in such a speech recognition of one person who deserves such praise.

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

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

PS.  I think Hamilton got a little ahead of himself in the final sentence.  I’d replace “deserves” with “would deserve.”

Update 8/23/11:  I just saw that Matt Yglesias has a similar observation.  Maybe my 99% comment was hyperbole.

Zinc price targeting, and beyond

Now that the multiple universe hypothesis is gaining increasing scientific acceptance, it’s time to soar beyond our own tiny universe and consider monetary policy in alternative worlds.  Consider a universe very similar to our own, but where central banks target zinc prices, not interest rates.

1.  They started with a “zinc standard,” maintained through open market operations.  It provided a sort of nominal anchor.

2.  Then an economist named Irwin Fisher noticed that the relative price of zinc is unstable, and hence the price level fluctuates even when nominal zinc price are constant.  Even worse, price level fluctuations seem to trigger fluctuations in output and employment.  He suggested lowering the price of zinc by 1% each time the price level rose by 1%, and vice versa.

3.  A few decades later a more sophisticated macroeconomist named Johan Tailor devised a more complex monetary rule, which tried to stabilize NGDP growth by adjusting zinc prices in response to both inflation and output deviations, according to an optimal rule estimated using state-of-the-art econometric techniques.  The zinc price that will stabilize NGDP was called the “Wicksellian equilibrium zinc price.”  The central bank was instructed to do OMOs until the actual free market price of zinc was equal to its Wicksellian equilibrium value.  It no longer even needed to hold stocks of zinc.  It bought and sold Treasury securities until the free market price of zinc moved to the right level.

4.   Then they decided to set up a NGDP futures market.  Now the central bank was instructed to adjust the monetary base until the price of zinc moved to a value that generated a NGDP futures price equal to the NGDP target.

5.  Eventually zinc price targeting started to wither away.  Zinc was increasingly viewed as a barbarous relic.  It played no important role in the monetary transmission mechanism, and the central bank began to directly target NGDP futures, without even bothering to use the intermediate step of zinc price targeting.  This brought about “the end of macroeconomics” as a separate field of study.  All “macro” analysis now had micro foundations.

In other universes other elements were used; cobalt, lead, chromium, etc.  Some used valuable compounds like H20, or NaCl.  In one universe zirconium was quite rare, and was the medium of account.  Diamonds were common, and used for small coins.   Oddly, the “zero lower bound issue” never arose in any of these universes.  Zinc prices can go as high as infinity (and also as low as you want in log terms, which is what matters.)  But in one poor benighted universe central banks adopted interest rates as an intermediate target.  Whenever the Wicksellian equilibrium nominal interest rate fell below zero, the central bankers didn’t know what to do—they ran around like chickens with their heads cut off.  Fortunately they too passed through that stage, and eventually moved to a system where OMOs were used to directly target NGDP futures prices (in the year 2037.)  But during the intermediate targeting period things sure were messy!