Archive for the Category Price Level Targeting


Reply to Thoma on NGDP targeting

Mark Thoma recently asked the following question:

So, for those of you who are advocates of nominal GDP targeting and have studied nominal GDP targeting in depth, (a) what important results concerning nominal GDP targeting have I left out or gotten wrong? (b) Why should I prefer one rule over the other? In particular, for proponents of nominal GDP targeting, what are the main arguments for this approach? Why is targeting nominal GDP better than a Taylor rule?

The entire post is rather long, and Thoma raises issues that I don’t feel qualified to discuss, such as learnability.  My intuition says that’s not a big problem, but no one should take my intuition seriously.  What people should take seriously is Bennett McCallum’s intuition (in my view the best in the business), and he also thinks it’s an overrated problem.  I think the main advantage of NGDP targeting over the Taylor rule is simplicity, which makes it more politically appealing.  I’m not sure Congress would go along with a complicated formula for monetary policy that looks like it was dreamed up by academics (i.e. the Taylor Rule.)  In practice, the two targets would be close, as Thoma suggested elsewhere in the post.

Instead I’d like to focus on a passage that Thoma links to, which was written by Bernanke and Mishkin in 1997:

Nominal GDP targeting is a reasonable alternative to inflation targeting, and one that is generally consistent with the overall strategy for monetary policy discussed in this article. However, we have three reasons for mildly preferring inflation targets to nominal GDP targets. First, information on prices is more timely and frequently received than data on nominal GDP (and could be made even more so), a practical consideration which offsets some of the theoretical appeal of the nominal GDP target. Although 20 collection of data on nominal GDP could also be improved, measurement of nominal GDP involves data on current quantities as well as current prices and thus is probably intrinsically more difficult to accomplish in a timely fashion. Second, given the various escape clauses and provisions for short-run flexibility built into the inflation-targeting approach, we doubt that there is much practical difference in the degree to which inflation targeting and nominal GDP targeting would allow accommodation of short-run stabilization objectives. Finally, and perhaps most important, it seems likely that the concept of inflation is better understood by the public than the concept of nominal GDP, which could easily be confused with real GDP. If this is so, the objectives of communication and transparency would be better served by the use of an inflation target. As a matter of revealed preference, all central banks which have thus far adopted this general framework have chosen to target inflation rather than nominal GDP.

1.  I believe the federal government could estimate monthly nominal GDP numbers that are accurate enough to be useful for policy purposes.  However, even if they could not I’d still favor NGDP targeting, because like Lars Svensson I believe the Fed should be targeting the forecast, that is, setting policy in such a way that the Fed’s forecast of future NGDP is equal to their policy target.  I also favor level targeting (recently recommended by Woodford), and I think this would reduce the overshooting problem associated with futures targeting.

2.  It seem to me their second point (which isn’t really a criticism at all) was actually disproved during the recent crisis.  Between mid-2008 and mid-2009 NGDP fell over 8% below trend (or about 3% in absolute terms.)  On the other hand core CPI inflation fell only slightly below trend.  Because the Fed is an (implicit) inflation targeter, the slight slowdown in CPI inflation did not present an unambiguous signal (in their view, not mine) for aggressive stimulus.  Hence they waited until November 2010 to undertake QE2.  If they had been targeting NGDP along a 5% growth trajectory, it would have been immediately obvious that NGDP was coming in well below target, and would remain below target for many years.  In my view the QE2 program would then have been adopted much sooner and in larger amounts, and I think it retrospect it is clear that additional stimulus would have been welcome in late 2008 and 2009.

3.  The third point is where I most strongly disagree with Bernanke and Mishkin.  In the current crisis we’ve seen just how difficult it is to communicate the need for higher inflation.  The public interprets that as the Fed trying to raise their cost of living.  I’m not surprised the plan is unpopular.  I’d guess that in 1997 Bernanke and Mishkin were thinking about the central bank communicating the need for lower inflation, not higher inflation.  In contrast, NGDP is essentially nominal income.  The Fed can tell the public they are trying to raise nominal growth to 5%, because a healthy economy requires the incomes of Americans to grow by about 5% per year.  That’s much less negative sounding that trying to raise the cost of living.  Of course the opposite could be argued on the upside, but the Fed has shown a much greater ability to hold inflation down that increase it, as the zero rate bound has left them spinning their wheels when inflation has fallen below target.  I think it would be easy to explain to the public that an excessively rapid growth in nominal incomes could be inflationary, and raise rates when needed.  Especially given that they were widely criticized for not raising rates enough during the housing bubble.

4.  Regarding revealed preference, NGDP targeting is more desirable the larger and more diversified the economy.  If an economy is dependent on just a few industries, then a major price shock in one export industry might force a dramatic contraction in other industries under NGDP targeting.  Price level targeting might provide for a better macroeconomic outcome in that case.  Thus I wouldn’t expect small countries to be the first to adopt NGDP targeting.  And would I be out of line in noting that the BOJ and ECB haven’t become famous for creativity and boldness?

Update:  I just noticed that Bill Woolsey has a long and very informative reply to my discussion of NGDP futures, and also a response to some of the points made by Brad DeLong.  Bill knows my plan better than I do, so I usually defer to his judgment.  He’s correct that I cut some corners in selling the idea to the National Review’s readers, and that the actual plan is more complicated than I suggested.  Indeed, I believe he was the first to use the phrase “index futures convertibility.”

Worthwhile Canadian Initiative

As people in the humanities would say, this post’s title is an “homage” to Nick Rowe.  JimP sent me this interesting Bloomberg article:

Montreal undergraduates may help reshape the Bank of Canada’s monetary policy and give Federal Reserve Chairman Ben S. Bernanke and Bank of Japan Governor Masaaki Shirakawa clues about how to ward off deflation.

About 240 students so far have spent two hours in a 25th- floor computer lab near McGill University, earning an average of C$30 ($29.88) by viewing combinations of economic data, including unemployment and gross domestic product, and then predicting what would happen to inflation. Central bank researchers are taking part in the project to see whether people can make such forecasts more easily if policy makers target specific levels in the consumer price index instead of the inflation rate — which might help households and companies make better decisions about spending and investing.

The more accurate the test subjects are, the more they earn. One did so well, “we tried to track this person to see if we could hire her,” said Jean Boivin, 38, a Bank of Canada deputy governor who is helping with the research and has also co-written paperswith Bernanke.

The experiments will help Canada decide if it should switch from inflation targeting to price-level targeting in 2012 and may help the bank better communicate its policies to the public, Boivin said. The test results also might benefit Fed policy makers, who discussed price-level targets on Oct. 15 and voted Nov. 3 to inject another $600 billion of reserves into the banking system to avoid deflation — a widespread drop in prices that has plagued Japan for more than a decade.

Broader Agenda

“Central banks need to know more about how expectations are formed, and so we see that as part of a much broader agenda,” Boivin said in an interview at the Bank of Canada’s Ottawa headquarters in the room where he, Governor Mark Carney and four other policy makers decide on interest rates, including a decision tomorrow that’s scheduled for 9 a.m. New York time.

A few weeks back a Bentley student named David Norrish pointed to a flaw in my NGDP targeting idea.  Why [he asked] should we expect the largest economy in the world to experiment with a risky monetary regime that had never been tried out anywhere else?  I seem to recall that ideas like inflation targeting were pioneered by smaller economies such as New Zealand.  So I’m glad to see that the Canadians are considering serving as guinea pigs for price level targeting, before the policy is deployed in the much more important American economy.

BTW, the critieria for success should not be defined solely in terms of accurate inflation forecasts.  Short term forecasts may be relatively accurate under inflation targeting, even if the price level follows a random walk.  It’s more important to have accurate inflation expectations over the life of nominal contracts (wage and debt contracts.)  That’s where the advantages of level targeting are strongest.

PS.  Canadian readers:  I was just kidding—playing the ugly American for cheap laughs.

Have conservatives always been this anti-intellectual?

Yes, I know about the famous JS Mill quotation.  But when I was younger I thought the right had a lot of intellectual momentum.  The world was moving away from statism and toward neoliberalism, and it seemed like conservatives had most of the good economic ideas.

Of course there has always been a anti-intellectual strain to populist conservatism, as when the right romanticizes the “Golden Age” of the 1950s, before all those evil liberation movements of the 60s gave rights to blacks, women, and gays.  But at least on economics I used to think of conservatives as being relatively hard-headed.  So what is one to make of this appalling column in Forbes magazine:

Amid the very reasonable handwringing about the Fed’s charitably naive attempts to stimulate the economy through “quantitative easing”, there’s an understandable drive among some Fed critics to severely reduce its mandate. Specifically, the Fed can’t create jobs as its defenders inside and outside the central bank presume, so better it would be limit its role to that of inflation watchdog.

All that is fine on its face, but in seeking to redefine the Fed’s doings, naysayers have happened upon the false notion of “price stability.” A recent editorial argued in favor of repealing the Fed’s dual mandate so that it can concentrate “on the single task of stable prices”, and then politicians such as Reps. Paul Ryan and Mike Pence have similarly called for price stability in working to redefine the activities of the world’s foremost central bank.

Sadly, handing the alleged wise men at the Fed control over prices is every bit as mistaken as allowing the central bank to manage unemployment.

Indeed, it is through prices that the market economy is organized. In that certain sense, prices rise and fall with great regularity as consumers tell producers what they want less and more of. Assuming the Fed could do what it cannot; as in fine tune economic activity on the way to stable prices, we would be much worse off if Bernanke et al were to actually succeed.

To see why, it has to be remembered that the cure for high prices is in fact high prices. Or better yet, high prices foretell low prices.

If producers create a consumer product that fulfills unmet needs on the way to high prices, the latter is the signal to other producers to enter the market for the same good on the way to lowering its cost. Gyrating prices are the necessary market signal telling businesses what we need.

Taking this further, if price stability were policy, it would still be the case that a phone call from Houston to Dallas would cost $15 for a half hour of conversation. It would similarly mean that we’d be paying thousands of dollars for flat-screen televisions, not to mention even more for computers that perform very few functions.

I’m not going to insult my readers’ intelligence by describing what’s wrong with the last paragraph.  If you don’t know, go read someone elses blog.  At first I thought this might be an innocent slip up.  Nobody’s perfect.  Editors are very busy people, they can’t spot all mistakes.  But the rest of the piece is equally bewildering:

In that case, rather than price stability, the sole goal of monetary policy should be dollar-price stability. Fed officials would credibly argue that the latter is the preserve of the U.S. Treasury, and they would have a point. Be it Treasury, or Treasury working with the Fed, the mandate should be in favor of stabilizing the dollar’s value.

Um, isn’t the entire point of price stability (which I don’t favor, BTW) stabilizing the value of the dollar?  Indeed isn’t true that, by definition, a stable value of money means a stable purchasing power?  Not to John Tamny.  He seems to define a stable value of money as a stable price of gold.  Why gold?  Why not a stable price of bricks, or toothpicks, or zinc?  He doesn’t say.  Nor does he seem to have the slightest intellectual curiosity about periods in history when the dollar price of gold was stable, like 1929-33, when we had severe deflation (which provided falling prices of electronic goods like radios!), and 25% unemployment, and so discredited capitalism that we elected exactly the sort of politician that Forbes magazine would despise.

Oddly enough, Marx once again had the answer there. Marx, much like the classical economic thinkers of his era, knew that for money values to be stable, they would have to be defined in terms of gold. Marx referred to gold as “money, par excellence.”

Looked at through the prism of today, the dollar lacks a golden anchor, and the result is a money illusion that distorts the real price of everything. Worse, with consumer prices sticky in concert with commodity prices that are most sensitive to dollar-price movements, the beneficiaries of the money illusion tend to be the hard, unproductive assets of yesterday (think housing, art, rare stamps, and oil) that are least vulnerable to currency weakness, and which in fact do best when the unit of account is devalued.

Well if Marx says money must be good as gold, who am I to argue?  Reading this column I can’t help but wonder why all this talk about currency depreciation is occurring when inflation is at the lowest point of my lifetime, indeed lower than during 1896-1914, the so-called Golden Age of the gold standard.

The answer to all of this is very basic. Price stability is a utopian concept on its best day that would hamper innovation on the way to reduced living standards.

The greater, more obvious answer is dollar price stability of the gold kind that would allow investors to rate ideas on their actual merits, as opposed to how they’ll perform amid dollar policy since 2001 that has erred in an economically crippling way in favor of weakness. Fix the dollar, and you fix the U.S. economy. Simple as that.

Isn’t that wonderful!  No need to worry about messy real world issues like macroeconomics.  No need to worry about how nominal shocks can have devastating real effects.  Gold is like a magic wand that will fix the US economy.  But there is one huge flaw with this argument; there are two types of gold standards, and neither produces anything like satisfactory macroeconomic outcomes:

1.  One type is a managed standard, such as we had in the US between 1879-33, and in a weaker form under Bretton Woods.  In that standard the nominal price of gold is fixed (just as Tamny wants) but its real value is highly unstable, as the economy would often suffer from deflation.  The most devastating example was 1929-33.  It’s true that the supply of gold rises at a fairly steady rate, but central bank real demand for gold was highly unstable, and thus the price level was unstable.  Of course you could argue that the central banks should have done a better job of stabilizing gold demand, but by that logic why not just have fiat money and then have them do a better job of stabilizing monetary policy.  Even worse, if we returned to the gold standard almost no other country would be nutty enough to follow.  In that case when people in places like China and India hoarded gold out of fear of inflation, America would suffer deflation.  And from history we know that deflation in America would lead to fears of devaluation, which would cause gold hoarding in America as well, and even more deflation.  Tamny doesn’t even think about those issues, but why should he when he considers deflation to be a good thing?

2.  Some have advocated a laissez-faire gold standard.  In this case the government simply pegs the price of gold, but doesn’t hold large stocks of gold.   This would be even worse than a managed standard, as the relative price of gold would then be determined exactly as the relative price of any other metal is determined, by “industrial demand.”   Rapid economic growth in Asia has been boosting the relative prices of other metals such as silver, copper and iron.  If gold was just an industrial commodity, then its relative price would also be quite volatile.

So either way the gold standard offers no advantages.  At best, a highly managed international gold standard might lead to rough price stability.  But if central banks were really able to manage gold that well, they’d also be able to mange fiat money.

I suppose I am wasting my time with this post.  If the right now believes that deflation doesn’t matter, that 1929-33 is like some bad dream that never really happened, then nothing I say will make any difference.

HT:  Bruce Bartlett

Why I don’t believe in liquidity traps

I’ve been asked to summarize my views on liquidity traps in one place, so brace yourself for a long post.  (Longtime readers will definitely want to skip this one.)

For simplicity, I’ll define the term ‘liquidity trap’ as a situation where a fiat money central bank with a freely floating currency is unable to boost nominal spending because nominal interest rates have fallen to zero.  There may be some cases where central banks are limited by laws regulating the sorts of assets they are allowed to purchase, but I know of no real world cases where that was a determining factor.  Indeed I know of no case where a central bank that wished to boost inflation and/or NGDP was unable to do so.  Nor do I think we need ever worry about that scenario actually occurring.

On the other hand, I do think the zero rate bound is a real problem for real world central banks.  Because central banks are used to using short term rates as their primary policy tool, policy may well become sub-optimal once rates hit zero.  But that would not be because an economy is “trapped” at a zero bound, rather it is because central banks are reluctant to aggressively use alternative policy tools, including tools that would be much superior to fed funds targeting even if the economy were not up against the zero bound.

Part 1.  Basic monetary framework

Unlike most economists, I don’t believe that changes in short term interest rates play an important role in the monetary transmission mechanism.  The liquidity effect is an epiphenomenon, having little impact on investment.  Woodford argues that what really matters is changes in the expected future path of interest rates.  I agree that policy expectations are a key, but find it more useful to think in terms of changes in the expected path of the supply and demand for base money.  Simply put, I believe that current and expected future increases in base supply relative demand cause expected future NGDP to increase.  This is because even if we are at the zero bound, and cash and T-bills are perfect substitutes, we are not expected to be there forever.

Increases in expected future NGDP (my preferred policy indicator) raise current asset prices (foreign exchange, stocks, commodities, commercial real estate, etc.)  Because wages are sticky in the short run, production of corporate fixed assets, exports, commercial and residential real estate, commodities, etc, increase as their prices increase.  The resulting higher real incomes also boost consumption.  The reverse is true during tight money, as in late 2008.

I don’t like the interest rate transmission mechanism because interest rates often move in the “wrong” direction in response to monetary surprises.  An unexpectedly small cut in the fed funds target in December 2007 sharply depressed equity prices at 2:15pm.  The fed funds futures market confirmed that the decrease was smaller than expected.  Keynesian theory says T-bond yields should have risen on the news.  Instead, yields fell from 3 months to 30 years, as investors (correctly) understood that the Fed’s pathetic response to the sub-prime crisis would slow economic growth, and hence future fed funds rates would have to be cut sharply.  (And they were in January 2008.)  The action slowed the economy, but not because interest rates rose.

The powerful monetary stimulus of 1933 (dollar depreciation) had little effect on interest rates or the current money supply, but sharply raised future expected NGDP.  This sharply raised current asset prices, and led to rapid growth in output.

If you buy my argument that changes in expected future NGDP (what Keynes probably meant by “business confidence”) is driving current asset prices and aggregate demand, then the next question is whether monetary policy can influence future expected NGDP at the zero bound.

Part 2.  Unconventional policy tools.

My favorite example of an unconventional policy tool is the 1933 dollar devaluation.  In 1932 the Fed had tried open market purchases to boost the money supply, but the policy failed as fears the US would be forced to devalue led to gold outflows, which negated most of the effect of the asset purchases.  This is the only example of a liquidity trap cited in the General Theory.  Unfortunately, Keynes confused two closely related problems.  A liquidity trap is where an increase in the money supply fails to boost NGDP.  In 1932 the constraints of the international gold standard meant that purchases of assets failed to substantially increase the money supply.  That’s gold standard economics 101, having nothing to do with liquidity traps.  As soon as we left the gold standard in March-April 1933, FDR was able to easily create rapid inflation despite 25% unemployment, near zero T-bill yields, and much of the banking system shutdown for many months.

FDR’s policy of raising the price of gold can be seen in one of two ways.  In one sense it was a devaluation of the dollar in the forex markets, as most countries did not follow his action by raising their purchase price of gold.  But even if the US had been a closed economy the Fed could have depreciated our currency by reducing the weight of gold in one dollar.  In ancient times this was called “debasing coinage” and no one worried about the zero rate bound preventing central banks from inflating.  As far back as 1694 John Locke used a reductio ad absurdum argument to criticize monetary ineffectiveness claims.

Another approach is to do quantitative easing.  But printing money (even under a fiat money regime) will not be very effective unless the currency injections are expected to be permanent.  Why would people bid up asset prices if the central bank was expected to pull the money out of circulation in the near future?  This is why the QE done in Japan around 2003 did not do much, and it is why Paul Krugman is skeptical about QE.  The other problem is that it is hard to make a credible promise to permanently increase the money supply by X%, because once you exit the zero rate bound the velocity of base money will rise sharply, and unless the base is reduced you will get hyperinflation.  Markets know this, and hence don’t expect QE to be permanent.

The solution is to adopt an explicit nominal target such as the price level, or better yet NGDP, and then do level targeting.  This is essentially a promise by the central bank to leave enough base money in circulation long term to allow for a modestly higher price level of NGDP.  For instance, they might want to target 5% NGDP growth.  Even if we are at the zero bound and monetary policy appears to be spinning its wheels, a commitment to higher future NGDP will tend to raise current AD.

The Fed made two mistakes.  First, they did not engage in level targeting.  It has long been understood that once nominal rates hit zero the central bank must adopt a level target.  Indeed Bernanke lectured the Japanese on exactly this point back in 2003.  So in September 2008 the Fed should have switched to level targeting, indicating that they wanted core inflation to grow along a 2% path until we were out of the recession, promising to later make up for any near-term shortfalls.  Instead they allowed core inflation to fall well below 2%, and then (implicitly) indicated that they were going to continue inflation targeting, allowing bygones to be bygones.  There was to be no above 2% inflation to catch up for the shortfall.  This actually made their job much more difficult, as it resulted in a more severe recession than necessary in 2009, and then plunging investment pushed the Wicksellian equilibrium nominal rate below zero.  They could no longer use their traditional policy instrument and they were reluctant to aggressively employ alternative measures, because they didn’t know how strong the effect would be.  For instance, when banks needed more liquidity in late 2008 the Fed neutralized the effects of the large monetary base injections by paying interest on reserves at a rate higher than T-bill yields.  Only when the recession drove stock prices to extremely low levels in March 2009, and deflation appeared on the horizon, was the Fed willing to do QE1.  And only when the recovery faltered during mid-2010 (as European troubles increased the value of the dollar) was the Fed willing to do QE2.

The best way to avoid the zero rate bound is to create and subsidize trading in a price level or NGDP futures market, target the futures price, and let the money supply and interest rates respond endogenously.  The Fed should be willing to supply an unlimited amount of reserves in order to keep NGDP futures prices rising along a 5% growth trajectory.   Because there is no zero bound for NGDP futures prices, the Fed will always be able to keep NGDP expectations on target.

The flaw in the Keynesian model is that it assumes sticky wage and prices, whereas only T-bond prices are flexible.  But there are lots of other asset prices that are also flexible, and that don’t have a zero lower bound.  These include commodities like gold and silver, stocks, and foreign exchange.  Unfortunately, all of those asset prices have drawbacks as targets for a major central bank like the Fed.  And the asset price that would work best (NGDP futures prices) doesn’t yet exist.

[BTW, it’s a disgrace that the government has not yet set up and subsidized trading in a NGDP futures market.  Contrary to popular impression the Fed isn’t trying to create more inflation; they are trying to create more NGDP.  For any given increase in NGDP, the Fed would actually prefer less inflation and more RGDP growth.  We desperately need a real time measure of market NGDP growth expectations in order to know whether AD is likely to exceed or fall short of the target.]

In this imperfect world the best the Fed can do is to focus on TIPS spreads as a crude measure of expected inflation, and a whole range of indicators for expected RGDP growth, such as the relative prices of stocks and commodities, as well as other indicators or real output trends.  The Fed needs to do enough QE to increase expected NGDP growth (using all these imperfect indicators) up to the desired level.  Since we are below trend, they should probably target slightly above 5% NGDP growth for a few years, then 5% thereafter.

Part 3.  Fallacious arguments in favor of the liquidity trap

There are so many, I hardly know where to begin.  One common argument is that swapping cash for zero interest T-bills is useless, because they are perfect substitutes.  I don’t view them as perfect substitutes at all.  When I get in the car to go shopping at Walmart I don’t think “Hmmm, should I take cash or T-bills.”  At this point people will say “Yes, but zero interest bank reserves and T-bills are near perfect substitutes.  And all the recent base injections are going into excess reserves.”  Yes, but there is no zero lower bound on interest paid on reserves (and yes I’m including vault cash in “reserves.”)

But let’s suppose cash and T-bills were perfect substitutes.  Even in that case a permanent injection of new base money would still be expected to raise the future level of NGDP, as liquidity traps don’t last forever.  (If they did we should legalize counterfeiting.)   Yes, a temporary currency injection wouldn’t do anything, but that’s almost equally true when rates on T-bills are positive.  Temporary currency injections don’t matter, permanent ones do.  It makes little difference whether rates are at zero or not.

The second fallacious argument is that monetary policy was ineffective in the Great Depression.  Actually, when the government got serious about inflating they left the gold standard, and then they had no difficulty in raising prices sharply.

The third fallacious argument is that monetary stimulus would not be effective at the zero bound because central banks are conservative and no one would believe their promises to inflate.  In fact, no one can provide an example of a central bank that tried to inflate but failed because they were stuck in a liquidity trap.  Some cite Japan, but that example doesn’t meet any of the criteria for a liquidity trap:

1.  The Bank of Japan has frequently expressed opposition to a positive inflation target.  Because they are not trying to produce inflation, it’s no surprise they have failed to produce inflation.

2.  It’s true that they pay lip service to avoiding deflation, but every time the inflation rate rises above zero percent they tighten monetary policy and go right back into deflation.

3.  Some point to the large QE the BOJ did around 2003.  But their promise to keep prices stable meant the QE was going to be temporary.  The public knew this and quite rationally refused to bid up prices.  Sure enough, when 1% inflation threatened to rear its ugly head in 2006, they promptly reduced the monetary base by 20%.

4.  They passively sat by and allowed the yen to appreciate strongly, even as deflation was accelerating in recent years.

5.  If it walks like a duck . . .

Some point to the alleged failure of the Fed to inflate, despite trying hard.  Yet a few months back when Brad DeLong asked Bernanke why the Fed didn’t adopt a 3% inflation target, Bernanke said that would be a horrible idea.  The Fed had worked so hard to bring inflation down to low levels.  If you heard an answer like that, would you expect the Fed to produce higher inflation?  It’s no surprise inflation expectations have remained low.  Admittedly the Fed doesn’t want deflation either.  My view is that when core inflation falls to about 1%, warning bells go off and the Fed grudgingly does some QE to boost inflation a bit closer to 2%.  If that’s not what they are trying to do, I’d love to know their policy goal.

There’s another problem with the view that QE is ineffective at the zero bound.  Even if the Fed couldn’t reduce nominal rates, they could always reduce real rates.  Indeed Mishkin’s textbook suggests about 10 different transmission mechanisms other than nominal rates.  Yet liquidity trap proponents ignore them all.  Even worse, when the mechanisms are shown to work they go into denial, asserting that it just can’t be true because their theory says it’s impossible.  So for instance during September and October there were more and more rumors of aggressive QE (and possibly even level targeting) emanating from various Fed officials.  Mishkin’s text says this should boost stock prices, it should depreciate the dollar, it should raise commodity prices, it should raise inflation expectations in the TIPS markets, and it should lower real interest rates.  And all of those things happened.  For years Paul Krugman has been arguing that what the Fed really needed to do was to raise inflation expectation.  Well they did it.  And his response seemed to be incredulity, as if the markets were nuts in thinking QE could actually raise inflation expectations.

Although Krugman and Robert Barro are poles apart ideologically, they both suffer from one weakness–relying too much on what their models tell them.  Both expressed skepticism about whether QE would do very much, because they looked at QE from a mechanistic perspective.  But QE is much more than that;  it is an implicit commitment by the Fed to seek (slightly) higher inflation.  Of course they need to do much more, but they did succeed in terms of their very conservative goals.  They did generate about 0.5% higher inflation expectations over 5 years.  The reason QE worked was not the operation itself (which I agree does little or nothing) but rather because it tells the market that the Fed is now more serious about boosting long term prices and NGDP.  In other words they are now willing to leave that base money out there long enough to get closer to their implicit inflation target.  The Fed was afraid to directly call for higher inflation (something Krugman thinks could work) so they spoke in code, hoping the markets would understand them but Sarah Palin would not.  Unfortunately for Bernanke, Sarah Palin has advisers who know exactly what the Fed was up to.

Part 4.  Reductio ad absurdum arguments

I can’t take anyone serious who actually believes in a complete liquidity trap–i.e. that no amount of monetary base injections would be inflationary.  Taken literally, that would imply the Fed could buy up all of Planet Earth without creating any inflation.  Among serious economists the debate is over magnitudes.  The skeptics will say that the amount of QE required would be unacceptable, it would expose the Fed to excessive risks if they later had to resell assets in order to prevent runaway inflation.

In fact, there are all sorts of reasons why this “risk” argument is bogus.  First of all, the high base demand is itself a product of the Fed’s contractionary policies, which allowed NGDP to fall in 2009 at the sharpest rate since 1938.  That’s why banks hoard reserves.  A much more aggressive monetary policy would mean less real demand for base money.  Second, the demand for base money has been artificially bloated by the IOR policy; the public is not hoarding much cash and they certainly would not do so if the Fed set a much higher inflation or NGDP target path.  Most importantly, any capital losses suffered by the Fed would be tiny compared to the gains the Treasury would get from much faster NGDP growth.  Remember that the big drop in NGDP is the number one reason the deficit ballooned in 2009—more important than even the fiscal stimulus.  Furthermore, many of the Fed’s purchases have been medium term T-notes, for which price risk is not that significant.  If people are actually worried about this issue, the Fed could buy equities and foreign bonds, which would appreciate with an expansionary monetary policy.  But in my view those (controversial) steps would not be necessary, as the risks are greatly overblown.

Maybe I should stop there—I feel like I am beating a dead horse.  Does anyone still believe in liquidity traps?  Is there even anyone still reading this post?

The last time the US government tried to raise the price level

My research career often focused on offbeat topics that no one else seemed to be interested in.  Now it might be paying off.  One of those topics was Roosevelt’s “gold-buying program” of October-December 1933.  The only other article I’ve ever seen on this topic was published in an agricultural journal back in the 1950s.  This program was the last time (and perhaps only other time) that the US government explicitly tried to raise the price level.  Admittedly the entire April 1933-January 1934 dollar depreciation policy was aimed at reflation, but only during the gold-buying phase was the policy made explicit, and was a methodical policy followed to raise prices.

I did a long post on this in early 2009, and won’t repeat it all here.  Check out the post if you want to know more about how it was done.  Instead I’d like to discuss one very interesting aspect of the program that is relevant to what is going on right now.  (The policy involved raising the dollar price of gold to devalue the dollar.)  Here is a short passage from my Depression manuscript:

Then on November 20 and 21, the RFC price rose by a total of 20 cents and the London price of gold rose 49 cents.  On November 22 the NYT headline reported “SPRAGUE QUITS TREASURY TO ATTACK GOLD POLICY” and on page 2, “Administration, Realizing This, Vainly Tried to Persuade Him to Silence on Gold Policy”.  As with the Woodin resignation, Sprague’s resignation led to a temporary hiatus in the RFC gold price increases, this time lasting five days.

Over the next several days the controversy continued to increase in intensity.  The November 23 NYTreported “RESERVE’S ADVISORS URGE WE RETURN TO GOLD BASIS; PRESIDENT HITS AT FOES” other stories reported opposition by J.P. Warburg, and a debate between Warburg and Irving Fisher (a supporter of the plan).[1]  Another story was headlined “WARREN CALLED DICTATOR”.  The November 24 NYT headline suggested that “END OF DOLLAR UNCERTAINTY EXPECTED SOON IN CAPITAL; RFC GOLD PRICE UNCHANGED”.  Nevertheless, over the next few days the NYT headlines showed the battle raging back and forth:


“SMITH SCORES POLICY . . . Says He Is in Favor of Sound Money and Not ‘Baloney’ Dollar . . . ASKS RETURN TO GOLD . . . Critical of Professors Who ‘Turn People Into Guinea Pigs’ in Experiments” (11/25/33)

“GOLD POLICY UPHELD AND ASSAILED HERE AT RIVAL RALLIES . . . 6,000 Cheer [Father] Coughlin as He Demands Roosevelt Be ‘Stopped From Being Stopped'” (11/28/33)

[1]  Fisher regarded Roosevelt’s policy as being essentially equivalent to his Compensated Dollar Plan.  Although there were important differences, the rhetoric used by Roosevelt to justify the policy was remarkably close to the rationale behind Fisher’s plan.

The Fed better fasten its seat-belt, as the previous price level raising policy was a bit controversial.  Several FDR advisers resigned in protest.

George Warren was the FDR advisor behind the plan.  Warren was to Irving Fisher roughly what I am to Milton Friedman—similar ideology but lacking the intellectual brilliance.   Here’s a more important passage:

“It is indeed difficult to find out exactly what are Wall Street’s views with regard to the monetary question.  When former Governor Smith made public his letter and stocks were going up, there seemed to be little doubt that Wall Street wanted sound money.  But yesterday, faced with the sharpest break of the month, opinion veered toward inflation again.  As one broker expressed it, it begins to appear as if Wall Street would like to see enough inflation to double the price of stocks and commodities, but little enough so that Liberty bonds can sell at a premium.” (NYT, 11/28/33, p.33.)

One explanation for this ambiguity is that investors distinguished between once and for all changes in the price level, and changes in the rate of inflation.  During the early stages of the dollar depreciation, long term interest rates held fairly steady, and the 3 month forward discount on the dollar (against the pound) remained below 1.5 percent.  The market apparently viewed the depreciation as a one-time monetary stimulus, which would not lead to persistent inflation.  Investor confidence was shaken during November, however, when persistent administration attempts to force down the dollar were associated with falling bond prices and an increase in the forward discount on the dollar.  Consistent with this interpretation, the Dow rose 4.6 percent in mid-January 1934, following the Administration’s announcement that a decision was imminent to raise, and then fix, the price of gold.  The NYT noted that:

“The satisfaction found by stock and commodity markets in the inflationary implications of the program was nearly matched by the bond market’s enthusiasm for the fact that the government had announced limitations to dollar devaluation.” (1/16/34, p. 1).

The takeaway from all this is that markets seem to really want higher prices, but not higher inflation.  You do that by switching from inflation targeting to level targeting, when inflation has recently run below target.  Yesterday when the Fed minutes suggested the Fed was about to do that, equity markets responded strongly all over the world.  I’d guess about $500 billion dollars in wealth was created worldwide in 24 hours by 13 words from the Fed’s minutes:

. . . targeting a path for the price level rather than the rate of inflation . . .

The markets already knew QE was likely, but now the Fed seems increasingly serious about level targeting.

In 1933, the markets were surprised when the gold buying program briefly pushed long term T-bond yields higher (Liberty bonds in the quotation.)  Under the gold standard, the expected rate of inflation was generally roughly zero.  Investors were used to a liquidity effect (easy money means low rates) but not a Fisher effect (easy money raises inflation expectations, and thus interest rates.)  Even Keynes was pretty much oblivious to the Fisher effect:

“If you are held back [i.e. reluctant to buy bonds], I cannot but suspect that this may be partly due to the thought of so many people in New York being influenced, as it seems to me, by sheer intellectual error.  The opinion seems to prevail that inflation is in its essential nature injurious to fixed income securities.  If this means an extreme inflation such as is not at all likely is more advantageous to equities than to fixed charges, that is of course true.  But people seem to me to overlook the fundamental point that attempts to bring about recovery through monetary or quasi-monetary methods operate solely or almost solely through the rate of interest and they do the trick, if they do it at all, by bringing the rate of interest down.” (J.M. Keynes, Vol. 21, pp. 319-20, March 1, 1934.)

Before we judge Keynes too harshly, recall that he lived in a time of near-zero inflation expectations, with the exception of clearly anomalous situations like the German hyperinflation.  So when FDR’s policy of reflation briefly seemed to be raising long term bond yields in November 1933, bond market participants were rather shocked.  And here’s what I find so fascinating; modern security markets are only now beginning to grapple with this distinction, which turns out to be pretty hard to wrap one’s mind around.  Here’s something from today’s news:

Neil MacKinnon, global macro strategist at VTB Capital, said the worry in the markets is that the Fed’s attempt to raise inflation may not be as manageable and as controllable as it thinks.

“The bond market is alert to the potential contradiction in Fed policy of buying U.S. Treasuries to keep bond yields down and ideas such as price-level targeting that are likely to raise bond yields,” he said.

That’s the conundrum; what counts as “success,” higher nominal bond yields or lower nominal bond yields?  Everyone seems to assume the Fed is trying to lower bond yields, but if the policy is expected to produce a robust recovery and higher inflation, how can bond yields not rise?  I can’t answer these questions, but my hunch is that it has something to do with the higher inflation/higher price level distinction.  If the Fed can convince markets that they can raise the price level without changing their 2% inflation target, it is likely that all markets will react positively.  If they are seen as raising inflation in a semi-permanent way, stocks may still rise (albeit by a smaller amount), but bonds will sell off.

This is such an unusual circumstance that I don’t have much confidence in my own opinion, nor anyone else’s.  I don’t even know of anyone else who bothered to study what happened the last time Uncle Sam tried to raise the price level.  Too busy doing those VAR studies and DSGE models.

PS:  Where did the $500 billion figure come from?  I guesstimated world stock market valuation at about $50 trillion, with a 1% bump from the Fed move.  The financial press reported that all the world’s stock markets were affected by the Fed action.  I noticed that European stocks rose about 2%, and the Fed move was cited as the primary factor.  So I think $500 billion is roughly the order of magnitude, although obviously the exact figure is unknowable.  BTW, sometimes it is possible to get semi-accurate estimates, as when a huge market reaction following immediately upon a 2:15 Fed announcement and we have relevant odds from the fed funds futures markets.  And in those cases the effect is often much bigger.  I can’t wait for November 3rd.