Deconstructing Bernanke’s speech

Pretty disappointing, but with one silver lining.  We pretty much know where the “Bernanke put” is, he drew a line at roughly 1% core inflation.  That means no more “depression economics.”  Let’s get costs down and we can get a faster economic recovery:

1.  Payroll tax cuts (at the margin, employer only.)

2.  Replace unemployment extended benefits with large lump sum payments to the unemployed.

3.  Temporary (two year) minimum wage cuts to $6.50.

Of course this won’t happen, but it would promote faster growth if it did.  They are things Obama could try.  Now for the speech:

Maintaining price stability is also a central concern of policy. Recently, inflation has declined to a level that is slightly below that which FOMC participants view as most conducive to a healthy economy in the long run. With inflation expectations reasonably stable and the economy growing, inflation should remain near current readings for some time before rising slowly toward levels more consistent with the Committee’s objectives.

Translation:  The Fed defines price stability as about 2% inflation, and it’s running around 1% (core inflation.)  Bernanke thinks that’s a bit lower than desirable.  But then there is also this:

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC. Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.

However, such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability.

Aaaargh!!  So which is it?  Is inflation too low, or not?

I wish those prominent economists calling for 4% inflation had followed my advice.  Call for level targeting.  Draw a 2% trend line for core inflation from September 2008.  We are now 1.4% below that trend line.  Shoot for getting back to trend.  I know that doesn’t sound like much stimulus, but given the slack in the economy it would actually take pretty fast NGDP growth to get 3.4% core inflation over 12 months.  Or 2.7% over 24 months.  You’ll never convince the Fed to change its inflation target to 4%, and there is no need to try.

But Bernanke definitely does understand the logic of the argument I have been making in recent posts:

First, the FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.

Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.  (italics added.)

Translation:  “Listen you inflation hawks, if things get even a tiny bit worse we will need more stimulus not just to boost growth, but to prevent further disinflation.”

I think we are already there, where more nominal growth is a win/win, and my hunch is that (to a lesser extent) Bernanke agrees.  After all, he basically said that in the first quotation I gave you, which I take to be his true feelings.  The hawks would never have said inflation is too low.  Bernanke is a patient man, but he is running out of patience.  Let’s hope the three new Board members push him hard this fall.

So if Bernanke wants to do more, why doesn’t he say so?  He explained why, if you read between the lines:

Central banks around the world have used a variety of methods to provide future guidance on rates. For example, in April 2009, the Bank of Canada committed to maintain a low policy rate until a specific time, namely, the end of the second quarter of 2010, conditional on the inflation outlook.4 Although this approach seemed to work well in Canada, committing to keep the policy rate fixed for a specific period carries the risk that market participants may not fully appreciate that any such commitment must ultimately be conditional on how the economy evolves (as the Bank of Canada was careful to state). An alternative communication strategy is for the central bank to explicitly tie its future actions to specific developments in the economy. For example, in March 2001, the Bank of Japan committed to maintaining its policy rate at zero until Japanese consumer prices stabilized or exhibited a year-on-year increase. A potential drawback of using the FOMC’s post-meeting statement to influence market expectations is that, at least without a more comprehensive framework in place, it may be difficult to convey the Committee’s policy intentions with sufficient precision and conditionality. The Committee will continue to actively review its communication strategy, with the goal of communicating its outlook and policy intentions as clearly as possible.

Translation:  We can’t communicate a clear objective because unlike in Canada and Japan, I can’t get those hawks to agree with my view of the appropriate “comprehensive framework.”  We will try to make our intentions as clear as possible, if we can ever agree on what they are.

[BTW, notice how in 2001 the BOJ promised to tighten policy as soon as inflation reached zero?  If you have deflation for years, and tighten the moment you hit zero (which was 2006) won’t you go right back into deflation?  The answer is yes.  So much for Paul Krugman’s theory that the BOJ is valiantly struggling to avoid deflation.]

What if more stimulus is needed, does the Fed have more ammo?

The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.

So Congress and the President are desperately looking for ways to boost demand, w/o ballooning the deficit.  The Fed has such tools, but sees no need to use them.  And what is the most likely tool?

A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve’s holdings of longer-term securities. As I noted earlier, the evidence suggests that the Fed’s earlier program of purchases was effective in bringing down term premiums and lowering the costs of borrowing in a number of private credit markets. I regard the program (which was significantly expanded in March 2009) as having made an important contribution to the economic stabilization and recovery that began in the spring of 2009. Likewise, the FOMC’s recent decision to stabilize the Federal Reserve’s securities holdings should promote financial conditions supportive of recovery.

I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed’s balance sheet would have to be weighed against potential risks and costs. One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions. In particular, the impact of securities purchases may depend to some extent on the state of financial markets and the economy; for example, such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high. The possibility that securities purchases would be most effective at times when they are most needed can be viewed as a positive feature of this tool. However, uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses.

Another concern associated with additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to execute a smooth exit from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might lead to an undesired increase in inflation expectations. (Of course, if inflation expectations were too low, or even negative, an increase in inflation expectations could become a benefit.) To mitigate this concern, the Federal Reserve has expended considerable effort in developing a suite of tools to ensure that the exit from highly accommodative policies can be smoothly accomplished when appropriate, and FOMC participants have spoken publicly about these tools on numerous occasions. Indeed, by providing maximum clarity to the public about the methods by which the FOMC will exit its highly accommodative policy stance–and thereby helping to anchor inflation expectations–the Committee increases its own flexibility to use securities purchases to provide additional accommodation, should conditions warrant.

Translation:  It worked last time (March 2009), there are a few minor problems, but we have addressed those problems.  He mentions other ideas like better communication and lower IOR, but you get the impression that he is much less enthusiastic about those ideas.  My guess is that he would only do a comprehensive stimulus with all three tools if things got really bad.  Actually things are really bad; I mean  if things got really, really bad.  If 3rd quarter NGDP growth comes in around 3% or lower, look for more QE in the fall (when the three new members are seated.)  BTW, I am less confident than Bernanke that QE worked last time.  But it is definitely better than nothing.


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44 Responses to “Deconstructing Bernanke’s speech”

  1. Gravatar of Liberal Roman Liberal Roman
    27. August 2010 at 08:50

    One thing I don’t understand. Doesn’t Bernanke still have a majority on the FOMC that will go along with moves that are necessary. I don’t know much about the parliamentary procedures of the FOMC but isn’t a simple majority all that is necessary to take action?

  2. Gravatar of Anthony Anthony
    27. August 2010 at 09:20

    “2. Replace unemployment extended benefits with large lump sum payments to the unemployed.”

    Wouldn’t that function as a rather large incentive to become unemployed short-term? Conspire with your employer to have layoffs and rehire a few months later, split the proceeds.

  3. Gravatar of Leigh Caldwell Leigh Caldwell
    27. August 2010 at 10:10

    I read Bernanke’s language as hinting that he is not the one making the decisions here. He is just the chair of a committee, and he’s partly reporting, and partly trying to influence, the thinking of the committee.

    I don’t read enough Fed statements to know whether they’ve always been this way, or if this is a clear style change from Greenspan to Bernanke (and whether Bernanke has been like this throughout his term). If it is a change, I also don’t know whether Bernanke has chosen not to be another autocratic Greenspan, or simply has not got the same amount of influence over the FOMC that Greenspan did.

    Can anyone more expert in Fed-reading than me comment on this?

    Either way, I think the answer to Liberal Roman’s question is: not really – and even if he can persuade them once he may not be able to keep doing so.

  4. Gravatar of Andy Harless Andy Harless
    27. August 2010 at 10:24

    I wouldn’t prepare the coffin for depression economics just yet. I don’t trust the location of Bernanke’s line in the sand. The recent behavior of Treasury yields suggests that the Wicksellian natural rate — even for longer-term securites — may be less than negative 1%. The yield on 10-year TIPS is below 1%, and the consensus seems to be that the economy will be merely treading water nonetheless. It seems plausible to me that it might take a cut by more than 2 percentage points to get a robust recovery. By the time we cross Bernanke’s line in the sand, it will be too late for that.

    I know, there are all sorts of things the Fed can do if it comes to that — reserve penalties, retroactive price level targets, massive gold purchases, and so on. And those things might work. But even if they would work, the Fed will be hesitant to adopt such policies, just as it is currently hesitant to expand Treasury purchases. In short, I think (1) a true deflationary trap is possible under current institutional arrangements and (2) even if we could rule out a deflationary trap, there is a large range of outcomes over which monetary policy responses will be inadequate.

    The decline in Treasury yields over the past couple of months — and especially over the past couple of weeks — has made me more pessimistic than I was about the efficacy of monetary policy. Quite possibly, things will turn out OK. But the Fed should be panicking now, as their tools are being taken away. The lack of panic on the part of the Fed is starting to make me panic.

  5. Gravatar of Indy Indy
    27. August 2010 at 10:36

    We need a Taylor-Rule for the unconventional tools. Take the deviation from trend unemployment, inflation, and NGDP-growth, create a “Krugman Fed-Fail” measure when at the zero-bound, and QE should go up, and IOR down, proportionally to that index.

    My hunch – we’re almost certainly looking at a 10-20% rise in the balance sheet ($200-$400B), and a drop in IOR from 25 to 10 basis points. Another few years of recession and we’ll have enough data to extract Taylor-Mankiw coefficients.

  6. Gravatar of Liberal Roman Liberal Roman
    27. August 2010 at 10:44

    Andy,

    You make some really good points. One of the arguments Scott uses against fiscal stimulus is all it does is delay action from the Fed since it is the last to act. But what if, it doesn’t act all? What if it is constantly behind the curve?

  7. Gravatar of Mark A. Sadowski Mark A. Sadowski
    27. August 2010 at 10:51

    Leigh Caldwell,
    I think you’ve expressed the situation very well. Bernanke had a reputation as a consensus forger at Princeton. He would sit silently through department meetings and then express the most vocal median viewpoint at the conclusion. He himself is quoted as saying something to the effect:

    “I served seven years as the chair of the Princeton economics department, where I had responsibility for major policy decisions, such as whether to serve bagels or doughnuts at the department coffee hour.”

    Bernanke is not a leader, he is a follower. Whatever he may have written in the past is immaterial to how he will run the Fed. In my opinion it is actually Charles Plosser who is currently effectively at the helm. (God help us!)

  8. Gravatar of Morgan Warstler Morgan Warstler
    27. August 2010 at 10:51

    “Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed’s hard-won inflation credibility.”

    “Together with other economic policymakers and the private sector, the Federal Reserve remains committed to playing its part to help the U.S. economy return to sustained, noninflationary growth.”

    I think these are the two crucial sentences in understanding the Fed’s attitude about targeting NGDP. It’s not gonna happen. And thank god.

    The fact they are willing to buy more T-Bills if we actually have significant disinflation puts the animus on Hawks and Tea Party crowd to demand that people stop looking at CPI including rents until after homes prices fall another 10%.

    It is already factored into our expectations on inflation, acting like when it happens is new information is unacceptable. Greenspan be damned.

    Come on Velocity!

  9. Gravatar of scott sumner scott sumner
    27. August 2010 at 10:56

    Liberal Roman, Yes, but he doesn’t like a split Fed. They like to move with near unanimity. But if things get bad enough he will move.

    Anthony, I thought about that. My idea was just to make it for those already unemployed. A one time deal. But you may be right. In the long run I favor self-insurance, through mandatory self-financed UI saving accounts. That eliminates the work dis-incentive.

    Leigh, You said;

    “I read Bernanke’s language as hinting that he is not the one making the decisions here. He is just the chair of a committee, and he’s partly reporting, and partly trying to influence, the thinking of the committee.”

    That’s what I think.

    Greenspan was more autocratic, but it is also true that the problems he faced were much smaller.

    Andy, Since I’m not a Keynesian the recent fall in rates has made me more confident of my take on things. Lower 10 year yields are a sign money is too tight. I don’t worry about whether the Fed can lower long rates enough, because we won’t get a robust recovery w/o much higher long rates. I’ve already assumed we are at the zero bound for short rates, and assume that at this point they will use other tools. No country that tried to inflate with fiat money has ever failed, and I don’t expect the Fed to be the first.

    I am confident that the various tools he outlines can get the job done, if he is willing to use them. BTW, gold worked for FDR only because we planned to later return to the gold standard. It worked through the expected PPP effect. Gold purchases would not work very well for Bernanke.

    To summarize, I completely agree the Fed should be panicking, I was panicking in October 2008. But I don’t see them as having lost any important tools.

    Indy, I don’t think we can construct a Taylor rule for unconventional policies. Their effects depend too much on expectations of future policies. What we do need is futures targeting.

  10. Gravatar of scott sumner scott sumner
    27. August 2010 at 10:59

    Mark, That is a sobering thought.

  11. Gravatar of David Glasner David Glasner
    27. August 2010 at 11:16

    What Bernanke is missing is that if the real riskless interest rate is now roughly zero (the yield on a 5-year inflation indexed Treasury bond has been fluctuating between 0.0 and 0.2 percent for the past month), then the return to holding cash is very close to the expected return at margin on investment (especially when adjusted for the very high perceived risk). Deflation would be fine if we had a real interest rate of 5 percent, but it’s a disaster with a real interest rate near zero. Bernanke seems oblivious to the distinction.

    And it’s not just banks who are sitting on cash, businesses are also hoarding cash, but don’t seem too eager to put any of it at risk. So inflation is necessary to make people less obsessed with adding to their cash balances. And perhaps the best way now to increase inflation would be through a series of competitive devaluations in which central banks would engage in unsterilized interventions on the foreign exchange markets to drive down the exchange rates of their own currency.

    I also don’t think that the AD/AS paradigm allows you to make the case for inflation. First of all, a leftward shift in AD with a flat AS curve (which is what we have now) doesn’t produce inflation, it only does so with a rising AS curve. In addition, the standard representation of how monetary policy works is through some interest rate effect, but with interest rates already at historic lows, that channel no longer seems promising. So the argument about monetary policy is whether it can even shift the AD curve to the left when interest rates are as low as they can go. More sophisticated expectational arguments are fine, but they lack a concrete mechanism to explain how the monetary authority can manipulate the public’s expectations of inflation if the monetary authority has no instrument with which to control inflation apart from manipulating expectations.

    As you have shown, the monetary authority does have a direct mechanism by which to control prices in terms of its currency, namely the exchange rate between the currency and a particular asset like gold or another currency. Raising the dollar price of gold produced immediate inflation in 1933 even though unemployment was at 25 percent. The inflation produced a recovery, not, as the AD/AS paradigm implies, the other way around. Rising prices increased profits and created an incentive to spend money to make more money rather than hold money to earn a real return from its appreciation. So I don’t think that the AD/AS paradigm allows you to properly make the case for inflation.

  12. Gravatar of JimP JimP
    27. August 2010 at 11:23

    Mark & Scott – r.e. Plosser

    I actually think Bernanke has more self respect than to in fact follow the hawks around. I think he will act if he thinks he needs to. I also think he has not acted up till now because he really does not think he has the votes, and doesn’t want a open split on the Fed. I think the real failure here is Obama – or Summers et all – who did not give him the votes he needs. Maybe he will get them (unless the crazed Republican deflationists block them – which they might) But I sure could be wrong.

  13. Gravatar of David Beckworth David Beckworth
    27. August 2010 at 12:04

    Bernanke’s speech had some good parts, but for me it was ultimately a big tease.

  14. Gravatar of Sam H Sam H
    27. August 2010 at 12:30

    “Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.”

    This passage irks me. Once inflation expectations do become unanchored the banks will have to expend significantly more effort to buoy expectations (whether it’s through NGDP or inflation targetting) back to a healthy level. This applies to volatility now. It would seem to me that a firm committment to restore the track of NGDP growth would galvanize expectations rather than erode them. It would indicate that the Fed is serious about maintaining price stability consistent with the long term trend guarding against deviations both upwards and downwards.

    Translation: Hypothesize that the Fed flexes it’s muscle in a strong effort to counteract excessive disinflation and makes it explicitly clear that they would not hesitate to act with similar tenacity to squeeze out inflation. Assuming they are successful in the first endeavor, why would this success not bolster their credibility? Price stability is price stability, right?

    My take: The Fed needs more nominal growth hawks not more inflation hawks.

  15. Gravatar of John Hall John Hall
    27. August 2010 at 13:57

    Scott,
    I normally don’t read Yglesias, but I thought this was a great post about receiving unemployment benefits as a lump sum: http://yglesias.thinkprogress.org/2010/07/improving-ui-with-lump-sum-payments/

    To me it makes a certain amount of sense for two reasons, 1) some people feel guilty or some form of shame getting the government check and are more inclined to try to find a job, 2) For some, every time you receive a check, you’re reminded how little it is compared to what you used to make, so you try to find a job that gives you more.

    I guess it’s possible that firms adjust their behavior in response to the insurance. However, so far as I can tell, that would just mean the data is upward sloping, not kinked like that. I didn’t read the paper though, perhaps there’s more detail.

  16. Gravatar of Benjamin Cole Benjamin Cole
    27. August 2010 at 14:51

    Excellent review by Sumner.
    At this point, we are all Bernanke-watchers.
    I never met the guy. Can only go on his writings, and his appearances on TV,
    Seems like a smart guy, very cautious. The caution part may be his Achilles tendon, in this case.
    Probably caution is a good trait, but as Sumner points out, sometimes doing the safe and conventional thing is not really the safe thing.
    But at least Bernanke is not giving idiotic speeches such as Richard Fisher, in which politics and monetary policy get confused.
    The three new boards seats may be very important–I share the questions of earlier posters. Wish I knew more about the internal workings of the Fed.

  17. Gravatar of Andy Harless Andy Harless
    27. August 2010 at 15:07

    I don’t worry about whether the Fed can lower long rates enough, because we won’t get a robust recovery w/o much higher long rates.

    I worry that you’re making the same mistake as Kocherlakota, only in the other direction. In the rational expectations equilibrium, long rates will rise when the Fed takes the necessary steps to induce a recovery. However, we can’t get to the RE equilibrium unless there is a credible threat about what the Fed will do when we deviate from the equilibrium path.

    If the nominal long rate starts out at 5%, there is no question that, given the current natural real rate, the Fed can get the actual real rate below it, so if the Fed indicates credibly that it intends to do so, both the real rate and the expected inflation rate rise, and perhaps the Fed manages to stimulate the economy without ever actually reducing yields. But if the nominal long rate starts out at 2%, it’s not clear that the Fed can get the actual real rate below the natural real rate. People won’t necessarily expect the Fed to succeed, and therefore the Fed will actually have to try (that is, it’s QE will affect yields), in order to convince them. And it may not succeed, because the natural nominal rate (given inflation expectations) may be below zero, and if agents are not confident in the Fed’s ability to induce a recovery, there is no increase in the natural real rate. If it does succeed, yields will eventually rise, but this isn’t guaranteed to be possible.

  18. Gravatar of StatsGuy StatsGuy
    27. August 2010 at 15:41

    On August 15, Tim Duy at FedWatch called the Fed’s strategy – which is to feed the markets a trickle of QE as needed. AKA, do as little as possible. The speech today was entirely consistent with this.

    http://economistsview.typepad.com/timduy/

    Nothing except a change in composition of the Fed is going to change this.

    The problem with Bernanke’s language is this – IF they see material evidence that things are falling apart, they’ll intervene, but they will never get ahead of the game.

    Bernanke signalled there is only one situation under which they _guarantee_ they will intervene, when QE is clearly called for – and that’s a liquidity crisis. I will define a liquidity crisis as a situation where bonds and stocks are falling simultaneously. That’s what happened in march 09, when the default risk for bonds began to trump the real interest rate gains. A true funding crisis, where there was a dollar-funding squeeze. That is the one situation where QE is an open/shut case, according to Bernanke’s speech.

    If you review the Fed’s actions, there’s one consistent trend – they have at each and every turn served the interests of creditors. I’m sorry, but I can’t share any optimism. We’ll see with the new appointees, but Bernanke has always been a sheep in wolves’ clothing.

  19. Gravatar of Bonnie Bonnie
    27. August 2010 at 16:59

    I’ve heard about the payroll tax cut plan floated around by Republicans that gives a payroll tax holiday for a year. They contend it would incentivise hiring.

    The problem with it is that, as I was part of corporate strategic planning, the planning window extends out to between two to three years. The annual buget just brings the next year, that was planned two to three years ago into closer focus and more deatil is hashed out. I guess what I’m pointing out is that it would be like cash for clunkers and the homebuyer’s credit. It would pull SOME employment into the present that would have happened at some time in the future, but when the incentive is gone, so are the jobs. It’s a shell game, nothing permanent.

    Additionally, it might have been a better idea to do something like that instead of the stimulus package last Feb., just flat out blowing $800B on all sorts of stuff. But that money is now water under the bridge and I doubt there’s any political support for that much revenue flying out the window over something that isn’t going to have a lasting effect.

    Perhaps it’s time to implement a flat income or fair tax and ditch all taxes related to employment; it is sort of insane to tax employment in a competitve global economy anyway.

  20. Gravatar of Bonnie Bonnie
    27. August 2010 at 17:33

    Just to add another point to my last post:

    To me, the Bernanke speech was just more of the same kind of blowing smoke up wherever he’s blowing it. It sounds the same as last time, “We have the technology, but we have to wait until things get worse before we’ll use it.”

    Personally, I don’t know how congressional members can sit there and listen to that same tune without popping a vein after being in the throughs of the worst recession in 80 years. Some of them must have forgotten that the Fed is a creation of congress based on its enumerated power to coin money and regulate the value thereof, and congress itself is responsible for what the Fed does or does not do. Why it tolerates deviance from legislated mandates to the detriment of the economic health of the country, and wholesale thumbing its nose at congress is beyond me.

  21. Gravatar of Andy Harless Andy Harless
    27. August 2010 at 17:52

    Actually, I take back the part about Kocherlakota. It’s not the same mistake, and it is in the same direction. It’s sort of a milder version of the same problem, but not exactly.

  22. Gravatar of scott sumner scott sumner
    27. August 2010 at 18:11

    David, I agree with your first point about low real interest rates. And given he studied Japan, it is surprising he misses that distinction. Mild deflation had a completely different effect on China.

    I don’t agree on AS/AD:

    1. I think you mean shift right, not left.

    2. SRASs are never flat, they are fairly flat.

    3. A fairly flat SRAS makes the case for inflation even stronger. It means to get 3% inflation you need to move the AD curve very far to the right. That’s what you want, a lot of growth and a little inflation.

    4. That’s exactly what happened in March-July 1933. I don’t know of 4 months better described by AS/AD. The WPI rose 14% and industrial production rose 57%.

    I’m fine with competitive devaluations, but there are many other more politically acceptable policies:

    1. Reduce the demand for money (negative IOR)
    2. Increase the supply (QE)
    3. Set higher explicit targets, level targeting.

    No fiat money country that tried to inflate ever failed, that’s not what I’m worried about.

    JimP, I agree.

    David, I was disappointed. But there were some clear signals that Bernanke wants to be very aggressive if things get even a little bit worse. He drew a line in the sand, which tells me he is running out of patience. He made some impassioned statements that would be anathema to the hawks, so I can see how the WSJ was right about the split at the Fed. The question is whether he is willing to press forward with a split Fed.

    Sam H. I noticed that too. That’s a discussion of level targeting. He says it might be needed, but the logic of the rest of his talk is that it is needed now.

    John Hall, Yes, I saw that article, but I’m not convinced it would lead to longer spells of unemployment.

    Thanks Benjamin.

    Andy, I am definitely not making the same mistake as Kocherlakota, because I don’t favor any sort of interest rate targeting at all. Nor do I think interest rates (real or nominal) are an important transmission mechanism for monetary policy. But I’m quite willing to admit that my speculation as to how interest rates would react to monetary stimulus might be wrong.

    On January 3, 2001 there was a spectacular case of monetary easing causing long rates to rise sharply, while long real rates rose slightly. Stocks soared in response.

    In March 2009 there was an opposite example, monetary easing (QE this time) caused long rates to fall, and stocks again rose.

    I think the 2001 case is much more typical, but have an open mind on the question.

    If 2001 is typical, then even low rates don’t preclude easing, because easing doesn’t lower nominal rates. So you don’t have to worry about running out of room to lower rates.

    It seems to me you are tacitly assuming that monetary easing works by lowering nominal and real long rates. That did happen in March 2009, and to your credit that is the case most relevant to the current situation. But it is not typical in my view.

    I’ll keep an open mind on this issue. I certainly agree that we’d be better off if the Fed was starting from a position where the long rate was 5%, not 2.5%.

    My transmission mechanism is:

    Signals about future policy->future expected NGDP->current prices of stocks, commodities, and real estate->current output (assuming sticky wages.)

    Statsguy, See my answer to David. I am a bit more optimistic than you, but not much. I don’t expect action until November. Hopefully expectations of action will keep things from falling apart.

    Bonnie, Those are good points:

    1. I think a smaller cut spread over three years would be better, for the reasons you give.

    2. Yes, the $800 billion already spent makes further stimulus unlikely. Unlike countries like Germany, it wasn’t well spent on job creation subsidies.

    3. The best tax is a consumption tax. Actually, however, a payroll tax is a consumption tax. I agree that supply-side reforms would help at this point. That’s one reason the 1983-84 recovery was quicker.

  23. Gravatar of Morgan Warstler Morgan Warstler
    27. August 2010 at 18:50

    Visualizing Ben’s Speech:

    http://paul.kedrosky.com/archives/2010/08/the_cloudy_ben.html

    OK, I’ll bite, in what bizarro world are payroll taxes consumption taxes? Because the payroll tax is added to the price?

    There’s a hooker she charges $200 per hour – half the population normally can’t afford her. But they do receive a tax credit check right up front every Jan, because we now have a progressive consumption tax. So every January, she’s extra busy. (let’s say she’s sticky with prices)

    Meanwhile she has to pay FICA on what her corporation pays out to her as salary.

    In a consumption tax world, the poor pay based on the amount they spend – $200 +$50 in tax.

    In a payroll based world, she’s running every loophole, fake tits cost money! clients demand an Italian red leather couch with white furry pillows, they like to watch the NFL Season package post coitus.

    and she’s paying herself $30K a year.

    I’m not an economist, but apparently tax avoidance has a dead weight loss.

    That and I really do think the poor deserve to enjoy their tax credit check.

  24. Gravatar of David Pearson David Pearson
    27. August 2010 at 22:09

    I agree with Statsguy: Bernanke is a fireman, and financial crises are the fire. To abuse the analogy a bit, the fireman doesn’t care if there is a drought, only if the fields catch fire and threaten the (bankers’) houses.

    Post-Jackson Hole, credit easing (CE) remains the policy of the Fed.

  25. Gravatar of StatsGuy StatsGuy
    27. August 2010 at 22:31

    ssumner:

    “In March 2009 there was an opposite example, monetary easing (QE this time) caused long rates to fall, and stocks again rose. ”

    Precisely correct. And if Bernanke ever finds himself in a situation where he’s confident QE will cause real rates to fall, we can expect he’ll do it.

    What does this say about the Fed’s objective function? The new voting members will give Bernanke enough balance to implement policies that he wants – but I’m not as confident as you that Bernanke wants to engage policies that would increase real rates.

  26. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    28. August 2010 at 02:37

    QE in March 2009? No. Size of Fed’s balance sheet has reached all time high in December 2008. Quasi-fiscal subsidy to housing sector – perhaps.

  27. Gravatar of scott sumner scott sumner
    28. August 2010 at 13:10

    Morgan, There is saving and consumption, and there is labor income and capital income. Theory says a consumption tax is identical to a labor tax. At least that’s what I was taught in school. Both exclude capital income.

    How do you know so much about high end hookers?

    David, What if the problem is deflation, but banks are doing OK? Don’t you think he’d do QE?

    Statsguy, I was with you until the last line. Did you mean DECREASE real interest rates? I read the speech as indicating he is worried about further disinflation, and doesn’t intend it to happen. Unfortunately even 1% inflation is not conducive to rapid recovery.

    123, You are right, I should have said “so-called QE.” I get sloppy sometimes.

  28. Gravatar of scott sumner scott sumner
    28. August 2010 at 13:15

    Bonnie, Unfortunately, Congress doesn’t understand monetary policy at all. They think it is very easy.

  29. Gravatar of Joe Calhoun Joe Calhoun
    28. August 2010 at 13:41

    In reference to Liberal Roman’s comment earlier about only needing a majority. I had to go back and read the minutes to confirm but during Volcker’s tenure, dissent seems to have been the norm. In 1979 just about every meeting had multiple dissents about policy. Several had as many as three or four dissenting from the policy directions given to the NY Fed. Of course, we didn’t have the openness at the Fed then we do now. They didn’t even announce policy changes; you had to figure them out from what was going on in the market. So, maybe it was easier for the Fed chairman to push an agenda back then when he wouldn’t be second guessed for years if ever. As bad as Volcker’s foray into monetarism proved in 1979, maybe we would have been better off with some second guessing.

    But today, I guess Bernanke is concerned about the reaction to a deeply divided Fed. How would the public react if Bernanke was only able to push through more QE on a one vote majority? The average guy has no idea what the Fed is doing but a big split would send a message he could understand – even these smart guys on the Fed don’t know what to do.

    So what does Bernanke do if things continue to deteriorate and the hawks won’t budge? Does he risk a narrow majority vote? I don’t think so which means we better hope the hawks come to their senses – soon.

  30. Gravatar of Morgan Warstler Morgan Warstler
    28. August 2010 at 14:04

    Scott, you are the economist, I’m just some guys who reads a lot, maybe you’d like to actually answer my example next time?

    If not, here’s something I read that says you are wrong…

    “For nearly a century now, the principal federal tax on individuals has been the personal income tax, which falls on both labor income (wages and salaries) and capital income (interest, dividends, and capital gains). Meanwhile, states and localities raise a large share of their revenue through sales taxes, which are taxes on consumption. The federal government also has a smattering of consumption taxes, such as the excise tax on gasoline.”

    http://www.econlib.org/library/Enc/ConsumptionTax.html

  31. Gravatar of StatsGuy StatsGuy
    28. August 2010 at 17:38

    “you mean DECREASE real interest rates?”

    Yes. Sorry.

  32. Gravatar of david glasner david glasner
    29. August 2010 at 07:50

    Scott, you wrote

    “I don’t agree on AS/AD:

    1. I think you mean shift right, not left.”

    Yes, I thinking that I’m becoming a leftist in my old age.

    “2. SRASs are never flat, they are fairly flat.”

    And a simplifier.

    “3. A fairly flat SRAS makes the case for inflation even stronger. It means to get 3% inflation you need to move the AD curve very far to the right. That’s what you want, a lot of growth and a little inflation.”

    My point is that the causality works in the opposite direction. First you get the inflation, then you get the growth. Which is the opposite of the causation implied by AD/AS in which the amount of inflation reflects the slope of the AS curve.

    “4. That’s exactly what happened in March-July 1933. I don’t know of 4 months better described by AS/AD. The WPI rose 14% and industrial production rose 57%.”

    No, inflation was fastest in those four wonderful months when with unemployment starting at 25 percent the rate of inflation should have been slowest. Instead there was an immediate inflation directly in response to the dollar devaluation. I claim that the increase in output was a response to the inflation. AD/AS implies that inflation was a response to the increase in output which, given the slope of the AS, requires inflation.

    “I’m fine with competitive devaluations, but there are many other more politically acceptable policies:

    1. Reduce the demand for money (negative IOR)

    2. Increase the supply (QE)

    3. Set higher explicit targets, level targeting.”

    We agree that all of the above are desirable. Bernanke seems to be saying that he (or the FOMC?) are afraid of any policy that would cause an increase in inflation expectations because once they become unanchored (at least in the upward direction) there is no telling where they will go.

    “No fiat money country that tried to inflate ever failed, that’s not what I’m worried about.”

    I agree, but the historical argument is not compelling, because there is no precedent for deflation with a fiat currency (except Japan). Can you cite an example of deflating fiat currency that has been converted into an inflating fiat currency? That’s why I think that operating directly on the exchange rate is the best way of generating an immediate price-level effect. The other advantage of announcing that we want the dollar/euro rate back at the level it was in, say, July 2008 ($1.55/euro) is that it will force the ECB and other central banks to inflate in self-defense or allow the US to create a competitive advantage for its exports.

  33. Gravatar of scott sumner scott sumner
    29. August 2010 at 07:56

    Joe Calhoun, Good points. I think at some point he would have to risk a split vote. Not all the super hawks are on the FOMC now. Some marginal hawks will go his way in a crisis.

    Morgan, That’s right, the income tax falls on both labor and capital income, whereas the payroll tax falls on only labor income–and is thus equivalent to a consumption tax. I plan a post on this if I can ever find the time.

  34. Gravatar of scott sumner scott sumner
    29. August 2010 at 08:13

    David; You said;

    “My point is that the causality works in the opposite direction. First you get the inflation, then you get the growth. Which is the opposite of the causation implied by AD/AS in which the amount of inflation reflects the slope of the AS curve.”

    I don’t see the causality that way. I see causality going from more nominal spending to more of both growth and inflation. With sticky prices it’s even possible that growth occurs before inflation.

    You said;

    “No, inflation was fastest in those four wonderful months when with unemployment starting at 25 percent the rate of inflation should have been slowest. Instead there was an immediate inflation directly in response to the dollar devaluation. I claim that the increase in output was a response to the inflation. AD/AS implies that inflation was a response to the increase in output which, given the slope of the AS, requires inflation.”

    As far as commodity prices I agree with you–they move instantly. But at monthly frequencies the aggregate data is almost simultaneous. I don’t follow your causality story. AS/AD doesn’t imply any sort of causality. There are some who interpret the SRAS like a supply curve, where causation goes from higher prices to more quantity supplied. Others (Keynesians) interpret it a some sort of equilibrium condition, where fast growth causes inflation. I don’t worry about those issues at all. It’s a black box to me. To me the SRAS merely shows the outcome, in terms of prices and output, of a sudden rise in NGDP. And in 1933 it did that beautifully well.

    You said;

    “We agree that all of the above are desirable. Bernanke seems to be saying that he (or the FOMC?) are afraid of any policy that would cause an increase in inflation expectations because once they become unanchored (at least in the upward direction) there is no telling where they will go.”

    There are two reasons that can’t happen:

    1. They can monitor infaltion expectations in real time (TIPS spreads)

    2. More importantly, level targeting prevents that. He advocated level targeting for Japan, why not the US?

    You said;

    “That’s why I think that operating directly on the exchange rate is the best way of generating an immediate price-level effect.”

    I’m not sure I follow your reasoning here. I agree it would work, but consider it completely beyond the pale in political terms. When I mentioned three alternatives, you didn’t say they wouldn’t work, you said the Fed thought the ideas were too risky, that inflation expectations might become unanchored. But currency devaluation wasn’t even an idea Bernanke mentioned and shot done. It’s like you can’t even mention it in polite company.

    You are right that others would retaliate, so the dollar wouldn’t actually go to 1.55. And you are right that competitive devaluations are a good thing, a race to the bottom would boost prices worldwide. But if that happens, we are back in a closed economy model, where you can only get inflation through one of the three items I mentioned. All countries would be doing QE to prevent their currencies from rising. Again, that would be a good thing, I just see it as less politically feasible than other policies the Fed is considering, that would work equally well. Indeed if all countries tried to competitively devalue, then de facto they’d end up doing policies from my list.

  35. Gravatar of david glasner david glasner
    29. August 2010 at 10:07

    Scott, you said

    “I don’t see the causality that way. I see causality going from more nominal spending to more of both growth and inflation. With sticky prices it’s even possible that growth occurs before inflation.”

    I agree that there are sticky prices, but there are also unsticky prices. The unsticky prices adjust instantaneously to a devaluation and the sticky ones adjust with a lag. The point is that the process is initiated with an immediate price effect before any new spending takes place.

    You said;

    “As far as commodity prices I agree with you-they move instantly. But at monthly frequencies the aggregate data is almost simultaneous.”

    Well it just seems implausible to me that you would get 14 percent inflation in 4 months out of an AS/AD model from a starting point of 25 percent unemployment. But maybe you’ve done the econometrics to shows that that is what comes out of the model.

    “I don’t follow your causality story. AS/AD doesn’t imply any sort of causality. There are some who interpret the SRAS like a supply curve, where causation goes from higher prices to more quantity supplied. Others (Keynesians) interpret it a some sort of equilibrium condition, where fast growth causes inflation. I don’t worry about those issues at all. It’s a black box to me. To me the SRAS merely shows the outcome, in terms of prices and output, of a sudden rise in NGDP. And in 1933 it did that beautifully well.”

    Again, it surprises me that an AD/AS model would generate that much immediate inflation with 25 percent unemployment.

    You said;

    “I’m not sure I follow your reasoning here. I agree it would work, but consider it completely beyond the pale in political terms. When I mentioned three alternatives, you didn’t say they wouldn’t work, you said the Fed thought the ideas were too risky, that inflation expectations might become unanchored. But currency devaluation wasn’t even an idea Bernanke mentioned and shot done. It’s like you can’t even mention it in polite company.”

    I agree that we are at a political impasse. But the gold standard was also sacrosanct in 1932 and the Fed was in denial (sound familiar). But FDR changed the rules and devalued. If Bernanke won’t do it now, the Treasury could. They could make a fresh start and sell this as an alternative to the failed stimulus programs of the past two years. It would be easy to package the policy as a program of dollar depreciation that would last only until the price level rose by 10 percent, at which point, the Fed/Treasury would stop depreciating.

    “You are right that others would retaliate, so the dollar wouldn’t actually go to 1.55. And you are right that competitive devaluations are a good thing, a race to the bottom would boost prices worldwide. But if that happens, we are back in a closed economy model, where you can only get inflation through one of the three items I mentioned.”

    That is right, but the advantage is that you either get an immediate price level effect or other countries have tolerate an increased real exchange rate which they generally seem not to like. So the advantage is that you are exerting leverage on other countries to fall in line with the expansion. QE doesn’t produce that kind of political pressure.

    “All countries would be doing QE to prevent their currencies from rising. Again, that would be a good thing, I just see it as less politically feasible than other policies the Fed is considering, that would work equally well. Indeed, if all countries tried to competitively devalue, then de facto they’d end up doing policies from my list.”

    As usual we are in 97% agreement. I think that depreciating the exchange rate produces an immediate and observable price level effect that would help to revive inflation expectations. It also puts direct pressure on the other countries to fall into line.

  36. Gravatar of ssumner ssumner
    29. August 2010 at 13:12

    David, You said;

    “Well it just seems implausible to me that you would get 14 percent inflation in 4 months out of an AS/AD model from a starting point of 25 percent unemployment. But maybe you’ve done the econometrics to shows that that is what comes out of the model.”

    You are talking about Keynesian AS/AD models where inflation is caused by growth. Yes, I agree that those models are useless, and that 1933 conclusively shows that. By AS/AD model I mean simply the graph, which even monetaristis use, except they regard AD as simply a rectangular hyperbola (as do I.) Prices rose 14% in four months and IP rose 57% in four months, that’s a pretty flat SRAS curve.

    The Treasury would have a far more difficult time devaluing than FDR did in 1933. The problem is expectations. FDR knew he could re-link to gold later at a higher rate, and because devaluations are rare (only one between 1879-1971) the action would lower the expected future exchange rate as well (against gold.)

    But the US has no plans to move back to a fixed exchange rate system, hence any lowering of the dollar would be viewed as temporary. But in that case the Treasury might have difficulty buying enough foreign exchange to make it happen. Only the Fed has the sort of deep pockets to force a devalaution, if speculators are going the other way.

    Yes, the US could clearly devalue, but I’m not so sure about the Treasury.

    I agree we are 97% in agreement. Ironically in my manuscript I use the same argument against the Keynesian version of AS/AD as you did against me. And I have recommended that Japan devalue. It just seems to me that it is a touchy issue given the size of the US. We’d look like a bully. The good thing about FDR is that he didn’t care what foreigners thought.

  37. Gravatar of Morgan Warstler Morgan Warstler
    29. August 2010 at 14:39

    “whereas the payroll tax falls on only labor income-and is thus equivalent to a consumption tax.”

    Scott my hooker parable was correct. I continue to assert, a payroll tax is not a consumption tax.

    As today, when you have a payroll tax, the hooker has incentives to pay herself less, and push consumption towards her company, so she can write it off as a cost of doing business.

    In a progressive consumption tax, suddenly the poor have a big upfront check, that gives them the ability to either save it carefully for use throughout the year, or spend it lavishly immediately, and find things more expensive the rest of the year. In such a model, the hooker doesn’t not go buy the white leather couch of the NFL package – unless it truly increases her profits. Meanwhile she’s paying herself more money, since it is not taxed, and she’s saving it – so she can loan it out and make decent interest.

    BTW, glasner is NUTS. There’s not a chance in hell we’re going to see devaluation.

    It’s AUSTERITY time baby, and the ones gonna bend over are public employees.

    It’s Clinton after 1994, or Obama is done.

  38. Gravatar of ssumner ssumner
    30. August 2010 at 07:53

    Morgan, I’ll explain this later with a new post.

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