Fiscal expectations traps: Reply to Woolsey

Bill Woolsey has a response to my fiscal expectations trap idea.  I agree with most of what he has to say, but want to respond to a few points:

Krugman’s argument needs to be that even if money expenditures were expected to remain growing at trend, the natural interest rate would remain more negative than the expected inflation rate. The only way to get the market interest rate that negative is to raise the expected growth path of nominal expenditures and so the expected inflation rate. Central banks won’t do that, and so, fiscal policy is the only option.

More precisely, future monetary policymakers (it is alleged) hint that monetary injections are temporary, so don’t you go bidding up asset prices.  I agree, in principle.  In other words they could sabotage current monetary policymakers who want to promote recovery, by winking to the public that those money injections are only temporary.  But in that case, why would they allow current fiscal policymakers to boost AD, and hence the NGDP growth path?  It makes no sense.  You say they wouldn’t dare try to sabotage Congress?  They already are doing it, all this talk of exit strategies is slowly grinding core inflation down to sub 1% levels.  Woolsey continues:

Sumner’s argument is reasonable. Krugman has responded. The government will actually employ people regardless of expectations. Sumner’s counter argument is that the private sector will contract to offset that effect due to expectations of the central bank’s future contractionary actions.

First, part of the reason why Sumner and his critics appear to talk past one another is the monetary transmission mechanism. Sumner argues that sooner or later, an excess supply of money results in higher monetary expenditures. The new Keynesians assume that monetary policy can only increase real expenditures through a decrease in the real interest rate. Fiscal policy, on the other hand, can expand real expenditure without decreasing the real interest rate:

Yes, the new Keynesians think in terms of interest rates, but they also assume that the quantity theory holds in the long run.  Thus a permanent monetary injection will raise the expected future price level, and this will lower current (real) long term interest rates.  Bill addresses this next:

From a new Keynesian perspective, the normal way that monetary policy impacts real interest rates is by changing short and safe nominal interest rates–the federal funds rate. Once “the” nominal interest rate is zero, real interest rates can only fall through a higher expected inflation rate. If the central bank is truly committed to never increasing the inflation rate, this possibility is out of bounds as well. If no one believes that the central bank will allow higher inflation, the real interest rate cannot fall if the nominal interest rate is already at zero. And so, real interest rates cannot fall. And so monetary policy cannot expand real expenditures.

Fiscal policy doesn’t have this problem because it expands real expenditures without lowering the real interest rate.

Yes, that nicely describes the monetary expectations trap.  But if the central bank is truly opposed to higher inflation (and here’s where I think the price level can clarify our thinking) or a higher price level, why would they allow the fiscal authorities to raise the price level?  How can they stop them, as fiscal policy will (allegedly) raise NGDP for any given level of real interest rates?  Easy, just reduce the expected inflation rate enough to raise real interest rates to a level that negates the fiscal stimulus.

Once again, I am not saying it is likely that a future central bank would try to sabotage a fiscal authority in any sort of blatant way.  But I think it even less likely that they would want to sabotage the current central bank.  Bernanke will probably be head of the Fed for a long time.  If the Fed announced a clear price level target path, level targeting, I think it highly unlikely that in 5 years Bernanke would stick out his tongue and say; “Nah nah, I fooled all you people who went long on stocks, commodities, and real estate.  You should have known I was tricking you, and bought 30 years T-bonds.”  (BTW, this last sarcastic comment isn’t directed at Woolsey’s post, I’m just trying to head off some implausible arguments in the comment section.)



6 Responses to “Fiscal expectations traps: Reply to Woolsey”

  1. Gravatar of Doc Merlin Doc Merlin
    5. June 2010 at 14:18

    “More precisely, future monetary policymakers (it is alleged) hint that monetary injections are temporary, so don’t you go bidding up asset prices.”

    Would EMH suggest that people would bid them up anyway?

  2. Gravatar of scott sumner scott sumner
    6. June 2010 at 05:33

    Doc Merlin. No. Suppose the Fed doubles the money supply. You might think “aha, the QTM says the price level will double–so I’m willing to pay $400,000 for that house that yesterday sold for $200,000. But if the Fed winks, and says, “don’t worry, the monetary injections will be removed next year,” do you really want to pay $400,000 for that house that will fall back to $200,000 next year? No. So the EMH holds down inflation.

  3. Gravatar of Pithlord Pithlord
    6. June 2010 at 06:15

    The Bank of Canada quite explicitly tried to undermine Ontario’s expansionary fiscal policy in the early nineties. The Bank won.

  4. Gravatar of Bill Woolsey Bill Woolsey
    6. June 2010 at 07:25

    The assumption is that the central bank has a 5% growth rate target for nominal expenditure, implying a 2% inflation rate in the long run. The natural interest rate is -3%. The nominal interest rate is 0% and the real interest rate is expected to be -2%. Nominal expenditure is growing only 1%. The inflation rate is 1.5%. Real output is shrinking .5%.

    Now, the central bank can only get nominal expenditure back to target if the real interest rate is -3%. This requires an expected inflation rate of 3%. It requires a target for nominal expenditures of 6%. But the Fed refuses this. And so, we are stuck with a real interest rate this is too high, -2%, nominal expenditures growing too slowly, 1%, and real output shrinking.

    Why will the Fed “allow” monetary policy? Because they want nominal expenditure to growth 5% and it is only growing 1%. Why can’t they use monetary policy? Because they must increase the target for nominal growth to 6% with a 3% inflation rate, and they don’t want that.

    I am not sure that this all makes sense with level targeting.

  5. Gravatar of Doc Merlin Doc Merlin
    6. June 2010 at 18:16

    I mean they would discount for the future, so a doubling wouldn’t result in a price doubling, but you would still have some amount of bid up. If the fed wasn’t 100% perfectly credible the uncertainty would also cause some bid up. If you combine both of these effects, we get fairly hyperbolic bid up, resulting a short term boom followed by a crash in the price, even in a weakly efficient market.

    If we right wingers are correct and expansionary fiscal policy has an adverse effect on private consumption and investment then the fed’s neutralizing expansionary fiscal policy will always keep inflation in check, but also always cause recession.

  6. Gravatar of scott sumner scott sumner
    7. June 2010 at 07:05

    Pithlord, Good point. Ditto for the US in the early 1980s.

    Bill, I don’t follow. If the Fed wants 5% NGDP growth, then presumably they also will refuse to allow the fiscal authorities to do anything that would lead to 6% growth. The Fed will increase the monetary base until expected NGDP growth equals 5%.

    Where is the problem?

    Doc Merlin, Well, I would just like to point out that they have doubled the base, but promised to remove the money later. And nothing happened to the price level.

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