Greg Ip on monetary policy

Where does all the time go?

I just noticed that I’ve fallen behind on the set of podcasts by David Beckworth, so I will work through the ones I’ve missed, starting with the Greg Ip, one of our best economic journalists.  Here’s my favorite comment by Ip:

And it actually may be better to have lots of small financial disruptions than one big financial disruption.

In Greg’s recent book he discusses this idea in more detail.  In the interview, Greg uses analogies such as the danger of continually preventing small forest fires, and thus building up fuel for a catastrophic fire.

Over the past 50 years the government has prevented financial crises about every decade or so, by either bailing out depositors of large banks, or arranging assistance in the case of LTFC (1998).  And this had the effect of storing up fuel (moral hazard) for an even bigger crisis in 2008.  But I would go much further that Ip, who approves of FDIC.  It’s not politically possible to abolish FDIC, but perhaps we could create a two-tier system where insured deposits are backed by safe assets, so that taxpayers are not put at risk.  Deposits used for lending to businesses and homebuyers would not be insured, but would offer higher interest rates to depositors.  Let bank depositors choose how much risk they are willing to take.  Ip also is appropriately critical of the regulatory overreach of Dodd-Frank. BTW, banks would hate my FDIC reform proposal, but it could be combined with the complete repeal of Dodd-Frank.

There are also a few areas where I disagreed with Ip.  At one point he wondered why there was so much discussion of the need for monetary stimulus. After all, unemployment in the US and Japan is relatively low, and the unemployment rate in the eurozone is now declining at a decent clip.  This is a good argument, but I think he’s also missing something important.  Monetary policy must be judged as a regime, not in terms of day-to-day considerations of macroeconomic stability.

For better or worse, central banks now focus most of their effort on inflation targeting, with some attention also paid to keeping unemployment close to the natural rate. Recall that the natural rate hypothesis predicts that the public will eventually adjust their expectations to match any inflation rate, and unemployment will eventually move back to the natural rate.  When viewed from this perspective, I think what Greg’s really asking is what difference does it make if the Eurozone has 1% inflation, or 1.9% inflation, as long as it is reasonably steady and as long as unemployment seems to be adjusting back to the natural rate.

I see two problems with the ECB allowing 1% inflation to be the new normal:

1.  If this were to occur, the public would lose faith in the ECB’s inflation promises. This would make ECB policy less effective in the next crisis.  If central banks are going to set inflation targets, then those targets should mean something.  If they decide not to target inflation (as I’d prefer) then it’s essential that they set some other target, such as NGDPLT.

2.  If 1.0% inflation, rather than 1.9% inflation, becomes the new normal in the ECB, then nominal interest rates will move to a permanently lower track.  And since real interest rates seem to be entering a new normal which is well below the rates we saw in the 20th century, a lower trend rate of inflation would mean that the ECB will be stuck at the zero bound for a much greater percentage of the time.  Indeed financial markets are already quite pessimistic about the future course of eurozone rates, especially for safe assets like German and Swiss long-term bonds.

Notice that points 1 and 2 relate to each other; both make it more difficult for the ECB to achieve its goals in the future.  So there is real value in taking an announced inflation target seriously, and trying to hit it.  BTW, the US is doing much better than the eurozone and Japan on the inflation front, but just today Kocherlakota warned that even the US is likely to fall short of 2% inflation going forward.  (I’m a moderate on this question—I think they’ll probably fall a bit short, but perhaps not as much as Kocherlakota and some of my fellow MMs believe.  I see something around 1.8% as the new normal.)

At one point Ip asked David the question of what should the Fed actually do to implement an NGDPLT policy regime.  I hate these “concrete steppes” questions, but we need to face the fact that this is what everyone wants to know.  The reason why I hate these questions is because I know the sort of answer people are looking for:

Desired answer:  Some big bazooka of a monetary policy instrument that is so powerful that it can clearly move NGDP to the desired policy path.

My answer:  NGDPLT is the big bazooka, and once implemented you merely need to do tiny little OMOs, like we did back before 2008.

And I know that this answer won’t satisfy anyone.  They think money has been very easy, and if we’ve fallen short then we must need very, very, very easy policy.  We MMs think money has been tight, and that a NGDPLT target could be hit with the sort of moderate policy we had before 2008.  In other words, if 5% NGDPLT were adopted in 2007, or right now, the policy would look pretty much like what you saw in Australia after 2007, or what you see in Australia today.  Positive interest rates.

But yes, you do need a big “instrument” bazooka lurking in the background, just in case.  That makes the system credible, so that you don’t actually have to use it. For David the big bazooka is the Treasury, promising to do a coordinated fiscal/monetary expansion if the Fed runs out of ammo.  For me the big bazooka is a Fed promise to buy any and all financial assets, anywhere in the world, until market expectations of NGDP growth are equal to 5% (or whatever the target chosen.)

And the other point I always make is that the lower the NGDP target (i.e. the lower the trend inflation rate) the bigger the Fed balance sheet as a share of GDP.  If NGDP growth is so low that nominal rates fall to zero, then the Fed balance sheet can get very large.  If the NGDP target rate is set high enough where rates stay above zero, then the Fed balance sheet stays small.  I prefer a small Fed balance sheet.

Inflation or socialism?  It’s your choice.


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32 Responses to “Greg Ip on monetary policy”

  1. Gravatar of Gary Anderson Gary Anderson
    2. June 2016 at 08:46

    I think the idea of tiered risk for bank deposits is a fantastic idea. I think the big bazooka could also be helicopter money as correctly explained by Lonergan.

  2. Gravatar of Gary Anderson Gary Anderson
    2. June 2016 at 08:47

    Helicopter money could actually reduce the Fed’s balance sheet if we could escape zero rates.

  3. Gravatar of Brian Donohue Brian Donohue
    2. June 2016 at 10:17

    Good post.

    Question: if the Fed raises the Fed Funds rate to 0.50%, do they increase IOR as well? What happens if they leave IOR at 0.50%? Would this be ‘net expansionary’?

  4. Gravatar of Kevin Erdmann Kevin Erdmann
    2. June 2016 at 10:28

    I think this issue contains a bit of question begging. This all only makes sense if we begin with the prior that excess lending caused home prices to rise significantly above intrinsic value. This should be a surprising enough outcome that economists demand proof, but the premise appears to have been broadly accepted as obvious. Then, since excess caused the “bubble”, we can blame the banks for not being prudent when we sat by and watched housing drop by 1% per month for a year. The fact that banks struggled when the national housing stock suddenly lost a quarter of its value is absolutely not a sign that they were too complacent. If they had failed with a 5% drop, that might have meant something. As it is, we have simply slouched into a point of view where literally every single expansionary move by a financial institution for the past 40 years is deemed to be part of the cause of the “bubble”, every dislocation of the bust is their fault, and every failure is due to their complacency. This paradigm exists above the plane of evidence.
    The value of NGDP level targeting is that it really would go a long way toward eliminating systemic uncertainty – and this would be an unmitigated public good. It would lead to more risk taking, which would be an unmitigated good. It would replace systemic risk with idiosyncratic risk. That is what we want. Adding systemic risk in an attempt to keep risk aversion high is basically the monetary equivalent of the broken window fallacy.

  5. Gravatar of H_WASSHOI (Maekawa Miku-nyan lover) H_WASSHOI (Maekawa Miku-nyan lover)
    2. June 2016 at 11:13

    This sentence should be in the short-intro.

    >Monetary policy must be judged as a regime, not in terms of day-to-day considerations of macroeconomic stability.

  6. Gravatar of Gary Anderson Gary Anderson
    2. June 2016 at 11:31

    Wouldn’t you agree, Kevin, that when the commercial paper market, that funded the shadow banks but was underwritten by the TBTF banks, crash, that it was the duty of the Fed to buy the paper, freeing up the banks to lend? As it was, billions upon billions of dollars of loans migrated from off balance sheet back on to the balance sheets of the banks. It froze the banks. Mark to market assisted in this destruction.

  7. Gravatar of ssumner ssumner
    2. June 2016 at 11:35

    Kevin, You said:

    “It would replace systemic risk with idiosyncratic risk. That is what we want.”

    Exactly.

  8. Gravatar of Gary Anderson Gary Anderson
    2. June 2016 at 11:35

    So, it looks as if you are right, Kevin, that a risk that should have been confined to housing suddenly affected most things, except for a time the banks still loaned out to the business economy, according to a chart Stephen Williamson showed me. Being from a do nothing school of economics, that seemed to satisfy him. I am not being mean. He would be the first to admit his economic school is the least activist.

  9. Gravatar of Kevin Erdmann Kevin Erdmann
    2. June 2016 at 12:07

    Gary, on this you are correct. If the Fed wasn’t willing to support the commercial paper and MBS market in the fall of 2007, then what is the point of having them. Supporting liquidity is their core function. A random number generator would be a better monetary policy mechanism than what we had in 2007-2008. But, considering that in 2016, we are still blaming the banks for a monetary blunder, it seems clear to me that the Fed had no other choice.
    If we had never had a labor disruption and homes and stocks were valued 40% higher than they are now, the Fed would be pilloried from the right and left for being the handmaidens of Wall Street, because nobody would be benchmarking to the counterfactual, which is the crisis that we have endured.

  10. Gravatar of AbsoluteZero AbsoluteZero
    2. June 2016 at 13:04

    Scott,
    “… in the case of LTFC (1998).”
    LTFC? Perhaps you meant LTCM?

  11. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    2. June 2016 at 14:40

    Today’s WSJ has a ton of interesting news, especially about banking regulation;

    http://www.wsj.com/articles/banks-embrace-of-jumbo-mortgages-means-fewer-loans-for-blacks-hispanics-1464789752

    ————quote———–
    Last decade’s financial crisis left many losers in banking. One winner is the jumbo.

    The biggest U.S. banks are tilting toward these high-dollar mortgages as they overhaul loan operations. And jumbo loans, which were less important during the subprime-loan boom, are helping banks take on less risk, as mandated by regulators in the postcrisis era.

    These loans, however, could put banks at odds with another federal regulatory mandate—one that says lenders should serve a racially diverse set of customers. As they approve relatively more jumbos, major banks are granting fewer mortgages to African-Americans and Hispanics than just before the crisis, a Wall Street Journal analysis found.
    ———–endquote———-

    Of course, it was the government’s idea that banks needed to make more loans to blacks and hispanics back in the 1990s that led to the reduced underwriting standards (i.e., “liar’s loans”) in the first place. Now;

    ‘Jumbos, loans above $417,000 in most markets, are attractive because they typically feature high credit scores, big down payments and low default rates. And they aren’t linked to the government programs that cost banks tens of billions of dollars in fines related to the subprime-loan debacle.’

    But those loans go mostly to whites and Asians.

  12. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    2. June 2016 at 14:47

    Weren’t we talking the other day about the prospects of private funding of infrastructure in the USA?

    http://www.wsj.com/articles/uber-raises-3-5-billion-from-saudi-fund-1464816529

    ————quote————-
    Uber Technologies Inc. raised $3.5 billion from the investment arm of Saudi Arabia, part of an arms race over the future of transportation that is attracting the world’s largest technology companies and auto makers.

    The investment from Saudi Arabia’s Public Investment Fund extends a fundraising that totals $5 billion, the largest single investment for a venture-backed company. Including the latest contribution, Uber is valued at close to $68 billion, some $20 billion more than General Motors Co., the nation’s largest auto maker.
    ———–endquote———–

    Maybe they’d like to build some roads of their own for their independent contractors to drive on.

  13. Gravatar of Benjamin Cole Benjamin Cole
    2. June 2016 at 15:31

    There is already plenty of consequences when a publicly held commercial bank fails. The shareholders get wiped out (shareholders are represented by a board of directors that should be governing). Bondholders take a haircut (and bondholder committees are often formed). If there are convertible bond holders, they could end up in control of the bank.

    Requiring only a fat layer of convertible bond holders for commercial banks and doing away entirely with Dodd-Frank is probably a good idea. The industry has never proposed such a solution. The industry appears comfotable with D-F.

    With inflation near zero, the elimination of FDIC Insurance could lead to a nation of cash hoarders. Already, the average US resident has about $4,400 in cash.

    Taxpayers have spent very little (net) on financial bailouts compared to nearly any other major category of expenditures.

    A funny observation: While pundits rant and rail against Dodd-Frank, go to the American Banking Association website. The ABA seems fine and dandy with Dodd-Frank. The industry has accepted Dodd-Frank.

    That may be bad news and may suggest regulatory capture.

  14. Gravatar of Lorenzo from Oz Lorenzo from Oz
    2. June 2016 at 15:53

    Kevin Erdman: “This all only makes sense if we begin with the prior that excess lending caused home prices to rise significantly above intrinsic value. This should be a surprising enough outcome that economists demand proof, but the premise appears to have been broadly accepted as obvious.”
    Above their value as (1) shelter or above their value as (2) a hedge against inflation or above their value as (3) a source of capital gains beyond their value as a hedge against inflation?

    Noting that (2) and (3) pertain to the land the house is on, rather than the large decaying physical object on said land.

  15. Gravatar of Daniel R. Grayson Daniel R. Grayson
    2. June 2016 at 16:39

    Re: “If NGDP growth is so low that nominal rates fall to zero, then the Fed balance sheet can get very large. If the NGDP target rate is set high enough where rates stay above zero, then the Fed balance sheet stays small.”

    Why is that? I’d be happy to learn.

  16. Gravatar of Major.Freedom Major.Freedom
    2. June 2016 at 16:57

    “Over the past 50 years the government has prevented financial crises about every decade or so”

    No, the government is the cause if those “prevented” financial crises. It is the government that is responsible for the inflationary credit expansion socialist central banking system that distorts economic calculation over and over again.

    “It’s not politically possible to abolish FDIC”

    This is just an arrogant presumption of being able to predict what people will learn, think and do in the future. Yes, it is politically possible to abolish the FDIC. The same reason you believe people will CHOOSE not to abolish it, is the same exact reason they could choose to abolish it.

    One of the hallmarks of the socialist mentality is to present one’s own beliefs of the future as if they were insights into some historical inevitability. This is a political posturing to persuade, nothing more.

    “Inflation or socialism? It’s your choice.”

    First, that is a false dichotomy. We can certianly have neither inflation nor socialism.

    Second, saying “inflation or socialism, you decide”, is like saying “Gestapo or the State, you decide.” The former IS an institution of the latter. Our inflationary system is a socialist system. Government control of the means of production. If the means of production are the means of producing money, and the government has a monopoly over it, which is the case, then it follows that our monetary system is socialist.

    The actual choice, the one that Sumner dares not think about, or read and learn about, or research himself, is “Inflation or Capitalism, you decide.”

    Contrary to the myopic, fear mongering, and butchery of history propaganda that is peddled on this blog, it is inflation that grows the state and leads to economic socialism, not an absence of it. This is true in the long run. The more you believe additional inflation can stave off Hitler 2.0, the more likely he becomes.

  17. Gravatar of jj jj
    2. June 2016 at 17:16

    Regarding the desired and actual answers, I think the quote “speak softly and carry a big stick” is applicable.

    In fact, searching the archives… looks like Statsguy brought that up in 2011

  18. Gravatar of Kevin Erdmann Kevin Erdmann
    2. June 2016 at 17:44

    Lorenzo:

    It was mostly neither 2 or 3, but #4: Access in a housing-deprived regime.

  19. Gravatar of Lorenzo from Oz Lorenzo from Oz
    2. June 2016 at 18:55

    Kevin Erdman: “#4: Access in a housing-deprived regime.” So, as shelter (1) then?

    No one was buying houses as a “will beat inflation” asset? Or adding a premium to their willingness to buy on that basis?

  20. Gravatar of BJ Terry BJ Terry
    2. June 2016 at 20:18

    David Beckworth’s podcast is quite excellent so far. If you are having trouble keeping up, consider listening to it at higher speed. I listen at 2x using my iPhone, which significantly reduces the time investment.

  21. Gravatar of Kevin Erdmann Kevin Erdmann
    2. June 2016 at 20:49

    Lorenzo, sure I guess. It’s semantics to an extent. The prices of homes just about everywhere were a reasonable reflection of rent and reasonable forecasts of future rents. The prices reflected that. The price of corn reflects expectations about the coming harvest. A million people buy or sell corn for a million different reasons. The price is the price. Homes in each city before 2008 tended to reflect discount rates, rent, and rent trends – present value of future rent income. The only possible exceptions were cities like Phoenix in 2004-2005 that basically had a California refugee crisis.

  22. Gravatar of Ray Lopez Ray Lopez
    3. June 2016 at 00:38

    It’s 2016 people. And you are still debating whether a three-month delay by the Fed in 2008 would have prevented a recession who’s effects are still with us today? Do you really think the US economy is that ‘tightly coupled’? You freaks are worse than the Marxists. Deprogram yourselves, please. Read Bernanke’s FAVAR paper: 3.2 to 13.2% effect of Fed policy shocks. Nearly trivial.

    Sumner: “Inflation or socialism? It’s your choice.” – sounds like a bogus bumper sticker.

  23. Gravatar of Major.Freedom Major.Freedom
    3. June 2016 at 01:39

    Ray, you’re the freak. You cannot even tell the difference between a positive number and zero.

    Nearly neutral is another way of saying non-neutral.

    Non-neutral never was “significantly non-neutral” or “massively non-neutral”.

    Non-neutral means only non-neutral.

    The weasal words you’re using like “nearly” and “pretty much” and “effectively” are just you conceding the point but too immature to admit it.

  24. Gravatar of LK Beland LK Beland
    3. June 2016 at 06:32

    Even considering the 35000 telecom workers on strike, the latest job report seems pretty bad. The employment-population ratio (25-54) has been flat since the beginning of the year, well below the through of the previous business cycle. U6 has been stalling at rather high levels. Quite sad.

  25. Gravatar of Dan W. Dan W.
    3. June 2016 at 11:25

    Kevin,

    Maybe it was just a throwaway line when you wrote “If we had never had a labor disruption and homes and stocks were valued 40% higher than they are now…”

    I understand that equities can trade independent of incomes. But how can housing? What percentage of a person’s income can go towards housing? What percentage of a person’s income can go towards health care? What happens when all the percentages add up to more than 100%?

  26. Gravatar of Kevin Erdmann Kevin Erdmann
    3. June 2016 at 11:33

    Dan W., it is important to distinguish between stocks and flows.

  27. Gravatar of Dan W. Dan W.
    4. June 2016 at 05:18

    Kevin,

    I understand that if housing were more affordable more housing would be built and this would increase the total economic value of housing. What is not obvious is the linkage between NGDP and affordable housing. Affordable housing is a local issue driven by local incomes, local job growth and local zoning policy. Building and working regulations, some of which are national, also influence housing costs. If one considers all the factors that influence the housing economy only interest rates policy has significance, and yet interest rates are a key driver in making housing more expensive. The linkage between NGDP expectations and housing only exists in the abstract.

    Now of course robust national economic growth will benefit the housing economy. But if there is underperformance in the housing economy, and I suspect as a whole this is the case, the answer is to look at the regulatory policies that might be causing this. And if regulatory changes would improve much of what ails housing perhaps regulatory changes would improve much of what ails the economy. The fix to monetary policy is to fix economic policy. The arrow of improvement points much strong in the one direction than the other.

  28. Gravatar of ssumner ssumner
    4. June 2016 at 09:24

    Absolutezero, Oops. Yes, I did mean LTCM

    Patrick, Thanks for those links.

    Ben, Agree that regulatory capture is a real risk–regulation favors the bigger businesses.

    I’m not too worried about cash hoarding without FDIC. There was very little cash hoarding in the 1920s.

    Daniel. The Fed’s balance sheet is basically the monetary base. The demand for base money as a share of GDP rises sharply when interest rates fall to zero, as that means the opportunity cost of holding base money also falls to zero.

    JJ, Ah, the days when we had a good comment section, before the Trumpistas took over. I wonder what happened to Statsguy?

  29. Gravatar of Kevin Erdmann Kevin Erdmann
    4. June 2016 at 20:42

    Dan W., clearly the Fed’s management of the money supply in 2006-2008 was shifted significantly downward because of widespread beliefs that homes were too expensive. In most of the country today, homes are extremely inexpensive relative to rents, given current real interest rates. You are right about local influences, etc. But, since the mid 2000s, continuing to today, the Fed has been explicitly pulling down growth because they are concerned about asset prices. Fixing the supply side policies would help real growth and would lower home prices and housing expenditures. But, until we do that, the Fed is erroneously trying to fix it by suffocating liquidity.

  30. Gravatar of Daniel R. Grayson Daniel R. Grayson
    5. June 2016 at 06:12

    Scott, re: “Daniel. The Fed’s balance sheet is basically the monetary base. The demand for base money as a share of GDP rises sharply when interest rates fall to zero, as that means the opportunity cost of holding base money also falls to zero.”

    Probably the opportunity cost is determined by looking at all other opportunities, not just lending. So perhaps you have in mind that investment is not a better opportunity than cash hoarding, as well. Can that really occur in a stable economy under NGDPLT?

  31. Gravatar of Dan W. Dan W.
    6. June 2016 at 04:34

    Kevin,

    Is not the problem that the “Fed” is conflicted in its objectives? On the one hand it is supposed to ensure a steady flow of “money” in the economy. On the other hand it is supposed to ensure the stability of the banking system. So all the while the central bankers are talking about the need for banks to lend more Federal regulators are watching every move bank managers make and dictating lending policies that are not economically advantageous.

    In other words, the problem is overregulation and it is destroying economic growth in all facets of the US economy. In this environment monetary policy is toothless, except for keeping the comatose patient on life support.

  32. Gravatar of Scott Sumner Scott Sumner
    6. June 2016 at 13:19

    Daniel, The op. cost is the overnight risk free interest rate.

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