If Hetzel’s right, then the prestige of futures targeting is about to soar.

I ended my previous post by pointing to a striking correlation:

It’s interesting to consider the small group of economists who have suggested that monetary policy can and should have done more, and/or the payment of positive interest on reserves was a mistake:  Thompson, Hall, myself, Woolsey, Glasner, Svensson, Jackson, etc.  Every one of them was in the even smaller group of economists that focused on forward-looking monetary regimes of one form or another.  Once you start looking at monetary policy in a forward-looking fashion, everything seems different.

To give you an idea just how striking this pattern is, consider the following two facts:

1.  In addition to this short list, I know of only two other economists who wrote papers advocating that monetary policy “target the forecast,”  Robert Hetzel and Kevin Dowd.  That’s just nine people.

2.  The ideas that I have promoted on this blog are widely viewed as quite heterodox, departing from the prevailing views of economists on both the right and the left.  Indeed, very few economists have publicly argued that Fed errors in late 2008 made monetary policy much more contractionary that it appeared, and that these errors (perhaps just errors of omission), contributed to a severe intensification of the recession.

When trying to characterize the views of a group of people, it is important not to oversimplify.  Thompson’s views were clearly stated in an article he published.  Four others participate in this blog, so you can judge their views for yourself.  Hall made three statements (in his blog with Susan Woodward) that led me to include him in this group.  First, he argued that the Fed’s explanation of the policy of interest on reserves was a “confession of contractionary intent.”  Second, he spoke highly of the negative interest rate on reserves idea soon after I sent it to him by email.  And third, he was contemptuous of the idea that monetary policy was ineffective in a liquidity trap, and pointed to the negative interest on reserves idea as a counterexample.

[By the way, I feel kind of guilty leaving out Hall’s co-author Susan Woodward, but I am interested here in economists who have previously advocated targeting the forecast, and I am not familiar with Woodward’s previous research interests.]

I include Svensson on this list for two reasons.  First, he dissented from the recent Swedish Riksbank rate cut on the grounds that it should have been even steeper, despite the fact that even the actual rate cut was viewed by the markets as a major expansionary surprise.   Much more importantly, his instituted the negative rate on reserves program in Sweden.  I doubt Svensson would ever publicly criticize his colleague Ben Bernanke (someone told me they are friends, but I don’t know that for a fact) but I don’t see how the negative rate policy could be viewed as anything but an implied criticism of the Fed’s positive interest rate policy.

So seven out of nine isn’t too bad.  One day later, it got even spookier; David Glasner sent me an outstanding paper by Robert Hetzel with this abstract:

The recession that began with a cyclical peak in December 2007 originated in a combination of real shocks because of a fall in housing wealth and a fall in real income from an increase in energy prices. The most common explanation for the intensification of the recession that began in the late summer of 2008 is the propagation of these shocks through dysfunction in credit markets. The alternative explanation offered in this article emphasizes propagation through contractionary monetary policy. The first explanation stresses the importance of credit-market interventions (credit policy). The second emphasizes the importance of money creation (money-creation policy). According to Federal Open Market Committee (FOMC) Chairman William McChesney Martin, “The System should always be engaged in a ruthless examination of its past record” (FOMC Minutes, 11/26/68, 1,456).

Hetzel’s paper contains so many nuggets of wisdom that I will return to it again and again in the next few weeks.  It is one of finest monetary narratives that I have ever read, and certainly far and away the best published narrative of this crisis.  In fact nothing else even comes close.  Just to whet your appetite, he presents a wealth of evidence that Fed policy became effectively more contractionary over the summer of 2008.  Some of this I was unaware of, but you can be sure I will have more to say in future posts.  Many of his views overlap with ideas expressed on this blog.

Also note that Hetzel never once cites his 1989 paper on targeting the forecast.  So the connection that I am drawing wasn’t necessarily obvious to Hetzel.  His futures targeting research may have subtly shaped his view of monetary policy options, but there is no evidence that Hetzel was conscious of that influence.

So we now have information on 8 of the 9 economists who have done work on targeting the forecast.  All 8 offer, or at least seem to offer, a critique of the view that monetary policy was powerless in late 2008 (which is the view of those on the left), and also the view that monetary policy was not excessively contractionary (which is the view of those on the right.)  There must be 10,000 economists who have published papers.  And yet look at how small these two groups are:

Did “targeting the            Viewed Fed policy as too                                                forecast” research           contractionary in late 2008

1.  Thompson                  1.   Thompson

2.  Hall                             2.  Hall

3.  Glasner                       3.  Glasner

4.  Me                              4.  Me

5.  Hetzel                         5.  Hetzel

6.  Woolsey                      6.  Woolsey

7.  Svensson                    7.  Svensson

8.  Jackson                      8.  Jackson

9.  Dowd                         9.  Congdon

What are the odds that two randomly drawn groups of 8 or 9 economists, drawn from a sample of roughly 10,000, would show this much overlap?  I dunno, how many atoms are there in the universe?

Nitpick all you want.  Find a few other economists who fit in column 1, and a few other economists who fit in column 2.  But I still say you’d be lucky to get the odds down to a quadrillion to one.  This pattern isn’t random.  Thinking about monetary policy from a forward-looking perspective makes one much more likely to critique Fed policy in late 2008.

One commenter pointed out that I left out Ken Rogoff, who advocated a 6% inflation target in the spring of this year.  I will do some more research on this, but I’d like to point out that merely advocating an inflation target doesn’t automatically put one in this camp.  I recall that Mankiw and Mishkin both recommended inflation targets in the spring, but neither have offered anything like the sharp critique of Fed policy seen in this blog and in Hetzel’s article.  James Hamilton has done some outstanding work in Econbrowser.com, and I particularly liked this passage on why the Fed started paying interest on reserves:

And the buck stops– where? In normal times, the process of banks putting any excess reserves to use would continue until there’s enough expansion of banking and economic activity that ultimate recipients did want to turn those reserves into green currency. And once that happens, it would not be a misleading summary of the bottom line to say that the Fed eventually paid for its original asset purchase by “printing money”.

But in the fall of 2008, the Fed did not want that to happen. It wanted to extend a trillion in new loans, but it did not want to see currency held by the public go up by a trillion dollars, out of fear the latter would be very inflationary. The Fed’s thinking was that we didn’t need a traditional inflationary expansion of credit, but instead needed to allocate credit to particular functions without having conventional measures of the money supply swell.

A couple points.  First, it’s clear from his other posts that Hamilton also thinks monetary policy had not lost its effectiveness in late 2008.  When I argue that the Fed could have prevented the severe drop in NGDP with a more expansionary monetary policy, I often get the feeling people think I’m a monetary crank.  “Oh, so you think all the world’s problems can be solved by printing money?”  No, just the problem of falling NGDP.  And since Hamilton (and perhaps even the Fed) seems to agree, I don’t see how anyone could argue that it is a wacky opinion.  Hamilton is a highly respected, thoughtful, and moderate expert on Fed policy.  He is no monetary crank.

Although I agree with many of Hamilton’s posts on monetary policy, I still would not put Hamilton in the group listed above.  He argues that monetary policy was too loose in early 2008, and that this contributed to the commodity price bubble.  He also argues that the high oil prices intensified the recession after mid-2008.  It is my view (and Hetzel’s view as well) that it was the Fed’s overreaction to those high oil prices that decreased AD in late 2008.

So for any ambitious grad students reading this paper, take a look at Hetzel’s paper.  Then ask yourself whether any other narrative of the crisis is even close to being as persuasive.  If you agree with me then start working on futures targeting schemes, as this select little club is about to expand rapidly if people come to believe that we correctly saw that the “real problem” in late 2008 was a nominal problem.  Not enough money.



33 Responses to “If Hetzel’s right, then the prestige of futures targeting is about to soar.”

  1. Gravatar of Chris Chris
    24. July 2009 at 12:25

    You offer a very persuasive argument, but I wonder if it has any predictive power? What set of circumstances would lead you to say that your view of NGDP targeting is incorrect?

  2. Gravatar of Carl Lumma Carl Lumma
    24. July 2009 at 13:08

    Hey Sumner: For whatever reason, your RSS feed has been showing up in Google Reader with a solid paragraph of “Purchase Cialis OnlineCialis From CanadaCialis PrescriptionOrder Cialis Without Prescription” in the summary. Been showing up that way for a couple weeks now. I would have told you sooner, and done so by e-mailing you directly, save that I couldn’t find an address for you on this site.


  3. Gravatar of ssumner ssumner
    24. July 2009 at 13:34

    Chris, Good question, Two things would change my mind.

    1. Evidence that central banks cannot control the path of NGDP, especially if they could not prevent it from falling. This is a very complicated issue, which I discuss in many posts on the blog. But I’m not convinced central banks in Japan and the US (1930s) were as powerless as others allege.

    2. Severe recessions in America where NGDP growth did not slow sharply. There was one in 1974, where NGDP slowed only slightly, but I attribute that to distortions from removing price controls plus the oil shock.

    Carl, Thanks, This is taking longer than before because we are working to change to a new platform. I hope it is fixed soon.

  4. Gravatar of 123 123
    24. July 2009 at 14:53

    Excellent paper by Hetzel. The only problem is his belief that credit easing (Bernanke’s version of QE) does not influence the natural interest rate.

  5. Gravatar of TJIC TJIC
    24. July 2009 at 17:24

    What Carl Lumma said – your blog has been hacked. You probably want to alert a sysadmin to what’s going on.

  6. Gravatar of Bill Woolsey Bill Woolsey
    25. July 2009 at 03:23


    Please elaborate on your view that credit market targetting will change the natural interest rate.

    My tentative view is that speaking of “the” natural interest ate becomes problematic. The policy, I think, would raise the natural interest rate on safe and short assets and lower it on risky and long assets.

    What do you think?

  7. Gravatar of Bill Woolsey Bill Woolsey
    25. July 2009 at 03:46


    I think you should stop with the “monetary crank” talk.

    I also think your (our) differences with most economists are less than you think.

    “Monetarists” believe that changing base money now will only impact nominal GDP in the future. Based upon historical experience, the changes in base money have been large. Most think that they are more than adequate to return nominal income to its past growth path after a long and variable lag. Increasing base money even more at this time would do now good in the near future, and exacerbate the inflation in the future.

    “Keynesians” believe that conventional monetary policy, of open market operations with T-bills, will do no good because we are so near the zero nominal bound. The situaion calls for fiscal policy. There are always spending increases or tax cuts that some Keynesians support for other reasons, and this is another argument in their favor.

    “New classical” macroeconomists believe that low and falling nomiminal income only impacts the price level and not real output or employment. The drop in output and employment must be due to some real factors that cannot be influenced by monetary policy. Perhaps fixing credit markets, particularly those associated with housing, will help fix these problems to the degree that is possible.

    It is only the “new classical” macroeconmists that can describe you as a “monetary crank,” though they surely must realize that they are the minority. Nominal income does matter, and prices aren’t perfectly flexible. You (we) recognize that there is some kind of real recession going on that involves a reallocation of resources away from housing. I would suggest emphasizing more that the drop in nominal income is superimposed over that problem (rather than discussing it in a temporal way.. that was the problem and now there is a different one.)

    As for the Keynesians, there is no real economic difference. You (we) advocate “unconventional” monetary policy. Forget interest rate targetting and increase base money whatever amount is needed to get nominal income back on target, and if assets aother that T-bills must be purchased then that must be done. The Fed should purchase whatever assets are needed. We should grant–conventional monetary policy has failed, and unconventional monetary policy should be used. Raise base money without regard to what happens to interest rates or with specfications as to what sort of assets should be purchased.

    The real debate between you (and me) and other economists is the long and variable lags. If heroic efforts to raise base money now will only cause nominal income to overshoot by more than it already will in 2010 or 2011, then there is no reason to do it.

  8. Gravatar of ssumner ssumner
    25. July 2009 at 04:34

    123, Good observation. Obviously when we get to the policy area I would describe things a bit differently that Hetzel does, but as far as diagnosing the problem, I though his paper was excellent.

    TJIC, Thanks, My tech support is working on it. I’ll pass along your suggestion.

    Bill, I think you are right, but I think people usually refer to the risk free real rate when they are discussing monetary policy. Does anyone know how Wicksell defined it?

    Bill#2, I see the long and variable lag issue as a big deal. Here’s how I view the standard conservative response the the crisis:

    “Crisis, what crisis.”

    Now of course I am being a bit sarcastic, but if they don’t think we need anymore monetary stimulus, then they obviously don’t think we need anymore fiscal stimulus. So if they were advising Obama in January on what to do about the rapidly rising unemployment and collapsing stock market, all they could offer is “nothing.” That view was correctly discredited in the Great Depression, and it is equally wrong now. So although I agree with how you characterize our differences, to me they seem huge. I believe that with futures targeting the unemployment rate in American right now would be about 5%.

    My differences with Keynesians are equally big, they think monetary policy is ineffective and support fiscal stimulus which they think is highly effective. I strongly disagree on all three counts. Most Keynesians do not even think unconventional monetary policy will work. That’s why they support fiscal stimulus.

    I don’t like the phrase “we should grant conventional monetary policy has failed.” The term ‘grant’ implies that the policy that we usually think is effective has now failed. I always opposed conventional monetary policy. The fact that it failed doesn’t count at all against our views, it is the Keynesians that should be embarrassed because it is the Keynesians who advocate interest rate targeting. Why do the Keynesians advocate a targeting procedure that is sure to break down exactly when the economy most needs stimulus? (That is, in a Depression.) Ask them.

    I think the real debate is that we think the Fed should target expectations and they don’t. Everyone agrees that TIPS spreads respond immediately to monetary policy, the question is whether TIPS spreads, or much better yet NGDP futures, are what should be stabilized. I agree that monetary policy might impact sticky prices in the headline CPI with a lag, I just don’t think that fact is relevant, as we shouldn’t be targeting the CPI. If we target prices at all (which is not the optimal target) we should target the expected future CPI, and there is no lag there.

    Strict new classicals have almost died out, but the RBC-types seem to think nominal shocks have only a modest effect. I don’t know how they explain the correlation between the sharp fall in NGDP and 9.5% unemployment. Just a coincidence I guess.

    I think most people take “monetary crank” as humor, real monetary cranks take themselves too seriously, and have no sense of humor. At least I hope it’s taken this way.

  9. Gravatar of Bill Woolsey Bill Woolsey
    25. July 2009 at 06:52


    Well, I read the Hetzel paper and I think it is good.

    Hetzel clearly supports interest rate targetting.

    I wish he would have explained better how purchasing long term bonds is supposed to raise the natural interest rate though a portfolio adjustment effect.

    Whle reading his explaination of all that is accomodated when things are working right (trend growth, trend inflation, changes in money demand relative to income, random shocks to money demand, inflation shocks, variance in headline inflation away for core inflation,) I kept on wondering what would happen to all of those things with nominal income path targeting?

    The section about how the Fed doesn’t review its errors because of the fundamental political situation where it must defend against the politicians temptation to use seniorage. I have often been puzzled by the Fed leadership’s unwillingness to accept responsibility. We did our best, but the quantity of money (or interest rates) were at the wrong level and so that is why there is a problem. They don’t say that. As you have noted in this crisis, it is like, the economy did all these things causing the problem. Interesting. Hetzel wasn’t clear to me, but I guess his point is that if the Fed said, “we messed up,” then the politicians would respond with, “print up as much money as we want to spend and give it to us.”

  10. Gravatar of David Pearson David Pearson
    25. July 2009 at 06:57


    Hamilton supports my view that the Fed is targeting the credit mechanism. This is why I think your interest on reserve idea puts the cart before the horse. FIRST, the Fed has to decide that it wants to raise inflationary expectation, and then, it has to choose the appropriate level of interest on reserves. The fact that it is paying 15bps now is not what is keeping the money in ER’s — it is their overall policy stance.

    Again, I think the question to ask is, “why is the Fed not trying to raise inflation expectations.” I would use a flu virus analogy to explain it.

    When the virus is present in the population but still not apparent in the host, a vaccine is appropriate. When the virus is apparent, its too late for a vaccine, and anti-viral drugs should be used.

    What Bernanke and the Fed are signaling is that the virus of deflation is present, but that it hasn’t “infected” us yet — its not self-reinforcing dynamic. He’s using a vaccine — targeting or allocating credit — as a prophylactic defense. And he’s assuming that the vaccine eliminates the need for true anti-virals, which in this case is policy that raises inflation expectations in the teeth of deflation.

    What will it take to change Bernanke’s mind? Perhaps declining incomes would do the trick. Until then, to prevent from being just another “monetary crank”, I would suggest that you explain to Bernanke not only HOW to fight deflation, but also WHY we should do it.

  11. Gravatar of David Pearson David Pearson
    25. July 2009 at 07:09


    Please don’t misunderstand — you have clearly explained why the Fed erred by letting NGDP expectations collapse in 2008. One might disagree, but the argument is clear.

    What is less clear is, why target NGDP now? What are the consequences of instead following the Fed’s policy prescription? It would be helpful if you could “fast forward” to the present instead of focusing on last year. Do you think prices will decline? When? Or is it a matter of NGDP being positive but not at potential? In this case, is the Fed’s current “mistake” of minor consequence or major?

    In short, what is the character of the deflation we face, and what are the risks that it is actually even worse? Until the Fed understands that, they will not change policy — unless of course deflation actually materializes, by which point it will be late in the game to start raising inflation expectations…

  12. Gravatar of Jeremy Goodridge Jeremy Goodridge
    25. July 2009 at 11:27

    Hi Scott:

    I just saw your debate with Cochrane. One thing that I noticed is that he said something like “the Fed has been buying billions of dollars of Treasuries”. But looking at the graphs you linked to on Econbrowser ( Hamilton ), I see the Fed really did not start buying Treasuries until March of this year. In fact, conventional monetary open-market operations were NOT tried! Before that the Fed mostly created lots of liquidity mechanisms for banks.

    The other interesting point is that the Fed didn’t really print that much money (another aspect of ‘conventional’ monetary policy). Instead it borrowed money from the Treasury, who in turn borrowed it from the public. So, in a way, the Fed moved money from long-term lending to short-term reserves. That ballooned the balance sheets more than would have happened if the Fed had actually printed money and bought Treasuries — even short-term Treasuries.


  13. Gravatar of Jon Jon
    25. July 2009 at 14:05


    The fact that it is paying 15bps now is not what is keeping the money in ER’s “” it is their overall policy stance.

    Do you mean the perception that the reserves can and will be withdrawn? Certainly if you expected a depositor to pull-out ‘soon’ you’d be weary of lending out his money. Or do you have something else in mind?

  14. Gravatar of Lawton Lawton
    25. July 2009 at 19:13

    Just wanted to highlight this from your comment: “Everyone agrees that TIPS spreads respond immediately to monetary policy”. That’s the kind of tidbit that would be useful in the FAQ, perhaps in the “long and variable lags” section.

    To make a compelling case, it’s often helpful to start with some basic points of agreement, including some of the textbook definitions that you’ve mentioned in various posts. Then, step by step (but in as few words as possible!), lead readers to what seems like an inescapable conclusion.

    Maybe that’s part of Bill’s point about “monetary crank”. Yes, it’s a fun joke among regular readers, but there should be a reference page of some sort that contains the core rationale with no snark or defensiveness.

  15. Gravatar of ssumner ssumner
    26. July 2009 at 05:06

    Bill, It wasn’t quite to so clear to me that Hetzel supports interest rate targeting. I think he clearly does think that a forward-looking Taylor rule might work, but so do I. On the other hand he seems to favor QE right now, and that is not interest rate targeting

    His proposal for targeting the forcast was more susceptable to the “circularity problem than our approach, because the Fed would still be determining the monety supply, and would adjust the money supply only when the TIPS spread got out of line. Ironically I have been forced to talk about his approach, because we don’t have an index convertibility system right now.

    I wonder if he lost interest in futures targeting after the Bernanke and Woodford critique of 1997. He still mentions the need for a forward-looking policy, and that is one thing I like about the paper. But what I liked best was the sophisticated understanding of Fed history, especially the months that led up to the post-Lehman fiasco. He does a great job of showing how the Fed went off course.

    If he did lose interest in his TIPS idea, he might have fallen back on interest rate targeting as the lesser of evils. And then tried to incorporate his forward-looking ideas into an interest rate rule. I was a bit disappointed by the last part of the paper, which didn’t clearly lay out exactly what an optimal monetary policy should look like. I plan to read it again and maybe I’ll see more the second time.

    David, You said:

    “FIRST, the Fed has to decide that it wants to raise inflationary expectation, and then, it has to choose the appropriate level of interest on reserves.”

    This really exasperates me (not you, but the Fed.) How can there be any doubt that the Fed wants to raise inflationary expectations? If they didn’t then there would have been zero reason for the Fed to recommend massive fiscal stimulus. Remember, the purpose of fiscal and monetary stimuli are identical, it is to raise AD, and by implication, inflation expectations.

    Sometimes the Fed acts like we need more expansion, and sometimes they don’t. I’d like to go with the “good Fed,” because obviously we do need more expansion. If they don’t think that then I might as well close up shop right now, as I am just wasting my time. If they are not concerned by rapidly falling AD and NGDP, then no advice anyone gives them will do any good.

    With all due respect David, I simply cannot believe that the Fed is as dumb as you suggest. And we also have Bernanke’s statements, where he clearly indicates that higher AD would be desirable.

    One thing that throws people off is the term “deflation.” It refers to falling prices, but when people use the term in a cyclical sense they always mean falling NGDP, if you look at the statement in context. Falling prices are not a problem if output is soaring because of rising productivity. So let’s focus on the real problem, falling NGDP. That is the problem the fiscal and monetary authorities have been trying to address by pumping up AD. The problem is that their policies have been extremely ineffective.

    I’ve raised the fiscal argument many times here, and not one person has been able to explain to me why Bernanke favors fiscal expansion, if he opposes higher AD. Remember, he is a Republican deficit hawk.

    David, You ask:

    “Please don’t misunderstand “” you have clearly explained why the Fed erred by letting NGDP expectations collapse in 2008. One might disagree, but the argument is clear.
    What is less clear is, why target NGDP now? What are the consequences of instead following the Fed’s policy prescription? It would be helpful if you could “fast forward” to the present instead of focusing on last year. Do you think prices will decline? When? Or is it a matter of NGDP being positive but not at potential? In this case, is the Fed’s current “mistake” of minor consequence or major?”

    The goal is to have a monetary policy that makes fiscal stimulus unneeded. Right now we are wasting billions of dollars in three ways:

    1. Automatic stabilizers
    2. Discretionary stimulus, only a tiny amount of which has been spent.
    3. Bank and auto bailouts (and who knows what’s next –pensions?)

    A quick recovery would definitely reduce 1 and 3, and might reduce number 2 if Obama has any sense. This would mean lower tax rates in the future.

    A quick recovery would also help the millions of unemployed find jobs more quickly.

    A quick recovery would also add credibility to future monetary policy, make it less likely that we would slip into a liquidity trap because the markets lacked trust in the Fed to maintain adequate NGDP growth.

    A quick recovery would also help the stock and real estate markets, but that motivation doesn’t figure in my calculus, and is just a side benefit.

    So there are lots of reasons to believe we would be better off with 6% NGDP growth in the next 12 months, and 5% thereafter (or even 4% thereafter if you are an inflation hawk.) Instead we will get maybe 2-3% over the next twelve months, if we are lucky. Obviously I may be too pessimistic, and the recent stock rally is heartening, but the TIPS spreads show we still need more stimulus. Inflation expectations are now about 0.4% over the next two years–that’s way too low.

    Jeremy, You are partly right.

    1. The Treasury balances at the Fed don’t raise the money supply, as you correctly note.

    2. Once the Fed started buying Treasuries in March the economy seemed to pick up a bit (or more correctly fell at a slower rate, and stocks signaled higher future growth.) So you are right about that as well.

    But much of the various liquidity injections did raise the MB sharply last fall, it wasn’t all Treasury deposits at the Fed. So Cochrane does have a point to some extent. But he completely ignores the fact that the Fed started paying interest on those ERs precisely in order to prevent them from boosting AD, just as Hamilton says. And that also undercuts Cochrane’s argument. QE was not tried last fall, and even this year was only weakly tried for a couple months. Interesting that things then picked up during those months, although I attribute most of that to stronger Asian growth. I really think they need an explicit inflation (or NGDP) target and a negative rate in ERs.

    Lawton, Good point. I meant that even the anti-EMH crowd believes that markets are efficient in one sense, they almost immediately incorporate new information into asset prices. Thus a major Microsoft earning announcement will move prices right away, by the time you hear about it, it will be too late to buy or sell. Studies show this is also true of government data. A new employment number from the first Friday of the month often strongly moves the bond market, and this occurs within minutes, or even seconds. The same is true of Fed policy announcements.

  16. Gravatar of David Pearson David Pearson
    26. July 2009 at 05:34


    With Core CPI rising at close to 2%, and the Fed’s 2010 forecast at around 2%, then we could well imagine that the Fed expects 4% NGDP growth, at least, in the next year.

    So the difference between your proposal and Bernanke’s policy is two percentage points of GDP NOMINAL growth, a few months earlier? Fine, but its hardly anything to get too upset about, especially in a political sense. With all due respect, I’m wondering how you define deflation, and how much of a problem you think it is.

    Deflation is a self-reinforcing dynamic of falling demand, rising unemployment, falling incomes, and falling demand. Japan did not experience deflation in this sense — prices fell at a 1% rate there consistently, and not in a self-reinforcing manner — presumably because they accessed external demand.

    Do you think deflation can happen here? What’s is the probability if the Fed sustains its current policy? From your comments, it seems you think the likelihood is small. I would disagree: In a nutshell, I think the Fed faces a stark choice between falling and rapidly rising prices, that it will eventually choose the latter, and that the longer it waits, the more those prices will rise.

    I don’t doubt that Bernanke wants AD to rise; what I doubt is that he feels its necessary to absorb the inflation cost to a policy that raises expectations. I believe he has never told us to expect more inflation in the future — just the opposite. He wants to keep those expectations anchored at 2%, and he thinks we can have a recovery (4% NGDP growth) next year along those lines. Who is arguing with him? Paul Krugman is, Roubini — the usual Keynesian suspects. Are the monetarists? This is what exasperates me. To my knowledge, they are not.

  17. Gravatar of 123 123
    26. July 2009 at 12:41

    “Bill Woolsey

    Please elaborate on your view that credit market targetting will change the natural interest rate.

    My tentative view is that speaking of “the” natural interest ate becomes problematic. The policy, I think, would raise the natural interest rate on safe and short assets and lower it on risky and long assets.

    What do you think?”


    while it is true that there is no single interest rate and at any moment there is full spectrum of interest rates, I don’t think that we can extend this fact to the concept of the natural rate, as there is only a single rate of inflation. So I think that credit easing is inflationary and thus it makes the conventional FOMC interventions more effective.

  18. Gravatar of ssumner ssumner
    26. July 2009 at 16:22

    David, You need to read more closely the answer to your question of why I thought nominal growth needed to be higher. If we don’t need any more nominal growth, then we are wasting hundreds of billions of dollars through totally unneeded fiscal deficits. I consider that a big deal.

    If the Fed thinks the likely inflation rate over the next two years is 2%, then they are far more stupid than even I could imagine. Two percent inflation is the typical rate during normal times. Firms are slashing wages and unemployment is 9.5% and going higher, why in the world would the Fed expect 2% inflation? And the TIPs markets show 0.16% over two years, while the CPI futures market (which probably overstates inflation expectations) shows only 0.66% over two years.

    I do agree with you that by far the biggest mistake was made last summer and fall, but they are still making a very serious error in monetary policy.

    In addition, we need to keep publicizing where they went wrong, or they will make exactly the same mistakes the next time around. In the NYT today Anna Schwartz said monetary policy should be even tighter.

  19. Gravatar of 123 123
    27. July 2009 at 12:39

    Scott wrote:
    “Bill, I think you are right, but I think people usually refer to the risk free real rate when they are discussing monetary policy. Does anyone know how Wicksell defined it?”

    Wicksell(1906) wrote: If, other things remaining the same, the leading banks of the world were to lower their rate of interest, say 1 per cent below its ordinary level, and keep it so for some years, then the prices of all commodities would rise and rise and rise without any limit whatever.

    So Wicksell made his argument before the myth of sovereign and risk free debt became popular.

  20. Gravatar of Current Current
    27. July 2009 at 13:40


    The problem with Wicksell is that he had theories about the natural rate that meant that it could be defined in several ways. Sometimes he used the another way.

    I’ll see if I can find a cite.

  21. Gravatar of ssumner ssumner
    28. July 2009 at 05:57

    123, That quotation is still true today—if you reduce the policy rate below the natural rate, and hold it there, the price level will explode toward hyperinflation.

    You are right that government debt was not risk free in those days; because of the gold standard they couldn’t just print money to pay off debts. But of course there is still the risk of inflation today, which is perhaps what you mean by “myth.”

  22. Gravatar of 123 123
    28. July 2009 at 08:57

    Yes, the quotation is still true today – that’s why we are mostly discussing natural rates in this thread. But the point is that there is nothing special about policy rates – the whole interest rate spectrum is important.

  23. Gravatar of van van
    28. July 2009 at 19:21

    hopingsomeone can fill me in on something in Hetzel’s paper. On the second page, one of the explanations given is of misallocation of resources, etc. seems very similar to the austrian view of boom busts-but he doesnt attribute it to the Austrian view directly. Am i correct in this? If so, then why is it Austrians believe their theory is the only correct one, when someone like Hetzel talks about it in a non-Austrian context? Perhaps i am missing something…

  24. Gravatar of ssumner ssumner
    29. July 2009 at 06:22

    123, OK, I see your point.

    Van, Perhaps an Austrian can answer. I think they’d say the general “credit view” is shared with others, but much of the specifics involving time and roundabout production is specifically Austrian.

  25. Gravatar of Van Van
    29. July 2009 at 06:45

    thanks scott. then i guess the follow up question to Austrians is why do Austrians have disdain for mathematics in economics? if two theories end up at the same “credit expansion” explanation, how could it be that the one using mathematics is more wrong or erroneous or less credible?

    Also, scott, if not already posted, a discussion on the advantages/disadvantages of a commodity standard currency would be great, versus fiat. trying to understand why one would be superior over the other.

  26. Gravatar of 123 123
    29. July 2009 at 08:20

    So I think that credit easing is supported by Wicksellian theory, and it is not necessary to do QE.

  27. Gravatar of Current Current
    29. July 2009 at 08:31


    As Scott says the ABCT is a quite specific theory. Others pick up particular parts of it. Many of these parts come from the British Currency School, Mises incorporated these into Austrian economics and other incorporated similar ideas into Neo-Classical economics.

    Austrian economists don’t think that the ABCT explanation is the only possible cause of recessions. Monetary disequlibria and real shocks may also do so.

    The situation with mathematics is complicated. Some Austrian economists, such as Selgin use mathematics. However, the main complaint is about use of simple-minded empiricism rather than economic logic. See Hayek’s nobel prize speech for example.

    That said I’m no expert.

  28. Gravatar of Carl Futia Carl Futia
    29. July 2009 at 10:38


    Here is an excerpt (edited to improve readability) from the preface to Hetzel’s 2008 book “The Monetary Policy of the Federal Reserve”. It is part of a March 1991 letter sent by Milton Friedman to Michael Bruno, then governor of the Bank of Israel:

    “..Hetzel has suggested…that the Federal Reserve be instructed by the Congress to keep the difference between a nominal and an indexed bond yield below some number. [This] is the first nominal anchor that has been suggested that seems to me to have real advantages over the nominal money supply. Clearly it is far better than a price level anchor which is always backward looking.”

  29. Gravatar of ssumner ssumner
    30. July 2009 at 04:35

    Van, Thanks, I’ll try to do one sometime.

    123, Because I bounce around between posts, it can be hard for me to remember context on a short comment like yours. I think you mean that we can still buy longer term T-bonds, where the rates are still well above zero. If so I agree. I still think the transmission mechanism (if it works at all), will run through expectations, just like QE. But I don’t dispute your point that credit easing may be possible. By the way, the other complication is that if successful, it should raise long rates.

    Thanks Current.

    Thanks Carl, I may do a post on that.

  30. Gravatar of 123 123
    30. July 2009 at 10:35

    No, credit easing as actually executed by Fed is lending collateralized by illiquid private sector securities and direct purchases of commercial paper. And according to Wicksell, it should have inflationary consequences.

  31. Gravatar of ssumner ssumner
    31. July 2009 at 13:08

    123, OK, I see what you mean, and I agree with Wicksell that it could have inflationary consequences. That doesn’t mean it will as there are other issues like temporary vs permanent question and the whole interest on ERsS question. But I entirely agree that it provides the Fed with an option once T-bill rates hit zero.

  32. Gravatar of 123 123
    1. August 2009 at 01:35

    I don’t think that credit easing is an option only when rates hit zero, for example ECB started enhanced credit support in August 2007.

    Interest on ERs issue should not be ovverrated – the key damage was done by the too high Fed funds rate.

  33. Gravatar of ssumner ssumner
    1. August 2009 at 06:59

    123, you said;

    “I don’t think that credit easing is an option only when rates hit zero, for example ECB started enhanced credit support in August 2007.

    Interest on ERs issue should not be ovverrated – the key damage was done by the too high Fed funds rate.”

    In one sense I agree, as the interest on reserve in October reflected a Fed desire to keep the FF rate above zero. But the magnitude of the increase in the base was huge. So in the absence of interest on reserves, it would have done far more than drive rates to zero, it would have been major QE. Think of it this way: Suppose there was no interest on reserves, and the Fed simply wanted to drive rates to zero. They could have done that with a few tens of billions in OMOs, at most. So the interest on reserves did two things; it kept rates above zero, and it negated major QE. But in the 3rd quarter I agree, the key mistake was not lowering the target rate aggressively in September when market signals turned very bearish.

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