Monetary offset and the time inconsistency problem
I recently ran across a very revealing article from April 24, 2012:
NEW YORK, April 24 (Reuters) – Federal Reserve policymakers are sounding the alarm over a “fiscal cliff” at the end of this year, when scheduled U.S. tax hikes and spending cuts could pose a big threat to the fragile economic recovery.
Along with its official mandate of watching unemployment and inflation, the U.S. central bank is keeping a close eye on a potentially debilitating political fight over how to fix the budget deficit.
If lawmakers in Washington do not get rid of the tax hikes and spending cuts due to take effect in early 2013, the country could easily careen into another recession. Any moves by Congress, however, aren’t expected until after the Nov. 6 presidential election.
The Fed is worried that individuals and companies could hunker down and curb spending, making markets antsy as the country awaits the outcome of an election that could pave the way for new tax and spending policies.
Though few expect Washington to do nothing while fiscal policies push the economy into another downturn, partisan politics could undermine the Fed’s unprecedented actions to revive the economy.
“I have been disappointed that the president and Congress are not taking action until after the election,” St. Louis Fed President James Bullard told reporters in Utah last week.
“I’m also worried that markets will react badly to the fiscal cliff at the end of this year. Markets might start to speculate about what might or might not happen … after the election,” he said.
Asked what the Fed can do, however, Bullard seemed to dismiss the possibility of resorting to new bond buying to counter the effects of political gridlock over the budget deficit and economic policy.
“It’s up to the Congress,” he said.
By the end of 2012, it was pretty clear that fiscal policy would sharply tighten in 2013. The Fed responded with QE3 and some additional forward guidance. Bullard was so confident that these steps would offset the fiscal guidance that he forecast an acceleration of RGDP growth in 2013, to around 3% to 3.5%. Actual RGDP growth (Q4 to Q4) turned out to be about 3.1%. So we have a nice example of monetary offset, with a happy ending.
But notice something strange at the end of the long quote; Bullard seems to be warning Congress not to expect the Fed to bail them out if the send the economy into a recession with reckless fiscal austerity.
When I was young I got a nice job offer from the New York Fed, at a salary 75% higher than my Bentley salary. My department chair took the offer to the Dean, who responded, “Tell him I hope he likes New York.” In the end I stayed at Bentley. (Feel free to insert dog retreating, tail between legs metaphor here.) I learned a lesson, and indeed not once have I ever told my daughter “If I catch you smoking pot you can forget about me paying for your college education.” My threats aren’t credible, due to the time inconsistency problem.
Matt Yglesias once wrote a post pointing out that the Fed denies that it engages in monetary offset:
A curious issue that in my opinion he and other proponents of the full monetary offset thesis haven’t fully grappled with is that Federal Reserve officials keep saying it’s not true. I heard John Williams of the San Francisco Fed say it’s not true at the Brookings event this morning. I heard Ben Bernanke say it’s not true at the American Economics Association meeting in Philadelphia earlier this month. I separately heard William Dudley of the New York Fed say it’s not true in Philadelphia. Janet Yellen has repeatedly said it’s not true. And since full monetary offset isn’t just an abstract economic thesis, it’s specifically a thesis about the actual behavior of the Federal Reserve, the fact that nobody in a position of authority at the Fed believes in it seems like a big problem worthy of a more substantive response.
You find lots of counterarguments in this post, written in response to Matt’s post. That post is my best counterargument. But I’d add this post as a footnote, as it shows how statements by Fed officials regarding their intentions may not accurately describe the Fed’s actual future policy response, but rather may reflect a desire to get Congress to do more of the heavy lifting.
That’s not to say that Matt’s completely wrong, indeed his views are actually about halfway between my view and the views of more traditional Keynesians. Here’s the very next paragraph of the Yglesias post:
What I think clearly is true is that partial monetary offset is very real. The people who thought the tight fiscal policy of 2013 would crush the economy were wrong, and they were proven wrong precisely because of monetary offset.
That’s a reasonable argument, and if my version of monetary offset were proved wrong at some later date, Yglesias’s view would be the alternative that I’d find most plausible. But thus far the data seem to support something close to full offset—both the 2013 case of austerity in the US, and the cross sectional study by Mark Sadowski. Of course “further research is needed.”
PS. Here’s a perceptive observation from the April 2012 article:
“We’re naive if we think that [fiscal cliff] doesn’t play into the Fed’s thinking about monetary policy,” said Tom Porcelli, chief U.S. economist at RBC Capital Markets in New York.
“But the way that the Fed would want to present it is a minor consideration at best, because they don’t want to be supplementing fiscal policy,” Porcelli said.
Porcelli clearly gets it, although the term ‘supplementing’ doesn’t really capture the idea he’s trying to express. He should have said, “offsetting.”
PPS. I have a new post on the euro over at Econlog.
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20. June 2015 at 14:13
What would you say this means about the BoJ pre-2013? My understanding was that the BoJ kept policy tight to make it harder for the governments of the day to avoid microeconomic reform. Was this not a credible threat or do you think they would have kept policy tight even if governments had engaged in reform? In other words, they never had any intention to provide more accommodation.
Since you raised it, why didn’t you take the NY Fed job? It probably needs some explaining for your non-academic readers.
20. June 2015 at 16:11
Egads. Is there anything worse than the effontry of central bankers, who tell voters and administrators in democracies to get their economic houses in order, because we plan monetary suffocation if you don’t. And they do have credibility—yes, I believe the Fed and the ECB (staffers nicely insulated from the real economy) enjoy applying the money noose around the economy’s neck.
Which brings up a problem that Kevin Eedman has been highlighting in his blogging and commentary. In the United States there is widespread criminalization of new housing in almost any place people want to live.
there is no national solution to this problem of locally mandated housing scarcity. In any good economy we will see housing inflation.
Of course, the Fed should target robust nominal economic growth. But if an IT is the best central bankers will allow, it should be a band and a couple percent higher than the current IT.
20. June 2015 at 17:47
What would be wrong with an independent monetary authority letting it be known that that it would do any amount of X (a vector of policy instruments) to keep to its politically mandated macroeconomic target even if that means that the composition of X will change if there are exogenous sub-optimal changes in fiscal policy (such as using a discount rate different from the borrowing rate for calculating the NPV of expenditures)? It seems that by threatening to miss their target if the fiscal authorities have sub optimal policies is treading on alien turf. True the ECB does this with Greece, but is it proper for the Fed to treat Congress that way?
20. June 2015 at 17:47
I am very glad you did not take the opportunity to become Fed-borged. A great mind is a terrible thing to waste.
20. June 2015 at 18:02
Rajat, I’m actually not sure why the BOJ had such a low inflation target. I certainly don’t think central banks should pressure the government, and I sort of doubt they do. After all, the Japanese government appoints the governors.
I probably should have taken the Fed job, if I cared about career advancement. But I preferred the academic life.
Ben, Yup, the Fed needs to focus on NGDP growth, let politicians handle fiscal policy.
Thomas, I agree.
Thanks Bonnie.
20. June 2015 at 19:07
Faith based economics, with untestable assumptions by Sumner about time inconsistencies. If Sumner’s theory does not work, you can blame ‘expectations’, a fudge factor. And his threats about pot smoking and college education are indeed, contrary to his assumption, quite credible to any responsible young person. Why Sumner has to impugn his daughter’s sense of responsibility is beyond me.
WordPress is not good with URL links, so Google these articles:
Simon Wren-Lewis Sunday, 11 January 2015 On the monetary offset argument (“But here there is a basic problem that MM has never to my knowledge answered. Just how much QE do you do to offset any fiscal contraction? We have no real idea, because we have so little experience”)
Monetary Offset in a World with Automatic Stabilizers by This is Ashok. January 4, 2014:
(“The empirical case for full monetary offset is stronger, but still wanting. Yes growth was a lot stronger than some Keynesian models suggested. That itself doesn’t mean anything, especially for anyone that (like me) believes in an at least approximate efficient market hypothesis. No model that can predict growth can exist. The question is whether growth today violates the Keynesian story. Perhaps a macroeconometrician will answer this better than I, but frankly the magnitudes don’t justify that explanation either”)
21. June 2015 at 04:42
Fed officials denying there is Monetary offset is even easier to imagine than Vox denying they are straight liberal rag. It’s part of their brand to deny it while they do it.
21. June 2015 at 05:09
I think the Fed’s denials of its own role in the economy, or at least to its full extent, is a smart play. Congress is elected by the voters, but the Fed’s officials and analysts are not. I don’t think the Fed wants to be pounding its chest “we run the economy despite what your elected officials do,” because this will cause Congress to start meddling with the Fed and monetary policy. I can think of only a few things worse than politicized monetary policy for an economy. Plus a declaration of that sort would fuel the crazies on both sides than bankers are unelected klepto/pluto-crats running the economy. It’s better if they stay in the shadows somewhat and downplay their role. It’s smart and very Straussian (Leo Strauss) in my opinion.
21. June 2015 at 05:09
Ray, If Ashok is saying the estimated multiplier is zero, but there’s a lot of uncertainty surrounding that multiplier, then I agree.
You said:
“Why Sumner has to impugn his daughter’s sense of responsibility is beyond me.”
Very clever, impugn my daughters sense of responsibility, while pretending it is I who am doing so.
Morgan, That’s right.
21. June 2015 at 06:45
@ssumner – you might want to do a post on Simon Wren-Lewis’ observation, which I repeat below. It’s the reason why nobody wants to adopt NGDPLT: nobody knows it will work, and the potential for mischief is great. It’s not enough to say ‘just try it’. Do you or your cohorts have a model other than mere words? One that can be run on a PC? Until you do so, I’m afraid nobody save like minded people will believe in your NGDPLT scheme. It’s like (as I said years ago) a version of the Townsend Plan (which ironically became later “Social Security”, but by chance, not be popular adoption)
Simon Wren-Lewis Sunday, 11 January 2015 On the monetary offset argument (“But here there is a basic problem that MM has never to my knowledge answered. Just how much QE do you do to offset any fiscal contraction? We have no real idea, because we have so little experience”)
21. June 2015 at 07:00
I mentioned this in the comments to an earlier post, but it probably is worth repeating it here. Here is Ben Bernanke himself: “If fiscal policymakers took more of the responsibility for promoting economic recovery and job creation, monetary policy could be less aggressive.” [http://www.brookings.edu/blogs/ben-bernanke/posts/2015/06/01-monetary-policy-and-inequality]
It’s a matter of framing. Fed officials deny that they deliberately offset fiscal policy, but they assert a preference for Congress to do more so that the Fed can do less. Of course, the bottom line is the same: the more fiscal stimulus, the less monetary stimulus, and vice-versa, i.e., offset. I have never heard a Fed official define their dual mandate to mean 2% inflation and full employment *before* accounting for fiscal policy, but actual inflation and employment could be quite different depending on actual fiscal policy.
21. June 2015 at 07:44
“statements by Fed officials regarding their intentions may not accurately describe the Fed’s actual future policy response”
That being the case, how can the Fed, or anybody, expect them to be credible?
21. June 2015 at 07:46
Ray, I’m not complicated in my MM analysis. A level target is crucial. That’s the magic baby.
The DG in 2103 was 16.77 trillion USD, if we publish we will have 4.5% for the next 10 years, 3.5% for the following 10 years, 2.5% for the following 10 years…
1. To make this work, we have to see the Fed LET GO of discretionary decision making, so this assumption we fiat in, you stipulate to it, and we move on to…
2. The entire private and public KNOW with god like (say like 98.5% in public opinion polls) certainty what USGDP will be September 2028.
Now Ray, as a tech guy, I look at that new Information Based Economic Reality let’s cal it (IBER) of knowing USGDP in future and I see how it integrates with digital contracts, and likely helps to stabilize Bitcoin blockchain, how it makes insurance, and capital markets more accurate in assessing risk. Think about labor wages contracts Ray.
The point is the BOOM PRODUCTIVITY GROWTH of epic crazy proportions to #2 really is awesome enough for us to look at #1 and say “sorry bubs, it’s worth it” to the Feds.
Now it’s possible to argue about “since we agree on level target” it follows “what should be the level target” – but that’s a different conversation Ray.
Let’s be level headed about this.
21. June 2015 at 08:27
Sumner wrote:
“Bullard seems to be warning Congress not to expect the Fed to bail them out if the send the economy into a recession with reckless fiscal austerity.”
A “true libertarian” is calling a decrease in government spending “reckless”, because it would temporarily reduce the production of goods such as weapons, bridges to nowhere, and temporarily reduce the production of particular “civilian” due to a removal of indirect income boosting brought about by a respending of funds spent by the government, and, finally, because it would temporarily reduce the number of hours worked by government workers, as well as those “civilian” workers who produce goods for those government workers and the number of hours worked by the same indirect means that brought about the goods that are produced with government spending.
This temporary reduction in the production of goods as such, with a subsequent reincrease in production of goods as such as capital and labor are reallocated over time to the production of goods in accordance with market forces rather than government forces, this, THIS is what this “true libertarian” is calling “reckless”.
Yeah, better to keep people employed another day making missiles any drones, and better to keep civilians producing “civilian” goods in a specific way on account of government intervention. That is less “reckless”, isn’t it.
21. June 2015 at 11:19
@MF: Do you really not bother to understand anything you comment on? Sumner is not himself calling fiscal austerity “reckless”. Nor does he believe austerity would send the economy into recession. (Nor, for that matter, does he think the Fed should be in the business of “bailing out” anybody.) Sumner has dozens of posts in support of fiscal austerity, and how monetary offset disconnects it from recession. Sumner is reporting on Bullard’s beliefs, not his own.
If you’re going to troll us, at least up your game and make it interesting. Try to respond to what is actually said, instead of just being irrelevant.
21. June 2015 at 12:22
Ray, Let’s see:
1. You keep telling me that no one supports my ideas, even as one big name after another endorses NGDP targeting, some quite recently. If that’s failure, then give me more.
2. You tell me I haven’t answered certain questions about NGDPLT, even though I’ve answered every question you are even capable of asking 100 times, if you read my old posts.
And what makes you think QE is my preferred solution to offsetting austerity? Or what makes Wren-Lewis think that? Forward guidance is more effective.
Yes, there’s lots of uncertainty about how much QE the Fed needs to do to hit its targets, but that’s equally true of whether there is austerity, or not. Japan did many years of fiscal stimulus and QE, and still had a hard time figuring out how much QE to do, and ended up doing the wrong amount.
BC, Good find.
Billikin, They are not completely credible. Fortunately they are semi-credible in at least a few dimensions, such as keeping inflation close to 2%.
21. June 2015 at 12:42
Sumner: The Fed “are not completely credible. Fortunately they are semi-credible in at least a few dimensions, such as keeping inflation close to 2%.”
They have demonstrated that they have a brake. And are willing to use it.
21. June 2015 at 12:47
Geddis:
Nowhere did Bullard say “reckless.”
Not even a paraphrasing makes a difference because then it would be a question of no additional inflation and cuts to government spending which Sumner has in more than dozens of posts said that this is capable of bringing about a recession.
But this is neither here nor there. For if the choice was between the government reducing spending and no additional inflation to “offset”, and government maintaining spending and no additional inflation, then he would call that not only reckless but all manner of pejoratives.
You have no clue what you are talking about. You’re missing the forest for the trees. If you’re going to troll me, at least have the arguments right.
21. June 2015 at 12:50
A “true libertarian” would also not pretend that Fed intervention is somehow less socialist than Treasury intervention. That fiscal austerity is somehow more capitalist than central bank austerity.
21. June 2015 at 18:03
Sumner: “Ray, Let’s see: … . You tell me I haven’t answered certain questions about NGDPLT, even though I’ve answered every question you are even capable of asking 100 times, if you read my old posts.”
Which old post Dr. Sumner shows a cause-and-effect relationship between what the Fed does and what the real (or even nominal) economy does? I am only aware of the below study*, and note the mere 60% confidence interval. I don’t expect an answer, as there is likely no such post. Indeed, if there was nobody would argue with MM. Nevertheless, thank you for your reply.
* Lawrence Christiano, Martin Eichenbaum, Charles Evan, “The Effects of Monetary Policy Shocks: Evidence from the Flow of Funds”, Review of Economics and Statistics, February 1996, 78-1, cited in Olivier Blanchard “Macroeconomics”, 2nd edition., p. 96, 5-6, ‘Does the IS-LM Model Actually Capture What Happens in the Economy?’ Shows that for data 1960 to 1990, that a 1% increase in Fed funds rate shows, over 4-8 quarters, a decrease in sales, decrease in output, decrease in employment, increase in unemployment rate up to 6 quarters (then a decrease after 8 to the original level). However, the “confidence band” is only 60% probability, not the usual 95% confidence interval.
21. June 2015 at 18:11
@MF: “cuts to government spending which Sumner has in more than dozens of posts said that this is capable of bringing about a recession.”
Liar. A dare you to locate a single such post.
21. June 2015 at 18:22
@Ray Lopez: “Which old post Dr. Sumner shows a cause-and-effect relationship between what the Fed does and what the real (or even nominal) economy does?”
There are hundreds of such posts, on all sorts of causal connections between changes in monetary policy, and nominal (and sometimes real) effects. Just off the top of my head, there is the consistent success of inflation targeting in the major economies over the last decades, and for that matter, Friedman’s thermostat. But since you’re just playing rhetorical games, rather than honestly trying to learn something, there’s no point in doing your homework for you.
21. June 2015 at 20:08
Fed officials know better. No one wants to go on record saying something that remotely may be perceived as “we’re undoing congress work”…
22. June 2015 at 00:22
@S.Sumner
“Japan did many years of fiscal stimulus and QE, and still had a hard time figuring out how much QE to do, and ended up doing the wrong amount.”
‘ While the Bank of Japan adopted the precise name of Prof Werner’s policy, it was somewhat less accurate when interpreting his actual proposal.
Incredibly, the Japanese version of QE that was eventually implemented was a policy Prof Werner had specifically ruled-out.
Prof’s argument was that, because more than 95% of the money supply in a modern economy is derived not from cash or reserves, but from private bank lending, it is essential to get banks to lend.
So he urged the Japanese government to enter into private long-term agreements to borrow from commercial banks, instead of issuing government debt.
The Bank of Japan’s version of QE, in contrast, involved creating money out of nothing at the central bank.
“That’s absolutely not what my policy was about,” says Prof Werner. “In my original article, I specifically argued against either lowering interest rates or expanding central bank reserves. That was my whole point – traditional solutions weren’t going to work. Actually, it was a bit upsetting.”
Then, in an additional twist, the Bank of England also later adopted Prof Werner’s QE label – but, again, to describe a policy with which he didn’t agree.
“It was one thing when the Bank of Japan did it, because that was over in Japan and was some time ago,” he says. “But once the Bank of England also started using the phrase, I thought ‘Hang on – I’ve got to speak up and make clear that the original definition is quite different.'”
The Bank of England’s interpretation of QE also involves the creation of central bank credits, as in Japan. But in the UK these have been used to buy government bonds from commercial banks rather than from the government directly.
Prof Werner says this is “a little better” than Japanese QE, as it “at least in theory increases commercial banks’ reserves”. He maintains, though, that the “best way to boost the economy is to increase bank credit”, and that can only be guaranteed by governments borrowing from banks directly.
“That creates new credit,” says Prof Werner. “The money supply then expands, transactions increase, there’s more demand, more employment, more tax revenues and suddenly you have a virtuous circle.”
In both Japan and the UK, QE isn’t working, he says, because it doesn’t focus on “the most important part of the money supply”, which is bank lending. “UK QE has singularly failed, as bank credit is still shrinking.” ‘
http://www.bbc.co.uk/news/business-24614016
“The US is currently enjoying similar fruits of this method: the economy has recovered, thanks to a recovery in bank credit creation.”
http://gdre2013.conference.univ-poitiers.fr/wp-content/uploads/sites/21/2014/05/Werner.pdf
22. June 2015 at 04:31
@Postkey
What if the banks don’t want to run more government risk, or market risk involved in holding government securities ? There’s also Dodd-Frank, Basle III and other local regulations. All of that led to banking system deleveraging …
22. June 2015 at 05:46
Ray, Google any of my posts discussing how markets respond to monetary surprises. If you want something more academic, read Friedman and Schwartz’s monetary history of the US.
BTW, I’m not impressed when you link to Christiano papers, as you clearly don’t know how to read them, they are way over your head.
Postkey, I’m opposed to government policies that encourage bank lending.
22. June 2015 at 06:03
@ssumner
I’m not opposed to policies that ‘work’!
22. June 2015 at 06:06
@ssumner
“Forward guidance is more effective.
Yes, there’s lots of uncertainty about how much QE the Fed needs to do to hit its targets, but that’s equally true of whether there is austerity, or not. Japan did many years of fiscal stimulus and QE, and still had a hard time figuring out how much QE to do, and ended up doing the wrong amount.”
Was ‘forward guidance part of Japan’s ‘policy mix’?
22. June 2015 at 06:20
@Jose Romeu Robazzi
“Banks have become risk-averse and are only willing to lend to the lowest risk borrowers. This is the government, able to command in theory even lower rates than the private sector prime rate. The Basel capital adequacy framework reflects this
reality. This is also true for periphery countries: banks’ solvency is ultimately guaranteed by governments, not the other way round. Thus lending to their governments, when undertaken as part of this proposal, will not hurt the banks. To the contrary, it will improve banks’s P&L and balance sheets, as well as the fiscal situation of the governments concerned, directly and indirectly, as economic growth will be boosted. ”
http://eprints.soton.ac.uk/339271/1/Werner_IRFA_QTC_2012.pdf
22. June 2015 at 09:06
@ssumner – “If you want something more academic, read Friedman and Schwartz’s monetary history of the US.” – ??? are you kidding me? Please, seriously, are you pulling my leg? You and Don Geddis are saying there’s ‘hundreds’ of cites showing the Fed can move the economy, but Geddis cannot cite one save “Friedman’s Thermometer” and you cite a paper from the early 1960s? While I cite the Christiano paper to show they used a 60% not a 95% confidence interval, and you don’t comment on this glaring fraudulent sleight of hand?
C’mon professor, you expect your readers to take you
seriously on MM when you cite as evidence to support MM Friedman et al’s revisionist account of the Great Depression, that arguably was due to structural factors (the US was transitioning from animal power to machine and electric power) as much as any monetary / magneto problems?
Please, I beg you, give us proles some meat to back up your claims. Where’s the beef, ssumner? Or does this post end up unanswered, in the Memory Hole? Sumner is like Big Brother, he knows best, you have to just trust him. Faith based economics as his critics assert.
22. June 2015 at 10:03
@Postkey
Yes, but banks have liquidity ratios too. They simply cannot leverage past a certain point, even if they have capital. Also, the industry lost a lot of human “capital”, and it is not that simple to rebuild entire banking teams.
It looks to me that Werner is proposing to releverage the entire industry under a different set of macro conditions. It seems far fetched too me, although in principle it seems possible.
23. June 2015 at 16:47
Postkey, They told the public not to expect any inflation.
Ray, I was wrong, there aren’t 100s of studies, there are 1000s. When I was young monetarism was one of the most popular dissertation topics. Zillions of money demand studies. They’re all still out there, collecting dust.
23. June 2015 at 23:37
Thanks.