No zero lower bound on words

The WSJ discussed a recent paper by Benjamin Friedman and Kenneth Kuttner, which supports two of the major themes of this blog:

New research on monetary policy is reinforcing the idea that when it comes to the Federal Reserve, watching what officials say is as much or maybe even more important than watching what they do.

A new paper published by the National Bureau of Economic Research, written by economists Benjamin Friedman and Kenneth Kuttner, sought to get to the heart of how monetary policy actually brings about changes in the economy. The economists note the world’s major central banks, most notably the Fed, can bring about changes in interest rates almost entirely by stating that they want a shift in the cost of borrowing.

This is one point I keep emphasizing, monetary policy is most effective when the central bank signals future policy intentions; movements in the fed funds rate only matter to the extent that they signal future policy intentions.  This means that when the central bank appears to be “doing nothing” it actually might be quite active.  The old Keynesian economics of the liquidity trap, which implicitly underlies all arguments for fiscal stimulus, is predicated on the assumption that a sort of singularity is reached when nominal rates hit zero.  They can’t be lowered, and political pressure makes increases unlikely during periods of high unemployment.  So (the argument goes) fiscal policy multipliers can be calculated under the assumption of “other things equal,” i.e. no monetary policy sterilization.  But that’s not how things work in the real world.  As soon as a massive fiscal stimulus is passed, and conservatives start worrying about inflation, then central banks start chattering about exit strategies.  This chatter is monetary tightening, just as surely as a rise in the fed funds rate.  We are always in the classical world, there is no Keynesian world.

“There is little if any observable relationship between the interest rates that most central banks are setting and the quantities of reserves that they are supplying,” the paper said. Studies of central banking action “consistently show no relationship between movements in policy interest rates and the supply of reserves” in the U.S., the euro zone and Japan, it added.

Instead, the change in rates across the yield curve, driven by a central bank shift in a very short-term rate few actually can access, is tied to what the institution has told financial markets.

“The announcement effect has displaced the liquidity effect as the fulcrum of monetary policy implementation,” the economists wrote. When it comes to the U.S. central bank, “on many occasions, moving the federal funds rate appears to have required no, or almost no, central bank transactions at all”-the market did the Fed’s work for it, the paper stated.

Woodford and Eggertsson are best known for the view that what really matters is not the current setting of policy instruments, but rather changes in the expected future stance of policy.  And in my own small way I reached that conclusion independently during my research on the Great Depression.  The Friedman and Kuttner paper provides support for the idea that Fed signals drive monetary policy much more than current changes in policy tools.  Of course eventually those policy levers must adjust, but that adjustment may occur over long periods of time.

The paper doesn’t assert that markets for bank reserves are steady, noting that “since 2000 the amount by which reserves have changed on days of policy-induced movements in the federal funds rate has become noticeably larger on average.”

But the trading is just noise: “In a significant fraction of cases-one-third to one-fourth of all movements in the target federal funds rate-the change in reserves has been in the wrong direction,” calling into question the central bank influence in the process.

The paper gives some hope to policy makers who believe that resolute talk about keeping inflation in check, along with preparation for future action, will keep prices contained in a time of historically high bank reserves.

It should be no surprise that reserves often move in the “wrong” direction.  Changes in overnight fed funds rates are not driving the economy, they are reflecting economic conditions.  Here is a simple example.  Suppose the economy booms and lots more transactions are occurring.  The boom will raise rates, and the level of reserves will also rise to reflect the higher level of transactions (assuming the Fed is inflation targeting.)  The whole process is driven by the Fed’s inflation targets; once those are set then the money supply and interest rates are both endogenous.  But there is a great danger in this kind of thinking:

Fed officials have argued managing market expectations is the key. If the Fed appears to remain a credible guardian of price stability, then inflation should remain in check. While that may seem like a rather ephemeral bulwark against an inflation surge, the paper says it’s this very notion of expectations and communications that drives policy in the best of times too.

Here’s real problem.  The Fed’s inflation targeting signals are far too vague.  Taken literally, sudden price stability would be a disaster.  If the Fed suddenly reduced inflation from the recent 2.5% norm to zero, then unemployment would rise sharply.  (Come to think of it, they just did that!)  Of course people will say; “By price stability the Fed implicitly means 2% inflation.”  Fine, but that requires a symmetric response to changes in inflation in either direction.  The WSJ writer clearly seems to think only excessively high inflation is a potential problem, not excessively low inflation.  And the Fed behaves as if they suffer from the exact same confusion as the WSJ writer.  The Fed is ever-vigilant against above normal inflation, but doesn’t seem vigilant against below normal inflation.  And that doesn’t even address the fact that their “dual mandate” implies they should actually be even extra vigilant against excessively low inflation.

Yes, Fed signals drive AD and NGDP.  But we need clear signals, signals that are consistent with the Fed’s policy goals.  And what are the Fed’s policy goals . . .

HT:  Tyler Cowen


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43 Responses to “No zero lower bound on words”

  1. Gravatar of Tim M. Tim M.
    28. July 2010 at 11:03

    As I’m sure you know, Arnold Kling recently asked Monetarists to pick one measure of money and show that movements in this variable have a consistent effect on inflation. Friedman and Kuttner’s paper seems to indicate Arnold is framing the entire debate completely wrong. It is expectations that matter.

    I am a big fan of Arnold’s work and sympathetic to his Recalculation story, but it seems as if he repeatedly ignores/misunderstands the role of expectations in the NGDP story.

  2. Gravatar of Benjamin Cole Benjamin Cole
    28. July 2010 at 11:24

    Well…do most people in the United States even know what is the Fed? Could they point out Ben Bernanke in a police line-up?

    Maybe senior people in policy and financial communities know about the Fed and money supply and expectations.

    But, I think I can assure you that even smart business guys, in homebuilding, cabinet-making, garments, etc. barely read newspapers. All they know is if they can get a laon, and is anyone buying their product.

    If the Fed is sending out signals, but 90 percent of the population is deaf, what does that mean?

    I have to say, real money down might be more influential.

  3. Gravatar of Nick Rowe Nick Rowe
    28. July 2010 at 11:39

    This is important confirmation of what we’ve been saying. Unfortunately only at the very short run level, applied to the interest rate target.

    I have heard people at the Bank of Canada say the same thing: “We announce the new target for the overnight rate, and it just goes there, without us doing anything”. Of course, it goes there in part because of people’s expectations about what the Bank would do if it didn’t go there. It’s the expectations about what actions would happen off the equilibrium path that keep us on the equilibrium path. But we never observe those off-equilibrium actions take place.

  4. Gravatar of Andy Harless Andy Harless
    28. July 2010 at 12:32

    If the Fed’s response is asymmetric, doesn’t that mean there is a role for fiscal policy? The Fed will respond to above-target inflation rates by tightening, either verbally or in actual policy actions. If inflation is below target, the Fed won’t respond unless the deviation from target becomes extreme. Doesn’t that mean that fiscal policy (conditional on the Fed’s likely inaction) will be effective in the range between the target inflation rate and the one that would prompt the Fed to loosen?

  5. Gravatar of jsalvati jsalvati
    28. July 2010 at 12:44

    @Tim M

    Indeed.

    Kling talks about Sumner and monetary economics a fair bit, but doesn’t quite seem to understand it.

  6. Gravatar of Matthew Yglesias » Recession-Response Has Worked Matthew Yglesias » Recession-Response Has Worked
    28. July 2010 at 14:16

    […] for progressives to get more engaged on all the other levers the government has””including just talking differently””to get output closer to its […]

  7. Gravatar of Morgan Warstler Morgan Warstler
    28. July 2010 at 14:38

    “Here is a simple example. Suppose the economy booms and lots more transactions are occurring. The boom will raise rates, and the level of reserves will also rise to reflect the higher level of transactions (assuming the Fed is inflation targeting.)”

    And once again you admit that all we need to do is decide to SELL MILLIONS OF FORECLOSED HOMES and we can raise interest rates.

    Jesus, why do you skip over the most obvious method of causing economic activity? We have 18M empty homes. 25% of mortgages are underwater.

    If we knew starting Aug. 1st, 4M homes would get sold in 90 days in $1 starting bid auctions, we could raise interest rates TODAY.

    I think the problem is you CAN’T STAND that the solution is micro, not macro. I think it annoys you that this might be solved simply by accepting that home prices are too high.

    We have a direct way of causing people with money to WANT to spend, and yet somehow you keep trying to figure out some roundabout way of making them spend (inflation).

  8. Gravatar of david david
    28. July 2010 at 15:10

    @Morgan Warstler

    Crying “liquidate the $_X!” has generally had a poor historical record.

  9. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    28. July 2010 at 15:36

    “If the Fed’s response is asymmetric, doesn’t that mean there is a role for fiscal policy? The Fed will respond to above-target inflation rates by tightening, either verbally or in actual policy actions. If inflation is below target, the Fed won’t respond unless the deviation from target becomes extreme. Doesn’t that mean that fiscal policy (conditional on the Fed’s likely inaction) will be effective in the range between the target inflation rate and the one that would prompt the Fed to loosen?”

    In my view of the Chicago Plan of 1933, that’s the point of a Reinforcing Stimulus.

  10. Gravatar of Morgan Warstler Morgan Warstler
    28. July 2010 at 18:06

    “Crying “liquidate the $_X!” has generally had a poor historical record.”

    Cites? Be VERY specific.

    We have a single vertical where the debt to asset value ratio has gone way off historical trend. Our equity is historically 40% of total home value. Make sure your example covers this specific scenario.

    Without a specific cite, please retract your macro scare story – I’m not screaming about hyper-inflation, I’m bringing micro to bare on something that deserve micro thinking.

    We face virtually no long term, spiral deflation from taking the FORECLOSED houses and selling them fast and furious. What it does is transfer the distressed assets from the insolvent banks (zombies who deserve and need to die) onto the balance sheets of the guys with dry powder…

    Making them FAR more positive about their own situation. Scott’s formula is to scare them (and everyone else).

    As Scott has pointed out, it will not effect overall price levels. Home prices are $4T too high against trend, so we KNOW EXACTLY when to end the auction process.

    Remember $4T in home price deflation, means lower rents, more renters, and therefore MORE spendable income on the rest of the economy…. the real goods and services that deflation matters about.

  11. Gravatar of ssumner ssumner
    28. July 2010 at 18:13

    Tim, I’m not a monetarist, but I believe they complain that the Fed isn’t measuring the right aggregate. They favor a divisia aggregate. But it is not my area of expertise, so I’ll let others comment.

    Benjamin, The markets play a huge amount of attention to the Fed, and the average guy plays attention to the markets. It is usually hard to see this happen because the Fed usually moves incrementally. But when they move aggressively, the effects are powerful.

    Nick, I haven’t read the article, but I thought the WSJ implied something more:

    “Instead, the change in rates across the yield curve, driven by a central bank shift in a very short-term rate few actually can access, is tied to what the institution has told financial markets.”

    The yield curve changes according to expectations of future rate changes. Sometimes short and long rates go in the same direction, sometimes not. It depends partly on what the Fed communicates, which is now often watched even more closely than the actual interest rate setting.

    You said;

    “I have heard people at the Bank of Canada say the same thing: “We announce the new target for the overnight rate, and it just goes there, without us doing anything”. Of course, it goes there in part because of people’s expectations about what the Bank would do if it didn’t go there. It’s the expectations about what actions would happen off the equilibrium path that keep us on the equilibrium path. But we never observe those off-equilibrium actions take place.”

    Just thinking out loud, in the US (during normal times) banks don’t want to hold much excess reserves. Almost all demand for base money is curency and required reserves. But you wouldn’t expect either currency demand or the demand for bank deposits to change immediately when the fed funds rate changes. So I’m not surprised the fed funds rate can move without much immediate change in the base. The Fed operates in such a way that the base seems endogenous, even though it is changes in the base that cause all the other changes we associate with monetary policy.

    Andy, That’s a good point, and ironically I did a post on that a few weeks ago. My argument then was that we entered a classical world when inflation hit its lowest acceptable level, say 0%. At that point the Fed would take extraordinary steps to prevent deflation. The fiscal multiplier would fall to zero (for polices of austerity.)

    I worded this post poorly. The “we are always in the classical world” referred to that set of assumptions. There are others where fiscal stimulus can work. As far as the actual fiscal stimulus in the US, I have an open mind. It might have boost NGDP, or it might be that the Fed would have done something aggressive in early 2009 if stimulus had not passed. I really can’t say. It would be more accurate to say that (in my view) we are always in the classical world if we have sensible monetary policy. As you know, I don’t worry about policy overshooting in a world where we observe TIPS spreads in real time.

    Jsalvati, I don’t think Kling’s request was aimed at me. I think he knows I don’t look at monetary aggregates. But perhaps I am wrong. If so, I ought to respond somehow.

    Morgan, I’m wondering how many times you are going to ask me to liquidiate housing. It’s not my job!

    David. Agreed.

    Don the libertarian Democrat, But if the Fed would agree to assist fiscal policy, why won’t they agree to do the needed stimulus on their own? You might be right, but it seems wasteful to me. Earlier Andy Harless argued that the effects of fiscal stimulus might be more predictable than monetary. But isn’t the Chicago plan essentially monetizing the debt? That would have extremely unpredictable effects on inflation. They would probably be powerful, but might be too powerful. So I’d think the Fed would be even less willing to do that, than to do what I ask for. But perhaps my memory is off regarding the Chicago plan.

  12. Gravatar of Morgan Warstler Morgan Warstler
    28. July 2010 at 19:00

    Scott, it is your destiny. It’s your mission. You are the NGDP guy, a MACRO guy who claims to be market oriented, if you suddenly switch tracks and scream:

    “F&F MBS doesn’t deserve tacit support from Fed!”
    “Mark to market!”
    “Upside to the dry powder guys, let’s motivate them with bigger balance sheets!”

    But mainly… if you scream:

    “Since, we can always target NGDP, let’s FIRST lose $4T in fake home value, get back to where we own 40% of our homes, and clear out the insolvent banks!”

    This is the key thing, you want to improve the economy… me too. I just want to do it AFTER the banks aren’t sitting on reserves and tons of foreclosed homes – while they wait for “Sumner to ride to their rescue.”

    You aren’t the calvary unless you ride in to save the right side. We are not all in this together. If suddenly the economy grows a bit, so the bad banks stay afloat, but we have only 25% of the equity in our homes, and we’re servicing higher mortgages – for years and years, you are the devil. The. Devil.

    I’ve shown you that the Fed knows people will KEEP paying off their homes until they are 62% underwater, but will mail the keys if interest rates go up… So the Fed will NOT raise interest rates, we’ll sit on ZERO for a long long time, while you cheer for 4% inflation.

    It’s ugly, and since your theory WILL DEFINITELY WORK, the moral issue is why not first liquidate homes, lower rents, get our equity up, and THEN you can be the calvary.

    Micro before the macro if you will.

  13. Gravatar of Fed Up Fed Up
    28. July 2010 at 20:08

    scott sumner said: “Yes, Fed signals drive AD and NGDP.”

    I believe you need to go thru the assumptions and steps for this.

  14. Gravatar of Fed Up Fed Up
    28. July 2010 at 20:15

    scott sumner said: “The old Keynesian economics of the liquidity trap, which implicitly underlies all arguments for fiscal stimulus, is predicated on the assumption that a sort of singularity is reached when nominal rates hit zero.”

    What is your definition of a liquidity trap?

  15. Gravatar of Joe Joe
    28. July 2010 at 21:08

    Professor Sumner,

    Two quick questions.

    Some call a liquidity trap by saying its just “rates are so low you can’d push them further,” others, like in Mishkin’s textbook, say that its due to some sort of “hypersensitivity” to interest rates?

    Like ‘Fed up’ asks, could you please state once and for all the eternal, timeless formal definition of the liquidity/expectation trap, and what it is? Unless of course there are variations on what it is, in which case its interesting to see the different verities. Perhaps even a whole post on it just to state explicitly what the debates and theories on it are as is (I know, of course this has been done forever, but would be useful in general)

    Second.

    In light of this new paradigm for a new macro based on “rational expectations (whose importance I finally see), what I am supposed to make of everything I learned in the Mishkin textbook?

    For example, the IS-LM curve. This is the most purely technical model which says if you do X, Y happens. No expectations. Have your beliefs now made the IS-LM curve meaningless(or changed just one part of)? Perhaps course on IS-LM need to now included the problems of expectations in each little change

    What about the price level, income, and expectations effects from changing the money supply that I learned. Are those still true?

    The fisher effect, still works? (I think it does)

    Milton Friedman’s statement, “Inflation is everywhere and always a monetary phenomenon”, since exceptions is the central point now, is even basic monetarism (money supply causes prices to go up) true?

    What about Fisher’s Keyne’s, and Friedman’s views on the demand for money, are they to be replaced with something new with reference to rational expectations?

    Finally, what about the basic basic fact one learns about the fed, “In a recession they print money to lower interests rates,” is this even true?

    And then what about the transmission process? Does lowering interest rates spur the economy? Or does increasing reserves allow for more spending and investing and allow for money multiplier to grow more wealth? If its all about expectations then this needs to be rewritten? No?

    Perhaps it is time for you to write some sort of epic treatise on YOUR fundamental views of monetary economics. Put all of your ideas, everything you’ve discussed, and bring it to the world. After the great Depression book happens of course. We will support you and help you to analyze your questions better (to the best of my non-PHD ability of course). If you’re right, which I know you are, go out there and write your epic treatises and speak with other academics.

    Why not bring your unique idea to famous right wingers like Barro and Mankiw, both of whom are local. What about Taylor. Though far away. All three are influential right wingers who might listen to you and spread your ideas. I truly believe you have powerful ideas to add to the Great Depression, monetary theory, the truly cause of the crash, and even defending neoliberal-ism.

    Don’t be afraid to make your mark in this work. Fortune favors the bold.

    Thank you for this great post,

    I wish all the best

  16. Gravatar of malavel malavel
    28. July 2010 at 21:17

    Off topic. I’ve been thinking about deflation, and there seems to be a problem with the phrasing: “Deflation is bad.”

    But is deflation really a problem? Isn’t the real problem ‘deflationary pressure’ without deflation? If prices weren’t sticky, we would have seen a big fall in prices (and salaries) but no fall in real output. But since we have sticky prices we don’t get deflation, just very low inflation.

    Am I making any sense?

  17. Gravatar of Luis H Arroyo Luis H Arroyo
    29. July 2010 at 04:21

    I have a problem. The problem is the bag of cash (option of doing nothing) that is right now sterilized in banking & corporate. On one hand this means something about the expectations; on the other, is an impediment to the Fed to act freely: if it need to give a message to boost the economy, this stock could fall too quickly in the markets … I do not know how the Fed can manage that.

  18. Gravatar of Alejandro Alejandro
    29. July 2010 at 05:14

    “The economists note the world’s major central banks, most notably the Fed, can bring about changes in interest rates almost entirely by stating that they want a shift in the cost of borrowing.”

    They are called “open mouth operations”

    profile.nus.edu.sg/fass/ecsjkdw/OpenMouth.pdf

  19. Gravatar of scott sumner scott sumner
    29. July 2010 at 05:54

    Morgan, No, it’s your destiny.

    Fed Up. Signals drive future expected monetary policy. Future expected monetary policy drives future NGDP. Changes in future expected NGDP (aka “confidence”) drive current AD.

    Fed up and Joe, There are different definitions of liquidity traps:

    1. Zero short term rates

    2. Long term rates that can’t be lowered further by monetary stimulus

    3. Conventional monetary policy (open market operations in T-bills) is ineffective.

    4. The same, except the OMOs must be temporary.

    5. All monetary policy is ineffective.

    I have seen each of the five definitions used, at one time or another.

    Joe, In upper level course they add rational expectations to IS-LM. But I never use the model, so I’m not the one to ask.

    The Fisher effect still works.

    Friedman said PERSISTENT inflation is always and everywhere a monetary phenomenon. I think that is still approximately true.

    No, lowering interest rates does not spur the economy. Just as higher oil prices don’t cause people to drive less. Never reason from a price change. Lower interest rates may reflect a weak economy. If lower rates are caused by more supply of money, then the extra supply of money will boost the economy, if they are caused by less demand for credit, then they don’t spur the economy.

    You said;

    “Why not bring your unique idea to famous right wingers like Barro and Mankiw, both of whom are local.”

    Interestingly, I did meet with each of those economists in late 2008, when I started my crusade for easy money.

    I suppose this blog (if read from the beginning) is my book.

    🙂

    malavel, You are partly right. The problem is that the equilibrium price level falls, but actual wages and prices fall by a smaller amount. Both of those things must happen before you have a problem. Since sticky wages and prices are a given, falling inflation is the proximate cause of our woes.

    Luis, The Fed needs to set a price level or NGDP target, Then changes in reserve demand and supply will not have a sudden disruptive effect on prices.

    Alejandro, That’s a good one.

  20. Gravatar of Morgan Warstler Morgan Warstler
    29. July 2010 at 06:22

    Scott I really wish you had the balls to deal with the moral priority argument I’m making.

    Since your plan will work, why not first make right, then do your plan?

    Mine is the utilitarian argument. Mine bakes justice into garden BEFORE you grow it…. to win the argument against me, you have to argue targeting NGDP won’t work IF we do my plan first.

  21. Gravatar of Jeff Jeff
    29. July 2010 at 06:26

    @Andy,

    You’re assuming facts not in evidence, i.e., that fiscal policy is effective if the Fed doesn’t counter it. Where is the empirical evidence of that?

  22. Gravatar of jj jj
    29. July 2010 at 07:06

    Morgan, are you arguing that the government needs to step in and make micro decisions whenever there’s a crisis? Isn’t it preferable that the fed just ensure NGDP grows on a path, and let the market deal with the rest?

    I see your proposal having moral priority only if it is for the govt to step in and correct its own past wrongs (various laws, regulations, agencies and bailouts). But I’m sorry to say I didn’t follow you clearly enough to recognize if that’s what you’re saying.

  23. Gravatar of JimP JimP
    29. July 2010 at 08:31

    http://blogs.wsj.com/economics/2010/07/29/feds-bullard-raises-policy-concerns/

  24. Gravatar of David Pearson David Pearson
    29. July 2010 at 08:45

    The Bullard piece seems quite Sumnerian. It is interesting from a Fed political perspective as it offers a a way out of the impasse between Fed hawks and doves: aggressive QE now, raise rates faster later. The hawks get rid of extended period language, the doves get more aggressive policy. From an organizational perspective, it sounds like a viable path forward, especially if one assumes the recovery has stalled.

  25. Gravatar of JimP JimP
    29. July 2010 at 08:53

    David

    Yes indeed. There is clearly a debate in the Fed right now – and that is a good thing.

    To quote from the WSJ:

    begin quote:
    One problem, he claimed, is that central banks remain “completely committed to interest rate adjustment as the main tool of monetary policy, even long after it ceases to make sense.”

    Instead, Bullard argued, the “appropriate tool” for tackling inflation expectations at such times is to expand “quantitative easing,” a policy of buying longer-dated monetary debt. The U.S. and the U.K. both applied variations of this policy amid the recent financial crisis and Japan has tried to do the same at different times.

    He said higher inflation data in the U.K. suggests that the Bank of England’s program has been somewhat more effective than the Fed’s at encouraging inflation expectations, while Japan’s efforts have failed because they lack long-term credibility.

    In his conference call, Bullard said he didn’t necessarily believe that the Fed should reopen the security purchases program that it concluded in March, but that it should explicitly state its willingness to do so if more extreme deflationary threats arise in the future.

    “This is a matter of being ready in case something else hits,” he said in that call. “What if there’s a terrorist attack? What if there is some kind of trouble in the Asian recovery, or something like that?

    In his paper, Bullard said that any policy regime shift intended to avoid a deflation trap needs to be “sharp and credible-policy makers have to commit to the new policy and the private sector has to believe the policy maker.”
    end quote

    Note the words “commit” and “sharp and credible” and “has to believe”.

    Lets hope Ben agrees with this.

  26. Gravatar of JimP JimP
    29. July 2010 at 08:58

    Though, of course, one would rather they did not wait for another crisis, but would rather act on the employment, or net GDP crisis that we are in right now.

  27. Gravatar of JimP JimP
    29. July 2010 at 08:59

    net = nominal

  28. Gravatar of David Pearson David Pearson
    29. July 2010 at 09:02

    JimP,

    The paper itself has a clear message for the hawks: “the sooner we dislodge the economy from its low-rate equilibrium with QE, the faster we reach the higher-rate equilibrium.” This is likely an attractive alternative for the hawks, some of whom (Hoening, Fisher) complain loudly about the distortions caused by ZIRP.

  29. Gravatar of JimP JimP
    29. July 2010 at 09:09

    David

    Yes. its kind of like the previously offered Sumner deal. Looser money in return for less fisk. A recognition that both sides have something to say in these debates.

    I really do wish the various tv commentators had a better understanding about these things. It is not just a pointless and depressing “left v right” debate. Everyone (except the real and actual economic moralists – the real deflationists)wants things to recover and get away from the bad equilibrium and onto the path of optimism and growth.

  30. Gravatar of JimP JimP
    29. July 2010 at 09:28

    The debate gets hotter. According to CNBC Fisher has just said “the fed will never monetize the debt.” (or some such – I did not see him say this). We are off and running. Fisher flashes his teeth. But Ben may have three new votes at the next Fed meeting. Lets hope so.

  31. Gravatar of Morgan Warstler Morgan Warstler
    29. July 2010 at 10:52

    jj, no.

    My approach is:

    1. Mark to market. Instantly the the really shitty banks go insolvent, so the inventory is out there. Spigots on houses open up.

    2. Fed tells Fannie and Freddie – we won’t buy MBS ever again, unless you liquidate / auction all foreclosed properties on calendar schedule. Highest bid at 30, 60, 90 days gets it kind of thing. Without any new funding Fannie and Freddie begin to shrink…. quickly.

    3. Fed raises interest rates. Home owners recognize home prices aren’t going up, but their payments are, and decide once and for all if they want to keep their house.

    4. Fed instructs banks that they are not allowed to buy assets directly. Banks are encouraged to require 30%+ down.

    5. This basic policy continues until we own 40% of the equity in our homes. The long term trend is re-established. Home prices have floated back to normal.

  32. Gravatar of Fed Up Fed Up
    29. July 2010 at 11:46

    JimP said: “The debate gets hotter. According to CNBC Fisher has just said “the fed will never monetize the debt.” (or some such – I did not see him say this). We are off and running. Fisher flashes his teeth. But Ben may have three new votes at the next Fed meeting. Lets hope so.”

    If you mean fisher from the dallas fed, he is an idiot beyond belief imo. Wasn’t he going on and on about a wage-price spiral right before the financial crisis hit?

  33. Gravatar of Fed Up Fed Up
    29. July 2010 at 11:56

    scott sumner said: “Fed Up. Signals drive future expected monetary policy. Future expected monetary policy drives future NGDP. Changes in future expected NGDP (aka “confidence”) drive current AD.”

    IMO, that is too much reliance on expectations (future) and not any focus on the realities of the present.

    Can you give me an answer based on the budgets (you would probably call it the balance sheets) of the major economic entities and based on the medium of exchange used?

    You might want to consider the following question related to the above: Is all NEW (emphasizing new) “money” debt?

    I might need your definition of monetary policy too.

  34. Gravatar of Fed Up Fed Up
    29. July 2010 at 12:04

    scott sumner said: “Fed up and Joe, There are different definitions of liquidity traps:

    1. Zero short term rates

    2. Long term rates that can’t be lowered further by monetary stimulus

    3. Conventional monetary policy (open market operations in T-bills) is ineffective.

    4. The same, except the OMOs must be temporary.

    5. All monetary policy is ineffective.

    I have seen each of the five definitions used, at one time or another.”

    Is it possible that one common element of all those is that an economy has gone from supply constrained to demand constrained, contrary to what almost all economists say (aggregate demand is basically unlimited and therefore an economy is basically almost always supply constrained)?

  35. Gravatar of Fed Up Fed Up
    29. July 2010 at 12:10

    scott sumner said: “Joe, In upper level course they add rational expectations to IS-LM. But I never use the model, so I’m not the one to ask.”

    For scott, Joe, and anyone else, what does it mean if an IS-LM curve has a negative interest rate?

  36. Gravatar of Fed Up Fed Up
    29. July 2010 at 12:17

    scott sumner said: “Here is a simple example. Suppose the economy booms and lots more transactions are occurring. The boom will raise rates, and the level of reserves will also rise to reflect the higher level of transactions (assuming the Fed is inflation targeting.)”

    Can someone expand on the level of reserves will also rise part? Thanks!

  37. Gravatar of scott sumner scott sumner
    30. July 2010 at 05:10

    Morgan, I could never win an argument with you.

    JimP, Thanks, I’m way behind in comments–already have a new post.

    David, Yes, I probably shouldn’t have been so critical in my new post.

    JimP, You quoted the WSJ:

    Instead, Bullard argued, the “appropriate tool” for tackling inflation expectations at such times is to expand “quantitative easing,” a policy of buying longer-dated monetary debt. The U.S. and the U.K. both applied variations of this policy amid the recent financial crisis and Japan has tried to do the same at different times.

    Yes, but the even more appropriate tool for low inflation expectations is a higher inflation target, which they won’t do.

    David, You said

    “The paper itself has a clear message for the hawks: “the sooner we dislodge the economy from its low-rate equilibrium with QE, the faster we reach the higher-rate equilibrium.” This is likely an attractive alternative for the hawks, some of whom (Hoening, Fisher) complain loudly about the distortions caused by ZIRP.”

    Excellent observation–see the end of my newest post.

    Fed Up, Was Fisher the one who wanted to raise rates in August 2008?

    I’ve devoted much of my blog (1000 pages?) to why current changes in Fed instruments are much less important than future expected changes. Contrast a doubling of the money supply expected to be permanent, with a doubling expected to be pulled back out a month later. Which has a big effect?

    I don’t know what you mean by “demand constrained” Do you mean the Fed can’t increase NGDP?

    In the last question, the Fed must increase reserves to accommodate the increased level of transactions, assuming it is inflation targeting.

  38. Gravatar of Fed Up Fed Up
    30. July 2010 at 08:47

    “Fed Up, Was Fisher the one who wanted to raise rates in August 2008?”

    Yes and from:

    http://www.nytimes.com/2008/08/01/business/economy/01fed.html

    Published: August 1, 2008

    “The policy makers assume that rational human beings, faced with higher prices, eventually demand and get higher pay, despite their apparent lack of leverage. They have built that assumption into their economic models, but they differ sharply on how quickly the wage pressure could resurface, an issue they will once again debate at their next meeting, on Tuesday.

    “The power to bargain for higher wages, a power that we assume was dismantled, may not be so feeble,” said Richard W. Fisher, president of the Federal Reserve Bank of Dallas, who is the most certain of all that a wage-price spiral is imminent.

    If the Fed anticipates a reawakening, organized labor itself certainly does not.

    “Real wages, adjusted for inflation, are falling, and there is no sign at all of any change in direction,” said Ronald Blackwell, chief economist for the A.F.L.-C.I.O., offering a view shared by Nigel Gault, chief domestic economist for Global Insight, a Wall Street firm, who argues that if prices go up, people will expect not a raise, but “their standard of living to go down.””

    There is the real reason for free trade.

    And, “Mr. Fisher, who has voted at past meetings to raise rates, sometimes casting a lone vote, argued in an interview that wages are rising for others around the world, particularly in Asia, and “American workers will react” by demanding higher pay for themselves.

    “I am concerned,” he said, “that at some point they will have to be accommodated because they can’t afford the rising costs of gasoline, food, utilities” and other everyday expenses.”

    No, that is what low interest rate debt is for, to make up for negative real earnings growth.

    How about working people in the USA come up with a visa program to import economists to replace the ones at the fed with 50% lower salaries? Maybe fisher will get the message?

  39. Gravatar of malavel malavel
    30. July 2010 at 10:15

    Scott,

    It still feels wrong to say that deflation/disinflation is the proximate cause. It’s like blaming the symptoms instead of the real cause. But perhaps that’s just nitpicking.

    However, what if people start thinking that mandatory wage raises and price floors would be a good thing? All this talk about deflation being a bad thing might miss fire.

  40. Gravatar of ssumner ssumner
    31. July 2010 at 07:48

    Fed Up, Thanks for the info. I have a newer post of Fisher.

    malavel, The root cause in lower NGDP. Deflation is an indicator of weak demand.

  41. Gravatar of malavel malavel
    31. July 2010 at 12:25

    Scott, we agree on the details. It’s just the semantics that I’m a bit ‘annoyed’ at.

  42. Gravatar of scott sumner scott sumner
    1. August 2010 at 06:32

    malavel, You might find the discussion in the causality post of interest, it’s a few posts more recent.

  43. Gravatar of TVHE » Links for today TVHE » Links for today
    1. August 2010 at 12:04

    […] In praise of clear targets for monetary policy:  Money Illusion. […]

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