Obama should have picked Woodford, not Yellen

Here’s a very important comment by Michael Woodford:

This proposal is different from that made in some quarters (and rejected by Fed officials) for an increase in the Fed’s inflation target. In order to obtain the benefits just cited, it is not necessary to make people expect a continuing high rate of inflation. Indeed, that would be counterproductive. To the extent that expectations of a permanently higher inflation rate would create uncertainty about the value of the dollar, for instance, they could easily make long-run real bond yields higher, rather than lower.

Instead, as suggested in a recent speech by William Dudley of the Federal Reserve Bank of New York, the Fed should commit to make up for current “inflation shortfalls” due to its inability to cut interest rates. If, for example, inflation was predicted to run half a percentage point below the Fed’s target for the next two years, the Fed could announce plans to offset this by allowing an additional one per cent rise in prices after that. Once the shortfall has been made up, the Fed would return to its previous, lower target.

Critics will say this will undermine the Fed’s credibility on price stability. They are wrong because the price increases allowed under this “catch-up” policy would be limited in advance. Catch-up inflation would simply put prices back on the path they would have followed had the Fed been able to cut interest rates earlier.

Others argue the opposite case: that a modest increase in prices would have too small an effect to boost the recovery. But the true value of such a commitment would be precluding a disinflationary spiral, in which expectations of disinflation without any possibility of offsetting interest-rate cuts lead to further economic contraction and hence to further declines in inflation. A commitment subsequently to offset any inflation deficit would allow higher future inflation to be anticipated in step with the size of the current inflation shortfall. This in turn would automatically limit the degree of disinflation that can occur.

The instinct of policymakers such as Mr Bernanke is to say less about future policy during a time of economic turmoil, on the grounds that the future seems especially difficult to predict at such times. Yet it is precisely when policymakers face unprecedented conditions that it is most difficult to assume that the public will be able to form correct expectations without explicit guidance. At times like the present, uncertainty about the future is one of the greatest impediments to faster recovery.  (Emphasis added.)

And what is true of “times like the present” was even more true of September/October 2008, when the Fed allowed enormous uncertainty to develop about the future path of prices and NGDP.  If they had followed level targeting at that time then the recession would have been far milder.

At the other extreme is Janet Yellen.  Last year I argued that she wasn’t qualified to serve on the FOMC.  Nevertheless, I would have voted to confirm her and the other two, who I also think are unqualified (despite one just getting a Nobel Prize) because I think we need more voices for monetary stimulus.  Now it’s not clear we got even that:

LONDON (AP) — World markets fell Tuesday after a leading U.S. rate-setter dampened expectations that the Federal Reserve is preparing a massive monetary stimulus next month and amid mounting speculation that China is planning to raised reserve requirements for banks to cool lending.

.   .   .

Comments from Janet Yellen, the vice chairman of the Fed, Monday reined in the most exuberant hopes in the markets.

In remarks to economists in Denver, Yellen warned that excessively easy monetary policy, involving ultra-low interest rates and an expansion in the Fed’s balance sheet, could create big problems down the line.

“It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage and excessive risk-taking,” Yellen said.

.   .   .

Yellen’s comments helped ease the pressure on the dollar — by mid-morning London time, the euro was down 0.4 percent at $1.3814 while the dollar was 0.2 percent lower at 81.93 yen.

Obama just can’t catch a break right now.  My commenter Benjamin Cole suggested that she might have been simply trying to establish credibility.  Yes, but the market reaction speaks for itself.  The stock market follows a random walk, meaning any changes are expected to be permanent.  (Yes, I know this isn’t precisely true, but it’s roughly true.) 

Instead of Yellen and Peter Diamond, Obama should have picked Woodford and Svensson.  Surely we could have stolen Svensson away from the Riksbank?

PS.  It’s entirely possible that in the entire world there are fewer people qualified to serve on the FOMC than there are seats.  (And no, I don’t see myself as being qualified.  The job requires knowledge in many different areas.)

HT,  Marcus Nunes,  JimP, David Glasner


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24 Responses to “Obama should have picked Woodford, not Yellen”

  1. Gravatar of Morgan Warstler Morgan Warstler
    12. October 2010 at 06:12

    Scott is appears Woodford is saying inflation goes above 2%, say 3.5% for two years, the Fed should just try to get it back down to 2% – NOT recover back to 2% on trend.

    Which immediately ruins any benefit of targeting…. the GUARANTEE that your money will be deflated 2% a year and not a drop more.

    Sounds like another vote for Cochrane’s method.

  2. Gravatar of marcus nunes marcus nunes
    12. October 2010 at 06:13

    “Controversies” abound.Even if you don´t consider the Fed “screwballs” – Hoenig and Co. – You get:
    1. Jim Hamilton: Prospective QE2 has already done all it could (priced in)
    2. Woodford: Clearly communicate your target price level and things will move.
    3. J. Yellen: Is trying to “change clothes” in mid air afraid of the “tinder” effect of continually low rates.
    4. Allan Meltzer: I´m not going to buy his book(s) on the History of the Federal Reserve because it seem he has learned nothing from it. So it cannot be good!

  3. Gravatar of Ram Ram
    12. October 2010 at 06:16

    Even if the U.S. does not adopt a futures targeting regime as you have proposed, perhaps it could appoint FOMC members (among other bureaucrats) using prediction markets a la Robin Hanson. Any citizen would be free to campaign for a seat, but they would be campaigning to traders rather than voters. Each candidate would have a separate prediction market in which traders bet on who is most likely to meet the Fed’s dual mandate if appointed. The candidate whose contract is priced highest over some stable period gets automatically appointed.

    While Joe the plumber, or Ron Paul, may campaign for a seat on the FOMC in such a system, so too would the Michael Woodfords, Lars Svenssons, and Ben Bernankes of the world. And if you’re right, traders would elect these folks, rather than the Janet Yellens of the world. And they would be held accountable, as anyone could propose to impeach them at any given time, so prediction markets would decide their fate on a nearly continuous basis.

  4. Gravatar of ssumner ssumner
    12. October 2010 at 07:24

    Morgan, He’s is favoring level targeting, which produces the most predictable inflation rate over the long run–2%. Right now we have no idea what the price level will be in 10 years. With Woodford, we know it’d be 20% higher (plus compounding.)

    marcus;

    1. Unless the Fed does more QE than the market current expects.

    4. If only Milton Friedman were still alive, and saying ultra-low interest rates are a sign that money has been tight.

    Ram, That’s a very clever idea, but is it really any more politically feasible than my idea? (Perhaps you were kidding, I can never tell with commenters.)

  5. Gravatar of Morgan Warstler Morgan Warstler
    12. October 2010 at 07:58

    Scott I think you assume too much…

    “Fed should commit to make up for current “inflation shortfalls” due to its inability to cut interest rates. If, for example, inflation was predicted to run half a percentage point below the Fed’s target for the next two years, the Fed could announce plans to offset this by allowing an additional one per cent rise in prices after that. Once the shortfall has been made up, the Fed would return to its previous, lower target.

    Critics will say this will undermine the Fed’s credibility on price stability. They are wrong because the price increases allowed under this “catch-up” policy would be limited in advance. Catch-up inflation would simply put prices back on the path they would have followed had the Fed been able to cut interest rates earlier.”

    If he really wanted to answer critics of Fedcred, he’d have said, “they will be PLEASED because when the rate goes to 2.5%, that means the Fed is now targeting 1.5%.”

    He SKIPPED the opportunity to make the stronger argument. You think that is assumed? or an oversight?

    I don’t see how, critics of Fedcred don’t live in the now – we live in the yesterday… we’re solely concerned about keeping inflation from going above 2%.

  6. Gravatar of Ram Ram
    12. October 2010 at 08:02

    I was kidding to the extent that I suggested my proposal was more politically feasible than yours, but I really do believe that, in a more rational world, we would adopt a procedure like the one I have described for appointing our government’s upper management. We would also adopt a similar procedure for lawmaking, with two prediction markets revealing traders’ expectations of social welfare under proposed legislation versus the status quo. As I mentioned in my previous comment, I have no claim to the originality of these proposals–if anyone does, it is probably Robin Hanson. The evidence we have is that prediction markets are the best of the forecasting mechanisms we have (in theory, the best of all possible forecasting mechanisms). To the extent that the wisdom of our decisions depends upon their future consequences, we ought to be relying on prediction markets to a much greater degree than we presently do. Appointing bureaucrats to positions of tremendous discretionary power seems like a pretty good place to start.

  7. Gravatar of Ted Ted
    12. October 2010 at 08:45

    Let’s assume “low” interest rates do bring about excessive risk taking (I’m not sure if this is true or not, but I’m pretty sure low rates don’t cause bubbles like some claim). Then isn’t that a regulatory policy issue? If appropriate monetary policy causes excessive risk taking – then you should regulate bank leverage more forcefully. Not force the general public to suffer because the banks take on too much risk. That just makes no sense. This is the Rajan argument. I recently read a paper by Diamond and Rajan where they argued that you needed to raise interest rates quickly and perhaps keep them sub-optimally high during “normal” times to prevent risk taking. This seemed like a bizarre policy recommendation and, unsurprisingly, it was derived in a bizarre, simplistic, partial-equilibrium framework where the whole economy is basically just the housing and banking sector. Well if you completely ignore the real-side of the economy and just have a financial sector, I’m not surprised you would get silly policy implications. I could find some other objections with the model that might even overturn their partial results – but what is this assumption among people that the banks are the sole concern of monetary policy? If our concern is excessive risk-taking by banks due to monetary policy, then the answer is to use regulatory policy to prevent excessive risk-taking while creating an effective resolution mechanism. Not use the blunt tool of monetary policy to regulate banks, but punish everybody else.

    Also, I’m curious if anyone has done the obvious to figure out if monetary policy leads to bank risk taking. I’ve never seen a study, but couldn’t you abuse the fact that some small countries banking systems almost entirely deal in dollars (either because they are dollarized or they are pegged). Since most small countries business cycles are not correlated with ours, you would almost have a perfect testing environment. You could look at El Salvador or Bolivia and check the correlations between the stance of U.S. monetary policy and lending and banking activity.

    Also, I think you can fill the seats easily. Ricardo Reis, also out of Columbia, has made similar statements about Fed policy. If I can find two people with reasonable views at one university, surely we can find a few more scattered somewhere in the United States.

  8. Gravatar of Ted Ted
    12. October 2010 at 08:47

    Slight correction, Bolivia’s peg went off in 2003 – forgot about that. But you could check Bolivia prior to that.

  9. Gravatar of FedUp FedUp
    12. October 2010 at 08:53

    Zero percent interest rates has just been wonderful. Thank you almighty ones for your guidance through these perilous times. Now time to pay the reaper.

  10. Gravatar of Benjamin Cole Benjamin Cole
    12. October 2010 at 09:02

    I can’t imagine anyone more qualified to sit on the FOMC than Scott Sumner.

    The job may require some knowledge in many areas.

    But better to be roughly right than exactly wrong. Right now, we need the FOMC to be roughly right about one big thing: QE and related efforts.

  11. Gravatar of Edwin A Edwin A
    12. October 2010 at 11:00

    If it makes you feel any better, Peter Diamond has written about your favorite magic trick ( http://tinyurl.com/29hssto ), although not in the context of monetary policy. But yes, I see your point.

  12. Gravatar of Obsolete Dogma Obsolete Dogma
    12. October 2010 at 11:23

    If it makes you feel any better, the latest FOMC minutes (http://read.bi/8Xejge) show the board considered implementing either a NGDP or price level target instead of targeting the rate of inflation.

    The FOMC brings to mind Churchill’s quip about Americans: they always do the right thing — after they have exhausted all other possibilities.

  13. Gravatar of MikeDC MikeDC
    12. October 2010 at 11:24

    If there are not enough people qualified to perform so important a task, isn’t it strong evidence the position has amassed an inefficient and downright unhealthy amount of power?

    > Obama just can’t catch a break right now.

    Obama could have caught plenty of breaks by making better decisions.

  14. Gravatar of Josh Josh
    12. October 2010 at 13:10

    I actually wrote a post arguing that Obama should choose Woodford back in March:

    http://everydayecon.wordpress.com/2010/03/06/filling-the-fed-seats/

  15. Gravatar of TheMoneyIllusion » The Fed “blithely declares” we should consider targeting NGDP TheMoneyIllusion » The Fed “blithely declares” we should consider targeting NGDP
    12. October 2010 at 14:59

    […] following comment from someone whose byline is an apparent reference to Keynesian economics (“Obsolete Dogma“): If it makes you feel any better, the latest FOMC minutes (http://read.bi/8Xejge) show the […]

  16. Gravatar of The Fed “Blithely Declares” We Should Consider Targeting NGDP The Fed “Blithely Declares” We Should Consider Targeting NGDP
    12. October 2010 at 18:12

    […] the following comment from someone whose byline is an apparent reference to Keynesian economics (“Obsolete Dogma”): If it makes you feel any better, the latest FOMC minutes (http://read.bi/8Xejge) show the […]

  17. Gravatar of bill woolsey bill woolsey
    13. October 2010 at 03:42

    Price level targeting is a bad regime.

    What happens when the price level is on target, and there is an adverse aggregate supply shock?

    I suppose if you have planned inflation, you only need to create an excess demand for money sufficient to slow the growth rate of money incomes (including wages) enough, so that inflation slows enough, to get the price level back to its targeted growth path.

    Perhaps Woodford has in mind a floor for the growth path of the price level. The target for the growth path of the price level is always at a 2% rate from where it happens to be. If the price level is below that growth path, the Fed brings it up to the path. If the price level is above, we shift to a new growth path, rising at a 2% annual rate from its current value.

    I don’t like it.

    Go with money expenditure targeting!!

  18. Gravatar of Morgan Warstler Morgan Warstler
    13. October 2010 at 07:01

    bill woolsey,

    glad to have you aboard!

    Scott poo-pooed my insistence of such (above), maybe he’ll re-read and confront with you noting same.

  19. Gravatar of Lee Kelly Lee Kelly
    13. October 2010 at 07:15

    Inflation is derivative of too many irrelevant factors, and disentangling them can be difficult. Monetary policy is likely to create monetary disequilibrium, because of unpredictable events over which the Fed has no control. Nominal expenditure targeting is far superior, since it is insensitive to the aforementioned irrelevant factors and better correlates with monetary equilibrium.

  20. Gravatar of scott sumner scott sumner
    13. October 2010 at 17:30

    Morgan, OK, But I see no reason not to make up for last year as well. He’s too passive.

    Ram, Yes, I like the futarchy idea as well.

    Ted, Yes, I agree. In the 1920s Governor Strong said “Do I have to spank all my children because one misbehaved” when people asked him to raise rates to stop the stock boom. He refused. But he died in late 1928 and in 1929 his replacement at the Fed followed Rajan’s policy. How’d that work out?

    Fedup, No, zero rates have been the result of extremely tight Fed policy—a huge mistake. They haven’t been great at all.

    Thanks Benjamin.

    Thanks Edwin, I didn’t know that.

    Thanks Obsolete Dogma.

    MikeDC; You said;

    “If there are not enough people qualified to perform so important a task, isn’t it strong evidence the position has amassed an inefficient and downright unhealthy amount of power?”

    Yes. The market should run monetary policy, not the Fed.

    I agree about Obama.

    Josh, You were right, I blame everything on Larry Summers. I don’t think he understands how important monetary policy is. The field isn’t his forte.

    Bill, I agree (see my more recent posts.) In fairness, I think he is talking about core inflation, where energy prices have little impact.

    Lee Kelly, I agree.

  21. Gravatar of Morgan Warstler Morgan Warstler
    13. October 2010 at 17:56

    “But I see no reason not to make up for last year as well.”

    I see 6M-10M reasons…. houses / hard assets that need to be in the right people’s hands.

    See Scott, getting your plan started 2011 has to be enough, its the only way to bring along the people demanding a blood letting.

    please see Tax / Mankiw thread.

  22. Gravatar of FedUp FedUp
    20. October 2010 at 09:26

    “Fedup, No, zero rates have been the result of extremely tight Fed policy””a huge mistake. They haven’t been great at all.”

    You didn’t understand my statement. ZIRP is a policy error. The Fed had better decide whether they want to remain as an independent body. Further accommodative measures places them into fiscal policy. That would be unfortunate if the Fed was a mere vassal of the U.S. Congress.

  23. Gravatar of Scott Sumner Scott Sumner
    21. October 2010 at 05:42

    Morgan, I disagree.

    Fed Up, You didn’t follow my answer. I am disagreeing with your assumption that money has been accommodative. It hasn’t.

  24. Gravatar of How Obama can fix the economy for free | PARTISANS How Obama can fix the economy for free | PARTISANS
    18. February 2011 at 15:31

    […] Obama should have picked Woodford, not Yellen by Scott Sumner […]

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