Robert Hetzel on the Fed’s new policy

Bob Hetzel has a new Mercatus paper that discusses the Fed’s new “flexible average inflation targeting” policy regime. He worries they may eventually overshoot to excessively high inflation. I’m less worried (medium term), but agree with his conclusion:

The newly announced strategy commits the FOMC to expansionary monetary policy to lower the unemployment rate to its lowest sustainable level as indicated by a persistence of inflation above the long-run 2 percent target. The announced strategy, however, leaves vague how the FOMC will then return inflation to the 2 percent target. One possible way to ensure the long-run discipline required to maintain price stability would be to accompany the policy with a long-run path for the price level.

I see level targeting as a way of permanently ending the longstanding and counterproductive debate between hawks and doves.

On another topic, David Beckworth has a new podcast where he interviews me on what I call the “Princeton School” of macroeconomics, by which I mean the work done by Krugman, Bernanke, Woodford, Eggertsson and Svensson back in the late 1990s and early 2000s. I see Krugman’s 1998 paper as perhaps the most important macro paper of the past 40 years, providing the best framework for understanding 21st century monetary policy. I plan to write a paper on this topic, and as usual I’ll have a slightly unconventional take on the subject.

PS. I also have a new piece in The Hill, which criticizes our response to Covid-19.



31 Responses to “Robert Hetzel on the Fed’s new policy”

  1. Gravatar of Robert Hetzel on the Fed’s new policy – FX Journo Robert Hetzel on the Fed’s new policy - FX Journo
    11. January 2021 at 11:19

    […] Original Article […]

  2. Gravatar of Garrett Garrett
    11. January 2021 at 11:40

    10y zero coupon inflation swaps at 2.257% today. They peaked at 2.281% last thursday. Back on 11/30/20 they were at 2.036%.

    Seems like the market believes in AIT so far.

  3. Gravatar of Garrett Garrett
    11. January 2021 at 11:45

    From your article:

    “Vaccine development was slowed by a number of unfortunate decisions. Trials were temporarily suspended if a participant became sick, even though the cost of delay is huge, with thousands of deaths each day. Medical ethicists discouraged “challenge studies,” which can speed up testing by giving young and healthy volunteers an injection of a virus to test a vaccine’s effectiveness. Challenge studies are already used for less serious illnesses, and the risks of COVID-19 for young and healthy people are low enough to justify them, especially given the huge cost of delay. It was a missed opportunity.”

    Seems like there’s still an opportunity to use challenge studies to confirm the vaccines work on the UK variant.

  4. Gravatar of Carl Carl
    11. January 2021 at 11:47

    Great article in The Hill. It seems public health officials need to consult more with economists. Aerosol physicists have been pointing out that public health officials should consult more with them as well. And from what I’ve read about the quality of the Imperial College COVID models, data scientists have some advice to offer as well.

  5. Gravatar of ssumner ssumner
    11. January 2021 at 12:10

    Garrett, We are certainly getting closer on the AIT front.

    Thanks Carl.

  6. Gravatar of rayward rayward
    11. January 2021 at 12:14

    Overshooting is definitely a risk (assuming the pandemic is controlled and business can return somewhat to normal). This is not your father’s high unemployment recession. But I don’t see how changing targets changes the outcome. Sure, I prefer NGDP targeting over inflation targeting, but for a different reason: we have been experiencing persistent asset price inflation not consumer price inflation because it’s become the policy choice for prosperity. The problem coming out of the public health crisis is that pent up consumer demand could easily trigger a rapid rise in consumer prices, even as asset prices fall as investors shift from investing (saving) to consuming.

  7. Gravatar of Mike Sax Mike Sax
    11. January 2021 at 12:36

    Certainly an interesting interview,Scott. Have you considered putting out an audiobooks version of your books? It’d be helpful for folks like myself who spend the whole day driving

  8. Gravatar of Benjamin Cole Benjamin Cole
    11. January 2021 at 13:02

    Robert Hetzel is a smart guy, and yet this 40-year long macroeconomic conversation (and obsession) on inflation is becoming increasingly irrelevant, and probably counter-productive.

    Look to Michael Pettis’ book “Trade Wars are Class Wars” for an understanding of how we might truly increase prosperity, particularly for the very large employee class.

    And would that the macroeconomics profession spent as much time wringing their hands about property zoning, as they do on whether inflation might be 2% or 3%.

    The Federal Reserve could do a wonderful job and hold inflation at 2%, but the forces of globalism and property zoning will ensure declining living standards.

  9. Gravatar of Thomas Hutcheson Thomas Hutcheson
    11. January 2021 at 14:17

    The 10 year TIPS breakeven rate on 11-30-2020 was 1.77 cf Garrett’s report of 10y zero coupon inflation swaps at 2.036 on that date. What is the difference between the two? [Presumably both refer to CPI, not PCE.] Does FRED have a time series on the zero coupon inflation swap?

  10. Gravatar of David S David S
    11. January 2021 at 15:29

    Hooray-monetary policy is back on this blog! But is Hetzel fighting a battle from 3 or 4 decades ago? We’re bound to see some sector specific inflation starting in Q2 and Q3 of this year, which would be a good thing. I don’t see how there is the structure for a mass addiction to a 2.5%-3% inflation rate beyond 2024. Most critical workers don’t have bargaining power to push us into a classic wage-price spiral. If it did happen, some future Fed chair can invoke the spirit of Volcker and squash it.

    It would be interesting to see a stabilization in some asset prices, like housing, but that’s subject geographic and political factors that seem to transcend interest rates and common sense.

  11. Gravatar of Thomas Hutcheson Thomas Hutcheson
    11. January 2021 at 20:30

    “The announced strategy, however, leaves vague how the FOMC will then return inflation to the 2 percent target.”

    I do not understand the question? Which instruments will it use? How quickly will they bring down the average? What is the period over which they will seek to produce the average of 2%

  12. Gravatar of Postkey Postkey
    12. January 2021 at 03:00

    ‘According to that column, a classic liquidity trap occurs when “a zero short-term interest rate isn’t low enough to restore full employment”. Krugman – who won the Nobel economics prize in 2008 – is widely regarded as the USA’s most articulate and effective spokesman for Keynesian ideas. For those uninitiated in macro-economic theory his words are taken as gospel. However, the trap called “classic” by Krugman is no such thing.
    Krugman talks about the “short-term interest rate”, by which he means the interest rate set by the central bank. Yet, Keynes’ trap arises when increases in the quantity of money cannot push nominal bond yields beneath a certain level (which must be above zero) because investors have perverse expectations about the price of bonds. Krugman’s trap holds when the central bank cannot, by increasing the monetary base, cut the short-term interest rate beneath zero. That leads to an unacceptably high real interest rate if people are concerned about falling prices. Krugman’s trap is not at all a classic trap originating in the debates of the 1930s. It is an entirely new trap that he has invented. Keynes’ trap is implausible and certainly does not exist today.
    Modern Keynesians are untrustworthy, if they can so willfully misunderstand and misrepresent their supposed intellectual hero. The supposed “liquidity trap” is a plaything of left-wing intellectuals, not an argument for the subversion of a hugely successful capitalist economic system. In the form suggested by Keynes the liquidity trap does not exist today. In the form suggested by Krugman, his so-called liquidity trap does not invalidate monetary policy because monetary policy can still be effective using instruments other than short-term interest rates. ‘

  13. Gravatar of xu xu
    12. January 2021 at 03:44

    The Princeton school is the “idiot school” that thinks they can centrally plan the economy.

    Interest rates are already rock bottom. You have nothing left except the “reserve currency” which is rapidly deteriorating.

    The economics profession is a religion and pseudoscience. It’s practitioners are it’s priests. The house of cards (AKA USA economy) will fall.

    The Federal Reserve has engaged in theft, and embezzlement, on a world scale. It is a disaster of epic proportion.

  14. Gravatar of ssumner ssumner
    12. January 2021 at 09:11

    Mike, My books have lots of graphs—I don’t think they’d work as audiobooks. But I’ll keep an open mind.

  15. Gravatar of Spencer B. Hall Spencer B. Hall
    12. January 2021 at 10:52

    Bank lending is inflationary. Nonbank lending is noninflationary.

    Banks don’t lend deposits. Deposits are the result of lending.

    Everything else equal, an increase in money products, e.g., QE-forever (LSAPs), decreases the real rate of interest and has a negative economic multiplier.

    Negative multiplier effect – Economics Help

    Whereas the utilization of savings products, activating monetary savings, increases the real rate of interest and has a positive economic multiplier, a ripple effect (“calculated by dividing the change in revenue with the change in spending”).

    The decline in “total factor productivity” (the main component of potential output growth) is not being driven by the lowering of interest rates, ZIRP. You can’t measure potential or expected growth by the level of R *.

    Business investment is driven by the “accelerator effects” of expected aggregate demand, money times transaction’s velocity.

    I.e., the “accelerator effects” results from savings products, activating savings (paradoxically increasing the real rate of interest), not by money products (money illusion).

    Potential expected growth comes from putting savings back to work.

  16. Gravatar of Gene Frenkle Gene Frenkle
    12. January 2021 at 11:10

    With respect to Krugman and increasing aggregate demand it would be fairly easy in America. So step 1 is identify a group of people that live paycheck to paycheck. Step 2 is throw money at the group. Step 3 is to design a program that somehow reduces their ongoing overhead costs giving them more disposable income without having to increase their wages. So in 2021 increasing aggregate demand would actually be fairly easy by paying reparations to descendants of American slaves, and offering all Americans access to a $150k mortgage with no interest along with encouraging cities like St Louis and Cleveland to offer incentives to attract new residents. So we could use several very negative aspects of American culture to our advantage in 2021 as we reset and reboot our economy. So paying reparations is merely a pretext to increase aggregate demand because most understand just throwing money at Americans willy nilly leads to asset price inflation and is thus counterproductive to increasing aggregate demand.

  17. Gravatar of Pyrmonter Pyrmonter
    12. January 2021 at 16:28

    Listened to the podcast, and paused to wonder: does anyone believe in long run monetary neutrality now?

    Simplified a good deal, the message seemed to be: increasing the supply of base money can lead to a permanent and sustained increase in output. Sounds like something we discussed in introductory macro studies and laughed at. What has changed? At the risk of being tendentious – what are the micro foundations? How is this different to the sort of ‘Keynesian’ expansionary polices pursued in the UK, Australia, Canada etc in the 1950s and 60s?

  18. Gravatar of Geoffrey Orwell Geoffrey Orwell
    13. January 2021 at 06:59

    Great podcast thanks Scott.

  19. Gravatar of bob bob
    13. January 2021 at 08:00

    The Fed is unconstitutional.
    Sumner and his cronies are trying to take our land and our labor.
    He supports CCP interests, supports the income tax, and wants to turn our children gay by placing Atrazine into our water. The next step by Sumner’s WTO Fed Agenda is to turn humans into cyborgs through forced vaccination. He is destroying the USD by printing more money and propping up democrat communists governors that shut down our businesses.

    Economists are evil. It’s time to take them all out, before they take us out.

    We’re human! And we’re coming!

  20. Gravatar of Spencer B. Hall Spencer B. Hall
    13. January 2021 at 09:27

    Lending by the nonbanks, the manufacture of highly liquid claims (activation of savings’ products), matches pre-existing savings with investments; whereas contrariwise, lending by the banks simply enlarges the money stock (injects ex nihilo money products).

    I.e., banks pay for their earning assets with new money. Liquidity risk and maturity transformation is an optical illusion from the standpoint of the entire payment’s system (an amalgamation of individual banks).

    The circular confusion is ultimately cataclysmic. The impoundment and ensconcing of monetary savings in our payment system is the direct cause of secular stagnation since 1981 (viz., the deceleration in savings velocity). It is not related to demographics, monopolization, globalization or robotics.

    It is related to the arrestment of savings (largely non-M1 component’s deposit turnover). I.e., all $15 trillion dollars in bank-held savings are fundamentally frozen (lost to either investment and consumption).

  21. Gravatar of LK Beland LK Beland
    13. January 2021 at 12:05

    That was a very interesting podcast.

    I have a comment about Paul Krugman’s shift towards the “left-leaning” interpretation of his 1998 paper. Misrepresentation of the 2013 US data is a contributing factor to this shift. Many progressive economists misread the 2013 ngdp data, and associated the “fiscal cliff” to a significant economic slowdown. The 2013 data was presented as evidence that monetary offset was not as robust as the “right-leaning” interpretation of the 1998 paper would suggest.

    Revisiting this data may be worthwhile, as it indicates that monetary offset can be quite effective in an ultra-low interest rate environment.

  22. Gravatar of Mike Sax Mike Sax
    13. January 2021 at 14:52

    I hear you regarding the graphs. From my standpoint I’ve already bought the Kindle book so I can always check out any graph I want later.

    Amazon offers a deal where when you buy the Kindle version you can also buy the audibook version at a discount rate…

  23. Gravatar of ssumner ssumner
    13. January 2021 at 14:54

    Pyrmonter, I still believe money is neutral in the long run.

    LK, That’s weird, because growth sped up in 2013.

  24. Gravatar of Spencer B. Hall Spencer B. Hall
    14. January 2021 at 06:45

    Beckworth: “The NDGP gap measures the percent difference between this average forecast and the actual level of NGDP.”

    Pig Latin.

    It is the Delta (Δ) between, the oscillation between Roc’s in short-term money flows (proxy for real output), and Roc’s in long-term monetary flows (proxy for inflation) on the given interval that’s critical. Whether it is in an increasing trend (a buy signal) or decreasing trend (a sell signal).

    In contradistinction to N-gDp level targeting (money illusion), real money constructs can be used to determine whether an injection of new money is robust (a buy signal), net neutral, or harmful (a sell signal). The demarcation is exact as the distributed lag effects of money flows are exact. That is monetarism, macro-economics, is an exact science.

    The FOMC’s monetary policy objectives should be formulated in terms of desired rates-of-change, roc’s, in monetary flows, volume times transaction’s velocity, relative to roc’s in the real-output of final goods and services -> R-gDp.

    Roc’s in N-gDp, or nominal P*Y, can serve as a subset and proxy figure for roc’s in all physical transactions P*T in American Yale Professor Irving Fisher’s truistic: “equation of exchange”. Roc’s in R-gDp have to be used, of course, as a policy standard.

  25. Gravatar of Spencer B. Hall Spencer B. Hall
    14. January 2021 at 07:54

    re Beckworth again: “He, Krugman, definitely has a traditional New Keynesian perspective on getting the real interest rate down to its equilibrium or natural rate level, by raising inflation expectations, and thus, doing it appropriately long enough, you’ll get the output gap clear, and you’ll be back to a healthy recovery.”

    Complete tripe. R * is a hoax. Investment hurdle rates are idiosyncratic. Business expenditures depend largely on profit-expectations, and favorable profit-expectations depend primarily on cost/price relationship of the recent past and of the present. Cost/price relationships are crucial, and they are particular; they cannot be adequately treated in terms of broad-aggregates or statistical weighted “averages”.

    According to Alfred Marshall’s “cash balances” approach, that prescription will backfire. To wit: Alfred Marshall’s cash balances (“Money, Debt and Economic Activity” (2nd ed.; New York: Prentice-Hall 1953), p. 197

    “If the public considers its real balances excessive or deficient, forces will be set in motion which will alter the value of the cash holdings of the public, but not necessarily in the fashion desired by the public.

    For example, if the public on balance considers the real worth of its cash balances deficient, this will bring about an increase in the demand for money and a decrease in its supply.

    The velocity of money will decline, and if prices tend to be sticky, sales, production, implement and payroll will fall off. This will lead to reduced bank lending, a decline in the volume of money, and this will not be compensated by an appropriate decline in prices.

    Under these circumstances’ equilibrium is never reached, and the public in seeking to increase its real balances so reduces its effective purchasing power as to create a condition of chronic stagnation.”

  26. Gravatar of Spencer B. Hall Spencer B. Hall
    14. January 2021 at 09:13

    Mish Talk: “The BLS reports a rise in the CPI of four-tenths of a percent in December. Year-over-year the CPI is up 2.4%.”

    Peter Schiff: “Agricultural commodities, in particular, are on fire. We’re seeing five-year highs on many commodities. Corn was up 5% on Wednesday (Jan. 13). Wheat was up 4.73%. Oats and rice were up over 2%.”

    FAIT doesn’t work. Lending by the banks is inflationary. Lending by the nonbanks is noninflationary. Banks don’t lend deposits. Deposits are the result of lending.

    The correct monetary policy is to drive the banks out of the savings business, aka, the Interest Rate Adjustment Act of 1966 is the correct policy.

  27. Gravatar of Spencer B. Hall Spencer B. Hall
    14. January 2021 at 10:13

    965,000 new unemployed. Inflation up. That’s stagflation, business stagnation accompanied by inflation.

    That’s the economic equation. FIAT and N-gDp Level targeting is just 70’s stagflation reincarnated. The engine is being run in reverse.

    The 2012 expiration of the FDIC’s unlimited transactions’ deposit insurance is prima facie evidence, miniscule reduction from unlimited to $250,000 (responsible for the “taper tantrum”)

  28. Gravatar of Spencer B. Hall Spencer B. Hall
    14. January 2021 at 10:18

    What’s the difference between Lyn’s: “The Curious Case of QE” (“chronic, systemic liquidity shortfall”) and the “taper tantrum”?

    Answer. Notice that during a period of policy tightening, short-term money market rates (not necessarily just the 3mo rate) became lower than the remuneration rate on interbank demand deposits. I.e., the FED induced nonbank disintermediation, an outflow of funds or negative cash flow (i.e., they only watch the banks, not the non-banks). The FED engineered a decrease in the supply of loanable funds.

  29. Gravatar of Spencer B. Hall Spencer B. Hall
    14. January 2021 at 10:25

    One increases the supply of loanable funds (activates savings). The other decreases the supply of loanable funds (impounds savings). Both are velocity relationships, one increasing, the other decreasing AD.

  30. Gravatar of Spencer B. Hall Spencer B. Hall
    14. January 2021 at 10:44

    re Chairman Powell: “In a discussion sponsored by Princeton University, Powell said prices might rise once the economy recovers and people start spending freely. At the same time, measured inflation will rise as weak readings from last March and April drop out of the calculation.

    However, Powell said he doubted that these prices gains would lead to persistently higher inflation.

    “If inflation were to go up for any reason, inflation doesn’t stay up” like it used to in the 1970s, Powell said”

    Yes, that’s right. The rate of change in monetary flows, volume times transactions’ velocity will level out after April.

  31. Gravatar of Kester Pembroke Kester Pembroke
    15. January 2021 at 06:26

    “Evidence” is a cop out.

    If you have a theory that says “if you move your arms this will happen” you cannot gain evidence for that by data obtained from a man in a straitjacket.

    The call for “evidence” and “data” is just a political ploy for avoiding discussing how arms move.

    The way to deal with mainstreamers is to ask them if they believe central banks can set interest rates such that all people in the economy will be fully employed and engaged. If they do then say we can test that by offering a $15 minimum wage job. If their theory is correct, nobody will turn up to take it.

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