It will be interesting to see the minutes of the recent Fed meeting, which discussed NGDP targeting.  Until then, you might want to sample this excellent Marcus Nunes post, which shows that the Fed was very interested in NGDP back in 1982.  I’ll just provide a few samples, but read the whole thing:

MR. MORRIS. I think we need a proxy-an independent intermediate target- for nominal GNP, or the closest thing we can come to as a proxy for nominal GNP, because that’s what the name of the game is supposed to be.

.   .   .

But we certainly don’t want to go back to interest rate targeting. Politically, I don’t think we could adopt a nominal GNP targeting approach even though theoretically that is what we ought to be doing. I don’t think we can do it. We need a proxy for nominal GNP.

VOLCKER. I do think we’re going to be forced into a more explicit rationale, whatever we do, in terms of the nominal GNP.

By the way, today I testified (electronically) in front of the Canadian House of Commons, in a hearing on inflation targeting.  I wish Nick Rowe had been asked, as he could have done a much better job than me.  I had trouble adapting to the video-conferencing format.  First I’d make a comment.  Then someone else would criticize it (and they had some good criticisms.)  Then I’d have to wait 1/2 hour, by which time I had to answer a completely different question.  I lost the debate to a couple of inflation targeting proponents.

One problem is that I can’t use the same arguments as I use here.  They pointed out that with a 5% NGDP target, inflation in Canada would gradually rise as demographics slowed the trend rate of Canadian RGDP growth.  I would have liked to say “inflation doesn’t matter, only NGDP growth matters.”  But lots of luck defending that argument in short sound bites, where you aren’t allowed follow-up.  So I argued the target could be adjusted for changes in the workforce.  But of course as soon as you make that concession it begins to undermine the simplicity of the proposal, which is one of its greatest selling points.

Still, I’m appreciative that Scott Brison of the Liberal Party invited me to speak.  Next time (in DC?) I’ll be more prepared.

It’s a bit sad to see how the once powerful Liberal Party has shrunk in the current Parliament.  Scott was the only Liberal member on the committee, so I had to wait a long time between questions.  I just sat in a room for two hours, watching a TV screen of Canadian MPs asking questions on Canadian monetary policy.  I learned about labor market conditions in Fort McMurray.  At least it beats watching paint dry.

PS.  My only regret is not suggesting that it would be a “worthwhile Canadian initiative” for our northern neighbors to “test drive” the policy before we tried it here in the much more important American economy.

Nick Rowe has a new post that explains what’s special about central “banks:”

What makes a central bank special?

The Bank of Canada can borrow and lend. So can the Bank of Montreal. So can I. Nothing special there.

The Bank of Canada can set any rate of interest it likes when it lends. So can the Bank of Montreal. So can I. Nothing special there. “If you want to borrow from me, you have to pay x% interest.” We can all say that. (Whether anyone will want to borrow from us at x% interest is another question.)

The Bank of Canada can set any rate of interest it likes when it borrows. So can the Bank of Montreal. So can I. Nothing special there. “If you want to lend to me, you have to accept y% interest.” We can all say that. (Whether anyone will want to lend to us at y% interest is another question.)

And yet there’s this utterly bizarre belief among many economists that it is the Bank of Canada that has the power to set Canadian interest rates, just by borrowing and lending. And that the Bank of Montreal, and ordinary people like me, somehow lack this special power. Even though we can borrow and lend too.

Now it’s true that the Bank of Canada is a lot richer than me. But what if I were a Canadian Bill Gates or Warren Buffet? And is the Bank of Canada richer than the Bank of Montreal? That can’t be the difference.

Now it’s true that the Bank of Canada can create money at the stroke of a pen, and I can’t. But the Bank of Montreal can. What makes the Bank of Canada special, compared to the other banks? What power does the Bank of Canada have that the Bank of Montreal lacks?

I’m going to give the same answer I gave nearly three years ago. And then I’m going to expand on it.

The fundamental difference between the Bank of Canada and the Bank of Montreal is asymmetric redeemability. The Bank of Montreal promises to redeem its monetary liabilities in Bank of Canada monetary liabilities. The Bank of Canada does not promise to redeem its monetary liabilities in Bank of Montreal monetary liabilities.

And then he ends the post as follows:

There is something very seriously wrong with any approach to monetary theory which says we can assume central banks set interest rates and ignore currency. It is precisely those irredeemable monetary liabilities of the central bank (whether they take the physical form of paper, coin, electrons, does not matter) that give central banks their special power. That’s what makes central banks central.

Now let’s consider a different monetary system.  Imagine a gold standard and a monopoly producer of gold.  The gold mine company would reduce short term interest rates by increasing the supply of gold.  Like currency, gold is irredeemable.  But no one would call this gold mining company a “bank” because it possesses no bank-like qualities.  Banks don’t create irredeemable assets, gold mines do.

Central banks may have some bank-like qualities, but what makes them special is their ability to produce currency–i.e. paper gold.  And that has no relationship to banking at all.

For years I’ve dealt with commenters who wanted to turn the discussion to banking:

“How do you know negative IOR will increase lending?”  I don’t care if it does, because banking has nothing to do with monetary policy.

“The Fed can’t cut rates any lower–how are they supposed to boost the economy?”  It doesn’t matter whether they can cut rates, because rates aren’t the transmission mechanism.

The Fed affects NGDP by changing the current supply and demand for the medium of account, and also the expected future path of the supply and demand.

“Monetary policy is already quite easy.”  No; credit is easy, monetary policy is ultra-tight.

In the comment section Nick says:

I just remembered. Back on the I=S post, IIRC, some people were complaining I didn’t talk about banks enough. OK, here’s a post on banks.

I’d say it’s a post on why central banks aren’t banks.

Has there ever been a more complete intellectual breakdown in our profession?  Economists of both the left and the right have been disdainful of the idea that the Fed and ECB adopted ultra-tight monetary policy in late 2008.  When I ask economists why, they often point to the low nominal interest rates.  When I point out that for many decades nominal interest rates have been regarded as an exceedingly unreliable indicator of monetary policy, they shrug their shoulders and say “OK, then real interest rates.”  At that point I explain that real interest rates are also an unreliable indicator, but if you want to use them it’s worth noting that between July and late November 2008, real rates on 5 year TIPS rose at one of the fastest rates in US history, from just over 0.5% to over 4%.  Then they point to all the “money” the Fed has injected into the system (actually interest-bearing reserves.)  I respond that the people who pay attention to money (the monetarists) don’t regard the base as the right indicator, as it also rose sharply in 1930-33.

Their best argument has been “OK, but M2 fell sharply in the Great Depression, and M2 has risen briskly in this crisis.”  At that point I am usually stumped, and merely remind people that the profession no longer paid attention to M2 after the early 1980s, regarding it as “unreliable.”  But now I have a better answer.  I was reading a post by Justin Irving and came across this very interesting graph:

At first glance it doesn’t look like much of interest has happened to the eurozone money supply.  But remember that growth tends to be exponential, and so please visually follow the red euro M2 line upward.  Notice the break in growth in 2008.  Where would the money supply be if the ECB had maintained steady eurozone M2 growth?  Justin also supplied me with the actual seasonally adjusted data.  Here are some data points:

Date                                    M2          growth from 27 months earlier

April 2004                      5339999               14.9%

July 2006                       6372397              19.3%

October 2008                8014245              25.8%

January 2011                8413040                5.0%

So after rising at fairly rapid rates for years, M2 growth slows to barely over 2% annual rate over the past 27 months.  What would Milton Friedman say about that?

If pressed, Keynesians will usually point to real interest rates as the right measure of monetary ease or tightness.  By that criterion the Fed adopted an ultra-tight monetary policy in late 2008.  Monetarists will usually say that M2 is the best criteria for the stance of monetary policy.  By that criterion the ECB adopted an ultra-tight monetary policy in late 2008.  And yet it’s difficult to find a single prominent macroeconomist (Keynesian or monetarist) who has publicly called either Fed or ECB policy ultra-tight in recent years.  Maybe tight relative to what is needed, but not simply “tight.”

I’m calling out my profession.  Do they really believe what they claim to believe about good and bad indicators of monetary tightness?  Or in a crisis do they atavistically revert to the crudest measure of all, nominal rates.  Joan Robinson is famous for once having argued that easy money couldn’t possibly have caused the German hyperinflation, after all, nominal interest rates in Germany were not low during 1920-23.  Have we advanced at all beyond Joan Robinson in the 73 years since she made that infamous remark?  I used to think the answer was yes; now I’m not so sure.

[BTW, modern monetarists like Michael Belongia and William Barnett advocate use of a divisia index for money.  I saw a paper by Josh Hendrickson that showed by that measure money became very tight in the US during 2008.]

Justin’s post also contains another interesting idea.  Notice how much more slowly Danish M2 grew as compared to Swedish, or even eurozone M2.  Sweden has a floating exchange rate and devalued sharply in late 2008, Denmark’s currency is fixed to the euro, and Denmark’s economy is much weaker than Sweden’s (in terms of NGDP and RGDP growth.)  Here’s Justin:

I am examining this issue in my Masters Thesis and it just occurred to me that it might be interesting to see how Denmark and the ECB compare to Sweden on Milton Friedman’s favored measure of monetary policy-M2 growth.  M2 is a standard measure of how much money there is in the banking system of an economy.  It is beyond the point of this post, but there is good reason to think that if M2 drops precipitously, that spending will fall and that the economy will grow below its potential.  Unfortunately we cannot see M2 for Finland alone as there is no real way of distinguishing between the stock of Euros within the Finnish economy, and those in the broader world.  The Danish crown however is something like that radioactive dye physicians inject into peoples veins so that they can see the circulatory system on an x ray.  The Danish currency is essentially the Euro, except that we can track it by the fact that it has pictures of Viking longships on it if it is currency, or a DKK currency ID next to it if it is electronic money.

Because Denmark fixes the price of the Danish Crown in terms of Euro, the central bank is constrained in how it can stabilize M2.  Central banking is, at the end of the day, pretty simple (no to be confused with easy).  The only thing the bank can really do is change the quantity of money and see how the market reacts.  Most of the time, central banks pick an interest rate they think appropriate and print money or pull it from circulation (by selling financial assets or foreign currency they have accumulated) until the interest rates moves where they want it.  When interest rates fall to zero, central banks need to pick other variables to guide their money printing decisions, such as stocks, exchange rates, consumer prices or nominal GDP.  In the case of Denmark, the central bank targets the exchange rate against the Euro by buying and selling the Danish crown in currency markets so that its rate against the Euro never changes.  As Denmark is an open economy with free capital flow, this means that they have essentially no control over their monetary policy.  Danish interest rates and money supply have to adjust to whatever is necessary to keep the Euro rate stable.

I love Justin’s radioactive dye analogy; it reminded me of something I noticed in the Great Depression.  In the US the monetary base fell 7% between October 1929 and October 1930, under the Fed’s tight money policy.  Then it rose substantially after October 1930.  But money didn’t become easier, rather the Fed was partially accommodating the hoarding of cash and reserves during banking panics.  But not fully accommodating the demand, as NGDP continued falling sharply after October 1930.  How could we know if this explanation is correct?  One answer would be to look for a similar economy, without banking panics.  In Canada there were no bank panics, and cash in circulation continued falling throughout 1929-32, if my memory is correct.  Because the US deflation was transferred to Canada via the international gold standard, they had no choice but to deflate their own currency.  Canada in the early 1930s is like Denmark in the past three years.

There’s an old fairy tale where a beautiful princess looks in the mirror and sees her true self, which looks more like an ugly witch.  The US monetary policy looked beautiful in the early 1930s, if one just focused on the base.  But all one had to do was look to the north to see just how ugly it really was.  If the ECB wants to take a look in the mirror, I suggest they take a look at the contrast between Swedish and Danish M2 growth.  The Danish policy it what their policy really looks like.  It’s not a pretty sight.

BTW, Justin’s blog post is more valuable than most master’s theses that I have seen.

PS.  I believe Canada may have done a small devaluation in late 1931, but not enough to prevent deflation.

As people in the humanities would say, this post’s title is an “homage” to Nick Rowe.  JimP sent me this interesting Bloomberg article:

Montreal undergraduates may help reshape the Bank of Canada’s monetary policy and give Federal Reserve Chairman Ben S. Bernanke and Bank of Japan Governor Masaaki Shirakawa clues about how to ward off deflation.

About 240 students so far have spent two hours in a 25th- floor computer lab near McGill University, earning an average of C$30 ($29.88) by viewing combinations of economic data, including unemployment and gross domestic product, and then predicting what would happen to inflation. Central bank researchers are taking part in the project to see whether people can make such forecasts more easily if policy makers target specific levels in the consumer price index instead of the inflation rate — which might help households and companies make better decisions about spending and investing.

The more accurate the test subjects are, the more they earn. One did so well, “we tried to track this person to see if we could hire her,” said Jean Boivin, 38, a Bank of Canada deputy governor who is helping with the research and has also co-written paperswith Bernanke.

The experiments will help Canada decide if it should switch from inflation targeting to price-level targeting in 2012 and may help the bank better communicate its policies to the public, Boivin said. The test results also might benefit Fed policy makers, who discussed price-level targets on Oct. 15 and voted Nov. 3 to inject another $600 billion of reserves into the banking system to avoid deflation — a widespread drop in prices that has plagued Japan for more than a decade.

Broader Agenda

“Central banks need to know more about how expectations are formed, and so we see that as part of a much broader agenda,” Boivin said in an interview at the Bank of Canada’s Ottawa headquarters in the room where he, Governor Mark Carney and four other policy makers decide on interest rates, including a decision tomorrow that’s scheduled for 9 a.m. New York time.

A few weeks back a Bentley student named David Norrish pointed to a flaw in my NGDP targeting idea.  Why [he asked] should we expect the largest economy in the world to experiment with a risky monetary regime that had never been tried out anywhere else?  I seem to recall that ideas like inflation targeting were pioneered by smaller economies such as New Zealand.  So I’m glad to see that the Canadians are considering serving as guinea pigs for price level targeting, before the policy is deployed in the much more important American economy.

BTW, the critieria for success should not be defined solely in terms of accurate inflation forecasts.  Short term forecasts may be relatively accurate under inflation targeting, even if the price level follows a random walk.  It’s more important to have accurate inflation expectations over the life of nominal contracts (wage and debt contracts.)  That’s where the advantages of level targeting are strongest.

PS.  Canadian readers:  I was just kidding—playing the ugly American for cheap laughs.

David Stinson recently sent me an interesting article on monetary economics written by Peter Howitt.  The author reminds me of people like Nick Rowe and David Laidler, as he can be sympathetic to mainstream new Keynesian ideas, but also understands the importance of older monetarist traditions.  The entire paper is worth reading, but this passage on page 22-23 caught my attention:

Moreover, it is not just the policy makers that are learning from monetary theorists. Often the conduct of monetary policy is way ahead of the theory, and we academic economists often have more to learn from practitioners than they have from us.  I came to realize this when I was a participant in monetary-policy debates in Canada in the early 1990s. The Bank of Canada was moving to inflation targeting at the same time as the country was phasing in a new goods and services tax. The new tax was clearly going to create a problem for the Bank by causing an upward blip in the price level. Even if the Bank could prevent this blip from turning into an inertial inflationary spiral, the immediate rise in inflation that would accompany the blip threatened to undermine the credibility of the new inflation-reduction policy.

The bank dealt with this problem by estimating the first-round effect of the new tax on the price level, under the assumption that the path of wages would not be affected, and designing a policy to limit the price blip to that estimated amount.  It announced that this was its intention, and that after the blip it would stabilize inflation and bring it down from about six percent to within one percent band over the coming three years.

At the time I was very skeptical.  Along with many other academic economists I thought it was foolish for the Bank to announce that it was going to control something like inflation, which it can only affect through a long and variable lag, with such a high degree of precision.  To me the idea reeked of fine-tuning, and I thought the Bank was setting itself up for a fall.  But I was wrong.  In the end the Bank pulled it off just as planned.  The price level rose by the amount predicted upon the introduction of the new tax, and then inflation quickly came down to within the target range, where it has been almost continuously ever since.

Two things struck me about this passage.  The first is that economists often overestimate the problem of “long and variable lags,” especially when the goal is to stabilize a nominal aggregate.  If the policy is credible, lags do not prevent the central bank from hitting short term targets, as the short run is strongly influenced by expected longer term outcomes (as Woodford has shown.)
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