Beautiful models and inconvenient facts
Macroeconomists sure like models. When they see a new and interesting stylized fact, they instantly want to create a model to explain it. Indeed they like their models so much that they sometimes forget to carefully check whether the stylized fact is, well, a fact. Consider the following from a new paper by James Bullard, President of the St. Louis Fed.
They suggested that the combination of an active Taylor-type rule and a zero bound on nominal interest rates necessarily creates a new long-run outcome for the economy. This new long-run outcome can involve deflation and a very low level of nominal interest rates. Worse, there is presently an important economy that appears to be stuck in exactly this situation: Japan.
That’s a pretty bold assertion. Is Japan really stuck in a deflationary trap? I read on, looking for the evidence. Unfortunately, I couldn’t find any. There was a graph showing that Japan had experienced some very mild inflation, but I was under the impression that the Bank of Japan was an ultra-conservative bank, and liked mild deflation. Indeed I thought that was pretty widely understood. I guess not.
Is there any way to tell if I’m right? Fortunately, the paper provides the answer a few pages later:
But for the nominal interest rate, most of the Japanese observations are clustered between 0 and 50 basis points. The policy rate cannot be lowered below zero, and there is no reason to increase the policy rate since–well, inflation is already “too low.””This logic seems to have kept Japan locked into the low nominal interest rate steady state. Benhabib, et al., sometimes call this the “unintended” steady state.
Hmmm. Inflation is “too low.” Japan is in an “unintended steady state.” And how would we know? The answer is simple, and is provided in the quotation. The Bank of Japan would never raise interest rates during a period when inflation is “too low,” that would make no sense. I agree. The problem is that the BOJ did raise interest rates during the 2000s, indeed more than once. So although Western economists consider Japanese inflation to be “too low,” it is quite apparent that the BOJ feels differently.
Of course there are many other reasons why we know that Japan is not stuck in any sort of deflationary gap. They let the yen appreciate strongly during the midst of the great deflationary crisis of 2008-09. They dramatically reduced the monetary base in 2006 to prevent inflation. Indeed almost every time the Japanese inflation rate approaches zero, from below, the BOJ seems to do something contractionary.
But why bother with facts when we have these beautiful models? Macroeconomists must have created a 100 models to explain how and why Japan became trapped in deflation. It’s a pity that it never happened, as they are quite clever models.
I shouldn’t have been so sarcastic, as the Bullard paper is no worse than any other in this respect. And in other respects it is far better than most. Let me finish up on a positive note, by quoting Bullard’s concluding paragraphs:
When the European sovereign debt crisis rattled global financial markets during the spring of 2010, it was a negative shock to the global economy, and the private sector perception was certainly that this would delay the date of U.S. policy rate normalization. One might think that is a more inflationary policy, but TIPS-based measures of inflation expectations over five and ten years fell about 50 basis points.
Promising to remain at zero for a long time is a double-edged sword. The policy is consistent with the idea that inflation and inflation expectations should rise in response to the promise, and that this will eventually lead the economy back toward the targeted equilibrium of Figure 1. But the policy is also consistent with the idea that inflation and inflation expectations will instead fall, and that the economy will settle in the neighborhood of the unintended steady state, as Japan has in recent years.
To avoid this outcome for the U.S., policymakers can react differently to negative shocks going forward. Under current policy in the U.S., the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of
Treasury securities.
Exactly! Promising zero rates as far as the eye can see is like promising failure for as far as the eye can see, because zero rates occur in depressed economies. QE is much better. And even better yet, supplement it with a price level or NGDP target. (Good to know that monetarism is not completely dead at the St. Louis Fed.)
PS. You might think I was quibbling about some rather small increases in nominal interest rates in Japan. How do I explain the fact that Japan has experienced mild deflation “despite” low interest rates? Easy, you’d expect mild deflation to cause very low interest rates, a point Milton Friedman made many years ago. Interest rates are behaving exactly as you’d expect if they were targeting mild deflation (low, but occasional nudges upward to prevent outbreaks of inflation) and not at all as you’d expect if they were stuck in a deflationary trap (interest rates stuck at zero, and never raised.)
HT: Benjamin Cole