Can the Fed learn to speak a non-interest rate language?

I was reading a new book by Tim Congdon and came across this interesting quotation, discussing the flaw at the heart of New Keynesian economics:

In the New Keynesian schema, it [the interest rate] became in effect the only policy instrument, the factotum of macroeconomics.

Why did we have to end up with the worst possible policy instrument?  The only instrument that has a zero lower bound.  We could have chosen the monetary base, or the trade-weighted exchange rate, or the price on NGDP futures, or the TIPS spread, or the price of zinc.  But no, we had to pick nominal interest rates.

We ended up with a steering mechanism that locks up just when you most need it to work.  Even worse, central banks have so fallen in love with the mechanism that they can’t seem to shift to a different target.  Instead we end up with never-ending attempts to manipulate interest rates, even when short term rates have hit zero.  Promise to hold rates at zero for X number of years.  Or attempts to lower longer term rates.  Or to reduce interest rate risk spreads.

These proposals have a slightly pathetic quality, because (as Nick Rowe reminds us in this recent post) a policy that is expected to be successful will actually raise nominal rates.  So you have the Fed announcing that the goal of QE2 was to lower long term rates, and then when they start rising the Fed announces that the policy must be working.  It’s a wonder the Fed still has any credibility.  How’s this for communication?

WASHINGTON “” The Federal Reserve made a rare promise on Tuesday to hold short-term interest rates near zero through at least the middle of 2013, in a sign that it has all but written off the chances of an expansion strong enough to drive up wages and prices. . . .

By its action, the Fed is declaring that it, too, sees little prospect of rapid growth and little risk of inflation. Its hope is that the showman’s gesture will spur investment and risk-taking by convincing markets that the cost of borrowing will not rise for at least two years.

The Fed’s statement, with its mix of grim tidings and welcome aid, contributed to wild market oscillations as investors struggled to make sense of the economy and the path ahead.  (emphasis added)

Well that will certainly whip up those animal spirits!

The zero rate bound doesn’t occur for variables like the monetary base.  Some Keynesians argue that this doesn’t matter; open market purchases become ineffective when rates hit zero, as one is merely swapping one asset for another.  But that’s not true, as a permanent increase in the base is inflationary.  And if the Fed had already been using the base, it would have been able to continue signaling future policy intentions as if nothing had happened.  In contrast, once rates hit zero the Fed can’t signal anything with changes in interest rates, because it can’t change interest rates.

Of course the New Keynesians also insist that interest rates are the transmission mechanism.  Not so.  When there’s a big apple crop, NGDP in apple terms soars.  No need to invoke interest rates.  Ditto for a big crop of Federal Reserve Notes.  And the mechanism that causes nominal shocks to have real effects is sticky wages and prices, not interest rates.  When I point out that rates hardly budged during the most expansionary monetary policy in US history, Keynesians start talking about rates falling relative to their Wicksellian equilibrium value.  Yes, but that’s pretty much true by definition, and true for any price.  If the Wicksellian equilibrium zinc price is the one consistent with 2% inflation, then the Fed can boost inflation above 2% if and only if it can raise zinc prices above their Wicksellian equilibrium.

The next meeting will be a big test for the Fed.  I don’t expect miracles, but I’d hope for at least some sign that they understand there’s nothing more they can do to generate recovery by fiddling with interest rates.  They need to indicate that they are at least attempting to communicate in some other language.

Most people seem to assume nothing major will be done until the three hawks leave in January.  In fact, Fed stimulus would be more credible if they could get at least one of the three to vote for it.  It seems to me that Kocherlakota offers the best hope.  At times he seems to indicate that he’s aware of the unemployment problem, but doesn’t like the lack of a nominal anchor in open-ended promises, such as two years of near-zero interest rates.  He might be willing to support stimulus, as long as there is an explicit promise to maintain prices or NGDP along a particular trajectory.  If I’m right, it’s quite possible that the fate of 100,000s of unemployed people might depend on what he decides.

It’s no way to run monetary policy.  We should have an explicit 5% NGDP target, and let the market set the money supply and interest rates.  But you go into recession-fighting with the Fed you have, not the Fed you wish you had.

Why are macroeconomists so obsessed with interest rates?

If I wrote a macro textbook, I would try to avoid any mention of interest rates or inflation.  The Fisher equation would use expected NGDP growth.  The AS/AD model would use hours worked as the real variable and NGDP as the nominal variable.  The transmission mechanism would not involve changes in interest rates, but rather the excess cash balance mechanism.  More cash would raise expected future NGDP.  This would raise the current price of stocks, commodities and real estate.  (As in Islamic economics, there’d be no interest rates.)  The higher asset prices would tend to raise current AD.  More nominal spending, when combined with sticky wages and prices, would boost output.

[Update 10/22/10:  This is why I shouldn’t do 4 posts in one day.  Commenters pointed out two flaws.  The Fisher equation uses interest rates.  And interest rates are important for inter-temporal decisions.  How about this:  A macroeconomics free of the concept of inflation, and a business cycle theory that did not use either inflation or interest rates.  Is that slightly less crazy?]

But obviously I’m the exception.  When rates hit zero and the Fed couldn’t move them anymore, I expected economists to shift over to some other mechanism; the money supply, CPI futures, exchange rates, etc.  Instead they started talking about how the Fed could promote a recovery by lowering long term rates.  (But if the policy is expected to work, wouldn’t it boost long term rates?)  Or they talked about how the Fed could reduce real interest rates by boosting inflation.  Some even argued that the Fed would have to boost inflation expectations to 6% in order to get a robust recovery, forgetting that this view directly conflicts with another key assumption of Keynesian macroeconomics—that the SRAS is very flat when unemployment is high.

Some of my commenters argued you couldn’t raise NGDP without first creating inflation expectations, which would lower the real rate of interest.  But that’s not necessary at all.  If you create higher NGDP growth expectations, then even if expected inflation doesn’t rise at all, the Wicksellian equilibrium real rate will rise and monetary policy will become more stimulative.  So the Fed doesn’t need to lower real interest rates in order to stimulate the economy.  Conversely, a policy such as interest on reserves might have had a devastating impact on aggregate demand, even if it had no impact on interest rates.

I’m genuinely confused.  When we explain why a big crop of apples makes NGDP in apple terms rise sharply, we don’t resort to convoluted explanations involving an interest rate transmission mechanism.  Why then, when there’s a big increase in the supply of money, do we think it will only affect nominal GDP in dollar terms via some sort of interest rate transmission mechanism?

Can’t we all just get along?

Here is Paul Krugman, right after I did a really nice post praising him:

Brad DeLong manfully takes on the efforts of various commentators to define away the paradox of thrift and redefine our current problems as somehow wholly monetary. As I see it, this is all a desperate attempt to cut and stretch things into a quasi-monetarist framework, for no good reason.

.   .   .

So what’s wrong with my “one model to rule them all”? Well, it doesn’t easily translate into anything that looks like monetarism “” for a good reason: when short-term interest rates are near zero, the distinction between the monetary base, which the central bank controls, and the much broader class of safe short term assets, which it doesn’t, more or less vanishes. That’s not a bug, it’s a feature; it says that when you’re in a liquidity trap, thinking in terms of the supply and demand for money is just not a helpful way to approach the issues.

Let’s start with some propositions that all us new Keynesians and quasi-monetarists can agree on:

1.  If interest rates are 5% and the Fed announces a doubling of the money supply, and also announces that all the new money will be pulled out of circulation a month later, almost nothing will happen to prices and output.

2.  If interest rates are 0% and the Fed announces a doubling of the money supply, and also announces that all the new money will be pulled out of circulation a month later, almost nothing will happen to prices and output.

3.  If interest rates are 5% and they announce a permanent doubling of the monetary base, prices will rise sharply.

4.  If interest rates are 0% and the Fed announces a permanent doubling of the money supply prices will rise sharply.

Monetary policy is never very effective if the injections are temporary, and (almost) always very effective if permanent.  (Unless the liquidity trap is expected to last forever.)  So the problem during a liquidity trap isn’t really that cash and T-bills are perfect substitutes, it’s more complicated.

So what’s the real issue here?  Unfortunately, just like in the game “wack-a-mole,” a new objection pops up as soon as you answer the previous one.  A little history might be helpful.  For decades the new Keynesians have been driving the economy using a flawed interest rate instrument.  They got away with it until rates hit zero.  Now they are looking for answers.  The quasi-monetarists are suggesting that the Fed increase the supply of base money (QE) and/or reduce the demand for base money (lower IOR and higher inflation targets.)  The more progressive new Keynesians like Krugman support these ideas, but get bent out of shape when quasi-monetarists try to define our AD shortfall problem as essentially monetary, rather than simply an implication of the paradox of thrift.  [BTW, I prefer autistic to Procrustean.]

So what are the issues that separate us?

1.  The quasi-monetarists have higher expectations for monetary policy.  We all agree the Fed could do a lot more.  We all want them to do a lot more, but only the quasi-monetarists actually assume that the Fed is still driving the car, still determining NGDP growth.

2.  Communication.  The new Keynesians drove the economy off the cliff, yanked off the steering wheel, handed it to the quasi-monetarists, and said “OK, you drive smarty-pants.”  But at the zero bound driving the economy requires a whole new form of communication.  We can’t use interest rates and the markets aren’t used to anything else.  Remember, only permanent money supply increases are effective.  But since base demand is so unstable at low rates, we can’t really target the base credibly; it would leave prices too unstable.  [That’s why we’re quasi-monetarists, not monetarists–we don’t assume stable money demand.]  So we have to combine changes in the money supply with changes in the inflation target.  We need to tell the public we’ll inject enough money to push prices X% higher over the next few years.  The new Keynesian will respond “Aha, but that’s not monetarism, that’s new Keynesianism.  The inflation target is doing all the work, not the money supply increase.”  Yes and no.  It is mostly the target, but not completely.  That’s because the Keynesian liquidity trap model is slightly unrealistic in several ways:

a.  The Fed can limit reserve demand by cutting rates on bank reserves to zero, or negative.  In that case it’s all about cash held by the public.  And the reasons people hold cash are different from the reasons they hold securities.  Most cash is held for tax evasion and petty transactions–neither of which can be easily done with T-bills.  So they aren’t quite perfect substitutes.  Still, rates on T-bills could go negative enough to make them near perfect substitutes.

b.  Cash is even less of a perfect substitute for other types of securities, which the Fed could also purchase.

c.   Most importantly, QE is also a form of communication.  If you are trying to convince markets that you are adopting a more expansionary monetary policy, it is easier to do if you both announce a higher inflation target, AND ALSO DO SOMETHING.  Roosevelt understood this, which is why he adopted a gold buying program in late 1933.  The amounts of gold purchased were far too small to have any macro effect, but nonetheless the program did move market prices.  Why? Because it was a signal that FDR was soon going to do something which would be effective—permanently devalue the dollar.  He bought gold at higher and higher prices, which was a signal to the markets about the likely future price of gold.  QE would be Bernanke’s gold-buying program, only slightly effective on its own, but very powerful when combined with a higher inflation target.  Even if the inflation target isn’t explicit, but merely hinted at.

It’s slightly annoying the way people like Krugman and DeLong imply their opponents don’t understand the paradox of thrift.  Yes, if people try to save more, and rates fall, the real demand for base money will rise.  And if the Fed doesn’t offset that then AD will fall.  We do understand that.  But we continue to insist the problem is fundamentally monetary because we see the Fed as being able to offset any shifts in public or private saving.  And how can Krugman disagree with that on theoretical grounds?  Hasn’t he just been hammering the Fed for not doing enough to boost AD?  It’s a bit late to claim the Fed can’t do anything when rates are zero.  Now he’s certainly entitled to claim that he doesn’t think the Fed would completely offset an attempt by the public to save more, or a program of austerity by the government, but that’s an empirical judgment.  It has nothing to do with new Keynesian theoretical models that supposed “prove” there is a paradox of thrift at the zero bound.

The paradox of thrift models are only pulled out at the zero bound, because that’s when monetary policy is (allegedly) ineffective.  So you have the bizarre spectacle of Krugman castigating the Fed every Monday, Wednesday, and Friday for not doing enough, and then on Tuesday and Thursday criticizing economists who don’t believe in the paradox of thrift—a model that only makes sense if the Fed can’t do anything!

As for Mr. DeLong, his reply to Nick Rowe’s comment is fine as far as it goes, but it doesn’t go anywhere near deeply enough into the problem.  No one is asking the Fed to merely do a few desultory OMOs, and then imply they’ll soon be reversed.   And at times he still seems to be struggling to free himself from the influence of 1930s Keynesianism, as when he claims the problem can’t be monetary, because interest rates on government bonds aren’t very high:

Thus we would expect a downturn caused by a shortage of liquid cash money to be accompanied by very high interest rates on, say, government bonds–which share the safety characteristics of money and serve also as savings vehicles to carry purchasing power forward into the future, but which are not liquid cash media of exchange.

I wish we could stop all this skirmishing on side issues, and focus on what really separates us–whether it is most useful to think of monetary policy driving inflation and NGDP growth, even at the zero bound.  Or whether (as Krugman and DeLong seem to believe) it is more useful to think of monetary policy as passive and ineffective at the zero bound, and do macro analysis on that assumption.  They’re entitled to that belief, but then I don’t see why the Fed should listen to their complaints that money’s too tight.

One final comment.  Keynesians argue that only permanent monetary injections matter at the zero bound, and thus that it is pointless to increase the current money supply.  But that’s true equally true of interest rates in normal times.  If you raise rates 1% and announce they’ll be cut again a month later, almost nothing will happen.  Woodford showed it’s all about the expected future path of policy.  So this argument that current changes in the money supply are not important is always approximately true, and equally true of interest rates.  Plan on quitting smoking?  Heh, light up another cigarette!  After all, it’s the long run path of your cigarette consumption that really matters.  My response would be that there is no better time to start QE than right now.  Remember, the longest journey begins with a single step.

OK, let’s all get together now and go after the real enemy—the hawks at the Fed.

BTW, Krugman says his model’s best because he predicted interest rates and inflation weren’t going to rise.  Well I predicted interest rates and inflation weren’t going to rise, AND I was screaming at the Fed to ease money in late 2008.  How does that call for action look now?  Sometimes one needs a relentlessly single-minded focus, and if people consider that Procrustean, so be it.

HT:  David Beckworth, TravisA

The lonely ones

I think we all form mental maps of our profession.  In my field (monetary economics) I saw the new classical/RBC groups as being on the right, and the old Keynesians (or Post Keynesians) as being on the left.  Both believed in “monetary ineffectiveness,” at least to some extent, but the right thought of the ineffectiveness in real terms and the left thought in nominal terms.  In this mental map the new Keynesians were in the middle, and thoroughly dominated the upper echelon of the profession.

I tended to read quite a bit of stuff by Bernanke, Krugman, Svensson, and Woodford, who I believe were all at Princeton sometime around the early 2000s.  To me, these economists seemed to be both at the ideological center of macro, and also at the cutting edge of research.  And when Bernanke was picked to run the Fed, it pretty much confirmed my image of new Keynesianism being the standard model of macroeconomics.

I now believe my mental map of the profession was completely false.  At least three of these guys are way out on the fringes, despite appearing to be in the center.  Perhaps the real split is between theoreticians and pragmatists.  Between those who take a common-sense approach, and those who understand the deeply counter-intuitive nature of monetary economics.  A few brief comments on each:

1.  Michael Woodford wrote what is generally regarded as the bible of new Keynesianism.  So I always sort of assumed that he was a towering figure in the profession.  But how often do you see his ideas discussed in the elite press?  (I.e., the WSJ,  NYT, FT, The Economist, etc.)  He argues that when rates hit zero you shouldn’t be doing inflation targeting, you need price level targeting.  Do you see those ideas being discussed?  I don’t.

2. Lars Svensson is a member of the Swedish Riksbank.  With no disrespect to the other 5 board members, I’d have to assume that his academic reputation towers over the others.  Yet look how little influence he has:

Sept. 17 (Bloomberg) — The Swedish Riksbank’s most outspoken board member on the risks of deflation said central banks shouldn’t raise rates to curb asset-price growth when inflation is low — a path his own bank is pursuing.

“The policy rate is an ineffective instrument for influencing financial stability,” Riksbank Deputy Governor Lars E. O. Svensson said in a speech delivered in Tokyo and published on the bank’s website yesterday. “The use of the policy rate to prevent an unsustainable boom in house prices and credit growth poses major problems for the timely identification of such an unsustainable development.”

Sweden’s central bank on Sept. 2 raised its benchmark repo rate a second time in as many months in part, it said, to cool the housing market. Inflation, which has lagged behind the bank’s 2 percent target since December 2008, slipped 0.2 point to 0.9 percent last month. Policy makers in Sweden, which emerged from an eight-month bout of deflation at the end of last year, may be underestimating the risk that price declines can return, some economists say.

“The Riksbank’s Monetary Policy Committee, except for Svensson, is not taking deflation seriously,” said Par Magnusson, chief Nordic economist at Royal Bank of Scotland Group Plc’s Stockholm office. “But they should. Deflation is a far greater threat than inflation.”

According to New York University Professor Nouriel Roubini, deflation is becoming a broader threat, with the U.S. also at risk of experiencing price declines as it faces the prospect of a sluggish recovery. Magnusson says deflation is tougher to tackle for central banks than inflation, especially when rates are already low.

‘So Much Worse’

“The effects of deflation are so much worse than the effects of slightly too high inflation,” he said. The Riksbank “really should rather be safe than sorry in their policy and not hike until they are dead sure” there’s no deflation threat.

Svensson was the only Deputy Governor of the Riksbank’s six board members to vote against the Sept. 2 quarter-point rate increase. “The market is right and the Riksbank is wrong about the level of the repo-rate path,” Svensson said, according to the minutes of this month’s meeting, published Sept. 15.

The Riksbank has signaled it will raise the main rate by another 0.5 percentage point over its next two meetings in October and December, bringing it to 1.25 percent by the end of the year.

“The market is right and the Riksbank is wrong.”  Replace ‘Riksbank’ with ‘Fed’ and you have described our own policy failures.

3.  Paul Krugman is easily the most influential economic blogger in the world.  The favorite columnist of many Democratic readers.  And recall that well over 50% of the Washington DC and NYC intellectual establishments are Democrats.  Three fourths of academic economists vote Democratic.  So his ideas on the need for more monetary stimulus must be really popular, right?  Then why does he consider himself (with Robin Wells) a voice crying in the wilderness?

In the winter of 2008-2009, the world economy was on the brink. Stock markets plunged, credit markets froze, and banks failed in a mass contagion that spread from the US to Europe and threatened to engulf the rest of the world. During the darkest days of crisis, the United States was losing 700,000 jobs a month, and world trade was shrinking faster than it did during the first year of the Great Depression.

By the summer of 2009, however, as the world economy stabilized, it became clear that there would not be a full replay of the Great Depression. Since around June 2009 many indicators have been pointing up: GDP has been rising in all major economies, world industrial production has been rising, and US corporate profits have recovered to pre-crisis levels.

Yet unemployment has hardly fallen in either the United States or Europe””which means that the plight of the unemployed, especially in America with its minimal safety net, has grown steadily worse as benefits run out and savings are exhausted. And little relief is in sight: unemployment is still rising in the hardest-hit European economies, US economic growth is clearly slowing, and many economic forecasters expect America’s unemployment rate to remain high or even to rise over the course of the next year.

Given this bleak prospect, shouldn’t we expect urgency on the part of policymakers and economists, a scramble to put forward plans for promoting growth and restoring jobs? Apparently not: a casual survey of recent books and articles shows nothing of the kind. Books on the Great Recession are still pouring off the presses””but for the most part they are backward-looking, asking how we got into this mess rather than telling us how to get out. To be fair, many recent books do offer prescriptions about how to avoid the next bubble; but they don’t offer much guidance on the most pressing problem at hand, which is how to deal with the continuing consequences of the last one.

Nor can this odd neglect be entirely explained by the mechanics of the book trade. It’s true that economics books appearing now for the most part went to press before the disappointing nature of our so-called recovery was fully apparent. Even a survey of recent articles, however, shows a notable unwillingness on the part of the dismal science to offer solutions to the problem of persistently high unemployment and a sluggish economy. There has been a furious debate about the effectiveness of the monetary and fiscal measures undertaken at the depths of the crisis; there have also been loud declarations about what we must not do””warnings about the alleged danger of budget deficits or expansionary monetary policy are legion. But proposals for positive action to dig us out of the hole we’re in are few and far between.

4.  If Krugman sometimes seems a figure of almost Shakespearian complexity, then Bernanke seems enmeshed in Hamlet’s predicament. (Someone with more skill than me should rewrite the famous soliloquy as “To ease or not to ease . . .”  I’ll spare you from my lack of literary talent.)

There are two ways to visualize Bernanke’s current position.  Perhaps he still does represent the ideological center of American macroeconomics.  In other words, maybe that center has shifted far to the right since the days when Bernanke was criticizing the Japanese for showing a lack of boldness, a lack of what he called “Rooseveltian resolve.”  Or perhaps he finds himself surrounded by lots of people who fail to understand the need for stimulus, and lots of other people who do realize that we need more AD, but fail to understand the effectiveness of unconventional policy tools.  I suppose we’ll find out when we read his memoirs.  I’m guessing they will provide yet another example of the famous maxim; “It’s lonely at the top.”