Words of wisdom from Matt Yglesias

The following comment left by Matt Yglesias is a gold mine, which will generate a number of posts:

The state of the art thinking in DC, as I understand it, is that with interest rates and capacity utilization low monetary policy may not be able to boost NGDP by arbitrary amounts. Under the circumstances, to push it up non-trivially might require “crazy” steps that cause inflation expectations to become dangerously unanchored. So you need fiscal policy + monetary accommodation (i.e., bigger short-term deficit + Fed holds interest rates low) to produce the kind of moderate AD stimulus that’s wanted.

Unclear to me where this model comes from, or what evidence people think they have for it. But it’s a popular view among professional staff at Treasury & Fed and is bouncing around in the heads of some important principals and “name” economists. See Peter Diamond’s remarks to Ryan Avent and what Donald Kohn and Joel Prakken told Dylan Matthews.

To me this seems like what happens when a bunch of really bright people fuck up. Rather than admit that they fucked up, they’re devising clever theories to explain why they haven’t fucked up.

Matt’s very well connected, so I don’t doubt his facts.  And his interpretation is also spot on.  But I think it’s worth discussing all the reasons why the conventional wisdom is all wrong, just as the identical conventional wisdom from the 1930s is now known to be 100% false.

There are all sorts of problems with the conventional view, but they boil down 2 fundamental problems:

1.  Grossly overestimating what the Fed has already done in terms of stimulus.

2.  Grossly overestimating how hard it is to prevent excessive inflation when exiting a liquidity trap.

Those who wrongly think the Fed has already been very accommodative, who think ultra-low rates and large injections of interest-bearing reserves represent “easy money,” are naturally inclined to throw up their hands and think; “If even this did nothing, then imagine how much stimulus would be required to boost AD.  And then think of the risk of hyperinflation.”  The commodity price rise following QE2 probably exacerbated that fear.

But money isn’t easy, it’s very tight.  Policies like Operation Twist were widely viewed as being almost a complete flop after it was tried in the 1960s; there was never any theoretical or empirical evidence that should have led the Fed to expect success by resurrecting that discredited tactic.  QE2 does seem to have had some effect; certainly on markets, and maybe on the monthly jobs numbers in early 2011.  But it was ended.  And things have gotten even worse since the signals were sent out that the Fed was stopping the program.

Most importantly, the Fed has never done any of the things that would really be effective.  The things Bernanke recommended the BOJ do, like level targeting.  I’m sure the Very Serious People in DC don’t care at all what I think, but it should give them pause to consider that no less than Michael Woodford thinks level targeting is essential when rates hit zero.  Better yet, level targeting is explicitly designed to prevent an outbreak of high inflation when a country is attempting to exit a liquidity trap.  Peter Diamond may have a Nobel Prize, but he isn’t 1/10th the monetary economist that Woodford is.  It makes no sense to say the Fed has already been aggressive, when they haven’t even tried state of the art ideas like level targeting, and they have done contractionary policies like IOR (which greatly reduces the effectiveness of QE.)

Fear of excessive inflation is even more unfounded.  Let’s start with a list of all the countries in world history that exited a liquidity trap and ended up with excessive inflation:


OK, now let’s discuss why it’s never happened.  The most aggressive monetary policy during a liquidity trap was FDR’s dollar depreciation policy of 1933-34.  It did produce rapid inflation during 1933-34, but not thereafter (except a brief burst in 1936-37, that was immediately reversed.)   But it failed to achieve the policy goal; reflation to pre-Depression price levels.  Not even close.  And yet at the time all the Very Serious People said it was an inflationary time bomb, which would explode in a couple years.  In fact, during 1934-40 the WPI rose by 5%, less than 1% per year.  One of the Very Serious People was Keynes, who criticized the policy as being too inflationary in late 1933 (when gold prices rose above $28.)  When FDR went back onto the gold standard in January 1934 (at $35/oz), Keynes congratulated FDR for rejecting the views of the “extreme inflationists.”  That’s right; if Krugman wrote for the NYT back in 1934 he would even be criticizing Keynes.

I don’t even need to talk about Japan, which has made no serious attempt to escape the zero rate trap; indeed which tightened monetary policy in 2000 and 2006 when inflation was roughly 0%.  And then went right back into deflation.  Believe me, there is no way the Fed’s going to overreact, whatever they do will be too little, and will almost certainly be judged too little by future economic historians.

In addition, wages don’t move until inflation expectations rise.  And the Fed can prevent that by monitoring TIPS spreads closely and not allowing 5 year spreads to exceed 3%.  I’m not saying they’ll hit their inflation target perfectly, but any overshoot will be trivial compared to the devastation of US and European labor and debt markets by the relentless decline in NGDP growth.  A few years ago 3% inflation didn’t even attract any attention.

Headline inflation is another story.  A robust recovery will cause a sharp, one-time rise in world oil prices.  Are we willing to pay that price, or do we prefer to keep 15 million unemployed so those with jobs can pay less for gas?  If we were at full employment and had $5 gas, should we purposely create 9.1% unemployment in order to bring gas prices down?  What do you think?

A recurring theme in this blog is that policymakers around the world are reacting to how things seem to be, not what history, theory, and logic tells us is actually going on.  Woodford has the theory and logic, and I have the history.  But most people don’t know the history, and few people have the deep understanding of monetary economics that Woodford has.  So we are going with our hunches.  But monetary economics is a very counter-intuitive field.  Really tight money can look just like really easy money.  And since policymakers rely on common sense, we are screwed.

Unfortunately, it increasingly seems likely that sound monetary policy won’t return until we can go back to targeting nominal rates.  Our only hope is to create a robust enough recovery where we can have positive interest rates without those higher rates representing tight money.  And every day that scenario recedes further and further into the future, partly due to the actions of the Fed itself.

Unless they change course dramatically, there is no light at the end of the tunnel—there is no 2% T-bill yield for as far as the eye can see.  And that means no prosperity.

Mr. Bernanke, listen to what the markets are telling you

Peter Laan sent me this headline, from Bloomberg.com:

Treasuries Drop After Bernanke Says Federal Reserve Poised to Take Action

Treasury prices dropped, meaning yields rose.  Isn’t that the opposite of Operation Twist?

My slow response to Tyler Cowen’s quick response

Tyler Cowen reacted to the recent Fed decision.  I don’t understand several of his cultural references, but I’ll respond to at least some of his points:

I would put it thus: the Fed probably decided to do the best it could within political constraints and a framework of more or less stable prices.  Which won’t do much good at all.

They are certainly operating under political constraints, and what they’ve done last week certainly won’t help.  But I also think they’ve shown a lack of creativity.  In some ways their actions (QE and Twist) seem more radical that 2% inflation targeting, level targeting.  But the latter policy would actually be far more expansionary.  Both NGDP and RGDP would have to grow considerably faster than currently expected to get inflation up to 2% over the next 5 years (especially using the Cleveland Fed measure of expectations.)   Admittedly, even that policy would result in a sub-par recovery.  But how radical is it?  It would essentially mean the Fed is reneging on the employment mandate, and targeting prices only.  And we now live in a world where even that sort of conservative dream policy is viewed as being too stimulative.

1. The median voter hates price inflation.  Don’t blame Bernanke.

The median voter doesn’t understand inflation.  They don’t know the difference between supply-side inflation and inflation.  So it’s no surprise that “inflation” is unpopular.  Bernanke would be creating demand-side inflation, which raises the real incomes of Americans.  It’s an open question as to how unpopular that would be.  There’s no question that QE2 wasn’t all that popular.  But I’d make two points.  Obama was significantly more popular when QE2 was creating 200,000 jobs a month and reducing the unemployment rate, than he is now, with oil prices falling fast.  Second, part of the oil price increase under QE2 was Libya, which isn’t demand-side at all.

2. Today price inflation will accelerate real wage erosion, or at least is perceived so, who wants to take credit for that?

Demand-side inflation reduces real hourly wages (sometimes) but raises real annual incomes.  People care much more about real annual incomes than real hourly wages.  They want to work.  A president would much prefer real hourly wages falling and real incomes rising, rather than the reverse.

3. Core CPI is already going up at a rate of two percent and 3.8 percent for the broader bundle, at least for the time being.  Voters don’t know or care what is embedded in the TIPS spread, etc.

Lots of presidents have been highly popular with 2% core and 3.8% headline inflation.  Those are very typical inflation rates.  Not many have been popular with 9% unemployment for as far as the eye can see.  Voters do care about headline inflation, but it’s only averaged 1% over the past three years, and is expected to average about 1.4% over the next 5 years.  Headline inflation isn’t the biggest economic problem in America, unemployment is.  That’s why Obama is highly unpopular.  Plummeting house prices mean lower “inflation.”  Do a poll and find out how many voters see “inflation” that way; see how many actually welcome lower housing “inflation.”  For most voters inflation is the price of gas, period.

4. Some of the “inflationists” ignored supply-side factors and bottlenecks and didn’t see this price pressure coming.  That has thrown their entire analysis into doubt, unjustly probably but nonetheless.  In any case it is no longer the simple story where Q goes up first and only later does P rise.

I strongly agree here.  I’ve always argued that AD raises prices—there is no such thing as a flat SRAS.   And it does so right away, due to commodity prices.  The peak oil problem makes this even worse, as Tyler indicates.  The rising inflation is an embarrassment to demand-siders who have focused their analysis on the need for higher inflation and who buy into Keynes’s “bottleneck” theory of inflation, or NAIRU models.  FDR disproved those models when he generated rapid inflation in 1933.  On the other hand NGDP growth has been slowing from an already low level, so us market monetarists are seeing our predictions vindicated.  If you don’t generate robust NGDP growth, you CANNOT get a robust recovery.

Every now and then, you ought to conclude that what you see is what you get and that is because of the rules of the game.  When it comes to further monetary stimulus, I’m not sure there’s so much more to say.

Maybe not right now, but this policy will eventually fail.  And when it does we’ll be right back here debating the need for more monetary stimulus.  Eventually the Fed will do what it should have done in 2008-09, but after much needless suffering.  Just as eventually (in 1981) the Fed did the tight money policy it should have done in 1966.  And eventually (in 1933) it did the easy money policy it should have done in 1930.  That’s why pundits need to keep up the pressure, no matter how much it looks like we are losing.

PS.  At the request of some commenters, I added a link to my new NGDP paper on the right side of this blog, in the category “Quick intro to my views.”  I think it is the best place to see my policy views in one place.

Why the dollar rallied

There seems to be some confusion about yesterday’s rally in the dollar.  Here is Kate Mackenzie and FT.com/Alphaville:

As Sumner adds, the dollar rose along with short-term Treasury yields on the news.

Stock markets are also reflecting a big risk-off sentiment.

Of course, it’s debatable how much of this is due to the Twist launch itself, and how much to the mention of “significant downside risks to the economic outlook”, and how much just to the general despair that this type/scale of action will be adequate in the face of a looming slowdown and contractionary fiscal policy.

Each of those sentences is individual correct, but together they create a slightly misleading impression.  The falling stock prices could have been due to a forecast of downside risks, but fears of a weaker US economy would make the dollar fall.  The dollar rally was produced by tighter than expected money, just as in late 2008.  Here’s Pablo Gorondi of Associated Press:

“The dollar’s reaction to Operation Twist has been the opposite of what we would have predicted; the dollar looks stronger after it, which makes little sense,” said analysts at U.S. energy consultancy Cameron Hanover. “It seems to be telling us that investors had already discounted a larger quantitative easing program. That would go a long way toward explaining the resilience of oil prices over the last few months.”

That’s right, it wasn’t Operation Twist, which was priced in (but ineffective), it was the lack of even a hint of anything more, of a backup plan.  Bye bye Bernanke put.

The Fed “succeeded” in flattening the yield curve

Some articles point out one “bright spot” in this dismal day—the Fed succeeded in lowering long term yields.  They also raised short term yields, making the yield curve flatter.  You might want to get out your money textbook to find out what type of monetary policy causes a flatter yield curve.  According the an article by Sharon Kozicki at the Kansas City Fed:

The yield spread reflects the stance of monetary policy. According to this view, a low yield spread reflects relatively tight monetary policy and a high yield spread reflects relatively loose monetary policy.

The yield spread is the long rate minus the short rate.  Kozicki says the conventional view is that a lower yield spread means tighter money.  Today the Fed made the yield curve flatter.  You might think; “They know what they are doing; surely they wouldn’t tighten monetary policy.  Sumner must have things backward.”

OK, how would tight money affect the dollar?  Here’s the euro/dollar (the fall means the dollar soared after 2:15, or 6:15 London time):













And here’s the Dow:










So what do you think, monetary stimulus or monetary tightening?  The only thing that’s “twisted” is the Fed’s logic.  They are so obsessed with the Keynesian low interest rate approach to stimulus that they’ve completely lost their bearings and ended up tightening monetary policy.

PS.  I forgot to mention one other piece of “good news,” the Fed action sharply reduced oil prices.  Less inflation “worries.”