Statsguy on the environmental impact of Fed/ECB policy

Here’s Statsguy from the comment section of an earlier post:

I would add only this: The Fed (and ECB) are doing tremendous STRUCTURAL damage by over-targeting (rear-looking) headline inflation. That doesn’t mean I don’t think headline inflation is important (it’s quite real, particularly if you’re in the lower income strata), but it’s counterproductive.

Why? Essentially, we’re knee-capping the economy to drop AD to bring down the price of oil (in dollars), which in a sense is SUSTAINING THE OIL INTENSITY OF THE ECONOMY to a great[er] degree than is optimal. What do I mean by that? Simply this: if the price of oil went up (relative to labor and debt), then economic actors would accelerate substitution away from oil – that is, they would substitute more people and more technology for expensive oil. INSTEAD, we’re dropping oil use not by encouraging substitution to alternatives (including increasing labor intensity, which would help with unemployment) but by preserving the current oil intensity and reducing overall consumption (including reduction of consumption of non-oil-intense products, like digital “goods”). It’s dumb.

In a sense, that Fed policy is also encouraging developing economies to move toward a more oil-intense infrastructure than would otherwise exist if oil were priced higher. It is encouraging LESS drilling, LESS technological innovation in the drilling sector, LESS demand for fuel efficient vehicles, LESS investment in alternative transportation, and WORSE city planning.

I don’t have strong views on this issue, but it’s an interesting perspective.

2.  Off topic, but I was originally planning on doing a post criticizing Felix Salmon.  Fortunately, David Beckworth saved me the trouble.  I highly recommend the post.

3.  I get frustrated with a developing argument that it’s tough to address this AD problem because inflation is unpopular.  There are all sorts of flaws with this, which I have discussed elsewhere.  (Opinion polls on inflation are meaningless, and in the past the public has seemed far more satisfied with a bit higher inflation and a lot more jobs.)  But here’s what really frustrates me.  We are letting the Fed off the hook.  The Fed used the biggest debt crisis in world history as an opportunity to drive inflation (and inflation expectations) to the lowest levels in 50 years, to levels lower than their mandate, to 1% over the past three years.  And all along the way Bernanke kept insisting that they had more ammo, but just didn’t think more stimulus would be appropriate.  None of the recent posts claiming the Fed has a political problem because the public hates inflation have addressed this issue.  I guarantee that if interest rates were 8.5%, many unions, Congressmen and business people would be demanding rate cuts right now, inflation or no inflation.  The Fed is EXTREMELY lucky that 99.999% of people don’t have a clue as to how monetary policy works (beyond interest rates.)

4.  Totally off topic, but Matt Yglesias’s predictions are quite similar to my own.  I’m agnostic on his health cost argument, and would clarify his point that although China can grow fast for many years, the actual growth rate will likely slow somewhat.  But those are my forecasts.  However if they are wrong I’ll blame Yglesias, as he’s much smarter than me and should have known better.

PS.  Yesterday I finally answered lots of old comments from a week back.  The backlog was overwhelming.  I do eventually read all the comments, and answer most.  But after three years I am reaching the end of the road for these two:

A.  Liberals asking how monetary policy can work when rates are zero.

B.  Conservatives conceding QE2 raised inflation, but asking how more inflation can boost output.

I think I’ll just start directing people to FAQs.  The blog isn’t really set up for people who don’t understand the AS/AD model.  If they disagree with it fine, tell me why.  But faking ignorance by claiming not to understand how nominal shocks can have real effects is very annoying.

Further thoughts on Switzerland

The recent Swiss devaluation has led to some interesting reactions in the blogosphere.  But one angle that I haven’t seen discussed is the relationship of the Swiss action and bubble theory.  I’m a believer in the EMH and hence skeptical of the idea of bubbles, a least as the term is usually interpreted.  But I’m in the minority, the vast majority of people think bubbles exist.  And if they do, then the recent move of the Swiss franc to near parity with the euro was surely a major bubble–as the currency appeared to be at a level that was unsustainable in the long run.

If the Swiss franc is wildly overvalued, then what should the Swiss do?  Because I don’t believe governments can identify bubbles, I’d be inclined to say they should do nothing.  But most people think bubbles are identifiable–indeed that’s a sine qua non for the existence of bubbles.  In that case the policy implications are clear–the Swiss government should buy massive quantities of foreign exchange, and then sell off the assets at a future date when the real exchange rate is at a more “reasonable” level.  The very rich Swiss would become even richer.  And because governments last indefinitely they can afford to wait out market irrationality, no matter how long it takes to dissipate.  BTW, this action need not involve monetary policy at all.

Now suppose Switzerland faces the threat of deflation, either due to an overvalued currency, or some other problem like currency hoarding.  What should the Swiss government do?  They should sell massive quantities of SF, until deflation is no longer expected.  BTW, this action need not involve the foreign exchange market at all.

As a practical matter the two actions I just describe will often be combined.  The Swiss will sell massive quantities of SF, and buy lots of foreign assets.  This would be appropriate if they think that Switzerland faces a threat of deflation and its currency is hugely overvalued.

Given my belief in the EMH, you might ask why I endorsed the Swiss intervention.  I don’t care at all about the overvaluation of the SF, my support was solely based on the assumption that the Swiss do face an actual risk of deflation.  I would also have supported a policy of price level targeting, or NGDP targeting.  I don’t much care if the Swiss end up winning or losing their bet on the SF.  The EMH says it’s a coin toss, and Switzerland’s a very rich country.  If they plan this game frequently, they’ll win as many as they lose.  Or if I’m wrong about the EMH, they’ll win way more than they lose.

Tyler Cowen had this to say about the action:

I am not unhappy but I am nervous.  Keep in mind the Swiss tried such pegs before, in 1973 and 1978, and neither lasted.  At some point limiting the appreciation of the Swiss franc implied more domestic price inflation than they were willing to tolerate (seven percent, in one instance, twelve percent in another).  You can argue about whether they should be, or should have been, nervous about seven percent price inflation but the point is that they were and indeed they might be again.

Fast forward to 2011.  It’s the Swiss saying “we can create money more decisively and more quickly than the speculators can bet against us, and keep it up.”  If the flight to safety continues, the Swiss can reap seigniorage by creating money but also there may be spillover into price inflation.  You can fix a nominal exchange rate but the market sets the real exchange rate through price movements and so Swiss exports could end up growing more expensive anyway, through the price adjustment channel.  If you’re holding and trading euros, and the Swiss central bank keeps churning francs into your hand at a good rate, at some point you will consider buying a chalet in Schwyz.

If the speculators sense less than a perfectly credible commitment from the central bank, they will continue to bet on franc appreciation.  In other words, the Swiss are putting their central bank credibility on the line, at least in one direction.  And even if they stay credible, they may not much lower their real exchange rate over a somewhat longer run, so why should they be fully committed to credibility?

I think I understand Tyler’s argument, but am not sure quite what to make of it.  It might help to slightly change the policy, and then see how it affects things.  Suppose the SNB says they will buy foreign exchange in order to drive down the value of the SF until inflation expectations rise to 2%.  In that case, it wouldn’t be much of a problem if inflation started rising, the SNB could simply abandon the program and declare “mission accomplished.”  This suggests that the real problem is a specific commitment to peg the SF at 1.20.  The SNB might have to abandon the peg if inflation started moving in a direction that conflicted with their macro policy goals.

In another post Tyler Cowen makes this comment:

And here is Scott on the Swiss unlimited pledge, a real test of credibility theories.

Just as with QE2, it’s not clear what is being tested.  QE2 was certainly credible—markets reacted powerfully to the news.  But the policy didn’t pan out as the had hoped.  And the Swiss announcement yesterday was certainly credible.  If it wasn’t markets would not have reacted so strongly.  It’s important not to confuse credibility and fidelity.  For instance a Don Juan may be credible, but not faithful.

It might be instructive to compare the ways in which QE2 might fail, with the ways in which the SNB policy might fail.  QE2 might have failed because it was not credible, because it didn’t increase NGDP expectations.  In fact, it did not fail for that different reason.  The real problem was that Fed didn’t commit to enough QE to hit a particular NGDP target, they committed to $600 billion in QE2.  Both the Fed and the markets initially thought that would be enough to significantly boost NGDP growth.  If it did (which is unclear) all it did was to prevent an even steeper slowdown than what actually occurred.  On the other hand if the Fed had promised to do whatever it takes in the form of QE, and if it was believed, it might have failed because it later reneged on that promise.  The Don Juan problem.  That’s a problem some people worry about, but not me.  Central banks aren’t Don Juans.  They don’t have fidelity problems, they have commitment problems.

In my view people are making too much of an issue of the risk that the SNB may not end up adhering to the 1.20 currency peg.  The SNB frequently intervenes in the forex market, as described in this recent post.  During recent years there were several interventions that seemed to achieve the SNB’s objectives, and then were abandoned when no longer needed.  Mission accomplished.  The macro aggregates in Switzerland are about where the SNB wants them, but there is concern about future trends.  Thus they are taking a pre-emptive action.

This recent action may be abandoned because the SNB’s macroeconomic goals are achieved.  But I don’t see how that would be a source of embarrassment for the Swiss.  It’s inflation and NGDP that matter, not the exchange rate–which is merely a means to an end.

Here’s Matt Yglesias:

I continue to be fascinated by the fact that lots of issues in monetary policy that are controversial when you talk about “monetary policy” become uncontroversial when the subject switches to exchange rates. Everybody knows that currency depreciation expands aggregate demand. This is what the Swiss are talking about. This is what Americans are talking about when they complain about Chinese “currency manipulation.” And everyone agrees that a determined central bank can achieve whatever exchange rate goals it sets. So despite the apparent disagreement over whether or not a determined central bank can boost aggregate demand, everyone in fact seems to agree that it can””but only if we agree to talk about exchange rates rather than “aggregate demand.”

I’d hope “everyone agrees.”  But here’s Paul Krugman (from last year):

Oh, and about the exchange rate: there’s this persistent delusion that central banks can easily prevent their currencies from appreciating. As a corrective, look at Switzerland, where the central bank has intervened on a truly massive scale in an attempt to keep the franc from rising against the euro “” and failed:

PS.  The other quasi-monetarists have had excellent posts on the Swiss move (Beckworth, Hendrickson, Glasner, Nunes, etc.)  I’m still jet lagged and struggling to catch up with all the news I missed, and what other bloggers have been saying.

Freaked out by Freakonomics

I have great respect for the work of Justin Wolfers, so it pains me to write this post.  But if you read the following, I think you’ll see why I couldn’t let it pass:

Typically, the Fed does this by reducing the Federal Funds Rate, which is an interest rate on overnight loans. Unfortunately, that short-term interest rate is now pretty much at zero, and can’t go any lower. The thing is, no-one actually cares about the Fed Funds Rate. You and I and the businesses we work for don’t borrow using short-term interest rates.  Instead, we finance our investments with longer-term loans.  The Fed Funds Rate only matters to the extent that it reduces long-term interest rates.

So the key is for the Fed to reduce long-term rates.

Recently, the Fed has been doing this by “Quantitative Easing.”  It’s a terrible name for a simple solution. Just as the Fed adjusts short-term interest rates by buying and selling overnight government securities, it can adjust long-term interest rates by buying and selling long-term government securities. That’s what QE2 did.

Many market commentators are disappointed that the Fed didn’t announce “QE3″””a renewed round of quantitative easing. But they shouldn’t be. The Fed still chose to reduce long-term interest rates, they just decided to do it with a different tool. They figured that if you can’t reduce short-term interest rates further, you should reduce ’em for longer. That’s what the Fed was promising, when they said they expect to keep their short-term rate at “exceptionally low levels for the federal funds rate at least through mid-2013.”  What does this do? Keeping short-term interest rates lower for longer will also reduce long-term interest rates. And that’s the main game. It has already worked””perhaps even more reliably than following QE2. The interest rate on two-year bonds is down to virtually zero, and the 10-year interest rate is down to 2.2 percent.

So yes, we got lower long-term interest rates.  That’s what matters. And it doesn’t really matter how we got there.

I certainly agree that the fed funds rate is unimportant.  But I’m afraid Wolfers has violated one of my favorite maxims: Never reason from a price change.

It does matter why rates fall.  In December 2007 the cautious Fed announcement so discouraged investors that the stock market crashed and long term interest rates fell (on expectations of recession–which turned out correct.)  Obviously I can’t say for sure that this explains the current movement in the long term bond market.  But consider the following:

1.  When AD is severely depressed, stocks react very positively to monetary stimulus.

2.  When AD is severely depressed, stocks tend to move in the same direction as bond yields.

3.  QE2 rumors seemed to clearly boost stock prices in the fall of 2010.

4.  In recently weeks both stock prices and bond yields have fallen sharply, and the falls have been highly correlated.

Put all those facts together and it seems much more likely that the recent decline in yields is due to fears that the Fed will allow NGDP to plunge, rather than the belief the Fed has adopted a truly stimulative policy.

Wolfers’ mistake is to forget that interest rates can change for many reasons.  It might be more demand for T-bonds from the Fed (expansionary) or more demand for T-bonds from people frightened that the Fed will do nothing to prevent a double dip (contractionary.)

HT:  JTapp

Update:  JTapp told me that Justin Wolfers made the following comment in Twitter:  “Scott Sumner failed to read my piece closely: I didn’t reason from a price change but from a Fed demand shock.”

I understand that Wolfers was assuming the fall in interest rates was in response to a Fed demand shock, but I’m arguing he had no basis for drawing that inference.  The Fed did not announce a policy of increasing its purchases of bonds by more than the market expected—if anything, just the reverse.  All we really know is that markets are responding to the Fed.  We don’t know exactly why.   Indeed the Fed’s action was so confusing that the markets initially didn’t even seem to know how to react, gyrating wildly up and down several times in the hours after the 2:15 announcement.  And recall that in December 2007 a contractionary surprise caused bond yields to plunge–why is this different?     So I’m afraid my criticism stands.

We really, really need a NGDP futures  market, which would eliminate all these debates about whether Fed actions are expansionary and contractionary.  And who is one of the two most famous proponents of prediction markets?  Justin Wolfers.  I’m sure Justin and I agree on that issue.

Update#2:  I just got an email from Justin Wolfers.  Perhaps I created the wrong impression in my “never reason from a price change” comment.  Justin certainly understands the distinction between supply and demand shocks, and I didn’t mean to suggest otherwise.  But monetary economics adds another degree of complexity.  The same action (buying bonds) can raise or lower bond yields, depending on expectations.  A one time open market purchase may well lower bond yields.  But an announcement that the Fed will buy enough bonds to create Zimbabwe-style inflation will raise bond yields.  So even if one knows it’s a demand for bonds shock (and we don’t know in this case) it’s still dangerous to draw inferences from interest rate changes.

Why we are losing (A shockingly uninformed statement by Alan Blinder)

In a recent post I argued that the opponents of having the Fed promote faster NGDP growth are full of “passionate intensity” while the supporters are strangely silent.  There is no better example of this weak passivity than this shockingly uninformed statement by Alan Blinder:

Creating jobs costs money””whether it’s via tax cuts or more spending. (The Federal Reserve normally can create jobs without budgetary costs, but with interest rates already near zero it says it’s out of ammunition.)

This is what Paul Krugman would call a “lie.”  (I think Blinder’s just uninformed.)  Alan Blinder (who used to be vice chair of the Fed!!), seems completely ignorant of the fact that the Fed repeatedly insists it is not out of ammunition, that it has many tools that it hasn’t even used.  Blinder’s statement isn’t even close to being true.  Here’s Ben Bernanke in 2010:

The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.

Perhaps Blinder got confused by statements made by some of the Fed hawks, who expressed skepticism that additional stimulus would help.  But these hawks are worried about more inflation.  They don’t deny that the Fed can inflate, but worry that more NGDP would not raise real output, just prices.  If the zero bound was a problem, they couldn’t even inflate.

The Fed has studies showing QE2 had a positive impact.  Bernanke insists that there are even more powerful tools that the Fed is still reluctant to use–lower IOR, higher inflation targets, or level targeting.  Or they could do a much bigger QE3.

It would be one thing if our Fed made phony claims about being unable to boost AD, as the BOJ sometimes does.  But the Fed actually insists it can do much more, it simply doesn’t think the economy needs more AD.

And much of the liberal establishment covers its ears and pretends not to hear.  Pathetic.

PS.  By the way, not only would aggressive monetary stimulus cost nothing, it would actually have negative budget costs, as it would sharply reduce our budget deficit.

HT Marcus Nunes

That’s what is technically known as an “opinion”

Here’s Paul Krugman criticizing Glenn Hubbard:

I’m late in getting to Glenn Hubbard’s debt column, but it still needs further bashing. Here’s what Hubbard says about the Obama administration:

“Ruling out long-term entitlement spending restraint, Mr Obama has argued that fiscal sustainability can be accomplished by raising marginal  tax rates on households earning more than $250,000 per year.”

This is what is technically known as a “lie”.

This caught my attention, as I held the same opinion . . . er, lie in my mind.  That got me thinking about the difference between opinions and lies.  Krugman points out that there are good arguments against Hubbard’s assertion, but I also see good arguments in favor.  And of course there are good arguments against many of Krugman’s assertions.

I’ve got to give Krugman credit, I’d have trouble looking people in the eye after calling them liars.

PS.  Here’s a tidbit from the New York magazine profile of Krugman:

One colleague at Princeton, where Krugman has taught since 2000, says the economist will avert his eyes when circumstance places the two of them alone in an elevator, his nose stuck in the corner, so as to avoid conversation.

I’d recommend the entire piece.  This is also interesting:

I brought up the work of the legal scholar Cass Sunstein, now with the Obama administration, who has studied the radicalizing effects of ideological isolation””the idea, born from studies of three-judge panels, that if you are not in regular conversation with people who differ from you, you can become far more extreme. It is a very Obama idea, and I asked Krugman if he ever worried that he might succumb to that tendency. “It could happen,” he says. “But I work a lot from data; that’s enough of an anchor. I have a good sense when a claim has gone too far.”

I get frustrated with conservatives who are oblivious to the fact that rumors of QE2 drove up TIPS spreads.  Don’t they follow the financial news?  Krugman’s focus on the data is part of the reason he is such a formidable debater.