John, In my view we need to use market NGDP expectations as an indicator of monetary policy.

]]>Having been accused, and found guilty, of rigging and manipulating virtually every possible asset class, perhaps it was inevitable that Deutsche Bank, currently on trial in Milan for helping Banca Monte dei Paschi conceal losses (as first reported last October in “Deutsche Bank Charged By Italy For Market Manipulation, Creating False Accounts”) is now facing accusations that it was actually running an international criminal organization at the time.

]]>“As emphasized by Friedman . . . nominal interest rates are not good indicators of the stance of policy. . . . The real short-term interest rate . . . is also imperfect. . . . Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation.”

However, I’m not sure how useful “[seeing] if an economy has a stable monetary background” by construction an index that’s basically a Taylor Rule minus the real interest rate part is. It’s pretty obvious if you look at GDP and inflation over the last few years that the recovery hasn’t been as fast or as large as anyone expected in 2007, and I guess this indicator gives us a number for exactly how bad or good the economy is relative to the central bank’s goals at a given point in time.

But I think everyone (except maybe gold bugs, John Cochrane, John Taylor, and a few others) would have been happy if the Fed had provided more stimulus throughout 2008 and in the 9 years since then. This indicator has the major flaw that it doesn’t give any quantitative estimate of what needs to be done. At least the Taylor Rule says how much lower the interest rate should have been. This indicator doesn’t tell the Fed how many more trillions of dollars of quantitative easing it needed to do to get inflation up to 2%.

It’s not like monetary aggregates that the Fed has close control over even have direct relationships with output and inflation anyway — the monetary base has grown by 354% since December of 2007 while inflation has been consistently below target and NGDP falling precipitously below its pre-recession trend. Heck, the Bank of Japan has been increasing Japan’s monetary base by about 80 trillion yen a year for about 4 years while CPI has remained flat (ignoring the VAT hike).

Ideally “interest rate free monetary policy” would tell central bankers how much extra stimulus is needed in units of something, rather than just being some index that says monetary policy was roughly “-3” in 2012. And this is before you consider that monetary base growth is a terrible predictor of actual data, let alone consider the obvious issues with monetary policy at the zero lower bound.

Comparing the monetary base to Bennett McCallum’s rule would probably make a lot more sense in terms of assessing the stance of monetary policy, but even then I doubt, for instance, increasing the monetary base to $5 trillion instead of $4 trillion would have had much effect if any on output and inflation.

]]>It’s just a bit of algebra after that:

i = π + r* + a(π – π*) + b(y – y*)

assume r = r*

0 = a(π – π*) + b(y – y*)

0 ≈ a((P-P_T)/T – (T/T)π*) + b(y – y*)

0 ≈ (a/T)(P-P_T – T π*) + b(y – y*)

0 ≈ (P-P_T – T π*) + α(y – y*)

where α = b/(a/T)

Of course if you assume r = r* always, then you’re just assuming interest rates don’t matter because they’re always at the equilibrium rate. You could similarly construct a ‘GDP-free Taylor rule’ by assuming y = y* or an ‘inflation-free Taylor rule’ by assuming π = π*.

]]>And, of course, we have seen declining rates of real growth and inflation since the 1980s.

The question is, in the current environment, should not the Fed be much more expansionary?

]]>I.e., interest rates are NOT the price of money, so why would they be a good guide.

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