“What should the Fed do?” is the wrong question

The right question is “Where should the Fed go?”  Several commenters asked me for a critique of Miles Kimball’s new post on monetary policy.  I like him a lot, but I’m afraid this post will be mostly negative.  Of course that’s not surprising, as Kimball is like 99.99% of other economists; he looks at monetary policy through the wrong end of the telescope.

Most economists think in terms of actions the Fed takes with interest rates or the money supply to move the economy.  In my view that has things backward.  The correct approach is to first decide where you want to go.  If you want NGDP to be 11% higher two years from today, you let the money supply and interest rates respond endogenously until NGDP is expected to be 11% higher.  I prefer an explicit NGDP futures market, but could easily live with Lars Svensson’s approach, which is to adjust monetary policy so that the central bank’s internal NGDP (or inflation) forecast is equal to the policy goal.

The reason many are pessimistic about various tools like QE is that they don’t understand that the Fed doesn’t have a robust policy goal.  The Fed seems pretty content with current NGDP.  In that case, there’s no reason to expect QE to work, because the markets would not expect it to be permanent.  I can probably make these points clearer by criticizing specific comments by Kimball:

So, interestingly enough, once the nominal Fed funds rate is zero, the level of the money supply doesn’t matter very much any more!

This is a common misconception.  Indeed even Paul Krugman makes this argument, despite the fact that his own (expectations trap) model says otherwise.  Consider the old “double the money supply” thought experiment so loved by the monetarists.  They claim it leads to the quantity theory result that the price level will also double, at least in the long run.  Now let’s consider two possibilities:

1.  The money supply doubles, but the extra money is expected to be withdrawn 60 days later.

2.  The money supply is permanently doubled.

Krugman would say in case one the doubling has no effect, and in case two the QT prediction applies.  That’s because liquidity traps aren’t expected to last forever.  Say it’s expected to end in 10 years.  Then the price level would rapidly double in year 10.  But if that was expected, then asset prices would soar in year 9, in anticipation.  By backward induction we get asset prices soaring immediately, and the doubling of the money supply has a powerful stimulative effect, even at the zero bound.  But only if expected to be permanent.

Krugman knows all this, but what he seems to overlook (and I suspect Kimball overlooks as well) is that it applies almost equally when nominal interest rates are 5%.  A doubling of the money supply might do a little bit more at 5% interest than 0%, but not much.  If expected to last only 60 days, asset prices won’t move much, as markets will understand the economy will go right back to the old situation in just 60 days.  Fed funds rates will fall briefly, but that won’t be enough to trigger much long term investment.  Investors care about where the economy will be in the long run.

So monetary policy is ALWAYS LARGELY ABOUT THE EXPECTED FUTURE PATH OF POLICY.  I can’t emphasize this enough.  And that’s what Kimball pays far too little attention to.  He talks about monetary policy in a very mechanical way, as buying various assets.  In fact, it’s mostly about signaling future policy intentions.  Now I’m certainly not saying asset purchases don’t matter.  I supported QE2.  But the reason QE2 boosted asset prices was mostly because it signaled a new Fed determination to boost AD, whatever it takes.  In other words, it was a indirect signal of future policy intentions.

Just to be clear, I’m not claiming the Fed should say the entire recent monetary base increase is permanent—that could lead to hyperinflation.  Rather they should say enough will be permanent to boost 2 year forward NGDP by a certain figure, say 11%.  But if they do that, then they don’t even need to talk about money, just set your NGDP target and let the market determine the appropriate levels of interest rates and money.  Failing to see the endogenous nature of interest rates can lead to bad reasoning:

All interest rates matter for the economy, so lowering almost any interest rate will stimulate the economy.

Kimball has yet to encounter my “never reason from a price change” maxim.  Interest rates plunged yesterday, and that was extremely bearish news for the economy (as we saw from the stock market crash.)  Kimball would probably respond “OK, but other things equal lower interest rates are surely a form of stimulus.”  But “other things equal” prices never change.  Something must cause them to change.  OK, how about “lower interest rates caused by monetary policy actions are stimulative.”  Not really, a highly contractionary policy announcement can cause expectations of recession, which depresses long term rates.  OK, how about short term rates?  In December 2007 a highly contractionary policy surprise caused the stock market to crash at 2:15 PM, and caused bond yields from 3 months to 30 years to fall.  I’ll grant you this, a stimulative monetary policy surprise will usually cause 3 month bond yields to fall, and will almost always cause the fed funds rate to fall.  But as we saw from the previous post, even top Fed officials seem to think lower long term rates are “good news,” so I can’t emphasize enough the folly of focusing on interest rates as an indicator of monetary policy.

It’s beyond my comprehension why our monetary policymakers have not spent a few million dollars setting up and subsidizing trading in an NGDP futures market.  Monetary policy decisions can wipe out trillions of dollars in asset values in a single day.  Millions of jobs are at stake. And our policy makers act like they aren’t interested in having a real time indicator of the stance of monetary policy.  Instead they fiddle around with the money supply and interest rates, like a ship captain steering a huge ocean liner through a thick fog, to a destination undetermined.

Monetary policy is all about shaping expectations of NGDP growth over the next two years.  Nothing else really matters.  Everything else should be subservient to that goal.  Until we start thinking of policy in those terms will be stuck in an Alice in Wonderland world where low rates might be easy money, or tight money.  Where an enlarged monetary base might be easy money, or the belated response to a tight money policy that drove NGDP so far down that nominal rates fell to zero.

PS.  Kimball’s post had some good points, such as the focus on many different asset prices.  But there is too much talk of the Fed directly affecting them via asset purchases, not enough talk about how they indirectly affect them via changing expectations of future NGDP, which then impacts current asset prices.  He also does the reductio ad absurdum of the Fed buying up all of  planet Earth.  I like that example, but (unlike Kimball) I’d characterize it is a success if it failed to boost NGDP.  After all, wouldn’t it be nice if America owned the whole planet, and we could all kick back and live off the work effort of others?

PPS.  Lars Svensson is one of the 0.01% who looks through the telescope from the right direction.



29 Responses to ““What should the Fed do?” is the wrong question”

  1. Gravatar of Saturos Saturos
    2. June 2012 at 09:46

    Thanks Scott! This was the post I wanted. We need to introduce Miles to our little friend Chuck Norris. Or email him excerpts from Woodford. Or get him to read the FAQs on this site.

    “Lower interest rates caused by a rightward shift of the supply schedule for loanable funds due to monetary injection is stimulative”. No, not if the expected path of policy is tight. “Okay then, a permanent downward shift in the term path of interest rates, all due to monetary injection, is stimulative”. No, NGDP is determined by M * V, or the supply and demand for money. If MV is held fixed, then looking at one transmission channel in isolation (borrowing and spending loanable funds, or even dissaving) doesn’t mean anything. Only a rise in the path of NGDP, caused by a change in the long-run supply and demand for money, is stimulative.

    And I don’t think Kimball does the reductio ad absurdum as well as Bernanke or Hamilton, he thinks monetary policy is bounded by all yields reaching zero. And owning the planet is no use unless employment and consumption rises, but unlike Nick Rowe (the famous concrete steppes post, which someone should send Kimball) doesn’t say how that would happen. He just thinks buying stuff is good because it causes yields to fall. Which ipso facto stimulates the economy. Not that you want any extra circulation of money, just more “spending”, whatever that means. (Y = C + I + G + NX. It’s all in that equation. Just keep staring at it until the light dawns.)

  2. Gravatar of Saturos Saturos
    2. June 2012 at 09:50

    Shoot, I’ll just link to it. All economists should be forced to read this: http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/10/engdp-level-path-targeting-for-the-people-of-the-concrete-steppes-.html

  3. Gravatar of Saturos Saturos
    2. June 2012 at 09:56

    “We need to introduce Miles to our little friend Chuck Norris.”

    To be clear, I don’t actually want Chuck Norris to come and beat up Miles Kimball. Except maybe the Keynesian part of his brain. Or the part that doesn’t appreciate the significance of ratex, even though that’s supposed to be what “New” Keynesianism is all about.

  4. Gravatar of Asdasdasd Asdasdasd
    2. June 2012 at 10:03

    Fantastic post, thanks!

    Would retiring a proportion of the bonds bought in previous rounds of QE be a strong signal of future AD policy?

    Which would have stronger effect on NGDP, retiring $Xbn bonds, or buying further $Xbn bonds?

    Apologies if this is a daft question.

  5. Gravatar of Joseph Joseph
    2. June 2012 at 10:20

    I liked reading other econ blogs a lot more before I started reading yours and you changed my views on many subjects. Now I read the 99.99% of blogs and can’t help but feeling frustrated at what they’re missing. Thanks for ruining the internet for me 😉

  6. Gravatar of dwb dwb
    2. June 2012 at 10:30

    one cannot leave comments on his blog!

    excellent blogging.

    PK says the ECB and Fed need to figure their €$ out “tomorrow”. Merkel was out agsin today, no euro bonds. sigh. one more negative german comment i thonk Rajoy says bye.

  7. Gravatar of Saturos Saturos
    2. June 2012 at 10:32

    dwb, Let’s face it, tumblrs aren’t really “blogs”.

  8. Gravatar of ssumner ssumner
    2. June 2012 at 10:39

    Saturos, I agree, especially about the Nick Rowe post.

    Asdasdasd, I’d stay away from retiring bonds. If the Fed wants to signal, it really needs to just directly signal what it want NGDP or the price level to do. Then I’d just buy enough T-securities to where the market expects it to happen.

    Joseph, But just imagine how much frustration I’ve had, and for how long! 🙂

    dwb, Yes, but to be honest, I don’t really want the Germans to say yes to euro bonds, I want them to say yes to a highly robust NGDP target, that drives eurozone asset values much higher.

  9. Gravatar of Mike Sax Mike Sax
    2. June 2012 at 10:43

    “to be honest, I don’t really want the Germans to say yes to euro bonds, I want them to say yes to a highly robust NGDP target, that drives eurozone asset values much higher.”

    But what if for whatever reason they don’t say yes to the robust NGDP target-would you still want them to say no to euro bonds?

  10. Gravatar of Mike Sax Mike Sax
    2. June 2012 at 10:45

    Ie, I get that you prefer a strong NGDPT to eurobonds but do you prefer the status quo to eurobonds?

  11. Gravatar of Saturos Saturos
    2. June 2012 at 10:52

    And John Cochrane thinks that being on the euro is itself as good as having eurobonds.

    Here’s a Perth economist making some good points, though I don’t fully agree of course: http://johnhcochrane.blogspot.com.au/2012/06/economists-haiku-for-europe.html

  12. Gravatar of dwb dwb
    2. June 2012 at 11:03

    Yes, but to be honest, I don’t really want the Germans to say yes to euro bonds, I want them to say yes to a highly robust NGDP target, that drives eurozone asset values much higher.

    i agree, but i see Merkels comments more as a signal. The ECB lowering rates to zero wont do much unless they are willing to adopt a higher inflation target (and potentially back it up with bond purchases, since its credibility will be doubted). Bond purchases add risk to the ECB balance sheet, which the Germans will have to bear.

    Ultimately, unwillingness to take on Euro bonds is in some sense equivalent to a lack of credibility wrt to an inflation target, because it signals an unwillingness to do what it takes to implement the higher inflation target. I think if Germany said “we accept higher inflation as long as the ECB does do QE to do it,” they might as well say no dice to a higher inflation target. And I do not think Draghi will act without German buy-in.

  13. Gravatar of dwb dwb
    2. June 2012 at 11:04

    “we accept higher inflation as long as the ECB does NOT do QE to do it,”

  14. Gravatar of ssumner ssumner
    2. June 2012 at 12:26

    Mike Sax, It depends on the endgame. With no NGDP growth, the euro probably collapses. If it’s going to collapse, I’d rather it do so without eurobonds. If dwb is right then I favor eurobonds. Readers might notice that I refrain from discussing aspects of the euro-crisis that I’m not well informed on. (in my posts, not in the comment section, which is more informal)

    Saturos, I don’t follow that at all. There are dozens of examples of horribly mismanaged fiat currencies that persist for many decades. I have no idea what he’s talking about.

    dwb, I don’t know enough to comment on that assertion.

  15. Gravatar of Saturos Saturos
    2. June 2012 at 12:39

    I think what he’s saying is similar to what Cochrane said here: http://johnhcochrane.blogspot.com.au/2012/05/leaving-euro.html

  16. Gravatar of Integral Integral
    2. June 2012 at 13:19

    Kimball is 90% of the way there. He’s encouraging strong off-equilibrium behavior by the Fed. There’s some game theory here: on the equilibrium path, the Fed will have no need to actually implement QE, negative IOR, et cetera, because private-sector expectations will do the heavy lifting. But those expectations are contingent on what the private sector expects the Fed to do off the equilibrium path, which is: PRINT MONEY and BUY ASSETS.

    The Fed’s credibility depends on what the private sector expects it to do if it makes a mistake.

    Prof. Kimball doesn’t crouch his arguments on the expected future path of asset purchases, but I am certain that he knows the importance of expectations and the entire time-path of monetary policy.

    @dwb: he desperately needs a better platform than tumblr.

  17. Gravatar of ssumner ssumner
    3. June 2012 at 06:42

    Saturos, I’m fine with the idea that default and leaving the euro are separate issues. They’ve already defaulted. But he really underestimates the whole sticky wage/devaluation issue.

    Integral, Go back to a recent comment section where Saturos finds something like 12 flaws with his post. I’d say Kimball is less than 90% of the way there.

    One also has to recall that the issue isn’t whether or how far off the equilibrium path we are now, but where we’d be with NGDPLT. My prediction is that right now we might need $5 trillion in QE, but with NGDPLT, we could immediately REDUCE the base by a trillion, and still hit the NGDP target.

  18. Gravatar of Saturos Saturos
    3. June 2012 at 06:54

    “Saturos finds something like 12 flaws with his post.”

    To be fair, I was mostly repeating myself there. But then you’ve been repeating these ideas for years now, and people still haven’t learnt. Even though they are all completely logical deductions from standard theory.

  19. Gravatar of Saturos Saturos
    3. June 2012 at 07:00

    Well maybe not all, but still, the conventional wisdom is appalling.

  20. Gravatar of dtoh dtoh
    3. June 2012 at 19:05

    Good post but I would argue (as I have in other comments) that MV is exogenous and determined by expectations of the the price of financial assets relative to the price of real goods and services (both consumption and investment). MV changes to accommodate changes in demand for real goods and services.

  21. Gravatar of ssumner ssumner
    4. June 2012 at 07:58

    dtoh, MV is determined by the Fed.

  22. Gravatar of Our new ‘policy makers’: Weather & Energy | Historinhas Our new ‘policy makers’: Weather & Energy | Historinhas
    4. June 2012 at 08:56

    […] the following paragraph taken from a recent Scott Sumner post is what journalists and commentators should be flaunting about, not ‘weather paybacks’: […]

  23. Gravatar of Integral Integral
    4. June 2012 at 09:55

    Scott: I may have to retract my “90%” enthusiasm as of Miles’ latest post. He states “Balance sheet monetary policy can powerfully stimulate the economy if the Fed does enough. But we might have to get used to open market purchases in the trillions and trillions.”

    He really is acting as if the primary transmission mechanism is through physical asset purchases, rather than through expectational channels.

    I quit. I give up. He knows better than this, and it isn’t about him being “New Keynesian” or whatever- all NK models stress the importance of the entire time-path of monetary policy. He’s acting as if the “direct” lever of open-market operations matters more than the expected future path of policy.

    There’s a difference between making off-equilibrium threats of buying trillions of dollars of assets, and actually planning to do so as one’s stated policy. I thought he was going for the former; it appears he really is talking about the latter.

  24. Gravatar of Saturos Saturos
    4. June 2012 at 10:03


    OH GOD.

  25. Gravatar of dtoh dtoh
    5. June 2012 at 00:45

    You said, “MV is determined by the Fed.”

    I agree. M directly and MV indirectly via asset prices.

    Scott, imagine a credit only economy with an MOA that can’t be owned by the public and is held in the Fed vault. Imagine the terms of credit are set by the Fed with appropriate risk adjustments. How would the Fed adjust AD. Simple… by adjusting the terms of credit, i.e financial asset prices.

  26. Gravatar of Saturos Saturos
    5. June 2012 at 02:09

    The Fed determines V by changing interest rates and by threatening to expand or contract the money supply.

    If you’re talking about an economy with means of credit and a medium of account but no medium of exchange, then there would be barter and no recessions. (Instead output would always be low.)

  27. Gravatar of dtoh dtoh
    5. June 2012 at 12:53

    No you would not have barter. Exchanges would just be settled with an IOU or some other form of promissory note. Fed or someone else could act as clearinghouse to offset overlapping claims.

  28. Gravatar of ssumner ssumner
    5. June 2012 at 13:00

    dtoh, Sorry, I can’t imagine an economy where the public can’t own the MOA. How is it’s value determined?

  29. Gravatar of dtoh dtoh
    5. June 2012 at 13:18

    The MOA can be anything you want seashells, specially minted gold coins, Fed MOA Notes, bits on a computer. You can set the value anyway you like. How was the value of the dollar initially set? The only important thing is that the public believes in it.

    If non-convertibility is an issue for you, then allow convertibility but only for the purposes of transactions. At midnight, everything has to go back into the Fed vault (or computer).

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