Your kid’s got a fever? Put him in the freezer.

Andy Harless and I have recently been picking on this Kocherlakota quotation:

If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation.

Let me emphasize that I do understand that there is a problem with promising low rates as far as the eye can see.  My problem with Kocherlakota is that he seems to think that the solution is tight money.  At least that’s what I infer from the totality of his comments.

I’ve been so frustrated by the events of the last few weeks that I worry I am getting too negative in my posts.  I’d like to maintain a high level of courtesy, like Tyler Cowen or Nick Rowe.  Instead I often get too sarcastic, like  .  .  .  like those other guys.

Thus I was a bit surprised, but also heartened, to read this comment from my favorite monetary blogger (and cattle herder), Nick Rowe:

That speech by Narayana Kocherlakota is really disturbing. This guy is a top macroeconomist, and he totally f***s it up. I mean totally. It wasn’t just misspeaking, because he is quite clear the second time he makes the mistake. If the natural rate of interest rises exogenously, and the Fed doesn’t raise the nominal rate in response, the result will be….DEflation! And he’s a Fed President (so presumably this guy has some sort of power over monetary policy?).

You guys in the US are so scr***d. (And maybe we up here are too, since you are so big, even though we’ve got flexible exchange rates).

He went straight from a math undergrad into a PhD. I bet that’s the problem. He missed Intro Economics. (And he has the nerve to cr*p on Intro Economics too).

If even mild-mannered Nick Rowe is this upset, then you can imagine how a hot-head like me feels.

And then there is the financial press.  Here is something Marcus sent me from the Wall Street Journal:

So what’s the problem? Here it is best to depart from monetarist terminology, with its heavy emphasis on the magical powers of the central bank. Those magical powers are highly overrated, as almost anyone who has ever run a central bank will likely tell you. The Fed can flood the banks with liquidity in an effort to stimulate economic growth (if it is willing to run the very serious risk of inflation). But that will not necessarily stimulate a demand for this money.

Correct me if I am wrong, but if the Fed is trying to boost AD, isn’t an increase in the demand for money the last thing they’d want?  More and more I just scratch my head at what I read.  From the same article:

But deflation and inflation predictions could both be right in a sense, if you aren’t too fussy about strict definitions. In the late 1970s, the last time Americans suffered from manic interventionism from Washington, we had “stagflation,” a combination of minimal economic growth and double-digit inflation. It wasn’t pretty.

Which year in the 1970s did we have deflation?  And this:

Since deflation, in simple monetarist terms, means too little money chasing too many goods, with a consequent fall in prices, the remedy should be easy. Can’t the Federal Reserve create as much money as it wants with just a few key strokes? Well, there are some things money can’t buy. In political circumstances like today’s, one of them is public confidence.

You need “confidence” to create inflation?  How much confidence did people have in Jimmy Carter?  How about the Zimbabwe central bank?  I had thought inflation was more likely to result from a lack of confidence.  I thought you got inflation by “committing to be irresponsible.”

Both of the guys I quoted are very smart–Kocherlakota is obviously far brighter than I am.  I probably agree with them both on most issues.  But money is a specialized field and I just don’t have much confidence that our decision-makers or the media people who shape the discussion are on top of this issue.  We need people who are “fussy” about definitions.  Who understand why monetary policy does seem like “magic” to the uninitiated.  Every single FOMC voter should have not only a PhD in economics but 20 years of research on monetary policy, monetary theory, and monetary history.  Not one, not two, all three areas.  It’s that important.  (For instance, does Kocherlakota know that the Fed tried Rajan’s exact proposal in 1931, they raised rates by 200 basis points when the economy was weak and rates were very low?)

Update:  I just noticed that Nick has a post with a lot of interesting discusssion.  I can see I’ll have to address this issue again tomorrow.



27 Responses to “Your kid’s got a fever? Put him in the freezer.”

  1. Gravatar of marcus nunes marcus nunes
    25. August 2010 at 18:57

    Williamson is to NK what DeLong is to PK?

  2. Gravatar of rob rob
    25. August 2010 at 19:15

    I’m just trying to make sense of what is going on. On CNBC at least there seems to be more expressed worry about China cutting down on buying US bonds. Is it possible that the Fed is mainly afraid of a worst case scenario: that unconventional monetary policy might send the signal that the US plans on inflating away its debt?

    Something rational must be going on in the Fed’s thinking. I can’t believe at this point that they are crazy or just acting according to institutional inertia.

    I want more insight into the question: If the Fed’s behavior is this stupid, why?

  3. Gravatar of Tom P Tom P
    25. August 2010 at 19:38


    It’s hard not to be a fatalist when the market (via TIPS spreads) has already taken into account all our future blog posts, arguments, and articles and has decided that inflation expectations will remain low nevertheless.

    Do we have “free will” even if markets know what is going to happen?

  4. Gravatar of Dilip Dilip
    25. August 2010 at 19:42

    BTw, about the 200 basis points issue, Dr. Rajan has a more detailed post on his proposal here:

  5. Gravatar of Benjamin Cole Benjamin Cole
    25. August 2010 at 20:00

    I am beginning to realize why I have struggled to understand monetary policy for 20 years. You have accepted experts such as Kocherlakota who mutter nonsense–or worse, let their political views get in the way of proper policy.

    Really, how is layman supposed to make progress if “experts” throw up boobytraps?

    In my most cynical moments, I suspect there are people who wish Obama to fail, for political reasons. One way to make him fail is to starve the economy of money.

    Improbable? Perhaps. But then, consider LBJ’s actions prior to the Vietnam War, or the long, long, long long-running R-Party investigation into Clinton’s sex life.

    Ulterior motives, anyone?

  6. Gravatar of marcus nunes marcus nunes
    25. August 2010 at 20:00

    Scott – Seems PK is “warming up” to you guys…

  7. Gravatar of Morgan Warstler Morgan Warstler
    25. August 2010 at 20:32

    Where exactly is it in monetary theory, that the function of money is to guarantee full employment?

    I can’t find it anywhere.

  8. Gravatar of Morgan Warstler Morgan Warstler
    25. August 2010 at 20:42

    Rajan just screwed Krugman with his pants on…. Scott, repent.

  9. Gravatar of Declan Trott Declan Trott
    25. August 2010 at 21:32

    “Every single FOMC voter should have not only a PhD in economics but 20 years of research on monetary policy, monetary theory, and monetary history.”

    At the risk of committing my usual mistake of taking your throwaway tongue in cheek lines seriously, how is this going to help? Does it even explain the current hawk/dove split at the Fed?

    You get a research career by building fancy models, which translates very loosely into practical wisdom in this kind of situation. (What Rowe said about Kochalakota going straight from math to a PhD.) Warren was an ag economist, right?

    You have said nice things in the past about Australian monetary policy. But the RBA is far less academic than the Fed or ECB. I’m not sure we’ve ever had a PhD economist running it – certainly not the current or previous governors. It doesn’t seem to have hurt any.

  10. Gravatar of Cameron Cameron
    25. August 2010 at 23:03

    I’m actually pretty optimistic on the future of monetary policy. A couple years ago most economists favored the fiscal stimulus package and agreed the economy needed more AD. Since then, any hope of additional fiscal stimulus has faded and so those who favor more AD have only one option – the one they should have chosen in the first place – monetary policy.

    If these arguments are the best conservative fed members can come up with it won’t be long before the majority of economists (including Obama’s advisors) start coming out in favor of additional monetary stimulus.

    Paul Krugman has already changed his tone on monetary policy. It’s not too hard to see many other’s following in his footsteps… if they haven’t already. It’s also nice to see how much more attention was paid to the last fed meeting. Unless you are a RBC or Austrian leaning economist, monetary policy now seems like the only option to “fix” the economy.

  11. Gravatar of Richard W Richard W
    25. August 2010 at 23:48

    If US RGDP was growing at 3% and CPI was 2% with full employment. In those circumstances if the Fed raised the Federal Funds rate by 200 basis points would they not expect RGDP growth to slow, CPI to fall and unemployment to rise? Why would that not happen now if they raised it by 200 basis points?

    It looks to me that there is a certain moralising mindset who just hate the Fed being in unchartered waters following unconventional policy. They have an instinctive bias against following unconventional policy and will use any bizarre reasoning to rationalise that their policy advice is really sound. Alternatively, as Paul Krugman said they are making it up as they go along.

  12. Gravatar of Bill Woolsey Bill Woolsey
    26. August 2010 at 02:54

    Kocherlakota is too equilibrium oriented. What long run equilibrium is consistent with very low nominal interest rates? Deflation. How rapid open market purchases that push down policy rates would get you to deflation is hard to understand.

    If you believe in equilibrium always (or at least for explaining quarterly data,) then the deflation should appear rapidly. The question of how rapid open market purchases this quarter get people to start lowering prices and wages this quarter so that the real interest rate is high enough to keep real expenditure equal to productive capacity during the current quarter… is hard to understand.

    And, of course, what is the problem?

    Don’t you remember reading some of the alternative money stuff from the new classicals, (maybe Wallace) back in the day? They were talking about real bills. Naturally, they had equations describing equilibrium states. Either interest rates or the goods prices could fluctuate. And my take on it at the time was that there was no plausible market process that would generate these equilibrium states. It was high nominal interest rates generate inflation and low nominal interest rates generate deflation. Very anti-Wisksellian. Oh so Minnesota Fed.

    Melloan is confusing money and credit. More exactly, the demand for money he is speaking of is the demand for loanable funds.

    The Fed can create more money (read credit.) But if there is no confidence, there is no demand for money (read credit, no one wants to borrow.)

    If people don’t want to borrow the money the Fed creates for banks to lend, then there will be no increase in spending.

    His view is the one we have been combating during the entire crisis. The problem is with the banks.

    Money and Credit still confused… the title of a Yeager paper from years ago.

    The stagflation concern is more justified, though it isn’t inflation and deflation at the same time, of course. And the depressed output isn’t due to an inability to sell because of low demand because of low confidence but due to problems in production.

    If you believe that the current price level/inflation rate is creating sufficient real expenditures to match the productive capacity of the economy (market clearing,) then the depressed level of real output must be caused by reduced productive capacity. A need to shift the composition of output would be one source. Not enough capacity of the things people want to buy.

    Efforts to expand aggregate demand will result in inflation.

    If you believe in targeting the growth path of money expenditures, then a downward shift in the productive capacity of the economy moves the price level to a higher growth path. During the adjustment period, there is higher inflation. If it is just a gradual shift in composition of demand and productive capacity, that will be partially (mostly?) reversed. The growth path of prices will fall, and the inflation rate will be lower as their is a return towards (or to) the old growth path of prices.

    Since I favor moving to a growth path for money expenditures consistent with a stable price level, the process is inflation and and then deflation. Capacity falls, the price level goes to a higher level, with inflation until you get there, and as capacity recovers, the price level falls and there is deflation until you get there.

    If you stick with the 5% growth path, it is higher inflation and then disinflation.

  13. Gravatar of scott sumner scott sumner
    26. August 2010 at 05:56

    marcus, SW seems to be relying on a flexible price model. In that case what he says is true, but it is also pretty useless for monetary policy analysis of the fed funds target. In that model if you want to raise the overnight interest rate 200 basis points, you raise the money supply growth rate 200 basis points, the real rate remains unchanged, and inflation rises 200 basis points. At least that’s what I think he is saying. Does that inflation happen overnight?

    rob, It is not a question of stupid, this stuff is complicated. It is obvious that the Fed looks at monetary policy in a totally different way than Milton Friedman did when he argued that low rates in Japan showed money was tight. So take me out of the picture. It’s the Fed vs. Friedman. One has to be “stupid” according to your view, but obviously both are smart. One is misguided.

    Kocherlakota just seems to be using the wrong model, as far as I can see.

    Tom P, Markets don’t “know,” they forecast, with great uncertainty. Markets can be surprised.

    And free will does not exist.

    Thanks Dilip.

    Benjamin, Possibly, but that can’t be the whole story, as the policy was at its worst when Bush was in office (late 2008.)

    Marcus, He likes Nick Rowe. Me, . . . not so much.

    Morgan, Nowhere.

    Morgan, That Rajan piece is one of the screwiest things I’ve ever seen a major economist post. I guess I’ll need to do another post. Damn!

    Declan, I suppose the first thing we need is for Congress to set an explicit goal. Look, Congress thinks we need more AD. They think the Fed agrees. But the Fed actually disagrees. It’s just that Congress doesn’t understand that. They need to spell out a specific goal.

    Australia arguably has an easier job. Because they can depreciate the Aus. dollar easily, there is no zero rate trap.

    Cameron, I hope so.

    Richard, Yes, that may be.

    Bill, He must be assuming a completely flexible price model, when the Fed raises rates by loosening monetary policy. Printing more money. Of course that makes no sense if you are talking about the fed funds rate.

    How can someone work at the Fed and not realize that they change rates via the liquidity effect? Tight money equals higher short term rates?

    The WSJ piece makes no sense even if you assume he meant credit. In that case the Fed could not increase the supply of money (i.e credit) as there would be no demand. But he said they can increase the supply of money.

  14. Gravatar of David Stinson David Stinson
    26. August 2010 at 06:24

    Good post, Scott.

    Also, excellent comments form Bill Woolsey.

    I keep repeating myself but, what the heck, so does everyone else. All this business just confirms my recent(ish) view that macroeconomics should renamed “The study of the Demand for Money (and related issues)”. Get that stuff right and change the perception of monetary poiicy from stimulus/contraction to monetary equilibrium/disequilibrium (or insert your desired relationship between money and supply here) and it seems to me that that’s 99% of macro policy.

    Of course, given most policy-related discussions of the demand for money in the public arena these days are confined to simplistic references to “velocity” as some sort of mysterious parameter that moves around in ways no one could possibly understand – the monetary version ofthose recalcitrant and inconvenient “animal spirits” – we are a long way away from salvation.

    What I take from all this is not that if we could just get smarter central bank bureaucrats and experts, we’d be OK (never been reliable in the past, unlikely won’t be in the future), it’s that free banking (or, at a minimum, some sort of free banking-inspired monetary policy rule) is the solution. We’ve tried for 100 years to figure out central bank monetary policy and we still haven’t got it right (or, if have, we haven’t got a useful consensus that allows us to reliably implement correct policy). The “philosopher king” approach to central banking hasn’t worked.

    Setting aside the above, I am not sure your suggestion (“Every single FOMC voter should have not only a PhD in economics but 20 years of research on monetary policy, monetary theory, and monetary history”) would help much.

    It seems to me that much of the confusion and debate is not about the super sophisticated sub-atomic level of economic theory, it is about all the basic front-end stuff that was bypassed in the rush to focus on the sub-atomic level and all the assumptions of convenience made to make the math work – equilibrium vs disequilibrium, homogeneous vs heterogeneous information and expectations, why (and if) prices really are sticky, the role of uncertainty, the effect of government intervention via fiscal (and other) policy in creating uncertainty and elevating the demand for money, the role and implications of heterogeneous labour and capital, do bubbles exist and if so how to identify them, just what is the natural rate of interest anyway, whether the whole boom/bust thing is purely nominal or whether there are real components in the form of malinvestments or other government-inspired clusters of entrepreneurial error, the nature and implications of the dynamic time-consuming process of adjustment, the dangers of relying on aggregates in macro, how do we know when we have monetary equilibrium, can asset price inflation exist in absence of normal price inflation, how should one define inflation in a manner consistent with one’s conception of monetary equilibrium, etc., etc.

  15. Gravatar of "You guys in the US are so screwed" – Economics – "You guys in the US are so screwed" - Economics -
    26. August 2010 at 06:46

    […] That is, it would be funny if it weren't so serious an issue. Scott Sumner is relatively restrained:Kocherlakota is obviously far brighter than I am…But money is a specialized field and I just […]

  16. Gravatar of Joe C Joe C
    26. August 2010 at 06:52

    “The Open Market Trading Desk (Desk) at the Federal Reserve Bank of New York is authorized to arrange open market operations in accordance with the operating directive of the Federal Open Market Committee (FOMC), which sets a target for the federal funds rate. Without authority to pay interest on reserves, from time to time the Desk has been unable to prevent the federal funds rate from falling to very low levels. With the payment of interest on excess balances, market participants will have little incentive for arranging federal funds transactions at rates below the rate paid on excess. By helping set a floor on market rates in this way, payment of interest on excess balances will enhance the Desk’s ability to keep the federal funds rate around the target for the federal funds rate.”

    I have an economics background but I am not a monetary expert at all so I did some reading about “Interest on Reserves” which very few economists mention as a possible policy tool; except for Scott.

    What the above excerpt says to me is that even if the fed at least lowered the rate on reserves to zero then banks would be more likely to lend to each other as the fed funds rate would now be higher as opposed to lower than the rate on reserves. Make interest on reserves negative; than how do banks NOT lend in that environment?

    I only emphasize this because I read Roubini on CNBC and he said we are in liquidity trap and there was no mention of “Interest on Reserves” as a possible solution.

  17. Gravatar of Mattias Mattias
    26. August 2010 at 07:43

    I was actually thinking of a different analogy. Let’s say you have a person who was fat and started to eat less and less in order to get in shape. Unfortunately he gets so obsessed with his weight that when he reaches a healthy size he becomes anorectic.

    What the hawks seem to say now is that you have to cure this anorexia by eating even less because otherwise he will probably be fat all over again. There is no in between. I think most people would realize how stupid that is.

    BTW I think the Feds decision to pay IOR is a very revealing detail. If you argue, like som people do, that the Fed can’t create inflation (like Japan) or that the Fed secretly is full of socialistic inflation lovers (buy gold!) that decision to IOR is very hard to explain.

  18. Gravatar of Silas Barta Silas Barta
    26. August 2010 at 08:06

    “But that will not necessarily stimulate a demand for this money.”

    Correct me if I am wrong, but if the Fed is trying to boost AD, isn’t an increase in the demand for money the last thing they’d want?

    It loks like you’re equivocating with the term “money”. You don’t want people to increase demand for cash holdings, while the Fed guy is saying that they won’t get people to borrow the money that banks have.

  19. Gravatar of Morgan Warstler Morgan Warstler
    26. August 2010 at 08:15

    Well Scott, if Full Employment is not a function of money, why exactly are we so hot an bothered to decrease the stored value of it b y 4% every year?

    Isn’t full employment someone else’s concern? Why is it left to guys who job it is to protect the stored value of savers?

    I get the dual mission, but let’s just get down to brass tacks – why should those concerned with maintaining the value of our currency be tasked with worrying about unemployment?

  20. Gravatar of "You guys in the US are so screwed" [The Economist] | DreamInn "You guys in the US are so screwed" [The Economist] | DreamInn
    26. August 2010 at 09:15

    […] That is, it would be funny if it weren’t so serious an issue. Scott Sumner is relatively restrained: Kocherlakota is obviously far brighter than I am…But money is a specialized field and I just […]

  21. Gravatar of Leigh Caldwell Leigh Caldwell
    26. August 2010 at 09:41

    I’ve had a go at constructing a Nick Rowe-style analogy to show more intuitively why Kocherlakota’s thinking is accurate in theory but useless in practice.

    If he’s a cattle-herder, I guess I’m a truck driver:

  22. Gravatar of Jeff Jeff
    26. August 2010 at 10:38

    Those magical powers are highly overrated, as almost anyone who has ever run a central bank will likely tell you. The Fed can flood the banks with liquidity in an effort to stimulate economic growth (if it is willing to run the very serious risk of inflation). But that will not necessarily stimulate a demand for this money.

    Wow, there is really horrible. It’s not just that it’s precisely the kind of whining (magic powers?) you would expect from a bureaucrat who doesn’t want to be accountable for his performance. It’s also the economic illiteracy. The Fed’s job is not to stimulate or depress the demand for money, it’s to accommodate shifts in money demand by adjusting money supply. No one without a grasp of that distinction has any business commenting on monetary policy.

  23. Gravatar of sourcreamus sourcreamus
    26. August 2010 at 10:42

    I agree with Rob. The Fed is scared that activist monetary will lead to creditors demanding higher interest rates to protect against the US inflating its way out of debt. Higher rates will cause bad things to happen at the big banks which are trying to unwind their exposure to bad mortgages. Also higher interest rates could cause the deficit to spike as it gets more expensive to finance the national debt.

  24. Gravatar of Jeff Jeff
    26. August 2010 at 11:30

    Wow, s/there/this/g is really horrible.

  25. Gravatar of W. Peden W. Peden
    26. August 2010 at 16:05


    I don’t see any massive need for an explanation for errors by the Fed. Central banks have been making mistakes for centuries and will continue to make mistakes for centuries. It’s part of human nature to hold false beliefs and to make incorrect judgements.

    What interests me is how people like Scott Sumner managed to hold true beliefs and make the right judgements. Put that way, the explanation to both questions is easier: some economists have adopted ways of thinking that reveal accurately what to do. The American central bankers have apparently not adopted this way of thinking, and the American economy is suffering unnecessarily as a result.

    The solution, of course, is to popularise the right approaches to the problem, especially to the people who actually matter in this regard.

    Benjamin Cole,

    I agree that respected experts have been talking nonsense. This has been apparent time after time since 2007, even when the evidence (like massive fluctuations in broad money) have been clear.

    But I don’t agree that any political conspiracy theories are required to explain this. It’s one thing to have evidence, but it’s another thing to recognise its significance. Economists largely forgot about the money supply, the relation of interest rates and the availability of money, the role of banks in the monetary process and so on. As a result, only those who had remembered the significance of the money supply noticed what was going to happen when the banks got into trouble in 2007 and broad money dive-bombed back in 2008.

    99% of the human population doesn’t understand the situation. Unfortunately, the people in the US with the power to deal with the situation are members of that 99%. The same problem existed in the 1970s, when the issue was inflation. It’s a tough thing to make get the people in power out of that 99%.

  26. Gravatar of A Geek’s Geek A Geek’s Geek
    26. August 2010 at 18:02

    […] I have just earned the title in the title of this post. Let me explain: Scott Sumner has been having a meltdown of sorts now that he’s back from vacation and sees that everybody turned into a deflationist […]

  27. Gravatar of scott sumner scott sumner
    27. August 2010 at 16:51

    David Stinson, My first choice is not smart FOMC members, it is having the market set monetary policy through futures targeting. I discussed that idea last year.

    Joe, Yes, I mentioned the idea of negative interest last year, and a prominent economist (Robert Hall) said it would definitely boost demand.

    Mattias, Hall called the Fed’s explanation for IOR “a confession” of contractionary intent.

    Silas, He meant credit, I understand that. But his statement still makes no sense, as it is a non-sequitor. He starts by talking about the supply of money, and then assumes it is expansionary only if it increases the demand for credit. But that’s not true. That’s why terminology is so important.

    Morgan, I favor NGDP targeting, not employment targeting. I can’t speak for others.

    Leigh, I’ll have to think about that one. How about this:

    People who exercise a lot are generally less tired. If you want to get less tired in the long run, do more exercising even though it makes you more tired in the short run.

    Jeff, I agree.

    Sourcreamus, The Fed should be praying for higher long term rates.

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