TEKNOIOT: Inflation
Showing posts with label Inflation. Show all posts
Showing posts with label Inflation. Show all posts

1 Sept 2020

Lessons of the ELB - Barokong

I gave a short presentation on monetary policy at the Nobel Symposium run by the Swedish House of Finance. It was an amazing conference, and I'll post a blog review as soon as they get the slides up of the other talks. Offered 15 minutes to summarize what I know about the zero bound, as well as to comment on presentations by Mike Woodford and Stephanie Schmitt-Grohé, here is what I had to say. There is a pdf version here and slides here. Novelty disclaimer: Obviously, this involves a lot of recycling and digesting older material. But simplifying and digesting is a lot of what we do.

Update: video of the presentation here. Or hopefully the following embed works:

Lessons of the long quiet ELB

(effective lower bound)

We just observed a dramatic monetary experiment. In the US, the short-term interest rate rate was stuck at zero for 8 years. Reserves rose from 10 billion to 3,000 billion. Yet inflation behaved in this recession and expansion almost exactly as it did in the previous one. The 10 year bond rate continued its gentle downward trend unperturbed by QE or much of anything else.

Europe's bound is ongoing with the same result.

Source: Stephanie Schmitt-Grohé
Japan had essentially zero interest rates for 23 years. And..

Source: Stephanie Schmitt-Grohé

Inflation stayed quiet and slightly negative the whole time. 23 years of the Friedman rule?

Our governments set off what should have been two monetary atomic bombs. Almost nothing happened. This experiment has deep lessons for monetary economics.

Stability Lessons

We learned that inflation can be stable and quiet--the opposite of volatile--in a long-lasting period of immobile interest rates, and with immense reserves that pay market interest.

The simplest theoretical interpretation is that inflation is stable under passive policy or even an interest rate peg. Alternative stories--it's really unstable but we had 23 years of bad luck--are really strained.

Stability is the central concept in my remarks today, and I emphasize it with the cute picture. If inflation is unstable, a central bank is like a seal balancing a ball on its nose. If inflation is stable, the bank is like Professor Calculus swinging his pendulum. Watching inflation and interest rates in normal times you cannot tell the seal from the Professor. Asking the professor might not help. Tintin fans will remember that the Professor, perhaps like the Fed, thought he was following the pendulum, not the other way around.

But if you hold still the seal's nose, or the professor's hand, you find out which is the case.

We just ran that experiment. The result: Inflation is stable. Many hallowed doctrines fall by the wayside.

Quantity lessons

The optimal quantity of money
We learn that arbitrary quantities of interest-paying reserves do not threaten inflation or deflation. We can live the Friedman-optimal quantity of money. There is no need to control the quantity of reserves. There is no reason for government debt to be artificially illiquid by maturity or denomination. Governments could offer reserve-like debt to all of us, essentially money market accounts. Too bad for contrary hallowed doctrines.

Interest rate lessons

The lessons for interest rate policy are even deeper.

\begin{align} x_t &= E_t x_{t+1} - \sigma(i_t - E_t\pi_{t+1} + v^r_t) \label{IS}\\ \pi_t &= E_t\pi_{t+1} + \kappa x_t \label{NK}\\ i_t &= \max\left[ i^\ast + \phi(\pi_t-\pi^\ast),0\right] \label{TR} \end{align} \begin{equation} (E_{t+1}-E_t) \pi_{t+1} = (E_{t+1}-E_t) \sum_{j=0}^\infty m_{t,t+j} s_{t+j}/b_t .\label{FTPL} \end{equation}

A common structure unites all the views I will discuss: An IS relation linking the output gap to real interest rates; a Phillips curve; a policy rule by which interest rates may react to inflation and output; and the government debt valuation equation, which states that an unexpected inflation or deflation, which changes the value of government bonds, must correspond to a change in the present value of surpluses

The equations are not at issue. All models contain these equations, including the last one. The issues are, How we solve, use, and interpret these equations? What is nature of expectations--adaptive, rational, or in between? How do we handle multiple equilibria? And what is the nature of fiscal/monetary coordination? Preview: that last one is the key to solving all the puzzles.

Adaptive Expectations / Old-Keynesian

The adaptive expectations view, from Friedman 1968 to much of the policy world today, makes a clear prediction: Inflation is unstable, so a deflation spiral breaks out at the lower bound. I simulate such a model in the graph. There is a negative natural rate shock; once the interest rate hits the bound, deflation spirals away.

The deflation spiral did not happen. This theory is wrong.

Rational Expectations / New-Keynesian I

The New Keynesian tradition uses rational expectations. Now the model is stable. That is a a big feather in the new-Keynesian cap.

But the new-Keynesian model only ties down expected inflation. Unexpected inflation can be anything. There are multiple stable equilibria, as indicated by the graph from Stephanie's famous JPE paper. This view predicts that the bound--or any passive policy--should feature sunspot volatility.

For example, Clarida Galí and Gertler famously claimed that passive policy in the 70s led to inflation volatility, and active policy in the 1980s quieted inflation. A generation of researchers worried that Japan's zero bound, and then our own, must result in a resurgence of volatility.

It did not happen. Inflation is also quiet, and thus apparently determinate, at the bound. This theory is wrong--or at least incomplete.

New-Keynesian II Selection by future active policy

Another branch of new-Keynesian thinking selects among the multiple equilibria during the bound by expectations of future active policy.

To illustrate, this graph presents inflation in the simple new Keynesian model. There is a natural rate shock from time 0 to 5, provoking a zero bound during that period. There are multiple stable inflation equilibria.

The lower red equilibrium is a common choice, featuring a deep deflation and recession. To choose it, authors assume that after the bound ends, the central bank returns to active policy, threatening to explode the economy for any but its desired inflation target, zero here. Working back, we choose that one equilibrium during the bound.

Forward guidance

In this view small changes in expectations about future inflation work backwards to large changes at earlier times. Therefore, if the central bank promised inflation somewhat above target at the end of the bound, that promise would work its way back to large stimulus during the bound. Forward guidance offers strong stimulus.

One of Mike's main points today is that a price level target can help to enforce such a commitment. Stephanie's policy of raising rates to raise inflation at the end of the bound can similarly work its way back in time and stimulate during the the bound, perhaps avoiding the bound all together.

Forward guidance puzzles

This selection by future active policy, however, has huge problems. First, promises further in the future have larger effects today! I asked my wife if she would cook dinner if I promised to clean up 5 years from now. It didn't work.

Second, as we make prices less sticky, dynamics happen faster. So, though price stickiness is the only friction, making prices less sticky makes deflation and depression worse. The frictionless limit is negative infinity, though the frictionless limit point is small inflation and no recession. These problems are intrinsic to stability, and thus very robust: stable forward is unstable backward.

New Keynesian Solutions

The new-Keynesian literature is ripping itself apart to fix these paradoxes. Mike, Xavier Gabaix, and others abandon rational expectations. Alas even that step does not fix the problem.

Mike offers a k-step induction. It is complex. I spent over a month trying to reproduce a basic example of his method, and I failed. You have to be a lot smarter or more patient than me to use it. Moreover, it only reduces the magnitude of the backward explosion, not its fundamental nature.

If we go back to adaptive expectations, as Xavier and others do--after a similar hundred pages of difficult equations--then we're back to stable backward but explosive forward. Stable backward solves the forward guidance puzzle--but the lack of a spiral just told us inflation is stable forward. Also, you have to modify the model to the point that eigenvalues change from less to greater than one. It takes a discrete amount of irrationality to do that.

Fiscal theory of monetary policy

So let me unveil the answer. I call it the Fiscal Theory of Monetary Policy. The model is unchanged, but we solve it differently. We remove the assumption that surpluses ``passively'' accommodate any price level. Now, we pick equilibria by unexpected inflation, at the left side of the graph.

For example, an unexpected deflation can only happen if the government will raise taxes or cut spending to pay a windfall to bondholders. (Or, if discount rates raise the present value of surpluses, which is important empirically.) For example, if there is no fiscal news, we pick the equilibrium with the big red square at zero.

This is not some wild new theory. It is just a wealth effect of government bonds. We're replaying Pigou vs. Keynes, with much better equations.

The result is a model that is simple, stable, and solves all the puzzles.

Instantly, we know why the downward deflation jump did not happen. The great recession was not accompanied by a deflationary fiscal tightening!

Tying down the left end of the graph, promises further in the future have less effect today and there is a smooth frictionless limit. Tying down the left end of the graph stops backward explosions. You don't have to pick a particular value. The limits are cured if you just bound the size of fiscal surprises, and thus keep the jump on the left hand side from growing.

We can maintain rational expectations. This is not a religious commandment. Some irrational expectations are a fine ingredient for matching data and real-world policy; introducing some lags in the Phillips curve for example. But Mike's and others' effort to repair zero bound puzzles by irrational expectations is not such an epicycle. It asserts that the basic properties of monetary policy depend on people never catching on. It implies that all of economics and all of finance must abandon rational expectations even as rough approximations. Just to solve some murky paradoxes of new Keynesian models at the lower bound? For example, Andrei Shleifer, earlier today, argued for irrational expectations. But even he build on the efficient market rational expectation model, suggesting deviations from it. He did not require irrational expectations to begin to talk about asset pricing, or require that all of economics must adopt his form of irrational expectations.

I did not think the day would come that I would be defending the basic new-Keynesian program -- construct a model of monetary policy that plays by Lucas rules, or at least is a generalization of a model that does so -- and that Mike Woodford would be trying to tear it down. Yet here we are. Promote the fiscal equation from the footnotes and you can save the rest.


Neo-Fisherism is an unavoidable consequence of stability. If inflation is stable at a peg, then raising the interest rate and keeping it there must lead to higher inflation.

Conventional wisdom goes the other way. But it is still possible that higher interest rates temporarily lower inflation, accounting for that belief.

The standard new-Keyensian model, as illustrated in Harald and Marty's slides seems to achieve a temporary negative sign. However it only does so by marrying a fiscal contraction ("passively,'' but still there) to the monetary policy shock. It also requires an AR(1) policy disturbance -- beyond the AR(1) there is no connection between the permanence of the shock and the rise or decline of inflation.

Can we produce a negative sign from a pure monetary policy shock -- a rise in interest rates that does not coincide with fiscal tightening?

FTMP, long-term debt  and a negative short run response

The fiscal theory of monetary policy can deliver that temporary negative effect with long term debt. The graph presents the price level, in a completely frictionless economy consisting only of a Fisher equation and the valuation equation. When nominal interest rates rise, the market value of debt on the left declines. (First line below graph.) If surpluses on the right do not change, the price level on the left must also decline. Then, the Fisherian positive effect kicks in.

FTMP, long-term debt, sticky prices and a realistic response

If you add sticky prices, then a rise in interest rates results in a smoothed out disinflation. This is a perfectly reasonable--but long-run Fisherian--response function.


In sum, the long-run Fisherian result is an inescapable consequence of stability.

The fiscal theory can give a temporary negative sign, but only if the interest rate rise is unexpected, credibly persistent, and there is long-term debt. Those considerations amplify Stephanie's call for gradual and pre-announced interest rate rises to raise inflation.

The contrast between the US, that followed Stephanie's advice and is now seeing a rise in inflation, with Japan and Europe, is suggestive.

The negative sign in the standard new-Keynesian model comes by assuming a fiscal contraction coincident with the monetary policy shock.

Beware! These arguments do not mean that high inflation countries like Brazil, Turkey, and Venezuela can simply lower rates to lower inflation. Everything here flows from fiscal foundations, and absent fiscal foundations and commitment to permanently lower rates, inflation is inevitable.


I promised that the ELB was an experiment that would deliver deep implications for monetary policy. Think of the hallowed doctrines that have been overturned in the last 15 minutes.

  • "The New-Keynesian Liquidity Trap'' December 2017 Journal of Monetary Economics92, 47-63.
  • "Michelson-Morley, Fisher, and Occam: The Radical Implications of Stable Inflation at the Zero Bound" Macroeconomics Annual 2017.
  • "Stepping on a Rake: the Fiscal Theory of Monetary Policy'' January 2018.  European Economic Review 101, 354-375.

What I've said today, and the graphs, are in these references. They go on to show you how the fiscal theory of monetary policy provides a simple unified framework for interest rate policy, quantitative easing, and forward guidance, that works even in frictionless models, though price stickiness is useful to produce realistically slow dynamics.

23 Aug 2020

Dollarize Argentina - Barokong

Argentina should dollarize, says Mary Anastasia O'Grady in the Wall Street Journal -- not a peg, not a currency board, not an IMF plan, just give up and use dollars.

Another currency crisis is roiling Argentina... The peso has lost half its value against the U.S. dollar since January. Inflation expectations are soaring.
The central bank has boosted its overnight lending rate to an annual 60% to try to stop capital flight. But Argentines are bracing for spiraling prices and recession.
...the troubles have been brewing for some time. On a trip to Buenos Aires in February, I got an earful from worried economists who said Mr. Macri was moving too slowly to reconcile fiscal accounts.
In 2016 and 2017 the government continued spending beyond its means and borrowing dollars in the international capital markets to finance the shortfall. That put pressure on the central bank to print money so as not to starve the economy of low-priced credit ahead of midterm elections in 2017....
A sharp selloff of the peso in May was followed by a new $50 billion standby loan from the International Monetary Fund in June. With a monetary base that is up over 30% since last year, in a nation that knows something about IMF intervention, that was like waving a red cape in front of a bull.
The peso was thus vulnerable when currency speculators launched an attack on the Turkish lira last month and the flight to the dollar spilled over into other emerging markets, including Argentina. After decades of repeated currency crises, Argentines can smell monetary mischief. A peso rout ensued.
Conventional Wisdom these days -- the standard view around the Fed, IMF, OECD, BIS, ECB, and at NBER conferences -- says that countries need their own currencies, so they can quickly devalue to address negative "shocks." For example, conventional wisdom says that Greece would have been far better off with its own currency to devalue rather than as part of the euro. I have long been skeptical.

It's not working out so great for Argentina. As Mary points out, short term financing means there can be "speculative attacks" on the currencies of highly indebted countries that run their own currencies, just as there can be runs on banks. And Conventional Wisdom, silent on this issue advocating a Greek return to Drachma, was full in that the Asian crises of the late 1990s were due to "sudden stops," and such speculative machinations of international "hot money."

Well, says CW, including the IMF's "institutional view," that means countries need "capital flow management," i.e. governments need to control who can buy and sell their currency and and who can buy or sell assets internationally.  Yet Venezuela and Iran are crashing too, and not for lack of capital flow "management." My understanding is Argentina does not allow free capital either. Moreover, if there is a chance you can't take your money out, you don't put it in in the first place. There is a reason the post Bretton Woods international consensus drove out capital restrictions.

So I agree with Mary -- dollarize. Just get it over with. What possible benefit is Argentina getting from clever central bank currency manipulation, if you want a dark word, or management, if you want a good one? Use the meter and the kilogram too.

There is a catch, however, not fully explicit in Mary's article. The underlying problem is fiscal, not monetary. To repeat,

"Mr. Macri was moving too slowly to reconcile fiscal accounts. ...In 2016 and 2017 the government continued spending beyond its means and borrowing dollars in the international capital markets to finance the shortfall."
So, I think it's a bit unfair for Mary to complain that Argentina's problem is that it "has a central bank." I don't know what any central banker could do, given the fiscal problems, to stop the currency from crashing.

If the government dollarizes, it can no longer inflate or devalue to get out of fiscal trouble. Argentina has pretty much already lost that option anyway. If the government borrows Pesos, inflating or devaluing eliminates that debt. But if the government borrows in dollars, a devaluation or inflation taxes a much smaller base of peso holders to try to pay back the dollar debt.

Still, a dollarized government must either pay back its bills or default. That's how the Euro was supposed to work too, until Europe's leaders, seeing how much Greek debt was stuffed into French and German banks, burned the rule book.

So the underlying problem is fiscal. With abundant fiscal resources, the government could have borrowed abroad to stop a run on the Peso. And without those resources, dollarization will not solve its debt and deficit problem. Dollarization will force the government to shape up fast, which may be Mary's point.

Dollarization will insulate the private economy from government fiscal troubles. This is a great, perhaps the greatest, point in its favor. Even if the government defaults, companies in a fully dollarized, free capital flow economy, can shrug it off and go about their business. Forced to use pesos, subject to sharp inflation, devaluation, capital and trade restrictions, the government's problems infect the rest of the economy.

Last, CW likes devaluation and inflation because it supposedly "stimulates" the economy through its troubles surrounding a crisis. That strikes me as giving a cancer patient an espresso. Argentina is getting both inflation and recession, not a stimulative boom out of its inflation.

Dollarization is not a currency board, which Argentina also tried and failed. A currency board is a promise to keep the peso equal to the dollar, and to keep enough dollars around to back the pesos. Alas, it does not keep dollars around to back all the governments' debts, so the government soon enough will see the kitty of dollars and grab them, abrogating the currency board. Dollarization means the economy uses dollars, period, and there is no pool of assets sitting there to be grabbed.

14 Aug 2020

Interview, talk, and slides - Barokong

I did an interview with Cloud Yip at Econreporter, Part I and Part II, on various things macro, money, and fiscal theory of the price level. It's part of an interestingseries on macroeconomics. Being a transcript of an interview, it's not as clean as a written essay, but not as incoherent as I usually am when talking.

On the same topics, I will be giving a talk at the European Financial Association, on Friday, titled  "Michelson-Morley, Occam and Fisher: The radical implications of stable inflation at the zero bound,"slides here. (Yes, it's an evolution of earlier talks, and hopefully it will be a paper in the fall.)

And, also on the same topic, you might find useful a set of slides for a 1.5 hour MBA class covering all of monetary economics from Friedman to Sargent-Wallace to Taylor to Woodford to FTPL.  That too should get written down at some point.

The talk incorporates something I just figured out last week, namely how Sims' "stepping on a rake" model produces a temporary decline in inflation after an interest rate rise. Details here. The key is simple fiscal theory of the price level, long-term debt, and a Treasury that stubbornly keeps real surpluses in place even when the Fed devalues long-term debt via inflation.

Here is really simple example.

Contrast a perpetuity with one period debt, and a frictionless model. Frictionless means constant real rates and inflation moves one for one with interest rates

$$ \frac{1}{1+i_t} = \beta E_t \frac{P_t}{P_{t+1}} $$

The fiscal theory equation, real value of government debt = present value of surpluses,  says

$$\frac{Q_t B_{t-1}}{P_t} = E_t \sum \beta^j s_{t+j}$$

where Q is the bond price, B is the number of bonds outstanding, and s are real primary surpluses. For one period debt Q=1 always. (If you don't see equations above or picture below, come back to the original here.)

Now, suppose the Fed raises interest rates, unexpectedly,  from \(i\) to \(i^\ast\), and (really important) there is no change to fiscal policy \(s\). Inflation \(P_{t+1}/P_t\) must jump immediately up following the Fisher relation. But the price level \(P_t\)might jump too.

With one period debt, that can't happen -- B is predetermined, the right side doesn't change, so \(P_t\) can't change. We just ramp up to more inflation.

But with long-term debt, any change in the bond price Q must be reflected in a jump in the price level P. In the example, the price of the perpetuity falls to

$$ Q_t = \sum_{j=1}^\infty \frac{1}{(1+i^\ast)^j} = \frac{1+i\ast}{i^\ast}$$

so if we were expecting P under the original interest rate i, we now have

$$\frac{P_t}{P} = \frac{1+i^\ast}{1+i} \frac{i}{i^\ast}$$

If the interest rate rises permanently from 5% to 6%, a 20% rise, the price level jumps down 20%. The sticky price version smooths this out and gives us a temporary disinflation, but then a long run Fisher rise in inflation.

Do we believe it? It relies crucially on the Treasury pigheadedly raising unchanged surpluses when the Fed inflates away coupons the Treasury must pay on its debt, so all the Fed can do is rearrange the price level over time.

But it tells us this is the important question -- the dynamics of inflation following an interest rate rise depend crucially on how we think fiscal policy adjusts. That's a vastly different focus than most of monetary economics. That we're looking under the wrong couch is big news by itself.

Even if the short-run sign is negative, that is not necessarily an invitation to activist monetary policy which exploits the negative correlation. Sims model, and this one, is Fisherian in the long run -- higher interest rates eventually mean higher inflation. Like Friedman's example of adjusting the temperature in the shower, rather than fiddle with the knobs it might be better to just set it where you want it and wait.

11 Aug 2020

Negative rates and inflation - Barokong

Have negative interest rates boosted inflation? Here is a nice graph (source macro-man blog, HT FT alphaville)

Source: Macro-man blog
Not really. Explanations? Choose the chicken or the egg:

1) But for negative rates, inflation would have been even lower

2) We're living in a Fisher effect world. Lower rates lower inflation. (Which is arguably a good, if unintended, thing)

8 Aug 2020

A Behavioral new-Keynesian Model - Barokong

Here are comments on Xavier Gabaix' "A Behavioral new-Keynesian model." Xavier presented at the October 21 NBER Economic Fluctuations and growth meeting, and I was the discussant. Slides here

Short summary: It's a really important paper. I think it's too important to be true.

Gabaix' irrationality fixes the pathologies of the standard model by making a stable model unstable, and hence locally determinate. Gabaix' irrationality parameter M in [0,1] can thus substitute for the usual Taylor principle that interest rates move more than one for one with inflation.

Gabaix imagines -- after three papers worth of careful math -- that people pay less attention to future income when deciding on consumption than they should.  Making today's consumption less sensitive to future income, means expectations of future income are larger for any amount of today's consumption. Thus, it makes model dynamics unstable.

But just a little irrationality won't do. If you move a stable eigenvalue, say 0.8, by a bit, say 0.85, it's still stable. You have to move it all the way past 1 before it does any good at all.

Thus, Gabaix puts irrationality right in the  middle of monetary policy. If Gabaix is right, you simply cannot explain monetary policy in simple terms with money supply and money demand, or interest rate rises lower investment and inflation via a Phillips curve, as simple approximations that more complex models, perhaps involving some irrationality, improve on. Monetary policy is centrally about the Fed exploiting irrationality, full stop, and cannot be explained or understood at all without that feature.

More in the comments. There are too many equations and figures to mirror it here, so you have to get the pdf if you're interested. This is for academics anyway.

Yellen Questions - Barokong

Fed chair Janet Yellen gave a remarkable speech at a Fed conference in Boston. I have long wanted to ask her, "what are the questions most on your mind that you would like academics to answer?" That's pretty much the speech.

Some commenters characterized this speech as searching for reasons to keep interest rates low forever. One can see the logic of this charge. However, the arguments are thoughtful and honest. If she's right, she's right.

The last, and I think most important and revealing point, first:

1. Inflation

"My fourth question goes to the heart of monetary policy: What determines inflation?"
"Inflation is characterized by an underlying trend that has been essentially constant since the mid-1990s; .... Theory and evidence suggest that this trend is strongly influenced by inflation expectations that, in turn, depend on monetary policy....The anchoring of inflation expectations...does not, however, prevent actual inflation from fluctuating from year to year in response to the temporary influence of movements in energy prices and other disturbances. In addition, inflation will tend to run above or below its underlying trend to the extent that resource utilization--which may serve as an indicator of firms' marginal costs--is persistently high or low."
I think this paragraph nicely and clearly summarizes the current Fed view of inflation. Inflation comes from expectations of inflation. Those expectations are "anchored" somehow, so small bursts of or disinflation will melt away. On top of that the Phillips cure -- the correlation between inflation and unemployment or output -- is causal, from output to inflation, and pushes inflation up or down, but again only temporarily.

What a remarkable view this is. There is no nominal anchor. Compare it, say, to Milton Friedman's MV=PY, the fiscal theory's view that inflation depends on the balance of government debt to taxes that soak up the debt, the gold standard, or John Taylor's rule. In the Yellen-Fed view, "expectations" are the only nominal anchor.

Even Fisher’s interest rates have vanished from the economics of inflation. Nominal interest rate = real interest rate plus expected inflation suggests something linking nominal interest rates and inflation, but that's gone too.

You can see also the implication: don’t worry about energy prices and other “disturbances” to inflation. Don’t even worry about "overheated" real economies, temporary Phillips-curve induced bouts of inflation. With "anchored" expectations, the inflation will melt away.

To be sure, “inflation expectations..in turn, depend on monetary policy.” But just how?

“…we need to know more about the manner in which inflation expectations are formed and how monetary policy influences them. Ultimately, both actual and expected inflation are tied to the central bank's inflation target, whether that target is explicit or implicit. But how does this anchoring process occur? Does a central bank have to keep actual inflation near the target rate for many years before inflation expectations completely conform? Can policymakers instead materially influence inflation expectations directly and quickly by simply announcing their intention to pursue a particular inflation goal in the future?”
The two paragraphs together are an interesting melange of old and new Keynesian economics. In full-on new-Keynesian economics, the answer to my question is straightforward. The Fed announces an inflation target, and a rule following the Taylor principle: for each 1% that inflation exceeds or undershoots the target, the interest rate will rise more than 1%. In new-Keynesian models, this leads to inflation or deflation that spirals away from the target. So, this threat of hyperinflation or deflation “coordinates expectations” around the Fed’s target. It’s a Dr. Strangelove sort of target — do what we want or we blow up the world.

What if inflation is so low that interest rates hit zero, as they have for the past 8 years? Don’t worry, sooner or later a shock will come and inflation will rise all on its own, the Fed can start manipulating inflation again. So, expectations that the Fed will in the future go about this Dr. Strangelove business can still anchor expectations of future inflation around the Fed’s target, and, working back, inflation today.

You can tell that this is a step too far for Mrs. Yellen, and most policy people trained in the 1970s (and me too, but for other reasons). Though “marginal costs” enter her Phillips curve, and though expectations of future inflation clearly anchor that Phillips curve, she clearly does not buy the idea that monetary policy affects those expectations by threatening explosive interest rates. Here she clearly has in mind the old-Keynesian view that higher interest rates lower and stabilize subsequent inflation, not the other way around.

Half her heart goes with adaptive expectations — “Does a central bank have to keep actual inflation near the target rate for many years before inflation expectations completely conform?” Anchored expectations come from the Fed’s painful success in the 1980s, and belief that it will do that again. But half her heart goes with the promise of new-Keynesian models: “Can policymakers instead materially influence inflation expectations directly and quickly by simply announcing their intention to pursue a particular inflation goal in the future?”

You see here some of the debate between the traditional ISLM Keynesians and monetarists at the Fed, on one side, and the promise of these new-Keynesian elements on the other. Both sets of traditional models took their adaptive expectations seriously, and worried that any increase in inflation would raise expectations of inflation and off to 1970s we go. Now both sets of traditionalists are the doves.

How much easier it could be to simply announce an inflation target, everyone believes it, and inflation or lack of inflation follows! It’s the ultimate in speak loudly enough and you don’t even need a stick.

I' skeptical. I think people have heard a lot of promises from public officials, and believe nearly none of them. Every year for the last about half-century the secretary of the Treasury has issued a forecast that the deficit will be eliminated one year after the President’s term ends. How many people in the US know the difference between Janet Yellen and Judge Judy? You have to spend a lot of time inside the walls of the Fed to think that Fed announcements of what their inflation target will be 10 years from now makes a difference to anyone but about 100 bond traders.

Our thesis topic for the week: Is it possible to write down this melange of new and old Keynesian models? You are looking for some model in which higher interest rates lower future inflation, which usually takes adaptive expectations, yet an announcement of a target can anchor expectations, which usually takes rational, forward-looking ones. I guess it’s possible to write down any model, so I should qualify, in a simple and vaguely believable way?

(I should put my horse in the race. I think the “anchor” is fiscal policy. Expected inflation is stable so long as people think fiscal policy is in control. That makes Mrs. Yellen right in a lot of ways. However, higher interest rates might make people quickly realize fiscal policy is not under control, which makes her critics’ nervousness also right. But today is not about my answer or the right answer, it's about Mrs. Yellen's and the Fed's views. I say this mostly so that I don’t get counted as one or the other side of the current hawk v dove debate.)

2. The Phillips curve

"While this general framework for thinking about the inflation process remains useful, questions about some of its quantitative features have arisen in the wake of the Great Recession and the subsequent slow recovery. For example, the influence of labor market conditions on inflation in recent years seems to be weaker than had been commonly thought prior to the financial crisis..."
Translation. Inflation just sat there and did nothing in the face of the hugest unemployment we've seen since the great depression. The Phillips curve, relating inflation to unemployment or output, has completely fallen apart.  This being the central piece of economics in Fed story for how it affects inflation — higher rates lead to less output and employment, lower marginal costs, lower prices — we’re a bit befuddled.

The implications of a vanishing Phillips curve are fun to debate. At a recent meeting at the Fed, I opined it was falling apart because huge variation in unemployment correlated with tiny changes in inflation. No, my counterpart said with a wry smile! It means that we can cure unemployment with only half a percentage point more inflation!

Putting the last two observations together, I think we see where the Fed is going. If inflation is just a trend, battered around by commodity prices, anchored by speeches, and immune to anything the Fed actually does; then that frees the Fed from what used to be its main job -- worrying about inflation -- to just worry about real stimulus with no worry about inflation. Moreover, if unemployment can skyrocket with no huge deflation, as it did, then the Fed can push unemployment way down without worry about more inflation, even in the short run. Instead of the Fed mainly determining inflation, with recessions an unfortunate byproduct, we now have a vision of the Fed mainly worrying about real stimulus, and not needing to worry about inflation. The fact that my first point, inflation, was Mrs. Yellen's last, encourages this reading.

3. Hysteresis. Does demand create its own supply? And vice versa.  (Yes, the Say's law echo is intentional.)

."..one study estimates that the level of potential output is now 7 percent below what would have been expected based on its pre-crisis trajectory, and it argues that much of this supply-side damage is attributable to... the deep recession and slow recovery..... a marked slowdown in the estimated trend growth rate of labor productivity. The latter likely reflects an unusually slow pace of business capital accumulation since the crisis and, more conjecturally, the sharp decline in spending on research and development and the very slow pace of new firm formation in recent years."
It is easy to read this as the latest excuse for dovishness, a new instance of the answer in search of a question. But take the argument seriously. Surely "demand" and "supply" -- poor concepts in the first place -- do leak to each other. If "demand" causes a long depression of investment in human or physical capital, then "supply" will be lower.

"...the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a "high-pressure economy," with robust aggregate demand and a tight labor market. ...More research is needed, however,.."
I hope the Fed will do that more research before jumping on this theory. Casual investigation of past episodes are not promising. The late 1970s are the textbook case of a "high pressure economy" stimulated by monetary policy and "demand." They did not produce wonders of "supply," either of greater capital or more economic efficiency.

"More generally, the benefits and potential costs of pursuing such a strategy remain hard to quantify, and other policies might be better suited to address damage to the supply side of the economy."
I have noticed a tendency for Fed economists to work hard on issues that have an ear at the top. I  wish Mrs. Yellen had mentioned one or two such "other policies" to reduce the chance that this is interpreted as a throw-away line, not an invitation to write papers proving hysteresis.

4. Heterogeneity.

For nearly a century, the main simplification of macroeconomics has been to gloss over differences between people. "Consumption" and "employment" may be too high or low, but the fact that gains and losses are not spread evenly does not matter, to first order, when understanding the movements of the same aggregates. Note, I do not say they don't matter -- they matter a lot. If one in 10 loses their job, it matters a lot to the person losing the job. The issue is, if you want to know how monetary policy affects average employment or consumption, does it matter that 1 in 10 loses a job and the rest keep their jobs, vs. each of us working 10 percent fewer hours?

Of course it matters, the layman says. But simplification is the key to progress in any science. Chemistry did not get going by working out quantum mechanics. Furthermore, you can see quickly that heterogeneity matters only if economic decisions are nonlinear -- and we know how to model that nonlinearity. Linear decisions add up and behave just like a single household with the average response. Again, the layperson says of course economics is nonlinear. But unless you know just how it's nonlinear, that complication doesn't help. Wrong nonlinearity and state dependence is worse than none at all.

There is a huge new literature on heterogeneity. When a shock hits, some people don't have any savings and have to stop spending, now. Others can dip in to savings. People who lose their jobs are different from people who lose some hours, in big ways.

Watching from afar, I, like Mrs. Yellen, am impressed by this effort, but still scratching my head to understand what it all means for the economy as a whole.

" the various linkages between heterogeneity and aggregate demand [and supply! and equilibrium! Please, Mrs. Yellen, there is more to life than "demand"] are not yet well understood, either empirically or theoretically."
She continues

"More broadly, even though the tools of monetary policy are generally not well suited to achieve distributional objectives, it is important for policymakers to understand and monitor the effects of macroeconomic developments on different groups within society."
That's another sentence that deserves careful study. It is easy to cross the line from "understand and monitor" to target. It's not just easy, it's inevitable. So, the mandate of monetary policy has stretched from price stability to add low interest rates and maximum employment (by statute), to "financial stability," which now means understanding and monitoring, and inevitably trying to control, asset prices, housing prices, debt levels, bank profits (not yet at the Fed, but clearly on the minds of ECB and BOJ policy), and now will be targeting inequality too. I wish for another throwaway line on "other policies." Yes, Fed policy does affect some people more than others. But if the Fed tries to counter the ill effects of other policies -- bad public schools, say -- by monetary policy, it will first do a terrible job of its main objective, and second it can no longer stay independent and a-political.

5. Finance

In light of the housing bubble and subsequent events, policymakers clearly need to better understand what kinds of developments contribute to financial crises. ...
Research on this topic has, of course, been ongoing for some time, and it has expanded greatly in the wake of the financial crisis. But I believe we have a lot more to learn about the ways in which changes in underwriting standards and other determinants of credit availability interact with interest rates to affect such things as consumer spending, housing demand and home prices, business investment (especially for small firms), and the formation of new firms.
I can hardly object to the idea that we need to better understand how finance links to macroeconomics. Since 2008, about 3/4 of the papers at every conference or job market talk are about putting various financial constraints into economic models. I'm interested that Mrs. Yellen is also still looking for something solid to come out of all this.

Again though, one can be quite uncomfortable with the implicit message that the Fed needs to understand everything and try to control -- or at least monitor -- everything. If 8 years of nonstop research have led to so little, is not the program of understand heterogeneity, nonlinearity, inequality, financial "frictions" and linkages, crises and bubbles, and then masterfully address them all, just a little hopeless?

Would the Fed not do better both economically and as an institution to say, "look, our job is the price level. We take care of inflation, we do it independently and a-politically. We are not the master planner of the economy."

6. General comments

As some of the commenters point out, the speech is pretty remarkable for its implicit admission of the fact that the Fed really has very little idea of how its policies work. The jump from cocktail party speculation about, say "hysteresis" or "secular stagnation" or "anchored expectations" to serious consideration of such effects at high levels is pretty short, by scientific standards.

But in defense of Mrs. Yellen and the Fed, Mrs. Yellen is remarkably in touch with the best there is (such as it is) on these questions. I cannot imagine the top-level administrator of any other government agency, from cabinet secretaries on down, anywhere near as conversant with the state and limitations of current research.

Indeed, there is not great academic research answering these questions. And not for want of effort. Saying snarky things about the state of macroeconomics is easy. Coming up with serious answers to Mrs. Yellen’s questions is a lot harder. She is remarkably honest about her, and the Fed’s, limited understanding of the system they are trying to manage.

Compare the Fed here to the rest of the economic policy world -- the FTCs regulation of mergers (about 50 years behind anti-trust economics and legal scholarship), the FCC's regulation of the internet, the SEC's regulation of financial markets, the FSOC (indulging the Fed) regulation of "financial stability,” the CFPB “protection” efforts and so on. Anchoring, hysteresis and heterogeneity are scientific bedrock compared to "contagion," “liquidity," "abuse" and all the other mumbo-jumbo these agencies think they understand and control. And their pretense of knowledge is off the charts greater than Ms. Yellen's humility.

(Thanks to commenters ona previous post who brought up the speech and have active and thoughtful commentary going on.)

3 Aug 2020

New Paper - Barokong

A draft of a new paper is up on my webpage, "Michelson-Morley, Occam and Fisher: The Radical Implications of Stable Inflation at Near-Zero Interest Rates." This combines some talks I had given with the first title, and a much improved version of "does raising interest rates raise or lower inflation?"


The long period of quiet inflation at near-zero interest rates, with large quantitative easing, suggests that core monetary doctrines are wrong. It suggests that inflation can be stable and determinate under a nominal interest rate peg, and that arbitrary amounts of interest-paying reserves are not inflationary. Of the known alternatives, only the new-Keynesian model merged with the fiscal theory of the price level is consistent with this simple interpretation of the facts.
I explore two implications of this conclusion. First, what happens if central banks raise interest rates? Inflation stability suggests that higher nominal interest rates will result in higher long-run inflation. But can higher interest rates temporarily reduce inflation? Yes, but only by a novel mechanism that depends crucially on fiscal policy. Second, what are the implications for the stance of monetary policy and the urgency to “normalize?” Inflation stability implies that low-interest rate monetary policy is, perhaps unintentionally, benign, producing a stable Friedman-optimal quantity of money, that a large interest-paying balance sheet can be maintained indefinitely. However, with long run stability it might not be wise for central bankers to exploit a temporary negative inflation effect.
The fiscal anchoring required by this interpretation of the data responds to discount rates, however, and may not be as strong as it appears.
Big novelties in this draft -- at least things I have learned recently:

1) There is now a mechanism that produces a temporary decline in inflation from a rise in interest rates. It comes out of the fiscal theory of the price level and long term debt. If the Fed unexpectedly raises interest rates, that lowers nominal bond prices. If the real present value of surpluses does not change (if monetary policy does not change fiscal policy), then a lower nominal value of the debt and unchanged real value of the debt require a drop in the price level. It works, but it has nothing to do with your grandfather's ISLM, "aggregate demand,'' Phillips curve, money, sticky prices, and so on.

2) In this case and more generally, a temporary decline in inflation when interest rates rise unexpectedly does not rescue traditional policy advice!

It's only temporary! So you do not get long-lasting disinflation or stabilization out of raising rates. Raising rates gives you a temporary disinflation, then inflation gets worse. This is a mechanism perhaps for the 1970s, when each rate rise fell apart in more stagflation -- Chris Sims calls it "stepping on a rake" -- not the 1980s. For that sort of disinflation you need fiscal policy too.

And since only unexpected rate changes have the negative inflation effect, it can't be the basis of systematic, expected policy, like the Taylor rule in old-Keynesian models.

3) If unexpectedly raising interest rates lowers inflation temporarily, and then they go up, and vice versa, that doesn't mean it's a good idea for the Fed to exploit this mechanism for fine-tuning the path of inflation. the Fed is likely better off just raising interest rates and waiting.

In sum, there is a big difference between a temporary negative sign and a long run positive sign, long run stability, and the traditional view which is a temporary and permanent negatives sign and long-run instability.

4) All of this stability needs fiscal backing or "anchoring." Why do people want government debt so much with awful prospective deficits? The only reasonable answer is that we live in a time of very low interest rates. The present value of surpluses is high because the discount rates are low, not because prospective surpluses are large, but because discount rates are low. Discount rates could change quickly.

There will be a few more drafts of this paper and slides and talks. Unless one of you finds a big mistake and clears up my thinking on it.

The fact: interest rates hit zero, and nothing happened. No deflation spiral. No sunspot volatility. It seems that inflation is stable when interest rates are pegged.

29 Jul 2020

Long Run Fed Targets - Barokong

What should the Fed's long-run interest rate target be? The traditional view is that the glide path should aim at 4% -- 2% real plus 2% inflation.


One big question being debated right now is whether the "natural'' real rate of interest -- r* or "r-star" in econspeak -- has declined below 2%.

Over the long run, the Fed cannot control the real rate of interest -- that comes from how much people want to save and what opportunities there are for investment, i.e. the marginal product of capital. So, if the real rate of interest is now permanently lower, say 1%, then one might argue that the glide path should aim for 3% long-run interest rate -- 1% real plus 2% inflation target -- not 4%.

Janet Yellen recently came to Stanford and gave a very interesting speech that talked in part about a lower r-star, and seemed to be heading to something like this view. See the picture:

Source: Federal Reserve.

(She also talked a lot about Taylor Rules, seeming to move much closer to John Taylor's view of how to implement monetary policy. See interesting coverage on John Taylor's blog. On r*, seeMeasuring the Natural Rate of Interest Redux by Thomas Laubach and John C. Williams for a central paper on r*. Henrike Michaelis and Volker Wieland have an interesting post on r* and Taylor rules, also commenting on Ms. Yellen's speech.)

Of course, cynics will say that it's just the latest excuse not to raise rates. But these are serious arguments which should be considered on their merits.


Should the glidepath head to 3% interest rates? Maybe not. How about zero?

Long ago, Milton Friedman explained the "optimal quantity of money,'' which is really the optimal interest rate. It is zero. Peramazero in St. Louis Fed President Jim Bullard's colorful terminology. At interest rates above zero, people hold less cash, and spend time and effort collecting bills early, paying them late, and so on. This is all a waste of time. Also, taxes on rate of return are a bad idea. With all rates of return that much lower, the tax distortion is that much lower. With 0% interest rates, and correspondingly lower inflation, infaltion-induced capital gains taxes vanish.

So maybe the glidepath should be to 0% interest rate, not 3%.  If the natural real rate is 1%, then inflation should be -1%.

In this line of thinking, the long-run interest rate is what counts directly. It is not a sum of a natural rate and an inflation target. Variation in the natural rate takes care of itself in variation in inflation.

4% ?

Why not? The primary reason often given is that interest rates at zero cannot go substantially below zero, at least without banning cash and many other gyrations of our monetary and financial system. So, if the interest rate is near zero, the Fed does not have "headroom" to stimulate the economy in a recession. I don't necessarily agree that this is so important, but let's go with it for a moment.

Additionally, conventional Keynesian policy analysts worry about a "deflation spiral," if the Fed can't lower rates. I'm not convinced this is a problem either, as recent experience and new Keynesian models don't spiral, (recent paper here), but again we're here today to flesh out the arguments not to adjudicate them.

(A correspondent points out Sticky Leverage by João Gomes, Urban Jermann and Lukas Schmid, and Optimal long-run inflation with occasionally binding financial constraints by Salem Abo-Zaid as two papers pointing to desirable positive long-term inflation and thus long-term nominal rates to keep away from the zero bound. Both have financing constraints as well.)

Both arguments for "headroom" above zero however seem to imply a direct nominal interest rate target, not inflation plus real rate. If the Fed needs four percentage points of headroom (2% real + 2% inflation) then it needs four percentage points of headroom (1% real + 3% inflation), no?

So, from the optimal quantity vs. zero bound-headroom argument it does not follow obviously that the interest rate target should move up and down with the ``natural rate.''


The question is, why is there a direct role for the inflation target? Why is that 2%, and then we add r* the long run real rate, to deduce the nominal rate glide point?

I think the answer is this: prices and wages are felt to be sticky, especially downward. That's the second argument against the Friedman rule: its steady deflation is said to require people to change prices and wages downward. That is said to cause disruption.

OK (maybe), no Friedman-optimal deflation. But why then 2% rather than 0% inflation?

Quality and pi star

One argument there is that inflation is overstated due to quality improvements. 2% is really 0%.

The issue: Suppose the iphone 6 turns in to the iphone 7, and costs $100 more. How much of that is inflation, and how much of that is that the iphone 7 is $100 better? Or maybe $200 better, so we are actually seeing iphone deflation? The Bureau of Labor Statistics makes heroic efforts to adjust for this sort of thing, but the consensus seems to be that inflation is still overstated by something like 1-2%.

Some reading on this: TheBoskin Commission Report suggested the CPI is overstated by about 1%, as of 1996. Mark Bils,Do Higher Prices for New Goods Reflect Quality Growth or Inflation? argued that it's a good deal more. Mark measured that sales move quickly to new models, which they would not do if it were a price increase after controlling for quality. But Mark's analysis was limited to consumer durables, where quality has been increasing quickly. Many other CPI categories, especially services, are likely less affected.  Philippe Aghion, Antonin Bergeaud, Timo Boppart,  Pete  Klenow and Huiyu Li'sMissing Growth from Creative Destruction suggest there is another 0.5%-1% overall because of goods that just disappear from the CPI. (This post all started with discussion following Pete's presentation of the paper recently.)

This is good news. Nominal GDP growth = real GDP growth + inflation. Nominal GDP growth is relatively well measured. If inflation is 1% overstated, then real growth is 1% understated.

It also means our real interest rates are mismeasured. If 2% inflation is really 0% inflation, then 1% interest rates are really +1% real rates, not -1% real rates.

But back to monetary policy. Suppose that 2% inflation is really 0% inflation due to quality effects. Does that mean we should have a 2% long run inflation rate target?

I don't think so. Again, the motivation for a positive inflation target is that there is some economic damage to having to lower prices. But during quality improvements of new goods, nobody has to lower any prices. They are new goods! No existing good has to have lower prices. In fact, actual sticker prices rise.

There is a deeper point here. Not all inflations are equal. One purpose of the CPI is to compare living standards over time. For that purpose, quality adjustments are really important. Another purpose of the CPI is to determine if people have to undergo whatever the pain is associated with lowering prices. For that purpose, quality adjustments are irrelevant.

(On both prices and wages, we also should remember the huge churn. Lots of prices and wages go up, lots go down. The individual is not the average. Changing the average one or two percentage points doesn't change that many individual prices.)

In sum,  the argument that quality improvements mean 2% inflation is really 0% inflation does not argue that therefore the inflation target should be 2% because otherwise people have to lower prices. They don't. Standard-of-living inflation is not the right measure for costs-of-price-stickiness inflation. In price stickiness logic, the Fed should be looking at a CPI measure with no quality adjustments at all!  (At least in this simplistic analysis. This is an invitation to academic papers. If new and old goods are Dixit-Stiglitz substitutes, what are the costs of price stickiness with quality improvements?)

(Update: my correspondent points to "On Quality Bias and Inflation Targets" by Stephanie Schmitt Grohé and Martín Uribe.)

So the argument for a separate inflation target much above zero seems to be weak to me. We're back to Friedman rule vs. headroom, which argues for a direct nominal interest rate target. Since I'm not much of a fan of headroom, I lean to lower values.

Leaving aside price-stickiness, I'm still sympathetic to a price level target on expectations grounds. If the quality adjusted CPI is the same forever, then we have a CPI standard, the value of a dollar is always constant, and long-run uncertainty decreases. We don't shortern the meter 2% every year. For this purpose, we do want the quality-adjusted CPI, and for this purpose the inflation target is primary. An interest rate target would have to rise and fall with r*.

Real rate variation

r* is the real rate. There really is no reason that the "natural" real rate only varies slowly over time. Interest rates crashed in a month 2008 because real rates crashed -- everyone wanted save, and nobody wanted to invest. The Fed couldn't have kept rates at 6% if it wanted to.

So, the procedures used to measure r*, like those used to measure potential output, are a bit suspect. They amount to taking long moving averages, and assuming that "supply" shocks only act slowly over time. More deeply, typical optimal monetary policy discussions use a Taylor rule

funds rate = r* + 1.5 ( inflation - target) + 0.5 (output gap)

and recommend active short run deviations from the Taylor rule if there are "supply shocks" i.e. r* shocks. Just how the Fed is supposed to distinguish "supply" from "demand" shocks is less clear in reality than the models, which presume shocks are directly visible. A "secular stagnation" fan might say that the moving averages used to measure r* are instead picking up eternally deficient "demand," like a driver with his foot on the brake complaining of headwinds.

Bottom line

As often in policy, we argue too much about the external causes and not enough about the logic tying causes to policy. r* may or may not have declined. But it does not follow that the glidepath nominal rate should be r* plus 2% inflation target. Maybe the glidepath should be 0% nominal rate or 4% nominal rate independent of r*.  You see lots of mechanisms and tradeoffs worthy of modeling.

28 Jul 2020

Target the spread - Barokong

What should the Federal Reserve do, to control inflation, given that

nominal interest rate = real interest rate + expected inflation,

and that real interest rates vary over time in ways that the Fed cannot directly observe? In this post I  explore an idea I've been tossing around for a while: target the spread between nominal and indexed bonds, leaving the level of interest rates to float freely in response to market forces. (It follows Long Run Fed Targets and Michelson Morley and Occam.)

Indexed bonds like TIPS (Treasury Inflation Protected Securities) pay an interest rate adjusted for inflation. In simple terms, if a one-year indexed bond offers 1%, you actually get 1% + the rate of CPI inflation at the end of the year. So, with some qualifications (below), markets settle down to

nominal interest rate = indexed rate + expected inflation

The Fed already uses this fact extensively to read market expectations of inflation from the difference between long-term nominal and indexed rates.

My modest proposal is that the Fed should (perhaps, see below) target the spread, and thereby force expected inflation to conform to its will.

A quick note to my fellow free marketers: The Fed (or some agency) has to do something. The price level is in the end our standard of value, and someone has to decide that we use feet instead of meters. Or, vice versa, but make up your mind. If we're going to use government debt -- dollars -- as money, then the government has to do something to establish its value, be it set a money supply, set an interest rate, promise a conversion rate to gold, to foreign currency, or, as currently, set a nominal interest rate.  (We'll leave bitcoin and private money for another day.) Or target the spread.

By targeting the spread and ignoring the level of rates, however, the Fed could focus on inflation control, and leave real rates to their natural market level.

One could argue whether real-rate floating is a good idea. For this post, I want to think about whether letting real rates float is possible. It's an interesting question under a general free-market prejudice that prices should be left alone where possible. The Fed and many economists seem to lean towards macroeconomic dirigisme (they call it "stabilization" or "management") rather than just inflation control, i.e. that the Fed knows better than markets what the right short run real rate is, and should actively control it to offset booms and busts, as it should more and more actively control bond prices, stock prices, real estate prices, and credit, even if inflation is stuck at 2%. I acknowledge that debate, but let's have it another day. For now, could the Fed target the spread, and let real rates float?

There are many kinds of "target" and monetary economists use the same word in many different ways, in an apparent attempt to confuse outsiders. First, a target could be like the target of an arrow, the thing you aim for not the thing you control. In this sense, the Fed could use its short run "target," or its "instrument" the nominal rate, together possibly with other "tools," to control the nominal-indexed spread. If the spread widens, indicating higher expected inflation, then raise nominal interest rates, and keep going until the spread settles down.

That's actually pretty much what the Fed does now, and "target the spread" means only doing it more aggressively, and focusing more on inflation and less on everything else. But, one problem, as inMichelson Morley and Occam, we're actually not that sure about the link between short nominal rates and the spread. Perhaps to lower expected inflation the Fed should lower rates, and promise to keep them there?

So, the second, and more radical idea, which is the centerpiece of the post. Perhaps the Fed should abandon manipulating the level of short-term rates all together, and simply target the spread directly. If it wants 2% inflation, offer to exchange, say, one-year treasury bonds in return for one-year indexed treasuries at a  2% premium, in any quantity you wish. Bring in a 1% indexed treasury, and you get a 3% non-indexed treasury, no matter what the going market rate or non-indexed treasuries. And leave the interest rate alone entirely.

Better yet, the Fed will enter a swap contract between indexed and non-indexed debt at a fixed 2%. That means you can go to the Fed, put no money down (but collateral), and at the end of the year you pay them $1 plus the rate of inflation, and they will pay you $3, or vice versa.

Will this work? That depends entirely on whether the central equation

nominal interest rate = indexed rate + expected inflation

is stable or unstable. The standard, old-Keynesian, way of thinking about it is that it is unstable. If the Fed targets the difference between nominal rate and indexed rate, the slightest puff of wind will set expected inflation spiraling away. This view would allow my first idea -- you can use this as a target, so move nominal rates aggressively to control the spread -- but not my second -- that fixing the spread expected inflation would follow.

The same question holds of standard monetary policy.  If the Fed raises the nominal interest rate and keeps it there, once real = indexed rates settle down (monetary policy does not affect real rates in the long run), does expected inflation settles down or explode? The standard view is, it explodes -- the Fed must actively move nominal interest rates to keep inflation from spiraling out of control.  Like so:

But the last 8 years of globally quiet inflation with rates stuck at zero, and Japan's 20 years, really challenge that view. Inflation seems mighty stable with no movements in interest rates. And, modern new-Keynesian, rational-expectations theory also predicts exactly that outcome.  So, perhaps

nominal interest rate = indexed rate + expected inflation

is not

seal's nose = (constant) + ball.

Perhaps it is instead stable,

Top of pendulum = (constant) + bottom of pendulum

This is the point ofMichelson Morley and Occam, which goes on for 120 pages to argue that stability makes sense.

If the relationship is stable, that means the Fed can (not necessarily should) just leave the nominal rate fixed, and let expected inflation follow, after the long run real rate settles down.

If the relationship is stable, however, that also means directly that the Fed can target the spread,  and expected inflation will follow much more directly, allowing the real rate to float up and down as it wishes. (This implication is not in the current draft ofMichelson Morley and Occam, because I worried about too much apparently crazy stuff in one paper, but it will be in the next one.)

You can also think of targeting the spread as a modern version of a gold standard. We understand how a gold standard works: The Treasury promises 1 oz of gold for every X dollars (X used to be $32). If that promise is really firm, that alone sets the price level and we don't need a Fed, at least for the purpose of setting the price level.

Gold won't work in today's economy. It would work for the Fed to operate Fed-Mart and offer to buy and sell the entire basket of goods in the CPI in return for dollars. But that's impractical too.

So, how about CPI futures? By offering to buy and sell CPI futures at fixed prices, it seems the Fed could nail expected inflation just as offering the CPI itself could (if it were possible) nail the price level.  Targeting the spread between indexed and non-indexed debt is exactly the same thing as targeting the CPI futures price. So we could call targeting the spread the "expected-CPI standard," and explain its functioning just like the gold standard.

There is also nothing magic about 2%. If like me you prefer 0% inflation, then target equality between indexed and non-indexed debt. If like me you like a price level target, then the spread target must rise and fall to bring the price level back to its immutable constant. If you like more inflation, set the target higher. However, the dynamics of stability suggest that really rock-solid expectations about the future spread target are vital. Discretionary raising and lowering of the target will destroy its stability.

On the other hand, if the relationship is unstable, activist targeting the spread rather than the level of short rates could also work. If inflation rises, then rather than keep the spread the same, the spread could rise. The spread Taylor rule could be

(nominal rate - indexed rate) = 1.5 x (inflation rate - target)

rather than

nominal rate = (long run real rate) + 1.5 x (expected inflation - target )

The only difference is whether we center the Taylor rule at the market indexed rate or the infamous r*.

For the rest of the post I'm going to pursue the idea of stability, though, and the possibility of directly targeting the spread to equal the inflation target.

Some important caveats, in addition to the obvious one that we should wait to really be sure that the relationship is stable not unstable. (No, if I were Fed chair I would not do this tomorrow. I wouldn't even be writing this post!)

One obstacle is that TIPS are illiquid, spread out over many maturities, and suffer a complex tax treatment that makes them poor indicators of expected inflation. The TIPS-Treasury spread went nuts like many other things in the financial crisis. This proposal requires a much larger and more liquid TIPS market. To some extent using swaps rather than actual TIPS will help. But only big banks use swaps, and we really want everyone thinking about inflation. It would help a lot for the Treasury to issue better, more liquid bonds, including better designed TIPS, the functional equivalent of reserves, and swaps that we can all access at treasury.gov. I outlined some ideas ina new structure for federal debt. Similarly, TIPS pricing like all bond pricing involves risk premiums as well as expected inflation. For this purpose, I judge it to be a minor issue, but that is a very superficial judgement and needs investigation.

Second, all monetary arrangements, and this one in particular, need much more attention to fiscal underpinnings. A gold standard does not depend on gold reserves, it depends on everyone's belief that the government has the power and will to borrow gold if needed, and to commit tax revenue to pay back that borrowing.

The spread-target policy also requires solid fiscal backing. A commitment to trade large quantities of indexed vs. nonindexed bonds, or to engage in swaps, clearly is a fiscal commitment. That is, deeply, how it works. If the government -- Fed + Treasury -- starts losing a lot of money on its inflation swaps, it will raise taxes or cut spending to pay off those debts. This fiscal contraction, ultimately, lowers inflation.

One might say therefore, that the Treasury rather than Fed should directly implement the target, offering to buy and sell bonds at fixed spreads or offering swaps at fixed prices, just as the gold standard was part of the Treasury to make clear it's commitment to find the needed gold.

I'm not sure that is necessary. Our current Fed's target of the nominal interest rate similarly pegs the level of the interest rate on all US government debt, and the Fed is taking on large fiscal commitments in its QE operations. If the Fed can peg the level of the nominal rate, it can likely peg the spread. But there is a backstop fiscal commitment from the Treasury that needs attention. If the Fed takes on a lot of swaps, and inflation rises anyway, the Treasury will have to make good on it, just as the Treasury will have to bail out the Fed if the Fed's mortgage-backed securities go bust or if interest rates rise too fast. And, the Treasury's commitment to make good on it is what stops inflation from happening in the first place. "Do what it takes" needs a big stick in the background. That the fiscal foundations of our current monetary arrangements is shaky is pretty obvious.

It is also not obvious that a floating short-run real rate is desirable. In the long run, there is nothing the Fed can do about real rates, the famous r*, because they are set by savings, investment, the profitability of capital, and so on. In the short run, it is felt, monetary policy affects real rates because prices are sticky. Conversely, then, a floating real rate will be influenced by "sticky" prices and wages. Adam Smith principles of the desirability of free floating prices don't necessarily hold when prices are sticky. I'm personally skeptical that our Fed can determine the "right" real rate better than markets, as nobody really understands "price stickiness," but there is a case to be made that the Fed should smooth real rate fluctuations.

But first, let's figure out whether a spread target, i.e. an expected-CPI standard, is possible.

Finally, let me be clear this is meant to provoke discussion. Many economists like to jump from their last working paper to policy prescriptions. I'm much more reserved. Any radical idea for policy should first be written, then published in peer-reviewed journals, then dissected, then distilled, then analyzed by the general class of thinkers and commentators, and finally when well accepted make its way to policy. We're still in that process, apparently, for the benefits of free trade and whether national income identities should inform trade policy. So, no, if by magic I woke up as Fed chair tomorrow, not even I would implement this overnight. But I do think we are much less sure about how monetary policy works than the illusion of technocratic expertise emanating from the Fed suggests, and that uncertainty should affect policy today.

But the weight of evidence and theory in favor of stability seems to be stronger, the attraction of a "standard" that can work in modern financial markets is strong, so it does seem an idea worth putting through that process.

27 Jul 2020

The Real Fed Issues - Barokong

The media are usually fixated on the angels on heads of pins question, will she or won't she raise rates 0.25%? As such Fed discussion misses many of the really important issues.Fed’s Challenge, After Raising Rates, May Be Existential by Eduardo Porter in the New York Times is an excellent counterexample and a nice primer on some of the really big issues facing the Federal Reserve -- and the nation -- going forward.

The pressing question for this era of populist policy making and popular anger is whether the Federal Reserve as we know it — arcane and academic, with the autonomy to set monetary policy as it sees fit — will survive the tension this time.
The Fed already lost powers it deployed to counter the recession spawned by the financial crisis a decade ago: The Dodd-Frank financial reform legislation stripped it of its authority to lend freely to nonbanks, which it used to keep money market funds, insurance companies and others that had bet on the wrong side of the housing bubble from imploding and taking the economy with them. [JC: The latter is an opinion not a fact, but let's press on.]
Though the article starts with monetary policy, and politician's desire for low interest rates, you can see we're quickly getting to, I think, bigger issues. The Fed was founded to be lender of last resort, not for monetary policy. But just who can it lend to, orchestrate bailouts, buy dodgy debts, is an entirely different issue, and one with a whole different set of arguments about independence vs. political accountability vs. political pressure, rules vs. discretion, and so forth.

Efforts that stalled in the last Congress — to subject the Fed’s funding to congressional approval, to reduce its discretion in setting monetary policy and to subject it to the oversight of Congress’s Government Accountability Office — have acquired a new lease on life, cheered from the right and the left.
The funding question is a little more delicate. The Fed now earns interest on treasuries, and does not have to pay interest on about $1 trillion of cash. So it earns interest on about $1 trillion of treasuries and MBS directly, and earns the interest spread between long-term treasuries and MBS (its assets) and the interest it pays on reserves. It rebates much of that profit to the Treasury, and keeps the rest to fund its growing operations. Don't be fooled -- every cent of that comes from you and me in the end. Every dollar of interest the Treasury pays to the Fed comes from our taxes. But unlike other spending there is very little oversight (benign) or political influence (not so benign view) of this money.

If we're just hiring a few hundred PhD economists to run models to think about interest rates this is not such a big deal. But the Fed's primary function these days is bank regulation in general and big bank / financial / stop the next crisis regulation in particular. The argument that a regulator should be independent and not even subject to the accountability of, say, the EPA or the securities and exchage commission is tougher. So putting the Fed on budget really means, I think, treating its regulatory activities as we treat those of other agencies, and an ideal worth consideration -- and an idea that is coming.

From later:

Perhaps there is a discussion to be had over whether the Fed should keep its role as supervisor of financial institutions, or whether the job should be placed with another agency. Maybe financial supervision should be made more rule-based, less subject to regulators’ discretion.
Or, if not with another agency, whether that part of the Fed should be cleaved off and treated like other regulatory agencies.

Next non-interest rate issue: The balance sheet.

Disgruntlement in Congress will only grow worse as the Fed gradually winds down the enormous stash of bonds it built over the last eight years
As blog readers know, I didn't think the balance sheet did any stimulating on the upside, and don't think keeping a big balance sheet does any harm on the downside. I think the Fed is a bit victim of its own marketing. By saying a roughly symbolic measure saved the world with great stimulus, it's awfully hard to turn around and say it isn't doing anything. But that's another big, not-about-interest rates issue to watch.

Congressional action might not be the Fed’s biggest problem. Mr. Trump’s appointments to the Federal Reserve Board could prove as destabilizing: Two of the seven positions are vacant, and a third will come open with the retirement of Daniel K. Tarullo in April. By the middle of next year, Mr. Trump will also have the opportunity to replace Ms. Yellen as Fed chief and Stanley Fischer as her deputy.
A scenario that the economy stalls a bit, and the Trump administration views the Fed as undermining its efforts with "high" interest rates, views the academics at the Fed as out of touch pointy headed fools, and puts in bankers and business people who "understand the importance of low interest rates", is not far fetched.

The argument for central bank independence is as powerful as ever. Political influence over monetary policy would produce more destabilizing booms — as politicians pumped up growth to serve their electoral purposes — and inevitable busts.
Yes, but remember, the big point is about the structural issues -- balance sheet, bank regulation, systemic regulation, and so forth, not interest rates. The argument for monetary policy independence, and the arguments for discretion, do not necessarily apply, or at least in the same way.

The popular mistrust of central bankers should not be ignored. After all, central bankers failed to prevent the most devastating financial crisis in generations — looking on idly, at best, while financial institutions peddled shady bonds to fuel a housing bubble of gargantuan proportions.
And central banks have emerged, at least implicitly, with a bigger job than before, adding the preservation of financial stability to their duty to ensure low inflation and, in the Fed’s case, full employment. Some central banks — though not the Fed — have been given new tools for this new job.
Given this power, it is inevitable that the enormous discretion central bankers have in executing their mandate will inspire popular mistrust.

... Maybe the Fed needs extra tools — to impose limits on indebtedness, for instance, or to adjust monetary policy to serve measures of financial stability.
This "financial stability" is the big new mandate at the Fed, has little to do with interest rates, and not obvious that the same discretion and independence are appropriate -- or that there is a consensus in Congress that it should be. The "financial stability" mandate, and how it should be approached is the big question, at least until inflation hits 5% or -5%.

I'm much more skeptical of "new tools," and Porter seems to be slipping in to the trap of assuming disinterested technocratic competence at the Fed; that all it needs is "more tools." What we're talking about here -- should the Fed, like other central banks, buy stocks and corporate bonds? Or, if it thinks a "bubble" is at hand, sell them? Should it direct bank lending directly, telling them to cool down "hot" markets or lend in to weak ones? Should it jigger capital and leverage constraints to boost or cool lending? You can see that all of these are much (even) more political than raising or lowering interest rates.

And yet the populist streak driving through American politics seems unlikely to yield such measured outcomes. The Federal Reserve was designed to be insulated from the full force of democracy in order to protect its mandate from political opportunism, to ensure that policy hewed to technical expertise. It was designed — precisely — to protect it from a moment like this. One can only hope that the protections hold.
In a democracy, the price of independence and discretion is sharply limited authority. If the Fed just sets short term interest rates, does not interfere in bond, stock, real estate, lending markets, it can have great independence. If it takes on these much more politically fraught areas, it will, and must, necessarily lose independence.

What about interest rates?

Real interest rates (interest rate minus expected inflation) must rise. Eventually, there are two immutable market forces behind real interest rates -- real interest rates are related to the profitability of investment (the marginal product of capital), and to the economic growth rate. As an economy grows better, there are more profitable opportunities, and people need to get the market signal to invest in those opportunities rather than spend now. (r = f'(k), and r = delta + gamma * expected consumption growth)

Higer real interest rates are, like high house prices, a sign of good times as well as a cause of bad times. Don't confuse the two sources. If growth and investment really are emerging, indeed the Fed should bend to market forces and allow rates to rise. Sometimes there is supply, not just demand, and that's where we are now.

In my somewhat eccentric view, it would be possible for the Fed to keep interest rates low, if everyone thought that would last basically forever, but then we would have to tolerate deflation like the late 1900s. If the Fed wants to keep inflation at 2%, then as long as the economy continues to expand, raising rates merely recognizes market forces.

But the expansion is long in the tooth. That doesn't argue for any change in policy, but I would like to hear a lot more stress testing from the Fed. If a recession emerges, here is what we will do. If China and then Italy blow up, here is what we will do. I presume they're doing all that quietly behind the scenes.

25 Jul 2020

Floating rates? - Barokong

I was interested to read in the Financial Times, "Iceland weighs plan to peg krona to another currency":

Iceland’s finance minister has admitted it is untenable for the country to maintain its own freely floating currency....Benedikt Johannesson told the Financial Times that the Nordic island of just 330,000 people would look at options to link Iceland’s krona to another currency, most likely the euro or pound.
“Is the status quo untenable? Yes. Everybody agrees on that. We’d like to have a policy that would stabilise the currency. It’s really not good when a currency fluctuates by 10 per cent in the two months since we took over,” said Mr Johannesson, who became finance minister in January.
The main thing is if you want to peg against a currency, do it against a currency where you do business. Once you decide on a currency, that will also change the future. You will do more business with that area,” he added, pointing to Denmark’s experience of doing more business with Germany after pegging its currency first to the Deutschmark and then the euro.

This is interesting in the context of Conventional Wisdom, which says the euro is a bad idea, and every tiny country needs its own currency, to devalue any time there is a "shock." In this view, Iceland is a great success because it did devalue after its banking crisis. I am a skeptic, largely favoring a common standard of value. Greece did not become a growth tiger from its previous umpteen devaluations. I'm interested that even the supposed success story for devaluation does not see it that way.

Update (via marginal revolution) here at Bloomberg. The idea is controversial.

Everyone wants a float after the fact, to devalue their way out of trouble. But everyone should also want a peg before the fact; the firm commitment that you will not devalue your way out of trouble makes international investment and trade flow much better.

22 Jul 2020

Douthat and Feldstein on Euro - Barokong

In case you missed it, this Sunday featured a creditable effort by the NY Times to look out of the groundhog hole. You have likely followed the explosion resulting fromBret Stephens' first column. Likewise,Ross Douthat tried to explain the attraction of Marine LePen.  I'm not a LePen fan, but appreciated his honest effort to explain how the other side say things.

I was interested in Douthat's views on the euro:

But on the other hand, our era’s “enlightened” governance has produced an out-of-touch eurozone elite lashed to a destructive common currency,..
There is no American equivalent to the epic disaster of the euro, a form of German imperialism with the struggling parts of Europe as its subjects...
And while many of her economic prescriptions are half-baked, her overarching critique of the euro is correct: Her country and her continent would be better off without it.
Douthat does not pretend to be an economist, and I have no beef with his expressing such views. Because such views are commonplace conventional wisdom from our policy elite. And if the euro falls apart, they will bear a lot of blame for its passing. Be careful what you write, people might be listening.  No, when Germany sends Porsches to Greece in return for worthless pieces of paper, it is not Germany who got the better of the deal. And while you're at it, get rid of that silly common meter, and restore proper nationalism of weights and measures too. (Of course perhaps my admiration for the euro is wrong. Then they will deserve credit for the wave of prosperity that flows over Europe once it unleashes the shackles of the common currency dragging it down. )

As a concrete example, consider  Martin Feldstein writing in the Il Sole series on the Euro, (I don't mean to pick on Feldstein. He has been a consistent anti-euro voice, arguing the great benefits for Italy and Greece of periodic inflation and devaluation. But he is just a good sober example of the common view in Cambridge-centered economic policy circles.)

Topic sentences:

Although Italy was an enthusiastic adopter of the euro when the single currency began, the Italian experience of the past decade suggests that was a mistake.
...it seems plausible that Italy’s economy would be in better condition today if Italy, like Britain, had decided to keep its own currency and therefore to be able to manage its own monetary policy and its own exchange rate.

Advocates of adopting the euro argued at the time that members of the Eurozone would be forced by market pressures to converge to a high common level of productivity and a corresponding level of real wages. That never happened. Instead, Germany powered ahead with rising productivity that has resulted in real per capita income 30% higher than Italy’s, an unemployment rate that is less than half Italy's and a trade surplus that is 8 % of its GDP.
Huh? It is a new proposition in monetary economics to me that adopting a common currency forces countries to move to common productivity, any more than adopting the meter forces countries to do so.  Alabama and California share a currency and not productivity. Fresno and Palo Alto share a currency and not productivity.   A common market in products with free movement of capital and labor might force out economic, legal, and regulatory inefficiency, but that would happen regardless of the units of measurement.

The most basic proposition in monetary economics: The choice of monetary unit has no effect on long-run productivity or any other aspect of the long-run real economy. Using the euro vs. the lira has no effect on long-run productivity, any more than using the meter forces Italian tailors to cut Norwegian-sized suits, or that using the Kilo forces Italian restaurants to serve bratwurst and beer rather than pizza and wine.

The countries that adopted the euro never satisfied the three conditions for a successful currency union: labor mobility, flexibility of real wages, and a common fiscal policy that transfers funds to areas that experience temporary increases in unemployment.
This is another repeated truism. In my view the main condition for a currency union was present in the euro and the problem was forgetting about it when the time came. In a currency union without fiscal union, bankrupt governments default just like bankrupt companies. Neither labor mobility (which exists in Europe), flexibility of real wages (doubtful in the US) or common fiscal policy (also limited in the US) are necessary. Europe lived under a common currency -- the gold standard -- for hundreds of years. Sovereigns defaulted.

I suspect Feldstein means by "common currency" far more than I do. I mean, we agree to use a common currency. I suspect Feldstein means far more than that, including that no government debt may ever default and that the ECB must print money to ensure that fact. Like all disagreements perhaps this one simply reflects a difference in meaning of the words. If so, it would be good to say so. Objections to "the euro" are not objections to a common currency per se, but objections to the rest of the legal, regulatory, banking, fiscal, and policy framework that accompanies the euro.

To be fair, there is also a different underlying world view here. In Feldstein's world, national governments and central banks can be relied on to diagnose "shocks," and artfully devalue currencies just enough to "offset shocks" when and only when needed; in the european case likely imposing "capital controls" as well, but to do this rarely enough that investors will still buy government bonds, invest in their countries, and avoid the slide to banana republic inflation, repression, and trade and investment closure. In my world, as I think in the real world of Italy and Greece before the euro, national currencies are not such a happy tool of benevolent dirigisme. The commitment not to devalue, inflate, and grab capital after the fact is good for growth and investment before the fact. A government sober enough to use Feldstein's tools wisely is also sober enough to borrow wisely when offered low rates. A government not sober enough to borrow wisely when offered low rates is not sober enough to artfully devalue, inflate, grab capital "just this once" in response to shocks.


Anies Baswedan