TEKNOIOT: Monetary Policy
Showing posts with label Monetary Policy. Show all posts
Showing posts with label Monetary Policy. Show all posts

7 Sept 2020

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.

21 Aug 2020

Kotlikoff on the Big Con - Barokong

In preparing some talks on the financial crisis, 10 years later, I ran across a very nice article,The Big Con -- Reassessing the "Great" Recession and its "Fix" by Larry Kotlikoff. (Here, if the first link doesn't work.)

Larry is also the author ofJimmy Stewart is Dead – Ending the World's Ongoing Financial Plague with Limited Purpose Banking, from 2010, which along with Anat Admati and Martin Hellwig'sThe Bankers' New Clothes is one of the central works outlining the possibility of equity-financed banking and narrow deposit-taking, and how it could end financial crises forever at essentially no cost.

Larry points out that the crisis was, centrally a run. He calls it a "multiple equilibrium."  Financial institutions have promised people they can have their money back in full, at any time, but they have invested that money in illiquid and risky assets. When people all do that at the same time, the system fails. Such a run is inherently unpredictable. If you know it's happening tomorrow, you run to get your money out and it happens today.

This is a common view echoed by many others, including Ben Bernanke. What's distinctive about Larry's essay is that he pursues the logical conclusion of this view. If the crisis was, centrally, a run, all the other things that are alluded to as causes of the crisis are not really central.  Short-term debt, run-prone liabilities are gas in the basement. Just what causes the spark, how big the firehouse is, are not central, as without gas in the basement the spark would not cause a fire.

Larry puts it all together nicely by starting with the 2011 Financial Crisis Inquiry Commission report:

"There was an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread reports of egregious and predatory lending practices, dramatic increases in household mortgage debt, and exponential growth in financial firms’ trading activities, unregulated derivatives, and short-term “repo” lending markets, among many other red flags. Yet there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner. "
Larry then takes apart each of these non-culprits, as below.

In my view, the understanding that the crisis was a run, that without a run there would have been no crisis, somewhat like the 2000 tech stock bust, and that lots and lots more capital is the only real answer, has emerged slowly over the last 10 years. Larry's essay is good for putting all the others to rest.

The insight is also optimistic. It is possible to fix one clear simple thing -- too much short-term debt, not enough capital. If all the long list of vague maladies named by the crisis commission need to be fixed by super-powerful and financially clairvoyant regulators, the job is hopeless despite the immense government expansion that would entail.

In many of these items, I think Larry oversteps a bit. The argument only needs to be that "these things might have been problems, indeed, they might have caused a recession, but without a run, induced by short-term debt, there would have been no financial crisis." Larry goes on to cast doubt whether any of them are problems at all, which is fun and provocative but more than necessary. Moreover, Larry really goes on to view recessions themselves as multiple equilibria, which is an interesting and provocative idea, but not necessary.

Larry's essay is even more to the point today. I'm at theFinancial Cycles and Regulation conference at the Bundesbank. Every paper so far takes it for granted that there is such a thing as a "financial cycle," a buildup of "excessive" or "imbalanced" debt that precedes an inevitable round of default and crisis. It is the regulator's job to manage such "debt cycles" actively. Larry's essay disagrees from the word go. It's nice to have two diametrically opposed ideas in mind.

Larry's List follows. If you get bored, skim to the bottom for his more provocative ideas on runs.

1) Liar Loans, No Doc Loans, NINJA Loans and Other Subprime Mortgages

There just weren't that many subprime defaults, especially before the crisis hit. (And, I would add, defaults not insured by fannie, freddie, etc.)

2) The “Unsustainable” Rise in Housing Prices

House prices have risen and fallen before. And, I might add, many are sustained. If you're waiting for houses in Palo Alto or Manhattan to fall to, say Joliet IL levels, you may have a long wait ahead of you.

Larry makes an interesting comparison of real house prices with real GDP,

.. real house prices can rise for years, indeed, decades. They did so essentially every year for the 32 years between Q1 1975 and Q1 2007. The rise was both smooth and gradual with real house prices only 64 percent higher in Q1 2007 than they were in Q1 1975 – this despite real GDP rising by 170 percent over the same interval.

The comparison between real house price and real GDP is unusual. Larry writes

In any case, it's not a financial crisis without short-term debt.

Certainly, a temporary drop in house prices could have produced a contraction in construction.... Moreover, a decline in a given sector doesn’t augur an economy- wide recession.

And, an important point

a drop in the price of homes does not adversely impact most homeowners. Yes, the value of their asset falls. ...

But you still get to live in the house. If you could pay the mortgage before, you still can.

if we’re talking about a nationwide decline in house prices, as we are with the GR, even those who moved experienced no economic harm because their ability to buy at a lower price offset their need to sell at a lower price.

The house price drop was great news for young people who live in apartments, as the stock price drop was great news for their retirement investment opportunities. Yes, there are theories in which the losers impact the economy asymmetrically, such as Mian and Sufi's, but we're straying away from the point here. A house price "bubble" and "burst" is not per se a reason for a financial crisis.

As in many of these "causes" it's important to distinguish events before October 2008 from those afterwards. Yes, there was a huge recession, and that caused house price declines, job losses, mortgage defaults, and so forth. But causes of the crisis have to come first.

3) Ratings Shopping

"overrating affected less than one half of one percent of the U.S. bond market. Furthermore, this small figure surely overstates the importance of ratings shopping as many of the downgrades were caused by the GR itself,"

4) Increased Bank Leverage

"Sky-high bank leverage is another part of the standard GR explanation....Bank leverage actually fell over the period 1988 through 2008.16 Equity rose from 6 percent of bank assets in Q1 1988 to 10 percent in Q1 2008."

Be careful here. Larry's point is that there was no voluntaryincreasein leverage, and especially as measured and monitored by regulators, and no such increase was a key cause of the crisis.  That doesn't mean the overall amount of leverage is fine. Larry's main point, as mine, is that the banking system has way too much leverage overall.

5) Too Little [Regulatory] Capital

"According to Cox [ Christopher Cox, Chairman of the U.S. Securities and Exchange Commission (SEC)..], Bear Stearns was well capitalized when it failed, with a capital ratio over 13 percent and a debt-equity ratio of 6 to 1. Indeed, it appears that Bear Stearns could have easily passed the current Dodd-Frank stress test immediately prior to its demise. Consider this statement from Chairman Cox.
"The fate of Bear Stearns was the result of a lack of confidence, not a lack of capital. When the tumult began last week, and at all times until its agreement to be acquired by JP Morgan Chase during the weekend, the firm had a capital cushion well above what is required to meet supervisory standards calculated using the Basel II standard. "
Lehman was also well capitalized prior to its demise. It had tier-1 capital of 11 percent when its creditors pulled the plug. An 11 percent capital ratio is close to the current banking system’s tier-1 capital ratio of 12.3 percent, calculated based on the Federal Reserve’s recent stress tests. This indicates that today’s banking system is no safer than was Lehman Brothers when it was driven out of business."

Again, in this draft, Larry doesn't emphasize enough that the point is adecline in capital, aweakeningof regulations, or a decline in regulatory capital. His and my overall point is that capital needs to be much, much larger overall, and that will stop runs. But the event of the crisis was a combustion of the regular old gas in the basement, not an addition of lots of new gas.

6) Egregious and Predatory Lending


"adjustable-rate mortgages, mortgages with balloon payments, interest-only mortgages, piggy-back, and so-called pay-option ARM loans."

of these,

"...in 2007, before the GR, the foreclosure rate was 5 percent. Its lowest value, between 2002 and 2007, was 3 percent, which was observed in Q3 2005.If one assumes that all of the 2 percentage-point increase in subprimes involved predatory lending, we’re still talking about predatory lending causing, at most, 0.3 percent more mortgages to definitely default, namely, enter foreclosure. This is simply too small a figure to matter to the overall economy. Indeed, given the size of the 2007 mortgage market, it represents just $32 billion. In 2007, U.S. GDP was $14.4 trillion. The economy’s 2007 total net wealth was $68 trillion."

The Dodd-Frank act piled every suggested fix to every perceived financial problem in one place. Even if one regards predatory lending as a problem, even if one does not regard competition as the best disinfectant and guarantor of good treatment, even if one thinks it needs fixing, Larry's point is that such a fix has nothing to do with stopping crises.

7) Dramatic Increases in Household Mortgage Debt

Surely, the addition of over $750 billion in mortgage debt in the course of 6 short years must represent a priori evidence that a massive recession was in the works. Not so. ... The increase in borrowing to purchase homes was not associated with a massive spending spree on the part of the American public. Indeed, the share of GDP consumed by the public remained fixed at roughly 67 percent between early 2002 and late 2007.

What about household debt payment service as a share of disposable personal income? There was an increase prior to the GR, but nothing extraordinary. Between Q4 2001 and Q4 2007, the ratio troughed at 12.1 percent in Q2 2004 and peaked in Q4 2007 at 13.2 percent. A 13.2 percent ratio is small and the increase from trough to peak is only 9 percent

As with houses, your debt is my asset. Larry is verging here into causes of the recession rather than the crisis. There is a case for asymmetries, but the first-order mistake is to think that just because I am in debt we all are in debt.

8) Exponential Growth in Trading Activity by Financial Firms

Here, again, we have a supposed reason for the Great Recession that has no counterpart in economic theory. If Joe and Sally sell the same share of stock back and forth to each other an infinite number of times in, say, a second, nothing real will happen to Joe and Sally or the economy.

9) Unregulated Derivatives and the Repo Market

The reigning narrative – that derivatives were misunderstood and over rated by compliant rating companies – has been questioned in a recent study by economists Juan Ospinal and Harald Uhlig. They examined 8,615 residential mortgage-backed securities (RMBS) over the period 2007-2013, almost all of which were rated AAA. Through 2013, the cumulative loss on these “toxic” securities was only 2.3 percent. Some three quarters of the AAA-rated RMBS had essentially zero losses through 2013. On a principal-weighted basis, the average loss rate was only 0.42 percent.

I think the logic here is that if securities were overpriced, then they should have fallen. That they did not is interesting. Of course, if they had fallen that is not necessarily evidence of overpricing, as there was a huge recession after the run!

Here again I think a big qualification is in order. The run on repo was a central part of the crisis, and I think Larry and I agree that way too much such run-prone financing was the key cause of the crisis. Again, I think the point Larry is making is that the financial system as constructed is always vulnerable, that the crisis was not brought on by some sudden and preventable increase in debt.

10) Investors Mispriced/Ignored Risk

11) Unaligned CEO Incentives

Yet another explanation for the GR is that CEOs of financial institutions had too little “skin in the game.” Jimmy Cayne, former head of Bears Stern, would surely disagree. Cayne lost close to $1 billion as his bank collapsed. Ken Lewis, CEO of the Bank of America, had $190 million to lose by making wrong decisions and succeeded in losing $142 million. Lehman Brothers’ Dick Fuld received most of his 2007 compensation in the form of Lehman Brothers’ stock.

12) Democratization of Finance

Under this theory, government sponsored enterprises (Fanny and Freddie) and government regulators were too permissive with banks in their quest to help the poor get into affordable housing. ...if this were the chief or even a major cause of the GR, subprime mortgages would need to have played a much larger role than they did.

13) The Federal Reserve Kept Interest Rates Too Low

Thirty-year mortgage interest rates were certainly lower between 2000 and 2007 than in the prior quarter century. But they weren’t that low especially adjusted for inflation. In the 1990s, the real 30-year mortgage rate averaged 7.91 percent. It averaged 6.27 between January 2000 and December 2007. This decline is hardly something to write home about, let alone pretend is the underlying GR culprit.


..the foundational bank-run models --- Bryant (1980), Diamond-Dybvig (1983), Pech and Shell (2003) and related models – admit multiple equilibrium in which financial-market collapse arises absent any fundamental financial- or real-sector problem...  from the perspective of these models, the question is not whether the banking system will fail, but when. Hence, it’s passing strange that the FCIC report makes no mention whatsoever of either paper, let alone the theory underlying bank runs.

(My emphasis.) Larry goes on for several pages documenting spreading panic. An earlier quote is good here

SEC Chairman, Mary Schapiro’s, 2010 testimony to the House Financial Services Committee...includes this statement.
The immediate cause of Lehman's bankruptcy filing on September 15, 2008 stemmed from a loss of confidence in the firm's continued viability resulting from concerns regarding its significant holdings of illiquid assets and questions regarding the valuation of those assets. The loss of confidence resulted in counterparties and clearing entities demanding increasing amounts of collateral and margin, such that eventually Lehman was unable to obtain routine financing from certain of its lenders and counterparties

The banks failed because they could. And they could fail because they were leveraged. They falsely promised to make repayments regardless of the circumstances.

Unsafe at Any Speed, and the limits on bailouts

The overall level of leverage is way too high. This reinforces my earlier interpretation of Larry's comment about leverage not being the problem -- there was way too much leverage, but its increase did not directly cause a crisis.

The next part is really interesting.

The Federal Reserve is also leveraged. In the aftermath of Lehman’s collapse, the Fed effectively insured not just checking and saving accounts, but also money market funds. These obligations were officially and, respectively, FDIC and Treasury obligations. They ran to some $6 trillion. But neither institution had $6 trillion in ready cash to make good on its insurance. Hence, the Fed would have been on the hook. Indeed, had things gotten worse, there would surely have been a run on the life insurance industry’s cash-surrender value policies, which, at the time, also totaled roughly $6 trillion.
Now imagine, as discussed in Kotlikoff (2010), that the government’s explicit and implicit pledges of insurance had been called by the public. I.e., suppose the public had, despite the promises of government insurance, headed straight to the banks, money market funds, and insurance companies to empty out their accounts and cash out their cash-surrender value policies. In this case, the Fed would have had to print $12 trillion virtually overnight. The M1 money supply at the time was just $1.5 trillion. Hence, this would have produced fully-justified fears of hyperinflation leading everyone to run for their money before prices soared
The U.S. has yet to experience a run on its central bank. But this is common in countries like Argentina, ...

Larry is, of course, an expert on all the explicit and implicit credit guarantees our government offers. I was unaware that $6 trillion of "cash surrender value policies" existed, and given the bailouts of other insurance policies we would certainly have seen them bailed out too. Fannie and Freddie guarantee most mortgages.

Though it does represent promises of payment, I don't think this really is "leverage" of the Federal Reserve. The government has, in essence, written a lot of put options, which is a different thing.

What happens in an even more massive run, with more massive bailouts is an interesting question. It's not as simple as "print [ing] $12 trillion overnight." The Fed issues reserves, convertible to cash, but always in return for something else. So, this would have put a big strain on the Fed's legal limitations of what collateral it can accept and from who.

The Fed mostly deals with commercial banks. Imagine a massive run on commercial banks, perhaps stemming from a rumored cyberattack that emptied one of them out. The Fed would have to lend against the entire portfolio of bank assets, not just liquid securities. Goodbye Badgehot.

As Larry points out, really the FDIC and Treasury are the ones guaranteeing non-bank debts.  The Treasury would have to borrow $12 billion overnight, sell it to the Fed, and then use it to bail out here and there. The ban on direct Fed-Treasury purchases would make this very hard, and would probably have to be scrapped.

But the huge increase in money would clearly be a temporary increase in money demand, and not obviously inflationary. Moreover, the Treasury, Fed, FDIC, etc. would take on assets. If these operations could be reversed after the panic passes -- if there is not a tremendous amount of actual lost value, as there was not last time, the money could be soaked up again. Even if not, the operation would not be inflationary if people thought the government could retire the debt and soak up the interest-paying reserves by future surpluses. We get inflation -- and Argentina gets inflation -- if and only if this nightmare involves a large fiscal transfer, that the US government cannot or will not pay off, that is financed by a permanent increase in non-interest-paying money.

US Federal debt is about $10 trillion larger than in 2008, and we're running $1 trillion deficits, with no end in sight. The reliability of the fiscal resources to make good on all these put options is, I think, a serious problem, and the heart of the potential inflation Larry describes.

The Role of Opacity

Bear Stearns was among the first to be picked off by those who stood to gain by a financial collapse because it was viewed as particularly opaque
The fact that Bear’s stock was valued at $60 per share one week before JP Morgan bought it for $2 per share (less a $29 billion sale of Bear’s troubled assets to the Fed valued at far less than $29 billion) tells us that no one knew anything about Bear’s assets, either before it died or when it died. Its valuation was, it seems, purely a matter of conjecture. Before it didn’t, the market apparently though Bear’s assets were worth something because everyone else thought its assets were worth something. This too is the stuff of multiple equilibria

Gary Gorton likens financial crises to a salad bar, where someone says "there's a news report of e-coli in the (inaudible)". So what do you do? Absent information on which ingredient has the e-coli, and the time or inclination to investigate, you go order a hamburger.

Now ask yourself, where is there a mountain of debt that can't be repaid, much of it very short term, phoney-baloney accounting, and opaque off-balance-sheet exposures (put options)? Sovereigns.

Bottom line

The first conclusion seems to me spot on. The second one is more provocative. Here Larry signs up with multiple-equilibrium theories of recessions, as well as simple multiple equilibria associated with run-prone assets like overnight debt. It's verbally plausible. If you think there will be a recession tomorrow, you fire workers and do not invest, and there is a recession today. But you can see a crucial derivative needs to be greater than 1.0 for that to work. Lots of formal models have multiple equilibria, but I've spent 10 years putting nominal multiple equilibria back in the new-Keynesian model, and real multiple equilibria are harder to get going.

Choose your equity-financed banking flavor, and we can end financial crises forever. Just why we don't do it seems an important -- and sadly forgotten -- question.

16 Aug 2020

Blueprint for America - Barokong

Some of the inspiration for this project came from the remarkable 1980 memo (here) to President-elect Ronald Reagan from his Coordinating Committee on Economic Policy.

Like that memo, this is a book about governance, not politics.  It's not partisan -- copies are being sent to both campaigns. It's not about choosing or spinning policies to attract voters or win elections.

The book is about long-term policies and policy frameworks -- how policy is made, return to rule of law, is as important as what the policy is --  that can fix America's problems. It focuses on what we think are the important issues as well as policies to address those issues -- it does not address every passion of the latest two-week news cycle.

The book comprises the answers we would give to an incoming Administration of any party, or incoming Congress, if they asked us for a policy package that is best for the long-term welfare of the country.

The chapters, to whet your appetite:


CHAPTER 1: The Domestic Landscape by Michael J. Boskin

IN BRIEF: Spending by George P. Shultz

CHAPTER 2: Entitlements and the Budget by John F. Cogan

CHAPTER 3: A Blueprint for Tax Reform by Michael J. Boskin

CHAPTER 4: Transformational Health Care Reform by Scott W. Atlas

CHAPTER 5: Reforming Regulation by Michael J. Boskin

CHAPTER 6: National and International Monetary Reform by John B. Taylor

CHAPTER 7: A Blueprint for Effective Financial Reform by John H. Cochrane

IN BRIEF: National Human Resources by George P. Shultz

CHAPTER 8: Education and the Nation’s Future by Eric A. Hanushek

CHAPTER 9: Trade and Immigration by John H. Cochrane

IN BRIEF: A World Awash in Change

CHAPTER 10: Restoring Our National Security by James O. Ellis Jr., James N. Mattis, and Kori Schake

CHAPTER 11: Redefining Energy Security by James O. Ellis Jr.

CHAPTER 12: Diplomacy in a Time of Transition by James E. Goodby

CLOSING NOTE: The Art and Practice of Governance by George P. Shultz

My chapter on a Blueprint for Effective Financial Reform is a better version of the talk on Equity Financed banking which I posted here. (The talk was based on the paper. Now you have the paper.)

My chapter on Trade and Immigration is new, and an uncompromising red-meat free-market view. I don't think one should compromise centuries old economic understanding just because it's not politically popular at the moment.

If you got this far, you might also be interested in my Economic Growth essay written for a parallel but similar project.

15 Aug 2020

A world without cash - Barokong

Max Raskin and David Yermack have a nice WSJ OpEd last week, "Preparing for a world without cash." The oped summarizes their relatedpaper.

What would a government-backed digital currency look like? A country’s central bank would need to become a deposit-taking institution and hold accounts on behalf of citizens and businesses. All of their debits would be tracked on the central bank’s blockchain, a digital ledger resistant to tampering. The central bank would pay interest electronically by adjusting the balances of depositor accounts.
I'm a big fan of the idea of abundant interest-bearing electronic money, and that the Fed or Treasury should provide abundant amounts of it. (Some links below.) Two big reasons: First, we then get to live Milton Friedman's optimal quantity of money. If money pays interest, you can hold as much as you'd like. It's like running a car with all the oil it needs. Second, it is a key to financial stability. If all "money" is backed by the Treasury or Fed, financial crises and runs end. As Max and David say,

Depositors would no longer have to rely on commercial banks to hold their checking accounts, and the government could get out of the risky deposit-insurance business. Commercial banks that wished to keep making loans would raise long-term capital in the debt and equity markets, ending the mismatch between demand deposits and long-term loans that can cause liquidity problems.
However, there are different ways to accomplish this larger goal. Do we all need to have accounts directly at the Fed, and is a blockchain the best way for the Fed to handle transfers?

The point of the blockchain, as I understand it, is to demonstrate the validity of each "dollar" by keeping a complete encrypted record of its creation and each person who held it along the way.

Its archival blockchain links together all previous transfers of a given unit of currency as a method of authentication. The blockchain is known as a “shared ledger” or “distributed ledger,” because it is available to all members of the network, any one of whom can see all previous transactions into or out of other digital wallets
That, and a limited supply to control its value, was the basic idea of bitcoin. But when we are clearing transactions by transferring rights to accounts at the Fed, the validity of the "dollar" is not in question. It's at the Fed. And, the big advantage relative to bitcoin as I see it, the value of the dollar comes from monetary policy and ultimately the government's demand for "dollars" to be paid in taxes, not from a fixed supply as was the case with gold.

The blockchain also appears to clear transactions more quickly and offer some security advantages. The latter are very attractive -- in my personal life I've recently had the questionable pleasure of spending days enjoying 19th century finance of multi-day clearing times, obtaining notarized signatures and medallion guarantees, and sending pieces of paper around. But not yet ironclad -- The same week of the WSJ has a string of articles on the security ofBitcoin following a recent hack.

The biggest stumbling block in my mind is "all members of the network, any one of whom can see all previous transactions into or out of other digital wallets." Per Max and David, this has pluses and minuses:

Tax collection would become much simpler, and tax evasion and money laundering could become prohibitively difficult.
Yet the centralization of banking under this system would also create a Leviathan with the power to monitor and control the personal finances of every citizen in the country. This is one of the chief reasons why many are loath to give up on hard currency. With digital money, the government could view any financial transaction and obtain a flow of information about personal spending that could be used against an individual in a whole host of scenarios.
This really is a big change in how "money" works. Traditional cash has a lovely property, that it has no memory. Its physical properties determine its value in a way independent of its history. It is incredibly efficient, in a Hayek information sense. The economy does not need the memory of every transaction. Blockchains turn this around.

The anonymity of cash makes it enduringly popular -- cash holdings are up, not down in the digital age. The same week of WSJ reading had articles delving into the continuing popularity of cash, and themechanics of handling it, the ongoing fury over theplaneload of cashdelivered by the Obama administration to Iran. It's not hard to figure out why both Iranians and Administration needed to send old-fahshioned bills on an unmarked plane, not a wire transfer.

Indeed creating this Leviathan is a danger, to the economy, and to our political freedom. Our government likes to pass aspirational laws that we don't really mean to enforce. Get rid of cash, and allow the government to see every transaction and enforce every law regarding payment of anything, and 11 million immigrants suddenly can't work at all and become penniless. Rigorous enforcement of all transactions would not only stop your kids lemonade stand and babysitting business, it would wipe out most of the employment opportunities for lower-income America. Many businesses would come to a halt.

The natural response is, well, maybe we shouldn't pass laws we don't really mean to enforce. Good luck with that.

More deeply,  "flow of information about personal spending that could be used against an individual in a whole host of scenarios" is truly frightening. I don't think there is a political candidate in the whole country who could not be embarrassed with one purchase at some point in their lives. Consider the brouhaha now over "disclosure" of political contributions -- there is a real fear that disclosure is a way of setting up hit lists for the administration to go after its political enemies. Multiply that by a thousand. Dissenters could easily be silenced if the government can monitor or block every transaction.

The ability to transact with anonymity and privacy has been a central freedom for hundreds of years. It's largely gone already. Losing it entirely and giving the government huge power to enforce any law it passes is not necessarily a good thing.

Mike and David opine

creating and respecting privacy firewalls and rethinking legal-tender laws could mitigate the dangers of monopoly and stifled competition in currency markets.
[Subject-free sentences (creating?) are always a sign of trouble!] The dangers are not of monopoly and competition, the dangers are in the vast loss of privacy that the government, and its leakers and hackers knowing all our transactions implies.

(Here I'm out on a limb on my blockchain knowledge, but I gather that one does have to wipe the slate clean occasionally. Otherwise, the blockchain gets ridiculously long. Imagine each dollar, a hundred years from now, attached to a list of everyone who has ever held it! That wiping out process could do a lot for privacy.)

So, back to basics. It is not at all clear to me in their analysis why the Fed has to manage all the accounts. The Fed, Treasury, and the government in general are very good at defining the units of a currency, and providing an easy standard of value -- cash, coins, liquid government debt, reserves.  That is their natural monopoly. I don't see that the government has a similar natural advantage in providing low-cost transactions services, especially on monitoring fraud in the use of those services. The Fed got hacked by employees of the central bank of Bangladesh.

So I leave with two big questions -- and these are questions, and this is an invitation to more thought.

Is a blockchain really better than accounts at the Fed, and instructions to flip a switch to send money from my account to your account? What is the best way to get low transactions costs and fraud prevention, given that we don't need authentication of the dollar itself and a supply limitation?

Is it really better for the Fed to handle all transactions directly, rather than for the Fed to provide clearing accounts, and "banks" (narrow!) to provide transactions services between people, using reserves as now for netting and clearing? The latter setup allows competition and innovation in transactions services, and a better hope for an information firewall retaining some privacy and anonymity in transactions.

(Note for readers new to the blog: I've written about some of these issues inA new structure for US Federal Debt, Toward a run-free financial system, A blueprint for effective financial reform and previous blog posts, such as here.)

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.)

5 Aug 2020

Balance sheet balance - Barokong

The Fed has a huge "balance sheet" -- It owns about $3 trillion of government bonds and mortgage backed securities, which it finances by issuing about $1 trillion of cash and $2 trillion of reserves -- interest-bearing accounts that banks have at the Fed. Is this a problem? Should the Fed trim the balance sheet going forward?

On Tuesday Dec 6, I participated on a panel at Hoover's Washington offices to discuss the book "Central Bank Governance And Oversight Reform" with very distinguished colleagues, Michael Bordo, Charles Plosser, John Taylor, and Kevin Warsh. We're not afraid to disagree with each other on panels -- there's no "Hoover view" one has to hew to, so I learned a lot and I think we came to some agreement on this issue in particular.

Me: The balance sheet is not a problem. The Fed is just one gargantuan money market fund, invested in Treasuries, with a credit guarantee from the Treasury. Interest bearing reserves are perfect substitutes to bonds. The Fed is just making change, taking $20 bills (Treasuries) and giving out $5 and $10 in return. The Fed can easily run monetary policy by just paying more or less interest on reserves.

Plosser: The balance sheet is a big problem. Yes, John's right that interest bearing reserves won't cause inflation so long as banks just sit on them. But will banks just sit on them? Right now, banks don't see enough profitable lending opportunities to care. But if they do, will the Fed really pay enough interest to keep hugely inflationary amounts of reserves from feeding the money supply? What will Congress say when the Fed is paying 3%, 4%, or more to banks to bribe the banks not to lend money to American business and consumers?

Worse, focus on what the Fed is buying not what it is issuing. If the Fed were just buying short-term treasuries John might have a point. But it's buying long term bonds, intervening in the bond market; mortgage backed securities, funneling money to houses. This is credit allocation. The ECB is buying corporate bonds and the BOJ is buying stocks. Congress already raided some of the Fed's assets. So there may not be a big economic problem but there is a huge political economy problem.

(This isn't a quote, and I'm going from memory as we don't have a record of the panel. I hope I'm not mis-characterizing Plosser's view too much. If I am, well, take it as what I learned from the discussion and my own much better sympathy for a countervailing view.)

Taylor: The Fed should not just wind down the huge balance sheet, but it should go back to a very small amount of reserves that do not pay interest. Then it should go back to controlling interest rates by open market operations, and a binding money multiplier. (Taylor, being a lot more polite than the rest of us, did not go into detail on this, but I think he's worried about the Fed being able to control interest rates under interest on reserves (IOR), and whether changing interest rates under IOR with a slack multiplier will make any difference. Again, if this isn't Taylor's view, at least it is a view that I appreciate more after the discussion.)

Well, how to we reconcile this?

I think Plosser is right about the asset side of the balance sheet, and he seems to think I'm mostly right about the liability side. How to square that circle?

I think we would all be happier if the Fed did not keep maturity and credit risk on its balance sheet. Instead, if the Fed really wants to intervene quickly in asset markets and buy anything but short term treasuries (a big if, but there seemed to be consensus that at least in a crisis such purchases might have to be made) then the Fed should swap them to the Treasury within, say, 6 months, so any long-term credit allocation and risk is in the Treasury where it belongs.

(This is, I think, illegal right now. The Fed cannot deal directly with the Treasury, one of many bright little ways our ancestors set up the system to prevent inflationary finance. But that can be fixed.)

And, granted that large amounts of interest-bearing reserves are a good thing -- lots of non-inflationary oil in the economic car -- the Fed doesn't have to be the one to provide them. I brought up again my proposal that the Treasury should issue fixed-value floating-rate small-denomination electronically-transferable debt -- i.e. reserves -- to everyone, not just banks. You should be able to go to treasury.gov and sign up for the treasury's money market fund. All the Fed is doing by buying short-term treasuries and issuing reserves is creating this new class of government debt out of other kinds of government debt. Why not have the Treasury issue it directly? Then the Fed could in fact wind down its balance sheet to near nothing, without losing any of the liquidity and financial stability benefits of interest on reserves.

Plosser seems to go along. Taylor not yet, but sitting on a panel it was hard for any of us to think how this would work in a world of very small non interest bearing bank reserves. (I think it would -- Treasury floaters would not be much different from short term treasury debt from a bank's perspective.)

So we learn from each other on the panel, as well as the sharp questions from the audience. Thanks to everyone who came (and to our second panel on the Blueprint for America), it was a very productive day.


Discussion now available online, embed below, link here. Now we can see how my memory matches up with the facts.

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.

2 Aug 2020

Chinese Tidbit - Barokong

From the WSJ moneybeat blog:

China’s central bank extended support on Friday to a group of unnamed but large banks...  the People’s Bank of China extended a longer-term but temporary liquidity facility... Details on the facility were typically vague. In recent weeks it has also injected record amounts of cash.
The move gives banks some breathing room for now, just as interbank liquidity stresses escalate. The new facility, analysts from ANZ say, doesn’t require banks to post collateral like other facilities typically do. And it makes it easier for them to reach a key regulatory barometer that monitors banks’ liquidity risk in cases of stress in the short term. A helping hand can lighten another burden–but not for long.
"Interbank liquidity stresses" and central bank long term "loans" without collateral are not a good sign. An escalating war on capital flight is not a good sign either.

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.


Anies Baswedan