Don’t raise rates in order to be able to cut them later

W. Peden sent me the following from the British Shadow Monetary Policy Committee:

In its latest email poll, the Shadow Monetary Policy Committee (SMPC) voted to raise Bank Rate by 0.25% in October, the second consecutive month it has voted for an increase. The vote came against the backdrop of the US Fed leaving rates on hold, citing China as one reason.

Those voting for a rate hike continue to warn – amongst other things – that in any future economic slowdown, the UK would not have the flexibility to respond by cutting rates if they are not raised soon. One argues that recent data revisions show that there is no negative output gap in the UK, and that is why earnings growth is rising so quickly, a sign that monetary policy is too loose. Those voting for unchanged rates continue to cite little price inflation in the actual data, slow growth in monetary statistics and signs that the economy may be losing momentum.

I don’t know enough about Britain to have an opinion on where they should set rates (although I do have the opinion that they should not target interest rates at all.)  But there is one serious flaw in the quote above.  And before explaining the flaw, let me point out that it is not one of those debatable issues, like whether QE is a good idea, or whether Switzerland should have abandoned the peg.  There’s a basic economic error in this part of the quote:

Those voting for a rate hike continue to warn – amongst other things – that in any future economic slowdown, the UK would not have the flexibility to respond by cutting rates if they are not raised soon.

That’s just wrong.  Monetary stimulus does not come from cutting interest rates; it comes from cutting them relative to the Wicksellian natural rate.  You can raise rates to 1000% if you want, but then cutting them back to 2% doesn’t make policy expansionary.  The problem with raising the target interest rate is that this would reduce the Wicksellian equilibrium rate.

If they are worried about having enough room to stimulate the economy in the next recession, before hitting the zero bound, then they should unquestionably NOT raise interest rates right now.  Raising them would reduce the Wicksellian equilibrium rate, and give the BoE less future room to maneuver. Period. End of story. I see this mistake all the time, and I don’t understand why it keeps being made.

Just to be fair and balanced, the other information in the quote does support a rate increase.  The rapidly rising wage growth is more important than the inflation, money supply, and real GDP data.  So I’m agnostic on the rate question.  But please, don’t raise rates to give yourself room to cut them in the future.

PS.  Don’t believe me?  Check out what the ECB and Riksbank rate increases of 2011 did to their Wicksellian equilibrium interest rates.

PPS.  I’ll be at a conference, and thus comment replies will be slow for a few days.

Garcia-Schmidt and Woodford on Neo-Fisherism

In the 1950s and 1960s, many liberals were anti-anti-communists.  In retrospect that was not a very wise political stance, but it was far better than being a communist. After reading part of Mariana Garcia-Schmidt and Michael Woodford’s new NBER paper on Neo-Fisherism, I’m inclined to call myself an anti-anti-NeoFisherian.

John Cochrane had shown that some New Keynesian models led to NeoFisherian conclusions, i.e. that cutting interest rates leads to lower inflation.  Garcia-Schmidt and Woodford propose an alternative approach, which replaces rational expectations with “reflective expectations”:

We argue that predicting what should happen as a result of a particular policy commitment requires that one model the cognitive process by which one imagines people to arrive at particular expectations taking that information into account. In this paper, we offer a simple example of such an explicit model of reasoning. Under our approach, a perfect foresight equilibrium (or more generally, a rational-expectations equilibrium) can be understood as a limiting case of a more general concept of reflective equilibrium, which limit may be reached under some circumstances if the process of reflection about what forward paths for the economy to expect is carried far enough. Our concept of reflective equilibrium is similar to the “calculation equilibrium” proposed by Evans and Ramey (1992, 1995, 1998): we consider what economic outcomes should be if people optimize on the basis of expectations that they derive from a process of reflection about what they should expect, given both their understanding of how the economy works and (as part of that structural knowledge) their understanding of the central bank’s policy intentions.

Here’s where Garcia-Schmidt and Woodford lose me:

In particular, we show that in our model, a commitment to maintain a low nominal interest rate for a longer period of time — or to maintain a lower rate, for any fixed length of time — will typically result (under any given finite degree of reflection) in increased aggregate demand, increasing both output and inflation in the near term, though the exact degree of stimulus that should result depends (considerably) on the assumed degree of reflection. This is true regardless of the length of time for which the interest-rate peg is expected to be maintained, and even in the limit of a perpetual interest-rate peg. Thus consideration of the reflective equilibrium resulting from a finite degree of reflection yields conventional conclusions about the sign of the effects of commitments to lower interest rates in the future, and does so without implying any non-negligible effects of changing the specification of policy only very far in the future.  (emphasis added)

I’m not denying that “the model” produces this result, but how is this any less far-fetched than Neo-Fisherism?  Indeed it seems even worse.  What would you think of a statement by the BOJ that they intended to keep nominal rates at zero forever?  I’d probably have the same reaction as John Cochrane.  Perhaps I’m missing something, these models are way over my head.

Let me propose a solution that is intermediate between the two extremes.  There is no paradox.  Easy money always raises inflation.  But easy money may or may not raise nominal interest rates. Even with complete rational expectations. Consider these two cases:

A.  The BOJ uses pure discretion.  Wages and prices are sticky, and expectations are rational.  The BOJ suddenly reduces the money supply unexpectedly.  Real money balances fall, and as a result short term interest rates rise. Inflation falls. This is all consistent with rational expectations. I don’t know whether it’s consistent with ratex NK models, but if it isn’t then perhaps the models should be revised.

B.  The BOJ commits to a 2% per year depreciation of the yen against the dollar (or 2% more than currently expected). Interest rates rise at all maturities due to the interest parity condition.  They simultaneously do a once and for all currency depreciation large enough to offset the impact of the higher interest rates.  There is no instantaneous change in AD, by assumption, but over time inflation rises by 2% due to PPP.

In both cases the BOJ raised interest rates immediately, and in case A the inflation rate fell and in case B it rose.  One produced a NeoFisherian result and one produced a conventional result.  This is how the world actually works, AFAIK. And we were able to get this result without jettisoning rational expectations.  Also notice that in case A the money supply fell, and in case B it probably rose, and certainly rose in the very long run.

Instead of focusing on ambiguous indicators such as the path of interest rates, we need to come up with a clear, unambiguous real time indicator of the stance of monetary policy.

NGDP futures anyone?

PS.  I would appreciate any help you can offer with the second quoted paragraph.  I should add that Garcia-Schmidt and Woodford are not recommending that central banks make commitments to hold rates low regardless of macro conditions, and later point out that this sort of open-ended policy could lead to wildly unstable results.

HT:  Thomas Powers

Bernanke on NGDP targeting

We’ll have to wait for the 2011 minutes to know exactly what happened, but this paragraph sent to me by Marcus Nunes and also Stephen Kirchner (apparently from Justin Wolfers tweet), confirms what I thought after I heard Bernanke’s response to a reporter on NGDP targeting, back in 2011:

[Update:  Marcus indicated it was Neil Irwin, Not Justin Wolfers who tweeted.]

Screen Shot 2015-10-05 at 8.50.08 PMAt the time, I thought Bernanke probably had at least some sympathy for NGDP targeting. That’s partly based on the comments he made at the 2011 press conference, which was sort of along the lines of “very interesting idea, but in the end we stayed with IT” (but not those exact words!) and also based on the fact that he is one of the few academics who used to discuss NGDP in the context of monetary policy, which shows the basic idea has been on his mind for many years. It’s also an idea that tends to appeal to people outside the Fed who have Bernanke’s general views on monetary policy. Like me!

I still think that if Bernanke had been an academic during the Great Recession he would have supported NGDP, or at least been very sympathetic.

Of course once you join the Fed your freedom to maneuver is far less.  Even I understand that the Fed would have looked crazy to suddenly adopt NGDPLT, just as they were finally settling on an explicit 2% inflation target.  I’ve always thought of this as a 10 or 20 year struggle, and still believe that.

Still it’s good to know that the objections are not too serious.  Over time the shift from IT to NGDPLT will look less opportunistic. Perhaps the shift could occur at a moment when NGDPLT would not lead to higher expected inflation.  And it’s actually much easier to explain NGDPLT to the public than IT, which Fed officials would realize if they ever bothered to read my papers on NGDP targeting.  (Try explaining to the public that you are trying to “raise their cost of living” for their own good, and be sure to use “Phillips Curves” in your explanation. Lots of luck!)

NGDP targeting is something that academic economists need to mull over for a while.  Once a majority of academic economists favor NGDPLT, it will be much easier for the world’s central banks to switch over to the new policy.

PS.  If you don’t agree with my take on Bernanke, read this post.

Multiplier mischief

Multipliers are ratios. That’s really all they are. There is the money multiplier (M2/MB), the fiscal multiplier (1/MPS) and the velocity of circulation (NGDP/MB, or NGDP/M2). If you assume these ratios are stable, you can derive some very interesting policy results. Of course the ratios are not completely stable, but may be stable enough to be of some value. Sometimes. My own view is that multipliers aren’t particularly useful, but today I’d like to assume the opposite, and show that the implications are not necessarily what you might assume.  (And please, no comments from MMT zombies “explaining” to me that multipliers don’t exist.)

Milton Friedman faced a quandary when trying to explain how bad government policies led to the Great Depression. If he defined the money supply as “the monetary base” (as I prefer), people would have pointed out that the base increased sharply during the Great Depression. Alternatively, he could have adopted the market monetarist practice of defining the stance of monetary policy in terms of changes in NGDP. Thus falling NGDP during 1929-33 was, ipso facto, tight money. His critics would have objected that this begged the question of how could the Fed have prevented NGDP from falling.

So he split the difference, and settled on M2 as both the definition of money, and the indicator of the stance of monetary policy. He suggested that, “What is money?” was essentially an empirical question, not to be determined on theoretical first principles. His statistical analysis led him to conclude that M2 (which unlike the base did fall during the early 1930s) was the preferred definition of money. And also that growth in M2 should be kept stable at roughly 4%/year.

In my view M2 no longer represents a good definition of money, using Friedman’s pragmatic criterion. Look at M2 growth in recent years:

Screen Shot 2015-10-05 at 3.38.24 PMI don’t know about you, but I see almost no correlation with the business cycle. Indeed M2 growth soared in the first half of 2009, making money look “easy”, which is obviously crazy. So if Friedman were alive today, how would he define money? The base still doesn’t work, as reserves also soared in 2008-09. Nor does M2. I don’t have a good answer, but I suspect that coins might be the best definition. Unlike the base and M1, periods of illiquidity probably don’t lead to massive hoarding of coins.  They are primarily useful for making transactions (although a sizable stock is held in piggy banks.)

Unfortunately, I could not find any data for the stock of coins in circulation. (Which is a disgrace, when you think about the 100,000s of data series the St Louis Fred does carry. As I recall, back in the 1990s coins were almost as important a part of the base as bank reserves.) But I did find data on annual coin output. For simplicity, I chose unit output, but value of output (which counts quarters 5 times more than nickels) would almost certainly lead to broadly similar results. In the list below I will show the change in annual coin output, compared to the year before, and also the change in the unemployment rate at mid-year (June) compared to the year before. The unemployment rate change is in absolute terms:

Year  * Coin Output  * delta Un

2000:   +28.1%           -0.3%
2001:    -30.9%          +0.5%
2002:    -25.7%          +1.3%
2003:    -16.5%          +0.5%
2004:    +9.5%          -0.7%
2005:   +16.1%          -0.6%
2006:    +1.4%           -0.3%
2007:    -6.9%             0.0%
2008:    -29.8%        +1.0%
2009:   -65.0%          +3.9%
2010:   +79.6%          -0.1%
2011:    +28.7%         -0.3%
2012:   +13.9%          -0.9%

Unfortunately my data ends at 2012, but that’s a really interesting pattern. Especially given that I don’t have the data I’d actually prefer.  I’d like the change in the size of the coin stock; instead I have the change in the flow of new coins (but not data on old coins withdrawn.)  It’s more like a second derivative.

In any case, it’s an amazing correlation. The signs are opposite in every case except the one where unemployment doesn’t change at all.  Coin output falls during years when unemployment is rising, even years like 2003 when unemployment is rising during a non-recession year.  And even better, the biggest change by far in coin output (proportionally) is in 2009, which also saw the biggest change by far in unemployment.

If you are not good at math then you’ll have to take my word for 2010 being a smaller change in proportional terms.  Indeed if you look at actual coin output in levels, 2010 was the second smallest in the sample, 2011 the third smallest, and 2012 the 4th smallest.  The decline in 2009 was so great that we never really climbed out of the hole.

Now let me emphasize that there’s an element of luck here.  If we had coin data for 2013 and 2014 I doubt the relationship would hold up.  Coin output seems to be in a steep secular decline.  So it’s partly coincidence that the signs are reversed in virtually every case.  But not entirely coincidence.  Perhaps someone could do a regression (using first differences of logs of coin output—so that the 2009 change will be larger than 2010) and confirm my suspicion that this relationship does show something real.  Falling coin output is associated with recessions.

But does it cause recessions?  If only you knew how tricky the term ’cause’ really is!  Krugman basically called Friedman a liar (soon after Friedman died) for claiming that tight money caused the Great Depression, whereas in Krugman’s view Friedman’s data pointed to the real problem being a non-activist Fed—they didn’t do enough to prevent M2 from falling. But they didn’t cause it to fall with concrete steppes.  The base didn’t fall.

I’ve always believed we should think of “causation” in terms of policy counterfactuals.  Suppose the Fed had acted in such a way that M2 didn’t fall.  And suppose that in that case there would have been no Great Depression.  Then if the Fed was capable of preventing M2 from falling (which is itself a highly debatable claim) then there is a sense in which Friedman was right, the Fed did cause the Great Depression.  Again, that’s if they could have prevented M2 from falling, and if stable M2 would have prevented a depression–both debatable (but plausible) claims.

My claim is that if we use Friedman’s pragmatic criterion for defining money, then coins might possibly be the best definition of money for the 21st century.  If the Fed had acted in such a way that coin output was stable in 2007-09, or at worst declined along its long run downward trend, then there would have been no Great Recession.  So in that sense the fall in coin output “caused” the Great Recession. But I could also find a 1000 other “causes,” such as plunging auto sales.

Can the Fed control the coin stock?  I’d say they could in exactly the same way they can control M2 (or nominal auto sales), via a multiplier.  The baseline assumption is that both the coin stock and M2 move in proportion to the base.  That would be the case if the M2 and coin multipliers were stable.  If the multipliers change, then the Fed simply adjusts the base to offset the effect of any change in the coin multiplier.

No let me quickly emphasize that I view the preceding as an extremely unhelpful way of thinking about monetary policy and the Great Recession.  I still prefer to define money as the base, as the base is directly controlled by the Fed.  And I prefer to define the stance of monetary policy as NGDP growth expectations.  And I prefer to think of tight money as setting the monetary base at a level where NGDP growth expectations fall below target, as in 2008-09.  I’d just as soon leave coins to children with piggy banks and nerdy collectors.  But if you insist on defining money using Friedman’s pragmatic criterion, then coins are my definition of the money stock.

A penny for your thoughts?

PS.  I have a new post on the Phillips Curve at Econlog.

There’s no such thing as “out of ammo”

This really misses the point:

It’s time for central bankers to ask for help.

As the International Monetary Fund prepares to downgrade its outlook for the world economy again, monetary policy makers are running low of ammunition to fight a fresh downturn. Bank of America Merrill Lynch calculates they have reduced interest rates more than 600 times since the 2008 collapse of Lehman Brothers Holdings Inc. with theReserve Bank of India extending the run on Tuesday by cutting its benchmark more than expected.

While the European Central Bank and Bank of Japan haven’t ruled out buying even more bonds, there are doubts over how much more quantitative easing can achieve given yields are already around record lows and inflation still remains beneath the target of most policy makers. Even easier monetary policy may just end up propelling asset markets rather than economies.

That leaves economists and investors increasingly looking toward governments to lead the rescue efforts should the China-led slowdown in emerging markets infect developed nations. BofA Merrill Lynch sees a 25 percent chance of a recession-like slump this year.

“Monetary policy is basically exhausted in terms of producing real growth and even inflation,” billionaire Bill Gross of Janus Capital Management LLC told Bloomberg Television this month. “Fiscal policy is the second piece of the leg that has to take place in order to get us back to where we want to go.”

Almost every day something happens that refutes the claims made here.  First of all, there is no evidence that central bankers are not achieving their goals.  The Fed is about to raise rates.  The ECB seems satisfied with its progress in promoting a eurozone recovery.  I don’t think it should seem satisfied, but it does.  Ditto for the BOJ.  Just weeks ago Draghi said he’d do more QE if necessary.  And yet if you believe what I just quoted above, Draghi’s recent announcement should have had no impact on the markets, either because there are no more bonds to buy (out of ammo) or because QE has no effect. Instead here’s what happened to the euro:

Screen Shot 2015-09-30 at 4.58.54 PMIf Bill Gross were correct then it should be impossible to guess what time of day Draghi made his announcement.  But I’ll bet even Ray Lopez can guess.  (Hint, easier than expected money usually makes a currency depreciate in value.)

A beggar thy neighbor policy?  Let’s see how Wall Street reacted:

Wall Street has also welcomed Mario Draghi’s pledge to take more stimulus measure if needed.

The Dow Jones industrial average, and the broader S&P 500, are both up by almost 1%.

The following sounds appealing, until you think about the implications:

If the world economy enters a downdraft, Steven Englander, global head of G-10 FX strategy at Citigroup Inc., proposes a more revolutionary response, akin to the “helicopter money” once advocated by Milton Friedman.

In what he calls “cold fusion,” politicians would cut taxes and boost spending. Central banks would then cover the resulting increase in borrowing by purchasing more bonds as part of a commitment to permanently expand their balance sheets. The easier fiscal policy would be covered by QE Infinity.

“Politically it is difficult for central banks to outright endorse monetization of government debt, but faced with another slump and armed with ineffective policy tools, we expect that central banks will quickly give the wink and nod to fiscal measures,” Englander said in a report to clients last week.

The upshot would be greater purchasing power would be injected straight into the economy, increasing activity and inflation. Long-term bond yields would rise, yet short-term yields adjusted for inflation would turn negative.

Give him credit for recognizing that easier money can end up raising long term bond yields.  And “cold fusion” sounds pretty cool. But otherwise this makes no sense. What does it mean to promise the injections will be permanent?  That suggests you are targeting the monetary base, which could have catastrophic results.  You need to make just enough of the injections permanent to hit your NGDP target.  But if you do that, then the fiscal stimulus is pointless.  Even Paul Krugman claims that monetary policy ineffectiveness occurs when central banks cannot make credible promises to make monetary injections permanent.  But if you assume the promises are made and believed, then the fiscal part of the policy does nothing other than increase the national debt, worsening a problem that is already becoming increasingly worrisome as the population ages.