Archive for the 'inflation' Category

On a Difficult Passage in the General Theory

Keynes’s General Theory is not, in my estimation, an easy read. The terminology is often unfamiliar, and, so even after learning one of his definitions, I have trouble remembering what the term means the next time it’s used.. And his prose style, though powerful and very impressive, is not always clear, so you can spend a long time reading and rereading a sentence or a paragraph before you can figure out exactly what he is trying to say. I am not trying to be critical, just to point out that the General Theory is a very challenging book to read, which is one, but not the only, reason why it is subject to a lot of conflicting interpretations. And, as Harry Johnson once pointed out, there is an optimum level of difficulty for a book with revolutionary aspirations. If it’s too simple, it won’t be taken seriously. And if it’s too hard, no one will understand it. Optimally, a revolutionary book should be hard enough so that younger readers will be able to figure it out, and too difficult for the older guys to understand or to make the investment in effort to understand.

In this post, which is, in a certain sense, a follow-up to an earlier post about what, or who, determines the real rate of interest, I want to consider an especially perplexing passage in the General Theory about the Fisher equation. It is perplexing taken in isolation, and it is even more perplexing when compared to other passages in both the General Theory itself and in Keynes’s other writings. Here’s the passage that I am interested in.

The expectation of a fall in the value of money stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e., the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital. This is the truth which lies behind Professor Irving Fisher’s theory of what he originally called “Appreciation and Interest” – the distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money. It is difficult to make sense of this theory as stated, because it is not clear whether the change in the value of money is or is not assumed to be foreseen. There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst, if it is foreseen, the prices of exiting goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalized, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent. For the dilemma is not successfully escaped by Professor Pigou’s expedient of supposing that the prospective change in the value of money is foreseen by one set of people but not foreseen by another. (p. 142)

The statement is problematic on just about every level, and one hardly knows where to begin in discussing it. But just for starters, it is amazing that Keynes seems (or, for rhetorical purposes, pretends) to be in doubt whether Fisher is talking about anticipated or unanticipated inflation, because Fisher himself explicitly distinguished between anticipated and unanticipated inflation, and Keynes could hardly have been unaware that Fisher was explicitly speaking about anticipated inflation. So the implication that the Fisher equation involves some confusion on Fisher’s part between anticipated and unanticipated inflation was both unwarranted and unseemly.

What’s even more puzzling is that in his Tract on Monetary Reform, Keynes expounded the covered interest arbitrage principle that the nominal-interest-rate-differential between two currencies corresponds to the difference between the spot and forward rates, which is simply an extension of Fisher’s uncovered interest arbitrage condition (alluded to by Keynes in referring to “Appreciation and Interest”). So when Keynes found Fisher’s distinction between the nominal and real rates of interest to be incoherent, did he really mean to exempt his own covered interest arbitrage condition from the charge?

But it gets worse, because if we flip some pages from chapter 11, where the above quotation is found, to chapter 17, we see on page 224, the following passage in which Keynes extends the idea of a commodity or “own rate of interest” to different currencies.

It may be added that, just as there are differing commodity-rates of interest at any time, so also exchange dealers are familiar with the fact that the rate of interest is not even the same in terms of two different moneys, e.g. sterling and dollars. For here also the difference between the “spot” and “future” contracts for a foreign money in terms of sterling are not, as a rule, the same for different foreign moneys. . . .

If no change is expected in the relative value of two alternative standards, then the marginal efficiency of a capital-asset will be the same in whichever of the two standards it is measured, since the numerator and denominator of the fraction which leads up to the marginal efficiency will be changed in the same proportion. If, however, one of the alternative standards is expected to change in value in terms of the other, the marginal efficiencies of capital-assets will be changed by the same percentage, according to which standard they are measured in. To illustrate this let us take the simplest case where wheat, one of the alternative standards, is expected to appreciate at a steady rate of a percent per annum in terms of money; the marginal efficiency of an asset, which is x percent in terms of money, will then be x – a percent in terms of wheat. Since the marginal efficiencies of all capital assets will be altered by the same amount, it follows that their order of magnitude will be the same irrespective of the standard which is selected.

So Keynes in chapter 17 explicitly allows for the nominal rate of interest to be adjusted to reflect changes in the expected value of the asset (whether a money or a commodity) in terms of which the interest rate is being calculated. Mr. Keynes, please meet Mr. Keynes.

I think that one source of Keynes’s confusion in attacking the Fisher equation was his attempt to force the analysis of a change in inflation expectations, clearly a disequilibrium, into an equilibrium framework. In other words, Keynes is trying to analyze what happens when there has been a change in inflation expectations as if the change had been foreseen. But any change in inflation expectations, by definition, cannot have been foreseen, because to say that an expectation has changed means that the expectation is different from what it was before. Perhaps that is why Keynes tied himself into knots trying to figure out whether Fisher was talking about a change in the value of money that was foreseen or not foreseen. In any equilibrium, the change in the value of money is foreseen, but in the transition from one equilibrium to another, the change is not foreseen. When an unforeseen change occurs in expected inflation, leading to a once-and-for-all change in the value of money relative to other assets, the new equilibrium will be reestablished given the new value of money relative to other assets.

But I think that something else is also going on here, which is that Keynes was implicitly assuming that a change in inflation expectations would alter the real rate of interest. This is a point that Keynes makes in the paragraph following the one I quoted above.

The mistake lies in supposing that it is the rate of interest on which prospective changes in the value of money will directly react, instead of the marginal efficiency of a given stock of capital. The prices of existing assets will always adjust themselves to changes in expectation concerning the prospective value of money. The significance of such changes in expectation lies in their effect on the readiness to produce new assets through their reaction on the marginal efficiency of capital. The stimulating effect of the expectation of higher prices is due, not to its raising the rate of interest (that would be a paradoxical way of stimulating output – insofar as the rate of interest rises, the stimulating effect is to that extent offset) but to its raising the marginal efficiency of a given stock of capital. If the rate of interest were to rise pari passu with the marginal efficiency of capital, there would be no stimulating effect from the expectation of rising prices. For the stimulating effect depends on the marginal efficiency of capital rising relativevly to the rate of interest. Indeed Professor Fisher’s theory could best be rewritten in terms of a “real rate of interest” defined as being the rate of interest which would have to rule, consequently on change in the state of expectation as to the future value of money, in order that this change should have no effect on current output. (pp. 142-43)

Keynes’s mistake lies in supposing that an increase in inflation expectations could not have a stimulating effect except as it raises the marginal efficiency of capital relative to the rate of interest. However, the increase in the value of real assets relative to money will increase the incentive to produce new assets. It is the rise in the value of existing assets relative to money that raises the marginal efficiency of those assets, creating an incentive to produce new assets even if the nominal interest rate were to rise by as much as the rise in expected inflation.

Keynes comes back to this point at the end of chapter 17, making it more forcefully than he did the first time.

In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest – namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of of Wicksell’s “natural rate of interest,” which was, according to him, the rate which would preserve the stability of some, not quite clearly specified, price-level.

I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the “natural” rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus, it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. . . .

If there is any such rate of interest, which is unique and significant, it must be the rate which we might term the neutral rate of interest, namely, the natural rate in the above sense which is consistent with full employment, given the other parameters of the system; though this rate might be better described, perhaps, as the optimum rate. (pp. 242-43)

So what Keynes is saying, I think, is this. Consider an economy with a given fixed marginal efficiency of capital (MEC) schedule. There is some interest rate that will induce sufficient investment expenditure to generate enough spending to generate full employment. That interest rate Keynes calls the “neutral” rate of interest. If the nominal rate of interest is more than the neutral rate, the amount of investment will be less than the amount necessary to generate full employment. In such a situation an expectation that the price level will rise will shift up the MEC schedule by the amount of the expected increase in inflation, thereby generating additional investment spending. However, because the MEC schedule is downward-sloping, the upward shift in the MEC schedule that induces increased investment spending will correspond to an increase in the rate of interest that is less than the increase in expected inflation, the upward shift in the MEC schedule being partially offset by the downward movement along the MEC schedule. In other words, the increase in expected inflation raises the nominal rate of interest by less than increase in expected inflation by inducing additional investment that is undertaken only because the real rate of interest has fallen.

However, for an economy already operating at full employment, an increase in expected inflation would not increase employment, so whether there was any effect on the real rate of interest would depend on the extent to which there was a shift from holding money to holding real capital assets in order to avoid the inflation tax.

Before closing, I will just make two side comments. First, my interpretation of Keynes’s take on the Fisher equation is similar to that of Allin Cottrell in his 1994 paper “Keynes and the Keynesians on the Fisher Effect.” Second, I would point out that the Keynesian analysis violates the standard neoclassical assumption that, in a two-factor production function, the factors are complementary, which implies that an increase in employment raises the MEC schedule. The IS curve is not downward-sloping, but upward sloping. This is point, as I have explained previously (here and here), was made a long time ago by Earl Thompson, and it has been made recently by Nick Rowe and Miles Kimball.

I hope in a future post to work out in more detail the relationship between the Keynesian and the Fisherian analyses of real and nominal interest rates.

Bhide and Phelps v. Reality

I don’t know who Amar Bhide (apologies for not being able to insert an accent over the “e” in his last name) is, but Edmund Phelps is certainly an eminent economist and a deserving recipient of the 2006 Nobel Prize in economics. Unfortunately, Professor Phelps attached his name to an op-ed in Wednesday’s Wall Street Journal, co-authored with Bhide, consisting of little more than a sustained, but disjointed, rant about the Fed and central banking. I am only going to discuss that first part of the op-ed that touches on the monetary theory of increasing the money supply through open-market operations, and about the effect of that increase on inflation and inflation expectations. Bhide and Phelps not only get the theory wrong, they seem amazingly oblivious to well-known facts that flatly contradict their assertions about monetary policy since 2008. Let’s join them in their second paragraph.

Monetary policy might focus on the manageable task of keeping expectations of inflation on an even keel—an idea of Mr. Phelps’s [yes that same Mr. Phelps whose name appears as a co-author] in 1967 that was long influential. That would leave businesses and other players to determine the pace of recovery from a recession or of pullback from a boom.

Nevertheless, in late 2008 the Fed began its policy of “quantitative easing”—repeated purchases of billions in Treasury debt—aimed at speeding recovery. “QE2″ followed in late 2010 and “QE3″ in autumn 2012.

One can’t help wondering what planet Bhide and Phelps have been dwelling on these past four years. To begin with, the first QE program was not instituted until March 2009 after the target Fed funds rate had been reduced to 0.25% in December 2008. Despite a nearly zero Fed funds rate, asset prices, which had seemed to stabilize after the September through November crash, began falling sharply again in February, the S&P 500 dropping from 869.89 on February 9 to 676.53 on March 9, a decline of more than 20%, with inflation expectations as approximated, by the TIPS spread, again falling sharply as they had the previous summer and fall.

Apart from their confused chronology, their suggestion that the Fed’s various quantitative easings have somehow increased inflation and inflation expectations is absurd. Since 2009, inflation has averaged less than 2% a year – one of the longest periods of low inflation in the entire post-war era. Nor has quantitative easing increased inflation expectations. The TIPS spread and other measures of inflation expectations clearly show that inflation expectations have fluctuated within a narrow range since 2008, but have generally declined overall.

The graph below shows the estimates of the Cleveland Federal Reserve Bank of 10-year inflation expectations since 1982. The chart shows that the latest estimate of expected inflation, 1.65%, is only slightly above its the low point, reached in March, over the past 30 years. Thus expected inflation is now below the 2% target rate that the Fed has set. And to my knowledge Professor Phelps has never advocated targeting an annual inflation rate less than 2%. So I am unable to understand what he is complaining about.

cfimg8685191149364015372

Bhide and Phelps continue:

Fed Chairman Ben Bernanke said in November 2010 that this unprecedented program of sustained monetary easing would lead to “higher stock prices” that “will boost consumer wealth and help increase confidence, which can also spur spending.”

It is doubtful, though, that quantitative easing boosted either wealth or confidence. The late University of Chicago economist Lloyd Metzler argued persuasively years ago that a central-bank purchase, in putting the price level onto a higher path, soon lowers the real value of household wealth—by roughly the amount of the purchase, in his analysis. (People swap bonds for money, then inflation occurs, until the real value of money holdings is back to where it was.)

There are three really serious problems with this passage. First, and most obvious to just about anyone who has not been asleep for the last four years, central-bank purchases have not put the price level on a higher path than it was on before 2008; the rate of inflation has clearly fallen since 2008. Or would Bhide and Phelps have preferred to allow the deflation that briefly took hold in the fall of 2008 to have continued? I don’t think so. But if they aren’t advocating deflation, what exactly is their preferred price level path? Between zero and 1.5% perhaps? Is their complaint that the Fed has allowed inflation to be a half a point too high for the last four years? Good grief.

Second, Bhide and Phelps completely miss the point of the Metzler paper (“Wealth, Saving and the Rate of Interest”), one of the classics of mid-twentieth-century macroeconomics. (And I would just mention as an aside that while Metzler was indeed at the University of Chicago, he was the token Keynesian in the Chicago economics department in 1940s and early 1950s, until his active career was cut short by a brain tumor, which he survived, but with some impairment of his extraordinary intellectual gifts. Metzler’s illness therefore led the department to hire an up-and-coming young Keynesian who had greatly impressed Milton Friedman when he spent a year at Cambridge; his name was Harry Johnson. Unfortunately Friedman and Johnson did not live happily ever after at Chicago.) The point of the Metzler paper was to demonstrate that monetary policy, conducted via open-market operations, could in fact alter the real interest rate. Money, on Metzler’s analysis, is not neutral even in the long run. The conclusion was reached via a comparative-statics exercise, a comparison of two full-employment equilibria — one before and one after the central bank had increased the quantity of money by making open-market purchases.

The motivation for the exercise was that some critics of Keynes, arguing that deflation, at least in principle, could serve as a cure for involuntary unemployment — an idea that Keynes claimed to have refuted — had asserted that, because consumption spending depends not only on income, but on total wealth, deflation, by increasing the real value of the outstanding money stock, would actually make households richer, which would eventually cause households to increase consumption spending enough to restore full employment. Metzler argued that if consumption does indeed depend on total wealth, then, although the classical proposition that deflation could restore full employment would be vindicated, another classical proposition — the invariance of the real rate of interest with respect to the quantity of money — would be violated. So Metzler’s analysis — a comparison of two full-employment equilbria, the first with a lower quantity of money and a higher real interest rate and the second with a higher quantity of money and lower real interest rate – has zero relevance to the post-2008 period, in which the US economy was nowhere near full-employment equilibrium.

Finally, Bhide and Phelps, mischaracterize Metzler’s analysis. Metzler’s analysis depends critically on the proposition that the reduced real interest rate caused by monetary expansion implies an increase in household wealth, thereby leading to increased consumption. It is precisely the attempt to increase consumption that, in Metzler’s analysis, entails an inflationary gap that causes the price level to rise. But even after the increase in the price level, the real value of household assets, contrary to what Bhide and Phelps assert, remains greater than before the monetary expansion, because of a reduced real interest rate. A reduced real interest rate implies an increased real value of the securities retained by households.

Under Metzler’s analysis, therefore, if the starting point is a condition of less than full employment, increasing the quantity of money via open-market operations would tend to increase not only household wealth, but would also increase output and employment relative to the initial condition. So it is also clear that, on Metzler’s analysis, apparently regarded by Bhide and Phelps as authoritative, the problem with Fed policy since 2008 is not that it produced too much inflation, as Bhide and Phelps suggest, but that it produced too little.

If it seems odd that Bhide and Phelps could so totally misread the classic paper whose authority they invoke, just remember this: in the Alice-in-Wonderland world of the Wall Street Journal editorial page, things aren’t always what they seem.

HT: ChargerCarl

What’s a Central Banker To Do?

The FOMC is meeting tomorrow and Wednesday, and it seems as if everyone is weighing in with advice for Ben Bernanke and company. But you can always count on the Wall Street Journal editorial page to dish up something especially fatuous when the topic turns to monetary policy and the Fed. This time the Journal turns to George Melloan, a former editor and columnist at the Journal, to explain why the market has recently turned “skittish” in anticipation that the Fed may be about to taper off from its latest venture into monetary easing.

Some of us have been arguing that recent Fed signals that it will taper off from quantitative easing have scared the markets, which are now anticipating rising real interest rates and declining inflation. Inflation expectations have been declining since March, but, until the latter part of May, that was probably a positive development, reflecting expectations of increased real output under the steady, if less than adequate, policy announced last fall. But the expectation that quantitative easing may soon be tapered off seems to have caused a further decline in inflation expectations and a further increase in real interest rates.

But Melloan sees it differently

We are in an age where the eight male and four female members of the FOMC are responsible for whether securities markets float or sink. Traders around the world who in better times considered a range of variables now focus on a single one, Federal Reserve policy. . . .

In the bygone days of free markets, stocks tended to move counter to bonds as investors switched from one to the other to maximize yield. But in the new world of government rigging, they often head in the same direction. That’s not good for investors.

Oh dear, where to begin? Who cares how many males and females are on the FOMC? Was the all-male Federal Reserve Board that determined monetary during the Great Depression more to Mr. Melloan’s liking? I discovered about three years ago that since early in 2008 there has been a clear correlation between inflation expectations and stock prices. (See my paper “The Fisher Effect Under Deflationary Expectations.“) That correlation was not created, as Melloan and his colleagues at the Journal seem to think, by the Fed’s various half-hearted attempts at quantitative-easing; it is caused by a dangerous conjuncture between low real rates of interest and low or negative rates of expected inflation. Real rates of interest are largely, but not exclusively, determined by entrepreneurial expectations of future economic conditions, and inflation expectations are largely, but not exclusively, determined by the Fed policy.

So the cure for a recession will generally require inflation expectations to increase relative to real interest rates. Either real rates must fall or inflation expectations (again largely under the control of the Fed) must rise. Thus, an increase in inflation expectations, when real interest rates are too high, can cause stock prices to rise without causing bond prices to fall. It is certainly true that it is not good for investors when the economy happens to be in a situation such that an increase in expected inflation raises stock prices. But that’s no reason not to reduce real interest rates. Using monetary policy to raise real interest rates, as Mr. Melloan would like the Fed to do, in a recession is a prescription for perpetuating joblessness.

Melloan accuses the Fed of abandoning free markets and rigging interest rates. But he can’t have it both ways. The Fed did not suddenly lose the power to rig markets last month when interest rates on long-term bonds rose sharply. Bernanke only hinted at the possibility of a tapering off from quantitative easing. The Fed’s control over the market is supported by nothing but the expectations of millions of market participants. If the expectations of traders are inconsistent with the Fed’s policy, the Fed has no power to prevent market prices from adjusting to the expectations of traders.

Melloan closes with the further accusation that Bernanke et al. hold “the grandiose belief . . . that the Fed is capable of superhuman feats, like running the global economy.” That’s nonsense. The Fed is not running the global economy. In its own muddled fashion, the Fed is trying to create market expectations about the future value of the dollar that will support an economic expansion. Unfortunately, the Fed seems not to have figured out that a rapid recovery is highly unlikely to occur unless something is done to sharply raise the near term expected rate of inflation relative to the real rate of interest.

What Gives? Has the Market Stopped Loving Inflation?

One of my few, and not very compelling, claims to fame is a (still unpublished) paper (“The Fisher Effect Under Deflationary Expectations“) that I wrote in late 2010 in which I used the Fisher Equation relating the real and nominal rates of interest via the expected rate of inflation to explain what happens in a financial panic. I pointed out that the usual understanding that the nominal rate of interest and the expected rate of inflation move in the same direction, and possibly even by the same amount, cannot be valid when the expected rate of inflation is negative and the real rate is less than expected deflation. In those perilous conditions, the normal equilibrating process, by which the nominal rate adjusts to reflect changes in inflation expectations, becomes inoperative, because the nominal rate gets stuck at zero. In that unstable environment, the only avenue for adjustment is in the market for assets. In particular, when the expected yield from holding money (the expected rate of deflation) approaches or exceeds the expected yield on real capital, asset prices crash as asset owners all try to sell at the same time, the crash continuing until the expected yield on holding assets is no longer less than the expected yield from holding money. Of course, even that adjustment mechanism will restore an equilibrium only if the economy does not collapse entirely before a new equilibrium of asset prices and expected yields can be attained, a contingency not necessarily as unlikely as one might hope.

I therefore hypothesized that while there is not much reason, in a well-behaved economy, for asset prices to be very sensitive to changes in expected inflation, when expected inflation approaches, or exceeds, the expected return on capital assets (the real rate of interest), changes in expected inflation are likely to have large effects on asset values. This possibility that the relationship between expected inflation and asset prices could differ depending on the prevalent macroeconomic environment suggested an empirical study of the relationship between expected inflation (as approximated by the TIPS spread on 10-year Treasuries) and the S&P 500 stock index. My results were fairly remarkable, showing that, since early 2008 (just after the start of the downturn in late 2007), there was a consistently strong positive correlation between expected inflation and the S&P 500. However, from 2003 to 2008, no statistically significant correlation between expected inflation and asset prices showed up in the data.

Ever since then, I have used this study (and subsequent informal follow-ups that have consistently generated similar results) as the basis for my oft-repeated claim that the stock market loves inflation. But now, guess what? The correlation between inflation expectations and the S&P 500 has recently vanished. The first of the two attached charts plots both expected inflation, as measured by the 10-year TIPS spread, and the S&P 500 (normalized to 1 on March 2, 2009). It is obvious that two series are highly correlated. However, you can see that over the last few months it looks as if the correlation has been reversed, with inflation expectations falling even as the S&P 500 has been regularly reaching new all-time highs.

TIPS_S&P500_new

Here is a second chart that provides a closer look at the behavior of the S&P 500 and the TIPS spread since the beginning of March.

TIPS_S&P500_new_2

So what’s going on? I wish I knew. But here is one possibility. Maybe the economy is finally emerging from its malaise, and, after four years of an almost imperceptible recovery, perhaps the overall economic outlook has improved enough so that, even if we haven’t yet returned to normalcy, we are at least within shouting distance of it. If so, maybe asset prices are no longer as sensitive to inflation expectations as they were from 2008 to 2012. But then the natural question becomes: what caused the economy to reach a kind of tipping point into normalcy in March? I just don’t know.

And if we really are back to normal, then why is the real rate implied by the TIPS negative? True, the TIPS yield is not really the real rate in the Fisher equation, but a negative yield on a 10-year TIPS does not strike me as characteristic of a normal state of affairs. Nevertheless, the real yield on the 10-year TIPS has risen by about 50 basis points since March and by 75 basis points since December, so something noteworthy seems to have happened. And a fairly sharp rise in real rates suggests that recent increases in stock prices have been associated with expectations of increasing real cash flows and a strengthening economy. Increasing optimism about real economic growth, given that there has been no real change in monetary policy since last September when QE3 was announced, may themselves have contributed to declining inflation expectations.

What does this mean for policy? The empirical correlation between inflation expectations and asset prices is subject to an identification problem. Just because recent developments may have caused the observed correlation between inflation expectations and stock prices to disappear, one can’t conclude that, in the “true” structural model, the effect of a monetary policy that raised inflation expectations would not be to raise asset prices. The current semi-normal is not necessarily a true normal.

So my cautionary message is: Don’t use the recent disappearance of the correlation between inflation expectations and asset prices to conclude that it’s safe to abandon QE.

How Did Bernanke Scare the Markets?

On Wednesday Ben Bernanke appeared before the Joint Economic Committee of the US Congress to give his semi-annual report to Congress on the Economic Outlook. The S&P 500 opened the day about 1% higher than at Tuesday’s close, but by early afternoon had already given back all their gains, before closing 1% lower than the day before, an interday swing of 2%, pretty clearly caused by Bernanke’s testimony. The Nikkei average fell by 7%. Bernanke announced no major change in monetary policy, but he did hint that the FOMC was considering scaling back its asset purchases “in light of incoming information.” So what was it that Bernanke said that was so scary?

Let’s have a look.

Bernanke began with a summary of economic conditions, giving himself two cheers for recent improvements in the job market. He continued by explaining how, despite some minimal and painfully slow improvements, the job market remains in bad shape:

Despite this improvement, the job market remains weak overall: The unemployment rate is still well above its longer-run normal level, rates of long-term unemployment are historically high, and the labor force participation rate has continued to move down. Moreover, nearly 8 million people are working part time even though they would prefer full-time work. High rates of unemployment and underemployment are extraordinarily costly: Not only do they impose hardships on the affected individuals and their families, they also damage the productive potential of the economy as a whole by eroding workers’ skills and–particularly relevant during this commencement season–by preventing many young people from gaining workplace skills and experience in the first place. The loss of output and earnings associated with high unemployment also reduces government revenues and increases spending on income-support programs, thereby leading to larger budget deficits and higher levels of public debt than would otherwise occur.

Bernanke then shifted to the inflation situation:

Consumer price inflation has been low. The price index for personal consumption expenditures rose only 1 percent over the 12 months ending in March, down from about 2-1/4 percent during the previous 12 months. This slow rate of inflation partly reflects recent declines in consumer energy prices, but price inflation for other consumer goods and services has also been subdued. Nevertheless, measures of longer-term inflation expectations have remained stable and continue to run in the narrow ranges seen over the past several years. Over the next few years, inflation appears likely to run at or below the 2 percent rate that the Federal Open Market Committee (FOMC) judges to be most consistent with the Federal Reserve’s statutory mandate to foster maximum employment and stable prices.

In other words, the job market, despite minimal improvements, is a disaster, and inflation is below target, and inflation expectations “continue to in the narrow ranges seen over the past several years.” What does that mean? It means that since the financial crisis of 2008, inflation expectations have consistently remained at their lowest levels in a half century. Why is any increase in inflation expectations above today’s abnormally low levels unacceptable? Bernanke then says that inflation appears likely to run at or below the 2% rate that FOMC believes is most consistent with the Fed’s mandate to foster maximum employment and stable prices. Actually it appears likely that inflation is likely to run below the 2% rate, perhaps by 50 to 100 basis points. For Bernanke to disguise the likelihood that inflation will persistently fail to reach the Fed’s own nominal 2% target, by artfully saying that inflation is likely to run “at or below” the 2% target, is a deliberate deception. Thus, although he is unwilling to say so explicitly, Bernanke makes it clear that he and the FOMC are expecting, whether happily or not is irrelevant, inflation to continue indefinitely at less than the 2% annual target, and will do nothing to increase it.

You get the picture? The job market, five and a half years after the economy started its downturn, is in a shambles. Inflation is running well below the nominal 2% target, and is expected to remain there for as far as the eye can see. And what is the FOMC preoccupied with? Winding down its asset purchases “in light of incoming information.” The incoming information is clearly saying – no it’s shouting – that the asset purchases ought to be stepped up, not wound down. Does Bernanke believe that, under the current circumstances, an increased rate of inflation would not promote a faster recovery in the job market? If so, on the basis of what economic theory has he arrived at that belief? With inflation persistently below the Fed’s own target, he owes Congress and the American people an explanation of why he believes that faster inflation would not hasten the recovery in employment, and why he and the FOMC are not manifestly in violation of their mandate to promote maximum employment consistent with price stability. But he is obviously unwilling or unable to provide one.

Why did Bernanke scare the markets? Well, maybe, just maybe, it was because his testimony was so obviously incoherent.

Wherein I Try to Help Robert Waldmann Calm Down

Brad Delong kindly posted a long extract from my previous post (about Martin Feldstein) on his blog. The post elicited a longish comment from Robert Waldmann who has been annoyed with me for a while, because, well, because he seem to think that I have an unnatural obsession with monetary policy. Now it’s true that I advocate monetary easing, and think monetary policy, properly administered, could help get our economy moving again, but it’s not as if I have said that fiscal policy can’t work or shouldn’t be tried. So I don’t exactly understand why Waldmann keeps insisting that he won’t calm down. Anyway, let’s have a look at Waldmann’s comment.

After making a number of very cogent criticisms of the Feldstein piece that I criticized, Waldman continues:

On the other hand I also disagree with Glasner. This is the usual and I will not calm down.

Well, you maybe you should reconsider.

Then, quoting from my post on Feldstein,

“does he believe the Fed incapable of causing the price level to increase?” Obviously not (it made no sense to type the question) as he fears higher inflation.

That’s true, I started by asking why Feldstein believed a 20% increase in commodity prices was a bubble. I pointed out in my next sentence that if the Fed was causing inflation, then the increase in commodity prices was not a bubble.

I wish for higher inflation, but, unlike Glasner, I don’t hope for it. the Fed has made gigantic efforts to stimulate and inflation is well below the 2% target. What would it take to convince Glasner that the Fed can’t cause higher prices right now ? It seems to me that his faith is completely impervious to data.

OK, fair question. My point is that the Fed is still committed to a 2% inflation target. If the Fed said that it was aiming to increase the price level by 10% within a year and would take whatever steps necessary to raise prices by 10% and failed, that would be a fair test of the theory that the Fed can control the price level. But if the Fed is saying that it’s aiming at a 2% annual increase in the price level, and its undershooting its target, but isn’t even saying that it will do more to increase the rate of inflation, I don’t see that the proposition that the Fed can control the price level has been refuted by the evidence. The gigantic efforts that Waldmann references have all been undertaken in the context of a monetary regime that is committed to not letting the rate of inflation exceed 2%.

Continuing to quote from my post, Waldmann writes:

“Rising asset prices indicate the expectation of QE is inducing investors to shift out of cash into real assets”

Note the clear assumption. QE is the only possible cause of any change in asset prices. Glasner assumes that nothing else changes or that nothing else matters. He basically assumes that there is nothing under the sun but monetary policy.

I think I am being entirely fair to him. I think that, in fact, he assumes not only that monetary policy affects macroeconomic developments but that it is the only thing which affects macroeconomic developments. He has made this very clear when debating me. I think his identifying assumption is indefensible.

Sorry, but where is that clear assumption made? I said that rising asset prices could be attributed to an expectation that QE would increase the rate of inflation. My empirical study showed a strong correlation between inflation expectations and asset values, a correlation not present in the data before 2008. I didn’t say and my empirical study never suggested that asset prices depend on nothing else but inflation expectations, so I am at a loss to understand why Waldmann thinks that that is what I was assuming. What I do say is that monetary policy can affect the price level, not that monetary policy is the only thing that can affect the price level.

Waldmann concludes with a question:

I am curious as to whether there is another possible interpretation of Glasner.

The answer, Professor Waldmann, is yes! Why won’t you take “yes” for an answer? I hope that helps calm you down. It should.

PS I am sorry that I have not responded to comments recently. I have just been too busy. Perhaps over the weekend.

Martin Feldstein Is at It Again

Martin Feldstein writes in the Wall Street Journal (“The Federal Reserve’s Policy Dead End”)

Quantitative easing . . . is supposed to stimulate the economy by increasing share prices, leading to higher household wealth and therefore to increased consumer spending. Fed Chairman Ben Bernanke has described this as the “portfolio-balance” effect of the Fed’s purchase of long-term government securities instead of the traditional open-market operations that were restricted to buying and selling short-term government obligations.

Here’s how it is supposed to work. When the Fed buys long-term government bonds and mortgage-backed securities, private investors are no longer able to buy those long-term assets. Investors who want long-term securities therefore have to buy equities. That drives up the price of equities, leading to more consumer spending.

What Feldstein fails to ask, much less answer, is why anyone is willing to pay more for the stocks than they are worth (based on expectations of the future net cash flows generated by the underlying assets) just because they have excess cash in their pockets. Feldstein is covertly attributing irrationality to investors, although to be fair, he intimates, and has previously asserted explicitly, that the increase in stock prices since QE started was a bubble. And to be fair one more time, he is accurately characterizing Ben Bernanke’s explanation of how QE is supposed to work.

But despite the Fed’s current purchases of $85 billion a month and an accumulation of more than $2 trillion of long-term assets, the economy is limping along with per capita gross domestic product rising at less than 1% a year. Although it is impossible to know what would happen without the central bank’s asset purchases, the data imply that very little increase in GDP can be attributed to the so-called portfolio-balance effect of the Fed’s actions.

Even if all of the rise in the value of household equities since quantitative easing began could be attributed to the Fed policy, the implied increase in consumer spending would be quite small. According to the Federal Reserve’s Flow of Funds data, the total value of household stocks and mutual funds rose by $3.6 trillion between the end of 2009 and the end of 2012. Since past experience implies that each dollar of increased wealth raises consumer spending by about four cents, the $3.6 trillion rise in the value of equities would raise the level of consumer spending by about $144 billion over three years, equivalent to an annual increase of $48 billion or 0.3% of nominal GDP.

Again, all that is irrelevant, because the portfolio balance rationale for QE misrepresents the mechanism whereby QE can have any effect. That mechanism is primarily by preventing inflation expectations from dropping. Each one of the QE episodes has been initiated when expectations of inflation were dropping. In each instances, the announcement or even the expectation of QE succeeded in reversing the downward drift of inflation expectations, thereby contributing to expectations of increased profits and cash flows and thus allowing stock prices to recover from their deeply depressed levels after the 2007-09 downturn and panic. I explained the underlying theory in my paper “The Fisher Effect under Deflationary Expectations,” which also provided supporting empirical evidence showing of a strong positive correlation since 2008 between inflation expectations as measured by the TIPS spread and stock prices, a correlation not predicted by conventional theory and not observed in the data until 2008.

This 0.3% overstates the potential contribution of quantitative easing to the annual growth of GDP, since some of the increase in the value of household equities resulted from new saving and the resulting portfolio investment rather than from the rise in share prices. More important, the rise in equity prices also reflected a general increase in earnings per share and an increase in investor confidence after 2009 that the economy would not slide back into recession.

Earnings per share of the Standard & Poor’s 500 stocks rose 50% in 2010 and a further 9% in 2011, driving the increase in share prices. The S&P price-earnings ratio actually fell to 17 at the start of 2013 from 21 at the start of 2010, showing the importance of increased earnings rather than an increased demand for equities.

In other words, QE helped to improve earnings, thus validating the expectations that caused the increase in stock prices.

In short, it isn’t at all clear that the Fed’s long-term asset purchases have raised equity values as the portfolio balance theory predicted. Even if it did account for the entire rise in equity values, the increase in household equity wealth would have only a relatively small effect on consumer spending and GDP growth.

Feldstein continues to attack a strawman, albeit one presented to him by Ben Bernanke.

Mr. Bernanke has emphasized that the use of unconventional monetary policy requires a cost-benefit analysis that compares the gains that quantitative easing can achieve with the risks of asset-price bubbles, future inflation, and the other potential effects of a rapidly growing Fed balance sheet. I think the risks are now clear and the benefits are doubtful. The time has come for the Fed to recognize that it cannot stimulate growth and that a stronger recovery must depend on fiscal actions and tax reform by the White House and Congress.

Feldstein’s closing comment reminded me of a piece that he wrote two and a half years ago in the Financial Times entitled “QE2 is risky and should be limited.” Here are the first and last paragraphs of the FT contribution.

The Federal Reserve’s proposed policy of quantitative easing is a dangerous gamble with only a small potential upside benefit and substantial risks of creating asset bubbles that could destabilise the global economy. Although the US economy is weak and the outlook uncertain, QE is not the right remedy.

The truth is there is little more that the Fed can do to raise economic activity. What is required is action by the president and Congress: to help homeowners with negative equity and businesses that cannot get credit, to remove the threat of higher tax rates, and reduce the out-year fiscal deficits. Any QE should be limited and temporary.

I was not yet blogging in 2010, but I was annoyed enough by Feldstein to write this letter to the editor.

Sir, Arguing against quantitative easing, Martin Feldstein (“QE2 is risky and should be limited“, Comment, November 3) asserts that Federal Reserve signals that it would engage in QE, having depressed long-term interest rates, are fuelling asset and commodities bubbles that will burst once interest rates return to normal levels.

In fact, since Ben Bernanke made known his intent to ease monetary policy on August 29, longer-term rates have edged up. So rising asset and commodities prices are due not to falling long-term rates, but to expectations of rising future revenue streams. Investors, evidently, anticipate either rising output, rising prices or, most likely, some of both.

Why Mr Feldstein considers the recent modest rise in commodities and asset prices (the S&P is still more than 20 per cent below its 2007 all-time high) to be a bubble is not clear. Does he believe that with 15m US workers unemployed, expectations of increased output are irrational? Or does he believe the Fed incapable of causing the price level to increase? It would be odd if it were the latter, because Mr Feldstein goes on to insist that QE is dangerous because it may cause an “unwanted rise in inflation”?

Perhaps Mr Feldstein thinks that expectations of rising prices and rising output are inconsistent with expectations that interest rates will not rise sharply in the future, so that asset prices must take a hit when interest rates finally do rise. But he acknowledges that expectations of future inflation may allow real rates to fall into negative territory to reflect the current dismal economic climate. Since August 29, rates on inflation-adjusted Tips bonds have fallen below zero. Rising asset prices indicate the expectation of QE is inducing investors to shift out of cash into real assets, presaging increased real investment and a pick-up in recovery.

Why then is inflation “unwanted”? Mr Feldstein maintains that it would jeopardise the credibility of the Fed’s long-term inflation strategy. But it is not clear why Fed credibility would be jeopardised more by a temporary increase, than by a temporary decrease, in inflation, or, indeed, why credibility would be jeopardised at all by a short-term increase in inflation to compensate for a prior short-term decrease? The inflexible conception of inflation targeting espoused by Mr Feldstein, painfully articulated in Federal Open Market Committee minutes, led the Fed into a disastrous tightening of monetary policy between March and October 2008, while the US economy was falling into a deepening recession because of a misplaced concern that rising oil and food prices would cause inflation expectations to run out of control.

Two years later, Mr Feldstein, having learnt nothing and forgotten nothing, is urging the Fed to persist in its earlier mistake because of a neurotic concern that inflation expectations may soar amid massive unemployment and idle resources.

Well, that’s my story and I’m sticking to it.

Hawtrey Reviews Cassel

While doing further research on Ralph Hawtrey, I recently came across a brief 1933 review written by Hawtrey in the Economic Journal of a short book by Gustav Cassel, The Crisis in the World Monetary System. Sound familiar? The review provides a wonderfully succinct summary of the views of both Cassel and Hawtrey of the causes of, and the cure for, the Great Depression. The review can still be read with pleasure and profit. It can also be read with wonder. It is amazing that something written 80 years ago about the problem of monetary disorder can have such relevance to the problems of today. Here is the review in full. And pay special attention to the last paragraph.

The delivery of a series of three lectures at Oxford last summer has given Professor Cassel an opportunity of fulfilling his function of instructing public opinion in the intricacies of economic theory, especially of monetary theory in their application to current events. This little book of just under 100 pages is the result. As admirers of Professor Cassel will expect, it is full of wisdom, expressed with an admirable clarity and simplicity.

He points out that so long as the policy of economising gold, recommended at the Genoa Conference, was carried out, it was possible to prevent any considerable rise in the value of gold. “The world reaped the fruits of this policy in an economic development in which most countries had their share and which for some countries meant a great deal of prosperity” (p. 27).

Progress up to 1928 was normally healthy; it was not more rapid than was usual in the pre-war period. It was interrupted in 1929 by the fall of prices, for which in Professor Cassel’s view the responsibility rests on the central banks. “The course of a ship is doubtless the combined result of wind, current and navigation, and each of these factors could be quoted as independent causes of the result that the ship arrives at a certain place.” But it is navigation that is within human control, and consequently the responsibility rests on the captain. So a central bank, which has the monopoly of supplying the community with currency, bears the responsibility for variations in the value of the currency (pp. 46-7).

Under a gold standard the responsibility becomes international, but “if some important central banks follow a policy which must lead, say, to a violent increase in the value of gold, the behaviour of such banks must be regarded as the cause of this movement” (p. 48).

Professor Cassel further apportions a heavy share of the responsibility for the breakdown to war debts and reparations. “The payment of war debts in conjunction with the unwillingness to receive payment in the normal form of goods led to unreasonable demands on the world’s monetary stocks; and the claimants failed to use in a proper way the gold that they had accumulated” (pp. 71-2).

Just as a reminder, if you have made it this far, don’t stop without reading the next and final paragraph.

Finally, for a remedy, “the best thing that the gold standard countries could do for a rapid economic recovery would be immediately to start an inflation of their currencies. If this inflation were the outcome of a deliberate and well-conceived policy it could be controlled, and the consequent rise of the general level of commodity prices could be kept within such limits as were deemed desirable for the restoration of a necessary equilibrium between different groups of prices, wages, and commercial debts” (p. 94).

Let’s read that again:

If inflation were the outcome of a deliberate and well-conceived policy, it could be controlled, and the consequent rise of the general level of commodity prices could be kept within such limits as were deemed desirable for the restoration of a necessary equilibrium between different groups of prices, wages, and commercial debts.

Robert Waldmann, WADR, Maybe You Really Should Calm Down

Responding to this recent post of mine, Robert Waldmann wrote a post of his own with a title alluding to an earlier post of mine responding to a previous post of his. Just to recapitulate briefly, the point of the post which seems to have provoked Professor Waldmann was to refute the allegation that the Fed and the Bank of Japan are starting a currency war by following a policy of monetary ease in which they are raising (at least temporarily) their inflation target. I focused my attention on a piece written by Irwin Stelzer for the Weekly Standard, entitled not so coincidentally, “Currency Wars.” I also went on to point out that Stelzer, in warning of the supposedly dire consequences of starting a currency war, very misleadingly suggested that Hitler’s rise to power was the result of an inflationary policy followed by Germany in the 1930s.

Here is how Waldmann responds:

I do not find any reference to the zero lower bound in this post.  Your analysis of monetary expansion does not distinguish between the cases when the ZLB holds and when it doesn’t.  You assume that the effect of an expansion of the money supply on domestic demand can be analyzed ignoring that detail. I think it is clear that the association between the money supply and domestic demand has been different in the USA since oh September 2008 than it was before.  This doesn’t seem to me to be a detail which can be entirely overlooked in any discussion of current policy.

Actually, I don’t think that, in principle, I disagree with any of this. I agree that the zero lower bound is relevant to the analysis of the current situation. I prefer to couch the analysis in terms of the Fisher equation making use of the equilibrium condition that the nominal rate of interest must equal the real rate plus expected inflation. If the expected rate of deflation is greater than the real rate, equilibrium is impossible and the result is a crash of asset prices, which is what happened in 2008. But as long as the real rate of interest is negative (presumably because of pessimistic entrepreneurial expectations), the rate of inflation has to be sufficiently above real rate of interest for nominal rates to be comfortably above zero. As long as nominal rates are close to zero and real rates are negative, the economy cannot be operating in the neighborhood of full-employment equilibrium. I developed the basic theory in my paper “The Fisher Effect Under Deflationary Expectations” available on SSRN, and provided some empirical evidence (which I am hoping to update soon) that asset prices (as reflected in the S&P 500) since 2008 have been strongly correlated with expected inflation (as approximated by the TIPS spread) even though there is no strong theoretical reason for asset prices to be correlated with expected inflation, and no evidence of correlation before 2008. Although I think that this is a better way than the Keynesian model to think about why the US economy has been underperforming so badly since 2008, I don’t think that the models are contradictory or inconsistent, so I don’t deny that fiscal policy could have some stimulative effect. But apparently that is not good enough for Professor Waldmann.

Also, I note that prior to his [Stelzer's] “jejune dismissal of monetary policy,” Stelzer jenunely dismissed fiscal policy.  You don’t mention this at all.  Your omission is striking, since the evidence that Stelzer is wrong to dismiss fiscal policy is overwhelming (not overwhelming enough to overwhelm John Taylor but then mere evidence couldn’t do that).  In contrast, the dismissal of monetary policy when an economy is in a liquidity trap is consistent with the available evidence.

It seems to me that Waldmann is being a tad oversensitive. Stelzer’s line was “stimulus packages don’t work very well, and monetary policy produces lots of fiat money but not very many jobs.” What was jejune was not the conclusion that fiscal policy and monetary policy aren’t effective; it was his formulation that monetary expansion produces lots of fiat money but not many jobs, a formulation which, I believe, was intended to be clever, but struck me as being not clever, but, well, jejune. So I did not mean to deny that fiscal policy could be effective at the zero lower bound, but I disagree that the available evidence is consistent with the proposition that monetary policy is ineffective in a liquidity trap. In 1933, for example, monetary policy triggered the fastest economic expansion in US history, when FDR devalued the dollar shortly after taking office, an expansion unfortunately prematurely terminated by the enactment of FDR’s misguided National Industrial Recovery Act. The strong correlation between inflation expectations and stock prices since 2008, it seems to me, also qualifies as evidence that monetary policy is not ineffective at the zero lower bound. But if Professor Waldmann has a different interpretation of the significance of that correlation, I would be very interested in hearing about it.

Instead of looking at the relationship between inflation expectations and stock prices, Waldmann wants to look at the relationship between job growth and monetary policy:

I hereby challenge you to show data on US “growth”  meaning (I agree with your guess) mostly employment growth since 2007 to someone unfamiliar with the debate and ask that person to find the dates of shifts in monetary policy.  I am willing to bet actual money (not much I don’t have much) that the person will not pick out QEIII or operation twist.    I also guess that this person will not detect forward guidance looking at day to day changes in asset prices.

I claim that the null that nothing special happened the day QEIV was announced or any of the 4 plausible dates of announcement of QE2 (starting with a FOMC meeting, then Bernanke’s Jackson Hole speech then 2 more) can’t be rejected by the data. This is based on analysis by two SF FED economists who look at the sum of changes over three of the days (not including the Jackson Hole day when the sign was wrong) and get a change (of the sign they want) whose square is less than 6 times the variance of daily changes (of the 10 year rate IIRC).  IIRC 4.5 times.  Cherry picking and not rejecting the null one wants to reject is a sign that one’s favored (alternative) hypothesis is not strongly supported by the data.

I think that the way to pick out changes in monetary policy is to look at changes in inflation expectations, and I think that you can find some correlation between changes in monetary policy, so identified, and employment, though it is probably not nearly as striking as the relationship between asset prices and inflation expectations. I also don’t think that operation twist had any positive effect, but QE3 does seem to have had some. I am not familiar with the study by the San Francisco Fed economists, but I will try to find it and see what I can make out of it. In the meantime, even if Waldmann is correct about the relationship between monetary policy and employment since 2008, there are all kinds of good reasons for not rushing to reject a null hypothesis on the basis of a handful of ambiguous observations. That wouldn’t necessarily be the calm and reasonable thing to do.

Charles Goodhart on Nominal GDP Targeting

Charles Goodhart might just be the best all-around monetary economist in the world, having made impressive contributions to both monetary theory and the history of monetary theory, to monetary history, and the history of monetary institutions, especially of central banking, and to the theory and, in his capacity as chief economist of the Bank of England, practice of monetary policy. So whenever Goodhart offers his views on monetary policy, it is a good idea to pay close attention to what he says. But if there is anything to be learned from the history of economics (and I daresay the history of any scientific discipline), it is that nobody ever gets it right all the time. It’s nice to have a reputation, but sadly reputation provides no protection from error.

In response to the recent buzz about targeting nominal GDP, Goodhart, emeritus professor at the London School of Economics and an adviser to Morgan Stanley along with two Morgan Stanley economists, Jonathan Ashworth and Melanie Baker, just published a critique of a recent speech by Mark Carney, Governor-elect of the Bank of England, in which Carney seemed to endorse targeting the level of nominal GDP (hereinafter NGDPLT). (See also Marcus Nunes’s excellent post about Goodhart et al.) Goodhart et al. have two basic complaints about NGDPLT. The first one is that our choice of an initial target level (i.e., do we think that current NGDP is now at its target or away from its target and if so by how much) and of the prescribed growth in the target level over time would itself create destabilizing uncertainty in the process of changing to an NGDPLT monetary regime. The key distinction between a level target and a growth-rate target is that the former requires a subsequent compensatory adjustment for any deviation from the target while the latter requires no such adjustment for a deviation from the target. Because deviations will occur under any targeting regime, Goodhart et al. worry that the compensatory adjustments required by NGDPLT could trigger destabilizing gyrations in NGDP growth, especially if expectations, as they think likely, became unanchored.

This concern seems easily enough handled if the monetary authority is given say a 1-1.5% band around its actual target within which to operate. Inevitable variations around the target would not automatically require an immediate rapid compensatory adjustment. As long as the monetary authority remained tolerably close to its target, it would not be compelled to make a sharp policy adjustment. A good driver does not always drive down the middle of his side of the road, the driver uses all the space available to avoid having to make an abrupt changes in the direction in which the car is headed. The same principle would govern the decisions of a skillful monetary authority.

Another concern of Goodhart et al. is that the choice of the target growth rate of NGDP depends on how much real growth,we think the economy is capable of. If real growth of 3% a year is possible, then the corresponding NGDP level target depends on how much inflation policy makers believe necessary to achieve that real GDP growth rate. If the “correct” rate of inflation is about 2%, then the targeted level of NGDP should grow at 5% a year. But Goodhart et al. are worried that achievable growth may be declining. If so, NGDPLT at 5% a year will imply more than 2% annual inflation.

Effectively, any overestimation of the sustainable real rate of growth, and such overestimation is all too likely, could force an MPC [monetary policy committee], subject to a level nominal GDP target, to soon have to aim for a significantly higher rate of inflation. Is that really what is now wanted? Bring back the stagflation of the 1970s; all is forgiven?

With all due respect, I find this concern greatly overblown. Even if the expectation of 3% real growth is wildly optimistic, say 2% too high, a 5% NGDP growth path would imply only 4% inflation. That might be too high a rate for Goodhart’s taste, or mine for that matter, but it would be a far cry from the 1970s, when inflation was often in the double-digits. Paul Volcker achieved legendary status in the annals of central banking by bringing the US rate of inflation down to 3.5 to 4%, so one needs to maintain some sense of proportion in these discussions.

Finally, Goodhart et al. invoke the Phillips Curve.

[A]n NGDP target would appear to run counter to the previously accepted tenets of monetary theory. Perhaps the main claim of monetary economics, as persistently argued by Friedman, and the main reason for having an independent Central Bank, is that over the medium and longer term monetary forces influence only monetary variables. Other real (e.g. supply-side) factors determine growth; the long-run Phillips curve is vertical. Do those advocating a nominal GDP target now deny that? Do they really believe that faster inflation now will generate a faster, sustainable, medium- and longer-term growth rate?

While it is certainly undeniable that Friedman showed, as, in truth, many others had before him, that, for an economy in approximate full-employment equilibrium, increased inflation cannot permanently reduce unemployment, it is far from obvious (to indulge in bit of British understatement) that we are now in a state of full-employment equilibrium. If the economy is not now in full-employment equilibrium, the idea that monetary-neutrality propositions about money influencing only monetary, but not real, variables in the medium and longer term are of no relevance to policy. Those advocating a nominal GDP target need not deny that the long-run Phillips Curve is vertical, though, as I have argued previously (here, here, and here) the proposition that the long-run Phillips Curve is vertical is very far from being the natural law that Goodhart and many others seem to regard it as. And if Goodhart et al. believe that we in fact are in a state of full-employment equilibrium, then they ought to say so forthrightly, and they ought to make an argument to justify that far from obvious characterization of the current state of affairs.

Having said all that, I do have some sympathy with the following point made by Goodhart et al.

Given our uncertainty about sustainable growth, an NGDP target also has the obvious disadvantage that future certainty about inflation becomes much less than under an inflation (or price level) target. In order to estimate medium- and longer-term inflation rates, one has first to take some view about the likely sustainable trends in future real output. The latter is very difficult to do at the best of times, and the present is not the best of times. So shifting from an inflation to a nominal GDP growth target is likely to have the effect of raising uncertainty about future inflation and weakening the anchoring effect on expectations of the inflation target.

That is one reason why in my book Free Banking and Monetary Reform, I advocated Earl Thompson’s proposal for a labor standard aimed at stabilizing average wages (or, more precisely, average expected wages). But if you stabilize wages, and productivity is falling, then prices must rise. That’s just a matter of arithmetic. But there is no reason why the macroeconomically optimal rate of inflation should be invariant with respect to the rate of technological progress.

HT:  Bill Woolsey


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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