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The FOMC Kicks the Can Down the Road

Published June 20, 2012 expectations , inflation , monetary policy 12 Comments

At its meeting today, the Federal Open Market Committee (FOMC) decided . . . , well, decided not to decide. Faced with a feeble US economic recovery showing clear signs of getting weaker still, and a perilous economic situation in Europe poised to spin out of control into a full-blown financial crisis, the FOMC opted to continue the status quo, prolonging its so-called Operation Twist in which the Fed is liquidating its holdings of short-dated Treasuries and replacing them with longer-dated Treasuries, on the theory that changing the maturity structure of the Fed’s balance sheet will reduce long-term interest rates, thereby providing some further incentive for long-term borrowing, as if the problem holding back a recovery were long-term nominal interest rates that are not low enough.

What I found most interesting in today’s statement was the FOMC’s assessment of inflation. In the opening paragraph of its statement, the FOMC states:

Inflation has declined, mainly reflecting lower prices of crude oil and gasoline, and longer-term inflation expectations have remained stable.

What is the basis for the FOMC’s statement that inflation expectations are stable? Does the FOMC not take seriously the estimate of inflation expectations just published by the Cleveland Fed showing that inflation expectations over a 10-year time horizon are at an all-time low of 1.19% and the expectation for the next 12 months is 0.6%, the lowest since March 2009 when the stock market reached its post-crisis low? And the FOMC’s April projection for PCE inflation in 2012 was in a range 1.9 to 2.0%; its current projection is now 1.2 to 1.7%. In contrast to 2008, when the FOMC was in a tizzy about inflation expectations becoming unanchored because of rapidly rising food and energy prices, the FOMC seems remarkably calm and unperturbed about a 0.3% fall in headline inflation in May.

Then in the next paragraph the FOMC makes another — shall we say, puzzling — statement:

The Committee anticipates that inflation over the medium term will run at or below the rate that it judges most consistent with its dual mandate.

So the FOMC admits that inflation is likely to be less than its own inflation target. Let’s be sure that we understand this. The economy is weakening, growth is slowing, unemployment, after nearly four years above 8 percent, is once again rising, and the Fed’s own expectation of the inflation rate for 2012 is well below the FOMC target. And what is the FOMC response? Steady as you go.

In a news story about the FOMC decision, Marketwatch reporter Steve Goldstein writes:

The Federal Reserve on Wednesday softened its growth and inflation forecasts over the next three years, as the central bank said the unemployment rate will hold above 8% through the end of 2012. The Fed also cut its inflation forecast down aggressively, to between 1.2% and 1.7% this year, as opposed to its forecast in April between 1.9% and 2%. The central bank targets 2% inflation over the medium term, so the reduced inflation forecast is likely to ratchet up expectations of additional central bank easing, possibly as soon as August. The Fed’s forecast for growth this year is down to a range of 1.9% to 2.4%, down from 2.4% to 2.9% in April — and its April 2011 forecast that 2012 growth would range between 3.5% and 4.2%. Also of note, it appears that the two newest voters, Jerome Powell and Jeremy Stein, are among the most dovish; the most recent breakdown of when the right time to raise hikes shows the only change is in 2015, which now has six members in that camp, up from four in April. Powell and Stein were recently sworn in as Fed governors.

So the optimistic take on all this is that the FOMC has set the stage for taking aggressive action at its next meeting. Since bottoming out last week, stock prices recovered, apparently in expectation of easing by the Fed. Today’s announcement is not what the market was hoping for, but there are at least signs that the FOMC will take action soon. In our desperation, we have been reduced to grasping at straws.

Money Is Always* and Everywhere* Non-Neutral

Published June 19, 2012 expectations , monetary policy , monetary theory 25 Comments

Via Scott Sumner I found another of Nick Rowe’s remarkably thoughtful and thought-provoking posts about the foundations of monetary theory. The object – at least as I read him – of Nick’s post is to explain how and why money can (or must) be neutral. And Nick performs this little (or maybe not so little) feat by juxtaposing two giants in the history of monetary theory, David Hume from the eighteenth century and Don Patinkin from the twentieth. Both, it seems, were convinced of the theoretical, indeed logical, necessity of monetary neutrality, but both felt constrained by observational experience to acknowledge that money has real effects, which is just another of saying that money is not (or at least not always) neutral.

I am not going to discuss Nick’s post in detail. Instead, I want to question what I take to be an underlying premise of his post, that there is a theoretical presumption that money is neutral, at least in the long run. In questioning the neutrality of money, I do not mean that one cannot easily write down a model in which it is possible to derive the conclusion that a change in the quantity of money changes the equilibrium in that model by changing all money prices proportionately, leaving all relative prices and all real quantities of goods produced and consumed unchanged. What I assert is that the real world conditions under which this result would obtain do not exist, with the possible exception of a currency reform in which a new currency unit is introduced to replace the old unit at a defined rate between the new and old units. In such a case, but only in such a case, it is likely that the results of the change would be confined to money prices, with no effect on real quantities. (It is because of this trivial exception that I inserted asterisks after “always” and “everywhere” in the title of this post.)

Let me give a few, certainly not all, of the reasons why money is never neutral. First, most agree as David Hume explained over 250 years ago that changes in the quantity of money do have short-term real effects. The neutrality of money is thus usually presented as a proposition valid only in the long-run. But there is clearly no compelling reason to think that it is valid in the long run either, because, as Keynes recognized, the long run is a succession of short runs. But each short-run involves a variety of irreversible investments and irrevocable commitments, so that any deviation from the long-run equilibrium path one might have embarked on at time 0 will render it practically impossible to ever revert back to the long-run path from which one started. If money has real short-term effects, in an economy characterized by path dependence, money must have long-term effects. Real irreversible investments are just one example of such path dependencies. There are also path dependencies associated with investments in human capital or employment decisions. Indeed, path dependencies are inherent in any economy in which trading is allowed at disequilibrium prices, which is to say every economy that exists or ever existed.

If workers’ chances of being employed depend on their previous employment history, short-term increases in employment necessarily have long-term effects on the future employability of workers. Chronic high employment now degrades the quality of the labor force in the future. If arguments that potential GDP has fallen since 2008 have any validity, a powerful reason why potential GDP has fallen is surely the increase in chronic unemployment since 2008.

Another way to make this point is that the proposition of long-run neutrality presupposes that there is one and only one equilibrium time path for the economy. The economy is in equilibrium if and only if it is on that unique time path. Under long-run neutrality, you can deviate from that equilibrium time path for a while, but sooner or later you must get back on it. When you’re back on it, monetary neutrality has been restored. But if there is no single equilibrium time path, there is no presumption of neutrality in the short run or the long run.

Let me also mention another reason besides time dependence and irreversibility why it is a mistake to conceive of an economy as having a unique equilibrium time path. As I have observed in previous posts on this blog, every economic equilibrium is dependent on the expectations held by the agents. A change in expectations changes the equilibrium. Or, as I have expressed it previously, expectations are fundamental. If a change in monetary policy induces, or is associated with, a change in expectations, the economic equilibrium changes. So money can’t be neutral. Ever.

PS Let me just mention that I have drawn in this post on an unpublished paper by Richard Lipsey “The Neutrality of Money,” which he was kind enough to share with me. Lipsey particularly emphasized path dependence as a reason why money, as he put, “is an artifact of economic models,” not a universally correct prediction about the world. Lipsey developed the idea of path dependence more fully in another much longer paper co-athored with Kenneth Carlaw that he shared with me, “Does History Matter? Empirical Analysis of Evolutionary versus New Classical Views of the Economy” forthcoming in the Journal of Evolutionary Economics. Perhaps in a future post, I will discuss the Carlaw Lipsey paper at greater length.

1970s Stagflation

Published June 18, 2012 expectations , inflation , monetary policy 15 Comments

Karl Smith, Scott Sumner, and Yichuan Wang have been discussing whether the experience of the 1970s qualifies as “stagflation.” The term stagflation seems to have been coined in the 1973-74 recession, which was characterized by a rising inflation rate and a rising unemployment rate, a paradoxical conjunction of events for which economic theory did not seem to have a ready explanation. Scott observed that inasmuch as average real GDP growth over the decade was a quite respectable 3.2%, applying the term “stagflation” to the decade seems to be misplaced. Karl Smith says that although real GDP growth was fairly strong unemployment rates were much higher after the early 1970s than they had been in the 1960s and even in the lackluster 1950s (a decade of low inflation and low growth). Yichuan Wang weighs in with the observation that high growth in GDP produced almost no measurable effect on real GDP growth even though a simple Phillips Curve or AD/AS framework would suggest that all that extra growth in nominal GDP should have produced some payoff in added real GDP growth.

Here are some further observations on what happened in the 1970s. Inflation expectations began increasing in the late 1960s, so that a very modest tightening of monetary policy in 1969-70 produced a minor recession, but an almost imperceptible reduction in inflation. Nixon, not wanting to run for reelection with a stagnating economy — the memory of running unsuccessfully for President in 1960 during a recession having seared in his consciousness — forced an unwilling Fed to increase money growth rapidly while cynically imposing wage and price controls to keep a lid on inflation. The political strategy was a smashing success, but the stage was set for a ratcheting up of inflation and inflation expectations, though markets were actually slow to anticipate the rapid rise in inflation that followed.

Thus, the early part of the decade fits in well with Scott’s interpretation. Rising aggregate demand produced rising inflation and rising real GDP growth. Unfortunately, wage and price control quickly began to have harmful economic effects, producing shortages and other disruptions in economic activity that may have shaved a few percentage points off real GDP growth over the next few years. More serious was the first big oil-price shock in late 1973 in the wake of the Yom Kippur war, causing a quadrupling of oil prices over a period of a few months as well as horrific gasoline shortages attributable to the effects of remaining price controls on the petroleum sector, controls that, for political reasons, could not be removed even though other price controls had mercifully been allowed to expire. So in 1974, there was a rapid increase in inflation expectations fueled both by a tardy realization of the inflationary implications of the Nixon/Burns monetary policy of 1971-73, and a presumption that increases in oil prices would be accommodated in output prices rather than prices of complementary inputs being forced down. But because of general anti-inflation sentiment, monetary policy was tightened at precisely the moment when aggregate supply was contracting as a result of rising inflation expectations and an exogenous oil-price shock. That meant that real GDP began falling sharply even while output-price inflation was accelerating. It was that temporary conjunction of falling real GDP, rising unemployment, and rising inflation in 1974 that gave rise to the term “stagflation.” After initially focusing on inflation, the newly installed Ford administration quickly pivoted and provided economic stimulus to generate a recovery and the temporary inflationary bulge worked its way through the system. The recovery was robust enough to have enabled Ford to have been re-elected but for Ford’s monumental gaffe in his debate against Jimmy Carter, denying that Poland was under Soviet domination, and for lingering resentment against Ford from his pre-emptive pardon of Richard Nixon for any crimes that he committed during his Presidency.

By the time that Jimmy Carter took office, the US economy was well into a cyclical expansion, but Carter, after replacing Arthur Burns as Fed chairman with the clueless G. William Miller, encouraged Miller to continue a policy of rapid monetary expansion, producing rising inflation in 1977 and 1978. Once again, excess monetary stimulus produced rising inflation and rising inflation expectations just before a second oil-price shock, precipitated by the Iranian Revolution, began in 1979. The combination of rising inflation expectations and rapidly rising oil prices (exacerbated by the continuing controls on petroleum pricing causing renewed shortages of gasoline and other refined products) induced a leftward shift in aggregate supply, causing inflation to rise while output fell. Hence the second episode of stagflation.

So what does this all mean? Well, if one looks at the periods of rapid increases in aggregate demand in which oil price shocks were absent, we observe very high rates of real GDP growth. In the 1960s from the third quarter of 1961 to the third quarter of 1969, real GDP growth averaged 4.8%. Over the same period, the average annual rate of increase in the GDP price deflator was 2.6%. For the 10 quarters from the first quarter of 1971 through the second quarter of 1973, real GDP growth averaged 5.9%, and for 15 quarters from the second quarter of 1975 to the fourth quarter of 1978, real GDP growth averaged 5.1%. The average annual rate of increase in the GDP deflator in the 1971-73 period was 5.2% and in the 1975-78 period, the rate of increase in prices was 6.4%. In the periods of recession or slow growth associated with the oil-price shocks (i.e, 1973-74 and 1979, the rate of increase in the GDP deflator was 9.3% in the former period, and 8.4% in the latter. Thus inflation was higher in recession or slow growth periods than in rapid growth periods. That was stagflation. Although economic expansions were about as fast in the 1970s as the 1960s, it would not be outlandish to suggest that rapid increases in nominal GDP in the 1970s did produce faster real GDP growth than would have occurred otherwise, though one might also argue that those temporary increases in real GDP growth had a non-trivial downside.

Why was unemployment so much higher in the 1970s than in the 1960s even though the rate of labor force participation was higher? I think that the obvious answer is that there was an influx of women and baby boomers into the work force without much previous work experience. Typically, new entrants into the labor force spend more time searching for employment than workers with previous experience, so it would not be surprising to observe a higher measured unemployment rate in the 1970s than in the 1960s even though jobs were not harder to find for most of the 1970s than they were in the 1960s.

The Cleveland Fed Reports Inflation Expectations Are Dropping Fast; Bernanke Doesn’t Seem to Care

Published June 15, 2012 expectations , inflation , monetary policy 21 Comments

Coinciding with the latest report on the consumer price index, showing the largest one month drop in the CPI since 2008, the Cleveland Fed issued its monthly update on inflation expectations.

News Release: June 14, 2012

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.19 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

As the attached chart shows, the current expected rate of inflation over a 10-year time horizon is at an all-time low, dropping 30 basis points in the last two months. But in his testimony to Congress this week, Chairman Bernanke did not seem to think there was any problem with monetary policy. It’s all those other guys’ fault. Well, who exactly is responsible for falling inflation expectations, Mr. Bernanke, if not the FOMC? Does a sharp drop in inflation expectations, the sharpest since the horrific summer of 2008 give you any cause for concern? If so, is there any change in policy that the FOMC plans to undertake at its next meeting? Or is the FOMC only concerned about inflation expectations when they show signs of becoming unanchored on the upside, not the downside?

UPDATE (3:44 PM EDST): A quick look at the excel file showing the Cleveland Fed’s estimates of inflation expectations at maturities from 1 to 30 years shows that one-year expectation fell last month to 0.6% from 1.4% the previous month. That is the lowest one-year inflation expectation since March of 2009 (-.0.3%) when the S&P 500 fell to 676, 10% below the previous trough of 752, in November 2008. We are treading on very thin ice, and the only thing that may be keeping us afloat is the market’s expectation that the FOMC has no alternative but to adopt another round of Quantitative Easing. Let’s see if the confidence of the market is justified.

How Did We Get into a 2-Percent Inflation Trap?

Published June 11, 2012 expectations , Friedman , inflation , monetary policy 13 Comments

It is now over 50 years since Paul Samuelson and Robert Solow published their famous paper “Analytical Aspects of Anti-Inflation Policy,” now remembered mainly for offering the Phillips Curve as a menu of possible combinations of unemployment and inflation, reflecting a trade-off between inflation and unemployment. By accepting a bit more inflation, policy-makers could bring down the rate of unemployment, vice-versa. This view of the world enjoyed a brief heyday in the early 1960s, but, thanks to a succession of bad, and sometimes disastrous, policy choices, and more than a little bad luck, we seemed, by the late 1970s and early 1980s, to be stuck with the worst of both worlds: high inflation and high unemployment. In the meantime, Milton Friedman (and less famously Edmund Phelps) countered Samuelson and Solow with a reinterpretation of the Phillips Curve in which the trade-off between inflation and unemployment was only temporary, inflation bringing down unemployment only when it is unexpected. But once people begin to expect inflation, it is incorporated into wage demands, so that the stimulative effect of inflation wears off, unemployment reverting back to its “natural” level, determined by “real” forces. Except in the short run, monetary policy is useless as a means of reducing unemployment. That theoretical argument, combined with the unpleasant experience of the 1970s and early 1980s, combined with a fairly rapid fall in unemployment after inflation was reduced from 12 to 4% in the 1982 recession, created an enduring consensus that inflation is a bad thing and should not be resorted to as a method of reducing unemployment.

I generally accept the Friedman/Phelps argument (actually widely anticipated by others, including, among others, Mises, Hayek and Hawtrey, before it was made by Friedman and Phelps) though it is subject to many qualifying conditions, for example, workers acquire skills by working, so a temporary increase in employment can have residual positive effects by increasing the skill sets and employability of the work force, so that part of the increase in employment resulting from inflation may turn out to be permanent even after inflation is fully anticipated. But even if one accepts Friedman’s natural-rate hypothesis in its most categorical form, the Friedman argument does not imply that inflation is never an appropriate counter-cyclical tool. Indeed, the logic of Friedman’s argument, properly understood and applied, implies that inflation ought to be increased when the actual rate of unemployment exceeds the natural rate of unemployment.

But first let’s understand why Friedman’s argument implies that it is a bad bargain to reduce the unemployment rate temporarily by raising the rate of inflation. After all, one could ask, why not pocket a temporary increase in output and employment and accept a permanently higher rate of inflation? The cost of the higher rate of inflation is not zero, but it is not necessarily greater than the increased output and employment achieved in the transition. To this there could be two responses, one is that inflation produces distortions of its own that are not sustainable, so that once the inflation is expected, output and employment will not remain at old natural level, but will, at least temporarily, fall below the original level, so the increase in output and employment will be offset by a future decrease in output and employment. This is, in a very general sense, an Austrian type of argument about the distorting effects of inflation requiring some sort of correction before the economy can revert back to its equilibrium path even at a new higher rate of inflation, though it doesn’t have to be formulated in the familiar terms of Austrian business cycle theory.

But that is not the argument against inflation that Friedman made. His argument against inflation was that using inflation to increase output and employment does not really generate an increase in output, income and employment properly measured. The measured increase in output and employment is achieved only because individuals and businesses are misled into increasing output and employment by mistakenly accepting job offers at nominal wages that they would not have accepted had they realized that pries and general would be rising. Had they correctly foreseen the increase in prices and wages, workers would not have accepted job offers as quickly as they did, and if they had searched longer, they would have found that even better job offers were available. More workers are employed, but the increase in employment comes at the expense of mismatches between workers and the jobs that they have accepted. Since the apparent increase in output is illusory, there is little or no benefit from inflation to outweigh the costs of inflation. The implied policy prescription is therefore not to resort to inflation in the first place.

Even if we accept it as valid, this argument works only when the economy is starting from a position of full employment. But if output and employment are below their natural or potential levels, the argument doesn’t work. The reason the argument doesn’t work is that when an economy starts from a position of less than full employment, increases in output and employment are self-reinforcing and cumulative. There is a multiplier effect, because as the great Cambridge economist, Frederick Lavington put it so well, “the inactivity of all is the cause of the inactivity of each.” Thus, the social gain to increasing employment is greater than the private gain, so in a situation of less-than-full employment, tricking workers to accept employment turns out to be socially desirable, because by becoming employed they increase the prospects for others to become employed. When the rate of unemployment is above the natural level, a short-run increase in inflation generates an increase in output and employment that is permanent, and therefore greater than the cost associated with a temporary increase in inflation. As the unemployment rate drops toward the natural level, the optimal level of inflation drops, so there is no reason why the public should anticipate a permanent increase in the rate of inflation. When actual unemployment exceeds the natural rate, inflation, under a strict Friedmanian analysis, clearly pays its own way.

But we are now trapped in a monetary regime in which even a temporary increase in inflation above 2-percent apparently will not be tolerated even though it means perpetuating an unemployment rate of 8 percent that not so long ago would have been considered intolerable. What is utterly amazing is that the intellectual foundation for our new 2-percent-inflation-targeting regime is Friedman’s natural-rate hypothesis, and a straightforward application of Friedman’s hypothesis implies that the inflation rate should be increased whenever the actual unemployment rate exceeds the natural rate. What a holy mess.

How Monetary Policy Works

Published June 7, 2012 Eurozone crisis , expectations , Great Depression , Hawtrey , inflation , Little Depression , monetary policy 16 Comments

These are exciting times. Europe is in disarray, unable to cope with a crisis requiring adjustments in relative prices, wages, and incomes that have been rendered impossible by a monetary policy that has produced almost no growth in nominal GDP in the Eurozone since 2008, placing an intolerable burden on the Eurozone’s weakest economies. The required monetary easing by the European Central Bank is unacceptable to Germany, so the process of disintegration continues. The US, showing signs of gradual recovery in the winter and early spring, remains too anemic to shake off the depressing effects of the worsening situation in Europe. With US fiscal policy effectively stalemated until after the election, the only policy-making institution still in play is the Federal Open Market Committee (FOMC) of the Federal Reserve. The recent track record of the FOMC can hardly inspire much confidence in its judgment, but it’s all we’ve got. Yesterday’s stock market rally shows that the markets, despite many earlier disappointments, have still not given up on the FOMC. But how many more disappointments can they withstand?

In today’s Financial Times, Peter Fisher (head of fixed income at BlackRock) makes the case (“Fed would risk diminishing returns with further ‘QE'”) against a change in policy by the Fed. Fisher lists four possible policy rationales for further easing of monetary policy by the Fed: 1) the “bank liquidity” rationale, 2) the “asset price” rationale, 3) the “credit channel” rationale, and 4) the “radical monetarist” rationale.

Fisher dismisses 1), because banks are awash in excess reserves from previous bouts of monetary easing. I agree, and that’s why the Fed should stop paying banks interest on reserves. He dismisses 2) because earlier bouts of monetary easing raised asset prices but had only very limited success in stimulating increased output.

While [the Fed] did drive asset prices higher for a few months, there was little follow-through in economic activity in 2011. This approach provides little more than a bridging operation and the question remains: a bridge to what?

This is not a persuasive critique. Increased asset prices reflected a partial recovery in expectations of future growth in income and earnings. A credible monetary policy with a clearly articulated price level of NGDP target would have supported expectations of higher growth than the anemic growth since 2009, in which asset prices would have risen correspondingly higher, above the levels in 2007, which we have still not reached again.

Fisher rejects 3), the idea “that if the Fed holds down long-term interest rates it will stimulate private credit creation and, thus, economic expansion.” Implementing this idea, via “operation twist” implies taking short-term Treasuries out of the market and replacing them with longer-term Treasuries, but doing so denies “banks the core asset on which they build their balance sheets,” thus impairing the provision of credit by the banking system instead of promoting it.

I agree.

Finally Fisher rejects 4), “the idea more central bank liabilities will eventually translate into ‘too much money chasing too few goods and services’ at least so as to avoid a fall in the general price level.” Fisher asks:

What assets would the Fed buy? More Treasuries? Would the Fed embark on such a radical course in a presidential election year?

Perhaps the Fed could buy foreign currencies, engineer a much weaker dollar and, thereby, stimulate inflation and growth. Would the rest of the world permit this? I doubt it. They would probably respond in kind and we would all have a real currency war. Nor is it clear the US external sector is large enough to import enough inflation to make a difference. If energy and commodity prices soared, would American consumers “chase” consumption opportunities or would they suppress consumption and trigger a recession? Recent experience suggests the latter. How much “chasing behaviour” would we get in a recession? Engineering a dollar collapse would be to play with fire and gasoline. It might create inflation or it might create a depression.

These are concerns that have been expressed before, especially in astute and challenging comments by David Pearson to many of my posts on this blog. They are not entirely misplaced, but I don’t think that they are weighty enough to undermine the case for monetary easing, especially monetary easing tied to an explicit price level or NGDP target. As I pointed out in a previous post, Ralph Hawtrey addressed the currency-war argument 80 years ago in the middle of the Great Depression, and demolished it. FDR’s 40-percent devaluation of the dollar in 1933, triggering the fastest four-month expansion in US history, prematurely aborted by the self-inflicted wound of the National Recovery Administration, provides definitive empirical evidence against the currency-war objection. As for the fear that monetary easing and currency depreciation would lead to an upward spiral of energy and commodity prices that would cause a retrenchment of consumer spending, thereby triggering a relapse into recession, that is certainly a risk. But if you believe that we are in a recession with output and employment below the potential output and employment that the economy could support, you would have to be awfully confident that that scenario is the most likely result of monetary easing in order not to try it.

The point of tying monetary expansion to an explicit price level or spending target is precisely to provide a nominal anchor for expectations. That nominal anchor would provide a barrier against the kind of runaway increase in energy and commodity prices that would supposedly follow from a commitment to use monetary policy to achieve a price-level or spending target. Hawtrey’s immortal line about crying “fire, fire” in Noah’s flood is still all too apt.

Do I See a Patch of Blue?

Published June 6, 2012 expectations , monetary policy 7 Comments

It’s June, and I’m in Washington DC; the sky is blue, and the temperature outside is in the low 70s. Oh, and stock markets around the world are soaring. This is as good as it gets.

With Europe on the brink of the abyss, and all the gloom and doom of the past month, is there really cause for optimism? I don’t know, but Scott Sumner got all excited yesterday about signs that people are finally starting to get it, especially this piece by Matthew O’Brien posted on the Atlantic website. Optimism seems to be catching, at least on the stock market.

There does seem to be a growing understanding that the conventional way of thinking about how monetary policy works – increasing the quantity of money causes interest rates to fall, inducing increased spending by business and households – is misleading, especially when interest rates are already close to zero. Instead, the way to think about the money supply is that the monetary authority ties its creation of money to a price or spending target. But for monetary policy to work in this way, the monetary authority has to announce, or at least make clear, that its policy is subordinate to the target it is aiming at, so that the public can revise its expectations accordingly. When the public’s expectations change in the appropriate direction, the battle is more than half won; the rest is a mopping up operation.

Also worthy of mention (a huge understatement BTW) are three recent posts by the precocious Evan Soltas (on monetary policy in Switzerland here and here and on monetary policy in Israel) which beautifully illustrate points that Scott and others have been making with little effect (on policy) since 2009. The voices crying out for a different approach to monetary policy are no longer lonely, and no longer in the wilderness. (And while handing out plaudits, I’ll just mention my own post about Switzerland back in September).

And here’s what one story (“Dow Surges on Stimulus Expectations”) says about the world-wide rise in stock markets today:

U.S. stocks were soaring Wednesday morning as investors rushed in from the sidelines on hopes the Federal Reserve could soon signal it’s open to additional stimulus measures.

The Dow Jones Industrial Average was rising 178 points, or 1.5%, at 12,306. The move puts the blue-chip index back in positive territory for the year.

The S&P 500 was up 20 points, or 1.6%, at 1305. The Nasdaq was surging 50 points, or 1.8%, at 2828.

All 30 Dow components were in positive territory, with Bank of America(BAC _), JPMorgan Chase(JPM _) and Hewlett-Packard(HPQ _) leading the gains.

Within the S&P 500, 95% of components were on the rise.

Gainers were outpacing decliners by a 7-to-1 ratio on the New York Stock Exchange and 4-to-1 on the Nasdaq. The leading sectors were basic materials, capital goods and energy.

The European Central Bank said Wednesday that it was keeping its benchmark interest rate at 1%. However, the markets continued to look for clues that the central bank would show an openness to lowering rates by July in the face of growing signs of recession on the continent and Spain’s troubled banking system.

“There is a necessity for them to show their cards when conditions turn urgent,” said Geoffrey Yu, analyst at UBS.

After the meeting, ECB President Mario Draghi indicated that short-term liquidity measures would continue but withheld clues on more aggressive plans to tackle the debt crisis.

“Today, we have decided to continue conducting our main refinancing operations as fixed rate tender procedures with full allotment for as long as necessary, and at least until … January,” Draghi said at a press briefing.

Federal Reserve Chairman Ben Bernanke testifies before Congress on Thursday, and it will be his first opportunity to comment on the weak jobs report last Friday. Given that the benchmark interest rate in the U.S. is already at a record low, the market will look for clues that the central bank could embark on a third round of quantitative easing.

The FTSE in London was rising 1.9% and the DAX in Germany was gaining 1.6%.

Maybe things really are darkest just before the dawn. We may be in for a long hot summer in Washington, but today I will enjoy the good weather and blue sky while it lasts. I sure hope Bernanke doesn’t spoil it all tomorrow.

OMG! John Taylor REALLY Misunderstands Hayek

Published June 3, 2012 Friedman , Hayek , monetary policy , Uncategorized 15 Comments

Since Friday’s post about John Taylor’s misunderstanding of Hayek, I watched the 57-minute video of John Taylor’s Hayek Prize Lecture. I will not offer an extended critique of the lecture, which was little more than a collection of talking points based on little empirical evidence and no serious analysis or argument. If that description sounds like a critique, so be it, but the lecture was more in the way of a ritual invocation of shared beliefs and values than an attempt to make a substantive case for a definite policy or set of policies. Whether those present at the lecture were appropriately reinforced in their shared beliefs by Taylor’s low-key remarks and placid delivery, I have no idea, but he obviously was not trying to break any new intellectual ground.

Though I found Taylor’s remarks generally boring, I did perk up about 33-34 minutes through the lecture when Taylor observed that Hayek had himself, on occasion, deviated from his own principles. How does Taylor know this? He knows this (or thinks he does, at any rate), because, as a fellow of the Hoover Institution at Stanford University, he has access to Hayek’s correspondence, which contains Keynes’s famous letter to Hayek praising The Road to Serfdom, a letter Taylor quotes from just before he gets to his point about Hayek’s “deviation,” and access to a letter that Milton Friedman wrote to Hayek complaining about Hayek’s criticism of his 3-percent rule for growth in the stock of money. Hayek made the criticism in a 1975 lecture entitled, “Inflation, the Misdirection of Labour, and Unemployment,” which was published in a 52-page pamphlet called Full Employment at any Price? (of which I own a copy) along with Hayek’s Nobel Lecture and some additional Hayek had written about inflation and unemployment.

Here is what Hayek said about Friedman’s rule:

I wish I could share the confidence of my friend Milton Friedman who thinks that one could deprive the monetary authorities, in order to prevent the abuse of their powers for political purposes, of all discretionary powers by prescribing the amount of money they may and should add to circulation in any one year. It seems to me that he regards this as practicable because he has become used for statistical purposes to draw a sharp distinction between what is to be regarded as money and what is not. This distinction does not exist in the real world. I believe that, to ensure the convertibility of all kinds of near-money into real money, which is necessary if we are to avoid severe liquidity crises or panics, the monetary authorities must be given some discretion. But I agree with Friedman that we will have to try and get back to a more or less automatic system for regulating the quantity of money in ordinary times. The necessity of “suspending” Sir Robert Peel’s Bank Act of 1844 three times within 25 years after it was passed ought to have taught us this once and for all.

A polite, but stern, rebuke to Friedman. Friedman, not well disposed to being rebuked, even by his elders and betters, wrote back an outraged response to Hayek accusing him of condoning the discretionary behavior of central bankers, as if unaware that Hayek had already explained 15 years earlier in chapter 21 of The Constitution of Liberty why central bank discretion was not a violation of the rule of law.

Somehow or other, Professor Taylor must have come across Friedman’s letter to Hayek, and thought that it would be edifying to mention it in his Hayek Prize lecture. Bad idea!

The following is my rough transcription of Taylor’s remarks, starting at about 33:50 of the Manhattan Institute video, just after Taylor quoted from Keynes’s letter to Hayek about The Road to Serfdom and Friedman’s comment about the letter that Keynes had obviously not read the chapter of The Road to Serfdom entitled “Why the Worst Get on Top.”

Now there’s always pressure for even the best-intentioned people to move away from the principles of economic freedom. And just to show you how this can happen, Hayek, himself, deviated, at least in his writings. There’s a book he wrote called Full Employment at Any Price [no intonation indicating the question market in the title], written in the middle of the 1970s mess of high inflation, rising unemployment. So people, you know, just really said, we gotta get – he wanted, of course, to get back to the rule of law and rules-based policy, but what about – well, we gotta do something else in the meantime. Well, once again, Milton Friedman, his compatriot in his cause — and it’s good to have compatriots by the way, very good to have friends in his cause. He wrote in another letter to Hayek – Hoover Archives – “I hate to see you come out, as you do here, for what I believe to be one of the most fundamental violations of the rule of law that we have, namely, discretionary activities of central bankers.”

So, hopefully, that was enough to get everybody back on track. Actually, this episode – I certainly, obviously, don’t mean to suggest, as some people might, that Hayek changed his message, which, of course, he was consistent on everywhere else.

Well, this is embarrassing. Obviously not well-versed in Hayek’s writings, Taylor mistakes the Institute of Economic Affairs, Occasional Paper 45, Full Employment at any Price? for a book, while also overlooking the question mark in the title. That would be bad enough, but Taylor apparently infers that the title (without the question mark) represented Hayek’s position in the pamphlet, i.e., that Hayek was arguing that the chief goal of policy in the 1970s ought to be full employment, in other words, exactly the opposite of the position for which Hayek was arguing in the pamphlet that Taylor was misidentifying and in everything else Hayek ever wrote about inflation and unemployment policy. Hayek was trying to explain that the single-minded pursuit of full employment by monetary policy-makers, regardless of the consequences, would be self-defeating and self-destructive. But, ignorant of Hayek’s writings, Taylor could not figure out from reading Friedman’s letter that all Friedman was responding to was Hayek’s devastating criticism of Friedman’s 3-percent rule, a rule that Taylor, for some inexplicable reason, still seems to find attractive, even though just about everyone else realized long ago that it was at best unworkable, and, in the unfortunate event that it could be made to work, would be disastrous. As a result, Taylor thoughtlessly decided to show that even the great Hayek wasn’t totally consistent and needed the guidance of (the presumably even greater) Milton Friedman to keep him on the straight and narrow. And this from the winner of the Hayek Prize in his Hayek Prize Lecture, no less.

Just by way of sequel, here is how well Hayek learned from Friedman to stay on the straight and narrow. In Denationalization of Money, published in 1976 and a revised edition in 1978, Hayek again commented (p. 81) on the Friedman 3-percent rule.

As regards Professor Friedman’s proposal of a legal limit on the rate at which a monopolistic issuer of money was to be allowed to increase the quantity in circulation, I can only say that I would not like to see what would happen if it ever became known that the amount of cash in circulation was approaching the upper limit and that therefore a need for increased liquidity could not be met.

And then in a footnote, Hayek added the following:

To such a situation the classic account of Walter Bagehot . . . would apply: “In a sensitive state of the English money market the near approach to the legal limit of reserve would be a sure incentive to panic; if one-third were fixed by law, the moment the banks were close to one-third, alarm would begin and would run like magic.

So much for Friedman getting Hayek back on track. The idea!

John Taylor Misunderstands Hayek

Published June 1, 2012 Hayek , monetary policy 17 Comments

In an op-ed piece in today’s Wall Street Journal, John Taylor, seeking to provide some philosophical heft for his shallow arguments for “rules-based fiscal, monetary, and regulatory policies” and his implausible claim that “unpredictable economic policy . . . is the main cause of persistent high unemployment and our feeble recovery from the recession,” invokes the considerable authority of F. A. Hayek. Taylor’s op-ed, based on his Hayek Prize Lecture to the Manhattan Institute on the occasion of receiving the Institute’s Hayek Prize for his new book First Principles: Five Keys to Restoring America’s Prosperity, shows little sign of careful reading of or serious thought about what Hayek had to say on the subject of rules.

Perhaps I shouldn’t take it too personally, but I can’t help but observe that just about six months ago, I wrote a post entitled “John Taylor’s Obsession with Rules” in which I quoted liberally from Hayek’s writings on monetary policy, especially from Hayek’s Constitution of Liberty. My earlier post was prompted by a critique of NGDP targeting that Taylor posted on his blog in which he compared NGDP targeting unfavorably with Milton Friedman’s 3-per cent rule for growth in the money supply. Taylor criticized NGDP targeting, because, unlike the Friedman rule, it allowed the Fed to exercise discretion in achieving its target, evidently not grasping the obvious fact that the Fed has no more control over M2 than it does over NGDP.

I cited Hayek’s views about monetary policy to make two basic points: 1) inasmuch as monetary authorities exercise no coercive power over individuals, the liberal principle that government action be undertaken only in strict conformity with known rules of general applicability does not apply to central banks, and 2) the nature of monetary policy unavoidably requires a central bank to employ some discretion in discharging its duties. Thus, the strict Friedmanian 3-percent rule, considered by Taylor to be the epitome of rules-based monetary policy, had no basis either in Hayek’s understanding of liberalism or in his understanding of the requirements of monetary policy. Indeed, Hayek on a number of occasions explicitly repudiated the 3-percent rule. After quoting several passages from Hayek explaining these points, I concluded with the following advice: “Professor Taylor, forget Friedman, and study Hayek.”

Well, I’m not sure what to make of Taylor’s invocation of Hayek in his op-ed. I guess if you are awarded the Hayek Prize, it’s only fitting to say something nice about the old sage, and at least feign some interest in what he had to say. But if Taylor did made a substantial investment in studying what Hayek wrote about following rules in the conduct of monetary policy, I see no evidence of it in his op-ed.

Let’s compare what Taylor with what Hayek said. Here’s Taylor:

Hayek argued that the case for rules-based policy goes beyond economics and should appeal to all those concerned about assaults on freedom. He wrote in his classic 1944 book, “The Road to Serfdom,” that “nothing distinguishes more clearly conditions in a free country from those in a country under arbitrary government than the observance in the former of the great principles known as the Rule of Law.”

Hayek added, “Stripped of all technicalities, this means that government in all its actions is bound by rules fixed and announced beforehand—rules which make it possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances and to plan one’s individual affairs on the basis of this knowledge.”

Now Hayek (from Chapter 21 of The Constitution of Liberty):

[T]he case against discretion in monetary policy is not quite the same as that against discretion in the use of the coercive powers of government. Even if the control of money is in the hands of a monopoly, its exercise does not necessarily involve coercion of private individuals. The argument against discretion in monetary policy rests on the view that monetary policy and its effects should be as predictable as possible. The validity of the argument depends, therefore, on whether we can devise an automatic mechanism which will make the effective supply of money change in a more predictable and less disturbing manner than will any discretionary measures likely to be adopted. The answer is not certain. (p. 334)

Taylor also mentions the point that a rules-based monetary policy enhances the predictability of monetary policy, which presumably results in increased predictability of the economic environment in which economic agents make their decisions.

Rules for monetary policy do not mean that the central bank does not change the instruments of policy (interest rates or the money supply) in response to events, or provide loans in the case of a bank run. Rather they mean that they take such actions in a predictable manner.

But in Chapter 21 of the CoL, Hayek went on to explain why a central bank could not effectively conduct policy by mechanically applying rules in a fully predictable fashion. (This conclusion might have to be revised if the monetary regime had a mechanism for targeting the expectations, but that possibility raises too many complicated issues to pursue here.) Back to Hayek:

There is one basic dilemma, which all central banks face, which makes it inevitable that their policy must involve much discretion. A central bank can exercise only an indirect and therefore limited control over all the circulating media. Its power is based chiefly on the threat of not supplying cash when it is needed. Yet at the same time it is considered to be its duty never to refuse to supply this case at a price when needed. It is this problem, rather than the general effects of policy on prices or the value of money, that necessarily preoccupies the central banker in his day-to-day actions. It is a task which makes it necessary for the central bank constantly to forestall or counteract development in the realm of credit, for which no simple rules can provide sufficient guidance.

The same is nearly as true of the measures intended to affect prices and employment. They must be directed more at forestalling changes before they occur than at correcting them after they have occurred. If a central bank always waited until rule or mechanism forced it to take action, the resulting fluctuations would be much greater than they need be. . . .

[U]nder present conditions we have little choice but to limit monetary policy by prescribing its goals rather than its specific actions. The concrete issue today is whether it ought to keep stable some level of employment or some level of prices. Reasonably interpreted and with due allowance made for the inevitability of minor fluctuations around a given level, these two aims are not necessarily in conflict, provided that the requirements for monetary stability are given first place and the rest of economic policy is adapted to them. A conflict arises, however, if “full employment” is made the chief objective and this is interpreted, as it sometimes is, as that maximum of employment which can be produced by monetary means in the short run. That way lies progressive inflation. (pp. 336-37)

So my advice of six months ago, “Professor Taylor, forget Friedman, and study Hayek” is still good advice. I hope, but am not confident, that Professor Taylor will follow it.

Expected Inflation and the S&P 500 Redux

Published May 17, 2012 expectations , inflation , Little Depression , monetary policy 4 Comments

On Monday I wrote a post with the chart below showing the close correlation since January of this year between the S&P 500 and expected inflation as (approximately) reflected in the spread between the constant maturity 10-year Treasury note and the constant maturity 10-year TIPS. A number of other bloggers noticed the post and the chart. One of those was Matthew Yglesias who coupled my chart with a somewhat similar one posted by Marcus Nunes on his blog on the same day as mine.

One commenter (“Fact Checker”) on Matthew’s blog criticized my chart accusing me of cherry picking.

The second graph is meaningless, as it does not work through time.

Here it is from 1990: http://research.stlouisfed.org/fredgraph.png?g=7gX
Again from 2000: http://research.stlouisfed.org/fredgraph.png?g=7gY
From 2005: http://research.stlouisfed.org/fredgraph.png?g=7gZ
From 2009: http://research.stlouisfed.org/fredgraph.png?g=7h0

And in another comment:

The S&P + inflation chart is reproduced below, with longer windows. And as you suggest there is no correlation in any time frame but the very short window cherry picked by MY.

Two points to make about his comment. First, if Fact Checker had read Yglesias’s post carefully, or, better yet, actually read my post (let alone the original paper on which the post was based), he would have realized that my whole point is that the close correlation between expected inflation and stock prices is generally not observed, and that one would expect to observe the correlation only when deflation exceeds the real rate of interest (as it does now when slightly positive expected inflation exceeds the negative real real rate of interest). So the fact that the correlation doesn’t work through time was precisely the point of my post. Second, the graphs to which Fact Checker links use survey data by the University of Michigan of the inflation expectations of households. I do not totally discount such data, but I regard survey estimates of expected inflation as much less reliable than the implicit market expectations of inflation reflected in the TIPS spread.

To show that the correlation I have found is reflected in the data since approximately the beginning of the downturn at the very end of 2007, but not before, here is a graph similar to the one I posted on Monday covering the entire period since 2003 for which I have data on the 10-year TIPS spread.

Before the beginning of 2008, there is plainly no correlation at all between inflation expectations and stock prices. It is only at some point early in 2008 that the correlation begins to be observed, and it has persisted ever since. We will know that we are out of this Little Depression when the correlation vanishes.

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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