## Wednesday, August 14, 2019

### The Reader's Guide to Optimal Monetary Policy

The Reader's Guide to Optimal Monetary Policy is a snazzy new website created by Anthony Diercks and Cole Langlois at the Federal Reserve Board.  Screenshot:

Who said 2% inflation is a good idea? The graph shows publication date on the horizontal axis, the optimal inflation rate on the y axis, and the size of the circle is the number of citations.

The sizeable number of dots around -4% reflect the "Friedman rule" idea. (Sadly, the graph doesn't include Friedman. It only goes back to 1990.) The idea here is that the nominal interest rate should be zero, so you earn the same on money as on bonds. Then there is no reason to economize on holding cash. Most of these were written when real rates were thought to be around 4%, so you need 4% deflation to get a nominal interest rate of zero. Ah, the good old days.

More dots show up around zero. These are mostly "sticky price" models. Now there are costs to changing prices. So the economy works best when people don't have to change prices at all, 0% inflation.

Note the paucity of papers at 2%, the Fed's inflation target. This is a nice testament to the honesty of  the Fed and its researchers.

The website allows you to graph many other issues, search for papers and so on. If you hover over a paper you get a great little two-sentence summary of the paper's main idea. If you click, you get the abstract and link to the paper. Have fun. Trigger warning: you may end up wasting a good deal of time.

1. The real return on bonds after taking inflation or deflation into account. Compared to zero interest cash.

Nominal interest rate refers to the interest rate before taking inflation into account.
https://www.investopedia.com/terms/n/nominalinterestrate.asp

The interest rate after taking inflation into account is referred to as the real interest rate.
Real Interest Rate = Nominal Interest Rate - Inflation
https://www.investopedia.com/terms/r/realinterestrate.asp

Cash = zero interest plus 4% general price deflation = 4 percent return.
Bond = 4% coupon plus 4% general price deflation = 8 percent real return, not zero percent.

2. @ jc

So what is your view on this. Your paragraph on cash and bonds is mathematically incoherent . See my comment Dinero August 15, 2019 at 11:50 AM . So what do actually think the case is.

3. Inflation or deflation actual or expected , affects the future return on cash or bonds equally, but bonds also have the interest, also inflation adjusted, on top of that return whatever that return is.

Therefore the returns to cash and bonds can not be equalised by any amount of inflation or deflation , Period. That is the maths.

As to whether or not Milton Friedman actually did ever say anything of a policy that covered cash and bonds and incorporating inflation, -

Does anyone have a copy of the original Essay by Milton Friedman, The Optimum quantity of money.
I could only find a partial quote. And it has no reference to inflation.
"Let the fed set out to keep interest rates down. How will it try to do so? by buying securities, This raises their price and lowers their yield and in the process creates more reserves available to banks, hence the amount of bank credit and ultimately the total amount of money."

4. Maybe it makes sense to look at it from the point of view of the person borrowing at the short rate. The ability to borrow has value so it should have a positive price. Cash in the mattress isn't doing anyone else any good while cash lent out is doing the borrower some good. That doesn't argue for 2%, but it does argue for something positive.

1. The 2% is not an interest rate it is an inflation rate, and it is not a positive contribution to the price it is a reduction in the price, even making it less than zero.

5. On the question of "Who said 2% inflation is a good idea?", a partial answer is given by the FRB of St Louis "Open Vault" blog publication titled "The Fed's Inflation Target: Why 2 Percent?" authored by Kristie M. Engemann, economic content coordinator in the St. Louis Fed’s Public Affairs division. Three reasons (i.e., rationalizations) cited in the article are: measurement bias, room to cut interest rates, and, avoiding deflation. One logical contradiction is thrown in for good measure:
"...stating an inflation goal—and maintaining credibility with respect to that goal—helps the FOMC manage the public’s expectations when it comes to inflation. In turn, **this helps in achieving price stability** as per the Fed’s mandate." [Emphasis added]

A two percent inflation rate is incompatible with "price stability", as may be easily demonstrated.

The notion that one raises the interest rate in order to lower it later when the economy reacts to 'tighter money' conditions and enters a recession is a false precept. We have paid the price many times over the course of the past 60 years as a result of this false notion on the part of the Fed.

Avoiding 'deflation' is one reason (rationale) cited, but how often has 'deflation' arisen (as opposed to 'disinflation')? Not often, but the financial market players continually cite 'deflation' as a risk; and it would be a risk to those who borrow and would in the event of deflation have to repay the debt in dollars that have appreciated in real purchasing power compared to the dollar they borrowed. This is the 'risk' for the borrower, the government as well.

Price stability? Not likely when Congress is spending more than it takes in in a year, every year from now unto Doomsday. Ergo, the '2% inflation target' mandate.

6. I think the ending statement sums it up, reading all this it can be fun but also a waste of time. As Arthur Clarke said, the truth always will be far stranger. Buckle up and enjoy the ride after 60 years of voodoo economics!

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Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.