Transitory Inflation: A Fisherian Fed?

Should the Fed raise interest rates fast? Or should it leave them alone, figuring inflation will be "transitory?" 

Lots of models, including ones I play with, predict that a constant unchanging interest-rate peg leads to stable inflation. If there is a fiscal shock, it leads to a one-period price-level jump, but no further inflation, so long as the interest rate stays where it is. The models in the first few chapters of The Fiscal Theory of the Price Level have this feature, also "Michelson Morley, Fisher and Occam.'' Martin Uribe has also written about this issue, here for example. 

The simplest example is \[i_t = E_t \pi_{t+1}\] \[(E_{t+1}-E_t) \pi_{t+1} = -(E_{t+1}-E_t) \sum_{j=0}^{\infty} \rho^j \tilde{s}_{t+j} \] where \(\tilde{s}\) denotes real primary surpluses scaled by the value of debt. If the interest rate \(i_t\) does not move, expected inflation does not move. A fiscal shock (negative \(\tilde{s}\) ) gives a one-period unexpected inflation, devaluing outstanding debt; essentially a Lucas-Stokey state-contingent default. Sticky prices smooth all this out over a year or two. 

You can replace the latter with standard new-Keynesian equilibrium-selection rules if you want. This isn't really about fiscal theory; the key is rational forward-looking expectations in the first equation, which also hold in the standard sticky-price extensions. This "Fisherian" property is a common though widely ignored prediction of most new-Keynesian models. 

It certainly seems plausible that we are seeing an inflationary fiscal shock, from trillions of money printed up and sent to consumers, while interest rates stay fixed. These models predict that such inflation will indeed be transitory if the Fed does not raise interest rates, and will rise if it does!  

However, like all lower-rates-to-lower-inflation arguments, there are lots of warnings here. In particular, the "transitory" inflation could last a long time once we put in sticky prices. The trick only works if the Fed is completely committed to not raising rates, to waiting as long as it takes for inflation to settle back down on its own.  If people suspect the Fed will raise rates, inflation rises. There are lots of temporary forces that go in the other direction. And there may be more fiscal shocks -- I sort of see one brewing in Congress -- so we may not be done with the unexpected inflation term. 

FTPL section 5.3 has a long discussion of all the preconditions for lower interest rates to bring down inflation, which still obtain. But we haven't been talking about this issue much since the low-inflation zero-bound era ended, and the discussion that maybe determined, permanent, pre-announced interest rate rises could eventually bring up inflation. The opposite sign works as well. 

In these models, with a few more ingredients than I show above, the Fed can also lower inflation by raising rates. Raising rates gives a temporary inflation decline before going the other way. So, the Fed has to raise rates, push inflation down, then quickly get on the other side. That's the historical pattern, and what it will likely do.  But it's only honest, and fun, to remember the prediction of the opposite possibility and to think about how it might work out. 

******

Update. A second try, with more English. The government, Fed and Treasury, basically printed up about $5 trillion of new cash and treasury debt -- these are largely perfect substitutes so the composition doesn't really matter -- with no change at all in plans to repay debt. By simple FTPL, a 25% increase in debt with no increase in expected future surpluses generates a 25% rise in the price level, 25% cumulative inflation. It basically defaults on outstanding debt and transfers that value to the recipients of stimulus. 

But then it ends. If there is no more issue of nominal debt, without additional surpluses, then there is no more inflation. 

Additional issues of nominal debt can come from more unbacked fiscal expansion, or it can come from monetary policy. Monetary policy also puts extra government debt (same thing as interest-paying reserves) out there, with (of course) no change in fiscal policy. 

So there is the FTPL case for "transitory."In the long run, no change in interest rate puts no extra government debt in the system, and higher nominal interest rates must mean eventually higher inflation and hence more unbacked government debt in the system. 

 

Interest rate survey

Torsten Slok passed on a lovely graph, created from the Philadelphia Fed survey of professional forecasters: 

It's not just the Fed, whose own forecasts and dot plots have the same characteristics. 

Some potential lessons

1) Just you wait. There is the story of the hypochondriac, who when he died at 92 had inscribed on his tombstone "See, I told you I was sick." More serious stories have been told of the 1980s high interest rates, worried for a decade about inflation that could have come but never did. Or the famous "Peso problem," persistently low forward rates that eventually proved to be right. 

2) A lot of fun is made in survey research about the "irrational" expectations revealed by surveys. Whether "professionals" are involved is often a used to select between "rational" and "noise" investors in asset pricing studies. Hello, the professionals are just as behavioral as the rest of us. As are the Fed economists whose forecasts look the same. The argument from irrational-looking surveys to let the "experts" run and nudge things never did hold water. 

3) Just what do survey forecasts mean? How many of these Wall Street economists, or their trading desks are heavily short 10 year bonds? How many of them lost money on that trade for 20 years running? It's a good bet the same economists work for firms that, to the contrary, have been riding this... well, call it a trend, call it a bubble, call it a golden two decades for long-term bonds. What is the risk premium story for believing long term bonds are about to take a bath, but buying a lot of them anyway? 

4) Just what do survey forecasts mean? We ask people "what do you expect," and scratch our heads that they do not reply with numbers that make sense as true-measure conditional means. The event of a sharp raise in rates might come with substantially higher marginal utility, i.e. a very bad event. Reporting risk-neutral measure, probability times marginal utility might make sense for many reasons. Reporting a 40% quantile, shaded to bad news, makes a lot of sense for many reasons. Clients who make money don't complain. Clients who lose money do.  

5) Just what do survey forecasts mean?  For most surveys, the interesting thing is not the average but the astounding variation around that average. In theory, asset trading should lead to common expectations. In fact it does not. I would love to see the variation around this mean forecast. 

Confessions. I've been ... well, not forecasting, but doom and glooming about a sharp interest rate rise for just as long. And, I have to report, the graph has not yet changed my mind. To some extent, one faces the problem of the value investor, who every time the stock goes down has to say, "now it's an even better deal!" I guess I have company.  See, I told you I was sick? 

Ip on Bidenomics

Greg Ip has a great column in the WSJ on Bidenomics.  It's not long, it's so well written that it's hard to condense the good parts, and you should really read it all. 

There is an intellectual framework to Bidenomics, and with that a scarily more durable move on economic policy. 

There used to be 

"certain rules about how the world worked: governments should avoid deficits, liberalize trade and trust in markets. Taxes and social programs shouldn’t discourage work."

By contrast President Biden's (really his team's) "embrace of bigger government" is founded on different economic ideas. To wit, abridged: 

Growth

Old view: Scarcity is the default condition of economies: the demand for goods, services, labor and capital is limitless, their supply is limited. ...faster growth requires raising potential by increasing incentives to work and invest. Macroeconomic tools—monetary and fiscal policy—are only occasionally needed to deal with recessions and inflation.

New view: Slack is the default condition of economies. Growth is held back not by supply but chronic lack of demand, calling for continuously stimulative fiscal and monetary policy. J.W. Mason.. said, that “‘depression economics’ applies basically all of the time.”

I guess I'm an old fogie. 

Inflation outlook at NRO. 1970s all over again?

Essay on monetary policy in National Review Online. 

Short version: The Fed's monetary policy has returned to the intellectual framework of the late 1960s. At best "expectations" now float around as an independent force, manipulable by speeches, but not tied to patterns of action by the Fed as analysis since the 1980s would require. 

If you follow the conventional reading of how monetary policy works, that observation leads to a natural prediction:  we're on the verge of reliving 1970s inflation. (Fiscal policy, entitlements, regulation and cities seem to be headed also to 1970s policy on steroids.) 

True, the Fed says "we have the tools" to stop inflation should it break out. But that tool is to rerun 1980. Does the Fed have the will? Will the Fed really induce a 2 year agonizing recession to bring down inflation, followed by 15 years of historically unprecedented high interest rates? Or will the Fed do what it did three times before that -- half-hearted interest rate rises that brought milder recessions, and a quick backtrack? Having even a nuclear weapon is useless if people stop believing you will use it. 

I don't follow that conventional reading, so I'm not confidently predicting inflation. I worry more about fiscal affairs directly than about the Fed, which leads to a fear of a larger but less predictable inflation, that the Fed will have little power to stop. But mine is definitely a minority view.   

Does the Fed’s Monetary Policy Threaten Inflation? (Contains Spoilers)

The central bank is headed back to the Seventies — a rerun that no one should want.

Does the Fed’s monetary policy threaten inflation? By conventional measures, yes. But those conventional measures have failed in the past. I believe that the short-run danger is less than it appears, but the long-run danger is larger.

If one reads Fed statements through conventional glasses, monetary policy seems to have been reset to the 1960s, and we know how that worked out.

Magical monetary theory full review

I read Stephanie Kelton's book, The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy,” and wrote this review for the Wall Street Journal. Now that 30 days have passed I can post the whole thing. 

I approached this task with an open mind. What I had heard of MMT has some overlap with fiscal theory of the price level, on which I work, and I hoped to see some commonality.

I was disappointed.

The review:

Modern monetary theory, known as MMT, erupted suddenly into the public consciousness when it won the attention of high-profile politicians including Bernie Sanders and Alexandria Ocasio-Cortez and their media admirers. Its central proposition states that the U.S. federal government can and should freely print money to finance a massive spending agenda, with no concern about debt and deficits.

What is MMT? Its advocates have told us in essays, blog posts, videos and tweets what MMT says about this and that, but what is its logic and evidence? As a monetary theorist who is also skeptical of conventional wisdom, I looked forward to a definitive exposition from Stephanie Kelton’s “The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy.”

Ms. Kelton, a professor of economics at Stony Brook University and senior economic adviser to Bernie Sanders’s presidential campaign, starts with a few correct observations. But when the implications don’t lead to her desired conclusions, her logic, facts and language turn into pretzels.

True, the federal government can spend any amount by simply printing up the needed money (in reality, creating bank reserves). True, our government need never default since it can always print dollars to repay Treasury bonds. But if the government prints up and spends, say, $10 trillion, will that not lead to inflation? Ms. Kelton acknowledges the possibility: “If the government tries to spend too much in an economy that’s already running at full speed, inflation will accelerate.”

So how do we determine if the economy is running at full speed, or full of “slack,” with unemployed people and idle businesses that extra money might put to work without inflation? Ms. Kelton disdains the Federal Reserve’s noninflationary or “natural” unemployment rate measure of slack as a “doctrine that relies on human suffering to fight inflation.” Even the recent 3.5% unemployment is heartlessly too high for her.

“MMT urges us to think of slack more broadly.” OK, but how? She offers only one vaguely concrete suggestion: When evaluating spending bills, “careful analysis of the economy’s . . . slack would guide lawmakers. . . . If the CBO [Congressional Budget Office] and other independent analysts concluded it would risk pushing inflation above some desired inflation rate, then lawmakers could begin to assemble a venue of options to identify the most effective ways to mitigate that risk.” She doesn’t otherwise define slack or even offer a conceptual basis for its measurement. She just supposes that the CBO will somehow figure it out. She doesn't mention that the CBO now calculates a measure, potential GDP, which does not reveal perpetual slack. And she later excoriates the CBO for its deficit hawkishness.

Really her answer is: Don’t worry about it. She simply asserts that “there is always slack in the form of unemployed resources, including labor.”

We’re not talking about a little slack either. Ms. Kelton’s “people’s economy” starts with the full Green New Deal and moves on to a federal job for anyone, free health care, free child care, the immediate cancelation of student debt, free college, “affordable housing for all our people,” national high-speed rail, “expanded Social Security,” “a more robust public retirement system,” “middle-class tax cuts,” and more. How much does this add up to? $20 trillion? $50 trillion? She offers no numbers. How is it vaguely plausible that the U.S. has this much productive capacity lying around going to waste?

In a book about money, the inflation of the 1970s and its defeat are astonishingly absent. History starts with Franklin Roosevelt—a hero for enacting the New Deal but a villain for paying for it with payroll taxes rather than fresh dollars. Ms. Kelton praises John F. Kennedy, too. He “pressured unions and private industry, urging them to keep wage and price increases to a minimum to avoid driving inflation higher. It worked. The economy grew, unemployment fell sharply and inflation remained below 1.5 percent for the first half of the decade.”

The second half of that decade—Lyndon Johnson’s Great Society and Vietnam War spending, inflation’s breakout, Richard Nixon’s [1971] disastrous price controls—is AWOL. Did we not try MMT once and see the inflation? Did not every committee of worthies always see slack in the economy? Did not the 1970s see stagflation, refuting Ms. Kelton’s assertion that inflation comes only when there is no “slack”? Don’t look for answers in “The Deficit Myth.”

Victory over inflation under Ronald Reagan and Margaret Thatcher goes likewise unmentioned. History starts up again when Ms. Kelton excoriates Thatcher for saying that government spending has to be paid for with taxes. She insinuates, outrageously, that Thatcher deliberately lied on this point in order to “discourage the British people from demanding more from their government.”

If spending can be financed by printing money, “why not eliminate taxes altogether?” Ms. Kelton begins consistently. She criticizes Sens. Bernie Sanders and Elizabeth Warren for claiming that they need to raise taxes to pay for spending programs. But then why raise taxes? Taxes exist to decapitate the wealthy, not to fund spending or transfers: “We should tax billionaires to rebalance the distribution of wealth and income and to protect the health of our democracy.”

She offers a second answer, more subtle, and revealingly wrong. She starts well: “Taxes are there to create a demand for government currency.” This is a deep truth, which goes back to Adam Smith. Soaking up extra money with fiscal surpluses [higher taxes or less spending] is, in fact, the ultimate control over inflation. But then arithmetic fails her. To avoid inflation, all the new money must eventually be soaked up in taxes. The new spending, then, is ultimately paid for with those taxes.

What about the debt? Ms. Kelton asserts the government can wipe it out. Again, she starts correctly: The Fed could purchase all of the debt in return for newly created reserves. She continues correctly: The Fed could stop paying interest on reserves. But in conventional thinking, these steps would result in a swift inflation that is equivalent to default. Ms. Kelton asserts instead that these steps “would tend to push prices lower, not higher.” She reasons that not paying interest would reduce bondholders’ income and hence their spending.

 The mistake is easy to spot: People value government debt and reserves as an asset, in a portfolio. If the government stops paying interest, people try to dump the debt in favor of assets that pay a return and to buy goods and services, driving up prices.

What about all the countries that have suffered inflation, devaluation and debt crises even though they print their own currencies? To Ms. Kelton, developing nations suffer a “deficit” of “monetary sovereignty” because they “rely on imports to meet vital social needs,” which requires foreign currency. Why not earn that currency by exporting other goods and services? “Export-led growth . . . rarely succeeds.” China? Japan? Taiwan? South Korea? Her goal posts for “success” must lie far down field.

The problem is that “the rest of the world refuses to accept the currencies of developing countries in payment for crucial imports.” Darn right we do. Her solution: more printed money from Uncle Sam—a “global job guarantee.”

She also advises small and poor countries to cut themselves off from international commerce. They should develop “efficient hydroponic and aquaponics food production” and install “solar and wind farms” rather than import cheap food and oil. They should refuse international investment, with the “classical form of capital controls” under Bretton Woods as an ideal. “We share only one planet,” she writes, yet apparently that planet must have hard national borders.

By weight, however, most of the book is not about monetary theory. It’s rather a recitation of every perceived problem in America: the “good jobs deficit,” the “savings deficit,” the “health-care deficit,” the “infrastructure deficit,” the “democracy deficit” and—of course —the “climate deficit.” None of this is original or relevant. The desire to spend is not evidence of its feasibility.

Much of “The Deficit Myth” is a memoir of Ms. Kelton’s conversion to MMT beliefs and of her time in the hallways of power. She criticizes Democrats, including President Obama and his all-star economic team, for their thick skulls or their timidity to state her truth in public. Republicans, such as former House Speaker Paul Ryan, are just motivated by dark desires to keep the people down and enrich big corporations and wealthy fat cats. President Trump’s tax cuts are a “crime.” How insightful.

In a revealing moment, Ms. Kelton admits that “MMT can be used to defend policies that are traditionally more liberal . . . or more conservative (e.g., military spending or corporate tax cuts).” Well, if so, why fill a book on monetary theory with far-left wish lists? Why insult and annoy any reader to the right of Bernie Sanders’s left pinkie?

Writing the book to “defend” an immense left-wing spending agenda destroys her argument. If you could only feel her singular empathy for the downtrodden, if you could, as she does, view the federal budget as a “moral document,” if you could just close your eyes and need it to be true as much as she does, your “Copernican moment” will arrive, and logic and evidence will no longer trouble you.

That effect is compounded by her refusal to abide by the conventional norms of economic and public-policy discourse. She cites no articles in major peer-reviewed journals, monographs with explicit models and evidence, or any of the other trappings of economic discourse. The rest of us read and compare ideas. Ms. Kelton does not grapple with the vast and deep economic thinking since the 1940s on money, inflation, debts, stimulus and slack measurement. Each item on Ms. Kelton’s well-worn spending wish list has raised many obvious objections. She mentions none.

Skeptics have called it “magical monetary theory.” They’re right.

****

Update. To "jabmorris" and "rob." How could you possibly know if I have or have not read the book? As a matter of fact, I read every word of it. You offer a false accusation of impropriety, that you could not possibly know anything about, instead of a shred of fact or logic. This seems about par for the course in MMT land.

Summers tweet stream on secular stagnation

Larry Summers has an interesting tweet stream (HT Marginal Revolution) on the state of monetary policy. Much I agree with and find insightful:

Can central banking as we know it be the primary tool of macroeconomic stabilization in the industrial world over the next decade?...There is little room for interest rate cuts..QE and forward guidance have been tried on a substantial scale....It is hard to believe that changing adverbs here and there or altering the timing of press conferences or the mode of presenting projections is consequential...interest rates stuck at zero with no real prospect of escape - is now the confident market expectation in Europe & Japan, with essentially zero or negative yields over a generation....The one thing that was taught as axiomatic to economics students around the world was that monetary authorities could over the long term create as much inflation as they wanted through monetary policy. This proposition is now very much in doubt.

Agreed so far, and well put. "Monetary policy" here means buying government bonds and issuing reserves in return, or lowering short-term interest rates. I am still intrigued by the possibility that a commitment to permanently higher rates might raise inflation, but that's quite speculative.

and later

Limited nominal GDP growth in the face of very low interest rates has been interpreted as evidence simply that the neutral rate has fallen substantially....We believe it is at least equally plausible that the impact of interest rates on aggregate demand has declined sharply, and that the marginal impact falls off as rates fall.  It is even plausible that in some cases interest rate cuts may reduce aggregate demand: because of target saving behavior, reversal rate effects on fin. intermediaries, option effects on irreversible investment, and the arithmetic effect of lower rates on gov’t deficits

Central banks are a lot less powerful than everyone seems to think, and potentially for deep reasons. File this as speculative but very interesting. Larry has many thoughts on why lowering interest rates may be ineffective or unwise.

The question is just how bad this is? The economy is growing, unemployment is at an all time low, inflation is nonexistent, the dollar is strong. Larry and I grew up in the 1970s, and monetary affairs can be a lot worse.

Yes, the worry is how much the Fed can "stimulate" in the next recession. But it is not obvious to me that recessions come from somewhere else and are much mitigated by lowering short term rates as "stimulus." Many postwar recessions were induced by the Fed, and the Great Depression was made much worse by the Fed. Perhaps it is enough for the Fed simply not to screw up -- do its supervisory job of enforcing capital standards in booms (please, at last!) do its lender of last resort job in financial crises, and don't make matters worse.

But how bad is it now? Here Larry and I part company. Larry is, surprisingly to me, still pushing "secular stagnation"

Call it the black hole problem, secular stagnation, or Japanification, this set of issues should be what central banks are worrying about...We have come to agree w/ the point long stressed by Post Keynesian economists & recently emphasized by Palley that the role of specific frictions in economic fluctuations should be de-emphasized relative to a more fundamental lack of aggregate demand. 

The right issue for macroeconomists to be focused on is assuring adequate aggregate demand.  

My jaw drops.

The unemployment rate is 3.9%, lower than it has ever been in a half century. It fell faster after about 2014 than in the last two recessions.

Labor force participation is trending back up.

Wages are rising faster and faster, especially for less skilled and education educated workers.

 There are 8 million job openings in the US.

Why in the world are we talking about "lack of demand?

Nobel Symposium on Money and Banking Day 2

Day 2 of the Nobel Symposium on Money and Banking focused on monetary policy. (My last post covered Day 1 on banking.)

Bernanke

Sadly Ben Bernanke's video and slides are not up on the website. Ben showed some very interesting evidence that the crisis was an unpredictable run, rather than the usual story about predictable defaults resulting from too much credit. Things really did get suddenly a lot worse in September and October 2008. Yes, it's easy to say this is defense against the charge that he should have done more ahead of time. But evidence is evidence, and I find it quite plausible that the relatively small losses in subprime need not have caused such a massive crisis and recession absent a run. Ben says the material is part of a paper he will release soon, so look for it. One can understand that Bernanke is careful about releasing less than perfect drafts of papers and videos.

History

Barry Eichengreen gave a scholarly account of why history matters, especially the great depression, and we should pay more attention to it. (Paper, video.) He aimed squarely at typical economists whose knowledge stopped at Friedman and Schwartz, or perhaps Ben Bernanke's famous non-monetary channels paper, in which bank failures propagated the depression. He emphasized the role of the gold standard and international cooperation or non-cooperation, and warned against facile comparisons of the gold standard experience to today's events and the euro in particular.

Randy Kroszner has a great set of slides and an engaging presentation. He also started on parallels with the great depression, and told well the story of the US default on gold clauses. He closed with a warning about fighting the last war -- particularly apt given the exclusive focus of most of this conference on the events of 2008 -- and on how to start a crisis. In his view when Bank of England Gov Mervyn King said: “We will support Northern Rock." People hear "Northern Rock's in trouble? Run!" Likewise, in my view, speeches by President Bush and Treasury Secretary Paulson did a lot to spark the run in the US.

DSGE

A highlight for me, was the session on DSGE models.

Marty Eichenbaum (video, slides, subsequent paper) gave a nice review of the current status of new Keynesian DSGE models, and how they are developing in reaction to the financial crisis and recession, and the zero bound episode.

Harald Uhlig

Critiques, or more precisely lists of outstanding puzzles and challenges, are often more memorable and novel than positive summaries, and Harald Uhlig delivered a clear and memorable one. (Video, Slides)

Asset prices are a longstanding problem in DSGE models. In typical linearized form, the quantity dynamics are governed by intertemporal substitution, and the asset prices by risk aversion, and neither has much influence on the other. (I learned this from Tom Tallarini.) Rather obviously, our recent recession was all about risk aversion -- people stopped consuming and investing, and tried to move from private to government bonds because they were scared to death, not a sudden attack of thriftiness. There is a lot of current work going on to try to repair this deficiency, but it still lives in the land of extensions of the model rather than the mainstream. Harald also points out a frequently ignored implication of Epstein-Zin utility, the utility index reflects all consumption and anything that enters utility

Financial frictions are blossoming in DSGE models, in two forms: First, HANK or "heterogenous agent" models, which add things like borrowing constraints and uninsurable risks so that the distribution of income matters, and in an eternal quest to make the models work more like static ISLM. Second, in response to the financial crisis (see first day!) stylized models of banking and intermediary finance are showing up. I'm still a little puzzled that the more standard time-varying risk aversion part of macro-finance got ignored, (a plea here) but that is indeed what's going on.

The conundrum, here as elsewhere in DSGE, is that the more people play with the models, the further they get from their founding philosophy: macro models that do talk about monetary policy, (now) financial crises, but that obey the Lucas rules: Optimization, budget constraints, markets, or, more deeply, structures that have some hope of being policy invariant and therefore predictions that will survive the Lucas critique. Already, many ingredients such as Calvo pricing are convenient parables, but questionably realistic as policy-invariant.

Harald points out that since most of the frictions are imposed in a rather ad-hoc manner, neither will they be policy-invariant. This is a deeper and more realistic point than commonly realized. Every time market participants hit a "friction," they tend to innovate a way around that friction so it doesn't hurt them next time. Regulation Q on interest rates was once a "friction," and then the money market fund was invented. The result is too often "chicken papers:"

The understandable trouble is, if you try to microfound every single friction from Deep Theory -- just why it is that credit card companies put a limit on how much you can borrow, in terms of asymmetric information, moral hazard, and so forth -- the audience will be asleep long before you get to the data. Also, as we saw in day 1, there is (to put it charitably) a lot of uncertainty in just how contract or banking theory maps to actual frictions. I think we're stuck with ad-hoc frictions, if you want to go that route.

Harald's next point is, I think, his most devastating, as it describes a huge hole in current models that is not (unlike the last two) a point of immense current research effort. The Phillips curve and inflation are the central point of the New Keynesian DSGE model -- and a disaster. 

The Phillips curve is central. The point of the model is for monetary policy to have output effects. Money itself has (rightly) disappeared in the model, so the only channel for monetary policy to work is via the Phillips curve. Interest rates change inflation, and inflation causes output changes. No surprise, it is very hard for that model to produce anything like the last recession out of small changes in inflation. (I have to agree here with the premise of the financial frictions view -- if you want your model to produce the last recession, other than by one huge shock, the model needs something like a financial crisis.)

The Phillips curve in the data is well known

Less well known, but worth lots of attention, is how the now standard DSGE models completely fail to capture inflation. Harald's slide:

The point of the slide, in simpler form: The standard Phillips curve is

inflation today = beta x expected inflation next year + kappa x output gap  + shock

Essentially all inflation is accounted for by the shock. The model is basically silent about the source of inflation. Looking at the model as a whole, not just one equation, Neither monetary policy shocks nor changes in rules accounts for any significant amount of inflation. 

I made a similar graph recently. Use the standard three equation model

Now, use actual data on output y, inflation pi, and interest rate i, to back out the shocks v. Turn off the monetary policy shock vi = 0. Solve the model and plot the data -- what would have happened if the Fed had exactly followed the Taylor rule? 

Answer: Inflation and output would have been virtually the same. The inflation of the 1970s and its conquest in the 1980s had nothing to do with monetary policy mistakes. It is entirely the fault, and then fortunate consequence, of "marginal cost" shocks that come from out of the model. This is a pretty uncomfortable prediction of a model designed to be about monetary policy! Or, as Harald put it

• Data: no Phillips-Curve tradeoff.
• QDSGE: don’t account for inflation with monetary policy shocks.
• The NK / Phillips-Curve-based NK QDSGE models may thus provide a poor guide for monetary policy.

Wait, you ask, what about Marty Eichenbaum's pretty graphs, such as this one, showing the effects of a monetary policy shock?

The answer: After a lot of work, the effects of a monetary policy shock look (at last) about like what Milton Friedman said they should look like in 1968. But monetary policy shocks don't account for any but a tiny part of output and inflation variation, quite contra Friedman (and Taylor, and many others') view.

Last, standard new Keyensian DSGE models have strong "Fisherian" properties. In response to long lasting or expected interest rate rises, inflation goes up. More on this later.

Ellen McGrattan

Ellen stole the show. (Slides.) Take a break, and watch the video. She manages to be hilarious and incisive. And unlike the rest of us, she didn't try to sheohorn a two hour lecture into her 15 minutes.

Her central points. First, like Harald, she points out that the models are driven by large shocks with less and less plausible structural interpretation, and thus further from the Lucas critique solution than once appeared to be the case. The shocks are really "wedges," deviations from equilibrium conditions of the model with unknown sources

What to do? Focus on rules and institutions. This is a deep point. Even DSGE modelers, in the desire to speak to policy makers, often adopt the static ISLM presumption that policy is about actions, about decisions, whether to raise or lower the funds rate. The other big Lucas point is that we should think about policy in terms of rules and institutions, not just actions.

Monetary policy and ELB

Stephanie Schmitt-Grohé (slides, video)  talked about the Fisherian possibility -- that raising interest rates raises inflation. New-Keynesian DSGE models, with rational expectations, have this property, especially for permanent or preannounced interest rate increases, and when at zero interest rates or otherwise in a passive regime where interest rates do not react more than one for one with inflation. She and Martin Uribe have been advocating this possibility as a serious proposal for Europe and Japan that want to raise inflation.

She presented some nice evidence that permanent increases in interest rates do increase inflation -- and right away, not just in the long run.

Mike Woodford. (slides, video)  gave a dense talk (37 slides, 20 minutes) on policy at the lower bound. During the ELB, central banks moved from interest rates to asset purchases and forward guidance. Mike asks,

To what extent does this mean that the entire conceptual framework of monetary stabilization policy needs to be reconsidered, for a world in which ELB might well continue periodically to bind? 

In classic form, Mike sets the question up as a Ramsey problem. Given a DSGE model, what is the optimal policy, given that interest rates are occasionally constrained? He derives from that problem a price level target. The price level target works, intuitively, by committing the central bank to a period of extra inflation after the zero bound ends. It is a popular form of forward guidance. The innovation here is to derive that formally as an optimal policy problem.

Mike's price level target is stochastic, changing optimally over time to respond to shocks. I'm a little skeptical that the central bank can observe and understand such shocks, especially given the above Uhlig-McGrattan discussion about the nature of shocks. Also, as I emphasize in comments, I'm dubious about the great power of promises of what the central bank will do in the far future to stimulate output today. I'm a fan of price level targets, but on both sides, not just as stimulus, but for utterly different reasons.

Mike takes on rather skeptically the common alternative -- quantitative easing, asset purchases during the time of the bound. He points out that to work, people have to believe that the increase in money is permanent, and won't be quickly withdrawn when the zero bound is over. As evidence, he points to Japan:

Similarly, he likes the price level target over forward guidance -- speeches in place of action -- as it is a more credible commitment to do things ex-post that the bank may not wish to do ex-post.

Finally, he addresses the puzzles of new Keynesian models at the zero bound -- forward guidance has stronger effects the further in the future is the promise; effects get larger as prices get less sticky, and so on. He argues that models should replace rational expectations with a complex k-step iterated expectations rule.

Me.

Video, slides from Sweden, slides from my webpage, written version. I covered this in a previous blog post, so won't repeat it all. I put a lot of effort in to it, and it summarizes a lot of what I've been doing in 15 minutes flat, so I recommend it (of course). It also offers more perspective on above points by Mike and Stephanie. My favorite line, referring to Mike's push for irrational expectations is something close to

"I never thought we would come to Sweden, that I would be defending the basic new-Keynesian program, and that Mike Woodford would be trying to tear it down. Yet here we are. Promote the fiscal equation from the footnotes and you can save the rest." 

Emi Nakamura

Poor Emi had to go last in an exhausting conference of jet-lagged participants. She did a great job (video, slides) covering a century of monetary history and monetary ideas clearly and transparently. These are great slides to use for an undergraduate or MBA class on monetary policy, as well. An abbreviated list:

• Gold standard
• Seasonal variation in interest rates under the gold standard; money demand shocks
• Money demand shocks in the 1980s -- how the supposedly "stable" V in MV=PY fell apart when the Fed pushed on M.
  
  
  
• Theoretical instability / indeterminacy of interest rate targets
• The switch to interest rate targets and corridors in operating procedures
• The (near-miraculous) success of inflation targets
  
• Taylor rules and other theory of determinate inflation under interest rate targets
• How is it "monetary economics" without money?
• Why did immense QE not cause inflation? 

The overarching theme is the grand story of a move, intellectual and practical, from money supply targets (of which gold is one) to interest rate targets.

Postlude

Monday featured two panels, Macroeconomic research and the financial crisis: A critical assessment, with Annette Vissing-Jørgensen, Luigi Zingales, Nancy Stokey, and  Robert Barro ; and Banking and finance research and the financial crisis: A critical assessment with Kristin Forbes, Ricardo Reis, Amir Sufi, and Antoinette Schoar.

Perhaps it's in the nature of panels, but I found these a disappointment, especially compared to the stellar presentations in the main conference. Also I think it would have been better to allow more (any, really) audience questions; the whole conference was a bit disappointing for lack of general discussion, especially with such a stellar group.

In particular, Luigi led by excoriating the profession for not paying attention to housing problems and financial crises. I thought this a bit unfair and simultaneously short-sighted. He singled out monetary economics textbooks, including Mike Woodford's, for omitting financial crises. Well, Mike omitted asteroid impacts too. It isn't a book about financial crises. And, after lamabasting all of us, he said not one word about events since 2009. What are we missing now? I had to stand up and ask that rude question, again suggesting that perhaps we are all not listening to Ken Rogoff this time. Annette went on to ask something like "don't you Chicago people believe in any regulation at all," and the respondents were too polite to say what an unproductive question that is and just move on.

Again, I offer apologies to authors and discussants I didn't get to. The whole thing was memorable, but there is only so much I can blog! Do go to the site and look at the other sessions, according to your interests.

Nobel Symposium on Money and Banking Day 1

I attended the Nobel Symposium on Money and Banking in May, hosted by the Swedish House of Finance and Stockholm School of Economics.   It was a very interesting event. Follow the link for all the presentations and videos. (Click on "program." )

This review is  idiosyncratic, focusing on presentations that blog readers might find interesting. My apologies to authors I leave out or treat briefly -- all the presentations were action-packed and even my verbose blogging style can't cover everything.

"Nobel" in the title has a great convening power! The list of famous economists attending is impressive. And each presenter put great effort into explaining what they were doing, in part on wise invitation from the organizers to keep it accessible.  As a result I  understood far more than I do from usual 20 minute conference presentations and 15 minute discussions.

The first day was really "banking day," giving a whirlwind tour of the financial economics of banking.

Trading liquidity

Darrell Duffie gave (as always) a super presentation on the effects regulation is having on arbitrage in markets. (Slides, video)

Eight Heresies of Monetary Policy

Eight Heresies of Monetary Policy

This is a talk I gave for Hoover, which blog readers might enjoy. Yes, it puts together many pieces said before. This post has graphs and uses mathjax for equations, so if it isn't showing come back to the original. Also here is a pdf version which may be more readable.

Background

As background, the first graph reminds you of the current situation and recent history of monetary policy.

The federal funds rate is the interest rate that the Federal Reserve controls. The funds rate rises in economic expansions, and goes down in recessions. You can see this pattern in the last two recessions. Since about 2012, though, when following history you might have expected the funds rate to rise again, it has stayed essentially at zero. Very recently it has started to rise, but very slowly, nothing like 2005.

The black line is reserves. These are accounts that banks have at the Fed. Crucially, these bank accounts now pay interest. Starting in 2008, reserves grew dramatically from about $20 billion to $2,500 billion. The three cliffs are the three quantitative easing' episodes. Here, the Fed bought bonds and mortgage backed securities, giving banks reserves in exchange.

Inflation initially followed the same pattern as in the last recession. It fell in the recession, and bounced back again in 2012.Inflation has been slowly decreasing since. 10 year government bonds have been quietly trending down, with a bit of an extra dip during the recession.

The next graph plots US unemployment and GDP growth.

You can see we had a deeper recession, but then unemployment recovered about as it always does, or if anything a little faster. You can see the big drop in GDP during the recession. Subsequent growth has been overall too low, in my view, but it has been very steady. If anything, both growth and inflation are steadier in the era of zero interest rates than they were when the Fed was actively moving interest rates around.

These central facts motivate my heresies: Inflation, long term interest rates, growth and unemployment seem to be behaving in utterly normal ways. Yet the monetary environment of near-zero short term rates and huge QE is nothing but normal. How do we make sense of these facts?

Heresy 1: Interest rates

• Conventional Wisdom: Years of near zero interest rates and massive quantitative easing imply loose monetary policy, "extraordinary accommodation,'' and "stimulus.''
• Heresy 1: Interest rates are roughly neutral. If anything, the Fed has been (unwittingly) holding rates up since 2008.

New Paper

A draft of a new paper is up on my webpage, "Michelson-Morley, Occam and Fisher: The Radical Implications of Stable Inflation at Near-Zero Interest Rates." This combines some talks I had given with the first title, and a much improved version of "does raising interest rates raise or lower inflation?"

Abstract:

The long period of quiet inflation at near-zero interest rates, with large quantitative easing, suggests that core monetary doctrines are wrong. It suggests that inflation can be stable and determinate under a nominal interest rate peg, and that arbitrary amounts of interest-paying reserves are not inflationary. Of the known alternatives, only the new-Keynesian model merged with the fiscal theory of the price level is consistent with this simple interpretation of the facts.

I explore two implications of this conclusion. First, what happens if central banks raise interest rates? Inflation stability suggests that higher nominal interest rates will result in higher long-run inflation. But can higher interest rates temporarily reduce inflation? Yes, but only by a novel mechanism that depends crucially on fiscal policy. Second, what are the implications for the stance of monetary policy and the urgency to “normalize?” Inflation stability implies that low-interest rate monetary policy is, perhaps unintentionally, benign, producing a stable Friedman-optimal quantity of money, that a large interest-paying balance sheet can be maintained indefinitely. However, with long run stability it might not be wise for central bankers to exploit a temporary negative inflation effect.

The fiscal anchoring required by this interpretation of the data responds to discount rates, however, and may not be as strong as it appears.

Yellen Questions

Fed chair Janet Yellen gave a remarkable speech at a Fed conference in Boston. I have long wanted to ask her, "what are the questions most on your mind that you would like academics to answer?" That's pretty much the speech.

Some commenters characterized this speech as searching for reasons to keep interest rates low forever. One can see the logic of this charge. However, the arguments are thoughtful and honest. If she's right, she's right.

The last, and I think most important and revealing point, first:

1. Inflation

"My fourth question goes to the heart of monetary policy: What determines inflation?"

"Inflation is characterized by an underlying trend that has been essentially constant since the mid-1990s; .... Theory and evidence suggest that this trend is strongly influenced by inflation expectations that, in turn, depend on monetary policy....The anchoring of inflation expectations...does not, however, prevent actual inflation from fluctuating from year to year in response to the temporary influence of movements in energy prices and other disturbances. In addition, inflation will tend to run above or below its underlying trend to the extent that resource utilization--which may serve as an indicator of firms' marginal costs--is persistently high or low."

I think this paragraph nicely and clearly summarizes the current Fed view of inflation. Inflation comes from expectations of inflation. Those expectations are "anchored" somehow, so small bursts of or disinflation will melt away. On top of that the Phillips cure -- the correlation between inflation and unemployment or output -- is causal, from output to inflation, and pushes inflation up or down, but again only temporarily.

What a remarkable view this is. There is no nominal anchor. Compare it, say, to Milton Friedman's MV=PY, the fiscal theory's view that inflation depends on the balance of government debt to taxes that soak up the debt, the gold standard, or John Taylor's rule. In the Yellen-Fed view, "expectations" are the only nominal anchor.

Interview, talk, and slides

I did an interview with Cloud Yip at Econreporter, Part I and Part II, on various things macro, money, and fiscal theory of the price level. It's part of an interesting series on macroeconomics. Being a transcript of an interview, it's not as clean as a written essay, but not as incoherent as I usually am when talking.

On the same topics, I will be giving a talk at the European Financial Association, on Friday, titled  "Michelson-Morley, Occam and Fisher: The radical implications of stable inflation at the zero bound," slides here. (Yes, it's an evolution of earlier talks, and hopefully it will be a paper in the fall.)

And, also on the same topic, you might find useful a set of slides for a 1.5 hour MBA class covering all of monetary economics from Friedman to Sargent-Wallace to Taylor to Woodford to FTPL.  That too should get written down at some point.

The talk incorporates something I just figured out last week, namely how Sims' "stepping on a rake" model produces a temporary decline in inflation after an interest rate rise. Details here. The key is simple fiscal theory of the price level, long-term debt, and a Treasury that stubbornly keeps real surpluses in place even when the Fed devalues long-term debt via inflation.

Here is really simple example.

Global Imbalances

I gave some comments on “Global Imbalances and Currency Wars at the ZLB,” by Ricardo J. Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas at the conference, “International Monetary Stability: Past, Present and Future”, Hoover Institution, May 5 2016. My comments are here, the paper is here 

The paper is a very clever and detailed model of "Global Imbalances," "Safe asset shortages" and the zero bound. A country's inability to "produce safe assets" spills, at the zero bound, across to output fluctuations around the world. I disagree with just about everything, and outline an alternative world view.

A quick overview:

Why are interest rates so low? Pierre-Olivier & Co.: countries can't  “produce safe stores of value”
This is entirely a financial friction. Real investment opportunities are unchanged. Economies can’t “produce” enough pieces of paper. Me: Productivity is low, so marginal product of capital is low.

Why is growth so low? Pierre-Olivier: The Zero Lower Bound is a "tipping point." Above the ZLB, things are fine. Below ZLB, the extra saving from above drives output gaps. It's all gaps, demand. Me: Productivity is low, interest rates are low, so output and output growth are low.

Data: I Don't see a big change in dynamics at and before the ZLB. If anything, things are more stable now that central banks are stuck at zero. Too slow, but stable.  Gaps and unemployment are down. It's not "demand" anymore.

Central Bank Governance and Oversight Reform

The Hoover Institution Press just published "Central Bank Governance and Oversight Reform," the collected volume of papers, comments, and discussion from last May's conference here by the same name. You can get the  book or e-book here at the Hoover press or here at amazon.com. The individual chapter pdfs are available here.  Press release here.

(My modest contributions are in the preface and a discussion of Paul Tucker's Chapter 1. I agree it would be nice to have a more rule-based approach to lender of last resort and bailout functions, but wouldn't lots of equity so you don't have to mop up so often be even better?)

This is part of an emerging series of monetary policy conferences at Hoover. Tomorrow we will have a conference on international monetary policy. Stay tuned...

Macro Musing Podcast

I did a podcast with David Beckworth, in his "macro musings" series, on the Fiscal Theory of the Price Level, blogging, and a few other things.



(you should see the link above, if not click here to return to the original).

You can also get the podcast at Sound Cloud, along with all the other ones he has done so far, or on itunes here.  For more information, see David's post on the podcast.

Neo-Fisherian caveats

Raise interest rates to raise inflation? Lower interest rates to lower inflation? It's not that simple.

A correspondent from an emerging market wrote enthusiastically. His country has somewhat too high inflation, currency depreciation and slightly negative real rates. A discussion is going on about raising rates to combat inflation. Do I think that lowering rates in this circumstance is instead the way to go about it?

As you can tell, posing the question this way makes me very uncomfortable! So, thinking out loud, why might one pause at jumping this far, this fast?

Fiscal policy.  Fiscal policy deeply underlies monetary policy. In my own "Fisherian" explorations, the fiscal theory of price level is a deep foundation. If the government is printing up money to pay its bills, the central bank can do what it wants with interest rates, inflation is coming anyway.

The Habit Habit

The Habit Habit. This is an essay expanding slightly on a talk I gave at the University of Melbourne's excellent "Finance Down Under" conference. The slides

(Note: This post uses mathjax for equations and has embedded graphs. Some places that pick up the post don't show these elements. If you can't see them or links come back to the original. Two shift-refreshes seem to cure Safari showing "math processing error".)

Habit past: I start with a quick review of the habit model. I highlight some successes as well as areas where the model needs improvement, that I think would be productive to address.

Habit present: I survey of many current parallel approaches including long run risks, idiosyncratic risks, heterogenous preferences, rare disasters, probability mistakes -- both behavioral and from ambiguity aversion -- and debt or institutional finance. I stress how all these approaches produce quite similar results and mechanisms. They all introduce a business-cycle state variable into the discount factor, so they all give rise to more risk aversion in bad times. The habit model, though less popular than some alternatives, is at least still a contender, and more parsimonious in many ways,

Habits future: I speculate with some simple models that time-varying risk premiums as captured by the habit model can produce a theory of risk-averse recessions, produced by varying risk aversion and precautionary saving, as an alternative to  Keynesian flow constraints or new Keynesian intertemporal substitution. People stopped consuming and investing in 2008 because they were scared to death, not because they wanted less consumption today in return for more consumption tomorrow.

Throughout, the essay focuses on challenges for future research, in many cases that seem like low hanging fruit. PhD students seeking advice on thesis topics: I'll tell you to read this. It also may be useful to colleagues as a teaching note on macro-asset pricing models. (Note, the parallel sections of my coursera class "Asset Pricing" cover some of the same material.)

I'll tempt you with one little exercise taken from late in the essay.

Open Letter on Economic Data

I joined a large number of economists signing an open letter supporting funding for economic data. The letter is here, twitter #SaveTheData, Financial Times story here, press release here.

Few public goods are as cheap or important as good economic data.  Much of our national policy discussion is based on government-collected data. Changes in inequality, wage growth or stagnation, employment and unemployment, growth, inflation... none of these are readily visible walking down the street.

Free, openly accessible, well-documented data, allowing comparisons over long periods of time, such as provided by the Bureau of Labor Statistics, is especially valuable.

Already, much of the data we get is based on decades-old measurement concepts. Perhaps someday internet big data will bring us alternatives. But that day is a long way away. Let's not fly blind in the meantime.

An essay. It's an overview of what a growth-oriented policy program might look like. Regulation, finance, health, energy and environment, taxes, debt social security and medicare, social programs, labor law, immigration, education, and more. There is a more permanent version here and pdf version here. This version shows on blogger, but if your reader mangles it, the version on my blog or one of the above will work better.

I wrote it the Focusing the presidential debates initiative. The freedom of authors in that initiative to disagree is clear.

Economic Growth

Growth is central

Sclerotic growth is the overriding economic issue of our time. From 1950 to 2000 the US economy grew at an average rate of 3.5% per year. Since 2000, it has grown at half that rate, 1.7%. From the bottom of the great recession in 2009, usually a time of super-fast catch-up growth, it has only grown at two percent per year.² Two percent, or less, is starting to look like the new normal.

Small percentages hide a large reality. The average American is more than three times better off than his or her counterpart in 1950. Real GDP per person has risen from $16,000 in 1952 to over $50,000 today, both measured in 2009 dollars. Many pundits seem to remember the 1950s fondly, but $16,000 per person is a lot less than $50,000!

If the US economy had grown at 2% rather than 3.5% since 1950, income per person by 2000 would have been $23,000 not $50,000. That’s a huge difference. Nowhere in economic policy are we even talking about events that will double, or halve, the average American’s living standards in the next generation.

Even these large numbers understate reality.

Open-Mouth Operations

(Note: This post uses mathjax and has embedded pictures. When posts are reposted elsewhere these often get mangled. If it's not displaying well, come to the original at johnhcochrane.blogspot.com)

Our central banks have done nothing but talk for several years now. Interest rates are stuck at zero, and even QE has stopped in its tracks. Yet, people still ascribe big powers to these statements. Ms. Yellen sneezes, someone thinks they hear "December" and markets move.

Buried deep in the paper I posted earlier this week is a potential model of "open mouth" operations, that might of interest to blog readers.

Use the standard "new-Keynesian" model \[ x_{t} = E_{t}x_{t+1}-\sigma(i_{t}-E_{t}\pi_{t+1}) \] \[ \pi_{t} = \beta E_{t}\pi_{t+1}+\kappa x_{t} \] Add a Taylor rule, and suppose the Fed follows an inflation-target shock with no interest rate change \[ i_t = i^\ast_t + \phi_\pi ( \pi_t - \pi^\ast_t). \] \[ i^\ast_t = 0 \] \[ \pi^\ast_t = \delta_0 \lambda_1^{-t} \] Equivalently express the Taylor rule with a ``Wicksellian'' shock, \[ i_t = \hat{i}_t + \phi_\pi \pi_t \] \[ \hat{i}_t = - \delta_0 \phi_\pi \lambda_1^{-t}. \] In both cases, \[ \lambda_{1} =\frac{\left( 1+\beta+\kappa\sigma\right) +\sqrt{\left( 1+\beta+\kappa\sigma\right) ^{2}-4\beta}}{2} \gt 1 \] Yes, this is a special case. The persistence of the shocks is just equal to one of the roots of the model. Here \(\delta_0\) is just a parameter describing how big the monetary policy shock is.

Now, solve the model by any standard method for the unique locally bounded solution. The answer is \[ \pi_{t} = \delta_0 \lambda_1^{-t}, \] \[ \kappa x_{t} = \delta_0 (1-\beta \lambda_1^{-1}) \lambda_1^{-t} \] \[ i_t = 0 \]

Here is the equilibrium path of inflation and interest rates (flat red line at zero).