Monthly Archives: June 2012

A Further Reply to David Andolfatto

David Andolfatto has written a response to my recent post on nominal GDP targeting. My initial response was largely a broader explanation of why a nominal GDP target might be optimal given a spectrum of posts that David and others have written on nominal GDP targeting. The post got so long-winded that I failed to respond in detail to David’s OLG model. Thus, in David’s recent post he summarizes the main conclusions from his OLG model and poses the following questions:

What is missing in my model? Are frictions other than nominal debt required? I have a hard time seeing how the presence of sticky nominal wages or prices are going to alter my conclusion here. But who knows, maybe someone can tell me?

I would like to take this time to answer these questions. I will do so first by discussing my view regarding nominal GDP targeting and why this element is missing from David’s model. Second, I will discuss minor issues with David’s model.


The main question to answer is what is missing from David’s model and why it might be important. I will answer this in a roundabout fashion. As I have previously noted, my own personal advocacy of nominal GDP targeting is due to the connection between liquidity and transaction assets. To illustrate why (I believe) this is important, consider a non-technical summary of a project that I have been working on — hopefully I will be able to post on the technical features in the very near future.

Suppose that individuals have three assets that they can use in transactions: fiat currency, government bonds, and claims to some private asset. One interpretation of this latter asset is a repurchase agreement. One question is why individuals would choose to hold all three assets. The argument that I make is that these assets have different liquidity properties, and I assume that these properties are exogenous (more on that assumption later). Government bonds differ from fiat money because they can only be used in a fraction of transactions. The same is true of the liquid assets, but in the case of liquid assets the degree of liquidity is stochastic.

Within the framework individuals are matched pairwise. Once they are matched, the liquidity shock is realized. As such, if the liquidity shock is negative, then the buyer in the pairwise meeting becomes liquidity constrained and must reduce their purchases relative to their original intentions. The result is a reduction in nominal spending and a corresponding reduction in real economic output (there is no mechanism to adjust the price level to raise the real value of the assets).

Within this type of framework, individuals gain utility from consumption. As such, the reduction in liquidity is welfare reducing. This is a characteristic to most all models in which liquidity is important. For example, Li, Rocheteau, and Weill have a paper in which the liquidity of assets is endogenous. The conclusion is the same. A reduction in aggregate liquidity results in a welfare-reducing decline in consumption.

Given the welfare properties of the model, an optimal monetary policy can come in one of two forms. The first, which I will call a first best policy is one that maximizes welfare in the steady-state. In models where money is important, this is almost always a money growth rule. In particular, optimal monetary policy is often the Friedman rule where money growth is equal to minus the rate of time preference. The second type of optimal monetary policy is one that minimizes deviations of consumption from its steady-state. In that type of framework a nominal GDP target can be shown to be consistent with that goal. (It is important to note that nominal GDP is not special in these models. Rather nominal GDP is a signal of a liquidity shock.)

What is missing from David’s model is the importance of the interaction between liquidity and transaction assets. In other words, liquid assets (i.e. money, broadly defined) are a medium of exchange. Reductions in the supply of liquid assets therefore lead to welfare-reducing declines in spending. This is absent from David’s model because money does not serve the role as a medium of exchange. Money is only a store of value. There are no liquidity shocks. A news shock could potentially take on the role of a liquidity shock as it seems to exhibit similar properties. However, the OLG framework gives different results in this context than a monetary search model would because in a search model individuals are meeting pairwise to trade.

Minor Comments on David’s Model

David makes the claim in his post that nominal GDP is suboptimal because of the responsiveness to bad news shocks when the news shock turns out to be fundamentally true. In particular, he claims in his follow-up post:

So, if the news is bad, the government should increase the supply of money to accommodate the increase in demand for money (via the asset substitution induced by bad news over the expected return to investment). But if the news truly is fundamentally bad, the future real GDP should decline, and along with it, the NGDP should decline as well (it’s decline is stemmed in part by maintaining the price level target). Stabilizing the NGDP in this context would mean increasing the price-level so high as to create a transfer of wealth from creditors to debtors (instead of debtors to creditors) — something these agents would have wanted to prevent ex ante if nominal debt could have been indexed to the price-level.

I have added the boldface because this is the sentence that I want to focus on. I don’t believe that the model is unambiguous with regards to this matter.

Suppose that there is a bad news shock. Proposition (1) in David’s model implies that q_t = M_t / p_t declines. Holding the money supply constant, this implies that the price level must rise. David implies above that both real economic activity should decline and that nominal GDP should also decline. It is not clear what happens to nominal GDP. Suppose that the shock is truly fundamental (i.e. productivity, z_t, declines). In this case, David is correct that real GDP should decline. However, since the price level rises, the extent to which this effects nominal GDP is therefore dependent on how much the price level changes relative real GDP. If the change is directly proportional, then nominal GDP remains unchanged and the monetary authority would do nothing. If I have understood his model correctly, and we assume that the marginal product of capital is constant, then this is indeed the case.

[Note: As David points out in an email, a bad news shock would increase q rather than reduce q. Thus, this criticism is incorrect as nominal GDP does unequivocally decline if the news is fundamentally bad.]

Is Monetary Policy Only About Expectations?

I have argued in the past that an explicit target for monetary policy is necessary for the central bank to accomplish its goals. For example, suppose that the central bank wants to increase the inflation rate by two percentage points. We know that they can do this by increasing money growth. But how much would they have to increase money growth in able to achieve their target? Well, one answer is that they can get out (I wish I could say dust off) one of their Old Keynesian forecasting models and recursively figure out the answer. In a lot of ways, it seems like this is what the Fed is doing. Whenever they announce asset purchases, they announce the nominal quantity of assets that they are going to purchase. An alternative strategy is to announce a target and to an intention to purchase as many assets as necessary to achieve the goal.

Now, of course, this doesn’t guarantee anything. If the Fed is targeting something that it cannot control or if policy doesn’t work in the way that the Fed believes, we might not get intended results.

But is announcing a strategy sufficient? According to what some in the blogosphere have referred to as the Chuck Norris strategy the answer is yes. And believe it or not, this is not the view that originated in the blogosphere. According to Benjamin Friedman and Kenneth Kuttner, for example:

Central banks no longer set the short-term interest rates that they use for monetary policy purposes by manipulating the supply of banking system reserves, as in conventional economics textbooks; today this process involves little or no variation in the supply of central bank liabilities. In effect, the announcement effect has displaced the liquidity effect as the fulcrum of monetary policy implementation.

The problem with the Chuck Norris strategy is that of commitment and credibility. The strong version of this Chuck Norris hypothesis is that an announcement is sufficient. The reference to Chuck Norris is due to (a version of) the following analogy. Suppose that Chuck Norris walks into a bar. He announces that he is going to beat everyone up if they don’t leave. Since he is Chuck Norris and everybody else is not, nobody bothers to fight him. They all leave. He doesn’t have to take action. Ironically, there is a flaw in this analogy that actually lends support to those of us who are skeptical about the Chuck Norris effect. Anybody who has ever been to a bar knows that not everybody will leave just because Chuck Norris makes the announcement. There will be somebody who challenges Chuck Norris — even if that challenge is futile. In other words, Chuck Norris cannot get by on credibility alone. He must follow up that strategy with commitment, i.e. he is going to have to beat a few people up.

Why do I bring this up? I bring this up because of the case of Switzerland. In order to prevent appreciation due to a flight to quality, the Swiss National Bank announced last year that they were pegging the Swiss franc at 1.20 per Euro. This is important because it seems to satisfy all the conditions for a Chuck Norris type policy. For example, a central bank has the resources and the means to buy and sell its own currency in foreign exchange markets to affect the exchange rate. Thus, it is targeting something that it can directly control and it is announcing its intended target. After announcing its intended target, this represents an explicit test as to whether or not the Chuck Norris effect is operational. Alas, Evan Soltas finds evidence that it is not:

I had implied in both posts that the floor was so credible that it did not require an active defense. Indeed, for several months after its establishment, the SNB did not have to conduct any trades. That is no longer true; I realize now that the correct conclusion to make was not that the Swiss currency floor would not require any currency purchases. Rather, the floor’s credibility eliminates the need for foreign currency purchases to the extent that those seeking to buy Swiss francs are speculating on exchange rates. To the extent, however, that Swiss franc buyers are seeking to park money in Swiss assets or deposit accounts, the SNB will have to purchase foreign currency to maintain the floor.

In other words, credibility is not enough. Central banks also need commitment. This is consistent with the view I described in the first paragraph. It is not consistent with the strong version of the Chuck Norris effect.

Economics and Politics, Part 2

My views don’t fit neatly into the left-right political spectrum boxes. This is both a gift and a curse. The gift is that I am not blinded by party biases. (I have my own biases, thank you!) The curse is that I observe others, on both sides of the left-right divide, suggest that the other side is littered with extremists. The latest example comes from Mark Thoma, who has a new column at the Fiscal Times that begins:

The upcoming presidential election gives voters a choice between two very different philosophies of government. For Democrats, an activist government is necessary to keep markets functioning, and to smooth economic fluctuations. Without government oversight, markets would be captured by monopoly power, consumers would be at the mercy of unscrupulous producers, there would be distortions from adverse selection, information asymmetries, moral hazard problems, and so on. In addition, if government does not take action when a recession hits, the downturn will be much worse and much longer than necessary.

For Republicans, however, activism is exactly the wrong approach to take. They believe that the key to making markets work and smoothing economic fluctuations is for the government to get out of the way and let the private sector work its magic. In general, markets react faster, incorporate more information, and regulate commercial behavior better than humans will ever be able to do.

There are several problems with these opening paragraphs, some economic and some factual. First, let’s deal with the economics. Thoma suggests that Democrats think that government intervention is necessary to ensure the smooth functioning of markets. I’m not in the business of understanding what Democrats think, so I will take him at his word as this seems a reasonable characterization. So why do Democrats think that government needs to intervene? Because markets suffer from adverse selection, moral hazard, information asymmetries, etc.

What is curious is that Thoma then suggests that in an economic downturn we need government intervention because of these information frictions. Really? I don’t see this as the argument for fiscal stimulus. The arguments that I see are that the government can fill the output gap, so to speak, or that the multiplier from fiscal stimulus is greater than one, or that deficit spending is self-financing (the irony of that last statement being uttered critics of supply-side economics makes my head spin). Regardless, it is not clear why fiscal stimulus follows from information frictions. (Perhaps there is a coordination failure argument here?)

But let’s get back to the information frictions. Do the existence of such informational frictions necessarily imply that we need government intervention? The answer is no. Asymmetric information is everywhere. It’s hard to think of markets where asymmetric information doesn’t play a role. Of course, to leave it at that would be unfair. In some cases the effects of asymmetric information is more important than in others. But let’s consider one of the most obvious cases of imperfect information. Suppose that individuals cannot perfectly and credibly commit to future actions. Two individuals meet to trade. One is a buyer. One is a seller. The buyer wants to give the seller an IOU in exchange for goods — i.e. he wants credit. In the absence of perfect commitment and without access to the trading history of the buyer, no seller will extend credit. This is why we need money. Governments, you might point out, can step in and provide fiat currency. However, the historical emergence of commodity money would seem to suggest that there are non-government solutions. Now, of course, fiat and commodity money have their trade-offs, but it is not obvious that fiat money is preferable — although it has the potential to be.

In addition, government policies can actually create information frictions and moral hazard. Thus, the existence of information frictions is not prima facia evidence that government intervention is necessary. Thoma admits this, but then goes back into attack mode:

Government isn’t perfect, but neither is the private sector (see the bulldozed waste from the housing bubble), and on net it’s helpful for the government to take action when relatively severe market failures are present. Traditionally, those who take a more hands off approach do not deny that all markets fail to some degree – no market is perfectly competitive. But for the most part they do not see these failures as having large consequences, and even when they do, government intervention is rarely the solution. In many, if not most cases, that just makes things worse.

In the modern Republican Party, these views have been taken to the extreme so that government is rarely, if ever, supported.

I don’t know, it seems to me that the Republican Party quite likes government intervention. It was George W. Bush who bailed out the automakers, ushered in TARP, gave (the always ineffective) tax rebates in early 2008, expanded Medicare, conducted nation building exercises in Iraq and Afganistan, etc.

Thoma continues:

Who will build bridges, provide sewage systems, national defense, roads, airports, water systems, and so on if not the government?

And here we get to the true source of debate. I agree. Let’s build bridges and roads and rebuild some infrastructure. We can finance these at historically low interest rates. But who is proposing doing that? The Democrats? Not likely. Supposedly President Obama wanted more infrastructure type projects in the stimulus package, but it ended up mostly being a transfer payment to the states.

Thoma concludes:

There was a time when extremists were not the main voice of the Republican Party, a time when we had some chance of dealing with important issues.

This is the meme on the left, but I don’t buy it. Mitt Romney is the presidential nominee — a moderate Republican from Massachusetts. Marco Rubio, his likely running mate, was called a “centrist” by the New Yorker (The New Yorker!).

I’m not trying to defend Republicans. However, the theme that I see on the left is that President Obama is an innocent victim of obstructionist Republicans. As an outside observer, I see obstructionism on both sides. The respective parties have drawn their lines in the sand and neither will budge. It’s also not clear to me that if either or both sides did budge, we would get anything akin to optimal policy. (Compromise is sometimes good — see Bill Clinton and the Republicans in his second term. However, it is sometimes bad — see No Child Left Behind.)

Finally, I think that it is misleading to suggest that only fiscal stimulus could have and can solve our economic problems. The view of the discipline prior to the recession was that monetary policy was effective and fiscal policy was irrelevant. I happen to agree with Thoma that infrastructure spending would be a good idea at historically low interest rates. However, my support comes from the view that the marginal benefit of these projects would outweigh the marginal cost. If the economy gets a boost from these projects, all the better. However, to suggest that the slow recovery of the economy is because of the Republican Party is opposed to government intervention is far from obvious and overly partisan — especially from someone who is usually more thoughtful on economic issues.

Nominal GDP Targeting: A Response to David Andolfatto

At his blog, David Andolfatto has raised several questions for those who advocate nominal GDP targeting. His most recent post is an attempt to look at nominal GDP targeting in an overlapping generations model. I would like to use this post to address David’s model as well as nominal GDP more generally.

I should start by saying that the thing that I enjoy about reading his blog posts is that they are both insightful and inquisitive. There is a subset of economists (unfortunately only a subset of economists) who want to use the tools of economics to address certain questions and see where those tools get them. One of the biggest misunderstandings about the mathematics of economic models is that the math is designed to feign sophistication or give the illusion of science. (Certainly there are some who like to work with (and perhaps show off) highly complex models, but this is not the point of the models and nor do I believe that this path leads to much enlightenment.) In reality, math is used simply to keep our logic consistent. The models allow us to make some assumptions and generate logically consistent implications based on our framework and assumptions. David’s scholarly work and blog posts are a great example of how to properly use these tools. Curiosity is what makes David interesting to read. He likes to make certain assumptions, write down a model, and see what conclusions the model provides.

In reading David’s posts, he seems to have two main questions for advocates of nominal GDP targeting: (1) Why should we care about nominal GDP? (2) Why should we target the level of nominal GDP?

I would like to answer these questions in a roundabout fashion. First, I will argue that I believe there are two main reasons for advocating nominal GDP targeting. Second, I will argue that to the extent that level targeting is desirable, it is because of rigidities (which David and I both have our doubts about).

I would like to start by discussing what a central bank can control and cannot control. I will argue that what the central bank can control one of two things: the price level or nominal income. I will then discuss why the central bank might choose one over the other.

In virtually any model that one writes down in which money plays a meaningful role, the price level and nominal income are determined by the money supply. Thus, if the money supply is defined as the monetary base or if the central bank can use the monetary base to control a broader definition of money, it is possible for the monetary authority to target the price level (inflation, if you prefer) or nominal income.

Given this basic premise, I would like to make two arguments as to why one might prefer a nominal GDP target to the price level. The first argument relies on the idea that economists and policymakers have imperfect knowledge of short-run fluctuations in the economy. I simultaneously like and dislike this argument. The second argument is that nominal GDP is not particularly important in and of itself, but that fluctuations in nominal GDP are indicative of a broader issue that monetary policy can potentially resolve. Finally, the argument frequently made by Scott Sumner and others is that a nominal GDP target is important because of sticky or rigid wages. Others, such as David Beckworth emphasize the role of debt and contracts. Thus, to the extent that one would want to target the level of prices or nominal income, this conclusion seems to come from nominal or real rigidities.

A simple way to characterize the difference between price level and nominal GDP targeting concerns is to appeal to money non-neutrality. This argument is largely one that relies on the fact that we have an imperfect understanding of short-run economic fluctuations. This argument is somewhat of a paradox. In some ways, this is perhaps the weakest argument for targeting nominal GDP. However, in some ways, it is perhaps one of the best because it does not assume that we know more than we actually do. The argument is as follows.

If money is neutral, it would seem that there is no reason to be concerned with nominal GDP. The price level is all that matters. (Even this is not necessarily true, however. One might want the price level to reflect changes in productivity. In which case, a nominal GDP target is likely to be more effective than a price level target. For a discussion of this issue more broadly, see George Selgin’s Less Than Zero.)

If money isn’t neutral, then monetary factors will have an effect on both the price level and real economic output. If this is case, targeting the price level or inflation requires some corresponding theory about how the effects of the monetary shocks are divided between real factors and the price level. Macroeconomists do not have a widely accepted theory of such a division. The New Keynesian view has two equations, the IS equation and the NK Phillips curve. I don’t find this view satisfying as I don’t view the Phillips curve as structural (see this, for as amusing example why). It certainly doesn’t help that this “structural relationship” is derived by the use of an assumption akin to the can opener.

A nominal income target, by contrast, does not require are particular theory or assumption about the effects of monetary shocks are divided between real output and the price level in the short run. This argument was first made by Bennett McCallum in the 1980s and the premise of imperfect knowledge remains. The strength of this argument is its simplicity. If monetary factors have real effects and if there is uncertainty about how these effects are transmitted, then nominal GDP targeting is preferable to targeting the price level or inflation.

The weakness of this argument is that it is unlikely to convince those who are skeptical of nominal GDP targeting — especially those armed with a particular model. (For example, frequent criticism of nominal GDP targeting by those of the New Keynesian variety is that IF monetary factors effect only with a lag, THEN nominal GDP targeting can be destabilizing. But what reason do we have to believe this is true? Apparently, just models — non-microfounded models to boot — that assume this is true.)

The second argument is one that I know David is familiar with as it is something that I have been working on. According to this view, there is nothing special about nominal GDP. However, the behavior of nominal GDP is indicative of something else — fluctuations in the liquidity of transaction assets. Suppose that there are a wide variety of transaction assets (e.g. currency, checking accounts, repurchase agreements, T-bills). We can generate an endogenous mechanism through which the relative liquidity of these assets fluctuates or, for simplicity, we can assume that the liquidity of each asset is exogenous. If we take this latter assumption, adverse liquidity shocks leave the holders of these assets liquidity constrained. This constraint reduces both real and nominal spending.

Why do we care about these liquidity shocks in reference to nominal GDP? We care for two reasons. First, it is possible that the central bank can relax this liquidity constraint by increasing the supply of perfectly liquid base money. Second, the liquidity shock is empirically observable through fluctuations in nominal GDP. It is possible to write down a model in which monetary policy and liquidity are the primary sources of fluctuations in nominal GDP. As such, a decline in nominal GDP signals that there is a shortage of transaction assets and monetary policy can be used to relax the liquidity constraint. By targeting nominal GDP, this type of policy has the potential to mitigate some of the effects of liquidity shocks.

Finally, it is important to consider the implications of targeting the level rather than the growth rate of nominal GDP or the price level. Like David, I am skeptical of sticky price/wage stories, but nonetheless this is one argument that is advocated by some supporters of nominal GDP targeting and there are explicit theoretical models.

Suppose that we start with the basic neoclassical growth model with a constant rate of productivity growth augmented with labor market search. Firms use capital and labor to produce economic output. In addition, firms use a small subset of their labor force to recruit new workers. Wages are rigid. In particular, it is assumed that when firms and workers are matched, the wage is given as

w_t = z_t w_{t - 1}

where w_t is the real wage, and z_t is labor productivity. This is the basic setup of the model in Robert Shimer’s new paper.

Now suppose that there is a transitory 1% reduction in the capital stock relative to the steady state. It follows from the model that investment, consumption, real GDP, and employment decline (see Shimer’s paper for details). After the initial shock investment, consumption, and real GDP begin to recover. However, employment does not. The reason that employment doesn’t recover is because of the assumption about the behavior of the real wage. Firms are willing to offer the higher real wage consistent with productivity growth despite the fact that the real wage is “too high”, but they reallocate their workers away from recruiting and towards production. As a result, less unemployed workers are matched with firms. A jobless recovery results.

This model has no analysis of monetary policy. However, the implications are consistent with those made by Scott Sumner and others. It is therefore possible — although, again, the model does not discuss monetary policy — that by targeting the price level, monetary policy could return real wages to the previous trend level. An interesting exercise would be to add money into this labor search model a la Berentsen, Menzio, and Wright and determine what the optimal monetary policy might look like and whether a price level would be consistent with optimal policy.

One can make similar arguments for nominal income level targeting with regards to debt contracts. David has discussed the role of nominal contracts extensively with David Beckworth on his blog and so I will simply refer readers to that conversation here.

I suspect this post will do little to change David’s mind. In fact, I don’t know how useful this post actually is in that these topics probably require more thought than blog posts allow or at least are able to convey. However, it is my hope that it will add something useful to the conversation — contrary to what has happened in the comment section of his recent blog post.

Money and Elections

I have noticed that there is concern, notably from my friends who are left-of-center, that the Citizens United decision will ruin the political process. Jeffrey Toobin has an excellent article in the New Yorker about the actual process through which the decision came to be. Toobin laments the decision as conservative judicial activism on the Supreme Court. Perhaps. However, I’ve noticed that among those who fit neatly into either the categories “left” and “right” an activist court ruling seems to be defined by whether or not they agree with the decision. Others, such as John Cassidy have suggested that the situation in Wisconsin highlights what is some sort of new class war in the U.S. that pits billionaires against union workers. Although he doesn’t explicitly mention it, it seems that the Citizens United case looms large. Finally, the New York Times ran a series of posts asking whether or not the upcoming presidential election can be won without Wall Street. The role of Super PACs and therefore the Citizens United decision again play an important role.

Despite the outcry about Citizens United, it isn’t necessarily clear that we should be concerned. However, as someone who isn’t (a) a political scientist or (b) familiar with the literature on the matter, I cannot say for certain whether the court decision will have any consequence in terms of election results. Nonetheless, there are some unanswered questions (at least that I haven’t seen answered) that would seemingly give some indication of whether or not one should be concerned about the effect of the Citizens United decision. I would like to discuss each of these questions in turn and hopefully those with knowledge on these issues can enlighten me either in the comments or through email.

1. Does causation run from campaign money to victories or does it run from probable victory to campaign money? This seems to be one of most important questions to answer? Essentially, it is important to know whether increased funding for a particular campaign actually increases the probability that the candidate wins the election. An alternative hypothesis is that campaign contributions come from two places: (1) diehard ideological supporters and (2) donors who are “on the bandwagon,” giving to the candidate they think might be the winner. If this latter hypothesis is true, then campaign spending isn’t causal and therefore we shouldn’t be particularly concerned with how much money is raised.

2. Even if the money raised by the campaign isn’t causal, this doesn’t mean there isn’t cause for concern. It might be the case that the candidates feel an obligation to “repay” their large donors. What evidence is there to support this idea? Again, this is a causation question. Suppose pro-choice groups give money to Obama and pro-life groups give money to Romney. One candidate wins the election. The one that wins signs into law something that the corresponding group supports. Is this because they gave the candidate money? Or, did they give the candidate money because they knew that the candidate would pass favorable legislation?

3. If campaign contributions have a causal effect on the probability of victory or create a system of “repayment”, this still doesn’t tell us about the marginal effect of the Citizens United decision. In other words, how much additional campaign funding is (will be) acquired as a result of this decision. The answer is not as simple as one might think. We have campaign finance laws, but these laws are broken. We know how many are charged and convicted with crimes related to campaign finance, but we don’t know how much of this type of behavior is not discovered. In other words, how much of the additional funding that candidates receive would have been given illegally anyway?

Also, note that if contributions have no causal effect, this question is irrelevant.

4. My left-of-center friends seem to think that the Citizens United decision will direct money from corporations and wealthy individuals toward Republican candidates. Perhaps I am blinded by the fact that I do not fit neatly into one particular ideological category, but is there any evidence that this is correct? Surely there are wealthy individuals who support Democrats. Hollywood, for example, seems disproportionately in favor of the Democratic Party.

There are many more questions that I could ask, but this seems like a good starting point. Hopefully those who know more than I do can offer some enlightenment.

Forward Guidance from the Fed

It would seem to me that the increase of transparency at the Federal Reserve has made Fed-watching harder rather than easier. In no particular order, here are recent statements from various Fed officials.

Charles Plosser, WSJ, May 29:

The U.S. Federal Reserve is well equipped to deal with any fallout from Europe’s escalating debt crisis, a top official said.

“There’s absolutely no reason for people in the United States to get all in a dither,” Federal Reserve Bank of Philadelphia President Charles Plosser said in an interview with The Wall Street Journal.


“I think we have the tools at our disposal if they become necessary,” he said.

Despite the uncertainty emanating from Europe, Mr. Plosser expects U.S. gross domestic product to expand by 2.5% to 3% this year and next, and the unemployment rate to drift gradually lower. Against that backdrop, central-bank interest rates would need to rise, he said.

“As long as that’s continuing, then I don’t see the case for [an] ever-increasing degree of accommodation,” he said.

Narayana Kocherlakota, June 7:

“Inflation was distinctly higher in 2011 than in 2010,” and even core inflation went up, the central banker said. “I see these changes as a signal that our country’s current labor market performance is closer to ‘maximum employment,’ given the tools available to the FOMC, Kocherlakota said.

“As I’ve argued in the past, appropriate monetary policy should be responsive to such signals,” the official said, in comments that appeared to suggest a limited appetite, if any, for more monetary-policy stimulus, despite a historically high unemployment rate.

Charles Evans, June 5:

Charles Evans, president of the Chicago Federal Reserve Bank, speaking just days after a government report showed paltry U.S. jobs growth in May, warned that the economy could suffer long-term consequences if the Fed does not act now.

“With huge resource gaps, slow growth and low inflation, the economic circumstances warrant extremely strong accommodation,” Evans said in remarks prepared for delivery to the Money Marketeers of New York University.

James Bullard, May 17:

“Generally speaking, the U.S. economy has done better than expected in the first part of 2012,” Bullard said today in Louisville, Kentucky. “My own forecast has rates going up a little sooner” than other central bankers, or “late 2013.”

Janet Yellen, June 6:

“I believe that a highly accommodative (Fed) policy will be needed for quite some time to help the economy mend,” Janet Yellen, vice chair of the Federal Reserve board of governors, said this evening in remarks to the Boston Economic Club. “I anticipate that significant headwinds will continue to restrain the pace of the recovery.”

Ben Bernanke, June 7:

Federal Reserve Chairman Ben Bernanke cited significant risks to the U.S. economic recovery but stopped short of signaling Fed action to combat them, during testimony on Capitol Hill Thursday.

When asked whether the Fed is planning to take more measures to boost growth, Mr. Bernanke said he and his colleagues “are still working” on that question ahead of their June 19-20 meeting. The main question they need to answer, he said, is whether the economy will be strong enough to make material progress on bringing down unemployment.

“We have a number of different options” for action if they decide to move, he told Congress’s Joint Economic Committee. “At this point I really can’t say anything is off the table.”

Economics and Politics

I repeatedly hear claims that solving the current global economic problems merely requires political will. If it wasn’t for the Republican obstructionists or the pigheaded Germans, the problems could (would?) be solved. What I find frustrating about this narrative is its simultaneous simplicity and certainty about the necessary policy prescriptions. Isn’t it possible that so-called Republican obstructionism is the result of a belief on the part of Republicans that the policies they are supposedly obstructing would be ineffective or deleterious? Isn’t it possible that the German leadership is opposed to many suggested policy prescriptions because they believe that many of these proposals simply kick the can down the road and leave them holding the bag? (Isn’t it possible to squeeze countless metaphors into one sentence?!)

The point that I am making is not that the Republicans or the Germans are correct, but rather that it is not certain that they are incorrect. And in the case of Germany, it would seem that they have little to gain and much to lose by helping troubled Eurozone members. Many forget that from the German perspective the ECB’s monetary policy is close to optimal. As such, Germany is likely to be the most insulated from a European economic slowdown — at least according to New Keynesian-style logic. If it makes economic sense for the German leadership to take the position that it does, how can we fault them? Perhaps one could argue that they should care about their fellow Europeans, but that is philosophical and something that is beyond the scope of economics.

In the U.S., what types of policies have been prevented by political obstructionism that would have helped? What evidence is there that these policies would have helped? Is there a competing narrative that can explain the same outcome?

Frequent readers know that I think that monetary policy in the U.S. has been suboptimal. There are “political will” narratives here as well. Those who think that monetary policy has been tight think that the Fed lacks the political will to do what is correct right now. Many of those who think that monetary policy is going to create higher rates of inflation in the near future think that the Fed will lack the political will to bring down inflation when it starts to rise.

A much simpler story is that the Fed is an inflation targeter, with a not-so-implicit-anymore target of 2%. Under this narrative, the past rate of inflation is irrelevant. What matters is preventing the inflation rate from being consistently below target. When I look at the data and when I read speeches by folks like Jim Bullard, this seems entirely more plausible than the political will narrative.

In addition, if the political will narrative is correct, then aren’t these arguments really arguments against the Federal Reserve itself rather than merely policy? In other words, if there is an optimal policy that the Federal Reserve refuses to pursue because of political risks such as diminished credibility, then why have a monetary authority in the first place?

The political will narrative is easy to adopt and probably has some psychological appeal as well. If the POTUS isn’t signing into law policies that you believe would help or if the central bank isn’t following the policy that you believe would be optimal, it is perhaps easiest to think that they simply lack the political will to get things done. Whether policy has been optimal also depends on the objective. If the Fed’s objective is 2% inflation, then they have done a remarkable job. If the Fed’s objective is a trend path for the price level or nominal GDP, then they have done a substantially less than remarkable job. Perhaps it is political will that explains the policy path that has been chosen, but it is possible that there are alternative and entirely valid explanations of such a path.