Category Archives: Fed Watch

Some Thoughts on Liquidity

The quantity theory relates not so much to money as to the whole array of financial assets exogenously supplied by the government. If the government debt is doubled in the absence of a government-determined monetary base the price level doubles just as well as in the case of a doubling of the monetary base in the absence of government debt. — Jurg Niehans, 1982

Seemingly lost in the discussion of monetary policies various QEs is a meaningful resolution of our understanding of the monetary transmission mechanism.  Sure, New Keynesians argue that forward guidance about the time path of the short term nominal interest rate is the mechanism, Bernanke argues that long term interest rates are the mechanism, and skeptics of the effectiveness of QE argue that it is the interest rate on excess reserves that is the mechanism.  I actually think that these are not the correct way to think about monetary policy.  For example, there are an infinite number of paths for the money supply consistent with a zero lower bound on interest rates.  Even in the New Keynesian model, which purportedly recuses money from monetary policy, the rate of inflation is pinned down by the rate of money growth (see Ed Nelson’s paper on this).  It follows that it is the path of the money supply that is more important to the central bank’s intermediate- and long-term goals.  In addition, it must be the case that the time path of the interest rate outlined by the central bank is consistent with expectations about the future time path of interest rates.  The mechanism advocated by Bernanke is also flawed because the empirical evidence suggests that long term interest rates just don’t matter all that much for investment.

The fact that I see the monetary transmission mechanism differently is because you could consider me an Old Monetarist dressed in New Monetarist clothes with Market Monetarist policy leanings (see why labels are hard in macro).  Given my Old Monetarist sympathies it shouldn’t be surprising that I think the aforementioned mechanisms are not very important.  Old Monetarists long favored quantity targets rather than price targets (i.e. the money supply rather than the interest rate).  I remain convinced that the quantity of money is a much better indicators of the stance of monetary policy.  The reason is not based on conjecture, but actual empirical work that I have done.  For example, in my forthcoming paper in Macroeconomic Dynamics, I show that many of the supposed problems with using money as an indicator of the stance of monetary policy are the result of researchers using simple sum aggregates.  I show that if one uses the Divisia monetary aggregates, monetary variables turn out to be a good indicator of policy.  In addition, changes in real money balances are a good predictor of the output gap (interestingly enough, when you use real balances as an indicator variable, the real interest rate — the favored mechanism of New Keynesians — is statistically insignificant).

Where my New Monetarist sympathies arise is from the explicit nature in which New Monetarism discusses and analyzes the role of money, collateral, bonds, and other assets.  This literature asks important macroeconomic questions using rich microfoundations (as an aside, many of the critics of the microfoundations of modern macro are either not reading the correct literature or aren’t reading the literature at all).  Why do people hold money?  Why do people hold money when other assets that are useful in transactions have a higher yield?  Using frameworks that explicitly provide answers to these questions, New Monetarists then ask bigger questions. What is the cost associated with inflation? What is the optimal monetary policy? How do open market operations work?  The importance of the strong microfoundations is that one is able to answer these latter questions by being explicit about the microeconomic assumptions.  Thus, it is possible to make predictions about policy with an explicit understanding of the underlying mechanisms.

An additional insight of the New Monetarist literature is that the way in which we define “money” has changed substantially over time.  A number of assets such as bonds, mortgage-backed securities, and agency securities are effectively money because of the shadow banking system and the corresponding prevalence of repurchase agreements.  As a result, if one cares about quantitative targets, then one must expand the definition of money.  David Beckworth and I have been working on this issue in various projects.  In our paper on transaction assets shortages, we suggest that the definition of transaction assets needs to be expanded to include Treasuries and privately produced assets that serve as collateral in repurchase agreements.  In addition, we show that the haircuts of private assets significantly reduced the supply of transaction assets and that this decline in transaction assets explains a significant portion of the decline in both nominal and real GDP observed over the most recent recession.

The reason that I bring this up is because this framework allows us not only to suggest a mechanism through which transaction assets shortages emerge and to examine the role of these shortages in the context of the most recent recession, but also because the theoretical framework can provide some insight into how monetary policy works.  So briefly I’d like to explain how monetary policy would work in our model and then discuss how my view of this mechanism is beginning to evolve and what the implications are for policy.

A standard New Monetarist model employs the monetary search framework of Lagos and Wright (2005).  In this framework, economic agents interact in two different markets — a decentralized market and a centralized market.  The terms of trade negotiated in the decentralized market can illustrate the effect of monetary policy on the price level. (I am going to focus my analysis on nominal variables for the time being.  If you want to imagine these policy changes having real effects, just imagine that there is market segmentation between the decentralized market and centralized market such that there are real balance effects from changes in policy.)  In particular the equilibrium condition can be written quite generally as:

P = (M+B)/z(q)

where P is the price level, M is the money supply, B is the supply of bonds, and z is money demand as a function of consumption q.  I am abstracting from the existence of private assets, but the implications are similar to those of bonds.  There are a couple of important things to note here.  First, it is the interaction of the supply and demand for money that determines the price level.  Second, it is the total supply of transaction assets that determines the price level.  This is true regardless of how money is defined.  Third, note that as this equation is presented it is only the total supply of transaction assets that determine the price level and not the composition of those assets.  In other words, as presented above, an exchange of money for bonds does not change the price level.  Open market operations are irrelevant.  However, this point deserves further comment.  While I am not going to derive the conditions in a blog post, the equilibrium terms of trade in the decentralized market will only include the total stock of bonds in the event that all bonds are held for transaction purposes.  In other words, if someone is holding bonds, they are only doing so to finance a transaction.  In this case, money and bonds are perfect substitutes for liquidity.  This implication, however, implies that bonds cannot yield interest.  If bonds yield interest and are just as liquid as money, why would anyone hold money? New Monetarists have a variety of reasons why this might not be the case.  For example, it is possible that bonds are imperfectly recognizable (i.e. they could be counterfeit at a low cost). Alternatively, there might simply be legal restrictions that prevent bonds from being used in particular transactions or since bonds are book-entry items, they might not as easily circulate.  And there are many other explanations as well.  Any of these reasons will suffice for our purposes, so let’s assume that that is a fixed fraction v of bonds that can be used in transactions.  The equilibrium condition from the terms of trade can now be re-written:

P = (M + vB)/z(q)

It now remains true that the total stock of transaction assets (holding money demand constant) determines the price level.  It is now also true that open market operations are effective in influencing the price level.  To summarize, in order for money to circulate alongside interest-bearing government debt (or any other asset for that matter) that can be used in transactions, it must be the case that money yields more liquidity services than bonds.  The difference in the liquidity of the two assets, however, make them imperfect substitutes and imply that open market operations are effective.  It is similarly important to note that nothing has been said about the role of the interest rate.  Money and bonds are not necessarily perfect substitutes even when the nominal interest on bonds is close to zero. Thus, open market operations can be effective for the central bank even if the short term interest rate is arbitrarily close to zero.  In addition, this doesn’t require any assumption about expectations.

The ability of the central bank to hit its nominal target is an important point, but it is also important to examine the implications of alternative nominal targets.  Old Monetarists wanted to target the money supply.  While I’m not opposed to the central bank using money as an intermediate target, I think that there are much better policy targets.  Most central banks target the inflation rate.  Recently, some have advocated targeting the price level and, of course, advocacy for nominal income targeting has similarly been growing.  As I indicated above, my policy leanings are more in line with the Market Monetarist approach, which is to target nominal GDP (preferable the level rather than the growth rate).  The reason that I advocate nominal income targeting, however, differs from some of the traditional arguments.

We live in a world of imperfect information and imperfect markets. As a result, some people face borrowing constraints.  Often these borrowing constraints mean that individuals have to have collateral.  In addition, lending is often constrained by expected income over the course of the loan.  The fact that we have imperfect information, imperfect markets, and subjective preferences means that these debt contracts are often in nominal terms and that the relevant measure of income used in screening for loans is nominal income.  A monetary policy that targets nominal income can potentially play an important role in two ways.  First, a significant decline in nominal income can be potentially harmful in the aggregate.  While there are often claims that households have “too much debt” a collapse in nominal income can actually cause a significant increase and defaults and household deleveraging that reduces output in the short run.  Second, because banks have a dual role in intermediation and money creation, default and deleveraging can reduce the stock of transaction assets.  This is especially problematic in the event of a financial crisis in which the demand for such assets is rising.  Targeting nominal income would therefore potentially prevent widespread default and develeraging (holding other factors constant) as well as allow for the corresponding stability in the stock of privately-produced transaction assets.

Postscript:  Overall, this represents my view on money and monetary policy.  However, recently I have begun to think about the role and the effectiveness of monetary policy more deeply, particularly with regards to the recent recession.  In the example given above, it is assumed that the people using money and bonds for transactions are the same people.  In reality, this isn’t strictly the case.  Bonds are predominantly used in transactions by banks and other firms whereas money is used to some extent by firms, but its use is more prevalent among households.  David Beckworth and I have shown in some of our work together that significant recessions associated with declines in nominal income can be largely explained through monetary factors.  However, in our most recent work, it seems that this particular recession is unique.  Previous monetary explanations can largely be thought of as currency shortages in which households seek to turn deposits into currency and banks seek to build reserves.  The most recent recession seems to be better characterized as a collateral shortage, in particular with respect to privately produced assets.  If that is the case, this calls into question the use of traditional open market operations.  While I don’t doubt the usefulness of these traditional measures, the effects of such operations might be reduced in the present environment since OMOs effectively remove collateral from the system.  It would seem to me that the policy implications are potentially different.  Regardless, I think this is an important point and one worth thinking about.

Re-Focusing the Federal Reserve

The Shadow Open Market Committee is scheduled to meet next week in New York City. In anticipation of the meeting, I would like to draw attention to SOMC member Peter Ireland’s position paper on Federal Reserve policy that he recently posted on his website. The paper is excellent and I would like to quote a few passages at length.

Ireland’s paper begins by assessing the current policy “predicament” of the zero lower bound:

With their federal funds rate target up against its lower bound of zero, Federal Reserve officials have been led — some would say forced — to experiment with a variety of new approaches to policymaking. Chairman Bernanke (2012) mentioned several of these novel strategies in his comments at Jackson Hole this past August; the minutes from the September meeting of the Federal Open Market Committee (2012) mention them again. They go by the names “maturity extension,” “forward guidance,” and “large-scale asset purchases.”

To be honest, the whole situation seems really, really complicated. But does it have to be? Or might the apparent limitations of more conventional policy measures reflect, not so much the constraints imposed by the zero lower bound on nominal interest rates, but instead the inadequacies of common intellectual framework that places far too much emphasis on the behavior of interest rates to begin with? Might it be more helpful, in these circumstance, to refocus on other variables that have always played key roles, but have been neglected in popular discussions for far to long?

Ireland’s paper does a great job of answering these questions. For example, changes in Federal Reserve policy are often communicated through changes in the federal funds rate in normal times. However, as Ireland points out, the fact that changes in the federal funds rate communicate policy changes does not mean that the federal funds rate is the only tool of monetary policy or the only variable capable of communicating the stance of policy. In fact, interest rates might provide incorrect interpretations about the stance of monetary policy. Ireland explains:

Under ordinary circumstances, like those that prevailed in the halcyon days pre-2008, the Federal Reserve eased monetary policy by lowering its target for the federal funds rate and tightened monetary policy by raising its target for the federal funds rate. That is why most economists and financial market participants, even now, associate Federal Reserve policy most closely with changes in interest rates.

But it is important to recall that even during normal times, the Fed does not control market rates of interest like the federal funds rate by fiat. Instead, Federal Reserve officials must act to bring about their desired outcomes, in which the actual federal funds rate moves in line with changes in their target. These monetary policy actions take the form of open market purchases and sales of US Treasury securities that change the dollar volume of reserves supplied to the banking system. That is, first and foremost, what a modern central bank does, as the one and only agent in the economy with the authority to change the supply of bank reserves.

And so it is the dollar quantity of reserves supplied that the Fed really controls.


Thus, during normal times, interest rates and money offer two ways of looking at exactly the same thing. One can view a monetary policy easing as either a decline in short-term interest rates or as an expansionary open market operation that increases reserves and the money supply. And one can view a monetary policy tightening as either an increase in short-term interest rates or as a contractionary open market operation that decreases, or at least slows down the growth rates of, reserves and the money supply.

Under more extreme circumstance, however, these tight links between interest rates and money may break down. An economy experiencing chronically high inflation, for instance, will very likely have high nominal interest as well, as these become necessary to compensate investors for the loss in purchasing power they would otherwise experience while holding nominally-denominated bonds. But those high interest rates certainly don’t signal that monetary policy is too tight! To the contrary, rapid growth in bank reserves and the broader monetary aggregates will correctly reveal that the inflation itself is being driven by an inappropriately expansionary monetary policy. At the opposite extreme, Milton Friedman and Anna Schwartz (1963) observe that when deflationary expectations take hold, as they did in the United States during the Great Depression, nominal interest rates can be very low. But these low interest rates do not mean that monetary policy is too loose. Instead, declining growth rates or even levels of reserves and, especially, the broader monetary aggregates will correctly indicate that monetary policy is much too tight.

Those who keep these considerations in mind will then feel puzzled that new terms like “quantitative easing” are even needed to describe some of the Federal Reserve’s policy actions over the recent period when the funds rate has been stuck at zero. For those observers will be quick to remind us that in both normal and extreme times, all monetary policy easings are quantitative,” in that they are associated with — and, in fact, originate in — expansionary open market operations that increase reserves and the money supply.

One reason that focus on the interest rate has become paramount is because of the logic of the New Keynesian model. According to the standard NK model, the interest rate is the sole mechanism available for monetary policymakers. When the nominal interest comes up against the zero lower bound, this model suggests that the main tool of monetary policy is in communicating the future time path of the nominal interest rate. Ireland, drawing on some of his own recent work, argues that this story is incomplete:

Furthermore, while Federal Reserve statements providing forward guidance have mentioned only short-term interest rates, they can be read as having implications for open market operations and the supply of reserves in the future as well. In particular, although these details are typically relegated to the background in most New Keynesian analyses, my own recent work (Ireland 2012) extends the basic model to account for the activities of a private banking system that demands reserves, accepts deposits, and makes loans. This extended model highlights that even under New Keynesian assumptions, movements in the federal funds rate are associated with — some might even say caused by — open market operations that add or drain reserves from the banking system, give rise to subsequent movements in the broader monetary aggregates, and lead ultimately to changes in the price level and all other nominal variables. Viewed from this broader perspective, forward guidance regarding the future path of the funds rate also signals the Fed’s intentions for future open market operations and the future path for the money supply. Unlike
maturity extension, therefore, forward guidance appears as a coherent part of a genuine monetary policy strategy.

But while the logic behind forward guidance certainly seems strong, one might still worry that, when it comes to a policy initiative that relies exclusively on promises for the future, the devil is in the details. Even as it argues, most forcefully and persuasively, in support of stronger and sharper forward guidance, for instance, Michael Woodford’s (2012) own paper from the Jackson Hole symposium must concede that central banks around the world have had mixed success in using their words alone to influence expectations of future monetary policy actions. Reflecting on this, one might wonder, as well, if the New Keynesian view that the short-term interest rate is all that matters is excessively narrow. To cite just one alternative: a long traditional of monetarist thought, summarized by Allan Meltzer (1995), asserts that the channels through which monetary policy actions impact on the economy are far too varied and complex to summarize using a single variable like the short-term interest rate. Efforts to encapsulate these monetarist ideas into a modern macroeconomic model that might compete more directly with the New Keynesian framework has thus far yielded mixed results — here again, therefore, we have an important topic for future research! Yet, consistent with the monetarist view, Eric Leeper and Jennifer Roush (2003) and my own paper with Michael Belongia (Ireland and Belongia 2012c) show that even in the most recent data, strong statistical information about the stance of monetary policy appears in the monetary aggregates that is not in contained in interest rates alone. But, above all, one might ask: why try so hard to finesse things, by making ever more audacious promises about future open market operations, when it remains perfectly feasible, even with short-term interest rates stuck at zero, to conduct those same open market operations today, for all to see as well as to believe?

In addition to the passages quoted above, the paper also addresses large-scale asset purchases, maturity extension through operation twist, and how the Federal Reserve can re-focus itself on nominal variables. I realize that I have quoted this paper at length, but I would encourage blog readers to read the paper in its entirety.

QE3 and the Optimality of Nominal GDP Targeting

The Fed’s announcement last week that they intend to conduct open-ended open market purchases has been seen as a victory for advocates of nominal GDP level targeting, especially market monetarists. Scott Sumner has received praise from a number of publications for leading the charge (see here and here). Scott has long advocated nominal GDP level targeting and was criticizing tight monetary policy from the beginning of the recession. The shift toward open-ended open market purchases is therefore certainly a change in the direction of policy and one that is much more in line with a level target. Nonetheless, I don’t think that this is as much of a victory for level targeters as is being claimed. Thus, I would like to take this post to describe my differing view and also the recent discussion of optimal monetary policy.

The intuition of a level target runs as follows. The purpose of the level target is to anchor long run expectations. Thus, suppose that the central bank announces that their objective is to target 5% trend growth in nominal GDP consistent with the trend from essentially 1983 – 2008. This policy announcement suggests that the central bank would like to create nominal GDP growth in the short term that is higher than 5% (since we have been below that trend since 2008), but once nominal GDP returns to trend, growth will return to 5%. So long as the central bank has a good degree of credibility in committing to these actions, this should help to anchor expectations.

Thus, if nominal GDP is significantly below the long run trend, the policy suggested by this intuition is for the central bank to announce its intention to conduct open market purchases sufficient to achieve its target. In other words, the central bank announces a plan to conduct open-ended open market purchases (i.e. whatever it takes to hit its target).

The recent Fed statement represents a stark change from previous policies specifically as it pertains to its efforts at quantitative easing. Specifically, rather than announcing particular dollar values of assets that they intends to purchase, the Fed has changed their statement to reflect their desire to “increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.” That’s clearly open-ended. However, advocates of a nominal GDP level target and similar objectives should NOT see this a clear victory.

As the description of the intuition behind level targeting makes clear, the use of open-ended open market purchases should be coupled with an explicit objective for policy. There is no such objective in the Fed’s statement. The duration of policy is not defined in terms of objectives, but rather time:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low level ofs for the federal funds rate are likely to be warranted at least through mid-2015.

The federal funds rate is not the objective of monetary policy, it is the intermediate target. In addition, and perhaps more importantly, we need the Fed to define what they mean by “after the economic recovery strengthens.”

The closest the FOMC statement comes to an objective is the following statement:

The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases. [Emphasis added.]

This is hardly an explicit objective for policy. In addition, not only does the statement leave out an explicit objective, its one mention of a criteria for adjusting policy is a reference to the labor market. Does the Fed now believe that they can target employment? So some less skeptical of the Fed, this question might seem facetious. However, the Fed explicitly put in the statement that they will judge policy in accordance with fluctuations in the labor market. What is an acceptable amount of unemployment to the Fed? To what extent do they think that they can reduce unemployment?

Note here the important difference between the nominal GDP targeting example given above and the actual policy that is being implemented. The adoption of a nominal GDP level target would lead to higher nominal GDP growth in the short run which, given non-neutralities, would lead to a corresponding short run increase in real GDP thereby reducing unemployment. Thus, the objective of the policy would be to increase nominal GDP growth. The result of the policy (assuming that it is successful) would be to reduce unemployment. The actual policy of the Fed, however, seems to be to use unemployment as their objective. This is not the same thing.

This brings me to my final point. Throughout the discussion above, I was comparing the difference between actual Fed policy and a hypothetical nominal GDP target. This latter type of policy has become substantially more popular in the public conversation thanks to Scott Sumner. Its popularity in the economic literature has been somewhat lagging, but once had the support of Ben McCallum, Greg Mankiw, and others. More recently, Michael Woodford quasi-embraced nominal GDP targeting in his recent talk in Jackson Hole. However, Woodford also stated that he doesn’t see nominal GDP targeting as optimal policy. Rather, flexible inflation targeting in which the central bank targets inflation, but gives some weight to the output gap is optimal within the New Keynesian framework.

On this last point, Woodford is clearly correct — he wrote the book on optimal monetary policy in New Keynesian models, literally. Nominal GDP targeting can be consistent with optimal monetary policy in these models, but it depends on the particular characteristics of the model and the value of the parameters. Nonetheless, it is in the New Keynesian framework that nominal GDP targeting should find much of its support. Optimal monetary policy within these frameworks is defined as the policy that minimizes fluctuations in utility around the steady state. By performing a second-order Taylor series expansion of the utility function around the steady state and some mathematical manipulation, it can be shown that the optimal monetary policy is one that minimizes the weighted average of deviations of inflation from its target and output from its “natural” level. (This, by the way, is contrary to the assertions by Scott Sumner and George Selgin that the welfare criteria in these models is ad hoc.) Woodford is obviously correct that in this context that flexible inflation targeting is the optimal monetary policy. However, how should one use this criteria to practically guide monetary policy? I would argue that New Keynesians should advocate nominal GDP targeting because flexible inflation targeting places a large knowledge burden on central bankers as it requires that they know what natural (or potential) output is an any given point in time. In fact, we have very poor estimates of the output gap in real time — a point highlighted in work by Athanasios Orphanides.

Regardless of what policy is optimal, however, recent Fed policy is only a minor step in the direction of the desired policy of advocates of more expansionary monetary policy.

Bagehot on Monetary Policy

“To lend a great deal, and yet not give the public confidence that you will lend sufficiently and effectually, is the worst of all policies; but it is the policy now pursued.”

— Walter Bagehot, Lombard Street

Monetary Policy, Level Targeting, and Political Coalitions

In a recent post Nick Rowe writes: “Who else can we get on our side? What sort of coalition could be built to support politically a commitment by central banks to a higher level-path of NGDP?”

The longer the process goes on, the more that I think that the policy battle is lost for level targeters for the time being, but not necessarily the future. The problem that those who want a NGDP level target or even a price level target face is that there is uncertainty about the policy — some warranted and some not — coupled with the fact that there is no precedent for such policy actions. Think of Fed policy under Paul Volcker. Would his policy have been possible without both the monetarist counter-revolution and the experience of the Great Inflation in the 1970s? I think not (although this is more conjecture than hard fact).

The Keynesian consensus prior to the late 1970s was that there was a particular rate of inflation associated with a particular level of unemployment. Higher inflation was a necessary trade-off to ensure lower unemployment. And if unionization or monopolization became stronger the curve would shift up and we would have to tolerate higher inflation in the face of the same level of unemployment. Even Arthur Burns, which I detail in my paper on the Great Moderation but can be understood in more detail by reading his diary, came to the view that incomes policies were necessary to restrain inflation. Think of how remarkably backward this period was. The Fed chairman didn’t think he had any responsibility for inflation! But a large portion of the discipline was with him. The policy regime was only able to change because (1) incomes policies were clearly failing, and (2) the monetarist counter-revolution offered the prescription.

Milton Friedman was arguing that inflation was a monetary phenomenon as far back as 1963 — and perhaps sooner — based careful and thorough research on a century of U.S. history. However, the United States experienced a decade of high rates of inflation before the policy regime was able to not only move away from disastrous policies, but also employ the type of monetary policies (at least publicly) that monetarists had recommended — low, stable rates of money growth.

The problem that those who want level targeting face is that (1) the theoretical underpinnings are not as clear as say the monetarist prescription for inflation, (2) there is very little evidence — good or bad — with respect to level-targeting, and (3) a failure — or perceived failure — of the policy.

With regards to point (1), consider a simple example. There are two idea of a Phillips curve. The first is the New Keynesian view in which

\pi_t = E_t \pi_{t+1} + (1/\alpha) y_t

where \pi_t is inflation E_t \pi_{t+1} is expected inflation and y_t is the output gap.

A monetarist, or expectation-augmented Phillips curve, is

y_t = \alpha (\pi_t - E_t \pi_{t+1})

Couple these ideas with an IS equation. In the NK model, higher short-term expected inflation raises output and inflation. In the monetarist version, an increase in inflation expectations increases output through the IS equation and reduces output through the expectations-augmented Phillips curve. Output could actually fall in the second scenario if \alpha is greater than the interest elasticity in the IS equation. Even if it doesn’t, an increase in short-run expectations of inflation would predominantly cause an increase in inflation rather than output. This brings me to my next point.

With regards to point (2), Scott Sumner and David Beckworth like to point to the devaluation of gold. Even as someone would would support an NGDP level target, I am skeptical that this provides evidence that the current Federal Reserve could necessarily achieve this goal. In this case of the devaluation of gold, the balance of payments will see to it that there is a necessary adjustment in the price level. That is Commodity Money 101. In the present context, there is no automatic mechanism and the Fed is hindered by the fact that they have already doubled the size of their balance sheet. Suppose that the Fed announced that they would buy as many assets as necessary to achieve an NGDP level target. This would mean that the Fed would have to commit to unlimited asset purchases until they reach their goal, which might bring them under political pressure and test their resolve. In addition, if inflation began to rise rapidly (rising from say 2% to 6%), this might also put the Fed under political pressure and test their resolve.

In addition, the Fed has a great deal invested in the credibility that they have achieved from stabilizing inflation around 2% for the past 20 years. Jim Bullard catches a lot of flak by those who favor additional easing. However, of all the Fed presidents who are skeptical of additional easing, he is the most clear on why he opposes such action. Bullard clearly sees the Fed’s main objective as that of inflation targeting — not price level targeting. In all his speeches he has praised quantitative easing for allowing the Fed to maintain a rate of inflation consistent with their 2% goal. He doesn’t oppose easing because he is a dunce (as some of these critics would have you believe), he opposes easing because he thinks that the Fed has achieved its objective. Do not discount this view within the Federal Reserve itself.

Thus, if level targeters want to achieve some level of acceptance and shape monetary policy, they need to provide evidence for its success (and within contemporary monetary regimes) and a more solid theoretical underpinning for why level targeting is preferable. Change takes time. Level targeters are almost certainly not going to be successful in the present. There are few political coalitions that rally around uncertain policy prescriptions. However, if they can take the steps I just described, they might be able to have an effect on policy in the future.

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.”

Monetizing the Debt?

Amar Bhidé writes in the WSJ:

Governments may pay lip service, but in times of stress they face a strong temptation to force central bankers to cover budget deficits through the printing press. Often the bankers don’t wait to be told (witness the Federal Reserve’s recent rounds of quantitative easing).

Suppose that we are uncertain as to the force that is driving the Federal Reserve’s behavior. What probability should we assign to this chain of events? I suspect it is very low. Is there evidence to support this hypothesis other than simple correlations? There are a lot of reasons to criticize the Fed, I’m not sure this is one.

Evans on Nominal GDP Targeting

Charles Evans has come out in favor of nominal GDP level targeting.

Bullard’s “Death of a Theory”

St. Louis Fed President James Bullard has released a paper entitled, “Death of a Theory”. Overall, I think that the paper is a useful overview of the issues surrounding the use of monetary and fiscal policy in the context of the New Keynesian model and in recent experience.

The basic argument made by Bullard is as follows:

1. The conventional wisdom prior to the crisis was the fiscal policy was largely ineffective as a stabilization tool and therefore stabilization should be left to monetary policy.

2. The New Keynesian model suggests that monetary policy is ineffective at the zero lower bound.

3. The effectiveness of fiscal policy is dependent on the role of monetary policy. Given the ineffectiveness of monetary policy at the zero lower bound, there is a potential role for fiscal stabilization policy.

4. There are three problems with this viewpoint:

i.) The political process in the United States is ill-equipped to make timely and effective decisions on fiscal policy.

ii.) Monetary policy over the last few years has shown that monetary policy is not ineffective at the zero lower bound.

iii.) “The actual fiscal stabilization policy experiment did not involve funding increased government spending with lump-sum taxes, as contemplated in the theory, but instead involved heavy borrowing on international markets. In models, the borrowing would be interpreted as promised future distortionary taxes, but it is exactly the shifting of distortionary taxes into the future beyond the period of the binding zero lower bound and financial market turbulence that can undo most or all of the benefits that might otherwise come from the fiscal stabilization program.”

Some useful quotes can be found after the jump.

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Expectations and Policy

I wrote in my previous post that expectations matter. This is something that cannot go understated and is often disregarded when talking about the effects of policy. For example, David Wessel writes:

In our time, says Mr. Ahamed, “I don’t think Keynesians or even monetarists ever realized that the numbers to make their policies work are so gigantic. Everyone had sticker shock.” The Obama stimulus seemed huge and the Fed’s quantitative easing—printing money to buy bonds—looked massive, but in retrospect perhaps they weren’t sufficiently large.

I continue to hear that the problem with fiscal and monetary stimulus in recent years has been one of magnitude. Monetary and fiscal policy have failed because they simply were not large enough. This is the argument prominent in the quote above. When I hear this, however, I cannot help but to think that we have failed to learn the lesson of the Lucas Critique.

I am fond of using the equation of exchange to communicate points about monetary disequilibrium. The modified equation of exchange that David Beckworth and I often use is:

mBV = PY

where m is the money multiplier, B is the monetary base, V is velocity, and PY is nominal income. This is essentially a reduced form equation that captures the determination of nominal income. Personally, I find this as a useful guide for explaining what happens when there are deviations of desired from actual balances. It is, of course, possible to explain this within other models (both simple and complex), but this seems to be a useful device for organizing one’s thinking on the topic and especially for communicating the concept through blogging.

With that being said, I do not under any circumstances see the equation of exchange as representing a menu of policy options. Why? Because expectations matter.

The (simplified version of the) lesson of the Lucas Critique for econometric policy evaluation is that we cannot simply plug in the size of a policy to some “structural” model of the economy and expect it to tells us the size of the effect of the policy. The reason is because when policy changes, this can effect expectations and therefore the marginal effect of a policy. In other words expectations matter.

One way to think about this is in terms of my original critique of the fiscal stimulus package. In that post I outlined the importance of Ricardian equivalence — the idea that government debt is not net wealth. (While there are many reasons to doubt that Ricardian equivalence holds, it does seem to be a close approximation to reality based upon empirical evidence.) To understand this concept, consider a simple scenario. Suppose that the only way to save is by purchasing government-issued bonds. Now consider the effects of a temporary tax rebate financed through deficit spending. In this scenario, the government issues a bond in the amount of the rebate and promises to pay the buyer back with interest. The government then uses the proceeds of the sale to give a tax rebate. If the individual receiving the tax rebate (correctly) perceives that they will have to pay back the amount of the tax rebate plus interest in the future, they would simply use the proceeds of the tax rebate to purchase the bond. In other words, there is no effect. Government bonds are not net wealth.

The lesson from this example is that expectations matter. The tax rebate does not alter the individual’s tax liability. Thus, the individual uses the rebate to increase saving in order to pay future taxes. Similarly, a permanent increase in government spending increases an individual’s future tax liability thereby producing a similar result. The increase in government spending is thereby offset by a corresponding reduction in consumption. Thus, when one looks at the effects of such a policy in its aftermath, one could either conclude that the policy was ineffectual or that the policy simply wasn’t big enough.

This brings me back to the discussion of monetary policy. The equation of exchange, as articulated above, is an organizing relationship that helps to understand the concept of monetary disequilibrium. However, the same logic applies to the role of expectations for monetary policy. For example, suppose that we observe a sharp reduction in the money multiplier (an increase in the demand for base money) and a corresponding reduction in nominal income. If monetary equilibrium is the policy goal (which I am assuming it is), then monetary policy needs to adjust to promote stability in nominal income by increasing the monetary base. I DO NOT, HOWEVER, pretend to know the magnitude by which the monetary base should increase nor is there any model in existence that can tell us with any degree of accuracy by how much the base should increase. In addition, it is undoubtedly true that the answer is not that which exactly offsets the decline in m that was observed. Why? Because expectations matter.

Just like with the example of fiscal policy, we can draw important lessons for monetary policy. The question is whether monetary base injections are perceived as net wealth. If the Federal Reserve were, for example, to announce that they were going to temporarily increase the monetary base because of the decline in m, this has an impact on the expectations of individuals in the market. If any introduction of new base money is expected to be pulled back out of circulation after a short period of time, money (like bonds in the previous example) will not be seen as net wealth and will simply be held. In the aftermath of such a policy, one could either conclude that the magnitude of open market operations wasn’t large enough or that the policy was ineffectual.

This does not, however, mean that monetary policy is impotent. It means that expectations are important. In fact, monetary policy can be successful if it partners the monetary injection with an explicit account of expectations. If monetary policy was conducted by announcing that the central bank would increase the monetary base until it met its target for a particular variable — say the price level or nominal income — this would help to shape expectations and help policy to be successful as the increase in the monetary base would have distributional effects.

The Federal Reserve’s focus on the size of its asset purchases represents a grave mistake. There is no model that tells us the precise size increase in the central bank balance sheet will get us to a desired level of nominal income. Those who continue to claim that the magnitude of monetary and fiscal policy haven’t been large enough fail to recognize this point. This is the lesson of the Lucas Critique. Expectations matter.