Category Archives: Macroeconomic Theory

Some Myths About Interest on Reserves

There are two myths that I see repeated about interest on reserves that I would like to address:

1. “Of course the banking system is holding more reserves. They have no choice. The quantity of reserves is set by the Federal Reserve.”

That last sentence is correct. However, the relevant question is why banks are holding these reserves as excess reserves rather than as required reserves.

The typical way that we teach students about open market operations is as follows. Suppose that each component of the bank’s balance sheet is consistent with profit-maximization given a binding reserve requirement. The central bank conducts open market operations by buying bonds from the bank and crediting the reserve account of the bank. The bank now finds itself holding excess reserves. If the central bank is not paying interest on reserves, this is costly for the bank since it is now holding more reserves than it would prefer. As a result, the bank would lend out these excess reserves. What follows is the process of multiple deposit creation. When this process concludes, the quantity of reserves in the system will not have changed, but since the reserve requirement is binding, no bank will be holding excess reserves. Each bank is holding the required amount of reserves.

To say that banks are holding excess reserves because they have no other choice is therefore incorrect. While it is true that banks must hold the quantity of reserves determined by the Federal Reserve, their decision-making will determine whether they hold these reserves as excess reserves or required reserves. If banks are holding excess reserves, this implies that there is no operative mechanism of deposit creation. We might want to ask ourselves why this is the case.

On this point, Dutkowsky and VanHoose have written an excellent paper that looks at the profit-maximizing behavior of banks. Their model provides for the possibility of three different equilibria: (1) an interior solution in which banks hold excess reserves and participated in the wholesale loan market, (2) an equilibrium in which banks participate in the wholesale loan (fed funds) market, but do not hold excess reserves, and (3) an equilibrium in which banks hold excess reserves, but do not participate in the wholesale loan (fed funds) market.

What they show is the equilibria that we end up in depends critically on the relationship between the interest rate on excess reserves and the fed funds rate. In particular, they show that the interior solution equilibrium is operable under very narrow restrictions on the relationship between rates. In other words, we tend to either be in an equilibrium in which there are no excess reserves OR in an equilibrium in which there is no wholesale lending. While it is slightly more complicated than this, a general rule-of-thumb from my reading of the paper is that if the interest rate on reserves is higher than the fed funds rate, then this results in an equilibrium in which banks hold excess reserves and do not participate in the wholesale loan market.

The interest rate on reserves has been higher than the fed funds rate since 2009. Dutkowsky and VanHoose show a corresponding precipitous decline in interbank lending that has taken place in the period since.

Why is this important?

Typically banks are not willing to hold excess reserves because doing so is costly. In fact, if the required reserves constraint is binding, then banks will never want to hold excess reserves because they do not even want to hold the required amount. However, if banks are willing to hold excess reserves, then this process of multiple deposit creation will not be operable — or at least not to the extent that it would be traditionally.

This leads me to the second myth about interest on reserves.

2. “Interest on reserves gives the central bank flexibility to provide liquidity without sacrificing its ability to conduct monetary policy.”

The idea behind this statement is that when the central bank pays interest on reserves, banks are willing to hold more reserves which helps to better facilitate payments and provide liquidity to the banking system. At the same time, or so the argument goes, the interest rate on reserves becomes the relevant policy interest rate. As a result, by paying interest on reserves, the central bank can increase the amount of reserves in the system, streamline the payment process, provide liquidity, and still conduct monetary policy as it normally does.

This argument, however, presumes that the monetary policy works solely through the short term interest rate. However, monetarists like Friedman and Schwartz and Brunner and Meltzer, argued that monetary policy worked through open market operations by adjusting the relative supply of assets. This change in the composition of assets required changes in relative prices since assets are not all perfect substitutes. The process of relative price adjustment continues until everyone is satisfied with their new portfolio. For example, consider Friedman and Schwartz’s description of the monetary transmission mechanism in their paper “Money and Business Cycles”:

Let us now suppose that an unexpected rise to a new level occurs in the rate of change in the money stock, and it remains there indefinitely…To be definite, therefore, let us suppose it comes from an increased rate of open market purchases by a central bank.

Although the initial sellers of the securities purchased by the central bank were willing sellers, this does not mean that they want to hold the proceeds in money indefinitely. The bank offered them a good price, so they sold; they added to their money balances as a temporary step in rearranging their portfolios. If the seller was a commercial bank, it now has larger reserves than it has regarded before as sufficient and will seek to expand its investments and its loans at a greater rate than before. If the seller was not a commercial bank, he is not likely even temporarily to want to hold the proceeds in currency but will deposit them in a commercial bank, thereby, in our fractional reserve system, adding to the bank’s reserves relative to its deposits. In either case, therefore, in our system, commercial banks become more liquid. In the second case, in addition, the nonbank sellers has a higher ratio of money in his portfolio that he has had hitherto.

Both the nonbank seller and commercial banks will therefore seek to readjust their portfolios, the only difference being that the commercial banks will in the process create more money, thereby transmitting the increase in high-powered money to the total money stock…

They go on to explain that this portfolio reallocation will result in changes in relative prices and ultimately economic activity until equilibrium is restored.

Similarly, Ben Bernanke has described the monetary transmission mechanism as follows:

I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve’s purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public.

Specifically, the Fed’s strategy relies on the presumption that different financial assets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.

The logic of the portfolio balance channel implies that the degree of accommodation delivered by the Federal Reserve’s securities purchase program is determined primarily by the quantity and mix of securities the central bank holds or is anticipated to hold at a point in time (the “stock view”), rather than by the current pace of new purchases (the “flow view”). In support of the stock view, the cessation of the Federal Reserve’s purchases of agency securities at the end of the first quarter of this year seems to have had only negligible effects on longer-term rates and spreads.

Implicit in these discussion is that there isn’t one particular asset price that matters for transmitted monetary policy. Rather, what matters are the relative quantities of the assets and the relative price adjustment necessary to get to an equilibrium in which everyone is satisfied with their portfolio.

If Bernanke and the monetarists are correct, then the change in the Federal Reserve’s operating procedures should give one pause about the ability of monetary policy to continue unaffected in a world of interest on reserves. Dutkowsky and VanHoose’s model suggests that open market operations should largely be irrelevant because we are currently in an equilibrium in which the interest rate on reserves is higher than the fed funds rate. As a result, banks are likely to hold excess reserves rather than engage in portfolio reallocation. Thus, one must rely on “the” short term nominal interest rate, in this case the interest rate on reserves, to influence economic activity. Whether or not this mechanism is sufficient depends on the sensitivity of macroeconomic variables to the short term interest rate. The empirical evidence suggests that the responsiveness of things like investment to interest rates is actually quite weak. As a result, there is some reason for concern about the ability of monetary policy to work as it normally does.

Are Helicopter Drops a Fiscal Operation?

This is meant to be a quick note on what I think is a common misconception about helicopter drops. I am not advocating that the Federal Reserve or any other central bank undertake the actions I am going to describe nor do I care about whether it is legal for the Federal Reserve or any other central bank. All I am concerned with is helicopter drops on a theoretical level. With that being said, let me get to what I believe is a misconception.

First, some context. Typically, when the Federal Reserve wants to increase the money supply, they buy assets on the open market in exchange for bank reserves. These are called open market operations. One potential problem is that the Federal Reserve is typically purchasing short-term government debt. When short term nominal interest rates are near the zero lower bound, many believe that open market operations are impotent since the central bank is exchanging one asset that does not bear interest for another asset that does not bear interest. Banks are indifferent between the two. The exchange has no meaningful effect on economic activity.

Given this problem, some have advocated a “helicopter drop” of money. Typically, they don’t mean an actual helicopter flies overhead dropping currency from the sky. What they are referring to is something like the following. Suppose that the U.S. Treasury sends a check to everyone in the United States for $100 and issues bonds to pay for it. The Federal Reserve then buys all of these bonds and holds them to maturity. This is effectively a money-financed tax rebate. Thus, it resembles a helicopter drop because everyone gets $100, which was paid for by an expansion of the money supply. However, many people are quick to point out that this is actually a fiscal operation. The U.S. government is giving everyone a check and the Federal Reserve is simply monetizing the debt.

But are helicopter drops really a fiscal operation? Certainly if we think about helicopter drops as I have described them above, it is correct to note that such action requires monetary-fiscal cooperation. However, let’s consider an alternative scenario.

The Federal Reserve has a balance sheet just like any other bank. The Fed classifies things on their balance sheet into 3 categories:

1. Assets. Assets include loans to banks, securities held, foreign currency, gold certificates, SDRs, etc.
2. Liabilities. Liabilities include currency in circulation, bank reserves, repurchase agreements, etc.
3. Capital.

The balance sheet constraint is given as

Assets = Liabilities + Capital

Let’s consider how things change on the balance sheet. Suppose that the Fed took large losses on the Maiden Lane securities purchased during the financial crisis. What would happen? Well, the value of the Fed’s assets would decline. However, the liabilities owed by the Fed would not change. Thus, for the balance sheet to remain in balance, the value of the Fed’s capital would have to decline.

So imagine the following scenario. We all wake up one morning to discover that actual helicopters are lifting off from the rooftops of regional Federal Reserve banks. The helicopters fly through each region dropping currency from the sky. People walk out of their homes and businesses and see money raining down upon them. They quickly scoop up the money and shovel it into their pockets. It is a literal helicopter drop of money!

But how can this be? How could the central bank do such a thing?

If the central bank were to do such a thing, think about what would happen to its balance sheet. Currency in circulation increases thereby increasing Fed liabilities. However, asset values are still the same. So capital declines. (The latest Fed balance sheet suggests that the Fed has $10 billion in surplus capital. This would decline dollar-for-dollar with the increase in the supply of currency.)

What this implies is that a central bank could (in theory) conduct a helicopter drop by effectively reducing its net worth. In the future, the Federal Reserve could restore its capital by reinvesting its earnings into new assets. Thus, the helicopter drop is a form of direct transfer to the public that is paid for by the Fed’s future earnings.

[Now, some of you might be saying, “Ah ha! If the Fed is retaining earnings these are earnings that would have otherwise gone to the Treasury and so it is still a fiscal operation.” I would argue that (a) this is semantics, and (b) there is no reason to believe this is true. The Fed, for example, could simply have used those earnings to furnish new offices at the Board and all of the regional banks — in that case it would be a transfer of wealth from the staff to the general public.]

Money and Banking

You might be able to teach an entire course on the microeconomics of money and banking based on the following thought experiment.

Imagine the following scenario. I want to start a business, but I need to borrow $10,000 to get started. You offer to provide me with that $10,000. However, since you won’t get to consume using that $10,000 and you won’t get to invest that $10,000 in anything else you require that I pay you some interest. I give you a piece of paper that promises to pay you back, with interest, at some future date in time. Intrinsically, that piece of paper that I have given you is worthless. It is just a piece of paper. However, if that piece of paper represents a legally binding agreement, then we call that piece of paper a bond. You are willing to accept that piece of paper from me because you anticipate that I am going to do something productive with your money. In the event that I don’t, you will be entitled to the assets of my business. So, the value of the bond is the expected value of the bond over the duration of the loan plus the value of the option to seize my assets in the event that I cannot/do not pay you back. Now, of course, there is some chance that between now and when I have promised to pay you back you will want to spend money. As a result, a market emerges that allows you to sell this piece of paper to other people.

Now imagine the following alternative scenario. Suppose that you want to save, but you don’t want to deal with trying to figure out how to invest that savings. Fortunately, we have a mutual friend who likes to do this sort of thing. So you give your $10,000 to our friend and he promises to give you your money back plus some interest payment. I also make a visit to our mutual friend, but I ask him to borrow $10,000. He agrees to lend me $10,000, but I have to pay him back with interest (slightly higher than what he is offering you). Since our mutual friend knows that you might need cash for unexpected expenditures in the future, he promises to give you the right to show up and demand your $10,000 (or some fraction thereof) at any moment you want. Thus, to our mutual friend, the value of the loan is the expected value of the loan over the duration agreed upon plus the expected value of the option to seize my assets in the event that I cannot/do not pay him back. The value of the contract for you is the expected value of the loan that you have given our mutual friend plus the value of the option to get your $10,000 back whenever you want plus the value of the option to seize the assets of our mutual friend in the event that the value of his assets decline below what he owes you.

What is the difference between these two scenarios?

Some would say that in the latter scenario the problem is that our mutual friend is offering to give you dollars that he himself does not have to give. Thus, he is “creating dollars out of thin air.” In fact, if he doesn’t have actual dollars, he might give you a piece of paper that promises to give you those dollars in the future. If you are able to trade these pieces of paper in exchange for goods and services, it would appear as though our mutual friend has really created money out of thin air. But has he really? Or is he merely allowing you to transfer some fraction of what he owes you to another individual?

Why might people be willing to accept these pieces of paper printed by our mutual friend and use them in transactions?

Replace “$10,000” with “7.5 ounces of gold.” Do your answers to these questions change?

Reasoning from Interest Rates

A quick note…

We can think of long-term yields as consisting of two components, the average expected future short-term rate and the term premium. However, it is important to note that the average expected future short-term rate itself is a function of the rate of time preference, expectations of future growth, and expectations of inflation. Also, the term premium is a function of duration risk, a liquidity premium, and a safety premium.

So suppose that you see long-term yields change, what can you learn about the stance of monetary policy?

What Are Real Business Cycles?

The real business cycle model is often described as the core of modern business cycle research. What this means is that other business cycle models have the RBC model as a special case (i.e. strip away all of the frictions from your model and its an RBC model). The idea that the RBC model is the core of modern business cycle research is somewhat tautological since the RBC model is just a neoclassical model without any frictions. Thus, if we start with a model with frictions and take those frictions away, we have a frictionless model.

The purpose of the original RBC models was not necessarily to argue that these models represented an accurate portrayal of the business cycle, but rather to see how much of the business cycle could be explained without the appeal to frictions. The basic idea is that there could be shocks to tastes and/or technology and that these changes could cause fluctuations in economic activity. Furthermore, since the RBC model was a frictionless model, any such fluctuations would be efficient. This conclusion was important. We typically think of recessions as being inefficient and costly. If this is true, countercyclical policy could be welfare-increasing. However, if the world can be adequately explained by the RBC model, then economic fluctuations represent efficient responses to unexpected changes in tastes and technology. There is no role for countercyclical policy.

There were two critical responses to RBC models. The first criticism was that the model was too simple. The crux of this argument is that if one estimated changes in total factor productivity (TFP; technology in the RBC model) using something like the Solow residual and plugged this into the model, one might be misled into thinking the model had greater predictive power than it did in reality. The basic idea is that the Solow residual is, as the name implies, a residual. Thus, this measure of TFP only captured fluctuations in output that were not explained by changes in labor and capital. Since there are a lot of things besides technology that might effect output other than labor and capital, this might not be a good measure of TFP and might result in attributing a greater percentage of fluctuations to TFP than was true of the actual data generating process.

The second critical response was largely to ridicule and make fun of the model. For example, Franco Modigliani once quipped that RBC-type models were akin to assuming that business cycles were mass outbreaks of laziness. Others would criticize the theory by stating that recessions must be periods of time when society collectively forgets how to use technology. And recently, Paul Romer has suggested that technology shocks be relabeled as phlogiston shocks.

These latter criticisms are certainly witty and no doubt the source of laughter in seminar rooms. Unfortunately, these latter criticisms obscure the more important criticisms. More importantly, however, they represent a misunderstanding of what the RBC model is about. As a result, I would like to provide an interpretation of the RBC model and then discuss more substantive criticisms.

The idea behind the real business cycle model is that fluctuations in aggregate productivity are the cause of economic fluctuations. If all firms are identical, then any decline in aggregate productivity must be a decline in the productivity of all the individual firms. But why would firms become less productive? To me, this seems to be the wrong way to interpret the model. My preferred interpretation is as follows. Suppose that you have a bunch of different firms producing different goods and these firms have different levels of productivity. In this case, an aggregate productivity shock is simply the reallocation from high productivity firms to low productivity firms or vice versa. As long as we think of all markets as being competitive, then the RBC model is just a reduced form version of what I’ve just described. In other words, the RBC model essentially suggests that fluctuations in the economy are driven by the reallocation of inputs between firms with different levels of productivity, but since markets are efficient we don’t need to get into the weeds of this reallocation in the model and can simply focus our attention on a representative firm and aggregate productivity.

I think that my interpretation is important for a couple of reasons. First, it suggests that while “forgetting how to use technology” might get chuckles in the seminar room, it is not particularly useful for thinking about productivity shocks. Second, and more importantly, this interpretation allows for further analysis. For example, how often do we see such reallocation between high productivity firms and low productivity firms? How well do such reallocations line up with business cycles in the data? What are the sources of reallocation? For example, if the reallocation is due to changes in demographics and/or preferences, then these reallocations could be interpreted as efficient responses to structural changes in the economy and be seen as efficient. However, if these reallocations are caused by changes in relative prices due to, say, monetary policy, then the welfare and policy implications are much different.

Thus, to me, rather than denigrate RBC theory, what we should do is try to disaggregate productivity, determine what causes reallocation, and try to assess whether this is an efficient reallocation or should really be considered misallocation. The good news is that economists are already doing this (here and here, for example). Unfortunately, you hear more sneering and name-calling in popular discussions than you do about this interesting and important work.

Finally, I should note that I think one of the reasons that the real business cycle model has been such a point of controversy is that it implies that recessions are efficient responses to fluctuations in productivity and counter-cyclical policy is unnecessary. This notion violates the prior beliefs of a great number of economists. As a result, I think that many of these economists are therefore willing to dismiss RBC out of hand. Nonetheless, while I myself am not inclined to think that recessions are simply efficient responses to taste and technology changes, I do think that this starting point is useful as a thought exercise. Using an RBC model as a starting point to thinking about recessions forces one to think about the potential sources of inefficiencies, how to test the magnitude of such effects, and the appropriate policy response. The better we are able to disaggregate fluctuations in productivity, the more we should be able to learn about fluctuations in aggregate productivity and the more we might be able to learn about the driving forces of recessions.

The Fed, Populism, and Related Topics

Jon Hilsenrath has quite the article in The Wall Street Journal, the title of which is “Years of Fed Missteps Fueled Disillusion With the Economy and Washington”. The article criticizes Fed policy, suggests these policy failures are at least partially responsible for the rise in populism in the United States, and presents a rather incoherent view of monetary policy. As one should be able to tell, the article is wide-ranging, so I want to do something different than I do in a typical blog post. I am going to go through the article point-by-point and deconstruct the narrative.

Let’s start with the lede:

Once-revered central bank failed to foresee the crisis and has struggled in its aftermath, fostering the rise of populism and distrust of institutions

There is a lot tied up in this lede. First, has the Federal Reserve ever been a revered institution? According to Hilsenrath’s own survey evidence, in 2003 only 53% of the population rated the Fed as “Good” or “Excellent”. In the midst of the Great Moderation, I would hardly called this revered.

Second, I’ve really grown tired of this argument that economists or policymakers or the Fed “failed to foresee the crisis.” The implicit assumption is that if the crisis had been foreseen, steps could have been taken to prevent it or make it less severe. But, if we accept this assumption, then we would only observe crises when they weren’t foreseen. Yet crises that were prevented would never show up in the data.

Third, to attribute the rise in populism to Federal Reserve policy presumes that the populism is tied to economic factors that the Fed can influence. Sure, if the Fed could have used policy to make real GDP higher today than it had been in the past that might have eased economic concerns. But productivity slowdowns and labor market disruptions caused by trade shocks are not things that the Federal Reserve can correct. To the extent to which these factors are what is driving populism, the Fed only has limited ability to ease such concerns.

But that’s enough about the lede…

So the basis of the article is that Fed policy has been a failure. This policy failure undermined the standing of the institution, created a wave of populism, and caused the Fed to re-think its policies. I’d like to discuss each of these points individually using passages from the article.

Let’s begin by discussing the declining public opinion of the Fed. Hilsenrath shows in his article that the public’s assessment of the Federal Reserve has declined significantly since 2003. He also shows that people have a great deal less confidence in Janet Yellen than Alan Greenspan? What does this tell us? Perhaps the public had an over-inflated view of the Fed to begin with. It certainly reasonable to think that the public had an over-inflated view of Alan Greenspan. It seems to me that there is a simple negative correlation between what they think of the Fed and a moving average of real GDP growth. It is unclear whether there are implications beyond this simple correlation.

Regarding the rise in populism, everyone has their grand theory of Donald Trump and (to a lesser extent) Bernie Sanders. Here’s Hilsenrath:

For anyone seeking to explain one of the most unpredictable political seasons in modern history, with the rise of Donald Trump and Bernie Sanders, a prime suspect is public dismay in institutions guiding the economy and government. The Fed in particular is a case study in how the conventional wisdom of the late 1990s on a wide range of economic issues, including trade, technology and central banking, has since slowly unraveled.

Do Trump and Sanders supporters have lower opinions of the Fed than the population as whole? Who knows? We are not told in the article. Also, has the conventional wisdom been upended? Whose conventional wisdom? Economists? The public?

So the populism and the reduced standing of the Fed appear to be correlations with things that are potentially correlated with Fed policy. Hardly the smoking gun suggested by the lede. So what about the re-thinking that is going on at the Fed?

First, officials missed signs that a more complex financial system had become vulnerable to financial bubbles, and bubbles had become a growing threat in a low-interest-rate world.

Secondly, they were blinded to a long-running slowdown in the growth of worker productivity, or output per hour of labor, which has limited how fast the economy could grow since 2004.

Thirdly, inflation hasn’t responded to the ups and downs of the job market in the way the Fed expected.

These are interesting. Let’s take them point-by-point:

1. Could the Fed have prevented the housing bust and the subsequent financial crisis? It is unclear. But even if they completed missed this, could not policy have responded once these effects became apparent?

2. What does this even mean? If there is a productivity slowdown that explains lower growth, then shouldn’t the Federal Reserve get a pass on the low growth of real GDP over the past several years? Shouldn’t we blame low productivity growth?

3. Who believes in the Phillips Curve as a useful guide for policy?

My criticism of Hilsenrath’s article should not be read as a defense of the Fed’s monetary policy. For example, critics might think I’m being a bit hypocritical since I have argued in my own academic work that the maintenance of stable nominal GDP growth likely contributed to the Great Moderation. The collapse of nominal GDP during the most recent recession would therefore seem to indicate a policy failure on the part of the Fed. However, notice how much different that argument is in comparison to the arguments made by Hilsenrath. The list provided by Hilsenrath suggests that the problems with Fed policy are (1) the Fed isn’t psychic, (2) the Fed didn’t understand that slow growth is not due to their policy, and (3) that the Phillips Curve is dead. Only this third component should factor into a re-think. But for most macroeconomists that re-think began taking place as early as Milton Friedman’s 1968 AEA Presidential Address — if not earlier. More recently, during an informal discussion at a conference, I observed Robert Lucas tell Noah Smith rather directly that “the Phillips Curve is dead” (to no objection) — so the Phillips Curve hardly represents conventional wisdom.

In fact, Hilsenrath’s logic regarding productivity is odd. He writes:

Fed officials, failing to see the persistence of this change [in productivity], have repeatedly overestimated how fast the economy would grow. The Fed has projected faster growth than the economy delivered in 13 of the past 15 years and is on track to do so again this year.

Private economists, too, have been baffled by these developments. But Fed miscalculations have consequences, contributing to start-and-stop policies since the crisis. Officials ended bond-buying programs, thinking the economy was picking up, then restarted them when it didn’t and inflation drifted lower.

There are 3 points that Hilsenrath is making here:

1. Productivity caused growth to slow.

2. The slowdown in productivity caused the Fed to over-forecast real GDP growth.

3. This has resulted in a stop-go policy that has hindered growth.

I’m trying to make sense of how these things fit together. Most economists think of productivity as being completely independent of monetary policy. So if low productivity growth is causing low GDP growth, then this is something that policy cannot correct. However, point 3 suggests that low GDP growth is explained by tight monetary policy. This is somewhat of a contradiction. For example, if the Fed over-forecast GDP growth, then the implication seems to be that if they’d forecast growth perfectly, they would have had more expansionary policy, which could have increased growth. But if growth was low due to low productivity, then a more expansionary monetary policy would have had only a temporary effect on real GDP growth. In fact, during the 1970s, the Federal Reserve consistently over-forecast real GDP. However, in contrast to recent policy, the Fed saw these over-foreasts as a failure of their policies rather than a productivity slowdown and tried to expand monetary policy further. What Athanasios Orphanides’s work has shown is that the big difference between policy in the 1970s and the Volcker-Greenspan era was that policy in the 1970s put much more weight on the output gap. Since the Fed was over-forecasting GDP, this caused the Fed to think they were observing negative output gaps and subsequently conducted expansionary policy. The result was stagflation.

So is Hilsenrath saying he’d prefer that policy be more like the 1970s? One cannot simultaneously argue that growth is low because of low productivity and tight monetary policy. (Even if it is some combination of both, then monetary policy is of second-order importance and that violates Hilsenrath’s thesis.)

In some sense, what is most remarkable is how far the pendulum has swung in 7 years. Back in 2009, very few people argued that tight monetary policy was to blame for the financial crisis or the recession — heck, Scott Sumner started a blog primarily because he didn’t see anyone making the case that tight monetary policy was to blame. Now, in 2016, the Wall Street Journal is now publishing stories that blame the Federal Reserve for all of society’s ills. There is a case to be made that monetary policy played a role in causing the recession and/or in explaining the slow recovery. Unfortunately, this article in the WSJ isn’t it.

The New Keynesian Failure

In a previous post, I defended neo-Fisherism. A couple of days ago I wrote a post in which I discussed the importance of monetary semantics. I would like to tie together two of my posts so that I can present a more comprehensive view of my own thinking regarding monetary policy and the New Keynesian model.

My post on neo-Fisherism was intended to provide support for John Cochrane who has argued that the neo-Fisher result is part of the New Keynesian model. Underlying this entire issue, however, is what determines the price level and inflation. In traditional macroeconomics, the quantity theory was always lurking in the background (if not the foreground). Under the quantity theory, the money supply determined the price level. Inflation was always and everywhere a monetary phenomenon.

The New Keynesian model dispenses with money altogether. The initial impulse for doing so was the work of Michael Woodford, who wrote a paper discussing how monetary policy would be conducted in a world without money. The paper (to my knowledge) was not initially an attempt to remove money completely from analysis, but rather to figure out a role for monetary policy once technology had developed to a point in which the monetary base was arbitrarily small. However, it seems that once people realized that it was possible to exclude money completely, this literature sort of took that ball and ran with it. The case for doing so was further bolstered by the fact that money already seemed to lack any empirical relevance.

Of course, there are a few fundamental problems with this literature. First, my own research shows that the empirical analysis that claims money is unimportant is actually the result of the fact that the Federal Reserve publishes monetary aggregates that are not consistent with index number theory, aggregation theory, or economic theory. When one uses Divisia monetary aggregates, the empirical evidence is consistent with standard monetary predictions. This is not unique to my paper. My colleague, Mike Belongia, found similar results when he re-examined empirical evidence using Divisia aggregates.

Second, while Woodford emphasizes in Interest and Prices that a central bank’s interest rate target could be determined by a channel system, in the United States the rate is still determined through open market operations (although now that the Fed is paying interest on reserves, it could conceivably use a channel system). This distinction might not seem to be important, but as I alluded to in my previous post, the federal funds rate is an intermediate target. How the central bank influences the intermediate target is important for the conduct of policy. If the model presumes that the mechanism is different from reality, this is potentially important.

Third, Ed Nelson has argued that the quantity theory is actually lurking in the background of the New Keynesian model and that New Keynesians don’t seem to realize it.

With all that being said, let’s circle back to neo-Fisherism. Suppose that a central bank announced that they were going to target a short term nominal interest rate of zero for seven years. How would they accomplish this?

A good quantity theorist would suggest that there are two ways that they would try to accomplish this. The first way would be to continue to use open market purchases to prevent the interest rate from ever rising. However, open market purchases would be inflationary. Since higher inflation expectations puts upward pressure on nominal interest rates, this sort of policy is unsustainable.

The second way to accomplish the goal of the zero interest rate is to set money growth such that the sum of expected inflation and the real interest rate is equal to zero. In other words, the only sustainable way to commit to an interest rate of zero over the long term is deflation (or low inflation if the real interest rate is negative).

The New Keynesians, however, think that the quantity theory is dead and that we can think about policy without money. And in the New Keynesian model, one can supposedly peg the short term nominal interest rate at zero for a short period of time. Not only is this possible, but it also should lead to an increase in inflation and economic activity. Interestingly, however, as my post on neo-Fisherism demonstrated, this isn’t what happens in their model. According to their model, setting the nominal interest rate at zero leads to a reduction in the rate of inflation. This is so because (1) the nominal interest rate satisfies the Fisher equation, and (2) people have rational expectations. (Michael Woodford has essentially admitted this, but now wants to relax the assumption of rational expectations.)

So why am I bringing all of this up again and why should we care?

Well, it seems that Federal Reserve Bank of St. Louis President Jim Bullard recently gave a talk in which he discussed two competing hypotheses. The first is that lower interest rates should cause higher inflation (the conventional view of New Keynesians and others). The second is that lower interest rates should result in lower inflation. As you can see if you look through his slides, he seems to suggest that the neo-Fisher view is correct since we have a lower interest rate and we have lower inflation.

In my view, however, he has drawn the wrong lesson because he has ignored a third hypothesis. The starting point of his analysis seems to be that the New Keynesian model is the useful framework for analysis and given that this is true, which argument about interest rates is correct, the modified Woodford argument? Or the neo-Fisherites?

However, a third hypothesis is that the New Keynesian model is not the correct model to use for analysis. In the quantity theory view, inflation declines when money growth declines. Thus, if you see lower interest rates, the only way that they are sustainable for long periods of time is if money growth (and therefore inflation) declines as well. Below is a graph of Divisia M4 growth from 2004 to the present. Note that the growth rate seems to have permanently declined.

Also, note the following scatterplot between a 1-month lag in money growth and inflation. If you were to fit a line, you would find that the relationship is positive and statistically significant.

So perhaps money isn’t so useless after all.

To get back to my point from a previous post, it seems that discussions of policy need to take seriously the following. First, the central bank needs to specify its target variable (i.e. a specific numerical value for a variable, such as inflation or nominal GDP). Second, the central bank needs to describe how it is going to adjust its instrument (the monetary base) to hit its target. Third, the central bank needs to specify the transmission mechanism through which this will work. In other words, what intermediate variables will tell the central bank whether or not it is likely to hit its target.

As it currently stands, the short term nominal interest rate is the Federal Reserve’s preferred intermediate variable. Nonetheless, the federal funds rate has been close to zero for six and a half years (!) and yet inflation has not behaved in the way that policy would predict. At what point do we begin to question using this as an intermediate variable?

The idea that low nominal interest rates are associated with low inflation and high nominal interest rates are associated with high inflation is the Fisher equation. Milton Friedman argued this long ago. The New Keynesian model assumes that the Fisher identity holds, but it has no mechanism to explain why. It’s just true in equilibrium and therefore has to happen. Thus, when the nominal interest rate rises and individuals have rational expectations, they just expect more inflation and it happens. Pardon me if I don’t think that sounds like the world we live in. New Keynesians also don’t seem to think that this sounds like the world we live in, but this is their model!

To me, the biggest problem with the New Keynesian model is the lack of any mechanism. Without understanding the mechanisms through which policy works, how can one begin to offer policy advice and determine the likelihood of success? At the very least one should take steps to ensure that the policy mechanisms they think exist are actually in the model.

But the sheer dominance of the New Keynesian model in policy circles also leads to false dichotomies. Jim Bullard is basically asking the question: does the world look like the New Keynesian model says or does it look like the New Keynesians say? Maybe the answer is that it doesn’t look like either alternative.