Matt Nolan

A different view of an inflation/price level target: No-monetization commitment

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In New Zealand a strange thing is happening.  While other countries are looking at making their inflation targets more explicit following the crisis, and many more countries are debating whether to use a level or growth target (eg the NGDP target is essentially a price level target with some flexibility – while flexible inflation targeting is very close to a NGDP growth targeting type rule), there appears to be calls here that we should throw these things away here.

We have discussed how these rules are useful a number of times in the past, especially important we always say is the ability these targets have for “anchoring expectations”.  After all, if we can anchor expectations of inflation then:

  1. We can largely avoid relative price distortions from unexpected inflation
  2. We increase certainty about the return on investment (by getting rid of purely nominal shifts for contracts without inflation adjustment)
  3. We have the ability to strongly respond in the face of a crisis – as inflation expectations are anchored, firms are monopolistically competitive, and some prices are sticky we can use monetary policy to help boost underlying demand in a demand constrained economy.
  4. As a result, fiscal policy only has to focus on the supply side of the economy and redistribution (unless we run into the zero lower bound, and the central bank isn’t allowed to print or buy assets to meet its targets).

However, for some reason this isn’t enough for people.  So lets look at the idea of expectation in a more public choice sense.

Governments don’t like us to know we are being taxed to pay for the treats we get given, some democratically elected officials are tempted to “monetize debt” in order to pay for it – its a silent tax!  To solve this, we give a central bank independence.  Ok, but the independence only exists in so far as the central bank is following a rule provided by government.  So we want contracts that help solve any possible “time-inconsistency problem”.  This is all fine and good.

So what should this contract be like?  Ultimately, the implicit tax appears whenever inflation is higher than expected – so when the central bank pumps in more juice than is consistent with the price setting behaviour of firms and households.  At first firms and households will be unsure if the extra currency is additional demand for their product/service, or for all products/services, so they will lift output/work … but once they see costs rise and once they see inflation itself is higher, they will respond by lifting inflation expectations.

This tells us that any extra output from breaking an inflation target, is only temporary, but the increase in inflation expectations will be permanent.  Again, this is one of our typical justifications … where does monetization come in?

Well the higher inflation also appears when we think about government bonds.  In money markets people ask for a nominal rate of return, based on expectations of inflation.  By increasing inflation past this level, we lower the real debt burden faced by government – they get a windfall, and the people paying for it are the people who lean’t to them.  However, this windfall is only temporary and ends up with higher nominal interest rates and higher inflation expectations (and realized inflation).

Government could commit to not doing this in two ways:  1)  Only sell inflation adjusted bonds,  2)  Have a central bank with an inflation target.

Here a credible inflation target also amounts to a commitment by government to not tax its citizens by stealth.

Inflation/price level/NGDP targeting (where we are targeting forecasts of the future) offers a clear and consistent way of dealing with the fact that we have a monopoly supplier of currency in a public choice sense, and it allows central bankers to manage the “demand side” of the economy IF we have appropriate information and an understanding of what is going on.  Getting a central bank to target “other things” outside of how they impact upon the forecast of inflation/price level/NGDP doesn’t make any sense.  [Note:  People weirdly seem to think that the Bank completely ignores them – this is completely wrong.  They focus on them as issues with regard to monetary policy, and all that information is captured in their inflation forecast]

If we think the “exchange rate is too high” ask why.  We might say the current account deficit has been high for a long time, but then why.  Well its high because the real exchange rate is high, and real interest rates are high – this tells us that domestic savings are too low … this has nothing to do with the inflation target of a central bank (as they do not control the long-term real interest or exchange rates) and everything to do with competition and fiscal policy in the domestic economy.  It is part of the “cost” of the policies that we have put in place as a society – so we should accept that there is a trade-off there, instead of destroying the RBNZ’s ability to do its job – as we have mentioned before.  Scott Sumner discusses this issue more here – and I think it is a fundamental confusion between the two that is creating so much noise in NZ at present.

 

Matt Nolan

An important warning regarding the monetary policy fine-tuning

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A recent opinion piece in the Herald, pitting Don Brash and Brendan Doyle in to debate the issue of monetary policy was good.  They seemed to agree that, ultimately, any issue is one of the real exchange rate – which is due to real economy factors.  A point I’ve heard a number of times before 😉

However, all this debate reminds me of a speech by Bernanke back in the day.  The choice quote:

Although a strict rules-based framework for monetary policy has evident drawbacks, notably its inflexibility in the face of unanticipated developments, supporters of rules in their turn have pointed out–with considerable justification–that the record of monetary policy under unfettered discretion is nothing to crow about. In the United States, the heyday of discretionary monetary policy can be dated as beginning in the early 1960s, a period of what now appears to have been substantial over-optimism about the ability of policymakers to “fine-tune” the economy. Contrary to the expectation of that era’s economists and policymakers, however, the subsequent two decades were characterized not by an efficiently managed, smoothly running economic machine but by high and variable inflation and an unstable real economy, culminating in the deep 1981-82 recession. Although a number of factors contributed to the poor economic performance of this period, I think most economists would agree that the deficiencies of a purely discretionary approach to monetary policy–including over-optimism about the ability of policy to fine-tune the economy, low credibility, vulnerability to political pressures, short policy horizons, and insufficient appreciation of the costs of high inflation–played a central role.

Is there then no middle ground for policymakers between the inflexibility of ironclad rules and the instability of unfettered discretion? My thesis today is that there is such a middle ground–an approach that I will refer to as constrained discretion–and that it is fast becoming the standard approach to monetary policy around the world, including in the United States

“Constrained discretion” is (arguably) very much the flexible inflation targeting framework we use now – the determination to “fine tune” is one that is coming out increasingly, and is based on an illusion of understanding and control regarding the macroeconomy (that and a few fallacious ideas of how things have panned out 😉 ).

No-one is arguing against having a further look at financial regulation, and trying to understand what has happened there.  However, this provides no case for messing around with the way the RBNZ performs monetary policy and the existence of a floating exchange rate – and in their determination to “do something” there are a set of politicians, journalists, and other analysts/economists trying to take us down a dark path.

Matt Nolan

Reframing the monetary policy debate: Some notes

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Update:  Given all the links in this post, I’m adding it to the rarely used “inflation debate” tab.  An area where I rant incoherently about monetary policy in a way that is aiming to help this debate – rather than just be critical.

From what I can tell, the current debate about monetary policy taking place in the public makes little sense.  While I am sure we all mean well with our opinion pieces, the issues, the problems, the causes, and the tools aren’t really being discussed in a way that someone with an open mind can sit down and look at.  Sadly, I lack the time – and probably the ability – to give this a fair go.  As a result, instead I will just list down some things we need to keep in mind here.

David Parker has recently said two things which he used to justify the RBNZ scrapping inflation targeting, and moving to targeting a bunch of stuff:

  1. The RBNZ needs to help exporters – as other countries are helping exporters
  2. The RBNZ is to blame for our “persistently high exchange rate”

I discussed a similar post of his earlier.  But right now, I want to state that neither of these things is really true – I can 100% understand how someone could come to believe this given what we see going on around us.  However, they aren’t facts – they are fallacies.

Note:  He does mention “protecting financial stability to help exporters” – this statement doesn’t make sense.  The RBNZ does focus on financial stabilty in a seperate role, and with seperate tools – a role that is related to, but seperate from monetary policy (just like fiscal policy).  In none of this is, or should, the RBNZ look at a certain sector in NZ and say “we’re giving you stuff” – that is just wrong.

Sidenote:  If you say “but helping exporters with monetary transfers helps all of us” I will laugh – if NZ goes down that path, I look forward to having my views vindicated in 20 years time 😉

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Matt Nolan

A point on NGDP targeting and inflation expectations

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I’m increasingly hearing people call for an NGDP target.  I’m not really convinced it is superior to inflation/price level targeting to be honest.  Let me discuss below.

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Matt Nolan

Expectations and commitment are monetary policy

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I know we hear a lot about what “monetary policy is” in New Zealand.  According to our media monetary policy can make our incomes the same as those in Australia, make the price of everything move in our favour, build us new houses, reduce our reliance on foreign everything, increase and decrease house prices, and make us generally happier.

Now, as readers of TVHE you have seen past this rouse, and you recognise that monetary policy is independent cyclical policy that is intended to ensure that “inflation” stays at a certain rate and that shifts in output due to “aggregate demand” are kept to a minimum.  Again, this is a simplification – but it gives us our role, something we have discussed in more detail here. [BTW, there is a good post on discussing the right practical target variable here].

When thinking about what real inflation is we get to the point that “inflation” is very much driven by expectations.  As a result, the goal of the monetary authority is to anchor inflation expectations!  This is exactly the point made here, and it is true – Chuck Norris and the central bank have a lot in common.

When we understand this, we can get an idea of what to do when we are in a liquidity trap.  Simply put, say you are going to violate the target and target a higher level – or find a way to commit to it if needs be (thereby getting those real interest rates down – something that has been forgotten recently).  There is wide agreement among economists on this from the left and the right, and yet peoples refusal to look at monetary policy in this frame is stopping society from putting in place the correct monetary policy/framework.

However, we can also get an idea of the real issues in monetary policy – do we really understand how expectations are formed?  Do we really have a way of measuring commitment by a central bank?  Do we get commitment of the target, or of the institution, when we do this?  Even so, it is off this true base of understanding that we can analyse the issue – instead of the ad hoc and patently ridiculous things that are written about monetary authorities a lot of the time.

Note:  Good post here discussing monetary policy in terms of expectations and co-ordination – good links at the end as well.

Matt Nolan

The Fed and policy: Temporary but not permanent

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Via Arnold Kling at Econlog we see this paper regarding the impact on Fed policy.  It is an interesting paper in an economic history sense, I would suggest reading it.  However, the passage I want to focus on is the same one Arnold mentioned:

First, spending and pricing decisions are assumed to be based on long-term assessments of real income and real rates of return. Second, changes in monetary policy can only change real interest rates temporarily. Ultimately, the forces of productivity and thrift determine them, not changes in nominal magnitudes on the central bank balance sheet. Combining the two propositions implies that the Federal Reserve’s interest rate policy, as long as it stays within the narrow range of experience, would not be expected to have a significant or long-lasting imprint on markets or activity.

This is a great result.  It suggests that the central banks ability to change the “structure” of the economy, or make any long lasting changes to economic conditions, is negligible.  Without any “long-run costs” of Fed policy this suggests that monetary policy CAN be used to stabilise activity in the very short run – so it reforces the view that a central bank should look at “smoothing the economic cycle” by keeping underlying inflationary pressures near a certain target.

This is consistent with the orthodox way of viewing monetary policy.  However, interestingly Arnold Kling states that this paper is something he agrees with, but it “puts (him) at odds with Scott Sumner and John Taylor, among many others.” – people who are also part of the orthodoxy.

I believe that the issue here is that people are talking past each other a little – in terms of strict monetary policy, the views that Scott Sumner and (originally) John Taylor focused on were short-run, and as a result they were interested in the stabilisation role of monetary policy.  Kling appears to have ignored the idea of the short-run to focus on the relevant view of the long-run – something we can’t do in the face of price/wage stickiness.

Now I agree with Arnold that many people give the idea that central banks can create miracles FAR too much weight.  I think that central banks should not be involved with structural policy, or if they are it NEEDS to be separated from their stabilisation role for the sake of transparency – but this issue is separate from the focus on thinkers like Sumner.