jamesz

With great power comes great responsibility

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Romer and Romer think monetary policy could do more if only central bankers believed in themselves. Scott Sumner might agree these days.

Our thesis in this paper is that overly pessimistic views about the power of monetary policy have been a more important source of these errors than have overly optimistic views. There is little doubt that an overinflated belief in the power of monetary policy has contributed to some major policy errors. Most famously, policymakers in the mid-1960s believed that they faced an exploitable long-run inflation-unemployment tradeoff, and thus that monetary policy could move the economy to a sustained path of low unemployment and low inflation. This belief led them to pursue highly expansionary policy, starting the economy down the path to the inflation of the 1970s. The record of such errors has led many to argue that perhaps the most important attribute of a successful central banker is humility.

In this paper, we present evidence that the opposite belief—an unduly pessimistic view of what monetary policy can accomplish—has been a more important source of policy errors and poor outcomes over the history of the Federal Reserve. At various times in the 1930s, faced with the Great Depression, Federal Reserve officials believed that the power of monetary policy to combat the downturn or stimulate recovery was minimal. In both the midand late 1970s, faced with high inflation, policymakers believed that monetary policy could not reduce inflation at any reasonable cost. And there is evidence that in the past few years, faced with high unemployment and a weak recovery, monetary policymakers believed that policy was relatively weak and potentially costly. In each episode, the belief that monetary policy was ineffective led to a marked passivity in policymaking.

Matt Yglesias comments.

Matt Nolan

Why revisions matter

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Via James I saw this excellent post by Lars Christensen on why data revisions don’t matter for NGDP targeting.  I think it shows how much traction that the NGDP people are getting, when critiques like this start to appear – and it is good they are making a concerted effort to answer them.

Now I’m not actually someone who thinks that NGDP targeting isn’t what should be done (at this point, I’m still in agreement with the 2011 version of myself) – I don’t think it is terribly far off, and it provides a rule which is the main thing, so if it was to become core policy I wouldn’t be terribly concerned.

Now data revisions.  I think Christensen overstates how little they matter – even more than those who criticise NGDP targeting overstate how important it is.  In truth, the revisions issue is an important one because we are LEVEL targeting, and LEVEL targeting makes policy history dependent.  There are three real differences between flexible inflation targeting and NGDP targeting for a large economy, one of which is that point that NGDP targeting is level targeting and inflation targeting is growth rate targeting (for a small open economy, changes in tradeable good prices cause further issues – and I think NGDP doesn’t do this appropriately) … note, one other is the fact that NGDP targeting allows less discretion around the rule and an easier way to “judge” policy, something every economist outside of a central bank sees as a good thing 😉 … note the third is that one is anchoring expectations of price growth unrelated to the market place, one is ahchoring expectations of the level of nominal income unrelated to the market place – here we can ask “which one is more important for business and household decisions”.

So through the arguments:

We target a forecast in both cases, but forecasts are poor for both NGDP and inflation

This is true.  However, just before Christmas I was reading a paper about how inflation is the variable economic models have some of the most success at forecasting – as compared to GDP forecasts which are significantly worse.  I was going to write on this, and probably will at some point.  But in the interim, here is the RBA 😀

We should be targeting off a market, as that provides expectations

This is just the forecast story again – and we can do that with inflation targeting as well.

The potential problem

“Furthermore, arguing that NGDP data can be revised might point to a potential (!) problem with NGDP, but at the same time if one argues that national account data in general is unreliable then it is also a problem for an inflation targeting central bank. The reason is that most inflation targeting central banks historical have use a so-called Taylor rule (or something similar) to guide monetary policy – to see whether interest rates should be increased or lowered.”

Indeed this is a problem for inflation targeting as well.  But lets think a bit.

CPI, business surveys, and the unemployment rate are virtually never revised (apart from methodology changes), NGDP is revised constantly.  Central banks target a certain measure of core CPI and they use a Taylor rule which relies on deviations from potential output.  What they estimate is the OUTPUT GAP not potential itself.  Oft times, this estimate of potential will use data from business surveys and the unemployment rate as well as the oft revised GDP numbers – and as a result the size of any revisions and any potential error are a lot smaller.

Inflation is dubious

All data is dubious – CPI has had more time spent on it for the fact it is used for policy setting.  If we are worried about whether CPI is systematically biased (which is level terms it likely is, but in growth terms it is not) then the issue is far far worse for the GDP stats!

Conclusion

“However, the important point is that present and historical data is not important, but rather the expectation of the future NGDP, which an NGDP futures market (or a bookmaker for that matter) could provide a good forecast of (including possible data revisions). Contrary to this inflation targeting central banks also face challenges of data revisions and particularly a challenge to separate demand shocks from supply shocks and estimating potential GDP.”

It is exactly right that the point is to set expectations – central bankers know that.  With expectations of inflation anchored, they can then just walk around changing their policy stance to respond to the evolution of demand in the economy – this is what central bank policy should do, aims to do (ignoring the ECB of course 😉 ), and what the NGDP targeters want!  In this way data revisions are pretty irrelevant in so far as both sides are asking each other to do the same thing.

But there is the kicker, the flexible inflation targeters are targeting GROWTH in demand and anchoring expectations of PRICE growth.  NGDP targeters are targeting the LEVEL of demand and anchoring expectations of NOMINAL INCOME.  As soon as we target a level instead of a growth rate we make history relevant – this very history that is filled with data revisions and changes.  As a result, this is definitely a more important issue for NGDP targeting than for flexible inflation or NGDP growth targeting – which is why it is being raised!

It is a cost of level targeting, those in favour of level targeting have to point out the counterveiling benefits of said targeting (outside of a liquidity trap, where the gains are widely accepted but can be done through commitments rather than a change in the rule) that will swamp this and other costs.

jamesz

UK debt and default

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There’s been a bit of discussion about the possibility that the UK government’s debt might be downgraded by the ratings agencies.

In response to those suggestions Jonathan Portes claimed that “…unlike countries in the Eurozone, there is no possibility of the UK defaulting, so our fiscal policy is not constrained by markets in the same way; and we should ignore the credit rating agencies, because they’re irrelevant.” He cites the head of the OBR, Robert Chote, as support for that view. Now I don’t deny that there is little chance of the UK defaulting, but I think Portes is only telling half the story. Read more

jamesz

Carney endorses NGDP level targeting!

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Mark Carney’s speech last night:

For example, adopting a nominal GDP (NGDP)-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add “history dependence” to monetary policy. Under NGDP targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP.
…
…when policy rates are stuck at the zero lower bound, there could be a more favourable case for NGDP targeting. The exceptional nature of the situation, and the magnitude of the gaps involved, could make such a policy more credible and easier to understand.

Huge news for the market monetarists! Here is comment from Sumner and Britmouse.

Matt Nolan

Why cyclical Kiwisaver would be an awful tool

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Via Rates blog I see that, at the conference on government finances over the past couple of days Michael Cullen suggested making compulsory Kiwisaver contributions pro-cyclical (combined with the scheme becoming universal) as a monetary policy tool.  I appreciate he wanted the auidence of academics there to think outside the box, but this is actually a pretty poor idea.  I am sure these matters were discussed at the conference, but I will lay them down here in any case:

There is little evidence Kiwisaver increases national savings – and when it does, it is because of the “credit constrained”

Remember, just because we have to contribute to one savings vehicle doesn’t mean that households won’t borrow or dissave from other vehicles to compensate.  Work by the Savings Working group and Treasury suggested that Kiwisaver had very little impact on savings, and in the long-term it may actually reduce savings due to it being a relatively blunt way to promote savings (inefficient).

Compulsory Kiwisaver would lift savings, in so far as it does, by making some people unable to borrow or dissave in order to meet the level of consumption/investment they desire – as a result, this policy only works to promote savings in so far as it makes people worse off …

It isn’t savings that is the monetary policy issue – it is investment/consumption demand

For kicks, lets pretend that Kiwisaver does push up savings depending on the contribution.

Also targeting domestic savings misses the point on what we are trying to do here.  Remember, we use interest rates for monetary policy because they determine the intertemporal “price” that determines when people consume or invest out of current income.  A low interest rate now makes it relatively more attractive to consume/invest now – and if resources in the economy are underutilised at current interest rates, we would like this “price” to be lower.  The combination of a clear inflation target, and central bank policy that chases down this price, helps us to smooth the ebbs and flows in the economy.

If we were a large closed economy, then we know that pushing up savings would force consumption and investment to fall for a given level of income (as disposable income is lower) – under some conditions this may well do the trick.  This is like some sort of paradox of thrift style view, with Kiwisaver actually determining savings (so it needs to bind on the upside AND the downside).

Although this is a stretch, matters are even worse than that!  We are a small open economy, households and firms can borrow from overseas if their disposable income temporarily falls.

We use interest rates because we are changing the incentive for NZer’s to invest and consume, using Kiwisaver has nothing to do with actually monetary policy in this sense.

It is not politically independent

This is an obvious one.

It is even blunter than interest rates

I’m adding this, but the first two points were really all I was interested in writing 😉

Tl;dr

Kiwisaver doesn’t necessarily change savings levels, and it is underlying consumption/investment demand that really matter.  Given this, “compulsory Kiwisaver with cyclically varying contributions” is too clever by half – and shouldn’t be considered as a stabilisation tool … especially not as part of “monetary policy”.

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.