The Seesaw Approach to Monetary Policy

In my last post, I made the following comment:

A NGDP target aims to stabilize total dollar spending. It is one target that has embedded in it both the supply of and the demand for money (i.e. total dollar spending = money supply x velocity of money). The beauty of a NGDP target is that the Fed does not need to know what is exactly happening to the money supply or money demand. All the Fed only needs to worry about is the product of the two components. There is no need to track the money supply or estimate money demand. By focusing on total dollar spending, the Fed will be fostering a stable monetary environment where movements in money supply and money demand are offsetting each other.

Another way of saying this is that by targeting the growth path of NGDP, the Fed will be taking a seesaw approach to monetary stability. That is, endogenous changes in the money supply will be automatically offset by changes in money velocity and vice versa. This is illustrated below:

 

Now to be clear, most money is inside money--money endogenously created by banks and other financial firms--and the Fed only indirectly influences its creation. However, it does so in an important way by shaping the macroeconomic environment in which money gets created. Consequently, it can have a large influence on inside money creation. For the same reason it can also influence how stable is the velocity of money. By successfully stabilizing the expected growth path of total dollar spending, the Fed will be causing this seesaw process to work properly.

Here is the interesting thing. Even though the Fed was not officially targeting NGDP, it effectively seem to be practicing the seesaw approach to monetary policy over much of the Great Moderation period. This can be seen in the figure below which shows the growth rate of Divisia M4- money supply and the growth rate of its velocity. Note how these two series tend to offset each other as implied by the seesaw approach:

Source

Now note the area in the the grey bar. During this time the figure shows there was no offsetting movements. The money supply and velocity both fell--the seesaw process was broken. It was during this time that the Fed failed to stabilize total dollar spending and this allowed the emergence of the Great Recession.

One way, then, to view the Fed's job is that it should aim to keep the monetary seesaw process working properly. For a long time it did that, but failed spectacularly in 2008-2009. It would be whole lot easier going forward if the Fed explicitly adopted a NGDP level target.

P.S. The seesaw process is another way of looking at Milton Friedman's Thermostat Approach to monetary policy, as noted by Nick Rowe.

The CATO Institute and NGDP Targeting

Guess which think tank gives this advice in its official hand book for policymakers:

The intent of Congress would be better served and monetary policy would be more effective if Congress instructed the Federal Reserve to establish a monetary policy that reflects both their concerns in a single target. The best such target, I suggest, would be the nominal final sales to domestic purchasers—the sum of nominal gross domestic product plus imports minus exports minus the change in private inventories... Congress is best advised (1) to specify a target rate of increase of final sales and (2) to instruct the Federal Reserve to minimize the variance around this target rate. The target rate of increase of final sales may best be about 5 percent a year, sufficient to finance a realistic rate of economic growth of 3 percent and an acceptable rate of inflation of about 2 percent.

So the think tank is advising policymakers to do something like nominal GDP (NGDP) targeting. It may surprise you to learn that it comes from the CATO Institute. But it should not be a surprise. Some of CATO's top monetary experts, like Lawrence H. White and George Selgin, also support versions of a NGDP target. They would prefer a free banking system, but given we have a Fed they would prefer it target NGDP. CATO Senior Fellow Steve Hanke also shares this view as does former CATO scholar Timothy B. Lee. The reason for their support of a NGDP target is because they see it as the most conducive to monetary stability. 

Here is why. A NGDP target aims to stabilize total dollar spending. It is one target that has embedded in it both the supply of and the demand for money (i.e. total dollar spending = money supply x velocity of money). The beauty of a NGDP target is that the Fed does not need to know what is exactly happening to the money supply or money demand. All the Fed only needs to worry about is the product of the two components. There is no need to track the money supply or estimate money demand. By focusing on total dollar spending, the Fed will be fostering a stable monetary environment where movements in money supply and money demand are offsetting each other. 

Another great feature of a NGDP target is that it allows supply shocks to be reflected in relative price changes. No attempt is made to offset them or their effect on the price level. For example, assume there is a technological innovation that raises a firm's productivity. Such productivity gains mean lower per unit production costs that, in turn, should translate into lower output prices given competitive pressures. Here, the increase in a firm’s output from the productivity gains is matched by a decrease in its sales price. For an economy-wide productivity innovation that affects many firms, this response would manifest itself in rising real GDP growth alongside a declining price level and vice versa. But note that the price level times real GDP is simply total dollar spending. Consequently, if the Federal Reserve directly targeted the growth of total dollar spending it would by default be allowing the price level to move inversely with productivity-driven changes in real GDP. This amounts to a monetary policy regime that ignores supply shocks. This feature is conducive to financial stability.

So there are good reason that many folks at CATO support some kind of NGDP target. I bring this up because CATO Senior Fellow Alan Reynolds had a recent article in Investor's Business Daily that bashed NGDP targeting. Unlike his colleagues at CATO, though, Reynolds shows an incredible amount of confusion in his article. So if you are looking to the CATO institute for guidance on monetary policy I recommend you turn to their other experts or its official handbook for policymakers.

Let me detail a few of the many problem with his piece. First, try this:

Prominent economists of all stripes have proposed that the Fed should focus instead on keeping the growth of nominal GDP (NGDP) growing at a steady rate. But growth of NGDP is simply the inflation rate added to the real GDP growth rate.

No, we directly observe NGDP and from it is derived real GDP based one some estimated index of the price level. Reynolds should listen to CATO monetary expert George Selgin on this issue:

The occasional, if tacit, treatment of NGDP as a value that is “derived” by taking the product of two directly observable magnitudes, real output (y) and the price level (P), is as mischievous as it is wrong. We must understand the behavior of both P and y to depend, the first in the long run and the second in the short run, on that of Py, rather than the other way around. That is why it is also important to insist that stabilizing NGDP is not just a rough-and-ready way of minimizing a loss function in which fluctuations of P and Y are separable components. No and no again: if the natural rate of y plummets (natural disaster or war, say), what is desirable is not that we should minimize both P and y movements subject to the supply-shock “constraint. It is rather than we should see P move the opposite way from y, which is done by stabilizing Py.

Here Reynolds esposuses an atheoretical model of inflation, something akin to trend analysis:

[T]he trouble with basing future policy on past inflation news is that inflation is always lower before it moves higher. PCE inflation rates of 0.8% in 1998 and 1.3% in 2002, for example, were followed by 2% inflation in 2003, 2.4% in 2004, and 2.9% in 2005.

What? Inflation is inherently an oscillating process? So the very thing Reynolds is criticizing, Fed policy, is not at all responsible for the path of inflation?

This is just a sample of the confusion in the article. So again if you are conservative and looking for guidance on monetary policy I encourage to look at the actual monetary experts at CATO.

P.S. You could also look to the monetary experts at the Mercatus Center like Scott Sumner. He has several articles there worth exploring.

The Cure for Neo-Fisherism: History

Noah Smith reports there is a "rebellion" brewing in macroeconomics. Some economists, including Stephen Williamson, John Cochrane, and Stephanie Schmitt-Grohe and Martin, are promoting a very provocative idea that challenges standard monetary economics. They argue that a central bank holding interest rates low for a long period will cause inflation to fall. The conventional view is that such actions should cause inflation to rise. This unorthodox view was first popularized in a 2010 speech by Minneapolis Fed President Narayana Kocherlakota who invoked the famous Fisher relationship to make his case:

The fed funds rate is roughly the sum of two components: the real, net-of-inflation, return on safe short-term investments and anticipated inflation. Monetary policy does affect the real return on safe investments over short periods of time. But over the long run, money is, as we economists like to say, neutral. This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run.

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation.

Kockerlakota has quit making this argument, but others who continue to do so often invoke the Fisher relation too. Here, for example, is Stephen Williamson:

 In the long run, standard asset pricing gives us the Fisher relation, which is 

R = r + i, 

where R is the short-term nominal interest rate, r is the real interest rate, and i is the inflation rate...Therefore, in the long run, if R is targeted at its lower bound by the central bank, 

i = - r - t 

So, if we think that r is invariant to monetary policy in the long run, then if the central bank pegs the nominal interest rate at its lower bound, and central bank liabilities are taxed, this will make long-run inflation lower.

The policy implication for today is that the Fed should consider raising its target interest rate soon or face the prospects of lower inflation. Given this view's reliance on the Fisher relation, Noah Smith has called this group the Neo-Fisherites. Smith, himself, acknowledges being lured by the siren calls of Neo-Fisherism. It is all so elegant and straightforward, so why not?

There are two reasons to be leery of Neo-Fisherism. First, it ignores Wicksell's cumulative process. This idea says that if the central bank pegs the short-term nominal interest rate below the natural interest rate the price level will eventually explode and vice versa. The Fisher relation is an equilibrium condition and says nothing about this disequilibrium dynamic. Rajiv Sethi and Nick Rowe note that once one acknowledges the potential for the Wicksellian cumulative process, it becomes apparent that the Fisher relation itself is not necessarily a stable equilibrium. These concerns are why the Taylor Principle is such a big deal in macroeconomics.

Second, Neo-Fisherism has been tested in the real world and failed. There are several historical experiences where monetary authorities pegged short-term interest rates for an extended period and they did not end in deflation. Also, there are other more recent experiences that raise doubts about Neo-Fisherism. Let's take a look at them.

Germany During and After World War I

Robert Waldman reminded us of this natural experiment back when Kockerlakota made his 2010 speech. Here is Waldman:

I think that it is important that in monetary models there are typically two equilibria -- a monetary equilibrium and a non-monetary equilibrium.

The assumption that the economy will end up in a rational expecations equilibrium does not imply that a low nominal interest rate leads to an equilibrium with deflation. It might lead to an equilibrium in which dollars are worthless.

I'd say the experiment has been performed. From 1918 through (most of) 1923 the Reichsbank kept the discount rate low... and met demand for money at that rate.

The result was not deflation. By October 1923 the Reichsmark was no longer used as a medium of exchange.

The Reichsbank pegged its official bank discount rate at 5% from 1915 through 1922. That is long enough to test the Neo-Fisherite view. The Figure below shows what happened: an explosion of the price level.

The next figure goes through 1923 where the price level really takes off. Here I put the price level in natural log to make the graph readable. Note that eventually the explosive inflation is followed by a rise in the nominal interest rate. So this experiment shows (1) a central bank pegs an interest rate too low for an extended period, (2) inflation begins to surge, and (3) the pegged interest rate is eventually forced up. This is the causality laid out in Wicksell's cumulative process. Strike one for Neo-Fisherism.

The United States and the Accord of 1951

From April, 1942 to March, 1951 the Fed pegged interest rates to help the government's financing of World War II.  Treasury bills were pegged at 0.375% while long-term bonds were set at 2.5%. During the war this arrangement was tolerated (and aided by price controls), but with the end of the war the Fed was eager to get out of this "straightjacket" as inflationary pressures built because of the Wicksellian cumulative process. This can be seen in the figure below which goes through 1948.

By February, 1951 CPI growth at annualized rate reached about 20%. A few months later the famous Treasury-Fed Accord was signed that gave the Fed independence. The figure below shows the struggle the Fed was facing between the end of World War II and the Accord. The Wicksellian process was unfolding and the Fed sorely wanted to raise interest rates enough to stem it. Here too we see (1) a central bank pegs an interest rate too low for an extended period, (2) inflation begins to surge, and (3) the pegged interest rate is eventually forced up. Strike two for Neo-Fisherism.

Canada Over the Past Twenty Years.

Nick Rowe provides us a different type of real-world example that challenges the Neo-Fisherite veiw:

For the last 20 years the Bank of Canada has been targeting 2% inflation. And the average inflation rate over that same 20 years has been almost exactly 2%.

The Bank of Canada has said it has been doing the exact opposite to what Neo-Fisherites would recommend: whenever the BoC fears that inflation will rise above 2% it raises the nominal interest rate, and whenever it fears that inflation will fall below 2% it cuts the nominal interest rate.

If the BoC had been turning the steering wheel the wrong way this last 20 years, there is no way it could have kept the car anywhere near the centre of the road. Unless it was incredibly lucky. Or was lying to us all along.

Strike Three for Neo-Fisherism. If they had not already struck out, I would also pitch Abenomics at the Neo-Fisherites. It is still a work in progress, but the evidence so far should give Neo-Fisherites pause.

The point of these examples is that history is filled with many examples of monetary policy regimes that violate Neo-Fisherism. In fact, it is hard to come up with examples that unambiguously fit the Neo-Fisherite view. For example, some proponents point to Fed policies and the low inflation rate over the past few years as evidence for Neo-Fisherism. However, there are empirical studies that show QE has actually raised inflation in the United States. And arguably, the reason the Fed's programs have not packed more of a punch is their temporary nature. In short, there is little solid evidence for Neo-Fisherism while there is much for the conventional view. So be very leery of Neo-Fisherism.

Update: Josh Hendrickson speaks to Stephen Williamson and learns that Williamson, Narayana Kocherlakota, and Milton Friedman actually are saying the same thing. Here is Josh:

The argument he was making was essentially that if the Federal Reserve chose to leave the interest rate at zero for an extended period of time, this would imply that eventually they would have to pursue a policy that was deflationary. If they didn’t pursue that type of policy, they couldn’t maintain their peg of the nominal interest rate. In addition, since we don’t expect the Federal Reserve to pursue a policy consistent with negative rates of money growth, the statement should be seen as a criticism of the Federal Reserve’s original attempt at forward guidance which suggested that the FOMC would keep the interest rate at zero for an extended period of time.

If only that had been made clear sooner!

Observational Equivalence

I often see this posted as a critique of government policies. However, I think it better serves as an illustration of observational equivalence. In this case, is the town experiencing a balance sheet recession or an excess money demand recession? Both views can be inferred from the empirical facts. Readers of this blog will not be surprised where I come down on this.

It is a slow day in the small town and streets are deserted. Times are tough and the economy is struggling.

A rich tourist visiting the area drives through town, stops at the motel, and lays a $100 bill on the desk saying he wants to inspect the rooms upstairs to pick one for the night.

As soon as he walks upstairs, the motel owner grabs the bill and runs next door to pay his debt to the butcher.

The butcher takes the $100 and runs down the street to retire his debt to the pig farmer.

The pig farmer takes the $100 and heads off to pay his bill to his supplier, the Farmer's Co-op.

The guy at the Farmer's Co-op takes the $100 and runs to pay his debt to the local prostitute, who has also been facing hard times and has had to offer her "services" on credit.

The hooker rushes to the hotel and pays off her room bill with the hotel owner.

The hotel proprietor then places the $100 back on the counter so the rich traveler will not suspect anything.

At that moment the traveler comes down the stairs, states that the rooms are not satisfactory, picks up the $100 bill and leaves town.

No one produced anything. No one earned anything... However, the whole town is now out of debt and now looks to the future with a lot more optimism. 

So what say you? Is this a balance sheet recession or an excess money demand recession?

Update: Nick Rowe builds upon this discussion.

A New Monetary Policy Target: Per Capita Alcohol Consumption

Today I was looking for time series data that was not macroeconomic in nature. I wanted something fresh to keep my time series class engaged. There are only so many macroeconomic vector autoregressions one can do before your students begin to lose interest. To my delight, I stumbled upon a time series set of alcohol consumption per capita in the United States going back to 1934. The data is reproduced in the figure below:

I thought the figure might be interesting to others and posted it to twitter. Later, I got this reply from Geoff Turner:

I first chuckled at his comment, but then started looking closer at the figure too. Whereas Geoff Turner saw his favorite TV show in the data, I began to see macroeconomic history. I quickly began downloading data from FRED and messing around with these series and to my surprise discovered the true underlying cause of the Great Inflation was not the usual suspects. It was not the breakdown of Bretton Woods, misguided U.S. monetary policy, negative supply shocks, or demographics. Instead, it was per capita consumption of beer and spirits as seen in the figure below:

It is amazing how the World War II surge in inflation and the Great Inflation both track per capita consumption of beer and spirits. (Adding wine to the mix weakens the relationship.) And here is the scatterplot of this data:

Clearly we have uncovered the holy grail of central banking. All the Fed needs to do is raise per capita beer and spirit consumption and our low inflation problem will be solved. No need to raise the inflation target or adopt NGDPLT.

Of course, this finding raises an interesting question: if more beer and spirits consumption leads to more inflation, why is inflation so low in Germany? They are one the largest per capita consumers of beer. Maybe the answer is that their inflation would be even lower if were not for all their beer consumption.

P.S. This post is a joke of course and I am NOT promoting more alcohol consumption. Just having fun with spurious relationships.

Bernanke vs. Friedman: Financial Intermediation Shock or Medium of Exchange Shock?

In preparing for a talk, I reread Jeffrey Rodgers Hummel's article comparing Ben Bernanke to Milton Friedman. It was good to look over it again. Hummel makes the case that Bernanke saw the crisis as a financial intermediation crisis where Friedman would have viewed it as a medium of exchange crisis. These two different perspectives imply different policy prescriptions. The Bernanke Fed focused on saving the financial system at any expense, including creating distortions in the credit market. The first phase of the Bernanke Fed response, for example, was to manipulate (but not expand) the asset side of its balance as a way to support distressed financial firms. This phase began in the fall of 2007. The Fed eventually did began to expand its balance sheet with QE1 in late 2008, but even then the emphasis was on 'credit easing' not stabilizing total dollar spending. The Fed's later QE programs, though better, also lacked the full commitment and predictability needed to fully restore total dollar spending to its full employment level.

The Friedman approach would have been to avoid picking winners and losers in the financial system and instead commit to adding as much liquidity as needed to maintain a stable level of total dollar spending. This medium of exchange approach would have let some banks fail while preventing a wholesale collapse in aggregate demand. Recall that the widespread bank run on the shadow banking system was not inevitable. As Hummel reminds us, we had severe banking crisis in the 1920s and in the 1980s with the S&Ls and yet there were no sharp economic downturns. The same could have happened in 2008-2009. One can look to how Australia fared over the past five years to see how things could have been done differently. The key to this approach is credibly committing to maintaining the level of nominal GDP in a predictable, rule-based fashion. From this perspective, the worst part of the financial crisis in 2008-2009 was the consequence of the Fed failing to stabilize expected path of total dollar spending.

In short, Bernanke viewed the crisis as result of a large shock to financial intermediation while Friedman would have seen it as a large shock to the medium of exchange. This echoes Bernanke and Friedman's differing views on the Great Depression. The former saw the 1930's banking collapse as the key catalyst behind the Great Depression while the latter saw the Fed's failure to stabilize expected total dollar spending growth as the reason for the banking collapse and resulting fall out in the broader economy. 

Read the Hummel's paper for more on this distinction.

This One Figure Shows Why Fed Policy Failed

What do you see in this figure from a recent New York Fed study? 

 

Technically, it shows that the Fed's balance sheet is expected to shrink and return to the path it would have been on had there been no large scale asset purchases (LSAPs) over the past five years. This projection is a reflection of FOMC's plan to eventually normalize the size of the Fed's balance sheet. Bonds markets have understood this plan from the beginning as is evidenced in their inflation forecasts. The FOMC formally announced its plan to normalize and shrink its balance sheet in its June, 2011 meeting. Subsequent speeches, press conferences, and congressional testimony by Ben Bernanke have reinforced this understanding. The point is the Fed never intended the LSAPs to be permanent.

So again I ask, what do you see in the above figure? What is the bigger message it is telling? In my view, the answer to these questions is unambiguously clear. It signals the Fed never intended to unload both barrels of the gun and fully offset the collapse in aggregate demand. In other words, the figure reveals why Fed policy failed to end the slump.

This is a strong claim I am making. You may be scratching your heard wondering how I got that message out of the figure. Here is my explanation, based on previous posts. First, in order for there to have been sufficient aggregate demand growth the Fed needed to commit to a permanent monetary injection:

[O]pen market operations (OMOs) and helicopter drops will only spur aggregate demand growth if they are expected to be permanent. This idea is not original to Market Monetarists and has been made by others including Paul Krugman, Michael Woodford, and  Alan Auerback and Maurice Obstfeld. Market Monetarists have been advocating a NGDP level target (NGDPLT) over the past five years for this very reason. It implies a commitment to permanently increase the monetary base, if needed.

Doing so would help in the following ways:

The key reason is that it would create an expectation that some portion of the monetary base growth from the asset purchases would be permanent (and non-sterilized by IOER). That, in turn, would mean a permanently higher price level and nominal income in the future. Such knowledge would cause current investors to rebalance their portfolios away from highly liquid, low-yielding assets towards less liquid, higher yielding assets. The portfolio rebalancing, in turn, would raise asset prices, lower risk premiums, increase financial intermediation, spur more investment spending, and ultimately catalyze a robust recovery in aggregate demand. (One could also tell a New Keynesian story where the higher future price level implies a temporary bout of higher-than-normal inflation that would lower real interest rates down to their market clearing level.)

The key to the above story is that some portion of the monetary base expansion is expected to be permanent. If the public believes the Fed's asset purchases are not going to be permanent and therefore the price level and nominal income will not be permanently higher, the rebalancing will not take place. I bring this up because this same point applies to helicopter drops or any other kind of fiscal policy stimulus.

Now to be clear, all that is needed is a commitment to permanently expand the monetary base if needed. But such a commitment, if credible, would most likely raise the velocity of the monetary base. In this case, the needed permanent monetary injection would be smaller. In other words, the figure above attests to the failure of the Fed policy not only because it shows a temporary increase in the monetary base, but also because it shows such a large increase in the monetary base. Had the Fed credibly committed from the start there never would have been the need for all the subsequent LSAPs. The Reserve Bank of Australia did just this and its economy was one of the few not hit by the prolonged economic slump. 

Another way to see how the above figure reveals monetary policy failure is to compare the Fed to the Bank of Japan. It too tried temporary monetary injections but then switched to permanent ones under Abenomics:

[T]he Bernanke Fed never tried Abenomics. That is, for all the Fed has done over the past five years it never tried to do the kind of monetary regime change now being done by the Bank of Japan. A year ago, Japanese monetary authorities shook things up by credibly committing to permanently raising the nominal size of the Japanese economy. The evidence so far shows this program to be a smashing success. From the start, the Bernanke Fed took the opposite approach. It credibly committed to a temporary expansion of its balance sheet. The U.S. monetary injections, therefore, were never intended to be permanent and this makes all difference in the efficacy of monetary policy.

So for all the praise the Bernanke Fed gets for preventing the second Great Depression, it should be equally noted that it allowed the long slump. By failing to do Abenomics for the U.S. economy, the Bernanke Fed effectively kept monetary policy tight for the past five years. There is no other way to say it.

Okay, maybe there is another way to say it. The Bernanke Fed failed to meaningfully address the endogenous fall in the money supply and the decrease in money velocity. The Bernanke Fed could have done an American version of Abenomics, like nominal GDP level targeting, that would have arrested these developments. Instead, it did not and passively allowed total dollar spending to remain depressed. This failure to act is no different than an explicit tightening of monetary policy in terms of damage done to the economy. The only difference is that the public is more aware of the explicit form.

So again I ask, what do you see in the above figure?

P.S. Yes, the Fed's ad-hoc decision making contributed to this failure.