Don’t target interest rates3rd April 2019
John Cochrane has a very long and interesting post, which advocates that the Fed target interest rates. I respectfully disagree.
But money has disappeared from more recent economic thinking. My preferred model of the world (fiscal theory of monetary policy) has an interest rate target, which sets expected inflation, fiscal theory which sets unexpected inflation, and money is not needed. Conventional academic wisdom uses new-Keynesian models with `active’ interest rate rules to produce determinacy. Older-school ISLM style models, which are still used by the Fed and capture completely the verbal explanations Fed officials offer for monetary policy, also are based entirely on interest rate targets.
I recall that Cochrane favors a NeoFisherian model of interest rates and monetary policy, which suggests that a lower interest rate peg will lead to lower inflation. But central banks have the opposite view, that lowering interest rates will raise inflation.
That doesn’t reassure me. It’s as if the designer of a bus insists that turning the steering wheel to the right makes the bus go to the right, while the actual drivers of the bus believe that turning the wheel to the right makes the bus go left. What could go wrong?
Even worse, I believe that turning the wheel to the right sometimes makes the bus go right and sometimes makes the bus go left. I’d prefer a different steering mechanism—one that wouldn’t be misused, causing NGDP to plunge 8% below trend in 2008-09.
I don’t think Friedman would be happy, as he might say inflation happens with long and variable lags, and the money demand shift happens before you can see the inflation. But Friedman is no longer with us, and doesn’t get the chance to modify his views with the evidence that inflation has ended under interest rate targets, and the amazing period of the zero bound, which turns on its head the experience of 1940s and 1950s interest rate pegs that so influenced him.
Friedman died in 2006. I don’t see anything that has happened in the past 13 years that would have surprised Friedman. He lived through long periods of the US being at the zero bound in the 1930s and 1940s, and also the Japanese experience of the late 1990s and early 2000s. We know his views on Japan. Our recent experience offers nothing new.
Monetarists always talked about how velocity is interest elastic in the short run it was “stable” in the long run. But it’s not. Money demand — reserve demand especially — has exploded by a factor of 300 at i−imi−im, and it’s not ever coming back as long as that is the case.
Monetarists did not favor targeting reserves, or even the monetary base. They favored targeting a broad aggregate such as M1 or M2. Just to be clear, I don’t favor targeting any sort of M, but recent moves in M2 velocity are nothing like recent moves in reserve velocity. Since 1959, M2 velocity has stayed within a range of 1.4 to 2.2. Again, reserve demand rose sharply during 1930s and more recently in Japan. It’s a predictable response to the zero bound, made worse by the payment of interest on bank reserves. (A contractionary policy that Friedman would have opposed in late 2008, even if he supported the general concept in normal times.)
In sum, the screaming lesson of the last 10 years in the US, and 25 in Japan, is that a “liquidity trap” with arbitrary reserves does not cause any inflation.
And what was the lesson of 1932-51 (when short-term rates were near zero?) I’d say the lesson was that near-zero rates and large reserve holdings don’t cause inflation when the natural rate of interest is low, and do cause inflation when the natural rate of interest raises above the policy rate. Have we learned anything new from the recent zero bound episodes? I’d say no.
Instead of targeting interest rates, we should target NGDP futures prices.
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