5th June 2019 Off By binary
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I am currently at a Fed conference called “FedListens”, which is evaluating options for improving monetary policy. One focus of the conference is the question of how best to address the zero bound problem. Here I’ll present a few initial impressions, based on the first paper (by Janice Eberly, James Stock and Jonathan Wright) and the following discussion. I should warn you that I may be misinterpreting the paper, but FWIW I’ll give you my impression of where I think it goes off course.

The authors argue that a negative 5% nominal interest rate would have been appropriate during the Great Recession, and then look at various counterfactual strategies for improving monetary policy, given the zero bound constraint. These counterfactuals include asset purchases, forward guidance, and a higher inflation target (3% or 4%), among others. The goal is to get the stance of policy closer to the negative 5% fed funds that would have been appropriate, if not constrained by the zero bound.

In my view, the basic mistake is to (implicitly?) assume that the need for a negative 5% fed funds rate was caused by an exogenous negative shock (something like the financial crisis, for instance), rather than excessively tight money during 2008, which sharply depressed NGDP growth expectations. If I’m right, then they underestimate the benefits of structural changes in monetary policy that lead to faster NGDP growth, and hence a milder recession. One of these benefits is that the real Wicksellian equilibrium rate would have fallen much, much less sharply.

Thus consider the counterfactual of a 6% inflation target. In a simple model where this policy counterfactual had no impact on the exogenous shock that reduced the Wicksellian equilibrium real rate, the Fed would still have had to reduce interest rates to negative 1% to achieve an appropriate real rate during the Great Recession. I find that assumption to be exceedingly implausible. In my view, even a 4% inflation target, and certainly a 6% target, would have prevented the Fed from ever hitting the zero bound. The extra NGDP growth expectations (both inflation and RGDP) caused by a higher inflation target would have prevented the equilibrium rate from falling anywhere near zero (see Australia), and thus none of the unconventional policy options would have been needed.

I believe this critique is related to John Taylor’s criticism of the paper, which was that they had not based their policy counterfactuals on a structural model.

The profession as a whole tends to have a Keynesian approach to these issues. The economy is inherently unstable due to “shocks”, and the Fed is a sort of fireman that comes to the rescue, by trying to depress rates to as close to the equilibrium rate as possible. In the monetarist framework (which is best explained in the work of Robert Hetzel), the Fed is more like an arsonist, creating nominal instability through monetary policy errors. Because wages and prices are sticky, this nominal instability creates labor market instability, which depresses investment and hence the equilibrium interest rate. A more effective monetary policy helps mostly by avoiding causing nominal shocks, not by reacting to instability in the private economy.

I don’t favor a 4% or 6% inflation target, but I believe a 4% or 5% NGDPLT would have had a similar stabilizing effect, which is not picked up in the paper presented.

Another way of putting things is that while most economists want to reduce interest rates to the Wicksellian equilibrium rate during a recession, I want to use asset purchases to raise the equilibrium interest rate.

Alternatively, this conference needs to take NeoFisherism more seriously. Although NeoFisherism as a stand alone theory is wrong, it’s a very useful critique of conventional macro. It reminds us that the ultimate goal should not be to get the policy rate as low as possible, but to create conditions where the equilibrium interest rate is much higher than it was in 2009. We need a regime that reduces the need to cut rates to below zero.

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