Will the Fed follow its rhetoric or its rule?

In recent years, the Fed has increasingly adopted the rhetoric of 1960s Keynesianism.  Go for growth.  Don’t worry about a bit more inflation.  Jobs are much more important.  Given that 1960s Keynesianism gave us the Great Inflation, should we be worried about today’s rhetoric?

Oddly, at roughly the same time that they adopted all this expansionary rhetoric, the Fed switched to average inflation targeting, which makes 1960s-style expansionary monetary policy totally impossible to implement.

So what will the Fed do in the 2020s?  Will inflation average 2%, or will it average 4%, 6%, or 8%?  I don’t know, but my hunch is that a portion of this Keynesian rhetoric is just the Fed trying to be PC, trying to keep up with a generally leftward shift in public opinion on stimulus.  Another part might be the Fed’s perceived need to create “credibility” for its 2% inflation target, given that inflation ran below 2% over the previous decade, and given that (until recently) market indicators have been skeptical that we’d reach 2% inflation, on average.

One way or another, we’ll soon find out.

Some people seem concerned by the fact that the markets expect interest rates to rise faster than the Fed itself current predicts.

But this isn’t actually a problem at all, at least if you take the Fed’s 2% average inflation target seriously.  At the moment, markets expect a modest overshoot of inflation over the next 5 years, to make up for the undershoot during 2020.  Then roughly 2% inflation for as far as the eye can see.  But that’s exactly what the Fed says it wants!  If the markets think that this good outcome will require higher interest rates than the Fed currently expects, that’s not a lack of policy credibility, it’s just a difference of opinion on the future path of the natural rate of interest.  A lack of policy credibility would occur if the markets didn’t expect inflation to average 2% during the 2020s.  More likely, rising rates reflect increased confidence that the Fed will achieve its goals.

Don’t confuse the rhetoric with the policy rule.  The rule is the actual Fed policy—the rhetoric is just a bunch of pretty words.

PS.  Of course the other problem with the tweet that Yglesias links to is that Perli is reasoning from a price change, assuming that rising longer-term yields reflect predictions of a tighter monetary policy stance.

PPS.  People often ask me about “yield curve control”.  That would be like a ship captain announcing “steering wheel control”, a commitment to hold the ship’s steering wheel at a fixed position for days on end, regardless of changes in wind and currents.  What do you think?  Does that sound like a good idea?


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An Unnecessary “Stimulus”

In two Defining Ideas articles in 2009, “Who’s Afraid of Budget Deficits? I Am” and “Furman, Summers, and Taxes,” I criticized Lawrence Summers and Jason Furman, two prominent economists who worked in the Obama administration, for their dovish views on federal debt and deficits. They had argued that we shouldn’t worry much about high federal budget deficits and growing federal debt. Of course, that was before the record budget deficit of 2020. Now even Summers is worried. In two February op-eds in the Washington Post, Summers argues against the size and composition of the Biden “stimulus” bill.

Summers makes a solid argument, on Keynesian grounds alone, that the proposed $1.9 trillion spending bill is much too large. He also, to his credit, digs into some of the details of the bill, pointing out how absurd they are. Had Summers looked at more details, he could have made an even stronger case against the measure. For instance, one major provision of the bill, the added unemployment benefits through August, will actually slow the recovery. And other provisions of the bill, like the bailout of state and local governments, are bad on other grounds. The fact is that this is not your father’s or your grandmother’s run-of-the-mill recession. It was brought about by two things: (1) people’s individual reactions to the threat of Covid-19 and (2) politicians’ reactions, in the form of lockdowns, to the same threat.

These are the opening two paragraphs of my latest article for Defining Ideas, “An Unnecessary ‘Stimulus’“, Defining Ideas, March 5, 2021.

And the ending:

First, the economy is recovering. In January, the International Monetary Fund predicted that real GDP will grow by 5.1 percent in 2021. Possibly that’s because the IMF understands that this is not a typical recession. The slump we’re in was due initially to people’s fear of the virus, a fear whipped up by Dr. Anthony Fauci and others. But now it’s due mainly to lockdowns. As the percent of the US population that has had COVID-19 rises and the number of people vaccinated rises, we are getting closer to herd immunity. Then people will feel even safer going out and governments will have fewer excuses to keep their economies locked down. We can all become Florida or Florida-Plus. That will all happen without any stimulus bill.

Second, the $1.9 trillion bill represents government taxing us or our children in the future to spend money in places where we the people have chosen not to spend it now. The bill is, in essence, a huge instance of central planning with government officials’ preferences overriding ours. The bill, for example, contains $28 billion for transit agencies, $11 billion in grants to airports and airplane manufacturers, and $2 billion in grants to Amtrak and other transportation. How does the government know that those are the right amounts? What if, as I predict, when the pandemic and lockdowns end we will still have fewer people wanting to ride transit because they and their employers will opt for a hybrid model of some at-home work and some in-office work? The effect of this misallocation of resources won’t necessarily show up in GDP because GDP measures government spending at cost rather than at value. But this spending will make us somewhat worse off. It’s far better to rely on people having the freedom to make their own allocations.

If the government gets out of the way, the economy will recover. Maybe it takes an outsider to see that and to say that. I just did.

Read the whole thing.


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Understanding MMT

I’ve mostly completed my study of MMT, although I have a few more papers to read. But I feel like I know enough to draw a few conclusions about how MMT relates to the broader field of economics.

When reading the Macroeconomics textbook by Mitchell, Wray and Watts, I was frequently struck by how MMT is almost the exact opposite of Chicago school economics, particularly the monetarist version I studied in the 1970s. On a wide range of issues, MMT is on one end of the spectrum, the Chicago school is on the other end, and the mainstream is somewhere in between.

Here on some examples:

1. Chicago economists believe that the supply and demand model is extremely useful for a wide range of markets, even markets that don’t meet the classical definition of “perfect competition”. Mainstream economists believe the S&D model is quite useful, but worry more about imperfect competition. MMTers are highly skeptical of S&D models, viewing the model as only useful in a very limited number of cases.

2. Chicago school economists believe that free market policies are almost always the best. Mainstream economists believe that free market policies are often optimal. MMTers are highly skeptical of what they call “neoliberalism”, viewing it as almost a religion.

3. Chicago school economists don’t believe there is much value in talking to bankers when trying to understand how monetary policy works. MMTers believe that knowledge of the nuts and bolts of the banking industry is highly important when trying to understand monetary policy.

4.  Chicago school economists believe that the concept of opportunity cost is extremely important, and applies to almost all policy debates.  That’s a bit less true of Keynesians, whereas MMTers assume that in many if not most cases the economy is well below full employment, and there is no opportunity cost to additional government expenditure.

5.  Modern Chicago economists are extremely skeptical of the “Phillips curve” approach to macroeconomics.  Earlier monetarists such as Milton Friedman thought there was a short run tradeoff between inflation and unemployment, but no long run trade-off.  Mainstream economists sort of agree with Friedman, but also argue that there might be some long run trade-off due to hysteresis.  MMTers seem to be most enthusiastic about the claim that boosting aggregate demand can boost employment over the long run, highly skeptical of natural rate models that say that AD doesn’t matter in the long run because money is neutral once inflation expectations adjust.

6.  Chicago school economists tend to favor relying on monetary policy to determine AD, and are highly skeptical of the efficacy of fiscal policy.  Mainstream economist favor of mix of the two, whereas MMTers prefer fiscal policy and are skeptical of the efficacy of monetary policy.

7.  Chicago school economists argue that it is most useful to treat money as exogenous, i.e. under control of the central bank, at least under a fiat money regime.  Mainstream economists treat money as endogenous in short run models with interest rate targeting, and exogenous in long run models trying to explain large changes in the trend rate of inflation.  MMTers treat money as being almost completely endogenous.

8. Chicago school economists believe that changes in interest rates primarily reflect the income and Fisher effects.  Thus falling interest rates are usually an indication that money has been tight in the recent past.  Mainstream economists view interest rates as being heavily influenced by monetary policy (the liquidity effect), but also reflecting the income and Fisher effects, especially in the long run.  MMTers see interest rates as almost entirely reflecting monetary policy, at least under fiat money.  They mostly ignore the income and Fisher effects, and reject models of the “natural rate of interest.”

9.  Chicago school economists see investment being determined by saving rates.  Mainstream economists see investment as being determined by saving rates during normal times, but also worry about a “paradox of thrift” when interest rates are extremely low.  MMTers see the paradox of thrift as being the norm.

10.  Chicago school economists believe high inflation is caused by excessive money growth.  Mainstream economists see high inflation as being caused by a mix of monetary policy and supply shocks.  MMTers see high inflation as mostly reflecting aggregate supply problems.

Because I’m a Chicago school economist, the MMT model doesn’t have much appeal for me.  That’s especially true because their arguments are often confusing and unpersuasive, even to mainstream economists.  In my view, MMT may have some success promoting ideas such as aggressive fiscal stimulus, due to the worldwide trend toward low interest rates.  I doubt, however, that they’ll make much headway in convincing the profession that their theoretical model makes sense, unless they can find a more persuasive way of explaining their ideas.

BTW, I’d say the same about market monetarism.  I expect we’ll have some success convincing the profession that NGDP targeting make sense, but very little success in convincing economists that the monetarist approach to monetary theory has value.  But I’ll keep trying.

PS.  It’s not clear to me that all of the ideas in the textbook I read are MMT beliefs.  Thus there may be some MMTers who are more favorably inclined to free market policies.


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Look at money!

I ended a recent MoneyIllusion post with this amusing equation, as a sort of throwaway:

M*V = C + I + G + (X-M)

The comment section convinced me to say a bit more about the equation. How should we think about it?

Start with a barter economy and look at the exchange of apples and oranges. If the price of apples in terms of oranges moves over time, how should we think of that change? Obviously it might reflect a shock in the apple industry, the orange industry, or both. Therefore it might be useful to compare each good against many other goods, to see if one of the two goods was clearly moving in price against almost all other goods.

A more familiar example is exchange rates. If the yen price of euros goes up, that might mean a stronger euro, a weaker yen, or both. Here again you might look at each currency in terms of all other currencies, to get a better read as to where the “shock” was concentrated.  If the euro appreciated against all other currencies, then that would be suggestive that the move didn’t just reflect events in Japan.

Of course most transactions involve money for goods.  My general view is that in a microeconomic context it makes more sense to focus on the good in question, whereas in macro I focus on the money side of the transaction.

Consider a case where global oil output suddenly falls by 2%, and oil prices shoot up by 20% in the short run.  (Oil demand is highly inelastic in the short run.)  In that case, money expenditures on oil rise by about 18%.  And yes, that expenditure is a part of NGDP.  So why do I focus on the OPEC output shock and not the money side when explaining why 18% more is spent on oil?  Because the oil market is just one of many uses of money.  If people spend more on oil, it’s pretty easy to move money over from other sectors, or from savings.

In macro it’s almost exactly the opposite.  When we spend more at a macro level, we have more money being exchanged for thousands of different types of goods, services, and assets, in a wide variety of markets.  Now it’s simpler to focus on the money side of the transaction.  It’s easier to figure out why M times V goes up, rather than explain spending on many different types of goods.

In my book on the gold standard I looked at changes in the price level, although I would have used NGDP if better high frequency data were available.  I found that the easiest way to explain the big fall in global prices (and NGDP) during the early 1930s was to look at changes in the supply and demand for gold, rather than C + I + G in dozens of countries.

That’s not to say it’s impossible to tell a “Keynesian” story.  You could claim that reduced animal spirits led to less investment demand and a lower equilibrium global interest rate.  A lower interest rate boosted gold demand (or reduced gold velocity.)  But in practice, animal spirits don’t typically change that dramatically for no reason, especially in the aggregate.  In the early 1930s, it was increased demand for gold by central banks that first triggered the Great Depression, and this is what later reduced “animal spirits”, leading to additional feedback effects that further boosted gold demand and further reduced NGDP and prices.

Overall, I believe that NGDP during the gold standard can be best explained by focusing on the global gold market, but it’s not the only option.  It’s when we turn to fiat money regimes that the argument for a monetary explanation for NGDP becomes completely overwhelming, for two reasons:

1. Central banks have almost infinite ability to impact M (and great ability to impact V as well—via IOER)

2. Central banks often have mandates to target things that are closely related to NGDP, like prices and employment.

Perhaps the following analogy would help explain why the money focus is even more desirable with fiat money than with gold.

With old-fashioned sailing ships, you might want to focus on the captain’s decisions when explaining the path of the ship, but wind and waves would also play a non-trivial role.

With modern oil tankers, you’d be crazy to not focus on the captain’s decisions when explaining the path of the ship; the role of wind and waves would be trivial.

Now let’s return to M*V = C + I + G + (X-M)

It’s an identity, so it tells us nothing about causation.  One can think of this equation as a sort of argument, a debate.  It reflects two ways of describing NGDP, and it can be viewed as a dispute as to which approach is more useful in explaining what causes changes in NGDP.  Should we focus on the goods sold, or the money spent on those goods?

When inflation is extremely high, it’s pretty obvious that the monetary approach is the most useful.  You can’t explain hyperinflation by looking at what causes prices rises in 13,000 individual markets, and then adding them up.  There’s obviously a common factor. In most cases, close to 99% of hyperinflation is due to money growth, and the rest is higher velocity.  When inflation is very low, it’s more debatable as to which approach is the most useful for explaining changes in P and NGDP.

I happen to believe the monetary approach continues to be the most useful framework at lower rates of NGDP growth and inflation, because even though M and P (or M and NGDP) are no longer closely correlated, the central bank can and should move M to offset changes in V.  When if fails to do so, we can think about monetary reform proposals to make that failure less likely in the future.  Such reforms were enacted after both the Great Depression and the Great Inflation, which is why we now freak out about 1.5% inflation when there’s a 2% target, instead of minus 12% inflation or plus 13% inflation, which used to happen before we fixed the Fed.

If the monetary approach were not the most useful, then it’s unlikely that Fed reforms would have eliminated the wild price level swings we used to see, from double digit inflation to double-digit deflation.  Perhaps fiscal reforms could be said to have fixed the deflation problem (I doubt it), but obviously fiscal didn’t fix the high inflation episodes.

So what does M*V = NGDP actually mean?  One definition is, “The person who wrote down this equation believes that one should explain movements in NGDP by looking at the market for money.”  It’s a sort of exhortation:  Look at money!

And what does C + I + G + (X-M) = NGDP actually mean?  One definition is, “The person who wrote down this equation believes that one should explain movements in NGDP by looking at the factors that determine each type of spending.”  It’s a sort of exhortation:  Look at the major expenditure categories!

Me:  Look at money!



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