There used to be a debate over interest rate control vs. base control of monetary policy. We always knew (at least some of us always knew) that interest rate control couldn't work in theory, but it seemed to work in practice, so eventually even the die-hard defenders of base control quietened down, or were ignored, and we all became "horizontalists" in practice. Modern central banks conducted monetary policy by setting a short term interest rate, so the LM curve, at least in the short-run, was horizontal.
It is time to revisit that debate. We need to understand why interest rate control cannot work in theory, why it seemed to work in practice, and why it now no longer works in practice.
I am following the same theme as my earlier post on whether quantitative easing is trying to raise or lower interest rates, and as many of Scott Sumner's posts, like this one, and especially this comment.
Why can't interest rate control work in theory?
It has long been known that for every equilibrium of a monetary economy there exists another equilibrium (or a whole set of equilbria) in which all real variables are the same as in the first equilibrium and all nominal variables are different in the same proportion (multiplied by some scalar k). Don Patinkin's "Money, Interest and Prices" formalised this insight, but it has been known at least since David Hume's essay "On money". This insight need not rest on any particular theory of the economy, and could even be re-formulated to apply to disequilibria. It rests only on the idea that real variables, not nominal variables, are what matter. All behavioural functions are homogenous of degree zero in real variables (including the real stock of money). Monetary units should matter no more than whether we measure in metres or centimetres.
If you take this homogeneity insight, and add the assumption that the supply of money is exogenous, you get the Quantity Theory of Money (a change in the supply of money will cause an equi-proportionate change in all nominal variables), and the Neutrality of Money (a change in the supply of money will affect no real variable).
Post-Keynesian horizontalists (and we are all horizontalists now, unfortunately, because that's the underlying problem) reject the Quantity Theory because they reject the assumption that the supply of money is exogenous. But that misses the point. A revised Quantity Theory can be re-formulated taking any nominal variable as exogenous -- the price of gold, or nominal GDP futures, for example. The homogeneity insight does not depend on any definition of money supply being exogenous.
One implication of the homogeneity insight is that interest rates stay the same when all nominal variables change. This is true for both real and nominal interest rates, provided the whole time-path of present and future nominal variables changes by some scalar k. (We think of the nominal interest rate as being a nominal variable, but it isn't really, because it has the units 1/time, rather than $; instead it represents the rate of change of a $ nominal variable, just like the rate of inflation.)
If we think of interest rate control as the central bank setting the time-path of the rate of interest, the price level is indeterminate. There is nothing to stop the price level (and the stock of money, and all nominal variables) jumping onto any of the other equilibrium time-paths.
Monetary policy via interest rate control can't work in theory.
Why did it seem to work in practice?
The standard argument of why interest rate control works in practice is that prices are sticky. The economy can't jump from one nominal time-path to another. It takes time for monetary policy, seen as a gap between the interest rate set by the central bank and the neutral or natural rate of interest, to affect inflation. Provided the central bank could adjust the rate of interest more quickly than prices can adjust, the central bank can keep the price level determinate. If the actual rate is below the natural rate, and inflation rises relative to target, the bank must quickly raise the interest rate in response, and raise it more than the increase in inflation (the Taylor Principle), so that the real rate of interest rises relative to the real natural rate, to bring downward pressure on inflation. Provided the bank could respond faster than inflation, and faster than expected inflation, interest rate control could work in practice.
Interest rate control is like riding a bicycle. You can't keep the steering fixed and expect to stay upright. You need to keep moving the steering, and move it faster than your tendency to fall over, if you want to stay upright. And also like a bicycle, you need to steer left if you want to turn right. If you want higher nominal interest rates you first need to lower interest rates, so that inflation starts to rise, and expected inflation starts to rise, at which point you can raise interest rates, and raise them higher than originally, so that inflation and nominal interest rates eventually settle down at some new higher level.
That's how it was supposed to work in practice. Why did it stop working in practice?
I think the short answer is that something moved more quickly than central banks' response to that something. But what exactly was that something?
The first and obvious candidate for the something that moved too quickly is expected inflation. If the actual rate is above the natural rate, actual inflation will fall, and expected inflation will fall. If expected inflation falls more quickly than the central bank can lower the rate of interest, it will continue to fall, because the gap between the actual rate and the nominal natural rate gets wider and wider. The system is unstable.
With a credible commitment to an inflation target, that's not supposed to happen in practice. Expected inflation is supposed to remain "well-anchored" to the inflation target. But what that means is that the public trusts the central bank to move quickly enough to validate that trust. If the public believes that the central bank is too far "behind the curve" to validate those expectations, it would be irrational to continue to believe that future inflation will stay at target. And as soon as expected inflation comes adrift from the target, the bank must move even more quickly to get ahead of the curve.
There are always lags in monetary policy. It takes time for the bank to realise that the actual rate is above the natural rate, to lower the actual rate, and for the lower actual rate to stop the disinflationary pressures. If people trust that the bank will eventually get ahead of the curve, the curve stays fairly flat, and it is easier for the bank to get ahead of it. But if people lose that trust that the bank will eventually get ahead of the curve, that loss of trust makes the curve steeper, and makes it harder for the bank to get ahead of the curve. The loss of trust can become a self-fulfilling equilibrium.
Is it just a coincidence that the Federal reserve does not have an explicit inflation target, and yet is the most important central bank in the world, and at the "epicentre" of the financial crisis? It is easier for expected inflation in the US to become un-anchored, because there is no explicit anchor in the US.
A second candidate for that something that moved too quickly is the real natural rate itself. If the actual rate is above the natural rate, it is not just inflation that will be affected. Real economic activity will also fall, and will be expected to fall. When people expect future real demand for goods to be lower, investment demand falls (the accelerator), and real consumption demand falls (the multiplier), so the real natural rate also falls.
If the actual nominal rate of interest is above the natural nominal rate, the gap widens for two reasons: expected inflation falls; and the real natural rate falls.
Again, if people trust that the central bank will eventually get ahead of the curve, expectations of future real activity will remain well-anchored, just like expected inflation. But if people lose that trust, the curve gets steeper, and it becomes harder for the bank to get ahead of the curve.
But there have been many times in the past when central banks needed to lower interest rates, because they saw disinflationary pressures, indicating that the actual rate must have been above the natural rate. Why did it not always end in tears?
The financial crisis must have been the final straw that exposed the inherent instability of interest rate control. When the financial system is fragile, and bits of it break, the natural rate moves more quickly than normal, and the financial system also becomes more fragile when the actual rate is above the natural rate. Falling expected inflation, and falling expected real activity, weaken an already fragile financial system, and this lowers the natural rate by more than it would with a robust financial system.
With a strong financial system, maybe the inherent instability of interest rate control is a problem in theory, but not in practice. The curve is flat enough that people's trust that the central bank can eventually get ahead of the curve is a self-fulfilling trust. But with a weakened financial system, maybe the curve is just too steep. People lose trust that the bank can eventually get ahead of the curve, and this loss of trust makes the curve steeper still.
We knew that implementing monetary policy via an interest rate instrument was an unstable control-mechanism in theory, but it seemed to work well enough in practice, so we shrugged our shoulders and kept doing it. But it only worked because we trusted it to work. There were always two equilibria: one with validated trust in which prices were determinate and fairly stable; a second with validated mistrust in which prices were indeterminate. We were lucky to be living in the first equilibrium. The financial crisis eliminated that first equilibrium. It will be hard to go back to it, even when the financial crisis is over.
We need to switch to some other instrument for monetary policy, one which does not cause that inherent instability. The homogeneity insight tells us that any nominal variable (anything with $ in the units) will work in principle, and make the price level determinate. But some will work better than others. I am not advocating a return to base control, or the gold standard. Though each of these would make the price level determinate, the equilibrium real money base, and real price of gold, are too variable. I've written a long enough post, so I am going to leave that second question unanswered.
But whatever nominal variable we choose for central banks to buy and sell and control the price of, we could use immediately for quantitative easing, as well as permanently for the new monetary regime. Zero nominal interest rates do not mean that monetary policy is powerless; they just mean we were holding onto the wrong monetary lever. That damned lever has a very peculiar connection to the price level, and in the long run has no connection at all.
Great post!
This business of interest rate targeting has always seemed to coincide with a lot of hand-waving about some of these issues. What I find interesting is that the father of the natural rate of interest, Knut Wicksell actually makes the argument in Interest and Prices that once prices start going up, raising the interest rate back to the natural level may not be sufficient to stem increases in the price level (although it might be able to stop the acceleration in the rate of inflation).
Posted by: Josh | April 18, 2009 at 04:29 PM
Is this the part of Hume you are talking about?
we must consider, that
though the high price of commodities be a necessary consequence of the
encrease of gold and silver, yet it follows not immediately upon that
encrease; but some time is required before the money circulates
through the whole state, and makes its effect be felt on all ranks of
people. At first, no alteration is perceived; by degrees the price
rises, first of one commodity, then of another; till the whole at last
reaches a just proportion with the new quantity of specie which is in
the kingdom. In my opinion, it is only in this interval or
intermediate situation, between the acquisition of money and rise of
prices, that the encreasing quantity of gold and silver is favourable
to industry. When any quantity of money is imported into a nation, it
is not at first dispersed into many hands; but is confined to the
coffers of a few persons, who immediately seek to employ it to
advantage. Here are a set of manufacturers or merchants, we shall
suppose, who have received returns of gold and silver for goods which
they sent to CADIZ. They are thereby enabled to employ more workmen
than formerly, who never dream of demanding higher wages, but are glad
of employment from such good paymasters. If workmen become scarce, the
manufacturer gives higher wages, but at first requires an encrease of
labour; and this is willingly submitted to by the artisan, who can now
eat and drink better, to compensate his additional toil and fatigue.
He carries his money to market, where he, finds every thing at the
same price as formerly, but returns with greater quantity and of
better kinds, for the use of his family. The farmer and gardener,
finding, that all their commodities are taken off, apply themselves
with alacrity to the raising more; and at the same time can afford to
take better and more cloths from their tradesmen, whose price is the
same as formerly, and their industry only whetted by so much new gain.
It is easy to trace the money in its progress through the whole
commonwealth; where we shall find, that it must first quicken the
diligence of every individual, before it encrease the price of labour.
Posted by: Greg Ransom | April 18, 2009 at 05:49 PM
Thanks Josh!
Not so much that bit of Hume Greg; that's where he gets into slow price adjustment, and falls into the fallacy of a stable Phillips curve that can be exploited by monetary policy: "The good policy
of the magistrate consists only in keeping it, if possible, still
encreasing; because, by that means, he keeps alive a spirit of
industry in the nation, and encreases the stock of labour, in which
consists all real power and riches."
I meant the earlier bits like this: "Where coin is in greater plenty; as a greater quantity of it is required to represent the same quantity of goods; it can have no effect, either good or bad, taking a nation
within itself; any more than it would make an alteration on a
merchant's books, if, instead of the ARABIAN method of notation, which
requires few characters, he should make use of the ROMAN, which
requires a great many."
Posted by: Nick Rowe | April 18, 2009 at 08:03 PM
Interest rate targeting doesn't look at global deflation/inflation pressures does it?
I'd like to see something done about fractional reserve banking. Not free banking, I'd rather eat my garden welly.
Posted by: Dee | April 18, 2009 at 10:26 PM
“But whatever nominal variable we choose for central banks to buy and sell and control the price of, we could use immediately for quantitative easing, as well as permanently for the new monetary regime.”
Some people want the Fed to charge interest on reserves – i.e. make current interest rates on reserves negative. I see this only as a variation on interest rate targeting. The interest rate on reserves is a natural lower bound on the trading of reserve balances among banks i.e. the fed funds rate. (The only reason the Fed has had some difficulty “enforcing” the lower bound since it started paying interest on reserves is that not all depository institutions with balances at the Fed earn interest on those balances. The Fed has already indicated this is an operational problem for short term interest rate control that it still has to deal with.) Of course, the only reason that the payment of interest on reserves, positive or negative, has become an issue is that the Fed has engaged in credit easing to the point where it has needed to expand its balance sheet and wanted to use excess reserves as a new incremental funding source. Otherwise, the time series for excess reserves has been remarkably non-volatile and relatively insignificant in size for the past 50 years.
Question:
What would happen under a different type of targeting to the mechanism by which the Fed determines the supply of excess reserves in order to control the fed funds rate? How does it decide how quickly and how far to change the supply of excess reserves and therefore the interest rate at which banks trade reserves, in response to such strategic nominal targets as nominal GDP futures? It can let the market “determine” the rate, but how quickly? It still has to decide on pace. Where does the element of judgement come in when it takes responsive action that it knows must have an immediate effect on short term interest rates? Doesn’t the judgement anticipate the specific immediate consequence it expects for short term rates? And doesn’t that effectively mean it must still implicitly target a path for short term rates as a function of its strategic nominal target? And doesn’t that mean the mechanistic operation of short term rate control doesn’t really change? This seems to be assumed away as a detail. Volcker had to deal with this question in strategically targeting broad money supply while taking action that caused short term rates to change along a particular path. He didn’t raise rates in one shot. It took time. He exercised some judgement in the pace. Ultimately he backed off before completely destroying the economy.
I think the only substantial question is whether the Fed should take nominal rates negative now. But I don’t think that’s necessarily equivalent to a targeting dilemma. The rate effect involves judgement that must be exercised regardless of what you target. Given the nature of the judgement required, no particular target type or reading would force the Fed’s hand to take rates negative at a specified point in time. There is no automatic mechanism that translates to a specific action, anymore than there is now – not unless you abandon all caution with respect to the pace of a particular response. Keep dumping excess reserves in until nominal GDP hits the number? At all costs? Whether the target were nominal GDP futures or a 2 per cent inflation rate, the judgement about taking rates negative when and by how much is essentially the same. And how do you know that rates will go negative without specifically setting them there anyway? It’s not exactly a natural mode of spread banking.
Posted by: JKH | April 18, 2009 at 11:57 PM
Nick,
"We need to understand why interest rate control cannot work in theory, why it seemed to work in practice, and why it now no longer works in practice."
Ok, first of all, "interest rate control cannot work in theory"?
http://faculty.chicagobooth.edu/john.cochrane/research/Papers/determination_taylor_rules.pdf
Cochrane shows that interest rate control combined with a non-ricardian fiscal regime does just fine. If you want to complain about the reference to the fiscal regime then I (and I suspect Cochrane as well) would refer you to the Sargent and Wallace unpleasant arithmetic paper which shows that trying to do it with the quantity of money requires the same sort of fiscal cooperation. (Cochrane even express a small worry that all he's really doing is rephrasing the whole Sargent and Wallace argument but I think he's too modest.)
Second, "why it now no longer works in practice". The zero bound. Where's the evidence that if Uncle Ben could get a negative REAL interest rate then we wouldn't get the desired results? Furthermore, I refer you again to the consumption Euler equations which can be written entirely with respect to real variables, consumption today, consumption tomorrow and the real interest rate. People will try to satisfy this equation, if the real rate is too high the consumption today will fall and none of what you're suggesting changes that. The only thing you can do is lower the real interest rate.
Posted by: Adam P | April 19, 2009 at 04:12 AM
In the post you link to, Sumner says this: "This paradox gets resolved by assuming the government determines nominal cash balances and the public determines real balances. Interest rates play no role."
Interest rates play no role in the public's determination of real balances???
Since real interest rates are central to determining aggregate demand this is tantamount to saying that aggregate demand plays no role in determining real balances, is that what we think? Now at this point in his post Sumner apparently has in mind a world without any borrowing or lending and thus there is no interest rate, fine. But then he goes on:
"Let’s start by asking why interest rates matter. In principle, a doubling of the money supply should immediately double the price level. Most economists think that the reason it does not is that wages and prices are sticky (although other factors also may play a role.) So if prices don’t double in the short run, then some other variable must equate the now doubled nominal supply of money, with the not yet doubled demand for money. That variable is nominal interest rates, which are not at all sticky. They immediately fall to a level where money supply and demand are equated. Now we are in the world of IS-LM.
But note that in the example I just gave, the short run fall in the interest rate can be viewed as simply a symptom of the stickiness of wages and prices, and also as a factor that slows down the rise in nominal spending (by temporarily raising money demand or lowering velocity.) So I it doesn’t have to be viewed as essential to the monetary policy transmission mechanism. It may be central, but as we saw in the island without banks, it need not be central to the determination of nominal aggregates.
At this point an IS-LM supporter might be extremely frustrated, because so far I am only concerned with what determines the path of nominal aggregates, whereas IS-LM is usually viewed as a model of real GDP determination, with inflation a sort of afterthought that depends on SRAS. I agree that you cannot get real effects from money with a model of perfect wage and price flexibility. However you can get such real effects with wage and price stickiness, but without interest rates playing any sort of important role in the transmission mechanism..."
The first two paragraphs of the quotation from Sumner is an accurate description of the LM side of the model but he makes no mention of the IS side. Yet, it is on the IS side that the real effects show up and the transmission mechanism is the real interest rate. Basicaly, because prices are completely fixed, the fall in the nominal interest rate is also a fall in the real rate and this increases aggregate demand through consumption euler equations of consumers and by increasing investment by firms trying to equate the marginal product of capital to the real rate.
Posted by: Adam P | April 19, 2009 at 04:54 AM
Just a quick follow up.
In the IS-LM model as usually presented (say in Blanchard's undergrad macro book) the virtical axis is the real interest rate and we express the LM side as equating demand for real balances to the supply of real balances. In Sumners example of doubling the money supply but keeping prices fixed, if the nominal rate falling did not mean that the real rate fell as well then you couldn't even get the LM part into equilibrium. (Notice that if the nominal rate fell but the real rate was unchanged then tomorrow's prices must have gone down, not up.)
The point is, people hold real balances to buy real stuff and if the real rate didn't change then you'd get no equilibrium. The supply of real balances would be higher but the demand would be unchanged. The higher demand for real balances comes from the higher demand for real consumption working again through feeding a lower real rate into the consumption Euler equation.
Thus, when Sumner says: "So if prices don’t double in the short run, then some other variable must equate the now doubled nominal supply of money, with the not yet doubled demand for money. That variable is nominal interest rates, which are not at all sticky. They immediately fall to a level where money supply and demand are equated.", he is not quite right. The fundamental variable that brings the LM side of the model into equilibrium is still the REAL rate.
Posted by: Adam P | April 19, 2009 at 06:34 AM
Dee: there are two questions: what is the instrument for monetary policy (interest rate, base, price of gold, etc.); and what is the target of monetary policy (inflation, nominal GDP, etc.). OK, there's a third question: what are the indicators the bank looks at when deciding how to adjust its instrument to hit its target. I am just looking at the first question -- the instrument, leaving the other two aside. I think global inflation fits in somewhere with the other two.
I am against 100% reserve requirements. I want to lean the other way. I would like to monetise all assets (in principle). Hold all your wealth in some great big account, and be able to write cheques against it to pay for stuff. Seems more efficient. But it's a separate question to the one addressed here.
Will return later to JKH and Adam P.
Posted by: Nick Rowe | April 19, 2009 at 07:26 AM
Nick,
Below is linked a very informative speech by William Dudley, new president of the New York Fed, on the Fed’s balance sheet.
I view the Fed itself as a practitioner of monetary policy. My view is that theorists of monetary policy should be reading and attempting to understand what practitioners say as much as vice versa. But I find that the anti-Fed blogosphere sentiment tends to be relatively ignorant of the mechanics of what the Fed actually does. (This is my general impression; this is not directed at you, Nick.)
I further believe that in general the quality of the analysis provided by the Fed on its own monetary policy activities is superior. Every time I read a Fed speech it tends to confirm my own understanding of what they are trying to do and refute the typical arguments of anti-Fed propaganda I’ve run into elsewhere. And it’s not about monetary ideology. It’s just analysis of how things work now.
This speech contains confirmation of a number of points I raised on a competitor blog that were denied by the monetary theorists there. I just wanted to list the salient issues here, given your reasonably open mind to the practitioner’s real world situation, and what I think the fundamental importance is of some of these points.
Specifically:
Where the credit crisis started:
“First, we addressed the acute seizing up of inter-bank financing markets.”
The path of the Fed’s response (note the importance of interest rates rather than money in the objective of the response):
“Third, once policy rates were near the zero-bound, we expanded the type of assets that the Fed purchased. In order to put downward pressure on general longer term borrowing rates ...”
The critical role of bank capital adequacy in the crisis (a point I’ve also raised with you):
“The second major intent of the liquidity facilities has been for the Fed to expand its balance sheet and, by doing so, offset some of shrinkage that has been occurring among non-bank financial intermediaries. The fact is the banking system is capital-constrained, with insufficient capital to expand its balance sheet fast enough to offset the shrinkage evident in the non-bank sector.”
And:
“First, the facilities cannot address the fundamental problem—the shortage of capital in the banking system. The facilities can slow down the deleveraging process, but until the banking system is viewed as being sufficiently well-capitalized and is able to expand its lending activity significantly, the limits on credit availability caused by an impaired banking system will make it more difficult to generate a sustainable economic recovery.”
Most importantly in my view, the idea that quantitative easing (money expansion) is not the primary purpose of the Fed’s balance sheet expansion. In fact, I’ve used the exact word the Fed uses here, “by product”. Monetary theorists elsewhere rejected this as laughable, but provided no counter to the following type of explanation:
“First, in my mind, the goal is not the expansion of the balance sheet per se, but the objectives that I laid out earlier. In this respect, the expansion of the balance sheet differs considerably from Japan’s experience with quantitative easing. In the current circumstance, the Federal Reserve’s liquidity programs act on the asset side of the balance sheet as the Fed lends funds against less liquid collateral and expands its asset holdings via purchases of agency debt, agency MBS and Treasuries. The goals are to slow down the pace of deleveraging to reduce the risk of catastrophic failure, improve market function and ease financial market conditions.
In contrast, the Bank of Japan worked on the liability side of the balance. Their goal was to expand the amount of excess reserves held by the banking system so that the banks would be more willing to expand their credit provisions. Although the Fed’s activities have led to a big jump in excess reserves, this increase is incidental—a by product rather than goal of the asset-oriented programs.”
For some reason, monetary theorists elsewhere reject the fact that payment of interest on reserves is for the purpose of establishing a lower bound on the Fed funds rate, but here it is in fact:
“More importantly, the Federal Reserve now has the tools to allow the conduct of monetary policy to be separated from the size of the balance sheet and the amount of excess reserves in the banking system. In September 2008, the Federal Reserve gained the authority to pay interest on excess reserves. This provides a tool that allows Fed officials to tighten monetary policy and raise private sector interest rates by raising the rate paid on excess reserves.”
And some resist further by observing that the lower bound idea hasn’t worked perfectly yet, when the Fed has provided a rational explanation as in the following - if only these people would read the Fed’s own material:
“Some skeptics note that when interest on excess reserves was first implemented, the federal funds rate traded somewhat below the rate on excess reserves. This has created worry in some quarters that paying interest on excess reserves might not work very well as a tool for controlling the federal funds rate.
On this issue, two points are warranted. First, the relatively large gap between the interest rate on excess reserves and the federal funds rate was due, in large part, to the impaired condition of the banking system, which inhibited the willingness of banks to arbitrage that gap. Because balance sheet capacity was scarce, banks were reluctant to use their balance sheets to purchase federal funds at a slight discount to the interest on excess reserves rate. As the banking system returns to health, this arbitrage is likely to become more attractive, causing the gap between the interest rate on excess reserves and the federal funds rate to narrow.
Second, the Federal Reserve could alter its monetary policy framework in order to increase its control of monetary policy in a large excess reserve environment. It is beyond the scope of this speech to get into the details, but we have plenty of options in devising incentives for banks to hold reserves at the Fed that would improve our ability to control the federal funds rate. The challenge will be deciding on the best option, not in finding a workable approach.”
There has been no shortage of Fed speeches referencing its balance sheet policy, but I find this one is well worth reading as an illustration of the practitioner reality and a valuable context for theoretical proposals.
http://www.newyorkfed.org/newsevents/speeches/2009/dud090418.html?date=041809
Posted by: JKH | April 19, 2009 at 08:55 AM
Great post and discussion. A couple of random thoughts.
Perhaps we should not confuse the virtues of spartan economic modelling and the use of "the interest rate" as a sufficient statistic in the context of spartan modelling versus the complexities of real-time monetary policy practice?
Economists have often debated the virtues of central bankers keeping an eye on financial asset markets, particularly potentially disruptive bubbles in those markets. Free markets are supposed to efficiently and smoothly coordinate economic activities in ways that surpass the abilities of benevolent dictators or communist bureacrats using input-output models.
Perhaps central bankers should pay more attention to unusual booms (if not bubbles) in consumer durable purchases? Clearly there was an unsustainable boom or bubble if you prefer in housing and automobiles in recent years. But central bankers, particularly US central bankers, were incredibly slow to react.
Relying on monetary policy to constantly stimulate material growth seems to carry the same dangers with it as using steroids to enhance strength or diet pills to lose weight.
Posted by: westslope | April 19, 2009 at 02:42 PM
Adam P @ 4.12: I have just read (OK, skimmed) the John Cochrane paper. Wow! is my first reaction.
Some thoughts:
1. Cochrane and I are at root, I think, asking the same quaetion. He looks at determinacy of the price level (and inflation, etc.) under interest rate control, and I am asking whether interest rate control got us into this mess, and that we need to abandon it to get us out of it.
2. For about the first half of his paper I thought he was mad. Then I slowly switched to think that he was just pretending to be mad in order to critique a mad literature, by playing the game on their turf.
3. If the determinacy of the price level under interest rate control rested on such esoterica as Non-Ricardian fiscal regimes (which introduce, I think, a trivial non-superneutrality of money, so that the real natural rate depends on inflation), or the Calvo Phillips curve of equation 27 (which introduces a non-super-duper-neutrality, since the real natural rates of output and interest depend on the rate of change of inflation), then I would say it's "game over" for determinacy under interest rate control. Those are far too thin reeds on which to rely on for the monetary system not blowing up in our faces.
4. In terms of Cochrane's paper, I want to line up very solidly behind the "Old-Keynesians". Neither the price level nor the rate of inflation are jump variables. There is not just price level inertia, but inflation inertia as well. I do not like the Calvo Phillips curve, just because it does not exhibit inflation inertia. But Cochrane misses the fact that you can get inflation inertia on a solid theoretical foundation if you reject Calvo-pricing (firms change prices at random) and replace it with Taylor pricing (oldest prices change first).
5. So I line up with the old Keynesians (inflation cannot jump), but I worry more about lags in the central bank's response. And not just expected inflation, but real output, and financial fragility, respond to monetary policy.
But I have probably not done his paper justice on such a quick read.
Posted by: Nick Rowe | April 19, 2009 at 03:19 PM
JKH @ 11.57:
In the 1970's the Bank of Canada used interest rate control *instrument* (very similar to what it does now) to *target* the money supply (whereas now it targets inflation). I am suggesting abandoning interest rate control as an *instrument*, but perhaps keeping the same inflation *target*.
What happens to interest rates? You let the market determine them, just as the market determines the exchange rate, ever since the Bank of Canada abandoned fixed exchange rates and stopped buying and selling forex. If need be you can have interest rates on positive or negative reserve balances at 25bp below and above some floating market reference rate (LIBOR, or something??).
So, the Bank of Canada buys and sells some real asset (bricks? plywood? GDP futures? the TSX300 index? real-return bonds?) and adjusts the nominal price on that asset (continuously? at monthly intervals?) so that it's target (future inflation?) stays at some fixed level (2%?).
But I'm still trying to get my head around why an interest rate instrument won't work. I'm not quite ready to say what I want to replace it with (I expect I should be, and have an alternative policy in place, but, Oh well, human weakness).
On negative nominal interest rates: if the central Bank(s) abandoned interest rate control as the instrument of monetary policy, and used some other, proper instrument to loosen monetary policy, I now believe (heretically) that short-term safe interest rates would rise. If zero interest rates are a sign of overly tight monetary policy, then negative interest rates are neither necessary nor sufficient for getting us out of the recession.
It's not that we need to raise interest rates. Rather, we need to do things with monetary policy which would, as a side-effect, raise short safe nominal interest rates. And we can do those things.
My views have been changing this last few months.
Posted by: Nick Rowe | April 19, 2009 at 03:52 PM
Adam P @ 4.54 and 6.34: I am leaning towards Scott Sumner's view, (I do not see the interest rate channel as essential) but my head is not clear on this.
Consider this thought-experiment:
Start in ISLM equilibrium, hold prices fixed, then pass a law which holds the interest rate fixed (sort of like a minimum wage law), to get a horizontal "RR" curve. Now increase the money supply (one-time helicopter drop if necessary). What happens? LM shifts right. IS does not shift (OK, there may be a purely temporary shift with a helicopter drop of cash, which is a one-time tax cut, but go past that point.
The RR curve determines the (nominal and real) interest rate. The LM and IS intersect below the RR curve. What determines y? Is it where the IS intersects RR, or where the LM intersects RR? Or neither?
You might say that y is determined where RR intersects IS? I would say it's somewhere between RR-IS and RR-LM. The excess supply of money, constrained by excess demand for bonds in the bond market, will spillover into the goods market directly. The ISLM has a very impoverished view of the transmission mechanism.
That old 1970's disequilibrium theory approach (the one I was rabbiting on about in my last post) could have answered this question formally.
By the way, I like to have both nominal and real interest rates on the vertical axis, then stick a wedge, equal to expected inflation, between the IS and LM curves.
Posted by: Nick Rowe | April 19, 2009 at 04:29 PM
Follow-up: suppose we live in a strict Islamic theocracy, where all interest is banned. And none of those fancy ways that clever Islamic bankers think up of getting around this regulation either. Now decrease the money supply. Does this reduce AD? Yes, I would say.
Posted by: Nick Rowe | April 19, 2009 at 04:31 PM
Nick 3:52,
I’ll try once more.
In the current interest rate targeting regime, the central bank is the monopoly provider of reserves to the system. It specifies the level of reserves required. It determines the level of excess reserves in the system and influences the short term rate by doing this.
Even in a system like Canada’s, with a reserve requirement of zero, the Bank of Canada can change rates by providing an excess or deficiency of clearing balances around the zero level. The actual required level (including a zero requirement) is irrelevant to the interest rate transmission mechanism. It is the differential achieved against the requirement to be at a specified level of balances held at the central bank that causes short term interest rates to change. The differential is the critical variable. That’s why the level of reserves per se and the multiplier idea are irrelevant to monetary policy.
So the question becomes, what does it mean for the market to determine interest rates? What is the mechanism relative to a central bank that still determines the level of clearing balances in the system, and that has the same ability to change interest rates by supplying or withholding balances?
What I’m saying is that whatever the monetary target, the central bank must still use judgement in translating deviations from that target into actions with respect to the supply of reserves and therefore with respect to the consequences for short term rates. So the central bank is still determining interest rates because it translates policy tracking to changes in reserves to interest rates. It may not set a fed funds target explicitly, but it will certainly set one implicitly on an iterative basis. This was my point on the Volcker methodology. He couldn’t help but make judgement on where interest rates should be at a given point in time, because his actions on restricting reserves were finite and iterative by definition. He didn’t make a decision to suddenly triple interest rates in one day and then it was over. He made judgements about reserve supply over many discrete time periods.
You say the market rate might be LIBOR, but the Fed’s actions with respect to supplying adequate clearing balances are going to affect LIBOR the same way that they do the fed funds rate now. (Actually, the appropriate market rate probably would not be LIBOR, which directly is an offshore Eurodollar rate rather than a domestic rate, although it’s used for some purposes as a domestic index.) The relevant rate would be the market rate equivalent of the effective fed funds rate now, which is, well, the effective fed funds rate. Remember that the effective fed funds rate is still a market rate. It’s the target fed funds rate that is an “administered rate.” The effective Fed funds rate is no less a market rate right now than is the repo rate or the t-bill rate or the treasury bond rates – all of which are set in markets in which the Fed has the option of participating. The fact that the fed can participate in a particular market doesn’t mean rates aren’t set according to the market. So the effective fed funds rate is a market rate now! The only difference that I can see is that the target fed funds rate would not be announced and would not formally exist. But it would exist in an implicit or soft way on an iterative basis in the minds of Fed officials who are deciding how aggressively to change the supply of reserves in the face of some deviation from the monetary target variable, as per Volcker. In fact, such a system would be less transparent than the one we have now, in the sense that the direction of market rates is still at the mercy of a Fed whose judgements on supplying reserves still have a lot of subjectivity in translating deviations from monetary targets to a given pace of changes to reserve supply and therefore interest rates!
The Fed is the monopoly provider of reserves. You can’t get away from interest rate targeting in such a market. Monopoly providers have pricing power one way or another, explicitly (target rate) or implicitly (rates resulting from Fed judgements on the effect of quantity decisions on rates).
You’d have to show me how you would completely change the bank clearing system and the Fed’s monopoly role in it to convince me otherwise. I don’t think it can be done without constructing something that is dysfunctionally chaotic for the bank clearing and settlement system. That’s why I think these various proposals to eliminate Fed interesting rate targeting are not fully baked at this point.
Posted by: JKH | April 19, 2009 at 04:48 PM
Nick,
Most of our debates on this blog seem to center on whether the real rate is the transmission mechanism for monetary policy, I think it's the only mechanism and you don't. Let me then explain my reasoning and then you can tell me where you disagree:
Let me set the context by asking and answering a basic question. Why do we think demand curves (for a single good) slope down. My understanding is that we think the substitution effect usually outweighs the income effect. If we raise the price of a good, holding all other prices constant, then people substitute away from the good that just got more expensive and towards the other, now relatively cheaper, goods. The key point here is that it's relative prices that are changing.
Now, why do we think that aggregate demand curves slope down? If we change the aggregate price level why do people demand less? Well, they do if we make current consumption more expensive relative to future consumption, then people substitute away from current consumption and towards future consumption. It's just like the preceding paragraph but the different goods are consumption at different points in time. But again, when comparing aggregate consumption at various points in time it's relative prices that matter and relative prices are given by real interest rates. After all, the consumption Euler equation is nothing more than the first order condition for intertemporal maximization of utility.
Thus it comes down to this, the idea that monetary policy can change aggregate demand without changing the real interest rate is tantamount to saying that monetary policy can make people stop maximizing their utility functions. I just can't get there.
Posted by: Adam P | April 19, 2009 at 05:07 PM
On your islamic example with all interest outlawed I'll distinguish 3 cases:
1) the reduced money supply is permanent in which case it's deflaionary, future prices will fall and the expected deflation is a raise in the real rate. AD falls but the real rate is still the transmission mechanism.
2) The reduced money supply is only this period but the supply of money is not reduced too much. The people just turn over the money stock they have more frequently, velocity increases and AD doesn't change.
3) Presumably velocity has some finite upper bound. If the money supply is reduced so much that velocity can't rise enough to keep output fixed then output does fall. Notice I said output, not AD. To me the problem here is that the lack of money has imposed transactions costs on society that weren't there before. This is an adverse productivity shock, not a reduction in AD as we usually conceive it.
Posted by: Adam P | April 19, 2009 at 05:15 PM
Quick follow up:
Ok, the real rate isn't quite the only transmisson mechanism. If an open market operation transfers money from people with a low marginal propensity to consume to people with a high propensity to consume then that can work too. However, I don't think that's a reliable way to conduct policy since you can't really know who has a higher propensity to cosume and anyway an agent's marginal propensity to consume is itself endogenous and thus not invariant to what you do.
Posted by: Adam P | April 19, 2009 at 05:26 PM
JKH @4.48 : Just some context. You know and understand a helluva lot more than me about the actual workings of the financial system. My brain doesn't work the same way. So when I don't seem to give your comments the proper response they deserve, that's what's at the root of it. It takes a lot of time for what you say to slowly seep into my brain, in a simplified and more abstract way.
And the ideas I'm putting forward here, especially in this post, are indeed a long way from fully-baked. I'm still trying to get my head around what I believe.
With that in mind, let me give a first response (it will probably take weeks for it to sink into my head properly, if it ever does).
First, some terminology: there's the monetary policy instrument, and the monetary policy target. The instrument is the thing the Bank moves up and down every few days or weeks in order to try to hit the target. So right now, we have an overnight rate instrument, and an inflation target. I'm saying abandon the overnight rate instrument. (I'm not yet sure what other instrument I want to replace it with).
In my very abstract and oversimplified way of thinking about an interest rate instrument, I think of the Bank as buying and selling short term "bonds" in order to manipulate the interest rate on those "bonds". And it moves that interest rate around, from month to month, in order to keep future inflation at the 2% target, as best it can. It's still a "market" interest rate, but the Bank intervenes in that market, by buying and selling "bonds", for Bank liabilities (base money). And the Bank does not buy and sell foreign exchange, shares, commercial paper, or anything else.
I want it to stop buying and selling those "bonds", and start buying and selling something else instead. That is what I mean by changing the instrument.
Now, I know that these "bonds" are not really bonds in any normal sense of the word. But in my way of thinking, any time A makes a loan to B, that is equivalent to A buying a bond from B. And we are talking about loans between the Bank of Canada and the commercial banks. So even though my way of thinking about interest rate control sounds totally different from any description of the settlement system, there must exist some dictionary that can translate between my way of thinking and bankers' way of thinking. (But I was never very good at understanding those details, and coming up with that dictionary myself).
At the moment, commercial banks settle payments between themselves on the books of the Bank of Canada (but they don't have to). The Bank of Canada conducts monetary policy by adding or subtracting from those settlement balances (buying and selling "bonds") in order to manipulate the interest rate in that market. It used to intervene in the market for foreign exchange, in order to manipulate the exchange rate (when we had fixed exchange rates), but it no longer does so (and it's scared to even talk about doing so, for fear of the US response). But we can imagine a world in which the Bank of Canada conducts monetary policy by buying and selling foreign exchange, rather than settlement balances, can't we? So the Bank of Canada would be a player in the forex market, but no longer a player in the overnight rate market, can't we?
But I am not at all sure whether I have missed your point entirely. And since I have a weak understanding of the current settlements system, I am not at all sure how the settlements system would have to be changed if the Bank adopted a new instrument and operating procedure.
But my instinct is to say: "the Bank should buy and sell plywood futures (or whatever), and manipulate the price of plywood futures to keep future CPI inflation at the 2% target, neither add nor subtract from settlement balances, and let the overnight rate go whereever it wants to, and let the bank rate and interest on reserves float at 25bp above and below the overnight rate."
Curses! I have to keep signing in, or else signing out, to get it to accept my comments. (If you have the same problem, remember to "copy" your comment onto the clipboard first, so you don't lose it, and can "paste" it back in).
Posted by: Nick Rowe | April 19, 2009 at 06:41 PM
Nick, if you have a spare hour, please watch this video. It gets more interesting in the second half and he discusses many topics we have discussed over the past few months.
http://mises.org/multimedia/video/misescircle-colorado09/05_Woods.wmv
Posted by: pointbite | April 19, 2009 at 07:09 PM
The speech is given by Thomas Woods, it's about the depression of 1920 and the reason nobody knows about it.
http://www.thomasewoods.com/
Posted by: pointbite | April 19, 2009 at 07:14 PM
JKH:
That certainly was not the point I was trying to make at Scott's blog. The argument being made was that Fed was neglecting simple quantity remedies as a corollary to its fixation on the overnight-rate as a mechanism of transmission. Scott argued that this fixation was made apparent by their decision to prioritize supporting a lower-bound on the FF rate rather than accomplish meaningful QE.
I don't think anyone seriously disputes that Fed is preoccupied with enhancing liquidity. This was the genesis of their interventions. We've moved long past that point to considering whether that policy is meaningful or effective.
As John Taylor and others have argued, the Fed's preoccupation with the liquidity of certain markets stems from an illusion and misapprehension of market dynamics. In essence: there is no liquidity problem only a solvency problem, and by its preoccupation with targeted liquidity, the Fed is missing the forest for the trees: i.e., by encumbering itself in a vast array of speculation that threatens to unmoor inflation expectations and ignoring the simple, limited QE necessary to revive the modicum of inflation that's needed.
Posted by: Jon | April 19, 2009 at 07:36 PM
Adam P: your last 3 posts are really helpful in getting to the crux of the disagreement between us.
Yes, let's ignore distribution effects (different MPC's etc.) We agree that's not the issue.
Why does the AD curve slope down? (Assume closed economy, price level on the vertical axis).
Your answer is very, very different from the standard textbook answer. And it's one I have not heard before. To be more precise, I have heard your explanation before, and I accept it as a valid explanation of something else, but *not* as an explanation of the downward slope of the AD curve.
The standard textbook answer is that the AD curve is drawn holding M fixed, so that when P falls, M/P rises. And the rise in M/P creates an excess supply of real balances. This excess supply of real balances causes: an excess demand for bonds, so bond prices rise, interest rates fall, consumption and investment demand rises (the standard "Keynes effect"). But monetarists might add that an excess supply of real money can also create an excess demand for goods directly, as people try to get rid of the excess money in the goods market, not just the bond market. (And the textbook might add the increased real wealth from higher M/P, but that is small. And it might also add a wealth effect from higher real bonds, but that's just a distribution effect, so let's ignore it).
Implicit in the textbook story is the assumption that expected inflation is constant, so the fall in the price level is assumed permanent.
Now this is totally the opposite implicit assumption as in your story. You are implicitly holding the expected future price level constant along the AD curve, so that when the current price level falls, goods today are cheaper relative to good tomorrow. But what are you assuming about the nominal interest rate? I think you are holding it constant along the AD curve.
So you see a change in expected inflation as a movement along the AD curve. I see it as a shift in the AD curve.
But if the AD curve slopes down for the reason you say (and for only that reason), a permanent change in the price level would not affect AD, so the price level would be indeterminate. You would need to pin down the expected distant future price level exogenously to make the price level determinate, no?
In the Islamic example: suppose the fall in the price level is permanent, and suppose we don't hit the upper bound on velocity. If money only affects AD via interest rates, and if interest rates can't change, by law, why would the permanent fall in the money supply cause either current or fiyture prices (or expected prices) to change?
Posted by: Nick Rowe | April 19, 2009 at 08:07 PM
Nice posts Nick. welcome back!
I wish I had something to add, but I'm still trying to catch up. Great discussion
Posted by: bob | April 19, 2009 at 08:12 PM
AdamP?
But I find that the anti-Fed blogosphere sentiment tends to be relatively ignorant of the mechanics of what the Fed actually does.
My impression is that the Feds are looking at this as a liquidity issue whereas the blogosphere are looking at it as a solvency problem.
Nick? Sorry, I was being unlimited in a limited discussion. ;^)
Posted by: Dee | April 19, 2009 at 08:39 PM
Thanks Bob! I'm still trying to catch up too, re-reading the comments, and feeling I still haven't addressed them properly. And the main reason I haven't addressed them properly: because this stuff is hard (for me, anyway), and my head is just not as clear on this stuff as I would like it to be.
Posted by: Nick Rowe | April 19, 2009 at 08:57 PM
Thanks, Nick for your 6:41.
That was actually VERY helpful. A light bulb has gone off. I’ll get back later.
Jon,
“As John Taylor and others have argued, the Fed's preoccupation with the liquidity of certain markets stems from an illusion and misapprehension of market dynamics. In essence: there is no liquidity problem only a solvency problem, and by its preoccupation with targeted liquidity, the Fed is missing the forest for the trees”
I don’t agree with this particular characterization. The Fed is very aware of the liquidity/solvency distinction, and the presence of solvency issues that the Fed itself can’t address. The proof is in the fact that Dudley makes this point about as explicitly as possible in the very sections of the speech I quoted in my 8:55 a.m. above. The Fed’s functional role is limited to secured lending. That’s why it must rely on Treasury to provide direct capital (i.e. solvency) support to the banks.
As to its effectiveness in its role, that’s a more legitimate debate. I happen to think they’re doing it about right for now, given the portfolio effect of Treasury’s capital support and Congress's fiscal support.
Posted by: JKH | April 19, 2009 at 09:13 PM
JKH:
I think the Fed has become more aware of the solvency aspects of the crisis over time. It is important to recognize that the Fed is a dynamic institution, staffed by intelligent people, who among other things do listen when someone like John Taylor speaks. Nonetheless, Bernanke argued repeatedly during 2008 that the Banks were facing a liquidity not a solvency crisis.
But you've missed the point: John Taylor argued here that the liquidity crisis was mostly a mirage, and as discussed on Scott's blog, there is really no evidence of a crisis in domestic interbank lending--the Fed had no trouble keeping the FF rate below target. The trouble then is that the liquidity interventions have complicated Fed operations and motivated expanding the balance sheet. These are actions that risk unmooring inflation expectations.
Could be, but it would sense for them to be unwinding their liquidity programs.Posted by: Jon | April 19, 2009 at 09:43 PM
Jon,
The proof that something was seriously amiss in the domestic Fed funds market lies in the relationship between total reserves and non-borrowed reserves starting in early 2008. There was an obvious crisis. Literally 50 years of stability between these two series was thrown out the window. Non-borrowed reserves plummeted, meaning that borrowed reserves skyrocketed. To say the resulting distortion in financial flows among banks was unprecedented is an understatement of the problem.
The typical operating relationship between total and non-borrowed was near equivalence for 50 years; the number for most of 2007 averaged about $ 42 billion each.
By comparison, to take just one month in the midst of the credit crisis, total reserves in October 2008 were around $ 300 billion and total non-borrowed reserves were around $ (300) billion. That means the banking system in total actually had to borrow twice the aggregate reserve level in total. That’s the degree of mal-distribution between those who had no problem funding their reserve positions in the market, versus those who had to go to the Fed. It’s been that way since the beginning of 2008. That’s a liquidity problem in the fed funds market. And the liquidity problem reflected a mistrust by some banks of the solvency positions of other banks.
And:
“The Fed had no trouble keeping the FF rate below target”
That’s no proof that there wasn’t a liquidity problem. The reason for that is explained clearly in Dudley’s speech, and I referenced it earlier in my comments here.
Posted by: JKH | April 19, 2009 at 10:12 PM
"Arguably, the actual distribution of funds affects liquidity in money markets."
John Taylor
Posted by: JKH | April 19, 2009 at 10:22 PM
Do you think the divergence of M1 and M3 growth post 2000 has anything to do with it?
Is risk-free interest too small a component in the total interest rate charged? This would make other forces (credit modelling, permanent income, animal spirits, etc.) dominant.
Posted by: Michael Buckley | April 19, 2009 at 10:56 PM
Fed Vice-Chair Kohn made a similar speech to Dudley, with the same key points:
“In our approach to policy, the amount of reserves has been a result of our market interventions rather than a goal in itself.”
“We are paying interest on excess reserves, which we can use to help provide a floor for the federal funds rate, as it does for other central banks, even if declines in lending or open market operations are not sufficient to bring reserves down to the desired level.”
http://www.federalreserve.gov/newsevents/speech/kohn20090418a.htm
Posted by: JKH | April 19, 2009 at 11:07 PM
JKH:
The Fed discusses the issue of nonborrowed reserves in a memorandum attached to the H.3 statistical release. In particular they note:
In essence, the level of borrowed reserves was engineered. Banks were forced to borrow from the TAF because the Fed was draining monetary base through tbill sales and then making that money available through the TAF. Note: that isn't said explicitly by the above paragraph, rather its apparent sequencing of OMOs and TAF activity. The Fed first drained the money then auctioned it off via TAF. Why all the moving parts? Because the discount window had been stigmatized. Consequently, the level of borrowed reserves is not proof of a liquidity issue, although it could mask one. Taylor attempted to show that jumps in OIS spread were tied to Fed activity (scary speeches, tbill sales) rather than endogenous events that the Fed subsequently corrected. A fair statement, but then isn't that the point of using a rate-target rather than a monetization target? To permit the demand for money to fluctuate even as the short-rate is stable.
There is also the second matter we discussed on Scotts blog: the level of interbanking lending does not drop until October, i.e., until after the level of nonborrowed reserves started to rise.
Posted by: Jon | April 19, 2009 at 11:07 PM
Jon,
“In essence, the level of borrowed reserves was engineered. Banks were forced to borrow from the TAF because the Fed was draining monetary base through tbill sales and then making that money available through the TAF.
That causality is not correct in my opinion. The Fed offered TAF to institutions that couldn’t source funds. The demand was sufficiently high that the Fed was forced to drain aggregate reserves in order to avoid mal-distributions of excess reserves among those institutions that were long. Remember that TAF funds were required to bring TAF borrowers from short to flat positions. If the Fed didn’t drain much of the aggregate excess from the system otherwise, the others with long positions would have been too long. In practice, TAF injections that increase reserves are “reasonably simultaneous” with the measures that drain aggregate reserves. But the requirement for TAF injections reflects a volatile distribution of shorts and longs in the system, for a given level of system excess. The shorts required covering. The longs didn’t need to be so long. Hence the requirement for iterative targeted injections and system drains. (The system drains could also be targeted in a sense toward those with the money to buy/lend back to the Fed.) But the TAF injection was the logical rationale for the system drain; not vice versa, in my opinion.
Posted by: JKH | April 19, 2009 at 11:28 PM
Jon,
“Isn’t that the point of using a rate-target rather than a monetization target”
I’ve provided a reference to the explanation a few times. But the larger point is that critics in general (not you necessarily) like to jump opportunistically all over this aspect. The problem of an operationally effective lower bound didn’t start until the Fed started to pay interest on reserves. And the Fed didn’t start to pay interest on reserves until it ran extraordinary excess reserve positions. And it didn’t start to run extraordinary excess reserve positions until it was considered this to be a reasonable funding alternative due to the extent of its unusual asset expansion. And it doesn’t intend to run extraordinary excess reserve positions forever. And the problem is self healing as provided in the explanation. And the problem is moot anyway at the zero bound until the Fed starts to move the funds rate higher, when the conditions that led to the problem as described begin to wane by definition. Yet the critics like to pounce on the aspect that this was an operational glitch for all of several months following the first time in 100 years that the Fed started to pay interest on reserves, until it hit the lower bound when the problem became operationally moot.
Posted by: JKH | April 19, 2009 at 11:53 PM
Nick,
Re your April 19, 2009 at 06:41 PM
“But I am not at all sure whether I have missed your point entirely.”
Not at all Nick. I think you hit the nail absolutely on the head with your previous sentences:
“But we can imagine a world in which the Bank of Canada conducts monetary policy by buying and selling foreign exchange, rather than settlement balances, can't we? So the Bank of Canada would be a player in the forex market, but no longer a player in the overnight rate market, can't we?”
This is exactly what I’ve been questioning.
First, some terminology: The instrument/target distinction is useful. I think I’m guilty of conflating the terminology myself. Or perhaps the terminology isn’t quite differentiated enough for what I’m trying to express. E.g. right now, I’d say the target of many central banks is a stated target or target range for inflation. The Bank of Canada is explicit. The Fed is non-explicit. E.g. I’d say that nominal GDP is one alternative target. I think the “target fed funds rate” terminology, while commonly understood, is confusing in this sense. It’s more of a sub-target. Another way of differentiating is between strategic and operational targets, where inflation is currently the strategic target (implicit for the Fed) and the target fed funds rate is the operational target (explicit for the Fed). “Overnight instruments” are such things as dealer repos and discount window borrowing in the case of the Fed. (Now it has a much bigger platter of extended “instruments” for monetary policy in the credit crisis.) I believe some have suggested that “nominal GDP futures” could be an alternative instrument, for example.
I can now visualize the operation of a central bank balance sheet according to your view:
“Neither add nor subtract from settlement balances, and let the overnight rate go wherever it wants to, and let the bank rate and interest on reserves float at 25bp above and below the overnight rate.”
I think this logically implies setting a fixed formula amount of excess reserves in the system and not manipulating that amount in order to influence interest rates as is done now. Required reserves apart from this excess position could be zero as in Canada, or non-zero depending on the central bank’s use of reserve requirements as a tax on banks. The banks would still compete for available reserves to meet their individual reserve requirements (e.g. cover short positions to meet a zero requirement), and that would be the mechanism to determine short term rates. The longer end of the yield curve would ripple back to the short end more than it does now. As you say, central bank lending rates could be determined on the basis of market rates.
The corollary to this arrangement is that all other central bank balance sheet transactions would have to be sterilized for their potential reserve effect. This would require automatic OMO responses as reserve offsets. This isn’t a whole lot different than what is done now except that the excess setting would be a fixed policy. This would allow short term market rates to float freely. The sterilization rule would then apply to the new intervention instrument. Any action taken by the central bank to set the reference price would produce potential reserve effects that would have to be offset to avoid interference in interest rate markets.
Where I start to see potential difficulties with this is the actual effectiveness of market intervention using the new instrument, and even the usefulness of it. Take your example of plywood for example (crazy, but illustrative). Who’s to say that if the US Fed started to intervene in the plywood market that it wouldn’t accumulate an inventory equivalent in value to China’s $ 2 trillion inventory of central bank reserves (crazy, but illustrative)? The plywood market isn’t the same as the bank reserve market. The Fed is a monopoly issuer of bank reserves with pricing power over them. This is the essence of its normal leverage over the monetary system. It is not a monopoly issuer of plywood futures. And the comparison with China is quite relevant, I think. China has a heck of an ongoing challenge sterilizing its FX purchases in such a way as not to wreak havoc on its domestic monetary platform. It’s got a tiger by the tail. Has this dimension been thought through yet for the non-interest rate instrument approach for the Fed?
But I see another problem. What if the Fed were to intervene in a nominal GDP futures market? Suppose, as some would argue it could be doing now, it wants to bid up NGDP futures. Isn’t the whole point of this that it wants to boost anti-deflation expectations by putting money into the system through increasing the monetary base? (Futures intervention per se would't put cash in, but the point stands on its own.) And doesn’t this bring us back to my original point, which is that using the monetary base as a quantitative instrument translates implicitly to interest rate pricing? Quantitative easing would contradict our assumption of a fixed excess reserve position. It would affect interest rates. Using reserves to affect interest rates is implicit pricing of interest rates.
So I still have a problem.
Posted by: JKH | April 20, 2009 at 01:02 AM
Nick: "The standard textbook answer is that the AD curve is drawn holding M fixed, so that when P falls, M/P rises. And the rise in M/P creates an excess supply of real balances. This excess supply of real balances causes: an excess demand for bonds, so bond prices rise, interest rates fall, consumption and investment demand rises (the standard "Keynes effect"). "
Yes, but why does this mean consumption and investment demand rises? It's a chain of causality. Moreover, only today's P has fallen. You haven't said anything about future (expected) P, first assume it's either unchanged or larger. Thus, expected inflation is higher, real rates are lower (by even more than the fall in nominal rates) and the Euler equations give you your higher consumption demand. If future expected P has fallen in line with current P then expected inflation is unchange and your fall in nominal rates is exactly a fall in real rates and again it's this fall in real rates that causes the rise in consumption and investment demand through the relative price mechanism that I describe.
The qestion for you is this, if today's P falls but tomorrows expected P falls even more, do you still say consumption and investment demand rises? I say they don't. Your story says they do.
Posted by: Adam P | April 20, 2009 at 01:45 AM
Now, as for the real balance thing. Whatever drives people to hold real balances they clearly want more if they plan more purchasing. When we have an excess supply of real balances the way to get the LM equilibrium is to get people to have higher demand for real balances. This goes through the interest rate in your own story! The excess supply of balances first goes to the bond market as people try to get rid of the money, rates go down which increases demand for real stuff and this in turn increases demand for the real balances that facilitate the purchase of that real stuff.
Finally, monetarists might say that the excess real balances cause higher spending directly because people try to get rid of the excess in both bond and goods markets. I don't think this happens because I think that you hold the minimum in real balances that will fund your purchases and provide your buffer against the need to make unexpected purchases that can't wait, you are not at a point where you are indifferent to holding a marginal dollar or not. You've minimized your real balance holding and so the marginal dollar unambiguously goes to the bond market.
Posted by: Adam P | April 20, 2009 at 01:46 AM
Just to clarify, the last paragraph from my comment at 1:45 should read:
The qestion for you is this, if today's P falls but tomorrows expected P falls even more and by so much that the reduction in expected inflation is larger than the reduction in nominal rates, so real rates have risen, do you still say consumption and investment demand rises? I say they don't. Your story says they do.
Posted by: Adam P | April 20, 2009 at 01:49 AM
Another clarification, I was not holding all of M, nominal rates and future P constant since I understand you can't have both M and nominal rates constant when you change current P. Perhaps the analogy with the micro case was misleading. The analogy was meant to focus on the simple point that what drives this is relative prices and a substitution effect. Let me restate the basic point without the misleading preamble:
"if we make current consumption more expensive relative to future consumption, then people substitute away from current consumption and towards future consumption. It's just like the preceding paragraph (micro example) but the different goods are consumption at different points in time. But again, when comparing aggregate consumption at various points in time it's relative prices that matter and relative prices are given by real interest rates. After all, the consumption Euler equation is nothing more than the first order condition for intertemporal maximization of utility."
As far as I see this is the textbook story you told, I just highlight that if the real rate doesn't change than neither will real aggregates.
And again, if we change the path of real aggregate consumption but don't change the real rate then we've somehow convinced people not to maximize utility. Can monetary policy really do that?
Posted by: Adam P | April 20, 2009 at 03:45 AM
And what about accumulated debt and interest payment flows? Read steve Keen.
Posted by: reason | April 20, 2009 at 07:14 AM
Nick,
Just to reiterate, I’m not sure how intervening in plywood futures or GDP futures alone is going to affect the path of future inflation or future nominal or real GDP. It’s just a central bank in the process of betting it knows the outcome of monetary policy better than the market does. But that’s not the same thing as the monetary policy itself. Why would the fact that a central bank buys a futures contract change the market’s view of how the central bank is going to influence inflation or economic growth unless the central bank also does something with quantity and or the price of money? And if it changes excess reserve levels, we’re back to my Volcker model, where short term money/rates are the effective instruments, regardless of whether the target is broad money supply or whatever.
I remember a speech from David Dodge somewhere where he said FX intervention was useless unless it was unsterilized. That’s the analogy, I think. The idea that excess reserve balances are kept constant is akin to full sterilization of whatever intervention instrument is used “instead” of bonds as per your model. And if it’s full sterilization, I don’t see that there’s a net impact to expectations for inflation or growth.
Posted by: JKH | April 20, 2009 at 07:47 AM
To clarify my comment - changes in nominal interest rates have distributive effects. So monetary policy changes are not neutral (whatever the net macro effect is).
Posted by: reason | April 20, 2009 at 08:20 AM
JKH:
" Has this dimension been thought through yet for the non-interest rate instrument approach for the Fed?"
Short answer: not by me. Nor have many of the dimensions of an alternative instrument for monetary policy been thought through by me. This is me thinking them through now (or trying to), by arguing with you.
I'm (mostly) only a Fed (or Bank of Canada) "critic" in the sense that I think they could have done better if they had understood monetary policy fully, where "fully" means better than anyone (including me) understood it at the time. So they are "responsible" only in some ideal sense, and I don't blame them. It's the job of academics to do Sunday morning quarterbacking.
Terminology is messy. The overnight rate *target* isn't really a target, because it's only a temporary means to an end, to be changed quickly in the light of new information. It's where they are trying to set the instrument. And the Bank of Canada uses the words "operational guide" to refer to core inflation!
The Bank of Canada has a monopoly on its own liabilities (currency and promises by the Bank of Canada to pay that currency on demand). It has a monopoly on its own brand name "This is 20 *Canadian dollars* TM". Because everyone else in Canada has decided to use the liabilities of the Bank of Canada, or promises which are redeemable in Bank of Canada liabilities, to pay for almost everything, this makes the Bank of Canada's monopoly of its own liabilities very powerful.
I have a monopoly on Nick Rowe liabilities, but since nobody uses Nick Rowe liabilities as a medium of exchange, or promises to redeem media of exchange in Nick Rowe liabilities, my monopoly doesn't give me any power.
All Bank of Canada liabilities are economically equivalent to Canadian dollar paper currency. The reserves and settlement balances of the commercial banks are economically equivalent to big wads of paper currency sitting in a box with the name of the commercial bank on that box.
In the olden days, central banks used to buy and sell gold. The price of gold was both their short-term instrument, and their long term target, but in principle we can imagine central banks manipulating the price of gold, by buying and selling gold for paper currency, in order to hit an inflation target (or other long-term target).
So central banks would hold gold reserves. If the public demand for a stock of paper currency were increasing over time (which could be caused by real growth, or a rising price level, or whatever), then the gold reserves of the central bank would be increasing over time. If the central bank decided it was holding "too much" gold, it could do an open market operation in the government bond market. Buy bonds for paper currency, the paper currency then gets redeemed for gold, so the central bank now holds less gold and more bonds. And it can do an open market sale of bonds if it decides its gold reserves are "too low".
Central banks would operate in the gold market for "fine tuning", to keep the daily price of gold instrument where they want it to be, and in the bond market for "gross tuning", to keep their gold reserves at roughly the right level, and sufficient for their expected requirements for fine tuning the instrument.
In my overly abstract and simplified picture of the Bank of Canada's current operations, they are operating in the market for settlement balances for "fine tuning", to keep the daily overnight rate instrument where they want it to be, and operating in the bond market for gross tuning, to keep their net liability position with commercial banks in the settlement market at roughly the right level, and sufficient for their expected requirements for fine tuning the instrument.
I want them to switch from fine tuning the overnight rate instrument by intervening in the market for settlement balances, to fine tuning some other instrument. They will still need to do gross tuning by OMO.
Now you might ask, as I think you and Adam P are asking, "why does it matter?" Doesn't it all come down to the same thing, since all these different policy levers (instruments) are connected inside the machine we are trying to control, so that if you grab one lever, and move it, all the other levers will move too?
My answer is that the overnight rate lever (or any other nominal interest rate lever) is a very peculiar lever, and is connected to our ultimate target (inflation, nominal GDP, whatever) in a very peculiar way. First it's unstable: if you hold that lever fixed, the machine will explode. Second it's got a non-monotonic relationship with any reasonable target. If you want to get raise the target variable, you have to first move the lever one way, then later move it even further in the other direction.
My bicycle analogy was getting at this point (if you want to turn right, you turn the front wheel left, so you lean right, and then you can turn the front wheel right to stop yourself falling over, and the bicycle turns right). Cars are much easier. If you want to turn right you just turn the front wheels right.
Here's a simpler analogy. Targeting (say) inflation by controlling an interest rate instrument is like balancing a pole upright in the palm of your hand. The position of the top of the pole represents inflation, and the position of the bottom of the pole (the palm of your hand) represents the interest rate.
First it's an unstable equilibrium. If you keep the palm of your hand fixed, the pole will fall over. You have to keep moving your hand to keep the pole upright.
Second, if you want the top of the pole (inflation) to move north, you have to first move your hand south, so the pole starts to lean north. You then need to move your hand north, to stop the pole falling over.
If it's a long heavy pole, so only leans slowly (inflation inertia), and if you can move quickly, and anticipate gusts of wind, or observe quickly which way the pole is leaning, you can keep it upright, and keep the top of the pole roughly where you want it to be.
But there's a wall to your south which you can't go beyond (the zero interest floor). And your hand is up against that wall, and yet the pole is leaning to the south. You want to move your hand south, to start the top of the pole moving north, but you can't.
Solution: turn the damned pole upside down so it becomes a stable equilibrium, and the target end of the pole always moves in the same direction as your hand.
Grab hold of a different lever. As soon as the pole/machine sees what you are doing, and that you are loosening monetary policy, nominal interest rates will rise.
Will return later.
Posted by: Nick Rowe | April 20, 2009 at 08:50 AM
We actually addressed the distributive effect somewhere up there, nobody denies that moving funds from those with low marginal propensity to consume to those with high mpc can increase AD.
Posted by: Adam P | April 20, 2009 at 08:57 AM
Where the bicycle/pole/lever analogy breaks down is that the machine has expectations, and is trying to figure out what you are trying to do. It's like an intelligent servo-assist in the steering. That's why nominal interest rates will immediately rise when the machine realises you are loosening monetary policy by grabbing a different lever and moving it north.
Posted by: Nick Rowe | April 20, 2009 at 08:58 AM
Adam P
Yes I found your comment now - but my emphasis is a bit different. Isn't non-neutrality important given the original model we were supposed to work with. You rejected using this non-neutrality as a policy lever - that doesn't mean it isn't important in its own right.
Posted by: reason | April 20, 2009 at 09:34 AM
Nick,
I agree terminology is messy. And I wouldn’t necessarily argue that the academic terminology isn’t superior to real world terminology. It’s something we have to work around, unfortunately. E.g. notwithstanding the ambiguous terminology, the distinction between the “target” fed funds rate and the “effective” fed funds rate is absolutely crucial to understanding the operational implementation of monetary policy and the role of excess reserve management by the Fed. But there we are with terminological ambiguity, and somehow we have to struggle with it as a handicap in conversation. The substance to which we attach terminological tags is the important thing of course, but it requires ongoing page checks for terminological translation.
Thanks for arguing with me, Nick. It’s particularly gratifying compared to the alternative I’ve experienced elsewhere.
I struggle with gold due to my feeble academic background. But somewhere I read that the international gold standard sort of failed in the 30’s because the Fed more or less attempted to engage in a type of OMO quantitative easing that was essentially incompatible with maintaining the gold level. Does that sound like a remotely accurate interpretation? Anything outside of epsilon of being completely wrong would be encouraging for me.
“In my overly abstract and simplified picture of the Bank of Canada's current operations, they are operating in the market for settlement balances for "fine tuning", to keep the daily overnight rate instrument where they want it to be, and operating in the bond market for gross tuning, to keep their net liability position with commercial banks in the settlement market at roughly the right level, and sufficient for their expected requirements for fine tuning the instrument.”
I think that’s perfect.
“I want them to switch from fine tuning the overnight rate instrument by intervening in the market for settlement balances, to fine tuning some other instrument. They will still need to do gross tuning by OMO.”
Problem for me - gross tuning of settlement balances means implicit tuning of short term interest rates, I think.
So I’m having a problem with why proposed alternatives to the “overnight lever” wouldn’t have an immediate consequence that equates to the continuing existence, at least indirectly, of the overnight lever that you would claim to be replacing. Maybe I’ve got this wrong, but when a central bank holds gold as reserves, and intervenes to defend the price of gold, isn’t there an effect on the overnight interest rate, probably via an effect on bank clearing balances at the central bank? Or, if the central bank sterilizes the monetary effect of such intervention, doesn’t that also imply overnight rate fine tuning by not allowing a non-sterilized adjustment? So doesn’t the instrument of gold imply the continuing existence of an overnight rate “sub-instrument” which is an unavoidable knock-on decision for the central bank, passive or active? So I’m asking, does the instrument of gold replace the overnight rate instrument, or does it determine the operational path of an overnight instrument that remains in place? In that sense, isn’t it merely a case of heightened operational intensity in the way in which the central bank decides on its path for overnight instrument intervention?
“First it's unstable: if you hold that lever fixed, the machine will explode.”
Isn’t that a potential problem with all fixed levers, though? E.g. China’s dollar peg; gold pegs. Haven’t gold pegs been subject to serial failure because of that very problem?
I’m still trying to get the feel of the bicycle analogy. Too many personal crash memories and related PTSS, I guess. But I’ll try and reflect more on it without getting too messed up.
Posted by: JKH | April 20, 2009 at 09:36 AM
(My take on monetary policy is that morgage debt in many ways dominates the financial economy). A substantial part of the population sees an increase in interest rates (rightly or wrongly) as a cut in their income and vice versa. In normal times, this is potent (broad based) transmission mechanism.
Posted by: reason | April 20, 2009 at 09:45 AM
(Of course I come from variable rate Australia, so that biases my view).
Posted by: reason | April 20, 2009 at 09:46 AM
I don't think I quite rejected it as a policy lever but I thought it wasn't what we wanted to pin all our hopes on.
From my side though this is largely a theoretical arguement, but an important one. Sumner thinks that it all works through the quantity of money and worrying about interest rates is dangerously misleading. I think this is all wrong, that it mostly works through the REAL rate and that worrying about the quantity of money is dangerously misleading.
Finally though, my story was exactly the textbook story Nick gave, just rephrased. I don't see how it's controversial. Now Euler equations don't specify causality so if you change AD and then that changes the real rate via the Euler equation it may not be that real rate was the transmission mechanism. But all the simplest, most basic models (like IS-LM and the New Keynsian ones) work by changing the real rate and having that cause the change in AD just as Nick himself described. I also think that's by far the most theortically coherent story and I think we should keep that in the front of our minds.
Posted by: Adam P | April 20, 2009 at 10:37 AM
JKH:
If I am thinking of the same case, what looked like a refusal to engage in argument was really a mutual failure of communication, so that each saw the other as failing to engage. I know your blogging well enough to know that your knowledge and way of thinking is very different from academic economists like me. (On a good day, I can remember what "CDS" stands for!)
To give you an example: I am very relieved that you liked my fine-tuning/gross-tuning description of the settlements balances/OMO question. I was scared I might be totally wrong about something I ought to understand. I find it very hard to follow practitioners' (like David Longworth's) detailed descriptions of the workings of the settlements system. I can only understand such things at a very abstract oversimplified level. But that same need to abstract and oversimplify gives me perhaps an advantage in other ways.
"But somewhere I read that the international gold standard sort of failed in the 30’s because the Fed more or less attempted to engage in a type of OMO quantitative easing that was essentially incompatible with maintaining the gold level. Does that sound like a remotely accurate interpretation?" Yes. And more than remotely accurate. It is also why fixed exchange rate systems commonly break down. But there's also a deeper, underlying reason. Why do central banks follow OMO policies that are incompatible with maintaining a fixed price of gold (or fixed exchange rate)? Because they have ultimate implicit targets (like preventing mass unemployment, or keeping inflation at roughly the right level, or printing enough money to finance the government deficit) that are incompatible with the stated target of maintaining a fixed price of gold. They try to hit both targets at the same time, and the system eventually collapses. In the long run, monetary policy can only have one target. (And not everything can be a target either, as we learned in the 1970's, when we tried to use monetary policy to target unemployment, a real variable).
Back to your main question. The economy is like a box, with lots of levers sticking out of it. But all the levers are connected up inside the box, with a clockwork mechanism. So if the Bank grabs hold of any one lever, and moves it, all the other levers will move as well. So isn't it arbitrary which lever the Bank grabs hold of?
It depends on the clockwork. As a kid, I had a pedal powered fire engine. The pedals were on a crank. You alternately pushed the right then left pedal to make it go. But half the time, if you pushed the wrong pedal, it would go backwards. And a few times, when one pedal was at the exact bottom, and the other at the exact top, pushing on either pedal would do nothing. So I pushed the rear wheel round by hand. Interest rate control is like pushing on those pedals. Buying plywood (or whatever) is like turning the rear wheel.
If the bank starts buying plywood, raising the price of plywood, and tells everyone it is going to continue to raise the price of plywood, nominal interest rates will rise.
If interest rates rise because the bank reduces settlement balances, that's a tightening of monetary policy (the fire engine goes backwards). If interest rates rise because the bank buys plywood, that's a loosening of monetary policy (the fire engine goes forwards). Exactly the same rise in interest rates in each case, but very different implications for the rest of the economy.
I must work on my metaphors.
I apologise for getting very behind in responding to the many good comments.
Posted by: Nick Rowe | April 20, 2009 at 11:12 AM
Nick,
“Why do central banks follow OMO policies that are incompatible with maintaining a fixed price of gold (or fixed exchange rate)? Because they have ultimate implicit targets (like preventing mass unemployment, or keeping inflation at roughly the right level, or printing enough money to finance the government deficit) that are incompatible with the stated target of maintaining a fixed price of gold. They try to hit both targets at the same time, and the system eventually collapses.”
That makes sense to me, as does the idea of interdependent levers. Let me apply/extend this to the point I think I’m trying to make.
First, there may be an unnecessary complication in the hypothetical case of a central bank using the futures markets rather than the cash markets for its intervention. So let me first use the case of cash plywood instead. In effect, this is more comparable to the case of gold or the case of fiat money where the central bank typically funds the fiscal deficit by the accumulation of treasury bonds as assets. All of these cases can be analysed easily in terms of the effect on the central bank balance sheet and the cash flows that go through it. I think that the root of the communication challenge in relating to academic models is that I tend to focus on balance sheets and balance sheet management. Moreover, Fed speeches have typically been based on an embedded importance of understanding the Fed as a balance sheet operation, or an asset-liability management operation as it’s conventionally known in commercial banking. It’s very interesting to me that the Fed is focusing in recent speeches even more intensively on communicating its policy by explicitly explaining its operations in the context of its balance sheet. I’ve linked earlier in this thread to two such speeches made in just the past several days. Bernanke and Company are now conducting a surge in heavy duty balance sheet explanation. I relate well to this type of presentation. So for me the challenge is to try and translate the academic models/proposals I’m trying to understand to the prototype central bank balance sheet they imply.
So the question becomes, what are the implications of cash plywood intervention for the Fed’s balance sheet?
“If the bank starts buying plywood, raising the price of plywood, and tells everyone it is going to continue to raise the price of plywood, nominal interest rates will rise. If interest rates rise because the bank reduces settlement balances, that's a tightening of monetary policy (the fire engine goes backwards). If interest rates rise because the bank buys plywood, that's a loosening of monetary policy (the fire engine goes forwards). Exactly the same rise in interest rates in each case, but very different implications for the rest of the economy.”
I disagree with you here, Nick; I think conventional easing and plywood easing should have comparable yield curve effects. Let me explain.
Let’s talk normal times first, above the zero bound.
Suppose the Fed is using its normal interest rate intervention. How does it normally “ease”? It lowers the target Fed rate. The bond market reacts. If the market thinks the Fed is too easy, it will expect inflation, so the yield curve will steepen. In fact, the default response is close to a steepening simply because the short rate drops.
Now, suppose the Fed uses cash plywood intervention. It “eases” by purchasing plywood.
But here’s the important question – how does the purchase of plywood affect its balance sheet? The corollary question is how does it affect the clearing balances that banks hold with the Fed; and further, how does it affect the overnight rate? And then, how does it affect the yield curve? My contention is that there’s a fairly clear mapping between target Fed rate intervention, and cash plywood intervention.
Here’s how I would see it:
The Fed intervenes in the plywood market. Why? To respond to its concerns about the same type of economic variables that it responds to in the case of conventional interest rate intervention.
Pick a variable. Suppose its nominal GDP. We want to get nominal GDP up. So the Fed “eases” by buying plywood.
What happens to its balance sheet? That depends on what the Fed wants to happen.
What does the Fed want to happen to its balance sheet? And why?
It’s got a bunch of plywood in inventory. It’s paid for the plywood by cutting a cheque. What’s it going to do with the potential increase in bank settlement balances that the cashing of those cheques will produce for its own balance sheet and for the balance sheets and reserves of the banking system?
What good is a huge inventory of plywood in terms of having an effect on nominal GDP? Well, if the Fed accumulates the amount of plywood that China accumulates in dollar reserves, probably quite a bit. But that’s silly. The Fed isn’t after “quantitative tightening” in the plywood market per se in order to produce inflation in the economy at large. It’s using the price of plywood as a signal, not the quantity of plywood.
But the signal is no good unless there’s substance behind it.
What’s the substance?
It’s not quantitative plywood tightening. I claim that’s silly.
So what is it?
I claim it’s the effect the Fed wants for bank excess reserves and therefore for the overnight rate.
This is the same sort of effect that the Fed aims for in conventional easing.
The Fed wants to ease, and it’s signalling to the market that the degree of its easing will be known via its actions in the plywood market.
Now technically, the Fed will probably sterilize almost all of its quantitative plywood tightening. This is because it needs only a miniscule amount of excess reserve easing in order to produce a desired change in the fed funds rate.
The net result will be a net amount of excess reserve easing and fed funds rate decline that could have been achieved by fed funds rate target.
The signal is different – the price of plywood versus the target fed funds rate.
But the NECESSARY intervention is the same – the “effective” (as defined) fed funds rate.
So the yield curve effect, my point of disagreement with you above, should be exactly the same.
The difference is that plywood intervention requires a real economy intervention as a demonstration of an intended knock-on interest rate intervention. Fed funds targeting requires only an announcement of the target rate and interest rate intervention to manage the effective rate according to target. But both amount to the same type of interest rate intervention at the end of the day.
This is also why now we can say that the plywood futures market would be a realistic alternative to the plywood cash market. Either way, the ultimate deployment of fed cash would mostly be sterilized, since the necessary excess reserve adjustment would typically be small relative to the policy outcome in terms of the fed funds rate. Using the cash plywood market as a price signal would probably use up a lot more cash to achieve the desired economic intervention, compared to futures.
Either way, plywood or direct fed funds, the modus operandi can be used in an attempt to influence any economically important variable – inflation, real growth, nominal GDP, broad money supply, etc. E.g. The Fed can try to encourage future inflation (at the margin, or 1st derivative) or nominal GDP. It’s just that plywood intervention gives the additional transparency of specific price targeting and indexing, versus the looser and more eclectic methodology that the Fed uses today.
Posted by: JKH | April 20, 2009 at 12:27 PM
Zombies eat money, not brains.
The almost 1:1 correspondence between excess reserves and the increase in base money seems to my non-economist brain to be a very telling symptom that something is really broken somewhere. Has there ever been a liquidity trap without zombie financial intermediaries? Banks where a mess during the GD, they where a mess in Japan, and the biggies are a mess today in the US...
Posted by: Patrick | April 20, 2009 at 12:28 PM
Oops. Banks were a mess.
Posted by: Patrick | April 20, 2009 at 12:29 PM
As Koo points out in his balance sheet recession arguement and as Krugman pointed out in his "It's Baaack" paper, the 1:1 correspondence between excess reserves and and the increase in base money doesn't necessarily mean something is wrong with the banks. It could just reflect the lack of aggregate demand, the lack of demand for credit or real balances. The banks are keeping excess reserves because nobody else wants the money.
However, to my mind it does show that Sumner is 100% dead wrong in his insistence that money is what matters.
Posted by: Adam P | April 20, 2009 at 12:38 PM
The 1:1 correspondence between excess reserves and the increase in base money results from the fact that the Fed is using excess reserves as its liability instrument of choice in funding its own balance sheet expansion.
The extraordinary level of excess reserves is far more important as a means of funding for the Fed, than it is as statement of inference regarding the condition of the commercial banks.
I agree at least directionally with the connection to Sumner's view.
Posted by: JKH | April 20, 2009 at 12:59 PM
JKH, but does that answer the question of why the money isn't loaned out? Or are you agreeing with me that their's just no demand for it?
Posted by: Adam P | April 20, 2009 at 01:03 PM
Adam,
That’s a more complicated question. I’m not ducking it, but one of the things to keep in mind that given the fact that the Fed determines the level of excess reserves in the system, there’s no way of determining whether or not the money is being “loaned out” simply by looking at the level of excess reserves per se.
The level of required reserves is about $ 50 billion right now. That’s $ 50 billion supporting a banking system with a balance sheet size of about $ 12 trillion, I think. The excess reserve level has averaged around $ 700 billion or so in the past few months. So if as the accepted wisdom goes according to some, the banking system were to “use up” these excess reserves by lending and generating new deposits (as per the magnificent multiplier), thereby converting excess reserves to required reserves, then the US banking system would have to expand to an aggregate size of about $ 170 trillion in order to do it. This is absurd. But so goes the thinking of those who don’t reflect a lot on the balance sheet proportions of what is actually happening here.
That said, and more simply, I can’t disagree with the idea that credit demand is an important factor, but I think you have to slice and dice a lot of cross currents in the overall profile of current credit flows.
Posted by: JKH | April 20, 2009 at 01:22 PM
"... the Fed is using excess reserves as its liability instrument of choice in funding its own balance sheet expansion"
From here: http://www.frbsf.org/news/speeches/2009/0104b.html
Yellen says:
"... the Fed, like the Bank of Japan, has increased the quantity of excess reserves in the banking system well above the minimum level required to push overnight interbank lending rates to the vicinity of zero. The creation of such a large volume of excess reserves, in the Fed's case, results from the enormous expansion in the Fed's discount window lending, foreign exchange swaps, and asset purchases."
Ok then ... Could someone please explain the mechanics of this? If excess reserves are in fact not measuring excess reserves (i.e money in excess of required reserves the banks are keeping in the proverbial vault), then how can we get a read on , ummm, excess reserves?
Posted by: Patrick | April 20, 2009 at 02:00 PM
Some interesting tidbits of bank data... See for yourself here: http://research.stlouisfed.org/fred2/
Total Consumer Credit Outstanding
Securitized Total Consumer Loans
Total Revolving Credit Outstanding
Bank Credit of All Commercial Banks (% Chg. from Year Ago)
Loan Loss Reserve / Total Loans for all U.S. Banks
Posted by: Patrick | April 20, 2009 at 02:19 PM
Adam P @ 1.45, 1.46, 1.49, and 3.45:
The "Keynes effect" story of the downward slope of the AD is indeed the standard, Keynesian, interest-rate only channel of the transmission mechanism. It assumes away other possible channels.
If the price level fell, and the expected future price level fell by more, then we do have two offsetting effects. The fall in the price level increases aggregate demand, but the fall in expected inflation reduces it. The net effect can go either way. And this is because the demand for money can either decrease (because of falling P) or increase (because of falling inflation), So we can get either an excess demand or an excess supply of money.
Let me try another thought-experiment: According to the standard interest-rate only story, A has an excess supply of money, so goes (only) to the bond market, bids up the price of bonds, and forces down the rate of interest. B sees the lower rate of interest, and so decides to increase consumption and investment. Now, suppose A and B are the same person?
I'm getting way behind. Might just have to start a new post!
Posted by: Nick Rowe | April 20, 2009 at 02:49 PM
Re: excess reserves
There’s no contradiction. The Fed decides on the level of excess reserves it wants for the banking system as a whole, and then creates them. It simply buys an asset (or lends money) and credits the seller/borrower’s bank's clearing account at the Fed.
The Fed’s been creating excess reserves aggressively through its various credit programs and balance sheet expansion.
The important point is that the banking system itself as a whole doesn’t determine its own excess reserve position; the Fed does. From there, individual banks compete for their required share of reserves. The competition in normal times determines the actual trading level for the fed funds rate.
Now, with the Fed’s extraordinary credit easing, there’s way more than the usual level of excess reserves in the system – by a factor about 300 or so. The Fed has done this deliberately. It’s paying interest to the banks on these reserves to compensate them for the fact that all of that excess is basically useless to them.
There’s a misconception about the role of excess reserves. In normal times, it’s simply a system buffer to have smooth trading in fed funds. Normally, the banking system doesn’t actually need excess reserves on hand to lend. That's because the Fed has the discretion to create new reserves whenever it wants. It can always supply any new requirements generated by new banking system lending and related new deposit creation. The result is that the ongoing operational requirement for system excess reserves is very small – normally about $ 2 billion – in a $ 12 trillion banking system.
These are not normal times. The Fed has expanded $ 2 billion to over $ 700 billion. The banks don’t need it operationally to lend. But the Fed has created it as the funding offset to its own asset expansion (excess reserves are a balance sheet liability for the Fed; i.e. a source of funding).
Posted by: JKH | April 20, 2009 at 02:50 PM
JKH @ 12.27: "My contention is that there’s a fairly clear mapping between target Fed rate intervention, and cash plywood intervention."
But the Hume/Patinkin homogeneity thought experiment tells us this *cannot* be true in the long run (and so, when we introduce expectations of the future, it cannot be true in the short run either).
Start in one equilibrium. There exists a second equilibrium, in which the price of plywood is doubled, all other nominal variables are doubled, the stock(s) of money are doubled, and yet all rates of interest are the same.
There is no long-run mapping between levels of interest rates and levels of nominal variables.
There is a long run mapping between rates of change of nominal variables and (nominal) interest rates, but the mapping is perverse, because higher rates of inflation map onto higher nominal interest rates.
The question is, how to translate from these long-run mappings (or non-mappings) into short-run mappings, when inflation adjusts slowly, and expectations (of inflation, real output, and the health of banks, etc.) are endogenous.
(Not sure how much this is helping you, but it's helping me get my head clearer.)
Posted by: Nick Rowe | April 20, 2009 at 03:05 PM
Nick,
I don't see that your latest though expirement counters my story but that's ok. It does bring up another point which I'll lay out. Before I said that the marginal dollar of excess reserves goes to the bond market because people are minimizing their real balances subject to being able to fund desired consumption (plus possibly a buffer against surprises). The formal model in the back of my mind that generates this story has money entering via the cash-in-advance constraint. As you get caught up you might counter with the portfolio choice story in which people are indifferent at the margin to putting an excess dollar towards the bond or goods market. Well, this won't save the monetary without interest rate channel story.
Why not? If it's monetary policy we're talking about then we DON'T mean an increase in total government debt (money and bonds outstanding). That would be FISCAL policy, that's basically a tax rebate. We mean an open market operation where the fed buys back a government bond for cash, thus the supply of cash has increaed but the supply of bonds has decreased. Before this happened everyone was maximizing their objective functions and so was indifferent between a marginal increase in real balances, bond holdings or consumption. But after the fed intervenes their is an excess supply of real balances in aggregate, however, if interest rates haven't changed then there is an excess demand for bonds. To restore equilibrium EITHER the interest rate changes or the excess real balance must find it's way to the bond market somehow. If the interest rate doesn't change then the extra money must go to the bond market.
How am I so sure that there was an excess demand for bonds? Because before the open market operation everyone was at a point of maximum in their objectives. If nothing else changed but the composition of their holdings then they are no longer at the max and will seek to return their.
Changing the money supply only has real aggregate effects if it changes the real interest rate.
Posted by: Adam P | April 20, 2009 at 03:17 PM
correction in the second paragraph: "But after the fed intervenes there is an excess supply..."
Posted by: Adam P | April 20, 2009 at 03:19 PM
An afterthought, my last comment also explains why QE is about lowering interest rates and not about increasing the money supply. The fact that it does happen to increase the money supply is irrelevant.
Posted by: Adam P | April 20, 2009 at 03:22 PM
Nick,
“But the Hume/Patinkin homogeneity thought experiment tells us this *cannot* be true in the long run.”
Case 1: The Fed eases by dropping short rates; inflation expectations increase; long rates increase. The yield curve steepens by directionally opposite changes at each end.
Case 2: The Fed eases by purchasing plywood; inflation expectations increase; long rates increase; AND short rates decline because the Fed’s expenditure increases the level of excess bank reserves (unless sterilized), which will have the same effect on the fed funds rate that an announced change has in Case 1. Again, the yield curve steepens by directionally opposite changes at each end.
The mapping I’m referring to is the short rate effect in Case 1 to the short rate effect in Case2.
I’m inferring not a particular mapping between interest rates and nominal variables, but a mapping between two similar effects on short rates in the two different types of easing in my example.
Posted by: JKH | April 20, 2009 at 03:39 PM
JHK: "it simply buys an asset (or lends money) and credits the seller/borrower’s bank's clearing account at the Fed" ... "it’s paying interest to the banks on these reserves to compensate them for the fact that all of that excess is basically useless to them"
Forgive my ignorance, but if the Fed buys an asset (e.g. a bond of some kind) from a bank and credits the bank's account, thus creating 'excess reserves', why is that money unavailable to the bank? What's the point of the asset sale then? What's stopping the bank from using the cash they get for the asset?
Posted by: Patrick | April 20, 2009 at 03:49 PM
JKH @ 3.39: Yes, *if* you assume that expectations respond in the same way in both cases. But what is anchoring those expectations? In Case 2, expectations of future plywood prices are anchored by the Fed's planned path for plywood prices (and this anchors expectations of all other prices). In Case 1, since the path of the price level is indeterminate for any given path of nominal interest rates, there is nothing to pin down expectations of future prices (of plywood, or anything else).
Posted by: Nick Rowe | April 20, 2009 at 03:53 PM
Nick,
Yes. That makes sense. The plywood pricing signal is more specific than the more general and uncertain price path inferred in Case 1. I agree that expectations wouldn't be identical. But they should be the same directionally.
Posted by: JKH | April 20, 2009 at 04:03 PM
Adam @ 3,17, 19, 22: If it were any good other than money, the medium of exchange, I might agree with you. But money is different.
The people who sell bonds to the Bank in an OMO willingly accept money in return. But this does not mean they plan to *hold* that extra money. They temporarily accept money because money is the medium of exchange. They plan to spend it on something else (and presumably not bonds, because otherwise they wouldn't have sold the bonds in the first place). Individually, each one thinks "I will get rid of this extra money by buying X". And individually, each one can do this. But in aggregate they can't.
Posted by: Nick Rowe | April 20, 2009 at 04:09 PM
Patrick,
Those are all the right questions, deserving of a thoughtful answer.
Let me get back in a bit.
Posted by: JKH | April 20, 2009 at 04:11 PM
Of course they don't necessarily plan to hold the money. Nonetheless, unless people don't want to return to the optimal point, some money must get back to the bond market or bonds must go up in price to become less desirable. It doesn't have to be the same dollars but if prices don't change then optimal holdings don't change and so somewhere some money gets back to the bond market.
Posted by: Adam P | April 20, 2009 at 04:22 PM
I mean really, we start in equilibrium with no excess supply or demand of bonds. Now you take some bonds away but you don't change the price of bonds, doesn't that mean we now must have an excess supply of bonds?
Posted by: Adam P | April 20, 2009 at 04:28 PM
JKH @ 4.03:
There is no guarantee that those expectations paths should be the same directionally.
Take a very simple macro model. The output gap depends on the real interest rate. The real interest rate equals the nominal rate minus the expected inflation rate. The rate of change of the inflation rate depends on the output gap.
In a model like that, very small changes in initial expected inflation could turn out to have very big consequences for long run inflation, for any given time path for the nominal interest rate. If people expect a little bit more inflation initially, the initial real interest rate is lower, so output increases, and inflation increases without limit, and people will rationally expect hyperinflation. And if people expect a little bit less inflation initially, the result is ever-increasing deflation.
By contrast, small changes in the expected price of plywood will only have small changes on everything else.
Yes, there does exist an equilibrium path for Case 2 which coincides with the equilibrium path for case 1. But Case 2 is an unstable path, and anything which slightly moves expectations away from that equilibrium (and currently they are well away from any stable equilibrium) will lead to an ever-increasing divergence.
Posted by: Nick Rowe | April 20, 2009 at 04:30 PM
This is hard stuff. My brain hurts. http://www.youtube.com/watch?v=IIlKiRPSNGA
I think I need to take a break, and come back to this topic later. There has to be another way to think about it. so it's clearer, both to me and to everyone else.
Posted by: Nick Rowe | April 20, 2009 at 04:39 PM
Patrick,
Reserves are at once an optical illusion and a logical conundrum. The Fed creates them out of thin air, but the banks don’t really need them. What on earth do I mean by this?
I’ll give you an example of how this works, but first let’s look at a system where the reserve requirement is actually zero – Canada.
The following is really simplified but essentially true of Canada:
The objective of banks in Canada like everywhere else is to meet their reserve requirement – which happens to be zero. What does this mean? It means their objective is to avoid an overdraft position with the central bank. Otherwise, they will be charged a penalty rate and face the stigma of discount window borrowing, etc. etc.
So the Royal Bank is sitting with zero reserves and wants to make a new loan. How can it make a new loan without having “the money” to do so?
That’s easy. It credits the borrower’s deposit account. That doesn’t require reserves. What happens if the borrower then moves his money to Bank of Montreal? Well, RB’s Bank of Canada account will be overdrawn, and BMO’s will be in surplus. How does the RB make this up? Well, it can go to BMO and bid for an interbank deposit. And it can cover its position in other ways that will have the same effect in terms of getting net credit at the Bank of Canada. Similarly, all of the rest of the activity that’s going on in the Canadian banking system is pushing deficit and surplus bank positions around and forcing the banks to react in the market in order to attract or lend enough funds to square their positions. And none of this requires the existence of positive reserves for the system as a whole. It’s the differentials against zero and the distribution of those differentials that make the system go round.
Now look at the US system, where there is a positive reserve requirement. Say the US system requirement in total is R. It actually resembles the Canadian system, except that the positions that are being squared consist of {r +} and {r -}, where each r is an individual bank reserve requirement with the Fed, and each r + and r – is an actual reserve position, surplus or deficit to requirement. Conversely, the Canadian system is equivalent to the US system where R = r = 0.
The most relevant thing is the distribution of the + and – positions as differentials against the r requirements. It is these differentials, not the r requirements per se, that are relevant. And that’s why Canada can elect to have R = r = 0. And the fact that Canada can set R = r = 0 is practical evidence that banks don’t require positive reserves to lend.
Going to your example, when the Fed buys an asset from a bank, the bank swaps its asset for a reserve credit. And you’re right. That puts the bank in a better position to be able to lend, other things equal. But the point is it doesn’t need that reserve credit to be able to lend. In the normal course of operations, it can just as easily cover its lending outflow with a deposit inflow, or for that matter sell an asset to somebody other than the Fed. In your example, the Fed has created additional reserves for the system with that particular transaction, which is an extra detail. (It may drain reserves from the system to offset the excess.)
The first moral of the story is that system required reserves R can be anything, including R = 0. Banks don’t require positive reserves to lend. They just need to be able to cover the differential of their shortages against a positive reserve requirement (US), or an overdraft against a zero requirement (Canada).
The second moral of the story is that the central bank sets the excess reserve position for the system as a whole, and in doing so affects the ability of individual banks to meet their requirements, thereby putting pressure on the interbank interest rate according to supply and demand for any excess reserves that are available. This is how central banks control short rates.
Now, look at today’s extraordinary situation in the US. Excess reserves have ballooned. But the story above should illustrate that the banks don’t need them to lend. One can construct a theoretical scenario in which all banks lend the same amount of money on the same day, resulting in new deposits all over the place, so that new assets and liabilities have been created throughout the system, but there is absolutely no change in total excess reserves or the distribution of those excess reserves. Everything nets out because individual banks are basically netting out against each other in clearing their positions at the central bank. A milder version of that scenario is happening all the time in the banking system. And in that scenario, the $ 700 billion that the US banks have now really serves no purpose.
In summary, the effective relevance of reserves is that of an accounting mechanism for the tracking of the flow and distribution of funds and the creation and destruction of asset and liabilities as they clear around the banking system in the normal course. The actual required level of reserves is irrelevant; it is the differential of actual against required that indicates a bank’s effective position and requirement to take further asset-liability action.
That’s long winded, but your questions are not that easy to answer. There are some counterintuitive aspects to the dynamics of the reserve system.
Posted by: JKH | April 20, 2009 at 05:16 PM
You didn't last very long, Nick. I'm disappointed.
:)
Posted by: JKH | April 20, 2009 at 05:17 PM
Nick,
"But Case 2 is an unstable path, and anything which slightly moves expectations away from that equilibrium (and currently they are well away from any stable equilibrium) will lead to an ever-increasing divergence."
I think I see where something analogous to plywood targeting is intuitively more stabilizing for expectations than free form fed funds targeting.
Thx for the discussion.
Posted by: JKH | April 20, 2009 at 05:47 PM
Posted by: Jon | April 21, 2009 at 01:20 AM
Adam P.
I guess your arguments are so good you can look after yourself.
But you missed a good come back to this
"If it were any good other than money, the medium of exchange, I might agree with you. But money is different."
Of course money is NOT only the medium of exchange it is also a store of value. Maybe a BETTER opportunity is expected in the future (yes I'm not a believer in continuous equilibrium, and I think some of these hypothetical arguments are just silly).
Posted by: reason | April 21, 2009 at 02:56 AM
In my view the most important theory in economics is the law of second best. We should spend more time finding out how things actually work and less time worrying about how they should work.
Posted by: reason | April 21, 2009 at 03:00 AM
That is, I cannot understand why we are having a theoretical about this question, we need to dig out some evidence about empirically actually happens.
Posted by: reason | April 21, 2009 at 03:02 AM
And Adam P. I realise that you have started off in that direction now.
Posted by: reason | April 21, 2009 at 03:03 AM
Good rule of thumb - every theory is wrong because it starts by making wrong assumptions.
Posted by: reason | April 21, 2009 at 03:18 AM
reason's query about why we're having this theoretical arguement brings me back to one of the questions I posed at the beginning of this thread which I don't think Nick ever answered.
... "why it now no longer works in practice". The zero bound. Where's the evidence that if Uncle Ben could get a negative REAL interest rate then we wouldn't get the desired results?
And btw, Mankiw has jumped on the bandwagon too... http://www.nytimes.com/2009/04/19/business/economy/19view.html?_r=1
Posted by: Adam P | April 21, 2009 at 05:09 AM
A good night's sleep, and I'm back in:
Adam P: '... "why it now no longer works in practice". The zero bound. Where's the evidence that if Uncle Ben could get a negative REAL interest rate then we wouldn't get the desired results?'
I see hitting the zero bound as a *consequence* of the failure of interest rate control, not just as a a *cause* of the failure.
We agree that if the central bank could create (big enough) expected inflation, the zero bound would not be a problem, because we could have negative real rates with positive nominal. (And I would add that if the central bank could get people to expect that real AD would be higher in future, consumption and investment demand would increase too, and the financial sector would recover, and these would increase the real natural rate as well).
Think back to the analogy of interest rate control as balancing a pole upright in the palm of your hand. You have to move south if you want the top of the pole to move north. But you have hit a wall (zero nominal bound) to the south, and the pole is falling over to the south. So you change the instrument: turn the pole upside down, grab the other end, and start walking north.
By increasing the price of plywood (gold, whatever), and letting it be known you will keep on increasing it, you raise expected inflation (and expected future AD), and get real rates negative (if needed).
As an aside, there are an awful lot of interest rates, and they are the ones that count for AD, that are decidedly non-zero.
Posted by: Nick Rowe | April 21, 2009 at 06:41 AM
Well, I don't agree that hitting the zero bound is a consequence of the failure of interest rate control. More importantly though, even if you want to insist that the quantity approach makes sense you still haven't said how you can change AD without changing the real interest rate. As I said before, you can argue that the changing AD caused the changing interest rates but if you want to argue that changing AD won't change the real rate (via Euler equation) then you really need to explain that and Nick is just ignoring it.
But then, if you admit that interest rates will move whenever you get your results then using an interest rate target becomes uncontroversial, it's much more observable then other things like money supply, and if you move it in the desired direction, by whatever action, you're going to get the right result.
Posted by: Adam P | April 21, 2009 at 07:14 AM
Nick,
I like the pole analogy as a problem analogy, up until the point you construct the solution of turning it upside down. The problem analogy is intuitive but the solution analogy isn’t. I can’t translate it.
There’s a contradiction in the idea that interest rate control is a failure. Interest rates are the sum of real rates and expected inflation. If interest rate control is a failure, why are you proposing solutions that have the objective of a specific constitution for interest rates (i.e. positive expected inflation components to the point they dominate negative real rates?). At the end of the day, any monetary strategy is geared toward an interest rate outcome, and that amounts to effective interest rate control. Whether you announce a target fed funds rate or a target expected inflation rate, which is a component of nominal rates, it effectively amounts to interest rate control. Interest rate control is not a failure. All you have to do is expand the idea of control from nominal rates to the real and constituent components of nominal rates. Picking up unconventional easing at the zero bound is an extension of interest rate control to the expected inflation component, rather than a failure of interest rate control.
Posted by: JKH | April 21, 2009 at 08:01 AM
JKH:
"I like the pole analogy as a problem analogy, up until the point you construct the solution of turning it upside down. The problem analogy is intuitive but the solution analogy isn’t. I can’t translate it."
Agreed. The analogy starts to break down at that point. Try this instead:
Pole upright in the palm of the Bank's hand. Bottom of the pole is the nominal overnight rate, top of the pole is the rate of inflation. There is a string tied to the top of the pole. At the other end of the string is a helium balloon. (The helium is just enough to keep the string upright, not enough to keep the pole upright). The balloon is the price (or maybe rate of inflation?) of plywood (or gold, or whatever). (OK, there are lots of balloons, each representing the nominal price of some good).
The pole starts to fall over to the south. Let go of the bottom of the pole, grab hold of the balloon, and move it north.
Will post this while thinking about Adam P's and the rest of JKH's comment (which are the same, and is the crucial point).
Posted by: Nick Rowe | April 21, 2009 at 08:22 AM
On second thoughts, I think I'm going to start a whole new post, to address Adam P's and JKH's other point. It's both too long, and too important, for a comment.
Posted by: Nick Rowe | April 21, 2009 at 08:33 AM
I like the balloon modification.
Targeting (grabbing onto) a single balloon runs the risk of popping it though, with resulting ineffectiveness in terms of inflating the critical mass of the rest of the portfolio of balloons.
Unconventional easing (quantitative, qualitative, credit, ... however defined) is an attempt to inflate the full portfolio of balloons, albeit indirectly, avoiding the concentration risk inherent in a single balloon target.
Posted by: JKH | April 21, 2009 at 08:43 AM
Just one more thing from the original post:
"If you want higher nominal interest rates you first need to lower interest rates, so that inflation starts to rise, and expected inflation starts to rise, at which point you can raise interest rates, and raise them higher than originally, so that inflation and nominal interest rates eventually settle down at some new higher level.
That's how it was supposed to work in practice."
Really? That's how it was supposed to work? I don't think so. This quote doesn't make any sense at all. (And as an aside, why would we ever just want higher nominal rates arbitrarily. The central bank is trying mangage rates to stabalize the price lever or inflation rate and maintain full employment.)
Posted by: Adam P | April 21, 2009 at 11:30 AM
Furthermore Nick says: "The standard argument of why interest rate control works in practice is that prices are sticky. The economy can't jump from one nominal time-path to another. It takes time for monetary policy, seen as a gap between the interest rate set by the central bank and the neutral or natural rate of interest, to affect inflation. Provided the central bank could adjust the rate of interest more quickly than prices can adjust, the central bank can keep the price level determinate."
Except for the fact that price stickiness is important this is manifestly not how these models work. An arguement that's closer to correct goes like:
Since price are sticky the central bank can change real interest rates (since changing the nominal rate is a change to the real rate if prices can't move right away). Changing real rates allows the central bank to affect AD. Buy influencing AD the central bank influences inflation via a Phillips curve.
Now, does that story get you price level determinacy? Not neccesarily. It depends on your Phillips curve specification. And the canonical New-Keynsian Phillips curve doesn't get you determinancy unless you're willing to make "we take the only bounded solution" statement which I don't like to do.
However, the Cochrane paper (http://faculty.chicagobooth.edu/john.cochrane/research/Papers/determination_taylor_rules.pdf) resolves the determinancy question to my satisfaction and my last paragraph then applies to explain how inflation can then be controlled by the central bank.
Posted by: Adam P | April 21, 2009 at 12:06 PM
Adam P: that's really how it did work in practice, during the 1970's and 1980's (only in reverse). At least, that's the absolutely conventional story of how it did work.
We had high inflation, and high nominal interest rates. The Bank of Canada (and other central banks) raised interest rates (tightened monetary policy). Eventually inflation fell, and then expected inflation fell, and then the Bank of Canada lowered nominal interest rates.
That's the received doctrine. I am saying nothing new there. There were a few monetary economists who thought that tighter monetary policy (announced in advance, and fully credible) would cause nominal interest rates and inflation to fall at the same time. They were wrong. Maybe they were wrong because it wasn't a credible announcement (the "credibility hypothesis"), or maybe they were wrong because of inflation intertia, or maybe both. But that is certainly the time path of the variables. Ask anyone who renewed a mortgage in the early 1980's to describe the episode. Both nominal and real interest rates went temporarily very high when central banks decided to get serious about reducing inflation.
Posted by: Nick Rowe | April 21, 2009 at 12:08 PM
When the central bank WANTED higher nominal rates it first lowered them in order to generate inflation?
Nick: "We had high inflation, and high nominal interest rates. The Bank of Canada (and other central banks) raised interest rates (tightened monetary policy). Eventually inflation fell, and then expected inflation fell, and then the Bank of Canada lowered nominal interest rates."
This statement seems to me to be prefectly correct but have nothing to do with:
"If you WANT higher nominal interest rates you first need to lower interest rates, so that inflation starts to rise..."
Posted by: Adam P | April 21, 2009 at 12:16 PM
Adam P. @ 12.16.
I thought I was saying the same thing (only with all the signs reversed, of course). If not, it must be because I wasn't clear enough when I said it the first time.
Let me re-phrase it this way: "If the Bank wants higher inflation and higher nominal interest rates in several years' time, it must reduce nominal interest rates this year, so that actual and expected inflation increases, and after they do, it can raise nominal interest rates to a level higher than they originally were"
@ 12.06 : I didn't see that comment while writing my own (we were writing at the same time).
That link doesn't work, but I think it's the same John Cochrane paper you linked to on the previous page of comments.
On reflection, I really like that Cochrane paper, but I take away a very different conclusion (both from you, and from Cochrane).
What he shows is that the verbal story New Keynesians give for price level determinacy under interest rate control totally contradicts the formal model with a canonical Calvo-style Phillips curve. That's important.
If I interpret you correctly, I think you are saying "keep the canonical Calvo NK Phillips curve, but make assumptions about the fiscal regime to get determinacy". Is that right?
I would take the other horn of the dilemna. I don't like the canonical Calvo NK formal Phillips Curve anyway, for other reasons. I believe in inflation inertia (which is harder to model formally, but can be done in principle). So I stick with the verbal story. But then, the determinacy of the price level becomes an empirical question, depending on how quickly the Bank can respond, relative to the speed at which inflation and expected inflation adjusts, before hitting the lower bound.
But of course, my maths is not up to it. I'm an old guy, never good at math, and burned out.
Posted by: Nick Rowe | April 21, 2009 at 02:17 PM
No,no. I hate Calvo pricing, we agree 100% on that.
However, I do think determinacy comes from the fiscal theory as set out in Cochrane's "Money as Stock" paper.
My choice of phrasing was to keep seperate the part of the theory that I think is coherent and generally valid, ie. not to dependent on something ad hoc like Calvo pricing.
How you specify the Phillips curve is still open so it was put in a different paragraph. I'm sympathetic to the form of the NK Phillips curve in principle but like you I don't buy it's derivation. Furthermore, it's fatally flawed. It fails the "Lucas Critique" test because the parameters of the Calvo pricing (average frequency of repricing for the firm) is treated as a physical constant that is exogenous and a constraint on the firm. That's just dumb, clearly in an unstable environment with high and volatile inflation firms would start changing prices more frequently.
However, even though I hate the derivation I am somewhat sympathetic to the final form of the NK Phillips curve. I think you do need an expected future inflation type term in there and that's what gives the in-determinacy when you try to get the Taylor rule alone to pin down the price level (without appealing to the fiscal regime).
Posted by: Adam P | April 21, 2009 at 02:40 PM