Why the Bank of Canada should 'rise' interest rates

I don't want tighter monetary policy; I want looser. I don't want the Bank of Canada to raise interest rates, but I do want the Bank to do something that would cause it to want interest rates to rise. I want it to buy real assets.

We have become so accustomed to thinking about monetary policy in terms of interest rates, both as monetary policy instrument, and as the monetary policy transmission mechanism, that it's hard to find the right words to describe it any other way. Which is why I abused grammar in the title of this post.

And this matters. Monetary policy is about expectations, and it works when people understand what it means. And right now people don't understand what it means, so it doesn't work.

On the CD Howe Monetary Policy Council, we are asked to give our recommendation for the upcoming Bank of Canada announcement (tomorrow), and our expectation of our recommendation for the following announcement (September), under the assumption that our first recommendation is implemented. I recommended keeping the overnight rate at 0.25%, and implementing an aggressive policy of "QE", for the upcoming announcement. If my recommendation were followed, I believe it would change people's expectations a lot, and that I would want to allow the overnight rate to rise to 0.50% in September.

So this gets picked up by the media. Not unreasonably, given the dominance that "monetary policy = interest rates" has on our thinking, it looked like I was recommending the Bank of Canada should begin to tighten monetary policy in September. Which is surprising, and so newsworthy. So I just did an interview on Business News Network where I had to try and explain what I really meant in a few minutes. Which is both hard, and great mental exercise. But I'm not sure I succeeded, so I'm going to try again here, at greater length.

We didn't always think of monetary policy in terms of interest rates. At one time we thought of monetary policy as setting the price of gold. Or setting the quantity of money. (Or setting the exchange rate, but that just postpones the question, because if we set the Loonie to the US dollar, what is the US dollar set to?). But ever since the monetarist experiment ended, we have thought of monetary policy as setting the rate of interest. If inflation is likely to fall below target, you lower the interest rate to loosen monetary policy to raise future inflation. If inflation is likely to rise above target, you raise the interest rate to tighten monetary policy to lower future inflation.

And this way of thinking worked fine, until now. We know it worked fine, because acting on that way of thinking worked. The Bank of Canada kept inflation close to target; about as close to target as could reasonably be expected, given the shocks, and the uncertainties. But it's not working now.

There are good theoretical reasons for believing that thinking of monetary policy in terms of interest rates won't always work. If we have a once and for all doubling of the stock of money, theory tells us that the new equilibrium will have all prices doubled, but the same rate of interest. And if we have an increase in the growth rate of the stock of money, theory tells us that the new equilibrium will have higher inflation, and a higher nominal interest rate. So a loosening of monetary policy can be associated with unchanged, or even higher nominal interest rates. And in the short run, when prices are sticky and money is non-neutral, if a tighter monetary policy causes people to expect lower real output in future, this fear of recession can cause savings to rise, investment to fall, and lower the equilibrium real interest rate too.

And these theoretical reasons are backed up by empirical observation. Interest rates tend to be high when inflation and real growth are expected to be high. And tend to be low when people expect deflation and recession.

What is surprising is that thinking about monetary policy in terms of interest rates could ever work. But theory can explain that too. As long as expectations of inflation and real growth remain reasonably well-anchored, any change in monetary policy will cause nominal and real interest rates to move in the same direction, and move relative to the more slowly moving underlying natural rate of interest. So loose monetary policy temporarily lowers interest rates relative to the natural rate, and so raises aggregate demand, real output (in the short run), and inflation (in the long run).

And theory can explain why it doesn't work now: because expectations of inflation and real growth are no longer well-anchored. And interest rates cannot anchor those expectations; the same interest rate could be both too low if people expect inflation and growth, and too high if people expect deflation and recession.

So, if we shouldn't think of monetary policy in terms of interest rates, how should we think of it?

Scott Sumner wants us to think of monetary policy in terms of private (or market) expectations of nominal GDP growth. He wants nominal GDP to follow some fixed path, growing at (say) 5% per year. If people expect less than 5% NGDP growth, monetary policy is too tight; if people expect greater than 5% NGDP growth, monetary policy is too loose.

Set aside the question of NGDP level path vs inflation targeting. It's not the most important question right now (since hitting either would be better than a deflationary spiral); I can't decide which is better; and anyway the Bank of Canada is still committed to its 2% inflation target. The important point is targeting private expectations, and keeping them well-anchored. (And I would argue that this is important even if you thought that private expectations, as revealed by a market, might not be the best available forecaster.)

Scott has influenced my thinking a lot, but the one aspect of his plan that worries me is the exact mechanism for keeping private expectations well-anchored. I can imagine a central banker, sitting at his control panel facing lots of dials and levers, saying to Scott in frustration: "OK, OK, I know monetary policy is too tight; now just tell me which goddamn lever to push or pull! And you had better show me the linkage where that lever gets connected to private expectations!".

"Quantitative Easing" is the term that gets banded about, but I confess that I still don't know what it means. Isn't all monetary policy printing money? And if it means "buying bonds", I don't really see how it differs fundamentally from "setting interest rates". The Quantity Theory tells us that if the money stock doubles, the nominal prices of all real goods and services should double in the new long-run equilibrium, but the nominal price of nominal bonds should stay exactly the same. If interest rates stay the same, and theory tells us they should, then the price of a bond which promises to pay a fixed stream of dollars should also stay the same. And a loose monetary policy that increased expected inflation and real growth should cause nominal bond prices to fall. "Let's see: you plan to buy bonds, expecting this to cause bond prices to fall? Huh?" It's exactly the same communication problem I faced in titling this post. Only the Bank of Canada's communication problem matters much more than that of a minor blogger. The Bank needs change expectations, and it needs to communicate how policy will work in order to change expectations.

Thinking about monetary policy in terms of influencing the nominal price of nominal bonds has exactly the same problem as thinking about monetary policy as setting interest rates.

Suppose instead that the Bank were to buy real assets. A looser monetary policy means an increase in the nominal price of real assets, both in the short and long runs. This sort of "Open Market Operation", in real rather than nominal assets, is much easier to communicate. "We plan to print money and buy bricks; you will know the policy is working when you see the price of bricks rise". And the price of bricks should indeed rise, along with the price of everything else. And it will be helped to rise by people seeing the initial rise, and understanding why there was that initial rise, seeing a loosening of monetary policy, seeing that it's working, expecting higher inflation and real growth, causing the price of bricks to rise further, generating the exact positive feedback loop the Bank wants.

The only problem with the Bank of Canada buying bricks is where to store all those bricks. The storage costs, plus the opportunity costs of having bricks sit idle, are too large. It could buy bricks and mortar instead, in the form of houses, and rent them out to tenants. But the Bank of Canada does not have a lot of expertise in being a landlord. Gold bricks, on the other hand, don't have those problems.

It doesn't have to be gold; any real asset with low holding costs will do. Gold, silver, the S&P-TSX index of shares: all would work.

I want the Bank of Canada to buy real assets, or claims on real assets, and announce it is going to keep on buying real assets until private expectations of inflation return clearly to the 2% target. This loosening of monetary policy would mean that, as a side-effect, nominal interest rates would need to rise.

If we thought about the monetary policy instrument as buying or selling real assets, it would have been so much easier for me to title this post. "Why the Bank of Canada should raise real asset prices" would be understood clearly. Much more importantly, the Bank of Canada's policy would be understood clearly. And if it were understood, it would be credible. And if it were credible, it would work.

Monetary policy moves the nominal prices of real assets in the same direction in the short run, when expectations are fixed, and in the long run, when expectations adjust. Monetary policy moves interest rates in opposite directions in the short run than in the long run. With expectations adrift, we need a monetary policy instrument that moves reality and expectations in the same direction.  The nominal prices of real assets have this property; interest rates don't.

Comments

[Stephen Gordon]

Are we sure that expectations aren't at 2 per cent already?

[Nick Rowe]

No, I'm not sure. I wish we had better data, both market and survey. But I think they are still below 2%, even if they are higher than they were. The latest Bank of Canada survey showed the median expectation still below 2%, though higher than it was a few months back. And I suspect that survey has a slight upward bias, since if you expect 2% you are inclined to answer "between 2% and 3%". The nominal vs real bond spread has also returned to just below 2%. But I think this measure also has a bit of upward bias too, because the real bonds are such a small segment of the market. http://www.td.com/economics/comment/mm0709_monitor.pdf

I wish I had written this post back in the Winter.

[Nick Rowe]

Plus, I think there would be a lot less variance in expected inflation: across time; across people; and for each individual, if people had more confidence in the Bank's ability to control monetary policy even under ZIRP.

[David]

Hi guys.

"Suppose instead that the Bank were to buy real assets. A looser monetary policy means an increase in the nominal price of real assets, both in the short and long runs. This sort of "Open Market Operation", in real rather than nominal assets, is much easier to communicate. 'We plan to print money and buy bricks; you will know the policy is working when you see the price of bricks rise'. And the price of bricks should indeed rise, along with the price of everything else."

It seems to me that the ability to manage inflationary expectations depends on a kind of stable expectations equilibrium involving a) a consensus understanding (among investors and policy makers) about how monetary policy works, perhaps based on theory as confirmed by experience to date, and b) a consensus understanding which is in fact an accurate depiction/proxy for the underlying mechanics of the economy (transmission mechanisms, etc.).

It's easy to see why central bank purchasing of bricks would raise the price of bricks and of course people would see their expectations in that respect validated. People would thus have confidence in the central bank's ability to raise brick prices (at least in the short run). But why would people infer that a general increase in prices would necessary follow from the observation that central banks can raise brick prices? In other words, what's the underlying transmission mechanism from (particularly expected) brick price increases to increases in prices for all other GDP components, the understanding of which would lead people to expect those other price increases?

[Mercure]

Rowe:
"A looser monetary policy means an increase in the nominal price of real assets, both in the short and long runs. This sort of "Open Market Operation", in real rather than nominal assets, is much easier to communicate. "We plan to print money and buy bricks; you will know the policy is working when you see the price of bricks rise". And the price of bricks should indeed rise, along with the price of everything else."

The question then is how is that different than a government infrastructure program (build and/or repair road, school and hospitals) and financing it with "printed" money”?

When the Central Bank buy government bond, it is paying the government debt with "printed" money: the government own the Central Bank, so it become owner of is own debt title. Interest paid on theses bond becomes profit for the central bank and are considered as income for the government. A QE with an equivalent increase of the deficit allows government to increase is debt but to pay the interest to itself.

The only difference is that the deficit solution implies that sometime in the future de government will repay the nominal value of that debt (the interest pay for themselves through seigniorage.)
http://en.wikipedia.org/wiki/Seigniorage
In the long run, the nominal value of the debt becomes insignificant.

The advantage of the deficit solution is that it solves your brick storage problem by making a good use of it.

[Mercure]

Rowe:
“It doesn't have to be gold; any real asset with low holding costs will do. Gold, silver, the S&P-TSX index of shares: all would work.”

There’s a negative side to inject too much easy money in the private markets: Bubbles.

Remember when so much capital was flowing to technology firms in the dot.com bubble. It was used to hire engineers and programmers to build hardware and software that ended up with no real value. And then it was the real estate bubble. America ended up with empty houses and condos.

Would you prefer to see printed money going into High speed train and schools or in the next private sector bubble?

Obviously I have nothing against private sector investments, but I think the problem right now is the lack of profitable projects, not a lack of capital. Remember that story:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/02/a-very-simple-macro-model-of-the-last-few-years.html

Instead of creating the next bubble, let’s build some useful infrastructures until:

“…recovery comes because low investment eventually produces a backlog of desired capital stock, through use, delay, and obsolescence. And eventually this leads to an investment recovery, which is self-reinforcing.”
(Krugman explaining Keynes)

[Nick Rowe]

Hi David:
Here's the simplest underlying story. Assume the Bank of Canada raises the price of bricks 100%, and that bricks are 1% of the basket.

1st round: each price setter says to himself: "Bricks have doubled in price, so money is now worth 1% less, so I need to raise all my prices by 1% to keep my real/relative price the same."

2nd round: "Hmmm. But I bet everyone else will think the same way also raise their prices by 1%, so money will be worth 2% less, so I had better raise my prices by 2%."

3rd round: "Hang on. But they will do that too, so I need to raise my prices by....

nth round: "Damn it! We all need to raise our prices by exactly 100% to keep our real prices the same".

Yes, it's unfamiliar. But the interest rate transmission mechanism is very unfamiliar to a lot of people too. And it's a lot more complicated. I can tell you exactly how much the price level will rise if the Bank doubles the price of bricks. But it's a lot harder to calculate the exact amount prices will rise if the Bank halves the rate of interest (for a temporary period, because it's infinite if it's permanent).

Hell, a lot of people still think that cutting interest rates lowers inflation. Because interest rates are a cost of production, and if you lower costs you lower prices. And in the 1970's, a lot of Keynesian economists still thought lowering interest rates was the way to lower inflation!

[Nick Rowe]

By the way, David, I really liked your paragraph: "It seems to me that the ability to manage inflationary expectations depends on a kind of stable expectations equilibrium involving a) a consensus understanding (among investors and policy makers) about how monetary policy works, perhaps based on theory as confirmed by experience to date, and b) a consensus understanding which is in fact an accurate depiction/proxy for the underlying mechanics of the economy (transmission mechanisms, etc.)."

Yes, it may take time to establish that consensus. The old consensus on interest rates fell apart when we hit ZIRP. "How can you cut interest rates to prevent deflation when interest rates are already as low as they can go???" The new consensus will not appear overnight.

[Don the libertarian Democrat]

"And the price of bricks should indeed rise, along with the price of everything else. And it will be helped to rise by people seeing the initial rise, and understanding why there was that initial rise, seeing a loosening of monetary policy, seeing that it's working, expecting higher inflation and real growth, causing the price of bricks to rise further, generating the exact positive feedback loop the Bank wants."

So, is the solution anything that can accomplish this?

[Nick Rowe]

Mercure: I agree with your first comment. And that's a good way of looking at fiscal policy.

If the government has an investment project that yields a higher return than (say) the TSX, then the "storage costs" would be lower if the newly printed money were used to finance that investment project instead of buying the TSX. But then the government ought to do that investment anyway, if it has high returns, regardless of whether we want to stimulate AD.

There are two problems though: it's much quicker to buy the TSX than to start new investment projects; and you can quickly sell the TSX if you need to reverse course and tighten monetary policy, but you can't easily and quickly sell roads, bridges, and schools.

I'm going to duck your second comment. If I answer it I will end up going waaaay off-topic into whether or not there was a bubble, in what, and whether monetary policy can cause or cure bubbles.

[Nick Rowe]

Hi Don! No. If you raise the price of bricks by, say, imposing a minimum price on bricks, making it illegal to sell bricks for less, that won't work. That changes the real 'equilibrium' price of bricks (I don't mean 'equilibrium' in the sense of 'market-clearing' but in the sense of the solution to the simultaneous equations.) It has to be monetary.

By the way Don, totally off-topic, but have you checked out this blog? http://understandingsociety.blogspot.com/

[David Stinson]

Nick.

I see your point about people wanting to maintain their relative prices. As I recall, that's really the mechanism by which the early rational expectations models arrived at the neutrality of expected monetary policy. But doesn't it depend on the assumption that individuals are sufficiently confident that they (and most others) can raise prices to maintain relative prices unchanged? In other words, they have to be sufficiently confident that neither they nor most others face a current or expected output gap (and therefore, I guess, no sticky prices?). I am wondering whether that assumption is reasonable in the current environment. In that respect, I think that the point you made in comments above for inflation is valid for a wide variety of economic variables - probability-weighted forecasts are currently more disperse both in aggregate and individually.

But perhaps that just goes to your point that a new consensus may appear only gradually.

BTW, thanks for liking my paragraph.

[Scott Sumner]

Nick, Really good post. I especially like the part about the central bankers not knowing what knobs to twist. I'm sure there are central bankers who are frustrated in that way, but hearing it just makes me want to scream:

FIRST TELL US WHERE THE H*** YOU ARE GOING!

Let's forget NGDP and go with inflation. I have no idea whether the Fed wants the price level in 5 years to be 105 or 110. And I have no idea whether if they want it to be 110 in five years, they will still target that price level if two years from now we are at 102 (which by the way is more inflation than we will likely have.) I think central banks have no idea how much this nominal uncertainty complicates the problems they face with managing expectations.

I'm a reasonably well-informed person, if the Fed can't convince me that they are committed to 2% inflation, how will they convince the average person. They have not announced an inflation target. Nor have they said what they would do if they fall short of the inflation target that they haven't even announced. Nor have they said what they will do to achieve this non-existent inflation target. Nor have they said whether this non-existent inflation target is "level targeting" (which is believed to better stabilize expectations.) So is it any surprise expectatations have become unanchored? The BOC may be better, but things are really bad at the Fed right now.

I just saw some scary data about the US CPI. Everyone's saying "at least we don't have deflation in the core CPI." But do you know why? It's all because of the housing component, which the brilliant statisticians in Washington insist is one of the fastest rising components of the core CPI over the last 12 months. Housing! And the weight is 29%. Measured properly, housing prices should be falling and the true core CPI is falling. We are in deflation already.

Buying real assets might help, but setting an explicit price level path is the key. They need to tell us where they want the CPI to be in 5 years, and they need to promise to do everything possible to get there, even if it means 10% inflation in the fifth year (after no inflation in the first 4.) If they do that, we won't have zero inflation for 4 years. Japan's deflator is down 12% in 15 years. The BOJ should have a 13% inflation target for next year. (Yes, I'm half joking, but it shows how far off course a central bank can get.)

[Nick Rowe]

David: I'm still thinking about (not ignoring) your last comment. It just shows the hegemonic power that interest rates have over my way of thinking!

Scott: thanks!

I (and everybody else) know almost exactly what the Bank of Canada is *trying* to do. They tell us, and we generally believe them. The main uncertainty concerns how quickly they want inflation to return to target, and how far they are willing to go to get it back to target quickly rather than slowly.

The Bank has historically been very committed to the view that monetary policy = interest rates, and I think still is. I have 3 hypotheses about recent BoC behaviour:

1. They got a bit behind the curve towards the end of last year, but believe that their monetary policy is sufficiently loose already to get inflation back to target in a reasonable time, and any looser monetary policy would be too disruptive of the real economy to be worth the benefits of getting inflation back to target sooner.

2. They believe that since interest rates are already as low as they can practically go, there is really nothing more they can do, and are keeping their fingers crossed it will be enough, and asking the government to use fiscal policy to help make sure it is enough.

3. Given that the rest of the world (the US, our biggest customer especially) is in a mess, there is nothing more that anyone in Canada can do. (I am unsure whether the rest of the world being in a mess is a real/AS or a nominal/AD shock; theory says AS only, since you can always use domestic policy to stimulate AD regardless of whether foreign demand collapses.)

Generally though, when we look around the world and see inflation targeting countries in roughly the same bad shape as the US, it is not obvious to me that an explicit inflation target by the Fed would make that much difference. Unless you argue that the lack of an explicit inflation target by the Fed is what is messing up the rest of the world. But it's not totally obvious how that would work, even granted the size of the US economy.

[David Stinson]

Hi Nick & Scott,

Expectations management as a tool of monetary policy requires not only that people be convinced of the policymaker's intentions, but that they have confidence in the ability or competence of the policymaker to successfully achieve those intentions. As I commented above, that presumably requires some sort of “expectations equilibrium”.

I wonder whether the US (and others?) has fallen out of the previous expectations equilibrium (I know I have):

• Inflation /deflation expectations are all over the map;
• Expert investor/academic/policy opinion is all over the map;
• Theoretical controversies assumed to have been resolved long ago have resurfaced;
• People are aware that the Fed may have played some sort of role in creating the crisis (either in creating the bubble or in failing to aggressively maintain aggregate demand a la Scott Sumner) and therefore the public has probably lost some faith in the Fed’s ability to do the right thing;
• People are generally aware that the Fed is operating in uncharted waters and that things could conceivably turn very bad (e.g., 1930s, Japan);
• The Japanese experience is quite disturbing because there doesn’t seem (from my perspective at least) to be anything like a tidy and persuasive story to explain it or to allow us to avoid repeating it.

Thus, it is likely that each individual’s forecast probability distribution of inflation is highly disperse. Even if the mean of the expected distribution is some positive level of inflation, they are still attaching a significant probability to deflation and to other levels of inflation. The relative lack of confidence in their estimates may discourage people from acting on their expectations or at least doing so in ways that cannot be reversed quickly. The result is lots of “wait and see” and the hedging of bets.

As a result, the Fed’s ability to create a critical mass of “actionable” inflationary expectations may have been badly impaired, with obvious implications for the “expectations management” channel of monetary policy.

Not to defend the Fed, but perhaps at this point they are concerned that announcing an explicit target and failing to achieve it (given the reduced ability to manage/implement expectations) might make things worse by further undermining confidence in the Fed and whatever remains of the previous expectations equilibrium. That’s not to suggest that they might not now be in a stronger position had they followed a policy of announcing explicit targets in the past.

BTW Nick, concerning your comment above to the effect that you are not ignoring me, I know how much effort you and Scott (and Stephen) must put into maintaining your respective blogs and responding to comments. You shouldn’t feel obligated to respond (to me at least). You guys do more than enough already. In other words, feel free to ignore me:). I will of course feel free to interpret it as tacit admission on your part that I am right (kidding).

[Scott Sumner]

Nick, I don't quite follow your reply. There are several possible ways of looking at small countries, but none of them has the implications you suggest:

1. Small countries could get faster inflation, but it wouldn't help because the loss of the US export market means their RGDP will fall anyway. That might be true, but that doesn't mean higher inflation in the US wouldn't help us and them both.

2. Small countries should get faster inflation, but for some reason they are not doing it. In this case you certainly cannot blame the liquidity trap, as they could easily devalue. So again, inflation targeting is not a factor, as they are not, in fact, targeting inflation.

Let's take the Eurozone, which I think you regard as an inflation targeting region. You are essentially saying "they target inflation, and yet look at the mess they are in." But that makes no sense. The ECB obviously doesn't think they are in a "nominal mess" or they'd cut rates. Of course you and I might think they should expand monetary policy, but the point is that the ECB doesn't. Didn't they refuse to cut rates at their last meeting? So how can you blame their problems on the failure of inflation targeting? Last October 6th, when the Fed adopted interest on reserves, the ECB rate was 4.25%, as the world economy was collapsing! Is that a failure of inflation targeting? Or a failure of people to adhere to their own supposed policy? BTW, this is why I prefer NGDP targeting, it doesn't allow the central banks to hide behind phony core inflation numbers. I should also use the term "price level targeting" because it is very different from inflation targeting, as and far as I know no country engages in price level targeting.

It's hard to explain all this because we really have a mix of problems:

1. Policy isn't forward-looking.
2. We target the inflation rate rather than the price level.
3. We target prices rather than NGDP.
4. We falsely think monetary policy is impotent, when it is not.

All four factors contribute to the mess. But the lack of an explicit target path (point two) is actually the key. This allowed expectations to float freely, and made the Fed's job much more difficult. I'm sorry I distracted you from Canada, but I don't know enough there to have an intelligent opinion.

[Patrick]

"... as they could easily devalue"

I don't think the BoC likes to intervene in forex markets. Also, the politics are awkward because of the 'beggar thy neighbour' problem of devaluation. Something like 80% of our exports go to the US, and exports are 40-odd% of the Canadian economy. There's a real danger that Congress could wreck our economy with the stroke of a protectionist pen.

[Phillip Huggan]

All levels of government fund R+D and government-run education institutes. These produce IP that has a real value. Auction off some IP and use that as a price signal to help the government set rates. I'm assuming R+D output is highly correlated with GDP.
And if we do abondon some CAD holding lets diversify to a currency that holds value like Swiss Francs or buy up Iceland on the cheap. Buy any University IP California auctions off.

[Jon]

Nick:

I think you specifically want an asset without a time-value. Commodities--such as gold--are one such asset.

In general the value of a commodity ultimately depends on the value of the final goods into which it is rendered whereas the value of a bond is based on its coupons. Its a time-value asset which in turn directly implicates the inflation-rate and creates the confusing paradox.

[learning james]

Nick,

I am sure you have seen this:

http://www.torontorealestateboard.com/consumer_info/market_news/news2009/pdf/nr_july_mid-month_09.pdf

Looks like someone IS getting the message that money is cheap and available and should be used.

As for some of us, I guess we are simply humans being irrational as we often are.

Love the writting.

Would love to see a post on CMHC and risk re: mortgage insurance.

Cheers !

[Don the libertarian Democrat]

Nick,

I love that blog. On measuring inflation or prices, I always assume that the govt has its own reasons for choosing a method and target of measurement. I assume that it usually is tied to being able to assess govt benefits and how they're distributed. Would that be true of Inflation and Prices?

[Nick Rowe]

Don: that blog looks good to me, but much of it goes over my head.

That's a good question on measuring inflation. You can define (at least theoretically) a price index that would be perfect for setting pensions and benefits etc., in that if the pension increased by the same amount as the price index, the utility of consumption would stay the same. But it is not at all obvious that the price index that best solves the pension/benefits problem is the best one for the central bank to target.

For example, one of the strongest arguments for trying to keep inflation low and stable is that some prices are sticky, and don't want to move to a new equilibrium. In which case, a good monetary policy is one that keeps the equilibrium growing slowly and steadily so the prices that don't want to move don't have to move. "Target the stickiest prices" would be the slogan.

learning james: I found a link to a blog called "American Canadian" (or maybe vice versa) on Garth Turner's blog Greater Fool. It had a recent post on CMHC that looked good to me. Found it: http://americacanada.blogspot.com/2009/07/cmhc-and-our-government.html I'm not sure if it's right, but I'm even less sure I could do better. I did a post on CMHC back in the Fall.

Jon: is it the time-value aspect? Or is it whether the coupons are real or nominal? I assumed it was the latter than mattered. If you want a nominal anchor, you have to peg the nominal price of something real, not the nominal price of something nominal.

Phillip: you really lost me there, I'm afraid. What's IP?

Patrick: I agree. But I would also like to think through the closed economy case, just so I could be theoretically sure it wasn't a beggar-my-neighbour policy.

Scott: I have been thinking about the international transmission of business cycles. If it's purely an AD effect (a US recession reduces Canadian AD), whether it works via IS, LM, or BP curves, it seems like there should be nothing to stop Canadian monetary and/or fiscal authorities from expanding AD to offset the foreign shock. Theory says we can control our own AD regardless (under flexible exchange rates). But I just have doubts about whether theory is always correct about this. But I can't figure out where it could be wrong. It's just a hunch, or uneasiness. So I can't make sense of my reply either ;)

Yes, it looks to me too that the ECB has failed to loosen monetary policy quickly enough. But what I fear is that we are in danger of becoming like old-fashioned Marxists who, when confronted with the failures of so many Marxist governments, replied "Oh yes, but they weren't really following true Marxist policies". Those old-fashioned Marxists might have been technically right, of course, but that only begs the question: there must be something wrong with a political theory if even those who claim to subscribe to that theory can never actually follow it in practice.

David: I really like and agree with your 11.15 comment.

Returning again to the question I postponed from your earlier comment (what happens if we start with less than full-employment or have some sticky prices?). (Sometimes I chicken out and don't comment at all, because I can't think of a good answer to a good question.)

Here's a couple of bad answers:

1. It doesn't matter if we start at less than full employment. The fact that we do gives us a deflationary force, but it can still be offset by a big enough inflationary force from monetary policy moving in the opposite direction. So it doesn't change my original answer.

2. If (some) prices are sticky, then monetary policy will have real effects. In principle those real effects under my sort of monetary policy instrument are the same as under an interest rate instrument, except that expectations of future instrument settings are different under different instruments. All we have changed is which variables are endogenous and which variables are exogenous; the equations linking them are the same.

Sorry. The economics part of my brain is returning to mush. I blame the fact that I have returned to university administration since July 1.

[Too Much Fed]

What if wage inflation is 0%, price inflation is 2%, and people can't borrow or have no assets to sell?

[Too Much Fed]

David Stinson said: "As a result, the Fed’s ability to create a critical mass of “actionable” inflationary expectations may have been badly impaired, with obvious implications for the “expectations management” channel of monetary policy."

Do you mean the fed is unable to sucker the lower and middle class further into debt to make up for negative real earnings growth?

[Too Much Fed]

David Stinson said: " ...by further undermining confidence in the Fed ..."

What confidence in the fed?

The only confidence I have of the fed is that they will continue to try to do everything they can to make themselves, the spoiled and the rich, and the bankers richer and more powerful at the expense of everyone else.

[Jon]

Jon: is it the time-value aspect? Or is it whether the coupons are real or nominal? I assumed it was the latter than mattered. If you want a nominal anchor, you have to peg the nominal price of something real, not the nominal price of something nominal.

Aren't you just repeating my question? Last I checked assets had nominal prices. The only assets whose real and nominal prices are identical are the ones that have no time-value.

I'm agreeing with you, but I'm using different language--which is to say I'm trying to make the argument that commodities are special.

'Gold' was supposedly a barbarism, but it did do a lot of things very well. To me, the meat of your post here is that commodities are special things.

I agree.

This raises another point which is that people confuse the 'gold standard' as such with maintaining a fixed gold-price and its concomitant autonomous policy. The latter mechanism has certain limitations. Limitations which can be breached by periodically moving the gold-peg.

[Nick Rowe]

Jon: "This raises another point which is that people confuse the 'gold standard' as such with maintaining a fixed gold-price and its concomitant autonomous policy. The latter mechanism has certain limitations. Limitations which can be breached by periodically moving the gold-peg."

Agreed. Or by moving the gold-peg continuously in time. Or announcing a medium term time-path for the gold price (perhaps making a conditional commitment -- that is conditional on CPI inflation, or whatever the target it).

But silver etc. would do as well as gold. So would contracts that promise to deliver commodities in the future, and so have a time-value component?

We might be miscommunicating on the real vs nominal distinction. I think of ordinary stocks/shares in a corporation as being real rather than nominal assets, because ultimately they are a claim on the real assets, and stream of real earnings of the underlying company. So in that sense they are like commodities, rather than government bonds or corporate bonds, which promise to pay a fixed number of dollars.

[Nick Rowe]

Too much Fed: "What if wage inflation is 0%, price inflation is 2%, and people can't borrow or have no assets to sell?" If people can't borrow, or have no assets to sell, we have a model where money printed by the central bank (cash in your pocket) is the only asset. That's when monetary policy is most powerful, because we don't have to worry about liquidity traps, which is where cash is highly substitutable for other assets. A quick helicopter drop of cash would do the job. We wouldn't be in this mess in the first place.

[Too Much Fed]

Can you expand on what "we have a model where money printed by the central bank (cash in your pocket) is the only asset." and "A quick helicopter drop of cash would do the job." means exactly?

[Too Much Fed]

I'd also like to go back to the monetary policy vs debt debate.

Let's start with where I think we agree.

If there are no savings and no debt, spending equals income. Is that correct?

Can you define spending?

[Too Much Fed]

"If inflation is likely to fall below target, you lower the interest rate to loosen monetary policy to raise future inflation. If inflation is likely to rise above target, you raise the interest rate to tighten monetary policy to lower future inflation.

And this way of thinking worked fine, until now. We know it worked fine, because acting on that way of thinking worked. The Bank of Canada kept inflation close to target; about as close to target as could reasonably be expected, given the shocks, and the uncertainties. But it's not working now."

IMO and from the U.S. perspective, targeting ONLY price inflation is wrong and a mistake.

[Scott Sumner]

David, Sorry I missed your reply, you made a lot of good points.

I'll only contest one thing you said, as most of the observations probably did play a role. I think the Japanese situation had been misunderstood, and is explainable. The current NGDP in Japan is roughly at the level of 1993, and the deflator is around 10-15% lower. I don't think things like that just happen. I have two theories:

1. The BOJ was limited not by a liquidity trap, but by political pressure from the US to keep the yen strong.
2. But I don't think the first explanation quite fits the facts, as the BOJ tightened monetary policy several times by raising rates (2000 and 2006) when they didn't have to. And they sometimes let the yen rally strongly when they didn't have to--for instance in 2008. Why not just assume the BOJ is so inflation-phobic that they are basically getting about what they want in terms of inflation. The deflation rate has hovered around 0% to minus 2%. And the BOJ has sometimes taken steps to prevent a breakup to the upside of that range. In 2006 they reduced the monetary base sharply. Why? Isn't the the most straightforward explanation that they feared inflation? And so they have successfully avoided inflation. if you can call that "success."

Nick, Small country open economy models aren't my forte, but I'll throw out one observation. Can't the Austrian mis-allocation story (which I normally think is overdone) explain part of the reluctance to stimulate in Canada? Suppose Canada exports a lot of cars to the U.S., and that market suddenly tanks. It's true that nominal spending or AD could be propped up with an expansionary enough monetary policy, but it isn't easy to suddenly move all of those auto workers over into other industries. Maybe the government prefers to wait out the world recession. On the other hand on my blog an Aussie commenter has presented some pretty convincing evidence that Australia has mostly avoided this recession due to currency depreciation (and sound regulation of banking, which sounds similar to Canada.) So I still lean toward the view that the BOC should have been a bit more stimulative--but I have an open mind.

[Too Much Fed]

"Monetary policy is about expectations"

What happens when reality trumps expectations?

[edeast]

How/why did the monetarist experiment fail?

[edeast]

nevermind