A Lucas Critique of monetary policy as interest rates

"The statistical relation between inflation and unemployment will not be invariant to the monetary policy regime". Economists will recognise that statement as an example of the Lucas Critique. They know it has implications for any policy that uses inflation to target unemployment.

"The statistical relation between interest rates and inflation will not be invariant to the monetary policy regime". I want economists to recognise that statement as another example of the Lucas Critique. I want them to recognise that it has implications for any policy that uses interest rates to target inflation. Or any other target variable, like nominal GDP.

Bill Woolsey has a post on whether the Fed set interest rates too low in 2001-2004. He makes two points.

Bill's first point is straightforward. He shows that judging by what happened to nominal expenditure relative to its long term trend, monetary policy was not too loose over that period.

Bill's second point is less straightforward. It's what inspired me to write this post. He argues that if the monetary regime had been different, monetary policy could have been looser, and yet the federal funds rate could also have been higher.

I will let Bill make the argument:

"On the other hand, if nominal expenditure has already grown too slowly for a substantial period of time, perhaps even falling, and nominal expenditure is now substantially below its target growth path, (as much as 2.7 percent in 2003 or more like 15% in 2010,) then having the Fed commit to low, or falling short term interest rates is almost certainly not an appropriate approach. The depressed level of nominal expenditure reduces credit demand at any given nominal interest rate. The equilibrium level of short term interest rates can easily be quite low because of the destructive effects of the drop in nominal expenditure.

If the Fed had a commitment, not to a series of changes in interest rate, but rather to change the quantity of money however was much is needed to get nominal expenditure back to target, rising credit demand could result in increases in nominal interest rates. And so, if the only way for the Fed to increase nominal expenditure back to a target for the growth path is to lower short term interest rates or keep them low, then the low interest rates were appropriate. However, since the Fed can expand base money by purchasing a variety of financial assets, the lower interest rates are simply an artifact of the Fed's approach to policy.

Of course, ce[]teris paribus, if the Fed purchases financial assets, this tends to raise their prices and lower their yields. But if the result is an expectation that nominal expenditure will have returned to its target growth path in the subsequent year, the direct effect of the Fed's purchases might be swamped by sales from the private sector, leading [to] lower prices and higher yields."

All I am doing is interpreting Bill's argument about the historical policy counterfactual as an application of the Lucas Critique. At root, it's the same point that Bill, Scott Sumner, and I have been making about current monetary policy.

Comments

[Scott Sumner]

Nick, I agree that this is an example of the Lucas Critique. However, I'd rather call inflation targeting (or NGDP targeting) the alternative policy. If you aren't committed to raising the price level, then an injection of cash might just be hoarded, driving nominal rates closer to zero. The injection must be at least partly expected to be permanent. And this would be equivalent to inflation targeting. But whatever you call it, any alternative monetary regime (exchange rates are another example) will break down the interest rate--inflation correlation.

[Nick Rowe]

Scott: agreed. I keep forgetting the Fed doesn't formally inflation target.

[Too Much Fed]

"If the Fed had a commitment, not to a series of changes in interest rate, but rather to change the quantity of money however was much is needed to get nominal expenditure back to target, rising credit demand could result in increases in nominal interest rates. And so, if the only way for the Fed to increase nominal expenditure back to a target for the growth path is to lower short term interest rates or keep them low, then the low interest rates were appropriate. However, since the Fed can expand base money by purchasing a variety of financial assets, the lower interest rates are simply an artifact of the Fed's approach to policy."

I would say:

1) Ignores wealth/income inequality

2) Ignores whether the economy is supply constrained or demand constrained

3) Sort of related to 1, buying financial assets from rich people does very little to help those with few financial assets

4) Define change the quantity of money (emphasis money)

5) it seems to me that the fed likes to price inflate with private currency denominated debt (the demand deposits created) which usually requires lower interest rates