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I am just an amateur but about the Fed's recent purchase of $1.25 trillion of agency MBS?

asdf: those are probably pro-cyclical, but I don't know for sure.

Nick, off topic for this post but another interpretion of what Kocherlakota had in mind:


The problem is two-fold. First as you have previously blogged, we may be having a bond bubble in the US. Please correct me if I'm wrong, but I believe this is unusual and a departure from past recessions.

Second, when the Fed buys things other than US Treasuries domestically, it opens itself up to charges of "favouring one market" and letting rent-seekers get in on the other side of its actions. The Fed doesn't face this criticism with bonds because it's primary clients are banks and the US Treasury. The Fed gets its muscle from being the US Government's fiscal agent.

This is a creative explanation for why Robert Shiller's Trills (Government issued claims to a % of GDP) could be an excellent monetary policy instrument, as opposed to the usual real versus nominal distinction.

I think the Fed is largely legally restricted from buying pro-cyclical assets, except in extreme circumstances. (However, I've never read the law, so I'm really just guessing based on a vague sense of what I have heard.) Basically, the Fed's function is to lend money, and I think, except under extreme circumstances, it can only lend to highly creditworthy borrowers. At the beginning of last year, with anything not issued by the US Treasury trading at a ridiculous spread, there was kind of a loophole, because certain assets that would normally be counter-cyclical were instead pro-cyclical. That is, the value of even high-quality non-Treasury debt instruments was dominated by the pro-cyclical credit (and liquidity) component rather than the counter-cyclical duration component. But that game is over.

One possibility, at which you hinted in an earlier post, is to have Fed continue buying bonds but set an intermediate target in some pro-cyclical asset -- much the way the Fed used to set targets for monetary aggregates. It might not work, but it wouldn't require any changes in the law. I'm actually pretty confident that it would work if the Fed actually did it and were committed to it -- assuming we start from a situation like the present and not one that has further deteriorated. Basically, the Fed would announce a target for, say, the S&P 500 and then buy as many bonds as necessary to get the S&P 500 to the target level. There might be doubts at first, but if the Fed were truly committed, it would be willing to push bond yields all the way down to zero if necessary, and I think, by the time the 30-year Treasury got down from 3.5% to 1.5%, the OMFG factor would set in and stocks would rise to the target. And at that point, hopefully, Tinkerbell would show up and start raising bond yields again. And if the initial target proves inadequate to spark a robust recovery, the Fed could set a higher target and start over.

Adam: thanks. Half on topic!

Determinant: I think you are probably right about the bond bubble being an unusual feature of this particular recession. The 82 recession didn't look like this. So "cyclical" might have to be re-defined for each particular episode. Your second problem (political bias in what it buys) is also a real practical problem. Less of a big deal than which bank to bail out, maybe.

dlr: Hmmm. Interesting thought. I'm not sure if Trills would be pro- or countercyclical in current circumstances though. The coupon=NGDP aspect is clearly pro-cyclical, but if the interest rate (or "yield", as JKH would properly say) were pro-cyclical too, it could go either way. The other trouble with Trills, as opposed to say the S&P, or house prices, is that there's a clear causal link from share prices and house prices to investment. Not so clear from Trills to NGDP. (except of course the money, in both cases). And Tinkerbell needs all the help she can get to establish credibility that it will work.

Andy: Good observations. I don't have anything useful to add.

Nick, Your entire post is based on the premise that a central bank might want to create inflation, but have difficulty doing so. Can you provide any real world example that would make me think this is a hypothetical worth devoting any time to thinking about? Is there some central bank that announced "we'd like to have higher inflation, but dog-gone-it we are having difficulty getting the job done. And don't say Japan, because the BOJ was quite clear that they were adamantly opposed to any inflation, even 0.1%. And don't say the US, because Bernanke just announced he is opposed to a higher inflation target. In the past 18 months the Fed has not cut interest rates once, and they've basically stopped QE. And please don't say the ECB. So that's my question; do you have some sort of real world problem in mind here? And if so, which specific problem is it? Or is this just an academic exercise, in case the problem ever arises in the future? That's perfectly OK, I'm just trying to figure out the motivation. I know this sounds sarcastic, but it's not--I am actually serious. My hunch is that most people look at this differently than I do. Most disagree with my assertion that no fiat money central bank ever tried and failed to inflate.

I view it as a non-issue. But I am really curious as to where you come down on this question.

Having said all that--if you buy into the existence of a problem here, then I think you have a pretty good post. Honk Kong did this once, BTW.

Scott: I expect my target audience (my imaginary reader) is someone who thinks the Fed should increase AD (by that I mean "shift the AD curve to the right", or you can read it as "increase NGDP" as a first approximation if you like), and yet worries that the Fed might not be able to do so, or who worries how the Fed might do so, because they think that monetary policy IS interest rates. There's a lot of them out there.

But I've always been more concerned than you, Scott, about the so-called "transmission mechanism" (from monetary policy to AD). (The Kocherlakota controversy was really about the transmission mechanism). I don't think there really is *A* transmission mechanism, at least, none that is independent of the monetary policy regime, and how people form expectations about monetary policy and the variables that change in equilibrium when monetary policy changes. And the trick is to find a way of implementing monetary policy that works with those existing expectations. The Fed has constructed itself into a corner, by thinking of monetary policy as interest rates. I am reminded of an old post I did on the Bank of Canada. It was trying to argue that it still had tools it could use, even at the zero bound, while still maintaining the official theory of the transmission mechanism via interest rates.

Yep, my working hypothesis is that the Fed wants to increase AD, but is unsure, and can't agree internally, on how to do it. It's scared of doing something that won't work,

Andy writes: "I think the Fed is largely legally restricted from buying pro-cyclical assets, except in extreme circumstances. (However, I've never read the law, so I'm really just guessing based on a vague sense of what I have heard.) "

Not exactly so. The legal strictures on the discount window are quite loose. When the government started running large surpluses, there was some interest in what would happen after the treasury market disappeared--one idea at the time was to switch to using the discount window as the primary means of provisioning credit.

This and other ideas were eventually summarized in this report:
Alternative Instruments for Open Market and Discount Window Operations

Scott, Nick,

"Is there some central bank that announced "we'd like to have higher inflation, but dog-gone-it we are having difficulty getting the job done. And don't say ..."

Do you have an example of a central bank that has announced "we'd like to have higher inflation" and achieved it? Just asking.


Given the instability of money velocity, maybe its a different ghost that needs to be summoned - MV rather than M.

Hey, isn't that NGDP?

Nick if you're interested. I'm struggling to see how RE helps Kocherlakota (as has been suggested by Rajiv Sethi).


When the Fed bought $1.25 T of MBS last year, did it create any general inflation? Looks like it only inflated high grade assets, which have since continued to inflate. Since banks' excess reserves at the Fed coincide in timing and size with the Fed's MBS purchase, it does not appear to be coincidence. Even if the Fed stopped paying the 25 bps in rate on excess reserves, why wouldn't the banks use the money to buy 1 yr. Treasuries, since the decline in private sector credit appears to be a trend?

Another concern with QE. High quality assets are already in tremendous demand. China is sterilizing their US trade surplus, Japan needs to buy down the Yen, and private investors run to safety every time a European country falters (note: none of this sounds like bubbly, speculative buying). So even though mortgage yields are historically low, the US market still can't originate enough MBS to satisfy demand, causing MBS settlements to increasingly fail. Therefore I'm not sure the Fed can start buying MBS again. http://ftalphaville.ft.com/blog/2010/08/27/328076/oops-mbs-settlements-failing-again/

The part of the credit market that is particularly tight is for small businesses. We need gov't sponsored securitization of those loans, which the Fed can buy.

The stimulus policies from the developed world central banks have created a lot of growth and inflation, just not in their own countries.

I think Andy Xie is right about this:


JKH: "Do you have an example of a central bank that has announced "we'd like to have higher inflation" and achieved it?"

I can't think of a clear example where a central bank has ever said "we'd like to have higher inflation", whether or not they actually achieved it. (I can think of loads of examples where they said they would like to have lower inflation).

I expect you could take any (successful) inflation targeting central bank. On average, the BoC has hit its target almost exactly, but in any given year it's above target half the time and below target the other half. So, implicitly, the BoC spends half its time saying "we'd like higher inflation", and has achieved it.

In practice though, we almost never hear anyone say "I would like X", unless they have some difficulty getting X, or don't really want to pay the price of getting X.

NR: "I want an MX6"
Reply: "Huh? So get one!"
NR: "Not so easy, I can't find one offered for sale, or the price is too high".

Central banks often say "I want lower inflation". What they really mean is "I'm scared of the short-run costs of getting to lower inflation".


FYI, Tim Duy linked to your post as thinking "outside the box when dealing with Main Street."


Interestingly, he linked to Interfluidity alongside you.

Now that's a twofer in unconventional thinking!

I think there’s a problem relating to more refined specification of intra-cycle behavior of what you define as pro and countercyclical assets.

The risk free rate may still be too high at the beginning of a cycle in order to get things going. If the CB takes action to get it down further, even at the zero bound – say by buying long treasuries – that becomes a supportive pro-cyclical asset price increase that will inevitably reverse direction later on when the cycle reaches an inflection point of steadier growth.

Similarly, credit spreads may be very wide at the bottoming point of the last cycle and the start of the current one, due to extended credit losses. Spreads start declining as the new cycle begins and risk experience improves. Spreads bottom out at some point in-cycle, but then move back out as the cycle proceeds to maturity, due to increased risk taking and demand for credit. The asset price translation of this pattern is similar to the example of the risk free rate above. This is the case for continued central bank credit easing early on in the cycle.

The fed cannot get money to people to increase aggregate demand by asset purchases for a few reasons illustrated well by considering just the housing market.

Reducing interest rates gave homeowners an opportunity to refinance at a lower rate which should have freed up money for household consumption; however, the people that really need that refinancing it have lost their jobs or taken a pay cut so that difference is a wash because they have no extra disposable income. Its also difficult to downsize because their home has likely lost as much value as their neighbors so they are stuck with the same size mortgage anyway.

If you are renting, landlords have refinanced, but rents have been slow to come down, and even when they do, the people who need it are the ones who have lost jobs, so many renters, who should also benefit from more disposable income are not. Renters who did benefit (Smarter people with more options and money) haven't stopped consuming so the extra money they now have they invest..... but what to invest in? No return on business investment so they go with bonds.

Investing in assets does help out investors and asset owners but does not necessarily mean that help will increase aggregate demand for consumption. Without aggregate demand for consumption there is no investment in new infrastructure or more production as it will be left idle or have to be stored. The increased money that owners of the asset earn isn't spent because their is no real prospects for growth... which is where you would say "queue Tinkerbell". But Tinkerbell cannot convince people of something that isn't logically consistent, people are too risk averse to trust her when they know she is wrong. The Fed has to continue to buy treasuries and the government has to commit to spending them to directly create jobs or nothing is going to work.

The key is to Imagine you are unemployed. Tinkerbell tells you everything is going to be ok. Do you spend what you can't afford in hopes that the future holds prosperity at the risk of family security?

Now Imagine you are an investor who is aware of the instability of the business market. Tinkerbell tells you everything is going to be ok. Do you risk investing in anything other than bonds?

To answer yes you would have to compromise everything you know is true in an act of blind faith. There is no way that blind faith can be a real policy choice.


I’d love to see a “rational expectations for dummies” piece, as it applies specifically to the K. speech – maybe part of a previous post, or a comment you made somewhere, or a rework of same?

I’m being mentally crippled by my failure to comprehend this aspect so far.

JKH, RE doesn't apply to the K. speech.

If FED buys an asset it does not lead to an increase in Aggregate Demand because aggregate demand is about production and not secondary market activity.

Adam P,

It would seem to apply at least in the sense there's apparently been a debate about whether it's assumed to apply and if so by whom?

Adam P,

i.e. my impression is that the majority consider RE to be somewhat flaky in that context at least - I'd like to understand better what it purports to say and how it goes wrong if indeed it goes wrong.


Practically speaking, I don't think much could be accomplished in the bond markets. Agency, RMBS, corporate and high yield spreads are already in "Tinkerbell Territory" -- that is, they are quite low relative to history. The Fed could buy private label MBS--subprime and Alt-A--except of course that this would not lead to new issuance, which is the real driver of AD. I wouldn't count muni's as terribly "pro-cyclical". That list of products accounts for the bulk of the non-Treasury bond/ABS market. Some have argued that the Fed should buy packages of small business loans, but there is a reason these are not securitized in the first place: the loans are difficult to service in securitized form.

If the Fed could, why not buy equities? After all, the only difference between NGDP and S&P level targeting has to do with corporate margins, which tend to regress to the mean. If margins were around the mean, then buying stocks would be the same as buying NGDP futures, as stocks will reflect long term expectations for nominal revenue growth, which in turn is a proxy for NGDP. The discount rate, but the way, would be much lower and more stable once the Fed made the announcement, given the resulting low amount of expected volatility in aggregate corporate earnings.

The question is, what could go wrong if the Fed were to target a level for the S&P or Willshire 5000? I think that would make an interesting post...

This is interesting. But don't you have to look at both sides of the Fed's balance sheet? It shouldn't matter if the Fed's assets are pro-cyclical relative to private assets as a whole; as long as they are more pro-cyclical than its liabilities, you're getting the effect you want.

what could go wrong if the Fed were to target a level for the S&P or Willshire 5000?

The obvious answer is that the Fed would be taking over the capital-allocation of the financial system. Which might actually be a good thing, depending on what kind of job you think the capital markets are doing at directing investment.

David Pearson: "The question is, what could go wrong if the Fed were to target a level for the S&P or Willshire 5000? I think that would make an interesting post..."

I already posted on this!:


Though that was thinking of the TSX (S&P) as the ultimate target, rather than an intermediate target. But yes, buying the S&P500, or Wilshire 5000, is the sort of policy I would lean towards.

JW: What you say makes perfect sense in terms of the Real Bills Theory. But I don't agree with that theory.

JKH: RE can mean a lot of things to different people. I interpret it as a long run equilibrium condition. "If we are in long run equilibrium, then expectations must reflect the best forecasts people can make, given their (limited) information. They won't make consistent mistakes in long run equilibrium." But, to make the K speech make sense, you have to interpret it much more strongly than that. Something like: "if an equilibrium exists, people will know where it is, and will expect the economy to go there immediately. Never mind why or how."

Rick: that isn't how monetary policy works, or is supposed to work. Money, income, wealth, are different things.

Nick, on the RE and Minnesota view stuff, I've had a brief conversation with Rajiv Sethi on his sight. I think it's hashed out clearly there.

will write another post when I get a chance.

Nick, in that 2008 post, you say: "I thought I would write a few words in defence of the idea, and then say why I no longer support it." Have you now changed your mind? Or do you think that the CB should target inflation in normal times but the stock market when faced with deflation?

Taken as a general policy, I was persuaded by the reasons for rejecting that you gave in your post, to which I would add a fourth: it is easy to see how, by creating money, the CB can raise the price of the market as high as it likes. It is not so easy to see how it can guarantee always to be able to lower it, because it cannot create more TSX. This policy is not without its own version of the zero boundary.

Phil: There's the ultimate target: inflation vs TSX vs price level vs NGDP
Then there's the intermediate target, the thing we buy and sell and adjust in the short run to try to hit our ultimate target.

I'm trying to figure out what assets go up in bad economic times(counter cyclical). Gold? Bond prices go up, at least for a while. Which means utility stocks go up too. Beyond that I can't think of any. Which means most assets are pro-cyclical.

Anyway, isn't this all talk about derivatives of the real thing: Production? And it appears we have too much production. Or too little demand for what can be produced. Which means the one asset we need to buy is labor. It's particularly undervalued right now. Like most assets, it's pro cyclical.

So I'd 'buy' labor by putting people to work building stuff. Engineers believe we have $2.2 trillion in infrastructure needs. Already identified. Could start there. If we had a national bank we could simply funnel money into small to medium sized businesses. But that wouldn't guarantee much job creation. If the phone's not ringing, employment isn't going up.

The fed is doing its job "sort of" by keeping short term rates low. The market has failed to invest in itself, so what's left? I know that the fed can't just pay for government stimulus in the US, that's not the goal of monetary policy, but they can help finance it by doing its job to keep short and medium term rates low. The point is there needs to be a team effort between the fed and the US government. The Fed alone can't bring the US out of crisis at this point. That doesn't mean it shouldn't try, but if we are really going to have an honest discussion it has to involve the role of government to step in and properly allocate resources for a temporary time frame. The alternative is to accept 10-15% unemployment as a new equilibrium and turn the other way to mass suffering as though we are back in feudal times. No amount of monetary policy or QE or whatever they want to call it will help fill the demand gap, thus the entire consumption based economy will continue to suffer. The government itself has to fill that gap with direct spending to create jobs.

As I understand it, under normal conditions the Fed can only buy Treasuries in the US market, although it can also operate in the foreign exchange market and gold market. However, the Fed has broad emergency power in abnormal times, and they are rather vaguely defined. It is therefore conceivable that the Fed could legally participate in domestic markets, even equities markets, in emergencies. The guiding principle seems to be act in extremis and explain it later under emergency powers.

The Fed has already demonstrated that it can influence the yield curve by buying long term instruments. Very little was said when the Fed extended its purchases to MBS, although a lot of eyebrows were raised, and some complained about the Fed taking the bank's toxic debt onto its own balance sheet. So much for that.

Chairman Bernanke has said that the Fed has more tools at its disposal, without mentioning them. I don't think he was just bluffing, as some seem to conclude. He knows that there is a lot that the Fed can do in emergencies that exceed its normal powers, and he doesn't want to reveal specifics unless he is forced to act.

He is hoping that knowledge that he has a "bazooka" will produce the desired result. However, it didn't work in 2008-2009. We'll just have to wait and see.

My take is that the Fed and President Obama's advisors see the way out as a relation of asset values to pump up the wealth effect, and encourage people to spend and borrow based on that, while relying on the automatic stabilizers to increase NAD directly. They are desperately trying to stabilize and then pump up housing. So far, it's not enough. I don't think it is going to be enough. Balance sheets have to be rebuilt before another cycle can begin.

I don't think the heart of low AD is due to uncertainty and sentiment, it is due to confidence in two facts: households are overindebted and new businesses are credit constrained. Households by historical standards have huge debt burdens, which in the case of mortgages they can't shed due to negative equity, and in the case of credit cards have huge credit premia regardless of the risk free interest rate. New businesses historically create half of new jobs, as well as contribute disproportionately to innovation. Most new businesses aren't funded through IPO's or VC's (which are rare now), but instead through home equity loans, credit cards, and small business loans - all of which are also tight now.

Buying equities or corporate bonds to signal markets will risk creating new bubbles and will likely drive new money to large firms that are already hoarding cash, causing them to hoard more cash, buy back shares, pay down debt, or acquire other firms; anything but invest in building more unneeded capacity. It would treat the symptom rather than the cause of the caution in consumption and investment. A bazooka would be for the Fed to buy household debt and to massively forgive principal and cut high interest rates; which may require cooperation with the Treasury and/or Congress. (or is that a howitzer?) A new/small business credit push would need Congress to create Fannie/Freddie like entities which would standardize, commoditize, and securitize business lending (not easy, but possible) so that the Feds could buy and stimulate investment.

Nick, I do understand that lots of people worry about this, but I'd first like to see the Fed announce that it would like to see higher inflation, and is trying to achieve it. Also tell us what steps they are taking. Instead Bernanke basically tells us there are 3 or 4 things they could do if they wanted to create inflation, but they just don't plan on doing any of them because they do not in fact want higher inflation.

He's called "Helicopter Ben" for a reason, he certainly knows how to create inflation, that's not the problem. The problem is getting the hawks at the Fed to go along.

I think where people get confused is the low rates and large monetary base. They think the Fed already has easy money, and despair over how it can be made easier. Or the don't know what happened in Japan. If you understand that money is now tight in the US and Japan, it is easy to envision how it could be made easier in all sorts of ways.

JKH, FDR decided to inflate in 1933 when there was similar skepticism, and succeeded immediately. He's not a central bank, but what he did was akin to price level targeting. But you do raise a good point. Because most people think inflation is bad, it is really hard to publicly call for higher inflation. That's why level targeting is a key, it allows the Fed to say they haven't changed their inflation target, they're just trying to catch up. Ditto for NGDP targeting. It sounds better to say you are try to pump more national income into Americans' pockets.

Two thirds of my commenters who attack me, say my ideas would overshoot to high inflation.

I don't think you can reach this long run equilibrium path without solving the chronic BOP payments issue. Tinkerbell won't help there.

And yes what Kent said, plus the best policy the Fed could adopt would be to allow the Government to
1. give every citizen a cash dividend
2. invest in infrastructure renewal
without financing it by selling treasuries.

"Then there's the intermediate target, the thing we buy and sell and adjust in the short run to try to hit our ultimate target."

Yes, my point exactly. 99% of what matters is the instrumentality, not the goal. Your long-term target will stand or fall according to how well you have chosen and deployed your instruments. So what is your proposed method? Do you have one?

Phil: "So what is your proposed method? Do you have one?"

Have the Fed buy pro-cyclical assets, as my post says.

"99% of what matters is the instrumentality, not the goal."

Nope. 99% of what matters is people's beliefs about the goal you are aiming at, and their belief you will get there. It doesn't matter much how they think you will get there, only that you will. Expectations matter.

reason: "1. give every citizen a cash dividend
2. invest in infrastructure renewal
without financing it by selling treasuries."

Consolidate the government and central bank balance sheets.
1. is helicopter money.
2. is buying real assets (that are probably pro-cyclical).

"I don't think you can reach this long run equilibrium path without solving the chronic BOP payments issue. Tinkerbell won't help there."

Yes she will. The "bubble" in US$ bonds and money is part of the reason the reason the exchange rate is so high.

Scott: a thought-experiment:

Suppose, just suppose, that we (I mean you Americans) had the current levels of actual and expected inflation, GDP, unemployment, etc., but that the FFR was (say) 2%. I think that Ben Bernanke would have no difficulty convincing or outvoting the hawks to lower the FFR. It's because they have to do something "new" ,and "unconventional", and because voting can split on which particular way to do it, that they don't do anything. Zero (FFR, and zero QE) is a magic number. It's a focal point in voting. The agenda matters for outcomes when voting.

Kent: "I don't think the heart of low AD is due to uncertainty and sentiment, it is due to confidence in two facts: households are overindebted and new businesses are credit constrained. Households by historical standards have huge debt burdens,...."

No they don't, and increasing household spending would reduce debt burdens.

The aggregate debt burden of US households is negative. They are owed more than they owe. The mistake is to look only at debtor households, and ignore creditor households. There is no debt burden to stop creditor households increasing their spending.

Plus, if every household increased its spending, aggregate household income would rise by the same amount, with no change in aggregate debt. And "debt burden" is best defined relative to income.

tjfxh: good points. The only place I would disagree is that the transmission mechanism from asset prices to AD is not just through a wealth effect (or balance sheet effects). In fact, those have nothing to do with the standard story of the monetary policy transmission mechanism. It's substitution effects. And Tobin's q (which is just one way of interpreting the substitution effect in investment). Consumption and investment Euler equations, in short.

Rick: "No amount of monetary policy or QE or whatever they want to call it will help fill the demand gap, thus the entire consumption based economy will continue to suffer."

Yes it can! Hopeless defeatist!

Nick, the problem is that at the heart of the argument you are calling for wasteful spending, either on behalf of the Fed or by (excuse the term) "non debt constrained households" to make up the demand gap. Your argument is essentially pretending that the Americans think that they are riding a broken bike when really all that has happened is that the chain has fallen off. Your contention is that if the fed puts the chain back on through unconventional monetary policy people will "understand" that nothing was wrong in the first place and drive that bike the same way as before..... I don't see how that's the case.

Is the Fed going to go out and buy commodities like copper or grains and give them away to industry who has no use for them? Will they buy goods like copper top batteries or bread to give them away to homes so they have some extra money to buy other things? (like what? and how will the Fed get away with it?) Will they buy equities at inflated values and hope that "non debt constrained households" that cash in on the purchase will buy twice as many batteries and bread?

I'd like you to do a complete path of the money that the Fed spends on asset purchases and justify how it is going to help aggregate demand?

There has to be a resource redistribution organized by the Federal Government. Either, as Kent suggested by creating Fannie/Freddie type entities to securitize business lending with the backing of the government, or spend directly to create jobs (give money directly to people for doing stuff), tax progressively (take money from people who are wealthy)to pay for it over the next 20 years. Hopefully they will focus on creating some research, education and development jobs that will pay off in the future so that you can reduce taxes and government spending as a portion of GDP over time. There is no other way.

"Nope. 99% of what matters is people's beliefs about the goal you are aiming at"

That is manifestly false. If it were true, Kocherlakota would be right and econ 101 would be wrong. It wouldn't matter whether you raise or lower rates in order to achieve higher inflation as long as everyone knew what you wanted and what you will do when you want it.

I really don't know if QE is the right way to go.

I mean we are talking possibly trillions of dollars ,which is a lot of money even for masters of the universe in Greenwich Connecticut for propping up, (quasi)-zombie banks reserves in the hope that they will resume their earlier lending practices...

Since what matters is changing expectations would announcing a higher inflation target Krugman-style not be a better option?

My copy of the Yellen notes is at home but have not forgotten what i learned about Tobin's q and other financial models

Take a look at the options-pricing model called Black-Scholes.

The model is based on the assumption that a trader can suck all the risk out of the market by taking a short position and increasing that position as the market falls, thus protecting against losses, no matter how steep.

Nearly every employee stock-ownership plan uses Black-Scholes as its guiding principle.

Good theory.

The glitch was discovered only after the fact:

When a market is crashing and no one is willing to buy, it’s impossible to sell short. If too many investors are trying to unload stocks as a market falls, they create the very disaster they are seeking to avoid. Their desire to sell drives the market lower, triggering an even greater desire to sell and, ultimately, sending the market into a bottomless free fall.

That’s what happened on October 19, 1987, when the sweet logic of Black-Scholes was shown to be irrelevant in the real world of crashes and panics.

It’s like trying to replicate a fire-insurance policy by dynamically increasing or decreasing your coverage as fire conditions wax and wane. One day, bam, your house is on fire, and you call for more coverage?”

So the very theory underlying all insurance against financial panic falls apart in the face of an actual panic.

And the model has a pernicious effect:

By leading investors to think they understand complicated financial risk when they actually do not, and by mispricing that risk, Black-Scholes encourages them to take more chances than they rationally should.


A few smart traders may have abandoned the theory, but the market itself hasn’t; in fact, its influence has mushroomed in the most fantastic ways. At the end of 2006, according to the Bank for International Settlements, there were $415 trillion in derivatives—that is, $415 trillion in securities for which there is no completely satisfactory pricing model.

So Black-Scholes didn’t work; trillions of dollars’ worth of securities may have been priced without regard to the possibility of crashes and panics. But until very recently, no one has bitched and moaned about this problem too loudly.

Lay folk might harbor private misgivings about the clergy, but as lay folk, they are reluctant to express them. Now, however, as the subprime market unravels, the beginnings of a revolt against the church seem to be taking shape

Phil: "That is manifestly false. If it were true, Kocherlakota would be right and econ 101 would be wrong. It wouldn't matter whether you raise or lower rates in order to achieve higher inflation as long as everyone knew what you wanted and what you will do when you want it."

If everyone believed that a 5% increase in nominal interest rates would cause a 5% increase in inflation, then Kocherlakota would be right. Standard economic theory would agree with him.

"If everyone believed that a 5% increase in nominal interest rates would cause a 5% increase in inflation ..."

Hang on - that is not the choice that a central banker faces. She has the power, if she is skillful, determined, and lucky, to change people's beliefs about how she will act, but not their beliefs about what effects those actions will have. So perhaps she can make people believe that if inflation falls, she really will raise rates. Then if the market sees disinflation, it will bet on higher rates. But that's all. People will draw their own conclusions about what effect those rates will have on future inflation and act accordingly.

The point is, nobody cares what the bank wants. People are interested in predicting what the bank will do; the bank's desires are secondary to this. So if people see that rates are at zero, they will not expect further rate decreases, no matter how badly they think the bank wants more inflation. And if they see that the bank has no TSX to sell, they will not expect further declines in TSX, no matter how badly the bank wants to reduce NGDP. The means matter.

Phil: "The point is, nobody cares what the bank wants. People are interested in predicting what the bank will do; the bank's desires are secondary to this."

But Banks often state what they will do in these terms: "we will move instrument I by however much it takes to get our target variable T to where we want it to be, T*" As long as that's credible, T* is what matters, not how much you think they will change I.

Yes, if people see that rates are 0%, and they think of monetary policy as nominal interest rates, and nominal interest rates only, then the bank's target T* won't be credible. Which is exactly the Kocherlakota problem (or part of it). (The Bank could presumably short the TSX, by the way).

Plus, there's also strong positive feedback. If I think everyone else will set higher prices, other things equal, I will want to raise my prices, since my demand curve and marginal cost curve will shift vertically up. If I think everyone else will spend more, then my income will go up, and I will want to spend more.

I'm surprised to hear that the household debt burden has not increased relative to personal income, I thought that household debt had been below income until around 2004, and has been higher ever since. Although debt has dropped lately, so has personal income. What don't I understand?

If household spending increases, but the trade deficit correspondingly increases, does the household income also increase? Will a of that increased spending end up as debt to an overseas creditor rather than a domestic household?

Kent: Imagine a closed economy with only households, no government. If one household has a debt, that debt must be owed to another household. So one household has a positive debt, and another household has a negative debt (a credit). Aggregate *net* debt must always be zero. People easily tend to forget this when talking about debt. The numbers that get reported ignore one half of the balance sheet. You read a report that says that average debt is (say) 100% of annual income (nothing magic about 100%, by the way, because it would be 1200% of monthly income) and you think "oh wow! we all owe one year's salary!", and forget that some of us owe it to others of us.

Your closed economy sounds a lot more like Canada than the US. The closed economy doesn't have massive holdings of household debt by foreign countries and the central bank (neither of which will buy US goods anytime soon). As the US household debt to personal income has increased from 57% in 1980, to 70% in 1990, to 76% in 2000, and now 113% in 2009, I can't help but think that both the debtors and creditors are worried about the debt being paid back. If we aggregate enough, I'm sure the debt nets out. But the creditors don't seem to be sharing their wealth.

Nick, net debts matter. They certainly matter between countries. Within countries, debts still matter, because of class inequalities.

While I see your point about "magic numbers" nevertheless if interest rates ever exceed growth rates, then debt outgrows the ability to repay.

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