What standard monetary theory says about the relation between nominal interest rates and inflation

This is what I understand "standard" monetary theory to say about the relation between inflation and nominal interest rates.

I want to distinguish two cases.

In the first case the central bank pegs the time-path of the money supply. The money supply is exogenous. The nominal interest rate is endogenous. Standard monetary theory says that a permanent 1 percentage point increase in the growth rate of the money supply will (in the long run) cause both the nominal interest rate and the rate of inflation to rise by 1 percentage point. The Fisher relation holds as a long-run equilibrium relationship. The real interest rate is unaffected by monetary policy in the long run.

In the second case the central bank pegs the time-path of the nominal rate of interest. The nominal interest rate is exogenous. The money supply is endogenous. Start in equilibrium (never mind how we got there). Standard monetary theory says that if the central bank pegs the time-path of the nominal interest rate permanently 1 percentage point higher, this will cause the price level, and the rate of inflation, and the stock of money, to fall without limit. The Fisher relation will not hold, because there is no process that will bring us to a new long run equilibrium. The real interest rate will rise without limit.

These two cases are very different, because a different variable is assumed exogenous in each case.

I am assuming super-neutrality of money, in long-run equilibrium. The Fisher relation is a long run equilibrium relationship. We never get to the new long-run equilibrium in the second case, and so the Fisher relation does not hold.

Comments

[Steve Williamson]

Nick,

In the second case you started in an equilibrium. What was determining anything in that equilibrium? Are you saying that there is indeterminacy? If so, there's still an equilibrium where you work back to the same equilibrium you had in the first case. The nominal interest rate and money growth rate are just flip sides of the same policy.

Steve

[Too Much Fed]

"Standard monetary theory says that if the central bank pegs the time-path of the nominal interest rate permanently 1 percentage point higher, this will cause the price level, and the rate of inflation, and the stock of money, to fall without limit."

How about it falls to the currency limit?

[Nick Rowe]

Steve: If prices (and expectations) are perfectly flexible, then yes, the outcome in the second case is indeterminate. I started in equilibrium just by assumption. There would be no reason to be there. In other words, talking about monetary policy as setting a nominal interest rate, and perfect price flexibility, are incompatible.

If prices are imperfectly flexible, so inflation continues under its own inertia, then we could, conceivably, by sheer fluke, be in equilibrium in the second case, if the time-path of nominal interest rates just happened to coincide with the time path of the natural rate. But then any exogenous change in that time-path of nominal interest rates (like a permanent increase) will create a permanent disequilibrium (excess supply of goods).

Yes, there is a "flip-side" argument. I have used it myself. (I want Central banks to stop talking about monetary policy in terms of setting nominal interest rates and talk instead about setting the time path of some variable that has $ in the units. Like the money stock, or nominal prices of real assets (the TSX?). But you have to be very careful about how you describe that case verbally. Because what counts as "tightening" or "loosening" monetary policy are very different.

There is a big difference between saying "I want the Fed to loosen monetary policy, by increasing the growth rate of the money supply; I recognise that this will cause nominal interest rates to rise as a side-effect/consequence", and saying "I want the Fed to increase nominal interest rates". Because the latter is interpreted as a tightening of monetary policy. And when you are a Fed President, you have to be really really careful to make this distinction.

In equilibrium, we can't tell the difference between equilibrium time-paths in which i is exogenous or M is exogenous. They are observationally equivalent. But it is expectations of out-of-equilibrium play that keep us on an equilibrium time-path. (Subgame perfect Nash blah blah). Old-fashioned macroeconomists, like me, mark the distinction in terms of what's exogenous and endogenous.

Another way of saying this: framing really does matter. It determines players' expectations of off-equilibrium-path play. It affects the sort of commitments players can make. There is a very big difference between a commitment to a time path for M, and a time-path for i.

(If I make a credible commitment to punish someone if he steals, that matters, even if he never steals in equilibrium, so we never observe by punishing him in equilibrium.)

I must go to bed. I'm losing it again.

[Too Much Fed]

"Standard monetary theory says that a permanent 1 percentage point increase in the growth rate of the money supply will (in the long run) cause both the nominal interest rate and the rate of inflation to rise by 1 percentage point."

That allows me to bring up this question. The way the system is set up now, is all NEW (emphasize NEW) money currency denominated debt, whether private or gov't?

[Robert Waldmann]

A qualification -- money is not generally assumed to be super neutral because higher inflation implies lower real balances and low real balances cause increased "shoe leather costs." It is generally believed that, if the money supply is increased say 10% every day, then the real economy will be affected. The desperate effort to manage with very little money implies reduced efficiency.

This effect is generally believed to be miniscule for inflation rates on the order of 10% per year or less.

OK now pegging interest rates. The Fed can certainly keep the federal funds rate as low as it wants. The reason is that the Fed loans charging the discount rate. This is normally slightly higher than the federal funds rate. The Fed funds rate can't be higher than the discount rate as banks will borrow from the Fed at the low rate and not from each other at the higher rate.

Assume that inflation has been zero for, say, a century. If the Fed were to peg the discount rate at a level below the market clearing real interest rate, then banks would borrow lots and lots of money from the Fed. This is an increase in the supply of high powered money and should lead to inflation. That would make the banks even more eager to borrow. The result would be a hyperinflation.

This is not theory. The Reichsbank kept it's discount rate very low (3.5% I think) from 1918 through 1923. It supplied all the money banks wanted. The result was not deflation. The economy converged to a new equilibrium in which the Reichsmark was worthless and transactions were conducted with other currency. In standard monetary theory, there is typically a steady state in which money is worthless.

[Too Much Fed]

Robert Waldmann said: "Assume that inflation has been zero for, say, a century. If the Fed were to peg the discount rate at a level below the market clearing real interest rate, then banks would borrow lots and lots of money from the Fed. This is an increase in the supply of high powered money and should lead to inflation."

Does that require borrowers?

[Jon]

"Standard monetary theory says that if the central bank pegs the time-path of the nominal interest rate permanently 1 percentage point higher, this will cause the price level, and the rate of inflation, and the stock of money, to fall without limit. The Fisher relation will not hold, because there is no process that will bring us to a new long run equilibrium. The real interest rate will rise without limit."

Agree until the last sentence. Eventually expectations will reset and the real interest rate will resume is prior value.

I suspect you are (wrongly) assuming that 'money' is the only money. Obviously it is not, bank notes and cheques will replace money as the medium of exchange.

[JKH]

Nick,

“I want Central banks to stop talking about monetary policy in terms of setting nominal interest rates and talk instead about setting the time path of some variable that has $ in the units...there is a very big difference between a commitment to a time path for M, and a time-path for i.”

Why couldn’t a central bank commit indirectly to M, by committing directly to the interest rates it expects are appropriate to M?

Presumably the interest rate path that would fall out of targeting M can be anticipated and targeted as the expected path for interest rates. The commitment to target the time path of interest rates that you suggest is pretty soft in normal times, and only becomes firmer at the zero bound, it appears. Either way, the commitment to target M is translatable to a commitment to an expected time path for interest rates, and vice versa.

In fact, central banks don’t actually commit indirectly to M exclusively, but they could if they chose to.

They don’t commit M indirectly (or directly) because they’ve apparently come to distrust M as an exclusive target.

Some input in the process that central banks actually use must be comparable to the role of M in this way, although what that is isn’t always clear.

Don’t they prefer to commit to expected interest rates because their alternative input to M is too eclectic to specify with numerical precision?

I guess I’m suggesting that to the degree an indirect commitment to M is feasible through interest rates, isn’t your beef more with the non-use of M per se (or some other exclusive target as you suggest), rather than the use of interest rates as an expectation flowing from a more eclectic target?

[Steve Williamson]

Nick,

Let's be more explicit. I know you don't like math and symbols, but they force some discipline on what you do. Suppose this is an infinite horizon, discrete-time model, t = 0,1,2,... . Now, in the first case, the initial money stock is M, the growth rate of the money stock is m. Suppose the environment is stationary (population, technology, preferences constant over time). Suppose in the first case the equilibrium nominal interest rate is R. What do we know about the first equilibrium? (i) M does not matter, i.e. money is neutral, and R is an equilibrium interest rate for initial money stock kM for any k > 0. (ii) As you said, the Fisher relation holds, if I increase m, then R increases one-for-one. Now, consider the second case. Suppose the central bank pegs the interest rate at R. Then there is a continuum of equilibrium money stock paths (and maybe more besides, but there are at least these) with initial money stock kM and money growth rate m that support that interest rate peg. The central bank gets to choose the one it wants. If the central bank choose a nominal interest rate R+x, it can support that with a money stock path kM and a money growth rate m + x. Done.

[Daniel Starr]

Steve,

If I read you correctly, you observe that the central bank can support any nominal interest rate R+x, so long as it provides the appropriate money stock path and money growth rate.

I believe Nick is concerned about the case where the central bank is not able or not willing to exercise control over the money stock and money growth rate, and *only* controls the nominal interest rate. In that case there is no mathematical reason to expect, and much empirical reason to doubt, that the economy will follow an equilibrium path, because the money supply is like to be wildly off the needed path for that equilibrium.

That is, doesn't your example depend on the central bank doing more than just setting the nominal interest rate?

Or are you merely observing that the economy *could* follow an equilibrium-maintaining money stock and money growth path, rather than asserting that it *will* follow such a path?

I think empirical observation suggests that when the central bank raises the nominal rate, bank lending declines (all other things equal), and the supply of money becomes less, not more. So however theoretically conceivable it might be to have the money supply grow to accommodate the higher nominal rate, in practice we would see what Nick described in his original post: contracting money supply, away from the equilibrium path, and so no validity for the Fisher relation.

Have I got that right? What am I overlooking?

[Daniel Starr]

Clarification: if the central bank does not control the money supply, but only the nominal interest rate, then at any given point there is certainly one nominal interest rate the bank can choose that sustains equilibrium for an economy already in equilibrium. If the bank chooses that rate, it's fine.

Likewise, if the bank chooses a path of changing rates that orbit around that equilibrium rate, the economy should experience only small and temporary, not large and permanent, divergence from equilibrium. (If you added in a nonstationary economy, this is more or less how I would model American central bank policy over the last few decades.)

It's the suggestion that the central bank can choose *any* rate path and rely on the money supply to move to match automatically without deliberate bank action that is surprising. Why should the money supply accommodate the central bank's choice of an arbitrary rate path, without additional central bank action?

Which brings things back to what I take to be Nick's central concern: focusing too much on the nominal interest rate, and only the nominal interest rate, seems to make central bankers stupid.

[JKH]

Does a 1:1 functional mapping exist between potential money growth paths and corresponding interest rate paths (just one such mapping will do). If that’s the case, and if the mathematical relationship is continuous, it doesn’t matter which variable is positioned as “exogenous” by the central bank. The bank chooses the dual path that it wants. It then has the choice of positioning money growth as the intended result of an exogenous interest rate policy, or positioning money growth as the exogenous policy and letting interest rates “be determined” by a rule of correspondence. Either way, the result is equivalent provided there is mathematical continuity of each variable as a function of the other. Regarding Nick’s example, I think the problem is that there is no reason for a central bank to shock exogenous interest rates 1 per cent higher if that policy is inconsistent with its desired money path, and there is no reason to reach that point if the relationship between the two paths is a continuous function. A one per cent policy shock is a mathematical discontinuity, which accounts for the dysfunctional result when the interest rate is exogenous.

[Daniel Starr]

JKH,

What if a 1:1 mapping between money growth and interest rate paths depends on allowing nominal interest rates that are negative?

Then paths that pass through the zero bound on nominal interest rates would deny the central bank the mapping it normally relies on.

[JKH]

Daniel,

If that's the case, and if nominal rates are not allowed to be negative, then that part of the mapping is out of bounds for conventional monetary policy purposes, whether you view money supply as a function of policy interest rates, or necessary interest rates as a function of targeted money supply. Either way, if the desired mapping point includes negative nominal rates, you have to do something else like unconventional monetary policy or fiscal policy. That zone of the mapping points to changing the nature of the policy.

[Rogue]

The Fed president’s speech leads me to believe that in his world, borrowers simply do not exist. His world is only populated by investors. It’s easy to believe that deflation will result if investors see rates at 0% when they should be at 2%.

This is possible if everyone has all the money he’ll ever need. The dynamics change once there are borrowers.

[Rajiv Sethi]

Nick, this controversy really illustrates the dangers of equilibrium analysis without proper consideration of disequilibrium dynamics. Clearly a long run equilibrium of the kind that Narayana has in mind exists. The problem is that the economy is not in its basin of attraction under the kinds of disequilibrium dynamics that you and Andy have in mind. And you are absolutely correct - holding down the FFR indefinitely (even as unemployment and capacity utilization reach normal levels) will result in deviations away from the deflationary equilibrium, not towards it.

[Nick Rowe]

Rajiv: Yep. And a simple verbal analysis of the process that might lead towards the new equilibrium would do the job of showing that something is seriously wrong in this case.

Steve: "Then there is a continuum of equilibrium money stock paths (and maybe more besides, but there are at least these) with initial money stock kM and money growth rate m that support that interest rate peg. The central bank gets to choose the one it wants. If the central bank choose a nominal interest rate R+x, it can support that with a money stock path kM and a money growth rate m + x. Done."

But how can a central bank simultaneously choose both k and i?

Let's think through the stability experiment. Start in equilibrium. Now suppose the bank wants a higher rate of inflation. Suppose it sets a higher i. At existing prices and expected future prices, the real interest rate is higher, so demand falls, there is excess supply of goods, and firms start to lower prices. And the (endogenous) money stock starts to fall too (higher i, lower P, and possibly lower Y too, if there's a recession). So we move away from the new, higher inflation, equilibrium. And we move away at an accelerating pace, because as inflation falls, expected inflation falls too, and so the real interest rate rises further.

I know you don't like sticky prices and sticky expectations, but think of it this way. Start out doing your analysis of the disequilibrium dynamics with sticky prices and sticky expectations. It moves away from the long run equilibrium. Now take the limit of your results as prices and expectations become more and more flexible. The system does not become long run stable in the limit. It just implodes more quickly.

Only at the limit can we say that anything is possible. But even at the limit, to get to the new equilibrium, the central bank would need a second policy lever. Direct control over (say) expectations.

[Nick Rowe]

Jon: Yep. I am making the assumption there's only one money (or, that all other monies are asymmetrically redeemable into that one, central bank money). Yep, in practice, the one money would either explode into inflation, or implode into deflation. In either case it will eventually be replaced by another, genuinely independent (non-redeemable into the first) money. Like Zimbabwe, in the first case. Or where people in deep recession resort to barter and hippy monies in the second case. But this is 'outside the scope of my model".

[Leigh Caldwell]

Daniel and Rajiv make some very helpful clarifications - as I have come to expect from Rajiv, an underrated blogger! Karl Smith's explanation at Modeled Behaviour is also good. Crossing it with some inspiration from Nick's analogy-making, I think we can find an intuitive explanation of why Kocherlakota is right in theory, in the long run, but completely wrong in the short run and in practice:

Imagine you're driving a truck up a hill. Its acceleration is determined by three variables: how much you push the gas, friction, and the incline of the hill you're on. Given that we're in equilibrium - i.e. constant speed, more gas implies that we must be on a steeper hill. But pushing the gas does not make the hill steeper!

However, in the long, long run...it kind of does. Not in any direct way - but because the only way to not crash your truck is to find a steeper hill.

A proper explanation here: http://www.knowingandmaking.com/2010/08/kocherlakota-and-monetary-analogy.html

[Jay Dixon]

1) My (eclectic and brief) reading of the literature is that as Nick says, interest rate pegging may lead to price-level indeterminancy (I don't understand how one gets an unbounded long-run decline in the real interest rate, or anything to fall without limit). BTW, at least some of the literature asserts that the price level becomes determinate if, for example, the public has (and believes) additional information on the evolution of the money supply.

2) It is clear from Kocherlakota's comments that, as Rajiv says, we are not talking about an economy in long-run equilibrium, but rather policy during an adjustment to one, so thought experiments (like the one starting this post) along the lines of "say we are in an equilibrium" ... may miss the real point.

3) More importantly, we are not talking about interest rate pegging- what we have is interest rate policy under in a de facto inflation targetting regime. We can argue whether it is credible or not, but if long-run inflation expectations are well-defined (Kocherlakota suggests that they are), doesn't the price level indeterminancy go away?

[Jay Dixon]

I could imagine the logic going something like this- the Fed has pumped a lot of liquidity into the system, which has not yet led to a large expansion in the money supply. It has ruled out a permanent increase in money growth (and it is

not
pegging the interest rate). In fact, it has given every indication that it will try to soak up the overhang as soon as things return to normal.

If it is slow to do so, though, the result may be akin to a discrete increase in the money supply as lenders rapidly lend out the stock of reserves they've built up. Depending how long the money takes to get into the economy, it will be soaked up by a corresponding jump in the price level before the fed gets the chance.

The process will stop when returns are equalized, which occurs at the current FF rate under deflation, sustained by a money supply that is growing slower than GDP.

Note that this sudden movement in the price level is not inflation, that in this case it comes from previous, not ongoing, attempts to expand the money supply, and that the fed is cultivating expectations that it will attempt to shrink the money supply in the future.

Put another way: in a sense, by arguing that maintaining a low FF rate under these conditions will lead to inflation, are we not claiming that expectations of negative money supply growth is inflationary?

[Joe]

Professor Rowe,

I've never respond to one of your posts, but I thought I'd ask a question.

I've recently finished going through both of Mankiw's Micro and Macro textbooks, and now Mishkin's finance/money textbook. I follow your blog, Sumner's, Woolsey's, Harless's, Beckworth's and Delong's in order to learn monetary theory.

All other blogs, television appearances, articles, and professional journals all talk about monetary theory in that complicated way economists do, following the same general ideas that Mishkin's textbook does, and complex mathematical modeling.

But all you guys talk about money in a really weird fantastic way, kind of like the "metaphysics of money." The same way philosophers have studies metaphysics and epistemology by justing theorizing and abstracting it and thinking about it, you guys write about it at a really really deep, abstract, almost metaphysical way. Its absolutely fascinating, and I could almost make a list of all those blog posts where you guys carefully and logically went through some aspect of money, Money supply, money demand, natural rate, say's law, monetary disquilibrium, natural interest rate, excess and efficient demand, velocity, MV=PY, "tight money," NGDP, paradox of thrift, IS-LM, AS-AD, liquidity, etc. etc. etc.

You guys seem to throw away all that modern technical macro gunk and just really try to understanding all of these things at their deepest basic level. I find this fascinating, but all I can find on monetary theory anywhere is either 100 year old books that I cant understand, basic stuff like Mishkin, advanced like David Romer's macro textbook, or just all those books and papers that go through macro in a really modern technical sense.

Where can I find books and authors that go through these topics the way that you do, without all the technicality and just almost philosophically try to understand all of it at the deepest level? I feel that I need to read some books before I tackle your writings because I find it very hard to follow your blog posts and commentaries, even though my gut tells me that its just not that complicated. I've heard many speak about Leland Yeager, is he worth a shot? Other authors that write like you guys? Heck, have you considered writing up a book. I think all your blog posts on monetary theory, if put together into some book, would be a brilliant corollary to the standard macro textbooks.

Best wishes,

Joe

[Too Much Fed]

Nick's post said: "Yes, there is a "flip-side" argument. I have used it myself. (I want Central banks to stop talking about monetary policy in terms of setting nominal interest rates and talk instead about setting the time path of some variable that has $ in the units. Like the money stock, or nominal prices of real assets (the TSX?). But you have to be very careful about how you describe that case verbally. Because what counts as "tightening" or "loosening" monetary policy are very different.

There is a big difference between saying "I want the Fed to loosen monetary policy, by increasing the growth rate of the money supply; I recognise that this will cause nominal interest rates to rise as a side-effect/consequence", and saying "I want the Fed to increase nominal interest rates". Because the latter is interpreted as a tightening of monetary policy. And when you are a Fed President, you have to be really really careful to make this distinction."

The way the system is set up now, I'm going to say all NEW money is debt. So, those paragraphs sound like low interest rates are about creating more currency denominated debt.

That also seems to confirm a theory of someone on another web site I read that actually got there was a housing and debt bubble.

It also sounds like you are assuming there is an aggregate demand shock not an aggregate supply shock.

[Gregor]

Hmmm, let's see.
Using the Kocherlakota/Williamson model, if the Fed credibly pledges to peg the Fed funds rate at 10% forever and the equilibrium real interest rate is 2% then this policy will result in 12% inflation. If the Fed credibly commits to 50% and then follows through with this commitment, this will result in 52% inflation. So, to the extent the central bank is credible, announcing that rates will be 10% three years from now should cause an immediate surge in long-term TIPS spreads.

Also, because high prices of apples are consistent with high levels of apple production, a massive increase in apple production should lead to a higher apple prices.

And because sales of sunscreen are associated with hot sunny weather, the government should purchase massive amounts of sunscreen when it cold and rainy, thereby producing a more tourist-conducive environment.

Do I have all of this that right?

[Pedro]

Joe: "Monetary Theory" by Alan A. Rabin

[Too Much Fed]

Gregor said: "Also, because high prices of apples are consistent with high levels of apple production, a massive increase in apple production should lead to a higher apple prices."

If demand for apples falls short, does the fed need to buy the excess apples?

[Adam P]

Gregor, you have it all right and yes, it's stupid.

[Nick Rowe]

Gregor: it's 8% and 48%. You should have subtracted, not added.

You are not right on the apples though. Here's a better one. Suppose the supply and demand curves sloped the wrong way. In that case, an increase in demand for apples would lead to a fall in the new equilibrium price. But we would not see an actual fall in price, because the equilibrium is unstable. Instead, the price will rise without limit.

Joe: Thank you for saying that. I don't have a clue what books to recommend. Sure, read Yeager, Clower, Keynes, Friedman. But someone else could better recommend something newer and comprehensive. I'm too out of it. And I couldn't get my act together to write a book. Read more blogs. Read Steve Williamson, David Andolfatto. I learn from them. Doesn't matter that I often disagree.

[Nick Rowe]

Jay: "...so thought experiments (like the one starting this post) along the lines of "say we are in an equilibrium" ... may miss the real point."

Agreed. But it makes things simpler. Because otherwise we would also have to argue about what would happen anyway if we didn't change policy, in order to figure out the difference that policy makes. That's why economists nearly always start in equilibrium in their thought-experiments.

"3) More importantly, we are not talking about interest rate pegging- what we have is interest rate policy under in a de facto inflation targetting regime. We can argue whether it is credible or not, but if long-run inflation expectations are well-defined (Kocherlakota suggests that they are), doesn't the price level indeterminancy go away?"

Here's my take on it. As long as expected inflation remained well-anchored, and as long as central banks changed the interest rate quickly enough, and faster than the economy could fall off the cliff on either side, everything worked OK. The price level stayed determinate. Then we got a really big quick shock, and central banks were too slow. Plus we hit the lower bound, and people lost faith in the Fed's ability to hit its implicit inflation target (Things were a bit better in Canada, maybe because the shock was smaller, maybe because the BoC had a more explicit inflation target, that inspired more confidence.)

[Too Much Fed]

Nick's post said: "Plus we hit the lower bound, and people lost faith in the Fed's ability to hit its implicit inflation target (Things were a bit better in Canada, maybe because the shock was smaller, maybe because the BoC had a more explicit inflation target, that inspired more confidence.)"

Using national accounts, I would say Canada is different because of the trade deficit/surplus. In the USA, more private currency denominated debt was the preferred way to fund the trade deficit.

[Jay Dixon]

Nick, I know economists simplify, but your simplified the model in a way that bears too little relation to the policies you're trying to critique. Your conclusions at the beginning may very well be correct (I haven't checked) if the economy is in equilibrium and the only change is a shift in monetary policy to one without a nominal anchor. But does it really tell me anything about the effects of discretionary nominal interest rate changes after a large real shock under a policy framework of implicit inflation targeting?

Also, empirically, I see no evidence of price level indeterminacy. As far as I can tell, inflation in the U.S. and elsewhere has been low and roughly stable. And I see no evidence that the markets are anticipating rampant inflation or deflation.

As for the original conjecture- low interest rates can promote deflation (rather than inflation) in long-run equilibrium- I don't think it as simple math as K. asserts, but it strikes me that it is possible. I tried to sketch out one possibility above. Would another be if markets rely too much for information about the underlying economy on the Fed's interest rate decisions?

[Leigh Caldwell]

Jay: "empirically, I see no evidence of price level indeterminacy."

You can't see price level indeterminacy empirically, by definition.

Indeterminacy means that the model cannot predict price levels. It's nothing to do with the real world.

Then again, perhaps we can empirically see that nobody has a model to predict price levels. That's not quite the same.

[Jay Dixon]

Volatile inflation numbers (a characteristic of very high inflation) would be evidence, I think.

My problem with Nick's analysis and his original, "hey, Minn Fed Pres. - take some intro-economics" post is that he is criticizing him on the basis of a model that clearly doesn't apply here. NK. spent most of his speech talking about (1) the Fed's price stability mandate and its credibility; (2) Fed's expectations on the economy, and the impact of its actions on market expectations. Only at the very end of his talk, he discusses the consequences of keeping the FF too low for too long in the current situation (admittedly, he makes it sound like an eternal verity).

A lot of the posts here and elsewhere nonetheless accuse him (and the Fed) of focussing exclusively on the nominal interest rate, and getting absolutely wrong what happens when you peg it permanently. It's a straw man dressed up as a thought experiment that is now replete with trucks and hills and apples and the like.

As far as the theory goes, my reading of it is as Steve and JHK and others have pointed out: as long as the market has some additional information nailing down the path of money growth, it doesn't matter whether the Fed targets the interest rate or some other variable. In practice, surely the price stability mandate and published insight into the Fed's thinking about the economy does the equivalent job.

[Adam P]

http://krugman.blogs.nytimes.com/2010/08/27/inflation-and-interest-dynamics/

[Jay Dixon]

Yeah, after reading Krugman's post, I'm none the wiser about the plausibility of what K. is actually saying. I'm still wading through the more advanced posts (see links attacthed to Delong's blog): http://delong.typepad.com/sdj/2010/08/stephen-williamson-commits-himself-to-cargo-cult-macroeconomics.html). None of them are at an Econ 101 level, and their still critical-of-K conclusions seem contingent on debatable (though perhaps highly realistic) assumptions rather than self-evident truths.

Krugman's post, on the other hand, essentially says- let's start from a point different from the one K. starts at, and imagine a policy that bears little relation to the one he is suggesting. The results that follow obviously demonstrate how stupid he is.

Don't know what the final answer really is, but my Econ 101 training predisposes me to believe that even the most trenchant critics are mostly right in their conclusions. But my training in other disciplines predisposes me to think their reasoning is less than university grade, and that the ad hominem attacks serve only to underline that fact.

[Patrick]

Jay:

I never took Econ 101, so maybe I'm just making a fool of myself. Wouldn't be the first time. Anyway, this was my thought when I read K's statement.

Refer back to K's original statement: He lays out a situation where we have high *structural* unemployment, but the economy otherwise purring along. In the long run, money is neutral (meaning it doesn't affect real variables like unemployment). So if over the long run the Fed holds rates low (I understood low to mean below the natural rate of interest) the money supply will blow-up. Inflation ensues.

Given my limited econ background, I can only imagine two scenarios where deflation results, but it's not the steady deflation K talks about. The first is in the very very long run after hyperinflation has left the economy a smoldering pile of rubble and everyone has reverted to barter or switched to some other currency I can imagine deflation taken hold as we revert to the stone age. The other is if one assumes the natural rate remains negative and the Fed is constrained by the zero lower bound. I can't imagine K was talking about the former, and he certainly wasn't talking about the later because he explicitly said the economy was back to normal and a negative real rate ain't normal.

[Jay Dixon]

The relevent papers, cited and (briefly) critiqued by Delong are:

Jess Benhabib et al. (2001), "The Perils of Taylor Rules," Journal of Economic Theory http://www.columbia.edu/~mu2166/perils.pdf

and

James Bullard (2010), "Seven Faces of 'The Peril'" http://research.stlouisfed.org/econ/bullard/pdf/SevenFacesFinalJul28.pdf

The Benhabib model argues that there is a zero interest rate deflationary steady-state, into which Japan, for example, has fallen (the peril). Bullard tries to match up the monetary policy rules w/ actual FOMC and BOJ policies. The policy rules discussed (both perilous and beneficial) bear no relation to the thought experiments of this post.

It strikes me that this is the situation Kocherlakota had in mind in his speech. What he seems to be advocating is that interest rates needs to rise in short order after the economy returns to equilibrium, lest a negative shock could force the economy into deflation while interest rates are still near zero.

[Too Much Fed]

Jay Dixon's post said: " ... as long as the market has some additional information nailing down the path of money growth, it doesn't matter whether the Fed targets the interest rate or some other variable."

Does that money growth actually mean currency denominated debt growth?

Plus, can somebody turn off the italics?

[Jay Dixon]

Patrick,

The papers I mentioned above are a little beyond me, and I too may be making a fool of myself, but I'm thinking about it this way: the economy experiences a weak recovery. Interest rates stay close to zero. Then the economy experiences a negative shock. One is left with deflationary expectations, with no active policy options to counteract them. This is a long-run equilbrium- interest rates can't fall because of the zero lower bound, and there is no expectation that they'll rise, because inflation is below target. One way to avoid the problem (or one interpretation of K.'s statement) is for the Fed to raise interest rates as the economy recovers, in a way that doesn't damage the recovery. It is a tough balance.

As to the doomsday scenarios, this is arguably the situation in which Japan finds itself in now, w/out a history of hyperinflation.

[Leigh Caldwell]

Italics off

[Leigh Caldwell]

Oops, italics not off. Trying again.

[Leigh Caldwell]

OK, one last try.

[Stephen Gordon]

It was much farther up - I've fixed it.

[Patrick]

Japan doesn't illustrate the point. During bouts of growth, the BoJ raised rates for fear of inflation (which is exactly what they needed), and sure enough it put the breaks on and they fell right back into the trap. If lower rates are deflationary, then surely raising them is inflationary ...

Anyway, I can think we can probably imagine pathological scenarios. But that's not what NK said. He explicitly stated that returns had normalized. He's also a Fed president talking to business people, so we have to assume that he was talking about the world we actually live in.

Personally, I think he just screwed-up and won't admit it. It happens to us all. When you're a mere mortal like me you get used to being wrong and you figure out that it isn't so bad because it's a chance to learn something. But when you're a 'scary smart' prodigy child math wiz Fed prez, the ego gets inflated and admitting you blew it gets a lot harder.

[Jay Dixon]

Patrick: "Japan doesn't illustrate the point"

It does and it doesn't. Or rather, it does and it may or may not: I'm not familiar enough with the evolution of their monetary policy. (I'm not convinced that momentary macroeconomic mistakes at key points can equal a lost decade, but that is another issue) It does illustrate it, because it is a case of zero short-run interest rates and mild deflation with no end in sight, which is precisely the scenario NK described. So is it possible? Apparently yes: evidence Japan.

Carefully re-reading NK's speech (something I'd encourage for all our esteemed Econ 101 boosters), I don't think he is saying that adopting lower rates is deflationary. Rather, if the Fed doesn't get ready to move off the lower bound once the economy recovers, we could find ourselves in a Japan-like trap: still at the lower bound and at the natural rate, with no obvious way out.

Is he right? I don't know- if I have to rely on reading Krugman and NK's other more intemperate critics, I guess I never will. They seem pretty obsessed with demonstrating that if the situation were completely different, adopting unrelated policies lead (you idiot!) to other conclusions. Swell.

[kevin quinn]

This has been quite an interesting discussion. I have just a little to add, and that little may be simply echoing what I got from Robert's comments. NK's suggestion that it may be important to increase the nominal interest rate to avoid deflation: the problem with deflation is that it sets a lower bound on the real interest rate the Fed can achieve and the Wicksellian natural rate may be below this lower bound. Then and only then is deflation something to worry about. But NK's case has nothing to do with this: he imagines a natural rate above the nominal interest rate, a case where the Fed is therefore in no way hindered from bringing the real rate in line with the natural rate, and then asks us to worry about deflation! Why? This is what makes the suggestion suspiciously disingenuous to me.

[Nick Rowe]

Kevin: yep. absolutely. If NK were right, escaping the zero nominal bound would be so easy. Just have the Fed raise the Federal Funds rate to create inflation! Problem solved.

For months now, I have been arguing (against e.g. Adam P), that there might be a way to escape the zero bound, if the Fed changes the way it frames monetary policy, switches to a different instrument, communicates differently, whatever, to have the Fed loosen monetary policy and have nominal interest rates rise, as a consequence, even in the short run. The best and brightest should be working on this, not someone like me. But they are not even at step one. So I suddenly find myself on the same side as Adam again, as we explain step one to our betters.

[Adam P]

I've missed a lot of discussion here but want to respond to Jay's comment from the 27th at 11:05am.

Jay says: "Krugman's post, on the other hand, essentially says- let's start from a point different from the one K. starts at, and imagine a policy that bears little relation to the one he is suggesting. The results that follow obviously demonstrate how stupid he is."

Krugman is not imagining a policy that bears little relation to what NK says, he's making a point that Nick has made several times on this very blog and that Scott Sumner constantly makes when he says that low interest rates don't necessarily indicate loose money. That point, in Krugman's phrasing, is that the stance of monetary policy is determined by the entire central bank reaction function, not by the current rate of interest.

On this blog Nick has phrased the point that way himself, Sumner uses different phrasing. Sumner would say something like: you need to make a permanent increase in the money supply. But increasing the money supply permanently is the same as reducing the interest rate in all future states of the world relative to what it would have been, that is it shifts the entire CB reaction function. That's why permanent monetary injection works where a temporary one doesn't.

Now, Kocherlakota is also talking about the Fed's reaction function, here's what he says:

"Eventually, the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level. The FOMC has to be ready to increase its target rate soon thereafter.

That sounds easy—but it’s not. When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation."

He's not talking about raising rates *today*, he's talking about the Fed's reaction function for future economic states. "When real returns are nomalized" is a state future state of the world we hope to once again reach, it's surely not today's state.

Furthermore, Jesus Fernandez-Villaverde also interprets it this way when he says "Imagine that the Fed is targeting the FFR and decides to lower the long run target from, let's say 4% to 2%...". He's talking about the long-run steady state value of the FF target, not today's setting.

Now, is what Kocherlakota said idiotic? Yes. Why? Well, Nick and Sumner and Harless and.... have all explained it well in their phrasing. Here's an explanation in Krugman's phrasing:

Once we understand that monetary policy is characterized by the entire CB reaction function and not just the current setting we have to ask what is that reaction function? Well, Krugman is saying that whatever else might be in there it's pretty certain that the reaction function involves raising rates only when inflation increases. So yes, the equations that characterize equilibrium in just about any model do say that deflation and low nominal rates will go together but none of those models say that low rates cause (or even *can* cause) the deflation. They just say that if deflation persists then the fed will keep the target lower.

Which brings me to a point that I think for the most part has been overlooked (though I was trying to make it to David Andolfatto), the very worst part of what Kocherlakota said is that he was advocating for a policy and that policy was to tighten monetary policy *TODAY*.

If the Fed stands ready to raise rates before inflation has increased (based on other indications of a normalization) then that is a change in the reaction function that constitutes a tightening. (Look at it this way, in Sumner's phrasing it is a statement that the Fed stands ready to reduce the money supply even earler than we though, the monetary injection has gotten *less permanent*).

This is just idiotic for anyone who knows what their talking about and who values the economic well being of the country.

[Adam P]

Nick, following on from what I just said, I'm not so sure we've been arguing against each other. I think we agree that what the fed needs to do is comunicate a change in the reaction function.

We disagree a bit on the underlying theory but that's a bit beside the point. I don't like your "social construction" stuff because I don't see that it helps. My view is that what Bernanke needs to do is exactly to ease by changing the reaction function, I think you agree. I also think the change should be a higher price level target.

Bernanke on the other hand as explicitly not changed the reaction function, he is not saying the Fed wants more inflation or targeting a price level 4% above the current. He's flat out saying that the reaction functioin is the same as always.

To me the reaction function expressed as a conditional mapping from economic state to i needs changing, for you the conditional mapping from economic state to M needs changing. Fine, the fact that the fed uses my formulation is not the problem (so the "social construction" is not the problem).

It's the conditional function that's the problem and on that I think we agree.

[Jay Dixon]

Yes, it is the Fed's reaction function, which seems to be in a state of flux. NK, in his speech, in fact refers to the Fed's unconventional measures in the past, and advocates more (but doesn't really specify) for the future. BTW, I don't get this assertion that the Fed communicates only via the FF rate- in fact, it pumps out a lot of information about the other things it is doing from which one can characterize its reaction function. While we might not be able to fit into our nice little models, I'd argue that the real world participants whom the models characterize can (discuss).

I think a greater problem is that the Fed honestly doesn't know what to do, and is feeling its way along. I blame the academics: standard theories don't seem developed enough to help at this point. I think underdeveloped theory explains why Krugman and others have focussed on thought experiments appropriate for, and backed by, examples where the standard theories really do help (Weimar Germany, the Volcker disinflation). It is interesting, though, that none of the thought experiments based on the standard models offered seem to be able to cope with the Japanese situation. [Interesting scientific fact: any model which excludes such a significant data point is not a good one.] It is rather closer to what a lot of the stuff, apart from the one offending sentence, NK seemed to be grappling with.

Bullard (following on Benhabib, links to both papers above) asserts that one could rule out the Japanese equilibrium with a discontinuous reaction function promising to tighten interest rates to, say, a (historically loose) 2% as a way of ruling out the Japanese equilibrium (italics)ex ante. But, he argues this is unexplored territory. It is probably not what NK was thinking of, but it would partially justify his claim.

It is incorrect to say that NK is saying up is down w/ respect to i, pi in the short-run, which a lot of the critics (this blog, initially Krugman, others) are arguing, i.e. if we find ourselves in deflation, we can just raise rates. The point is that we could find ourselves stuck in an equilibrium characterized by NK's Fisher equation, and NK's point is that we really want to take policy actions to avoid it, because if we don't we could be, like the Vapours, Turning Japanese (which, if you recall, is no sex, no drugs, no wine, no women and, for the central bank, no fun. Aside: Incubus does a very good cover).

Two notes: Delong says he "dealt with" Bullard's argument. I can't really tell from his sloppy exposition, but it looks to me like he just mischaracterizes it. I've not got Delong himself or somebody else serious to engage the issue. Even if I'm trivially wrong, it is curious because they seem otherwise willing to seize on every trivial issue that comes along.

Second, there is another argument (most closely associated w/ Adam Posen) that Japan is not in a long-run equilibrium, but is repeatedly beaten back into something that looks like an absorbing state by an ongoing series of policy mistakes. It is possible, but not decisively argued. Nevertheless, a lot of people just cite it as justification for excluding the Japanese problem from their models. I've trouble with Posen's framework- it doesn't make sense to me yet his claim that one-off policy mistakes at "crucial" times can produce a lost decade.

[Jay Dixon]

One further note: I'm new to the blogosphere, and I'm not a full fledged macroeconomist, though I do play one in a public policy school. Some of my posts on this issue have bordered on snarky, but I think it's because I was offended by the Econ 101 thing. In general, while the follow-up discussions to a lot of these blogs have been fascinating, and as a student of economics I've learned a lot, but the headline blogs have been unedifying.

But let's stick with the Econ 101 theme, and the stuff we'd fail our students for. Turnabout is fair play: It is a big thing nowadays for students to evaluate their teachers. The scores so far: based on his Fed speech, I wouldn't go with Kocherlakota because the paragraph we've been dwelling on really wasn't clear and is open to multiple interpretations-indeterminacy, if you will. You can resolve the indeterminacy by applying your own prejudices, as Krugman does- but then you learn more about Krugman than the economy. So no. Nick Rowe? I've got apples and poles, but none of it is really on point. Start with an arbitrary equilibrium and then permanently peg the interest rate 1% higher? Oh Christ, Oh Christ, Oh Christ- how about starting out of equilibrium, and choose a point near the lower bound, which is actually the case we are discussing? Williamson? It is clear to him what NK. was talking about, but it isn't clear to me. He's found an equilibrium where NK is right. Great, but how do we get there? You need a model, as Delong points out. Problem with models is that they are like assholes: everybody's got one. Delong's model? Well, I got the most useful bibliography off of Delong's site, so he is in the lead, but if you draw your graphs in an arbitrary fashion, you get arbitrary results.

Anybody else teaching Econ 101?

[Adam P]

Jay, your characterization of the existing theory is utterly false. The theory says exactly what the Fed should do in the current situation, it's just that Bernanke hasn't yet decided to follow the advice of this theory.

As for Kocherlakota, he said much more than just: low rates and deflation go together. We'd all agree with that. And Williamson did not find and equilibrium where NK is right. Williamson simply found an equilibrium where low rates and deflation go togther. Kocherlakota said much more than that.

Here's part of NK's quote taken from Nick's post:

""To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation."

That could be interpreted two ways: a wrong way, and maybe, just maybe, a right way.

"When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation."

Nope. He definitely meant it the wrong way. If the economy returns to normal, and the natural rate of interest rises, the Fed must raise its target rate of interest. (So far so good). If it doesn't, the result would be....deflation. ("Inflation" would be the right answer)."

Nick is right, NK is wrong, the right answer would be inflation. It's deflation that causes the low rates and not the other way around.

[Jay Dixon]

Adam, the issue isn't low rates now, it is promises of low rates in the future, which have a different impact. And I don't think anyone but you seriously believes that the monetary "silver bullet" out of this crisis is in every Econ department across the land, just waiting to be loaded. I've seen no overwhelmingly persuasive theories accounting for Japan.

[Adam P]

Jay, you said: "I think a greater problem is that the Fed honestly doesn't know what to do, and is feeling its way along. I blame the academics: standard theories don't seem developed enough to help at this point."

I said that's wrong, the standard theory (at least a large body of it) does offer a prescription but the Fed has so far refused to implement it. I never once claimed it was a silver bullet guaranteed to work. But how can you blame the academics if their prescriptions have been ignored?

Would you also blame your doctor if he prescribed you a medicine but you refused to take it and got sicker?

[Jay Dixon]

Adam: so what should the Fed do?

[Adam P]

Decalare a price level target for 2 years from now that is 10% higher than the current price level. Explicitly promise that if the price level falls short of the target the same thing will be repeated with another 10% added to the previous target (so if cumulative inflation over the next 2 years is 7% then the fed aims for 13% over the following 2 years).

Back it up by expanding he balance sheet to $5trillion beginning immediately.

[Jay Dixon]

Essentially Quantative Easing- do we really know if/how it works? (Papers, studies?)

[Adam P]

No, the driver is the price level target. The balance sheet expansion to facilitate hitting the target works by reflating asset prices (important for Bernanke-Gertler reasons to facilitate an expansion in private credit).

For the papers see Woodford, Svensson and friends.

Unless you count devaluing against gold in depression, which did work, I don't know of any examples where this has been tried. But if it works the theoretical papers tell us perfectly well how it works.