OK, now I'm really confused (the snake and the peg)
By Scott Sumner
Here’s an imaginary dialogue:
Student: So the central bank sets the level of interest rates, right?
Professor: Not really. It would be more accurate to say that interest rates mostly reflect the condition of the economy. Higher inflation and/or higher real growth causes higher nominal interest rates. I.e. NGDP growth is the main determinant of rates.
Student: So the central bank cannot control interest rates?
Professor: That’s too strong a statement. They can peg the short term nominal interest rate. But as a practical matter the peg is greatly constrained by economic conditions. There is a fairly narrow band of choices for the short term rate. If they move out of that band then the economy will become highly unstable, moving toward hyperinflation or hyperdeflation. Before that happened they’d have to move rates back within the safe band.
Student: So central banks can move rates slightly higher or lower, but cannot cause huge swings in nominal rates, such as what we saw in the period from the 1960s to the 1980s.
Professor: That’s not quite right either. Imagine a time series diagram of the interest rate on 3 month government bonds. Now surround that time series line with a band that is about 1% wide. Now it looks sort of like a snake slithering across time. Let’s call that band the snake. My claim is that central banks must (as a practical matter) keep their interest rate peg within the snake. They have a little room to maneuver, but not much. However you forgot one thing, the central bank can move the snake! So they can move rates a great deal over an extended period of time. But only by moving the underlying determinants of the snake, inflation and growth.
Student: Hah! I see where you are going with this. So if the central bank wants rates to rise much higher, it can push rates toward the top edge of the snake, bumping up against the top of the band. The snake reacts by shifting upward to reduce the “pressure”, just as a horse responds to pressure put on it by the reins.
Professor: Nice metaphor, but unfortunately this snake is a bit perverse. You have described a Williamsonian snake, but the interest rate band is a Rovian snake. If you want the snake to shift upward, you lower the rate until it falls to the lower part of the band. I know this sounds confusing, but trust me, it’s true.
Student. OK, now I finally get it. Within the snake itself the central bank has very little leeway. The current setting of rates is mostly determined by economic conditions. The central bank can also move its short term interest rate peg higher or lower within the snake, but only slightly. Over longer periods of time they can actually move the snake much higher or lower, but only by first moving interest rates in the opposite direction from where they wish to go in the long run. That moves inflation and GDP in the opposite direction, which moves the snake. By moving the snake they can move the peg by a large amount over an extended period of time.
And this means that although we cannot directly see the snake, we can infer that in the short run it is usually moving in the opposite direction from the interest rate peg.
Professor: You were exactly right until “And this means . . .” In fact, the interest rate peg and the snake usually move in the same direction.
Student: Ok, now I’m really confused. Didn’t you just say that a change in the interest rate peg causes the snake to move in the opposite direction?
Professor: Good point, that was a bit of sloppiness on my part. What I meant to say is that an exogenous shift in the interest rate peg causes the snake to move in the opposite direction. But the snake usually moves for reasons unrelated to shifts in the central bank’s interest rate peg. In mid-2008 most snakes were steadily falling, even as central bank pegs were pretty stable. When central banks did start cutting rates, the changes were mostly endogenous, they were simply following the market. As the snakes fell all over the world, the central banks followed them lower, with an unfortunate delay. So snakes and interest rate pegs usually move in the same direction, even though exogenous changes in the peg cause the snake to move in the opposite direction.
Student. Are there any situations where central banks cannot move the snake by adjusting the interest rate peg?
Professor: Yes there are. When most of the body of a Rovian snake falls below zero he is difficult to budge. That’s because the central bank cannot lower the interest rate peg below zero. So they cannot lower it to the bottom portion of the snake, which is what is required to nudge the snake higher.
Student: So in that case there is nothing the central bank can do to nudge the snake upward?
Professor: I’m afraid you are wrong once again. Listen more closely to what I am saying. They can’t move the snake by adjusting their peg. But the central bank still has several other options. They can switch to a Kimbellian snake, which has no fear of the number zero. But those snakes are exceedingly rare and inconvenient to work with. Or they can try an alternative approach. The central bank can whisper into the snake’s ear that there are some tasty treats up around 3%, perhaps a box full of hamsters and gerbils. Snakes are very trusting, and respond well to this sort of forward guidance. Even Japanese snakes, which have an undeserved reputation for being cynics.
Student: But what if there are no tasty treats up around 3%?
Professor: You better be sure there are! If you make this promise and then don’t carry through with it then the snake will never again respond to your sweet talk. In that case you’ll have to give the snake a great deal of money up front, and tell him that he can keep all the money if the gerbils are not there as promised. Otherwise he won’t budge.
Student: I’m afraid we are getting too deep into metaphors here. What is the real world counterpart to the offer of a great deal of money?
Professor: NGDPLT futures targeting.
Student: What makes that policy so attractive?
Professor: It’s not easy to estimate the path of the snake when NGDP is expected to grow at 5% per year. The futures targeting helps the snake to find the path that will lead to 5% growth. More specifically, the futures program rewards all the millions of people who give the snake useful advice on which path is best. It makes their advice more credible.
The level targeting part of the policy helps in two ways. First, it helps keep the snake above zero when he’s hit by a sudden shock, such as the crisis of 2008. This is one reason the Australian snake never hit the zero bound. Second, it makes it easier to keep NGDP growth on target, because temporary shocks to NGDP cause future expected NGDP growth to move in the opposite direction. And those changes in expected NGDP growth help move actual NGDP back on target.
Indeed with the futures market and level targeting system, central banks can now ignore interest rates entirely, and just peg the price of NGDP futures. The snake will still be there, invisible to our eyes, but he will no longer matter. Inflation won’t matter either, as NGDP targeting will leave only optimal movements in the price level.
And NGDPLT futures targeting will allow us to stop teaching huge portions of macroeconomics. Because expected future AD will always be on target, we will live an a classical world where all the opportunity cost-based classical nostrums apply. No bailouts, no beggar-thy-neighbor, no paradox of thrift or toil, no fiscal stimulus. When the snake is finally tamed the world will be a much simpler and more pleasant place.
Student: I love stories with happy endings.