John Cochrane on modern macro
By Scott Sumner
When John Cochrane writes on finance I prefer him to be “the grumpy economist.” When he writes on macro, I prefer the less grumpy version. His new (non-grumpy) post on macro is outstanding, full of so many important insights that I’ll need to do several more posts. Here’s one important point:
I long ago sat at a hilarious academic advisory meeting at a Federal Reserve, at which the bank president asked, bottom line, whether we thought the Fed should raise, cut, or leave alone the funds rate. Academic after academic gave beautiful speeches about the right policy rule. (Me, an ode to price level targets rather than inflation rate targets.) The poor exasperated president said, “that’s all very nice, but what should we do now?”
This call for action, for activist discretionary response, is at the core of Keynesian economics. It’s very very hard to talk about rules and institutions rather than actions. And the core answer of modern intertemporal economics is to unask the question. But people expecting a daily discretionary decision just don’t want to hear about the rule. In this regard, the policy mindset still is decidedly old-Keynesian.
As a counterexample, consider asking the question “what should monetary policy do about unemployment” in the 1800s. There was no Fed. “Monetary policy” consisted of the gold standard, implemented by the Treasury. The answer would be, “the price of gold is $20 per ounce. What’s your question?” I’m not (!) saying that’s the right policy, but it is a pure example of a rule rather than activist discretion. A serious discussion about a rules-based Fed would start by canceling the regular FOMC meetings and the economic review. That just presupposes that the whole process is to come to a discretionary decision.
I often get frustrated when people debate whether the Fed should raise interest rates next year, without first spelling out the goal of monetary policy. How can one evaluate the wisdom of a rate increase when we don’t know what it is trying to achieve?
One can think of monetary policy in terms of two issues; what is the policy rule, and how best can that rule be implemented? The Fed does have a very fuzzy rule, but it’s far too fuzzy to allow us to answer the question of whether a rate increase next year would be appropriate. (Here I’m assuming that the unemployment rate will be about 5% next year, slightly below the Fed’s estimate of the natural rate. If unemployment is still 5.8% and inflation is still below 2%, then a “no” answer seems obvious.)
So what’s the problem with the Fed meetings? Why does Cochrane want to abolish them (and why do I agree)? Two distinct issues are debated at Fed meetings, even though only one debate is acknowledged. What should the rule be, and how should it be implemented? If everyone accepted the same policy rule, the debate would be 100% focused on how best to get there. There would be no consistent inflation “hawks” or “doves,” as 2% would be the agreed upon target. In reality, you’d have to be pretty naive to believe that Yellen and Plosser have the same policy goals, in terms of the optimal path of inflation and unemployment. So there’s also a (hidden) debate over goals. In the 1970s the doves had a hidden agenda. They claimed to favor low inflation, but did not vote that way. Now the hawks have the hidden agenda; they claim to accept the 2% inflation target, but don’t vote that way. (It’s even worse in Germany.)
One way to reduce the “hidden agenda” debate is to establish a non-fuzzy rule. I prefer NGDP level targeting, but you could construct a reasonable alternative out of a weighted average of inflation and output gaps. In that case FOMC meetings would have a clear agenda, and you’d get rid of the hawk/dove problem. Level targeting takes the long run NGDP growth rate (and hence inflation rate) off the table, and both hawks and doves tend to favor less nominal volatility. So monetary policy would become a purely technical problem–smoothing the growth of NGDP. And at that point I think both Cochrane and I favor turning over the mechanics of implementation to the market (say via TIPS spreads targeting (Cochrane), or NGDP futures (me).) So there’d be nothing for the FOMC to do.
Now go back to where Cochrane discusses the frustration of the Fed bank president:
“that’s all very nice, but what should we do now?”
The bank president doesn’t realize that the answer to that question depends on how the same question will be answered next month, next year, and 5 years from now. Without knowing those subsequent answers, it’s impossible to give a reliable answer today.
Now in fairness the Fed must be careful here. In the past, various central banks have made highly credible commitments to rules, which later turned out to be huge mistakes (the US committing to gold after WWI, Argentina to a currency board in 1990, and Greece committing to the euro.) One area where I differ slightly with Cochrane is the time inconsistency problem. I think central banks can easily overcome that problem, if they have a policy rule that actually embodies their policy objectives. Hence I worry more about a rule that is almost irreversible (like the euro), than one that is too easy to abandon. But “easy to abandon” need not mean fuzzy. They need to very precisely spell out where they want the economy to go in terms of some clear nominal metric, and set policy levers to a position where the markets expect them to succeed. And that means never revising their longer-term nominal forecasts of the policy goal, rather revising the policy instruments as needed to hit those goals.
If you are a ship captain, don’t adjust your “port city destination forecast” when there is wind and waves buffeting the ship, adjust the steering wheel. Simple common sense? Monetary policy is still far from achieving even that minimum level of competence, both in the US and elsewhere.
PS. If we apply the ship steering metaphor to the “when to abandon a policy rule,” then you don’t want to abandon your target post city when wind and waves have pushed you off course, but may want to if you receive radio communication that a plague is sweeping the destination port.
Here’s another analogy. When do you abandon a promise to help one of your friends move out of an apartment?
a. Whenever it is in your momentary interest, as when another friend gets extra tickets to a NBA game.
b. Only under extreme duress, as when your wife in in the hospital with serious injuries.
In the 1970s, many central banks were like the fair-weather friend of answer “a.” Today (as in the 1930s) some have veered too far towards answer c, especially the ECB.