Marcus Nunes and Ryan Avent were right
By Scott Sumner
Marcus Nunes had quoted from a 2012 Ryan Avent column. I’m going to provide an extensive Ryan Avent quotation, as it gets to the core of what’s still wrong with macroeconomics eight years later:
At the AEA meetings a year ago in Denver, I listened to Mr [Robert] Hall speak a few times on this issue and point out that with the market-clearing interest rate below zero the economy was stuck with high unemployment. At the time, I wondered why, if that were true, that the answer wasn’t simply a higher rate of inflation, which could combine with a zero nominal interest rate to move the real interest rate below zero.
This time around, Mr Hall addressed the point head on. He noted that in a liquidity trap, the real rate of interest was simply equal to the negative inflation rate. In other words, if the Fed’s nominal rate is at 0% and the inflation rate is 2%, then the real rate of interest is -2%. If a -3% real interest rate is necessary to clear the economy, then all that’s needed is a higher rate of inflation—3% rather than 2%. Mr Hall noted that this was an important point because potentially the Fed could have an enormously helpful impact on the economy simply by raising inflation just a little. And here’s where things got topsy-turvy. Mr Hall argued that (my bold):
- A little more inflation would have a hugely beneficial impact on labour markets,
- And a reasonable central bank would therefore generate more inflation,
- And the Federal Reserve as currently constituted is, in his estimation, very reasonable; therefore
- The Federal Reserve must not be able to influence the inflation rate.
Now, perhaps there was a political economy subtext to this argument; if so, I missed it. Rather, he seemed to be saying (as others, like Peter Diamond, have intimated) that at the zero lower bound it is simply beyond the Fed’s capacity to raise inflation expectations. Now admittedly I haven’t done a rigorous analysis, but it seems clear to me that the Fed has been successful at using unconventional policies to reverse falling inflation expectations. Why is Mr Hall—why are so many economists—willing to conclude that the Fed is helpless rather than just excessively cautious? I don’t get it; it seems to me that very smart economists have all but concluded that the Fed’s unwillingness to allow inflation to rise is the primary cause of sustained, high unemployment. And yet…this is not the message resounding through macro sessions. Instead, there are interesting but perhaps irrelevant attempts to model the funny dynamics of a macro challenge that actually boils down to the political economy constraints (or intellectual constraints) facing the central bank. Let’s focus our attention on that, for heaven’s sake.
In 2015, I said the fact that the Fed was planning to raise interest rates despite low inflation showed that the problem was not a powerless Fed, rather the wrong policy. Nunes and Avent were right.
Today the evidence in favor of Nunes and Avent is far stronger than in 2015. We have another 5 years of “lowflation” and a Fed that raised rates nine times between 2015 and 2018. Yes, there are a few heterodox economists who don’t think Fed policy is effective even at positive interest rates, but the Fed itself most certainly does not agree. Thus if the Fed is raising interest rates and inflation is staying below target, then there are only two logical possibilities:
1. The Fed is being disingenuous, and doesn’t really want 2% inflation.
2. The Fed relied too heavily on bad (Phillips curve) models that suggested their policy moves would soon deliver 2% inflation. (That’s my view of what went wrong.)
Here’s the important point. Regardless of whether explanation #1 or #2 is correct, Robert Hall was definitely mistaken is his argument summarized by Avent. The fact of low inflation in 2012 did not mean the Fed was unable to raise inflation. Maybe they were unable to raise inflation, but that proposition would have to be established on some other basis.
Why am I obsessing so much on what Robert Hall said back in 2012? Because I’m convinced that his view has become the standard view within the profession. In 2007, if you had asked economists about the Great Deflation of 1929-33 they’d have said, “The Fed screwed up.” If you asked them about the Japanese deflation they’d have said, “The BOJ screwed up.” But the average (American) economist has far more respect for the modern Fed than for the Fed of 1929 or the BOJ, and hence they weren’t willing to conclude that the Fed screwed up during the 2010s. Instead, a novel theory of Fed impotence was developed solely on the basis of unwarranted respect for the Fed. “If it’s not succeeding, it must be powerless.”
This is why it’s so important to revisit this issue in 2020. Even more than in 2015, we know that Hall’s 2012 argument is clearly wrong. It’s no longer even debatable. Again, the Fed may be powerless (I doubt it), but its failure to hit its 2% inflation target does not show that.
In the same post where he quoted Ryan Avent, Marcus Nunes also quoted from a Greg Mankiw blog post:
Not surprisingly, the rule recommended a deeply negative federal funds rate during the recent severe recession. Of course, that is impossible, which is why the Fed took various extraordinary steps to get the economy going. But note that the rule is now moving back toward zero. As Eddy points out, “At the current inflation rate, the unemployment rate needs to drop to 8.3% from the current 8.5% for the model to signal positive rates. We’re getting close.”
Mankiw is right that a lot of these interest rate rules called for rates to begin moving up above zero while the unemployment rate was still quite elevated. In retrospect, this sort of “Phillips Curve approach” has done very poorly in recent years, and may explain why the Fed has consistently set interest rates too high to hit its 2% inflation target. If so, it would further undercut Hall’s 2012 argument, as it provides a plausible explanation for why the Fed has consistently failed. They weren’t powerless; they simply followed the wrong model, or at least a model that did not serve them well during the 2010s. (We can debate the utility of Phillips Curve models in general, but obviously they haven’t worked well in recent years.)
Hall’s mistaken assumption that the Fed must be powerless has led to calls for using fiscal stimulus to supplement monetary policy. I think this is a mistake. Given the dysfunction in Congress and the Presidency, fiscal policy is unlikely to be utilized effectively. Indeed right now fiscal policy is highly procyclical, making the economy more unstable. If we recognize that the Fed really does have the power to control inflation, then we are more likely to work on improving monetary policy so that it does not repeat the mistakes of the 2010s. We should remove any political or technical barriers to the Fed hitting its targets. The Fed should rely on market forecasts, not Phillips curve models. Those sorts of reforms would be far more useful that chasing the chimera of “fiscal policy”.