Back in 2015, I did a post entitled “Marcus Nunes was right“, which revisited a 2012 post by Marcus Nunes. I should have added Ryan Avent to the post title, as you will see.
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”.
READER COMMENTS
Brian Donohue
Feb 3 2020 at 3:47pm
Bravo to all involved. When you write it up like that, monetary policy seems graspable to all with ears to hear.
Henri Hein
Feb 3 2020 at 3:57pm
My understanding of Monetary Theory is too superficial for a nuanced evaluation of the various models, but one thing I like about the NGDP targeting rule is its relative simplicity. A relevant concern with an institution like the Fed is that as long as people are making decisions, given enough time, they will make mistakes, and given the importance of the Fed, those mistakes can be disastrous (to use your term). With a simpler model, the times between those mistakes will be longer.
In another blog post, you wrote about The best critiques are from within. You mentioned Marc Nunes is an amateur. I agree that the best critiques are generally from within, but that makes the successful criticism from outside that much more interesting. Would you say Nunes’ is a successful outside critic? Of course, in this case, he didn’t develop a theory that was not already present within the field, so probably not. Still, it stood out.
Scott Sumner
Feb 3 2020 at 6:28pm
Henri, I’d say he was an outsider, perhaps Avent as well. However I’d say that both were criticizing a specific policy view where a number of insiders (like me) are also critical.
Nonetheless good example.
Where outsiders get into more trouble is trying to reinvent economics from the ground up. That’s hard to do.
Keenan
Feb 4 2020 at 5:38am
I’m confused about the zero lower bound… why is the rate bound at 0, is the Fed not allowed to make the policy rate -0.5%, or -1.0%, etc?
Capt. J Parker
Feb 4 2020 at 3:42pm
It’s hard because if you are penalized for having bank balances that carry a negative nominal interest rate then you simply convert all your bank balances to cash which carries a zero nominal rate.
Thaomas
Feb 4 2020 at 12:37pm
Isn’t this just a problem of targeting the inflation rate (ok mis-targeting because of using a “Philips Curve”) instead of price level targeting?
Capt. J Parker
Feb 4 2020 at 4:34pm
I’d like to play Krugman’s advocate and suggest that the theory was not that “If it’s not succeeding, it must be powerless.” The theory was that “the Federal Reserve as currently constituted is, very reasonable” and therefore it directly follows that for the Fed to “credibly promise to be irresponsible (Krugman’s catchphrase for what would be required to increase inflation expectations)” would be a very difficult task for a reasonable Fed.
My personal cynical view is that once the Fed converted the banks worthless MBS into interest bearing reserve deposits it said mission accomplished – the best thing the Fed can do to promote full employment, it reasoned, is to repair the balance sheets in the banking sector. As for monetary vs fiscal stimulus, does the Fed or the banks gain anything by having less government debt?
Mark Z
Feb 5 2020 at 12:13am
It seems odd to me that someone would characterize doing the wrong thing as reasonable. Didn’t Krugman specifically fault the BOJ for failing to ‘commit to be credibly irresponsible?’ As opposed to defending them as reasonable but insisting that unreasonable times call for unreasonable measures? I would understand it if the position were, “these people are hopelessly incapable of doing what needs to be done, so we need fiscal policy,” but it seems like he changed his tune between the BOJ in the 90s and the Fed during the Great Recession.
Capt. J Parker
Feb 5 2020 at 10:39am
I think Krugman has been consistent in his analysis of a depressed economy with zero nominal interest rates (a liquidity trap.) And I think Krugman has been consistent in saying that debt financed government spending can get you out of a liquidity trap OR central bank policy that increases inflation expectations can get you out. If he changed his tune about anything it would be that in 2008 he expressed a strong preference for government spending while with 90s Japan he was more focused on the details of monetary policy needed to exit a liquidity trap.
In this 1998 Krugman paper he said the following things: “…Bank of Japan does not announce whether its changes in the monetary base are permanent or temporary. But we may argue that private actors view its actions as temporary, because they believe that the central bank is committed to price stability as a long-run goal. And that is why monetary policy is ineffective!” “… This means that the central bank must make a credible commitment to engage in what would in other contexts be regarded as irresponsible monetary policy – that is, convince the private sector that it will not reverse its current monetary expansion when prices begin to rise!”
This means the debate over the effectiveness of monetary stimulus in a liquidity trap mostly about the psychology of inflation expectations not central bank competence.
Thaomas
Feb 5 2020 at 10:35am
When an institution is clearly not doing what it should be doing — maintaining inflation at an average of 2% on it’s own definition in this case — is it an “outside” view that it should be doing something different?
P Burgos
Feb 5 2020 at 12:05pm
Is the Fed still using Philips curve models? It’s been an entire decade or more of below 2% inflation. I suspect that the Fed simply views 2% inflation as a ceiling, not a target. It seems to me the simplest explanation of why they never hit 2%. Generational replacement seems the likeliest path to change the Fed’s behavior.
bill
Feb 5 2020 at 8:09pm
If some voting members want 2% inflation and a few are more timid about exceeding it, then as a group, 2% becomes a ceiling.
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