Scott Sumner  

John Cochrane on modern macro

The Moral Case for Fossil F... My Apologies...

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.

c. Never.

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.

Comments and Sharing

CATEGORIES: Macroeconomics

COMMENTS (14 to date)
Nick writes:

A quibble:
Ship captains do change the intended destination due to weather, not just plauge. Some storms are not worth going through, regardless of original intention. Mechanically tying ship steering to market forcasts of future wind and current strength would be disastrous. Someone must be there to choose when the risk of losing the ship itself outweighs the need to end up where you thought you were going. In fact the fed as ship captain metaphor lends itself to discretionary policy, lagging effects, and all kinds of troublesome stuff.

Vaidas Urba writes:

"both hawks and doves tend to favor less nominal volatility. So monetary policy would become a purely technical problem--smoothing the growth of NGDP."

Not exactly. There is always a question of how many resources should allocated towards smoothing the growth of NGDP.

foosion writes:

Explain why the Fed is so eager to signal a rate increase next year.

They claim to be targeting 2% inflation. We are persistently below 2% and, based on current TIPS spreads, don't expect to hit 2% for 30 years. Based on the Cleveland Fed survey, it will only take 15 years.

Nonetheless, the Fed intends to raise rates. How do they justify this, especially without picking a new target?

Scott Sumner writes:

Nick, Fair point, but don't big ships end up at the intended port at least 99% of the time? If only monetary policy . . . .

Foosion, They have a dual mandate. AFAIK they expect slightly below 2% inflation at that time, and also expect to be slightly below the unemployment target. If true, they'd be right on target for the dual mandate.

I think they may be a bit optimistic, and of course I don't like their target. But they are not just targeting inflation.

Liberal Roman writes:

Scott, you write:

"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?"

The problem is that the goal of Plosser and other so called hawks IS to raise rates. That is what they are after and that is what they are trying to achieve.

To explain why, I have to say that I sense a lot Burkean conservatism in these hawks. Just simply that they are uncomfortable with low rates because, well, it has never been done before. I really don't think it gets any deeper than that. Maybe if you push them you begin to get non-sensical explanations like persistently low rates are a risk to financial stability, or increase inequality or lead to hyperinflation, but at the root of it is just a deep reflex against something that seems out of the ordinary and different.

Dan W. writes:


Nice column and a fair criticism of current and past Federal Reserve policy. I can think of three explanations why the Federal Reserve puts forward fuzzy rules (1) It does not want to bind itself to a firm rule, as no committee wants to do. (2) The Federal Reserve does not trust the clarity of data it gets (ie the data is fuzzy). (3) The Federal Reserve is not confident it can realize policy objectives (ie the mechanics of monetary action are fuzzy). I could be wrong on all accounts but there are reasons the Federal Reserve acts the way it does.

Concerning mandates for the Federal Reserve where does the responsibility to maintain a stable financial system fit into the equation? Do you believe the Federal Reserve is competent to this task? Do you believe it appreciates credit risk and is ready to respond quickly to credit crisis? The boxer Mike Tyson said: Everyone has a plan until they get punched in the mouth. Do you believe the Federal Reserve is prepared for the punch? More important, does the market have confidence the Federal Reserve can take a punch? What should the Federal Reserve be doing to convince skeptics?

foosion writes:

Scott, the other half of their dual mandate is maximum employment. How is increasing rates consistent with that?

If a level of unemployment is below some target and inflation (actual and expected) is also below target, how does one argue we are at maximum employment?

BTW, there's also an obligation to maintain moderate long-term rates. Everyone ignores this.

"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."

foosion writes:

Reasoning from a price change, specifically the drop in oil prices, is popular these days. Anything to add?

Andrew_FL writes:

I'm sorry I got distracted by him referring to the definition of a dollar in the 1800's as a "price."

One might as well say, as if it were a meaningful commentary on monetary policy today, "The price of a dollar is one hundred pennies. What's your question?"

Vaidas Urba writes:

My previous comment was put on hold pending confirmation of email address, so here is a much longer version. You wrote:
"both hawks and doves tend to favor less nominal volatility. So monetary policy would become a purely technical problem--smoothing the growth of NGDP."

But there is a question of how many resources should be allocated towards smoothing the growth of NGDP. Friedman rule (with IOR) is a good way to answer this question, but in practice we would see a big disagreement between hawks and doves. First, it is not clear how to implement the Friedman rule in practice. Second, some disagree that the Friedman rule is a good idea. For example, Charles Plosser is a strong proponent of a "small footprint" central bank.

Roger McKinney writes:

An even better solution would be free banking.

To get the FOMC to do nothing you would have to re-write the legislation creating the Fed. The whole point of the FOMC is to do something. Doing nothing is like asking Congress not to pass laws, or federal agencies not to create new regulations.

The FOMC exists only to control money and banking, so they're going to do what they're hired to do.

Scott Sumner writes:

Liberal Roman, Ironically the hawks are the ones pursuing the low rate policy, they just don't realize it.

Dan, You might be right about those three points being their motivation, but none of the three are good reasons for rejecting NGDPLT.

Monetary policy cannot stabilize the financial system, although it can increase instability. They might have some ability to stabilize the financial system through regulation or deregulation, but I'd rather that be handled by the Treasury.

foosion, The best way to maintain low long term rates is with tight money. The tighter the money the lower the long term rates. Look at Germany. NGDPLT at 4% or 5% will give you moderate long term rates.

The Fed believes it cannot impact the natural rate of unemployment, and hence interprets "high employment" as keeping the rate near to the natural rate. In the dual mandate context, that means running inflation below 2% when unemployment is low, and above 2% when it is high.

Vaidas, I also favor the small footprint, although Plosser's preferred policy would of course lead to a really large footprint. I believe a smaller footprint makes it easier to stabilize NGDP growth, as the zero bound is not a factor.

Roger, I don't agree. Central banks have adopted IT, no reason they cannot adopt NGDPLT.

dlr writes:

Scott, Cochrane has a current WSJ editorial that repeats his previous argument that sticky prices/wages aren't a big deal without massive deflation, citing some of the usual reasons. I think this is the most under-discussed, yet most quietly pivotal, part of the of the current battle for the hearts and minds of monetary policy observers. Probably because it was discussed to death years ago and nobody really came up with anything persuasive on a model or micro level despite exhaustive attempts, so people moved on to models that pretend sticky prices matter but are really RBC (NK) or search-theoretic models that are almost always written in a way that largely take the nominal out of nominal rigidity.

It seems like it would be helpful to see a post describing why you think some of common objections to the importance of the sticky price-moderate nominal shock story are misplaced, and why it might make sense that this is sort of story has been very hard to suss out well in micro-oriented empirical research.

Ray Lopez writes:

@dlr - I'm late to this party but let me point out that 'sticky prices' are a myth, except in a laboratory setting. Wages were not sticky in the 1920-21 contraction nor so much in the 1930+ contraction. Who says? Ben Bernanke.

Chapter Title: The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison
Chapter Author: Ben Bemanke, Harold James
Chapter URL:

The reliance on nominal wage stickiness to explain the real effects of the deflation is consistent with the Keynesian tradition, but is nevertheless some-what troubling in this context. Given (i) the severity of the unemployment that was experienced during that time; (ii) the relative absence of long-term contracts and the weakness of unions; and (iii) the presumption that the general public was aware that prices, and hence the cost of living, were falling, it is hard to understand how nominal wages could have been so unresponsive.

Wages had fallen quickly in many countries in the contraction of 1921-22. In the United States, nominal wages were maintained until the fall of 1931 (possibly by an agreement among large corporations; see O'Brien 1989), but fell sharply after that; in Germany, the government actually tried to depress wages early in the Depression. Why then do we see these large real wage increases in the data? {maybe: measurement problems} ... The case for nominal wage stickiness as a transmission mechanism thus seems, at this point, somewhat mixed.

Union membership was low in the 1930s, Bernanke's point #2, see:

Proportion of people in employment who are members of a trade union; United Kingdom 1900 to 2000. 10% to 1910, then jumps to 40% by 1920, then drops to 25% by 1930, rises to 45% in 1945 and peak of 55% in 1978, down to 30% today.

In the USA, the peak union membership was only 35% in 1954, 7% in 1930, 12% or less today

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