Scott Sumner  

It's worse than it looks

The Happy Hypocrisy of Unpaid ... Government's Misinformation ab...

By "it" I mean the current stance of policy. To see why, we need to review the circularity problem. Asset markets look at the Fed, and the Fed looks at asset markets. When there is enough blood on the floor, the Fed reacts to asset markets by adjusting policy. This reaction reduces the severity of the problem. But of course markets understand this. They see deflationary shocks (actually negative AD shocks), and they see the likely Fed reaction to deflationary shocks. All that gets factored into asset prices.

Let's suppose that 30-year bond yields fall by 50 basis points, due to a deflationary shock. Also suppose the markets expect the Fed to offset 1/2 of the shock, with easier money. That means the shock is big enough to drive 30-year bond yields 100 basis points lower, if the Fed doesn't react as expected. Because asset prices already incorporate the expected Fed reaction, they understate the size of demand shocks buffeting the economy.

In a superficial sense the shock looks like it is coming from China. But that's misleading; nothing in China would have that big a direct effect on the US economy. Instead what's happening is that the Chinese investment slowdown is reducing the Wicksellian equilibrium interest rate all over the globe. Because central banks foolishly target interest rates rather than inflationNGDP growth, that slowdown is (unintentionally) tightening monetary policy all over the world (even more in Japan and Europe). As an analogy, the drop in housing investment in 2008 lowered the Wicksellian equilibrium rate, and tightened monetary policy in all countries that target interest rates.)

Under similar conditions in 1998, Alan Greenspan reduced the fed funds target and the US avoided any spillover effects. Will Janet Yellen reduce IOR? How about level targeting?

PS. The 30-year bond yield is down to 2.66%. Is there anyone who still doubts my claim that relatively low interest rates are the new normal for the 21st century? The world's central banks still rely on a 20th century Keynesian interest rate target mechanism that doesn't really work in the 21st century. How long will it take for them to figure this out? Let's hope they are getting some sensible advice at Jackson Hole.

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COMMENTS (13 to date)
foosion writes:

At least your good friends Larry Summers and Paul Krugman agree that it would be nuts for the Fed to raise rates.

Krugman thinks it's cultural:
"The whole culture of central banks involves saying no to stuff people want, taking away the punch bowl as the party gets going, having the courage to do unpopular things; everyone wants to be Paul Volcker. The Fed is really, really eager to return to that position — and is, I fear, engaging in wishful thinking, believing much too readily that a return to normalcy is appropriate."

Kenneth Duda writes:

I wonder if what's happened here is basically this:

1. Fed lost control in 1970's

2. Fed proved in early 1980's that it could and would control inflation

3. The markets believe that --- that the Fed can and will

4. Because of people's confidence in low inflation moving forward, the *nominal* Wicksellian rate comes down close to zero, or sometimes below

5. When the Wicksellian nominal rate gets too low, it becomes hard to boost AD through interest rate targeting

6. Because interest rate targeting no longer works, we just have to move to NGDP level targeting to boost AD

In other words, the very success of interest rate targeting at combatting inflation has led to its ultimate failure to avoid output gaps. Interest rate targeting needs to go. The "recovery" of the last few years has not actually relieved the urgency of moving to NGDPLT.



Kenneth Duda
Menlo Park, CA

Jose Romeu Robazzi writes:

Prof. Sumner
This post highlights the less intuitive characteristic of your model. Since most macro models don't take money demand into account, they fail to see that sometimes "doing nothing" means tightening monetary policy stance. The model is symetrical, and sometimes "doing nothing" will mean loosening stance, but right now, doing nothing means tightening, given the the expected NGDP growth rate...

EB writes:


When Scott agrees with Larry and Paul, it's time to close the Fed. Their infatuation with government, and the Fed in particular, is a reminder of the failure of Public Choice to be taken seriously by most economists.

In the past 30 years, the Fed has become the Great Manipulator of U.S. Financial Markets. Although the policy reversal under Volcker was initially celebrated as recognition that inflation in 1960-80 had been a consequence of financing government with the inflation tax (as claimed by Milton Friedman and other monetarists), soon it became clear that thereafter government deficits would be financed by borrowing in financial markets and that the Fed's new task would be to manipulate the terms of this financing, particularly in times of extraordinary government deficits.

Jose Romeu Robazzi writes:

There is a big differece between believing that Central Banks have a wrong framework and should move to a more reliable framework, and have less discretionary powers, then simply believing that for cultural reasons a central bank is wrong. Make no mistake, Summers and Krugman believe that that a central bank should keep its all encompassing discretionary powers, they should just "do the right thing", which is what they believe is right.

TravisV writes:

Prof. Sumner,

You wrote:

"Because central banks foolishly target interest rates rather than inflation, that slowdown is (unintentionally) tightening monetary policy all over the world"

Technical point: in 2008, even if the Fed had targeted inflation, that would have been inadequate due to oil shortages (negative supply shock), right?

Njnnja writes:

Not sure if you saw this:

When the Fed chief is looking to the Phillips curve for monetary theory then, yes, it's definitely worse than it looks.

baconbacon writes:

The math in the 2nd paragraph is misleading (at best). If the Fed is ooking at asset markets and seeing a 50 basis point drop and the markets expect the fed to do 1/2 as much as they should then the Fed would only offset a 25 basis point shock. If the markets are moving with the Fed's expected reaction in mind and the Fed is looking to the markets for information then they can never hit their target.

To demonstrate how perposterous (and unproductive) this line of thinking is what if the markets thought the Fed was going to perfectly offset the shock then the rate wouldn't move at all, of course that would lead the Fed to do nothing and see no shock. Once on this slope of reasoning the Fed can either do no wrong (expectations of perfect behavior and reaction is a self fufilling prophecy and the actual actions are unimportant) or the Fed can do no right and the better they are at reacting to shocks the worse they are at reacting to shocks.

And for the final wrench- how does the Fed get the reputation that becomes expectations? Through its actions. So Fed policy is either perfect from inception or perpetually and irreparably flawed (and targetting nGDP does nothing to amerliarate this, and could in fact amplify that problem). Either this analysis is bunk, or the Fed is.

ThomasH writes:

I had not heard anyone say before today that central banks target interest rates. I guess they could try to always have an estimate of the "natural" rate of interest and constantly move long term rates to equal that rate.

That seems like a bad target because markets would not know what the estimated target was.

Price level targeting wold seem to be much better, which is what central banks claim to do. And it ought to work if they would actually do it. Instead, they apparently in reality have inflation rate ceilings and floors and in between, no one knows what the policy is.

Why do you think central banks do not target the price level trend?

Scott Sumner writes:

I agree with the first three comments.

EB, The problem over the last decade is that the Fed has paid too little attention to the messages being conveyed in asset prices. This was especially true in 2008. That's why we are where we are today. We'd be better off if the markets determined interest rates and exchange rates and the money supply, not central banks.

Travis, That was a horrible typo on my part, I meant NGDP growth, not inflation. I changed it now.

Njnnja, Yup, the Phillips Curve (which I seem to recall that Krugman and Summers believe in) is a big part of the problem.

bacon, In order to perfectly offset markets, they'd need a market forecast of the optimal instrument setting, which they don't have. I don't follow the rest of your comment.

Thomas, In the long run they do target inflation, to some extent. But my complaint is that in recent months they have become more interested in getting interest rates above zero, than in getting inflation up to target.

EB writes:

In the introduction to their forthcoming book Phishing for Phools, Akerloff and Shiller write

"The distinction between the two types of tastes and the example of the capuchins gives us an instructive image: we can think about our economy as if we all have monkeys on our shoulders when we go shopping or when we make economic decisions. Those monkeys on our shoulders are in the form of the weaknesses that have been exploited by marketers for ages. Because of those weaknesses, many of our choices differ from what we “really want,” or, alternatively stated, they differ from what is good for us. We are not generally aware of that monkey on our shoulder. So, in the absence of some curbs on markets, we reach an economic equilibrium where the monkeys on the shoulder are substantially calling the shots."

Yes, I laughed when I read the introduction. I hope the rest of the book—subtitle: The Economics of Manipulation and Deception—will be as funny as the introduction. I’m curious to know if all, some, or just a few marketers have been exploiting us for ages. Being an old Argentinian economist interested in politics, for 60 years I have been assuming that the ones phishing for phools were always politicians, public servants, or government-licensed crooks. In my lists I have always given special mention to presidents of central banks, in particular economists that pretend to know something that 99.9999% of humans don’t know about money and banking. Maybe George, with Robert’s insights, can tell us what Janet knows to claim a place on our shoulders, and why she has been working so hard to divert our attention away from what we “really want”.

Dustin writes:

I think bacon is trying to say that if the Fed could continuously nail its target, say 5% NGDP, then folks wouldn't bet otherwise. Then if no one is placing bets, the Fed would have no signal. In the end the target would become a self-fulfilling prophecy and everyone leaves the party.

I'd be interested in your response to this. Though my reaction is that bacon made a mistake in overlooking that the Fed's target would be a level target and not a continuous, unerring path. The futures market subsidization you've discussed may also come into play here. Finally, if the market implicitly assumes 5% growth, then great (that is the point after all).

michael pettengill writes:

As I understand it, corporations are sitting on trillions in cash because they can't see anything worth spending it on.

Individuals are sitting on trillions in cash because they can't see anything worth spending it on.

Given that, should the Fed increase or decrease or stand pat on the cash it has created?

It seems to me, the problem is the people with cash have bought all the consumer goods they can - how many Big Macs can you eat everyday - while the people without cash have low wage at will jobs so they can't borrow and have very little money to spend on anything.

With consumer spending depressed by low wages, investing in building new factories by paying construction workers is a bad thing to do with corporate cash because that will lead to too much production driving down prices and thus driving down profits and draining the source of the cash build up. That would create a GM situation where cars are sold at no profit and even no return on capital, which since 1980 means you are bankrupt, out of business, dead. Only if you have monopoly profits are you a viable business by Wall Street standards.

In fact, the view seems to be that capital assets need to be consumed and not replaced. Let the roads and water systems and such decay from use and do not pay workers to fix them because paying workers to do anything is a waste of money. Labor costs need to be reduced from the levels of today to create a better economy.

I guess.

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