Scott Sumner  

The Monster in the Mirror

Low interest rates: They are n... Sunday Reading...

I seem to vaguely recall a horror story where the protagonist searches everywhere for the monster, and at the end sees himself in the mirror, realizing that he is the monster. If there is no such story, there should be.

I was reminded of this when reading an article about Janet Yellen's recent speech at the Fed's Jackson Hole conference:

For all the talk of a radical shift in central banking policy, from the permanent use of negative rates to helicopter money drops, Federal Reserve Chair Janet Yellen appears to believe she can tackle any future downturn using the tools currently at her disposal.

Speaking in Jackson Hole, Wyoming, on Friday after a Fed policymaker and other economists proposed a radical overhaul of central banking, Yellen argued that bond purchases and the ability to pay interest on excess reserves as well as forward guidance would be enough to combat any downturn.

"Our current toolkit proved effective last December (when the Fed raised rates)," Yellen said in a speech in which she firmed up expectations of a second rate rise from the Fed, possibly as soon as September. . . .

Yellen on Friday defended the models used by the Federal Reserve.

She said that barring an "unusually severe and persistent" recession, its policy tools were sufficient and rates did not need to go negative, as even at the lower bound for interest rates asset purchases and forward guidance could push long-term rates even lower on average than when nominal rates fell below zero.

There's an element of circular reasoning in these remarks. In the past, "unusually severe and persistent recessions" tend to occur when the economy is at the zero bound. Even worse, these recessions are almost certainly caused by a failure of monetary policy. The Fed persists in viewing itself in a role similar to a fireman, rescuing the economy when it goes off course. But that's not at all the right metaphor. They are more like a ship captain, steering NGDP or inflation, and if the ship is off course it's because they've done a poor job in steering it.

Interest rates tend to fall about 500 basis points during recessions. How can we have confidence in the Fed's current regime, which relies on conventional policy tools, if the level of interest rates is likely to be no more than 1% at the peak of the next boom? (According to fed funds futures markets.) How will the Fed prevent another sharp drop in NGDP, as occurred in 2008-09? They don't have any good answers, and outside economists are not impressed:

"Yellen seems to have developed into the ultimate 'status quo'-chair," said Lars Christensen founder and owner of Markets and Money Advisory, an independent firm focused on monetary policy issues.

"It is clear that she fundamentally does not want to see any change to the Fed's policy framework despite the fact that inflation expectations have become de-anchored and markets have lost trust in the Fed really fundamentally wanting to deliver on its 2 percent inflation target," Christensen said.

One option is negative interest on reserves:
Yellen's seeming reliance on more quantitative easing was challenged at Jackson Hole by Marvin Goodfriend, a professor of economics at Carnegie Mellon University and a former policy adviser at the Richmond Federal Reserve bank, who said he believed negative rates would be a far more effective policy tool.

"Interest rate policy is by far the most flexible, the least intrusive to markets, and has proven capable of targeting low inflation," he said in a presentation after Yellen spoke.

I first suggested this idea back in early 2009, and it's clearly a useful policy tool. But I think a much more fundamental change is needed. Switzerland has cut its interest on reserves to negative 0.75%, and still falls short of its inflation target. Even worse, 50-year government bond yields in Switzerland recently went negative.

Elsewhere I've criticized the NeoFisherian model, but they do make one good point. A policy regime of low interest rates forever is likely to be associated with very low inflation. Hence low nominal interest rates alone are not an adequate form of monetary stimulus. As I've said 100 times before:

It's the regime, stupid.
We need level targeting, preferably NGDP level targeting.

Comments and Sharing

COMMENTS (11 to date)

Actually it's an entire genre of horror stories:

Daniel Klein writes:

Here's final scene from Twin Peaks:

bill writes:

The Fed is becoming a sick joke. The somehow believe that they will have a Fed funds rate over 1.5% a year from now. Which means that IOR will have to be 1.5%. How will they even pay the IOR when the next 25 bps increase in the FFR will push the yield on the 10 year T below 1.25%, maybe even below 1.00%?

Christopher Ashbaugh writes:

H.P. Lovecraft's short story "The Outsider" matches your description.

Scott Sumner writes:

Thanks everyone, Twin Peaks and Lovecraft are two of my favorites.

Bill, Good question.

Dennis writes:

I think you've said before that you regret supporting Yellen over Summers for Fed chair; I think the case is becoming more clear, especially as he claims he would not have been assimilated by the Fed Borg.

From August 18: "I do understand the pressures on those in office to adhere to norms of prudence in what they say. But it has been years since the Fed and the markets have been aligned on the future path of rates or since the Fed’s forecasts of future rates have been even close to right. I cannot see how policy could go badly wrong by setting a level target of 4 to 5 percent growth in nominal GDP and think that there could be substantial benefits...Moreover even accepting the current framework, I find the current policy framework hard to comprehend. If as it asserts, the Fed is serious about the 2 percent inflation target being symmetric there is an anomaly in its forecasts. Surely if, as the Fed forecasts, the economy enters a 10th year of recovery with unemployment below five percent inflation should be expected to be above 2 percent at that point. How else could inflation average 2 percent over time given the likelihood of downturns and recessions?"

Harry Chernoff writes:


Two questions:

First, if in the late 1980s you were tasked with establishing NGDP level targeting to maintain Japan's then-current levels, what would you have done and what would have happened?

Second, same question except for China right now.

Dennis writes:

Wow, Larry Summers Washington Post piece today really seals it! Too bad he didn't say any of this stuff when he was being considered, though I suppose goldbug Republicans would have probably threatened to treat him ugly.

bill writes:

I wonder if there was ever any other time in history when the Fed thought that within 24 months months it would be able to raise the Fed funds rate 150 bps higher than the current 10 year Treasury? Maybe some time around 1980?

R Richard Schweitzer writes:

We may be looking forward to "asset price manipulation" as a "tool."

Scott Sumner writes:

Dennis, I wish Summers had said those things before the nomination process!

Harry, Good question. I'm not sure what I would have recommended, but a couple principles:

1. Any change from the current trend should be gradual. Thus China should probably reduce its NGDP growth rate over time, but in a very gradual fashion.

2. The target should probably be set on a per capita basis, or per working age population.

It seems to me that a number like 3% per capita NGDP growth would work fine in the long run, in either country.

Bill, Very good question.

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