Scott Sumner  

Ryan Avent asks some very good questions

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Ryan Avent, who writes for The Economist, sent me an email with some very good questions about monetary policy rules. (He was a moderator at the recent Mercatus/Cato conference on monetary policy rules.) Ryan allowed me to reprint them here, and I'll take a stab at answering them:

1. Why haven't central banks been successful at hitting their policy targets? (And would proposed rules overcome whatever obstacles are currently inhibiting central banks?)
Screen Shot 2016-09-10 at 8.31.57 PM.png 1. Central banks have made two key mistakes. First, they've done a poor job of forecasting. They've generally set policy at a level where they expected to hit their inflation targets in a couple years, but those expectations were unrealistic. Instead they should have relied more on market forecasts. Perhaps the most egregious error of this type occurred at the Fed meeting of September 2008, when they forecast excessively high inflation at a time the TIPS markets were forecasting very low inflation. The ECB has done a particularly poor job in this regard.

Second, they have failed to understand that in the long run the amount of unconventional policy that is required is inversely related to the aggressiveness of policy today. Thus the Swiss National Bank wrongly thought that by allowing the Swiss franc to appreciate in January 2015, they would not have to buy so much foreign exchange. Instead this revaluation made Swiss inflation even lower, and now the SF is an even more appealing asset, the hardest currency on Earth. Similarly, if the Fed had been more aggressive with QE in 2008 and 2009, they could have ended up with a smaller balance sheet today. In my view the central banker fear of unconventional policy is unjustified, but their actual policies cannot be justified even if you assume the fear is valid. They are their own worst enemy. Like someone who wades into cold water one inch at a time, dragging out the pain, rather than diving right in.

Many of the current problems would go away if central banks switched to level targeting, and/or relied on CPI/NGDP futures markets.

2. How confident are we in the robustness of monetary rules? Is the failure of past regimes a sign of their imperfections or the impossibility of finding one rule to rule them all?
Screen Shot 2016-09-10 at 8.30.57 PM.png Some monetary rules are not very robust, for example the gold standard and/or a fixed exchange rate. Money supply rules are also unreliable. In my view, the most robust rule would target total labor compensation per working age population, level targeting. But I don't doubt that even better rules will be discovered in the future. Which is fine.

As long as each failure is not as bad as the previous failure, we are making progress. There is no such thing as perfection in the social sciences.

3. Should a new rule be consistent with recent policy or should it represent "regime change"?
Here it's a matter of degree. In my view, you'd like any new rule to be as close to the current rule as possible, for reasons of policy credibility. Thus if we switch to my preferred NGDPLT rule, I'd favor us adopting a rule that led to about 2% expected inflation, at least initially. If we found that this led to frequent bouts of the zero bound problem, we could increase the trend rate very gradually.
4. What role should the government play in setting the rule (and the target), in monitoring central-bank performance and holding the central bank accountable, and in contributing to stabilisation? Are fiscal rules an appropriate stabilisation measure?
The government should instruct the central bank in broad terms, such as the current dual mandate that the Fed operates under. At that point I'd let the central bank figure out how to make the rule operational, although the government certainly could and should step in with more detailed instructions if they are unhappy with the specific rule that the Fed adopted. Currently there is not enough opposition in Congress to change the Fed's 2% inflation target.

Central banks need to be made much more accountable. I've proposed that the Fed be required to evaluate past decisions periodically, say 4 times a year. In each case they would report to Congress whether, in retrospect, their policy settings in recent years appear to have been too expansionary, too contractionary, or about right. In each case they would need to cite specific economic data to explain to Congress how they made that determination. I.e., they might point to recent inflation and employment data.

I oppose fiscal stabilization policy, as I think it's much too hard to coordinate with a sensible monetary policy rule. If the central bank is having trouble hitting its target, it should ask Congress for more power.

5. Why have central bankers had such difficulty manipulating expectations? Is it for lack of trying or because they have been ineffective in their communications?
Central banks rely too much on their own internal models, which often employ flawed theoretical concepts such as the Phillips Curve. Instead they should rely on market expectations. If they set policy at a position where the market expected on-target inflation, then policy would be much more credible.

Last December, the Fed should have never tried to convince markets that 4 rate increases were likely this year. That's not the Fed's job. Rather the Fed should "ask" the markets how many rate increases are needed in order for 2017 inflation to come in at about 2%. If they operate that way, then policy will be credible.

6. Are we certain that rules are an effective way to set expectations in a stabilising way?
No, but that's my best guess.

Comments and Sharing

COMMENTS (11 to date)
ScottN writes:

The Fed is hitting it's target, at least according to Kocherlakota.

bill writes:

Level targeting is key as it will correct for bad forecasts in two ways. The first way is the obvious one, that the Fed would have to make up for past errors. Right now, if the Fed had adopted LT 8 years ago, it would be about 8% off target and that would need to be made up. ie, they couldn't say, "inflation is close to 2% so we're close to target". The second one is more subtle, but maybe more powerful and it might even correct their current forecasting biases. The Fed is content with 1.5% inflation. But it would be upset if 1.5% inflation meant that the following year they had to hit 2.5% inflation (and they'd be apoplectic at the possibility of having to hit 6% inflation for 2 years to make up for the last 8 years). In fact, their 2% inflation target is somewhat disingenuous. I bet that a majority of the Fed, if given the option of having a record of 1.5% inflation every year for 10 years versus having a record of averaging 2% but with inflation that swung back and forth from 1.5% to 2.5%, they'd choose the steady 1.5%. Not only that, Congress and the public would never complain under that scenario. And everyone could discuss theories of secular stagnation and the need for fiscal stimulus to their hearts' content. Attitudes line up to make 2% a soft ceiling (not as bad as the ECB hard ceiling, but more malign than a truly symmetric 2% inflation target). Many R's like the lower inflation and many D's subconsciously like that it makes deficit spending implicitly acceptable.

bill writes:

My guess is that level targeting will not be on the table while the Fed keeps inflation in the 1% to 2% range with a stated target of 2%. That only once they miss that range will there be much support for any change outside of a limited audience with an interest in monetary policy. Depressing (pun not initially intended). And a miss to the upside will actually present the best opportunity to push for level targeting.

Philo writes:

In #4., is Avert viewing the central bank as not part of the government? (If so, that's odd.)

Your answer might have spared a few words for the idea that the government should play no role, allowing the monetary system to function completely independently. Admittedly, that would take the discussion outside the domain of immediately practical politics.

LK Beland writes:

In regards to #4:

Your answer seems appropriate in the case where a single government is in charge of a monetary zone. How about the role of state governments in the US? Or the role of Euro Zone members? Or Canadian provinces?

In that case, the monetary offset argument doesn't necessarily hold, especially for jurisdictions with small population. What should be the role of these governments in providing nominal stability?

Michael Byrnes writes:

Are you and/or Ryan assuming the Fed wants to hit its target but thinks it cannot? What about the "revealed preference" idea - that the Fed has inflation exactly where it wants it?

ThaomasH writes:

"Currently there is not enough opposition in Congress to change the Fed's 2% inflation target."

There is zero evidence that the Fed has a 2% inflation target. It may have a 2% inflation ceiling target (or maybe the constraint is a misplaced fear of the amount of QE it thinks would be necessary to maintain a 2% target) but is apparently content to allow the price level trend to drift arbitrarily far below a 2% pa trend. Bu not pointing out that the Fed does NOT have an inflation target, you join other enablers.

[Any comment on ?

The site itself does not allow comments!]

Scott Sumner writes:

Scott, I don't agree with Kocherlakota on that point. But he does point to a problem with Fed policy, they were aiming for procyclical inflation, when they should have been aiming for countercyclical inflation.

Bill and Michael. I think it's too soon to say whether the target in symmetrical.

Philo, He means the non-Fed part of the government.

LK, I don't think state governments should try to provide nominal stability, and I think they'd fail if they did try.

Maximum Liberty writes:

On #2, you say:

Some monetary rules are not very robust, for example the gold standard and/or a fixed exchange rate.

When you refer to the gold standard, do you mean the historical gold standard that ended in 1973 (or pick another date in the last 150 years)? Surely you don't mean, for example, a gold coinage with only private note issuance? Unless you count "politicians want to replace it with something easier to manipulate" as "not very robust."


LK Beland writes:

"LK, I don't think state governments should try to provide nominal stability, and I think they'd fail if they did try."

Since the fiscal multiplier actually makes sense for these governments, shouldn't they take it into account when they make decisions? For example, I can imagine Alaska or North Dakota trying to generate surpluses during oil booms and to run deficits during oil crunches.

James Alexander writes:

Swiss National Bank balance sheet still rising.

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