Raise the inflation target to 4 per cent.

A post from me on this topic that appeared on Ben Chu’s ‘Chunomics’ blog at the Independent.

Posted in Uncategorized | 5 Comments

Post hawk ergo propter hawk

A rather forced pun to begin this waiting-room queue blog.

But post hoc ergo propter hoc refers to the fallacy of concluding that since after all A we observed B, A must have caused B.

This is a summary of Andrew Sentance’s response to my and Paul Krugman’s posts on why we should not opportunistically lower the inflation target to take advantage of currently low measured inflation.  Essentially, he looks back at periods when inflation was low or prices were falling, and says ‘often things weren’t all that bad’.

There’s no disputing that.

But it’s not adequate to stop there in my view.   If he wants to make progress beyond the tit for tat ‘well look at Japan’, Andrew needs to address the arguments and evidence for why mainstreamers fear deflation directly.

To itemise what I think he would need to do to mount a succesful counter, he has to:

1) Address whether he agrees that measured inflation overstates true inflation [part of the reason for the 2 per cent target] and, if not, why not.

2)  Explain whether he concurs that interest rates encountering their floor risks losing control of inflation on the downside, and that this would be a bad thing, and, if not, explain why not?  Doing this would be quite ambitious, since it would involve erecting an alternative analytical macro model that explains the data better than the one that we have currently, on which fears of deflation is based.  He’d also have to erect a model that didn’t contradict his own voting record, which often stressed the need to use interest rates to control inflation, via his urge to raise rates to stop inflation spiralling up.

3) Explain whether he concurs that much debt is set in nominal terms [if not why not] and that this risks debt-deflation spirals if the target is set too low.  If not, why not?

4) Explain whether he concurs that there is downward nominal rigidity in wages, which would lead to excess unemployment with a too-low inflation target.  And, if not, why not?

5) He has to find something that tilts the scales against the lessons learned from the crisis, which is that i) recessions are larger, and need more monetary stimulus to counter them, than we thought, and hence we need more room clear of the zero bound that a higher target would provide and ii) that equilibrium real rates are, on account of demographics, savings flowing uphill from the East, and cheaper investmen goods, likely to erode some of that ‘room’ in the future.  [It’s Andrew after all that talks of secular stagnation through the language of ‘the new normal’.]

In essence, looking back at time series charts of inflation and growth is not enough.  We need empirically validated models of the structural features in contention [DNR in wages, nominal debt, zero bound, expectations] to replay those histories and work out what inflation target would have been best then, and will be best in the future.

I’ll give Andrew a helping hand on tasks 3 and 4.  It would be possible to mount an argument like:  yeah, there’s nominal rigidity now, but this would erode pretty sharpish once people felt the pain of deflation.  Perhaps.  And perhaps the benefits would exceed the transitional pain.  But, on both counts, probably not.



Posted in Uncategorized | 1 Comment

One wrong Sentance after another

Andrew Sentance’s FT comment column this weekend needs a reply.   So much that it’s worth running the risk that this blog starts to be seen as the Andrew Sentance rebuttal unit.

One thing Andrew says is:

“By acting as instruments of government policy, central banks are straying from their own dominion into political territory.”

I want to point out here that Everything central banks do is an exercise of a power delegated to them by government.  They are always and everywhere an instrument of government policy.  They don’t have ‘their own dominion’, and it’s unhealthy to suggest that they do.  When that idea takes hold, it sews the seed of someone saying ‘why should central banks do inflation policy?  let’s do it ourselves and have loads of it!’  If HMT instructs the Bank of England to do macro-prudential policy in statute, the BoE has no business doing anything but doing exactly what it’s told.  Once safely in its list of delegated powers, an instrument is not ‘political territory’.

Andrew would be right to warn central banks from taking the initiative to undertake missions or pull policy levers that were not explicitly delegated to it.  This is the German critique of the ECB.  (And relies partly, in my view, on fallacious attempts to distinguish ‘monetary’ from ‘fiscal’ things, as I wrote previously).  But it does not apply to the BoE, the Fed, or the BoC.  All of which simply doing what they were mandated to do.

Sentance appears to include unconventional monetary policy in the list of political actions that ‘have risks’.  But this is a puzzling argument for him to make, given his own MPC voting record, which persistently supported quantitative easing.

But the idea in the column that most needs contesting is the idea that we should take advantage of currently very low measured inflation and lower the target to zero.  Andrew has been consistently calling for higher rates, even as inflation headed South of the target, and one wonders whether the reason for that was not that tighter policy was necessary to get 2 per cent inflation, but that 2 per cent was too much.

Andrew writes:

“The 2 per cent inflation target served policy makers well as a definition of price stability when they felt that zero inflation was not achievable. But price stability could mean what it says on the tin.”

The target for measured inflation was set at 2 not because 0 was not achievable [inflation is a monetary policy phenomenon].  But for two reasons.  Reason one is that it’s well known that, like all CPI inflation measures, ours contains a large upward bias.  So Andrew’s desire to lower the target to current rates would almost surely mean generating true deflation.  If you like, in Andrew’s words, the inflation measure itself does not quite do ‘what it says on the tin.’  [For more, and some nice links, see a previous post].

Reason 2 is that the inflation target needs to be such that the average level of nominal rates consistent with it is high enough to leave room for responding to busts.  It wasn’t that 0 was not ‘achievable’, it’s that it was not desirable.  If there is no room to cut rates sufficiently, then there is a risk of not just inadequate demand, but losing control of inflation itself.  Take a look at Japan.  And wonder too whether persistently below target inflation in the US, US and EZ is not the harbinger of us becoming ‘like Japan’.

In this regard, lowering the target is exactly the opposite of the lesson to be learned from the crisis.  The target was set at 2 when it was thought i) that average nominal rates would be about 6% and ii) that we had had our last financial crisis and large recession.

Looking ahead, surely everyone has lowered their guess at average nominal rates consistent with 2% inflation to about 3-4.  And surely we have woken up to the fact that the Great Moderation was an illusion.  So, we now realise that large recessions are a real possibility, and so too the necessity for large interest rate cuts to stabilise inflation;  and we realise that we will have less room for these cuts than in the future.

So today’s target already implies much more time spent at the zero bound than planned, and relying on unconventional policies (which Andrew seems to dislike).   The lesson then is that the target needs to be raised, not lowered.  [See also previous posts].

Andrew could try to defend his suggestion by arguing that inflation is SO costly that lowering it by 1-2pp would bring benefits that would exceed the cost of giving up the ability to stabilise your economy.  But, to repeat:  it’s inflation that one would risk losing control of too.  So lowering inflation on this count risks generating more variable inflation, which, by the same argument, must be costly.  And, as an aside, there’s no support for thinking inflation is so costly in the macro literature.

This sentence by Sentance is worth quoting.

“..the very institutions that won their credibility by keeping a lid on prices now seem to be trying to create inflation, not subdue it.”

Isn’t that because inflation has been persistently below the targets set by their government owners?  ‘Credibility’ is the reputation you have for doing what you say you will, not a reputation for leaning down on inflation.  Fighting to create as much inflation as you promised is just as important as the old problem of resisting the temptation to create too much of it, as Japan is learning, and we may too.

Note too how the insidious ‘lid’ metaphor invites us to think of inflation that is always ready to escape upwards, out of the pot.  At least once monetary policy has been successfully delegated to central banks, this has no economic foundation.  So far as we understand the inflation process, we can lose control over inflation on the downside too.  And some arguably have already.


Posted in Uncategorized | Leave a comment

Market monetarists and the ‘myth’ of long and variable lags

One of the tenets of market monetarism is that acivist fiscal policy is a waste of time, since monetary policy can do all the stabilisation that’s needed.  On Twitter last night Joe Wiesenthal at Bloomberg wondered what MaMos would think of a strict balanced budget rule.  Would that leave monetary policy able to achieve nirvana?

I thought:  surely MaMos would accept that monetary policy works with long and variable lags, the phenomenon, emphasised by Milton Friedman, that this blog is named after?  And that therefore we’d get macroeconomic volatility from imperfect control?

Believing in Friedman’s dictum would not undermine MaMoism, since if both fiscal and monetary policy worked with the same long and variable lags, and in the same way, ie if they were perfect substitutes as an instrument, then there would be no need for both.

However, Noah Smith pointed me to this post by Scott Sumner, the leading MaMoist, which contains the phrase ‘long and variable lags is a myth’.  The argument in this post seems to me to be full of holes.  So, while I wait for an anti-MaMo Matlab program to finish, I will explain why.

First off, it seems to make the argument that mainstream macroeconomists wrongly identify the interest rate (or the money supply) as the sole monetary policy instrument.  And therefore – I think – it follows that all the VAR evidence showing how shocks to monetary instruments take time to have their full effect on variables central banks might care about is misguided.

Well, no.  Certainly, if one maintains the argument that expected future monetary policy is potent [which, provided you believe in forward-looking expectations is reasonable], and one is prepared to contemplate that there are shocks to expected future policy, VAR based studies that identify only shocks to the contemporaneous instrument are not enumerating all the volatility in the data injected by monetary policy.  [And in fact work by Gurkaynak et al, and others, seeks to identify shocks to both current and expected future interest rates in just this way].  However, it does not follow from this that the VAR incorrectly measures the effects of shocks to the instrument.  Moreover, as the work that does identify expectations shocks shows, those also take time to have their full effects.  In other words, they work with long lags too!

Second, as a purely analytical matter, noting that you can manipulate expected future rates to affect the economy doesn’t preclude that those manipulations, or changes in today’s instruments, take time to have their full effects.  In fact, so far as the empirics tell us, both changes in today’s interest rate and changes in expected rates take time to have their full effect [on variables like inflation, GDP, etc].

I’ll attempt an analogy.

If I am playing chicken timidly, I might be able to influence the trajectory of the other car by calling the driver’s mobile, and explaining that I will turn out of the way, perhaps persuading the driver to turn her car back towards mine.  However, the other driver might take time to process what I say, and it will still take time for my turn of the steering-wheel to have its full effect on the path of my car.

I’m not sure how well that analogy went.  But at any rate, the phenomenon is true of macroeconomic models of policy and the associated empirics.

And the corollary is that because the economy will be buffeted by shocks, and it takes time to respond and counter them, no policymaker would be able to generate stable outcomes for goal variables.

Backing up, I don’t accept, of course, the premise of this line of thinking at all, that monetary and fiscal policy are perfect substitutes, and therefore that the former can be dispensed with.  But it’s worth bearing in mind that the logic gone through here works for fiscal policy too, both in the models, and in those attempts to identify shocks to fiscal policy today and in the future.

Sumner cites Woodford and Krugman as commenting on the potency of expectations, and uses this in support of his thesis that changing expectations changing things refutes the long and variable lags thesis.  But I am quite sure neither of them believe any such thing.  Estimated versions of Woodford’s model (for example, the original Rotemberg-Woodford model) behave just like my account above.  And Krugman is a firm believer in sticky prices, talking interchangeably between IS/LM and New Keynesian models.  Which behave just as I’ve explained above.

The only model I know where monetary policy has its entire effect instantaneously is the flexible price rational expectations monetary model.  And in this case there is no point in monetary stabilisation policy at all.  Money has no short-run effects on output.  Optimal policy in this model is to set rates at zero permanently, obeying the Friedman Rule.  If there are real frictions in this model, like financial frictions, there will still be a role for fiscal stabilisation, however.

I’m sure these mix-ups would get ironed out if MaMos stopped blogging and chucking words about, and got down to building and simulating quantitative models.  Talking of which….

[Update:  Scott Sumner replies on The Money Illusion here, including some priceless phrases about how his research found that there were in fact, no lags at all between monetary policy changes and their effects, and some other collectibles about there not being a NGDP futures market.]

Posted in Uncategorized | 16 Comments

The One Bank [of England] Research Agenda Launch

There’s lots to find encouraging about today’s One Bank Research Agenda Launch Party.  [Caveat:  my recovering kidney meant I could not sit for very long on the mis-shaped BoE conference centre chairs and had to bail out of most of it].

1.  It symbolises the new emphasis placed on research.  Along with the reorganisation of that function, Bank-wide, under the Chief Economist, Andy Haldane.

2.  The launch falls in with a pattern of ever-increasing openness and transparency at the Bank.  The very fact that the agenda is disclosed up front, inviting comment, in a way that wasn’t done previously, allowing an informal holding to account for how taxes used to fund it is spent, has to be applauded.  [We trust there will be a ‘where have we got to?’ Party to at some point.]

3.  The stated openness to new ideas, new methods, new thinking, and the recognition that what was thought before may not have been the answer.  It’s not long ago that this would have been unheard of (in public) in a central bank, when it was held that the credibility of all functions depended on communicating omnipotence, and communicating as little as possible.

4.  The ‘crowdsourcing’ initiative.  Although the Old Street tech Roundabout language made me cringe a little, the idea is helpful.  Write down lots of important policy questions that others in academia might not be aware of, and try to encourage others to help.  Those interested in macro and finance in academia are strewn about the country, isolated in small groups.  Initiatives like this help bring people together, not only physically, but in instilling common purpose.

But.   Everywhere I felt that babies were being thrown out with the post crisis bath water.

1.  We had the suggestion that before the New Enlightened Era, which began some time after Northern Rock collapsed (?), researchers de-emphasised empirical work, and did not do inductive research – taking data to the theory, rather than the other way round.  Well, that was news to me.  Perhaps around the mid 1990s I started to hear the term ‘empirical macro’.   But I know now that it much predated when I first understood it, and goes back to work by Sims, Sargent, Quah, Geweke, and was developed later by Stock, Watson, Reichlin and others.  This sub-discipline was all about putting the data first.  And, incidentally, using a lot of it.  Although this would probably still be called, insightfully, ‘small data’, in today’s lexicon.

2.  There was the implication that we should stop looking for causation, and satisfy ourselves with correlation.  Relatedly, theory [unless it’s ‘complex systems theory’] is out.  But lurking behind the tension between empirical and theoretical macro is the Lucas Critique.  The upshot of which is that correlations don’t provide reliable guides to policy.  Neither does theory, mind you.  But nothing about the crisis explains how correlation can now suffice.

3.  There’s a contradiction between the pervasive idea that old methods and lessons are done for, and, well, almost everything else the Bank is seeking to do outside its Agenda.  For example, the inflation target;  the pursuit of it by the setting of interest rates and quantitative easing;  the credit easing policy and the calibration of the subsidy;  the support for higher capital requirements;  macro prudential intervention in respect of high loan to value mortgages.  All these things are underpinned by decades of theory.  It seems that we aren’t sweeping all that away today.  But if not, why not? Are some of these bits of wisdom still reliable?  All the while received understanding is scorned, a bunch of hard-working staff are turning the handle on the Bank’s COMPASS model, producing a forecast and studying the impact of alternative policies.  How does that square?  I suggest that these old-fashioned actions speak louder than the radical, landscape altering rhetoric, which I suggest is impractical and overblown.

4.  There are some dangers in the new research agenda.  Read one way, it purports to set the Bank on a path to research everything, using every possible method, quantitatively and quantitatively, exploring all possible interdisciplinary synergies.  One of the very few management lessons that ever made it through my muddled business consciousness is that if you set out to do everything, you end up doing nothing.  Despite the ambition in the program, discussants, amusingly, managed to find all kinds of gaps and nuances that were missed.  Bank staff were diligently writing these suggestions down, but I hope most of them are set aside, as complicating an already difficult task.

5.  I’m in two minds whether all the nice infrastructure of Themes and Questions and the Agenda is catalysing and energising, or a necessary evil to show that due process is being adhered to, or a terribly costly, suffocating superstructure.  I can only imagine all the meetings and brainstorms that gave birth to it all.  Most of the successful research that appears in the top journals [granted that might not be what the BoE is after] was done by individuals operating without the benefits that all this management overhead conferred.  They were researchers being paid, choosing their own topic, finishing to their own timetable, responding to incentives.  An opposing model to the one being followed is:  these are our core purposes:  we think that research is a necessary part of them; and this is how attractive the job will be if you come and work for us [fill in pay and conditions here].

6.  Today was a real showcase for various strands of what you might call heterodox economic thought and practice.  Or not.  Two things bugged me about the discourse.  First, there were so many instances throughout the short time I was there where the determination was to do heterodox thing X, when, actually, this has been part of standard macro practice [eg empiricism].  Second, was the way the heterodox discourse drew common cause in every possible critique of mainstream practice, even though these critiques are sometimes mutually exclusive.  It reminds me of listening to some who espouse alternative medicine.  In fact several, mutually exclusive alternative medicines.

7.  I still am not getting Big Data.  Today’s slide show was delivered like many I have seen.  Shouted, with missionary zeal, as though The Fog Is To Be Lifted From Our Unseeing Eyes.  Why doesn’t someone simply say:  computing power and the internet means there’s a lot of data now, and you econometricians and forecasters can do a lot more of what you used to do, but with the same health warnings?  There’s also an element of ‘you mainstreamers have really missed something here’.  Yet heterogeneous agent macro and micro people have steadily been chewing through many huge data sets.   Big Data – or how about abundant data and computing power – is not a methodological challenge to mainstream economics, it’s an opportunity for it, and one already being embraced.

8.  The Bank of England tweeted out, graciously, Charles Goodhart’s comment that people will be astonished in the future to learn that central bank models exclude the banking sector.  Minor detail – so does the BoE’s model, still, some years into our post banking crisis phase!  As the BoE tweeter hinted subsequently, there are models with banks in the ‘suite’ of models that make up their forecasting toolkit.  But is this a substitute for the real thing, building them in the core model? I doubt it, though the argument is more nuanced, and not as ridiculous as it seems on the surface.

If you haven’t already bored of my thoughts on this, I have blogged here and here on related issues.

Posted in Uncategorized | 1 Comment

Proximate roots of German monetary and fiscal conservatism

This post is all speculation and stereotype, but I think worthwhile passing on as it’s the sort of thing often talked about on the academic conference circuit.  It recaps on a bunch of tweets sent Thursday 18.

The starting point is the observation that the Anglo-American-Latin view that monetary and fiscal policy does best by being strongly counter-cyclical, smoothing out booms and busts.  What Greece needs now, on this view, is sharply expansionary fiscal policy, not a primary surplus, and debt forgiveness [or whatever passes for it] to make that possible.

That view springs most recently from New Keynesian economics, which was invented in the US by the leading academics there.

The influential jobs in German money and finance [Buba/ECB/Finance Ministry] are either staffed by senior German academics, or those that mix with them.  [Like many countries].

German academia is unusually cut-off from American academia.  It’s disporportionately staffed by locals, who trained in Germany.  Partly as a result of this, New Keynesianism and its policy prescriptions did not catch on.  And because of that, German economic policy did not shift with the times either.

There are two significant ideas that did not catch on.  One was the subversion of the old supremacy of money targets as the nominal anchor, and money growth monitoring as the means to achieve them, with inflation targets as the nominal anchor, and attention to interest rate rules as the means to achieve them.

This New Keynesian idea was an anathema to the Buba and ECB Germans that I encountered in my stay in Frankfurt in 2002.  You can see its imprint, rather the lack of it, in the prevalence of the ‘money pillar’ in the old monetary framework of the Issing era, and in the refusal to call the inflation target a ‘target’ (instead it was a ‘clarification’ of an ‘objective’).  And in the ‘close to but below’ wording attached to the 2 per cent figure.  One could speculate too that this was part of the reason for – what some saw at least as – the relatively slow response of the ECB monetary instruments to the onset of the financial crisis.

The second idea that did not catch on was the use of counter-cyclical fiscal policy.  You can see the imprint of that in the Stability and Growth Pact.  And, if you’d sat in on the lunches I had in my ECB secondment, you’d have seen how it infused the thinking of the German economists there.  It also seems clear to me that in the 2010 negotiations over Greece and now, the benefits of pro-cyclical fiscal policy are not appreciated by the German representatives.  Or, if they are, that’s kept quiet as a negotiating tactic.

Most of this, as you can tell, is without much factual basis, except the gossip I listened to on the conference circuit, and my own time on secondment, and casual observation of what has been going on.  So it should be treated more as a hypothesis, rather than a solidly researched point of view.

My tweets did not get that much response on Twitter.  One anonymous follower sent back a series, confirming that German academia was relatively insular;  that appointments favoured locals with long lists of German publications;  and that New Keynesian ideas were frowned upon.   A couple of others concurred, but a couple thought this was either wrong, or a red-herring.

I should point out that there are several great German economists I know working in and outside Germany, and I don’t wish to denigrate any of those.  Mentioning a few inside:  the unsung heroes of Heer and Maussner;  Wolker Weiland.  They absorbed US methods and made them their own, and research in this tradition.  Outside:  too numerous to mention.   But these are exclusively those who were exposed to the US-based frontier thinking, and who subsequently bore the task of pushing back that frontier.

Many might read this and wonder why we should mourn that some policymakers did not absorb New Keynesianism.  For instance, someone should try writing that as a comment on John Cochrane or John Taylor’s blogs, and see what response you get.  ‘So much the better!’ they would say, along with the others who stay within the Real Business Cycle tradition, that thinks business cycles are best left to themselves.

But although I have taken sides on this myself, the point of this post is not to stress that normative point again.  It’s simply a theory that the German negotiating position is partly a product of its isolated academic tradition that left it unnourished/untarnished by modern thinking.

Update:  see the exchanges following Simon-Wren Lewis’ recent post on Mainlymacro, which go into this very subject, the exposure or lack of it of the German economics elite to NK macro.

Posted in Uncategorized | 10 Comments

On the binariness of the euro, or lack of it

Following on from my last post, a part of the argument that the Eurogroup will try to strike a deal at all costs is that they are seeking to protect the sacrosanct nature of the euro, which involves preserving that it is not possible to exit from it.  Once there is an exit, all the euroness is gone and the project is in tatters, and the euroness possessed by those that are left behind is suddenly tainted and now temporary.

Two points on this.

First, nothing is credibly forever.  The euro is a set of rules flowing from a series of agreements signed by past member state governments, long since gone.  Like all constitutions, given sufficient changes in public opinion of its signatory countries, it can and would change.  There is no credible ‘foreverness’ that a Grexit spoils for good.

There are simply probabilities of various currency and fiscal possibilities, defined by the signatories, and the rules governing how different policy instruments covered by them (including interest rates, asset purchases, fiscal redistribution) are set.  Grexit might well change those probabilities, but how much is moot.  As I argued in my last post, saving Greece now may not change the probabilities of a future Grexit that much, because they could find themselves in the same situation in a year or two.  And for different reasons the large country exit probabilities might not alter much [they are too big to save anyway] and the same for the smaller ones [they are easy to save, and their ‘good behaviour’ has instilled the solidarity to save them].

Part of the reason things are not – and never have been – credibly, forever, is that circumstances, including what we know about what is optimal monetary and fiscal policy, change.  Setting out to claim that this is the answer [eg the euro, with current membership] once and for all, is hubris.  It’s understandable that the euro pilots did this at the outset, of course, because they hoped to make its continuity a self-fulfilling prophecy.  But no-one should have believed it, and I presume not everyone did.  Instead, as Tom Sargent once pointed out, monetary arrangements can be seen, at best, as a form of slow-motion trial and error, hopefully feeling one’s way towards the arrangement that best fits the times and one’s state of knowledge.  Those that argue that Eurogroup will value permanence of membership above all else are arguing that there would never, rightly, come a time when people sit down and think ‘actually, we should never have got into this’ or ‘you now, maybe this isn’t working out any more’.

Moreover, part of this trial and error could be the evolving assessment of the nature of other aspects of the currency arrangements aside from the permanence or otherwise of its members.  Suppose permanence is valuable [the above has been about arguing permanence also has costs, but, leave that aside].  But so might be adherence to a set of rules of monetary and fiscal conduct by member states.  Since adherence to these rules would govern what was sustainable monetary and fiscal policy for the collective, in the future, and thus, what the benefits of membership were.

Of course these rules in the Eurozone have, through the process of trial and error, been bent and changed, and there is much argument about whether the twists and turns have improved matters or not [see contrasting views of Hans Werner Sinn and, well, most economists outside Germany for a sample of the controversy].  The stability and growth pact was set aside frequently.  And we are inventing embryonic fiscal transfers via the banking union, the ESM/EFSF, and the Troika loans and its terms.

But in assessing what should be the enduring nature of the euro for the future, it would not be rational – and I naively assert, therefore, will not be part of the calculus – to weigh non-exit above all else.  Permanence of membership might have its advantages.  But so might enduring rules of membership.

In short, avoiding Grexit for the sake of preserving expectations that no-one would ever exit is futile, because those expectations won’t be altered that much by this deal:  nothing is or should be forever.  Second, in so far as it’s good that things are enduring, if not forever, Eurozone policymakers will no doubt value maintaining the expectation that the rules of the game don’t change as well as expectations about who gets to be in the club.


Posted in Uncategorized | 4 Comments