Krugman scolds the Fed. Unfairly.

So the Fed did not predict the panic in global stock markets.

So what?  Who could have?  It wasn’t a mistake not to have.

Krugman doesn’t scold them for this, but he does scold them for not postponing a hike on account of the asymmetric risks posed by stock market volatility.  The asymmetry being on account of the zero bound, which leaves them unable to stimulate if markets crash, but able to hike quickly if they boom.

But I don’t think that the hike in and of itself shows that they failed to take account of this risk.

Think of a standard New Keynesian model projecting the awful shocks of the financial crisis, instructing the Fed to lower rates down to the zero bound, purchases assets [ok, I’m stretching the thought experiment here, but bear with me].   Eventually, once the effects of the shocks wear off, the model will be signalling that rates should be normalised.

The trajectory for rates will look different because of the asymmetry imposed by the zero lower bound [and the inability of asset purchases to make up for it].  From memory, it would involve a sharper cut on the way to the zero floor, and then a more protracted period of low rates [Woodford’s ‘lower for longer’].

But, at some points interest rates would rise.  So the Fed might be judged simply to have followed through on its asymmetry-inclusive path.

Or, we could think of them responding to positive news relative to the previous plan, which, again, zero bound included, would warrant a hike at some point, and this time earlier than before.

There are a few Fed speeches [I recollect Evans and Williams at least worrying about asymmetry] that cover the issue too, so this is more circumstantial evidence on which to acquit the Fed.

[Added later..]

Taking the argument to the extreme;  for a hike always to be wrong in the face of the zero bound implies that rates have to stay where they are forever.  Which is clearly not right.  So there is some prior forecast, or some incremental news that would have justified a hike, in the face of potential market volatility and the zero bound.  It’s just a question of whether that hurdle was cleared in this case or not.

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3 Responses to Krugman scolds the Fed. Unfairly.

  1. Tony, I’m not sure about PK’s arguments on asymmetry of risks I think the fed can be criticized on Svenssonian grounds. Before I get to those a quick note: As you state in your NK model you are assuming that at each time period the Fed optimally responds to the shock, but this has not been the case. The fed has a number of constraints (eg politics, time lags between decisions and implementation etc). Additionally, the NK model assumes that the private sector optimally responds to shocks and can in fact derive the interest rate at the same time as the fed implements it. So I’m not so sure a vanilla NK model and the dynamics it predicts should be a guide for fed policy.

    But let’s get to the Svenssonian part of the story. As long as we accept that the CB should target the forecast inflation, if forecast inflation is bellow target, a rate hike will be bad for welfare. The fed should have kept rates of hold simply because there were little grounds to believe that the inflation target will be met or exceeded by the time of the next monetary policy meeting.

  2. foosion says:

    The problem isn’t asymmetric risks to the stock market, it’s asymmetric risks to the economy.

    Leaving rates alone, or even additional stimulus, risks higher inflation. However, just about all signs are that inflation is not a problem and won’t become a problem anytime soon. Even if it becomes a problem, the Fed can deal with it.

    Raising rates risks the economy slowing down, including lower employment and lower wages than would otherwise be the case. This can do real damage to real people.

    The stock market and bond market are commentary on policy, not the issues policy should be addressing.

    The Fed claims to be targeting 2% inflation. That they aren’t hitting that target, don’t appear to be likely to hit that target for a rather long time and are acting to make it harder to hit that target is not good for their credibility. Credibility is essential for a CB.

  3. daniels says:

    I have a suspicion that Krugman and some others want is that the Fed and ECB should just leave rates at the zero lower bound for longer and longer, maybe just peg it to close to zero permanently and save the resources on actually doing classic interest rate policy (maybe reallocate some resources to financial stability). There’s the issue of the modern central banking trade-off that a low rate bias when it’s not really required reduces monetary policy space in actual recessions. But if you’re Krugman or Summers, that’s fine because you just want to return to times when fiscal policy was responsible for business cycle stabilisation anyways and monetary policy wasn’t so centrl.The question is what happens then? Old Keynesian models and some New Keynesian models with learning say inflation explodes. The Fisher equation says we get something like Japan (one of the most underestimated economic performances of the last 15 years, given many people’s tendency to confuse headline gdp growth with per capita or per worker gdp growth and forget about demographic differences).

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