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.

Advertisements

John Taylor on auditing all the world’s Feds.

This paper explains John Taylor’s view that if only central banks committed to monetary policy rules, international monetary disorder, and indeed large-scale capital flows, would be eradicated.

It’s an extension of his earlier argument that the US’ financial crisis and recession was caused, predominantly, by a departure from the Taylor Rule for monetary policy, and by fiscal uncertainty.

I didn’t find the earlier arguments convincing, and this one doesn’t persuade me either, for related reasons.

This new contribution repeats a problem with the original one, the contention that monetary policy was too loose in the early 2000s.  This was dealt with convincingly by  Bernanke in 2010.  The Fed set rates pretty close to a ‘forward-looking’ Taylor rule in which one inserts not current, but forecast inflation.  Very low rates back then was to head off forecast deflation.

The proposal amounts to assuming away one aspect of the problem.  If authorities could just stop engaging in competitive, beggar-thy-neighbour monetary policy stimulus, then there would be no competitive, beggar-thy-neighbour monetary policy stimulus.  In the real world, such problems exist because national objectives diverge, and there is frequently and incentive to depart from cross-country commitments.  All international monetary and economic agreements reveal how this story goes.

In one version of the argument Taylor seems to think it realistic that central banks would never need to respond to exchange rate movements.  He has in mind a model economy in which all central banks are simply following through systematic monetary policy, in turn derived from first principles using statements about central bank objectives.  For Taylor, the financial crisis does not seem to have caused him to question the models that decades ago helped fashion the Taylor rule as a useful tool for monetary policy.  For many others in the profession, the initial absence of finance from those macro models looks to have been a mistake, and we seem further than ever from a position where we could possibly agree to a formally and transparently stated monetary policy rule.  For the same reason a commitment of this sorts would be nonsensical [and as a corollary not credible] for the Fed, it would be nonsensical for all world central banks.

For the foreseeable future, central banks are going to have relatively vague mandates, translated into broad statements of intent, and leaving them always pondering the causes of exchange rate movements and whether they warrant a response.  And all with good reason related to the incompleteness of our models and knowledge.

Taylor globalises a thesis that he first applied to the US, which is that the financial crisis has a predominantly monetary cause, from which it is natural that he then concludes, in my view incorrectly, that it can have a predominantly monetary solution.

In the US, there are a long list of non-monetary causes suggested.  A failure of risk management in systemically important banks and shadow banks;  political interference in the government agencies tilting lending towards sub-prime;  a failure to regulate;  over-optimistic expectations about the correlatedness or otherwise of exposures by banks and non-banks;  over-optimism about future long run growth;  the possibility of runs on perfectly healthy institutions/markets/asset classes.

Correspondingly, there are a long list of non-monetary agents that may have contributed to the globalisation of the crisis.  Most prominent are the ‘imbalances’ and capital flows ‘uphill’ into the UK/US/non-Teutonic-Eurozone caused by some combination of incorrect expectations about relative long run growth prospects, incorrect perceptions of relative risk, and a demand for safety [as, for example, articulated in Caballero-Farhi] away from the vagaries of  property-rights disorder in China and the other emerging markets.  These causes are ‘real’, ie they can be thought of in non-monetary economies, and are frequently described as such using a basic modelling philosophy that is common to the tradition in which the benefits of Taylor rules were worked out [though in that case of course the models were monetary sticky price models].

In his ‘Taylor rules for the whole world’ solution, Taylor does not grapple with the long literatures on sudden stops, or the newer literatures on how financial fluctuations, with rational and irrational causes, can amplify business cycles, and might have solutions in the form of taxes on capital flows of one sort or another.

The work of Taylor, Henderson and Mckibben on monetary policy rules is rightly praised for having transformed how we think about what central banks do.  But it doesn’t provide a clue to how to avoid another convulsion in global finance, nor a template for a new international monetary system.

 

The German minotaur

I was interested to read Simon Wren Lewis‘ post on the dysfunction in the Eurozone caused by German improved ‘competitiveness’.

Is this right?  Well, one thing I learned from those in my team at the Bank of England who were experts at international macro [main tutors were De Paoli and Lipinska, now of the Fed], is that with relatively little effort, you can get pretty much whatever result you like.

So the answer is:  who knows?  One cannot speak definitively about German dysfunction.

Nonetheless, here is another Wren-Lewis like story, told in the language of Balassa-Samuelson, plus downward nominal rigidities.

Germany gets better at making tradable goods.  This increase in German wealth drives up the price of German non-tradeables.  The relative price of tradeables does not change much, as, in this sector, the law of one price holds more nearly.  For a given inflation rate in the Eurozone as a whole, this Balassa-Samuelson runaway effect [runaway being the opposite of the ‘catch up’ we thought was happening before the crisis started] should mean above average inflation in Germany, and below average inflation in Greece.

If the runaway effect is large enough, or, put differently, if ECB monetary policy fails to generate enough inflation to accommodate the runaway, this may mean negative inflation in Greece.  If there are downward nominal rigidities, the force that would otherwise generate negative inflation [in particular negative nominal wage inflation] generates high unemployment.

In this story, the solution is to set the inflation target such that it is higher, the greater is the relative price change that technology runaways requires.  I doubt very much that, even if this were possible, it would have been allowed by the ECB.

But there was the additional problem that the collapse in demand caused by debt-deleveraging, coupled with the zero lower bound, meant that the ECB could not even meet the 2 per cent inflation target, let alone generate enough to accommodate the problems described here.

Mind changes: post script

Actually, I wonder about this mind changing business….

Two correspondents, Julian Echave, and another, privately, questioned the crudeness of this concept.

One way of responding to what they said is to note that, for example, from a Bayesian perspective, the binary shift in beliefs is a bit of a nonsense.

Mind changing perhaps could mean, from this perspective:  given a binary choice between two policy options [say, minimum wage or no], my posterior probability mass on the event that a minimum wage of a given level would have such and such an effect on employment outcomes shifted – in the light of evidence – such that my binary choice shifted from preferring no minimum wage, to supporting one.

 

Mind changes

It’s fashionable now to get out there what you’ve changed your mind on.  The calculation being, perhaps, that unless you do, you will get nowhere arguing hard for your other, unalterable priors.

In that spirit, here are a few thing I changed my mind on.

1.  The importance of financial ‘plumbing’.  I, like most macro people I talked to, used to think banking in macro was cluttering up models for the sake of it.
2.  The lack of any effect of minimum wages on employment.
3.  The minor effects on wages of immigration.
4.  How sticky price DSGE models are not, clearly, realistic enough to take seriously as devices on which to perform quantitatively relevant optimal control exercises.  For example, I used to admire what the Norges Bank and Riksbank did and thought we at the BoE were well behind the curve.
5. The usefulness of atheoretical empirical macro.  I used to think we were surely beyond just fact generation and sharpening.  But, the crisis having shaken my faith in the models, fact generation now seems attractively humble.
6. The efficacy of macro prudential, counter cyclical tools.  It’s early days.  But when I first read about these in 2009 or so, I thought [extrapolating from the ‘life is just a New Keynesian optimal control exercise] ‘here are some great taxes we can tweak about, problem solved’.  Now I am not so sure.
7. The effects of technology on the wage distribution.  The ‘hollowing out’ stuff is fascinating and I would not have guessed at that.  I came into those papers thinking that those at the bottom always lost.
8. How far authoritarian capitalism could get before imploding.  I would not have guessed China could have increased income per head this much without imploding first.  Maybe it will, yet, proving Acemoglu and co-authors right.
9.  The likelihood of a zero bound episode, and the optimal rate of inflation.  I was signed up for 2 per cent.  But look!
10.  The efficacy of quantitative easing.  There are lots of question marks still over what it did, and how durably.  But the initial impacts, and the unanimity, were a big surprise to me.

It’s probably not wise to get too excited about the moral grandeur of me declaring mind changes on 2 and 3, which revolve around the labour market, as I’m one of those macro people who have definitely not read enough labour economics.  A bit like me writing ‘I changed my mind about how quantum physics worked.’  [Incidentally, on that, I have, several times.]  Note that I ommitted a socialism-capitalism mind change, on the grounds that that occurred before the end of adolescence.

Why weak nominal wage growth is of concern to flexible inflation targeters

Today’s UK labour market data show nominal wage growth falling back – to about 2% annual growth, from a local peak last year of 3% – at the same time as the employment rate increases.  This is another important interregnum for those who thought the UK economy was following a trajectory that would justify a first hike in rates and the beginning of the process of normalising monetary policy.

Recent speeches by both Vlieghe and Carney on the MPC warned that nominal wage growth and other inflation indicators had to show clear signs of picking up before they were prepared to raise rates.

But students of modern monetary policy models will know that these models suggest monetary policy pay attention to nominal wages not just in so far as they are potentially indicators of future inflation, but for their own sakes too.  In these models, stabilising nominal wages around their long run growth rate is just as important as stabilising inflation around its target.

The mandate itself does not give the MPC a nominal wage growth target.  But its signal to support the government’s objectives of achieving ‘strong, sustainable and balanced growth‘, and the March 2013 review of the mandate by HMT which explicitly characterised what MPC should be doing as ‘flexible inflation targeting’ gives policy makers ample scope, in my view, to place independent emphasis on stabilising nominal wages.

You might wonder whether having this independent concern for nominal wages makes a difference, if they are anyway an important indicator of future inflation.

There are 3 things to say about this.

First, central banks have a long history of debating in fact whether short run correlations imply that nominal earnings follow inflation, rather than signal future inflation.  If you care independently about nominal wages, this debate is less relevant.

Second, a shift in labour’s bargaining power [or equivalent concepts] could well mean that nominal wages decelerate at the same time as firms’ prices accelerate.  Caring independently about nominal wages means that one would not respond to such a change by simply accommodating all of the nominal wage fall.  Policy would be faced with a trade-off.  [This is topical as on some measures core inflation has surprised on the upside].

Third, without a motive to care independently about nominal wages, these data become just one out of several pretty noisy indicators of future inflation that it may be easy to find reasons to downplay.   Not so if policy ought to care about nominal wage growth for its own sake.

Letter to Danny Blanchflower re the McDonnell BoE mandate review

This letter sent to Danny today, should contain no surprises.  But it gathers together the various views I’ve ranted about on the framework / mandate for monetary policy in the UK.

At some point I will update with a version that provides links to old posts that go into each topic in more detail.