Why a good “policy stance” might matter

I haven’t read John Taylor’s newest working paper yet, but its about the Fed’s start-stop policy stance under the ancien régime. The story he’s riffing on in that paper is pretty standard. There was high and variable inflation under the old monetary policy regime because the Fed didn’t fully accept its role in determining inflation. It would have moments of commitment to fighting unemployment or the output gap and so it would loosen policy. When inflation came, they’d commit to lowering inflation. They’d tighten policy long enough to induce a contraction in output, but not long enough to re-anchor inflation expectations at lower rates. Rinse and repeat. Stagflation and uncertainty.

Then Volker came and saved the day!

The Great Inflation is the time before 1985 and the Great Moderation is the time after. I’ve labeled the regime average and standard deviations.

I’m not interested in debating the reasons for the Great Moderation starting in the mid-80s, but at least one reason for the decrease in volatility in both output and inflation is that the policy stance of the Fed changed. It gained credibility as an inflation stabilizer. It was going to set an (implicit) inflation target and do what it needed to hit it.

Compare the 25 years before 1985 to the 25 years after. The old regime saw 5 recession, the new regime only three (and two of those were pretty mild). As you can see in the graph (which includes the most recent recession), volatility of output decreased. Similarly, volatility of inflation and consumption also decreased. As Bernanke pointed out in his Great Moderation speech, these trends are evident in other countries as well.

The thing that changed was the adoption of a confident and credible policy stance by Central Banks around the world. They woke up to their power to control inflation. And Bernanke was trying to wake up the Bank of Japan to its power as an effective manipulator of inflation; to build their confidence. Central Banks also learned the power of credibility. And this is why Bernanke responded to Delong’s question the way he did.

Prediction: no William Wallace speeches from Ben

In the next two years — before the memory of this recession fades, but long enough from now that it doesn’t risk unanchoring expectations — Ben Bernanke will begin peppering his speeches and testimony before Congress with references to some form of history contingent policy (e.g. price level or nominal output targeting, state-dependent inflation targets, etc). This will signal a move of policy in this direction.

I give (much) lower odds that there will be a Volker-esque announcement of an explicit move to such a policy.

We watch too many movies if we think the Fed chairman giving heroic speeches would affect people’s expectations of Fed policy ((At least affect them in the way he or she would want. If Ben gave a speech tomorrow announcing a return to the gold standard, people would think he was crazy.)). As Forrest Gump might say, “policy is as policy does”.

Costs of discretion

In the previous post, I argued upping the inflation target would have no impact on unemployment and it would risk unanchoring inflation expectations. If expectations became unanchored we would be trading off a permanent increase in expectations for a temporary decrease in unemployment.

Assume we gave half of those currently unemployed a job, output would rise by about 5%. Without retargeting, I’m guessing it’ll take 5 years for unemployment to get below 5% (unemployment has a two-year half life). So we’re getting about 13% of GDP by retargeting.

The costs of 10% of inflation are estimated between 1% and 5% of GDP per year. Woodford estimates that under a discretionary policy, inflation would be about 10% (I’m looking at figure 7.1 in his textbook). Discretion isn’t really permanent, its just really hard for the Fed to get expectations reanchored. Suppose x is the number of years of unanchoredness and so its the number of years we’d have 10% inflation.

How big can x be and still make retargeting cost effective? Using a low-end estimate of cost of inflation of 1%, x is 17 years. Using a high estimate of 5%, x is 2 years.

I must be crazy

Because the rest of the world seems crazy. Even Cowen and Sumner seem to think changing the inflation target right now would be a good idea.

First, does the Fed have an inflation target and are expectations anchored, i.e. are they equal to the target? Yep and yep, see the graph Prof. Delong put up.

Second, what would the impact of a change in the target be? Suppose expectations remain anchored, increasing the target will increase expected inflation, shift the Phillips curve up and we would be right back where we started. More precisely, there would be no change in output and assuming the mechanism behind Okun’s law is invariant to this change in policy, there would be no change in unemployment. (No, I don’t think expectations of inflation are backwards looking, especially now. And even if they are backwards looking, this would increase the chance that changing the target would unanchor expectations. If I did something wrong, my parents were always more pissed if I lied to them about it.)

Third, why might increasing the target unanchor expectations? The Fed could be seen as acting with discretion; that they’ll up the target anytime the public or politicians start whining. Here’s a post explaining why discretion is bad. Its really hard for the Fed to get expectations reanchored.

Fourth, what would be the impact of unanchoring expectations? Inflation would increase and its volatility would be greater. If the public thinks the Fed will do whatever is expedient, they will expect higher inflation. Also, because the Fed’s behavior is less predictable, expectations and actual inflation will be more volatile. High inflation and highly volatile inflation are bad. My bet is that this *permanent* negative effect would be much greater in welfare terms than the cost of the *temporary* high unemployment we’re experiencing now.

Japan data

Japan bashing is popular. Looking at the data since QE started:

Real per capita GDP has risen 1.4% a year and yet prices have been constant.

I’m not sure why any one inflation target (positive or negative) is better than any other ((Woodford chapter 7 argues a target that tends to zero is optimal or a target that has expectations of inflation tending to zero is optimal.)). In any case, the level of the target is of second order importance to having stable inflation (and thus stable inflation expectations and thus having a target). The costs of discretion are much larger than the costs of minimal inflation (or deflation).

Accelerating output and prices equals additional stimulus?

The Fed made a mistake last year. No doubt the Fed chairwoman 70 years from now will give a speech admitting fault for the “Great Recession”. Fine.

It does NOT follow from this that we need more aggregate demand stimulus now. Obvious, right?

Now, unemployment is high. Empirically, we know two things about unemployment. It goes down when output is increasing (the so-called Okun’s law) and it lags output. We have increasing output and inflation. If those empirical regularities rear their ugly heads this time around, we know that unemployment will decline eventually, too.

Politically, I get why presidents react to bad-sounding headlines and hold “job summits” when unemployment goes above magic numbers. I don’t get the argument from economists for more stimulus. What theory, what mechanism of lagging unemployment would suggest we need increased stimulus even though output and inflation are rising?

I can think of a few things:

  1. Laid off workers are just waiting to be rehired by their former employers
  2. There wasn’t enough stimulus and we’re moving towards long-run equilibrium too slowly
  3. Variant: policy makers were too concerned about inflation and they should put more weight on unemployment going forward

It seems the internets are discovering the fact that this recession hasn’t been characterized by a large number of job losses. Instead, unemployment has been increasing because its harder for people who would have lost their job anyway to find new jobs. The JOLTS data, in other words, suggests that even in the recession laid off workers weren’t temporarily let go. They were fired and no amount of stimulus will get their old employer to hire them back. I’m willing to wager most fired employees have no expectation that they’ll be rehired by the same employer that fired from. In fact, I’m looking at data that suggests they shouldn’t even expect to be rehired in the same occupation; they’re going to have to go out and acquire new skills and find a whole new line of work.

Number one is bunk. What about number two? The problem with the “recovery is too slow” argument is that we don’t know what “too slow” means. Looking at the model I shared the other day, even under the optimal policy that makes the proper trade-off between unemployment and inflation, it takes two years to get half way back to normal unemployment rates. If you believe in the “too slow” theory, then you have to write down a model that would generate faster decreases in unemployment (and not just increases in inflation).

Number three? According to the Gali/Blanchard model, if the Fed is heartless and only cares about inflation, then unemployment is much worse at the time of the shock. This is true. However, as the first graph I showed indicates, the decline in unemployment is much faster. From the peak of unemployment it takes less than two years for unemployment to get half way to its normal level.

Under the third scenario, you might say the Fed should switch to the optimal policy. It should put more weight on unemployment and so it should ease policy. Well, according to the Taylor rule that approximates the optimal policy in the Gali/Blanchard model, interest rates should be about 0.5% 0%. Even under optimal policy where both inflation and unemployment are targeted, no further easing is necessary (and current policy might even be slightly inflationary).

UPDATE: as always I got my arithmetic wrong… post updated with strikes to show what changed.

A model

Blanchard and Gali (2008) incorporate unemployment into the standard model. They have some interesting findings, but this one stuck out:
Unemployment under inflation targeting
This is the response of the unemployment rate over time to a 1% decrease in productivity of the economy (a “real” shock) WHEN the Fed has a inflation-only target (i.e. it doesn’t care about unemployment). Blue is the response in the model when its calibrated to look like the American economy and red is the response when its calibrated to look like Europe. Unemployment keeps increasing after the shock for a couple periods and then gradually declines. Look familiar?

Here’s the same graph but for when the Fed has the *optimal* policy of targeting a weighted average of inflation and unemployment:
Unemployment under optimal policy
Unemployment still jumps but it doesn’t have the hump shape. More importantly, notice how little the unemployment increases when the Fed is following optimal, or best, policy… almost an order of magnitude difference in the response of unemployment.

What does this mean? This paper gives us two ways to interpret what happened since last Fall. One, there was a small to medium sized real shock but because the Fed cares too much about inflation, unemployment sky rocketed. Reality looked (and looks) like the first graph. Or two, the Fed is following optimal policy but there was a huge real shock. Our reality is more like the second graph, but amplified.

Ironically, those making a bunch of noise about banking regulation, centering the blame for the recession on the financial sector, are arguing for the second graph. My impression is that those people are also more likely to be agitating for more aggregate demand policy. The second graph has the Fed acting optimally, i.e. there’s no need for further stimulus because the Fed is doing everything necessary. If you buy the logic of this paper, however, you can’t have it both ways.

PS – This model also has a positive response of inflation to the real shock. Given we saw a negative response last Fall there’s still room for a monetary shock in the story.


The problem with most stories is that they’re just words. With just words its easy to sound like you’re making sense, that the one thing you said leads to the other. For example, Ryan Avant says we need more stimulus and so does Scott Sumner (e.g. ?).

So, we have increasing inflation and GDP. Understanding the limited ability of policy makers to fine tune the economy, what model under conditions of increasing inflation and increasing GDP recommends more stimulus?

Speaking of which, I’m embarrassed to say that I have no idea why unemployment is a lagging indicator, but I do know that it has been so for a long time. This means high (but decreasing?) unemployment isn’t necessarily an indicator of insufficient aggregate demand.


The problem with academic macroeconomists is that they’re terrible at telling stories. We say recessions are caused by real and nominal shocks and people snore. And monetary policy is too boring to be the best aggregate demand policy.

“You mean to tell me that buying and selling some debt instruments is the key to solving all of our problems. What, no knight in shining armor riding down from Capital Hill to save us? No brilliant grand plans from genius economic advisors in the White House?”

When I taught the Great Depression this summer, you could see the disappointment on my students’ face when I told them that bad monetary policy was the primary cause of its depth and breadth. They wanted epic stories about Wall Street versus Main Street, evil cabals of foreigners or bumbling Presidents. A student dropped the course when he realized the monetary policy explanation didn’t involve a conspiracy of bankers but just the Fed’s legitimate misunderstanding of the role of money in the economy. He told me “this class isn’t teaching me real economic history”.

Arnold Kling says recessions are caused by Great Recalculations, credit cycles and monetary fluctuations. He talks of great showdowns like “folk-Minsky-ism” v. “folk-Keynesian-ism” or academics v. policy makers. He tells good stories.

As far as I can tell, though, his stories map completely onto what he calls the scholarly consensus in monetary economics. Recessions, including this last one, are caused by real and nominal shocks.