Isn’t or Shouldn’t?

Sumner argues that if Krugman’s claim is true that the Fed is too conservative, that they will do whatever to curb inflation, then fiscal policy won’t work either. Fiscal policy moves the AD curve right, but the Fed will just move it back left.

Sumners argument only works if policy is not limited by the zero lower bound. Suppose the Fed’s conservative policy requires it to set interest rates at -2%. It can only set them to 0%. When fiscal policy moves the AD curve right, the Fed resets the target rate to -1%, say. Actual rates stay at 0%, the Fed can’t move the AD curve left and so fiscal policy is effective. Sumner says either “the Fed isn’t constrained to just set interest rates (e.g. currency interventions)” or “the Fed shouldn’t be constrained to just set interest rates”.

Its the “isn’t” and “shouldn’t” that is the core of the disagreement. Is there evidence for a political economy constraint on the Fed that prevents it from doing the right thing? As Tyler Cowen put it, assuming AD is too low, why isn’t the Fed following Sumner’s advice? If they’re not following Sumner’s advice then fiscal policy can be effective, right?

“My beef with Scott Sumner” OR “Dude, you’ve already won the debate!”

Pleasantries: brilliant blog. Anyone remotely interested in monetary policy, a.k.a. “the only remotely possible technocratic method to manage an economy”, should read it.

Ok. Prof. Sumner is absolutely right that the Fed made a mistake in fall of 2008. This is illustrated by the sharp decline in inflation expectations as illustrated in this graph (stolen from here):

But Sumner often slips from this valid critique into a claim that the Fed continues to make a mistake (e.g. here: “Throughout much of 2009 I kept challenging liberals to push harder for monetary stimulus.”). This is not a valid argument. For example, the Fed made a mistake in the late 1920’s trying to prick what they thought was a stock bubble. Their actions helped precipitate the Great Depression. Flippantly: this doesn’t mean policy is still too tight today. More relevantly: its not the reason why policy was too tight in 1930, 1931, 1932 and early 1933. The mistakes they made in those years where independent of the original mistake.

The sharp up-tick in inflation expectations through 2009, as seen in the graph above, suggests the Fed is no longer making a mistake; policy is no longer too tight.

What to do about high unemployment (illustrated below)?
First, unemployment has — hopefully! — topped out. This is more evidence that policy is, if not appropriately loose, at least loosening. Second, we don’t know the mechanisms linking macro policies to employment. The Fed doesn’t (and can’t!) determine the unemployment rate in any given month even if completely ignored inflation. Its hubris to suggest that it can. Third, even if money policy’s effects on inflation expectations is immediate, in a world of very slow moving wages, there’s long lags between policy changes and employment changes. The current policy could be producing improvements in the unemployment rate maybe today, maybe in three months, maybe in nine months… we don’t know.

All this said, I support Sumner’s goal of moving the Fed towards history dependent policy (aka “level targeting”). This policy, if even implementable, would make mistakes like the one the Fed made in fall 2008 less severe. I’m just not sure why Prof. Sumner insists on arguing policy is still too tight today, nearly 16 months later, when he doesn’t need to in order to make a case for this policy change.

What is progress?

I’m a political newb, but even I can see why progressives would concern themselves with “stagnating” middle class wages rather than poverty (e.g. here). Poor folks don’t vote, but if you can convince the middle class (which is like everybody if you ask ’em) they’re getting screwed and you’ll fix it, then you’ll get elected.

The thing is, you’re already elected, progressives!

And if you’re looking for more electoral advice from a political naif: everybody cares about poverty. Nobody likes to see people suffer. If you want to broaden your political base even further, tackle poverty.

I recently learned of a group of people called the “undeserving poor”. These people, apparently, don’t deserve to not be poor. You don’t want to associate your anti-poverty rhetoric with them, of course. What you do then, is talk about how the current social safety net actually encourages people not to work!

In fact, progressives, if you want to have the greatest chance of helping people — you know, to make progress— you might consider non-state-based anti-poverty programs. Half of folks think the government can’t do anything about poverty anyway. You come up with a way to help poor people that doesn’t involve the government and you’ll win a lot of those folks over to your camp. An idea I haven’t heard a good argument against is to replace the current welfare state (including tax deductions and credits and the minimum wage) with a basic income guarantee or the EITC on steroids.

In the end, its about making progress, right?

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.

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 CBO says… moooo

I imagine this is how it worked for court alchemists. The CBO says that it has been ordered to give a prediction of the effect the ARRA and so it has.

The Economists suggests this reverse crystal ball gazing is valid because its model driven. Alchemy was model driven: if there is a Philosopher’s Stone, then you can turn copper to gold with it. Hey, alchemists models were even internally consistent; Philosopher’s Stone had the properties needed to make the transfiguration possible. The problem is they weren’t empirically relevant. Despite the evidence from the Harry Potter franchise, it turns out there is no Philosopher’s Stone.

Why is this alchemy? The CBO report talks about uncertainty of so-called “multipliers” as if it was trying put a confidence interval around a fixed, but unknown value. “The ranges between high and low multipliers are designed to encompass most economists’ views about the direct and indirect effects of different policies.” ((BTW, why is “most economists’ views” considered a valid way to estimate parameter uncertainty. Even assuming multipliers are structural and thus throwing 30 years of research in macroeconomics out the window, estimates of multipliers are uncertain because we don’t have sufficient data to estimate them NOT because 3/4 of economists get their estimates of multipliers from Mankiw’s textbook.)) But we know multipliers are not structural, that for different policy and economic environments the multipliers will be different. If we had Sumnerian monetary policy, fiscal multipliers would be zero. If we were in a liquidity trap or if the Fed gave up on monetary policy, multipliers would quite high. By assuming constant multipliers, the CBO is manufacturing the result.

How good are the CBO at forecasting (or hindcasting in this case)? Not good at all. Since 1976 their forecasts have been WORSE than random walk forecasts.

So the King orders copper to be turned to gold and the alchemists comply. The King’s happy. His subjects are happy. Their reality is unperturbed by actual reality.