Kocherlakota loose money and deflation

Robert Waldmann

Minneapolis Fed President and famous economist Narayan Kocherlakota made my jaw drop with this argument

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

Kocherlakota asserts that expansionary monetary policy will eventually cause deflation. This is very odd. My honest opinion is that he wants to argue for a higher target federal funds rate and he’s decided to present every argument that supports that proposal even if it is half baked, unbaked or negabaked (frozen ?). However, I can’t resist trying to make sense of the argument (after the jump I try and fail).

First, as noted by Andy Harless, Kocherlakota is asserting super-neutrality – not just that the level of the money supply doesn’t affect real variables in the long run but also that the rate of growth of money doesn’t affect real variables in the long run. Kocherlakota is right that this claim is not controversial – it is uncontroversially false as argued in, say, much of Kocherlakota’s academic work. Weird.

Second, Kocherlakota does not say anything about economic agents and their objectives. For there to be deflation firms must lower prices. Kocherlakota does not discuss why firms might do that. This is very strange coming from an economist who was, until recently, chairman of the Minnesota economics department.

update: This is not as unoriginal and pointless as the rest of the post.

Immediately above the quoted passage Kocherlakota wrote

As I said, the FOMC meets eight times a year. Its decisions are always influenced by fairly recent economic data. But, at the same time, its decision-making has to be shaped by long-run considerations. In that vein, let me close by offering some thoughts about long-run inflation—or really, long-run deflation. I mentioned earlier that inflation has been near 1 percent recently. These data have led some observers to worry about the possibility of a multiyear period of falling prices—that is, persistent deflation. I don’t see this possibility as likely. It would require the FOMC to make the surprising mistake of ignoring the long run in its desire to fix the short run.

He notes that there is a long run equilibrium in which the Fed funds rate is very low and inflation is negative. He strongly suggests that this would be a bad thing. In Kocherlakota’s academic work, he asserts that optimal policy implies an euqilibrium with deflation and a very low nominal interest rate (optimally 0). This is called the Friedman rule. So why would reaching such an equilibrium require a mistake. The argument about the equilibrium real interest rate is an argument about the real interest rate which corresponds to unemployment equal to the natural rate. The problem with deflation is that it can cause real interest rates to be higher than that rate. Kockerlakota assumes that there is no problem caused by deflation in his warning that loose money might lead to deflation.

[intemperate outburst deleted]

end of update.

Further up in the speech, Kocherlakota notes that it makes no sense to consider a policy of keeping the federal funds rate at 0.25 percent from now until T= infinity, since the question at hand is the target rate for the next month and a half. He then just says this doesn’t matter (1.5 is approximately equal to infinity). I think that to the man in the street, this is stranger than deciding micro foundations are optimal and that neutrality implies super neutrality.

However, I find it comprehensible. When one attempts to deal with difficult mathematical models, the temptation to consider steady states is almost irresistible. Furthermore Fresh water economists have been saying “that may be true in the short fun but not in the long run” for decades. In fact, economists have been dodging questions by talking only about the long run since before Keynes wrote “in the long run we’ll all be dead” to respond to exactly that invalid argument.

Another key point is the immense power of “if.” Kocherlakota discusses the irrelevant question of sticking to 0.25% target forever (he doesn’t consider sticking to it for a mere million years). He thus implicitly assumes that the Fed can keep the Fed funds rate at 0.25 from now to infinity without interruption. I think that is impossible and it certainly won’t happen if the Fed follows the policy opposed by Kocherlakota.

The Fed has been keeping the Fed funds rate that low via open market operations in which it issues high powered money in exchange for other assets. Such an approach might fail to achieve the target because it leads to inflation. It is easy to see how a policy of trying to keep the federal funds rate below the equilibrium real interest rate would cause high inflation until the Fed would lose its ability to drive short term interest rates down because the real value of new high powered money issued would be too small – that is the amount of money they create doesn’t matter if no one wants it.

I not sure that it’s even possible to write down a model in which such a policy succeeds in keeping the Fed funds rate 0.25% for the long run and leads to an equilibrium with deflation. Certainly no such model currently exists.

The Fed could achieve 0.25% starting in around 2020 and lasting forever by reducing and reducing the money supply, however that would imply very high nominal interest rates in the near future (this isn’t theory it is an empirical observation) and it is not the proposal which Kockerlakota opposes.

I guess I have wasted your time. I started with no clue about Kocherlakota’s mental processes and and I still have no clue.