Necessary and Sufficient Conditions for Effective Monetary Policy at the Zero Lower Bound
As long since noted by Krugman, for the monetary authority to be able to stimulate demand when the safe short term interest rate is almost exactly zero, it has to be able to credibly pre-commit to causing high inflation, by keeping that interest rate extremely low in the future when the economy has recovered and is overheating. This is enough of a problem that the leading theorists and practitioners of monetary policy at the ZLB (obviously Krugman, Michael Woodford, Ben Bernanke Sinzo Abe and Haruhiko Kuroda *) insist that efforts to stimulate with unorthodox monetary policy be complemented by expansionary fiscal policy.
I think, however, that there is another problem. I do not find arguments including “credibility” to be credible. At the very least the word should be “credited” that is believed, not “credible” that is believable. The assumption of rational expectations has snuck into the language, which is a problem since it has nothing to do with reality. Once we understand that the issue is what people do believe and not what they should believe, we must ask which people ? My efforts to check on the effectiveness of non-conventional monetary policy have been total Fred. I look (often) at interest rates on TIPS and normal nominal Treasuries. I am finding out what bond traders seem to believe. But my interest is in the effect on aggregate demand most of which is not purchases by bond traders (a large fraction of them are rich, but there aren’t all that many of them).
I will hint at a model with three sectors non-durable goods, houses, and financial assets. Note the goods and houses are made from pure labor without any productive capital and the assets are traded on street corners or something without any bank buildings. I think this corresponds to one of the two real puzzles and problems with the US economy, which is why housing construction has not recovered (the other is why does the Republican party still exist but I have no clue on that one). Financial assets include overnight loans and 30 year fixed interest rate mortgages.
There are two ways in which expected inflation can affect demand, in both cases demand for housing. First higher expected inflation implies higher nominal wage growth so the fixed nominal mortgage payments correspond to fewer hours of work. Second house prices generally rise proportional to other prices (except for a relative decline during the depression, increase during WWII and the recent bubble). Expected house prices should move roughly one for one with the expected CPI (price of the non-durable). So if potential home buyers and home builders understand these basic stylized facts expected inflation will cause higher expected demand and a pony.
Look economists don’t know much, but we do know for sure that people do not believe that inflation causes high wages and house prices. If people are asked what’s wrong with inflation (which they totally hate) they tend to say it means you can’t buy as much. That is, they assume that inflation means higher prices but not higher wages so real wages are lower. This means that if people believe there will be high inflation, they will tighten their belts reducing demand. Similarly people other than Robert Shiller didn’t notice the almost perfect correlation of housing prices and the CPI.
I don’t really know this. I am assuming the result of a poll which I haven’t conducted. But I am willing to bet that if people are asked whether high inflation makes it rational to buy a larger and more expensive house or a smaller cheaper house more will say that inflation should cause reduced demand for housing. I am willing to make this bet mostly because I am confident the poll won’t be conducted so I won’t risk losing it. I do not think it is wise to bet the economy on the confident assumption that I have it backwards.
OK so let’s assume I’m wrong and that people will buy more and or larger houses if they expect higher inflation. Let’s assume that home builders know this, so they hire more construction workers and build more houses if they expect higher inflation. Does this mean that we can tell if policy is effective by observing asset prices ? Well we can if we assume a representative agent so there is only one subjective expected inflation rate. Not so much if we imagine that maybe the average bond trader pays more attention to hints of possible tweaks to monetary policy than the average home buyer does.
I will present a model in which H. Kuroda can influence asset prices but not aggregate demand. Above I mentioned financial assets which include overnight loans and 30 year mortgages. As that suggests, I assume that there are other financial assets whose value depends in part on what H Kuroda does. Can we determine the effect of monetary policy on aggregate demand by observing H Kuroda and those asset prices ? Obviously not.
To be more clear H. Kuroda is Hiroki Kuroda, the baseball player, not Haruhiko Kuroda, the central banker, and the financial assets are bets on the outcomes of baseball games. Yes if H Kuroda gives up, asset prices will change, But the point spread on Yankees games is not the key to recovery. Of course this is silly. Point spreads have very little to do with the real economy while every twist and turn of asset prices on Wall street is worthy of obsessive attention. Suuuure.
If I remember the 1970s, high inflation led people to believe that they had to buy as much stuff as they could afford as soon as possible, before it cost them more. This might not have been rational, as wages were rising back then, but it was sure what was happening. As to whether inflation increased the demand for housing back then or whether it was the increased demand for housing by the baby boomers that drove inflation, I cannot really say. I do know that the demand for housing was rising and there was a certain urgency driven by general price inflation.
Otherwise, I am looking forward to your model. The Fed has lost its credibility. No one believes that monetary policy alone is capable of inducing inflation any more than it can increase demand. It’s not as if the Fed’s loan rates for major financial players has anything to do with the rates charged to consumers. (Maybe Elizabeth Warren was on to something. The Fed should go retail and cut the financial sector out of the credit market. We could balance the budget on the profits and revive the economy in one quick shot.)
Kaleberg
according to Greider (Secrets of the Temple) the inflation was caused … by inflationary expectations. but the Fed’s fighting of inflation was ineffective because the Fed did not know what “money” was (did not count savings in savings and loans). and worse, the Fed kept on fighting inflation after it was dead… causing the Reagan recession in spite of Reagan’s basically Keynesian tax policies. Worse yet, Volker kept at it until the recession started to drive the banks themselves into failure. And just for laughs, the high dollar is what caused the first big wave of offshoring… not labor costs.
So if he is right… or I remember it right… monetary policy may not be effective, because the folks driving the car can’t see too good.
I am pretty sure most people buy houses when they think they can afford one… stable job, family is growing… not because they are reading the Wall Street Journal.
or as they used to say, “Buy now.”
well, someone has to say it.
balancing the budget is not important.
getting people back to work is.
I look forward to the model. But for me monetary theory broke down the moment productivity rise broke from wage increase.
But, this did not finish it. The finish came at the moment math formulated trades implimented via computers passed over the 50% of all trades mark. With such there is no longer a market in the classic use of the word (as in 2 people coming to agreement based on each’s need). This is because computer math driven trades no longer involve the end user of the product that such trades are based on. End user other wise known as the Consumer.
Krugman et al have not reconciled their theory with the disconnection of the citizen consumer from production.
Kaleberg remembers the 70’s correctly. It wasn’t just housing prices. It was TV sets, furniture, plumbing supplies and golf balls.
The big difference between then and now, that doesn’t get talked about much, is that in the 70’s the phrase “COLA” was common because wages were frequently adjusted up. Now, inflation below 2% for a decade is devastating to ordinary people because their wages have, if anything, fallen.
I don’t have a religious belief in the expectations argument, but at a time when inflation is in the news almost daily, you see its effects at the grocery and hardware stores AND your pay check is bouncing up along with it, it might just filter into your wold view. Buy now before the price goes up was very real back in those days.
Now — not so much.
JzB
Coberly, agree 100% regarding 70’s inflation. Also agree that nobody buys a house based on their inflation expectations. Most normal folks inflation behaviors are probably reactionary, and not leading. Look at all the people that expected inflation with QE. Inflation is at a easily 1.7%.
The other anomaly I have seen is that sinc e Nixon took us off the gold standard inflation has matched the Fed Funds Rate, except when Volcker cranked it way up. Here is the chart since 1980. You can run it starting earlier and see the same pattern.
http://angrybearblog.strategydemo.com/wp-content/oldimages/angrybear/3/-yX8GJO7BGso/UV1Cm0Yn3BI/AAAAAAAABnA/–Uhevga_nc/s1600/matthee2.png
The 70s story I read from K and JzB is just very low real interest rates should cause high consumption. I don’t recall so clearly (wow I feel young — was not of TV buying let alone house buying age). I have two thoughts.
1) understanding that inflation means buy now and does not mean poverty ahead might take time. We need stimulus now not years from now (when no longer at ZLB). For macro policy a delayed effect can be worse than no effect.
2) regulation q. There were restrictions on allowed nominal interest back then. The max rate on a checking account was zero. Things are very different if one has access to interest bearing assets or one is in debt and paying 20% per year. It would take a whooooole lot of inflation for it to no longer be optimal for a whole lot of people to pay their credit card balances if they could. Many more people are in debt and paying penalty interest rates.
“buy now” was actually the government sponsored slogan during the recession of the late fifties. i guess the idea was that if people went out and bought stuff the recession would end. i seem to remember that idea being promoted much more recently. the free market, you know.
i remember the inflation of the eighties. wages did not keep up with prices. a little earlier than that, whatever checking accounts paid, you could get impressive interest from your Savings and Loans… just about four percent less than the rate of inflation. so i don’t remember it as a time of everyone spending to get stuff before the price increased. if anything, people tried to save because they were afraid of not having enough money to pay for stuff they needed.
i don’t claim that is always the way everyone will act. i do claim there is enough uncertainty that it is foolish to base policy on some economists idea of “rational expectations.” and it is approaching criminal stupidity to drive the country into recession because you believe that monetary polices ought to work and keep on jiggering that game while people get poorer and poorer.
but don’t expect relief any time soon. the current stupidity was baked into the pie in 1980 and it won’t go away until the politicians and economists of that era are dead. which in the long run…
This post is evidence — as if we needed it —
Dear Bobby W is always worth “a read”
The Seventies Inflation was the result of Vietnam War time spending and quite simply the domestic programs meant to curb poverty. A classic battle of guns vs butter. Johnson wanted both. Add to this Nixon’s Price and Wage Controls followed by spurts in food and oil under Carter; of course, Inflation was out of control. Hell, I used to get 15% raises and mortgages were 12%. You could borrow money at a lower rate, invest it, and come away with a better return. Volcker took over for Miller(?) and crashed the economy at the expense of Labor.
Run
that is no doubt one of the causes, but people get married to their favorite theories. you might want to give Greider’s Secrets of the Temple a read and see if he convinces you.
At least it’s better than Paul Samuelson saying inflation was caused by people who refused to work unless they were paid more than they were worth.
Coberly:
Thanks for the other input. I will certaiinly give it a look.