In Which I try to Defend Janet Yellen from Brad DeLong
Fed Chair Janet Yellen said, among other things,
For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy. To support taking this step, however, I will need to see continued improvement in labor market conditions, and I will need to be reasonably confident that inflation will move back to 2 percent over the medium term.
After we begin raising the federal funds rate, I anticipate that the pace of normalization is likely to be gradual. The various headwinds that are still restraining the economy, as I said, will likely take some time to fully abate, and the pace of that improvement is highly uncertain. If conditions develop as my colleagues and I expect, then the FOMC’s objectives of maximum employment and price stability would best be achieved by proceeding cautiously, which I expect would mean that it will be several years before the federal funds rate would be back to its normal, longer-run level.
The news is that “some point this year” means “not next month” A possible increase in June 2015 used to be discussed a lot.
Brad DeLong argues that raising rates “sometime this year” would be crazy. The justification is that unemployment will be low and inflation will not be far below target. This would imply no normal reason to raise rates. Brad’s main point is that the speech includes no consideration of the risk of hitting the zero lower bound due to a shock after raising rates.
After quoting Brad, I’m going to go to a long boring comment. The main point, if any, is that a speech describing a sub-optimal plan for interest rates (as a function of future information) may be an optimal speech. But I also type about optimal control (both of us are trying to do math in our heads using plain English). I want to stress here that I think Brad is making a very important very valid point.
Finally I hand him the mike
If your control variable has a bound–like the zero lower bound on interest rates–the optimal control policy is different. The fact that you cannot lower your control variable below its bound adds an extra term to the math. This extra term makes it unpleasant to be even near the bound. So you should take steps to stay away from it–which means lowering your control variable closer to the bound as you get near it. And the nearer to it you are, the more you lower it below what it would be if there were no bound constraining it.
this bound principle has the implication that if do you wind up at the bound, you want to get off of it as soon as possible in a way that makes it highly unlikely you will wind back at it. Hence you stay at the bound until your optimal policy in the absence of the bound is well away, and then you move your control variable rapidly until it once again is expected to drift only slowly.
Thus Janet Yellen’s declaration today makes no sense: from an optimal control of you, you want to wait to raise interest rates until the economy is sufficiently strong that the appropriate interest rate raise is a substantial one.
I think the last words should be “is sufficiently strong that the interest rate which would be appropriate if there were no lower bound is substantially greater than zero” Way at the end of the post, I explain why this is different from what Brad wrote.
Most of my comment is after the jump
This is a public speech. I have a story for why she thinks it was optimal. It goes as follows
Remember how the markets freaked out when we said we would taper QE3 ? We promised we weren’t going to raise the target federal funds rate and federal funds futures freaked fiercely. It is clear that lots of investors are just waiting for us to turn back into normal central bankers all of a sudden.
Sooner or later, we will have to raise the federal funds rate. There is a risk that investors will assume that we are going to turn into Trichet. This would be very bad. So we have to start now saying it won’t be a huge deal when we raise the target a bit.
I think she is saying we aren’t going to do anything dramatic and scary. Don’t be scared by anything we do. Don’t panic.
It seems to me to be optimal control to say that. The instrument I am discussing is the speech *not* the federal funds rate.
Second there is the goal of also proving that she is not a raging reincarnation of Rudolf Havenstein. Repeated statements that even discussing raising rates is insane are accurate, but would infuriate powerful people. It is useful for Yellen to Clinton and say “I feel your desire to inflict pain.”
Third I don’t see why a the rate increase is large when, finally, an increase is optimal. At all.
Consider a pretend forecast. In the next few months, unemployment falls to to 5% and stays there. I sat keep rates as low as possible. Core inflation creeps up 0.1%/yr each month (with no wiggles cause I am making this up). everything else grows at a normal rate. Some FOMC meeting should raise the target rate certaainly before inflation hits 100% per year.
Say the month of Austember is the one when it should raise the rate, In constrast during Stimember (the month before austember) the target FF rate should be 0-0.25% . There must be two such months if 100% inflation is not optimal. From Stimember to Austember the only change is an 0.1% increase in the core inflation rate. This can have only a small effect on the marginal cost of inflation (which I consider trivial at 4% inflation) and also only a small effect on the expected present discounted cost of the future ZLB (being the value of the option to set interest rates below zero which we wish we had).
All has changed little so the optimal federal funds rate can’t be high — the costs and benefits of raising it to 0.5% have changed a little (just enough so the benefits are greater than the costs). How can it be sensible to raise it to 1% ?
update: Brad explains what he meant (I was tempted to leave out the words, because the figure is enough for me, but I’m not sure I know what is clear ( see the comment including “gibberish” below))
Robert – Core CPI (the measure that the Fed tracks) was up at an annual rate of 3.6% in April. That’s nearly double the Fed’s target of 2%.
You talk about waiting till the core rate gets to 100%?? Please…..
“Brad DeLong argues that raising rates “sometime this year” would be crazy. The justification is that unemployment will be low and inflation will not be far below target. This would imply no normal reason to raise rates. Brad’s main point is that the speech includes no consideration of the risk of hitting the zero lower bound due to a shock after raising rates. “
I believe that the risk mentioned is real but these low interest rates are adversely affecting ‘savers’, encouraging speculation, and encouraging consumers to maintain high debt levels.
The unemployment rate is decreasing and is approaching what has been considered normal. But the labor participation rate is also decreasing and is currently at about 1978 levels. This would seem to make “hitting the zero lower bound due to a shock after raising rates“ even more likely.
But the lower unemployment rate has also been the result of creating poorly paid service jobs. Real wages have been stagnant for the most part, and consumer debt is very very high.
This is not a normal consumer based economy and we need to return to one.
Or we can hover where we are for another decade or two. Japan has been depending on stimulative monetary policy for about 24 years.
Discouraging speculation, rewarding ‘savers’, and discouraging new consumer debt, would all be improvements in the long run. Debtors and their creditors will have to take their lumps. They have spent their future.
Monetary policy has its limits. The Fed needs some help.
@BKrasting. First the 100% was meant to be an absurdly high number. I was talking about it, but just to say it is obviously unacceptable. I guess I should have types 1,000,000% but then you might be alarmed that I was talking about million percent inflation.
I can’t find the April PCE deflator excluding food and energy (google sends me to the March index again and again). Core PCE deflator increased from February to March at an annualized rate of 1.77% < 2%.
I note that the Fed does not focus on core CPI. Your assertion is simply incorrect. The PCE deflator is not the CPI. They are different indices both overall and excluding food and energy.
http://www.federalreserve.gov/faqs/economy_14419.htm
"The Fed often emphasizes the price inflation measure for personal consumption expenditures (PCE), produced by the Department of Commerce, largely because the PCE index covers a wide range of household spending. However, the Fed closely tracks other inflation measures as well, including the consumer price indexes and producer price indexes issued by the Department of Labor."
The CPI is there with the PPI in the also tracked (but not often emphasized).
@Bkrasting Also the increase in CPILFESL from March to April 2015 was 0.25582% which annualizes to 3.11 % < 3.6%.
https://research.stlouisfed.org/fred2/graph/?graph_id=239734&updated=5298
My current best explanation for your numerical error is that you justs multiplied by 12 (a reasonable approximation) which give 3.06% then miss typed.
Your comment consists of taking a rhetorical question literally,
incorrectly describing Fed policy, and an incorrect number.
The graph also includes the PCE deflator (the index on which the FOMC concentrates) for which the latest datum is from March and shows annualized monthly inflation of 1.79% and also the annual change in core CPI through April 1.81%. You will note in the official document to which I link above , that the Fed stresses that it smooths monthly series (though not by averaging over 12 months).
I understand what Yellen and Delong said.
What are you trying to say? What you’ve written is mostly gibberish (would definitely benefit from a proof read, but that won’t fix the substance which is ?) and seems like the result of poor reading comprehension on your part.
Dear Miami Vice
I’m sorry you have a very low opinion of my post, but I’m not sure what I can do for you.
On reading comprehension, I found Brad’s post and Yellen’s speech very clear. I was guessing that Yellen really thinks something quite different from what she said.
On proof reading. Uh oh. In fact I don’t know the standard English spelling of many words, so, while I find typos, I don’t find all spelling errors. Stimember and Austember were supposed to be jokes.
I did assume that angrybear readers know who Jean Claude Trichet (former President of the European Central Bank) is and who Rudolf Havenstein (president of the Reichsbank during the German hyperinflation) was, and, also, that Bill Clinton often said “I feel your pain”.
The last 3 paragraphs are stochastic optimal control discussed in English. Many people find the math difficult and following math expressed in English without notation very difficult. It seems very clear to me. Do you disagree with my conclusion ?
I’m sorry about that, but I did warn that my comment was long and boring.
Robert:
We got it.
unemployment is not low