Luck draw­ing con­clu­sions about mon­e­tary pol­icy

The Pak Banker - - OPINION - Noah Smith

WITH the U.S. econ­omy mostly re­cov­ered from the Great Re­ces­sion, ar­gu­ments about mon­e­tary pol­icy have died down a bit. But the lessons of the slow re­cov­ery are still per­co­lat­ing through the eco­nom­ics pro­fes­sion. The years 2008 through 2014 saw some mon­e­tary ex­per­i­ments that were un­prece­dented in the U.S. -- a long pe­riod of zero in­ter­est rates, sev­eral ver­sions of quan­ti­ta­tive eas­ing, new types of for­ward guid­ance and the pay­ment of in­ter­est on ex­cess re­serves. Al­though th­ese ex­per­i­ments give us a lot of new in­for­ma­tion, the lessons are not clear, and con­tinue to pro­voke spir­ited de­bate.

One of the most in­ter­est­ing de­baters is Narayana Kocher­lakota, for­mer pres­i­dent of the Fed­eral Re­serve Bank of Min­neapo­lis. Kocher­lakota be­came fa­mous for switch­ing his out­look on macroe­co­nomic pol­icy -- once among the most hawk­ish of the in­fla­tion hawks, he now wants to use easy mon­e­tary pol­icy to boost em­ploy­ment. Kocher­lakota has re­cently be­gun to make his thoughts known on Twit­ter, and has started blog­ging as well.

Kocher­lakota's main ar­gu­ment is that Fed pol­icy with rates at 0.50 per­cent is too tight right now. Not only does he fear that this is keep­ing peo­ple out of work, but he also wor­ries that the Fed is sac­ri­fic­ing its cred­i­bil­ity. Al­though the of­fi­cial tar­get for in­fla­tion is 2 per­cent, it is rais­ing in­ter­est rates even though in­fla­tion ex­pec­ta­tions are well below the tar­get. That could con- vince the pub­lic that the Fed is be­ing disin­gen­u­ous about its in­fla­tion tar­get -- that it re­gards 2 per­cent as a ceil­ing on the ac­cept­able rate of in­fla­tion, rather than the tar­get to aim for. Cred­i­bil­ity is very im­por­tant for the Fed; if the pub­lic stops be­liev­ing that the Fed means what it says, then fu­ture ef­forts to com­bat de­fla­tion, or even in­fla­tion, might be much harder.

That should be fairly un­con­tro­ver­sial. Even if you be­lieve -- as a few macroe­conomists still do -- that the Fed can't re­ally af­fect un­em­ploy­ment, you prob­a­bly still want the Fed to be trans­par­ent and main­tain its cred­i­bil­ity as a sta­bi­lizer of prices. How­ever, Kocher­lakota's case rests on a big hid­den as­sump­tion -- mon­e­tary pol­icy has to work the way main­stream macroe­conomists think it does. Most macroe­conomists think that low­er­ing in­ter­est rates -- or promis­ing to keep them lower for longer -- raises the rate of in­fla­tion. Ev­ery­one from Mil­ton Fried­man to the New Key­ne­sians be­lieves in this ba­sic idea. But re­cently, the no­tion has come un­der fire from a group of econ­o­mists called Neo-Fish­e­ri­ans (a term I ac­tu­ally coined, but which they have now adopted), who say that low in­ter­est rates ac­tu­ally cause low in­fla­tion, at least in the long run.

Steve Wil­liamson, one of the orig­i­nal Neo-Fish­e­ri­ans, uses this idea to crit­i­cize Kocher­lakota. If we re­ally want to hit a 2 per­cent in­fla­tion tar­get, Wil­liamson and his fel­low-trav­el­ers say, we shouldn't cut the nom­i­nal in­ter­est rate -- we should raise it to 2 per­cent and keep it there. Al­though Kocher­lakota him­self was one of the first to sug­gest the Neo-Fish­e­rian idea, back in 2010, he now dis- avows it, and he and Wil­liamson have en­gaged in vig­or­ous de­bate.

Ac­tu­ally, this de­bate is in­ter­est­ing, be­cause the two sides should re­ally be agree­ing on pol­icy. Neo-Fish­e­ri­ans like Wil­liamson are gen­er­ally in­fla­tion hawks, and would prob­a­bly not mind if in­fla­tion stayed around 1 per­cent for­ever, or even lower -- and they be­lieve that keep­ing in­ter­est rates low will ac­com­plish this. Mon­e­tarists like Kocher­lakota would rather try to boost em­ploy­ment, and keep in­fla­tion around 2 per­cent -- and they be­lieve that keep­ing in­ter­est rates low will ac­com­plish this! So al­though they dis­agree over the­ory, they should agree on keep­ing rates low.

The more im­por­tant point, though, is that no one re­ally knows what is go­ing on with mon­e­tary pol­icy right now. No one knows what the Fed is re­ally try­ing to ac­com­plish, or what it can ac­com­plish, or how to go about ac­com­plish­ing it. Is it still set on rais­ing in­ter­est rates in or­der to avoid the sem­blance of ab­nor­mal­ity from keep­ing them close to zero? Is it wor­ried about de­mand- side shocks from China's slow­down? Does it want the pub­lic to think that it will never let in­fla­tion go above 2 per­cent, or does it want us to think that 2 per­cent is in the middle of the ac­cept­able range? Is it try­ing to raise in­fla­tion and fail­ing?

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