Sunday, August 22, 2010

PK Froths

Here's PK's morning blog entry. The second paragraph is:
Yet from late 2009 until just the other day, all the Very Serious People were mainly concerned about the possibility of surging interest rates. Why?
Who are all these "Very Serious People?" It's not clear. There is a link to an article in Forbes, then he picks on Kocherlakota. Apparently PK doesn't like this part of Narayana's speech. :
To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation. The good news is that it is certainly possible to eliminate this eventuality through smart policy choices. Right now, the real safe return on short-term investments is negative because of various headwinds in the real economy. Again, using our simple arithmetic, this negative real return combined with the near-zero fed funds rate means that inflation must be positive. Eventually, the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level. The FOMC has to be ready to increase its target rate soon thereafter.

That sounds easy—but it’s not. When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation.

While this scenario is conceivable, I consider it to be a highly unlikely one. The FOMC and the Board of Governors have displayed exactly the required unconventionality in solving many seemingly intractable problems over the past three years. I am confident that the Federal Reserve will display that same attribute if this deflationary challenge should ever arise. I am sure too that households and financial markets will share my confidence—which would actually eliminate the need for the Fed to ever confront hardened deflationary expectations.
Now, this seems quite unobjectionable. The reasoning is good, and Narayana is doing the best he can to articulate this so that a lay audience can understand it - though they probably still had some trouble with it I'm sure.

Then Krugman finishes with this:
And though the story shifts, the moral is always the same: the little people have to suffer.
Of course this is just the standard Krugman narrative. (i) Set up a straw man. (ii) Beat him to death. (iii) Characterize the fight as the morally-upright PK battling the Very Serious People for the cause of the poor little people.

What we need here is something more constructive. Try to get beyond these vague calls for more Econ-101-type Keynesian intervention. Help us figure out what exactly (if anything) is ailing the economy. Show us how policy can solve the problem. Be specific. Address all the risks involved. Be more subtle.


  1. Andy Harless also has some harsh words for Kocherlakota:

  2. Yes, that's a bizarre piece (I mean Harless's) isn't it?

  3. Harless's piece was an interesting read, but after going through it twice, I think he's got a good point.

    Nick Rowe also takes Kocherlakota to task

    Nick particularly objects to Kocherlakota's claim that "To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation."

    I believe this was the claim that PK was objecting to.

    Do you agree with Kocherlakota's assertion that a low fed fund rate must lead to deflation?

  4. Of course. It's nothing more than Irving Fisher at work. The Fisher relation holds in the long run, so if the central bank pegs the nominal interest rate at a sufficiently low rate forever, this must imply deflation. For example, suppose a cash-in-advance model with a rep. consumer, period utility u(c), discount factor b, constant aggregate endowment y. c is consumption. Then the real interest rate is constant at 1/b -1. Have the money stock grow at a constant rate m. Then the nominal interest rate is (1+m)/b - 1, and the inflation rate is m. Now make m sufficiently small. Q.E.D.

  5. Thanks for the reply, and the new post!

  6. Thanks for the post. What do you think of Scott Sumner's ideas on this subject?


  7. You need a dynamic model, not a static one. It's true that if interest rates are low, and inflation is constant, then inflation must be low. But why are you assuming that inflation must be constant?

    If inflation need not be constant, and the fed sets a nominal interest rate so the real rate is below the natural rate, then inflation will accelerate upwards. There won't be a steady state for you to solve for.

    Someone analogized this to balancing a pole on one end. If you hold the bottom (the fed funds rate) at x=1, AND THE POLE DOESN'T FALL OVER, then the top (the inflation rate) must be at x=1. But if the top starts at x=1, and you insist on holding your hand at x=2, the top will accelerate to the left, not magically shift over to x=2. To increase the inflation rate and the fed funds rate in the long term, you must start by shifting the fed funds rate _down_.

  8. 1. I'm always thinking dynamically. Constant inflation is just an example for the sake of argument.
    2. "If inflation need not be constant, and the fed sets a nominal interest rate so the real rate is below the natural rate, then inflation will accelerate upwards. There won't be a steady state for you to solve for." This sounds like Wicksell, which never made any sense to me. You have to write down a serious model to explain that one.
    3. The stuff about the pole is from Nick Rowe, right? Again, write down the model; the analogy doesn't help me.

  9. 1. Your argument is about the path of inflation in the future, so the value of dInflation/dt belongs in the conclusion of your argument, not in its assumptions.
    2. I believe it does come from Wicksell. I think it'll also come out of any model in which monetary policy has real effects. In the simple model you've given, the real interest rate is fixed, so I don't see how monetary policy affects the real economy. You don't like sticky prices, so my usual explanation of how that happens won't convince you. What model do you usually use to explain how the Fed affects the real economy?
    3. It must be. I didn't remember where I'd seen it.