## Friday, October 5, 2012

### How Central Bankers Think

When I read Charles Evans's most recent speech, I was struck by these two sentences:
Whenever the economy operates below its potential, the key mechanism that returns the economy back to potential is a fall in real interest rates. This decline reduces the supply of saving and boosts the demand for investment, resulting in increased spending.
Ben Bernanke tells us about how the Fed can speed the adjustment to "potential:"
Generally, if economic weakness is the primary concern, the Fed acts to reduce interest rates, which supports the economy by inducing businesses to invest more in new capital goods and by leading households to spend more on houses, autos, and other goods and services. Likewise, if the economy is overheating, the Fed can raise interest rates to help cool total demand and constrain inflationary pressures.
Those two quotes encapsulate the dominant school of central banking thought on the FOMC. We could even write this down formally - it's simple. Here are three equations that describe the economy and what monetary policy does, according to Evans, Bernanke, Kocherlakota, and I think Rosengren and Yellen, at least:

(1) r = R - i
(2) u = f(r-r*)
(3) I = i + g(r-r*)

In equations (1)-(3),

r = real interest rate
R = nominal interest rate
i = anticipated inflation rate
u = unemployment rate
r* = efficient real interest rate
I = actual inflation rate
f(.) is an increasing function
g(.) is a decreasing function

In this model, R is set by the Fed, i is exogenous, and r* is exogenous. Equation (1) is a Fisher relation. The real rate is the nominal rate minus the anticipated inflation rate. When the Fed says that "inflation expectations are well-anchored," what they mean is that i is independent of how the Fed sets R (as the Fed can always say reassuring things about how it is committed to price stability, apparently). Thus, when the Fed moves the nominal rate R, the Fed thinks it moves the real rate in lockstep.

The economically efficient real interest rate r* is what Woodford would call the "Wicksellian natural rate." In Woodford's world, this would be the equilibrium real interest rate if all wages and prices were flexible. This may or not be what Bernanke has in mind - he tends to leave unspecified the sources of the inefficiencies he is trying to correct. Equation (2) states that the unemployment rate rises if there is an increase in the difference between the actual real interest rate and the efficient real interest rate. But how do we know what r* is? From Charles Evans's point of view, that's easy. If Fed policy stayed unchanged (so that r is unchanged), and the unemployment rate went up, r* must have gone down.

Equation (3) states that the the current inflation rate is the anticipated rate of inflation, plus a term that depends negatively on the difference between the actual real rate and the efficient real rate. Therefore, if the real rate is above the efficient rate, the inflation rate will be low. Implicit in equations (2) and (3) is the Phillips curve - a central part of FOMC religion. FOMC statements and public discussion by Fed officials are replete with Phillips curve language. Note that changes in R which translate into changes in the same direction in r will move u and I in opposite directions - a movement along the Phillips curve.

Some readers will recognize the similarity between equations (1)-(3) and the three equations that some New Keynesian researchers work with. Typically the three New Keynesian equations are: (i) IS curve; (ii) Taylor rule; and (iii) Phillips curve. What I wrote down above is roughly the same idea, and that's no accident. What Woodford and his disciples did was to essentially reverse-engineer actual Fed policymaking. That's why central bankers are infatuated with New Keynesian economics - it rationalizes what they do.

Here is how the FOMC sees its current predicament. r* is really low, making u really high. The optimal thing to do would be to lower R to reduce r and reduce u. But R = 0 and can't go lower. Solution: There are long-term Rs that we can go after, which are currently above zero. Let's buy long-maturity assets and lower long-term Rs instead. You can read about that in Bernanke's speech.

But what's wrong with this approach? These ideas may be easy for Fed officials to explain to the Rotary club, but if you recite the ideas enough you start to believe them. How can anyone think that our current problem is that efficient real interest rates fall far below actual real interest rates? A short rate of -2% is too high? Why? TIPS yields of -1.65% (5 year) or 0.37% (30 year) are too high? Again, why? No one thinks that monetary policy has any long run consequences. Over what horizon do FOMC members think that they can essentially peg a real interest rate? Didn't exploitation of a perceived Phillips curve tradeoff get us in trouble in the past? Aren't we worried about that? Why did Phillips-curve "theory" become the dominant theory of inflation among policymakers? Why did monetary theory disappear? We know there are problems with the targeting of monetary aggregates, but surely most of us think that exchange in some class of assets is what drives long-run inflation. Where's the money?

1. Nick Rowe would agree that central bankers should talk less about interest rates. They should talk NGDPLPT instead!

2. I know what NGDP is. What's LPT?

1. This comment has been removed by the author.

2. Path, price, whatever. Need coffee.

Regarding this: "Didn't exploitation of a perceived Phillips curve tradeoff get us in trouble in the past?"

At some point one needs to go beyond this kind of argument. Weimar inflation! Chamberlain at Munich! Alger Hiss! The past offers lots of mistakes one can wave at. Failure to deal with mass unemployment also got us into trouble in the past, much worse trouble than a few years of double-digit inflation. Maybe you have a case but that paragraph with '?' at the end of nearly every sentence doesn't make it.

3. That's exactly the problem. You're falling into the same trap. We understand the Phillips curve problem very well by now. The central bank is tempted to think it can get some mileage in reducing the unemployment rate, but the results are at best temporary, and then you're left with an inflation rate that is persistently high, and it's costly to bring it down. Simple.

3. LPT: level path targetting. (Typed "path" above, hence deletion.) Think Nick Rowe created that abbreviation:

1. I'm OK with some of that. Forget the NGDP part though. See this:

4. "How can anyone think that our current problem is that efficient real interest rates fall far below actual real interest rates?"

Could it be that the real concern of policy makers is lowering government borrowing costs, not getting to an efficient real rate?

1. Could be. That's not what they're saying of course. Two questions: (i) Is it even possible to do this temporarily? (ii) Permanently?

2. As you suggest below, a shortage of safe assets can lower the real rate. By buying up what are considered the safest assets in the world, the Fed can temporarily cut government borrowing costs.

They can't do it permanently because 1. alternative safe assets will emerge and 2. investors will eventually question the safety of U.S. Treasury securities.

5. It seems obvious to you that the "efficient real rate" cannot be sharply lower than the current rate.

Do you have any actual reasons to offer for your view, beyond armchair incredulity? Because we surely need some explanation for real GDP staying so far below long-term trend.

1. I see no reason why anything that happened post-2007 should have changed the efficient real rate. If anything, there are good reasons to think that the real rate is currently too low because of worldwide shortage of safe assets.

2. It seems to me that the shortage of safe assets (or rather, assets believed to be safe) lowers the efficient real rate. When people thought they could invest safely in mortgages, they were willing to finance capital (housing) and consumption (mortgage equity withdrawal) via assets they thought were safe. Now people who want safe assets can no longer use their ostensibly safe investments to finance capital and consumption, so in order to get the efficient amount of capital and consumption (i.e., enough to utilize available resources), the safe interest rate has to go lower, so that people (assuming a downward-sloping demand curve) will stop buying so many safe assets and instead consume more or invest more in risky assets.

3. You can think of the efficient real rate as being determined by preferences and technology. None of that has changed. The shortage of safe assets lowers the actual real rate, but I don't see how it changes what is efficient. Presumably the shortage is temporary. I think if the government temporarily runs a larger deficit, and floats more debt, that you relieve the problem. You can't fix it with monetary policy. Of course you want to withdraw the debt when the problem goes away - too much to ask of the U.S. government I think.

4. Arguably preferences and technology have changed. People who used to prefer to buy various mortgage derivatives no longer do, and/or the financial technology for converting high-risk assets into low-risk assets has disappeared. Admittedly, those aren't really changes in preferences and technology; they're changes in information. But that's the thing: now that we have better information, we realize that the efficient real interest rate was low even before 2007, but that situation was disguised by the behavior of people who, acting on the basis of bad information, were acting as if either their preferences or the available technology were different than was actually the case. People were deceived into behaving in ways that didn't maximize their utility. Under such circumstances, there is a first-best real interest rate, which was then as low as it is now, but there was also a second-best, conditioning on people's suboptimal behavior, which was higher than it is now.

5. In economics, I think we typically think of "explanations" that rely on changes in preferences as non-explanations. Why did that happen? We just liked it that way.

6. What if no one with common sense will borrow at any rate of interest?

7. What if all potential borrowers are irrational and will not borrow at any rate of interest?

In sum, the model is obviously intellectually blind.

1. What if a moron posted and no one responded? Oh wait, that just happened twice. John D, get back to your mom's basement, your tinfoil hat and imaginary puppet friends are lonely.

8. Thanks for an excellent summery of current New Keynesian orthodoxy.

I think you implicitly mischaracterize the view of some of the academic New Keynesians, such as Woodford, though. He, rightly in my view, thinks that Wallace neutrality kills the effects of QE2, twisting and QE3. Woodford’s idea, if I understand him correctly, is that since the Fed, due to the lower bound on the short term nominal interest rates, cannot force the short term real interest rate down to the assumed depressed short term Wicksellian rate, the Fed should promise not to oblige by the Taylor rule in the future as it normally would have done when the recovery pushes up the Wicksellian rate. Assuming that the Fed controls expected inflation, such a pledge not to tighten when the “output gap” shrinks cuts the market’s forecast of future short term real interest rates. This decreases long real interest rates, reduces saving, increases investment and accelerates GDP and employment now.

As I see it there are two problems with this approach – an approach which was reflected in the Fed’s September 13 statement.

Firstly: If the second leg of your third New Keynesian equation is correct, that is, if actual inflation, for a given short term real interest rate, is an increasing function of the Wicksellian rate, then the Fed cannot, as assumed by the New Keynesian interpretation of your first equation, both control long term inflation expectations and commit itself not to apply the Taylor rule. With a self-imposed low upper bound on the policy rate, markets, assuming that they too think that the economy is New Keynesian, will lift inflation expectations in anticipation of a recovery driven rise in the Wicksellian rate. This problem is less relevant, though, if one thinks that Phillips, Samuelson, Solow and their New Keynesian offspring are mistaken in linking disinflation to “output gaps” and reinflation to demand banging its head in “potential GDP”.

Secondly: As you note, central banks cannot control real variables in the long run. And that goes for the real interest rate too. What central banks can control is how much they remunerate bank deposits in the central bank. Assume that the recovery gathers speed and the Wicksellian rises – it takes a higher real interest rate to equilibrate planned demand for goods and services and planned supply of goods and services. What the real economy need it eventually gets. The real rate is pressed up first through lower inflation expectations and then expected deflation. Hence, with the Fed on sedation, the New Keynesian assumed exogenousess of inflation expectations drops out of your first equation and the Fisher effect and the Wicksellian rate determines price level movements. The path Bernanke & Co now has staked out might therefore lead them to Tokyo. And deflation is a problem for central bankers with an inflation target.

To finish off an already too long comment, I’ll just add that, contrary to your claim, I do not think that any of this ignores money. Monetary units are arbitrary denominations of central bank liabilities. Whether central banks adjust the amount of money or meddle with the units comes to the same thing. Paying interest on central bank deposits is like a currency reform played out continuously over time. Instead of deciding today that in one year ahead a current dollar deposited with the Fed will be exchanged for a new dollar at a rate of 1.0025 new dollars for each old dollar, the Fed gives you back 1.0025 old dollars in one year’s time. It is as if OPEC did not determine production quotas but decided on the definition of a barrel of oil. Quoting Keynes, the game changed when the ”state claimed the right not only to enforce the dictionary but also to write the dictionary”.

1. I'm not trying to explain New Keynesian economics, just central bankers. Central bankers sometimes use New Keynesian Economics to justify what they do, but Bernanke is not a Woodford clone.

9. Ah, sorry, forgot to proof read before I published. Blissfully my Norwegian English teacher is no longer among us.

10. Stephen, central bankers have their own minds and chose and pick among diverse academic input. But currently New Keynesianism rules the mindset of mainstream central bankers, who non-cynically, I think, try to do handle current affairs by basing their thinking and decisions on what they consider the best economic research. Hence, trying to explain how leading officials at the Fed and most other central banks speak and act, boils down to explicating New Keynesian teachings. Which I thought was your purpose.

11. I suppose that if you really pressed Bernanke, he might say:

"A 0.37% 30yr real rate is too high for potential home buyers. If we lowered r(30yr) to -2%, this would: resuscitate housing demand; spark a housing investment boom; eliminate financial frictions (low collateral values); and clear the labor market."

In other words, Fed thinking is really just, "more of what ails you". Again, that's assuming Bernanke has really thought it through beyond some immaculately-conceived simultaneous equilibrium.

12. Corporate managers face a historically low term real risk-free rate and normal risk premia. It is unlikely that the impediment to new investment is a "too high" risk-adjusted r. Similarly, its clear government net spending is not "challenged" by the current r. This leaves households. Perhaps Bernanke would weave some narrative about how households are excessively deferring consumption. Maybe he wants them to borrow to spend at more "normal" levels: to buy a house even, or, more likely, to buy a house especially.

In other words, Fed thinking might be boiled down to, "more of what ails you."

13. Steve, I do have one question: Why do you believe that r*, the efficient real rate of interest, cannot remain negative for long periods of time?

1. Why should it be low? I can think of good reasons why r* is higher than r, but not vice-versa.

2. I guess I don't understand what really governs r*. A consumption Euler equation?

One reason modern macro models annoy me so much is that I don't feel like they give me much intuition for thinking about questions like this. But maybe that is as much my fault.

BTW are you going to be at the St. Louis Fed conference next weekend? I'm going!

3. What do we know about r*? If we think like Woodford, we would take the neoclassical growth model (flexible wages and prices) as our benchmark for efficiency, and the steady state with no shocks (around which he is going to linearize) as the baseline case. In that steady state, r* is a constant, determined by the rate of time preference. Then, fluctuations in the benchmark model would be due to whatever stochastic shocks we want to throw into the model - e.g. TFP shocks and preference shocks. There's also some other stuff, such as "markup shocks" that are put in to fit the data in empirical versions of these models. As you say, r* will be determined by a consumption Euler equation. r* will be low if there is a good TFP shock, or a preference shock that lowers the current marginal utility of consumption. Neither of those seem to be where we want to go. The financial crisis looks like neither a positive shock to TFP nor a contagious distaste for consumption. Or maybe r* is low because of contagious patience? I don't think so. Read this post:

http://newmonetarism.blogspot.com/2012/09/eggertssonwoodford-and-forward-guidance.html

And also look at the Eggertsson/Woodford 2003 paper. You'll notice that in the linearization, there is a shock to r* (or whatever they call it). That's important. To make the New Keynesian story make any sense as supporting current monetary policy, that shock has to be in there. But what is it? Beats me.

I'll see you next week at the conference.

14. Greg Mankiw made great use of Laurence Meyer’s recent memoir A Term at the Fed.

The book leaves the reader with one clear impression: Recent developments in business cycle theory, promulgated by both new classicals and new Keynesians, have had close to zero impact on practical policymaking.

Meyer’s analysis of economic fluctuations and monetary policy is intelligent and nuanced, but it shows no traces of modern macroeconomic theory.

It would seem almost completely familiar to someone who was schooled in the neoclassical-Keynesian synthesis that prevailed around 1970 and has ignored the scholarly literature ever since.

1. It's no news to me that Laurence Meyer is out of it. Read this:

http://newmonetarism.blogspot.com/2010/10/why-are-forecasters-grumpy.html

15. Stephen, why are you discounting the idea of a shock to the rate of time-preference? One does not need to interpret it as increased patience. It is also possible that all this talk about the need to "fix" social security and Medicare and reduce reliance on government programs is motivating people to increase saving for retirement. If this is true, shouldn't we expect a permanent decrease of the efficient rate?

1. It's easy to explain anything by a change in preferences. The Great Depression is a contagious attack of laziness, for example. Further, the effect you're mentioning is an optimizing response to a change in government policy, not a change in preferences.

2. Stephen, you are right, I was just trying to fit it in a simple Euler equation. The truth is, there are many reasons why the efficient rate may have gone down. I mentioned one, and Andy Harless mentioned above the adjustment of expectations (for example regarding the evolution of home prices). It may also be that, as Robert Gordon proclaims, the IT revolution has run most of its course and productivity growth is reverting back to its 1970s rate. Maybe its all of the above.

3. "...I was just trying to fit it in a simple Euler equation."

If you're holding the discount factor constant, and there are no preference shocks (which I hope is the case), then if you think the shock (whatever it was) makes consumption temporarily efficiently low, then the efficient real rate is high. A permanent reduction in productivity growth, which reduces the rate of growth in consumption, will indeed reduce the efficient real rate. But it's not going to give you something smaller than -2%. And that's not an argument I hear coming from the people advocating these policies.

4. I see what you are saying. Without a change in preferences or the rate of technological growth a steeper consumption path necessitates a higher real rate of interest.

But my question is, if people think they can rely less on inter-generational transfers and decide to save more, wouldn't that lower the MPK (which is equal to the interest rate in the neoclassical growth model)? Also, there is the question of what caused the increase in consumption as a share of GDP from around 64% before 1983 to around 70%. If this unidentified shock has been reversed, wouldn't again the MPK decline? The basic growth model is not rich enough to capture such changes, so the best I could think of was to represent their impact as an increase in the discount factor. Regardless, is my intuition wrong?

5. In incomplete markets models you get that kind of effect. To self-insure, people accumulate a lot of assets, and that gives a real interest rate that is low, in the sense that it is less than the steady state real rate you get with complete markets. With more uncertainty, I think the real rate goes down. But it's essentially a shortage of safe assets. More government debt makes the real rate go up.

6. Talking about shortage of assets, I finally was able to spend enough time on your paper published in October's AER (congratulations!). The model has plenty of what Sargent would call "beautiful math". But if I understand the math correctly, I have some concerns about its practical relevance.

The shortage of assets (and hence the need for an increase in the real rate) stems from three assumptions: 1) In a liquidity trap the rate of interest is lower than the rate of time preference, so monitored buyers want to increase consumption but they can't because there is not enough medium of exchange. 2)The medium of exchange used by monitored buyers is bonds. These buyers buy consumption goods by exchanging claims on them. 3) Increases in government liabilities result in a proportional increase in the price level.

With respect to 1, I have a hard time accepting that people have been forced to reduce consumption below what they want it to be because they cannot get their hands on bonds. Moreover, why can't monitored buyers use instead some of the excess reserves? With respect to 2, is this really a reasonable representation of how bonds are used in transactions? With respect to 3, why assume that supply is perfectly inelastic? Would the results hold if the government participated as a buyer in one of the markets, and effort responded to government demand (so prices did not rise one to one with an increase in the growth of liabilities)? To me, this seems more reasonable given the current unemployment numbers.

Of course, it may be the case that I have completely misunderstood the model, in which case I apologize in advance.

16. Stephen, if I understood you correctly you think it's unlikely that r* is negative. Do you know of a model that provides an alternative explanation (to Woodford's) for Japan where we have low interest rates and low inflation for a long time? Do you expect the current US policy to be highly inflationary? This will be a test which model is right!

17. Stephen,

Here's a Romer piece that you might enjoy dissecting: http://elsa.berkeley.edu/~cromer/What%27s%20at%20Stake%20Written%20Version.pdf

18. One answer, which you probably will not find satisfactory, is that current output affects households' expectations of permanent income and businesses expectations of the return on capital. In other words, u is a function of r* but r* is also a function of u, so there may not be a unique Wicksellian natural rate but a continuum of them, corresponding to different levels of output.

So r* really is lower currently than in 2007, even though, as you say, there is no evidence for any kind of technological shock that would have reduced it. Low r* is the result of extended low unemployment, which has depressed expectations of future income. If policy is successful in reducing r and u, in this story, r* will rise back to its old level.

Again, I doubt you'll find this an acceptable story. But it does rationalize one part of conventional central bank thinking which is not captured by standard NK models, namely, that temporary changes in policy can have permanent (or at least long-lasting) effects on the output gap, as expressed by phrases like "pump-priming."

1. Sorry, that should be

Low r* is the result of extended high unemployment

19. Now you're thinking about an entirely different story. Modern-day Woodford doesn't think about multiple equilibria, which is what you have in mind. But, if you think the problem is that we are in a bad equilibrium, then you must think that can persist forever. Presumably, the real rate if you are in the bad equilibrium forever is the same as the real rate if you are in the good equilibrium forever, more or less. If you think "pump-priming" is some policy that kicks you into the good equilibrium, and if we all anticipate that policy and its effects, that would call for a high real rate today, and that real rate would be "efficient," in the sense that the policy is optimal.

20. Yes, that is exactly the story I have in mind.

You're right, Woodford is not thinking of multiple equilibria. But he would be better off (IMHO) if he did, since then he would not be left with the mystery of the unexplained fall in r*.