Monetary Policy in a Liquidity Trap
Robert Waldmann
Matthew Yglesias is puzzled by something Paul Krugman wrote.
I don’t totally understand this argument, however:
It’s also crucial to understand that a half-hearted version of this policy won’t work. If you say, well, 5 percent sounds like a lot, maybe let’s just shoot for 2.5, you wouldn’t reduce real rates enough to get to full employment even if people believed you — and because you wouldn’t hit full employment, you wouldn’t manage to deliver the inflation, so people won’t believe you.
Right now we’re very far from full employment. But we still have a little inflation. And so it seems to me that if real rates go down a bit, we’ll get a bit closer to full employment, and thus a bit more inflation. The result would be a much slower than necessary recovery, but still better than the current path.
I’m not sure my attempted explanation is of any use, but in case it is, it is after the jump.
This was two comments at Yglesias’s blog so it is addressed to him.
Krugman’s argument is that increasing the inflation target from 2 to 2.5% won’t cause any increase in inflation for the foreseeable future and, so, won’t cause any increase in expected inflation and so won’t affect expected real interest rates.
Your counter-argument is that inflation is now positive. it is important to remember is that standard macro models tell us something about the change in inflation not the level of inflation. In these models the level of inflation doesn’t tell us anything. The only points that matter are that the federal funds rate is almost exactly zero and inflation is declining.
Here we have Krugman academic economist (he made this exact proposal discussing Japan in the 90s). That means he is assuming rational expectations. Basically, if the Fed makes a promise it can’t keep, then people don’t believe them.
Your view of monetary policy is different, because you are sure that, even if the Fed couldn’t do anything to produce inflation for the foreseeable future, an increase in the declared inflation target will cause higher expected inflation. I’m not sure that Krugman would have come up with the 2.5% no good conclusion if he started fresh in his current avatar Paul Krugman columnist blogger.
In case anyone is still reading, I will explain the logic of the argument.
1) what the Fed does while we are in a liquidity trap has no effect on anything
(here really what’s true is that a huge intervention has a modest effect. Something involving as many dollars as QE1 (Fed interventions in 2008-9) was inconceivable in the 90s).
2) The Fed can cause higher inflation only when we are out of the trap. In this context “out of the trap” means that a zero federal funds rate implies rising inflation, that is unemployment below the NAIRU.
3) a modest increase in expected inflation will cause a modest decline in unemployment to a level such that the Fed will certainly want negative nominal interest rates even if it had a low inflation target. The assumption is that if unemployment is below the nairu inflation will decline (that’s what the acronym implies and Krugman assumes that there is a non inflation accelerating inflation rate of unemployment).
So actual Fed actions are the same whether the target is 2% or 2.5%. In either case the Fed sets the federal funds rate to zero.
So inflation expectations are the same whether the target is 2% or 2.5% (this argument very much relies on the assumption of rational expectations).
So changing the target from 2% to 2,5% has zero effect.
Krugman makes an implicit assumption that we will never ever get out of the liquidity trap with current policy. He discusses the resulting unemployment rate as if it were constant. In the real world, unemployment will decline, although it might take decades (basically firms will have to start investing again when a lot of their current capital will have depreciated). So Krugman is implicitly assuming that this FOMC can’t make promises which are binding decades from now. In fact, he doesn’t believe that promises made now will bind tomorrow (the assumption that outcomes are subgame perfect Nash equilibria).
In the academic economics literature “it is possible if the Fed can make a binding commitment to do something in the future which it won’t want to do when the time comes” is just like “it is possible if pigs can fly.” This isn’t because any of us believe in rational expectations (one guy once claimed to but I think he was joking). It is because … oh it’s just a rule of the game. Krugman has stopped playing the game, but he remains loyal to this specific conclusion.
There is huge difference between expectations mattering and those expectations needing to be rational expectations. Inflation expectations matter.
Isn’t all predicated upon the Phillips Curve? Sure it is, so there you go. In a gobalized capital and labor economy the Phillips Curve has no efficacy for individual national economies. We will get their inflation of prices in fits and starts as the Fed prints and prints and prints again. If we are lucky UE will decline to near 5%, we will have a 20% poverty rate and the top decile will hold 90% of all assets. DOW 36,000 and tribes of homeless wandering the land was my prediction in 03 and I am sticking with it.
Isn’t all predicated upon the Phillips Curve? Sure it is, so there you go. In a gobalized capital and labor economy the Phillips Curve has no efficacy for individual national economies. We will get their inflation of prices in fits and starts as the Fed prints and prints and prints again. If we are lucky UE will decline to near 5%, we will have a 20% poverty rate and the top decile will hold 90% of all assets. DOW 36,000 and tribes of homeless wandering the land was my prediction in 03 and I am sticking with it.
Isn’t all predicated upon the Phillips Curve? Sure it is, so there you go. In a gobalized capital and labor economy the Phillips Curve has no efficacy for individual national economies. We will get their inflation of prices in fits and starts as the Fed prints and prints and prints again. If we are lucky UE will decline to near 5%, we will have a 20% poverty rate and the top decile will hold 90% of all assets. DOW 36,000 and tribes of homeless wandering the land was my prediction in 03 and I am sticking with it.
Much of believability is force of character. Now neither Obama nor Bernanke is believable.
The expectation is that people are tapped, and despite easy monetary policy people cannot borrow, spend, thus push prices up. Why is he suprised there are low expectations.
On the other hand, devaluing our currency through low rates and lots of debt may push up commodity prices, and we get the wrong kind of inflation. This is the scenario I see happening, but will take 5 years to develop. It may help exports, but this will be offset with lower wages resulting from hard asset inflation.
I am currently reading “When Money Dies”, and it is a good perspective on the role of expectations play in terms of inflation both domestic and global. War reperations owed by Germany, combined with high unemployment caused the printing presses to run overtime. Meanwhile foreigners dumped the German currency, becuase their expectation was that it would be worthless and they could not pay their debts.
Book link – Kindle version availble:
http://www.amazon.com/When-Money-Dies-Devaluation-Hyperinflation/dp/1586489941/ref=sr_1_1?ie=UTF8&qid=1288727297&sr=8-1
Disclaimer: IMO, the Fed should target 4% or 5% inflation, and probably should have done so for many years. However, Krugman has posted in response to Yglesias, to clarify his (Krugman’s) thinking.
Krugman: “If the public believed we would have 2 percent inflation, according to the first figure this would lead to 6 percent unemployment. But according to the second figure, 6 percent unemployment would lead to only 1 percent inflation. So a Fed commitment to achieve 2 percent inflation wouldn’t be credible — because even if believed, it wouldn’t deliver. And so the whole edifice would collapse.”
Even assuming that Krugman’s argument were rational — It is not, See The Unexpected Hanging — it shows a disconnect with the real world. Economists may follow such a train of thought, but the people whose expectations matter, the public, would not. Not that people do not think that their beliefs matter, they do. But they have more faith than economists.
Suppose that the Fed targeted 2% inflation, the public expected 2% inflation, and, lo and behold, we got 6% unemployment and 1% inflation. Would people stop believing? (Probably not.) More importantly, what would the Fed do? Would it say, well, we have done what we could, so sorry? Or would it take further action? It would pretty well have to do so, to maintain credibility, wouldn’t it?
Now, I do not know what assumptions are behind the curves Krugman draws, but I seriously doubt if they would hold in the above scenario.
Disclaimer #2: I seriously doubt that anything the Fed does by itself will get us to full employment in a timely fashion. Even if it said it was targeting 4% inflation, I would not believe it. (Either that they were serious, or that they were able to deliver.) Would you?
I have read a St Louis Fed report: http://research.stlouisfed.org/fred2/series/MULT that suggests that the fed is now pushing up hill with injecting money into the economy. It looks like starting in 2008 one dollar created creates only $.95 of M1 with the rest of the money coming from the fed to the fed. This reinforces my conclusion that everyone has decided that debt is bad and that the old meme about being able to borrow whenever you need to is discredited.
My suspicion is that the large corporate cash positions reported are safety measures so that they can go a long time before having to borrow. It may be a start of moving back to a less leveraged economy, and we pay for borrowing from the future over the next several years. Essentially the 2000-2008 where borrowing demand from the future. (Thats what leveraged buying is)
OT: It’s election night and none of the main posters can put up an open thread. What’s up with that?
Krugman meant that the cows were milling about in the center of th pasture, too far to smell the truck load of hay parked just outside the fence. They can’t find their way over for dinner, so we need at least twice the hay pile to get their attention but only half that to feed them.