Monetary Policy with Interest On Reserves

Or, Heretics Part II

I just finished a big update of a working paper, "Monetary Policy with Interest on Reserves." It also sheds light on the question, what is the sign of monetary policy? (Previous posts here, here and here).

Again, the big issue is whether the "Fisherian" (Shall we call it "Neo-Fisherian?") possibility works. The Fisher equation says nominal interest rate = real interest rate plus expected inflation. So by raising nominal interest rates, maybe expected inflation rises?

The usual answer is "no, because prices are sticky." So, I worked out a very simple new-Keynesian sticky price model in which prices are set 4 periods in advance.

The top left panel of the graph shows the heretical result. I suppose the Fed raises interest rates by 1 percentage point for two periods, then brings interest rates back down (blue line). Prices are stuck for 4 periods (red line) so don't move. After 4 periods prices fully absorb the repressed inflation -- the Fisher equation works great, only waiting for prices to be able to move.

In the meantime the higher real interest rates (green) induce a little boom in consumption. So, raising rates not only raises inflation, it gives you a little output boost along the way! Raising rates forever does the same thing, but sets off a permanent inflation once price stickiness ends.  

Why do conventional models give a different result?

There are two big reasons.  If the Fed raises interest rates, and this causes a deflation, then the Treasury has to raise taxes to pay bondholders the greater real value of their debt. Most models implicitly pair monetary policy shocks with fiscal policy shocks of this sort. In this model, I kept monetary and fiscal policy shocks separated. In the top left panel, I asked, what if the Treasury doesn't go along -- or can't -- and the stream of real surpluses or deficits does not change when the Fed changes monetary policy?

The top right hand panel shows a pure fiscal policy shock. Here the Fed leaves nominal interest rates alone, but there is a positive fiscal shock, raising the value of future surpluses by 3%. This is a deflationary shock, and as soon as prices can move they jump down 3%. In the meantime, consumption falls. The "austerity" if you will (we should banish this horribly misused word, but only after I use it here for effect) induces a recession and deflation.

The bottom panels show a conventional new-Keyensian style prediction. Here I paired the higher interest rate -- monetary policy of the top left panel -- with a deflationary fiscal shock, as in the top right panel. Now you see the "conventional" pattern emerging. The higher interest rate is associated with higher real interest rates and lower consumption, and lower output (the same thing here). In fact, here there is no long-run inflation effect. This combined monetary - fiscal policy shock is a purely real "cooling off" policy, and its opposite a pure "stimulative policy" with no effect on inflation. That may explain why so many actual policies in the data, which we think of as just "monetary policy" are in fact coordinated monetary - fiscal policies of this sort. The government wants to smooth output without causing inflation, and this coordinated monetary-fiscal policy shock does the trick

The system is linear, so you can eyeball what happens by mixing different amounts of the two shocks. I wanted to produce an interest rate rise that leads to less inflation, and the bottom right picture does it by adding a larger fiscal shock to the monetary shock. This picture accords with the textbook "response to a monetary policy shock" in textbooks. By the "passive fiscal" assumption, the textbook response is paired with contractionary fiscal policy. But you can see, when we break it apart, that it's the fiscal policy doing the deflating, and the monetary policy is actually pushing the opposite way.

While the bottom right response is a sensible thing that a government might want to do to offset an output shock, the bottom right one does not look like a very sensible way to cause more or less inflation. If you want only to cause inflation, the top left looks like a better possibility.

In sum, this graph suggests that monetary policy alone could well be "neo-Fisherian," that a rise in interest rates, even with sticky prices, might produce larger output, and eventually inflation, not the opposite. It suggests that we think otherwise, because our past interest rate increases have been been coordinated with fiscal tightening. They have done so, because they wanted to affect the economy and not cause inflation. If you want just to cause inflation, maybe do something different.

The paper suggests another reason why we may be in a "Neo-Fisherian" moment, unlike past experience. In the past, to raise interest rates, the Fed had to lower reserves, lower the money supply. This worked through the money multiplier, lower lending, and all that standard story. Now, the Fed will raise interest rates by simply raising the interest on reserves, without "rationing liquidity" at all. An interest rate rise with no change in money supply, with no rationing of liquidity, with no impact on reserve requirements, etc. may have much  more "frictionless" effects than past interest rate rises that went with all this money-rationing.

Before my favorite blog antagonists go all nuts about this and campaign for a quick public stake-burning of heretics, let me clarify that I think this is a fun idea to investigate, but not nearly ready for policy. I spend so much time bemoaning my colleagues' well intentioned but hubritic tendency to fly to Washington and advocate for a trillion dollars to be spent on the latest clever idea they worked out on the plane, that I want to keep some scientific reserve on how quickly this idea translates to opeds and policy advice.

But it is an interesting idea to think about. Needed: more realistic models, better understanding of the fiscal coordination and communication mechanism (the paper suggests that inflation targeting is a fiscal communication device, a constraint on the Treasury, not the central bank), and a follow-up on this idea that perhaps interest rate rises that do not ration liquidity are more neo-Fishererian.

Update: Josh Hendrickson, the Everyday Economist, has a nice post on this issue.  He points out, essentially, that all models have an equilibrium at nominal interest = real interest + expected inflation. The key is stability: If you peg nominal interest, do small deviations lead to explosions, or does the system converge? In old Keynesian models, with backward looking expectations, they explode. In new Keynesian models, however, if you peg interest rates (no Taylor rule), the system is stable. There may be too may equilibria, but pegging the nominal rate, inflation converges to the Fisher value. 

Heretics

Low inflation is back in the news.  The Wall Street Journal covers the latest decline in European inflation. Peter Schiff has a nice article explaining that inflation is not such a great thing, unless of course you're a government that wants to pay back debt with cheap money. I dipped into this heresy in an earlier post, explaining that maybe zero rates and slight deflation just represent the arrival of Milton Friedman's optimal quantity of money.

But this news also brings to mind some thoughts on the second heresy -- maybe we have the sign wrong, and we're getting low inflation or deflation because interest rates are pegged at zero, and maybe the way to raise inflation (if you want to) is for the Fed to raise interest rates, and leave them there. (Earlier posts on this question  here and here)

Back in 2010, Narayana Kocherlakota explained the basic idea

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

To sum up, over the long run, a low fed funds rate must lead to consistent, but low, levels of deflation.”

It's really simple. One of the most fundamental relations in economics is the Fisher equation, nominal interest rate = real interest rate plus expected inflation. Real interest rates can be affected by monetary policy in the short run. But not forever. So if the Fed raises the nominal interest rate and leaves it there, expected inflation should eventually rise to meed that nominal rate.


In conventional thinking, no. There is an instability in the system in conventional thinking, so that raising the nominal rate raises the real rate, sends output down and inflation declining. While the equation is a "steady state" it's an "unstable" one.  So, interest rates have to be like a sheep dog corralling sheep -- go way off to the right to move them left, then go way off to the left to move them right, and so on.

Well, maybe not. Maybe it's more like "Babe" and just calmly heading for the pen will work.

Stephanie Schmitt-Grohé and Martín Uribe's  The Making Of A Great Contraction With A Liquidity Trap and A Jobless Recovery is a new paper investigating to this point. They study a pretty complicated model, with employment dynamics, sticky wages, and long-run expectations. But the bottom line is interesting.

The paper... shows that raising the nominal interest rate to its intended target for an extended period of time, rather than exacerbating the recession as conventional wisdom would have it, can boost inflationary expectations and thereby foster employment

Here is the central figure making the point. The solid lines are the model's dynamics replicating where we are now. The dashed line shows what they think would happen if the Fed were to peg the interest rate at 6% and leave it there.

Source: Stephanie Schmitt-Grohé and Martín Uribe

In the model (as I understand it, which is not well) the basic problem is that long-run inflation expectations can get stuck too low, or revert back to a higher level. By pegging the interest rate at a higher level and just leaving it there, the Fed communicates that expected inflation had better rise in the Fisher equation. 

This may be a case of the difference of new vs. old Keynesian models. The unstable intuition is how Friedman's 1968 address and old style Keynesian models work, because expectations are backward looking. In new Keyensian models, if the Fed can change expected inflation -- by, in this case, a rock-solid peg -- then interest rates can rise quickly and actual inflation will adjust to expected inflation. 

(If commenters understand the story behind Stephanie and Martín's graph and equations better than that, post away!) 

Chicken and Egg Inequality

The FT's Martin Wolf weighs in on "Why inequality is such a drag on economies"

This is the question that was bugging me last week. Why is inequality a problem in and of itself, rather representing a symptom of problems that should be fixed for their own sake?

Since last week's review of these ideas was rather scathing, I hoped Wolf would offer some new, and better tested ideas.

Alas, and interestingly, no.

Just why is inequality "a drag?" Why is it that "big divides in wealth and power have hollowed out republics before and could do so again?" - Notice the clear cause and effect here.

Most of the column summarizes facts on inequality, which are not important to the title and the thesis. Here is the "why" part:

A report written by the chief US economist of Standard & Poor’s, and another from Morgan Stanley, agree that inequality is not only rising but having damaging effects on the US economy. 

...These reports bring out two economic consequences of rising inequality: weak demand and lagging progress in raising educational levels.

...The economy will not become buoyant again without a redistribution of income towards spenders or the emergence of another source of demand. 

...The “secular stagnation” in demand, to which Lawrence Summers, the former US Treasury secretary, has referred, is related to shifts in the distribution of income. 

Aha, inequality is a drag because a "report" says so. And the "report" says we have to confiscate the wealth of the rich and give it to the government because the rich, and our economies overall, don't spend enough. (Except, as reviewed last week, when the rich are spending too much.)

I reviewed the S&P report before. The grand total sum of documentation it offered for this proposition was a quote from Robert Reich, opining that the marginal propensity to consume of the poor was greater than that of the rich.  Wolf cites Larry Summers, but if you actually read him, Larry is admirably clear that he has neither model, measurement (of strongly negative "natural rate" of interest), or test; it's an idea resurrected from a 75 year old speech that he thinks might be worth investigation.

The interesting point here is how by issuing a "report," the S&P can turn pure speculation into theory that is apparently completely worked out, empirically tested, and ready for implementation in one of the greatest wealth transfers of all time. And similarly just by quoting Larry's speculations. In other contexts there is a lot of debate about one side or the other "ignoring science." This is not science.

The education angle is new, and I'm looking for new mechanisms. Let's read and see if we find something there.

American education has also deteriorated. It is the only high-income country whose 25-34 year olds are no better educated than its 55-64 year olds. ... It is also because children from poor backgrounds are handicapped in completing college. 

[ statistics on poor not going to college] ... Yet, without a college degree, the chances of upward mobility are now quite limited. As a result, children of prosperous families are likely to stay well-off and children of poor families likely to remain poor. 

This is not just a problem for those whose talents are not fulfilled. The failure to raise educational standards is also likely to impair the economy’s longer-term success. ...Yet a better educated population would also raise everybody to a higher level of prosperity.

The facts are fine, and just what I was writing about last week. You bet "children from poor backgrounds are handicapped in completing college." They go to terrible schools, hijacked by inner city teacher's unions. They come from broken homes, where nobody reads to them at night. They don't see anyone around them who is working at legal jobs. And so on.  This is just the case that Kevin Murphy and others have made about the increasing skill premium.

But that's all inequality as a symptom of other things gone wrong, and those things desperately needing fixing no matter how much the top 1% earn. This article is supposed to be about how inequality is the cause of bad education. That "fixing inequality" will by itself improve "lagging progress in raising educational levels." Leave the schools, the jails, all the social ills in place..if we just tax away the wealth of the rich, and reduce "inequality," the poor will suddenly go to Harvard? 

I expected a lot more clarity on cause and effect.

Now, of course, Wolf's column will be re-cited and re-tweeted, that "Wolf Shows Inequality is  a Drag on The Economy." I regretted a bit last week saying that inequality theories were being made up passed around like internet cat videos. I think now I was being unfair to internet cat videos. 

Envy and excess

In the inequality post, I puzzled over the following conundrum:

Why does it matter at all to a vegetable picker in Fresno, or an unemployed teenager on the south side of Chicago, whether 10 or 100 hedge fund managers in Greenwich have private jets? How do they even know how many hedge fund managers fly private? They have hard lives, and a lot of problems. But just what problem does top 1% inequality really represent to them? 

I emphasized the quantity issue here. His grandfather in the 1930s watched movies and saw glamorous lifestyles way beyond what he could achieve. Increasing inequality is about larger numbers who live a lavish lifestyle. And the claim is that increasing inequality is changing behavior.

There is a view motivating the left that inequality is just unjust so we - the federal government is always "we" -- have to stop it. If they'd say that, fine, we could have  productive discussion.

But they say, and I was going after in the post, all sorts of other things. That inequality will cause poor people to spend too much, that it will cause them to rise in political rebellion, for example. For that to happen, for the presence of the rich to affect their behavior in any way, they have to know about how the exploding 1/10 of 1% live, and how many of them there are. Which just doesn't make any sense.

Paul Krugman had a few revealing columns over the weekend. (No, not the endlessly repeated Say's Law calumny. I trust you all understand how empty that is.)
In "Our invisible Rich,"

In fact, most Americans have no idea just how unequal our society has become.

The latest piece of evidence to that effect is a survey asking people in various countries how much they thought top executives of major companies make relative to unskilled workers. In the United States the median respondent believed that chief executives make about 30 times as much as their employees, which was roughly true in the 1960s — but since then the gap has soared, so that today chief executives earn something like 300 times as much as ordinary workers....

So how can people be unaware of this development, or at least unaware of its scale? The main answer, I’d suggest, is that the truly rich are so removed from ordinary people’s lives that we never see what they have. We may notice, and feel aggrieved about, college kids driving luxury cars; but we don’t see private equity managers commuting by helicopter to their immense mansions in the Hamptons. The commanding heights of our economy are invisible because they’re lost in the clouds.  

Finally, here is something I can agree with him about. The rich are invisible. The average person has no idea really about the difference between taking a limo or a helicopter to the Hamptons, irksome as that may be to Paul. And less idea of whether there are 10 such people, implying no change in the distribution of income, or 1000, a big increase in the upper tail.

But this seems to play exactly to my point. If most Americans have no idea how the superwealthy live, or how many superwealthy there are, just how can their existence influence the behavior of people who don't know they are even there?

If a tree falls in the woods and nobody hears, did the tree fall? If a hedge fund manager has a $2,000 bottle of wine in his Hampton estate, how do you reach for that better beer you can't afford?

Again (before comments fill up with "heartless shill of the rich" nonsense)  Inequality as a symptom of problems I'm all on board with -- cronyism, connections getting you access to education, to favorable treatment by Federal Regulatory agencies, and so on are problems. That we need to fix rotten education and other problems of the poor I'm on board with.  But the claim is that inequality by itself, even if fairly gained, causes changes in behavior among people who don't even know it's there.

In "Having it and Flaunting it," Going after a very nice David Brooks piece, Krugman went on,

..for many of the rich flaunting is what it’s all about. Living in a 30,000 square foot house isn’t much nicer than living in a 5,000 square foot house;...So it’s largely about display — which Thorstein Veblen could, of course, have told you.

... If you feel that it’s bad for society to have people flaunting their relative wealth, you have in effect accepted the view that great wealth imposes negative externalities on the rest of the population — which is an argument for progressive taxation that goes beyond the maximization of revenue. 

This is all quite revealing. But if the average American doesn't know how the super-rich live -- first column -- it is simply impossible to have "negative externalities" of wealth per se --not, I need to keep reminding you, as a symptom of something else. So the second column flatly contradicts the first.

And, if the "average American" has no idea how the rich live -- first column --  they are surely not "flaunting" or "displaying" their wealth to the average American -- second column. Again, that's a flat out contradiction.

As I surveyed in the inequality post, the other big economic "problem" resulting from inequality is that the rich don't consume enough, so we have secular stagnation. Well, are the rich consuming too much or too little? Let's make up our minds here.

But 2+2 do make 4. "We," you and I, may not "see private equity managers commuting by helicopter to their immense mansions," but Paul sure sees it and knows about it. The super-wealthly aren't causing any "negative externalities" to you and me, and the less fortunate who surround us. But they sure are bugging Paul.

So what I see expressed crystal clear here is an age-old sentiment. The established liberal establishment aristocracy bemoans the garish tastes of the nouveau-riche. Plus ca change.

Except now it's not just, "let's not let them in the country club deah." It's "an argument for progressive taxation that goes beyond the maximization of revenue. " Read that again. It means take it, not to fund programs but simply to lop off their heads because Paul doesn't like their fancy haircuts.

As for Veblen and the theory of conspicuous consumption, if you haven't read H.L. Mencken's review, stop everything and do so now. (Google found me this one, there may be better) It ends,

But why don’t we keep flocks? Why do we renounce cows and hire Jugo-Slavs? Because “to the average popular apprehension a herd of cattle so pointedly suggests thrift and usefulness that their presence . . . would be intolerably cheap”. Plowing through a bad book from end to end, I could find nothing sillier than this. Here, indeed, the whole “theory of conspicuous waste” was exposed for precisely what it was: one per cent. platitude and ninety-nine per cent. nonsense. Had the genial professor, pondering his great problems, ever taken a walk in the country? And had he, in the course of that walk, ever crossed a pasture inhabited by a cow (Bos taurus)? And had he, making that crossing, ever passed astern of the cow herself? And had he, thus passing astern, ever stepped carelessly, and —

Returns to unwanted education

In my inequality post, I wrote, somewhat speculatively,

The returns to education chosen and worked hard for are not necessarily replicated in education subsidized or forced.

Marginal Revolution points to a nice new paper by Pierre Mouganie making this point. From the abstract:

In 1997, the French government put into effect a law that permanently exempted young French male citizens born after Jan 1, 1979 from mandatory military service while still requiring those born before that cutoff date to serve. ... conscription eligibility induces a significant increase in years of education, which is consistent with conscription avoidance behavior. However, this increased education does not result in either an increase in graduation rates, or in employment and wages. Additional evidence shows conscription has no direct effect on earnings, suggesting that the returns to education induced by this policy was zero.