On the one hand: it's very good news that Michael Woodford has endorsed NGDP level path targeting (pdf). (For non-economists, Michael Woodford is the most influential living academic monetary economist; he's the one who wrote the book that defines how graduate students think about monetary policy.)
On the other hand: I'm going to rain on our victory parade. Nothing important has changed.
The fundamental problem is the strategy space. We think of monetary policy as a conditional path for a nominal interest rate. "Setting an interest rate is what central banks really really do". That way of thinking about monetary policy is what creates the problem. That strategy space fails when the nominal interest rate hits the Zero Lower Bound. Michael Woodford's text reinforced that way of thinking about monetary policy. It helped to define that failed strategy space. His Jackson Hole paper re-endorses that failed strategy space.
Imagine an alternate monetary history where central banks had maintained direct convertibility of their monetary liabilities into gold. But not at a fixed price of gold, like under the old Gold Standard. Instead, they adjusted the price of gold at their discretion. Perhaps on a daily basis. In the alternate 1960's and 1970's there was a problem of steadily rising inflation as central banks kept increasing the price of gold in order to try to target full employment. Then an alternate Milton Friedman argued that the long run Phillips Curve was close to vertical, so central banks should not be increasing the price of gold so quickly. Eventually, in the alternate 1990's, central banks adjusted the price of gold to keep inflation on target. (Like Irving Fisher's Compensated Dollar, except with an inflation target rather than a price level target).
We could imagine an alternate Michael Woodford writing a text with the title "Gold and other prices", arguing we did not need to talk about the quantity of money, because what central banks really really did was adjust the price of gold, not the quantity of money.
We could imagine some economists in that alternate monetary history saying it would be better to adjust the price of gold to target the NGDP level path, rather than to target inflation.
But we could not imagine an alternate Michael Woodford advocating an NGDP level path target in order to escape the Zero Lower Bound on nominal interest rates.
If in that alternate history we had thought nominal interest rates were too near zero, and we wanted to loosen monetary policy, and we wanted to cause nominal interest rates to increase above zero, the central bank would just start raising the price of gold. It would be obvious to everyone. Raising the price of gold is how central banks loosen monetary policy
There's nothing special about the price of gold, of course. Except history. But the price of gold does have the right units, because it's got $ in the units. There's no $ sign in the units for an interest rate. And what central banks really really ultimately do is determine the value of that $ unit.
Update: OK, I expect you might say that Michael Woodford is trying to get himself out of the strategy space hole he dug for himself. He recognises that communications policy is important. But he doesn't seem to realise that talking about monetary policy as interest rates is just another communications strategy. It's not what central banks really really do.
Worthwhile Canadian Initiative 
Matt, That’s all fine, but then my response is that there has never, ever, been a single monetarist in all of world history, at least as Woodford defines monetarism. No one believes that temporary swaps of cash for T-securities of any maturity have significant effects. I’ll do a post to more fully explain.
I’ve been reading Woodford’s paper. It’s great, but he attacks a straw man in the Japan section. The debate is not at all as he claims.
JKH,
“when the Fed must pay interest on excess reserves”
In that case this whole conversation is moot. None of monetarist logic works at all unless the non-pecuniary convenience yield on money is offset by the pecuniary cost (FF-IOR) of holding it. How can money be a hot potato if it’s like T-bills and it provides liquidity?
K,
Thanks.
I’m not sure I understand this at all.
When you say “this whole conversation is moot”, do you mean the case where the Fed must pay interest on excess reserves? Because that case is a certainty – if there are excess reserves of any magnitude more than the historic level (less than $ 10 billion) after what Woodford describes as “lift-off”. There’s just no question that that is what has to happen, if excess reserves are meaningful and we have “lift-off”. And the FF –IRR is going to be zero in that environment, or close enough to zero to be irrelevant to anything else that matters. There’s also no question about that. And that means that the idea of a “permanent” increase in the excess reserve component of the base means a permanent commitment to the zero bound, without lift off. In which case, the idea of a “permanent” increase in excess reserves is moot itself, if not meaningless.
Is that what you’re saying?
JKH, remember that older thread at NEP where Fullwiler and Sumner were debating about this (I believe you also chimed in)? If I recall correctly, Sumner refused to accept that “there’s just no question that that is what has to happen.”
wh10
I don’t recall that; but I know which side Fullwiler would take
I’m just trying to understand the motivation behind this idea of a permanent increase in the monetary base and whether it actually depends on the opposite view; maybe that’s what K was saying but I’m not sure; it seems to be very ingrained in the literature from various accounts
It’s also one area of Woodford’s paper where I know I’m not sure what he’s saying also – because in the rest of it he’s quite remarkably close to a post Keynesian view of monetary operations – not all the way there, but fairly so
Scott: “No one believes that temporary swaps of cash for T-securities of any maturity have significant effects.”
“Temporary” meaning “ending before the short rate rise above zero,” right? I understand that you don’t like to talk about rates, but in this case that seems like a concise and accurate way to quantify what you mean?
I think it’s worthwhile considering the monetary mechanics of the moment the short rate leaves the zero bound. Lets assume the Market Monetarists are appointed to run the FOMC and you make some commitment to maintain the balance sheet at some level (presumably significantly reduced from the current level). Perhaps the level is where ever it was at the end of 2008 plus 5% per year until NGDP is on target (much like Milton Friedman would have done, but with the NGDP “target” in place). For the first while there are excess reserves. Since IOR is zero (otherwise this whole conversation is moot), that means that the FF rate must also be zero, or there is no way you can have excess reserves. Eventually, lets assume you reach your NGDP target. At this point the short rate will have to rise, or NGDP will rise above target. Since the short rate cannot rise with excess reserves in the system, you will presumably have guided total reserves down to the level of mandatory reserves at this point.
So what have you done? You have kept the short rate at zero until you reached your NGDP target. After you reach your target, you can no longer control the quantity of reserves since total reserves=mandatory reserves. So afterwards all you’ve got is short rate policy.
Before you exit the ZLB, the path of excess reserves was irrelevant. After exiting the ZLB, the path of excess reserves was flat at zero. Mandatory reserves are always irrelevant since they cannot be used for liquidity. So no relevance of reserves before or after exiting the ZLB.
JKH,
I wrote the above before reading your comment. I assumed that excess reserves would have to be taken to zero at the moment of liftoff. I think that can be done quite easily. As Woodford points out, the BoJ took off massive quantities of QE in a matter of months, so its all highly reversible.
We can run your scenario in which IOR=FF and excess reserves can stay on post liftoff. But then where’s the hot potato if money yields T-bills + liquidity convenience??? So no present hot potato and no future hot potato. Again no relevance for the post liftoff path of quantity.
K,
We may be saying the same thing; I don’t know.
You can’t have excess reserves of any material amount after “lift-off” unless you pay interest on excess reserves. And that for all purposes has to be the target rate for fed funds.
I don’t question the ability to drain excess reserves prior to lift-off, although the Fed certainly isn’t going to do that. They’re going to pay interest and work the reserves off gradually as they increase the funds rate. They’ve signaled that ages ago. The whole idea of “exiting” the excess reserve position is a non-issue as far as I’m concerned. They can lift the funds rate as high as they need to with or without excess reserves.
So I still don’t understand why this idea of a permanent increase in “the base” is relevant. If its permanent after lift-off, you must pay interest on excess reserves. If its permanent without lift-off, who cares, because that means ZIRP is permanent.
Nick, perhaps you understand the question I’m asking?
JKH,
“We may be saying the same thing; I don’t know.”
We are.
“You can’t have excess reserves of any material amount after “lift-off” unless you pay interest on excess reserves.”
Correct.
“So I still don’t understand why this idea of a permanent increase in “the base” is relevant.”
It’s not relevant. As I said, there’s no relevance for the path of the quantity of reserves under all possible scenarios. The quantity of excess reserves either doesn’t matter or it’s zero and it’s the short rate that matters.
We are in 100% complete agreement.
JKH,
Maybe my comments were confusing if you read them with the assumption that IOR=FF. I assumed IOR=0. Otherwise, as I said, the whole thing is moot, which is your point. I don’t see how you can have any kind of monetarism if IOR=FF. Scott has claimed to me that it doesn’t matter. I don’t think I’ve ever heard Nick elaborate a clear position.
K,
Excellent. Thanks.
Nick
But changing expectations about future hot potatoes is supposed to make existing potatoes hotter. The actual future potatoes do not come into picture, expect in a passive demand-determined way – which is then consistent with the actual operations of the monetary system. You can talk about unexpected actual base changes- where the actual quantity is important – or talk about changes in expectations, where the quantity is not important. Unless you have a model/ theory that links the amplitude of the signal with the actual quantity of money, you can’t talk about both at the same time. But your theory is explicitly that the amplitude of the signal is not related to the size of the base.
Nothing is a hot potato if it is anticipated.
Nick
I am being so nitpicky about this because Scott and you always seem to like what the other has to say (he acknowledges hot potatoes and your Chuck Norris is very ratex-y) yet the revealed preferences that you display when actually making your formal arguments is very different. Scott always talks about asset markets,and you always talk about operations of the payment systems. The asset markets view of the world is compatible with the mainstream view of the world, though the explanation is different (expected inflation and income vs wealth effects/ Tobin’s q). The hot potato operations view of the payment systems is not compatible with the mainstream, and not compatible with Chuck Norris/ Scott Sumner/ ratex. The only way I can reconcile them in my mind is through expected inflation/income, or making existing potatoes hotter. Do you agree with this?
K, JKH
It should not all be surprising that Woodford seems to sound almost post-Keynesian, though I would say that someone like Mike Sproul would find more common ground with him than a post-Keynesian.
As Perry Mehrling so wonderfully illustrates, Woodford’s Interest & Prices, like all the great monetary theory texts of their generations, was written in response to the challenge presented by contemporary developments in the macro-economy/ monetary system. In Woodford’s case, the challenge was not simply interest rate rules, but Fischer Black and the challenge of finance. People tend to think that Woodford is simply Taylor++ because he has Keynesian models where fiscal policy works and is somewhat a darling of the saltwater crowd, but he has also written extensively on the fiscal theory of the price level, where Cochrane finds common ground with him. His is a banking school view of the world – he believes in reflux (suitably modified in today’s world as Wallace neutrality), he models systems where bank deposits, reserves andindeed all forms of money pay interest. But while the Post-Keynesian views are closest to someone like Alvin Hansen (banking school ergo monetary authority should be passive and fiscal authority dominant) Woodford’s views are probably closest to someone like Edward Shaw(who was a fiscal conservative), with a bit of Keynes thrown in.
Here’s the source(s) of my views :
Click to access the_money_muddle.pdf
Click to access mr_woodford_and_the_challenge_of_finance–revised.pdf
thanks, Ritwik
he seems to have gargantuan status in macro, from the reactions I see to his paper
what would you attribute that to?
his capacity to span freshwater, saltwater, etc.?
other?
Ritwik,
I took a quick scan of the second link paper and it looks interesting, but I couldn’t find anything at the first link.
On the second, I read the section where Mehrling describes the nature of the channel system as the CB making an unlimited two way market, which is pretty familiar to me. That reminds me of a question I have about the Woodford paper for you or anybody here.
As I understand it, Woodford is pretty sceptical of the “portfolio balance” theory of interest rate determination, as it relates to LSAP effects on bond yields.
Suppose the CB makes an unlimited two way market in the 10 year bond, just the way it would in a channel system for the overnight rate. Then there’s no question that it determines the yield on the 10 year, just as it does for the overnight rate in a channel system. That would seem to be the limiting case of the portfolio balance model, the way I see it, with respect to LSAP intervention at 10 years.
My question is – where’s the inflection point between not believing in and believing in the portfolio balance model, with respect to the size of an LSAP intervention? And if that sort of function is continuous (which it seems to me it logically should be), then doesn’t that support the portfolio balance model in effect, qualified by the size of the intervention?
JKH
Pg 298 in the first paper gives the typology of monetary thought, one which I have found very useful.
Will think about your question later.
K, I’ve never claimed the quantity of reserves is important, what matters is the monetary base. After you exit the zero bound, base money becames a hot potato. The Fed controls the base in such a way as to hit their NGDP target. The don’t do that by directly targeting the base, but rather endogenously adjusting it to keep expectations of NGDP growing at about 5% per year.
I do agree that ERs are roughly zero once short rates rise above zero, if there is no IOR.
Scott: “I’ve never claimed the quantity of reserves is important, what matters is the monetary base…The Fed controls the base in such a way as to hit their NGDP target.”
OK. But in order for the hot potato effect to work, there needs to be some point in time (now or in the future), in which the Fed controls the quantity of some non-interest bearing money. If it’s interest-bearing it can’t be a hot potato. But they have no control over the quantity of currency, which is entirely at the discretion of the representative household. What they do control is the total base, i.e. the sum of reserves and currency.
If we have IOR away from the ZLB, then currency will just be converted to reserves as interest rates rise. Why would I spend it, if I can just convert it to reserves and back to currency if I want to spend it later?
If IOR=0, but FF is above zero, there will be no excess reserves. The CB is forced to buy back any excess reserves in order to maintain FF above IOR. So now if people feel they have too much currency they will convert to reserves and the CB will convert that to T-bills. So instead of an equilibrium between currency and reserves, there’s an equilibrium between currency and T-bills. Makes no difference. The quantity of non-interest bearing money is chosen exclusively by the representative household as a function of its preference for interest vs relative liquidity of currency over deposits/t-bills. There is simply no state of the world in which the Fed controls the quantity of anything that can conceivably be described as “high-powered money.”
K
The absolutely only way I can make sense of the hot potato story is through increase in inflation (or increase in income), thereby making existing (or even the path of) monetary potatoes hotter than is previously anticipated. It’s about reducing money demand, not increasing base money. I’m never quite sure what Nick and Scott are on about when they talk about expectations and the hot potato, if they don’t mean this.
For anyone for whom it isnt’ obvious, the gold price mechanism is that the central bank buys at sells gold at a target price, with that price being adjusted regularly–perhaps daily as Nick said, but every 6 weeks would be natural.
I would assume that such a central bank would do ordinay open market operations in bonds so that its actual gold reserves are near zero. So, if it raises the price of gold and people actually sell gold to the central bank, the central bank would undertake open market operates until people buy that gold back from the central bank. And vice versa. If people buy gold from the central bank, it would then sell government bonds until people sell that gold back to the central bank.
Now, in a liquidity trap, interest rates on some kind of government bonds might be driven to zero, but the central bank could still make periodic increases in the price of gold. However, I think the “problem” would show up as the central bank accumulating gold reserves and not being able to get rid of them. It would be buying government bonds and expanding base money. The interest rate on those bonds would stay at zero.
Now, assume that the target was unchanged–say a nominal GDP growth path. Nominal spending is below target right now, but everyone beleives that we will eventually get back to target. And that belief has impacts now. It is one reason why nominal GDP is not quite as far below target as it otherwise be–say if we had inflation targeting.
Further, everyone believes that the price of gold in the future will be set to keep nominal GDP on target.
The issue, then, is whether having the price of gold increase now will do any good, when nominal GDP is below target, despite the expectation it will eventually return to target. While people may not be sure as to whether any current increase in the price of gold will be eventually reversed, they know it will be reversed if it would result in nominal GDP going above target.
Do temporary increaces in the price of gold at the central banks window cause spending on output to rise, when the T-bill yield has already been driven to zero?
I think there is an income effect for those in the gold mining industry. And don’t those folks who would have purchased gold, but who are deterred by the high price purchase other goods instead?
If it is true that the central bank cannot get rid of the gold reserves, does the risk of capital loss on those gold reserves translate into less fiscal transfers to the treasury and so higher taxes and so a desire to accumulate more money to pay the taxes?
Anyway, it is an intersting thought experiment.
Bill: “I think there is an income effect for those in the gold mining industry. And don’t those folks who would have purchased gold, but who are deterred by the high price purchase other goods instead?”
Yes, exactly. If we were in my “goldpunk” alternative history, people would not be talking about the transmission mechanism from the overnight rate rippling out through other interest rates and asset prices to consumption and investment demand. Instead they would be talking about a rise in the price of gold encouraging gold mining, and rippling out through silver and platinum and other metals, and all the other goods etc. etc. And in that alternative transmission mechanism people would argue about whether or not the monetary hot potato is or is not an essential part of the story, just as they do with interest rates, and argue about the role of expectations etc.
Ritwik: “The hot potato operations view of the payment systems is not compatible with the mainstream, and not compatible with Chuck Norris/ Scott Sumner/ ratex. The only way I can reconcile them in my mind is through expected inflation/income, or making existing potatoes hotter. Do you agree with this?”
Good question. I think they are compatible. I think they are different aspects of the same thing. But it is currently beyond my abilities to provide some over-arching perspective that could capture both at the same time. It’s too damned hard to think about this stuff.
Thanks Andy and Matt. It seems to me that one of the practical difficulties of tying the NGDP target to an interest rate interest instrument is how clearly the Fed’s intentions can be signaled. Would the public and markets really respond forcefully from the Fed saying its policy rate will be kept low until some NGDP target is hit? Although different, the experience from the Fed’s long-term ffr forecasts don’t give me hope. The problem with this approach is that is not clear how to interpret the stance of monetary policy without knowing the natural rate. Maybe if the Fed published the natural rate too it would help, but then it gets even harder for the public to understand. They have to know the conditional path of the ffr, the expected path of the natural rate, and the NGDP target.
If the Fed did conditional LSAPs every week tied to a NGDP target that would be far easier for the public to understand. The experience from the past QEs and expected future ones (e.g. Draghi’s comments about doing whatever is necessary) make me think this approach would pack more of a punch. It would provide the slap to the market’s face needed to catalyze robust nominal spending.
@K
If IOR=0, but FF is above zero, there will be no excess reserves. The CB is forced to buy back any excess reserves in order to maintain FF above IOR. So now if people feel they have too much currency they will convert to reserves and the CB will convert that to T-bills. So instead of an equilibrium between currency and reserves, there’s an equilibrium between currency and T-bills. Makes no difference. The quantity of non-interest bearing money is chosen exclusively by the representative household as a function of its preference for interest vs relative liquidity of currency over deposits/t-bills. There is simply no state of the world in which the Fed controls the quantity of anything that can conceivably be described as “high-powered money.”
I think the hidden piece of this story is the “excess” in excess reserves. What if, concomitant with the rise in the interest rate, the quantity of required reserves increases to absorb the entire excess (i.e. bank lending increases)? What if when the central bank even implements a “permanent” monetary injection by promising not to raise rates until this has happened?
If you had a central bank that didn’t target interest rates at all, that completely ignored them, that’s precisely what would happen if the central bank promised a permanent expansion of the base while rates would zero – they would stay zero for a while, and eventually rise above zero after all the excess reserves had become required reserves.
Nick
Off the topic, but have you read Tyler’s post on the rise of barter in Spain? Well it’s not truly barter, more like parallel currencies but an important bit was about some payments being done in ‘hours’ rather than euros.
You must have noticed how I often talk about the atemporal exchange vs. inter-temporal coordination theories of recessions. I think this provides a neat natural experiment.
If the atemporal exchange theory is more likely, we should see these localised parts of the Spanish economy overcoming the recession. If the inter-temporal coordination theory is more likely, this may not happen and the ‘hours’ might be hoarded.
We might never know because post-facto data will might be sparse andmixed with many other signals, but do you agree that this is indeed a good test of Wicksellian vs nominal theories of the recession?
Ritwik: No I hadn’t. (I’ve been otherwise occupied recently). But it sounds important. Thanks for the tip. Need to get my brain going before even thinking about the answer to your question.