Monday 20 January 2014

The Monetary Policy Debate

FRED Graph

For the purpose of this post I'll constrain my description of the current monetary policy debates to an extremely simplified summary.

I'll frame it in terms of the following identity:

(M)(V) = (P)(Y)

where (vaguely):

M = Money Supply
V = Velocity (The rate that the money supply recycles)
P = Price Level of Goods
Y = Quantity of Goods Consumed


(P)(Y) = Nominal Gross Domestic Product = (M)(V)

The status quo for monetary policy is some form of the dual mandate used in the United States. Stable inflation and a healthy level of unemployment are typically the policy aims, inflation and unemployment are the usual indicators, and key interest rates and/or the quantity of money, (communicating changes, and actually changing conditions to achieve the desired changes) are the typical transmission mechanisms.

Different models and ideologies tend towards different models, making different assumptions, and thus push different aims and the mechanisms to achieve them.

Now, in order to judge a model we need to consider the real world predictions and, although imperfect, judge the validity of it's approach. There have been a few interesting monetary policy tests during the latest financial crisis and the ongoing recovery.

Which method best describes these aggregate variables:

a). would an expansion of the fed balance sheet and money supply result in high levels of inflation?
b). would monetary policy be effective at the zero interest lower bound?
c). would fiscal austerity have a positive or negative impact?
d). would fiscal austerity with monetary offset (expansionary policy) have a positive or negative impact?

The reason that so much ambiguity can exist in this field is that variables like inflation, unemployment, and interest rates don't behave in a uniform manner. The response of these variables to certain stimulus might even move in contradicting directions under different economic circumstances.

I'll aggregate three main monetary viewpoints and how they seem to break politically (my own opinion and simplified characterization).

This isn't an: x believes y, which predicts z type of reasoning. It's more of a: those identifying themselves as x, tend to believe in the validity of models like y, which results in predictions, under varying assumptions, of z. Ie. it's loose, approximate, and open to my own interpretation error.

1. Austrian/Monetarist/Real Business Cycle: 

For the most part a small government group that has long been preaching/predicting that inflation/hyper-inflation/debt fueled collapse is right around the corner.

In the context of the MV=PY identity this school would typically suggest that Y (demand) and P (price) are both best left to the market to equilibriate. Prices are rationally set against the underlying economic forces and demand adjusts accordingly. Y, essentially a measure of the overall economic health adjusts, but over a longer time period then P. V (velocity) in a sense this can be considered the demand for money. It is typically considered to be fairly stable. Thus, M (money supply), controlled by the FED, must be adjusted to maintain stability in the other variables (monetarist), or when altered by the FED leads to distortions in what should be market determined variables (Austrian).

For example:

(M)(V) = (P)(Y)
($100)(10) = ($50)(20)

If (P)(Y) = is observed, or is expected to be observed, at ($50)(10) then the interpretation might be that the economy was out of whack and given those underlying factors the market has adjusted Y down to 10. The monetary policy reaction should be to reduce M before P (inflation) rises to equilibriate.


(M)(V) = (P)(Y)
($50)(10) = ($50)(10)

Thus, when the FED began injecting liquidity into the system this school of thought was predicting significant inflation risks.

If M goes from $50 to $100 in conjunction with falling Y from 10 to 8, then assuming stable velocity, price must rise from $50 to $125.

In the context of the current recession this school of thought has failed miserably right out of the gate. There also hasn't been much of a re-think or a restructuring of models to explain the lack of inflation and Krugman summarizes that here, I largely agree with his general sentiment (when it comes to monetary policy in this recession).

Here's an open letter to Ben Bernanke that was published in November 2010 which was signed by some prominent figures on the right, John Taylor being the highest profile economist:
We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued.  We do not believe such a plan is necessary or advisable under current circumstances.  The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.

2. New Keynesian:

For ease of discussion I will simplify this school of thought to being typified by Krugman. He's certainly the most visible and arguably the best blogger of the bunch. In the MV = PY framework, the collapse of Y and V posed a greater risk of deflation, falling P, then anything.

Essentially, the fall in Y and V in this case are seen as demand side phenomenon (agree). With the public deleveraging  post housing collapse they essentially stopped buying as much stuff (as opposed to supply side phenomenon where the less stuff is made).

Keynesians were correct that the economics were such that a rapid build up in the monetary base would not cause inflation. An additional prediction was that as interest rates pushed up against the zero lower bound the effectiveness of monetary policy was minimal (the Japanese quantitative easing experience in the early 2000s as evidence).

Thus, fiscal policy has been held up as the answer. Without expansionary monetary policy defalation was expected. Krugman has admitted as much (sort of). To return NGDP to a level that would return unemployment rates to more historical levels, this school of thought suggested that increasing Y (via government spending) was paramount.

2013 pushed an interesting experiment to the forefront of the US. As explained in a post (that has gotten ALOT of play in the economic blogosphere as of late) by Mike Konczal in the Washington Post in April:
We rarely get to see a major, nationwide economic experiment at work, but so far 2013 has been one of those experiments -- specifically, an experiment to try and do exactly what Beckworth and Ponnuru proposed. If you look at macroeconomic policy since last fall, there have been two big moves. The Federal Reserve has committed to much bolder action in adopting the Evans Rule and QE3. At the same time, the country has entered a period of fiscal austerity. Was the Fed action enough to offset the contraction?
Interestingly, the economic data was supporting the Keynesian case at the time; showing that the FED would be unable to offset the reduction in fiscal expenditure (austerity) and the economy would suffer.

As 2013 came to an end, the evidence has overwhelmingly not supportive of this. Keynesians back peddled hard. And the blogosphere went crazy (always entertaining to watch really smart people put their name to ideas, even if they aren't always intellectually consistent).

3. Market Monetarism:

This is a relatively obscure school of thought that has emerged in this crisis as offering, in my opinion the best frame work to base monetary policy on. What is that framework? I'm not sure how fully I grasp it, here's a summary by Scott Sumner (whose blog introduced me to MM ideas):
It is not about being smart, it’s about setting specific goals and promising to do whatever one can to meet those goals. 
I’d like to see the Fed set an explicit target path for nominal GDP.  But at this point even a price level or inflation target would be better than nothing. 
Do “level targeting,” which means you commit to a specified path for NGDP or prices, and commit to make up for any deviations from the target path.  Thus if you target NGDP to grow at 5% a year, and it grows 4% one year, you shoot for 6% the next.
Market Monetarism suggests that Monetary policy's aim should be to stabilize the short run economy. Not controversial to the Keynesians. Rather then deciphering the dual unemployment and inflation indicators, Market Monetarism suggests that we look at NGDP. If monetary policy is useful in it's mitigation of AD short run shortfalls. Then why not look for a variable that that provides a close approximation of AD (which is an abstract concept). Market Monetarists elevate NGDP to that position.

So, we have a new simpler indicator. What about implementation? We know that the FED has consistently under performed on it's 2% inflation target since 2008 when it has been needed the most. Market Monetarists suggest that establishing a "level targeting" regime would not only ensure that chronic undershooting does not occur, but actually reduces the amount of work to be done.

If markets know that failing to hit the target in a time period 1 will be made up in the proceeding periods in order to maintain the stated level, the chances of policy missing in period 1 is diminished.

A better target, a better strategy, Market Monetarism makes alot of sense to me on these merits. It's time to reduce the discretion in monetary policy.

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