Woodford at Jackson Hole

Key new Keynesian macroeconomist, Micheal Woodford, was invited to give a paper at the Federal Reserve's Jackson Hole conference.     The paper, "Methods of  Policy Accommodation at the Interest-Rate Lower Bound," is very heartening from a Market Monetarist perspective.   Most importantly, he gives support to a nominal GDP level target.   He writes:

An alternative that I believe should be equally easy to explain to the general public, but that would preserve more of the advantages of the adjusted price-level target path, would be a criterion based on a nominal GDP target path, as proposed by Romer (2011) among others. Under this proposal, the FOMC would pledge to maintain the funds rate target at its lower bound as long as nominal GDP remains below a deterministic target path, representing the path that the FOMC would have kept it on (or near) if the interest-rate lower bound had not constrained policy since late 2008. Once nominal GDP again reaches the level of this path, it will be appropriate to raise nominal interest rates, to the level necessary to maintain a steady
growth rate of nominal GDP thereafter.

He also includes a diagram, very familiar to Market Monetarists, showing nominal GDP falling far below the trend of the Great Moderation.  Options

Woodford considers a nominal GDP target inferior to a "gap adjusted price level target," which he has advocated before.   While I was aware that Woodford was among those who argued that a price level target is superior to an inflation target when there are problems with the zero bound on interest rates, I was not aware that he advocated a  gap adjusted price level target.   "Gap adjusted" means that the target for the price level is adjusted based upon the "output gap."  For example, an adverse supply shock would likely generate a negative output gap if the price level were held constant--real output would fall below potential output.   Woodford's proposal would raise the target for the price level in proportion and then, even further, to close the output gap.

Why does Woodford suggest that a nominal GDP level target is superior?   He gives exactly the reasons that I would give.   Complicated formulas are difficult to explain to the public, and the output gap is subject to controversy.   What is the exact value of potential output?

Woodford also takes a stand on the "What would Milton Friedman do" issue:

On the one hand, the Fed’s ability to directly control broad monetary aggregates (the ones more directly related to nominal income in the way that Friedman assumed) can no longer be taken for granted, under current conditions; and on the other hand, modern methods of forecast
targeting make a commitment to the pursuit of a target defined in terms of variables that are not under the short-run control of the central bank more credible. Under these circumstances, a case can be made that a nominal GDP target path would remain true to Friedman’s fundamental concerns.

He even cites David Beckworth's blog posts on the "Milton Friedman" question.    While it would have been nice to see some more general citation of Market Monetarism, rather than perhaps including us in the "others" who support nominal GDP targeting, perhaps Beckworth is the best citation right now, since as editor, his name appears on Boom and Bust Banking: The Causes and Cures of the Great Recession.

Woodford specifically rejects what I have been describing as the "the new Keynesian" approach to the zero bound problem--promising to keep interest rates at zero for an extended period of time.   He insists that his position has always been that the policy rate should be kept at (or near) zero until some nominal economic value returns to target--such as nominal GDP.   He even points out what many Market Monetarists have been saying, that talk about it being appropriate to keep interest rates near zero for an extended period of time can be immediately contractionary if this is taken to be a forecast that the economy will perform poorly for an extended period of time.   In other words, the Federal Reserve's actual policy response has been useless if not counterproductive.

Woodford also avoids the "inflationista" bias that has run through too much new Keynesian commentary--particularly Krugman and DeLong.    Woodford writes:

Standard New Keynesian models imply that a higher level of expected real income or inflation in the future creates incentives for greater real expenditure and larger price increases now; but in the case of a conventional interest-rate reaction function for the central bank, short-term interest rates should increase, and the disincentive that this provides to current expenditure will attenuate (without completely eliminating) the sensitivity of current conditions to expectations. If nominal interest rates instead remain unchanged, the degree to which higher expected real income and inflation later produce higher real income and inflation now is amplified. If the situation is expected to persist for a period of time, the degree of amplification should increase exponentially. Hence it is precisely when the interest-rate lower bound is expected to be a binding constraint for some time to come that expectations about the conduct of policy after the constraint ceases to bind should have a particularly large effect on current economic conditions — to the extent, that is, that it is possible to shift expectations about conditions that far in the future.

Yes, the inflation is there, but the increase in real income is given equal weight.    It is close to the Market Monetarist view that expectations of increased nominal expenditure in the future results in increased nominal expenditure in the present, with the precise mix of inflation and real output being secondary.  And, of course, for purposes of human welfare, the more real output and less inflation the better.

Woodford reviews empirical evidence that central bank talk about keeping short term rates low in the future causes market participants to expect interest rates to be low in the future.   And while the opposite result, that no financial traders paid any mind to the Fed, would be pretty damning, there is still little evidence of the key new Keynesian and Market Monetarist claim--if the central bank promises to get nominal GDP back up to the target growth path in the future, this will stimulate spending now.

Woodford is very skeptical about the effectiveness of quantitative easing.    While many Market Monetarists agree that it is pointless without fixing the target--a nominal GDP growth path--Woodford's unfortunate continued allegiance to interest rate targeting shows through in this section of his paper.

On a positive note, Woodford describes "pure" quantitative easing as a focus on the quantity of money--the central bank's liabilities--rather than the purchase of particular assets to direct credit to particular markets.    Unfortunately, his brief explanation of the quantity theory suggests a fixed relationship between base money, some broader measure of the quantity of money, and then nominal expenditure on output, which is hardly essential to the quantity theory perspective and specifically rejected by Market Monetarists.  

Interestingly, Woodford agrees that it is only permanent changes in base money that solve the "zero bound" problem.   Or more exactly, it is the future levels of base money that do the trick.   He then rather quickly insists that promises of future policy interest rates are the equivalent.

While there is nothing really new here, to what degree has the quantity theory of money always included an implicit assumption that quantity of money is "permanent."   That is, the thought experiments are always about fixed levels or growth paths of some "quantity of money."   And to what degree do "long and variable lags" and "adaptive expectations," assume that people are learning about new permanent growth paths?  

Consider a traditional monetarist story.   Velocity is fixed, and the money multiplier falls 10 percent.   This will tend to cause the M2 money supply and nominal GDP to fall to a 10 percent lower growth path, with a likely recession of real output and then a gradual recovery with the price level permanently shifting to a 10 percent lower growth path.    To avoid that recession in output and deflation of prices, the central bank would permanently expand base money, offsetting the decrease in the quantity of money, and ideally, leaving the M2 measure of the quantity of money on target.   Nominal GDP would hardly be effected, and the recession in output and the deflation of prices would be avoided.  

Now, what would happen if the central bank increased base money for a few months and then reduced it again?    I think the traditional monetarist approach would suggest a postponement of the recession and deflation.    On the other hand, if the money multiplier shifted again, then responding with a further change in base money would be entirely appropriate.      Of course, with money supply targeting, it is some measure of the quantity of money that is being kept on a permanently stable growth path.

Market Monetarists don't favor any commitment to a future level of base money.   It is rather that base money in the future will follow a path that will keep nominal GDP on target.    How is this any better than promising that a policy interest rate will follow a future path consistent with keeping nominal GDP on target?   At the very least, we don't have to worry about anyone thinking that a low nominal interest rate will cause falling nominal GDP and deflation enough to keep the real interest rate at equilibrium.   While there are people who seem to think that the quantity of base money doesn't matter, I don't know of anyone who thinks that increases in base money lead to deflation.

Woodford argues that expanding base money by purchasing Treasury bills does not directly impact spending on output at the zero bound for interest rates, because the demand for base money becomes infinitely elastic.   Only if the the quantity of base money is expected to be higher after the zero bound no long applies (after the natural real interest rate rises above zero, or rather becomes less negative than the expected inflation rate)  will it be expected to expand spending on output in the future, and thereby impact spending now.   This argument is consistent with Market Monetarist thinking.

However, Woodford also casts doubt on the effectiveness of expanding the quantity of money by the purchase of assets whose interest rates are not near zero.    That is, assets that are not near perfect substitutes for money, so that their purchase simply changes the form rather than quantity of some more inclusive concept of money.

This is important because while Market Monetarists are very supportive of a target for a growth path for nominal GDP, most are not entirely comfortable with an expectations-only approach.    What if no one was paying attention to the Federal Reserve's announcements?   Or what if no one believes that anyone else is responding to them?     If an increase in the quantity of base money would result in increased expenditure despite naive expectations, that would provide a reason to expect that the central bank can eventually get nominal GDP on target.   It would be a little worrisome if it only can work if people believe it will work.

Here Woodford provides an accessible explanation of  Wallace equivalence--a reason why open market operations of long term to maturity and risky bonds do not matter.   Interestingly, in Woodford's account, there is a connection with Ricardian equivalence.     Suppose the Fed purchases long term and risky securities and issues short and safe securities.   This increases the risk of loss to the Fed and a risk of higher taxes for someone to make up for the shortfall of revenue going from the Fed to the Treasury.    Investors will then want to hold fewer risky securities and more safe securities to offset the risk of these tax hikes.   And so, investors increase their demand for these safe securities created by the Fed.  There is no excess supply of them and so no motivation to spend more on output.  

I don't believe in Ricardian equivalence and I find this even more incredible.  That is, I don't believe that people expand saving enough to earn enough interest to pay the added taxes that they and their descendants will have to pay to cover interest and principal payments on government debt.   And so, adding more complications through risk of loss by the central bank and so a risk of reduced transfers to the treasury and so higher taxes in the future seems even more implausible.

Aside from skepticism about the desirability of using models of God-like knowledge and optimization abilities  to analyse real market economies, I think that another problem with the application of Woodford's analysis to truly heroic open market operations is corner solutions.   When there are no other existing asset holders to sell to the Fed, and that the Fed is instead solely purchasing new issues, then it seems to me that spending on output increases.

Of course, the Fed has not been following a strategy of quantitative easing until a nominal target is hit, but rather making purchases of specific amounts of assets.    Further the Fed has claimed that its purpose is to lower interest rates on those assets.  Woodford argues that much of the effect on interest rates associated with these purchases was  instead due to the Fed's promise to keep policy rates lower in the future.   Interestingly, he also reports on evidence that the asset purchases resulted in higher expected inflation, which would tend to raise nominal interest rates.

Market Monetarists have long insisted that the purpose of quantitative easing should be to raise spending on output, and if this is expected to work, then the result would higher real and nominal interest rates.    This would involve market participants selling more securities than the Fed is buying, using the funds to purchase capital goods or consumer goods.

Rather than making open ended commitments to quantitative easing combined with a nominal GDP level target, which is the Market Monetarist approach, Woodford seems committed to instead keeping the policy rate at zero until nominal GDP reaches the target level.    Rather than depend on the effects of such quantitative easing to expand spending, he favors fiscal policy--tax cuts or expanded government spending--to directly raise demand for output.

While I don't doubt that government borrowing and spending in the context of a central bank willing to create whatever amount of money people want to borrow can expand spending, I don't think that is a wise policy when government spending and debt is already too high.