More on Negative Interest Rates

Miles Kimball wrote a kind response to my previous post.  However, it was quite critical.   One small advantage that I have over Kimball is that I regularly read his blog, and so am familiar with his arguments.   In fact, I have written posts in response to a number of the points he brought up.

Most of his points amount to criticism of nominal GDP level targeting.   While I favor that  regime, I grant that it falls short of perfection.   However, I have not yet been convinced by Kimball that price level targeting is better.

My approach to supply shocks is fundamentally microeconomic.   It roughly follows the analysis in Selgin's monograph, "Less Than Zero."    I suppose that an "oil price shock" is the sort of supply shock that concerns me, though a shift in supply for any single good or service creates the same issue.

If there is a shift in supply for a single good in a multi-good economy, the least bad option is for the price and quantity of that particular good to change without any response by the macroeconomic regime.   In particular, generating monetary disequilibrium to force all of the other prices in the economy, including nominal wages, to change in the opposite direction to stabilize some price index is an undesirable policy.  

Now, Kimball has that problem solved.  First, he proposes to only stabilize the price level within a broad band.   Make the band broad enough, and then, sure enough, any change in the price level due to a shift in supply of some particular good can be ignored.   Second, he proposes to stabilize "core" inflation, and ignore volatile prices.   Any shift in supply of any of the goods whose prices are counted as volatile will be ignored.    And finally, he proposes that a new price index be stabilized, one that focuses on sticky prices.   Any shift in supply of any good with a sufficiently flexible price will be ignored.

I think a target growth path for spending on output is superior to all of these fixes for price level targeting.   I am very open to the use of bands in monetary rules.   These rules are best understood as constraints on the monetary regime.   However, making the band so broad that changes in the price level due to shifts in the supply of particular goods are likely to stay within the band is not constraining enough.

Since I favor targeting the growth path of spending on output, I naturally would consider some shift in spending away from trend under Kimball's approach to price level targeting.   For example, suppose spending on output falls.   Some prices fall as well.   Almost by definition, these would be the flexible ones.   Some of them might be volatile as well.   The low relative prices of those goods discourages production, even though markets clear.   And firms with sticky prices reduce production to prevent an excessive build up of inventories.   The central bank can congratulate itself on keeping the price level within its wide band, and really it was only the volatile and flexible prices that shifted.   It sounds like 2008 to 2014 all over again.

Of course, if we require that the central bank also manage the output gap, then there would still be a problem with the scenario above.  But we know that there are central bankers that will consider a job half done (price level target achieved, at least) as good enough.  And further, there are plenty of economists who can cast quite plausible doubts on any measure of the output gap.

Keep nominal GDP on a target growth path, or within a narrow band, is a simple rule.   For those of us who believe that the discretion of central bankers should be limited, that is an important criterion.  That it is the same thing as keeping the quantity of money on a stable growth path in the special case where velocity is constant is also important.  The central bank is not using monetary policy to manipulate the economy--it is just accommodating shifts in velocity.

Kimball cites a paper that argues that the price level should be stabilized in the face of  a positive productivity shock  That was in response to my statement, "Negative interest rates to prevent unusually rapid growth in productivity from causing deflation seems like a very bad idea."    

Here I had in mind the arguments made by David Beckworth.   Productivity rises, pushing inflation below trend. But the natural interest rate rises due to the additional productivity growth.  The Fed keeps interest rates low to get inflation back up to its two percent target.   If, like Kimball and I, you favor a trend inflation rate of zero and an ability to have short and safe interest rates less than zero, then this sort of scenario could play out with deflation and negative short and safe interest rates aimed returning the price level to target.

However, I am really more concerned with the following scenario.   Peace breaks out in the Persian Gulf.   Oil prices drop significantly.   The CPI in the U.S. falls significantly.   The natural real interest rate is little impacted, but the deflation is greater than the real interest rate.   To keep the CPI stable, it is necessary to generate increases in the prices of other goods and services, including nominal wages.   The nominal interest rate is pushed below zero to cause the real interest rate to fall below the natural rate, generate a boom, increase the prices of goods and services other than oil, and create a sufficient shortage of labor to raise the growth path of nominal wages.   What a bad idea.

My understanding of Kimball's argument is that the scenario is quite different.    Labor productivity rises.   During the adjustment period, there is a decrease in labor's share of income and an increase in capital's share of income.   In the long run, continued saving and capital accumulation returns the income shares to the initial values, consistent with steady state growth.   If nominal income shifts up to a higher growth path, total nominal wage income can continue on an unchanged growth path and capital income can rise to a higher growth path.   Nominal wage rates can continue on an unchanged growth path.  As the economy adjusts to the long run steady state and the share of labor income recovers, nominal wage income shifts to a higher growth path as do the nominal wage rates.   Capital income shifts down to a lower growth path.

While I wouldn't describe this as a reason why the price level should be kept stable, I might see this as a reason why stabilizing the growth path of wage income is better than stabilizing total nominal income.   Glasner and Sumner both have argued for stabilizing the growth path of a wage index for much the same reason.    These are the sorts of reasons why most of us understand that nominal GDP level targeting is not perfect, just better than inflation or price level targeting.

How important is this problem in the real world?   Was employment stabilized by the Fed's efforts to keep inflation stable in the face of more rapid growth in productivity?   I am doubtful of any overall boom in 2002, but I do think there was a boom in late nineties.  A cursory look at the time series shows a bump in nominal GDP, real output and employment above their long run growth paths.  

As for free banking, I think Kimball has not fully internalized the idea of a monetary regime where hand-to-hand currency is not base money.   If base money solely takes the form of deposit liabilities of the central bank, then currency just isn't that important.   Sure, it has some advantages for some transactions.   Some of those transactions are even legal.   But there is no need to worry about financial collapse if there is a temporary suspension of hand-to-hand currency payouts when the currency is not base money--when the deposits are not defined as promises to pay currency.  

I have been interested in such systems for a long time.   While the term "free banking" is sometimes identified with a system with no central bank, full privatization of hand-to-hand currency is consistent with all sorts of monetary policies directed by a central bank.      In my view, having the central bank provide deposit accounts directly to the public or manage a currency at a varying exchange rate is just a bit too rube goldberg.    Of course, I admit that any government dominated scheme, no matter how convoluted, is more politically feasible than complete privatization of hand-to-hand currency.