Please! Professor Meltzer!

Allan Meltzer has criticized the Fed's proposal for a new round of quantitative easing.

He claimed that the Great Inflation was caused by the Fed choosing to target higher inflation in order to reduce unemployment.

Increasing inflation to reduce unemployment initiated the Great Inflation of the 1960s and 1970s. Milton Friedman pointed out in 1968 why any gain in employment would be temporary: It would last only so long as people underestimated the rate of inflation. Friedman's analysis is now a standard teaching of economics. Surely Fed economists understand this.

That isn't the way I understand the history. On the contrary, the Fed targeted short term interest rates in order to lower unemployment, or at least to prevent it from rising, and claimed that inflation was caused by "cost push" factors. So, for example, the Fed would observe rising inflation, and refrain from raising short term interest rates because unemployment was too high, or at least, wasn't too low.

The implicit model was that the Fed controls the short term nominal interest rate, which impacts real expenditure. Real expenditure impacts real output, employment, and unemployment. Inflation depends on "cost push" factors. If the Fed's target for the unemployment rate is too low, then this "model" can easily result in progressively worsening inflation--something like the Great Inflation.

I am no fan of the "new Keynesian" approach, but the model today would be that higher expected inflation reduces real interest rates on short term, safe assets that already have nominal yields near zero. This directly raises real expenditure, but also creates a shift towards riskier and longer term securities that have higher real yields, lowering those real yields as well. This also results in greater real expenditures. The higher real expenditures raises real output and employment and lowers the unemployment rate. Inflation rises consistent with the higher expectations of inflation.

While this approach does imply a higher inflation rate, and perhaps it won't work to reduce unemployment, there seems to be little danger of a return to the Great Inflation of progressively worsening inflation. If inflation rises "too much" then the new Keynesian approach calls for an increase in short term, low risk, nominal interest rates by more than the increase in expected inflation.

While the Fed and the new Keynesians remain wedded to interest rate targets, Milton Friedman won the war about the Fed's responsibility for inflation. Treating a target for unemployment as a goal of monetary policy (say, keep unemployment at 4%,) has next to no support.

Some of Meltzer's other comments are even more disappointing. He claims that there is plenty of liquidity. However, the proper standard isn't how much was apparently needed in the past, but rather relative to the current demand to hold liquid assets. With money expenditures well below their trend from the Great Moderation, it is apparent that there isn't enough to meet the demand.

Surely Meltzer hasn't adopted the "market clearing" approach which implies that the current level of prices and wages must be at the level that keeps the real quantity of money equal to the real demand for money, and simultaneously, the flow of real expenditures equal to the productive capacity of the economy. Sure, there is always enough liquidity to meet the demand if that is true, but how realistic is that?

Similarly, real interest rates, especially on short and safe assets, are very low by historical standards, but apparently they are not low enough to coordinate saving and investment. Perhaps the Obama administrations policy of green jobs, health care reform, and making the rich pay their "fair" share of taxes to fund out of control spending depresses investment. But real interest rates should coordinate saving and investment given expectations of future profitability, not only if business people feel comfortable with the current political leadership.

I am very puzzled by Meltzer's concern that the Fed cannot reduce the excess reserves in the banking system when the demand for credit recovers. The Fed gets weekly data on bank deposits and loans. While the Fed would probably need to raise its target for the Federal Funds rate in the face of growing loan demand, the quantity of credit offered by the banking system doesn't have to shrink, but could even grow. The notion that they must passively allow the quantity of money to expand enough so that all of the excess reserves in the banking system today become required, or perhaps, drained off into currency holdings, is absurd.

Of course, to the degree the Fed holds bad securities (say, mortgage backed securities that are claims to lots of mortgages in default,) the Fed might run into problems. Further, their failed new Keynesian approach of dealing with the zero bound on short term and safe assets by promising to keep interest rates low for a good long time, is a bit of a problem.

Meltzer really does seem to remain committed to some kind of quantity of money rule. And if the demand to hold money rises, so that a quantity of money rule results in monetary disequilibrium, and reduced money expenditures, then the problem is the economy. They shouldn't demand so much money.

No! The quantity of money should adjust to accommodate the demand to hold money, with a nominal anchor of a stable growth path for money expenditures. With such a policy, real output, employment, unemployment, the price level, and inflation all depend on market forces. Still, there is no way that such a policy would result in another Great Inflation. Well, unless the the target for the growth path of money expenditures is in double digits.

Like Meltzer, I am a critic of the Fed. But I think QE2 (another round of quantitative easing) is appropriate because money expenditures are far below any reasonable trend.

I agree with Meltzer that a higher target for the inflation rate is a mistake, but not because I think the current target of 2 percent is optimal. On the contrary, inflation targeting should be replaced by a target for the growth path of money expenditures consistent with zero inflation in the long run.

And what I would like to see from Meltzer is evidence that he remembers the distinction between money and credit and doesn't consider the Federal Funds rate, or any other interest rate, as providing any clear signal of the stance of monetary policy.

Can the Fed come to its Senses?

At the last Fed meeting, somebody mentioned a target for the growth path of money expenditures.....

Participants noted a number of possible strategies for affecting short-term inflation expectations, including providing more detailed information about the rates of inflation the Committee considered consistent with its dual mandate, targeting a path for the price level rather than the rate of inflation, and targeting a path for the level of nominal GDP.

Last but not least?

I might also complain a bit about seeing money expenditure targeting as a means to raise short term inflation expectations (and so, lower real short term interest rates and the output gap.) The actual point would be to raise expectations of real sales, and so increased investment at any level of real interest rate as well raise expectations of employment, and real consumption expenditure. The increase in real expenditures should increase real output (reduce the output gap) and employment. That this might result in higher inflation is an undesirable side effect. While people expecting this unfortunate side-effect shouldn't count as a cost, generating such an expectation is hardly the point.

More importantly, a target for the growth path of money expenditures--if it is permanent--protects against any temporary inflationary impact from creating expectations of permanently higher inflation. Once money expenditures return to an appropriate target, persistently higher inflation would involve firms pricing themselves out of sales. Since firms would be motivated to avoid that sort of suboptimal behavior, expecting such inflation would not be rational.

Most fundamentally, the reason for targeting the growth path of money expenditure is that it provides the least bad macroeconomic environment for microeconomic coordination. Memoryless inflation targeting has proven a failure in the face of a large negative shock to monetary expenditures. Price level targeting would surely be a disaster in the face of any significant adverse supply shock and perhaps bubble prone if there were a favorable aggregate supply shock. Short term interest rate targeting has failed, once again, this time in the face of a severe financial shock that involved a shift away from holding more risky assets to holding safer assets.

It is time for something new.

Well, at least it is on the Fed's radar now.

HT to David Beckworth

P.S. OK, so Scott gets to be Frodo. I have always liked Pippin, and I am clearly not the faithful follower type, but Sam did become Mayor.

Money Expenditures in Japan

What was up with Japan's "lost decade?" Will the U.S. suffer a similar fate?

The monetarists look at some measure of the quantity of money. The neo-Keynesians look at expected inflation and short term interest rates. And what about monetary disequilibriumites? (O.K. As bad as quasi-monetarist sounds, perhaps it is the least bad option.)

I date the "Great Moderation" from 1984 to the third quarter of 2008. I measure money expenditures using Final Sales of Domestic Product. For Japan, I am instead using GDP (which is nominal GDP. Later, I will try to construct Final Sales of Domestic Product for Japan.)

From 1984 to 1990, money expenditures in Japan remained very close to a growth path that increased at a 6 percent annual rate. From the perspective of a "quasi-monetarist," there was a regime change at that time, and a shift to a much lower .12 percent growth path.

There were substantial fluctuations around that trend, rising to as much as 6 percent above trend in 1997 and 3 percent below trend in 2003.

In 2008, the "Great Recession" hit early in Japan, with money expenditures shrinking at a 5 percent annual rate in the second quarter, and then continuing to shrink at that rate until the first quarter of 2009, when they dropped at the remarkable 18 percent annual rate.

Money expenditures remain about 8 percent below the growth path of 1990-2008. (If you look at the 6 percent growth path from early in the Great Moderation, money expentures are 65 percent below that trend. )

Target(s) for Money Expenditures (again.)

The revised figures for money expenditures in the second quarter of 2010 as measured by Final Sales of Domestic Product was $14.5 trillion. The level consistent with the growth path of the Great Moderation is 16.5 trillion. The gap continues to grow, having reach 13 percent. In order to return the growth path of the Great Moderation by the second quarter of 2011, which will be $17.4 trillion, money expenditures would need to grow 20 percent over the year. The targeted growth rate would then be 5 percent in the future.

I favor some opportunistic disinflation from the Great Recession, shifting to a new, 3 percent target growth path for money expenditures, starting at the end of the Great Moderation, which I take to be the third quarter of 2008. The target for the second quarter 2010 would be $15.8 trillion, so the current value is 8.8 percent below target. The target for second quarter 2011 will be $16.3 trillion, so returning to target would require 13.4 percent growth in money expenditures over the next year. (That includes the already completed part of the year.) Of course, the targeted growth path of money expenditures would afterwards grow at 3 percent into the indefinite future.

Money Expenditures Growing Faster...

But still too slow.

Final Sales of Domestic Product grew at a 2.9 percent annual rate in the second quarter according to the revised figures. I favor a 3% target and so this figure is nearly there. Unfortunately, the level of Final Sales of Domestic Product remains way too low, and it will never catch up at this rate.

Interestingly, the inflation rate estimated Final Sales of Domestic Product grew at a 1.9% annual rate. This is close to the Fed's target for inflation (thought the core CPI is their favorite measure of the price level.) Note that this implies that real Final Sales of Domestic Product is growing approximately 1 percent. While the productive capacity of the economy is supposedly growing slowly, this growth rate of real expenditures will result in a growing output gap.

It is interesting that there was deflation for both durable and nondurable consumer goods, and a 1.8 percent inflation rate for consumer services. Deflation continued to impact equipment and software and residences. Oddly enough, nonresidential structures had a 2.6% annual inflation rate.

The most significant inflation rate was exports--4.8%

Victory!

I won the race for Mayor of James Island. It was a five way race, with no run off.

http://www.postandcourier.com/news/2010/aug/04/woolsey-wins/

I received just under 40 percent of the vote. The incumbent received 20 percent and

the others less.

I spoke to voters at about 750 homes. The registered voters in the town live in about

7000 homes. I personally knocked on 1500 doors. I haven't checked all the figures,

but we probably left literature at 35 percent of the homes. I raised and spent about

$4000.

Unemployment unchanged. Final sales continue to grow very slowly and is way below

any reasonable target for its growth path.

But right now I need to worry about the budget for James Island and road and drainage

ditch maintenance. :)

P.S. When I turn on my computer, this is what shows up now http://www.nhc.noaa.gov/

Sumner vs. Krugman

Scott Sumner argues that fiscal policy is more subject to an expectations trap than monetary policy. The expectations trap is the claim that an expansionary policy by the Fed in response to an recession will fail if it is expected to be reversed.

Sumner's version of the expectations trap is that an expansionary monetary policy can eventually raise money expenditures. Firms expecting higher future sales of their products will purchase more capital goods now. Households expecting their employers to sell more in the future will be more assured of their future employment and purchase more consumer goods now.

The increase in present expenditures will raise the demands for capital goods and consumer goods now, resulting in higher production and higher prices. The expectations trap arises if the central bank is expected to respond to the rising prices with a contractionary policy. That will be expected to eventually reduce money expenditures and those expectations will result in lower current purchases of capital goods and consumer goods. But that is exactly the same time that the initial expansionary monetary policy was supposed to expand money expenditures! And so, firms and households will not expect the increase in money expenditures, and so current investment and consumption will not expand after all.

Sumner argues that this will apply to fiscal policy. The expansionary fiscal policy will be expected to increase nominal expenditure. The expected future sales (to the government and to added government employees,) results in an immediate increase expenditures on capital goods by firms and purchases by households who are more secure in their jobs. That growing demand will raise production and prices immediately.

How it applies to fiscal policy is clear. If the central bank responds to the rising prices by a restrictive monetary policy, then it will eventually result in less nominal expenditures. The immediately contractionary impact of expectations of decrease in future money expenditures will offset the expansionary impact of the fiscal policy. And so, there will be no immediate expansion of investment and consumption.

Sumner's argument is reasonable. Krugman has responded. The government will actually employ people regardless of expectations. Sumner's counter argument is that the private sector will contract to offset that effect due to expectations of the central bank's future contractionary actions.

First, part of the reason why Sumner and his critics appear to talk past one another is the monetary transmission mechanism. Sumner argues that sooner or later, an excess supply of money results in higher monetary expenditures. The new Keynesians assume that monetary policy can only increase real expenditures through a decrease in the real interest rate. Fiscal policy, on the other hand, can expand real expenditure without decreasing the real interest rate.

From a new Keynesian perspective, the normal way that monetary policy impacts real interest rates is by changing short and safe nominal interest rates--the federal funds rate. Once "the" nominal interest rate is zero, real interest rates can only fall through a higher expected inflation rate. If the central bank is truly committed to never increasing the inflation rate, this possibility is out of bounds as well. If no one believes that the central bank will allow higher inflation, the real interest rate cannot fall if the nominal interest rate is already at zero. And so, real interest rates cannot fall. And so monetary policy cannot expand real expenditures.

Fiscal policy doesn't have this problem because it expands real expenditures without lowering the real interest rate. From a Wicksellian perspective, the problem is that the natural interest rate has turned more negative than the inverse of the target for the inflation rate. (For example, less than minus 2 percent.) The central bank lowers the nominal market interest to zero, making the real market interest rate equal to the negative of the expected inflation rate. It remains above the natural interest rate by assumption. Savings is greater than investment, and so total real expenditures is less than the productive capacity of the economy.

Fiscal policy is a decrease in national saving (ignoring additional private saving to fund future tax liabilities--Ricardian equivalence.) That increases the natural interest rate, and saving moves closer to investment. As saving moves nearer to investment, real expenditures moves closer to the productive capacity of the economy. Once the natural interest rate rises to the negative of the target inflation rate, real expenditures equal the productive capacity of the economy. Fiscal policy does not require a credible increase in the target for the inflation rate.

Sumner sometimes says, but it is often in the background, that the only reason worth worrying about for the natural interest rate to be negative is money expenditures are below their trend growth path. In his view, because of sticky wages, a decrease in nominal expenditures below its trend growth path results in depressed real output for an extended period of time. And expectations that this will occur, or even persist, can result in a negative natural interest rate. If money expenditures are expected to return to their trend growth path, then real output will recover. Expectations that real output will recover will raise the natural interest rate. In other words, it is not essential for the real market interest rate to turn negative--and certainly not more negative than the inverse of the target for the inflation rate.

One possible scenario would be for real output to grow only slowly from its depressed levels as money expenditures grow, and so inflation will be temporarily higher. The real market interest rate would turn very negative motivating the growth in money expenditures. But that isn't the only possibility, and it is actually the less desirable one. The better scenario would be for real output to grow rapidly and inflation to rise only moderately, if at all. The rapid growth of real output raises the natural interest rate, so that it becomes less negative and so is no longer less than minus 2 percent, or whatever is the current inflation target.

Krugman's argument needs to be that even if moneyl expenditures were expected to remain growing at trend, the natural interest rate would remain more negative than the expected inflation rate. The only way to get the market interest rate that negative is to raise the expected growth path of nominal expenditures and so the expected inflation rate. Central banks won't do that, and so, fiscal policy is the only option. This will reduce national saving and raise the natural interest rate consistent with real expenditures growing with the productive capacity of the economy and money expenditures growing at trend. Only fiscal policy can raise real expenditures while the inflation rate remains on target.

Of course, there isn't a single interest rate, and there are very few nominal interest rates that are near zero. If a central bank is restricted to purchasing only those securities with near zero interest rates, then much of the new Keynesian argument follows. However, the Federal Reserve is buying all sorts of assets, and all of them have nominal interest rates well above zero. And while it might be necessary to purchase much larger quantities of those assets if the problem is something other than low money expenditures, Sumner is almost certainly correct that the depressed level of real output and expectations of a very slow recovery is currently depressing "the" natural interest rate.

In other words, if the Fed committed to purchase whatever quantity of securities with currently positive nominal yields to return money expenditures back to trend, then only limited purchases would actually be needed. There would be no need for higher expected inflation and lower real interest rates. Perhaps there would be higher expected inflation and lower real interest rates, but it is more likely that rapid real growth in output would raise the natural interest rates, with only a modest increase in expected inflation and reduction in the real interest rates on short term government debt.

Now, if nominal expenditures return to the long term trend growth path, and real expenditures remain depressed, then either expected inflation must rise, or the Fed would need to hold a much larger portfolio of long term, and risky assets. Or, of course, the more radical reforms of moving away from basing the financial system on zero interest, no nominal risk, hand-to-hand currency could be considered.