Friday, November 23, 2012

The Rules vs. Discretion Paradox

Marcus Nunes posted the following report from the Cato Monetary Conference in a comment on Sumner's Money Illusion:

"One young man asked whether the adoption of a nominal GDP target would satisfy Mr Taylor’s desire for the Fed to be governed by rules rather than the whims of policymakers. Mr Taylor had no problem with steady nominal GDP growth as a goal of monetary policy but he did not see how a rule along the lines of “keep NGDP on its trend path” would be useful because it does not address how to achieve this objective. Expectations matter, he noted, but they are nothing without actions that justify those expectations. A policy rule is useless if it does not to relate to the instruments at the disposal of policymakers."

This points to a paradox regarding rules and discretion.    Are the consequences of a rule desirable, or at least, tolerable?   Market monetarists argue that nominal GDP level targeting has consequences are tolerable, and more to the point, better than the alternatives.   Unfortunately, the direct actions of a central bank can only impact nominal GDP--spending on output--by influencing the spending decisions of millions of households and firms.  

While this suggests that the direct actions of the central bank might not be able to influence the choices of those households and firms so that nominal GDP cannot be kept on target, perhaps more to the point, central banks have no confidence in their ability to keep nominal GDP on a target.    They prefer to commit to doing things that they are confident they can accomplish.

And what do central banks feel they can accomplish?  

First, what can they actually do directly?   They can purchase specific amounts of particular assets--what has come to be called quantitative easing.   Or, they can control the total amount of their liabilities--targeting base money. (Market monetarists, like other monetarists, tend to fixate on this)   They can also control the interest rates at which they make loans to banks--the discount rate in the U.S. (or primary and secondary credit rates.)    And they can directly control the interest rate they pay on the reserve balances that banks hold with them.

However, it is clear that some of those things that central banks can do, they have little interest in doing.   As all monetarists know, getting a central bank to make some kind of commitment regarding base money is nearly impossible.   While they have been willing to commit to purchasing certain types and amounts of financial assets, they don't seem very comfortable following that approach.

No, they like to manipulate supply and demand conditions in short term credit markets so that some kind of market interest rate is on target.  They keep short term interest rates steady, and then at periodic meetings, they decide to make adjustments.   In the US, the Fed uses the federal funds rate as a benchmark.   (Interestingly, when other short term interest rates failed to move with the federal funds rate in 2008, the Fed began all sorts of new interventions to directly impact other short term rates.)   Clearly, the Fed believes that it can "control" short term market interest rates, even though this control is indirect for anything other than the interest rate the Fed itself charges on the loans it makes or pays on the deposits it accepts.

Of course, keeping short term interest at some particular level is not a tolerable rule.    If interest rates (either nominal or real) are set too low, the result is a hyperinflationary disaster.    If, on the other hand, interest rates are set too high, the result would be an equally disastrous deflationary depression.

Central bankers appear to have learned that they must adjust the interest rates they "control" to prevent disaster.   Rising consumer prices and rising unemployment both upset voters, and so, indirectly, the politicians.   If consumer prices start rising to much, central banks have learned that they must raise interest rates and if unemployment starts to rise too much, they need to lower interest rates.

If we look at a period where inflation and unemployment both remained acceptably low, like the Great Moderation,  then we can see exactly how much the central bank adjusted interest rates during those period where inflation or unemployment began to rise.   We can then advise central bankers to continue with that approach.   If the "natural" unemployment rate  is steady over the period, then the changes in unemployment would reflect deviations of the unemployment from the natural rate.   So, the central banks actions can be characterized as responding to inflation and deviations of real GDP from potential GDP.

Keeping inflation at a low, steady rate, and real GDP close to potential is a tolerable rule.   Of course, central banks can only influence inflation and real GDP through the spending decisions of millions of households and firms--much like the level of nominal GDP.   (The primary difference between nominal GDP and inflation and unemployment is that voters don't care about nominal GDP statistics, but they do care about inflation and unemployment.)

What Taylor proposes is to take the observed relationship between the interest rates that a central bank "sets" and inflation and the real GDP gap (which is related to the unemployment rate that voters and politicians worry about,) and then tell central bankers to continue to adjust interest rates in that fashion.   Take what was their discretionary response to money market conditions constrained by the need to avoid excessive inflation and unemployment, and make that into a mechanical rule.

If the relationship between inflation, unemployment, and short term interest rates remain similar to those that held over the "good" period, then such an approach seems reasonable.   But what happens when conditions change?

In my view, the notion that economists can develop a simple formula relating something that central bankers are confident they can control and those things that it is at least tolerable to control, is hubris.   Sure, it appears that it is possible to find some useful rules of thumb that work in some times and and some places.   But reifying those rules of thumb into binding constraints on a central bank is an error.   (Of course, in practice, central banks have followed such rules just as long as they felt like it.   When they believe conditions have changed, they quit following them.)

In my view, the binding constraint on the central bank should be something that is tolerable--nominal GDP level targeting.   If central banks can develop rules of  thumb that relate something they are confident they can control--like short term interest rates--to the level of nominal GDP, then that is just fine.   But when the rule of thumb breaks down, the central bankers need to change what they are doing.

For example, when the rule mandates a lower short and safe interest rate, and it is already at zero, then the central bank needs to drop the rule of thumb and  seamlessly shift to raising the level of base money.   If the relationship between short and safe interest rates and other interest rates change, there should be no notion that the central bank needs to get all the other interest rates to move so that they have the "proper" (really the past) relationship with short and safe interest rates.   If the rule of thumb breaks down, then adjust the short and safe interest rates more than ordered by the broken rule.

To sum up, the paradox is that those things that it is sensible, or at least tolerable, for a central bank to control, the central banks have no confidence in their ability to control.   And those things that the central banks have confidence in their ability to control can lead to intolerable macroeconomic consequences.  It is to avoid those disasters, or at least intolerable macroeconomic results, that central banks need to be limited by rules.  

I think the answer is discretion subject to constraint.   Some way needs to be developed so that those actually issuing money can adjust the interest rates they pay and charge and/or the quantities of monetary liabilities they issue, subject to the constraint that the expected value of some relevant nominal quantity remains anchored.

I think the least bad nominal anchor is a steady growth path for nominal GDP.    While index futures targeting (or convertibility) is a promising approach that deserves more research, the least bad option today is to allow a central bank discretion to manipulate those things it directly controls subject to the constraint that it try to keep nominal GDP on target is the least bad approach.   In my view, the first step is for Congress to legislate the target growth path and then hold the central bankers accountable for hitting that target.    If they fail, then they can appear before Congress and explain why.   And they can also explain what they are doing differently to try to get nominal GDP to the target growth path.





9 comments:

  1. "Unfortunately, the direct actions of a central bank can only impact nominal GDP--spending on output--by influencing the spending decisions of millions of households and firms"

    A policy where a combined monetary/fiscal action are adopted (for example: new money creation is used to subsidize spending on output) would seem to allow a much greater degree of control over NGDP.

    Why aren't such proposals taken more seriously by Market Monetarists ?

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  2. "In my view, the first step is for Congress to legislate the target growth path and then hold the central bankers accountable for hitting that target."

    Something that Market Monetartists don't talk much about is volatility. You could in theory have an economy which was "on track" at, for example, two year intervals but with wild swings in between. A central banker might desire the discretion to miss the targets as long as the economy is moving closer to the target, in order to reduce volatility.

    You probably read this piece by James Bullard ( http://www.stlouisfed.org/publications/re/articles/?id=2278 ) where he argues that a slow recovery is better than a fast recovery because "we would not want or expect key variables to move wildly about their long-run values under an appropriate monetary policy."

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    1. Max
      Maybe MM´s don´t talk much about volatility is that because if NGDP is level targeted volatility basically "dissapears".
      http://thefaintofheart.wordpress.com/2012/09/18/50-years-of-us-growth-and-inflation-history-from-a-market-monetarist-perspective/

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  3. "[..] he did not see how a rule along the lines of “keep NGDP on its trend path” would be useful because it does not address how to achieve this objective. Expectations matter, he noted, but they are nothing without actions that justify those expectations. A policy rule is useless if it does not to relate to the instruments at the disposal of policymakers." ->

    Seems to me that he's simply referring to the zero bound?

    Right now, if the BoJ announced that their new inflation target is 8%/year, the market would have a good laugh and go on with its day like nothing happened.

    Now if the BoJ announced its new inflation target of 8%/year, and that it will push rates into the negative range if needed, that would be an entirely different story.

    I read his main point as: expectations are expectations of actions, not expectations of targets. If the set of actions you can take doesn't include any that can achieve your target, it doesn't matter what you declare your target to be, expectations won't fall for it.

    But I have no information on what Taylor meant other than what you pasted in your post.

    "For example, when the rule outputs a lower short and safe interest rate, and it is already at zero, then the central bank needs to drop the rule of thumb and seamlessly shift to raising the level of base money." ->

    How does that have any impact on the price level? I'm having that exact debate with Scott Sumner here and I wrote a post about it. Would love to hear your explanation of how an increase in base money at the zero bound does anything to the price level.

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    1. "Right now, if the BoJ announced that their new inflation target is 8%/year, the market would have a good laugh and go on with its day like nothing happened."

      I don't think so - assuming it was believed. For it to have no effect, people would have to calculate that the probability of the economy spontaneously exiting the liquidity trap is zero.

      It would be even more powerful to set a price level target increasing every year. That way, misses are not "forgiven" but place even more upward pressure on expected inflation.

      It's not hard to change market expectations because they are so unstable to begin with. Markets soar and crash on whispers. The hard part is not moving the markets, it's getting the consensus that the markets should be moved.

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  4. Ronson:

    An expansionary fiscal policy creates a budget deficit and larger national debt. I think those are undesirable. Funding it today by money creation is of no significance. When the demand for money falls, interest bearing debt must be issued.

    More importantly, fiscal policy already has a job--pulling resources from the private sector to produce public goods.

    Monetary policy has only one job--keeping the quantity of money equal to the demand to hold it consistent with the nominal anchor remaining on target. It doesn't require a budget deficit or expand the national debt.

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    1. "When the demand for money falls, interest bearing debt must be issued"

      Couldn't fiscal policy be used to reduce the money supply ? For example if NGDP is heading above target couldn't a tax on final sales be used to this end ?

      If fiscal policy has a more direct effect on NGDP than monetary policy I don't see why it can't be used for both policy goals (NGDPT and socially desirable transfers) - something like a sales tax/subsidy would be somewhat neutral in regard to social goals (or at least as neutral as QE via OMO)

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  5. DOB:

    I don't think he is worried about the zero nominal bound. He wants a formula relating a policy insturment to a policy goal.

    Take the Talyor rule and replace inflation and the output gap with the deviation of nominal GDP from its target growth path. R = 3 + .5 (Y - Y*). Then, the next step is to use a workhorse dynamic stochastic model to see how it works compared to the Taylor rule in maximizing utility.

    As you can imagine, just saying "adjust base money to keep nominal GDP on target" doesn't give you anything to put into the dynamic stochastic model.


    McCallum did this work some years ago, and nominal GDP level targeting can generate instability.

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  6. Max:

    I think the time horizon should be adjusted so that keeping expected nominal GDP on target is pretty much all that can be done.

    As for Bullard's claim, I don't think he meant short term fluctuations in unemployment or inflation (nominal GDP for us,) but rather other things. I don't care about fluctuations in the quantity of money. It should fluctuate according to changes in the demand to hold money. I don't think that errors are a good thing, but I don't worry about them much. I don't favor stablizing short term interest rates. They should adjust to keep saving and investent equal, or equivalently, to continuously clear credit markets. While having them deviate from equilibrium is a bad thing, I don't see it as much of a problem. As for long term assets, they should fluctuate with expecations about fundamentals. I don't think it is a good thing if they are impacted by mistaken excess supplies or demands for money but I don't worry about it much. Buy and hold.

    So, it really comes down to fluctuations in final sales and inventory investment and disinvestment. That is real, but of a second order of magnitude less important that fluctuations in real output. And so, keeping nominal GDP on target is what counts.

    I don't think the monetary policy "push" is nearly as effective than the "pull" of expectations that they will sooner or later get back to the level target.

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