John Cochrane, Michael Woodford, and the Efficacy of Monetary Policy

Michael Woodford's speech last week has generated much discussion.¹  That should not come as surprise since the speech was given at an important conference and was delivered by one of the top monetary economist in the world. While most commentators recognized the speech for what it was--a rebuke of Fed policies that have failed to reverse the shortfall in aggregate nominal expenditures and a call for a NGDP level target that would directly address it--some have misconstrued Woodford's main points.   John Cochrane, with whom I often agree on issues, is the probably the most notable one.   His recent post on the speech highlighted much of Woodford's critique of Fed policy, but failed to properly characterize the deeper reasons for his critique and endorsement of a NGDP level target.

Cochrane has already received pushback on his post from Scott Sumner, Bill Woolsey, and David Glasner.  Here, I wanted to provide my own response to two of Cochrane's statements that highlight the divergence between his and Woodford's actual views on the efficacy of monetary policy at the lower bond and its ability to keep long-run inflation expectations anchored.  Here is the first of Cochrane's statements:

Mike recognizes, as I do, that the Fed can do nothing more to raise nominal GDP today. Rates are at zero. The Fed has did what it could.

This is not Woodford's view.   He is a firm believer in the power of expectations to create immediate and meaningful monetary stimulus, even at the zero-bound.  Woodford makes this point very clear early in the paper:

It is important to recognize first that according to standard macroeconomic theory, people’s expectations about future policy are a critical aspect of the way in which monetary policy decisions affect the economy. The overnight interest rates (such as the federal funds rate in the US)... are not in themselves of such import for the economic decisions (about spending, hiring, and price-setting) that central bank ultimately wishes to influence. It is instead the anticipated path of short-term rates, years into the future...that is a more important determinant of these decisions... It follows from this view that, even when the current policy rate is constrained by the lower bound, a variety of different short-run outcomes for the economy should remain possible, depending on what is expected about future policy.

This is why Woodford endorsed a NGDP level target.  He sees it as a practical way for the Fed to conditionally commit to a future path of monetary policy that would raise aggregate nominal expenditures today.  To underscore this point, Woodford notes this approach would be equivalent to the Fed convincing the public that some part of the increase in the monetary base were going to be permanent, something that has not happened with the Fed's QE programs:²

If, instead, one were to assume a permanent increase in the size of the monetary base, and assume that it is immediately understood by everyone in the economy that  such a permanent change in policy has occurred, then such a policy would be predicted  to have an immediate positive effect on economic activity during the period in which  the lower bound binds, in either the model of Krugman (1998) or Eggertsson and  Woodford (2003).

Here, the expectation of a permanently larger monetary base in the future implies permanently higher nominal spending and nominal income in the future as well.  Households and firms, in turn, increase their nominal expenditures today in expectation of these future developments.   A NGDP level target, then, is a way of managing expectations about the future path of the monetary base or the policy interest rate that would raise aggregate spending today.  Contrary to Cochrane's claim, then, Woodford believes there is much the Fed can do but simply has failed to do so.  (That the Fed could be doing more, but is not is tantamount to the Fed passively tightening. Other evidence also points to monetary policy being effectively tight) 

One implication of this understanding is that the real reason for the limited success of the Fed's QE programs is not that the Fed is doing a futile asset swap of near perfect substitutes, but that the Fed has failed to appropriately change expectations with these programs. Even though bank reserves and treasury bills may be near substitutes now, they will not always be as interest rates will eventually rise.  Forward-looking markets know this and would respond by rebalancing portfolios towards riskier assets if they thought yields would rise high enough in the future.  The fact that portfolios have not significantly rebalanced and kick started a robust nominal expenditure recovery is an indictment that the Fed has failed to properly manage expectations about the future path of monetary policy.

The second of Cochrane's statement speaks to ability of the Fed to keep long-run inflation expectations anchored if it allows temporarily higher inflation:

More deeply, how does the Fed commit to allowing "just a bit" of inflation in the future, and not starting down the path of the 1970s again?

This concern, shared by many, is misplaced since Woodford proposes a NGDP "target path" or level target.  A level target anchors long-run inflation expectations, but allows for temporary catch-up growth or contraction in NGDP so that past misses in aggregate nominal expenditure growth do not cause NGDP to permanently deviate from its targeted path.  Woodford notes that currently NGDP is anywhere from 10-15% below its trend (and thus expected) growth path.  Any increase in inflation under this target, therefore, would not be some ad-hoc temporary increase but part of a systematic approach that would return NGDP to its trend.  I have used the following figure before to illustrates this idea:

The black line has NGDP growing at a 5% annualized rate.  Then, at time t a negative aggregate demand (AD) shock causes NGDP to contract through time t+1.  There is now an a NGDP shortfall.  To make up for it, the Fed must actually grow NGDP  significantly faster than 5% to return aggregate nominal spending to its targeted level.  For example, if NGDP fell 6% between t and t+1 it is now 11% under its trend.  Next period the Fed must make up for the 11% shortfall plus the regular 5% growth for that period.  In short, the Fed would need to grow NGDP about 16% between t+1 and t+2 to get back to trend.  There might be temporarily higher inflation as part of the rapid NGDP growth, but over the long-run a NGDP level target would settle back at 5% growth.  Nominal and thus inflationary expectations would be firmly anchored.   Woodford explicitly makes this point:

[S]uch a commitment would accordingly require pursuit of nominal GDP growth well above the intended long-run trend rate for a few years in order to close this gap. At the same time, such a commitment would clearly bound the amount of excess nominal income growth that would be allowed, at a level consistent with the Fed’s announced long-runt target for inflation.

Woodford also notes that such a rule would actually tend to reduce AD shocks since it would create well-anchored nominal spending and nominal income expectations that wold prevent such a shock from materializing in the first place:³

A commitment not to let the target path shift down means that, to the extent that the target path is undershot during the period of a binding lower bound for the policy rate, this automatically justifies anticipation of a (temporarily) more expansionary policy later, which anticipation should reduce the incentives for price cuts and spending cutbacks earlier, and so should tend to limit the degree of the undershooting. Such a commitment also avoids some of the common objections to the simple Krugman (1998) proposal that the central bank target a higher rate of inflation when the zero lower bound constrains policy.

These are all points that Market Monetarist have been making for some time, so obviously I agree with Woodford.  The only difference between us is that he focuses on interest rate instrument where we focus on the monetary base.  My hope is that John Cochrane will reconsider these issues.

¹For example, see Matthew Yglesias, Dylan Matthesws,  Joe Weisenthal, James Pethokoukis, Joseph Gagnon,  Cullen Roche, Nick Rowe, and Marcus Nunes.

² Woodford further notes the equivalence in this passage: "The demonstration by Auerbach and Obstfeld (2005) that welfare can be increased by permanently increasing the supply of base money could alternatively be used to show that welfare could be increased by committing to keep the nominal interest rate at zero until it is possible to hit a certain deterministic target path for nominal GDP, and then use monetary policy to keep nominal GDP growing at a steady rate thereafter. The inferior initial equilibrium is instead one in which nominal GDP is allowed to follow a permanently lower path, albeit with the same long-run growth rate."

³Another benefit of returning nominal GDP to its pre-crisis trend is that it would restore nominal incomes to where they were expected to be when creditors and debtors agreed to fixed nominal contracts prior to the crisis. This would help repair household balance sheets and further strengthen a recovery.