Wednesday, April 22, 2015

Was Monetary Policy Loose During the Housing Boom?

Did the Fed's set its policy interest rate rate below the market-clearing or 'natural' interest rate level in the early-to-mid 2000s? Or did it simply lower its policy interest rate down to a depressed natural interest rate level during this time? The answers to these questions determine whether U.S. monetary policy was loose during the housing boom. 

John Taylor believes the Fed pushed interest rates below their natural interest rate level. He views this departure from a neutral stance as a key contributor to the housing boom. Ben Bernanke and Larry Summers believe otherwise. They see the Fed simply doing its job back then by adjusting its policy rate down to a low natural interest rate level. Bernanke believes the natural interest rate level was low because of a saving glut while Summers holds that its was depressed because of secular stagnation. Either way, both individuals do not blame the Fed for any role the low interest rates played in fostering the housing boom. The Fed''s lowering of interest rates was simply an endogenous response.

George Selgin, Berrak Bahadir, and I recently published an article that lends support to John Taylor's view of Fed policy during this time. It received some pushback from Scott Sumner who is sympathetic to both the saving glut and secular stagnation views. At the same time, Tony Yates provided a critique of John Taylor's argument on the financial crisis that was heartily endorsed by Paul Krugman. So the debate over the Fed policy during this period continues.

What I want to do here is to step back from this debate and review what I see as the key economic developments that affected U.S. interest rates at this time. Then, given these considerations, I will jump back into the debate and ask whether Fed policy pushed interest rates in the same direction as that implied by these developments.

The key developments as I see them are threefold: a falling term premiums, a spate of large positive supply shocks, and the emergence of a monetary superpower. Let us consider each one in turn.
I. Falling Term Premiums on Long-Term Treasuries
The term premium is the extra compensations investors require for the risk of holding a long-term treasury bond versus a sequence of short-term treasury bills over the same period. The term premium had been declining since the early 1980s and therefore put downward pressure on long-term interest rates. This development can be seen in the figure below which is created using the Adrian, Crump, and Moench (2013) data. (For more on this data see here.)


The decline has been attributed to several factors. First, there was a decline in inflation volatility and an overall improvement in macroeconomic stability during this time that made investors less risk averse to holding long-term bonds. They therefore demanded less compensation. Second, regulatory and accounting changes for certain firms increased their demand for treasury securities relative to their supply. This further reduced the term premium. Third, globalization was taking off, but without a concurrent deepening of financial markets in many of the affected countries. That meant that global income was growing faster than the world's ability to produce safe assets. Consequently, many developing countries started turning to the United States for safe assets. This further depressed the term premium and is the basis for Bernanke's saving glut theory.

A close look at the above figure shows this term premium decline intensified in 2003, falling about 1.4 percentage points over the next two years. This happened right during the time the Fed pushed its policy rate to record-low levels. This, then, appears to support the endogenous view of the low policy rates argued by Bernanke and Summers.

However, this conclusion needs to be tempered. For the next two developments discussed below suggest that a sizable portion of the declining term premium at this time may have been an endogenous response to the Fed's low interest rates policy during that time. 

II. A Spate of Large Positive Supply Shocks
The second important development is that the global economy got buffeted with a series of large positive supply shocks from the  opening up of Asia--especially China and India--and the rapid technology innovations that reached a crescendo in the early-to-mid 2000s. Global growth accelerated because of these developments as seen in the figure below:



The opening up of Asia significantly increased the world's labor supply while the technology gains increased productivity growth. The uptick in productivity growth, which peaked between 2002 and 2004, was widely discussed in the early 2000s and raised long-run expected productivity growth at the time. This can be seen in the figure below which shows a consensus forecast of annual average productivity growth over a ten year horizon:


Note that the rise in the labor force and productivity growth rates both raised the expected return to capital. The faster productivity growth also implied higher expected household incomes. These developments, in turn, should have lead to less saving and more borrowing by firms and households and put upward pressure on the natural interest rate. Interest rates, in short, should have been rising given these large positive supply shocks during this time. 

III. Emergence of a Muscle-Flexing Monetary Superpower 
The third development is that in the decade leading up to the financial crisis that the Fed became a monetary superpower that could flex its muscles. It  controlled the world's main reserve currency and many emerging markets were formally or informally pegged to dollar. Thus, its monetary policy got exported across much of the globe, a point acknowledged by Fed chair Janet Yellen. This meant that the other two monetary powers, the ECB and the Bank of Japan, were mindful of U.S. monetary policy lest their currencies became too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy got exported to some degree to Japan and the Euro area as well. Chris Crowe and I provide formal evidence for this view here as does Colin Gray here.
Now let's tie all these points together and see what it says about the Fed's role in the housing boom. Let's begin by noting that when the large positive supply shocks buffeted the global economy they created disinflationary pressures that bothered Fed officials. They did not like the falling inflation. So Fed officials responded by easing monetary policy. Recall, though, that the supply shocks were raising the return to capital and expected income growth and therefore putting upward pressure on the natural interest rate. The Fed, consequently, was pushing down its policy rate at the very time the natural interest rate was rising. Monetary policy was inadvertently being loosened.

This error was compounded by the fact that the Fed was a monetary superpower. The Fed's easing in the early-to-mid 2000s meant the dollar-pegging countries were forced to buy more dollars. These economies then used the dollars to buy up U.S. treasuries and GSE securities. This increased the demand for safe assets and ostensibly reinforced the push to transform risky private assets into AAA assets. To the extent  the ECB and the Bank of Japan also responded to U.S. monetary policy, they too were acquiring foreign reserves and channeling  credit back to the U.S. economy.  Thus, the easier U.S. monetary policy became the greater the demand for safe assets and the greater the amount of recycled credit coming back to the U.S. economy.  The 2003-2005 decline in the term premium, in other words, was to some extent an endogenous response to the easing of Fed policy during this time.

The figure below highlights this relationship for the period 1997-2006. It comes from my work with Chris Crowe and shows that almost 50% of the foreign reserve buildup was tied to deviations of the federal funds rate from the Taylor Rule. Colin Gray estimates several regression models on this relationship and finds that for every 1% point deviation of the federal funds rate below the Taylor Rule, foreign reserves grew by $11.5 billion. The Fed, therefore, was putting downward pressure on interest rates not only directly via the setting of its federal funds rate target, but also by raising the amount of credit channeled into the long-term U.S. securities.


Given these points, I think it is reasonable to conclude the Fed contributed to the housing boom. I hope they give Scott, Tony, and Paul something to think about.

Let me be clear about my views Even though the Fed kept its policy rate below the natural rate for a good part of the housing boom period, the opposite happened after the crash due to the ZLB. This is a point Ramesh Ponnuru and I made in a recent National Review article. So unlike some observes who see the Fed as being eternally loose, I take a different view: the Fed was too loose during the boom and too tight during the bust. 

Update: There are multiple measures of the output gap that show the U.S. economy overheating during this time. Below is a figure from this article that compares the real-time and final measures of the U.S. output gap. Everyone shows ex-post an overheating economy during the housing boom:

33 comments:

  1. Canada allowed their currency to significantly strengthen against the dollar, yet they experienced similar home price increases. What confuses me is that core PCE barely blipped past 2.2% from 2003 to 2006. Is that level of inflationary pressure consistent with a real rate that allows for a major housing bubble?

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    1. A,
      Recall that there was a major productivity surge putting downward pressure on inflation. So we can't look to inflation in this case as signal of whether an economy was overheating.

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    2. The boom in Canada was much less substantial than the U.S. boom, just as the bust was less so; see http://topforeignstocks.com/2012/10/05/a-comparison-of-canadian-and-u-s-housing-markets/

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    3. Jose Romeu RobazziApril 23, 2015 at 9:51 AM

      This event highlights one of the problems with inflation targeting. If RGDP increases by a positive shock, monetary authorities will see lower inflation and may assume there is labor market slack (NAIRU went down). With this scenario, authorities may be tempted to stimulate the economy further, potentially creating imbalances. Under NGDP targeting, all we could see would be rising RGDP and lower inflation, nothing to do...

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  2. I think you have the wrong model. The natural rate of interest is the real rate consistent with output at potential and stable prices (or similar definition). So, positive supply shocks lead to a lower natural interest rate, not higher.

    A positive supply shock means that potential output is increased. This means that the economy has the potential to grow at a faster rate without causing inflation. This means that a lower interest rate is now consistent with output at potential and stable prices. This means that the natural rate of interest is lower, not higher.

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    1. This sounds right to me. I don't know why you wouldn't look to inflation and price stability as a signal of whether or not the economy was overheating.

      The housing market was "overheating" not the economy. The housing market needed better regulations but that goes against conservative ideology.

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    2. Anonymous and Peter:

      Standard growth models show the natural interest rate to be positive function of expected productivity growth rate (as well as population growth and time preferences). This can also be seen in standard New Keynesian business cycle models. See, for example, E. Sims (2012). "Taylor rules and technology shocks", Economic Letters, 116 (2012) or Christiano, L., Motto, R., & Rostagno, M. (2007). "Two reasons why money and credit may be useful in monetary policy." NBER Working Paper No. 13502.

      The Christiano paper notes that given a rise in expected productivity growth the following happens (page 18): “In the equilibrium with the Taylor rule…the real wage falls, while efficiency dictates that it rise. In effect, in the Taylor rule equilibrium the markets receive a signal that the cost of labor is low, and this is part of the reason that the economy expands so strongly. The ‘correct’ signal would be sent by a high real wage, and this could be accomplished by allowing the price level to fall. However, in the monetary policy regime governed by our Taylor rule this fall in the price level is not permitted to occur: any threatened fall in the price level is met by a proactive expansion in monetary policy.” In other words, the optimal outcome should be rise in the policy interest rate not a decline given the expected productivity growth.

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    3. Anonymous and Peter,

      See the output gap figure I added in the update section of the post.

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    4. David, thanks for the reply. My argument is that your model is wrong for the reason given in my first comment. Why is that logic invalid?

      Let's put it another way. Say we have an economy with output = potential output, inflation = 0% and real growth = g. Then, imagine that a new technology, such as the internet, increases potential, such that potential growth = 2g. I think we can now make the following statements:

      1. We must now grow at a rate = 2g to make output = potential.
      2. We can now grow at a rate = 2g without causing inflation to rise.
      3. Lower real interest rates cause higher growth and vice versa.
      4. A lower real interest rate is now consistent with output = potential and stable prices.
      5. The natural interest rate is now lower.

      Which of these statements do you believe is false?

      You suggest that the optimal response is a rise in the policy rate. I suggest that this would be a disaster. In the example above, we are faced with an economy which is now producing at well below capacity. If the policy rate was left unchanged, this would cause prices to start falling, which would cause a rise in real interest rates, which would cause the economy to slow, which would mean further falls in capacity utilization etc. This would be bad enough. Your suggested rise in the policy rate would make a bad situation worse.

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    5. If I might interject here, point 3 listed above is wrong.

      The real interest rate is positively correlated with economic growth, both in theory and in practice.

      The natural rate of interest is the marginal product of capital. This is how it is defined in Wicksell. This is how it is defined in the present literature. Productivity is the source of growth and the crux of David's story. If productivity rises, economic growth increases and potential GDP rises. An increase in productivity also causes the marginal product of capital to rise. An increase in productivity causes the natural rate of interest to rise. This violates points 3 - 5 on your list.

      I suspect that your logic is incorrect because you are reasoning from a price change. Decreases in real interest rates don't cause growth, but can be coincident with growth. You can argue that an increase in the supply of saving causes the real interest rate to fall, which causes investment to rise. This could explain a short-term increase in growth. But an increase in productivity, increases the demand for capital thereby increasing the real interest rate at the same time that growth is increasing. Since productivity, not savings, is at the heart of David's story, it seems that his logic is correct.

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    6. To the second anonymous, thank you for interjecting, but I disagree with your comment because:

      1. Wicksell did not define the natural rate as the marginal product of capital. He defined it as "a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them". I could provide you many references that fit with my definition above, including some from the Fed. When Fed chairs say that the Fed discusses the natural rate at every meeting, they are talking about my definition of the natural rate. It is the widely used definition.

      2. Of course you can define the natural rate any way you want, but your definition of the natural rate is not relevant to this discussion. The question at hand is whether a positive supply shock should cause central banks to raise or reduce policy rates to meet their objectives of full employment and stable inflation. A rise in productivity may cause the marginal product of capital to rise, but so what?

      3. You say that the "real interest rate is positively correlated with economic growth". That's correct, if you look at the very long term. It's not correct if you are discussing the policy rate changes that the Fed should make on the timescales discussed in David's article. Why do you think the Fed acts to lower real rates when it wants more growth? Why do you think growth falls when the Fed raises rates? Are you saying the whole world has this the wrong way round?

      4. Productivity increases lead to increases in growth potential, not growth per se. They do lead to growth once the effects have rippled through the system, but this may take decades. Again, you are talking about something that takes place on a much longer timescale to that discussed in David's article.

      5. Because of the above, you have not addressed the argument I put forward, but thanks for your input.

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    7. Anonymous #1, your arguments seem to start from the premise that the "natural" interest rate is the one that gives you zero inflation. Well, can't blame you for this, since Wicksell made the same mistake. (He had several criterion, including dP=o; the latter was, IMHO, mistaken.) Anyway, we don't accept that premise. I also agree with the observations made by Anonymous #2.

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    8. You don't know if "potential" is that far below or not. These things are changed and revised, reanalysis occurs. IMO, digitalization of the economy may have meant mid-90's to present GDP was higher than what is currently calculated. This would further undermine some current positions and probably tell us the "Great Recession" was weaker in impact than first thought.

      IMO, what is missing in the analysis is the offshoring boom of 2001-05 and the replacement with cheaper, service sector domestic jobs. This helped along with the surge in productivity(which it enchanced) the illusion of disinflation and monetary policy fell for this illusion in 2002-3. To me the expansion that began in 1991 really never ended until 2008. From a financial standpoint, it sure didn't. Businesses over cut production and made a mistake that "contraction" was coming when credit was free flowing faster than ever and offshoring was reducing industrial capacity further. They needed to rebuild balance sheets in the early 2000's after the Y2K era splurge, but overdid it. IMO, that also created a mess of monetary policy.

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    9. Anonymous #1,

      Wicksell defines the natural rate of interest in the first paragraph of Chapter 8 of Interest and Prices:

      "This is necessarily the same as the rate of interest which would be determine by supply and demand if no use were made of money and all lending effect in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital."

      So you are wrong on this point as well.

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    10. Anonymous 1 is correct.

      The definition (s)he supplies from Wicksell (in translation) is correct. This is the definition. To say that "It comes to much the same thing to describe it as the current value of the natural rate of interest on capital" is a different issue. That is not a definition at all. It is an argument for approximate equivalence.

      I would like to see David answer the question. Which of statements 1-5 does he believe false? It was claimed above by another commentor that statement 3 was false. This is wrong. It is correct to say that lower real interest rates cause higher growth. If the opposite was true, all the Fed would have had to do in 2009 was raise nominal rates to 25% and we would have seen powerful growth!!

      Clearly David does not believe that statement 3 is false. He is arguing that the economy was "overheating" prior to the last recession and says that rates should have been higher, not lower, to counteract this.

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    11. point 2 is incorrect

      It should read : We can now grow at a rate = 2g without causing inflation to rise, at the new equilibrium interest rate
      Read more carefully david's answer, the neutral interest rate is a positive function of productivity.
      In a taylor rule framework, your neutral interest rate (i.e your intercept) has risen.

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    12. I am anonymous #1.

      Charles - thank you. A definition is very different to "much the same thing".

      Note also that David supplies further evidence that he agrees with statement 3 when he argues above that interest rates should, if anything, have been lower after the crash.

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    13. jeanpy

      You ASSUME that the equilibrium/neutral/natural interest rate is higher because of higher productivity. Read my posts. That is the assumption I'm challenging. I argue that it is lower. I am challenging the model that you and David are using as being unrealistic.

      You can change statement 2 to include “at the new equilibrium interest rate” if you want, but don't just assume that this rate is higher.

      You can't prove me wrong by simply repeating your assumption. You can show me to be wrong by showing WHY the rate is higher, but just assuming it so does nothing to challenge my argument.

      See my next comment to David.

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    14. David

      I have looked at the papers that you referred to. They do nothing to support your case because they effectively ASSUME the conditions regarding the natural rate. No attempt is made to show that this is realistic.

      They do not even support your argument in the way that you think they do. Take the first one. It says that "the natural rate is the expected growth rate of productivity". Think what that means. It means that the natural rate is the EXPECTED FUTURE growth rate of productivity.

      So, in your model, just because there has been a positive productivity shock means nothing. The expected change is all that matters and the expected growth rate of productivity could be anything. In fact, it would be more logical for the expected rate to reflect a reversion to the mean i.e. a period of high growth will be followed by lower growth and so the natural rate should fall. So, even according to your model, this suggests that you are wrong to assume a higher natural rate.

      If you are going to defend your position, please do so by showing where you believe my statements 1-5 are invalid.

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  3. I am not understanding how the demand for safe assets ties into all of this.

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    1. Peter, the idea is that some of the rise in demand for safe asset was endogenous to Fed policy given the large number of countries that peg in one form or another to the dollar. Here is older post that should make this point clearer (albeit in a satirical manner): http://macromarketmusings.blogspot.com/2012/03/bernanke-student-conversation-you.html

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  4. We should not underestimate the disruptive effect of large capital inflows primarily from China into Treasuries and MBS. The attraction was not a safe haven, nor the (low) yield, but suppression of the yuan in order to maintain an export advantage. The impact was so great that 10-year treasury yields failed to respond when the Fed lifted the funds rate in 2004 - 2006, effectively lowering the term premium until the yield curve was negative.

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  5. Fed policy is suppressing the natural interest rate. The rate targeting regime of the early 2000's stimulated too much credit. Much of this credit went to housing and also contributed to financialization, undermining RGDP and hence the NRI.

    Policy tools which effectively stimulate ngdp or inflation at higher interest rates are the key to avoiding bubbles and avoiding undermining RGDP growth and the NRI. Hel-e's are the tool needed to improve monetary policy.

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  6. Jose Romeu RobazziApril 23, 2015 at 10:12 AM

    @Anonymous #1
    I followed all the links, and forgive for saying this, but you also have an unproved assumption that higher expected productivity growth lead to lower natural rates. If you think that a technological discovery created opportunities, certainly growth will not rise "by magic". Companies and entrepreneurs will have to employ/raise capital to the idea and create growth by investing in capital goods in order to achieve higher productivity. That will put pressure on the loanable funds markets and raise rates. There is nothing mysterious about this model (supported by research provided on the links David posted)

    @goldstocksforex
    Buyin foreign currency is a way of loosening monetary policy (e.g. China), so, China was effectively following the FED on a loose monetary policy around the time period mentioned above.

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  7. Anonymous #1,

    (1) The papers above that you criticize for 'assuming' the natural rate follows productivity are standard. There are many, many more papers like them. In fact, I would argue there is an consensus on this point. You are not just arguing against me, but a bunch of other folks far smarter than me.

    (2) One reason they accept this assumption is that there is plenty of empirical evidence that shows real rates tend to go up given productivity shocks. This is not a controversial point. Now many of these studies could be refined since they look at observed real rates rather than the natural real rate, but they make the general point.

    (4) This debate is really a rehashing of the ‘divine coincidence’ debate. Divine coincidence is when stabilizing inflation also stabilizes output gap. Many observers are skeptical for the very reason that supply shocks tend to push output and inflation in opposite directions. My point in the post is that this happened in the early 2000s and caused the Fed to inadvertently ease.

    (3) I recognize that the two papers above deal with expected productivity. And that is why I said things like "The uptick in productivity growth, which peaked between 2002 and 2004, was widely discussed in the early 2000s and raised long-run expected productivity growth at the time. This can be seen in the figure below" I then provided a figure showing a noticeable rise in expected productivity around that time. Right after that figure I have a whole paragraph talking about how expected productivity will cause rates to rise. So, yes, I am in complete agreement with them.

    (4) If it helps, let me lay out a micro story. Assume an economy-wide technology shock hits that is expected to raise the productivity growth rate. This productivity surge means firms will have lower per unit production costs and thus increase the return to their capital. Firms, consequently, respond by borrowing more/using up existing savings to build more plants. This pushes up interest rates. Firms now have lower per unit production costs and given competitive pressures—it was an economy wide shock—begin to lower their output prices in an attempt to gain market share. Their profit margins should remain relatively stable because the drop in their output prices are matched by a drop in their unit costs of production. (Here I assume firms have some market power and find it relatively easy to adjust their output prices. However, firms are only willing to quickly adjust output prices downward in the case of positive productivity shocks, not negative demand shocks, since only in the former case are per unit production costs falling, which allows firms to maintain relatively stable markups over marginal cost.)

    Note that all firms are lowering their output price because of this process. Consequently, the price level, an average of firms’ output prices, will also fall if the central bank does not stop it. So in addition to interest rates going up because of increased investment demand, the price level is gently falling. Also note that that profit margins remain stable because the drop in output prices is matched by a drop in per unit costs of production.

    Now enter your central bank that would fight this process—try to offset the downward pressure on output prices—by lowering its interest rate target. If successful, this monetary easing will stabilize output prices, but given sticky input prices like wages it will also expand profit margins. Firms that fail to appreciate the temporary nature of the swollen profit margins—eventually input prices will adjust up--will increase production beyond sustainable levels. A positive output gap will emerge. Your central bank just created an unsustainable boom.

    This is why I believe your view that the Fed should lower its interest rates in response to a productivity shock is wrong.

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    1. David

      Thanks for your excellent reply. I agree with a lot of it and you're right to correct me on the issue of expected productivity growth. I apologize for misrepresenting what you said. I'm not expecting you to post again, but these are the points I would make in reply:

      1. I agree that real rates will often rise after the shock and your micro story explained why, but this is a very different issue to the natural rate.

      2. We agree that the shock causes the price level to fall, meaning that real rates are already rising. We disagree about what happens after that. I do not believe there is any reason to believe that profit margins will increase on an economy-wide basis. Sales prices are falling, real rates are rising and real rates are negatively correlated with profit margins. Indeed, if prices have tipped into deflation, then given sticky wages, there is every reason to suppose that profits start falling. Even if profit margins rose, there is no reason to suppose that firms would be confused by this and create an unsustainable boom. Profit margins are extremely high right now (in the real economy, not our imaginary one) but investment is very low and there is no sign of an unsustainable boom.

      3. We agree, with our output shock, that the increase in output potential has caused falling prices and increasing real rates, which will tend to slow output growth. This in itself is strong evidence that the policy rate is below the natural rate i.e. the rate consistent with output at potential and stable prices. This is why the policy rate should be lowered in this situation.

      4. There is no reason to suppose that this creates an unsustainable boom. Remember, we have so much output potential that prices are falling and real interest rates are rising. There is a long way to go from that position to an unsustainable boom. Let the Fed change course when unemployment is low and inflation creeping up.

      5. In contrast, I suggest that your policy proposal - an increase in rates - would be the wrong thing to do while output is below potential, prices are falling and real rates are rising. That is not a comment on rates a decade ago because there are many other issues around that. It is simply a general comment on the appropriate response to a positive supply shock.

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    2. On point 3, I should have said: "strong evidence that the policy rate is ABOVE the natural rate"

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  8. Jose Romeu RobazziApril 23, 2015 at 11:39 AM

    Complementing all the views on this comment section, I think that Greenspan was looking at the low inflation and thinking about the 4% unemployment that existed in 2000. He was probably thinking (during 2003): "If the NAIRU is 4%, there is plenty of room to stimulate further ... I am not a FED watcher, but maybe one of the people following this post may remember FED official's remarks around late 03, early 04 ...

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    1. Jose Romeu Robazzi,

      I think you nailed the crux of the problem. Central bankers have to guess what is NAIRU or alternatively the output gap. This is a herculean task that gets only more challenging if there are large supply shocks. That is why I like Orphanides work so much. And it is why I think a simple rule like NGDP targeting would be much better .

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  9. Jose Romeu RobazziApril 23, 2015 at 2:27 PM

    Hello, David, thank you for your comment, I probably read you, Scott Sumner and Marcus Nunes a lot :-) . I am new to this concept, NGDP targeting, but now I wish I had learned about it much sooner. I am a practitioner, and most times I am amazed how people overlook how hard it is to estimate variables such as NAIRU and output gaps. These concepts are insightful, help us undertand what is going on, but once people try to use them, they face all sort of practical problems. Two people with the same theoretical beliefs may end up with two very different policy suggestions just because their estimates of crucial variables differed. And that happens all the time! Looking to NGDP is so much simpler ...

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  10. David

    One further point on this. In your model, the natural rate is equal to the expected future growth rate of productivity. You claim that this will rise AFTER a positive productivity shock. But there is no reason for the expected future growth rate to rise after the shock, unless people are irrationally projecting recent deviations in productivity growth in to the future.

    So, to say that the natural rate will rise after a positive supply shock is to say that people are behaving in a systematically irrational way. In this case, this means that the theory of Rational Expectations is false. This in turn means that the theories behind Market Monetarism are false.

    So if, as you claim, the natural rate rises after positive productivity shocks, then the theories of Market Monetarism are false. You can not believe in both. Take your pick!

    Further than that, you suggest that lots of smart people believe the same as you. Presumably, these people also believe in standard economic theory which includes Rational Expectations. Are they aware that their beliefs contain a contradiction?

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  11. Excellent post. Nonetheless, o have a "but". Is it not better to use the private/public debt as risk premium reference? For example,
    http://research.stlouisfed.org/fredgraph.png?hires=1&type=image/png&chart_type=line&recession_bars=on&log_scales=&bgcolor=%23e1e9f0&graph_bgcolor=%23ffffff&fo=verdana&ts=12&tts=12&txtcolor=%23444444&show_legend=yes&show_axis_titles=yes&drp=0&cosd=1980-06-02&coed=2015-02-14&width=670&height=445&stacking=&range=Custom&mode=fred&id=BAA_DGS10&transformation=lin&nd=&ost=-99999&oet=99999&lsv=&lev=&scale=left&line_color=%234572a7&line_style=solid&lw=2&mark_type=none&mw=1&mma=0&fml=a-b&fgst=lin&fgsnd=2007-12-01&fq=Monthly&fam=avg&vintage_date=&revision_date=

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  12. http://www.miguelnavascues.com/2015/04/prima-de-riesgo-y-politica-monetaria.html

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