Friday, May 11, 2012

Fed Nominees, the Natural Interest Rate, and Safe Assets

Some parting thoughts for the weekend.

1.   Chris Hayes nails it in this interview on the implications of Senator David Vitter blocking President Obama's Fed nominees.  He correctly notes that Senator Vitter's actions are preventing a robust recovery in aggregate nominal spending.  This, of course, worsens President's Obama's chances of getting relected which is politically smart for Senator Vitter.  But it is also prolonging the human suffering caused by the ongoing economic slump. Here is Chris Hayes:  


What Senator Vitter and other hard-money advocates fail to realize is that the Fed has effectively kept monetary policy tight. They also fail to realize there is a rule-based remedy to this problem called NGDP level targeting. It would minimize the Fed's "activism" that bothers the senator so much, but still spur a recovery in aggregate nominal spending.

Senator Vitter should also note that by preventing the Fed from doing more, he is effectively creating a larger cyclical budget deficit and opening the door for more government intervention. Conservatives do not realize it, but they need more (systematic) monetary policy if they want less government involvement in the economy.  For more on this point see my article with Ramesh Ponnuru in The New Republic or my QE2 article in the National Review.   (hat tip Mike Konczal)

2. Scott Sumner recently had the following to say in a recent post:
I don’t think Keynesians should be arguing that lower real interest rates are the key to recovery.  A bold and credible monetary stimulus that was expected to produce much faster NGDP growth might well raise long term risk-free interest rates.
This elicited a response from Tim Duy and Bill Woosley who both agreed that interest rates would ultimately go up if the Fed were doing a better job.  That is, a more aggressive monetary stimulus program by the Fed should raise expected economic growth and, in turn, raise the demand for credit.  These developments would then raise interest rates.  Duy and Woolsey explain this thinking using a modified IS-LM model, something that Paul Krugman and I have has done in the past too.

A key insight from the IS-LM model is that one can only infer the stance of monetary policy by comparing the policy interest rate to the natural interest rate. One cannot simply look at low policy interest rates and conclude that monetary policy is easy.  The policy interest rate has to be low relative to the natural interest rate for there to be monetary stimulus. Right now a strong case can be made that the federal funds rate is not below its natural interest rate counterpart.  Unfortunately, too few people understand the concept of the natural interest rate.  As a result, there is a lot confusion over the stance of monetary policy, financial repression, and Fed activism.  Imagine how different the debate over monetary policy would be if everyone understood this concept.  I now make it a point to drill into my students heads the importance and implications of the natural interest rate. [Update: If the Fed were to raise expected economic growth through a NGDP level target, the natural interest rate would rise.  The Fed then could raise the federal funds rate without harming growth.  Note the order: improved economic growth prospects first, higher interest rates second.]

Here is Scott's argument is a graph.

3.  Izabella Kaminsky and Cardiff Garcia have been doing a great job at FTAlphaville following the safe assets shortage issue.  For example, see here and here.   I have been meaning to do a full post response for them.  For now I want to note the following. It is how I view the safe asset problem in light of NGDP level targeting:
Gorton, Lewellen, and Metrick (2012) show that safe assets have constituted a relative stable share of all assets since the 1950s. They also show, as does Bansal, Coleman, and Lundblad (2011), that public and private safe assets tend to act as substitutes in providing liquidity services.  Given these findings, it stands to reason that when the central bank is doing its job and nominal GDP (NGDP) is growing at its appropriate trend, then there will be enough safe assets being privately provided.  If, however, the central bank slips and NGDP falls below its expected path, then some of the privately produced safe assets disappear, creating a shortage of safe assets. The government steps in and creates safe assets that, if produced sufficiently, would restore NGDP back to its expected path. In other words, if monetary policy does not do its job then fiscal policy could substitute for it, but in a way not normally imagined. It would do so not by increasing aggregate demand via higher government spending, but by making up for the shortage of safe assets that facilitate transactions.  All this requires is running a budget deficit which may or may not imply higher government spending (i.e. it could also come from tax cuts).  Debates about Ricardian equivalence, crowding out, and other fiscal policy concerns become moot.  What matters is if there are enough safe assets, and if not, whether fiscal policy can provide them in the absence of a NGDP-stabilizing monetary policy. 
For more on this excerpt and my views on this matter see here, here, and here.


  1. Senator Vitter should also note that by preventing the Fed from doing more, he is effectively creating a larger cyclical budget deficit and opening the door for more government intervention. Conservatives do not realize it, but they need more (systematic) monetary policy if they want less government involvement in the economy.

    thats exactly it: ngdp targeting removes a huge hurdle to the balanced budget amendment because it eliminates the fiscal stabilizer argument. the balanced budget amendment has been the Holy Grail of fiscal conservatives since I was a wee lad. I would think Dallas Fed's Fisher (whose "favorite subject" is fiscal policy) would be a big fan.

    Yet, some of these guys are so blinded by what its hard to say they cannot see the Holy Grail in front of them.

    I mean, I understand why Taylor favors the Taylor Rule, I dont expect him to dis his namesake...and I understand the click of Austrians advising Ryan and Ron Paul. but why other economists advising republicans dont pick it up I dont understand.

  2. David, why do you use the forecast of NGDP instead of the actual NGDP growth over the course of those 10 years? Admittedly, the observation doesn't really change anything if the window is the past 20 years, but I found that the correlation between NGDP growth and bond yields were decidedly negative in the early 1970's.

    I drew up the graph and made some ancillary observations here: and I was wondering if I could solicit your opinion.

  3. Excellent blogging.

    I wonder if the core of the GOP just wants Obama to lose, and so they are honking about federal deficits and loose money now.

    Don't forget, when Reagan was present, Don Regan, Treasury Secy lambasted Volcker and called for Fed powers to be transferred to the Treasury. Volcker was penurious, he said. The WSJ went along on the attack on Volcker's tight money. Reagan was running huge deficits.

    If Romney wins, looks for the GOP to go back to "deficits don't matter" and the new talk will be that the Fed should help "get the America working again."

    It has gotten to the point where I am hoping for a Romney win just so that we can can get a bullish Fed.

  4. PS Is Vitter the most stupid man alive?

  5. Benjamin,

    I don't think Vitter is stupid. Like many other hard-money advocates, he probably is sincere in his beliefs and hasn't had much, if any, exposure to alternative money views like ours. If he got some exposure to market monetarism, I bet he would better appreciate the points we are making. Maybe he could invite one of us to present to him.

    I would die to get him, and other congressional Republicans in one room for a presentation on Market Monetarism.

  6. Yichuan,

    I focus on expected NGDP because that it the shaping of expectations that matter for current spending decisions.