Friday, April 17, 2015

It Takes A Regime Shift to Raise an Economy

This week we learned that Ben Bernanke does not view NGDP level targeting, price level targeting, or a higher inflation target as the best way to deal with the zero lower bound (ZLB) problem. Now I believe the "what to do at the ZLB" debate is becoming moot as the U.S. economy improves, but it is interesting to consider Bernanke's thoughts on these alternative approaches to monetary policy. Here he is questioning their usefulness at the ZLB relative to his preferred approach:
The second possible direction of change for the monetary policy framework would be to keep the targets-based approach that I favor, but to change the target. Suggestions that have been made include raising the inflation target, targeting the price level, or targeting some function of nominal GDP... a principal motivation that proponents offer for changing the monetary policy target is to deal more effectively with the zero lower bound on interest rates. But economically, it would be preferable to have more proactive fiscal policies and a more balanced monetary-fiscal mix when interest rates are close to zero. Greater reliance on fiscal policy would probably give better results, and would certainly be easier to explain, than changing the target for monetary policy.
So Bernanke wants the Fed to keep its inflation target of 2% and complement it with more aggressive use of fiscal policy when up against the ZLB. It sounds reasonable, a more balanced mix of monetary and fiscal policy. What could possibly go wrong? A lot, actually, if you believe this approach would have generated substantially greater aggregate demand growth over the past six years.

Here is why. Fiscal policy can only create aggregate demand growth up to the point it pushes inflation to the Fed's 2% target. The Fed's preferred inflation measure, the PCE deflator, averaged 1.4% since 2009. That means fiscal policy would have had 60 basis points on average with which to work over the past six years in closing the output gap. Do we really think that would be enough for the level of aggregate demand shortfall experienced over this time?

What was needed was a monetary policy regime shift, one that would have allowed, if needed1, a permanent increases in the non-sterilized portion of the monetary base to spur rapid growth in total dollar spending. It was never going to happen with a 2% inflation target. Imagine, for example,  the U.S. Treasury Department sent $5000 checks to every household. As individuals began to spend their new money inflation would start rising, but it could only rise by 60 basis points before the Fed started tightening policy. The 'helicopter drop' would be stillborn.

As a counterexample, consider a regime shift to a price level target. This is not my preferred approach, but it illustrates well that the type of monetary regime needed to restore full employment over the past six years was far from a 2% inflation target. Here is how I describe it from an earlier post:
One [such] monetary regime change would be a price level target that returns the PCE to its pre-crisis trend path. To return the PCE to its targeted path would require a temporary burst of higher-than-normal inflation. The expectation of and realization of this inflation burst would be the catalyst that spurred robust aggregate demand growth.
Now let us pretend the Fed actually implemented a price level target back in 2010 when it began QE2. Specifically, imagine the Fed had made QE2 conditional on the PCE returning to its 2002-2008 trend path. The figure below shows this scenario with three different paths back to the price level target. Note that each path represents differing rates--5%, 4%, and 3%--of 'catch-up' inflation and for each path there is a significant amount of time--16 months, 26 months, and 49 plus months--involved to catch up to trend.

What this illustrates is that to get the kind of robust aggregate demand growth needed to close the output gap back in 2010, there needed to be a sustained (but ultimately temporary) period of higher-than-normal inflation. Doing more fiscal policy to squeeze out the last 60 basis points of the Fed's 2% inflation target would not cut would be tinkering on the margins. If fiscal policy really wanted to close a large output gap at the ZLB it too needs the support of monetary regime change.
Again, I think the ZLB debate is becoming moot for the U.S. economy. But this discussion highlights why I believe greater use of fiscal policy over the past few years would not have heralded a stronger recovery. The U.S. economy has been chained to a monetary regime that while effective in anchoring inflation expectations also served to stymie a full-throttle recovery. If you want fiscal policy to work, you have to have a monetary regime that works. This was the core issue, not the degree of monetary-fiscal policy mix.

So yes, a regime shift was needed over the past six years. I would like to have seen a shift to a NGDP level target. Not only would it addressed the ZLB problem, but it also deals with the knowledge problem, financial stability, and supply shocks better than a price level or higher inflation target. For an accessible discussion of these points see my piece with Ramesh Ponnuru on the right goal for central banks. For a NGDP proposal that utilizes a monetary-fiscal mix see this post.
1A permanent increase in the monetary base may not be necessary if the the regime shift causes the velocity of money to sufficiently change. The actual expansion may not be needed or be very small if this commitment is credible. To see this, imagine the Fed targets the growth path of nominal GDP (i.e. a NGDP level target). If the public believes the Fed will permanently expand the monetary base if NGDP is below its targeted growth path, then the public would have little reason to increase their holdings of liquid assets when shocks hit the economy. That is, if the public believes the Fed will prevent the shock from derailing total dollar spending they would not feel the need to rebalance their portfolios toward safe, liquid assets. This, in turn, would keep velocity from dropping and therefore require minimal permanent monetary injections by the Fed to hit its NGDP level target.


  1. A regime shift also requires employing superior tools. It will be difficult to achieve a NGDPLT if the tools employed undermine real GDP and create too much instability.

    Lowering rates or conducting asset purchases to stimulate inflation increases the financial sector and instability more than a policy which stimulates without AP’s while maintaining higher interest rates. Lower rates (ceteris paribus) make credit grow more than a higher rate and because the finsector underpins credit, financial asset trading and creation the finsector will grow also. A larger financial sector undermines real gdp while lower rates facilitate speculative activities more.

    Heli drops of central bank generated e-money are a tool that need to be trialed because they effectively stimulate AD at a higher level of interest rates.

    1. CMA, even a helicopter drops of e-money will do no good at the ZLB the Fed continues to stick to its 2% inflation target. So it not about proper tools as it about proper monetary regime.

    2. CMA, see this post by Krugman who makes the same point I do here:

    3. If the fed targets a price level the tools are very important. E-money heli's (hel-e's) stimulate AD growth while stimulating less credit and financial sector growth than the current rate targeting approach or QE. Hel-e's stimulate while maintaining a higher interest rate becuase expansions of money arent accompanied by increased demand for bonds by fed and because loanable funds dont increase when the fed expands into emoney accounts. Higher rate means less credit. Therefore financial sector growth will be less, positively affecting real GDP. Less credit means less instability.

      Krugman's post is assuming standard fiscal/monetary heli's with gov budget contraint. If the fed conducts emoney heli drops independantly it has no budget constraint.

  2. The issue of what to do at the zero bound is not "moot". Contingency planning suggests it is urgent.

    1. Eric, I agree it is important to know how to handle a ZLB crisis should it arise again in the USA. All I am saying is that it is "becoming moot" as the economy improves.

  3. I know all the economic professionals have the monetary tools down pat and will discuss them forever. My reading of the long dead economist Keynes, is that the metric we should all concentrate on is not interest rates or inflation, but employment. If the tool isn't creating jobs and income growth guaranteed, it should be discarded. In the real world that means direct hiring by the government. Tax cuts, another fiscal tool discussed ad nauseam, are obviously ineffective. We had better economic growth when the top marginal rate was 94 percent!

  4. David,
    Here's the piece of this which I don't see addressed in these blog conversations (though no doubt its in the literature):

    Preferring a monetary policy response over a fiscal response seems to imply a cyclical fiscal policy response, but this leaves a large implicit assumption that the structural level of fiscal policy contribution to the economy is correct.

    But, I never see anyone model out what the appropriate structural level of fiscal contribution to the economy is, nor argue why, nor argue how to regulate that level to push it to the 'correct' level.

    What am I missing?

    It seems awfully random and almost certainly not optimal to assume that the product of various government regimes in the world all result in the right structural fiscal contribution for their respective economies.

    It seems entirely possible that structural Fiscal policy in the US is at the wrong level.

    Why just assume that it is?

  5. It would be good to experiment with a Fed policy of having an inflation target, not an inflation ceiling target.

  6. > To return the PCE to its targeted path would require a temporary burst of higher-than-normal inflation.

    We could be a little more conservative and simply decide to institute a price-level target equivalent to 2% per annum, starting today and today's prices. It's basically the same as today, but with catch-up (and catch-down) in the future, based on a trend which is 'reset' to start from today. This would create some confidence that, 5 years from now, prices should have increased by about 10.4%. Under the current regime, I wouldn't be surprised if prices are the same (or even smaller) in five years' time than they are today. Then again, I wouldn't be (entirely) surprised if they went up 15%!

    The current regime, without catch-up and catch-down, means that uncertainties about prices in the long term just get bigger and bigger.

    If inflation is below target for a couple of years, a catch-up/down regime, means the inflation 'timebomb' just gets "worse" over time. But that's actually a good thing as investors will want to get ahead of the explosion, spending their cash piles before inflation destroys them overnight.

    The end result may actually be that the 2% per annum target is closely achieved forever. Rather that being a "regime change", it simply becomes a more successful implementation of the current regime.

    Yes, it is still too conservative to my (layman's) eyes. But it's a good way to start people thinking about change. It's still a 2% inflation target, just with less variability around long-term price expectations. What's the dislike about that?