Goodhart’s Law – in Good Times and in Bad

A large part of the success of central banks all around the world during what became known as the Great Moderation is often attributed to the successful anchoring of inflation expectations to the levels that central banks would like to see – generally defined as 2% in most of the industrialized world. In basic theory this is awesome: if the inflation rate, through some kind of phillips curve or any other structural relationship you prefer, is linked to the aggregate level of economic activity in a stable way, than a stable inflation rate also leads to a stable level of economic activity.

In comes Charles Goodhart, former member of the Bank of England’s Monetary Policy Committee, who stated something as profound as at the same time similar to the famous Lucas Critique: Goodhart’s Law. In it’s most common version it says that “when a measure becomes a target, it ceases to be a good measure”. In other words, once a central bank (or in theory indeed any institution with enough clout to consistently affect the economy) states that it will do whatever it needs to in order to keep a given indicator at a level it so desires, the market structure will be affected by this, expectations of market agents will adapt, and the target will be achieved, even if the central bank does not really even do much – it just has to credibly promise that it would.

First of all, and on a very deep level, this of course could be seen as qualifying the very success of central banks in “anchoring” inflation rates. Has inflation in the past two decades been so tame because central banks have become better, or simply because they somehow managed to credibly make everyone believe that they have become better? In the end, the answer doesn’t matter much – it is outcomes that we want, who cares about how we get there. However, while the upside to this stable inflation anchoring in good times is enormous, it seems to have come back to haunt us at a time when we most need our monetary authorities to act. Even though inflation both in the US as well as in the Eurozone is considerably below target, inflation expectations are awkwardly close to those targets over the near-term (e.g. here for the Eurozone). Given most central banks nowadays target the forecast, they might interpret this as signalling that there is no real big need to act, and thus not act in the first place. I personally find this to be one of the most compelling explanations as to why the ECB continues to fail to do its job. As Draghi stated, “inflation expectations are firmly anchored in line with price stability“. Exactly. That’s the problem.

The Fed is in a somewhat better position since it does not only target inflation but also full employment – even if inflation sticks to 2%, as long as unemployment is above target it will (or should) ease monetary policy. The ECB, on the other hand, focuses essentially solely on inflation, and at the moment there are great doubts as to whether inflation (particularly inflation expectations) are of any use at all as a signal for what it should be doing. This monthly bulletin by the ECB (dating back to 2011, .pdf), for example, states that “well anchored expectations have contributed to enhancing the effectiveness of monetary policy and will assist the ongoing economic recovery”. Sure, stable inflation expectations also prevent us from falling into outright deflation in a scneario were we assume the central bank to be asleep. Further, as Clarida states (.pdf), “inflation inertia is the enemy of reflation once deflation set in”. However, I would state that somewhat differently: inflation inertia (in the context of this post in terms of expectations) is the enemy of reflation – period. At the moment it mostly provides a convenient excuse for central banks to do less than they should. Currently, it would seem that those well-anchored inflation expectations are part of what’s preventing effective monetary policy in the first place.

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The Mystery of the Falling Natural Real Rate of Interest

A couple of weeks ago Larry Summers held a widely praised speech on the difficulties ahead for economic stabilization policy. As far as I can tell, not much of it was really new, as also pointed out by e.g. Krugman, but that does not mean it wasn’t a great speech, and one that seems to have had considerable influence on the policy debate. In essence it boils down to the problems we face due to the zero lower bound on nominal interest rates, and what happens in a world where the real interest rate required to establish full employment, sometimes also called the natural real interest rate, is negative, as it almost certainly is right now.  Yet from the regression’s I have been running, it would seem that the equilibrium real interest rate was already considerably lower than in previous periods even before the crisis started. In other words, even before the crisis struck, monetary policy already had considerably less room to maneuver than in the decades preceding the the 2000s. To recap, let’s again take a look at a fairly simple Taylor rule one might use to describe Fed policy in the 2000s, more precisely from the first quarter of 2000 to the second quarter of 2009, which is roughly around the time when the zero lower bound started binding.

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What Does “Easy Money” Even Mean?

Gerald brought up a really good question in my last post on ECB monetary policy stance since the crisis. I’m afraid Buttonwood got a bit trampled there, which in retrospect seems somewhat one-sided, since a big deal of his post is actually very good. Anyways, to the question:

What do you think a really easy monetary policy by the ECB would look like? Is it mostly about increasing the inflation target? Or would your rather have the central bank buy the debt of troubled economies like Greece?

At first I wanted to rush straight into it, but then I noticed that is pointless without clearing up what my definition of “easy money” is in the first place. I’ve spent quite a bit of time in this blog arguing that monetary policy all around the world, but particularly in the eurozone, is much too tight no matter which way you look at it. Let’s see what the ECB announcement brings today. A big issue i have with a lot of the current discussion, particularly in the Media, is that the currently historically low nominal interest rates are assumed to, by themselves, prove that money is “easy”, which is just wrong. So let me try and clarify some of the issues involved from my perspective.

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Alan Greenspan on The Daily Show

First of all, Jon Stewart is awesome. I have no idea how I could have gone so long without ever stating this here. If you are even remotely interested in American politics and enjoy good comedy, The Daily Show is as good as it gets.

If you’re here just for the economics, you can always just skip the first part and scroll right to the interview, which starts at around 14:00. Clearly, The Daily Show is not the platform for overly wonkish, in-depth policy discussion, but still very worthwhile. From what I’ve read on his new book, the degree to which Greenspan has changed his views since the financial crisis seems to be fairly limited, but no real comment on that for now.

PS: It seems I cannot embed the second part of the interview. Here’s the link to the Daily Show directly.

To Inflate or Not to Inflate

The nomination of Janet Yellen to the chair of the FED seems to be as good an occasion as any to bring this blog back from the dead. No real comment on that other than it’s awesome, so let’s get back into some general monetary economics.

Following the Great Recession there has been a lot of talk about the adequacy of the monetary policy response in its aftermath. Particularly the issue of the zero-lower-bound, well-known to Japan but often treated as something akin to an exotic decease that would never concern countries such as the United States, has been hotly debated. One of the most common calls to try and avoid the issue in the future, or at least make it’s occurrence more unlikely, has been to increase the inflation rate targeted by central banks. In the case of the United States the talk is often about raising it from 2% to 4%, whereas Japan has stopped talking and finally moved to do something about its long-lasting problem by increasing its target from 1% to 2%. And for all it’s worth, it seems to have worked fairly well. The two opposing views on this issue usually range from some weird notions of the “danger of inflation”, of “unanchoring inflation expectations” and everyone dying (or something) on the one hand to an essential no-brainer with little down-side risk on the other hand.

There is not much to say about the first notion other than there seems to be no compelling reason that central banks would have a harder time stabilizing inflation at 4% than at 2%. Even the lowest threshold value found in studies regarding the level at which things start spiraling out of control is around 8% and 4% certainly seems far enough away. Also, fear of inflation in general is essentially the view held by Niall Ferguson, which alone is a pretty safe indication that it is almost certainly wrong. The second view, however, is much more interesting. Indeed, in a perfectly nominal world (i.e. one where everyone and their dog is protected from the effects of inflation), increasing the inflation target by 2 percentage points would seem like the closest thing to a free lunch one might find.

However, and even if it is often downplayed, it would not seem to be that the issue of what a permanently higher level of inflation does to an economy over a longer period of time is as trivial or well-understood as is often portrayed. At least from my review of the somewhat limited literature on the topic it does not seem to be the case that we have all that good of a grasp of what would actually happen. My list of possible channels through which (either directly or indirectly) a higher level of inflation could affect income and wealth distribution, for instance, is solid two pages long and probably more than just incomplete. It also includes a lot of ifs and buts’, necessary assumptions regarding the distribution of creditors and debtors within the society, the nature of government institutions, the nature of different types of contracts and the bargaining power distribution between e.g. workers/unions and companies, just to name a few examples. Changing any of those assumptions flips the entire outcome.

It also does not seem entirely certain to me whether the effects this inflation would have on income distribution and wealth distribution would tend to be pointed in the same direction. And most importantly, the time frame used to make such analysis is vital. In times where the higher level of inflation boosts output back to its potential through monetary stimulus this would seem to almost certainly lower both types of inequality as measured by conventional inequality measures. What happens to the middle class is another entirely different story. It is unlikely to be the case anytime soon that we can declare that the “central problem of depression-prevention has been solved” (as Robert Lucas infamously declared back in 2003), so there will probably be another occasion where we could very much use the higher level of initial inflation. Krugman is also essentially correct in claiming thatone of the dirty little secrets of economic analysis is that even though inflation is universally regarded as a terrible scourge, efforts to measure its costs come up with embarrassingly small numbers”, yet as far as I can tell Friedman’s finding that Inflation is always and everywhere a monetary phenomenon” is about as much as we can say with real certainty.

Overall, systematic changes in inequality are generally a long-run issue, and despite price stickiness and whatnot money remains essentially neutral in the long run for the levels of inflation we’re talking about. Further, inflation most likely impacts inequality mainly through its effect on output to begin with, and from this point of view there is little reason to believe there would be any difference at all between 2% and 4% inflation during normal times. Yet maybe the fact that we would like to increase the inflation rate target says more about the nature of the target itself than about its fairly arbitrary numerical value.

The importance of overshooting monetary policy

The general concept that monetary policy should react in a strong fashion to try and bring an economy back on track is fairly widespread. In fact, it makes up a big part of how even John Taylor, nowadays on the very hawkish side of things when it comes to monetary policy, thinks central banks should proceed when they feel the need to act. In particular, the Taylor principle states that in order for a central bank to cool an economy it perceives to be overheating, it needs to raise interest rates by more than the expected rise in inflation. If inflation, for instance, deviates from the central bank target rate by 1%, the central bank should raise interest rates by something like 1.5%. Of course this basic prescription follows the idea that the real interest rate equals the nominal interest rate minus (expected) inflation. If you want to reduce economic activity by raising real rates, you clearly have to raise nominal rates by more than expected inflation. But the importance of this basic notion goes far beyond this almost trivial explanation, and more so in the case of current policy. Kugman’s concept of “credibly promising to be irresponsible” (.pdf) is also aimed in this direction. Overshooting, or “doing more than strictly necessary”, is essential not only for monetary policy to be truly effective, but also for it to remain effective in the future. Ryan Avent over at The Economist discusses the issue with regards to the current debate surrounding the FED’s “tapering”:

I understand that the Fed is generally uncomfortable with unconventional monetary policy and has concerns about the side-effects from large-scale QE. That’s eminently reasonable. The trouble is that the Fed seems not to have learned that aiming to overshoot on the pace of employment growth and inflation is the safer, more conservative route. Overshooting maximises the chance that monetary policy will maintain its potency the next time trouble hits. Overshooting provides the best means to safely and quickly end growth in the balance sheet. Overshooting is the sustainable route to healthy increases in interest rates. But overshooting, the Fed has made entirely clear, is the one thing the American economy should not expect.

And the risks involved in not overshooting have become even more clear in the aftermath of the recent crisis, as discussed by Yichuan Wang, who seems to hit the nail on the head with this statement with regards to how the FED got stuck in the liquidity trap in the first place:

It is important to remember the sequence of these events. It is easy to think that the downward pressure on interest rates was the inevitable consequence of financial troubles. […] The Fed’s sluggishness to act is even more peculiar given that there were already serious concerns about economic distress in late 2007. [T]he decision to wait three months to lower interest rates to zero was a conscious one, and one that helped to precipitate the single largest quarterly drop in nominal GDP in postwar history. The chaos in the markets did not cause monetary policy to lose control. Rather, the Fed’s own monetary policy errors forced it up against the zero lower bound.

In a way monetary policy (and not just by the FED) made the same mistake as fiscal policy in the aftermath of the crisis – it tried to be optimistic, “on the safe side” of things, and ended up providing stimulus that ended up being massively inadequate. Not only does this mean it now faces a much deeper slump than necessary, making its job much more difficult. It also means that the very ability of it to do its job is put in question. Just like the “failure” of the Obama stimulus plans to keep unemployment in the single digits has been the main argument against fiscal stimulus in general, monetary policy being stuck in a “liquidity trap” that it to some degree helped create in the first place has also been the main argument for those who say monetary policy can’t do anything more either!