“Much ado about ‘nothing’”

That´s just a parody on Krugman´s “Much ado about zero”:

Ryan Avent and Matt Yglesias have been having a debate about whether the zero lower bound really matters for monetary policy, which is related to — but not the same as — the debate about whether the Fed is falling way short on the job. So let me throw in my two basis points here.

The shared starting point here is that we are in a situation in which the Fed would clearly cut rates if it could; based on historical relationships between unemployment, inflation, and policy rates, the Fed funds rate “should” be something like -4 percent. But the Fed can’t do that. What it could do, however, is try to reduce real interest rates by raising expected inflation.

Changing inflation expectations may be similar in its implications to just cutting rates, but it’s very different in terms of implementation. The Fed can cut rates simply by telling the open-market desk to make it so; it can only change expected inflation by shifting market beliefs about what it will do some years down the road — by credibly promising to be irresponsible, as I put it way back when — which is a much more iffy task.

And ends:

So the zero lower bound does matter. By all means, let’s harass the Fed from the left, and demand that it do more. But I hope it’s possible to accept simultaneously the insight that the Fed could and should do more, and that it’s hard at the zero lower bound, and it would really help if the Fed had fiscal help.

The ZLB matters only because the discussion has equated monetary policy with setting an interest rate (FF) that has dropped to “zero” so that it´s not operative. But it doesn´t have to be so. The Fed could set a target other than an inflation target, which has for many years been “married” to the interest rate target.

The guys were right in spending a lot of time over the last 12 years discussing “The conduct of monetary policy in a low inflation environment”, which, incidentally is “proof” that “targeting inflation” through the intermediate target of interest rates was not perceived as robust.

A target such as a nominal GDP level target is NOT a promise to be irresponsible. It has the additional advantage that it dispenses with “help” from fiscal policy, something that only “muddies” the waters as the last few years have shown.

In an earlier post Krugman conclude the discussion about Bernanke´s “turn-about” after becoming Fed Chair with (where Menu B is composed of such dishes as “keeping rates low for long” and Menu A is composed of dishes such as “higher inflation target”)

You can see where I’m going here. Menu B is, if you like, safer for the Fed than Menu A, because it is defined in terms of actions rather than results; the Fed can point to what it is doing, rather than announce a target for long-term rates or inflation that it might fail to hit. So Menu B serves institutional objectives better. Unfortunately, it doesn’t do the job for the economy. To be fair, we don’t know that Menu A would, in fact, be sufficient. But Benanke the Younger — BB before he was assimilated by the Fedborg — would have said that this was no reason not to try.

Maybe BB still thinks the same way as when young. Check this answer to a question after his first press conference one year ago:

Mr. Chairman, [Carmen Reinhart and Kenneth Rogoff] wrote a book looking at 800 years of financial history and discovered when you have a financial crisis it takes a lot longer for the economy to recover.

Are people expecting too much from the Federal Reserve in terms of helping the economy recover? Has that complicated your monetary policy making?

Mr. Bernanke wasn’t ready to concede that the Fed is quite as powerless as the questioner suggested:

I enjoyed that book very much. I thought it was informative and as you say, it makes the point that as a historical matter, recoveries following a financial crisis tend to be slow.

What the book didn’t do is give a full explanation of why that’s the case. Part of it has to do with the problems in credit markets. My own research when I was in academia focused a good deal on the problems in credit markets on recoveries.

Other aspects would include the effects of credit problems on areas like housing and so on. We are seeing all that, of course, in our economy.

That said, another possible explanation for the slow recovery from financial crises might be that policy responses were not adequate. That the recapitalization of the banking system, the restoration of credit flows and the monetary fiscal policies were not sufficient to get as quick a recovery as might otherwise have been possible.

And so we haven’t allowed that historical fact to dissuade us from doing all we can to support a strong recovery. That being said it is a relatively slow recovery.

What exactly does the “might otherwise” refer to? Maybe stuff he recommended to Japan 13 years ago? Things like setting a price level target – which FDR did and had immediate success in turning the economy around? And he has mentioned NGDP targeting at one time or another.

Bottom line: he knows there are alternatives. He knows, contrary to Krugman, that the ZLB for interest rates is not binding. But he still doesn´t take appropriate action!

Update: Nick Rowe has a much better post on this topic:

The natural rate of interest is not a number; it’s a time-path. And the central bank doesn’t observe that time-path, so when it sets the actual rate it will almost always miss the natural rate time-path. And when the economy is off that time-path, that will cause the time-path to shift. Because expectations will change. And because reality will change too, as investment changes and capital stocks (understood in the broadest sense to include human capital and the stock of employment relations) change too. So, while useful as a theoretical concept, the natural rate of interest is perhaps not so useful as a practical guide to monetary policy as the Neo-Wicksellian approach requires.

Which is perhaps why all of us, central banks especially, should stop framing monetary policy in terms of interest rates. Setting interest rates is not what central banks really really do. It’s a social construction of what they do. When central banks talk about setting interest rates that is only a communications strategy, and not a very good communications strategy, especially at times like this.

One thought on ““Much ado about ‘nothing’”

  1. Pingback: "Much ado about ‘nothing’": the ZLB on interest rates is really not binding, much to Krugman´s chagrin « Economics Info

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