Economics 470/570 - Monetary Theory and Policy

Lecture 17 on Thursday 3/13/2014

Brief Outline of Topics Covered in Lecture 17

Review for final exam

Video

Practice Problem Set 5

Economics 470/570 
Winter 2014
Practice Problem Set 5

1. Explain the activist and non-activist positions on the use of government policy to stabilize macroeconomic variables such as real output. What problems are encountered in the pursuit of activist policies?

2. Does stabilizing the inflation rate stabilize the economy? Explain (for AD shocks, SRAS shocks, and LRAS shocks).

3. What is the Lucas critique of econometric policy evaluation? Why is it important?

4. What is time consistency?

5. What are the arguments for and against rules over discretion?

6. What is constrained discretion?

7. What is a nominal anchor, and how does it help with credibility?

8. Show that credibility of the Fed helps to stabilize output when there are negative AD shocks.

9. Show that credibility of the Fed helps to stabilize the inflation when there are positive AD shocks.

10. Show that credibility of the Fed helps to stabilize both output and inflation when there are SRAS shocks.

Lecture 16 on Tuesday 3/11/2014

Brief Outline of Topics Covered in Lecture 16

Chapter 24 The Role of Expectations in Monetary Policy [continued]

• Discretion and Time-Inconsistency
• Types of rules
• The case for rules
• The case for discretion
• Constrained Discretion

The role of credibility and a nominal anchor

Credibility and aggregate demand shocks

• Positive and negative  AD shocks
• AS shocks
• Credibility and anti-inflation policy

Video

Extra Reading:

Tim Duy:

Unemployment, Wages, Inflation, and Fed Policy: I apologize if that was a misleading title.  This post is not a grand, unifying theory of macroeconomics.  It is instead a quick take on two posts floating around today.  The first is Paul Krugman's admonishment to the Federal Reserve against raising interest rates before wages rise:

So far, no clear sign that wage growth is accelerating. Even more important, however, wages are growing much more slowly now than they were before the crisis. There is no argument I can think of for not wanting wage growth to get at least back to pre-crisis levels before tightening. In fact, given that we’ve now seen just how dangerous the “lowflation” trap is, we should be aiming for a significantly higher underlying rate of growth in wages and prices than we previously thought appropriate.

I don't think that you should be surprised if the Federal Reserve starts raising rates well before wage growth returns to pre-crisis rates.  I think you should be very surprised if the Fed were to do as Krugman suggests.  Historically, the Fed tightens before wages growth accelerates much beyond 2%:

As I have noted earlier, wage growth tends to accelerate as unemployment approaches 6 percent, and so if you wanted to be ahead of inflation, they would be thinking about the first rate hike in the 6.0-6.5% range.  That 6.5% threshold was not pulled out of thin air.  

The second point is that the tightening cycle is usually topping out when wage growth is in the 4.0-4.5% range.  One interpretation is that the Fed continues to tighten policy to prevent workers from gaining too much of an upper-hand, thereby contributing to growing wage inequality.  Of course, I doubt they see it that way.  They see it as tightening monetary conditions to hold inflation in check.  Either way, the end is the same.  It would represent a very significant departure from past policy if the Fed waited until wage growth was at pre-recession rates before they tightened policy or if they allow conditions to remains sufficiently loose for wage growth to eventually rise above pre-recession rates.

If you want the Fed to make such a departure, start laying the groundwork soon.  The best I can offer is my expectation that Fed Chair Janet Yellen is more inclined than the average policymaker to wait until wages actually rise before acting.  I have trouble believing that even she would wait until wage growth accelerates to pre-recession trends.

Second, the Washington Post's Ylan Mui has this:

But a funny thing happens once unemployment hits 6.5 percent: The behavior of inflation starts to become random, as illustrated in this chart by HSBC chief U.S. economist Kevin Logan.

 

The black line represents the average annual unemployment rate for the past 30 years. You can see that in all but two cases (both of which were temporary shocks), inflation declined when the jobless rate was above 6.5 percent. But when unemployment rate fell below that point, inflation was almost as likely to increase as it was to decrease. In other words, what happens to inflation below the Fed’s threshold is anybody’s guess.

I would take issue with the idea that inflation behavior becomes "random" at unemployment rates below 6.5%.  You need to consider this kind of chart in the context of expected inflation and expected policy.  If inflation expectations are stable, and if the Federal Reserve provides policy to ensure that stability, you would expect random errors around expected inflation.  Couple this with downward nominal wage rigidities, and you should expect the same even under circumstances of high unemployment.  Here is my version of the same chart:

 

The data is monthly.  This y-axis is the change in inflation from a year ago, where inflation is measured as the year-over-year change in core-pce.  Unsurprisingly, since 2000, changes in core-inflation vary around zero.  Stable and low inflation expectations.  During periods of the 1970's and 1980's you see the impact of unstable expectations as the relationship circles all over the place.  But you also see the general pattern of disinflation since the early 1980's with the downward sloping relationship and many inflation observations, even at low unemployment rates, below zero.

Now it is fairly easy to put both of these posts together.  The Fed, wanting to ensure stable inflation expectations, begins raising interest rates well before wage rates begin rising.  This is turn controls the growth of actual inflation so that inflation rates do not rise as unemployment falls further.  The deviations of inflation from expectations are then just noise.  But actual inflation is not "random."  It is the result of specific monetary policy.

Bottom Line:  If the Fed follows historical behavior, they will begin tightening before wages rise and in an environment of low inflation such that inflation remains stable even as unemployment falls.  In other words, in recent history that have not exhibited a tendency to overshoot.  Explicit overshooting would represent a very significant shift in the Fed's modus operandi.

Midterm 2 and Solution

Midterm 2 and solution.

Lecture 15 on Thursday 3/6/2014

Brief Outline of Topics Covered in Lecture 15

Chapter 24 The Role of Expectations in Monetary Policy

The Lucas Critique of Econometric Policy Evaluation

Rules versus Discretion

• Discretion and Time-Inconsistency
• Types of rules
• The case for rules
• The case for discretion
• Constrained Discretion

The role of credibility and a nominal anchor

Credibility and aggregate demand shocks

• Positive and negative  AD shocks
• AS shocks
• Credibility and anti-inflation policy

Video

Extra Reading:

Tim Duy:

Fed Talk Shifts to Higher Rates, by Tim Duy: First off, sorry for the limited blogging of recent weeks. In the weeds at the office and the time to complete my winter to-do list before spring break is growing short.

With the end of asset purchases in sight (and assuming activity does not lurch downward) Fed officials will increasingly turn the discussion toward raising interest rates. It is not as if the anticipated time line has been any secret. The Fed's forecasts clearly show an expectation of higher rates in 2015 with the exact timing and pace of that tightening dependent upon each participant's growth and inflation forecast. Fed officials would want to clearly telegraph such a move well in advance. Hence they will pivot from talk of sustained low rates to raising rates. Of course, we would expect hawks to be first in line, as they have been. For instance, Philadelphia Federal Reserve President said last week (via the Wall Street Journal):

“Most formulations of standard, simple policy rules suggest that the federal funds rate should rise very soon–if not already,” Mr. Plosser told a conference sponsored by the University of Chicago‘s Booth School of Business.

Such warnings from Plosser are not new. More notable is San Fransisco Federal Reserve President John Williams' interview with Robin Harding at the Financial Times. Williams is generally seen as a dove, but he was also was one of the first to telegraph the end of asset purchases. Williams on the forecast:

In his own economic forecast, Mr Williams said, the Fed will raise interest rates in the middle of next year with the unemployment rate at about 6 per cent, inflation at 1.5 per cent and “everything moving in the right direction”.

“At that point if we don’t start to adjust monetary policy there’d be a risk of overshooting,” he said. “You don’t wait until you’re at full employment before you start to raise interest rates from zero.”

There is a lot to think about in those two paragraphs. First is a forecast of 6% unemployment 15 months or so from now. Given the rapid drop in the unemployment rate, it is completely believable that we reach 6% before asset purchases are predicted to end later this year. Given Williams' forecast, this suggests to me that the risk here is a more rapid tapering or earlier rate hike. The second is the idea of raising rates when inflation is only 1.5%. This to me suggests that Williams is expecting to reach the 2% target from below, not above. This seems clear from the next point: Williams wants to take the possibility of overshooting off the table.

Note that Williams' position differs greatly from that of Chicago Federal Reserve President Charles Evans. From a speech last week:

A slow glide toward our goals from large imbalances risks being stymied along the way and is more likely to fail if adverse shocks hit beforehand. The surest and quickest way to get to the objective is to be willing to overshoot in a manageable fashion. With regard to our inflation objective, we need to repeatedly state clearly that our 2 percent objective is not a ceiling for inflation. Our “balanced approach” to reducing imbalances clearly indicates our symmetric attitudes toward our 2 percent inflation objective.

Evans is obviously willing to overshoot, where Williams is not. Whether the consensus sides with Williams or Evans is critical to the timing of the first rate hike. If the consensus is set on hitting the inflation target from below, then we have have to consider the Fed's own forecasts as suspect. They will find themselves moving sooner than they expect.

I would say, however, it is widely believed, on the basis of her "optimal control" analysis, that Federal Reserve Chair Janet Yellen leans toward Evans. Any suggestion that Yellen leans toward Williams on the overshooting question would be notable.

Regarding asset purchases, Williams joins the chorus indicating the bar to change is high:

Mr Williams said it would take a “substantial change in the outlook” before he was willing to revisit the Fed’s plan to slow purchases by $10bn at each meeting, and despite some weak data, that has not yet happened. “We haven’t really changed our basic outlook for the economy.”...

...Mr Williams said that as long as average monthly jobs growth stays well above 100,000 then unemployment will continue to come down. “What would worry you is if you don’t have an explanation for why it’s weaker and you get multiple months below that,” he said.

I don't think this should come as a surprise. The Fed has been looking to get out of the asset purchase business since the beginning of 2013. The end is now in sight, and only the most disconcerting of data will change that. They may say they are data dependent (Williams of course adds that he could envision circumstances in which the Fed slow or even reverse tapering), but the reality is they have a bias against asset purchases.

The desire to exit asset purchases only increases as the unemployment rate falls. I think that Joe Weisenthal is on the money here when he points out that economists are gravitating toward the idea the the changes in the labor market are largely structural. In other words, as St. Louis Federal Reserve puts it (via the Wall Street Journal):

“I think that unemployment is really sending the right signal about the labor market” and the decline in the labor force participation rate is largely a demographic issue that will play out over a long time horizon, he said.

I think that Fed officials have long seen the risk that this might be true, which is one factor that biases them against asset purchases. Increasing, though, I suspect they do not see is as a risk, but as reality. Again, the consequence is that rates might be rising sooner than Fed officials currently anticipate. It is worth repeating this chart:

In the past, wage growth accelerates as unemployment hits 6%. With unemployment well above 6%, it was difficult to conclusively say much one way or another about the exact amount of slack in the labor market as there was certainly enough slack to keep wage growth in check. If the unemployment rate is no longer the appropriate indicator of labor market slack, then we should not expect to see upward wage pressure as 6% looms. If that pressure does emerge, then I think we learn something about the amount of slack. From the Fed's point of view, if they see wage growth, they will suspect their isn't much. Wage growth will raise concerns about unit labor costs, which will in turn raise concerns about inflation.

Weisenthal, however, adds:

The view from the left is basically: Even if the labor market is getting tight (which they deny), the Fed should press hard on the gas pedal, so that employers start to employ the long-term unemployed.

And that might be the proper path, and if there's anyone who has the stomach to engage in the strategy, it's probably Janet Yellen.

Once again, this implies that Yellen is willing to risk overshooting. Her views on overshooting are critical to the evolution of policy at this point.

Bottom Line: Put aside the possibility of an international crisis-fueled collapse in activity. The Fed's baseline view is that economic growth continues this year at a pace sufficient to end the asset purchase program. The Fed will resist changing that plan for any minor stumble in activity. The pace of job creation itself might not be that critical; it simply needs to be fast enough to lower unemployment to justify continuing the taper. Moreover, we are reaching a point where the Fed will need to decide to what extent it will risk overshooting. That was never really a risk of overshooting above 6% unemployment. Soon it will be an interesting question. The timing of the first rate hike and the subsequent tightening is dependent upon the consensus on overshooting. If wage growth starts to accelerate, the Fed's focus will shift from fears of too much to too little slack. If they are concerned about overshooting, they will need to accelerate the tightening time line. Where Yellen ultimately falls on the issue is critical.

Lecture 14 on Tuesday 3/4/2014

Brief Outline of Topics Covered in Lecture 14

Chapter 23 Monetary Policy Theory [probably won't get very far into this chapter, if at all]

Response of monetary policy to shocks

• Response to an AD Shock
• Response to a permanent supply shock
• Response to a temporary supply shock
• Summary

How active should policymakers be?

Is inflation always a monetary phenomenon?

• Causes of inflationary monetary policy

Chapter 24 The Role of Expectations in Monetary Policy [probably won't get this far]

The Lucas Critique of Econometric Policy Evaluation

Rules versus Discretion

• Discretion and Time-Inconsistency
• Types of rules
• The case for rules
• The case for discretion
• Constrained Discretion

The role of credibility and a nominal anchor

Credibility and aggregate demand shocks

• Positive and negative  AD shocks
• AS shocks
• Credibility and anti-inflation policy

Video

Extra Reading:

Robert Shiller:

In Search of a Stable Electronic Currency, by Robert Shiller, Commentary, NY Times: ... Bitcoin’s future is very much in doubt. Yet whatever becomes of it, something good can arise from its innovations... I believe that electronic forms of money could give us better pricing, contracting and risk management. ...

Bitcoin has been focused on the wrong classical functions of money, as a medium of exchange and a store of value. ... It would be much better to focus on another classical function: money as a unit of account...

This has already begun to happen. ... For example, since 1967 in Chile, an inflation-indexed unit of account called the unidad de fomento (U.F.), meaning unit of development, has been widely used. Financial exchanges are made in pesos, according to a U.F.-peso rate posted on the website valoruf.cl. One multiplies the U.F. price by the exchange rate to arrive at the amount owed today in pesos. In this way, it is natural and easy to set inflation-indexed prices, and Chile is much more effectively inflation-indexed than other countries are. ...

With electronic software in the background, we can ... move beyond just one new unit of account to a whole system of them...

Bitcoin has been a bubble. But the legacy of the Bitcoin experience should be that we move toward a system of stable economic units of measurement — a system empowered by sophisticated mechanisms of electronic payment.