Williamson: Monetary Policy Issues

Stephen Williamson discusses the Wall Street Journal Symposium on monetary policy. He reacted much as I did, though as noted below I at least found one statement I could support:

Two days ago, the Wall Street Journal published a "symposium," titled "What Should the Federal Reserve Do Next," with short pieces by John Taylor, Richard Fisher (Dallas Fed President), Frederic Mishkin, Ronald McKinnon, Vincent Reinhart, and Allan Meltzer. The WSJ picked a group of conservative economists with a considerable amount of accumulated policy experience among them, and including one sitting Federal Reserve Bank President (Fisher). One would think we could get something useful out of these guys. Well, apparently not.

While I mostly agree with what he says, I have a few quibbles. Stephen Williamson says:

Many central banks focus on "core" measures of inflation. I think that's nonsense. The idea is that we should ignore volatile prices when we think about inflation targeting, which seems akin to ignoring investment and consumer durables expenditures during recessions. Some people draw distinctions between prices that are "sticky" and those that are not, which seems like a related, and equally bad, idea. Since the costs of inflation are related to the fact that we write contracts in nominal terms, which makes inflation uncertainty bad, it seems we should aim for predictability in the rate of change in the broadest possible measure of the price level, which for me is the implicit GDP price deflator.

Monetary policy works with a lag, so we need to know about inflation in the future -- that's the target we are trying to hit. There is evidence core inflation is better than headline inflation at predicting future headline inflation. Here's Mike Bryan of the Cleveland Fed (see here too):

Michael Bryan, an economist at the Cleveland Fed, says the bank’s trimmed mean consumer price index does a better job in the short term at predicting future overall inflation than core inflation does. “It’s really reducing the noise and improving the signal,” Bryan said. “There’s almost no signal in the overall month-to-month CPI.”

The same is true for inflationary expectations. I should add that the evidence is a bit more mixed than this implies, e.g. there is one paper that argues the core inflation rate produces a biased estimate of future inflation, but my point is that there isn't an open and shut case against the use of core inflation even if you think headline inflation is the right quantity to target. We also differ on which price measure to use, I prefer the PCE index rather than the nominal GDP deflator since I think it produces a measure closer to what we have in mind in our theoretical models.

I should also add that the objection to using a weighted price index, perhaps one that includes wages and asset prices in addition to the usual components -- where the weights are based upon the degree of stickiness -- is really an objection to the underlying mechanism used to model price stickiness (the "Calvo Fairy"). If you accept the mechanism, then this approach has theoretical support (see here for a discussion from Woodford on this point).

He also objects to the use of the output gap in the Taylor rule, partly based upon measurement issues, and calls for pure inflation targeting. However, while I agree measurement is always a difficult issue, one that goes beyond concerns about how to measure the gap (e.g. which inflation measure is best?), that concern is not uncommon and not enough to pose an insurmountable objection. More importantly, the literature on divine coincidence (here and here) suggests that there can be advantages to a rule that includes gap measures. That is, a pure inflation target does not do as good a job of maximizing welfare as a rule that includes both inflation target and and output gap components.

But I have no disagreement at all with his (mostly negative) comments regarding the contributions of Fisher, Taylor, and Meltzer. On Fisher he says:

Let's start with the low point. Fisher should win the bad analogy contest with this:

One might assume that with more than $1 trillion in excess bank reserves and significant amounts of cash held by businesses, the gas tank of those who have the capacity to hire is reasonably full. One might also conclude that the Fed, having cut the cost of interbank overnight lending to near zero and used quantitative easing to coax the entire yield curve downward, has driven the cost of gas to virtually nil for businesses that are creditworthy. And yet businesses still aren't hiring.

So, the gas is in the tank, the Fed has done all it can by making the cost of gas zero. So why won't the car go? Fisher says:

If businesses are more certain about future policy, they'll release the liquidity they're now hoarding.

He's talking about fiscal policy:

Fiscal and regulatory authorities share significant responsibility for incentivizing economic behavior through taxes, spending and rule making.

So, apparently the person driving the car, which is full of cheap gas, is paralyzed with fear - he or she might get stopped at the toll both, have to obey speed limits, etc. If Fisher is worried about policy uncertainty, he should probably clean his own house first (to use another analogy). What does the Fed intend to do with the more than $1 trillion in mortgage-backed securities (MBS) on its balance sheet. Will it hold those forever? Will they be sold off slowly? If so, when, and at what rate? What's with that "extended period" language in the FOMC policy statement? How long is that period? How do we know when it is time for the Fed to tighten? When the time comes to tighten, how does the Fed intend to do it - raise the interest rate on reserves, sell Treasuries, sell MBS?

Finally, Williamson doesn't discuss the contributions of Reinhardt, McKinnon, and Mishkin, and while Mishkin and McKinnon deserve to be ignored, I thought Reinhardt had the most reasonable answer, one I could support:

The Fed should promise to purchase government and mortgage-related securities between its regularly scheduled meetings as long as activity is forecast to be subpar and inflation is low or headed down. Purchases of, say, $100 billion every six-to-eight weeks would add up to a number worthy of shock and awe for those with a somber economic outlook.

But those foreseeing a quick return to above-trend growth or expecting a slower trend would similarly be reassured that the Fed would not keep its foot on the accelerator for too long. Most importantly, by linking to economic conditions, the Fed would not be providing an open-ended promise to monetize the federal debt.