Credible Promises about 'Irresponsible' Policy

Paul Krugman discusses Michael Woodford's important paper:

Woodford on Monetary Policy (Sort of Wonkish), by Paul Krugman: I’m not in Jackson Hole... No matter. I can still read the papers — and the most important one was by Mike Woodford (pdf). Woodford’s paper is long and really dense... But the bottom line is “Ben, ur doing it wrong”.

The topic is what, if anything, monetary policy can do when interest rates are up against the zero lower bound... Under these conditions, conventional monetary policy ... has no traction.

Yet this need not mean that the central bank is without options. I think I was the first to make a point (pdf) that Woodford and Gauti Eggertsson greatly expanded in 2003, namely, that the central bank can still gain traction if it can convince the public that it will pursue a more inflationary policy than previously expected after the economy recovers. As I wrote way back then, the central bank needs to credibly promise to be irresponsible.

But can it really do this? Woodford devotes the first half of the paper to an extended review of the evidence on “forward guidance”, in which central banks signal their future intentions — and finds strong evidence that such talk matters. So his answer is yes, the Fed could boost the economy by making a commitment to hold off on raising interest rates when recovery finally kicks in.

But that isn’t what the Fed has mainly done... So what should the Fed be doing? Woodford concludes that ... it needs to promulgate a view of its intentions that would lead it to be slower to raise rates following a big slump than it would in other circumstances. And let me repeat the past tense: following a big slump, not just when you’re in it.

How to do this? Nominal GDP targeting would be one answer, because it would give the Fed a reason to hold off for a long time on rate hikes. Other schemes might also do the trick.

The point is that this is exactly what the Fed has not done. Bernanke has gone to great lengths to reassure politicians that policy will revert to normal as soon as possible, that the Fed remains as vigilant as ever about inflation; and while Woodford doesn’t quite say this, all this amounts to offering forward guidance in exactly the wrong direction.

Important stuff.

As I explained long ago, here's the problem:

[The effectiveness of policy] relies upon changing expectations of future inflation (which changes the real interest rate). People must believe that the Fed will actually be willing to create inflation in the future when it comes time to do so. However, it's unlikely that it will be optimal for the Fed to cause inflation when the time comes. Because of that, the best policy is to promise to create inflation, then renege on the promise when it comes time to follow through. Since people know this, and expect the Fed will not actually carry through and create inflation, it's hard to get them to change their expectations now. All that credibility the Fed has built up and protected concerning their inflation fighting credentials works against them here.

That's why Krugman says repeatedly that the Fed "needs to credibly promise to be irresponsible."

One more note. While everyone has jumped on the statement about nominal GDP targeting, Woodford also says that tying policy to specific goals, e.g. promising to leave interest rates low until unemployment or inflation crosses some threshold, say 4% for inflation or 6.5% for unemployment, "would be an 'important improvement' on what the Fed is doing now, though he said it had flaws." In the short-run, this is probably much more politically viable than moving to a nominal GDP target (Charles Evans, president of the Chicago Fed has been the most vocal proponent of this approach, and I have endorsed it as well).

But let me turn the microphone back to Paul Krugman:

Monetary Versus Fiscal Policy, Revisited, by Paul Krugman: One recurring complaint from commenters on this blog is that they can’t figure out where I stand on monetary versus fiscal policy as a response to a deeply depressed economy. Sometimes, they say, I declare that monetary policy is ineffective once you’re at the zero lower bound; other times I berate Ben Bernanke for not doing more. Which is it?

But it’s not a contradiction. Mike Woodford’s latest paper, especially taken in tandem with his paper last year at the Cambridge Keynes conference, actually explains it all.

What Mike demonstrates is the point that liquidity-trap worriers have been making for a long time – actually, ever since my 1998 piece. Current monetary policy is indeed ineffective in a liquidity trap; but there is still scope for central bank action in the form of credible commitments to keep monetary policy easy in the future, when the economy is no longer at the zero lower bound.

The trouble is how to make those credible commitments. ...

What about fiscal policy? As Mike pointed out in his earlier paper, fiscal stimulus in a liquidity trap doesn’t require that you convince the market that you’re going to behave differently once the crisis is past. It doesn’t depend on expectations at all; the government just goes out and creates jobs. So it made a lot of sense to argue for stimulus as the main immediate response to the slump.

But isn’t fiscal stimulus also a hard sell politically? Yes, indeed...

So what should well-meaning economists do now, with both fiscal and monetary policy falling short? The answer is, campaign on both fronts...

Which is very much the approach I've pushed -- don't put all our policy eggs in either the monetary or fiscal policy basket. I've worried that there has been too much focus on monetary policy lately, and that has let fiscal policymakers -- who must join the battle to lower our crisis level of unemployment -- off the hook. Fiscal policy has an important role to play:

...one of the points that Eggertsson makes is that government spending does not have the credibility problem that plagues monetary policy. He says:

...Expansionary monetary policy can be difficult if the central bank cannot commit to future policy. The problem is that an inflation promise is not credible for a discretionary policy maker. ...

This credibility problem is what Eggertsson (2006) calls the "deflation bias" of discretionary monetary policy at zero interest rates. Government spending does not have this problem. ... The intuition is that fiscal policy not only requires promises about what the government will do in the future, but also involves direct actions today. And those actions are fully consistent with those the government promises in the future (namely, increasing government spending throughout the recession period). ...

We need to push on both the monetary and fiscal policy fronts. Neither policy alone will be sufficient to get the job done (even without the political hurdles standing in the way), and it's far past the time for both Congress and the Fed to do more about our crisis level unemployment problem.