Hit and Run on Sumner
We have a super duper awesome conference this weekend here at the Free Market Institute, so I have to be brief. Let me first motivate this post by issuing the following statement, to which I want you to react:
*** Ten-year bond yields have plummeted to 1.83%, from about 2.2% when the Fed “raised” interest rates in December. I hope all the Market Monetarists whining about the Fed’s “target rate being above the natural rate” are pleased to have gotten your way. ***
Let that sink in for a moment. I’m guessing any Market Monetarist fan reading this post will now be sure–in case there was any doubt before–that I am either (a) an idiot, (b) an intellectually dishonest scoundrel, or (c) both. If you think about the above statement, you’ll realize that there are at least three things wrong/unfair about it, and that I would have no business leveling that against Market Monetarists.
The reason I bring this up is that in reality, here is what Scott Sumner recently wrote on his blog:
“Or how about 10-year bond yields plummeting to 1.83%, from about 2.2% when they “raised” interest rates in December. I hope all you Austrians who whined about “artificially low rates” being set by the Fed are pleased to have gotten your way.”
Now on to something far more substantive. Look at how Scott–one of the world’s leading free market experts on monetary policy–thinks about this stuff: “In a better world the risk of recession and the risk of the economy overheating would always be evenly balanced. And I mean always, every single day of the year.”
And there you have it. When people in the comments refer to Scott as a Keynesian, this is what they mean. This is straight up crude demand management. We don’t need to know about relative prices or capital structure. There is a tradeoff between unemployment and (price) inflation and it’s the Fed’s job to turn the dial one way or the other to coast through the sweet spot.
Against that perspective, consider Hayek from his Nobel address:
The theory which has been guiding monetary and financial policy during the last thirty years, and which I contend is largely the product of such a mistaken conception of the proper scientific procedure, consists in the assertion that there exists a simple positive correlation between total employment and the size of the aggregate demand for goods and services; it leads to the belief that we can permanently assure full employment by maintaining total money expenditure at an appropriate level. Among the various theories advanced to account for extensive unemployment, this is probably the only one in support of which strong quantitative evidence can be adduced. I nevertheless regard it as fundamentally false, and to act upon it, as we now experience, as very harmful.
P.S. I realize Scott was just venting on this particular blog post, such that he devolved into jokes about the NBA. Take my remarks above in the same light-hearted spirit.
Yeah damned those Keynesians like Milton Friedman.
If you want to this to be serious (though your postscript tells us otherwise), then this is really about the cantillon effects argument from a couple years ago. So we should all return there, everything else is a red herring.
Ryan Murphy wrote:
Yeah damned those Keynesians like Milton Friedman.
Wait, Ryan, you have a quote where Friedman says, “Every day, the Fed should adjust policy so that the chance of recession is evenly balanced with the chance of overheating”?
I don’t because old monetarists wanted to regulate the banking and financial system in such a way that velocity would be stable, remember?
OK, sure, I’ll react. Direct empirical confirmation of the Irving Fisher equation.
If, in my belief, the government has set the short term interest rate too low right now (i.e. below the “natural rate”) then automatically I also expect some sort of inflation to happen and thus I add a discount factor to a ten-year bond rate in order to compensate for this expected inflation. Once I see the Fed is raising rates (finally!) my expectation of future inflation is dampened and thus I would reduce the nominal rate for a ten-year bond.
This is totally consistent with the Fed’s rate being below the natural rate (leading to a steep yield curve as everyone attempts to protect themselves from inflation) and moving towards the natural rate (thus slightly flattening the yield curve, and bringing us to some sense of normality).
As the British say: “swings and roundabouts”.
Do Texans have a similar expression?
Well it WAS below natural dang it! And Yellen did the right thing by raising rates (OK, that’s wrong thing by Keynesian standards, and wrong thing in terms of short term pain, but right thing from an Austrian perspective and overall I think it will benefit the US economy in the long term).
This is now the biggest challenge for Yellen… will she hold steady and carefully balance inflation against deflation? Or will she do what Peter Schiff believes she will do and unload QE all over the place to give a temporary boost just before the election?
I have more respect for Yellen than Schiff does, I think she has a bit of an idea that interest rates were too low for too long and she will hold her resolve and not go back to QE. If Schiff turns out to be right then my respect for Yellen will evaporate but I’m just saying don’t be too sure that more QE is coming.
Yield curve is flattening, isn’t that the wrong signal for Yellen for further increasing rates? I mean the yield curve can flatten just by holding steady..
I suspect Yellen will be very cautious in terms of further rate rises.
For what it’s worth, Yellen was asked, in the relatively recent past, about what the Fed could do if the economy went “back into recession” (really a correction), and she said that QE was one of the tools that could be used because, as Peter Schiff claims she said, “it worked so well the last time”:
[Time stamped]
Damn the Data, Rate Hike Ahead
https://www.youtube.com/watch?v=5t-DQYQz5RQ#t=15m11s
Data Be Damned, Rate Hike Ahead?
[www]http://www.schiffradio.com/data-be-damned-rate-hike-ahead/
I am still baffled, no wrong, I am baffled more every day how smart people can actually believe by adjusting AD you can optimize the hugely complex process of wealth creation.
It is like thinking, that you only need to adjust the amount of notes played in a song to get a good song…
Good analogy.
Well, many people seem to admire guitar players simply because they can play a bunch of notes per second. I’m not one of them.
Austrians believe the current Fed rates are *below* the natural rate. Sumner believes they are *above*. Now, how do we decide who’s right?
We can’t just answer: “let’s look at inflation: if there is inflation, they must be below the natural rate; if there is deflation they must be above”. We can’t say that, because a positive supply shock can prevent inflation even if they are below the natural rate; and a negative supply shock can prevent deflation even if they are above.
Suppose, as Austrians, we believe the Fed caused the 2008 recession by setting rates *below* the natural rate. Does it follow that *right now* rates are still below the natural rate? No: it could be that the Fed destroyed the structure of capital so much that natural rates dropped below the fed rate. So right now fed rates could be too high, not too low.
So how do we tell who’s right? How do we tell if rates are currently too high or too low? I don’t know the answer.
But: if we adopt NGDP level targeting, maybe we don’t care what the answer! With NGDP targeting, is it possible *in theory* for the Fed rate to be below the natural rate? I don’t think so. Consider: NGDP targeting does *not* prevent prices from dropping when there is a positive supply shock (because it stabilizes Py, not P). So it prevents the Fed rate from being below the natural rate in that case. And in normal times, with no supply shock, can rates be below the natural rate? Again, thay can’t, because then we would have inflation, but NGDP prevents inflation (by stabilizing Py, which is = P since we are assuming no supply shock).
You were doing so awesomely until the last paragraph.
The natural rate in Austrian theory is not the same natural rate in monetarist or Keynesian theory. It has nothing to do with whether aggregate prices are rising or falling.
In Austrian theory, the natural rate is about differences in valuations between present and future goods, which can change without there being any change to average or aggregate prices.
To say that rising prices is not indicative of the market rate going below the natural rate, because of possible supply shocks, is another way of saying it isn’t prices in the first place.
Bob (or anyone well-versed in Austrian School econ), if you ever get the time, I have a question:
Would it be fair to say that one problem with Market Monetarism is that it actively seeks to destroy the pricing information carried by inflation indicators? The thinking here being that, under an MM framework, people no longer “have to care” about inflation expectations because, no matter what, the central bank will utilize policy to ensure that there is no net change.
“And there you have it. When people in the comments refer to Scott as a Keynesian, this is what they mean. This is straight up crude demand management. We don’t need to know about relative prices or capital structure. There is a tradeoff between unemployment and (price) inflation and it’s the Fed’s job to turn the dial one way or the other to coast through the sweet spot.”
I think it is fair to say that Market Monetarism is in the business of recommending “demand management” – that really is the whole point of targeting stable NGDP isn’t it ?
However I don’t think you can go from there to “there is a tradeoff between unemployment and (price) inflation”. This is not the theory (hidden or otherwise) behind Market Monetarism. Rather, by using NGDP as a guide , policy makers can (in theory) match the supply of money to match the demand and minimize the risk of “demand shocks’ leading to recessions. This will keep the economy close to equilibrium and unemployment will hover around its natural level.
NOTE: In this model inflation and unemployment will tend to move together to reflect underlying movements in RGDP. There is no tradeoff.
Transformer, right, I didn’t talk about Sumner believing in a tradeoff between unemployment and (price) inflation before, based on his advocacy of NGDP level targeting.
instead, it was based on his comment that I quoted in the OP:
“In a better world the risk of recession and the risk of the economy overheating would always be evenly balanced. And I mean always, every single day of the year.”
That was the anchor point of the “And there you have it:” that you yourself quoted from me.
I’m not trying to be sore or react harshly to criticism, but it seems weird to me that I can quote Sumner saying something, then I say “And there you have it…” and then you Transformer completely ignore the thing Sumner said, and act like I don’t know anything about his views.
OK, so then I have a question: Why “In a better world the risk of recession and the risk of the economy overheating would always be evenly balanced. And I mean always, every single day of the year” would there be a tradeoff between inflation and unemployment ?
Transformer, did you read Scott’s original post? He is mad that the Fed is erring on the side of too little inflation, and not enough real growth. He thinks the Fed should be more aggressive, so that the risk of too much inflation goes up and the risk of falling into another recession goes down. Right?
I mean, it makes sense to say, “The FDA should balance the risk of approving a harmful drug with the risk of banning a helpful drug,” because there’s a tradeoff. It wouldn’t make sense to say, “The FDA should balance the risk of approving a harmful drug with the risk of an overheating economy,” because we don’t think there is a tradeoff between those two things.
Transformer look at Beckworth’s discussion with Ip on Twitter. Notice how he says Fed can over- and undershoot inflation target to help smooth out the business cycle.
Beckworth says:
‘sometimes Fed should tolerate above & below 2% as it stabilizes business cycle. But on average over business cycle should hit 2%”.
In MM terms I think this means that over business cycle inflation will be high when RGDP falls below trend (when unemployment will be high too), and low when RGDP rises above trend.
This is the exact opposite of what you are quoting Sumner as saying.
Bob, I was referring to Austrians who seemed to think that the cause of low long term rates was that the Fed was artificially holding down short term rates. So your analogy seems a bit off base.
Its worst than that Bob.
The 10 year break even inflation rate on Dec 16th was 1.46%, basically unchanged from the 15th (1.48%) and ROSE for the next 2 weeks up to 1.56%, and the 5 year rate went from 1.20 to 1.31.
As Steve Williamson points out in the comments section the decline in future expectations happens (more closely) in line with lowered expectations of future rate increases. The immediate result of the rate increase is either nothing or increased future expected inflation (by SS’ chosen metric).