Thoughts on the Michael Woodford Paper….
Unless you’ve been sleeping under a rock for the past few days you’ve likely heard about Michael Woodford’s presentation at Jackson Hole. The paper he presented (see here) is an expansive review of current Fed policy and potential policy options. Like all of Professor Woodford’s work, it’s quite excellent in its detail and thoroughness regarding some highly theoretical and uncharted territory.
The primary takeaway from Professor Woodford’s paper was his endorsement of NGDP Targeting. This view has been praised by Paul Krugman, Christina Romer, the Market Monetarists (of course) as well as several media outlets. The paper has been described by Ezra Klein as “the year’s most important academic paper”.
NGDP Targeting is a fairly new policy idea that has come about with the Market Monetarist school. Scott Sumner and David Beckworth have been particularly vocal about it. In essence, they believe the Fed can stimulate the economy by establishing a firm commitment for nominal GDP and anchoring expectations through this verbal commitment. Essentially, the Fed says: “monetary policy will remain extremely accommodative until we hit X% NGDP”. The goal is to anchor expectations so that economic agents have a greater certainty regarding their futures. According to Market Monetarists this doesn’t even require further Fed action (like QE) and can be achieved simply via a firm verbal commitment (though Beckworth has described in great detail why he believes QE’s portfolio rebalancing effect can be stimulative).
Personally, I am skeptical of what the Market Monetarists refer to as the “Chuck Norris” effect. Ie, Chuck Norris doesn’t kick your ass. He just threatens to kick your ass and it has the same effect. The only problem is that I used to watch a lot of martial arts movies when I was younger. In particular, I used to watch a lot of Bruce Lee. And anyone who has seen “Way of the Dragon” knows that Bruce Lee kicked Chuck Norris’s ass. Bruce Lee once famously said:
“willing is not enough, you must do.”
Fed policy works primarily because market participants know the Fed can “do”. For instance, in setting the Fed Funds Target the verbal commitment to set the target rate “works” because the Fed is always willing to smash a few bond traders into the pavement if they don’t behave. And with a bottomless pit of reserves anyone who decides to compete with the Fed on price will inevitably lose. The verbal commitment is powerful (very powerful), but “willing is not enough, you must do”. This is why I’ve been skeptical of QE as it’s been implemented. Monetary policy is about price, not quantity. So the “doing” is all in setting prices. I’ve said that QE could “work” if the Fed were to come out and set the long bond at, say, 1% (though, to be clear, I do not endorse this specific approach). The Fed would then be verbally committing to this price and would essentially challenge the bond traders to move the market. As the reserve monopolist, the Fed would win and after smashing a few bond traders into the ground they’d slowly learn their lesson – you don’t fight Bruce Lee. The verbal commitment is powerful, but “willing is not enough”.
Regarding NGDP Targeting I am definitely skeptical that the Fed’s commitment to a NGDP target will have the stimulative effects that some hope it will. I still fail to see the transmission mechanism whereby balance sheets are meaningfully impacted in a manner that alters current income. Fed policy usually works through altering credit markets by making inside money less expensive and inducing borrowers to borrow. Obviously, at the zero bound with low demand for credit this policy approach has run aground. QE could “work”, but it’s been implemented incorrectly or at least inefficiently in my opinion since monetary policy is about price and not quantity. The portfolio rebalancing effect is interesting, but I have my hesitations about the unintended consequences of targeting nominal wealth as a form of putting the cart before the horse. Ie, the Bernanke Put has its negative side effects. But I am not against trying policies with the understanding that I could definitely be wrong. At this point, the economy is so abysmal and unstable that we should be trying more.
I won’t belabor the point here because I am tired of debating (and seeing others debate) the merits of “my side versus your side”, but I think the key to Dr. Woodford’s speech was not in championing any single approach, but in describing how a multi-faceted approach is most appropriate. This was the most important takeaway from Professor Woodford’s presentation. Indeed, Professor Woodford writes in his conclusion:
“the most obvious recipe for success is one that requires coordination between the monetary and fiscal authorities. The most obvious source of a boost to current aggregate demand that would not depend solely on expectational channels is fiscal stimulus — whether through an increase in government purchases, tax incentives for current expenditure such as an investment tax credit, or subsidies for lending like the FLS. At the same time, commitment to a nominal GDP target path by the central bank would increase the bang for the buck from fiscal stimulus, by assuring people that premature interest-rate increases in response to rising economic activity and prices would not crowd out other types of spending than those directly affected by fiscal policy.”
Read that again because it’s extremely important. Woodford is not just endorsing NGDP Targeting. He is recommending a multi-faceted approach. I’ve talked to both David Beckworth and Scott Sumner and both seem agreeable to the idea of multi-faceted policy approaches (tax cuts in particular are attractive) though they obviously prefer the NGDP route. One of our goals with Monetary Realism is to help bridge the divide between so many schools of thought. No school is 100% right. And in these uncharted waters we need to be attacking our economic disease with everything we’ve got. That means unified policy approaches and not the partisan bickering we seem to see all over the place.
I do believe Professor Woodford may have written the most important academic paper of the year. But not because it endorsed any single specific policy. But because he calls for bridging the divide between what has become an ideological debate between monetary and fiscal policy. We did this in 2008/9 when the country most needed it. And we should do it again. We can cut taxes AND implement a strategy of NGDP Targeting. That’s like having Bruce Lee AND Chuck Norris on your side. And who in the world would be crazy enough to challenge those two? The only question is whether we can coordinate policy in a manner that actually gets things done. Or whether we will continue to bicker about whose ideology is right while Rome burns.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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41 Comments
But the US administration doesn’t seem to want to play ball with what Woodford is saying/advocating. Remember the words “Fiscal cliff” ?
We will definitely continue to bicker. Politicians care more about getting re-elected than coming together to implement policy that might actually help the country.
Whenever anybody says he doesn’t want to bicker about policy and that he’s tired of the debate, it makes me think that he just wants me to go along with his ideas.
….
And I see what you’re doing with the tax cuts idea. You’re hoping you can win over people concerned about deficits by promising them tax cuts.
Getting things done is about compromise. Cullen seems to understand that overcoming your own personal ideologies might be necessary to get things done. You, on the other hand, seem unable to overcome your own ideologies.
A tax cut has the same budget impact as a spending increase.
Where is the compromise? A tax cut would be ‘paid for’ by deficit spending, which would create more problems down the road than it would solve, especially a $1 trillion tax cut, probably for several years, which is the idea, isn’t it?
What is advocated here is a huge stimulus. So make the case. Don’t tell others to just go along.
And yes, this is an idealogical debate, on both sides. Don’t pretend it’s not.
We MIGHT get NGDP Targeting because the Fed is independent. But the tax cuts look like a stretch now. That basically means more of the same.
Great post. Although I’m dubious of the Fed’s ability to control inflation, let alone NGDP, I do like Woodford’s balanced approach. I also liked the data targets rather than time targets. For example, instead of the Fed committing to leave rates at zero until the end of 2014, they will do so until the unemployment rate drops below, say, 7 percent.
Good description Cullen. The monetary-fiscal cooperation approach was described briefly by Bernanke in his 1999 paper on Japanese monetary policy. He called it “money financed transfers”, and clearly recognized it was something the central bank could not do alone. And yet people continue to point to those passages in the paper as evidence that the CB alone can do some unspecified “more”, and wonder why Bernanke isn’t doing it.
Time for grandma to switch from 9-Lives to generic store brand.
NGDP Targeting ? In that case expect gold at 3000 or more. Not because gold is better than milk chocolate but because a lot of people will believe that the US are headed to hyperinflation… and of course you will need a new mortage every time you have to fill the gasoline tank. Professors will never understand the basic behaviour of the man-animal.
Cullen, the other aspect is fairness. Who are the winners and losers with any approach, and is it fair. Should we *just* be cutting taxes, or cutting taxes and rolling back public pensions and benefits which are greater than the private sector?
Experimentation is also okay, but we should be clear what is successful or not. Are we willing to reduce unemployment at any price (even if debt/income levels rise? even if real interest rates hit -10%? even if we build $1T ice factories in Alaska? )?
Cullen can you please explain nominal wealth targeting or the Bernanke Put to me?
There are a lot of moving parts here. The nominal wealth targeting component of QE refers to the idea that we can push asset prices up and create a wealth effect that makes people spend more by feeling richer. But this is backwards thinking. Assets prices like stocks are traded in secondary markets and are nominal wealth (unrealized). Pushing the assets up does not make the economy better off because it doesn’t mean the value of the real underlying assets has improved. Ie, there’s no guarantee that prices should be sustained and those values so the gains are more than likely termporary and not long-term. This is a big element of the Bernanke Put. This is the idea that you can prop up the economy by placing a put under the market. And by not letting the market fall you prop up nominal wealth. This likely leads to market instability by creating a divergence between market prices and their underlying assets.
Not to mention the fact that the vast majority of people in this country don’t have any assets to push up.
In fact, QE may be having the opposite effect for those retired or near retired with bond-rich portfolios, because lower interest rates means lower current and lower expected future income, which increases current savings. Younger people hate the stock market, so it’s not going to help them. You can also see this in the increases in many pension funding liabilities. The only people it helps are those that have balance sheet issues … banks.
Cullen, many thanks for taking the time to enlighten the ignorant. It is much appreciated.
Stocks may be claims on assets (the underlying company’s assets) but bonds in a way are more senior claims on the very same assets to which stocks technically have a claim on which puts them in conflicting positions.
In a way both bonds and stocks are not realizable on a system level (although clearly any given holder likely can sell his/her holdings) but collectively stock holders cannot sell because somebody has to buy them. Collectively, society has certain assets and only question is who has the legal claim to those assets, not whether they can be “realized” or not. The underlying assets are real regardless which holder owns them.
In other words, somebody has to own the assets which makes the difference between unrealized and realized quite fuzzy (again, on a collective level, not an individual level).
I think it was you who pointed out that money has 2 ways in which it can be used; one is to satisfy a purely monetary demand (to pay taxes) and the other as a proxy for goods and services. In the proxy use of money the number of currency units one has to pay for a percentage of goods and services by itself is irrelevant – what matters is the utility one derives from those goods and services.
Cullen,
Glad you shared your thoughts, even if it took longer than 5 paragraphs. One question…how does the Fed credibly commit to maintaining rates low for a period that potentially extends beyond Bernanke’s term or the voting term of several members?
Great question. Maybe David Beckworth is around in the comments to answer that one. I’d be interested in the answer as well….I presume you’re guessing (correctly in my opinion) that a new Fed Chief will destroy any expectations and increase market uncertainty. So you’d need certainty of the Fed chief’s tenure. Frankly, you’d need certainty of the FOMC board. Hard to achieve the necessary certainty over many years….
I was thinking the same thing myself. No Fed can commit beyond the expiration dates of the members of the Majority, any more than a Congress or President can. Bernanke’s term expires at the end of 2013, and if Romney is elected, we already know that Bernanke will not be reappointed Chairman (although he remains a board member until 2020).
I was recently having a discussion of American vs Scandinavian societies RE: taxes and stress and was linked to an interesting article that discussed Sweden setting multi-year budgets (with some strings attached) vs the single year budgets set in the USA.
Seems somewhat relevant to the “future expectations” and uncertainty discussion.
http://www.economonitor.com/dolanecon/2011/07/31/how-smart-fiscal-rules-keep-swedens-budget-in-balance/
I have a hard time believing that consumers and businesses are delaying purchasing/investment decisions because they think rats may be going up soon. In fact if they thought rates were going to increase you may get some frontloading of those expendatures.
Promising not to raise rates until we hit a certain level of GDP is similar to the mistake the BOJ made when they said they would not raise rates until CPI hit 1%. It did briefly when oil prices spiked, the BOJ raised rates – everyone knew it wasthe wrong thing to do – and they had to quickly cut rates again.
Its just a bd idea for the central bank to paint themselves in a corner like that.
NGDP Targeting is not a new idea. http://research.stlouisfed.org/publications/review/93/05/Nominal_May_Jun1993.pdf
That proposal is QE based.
That is not what Woodford discusses here. In fact, it’s precisely what he says the Fed shouldn’t do. Critics of the Woodford paper should give it a read before blindly shrugging it off as an endorsement of old monetarist policies. That’s not at all what it is.
Would it be too crass to more explicitly devalue the USD, to boost USD NGDP (i.e. unlimited purchases of Asian currencies)? I’m wondering if trading partners would see NGDP targeting as just a currency war.
Does NGDP targeting (really National Income) sort out productive and unproductive spending? The National Income and Product Account (NIPA) counts asset inflation as growth. Ha. In other words, our cognitive filters don’t even acknowledge that there are unproductive and productive assets. This filtering finds itself expressed in malformed concepts like NIPA.
In other words, there are statistics and damn statistics, which are influenced by our preconceived notions. Monetarists famously ignore the debt dimension due to their ideological blinders; have they done it again?
The debt overhead is really savings that wants to grow at compound rates. Sterile money wants to grow unnaturally and exponentially and it finds an outlet on the organic economy, which has a different growth curve. How can price of the market be derived when the market is being moved by the “claims” that must be out of sync.
These claims cycle through the worlds financial markets every day, a Tsunami of claims. Claims are mortgages, bonds, swaps, and other “overhead” financial vehicles looking to intersect the real economy. These claim savings are recycled as new debt as the “savings” are invested. For example, Shadow Banking is short term claims seeking out derivatives based on long term housing mortgages. Bonds often attach themselves to new loans as a counterparty on the ledger.
Debt deflation will not go away if the real economy vectors its wealth away to service this claim overhead. If the overhead is unproductive, it causes asset inflation or it can cause debt peonage by seeking to put debt claims on every income stream.
The German economic miracle after WW2 was effected because unproductive Nazi savings (claims) were wiped out. This left productive investment in place to drive the real organic economy.
I’m still convinced our debt money system needs to be scrapped. The 100 percent reserve solution wipes out the debt problem as money itself is redefined and becomes money, not a debt instrument. Read the IMF whitepaper. And yes, the IMF is usually monetarist, so this paper represents a schism in their ranks.
(Actually monetarism begins to work because debt as money variable goes away in a 100 percent world. In a debt money world monetarism cannot work.)
http://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf
Interesting that the IMF would write such a thing.
“Actually monetarism begins to work because debt as money variable goes away in a 100 percent world. In a debt money world monetarism cannot work”
-> an interesting point as well.
One think with inflation targeting is that you let the economy ‘on itself’ sort out which level of growth it can produce. If you start targeting NGDP, and your target is too high, you will simply raise long-term inflation. And the optimal NGDP target may depend on fundamentals, like demographics, population growth, energy/resource scarcity and prices, etc. So you’d probably need a method to adapt your NGDP target up, but also down, slowly, over the longer term.
But whenever you’d be adapting your NGDP target downwards, that would be an implicit message to the government that you’re going to reduce tax revenues, and that it is time for government to cut spending. Same thing vice-versa. That means that the FED would get closer to fiscal policy, resulting in political pressure.
Perhaps the Fed should target that every household will earn a million dollars per year, minimum, and state a firm commitment to achieving that outcome.
And after that the Fed can target pigs learning how to fly by January, 2013.
The outcome of the US economy is not going to be determined by a handful of bearded academics sitting in an oak paneled conference room.
Why does everyone assume that ultra-low interest rates will lead to inflation? We have the example of Japan staring at us in the face, but no one will heed it. Isn’t it just possible that the loss of income from low rates outweighs their stimulative effect, especially in our present demographic situation? If low rates were enough to stimulate housing starts shouldn’t they have jumped by now?
The lead sentence to the professor’s paper:
‘Recent events have confronted many of the world’s leading central banks with a situation that was regarded a few decades ago as merely a theoretical curiosity …’
…
Excuse me, but if you don’t know how we got here, why should I take your advice?
1) The primary effect of QE has been asset price inflation. Do you believe there has been no derivative effects at all?
2) Let’s pretend NGDP could actually work. If 3-4% growth were achieved, interest rates would have to rise (I think). But rising interest rates portend lower growth. Would an above-targeted GDP growth rate be needed to raise interest rates and ultimately meet the targeted growth?
Do expectations matter?
We’ll do whatever it takes to win in Vietnam.
We’ll do whatever it takes to win the war on drugs.
We’ll do whatever it takes to win the war on terror.
The only beneficiaries were: defense contractors, police enforcement, Blackwater. Did it help the overall economy?
Those are not expectations, those are ‘promises’, that’s a completely different thing strictly speaking. What you’re asking is “can the government/cb affect expectations?”
Doesn’t work. Won’t work. Nonsense, in my opinion…
Here’s a link to a news article from February 2012 describing the Japanese central bank’s targeting of inflation:
BOJ Unexpectedly Adds Stimulus As It Sets 1% Target For Inflation: Economy
And the headline from a couple of days ago (Bloomberg):
Deflation Deepens As Japan Contraction Risk Intensifies Economy
Second this question.
It depends, but what Woodford is primarily discussing here is a verbal commitment to remain accommodative until NGDP hits a specific level. So, instead of the Fed saying they’re going to target 2% inflation they say “we’re going to remain ultra accommodative and will not change policy until NGDP hits 6%”. Or something like that. They don’t even change policy. They just make a firm commitment. Some variations of this include QE, but that’s not what Woodford is endorsing.
Hello Iluvatar, Hello Cullen,
Re:
1) They directly control the Federal Funds Rate (Aka FFTR),
2) They CAN control the whole Trsy Bond Rate Curve if they so choose (even the long bond)
3) They control the money supply & inflation (defined in Austrian terms as the monetary inflation)
1) Check
2) Check
3) ??? I thought the Congress controlled the money supply via voting on fiscal spending and tax actions; and that the growth of money supply was created outside the FED in the banking system when a customer with credit was approved for a loan, and that the FED can swap assets but not create them without Congressional approval. What happened to the FACTS of the Sectoral Balance in this discussion? http://www.brianripley.com/1/post/2012/06/mmr.html
Hmmm… perhaps I am introducing fiscal reality into this conversation and it may not belong, but:
FROM: http://pragcap.com/understanding-modern-monetary-system
“Monetary policy is quite distinct from fiscal policy though the two do overlap and there is much coordination between the domestic monetary authorities. Consider that the US Federal Reserve’s “aggressive” interventions during the crisis, particularly after the collapse of Lehman Brothers, effectively “bailed out” financial institutions. In taking distressed assets off the balance sheets of financial businesses in such large volumes there was a fiscal component to the Fed’s actions (that did not require Congressional approval). By supporting these firms and essentially “making a market” in illiquid assets (and even removing them from bank balance sheets) the Fed was able to keep asset prices higher than they otherwise would have been and helping make these firms more solvent than they otherwise would be.
It’s important to make a distinction between buying Treasury bonds (which are risk free assets) and private market assets (such as mortgage backed securities). When the Fed engages in purchases of T-bonds they are swapping assets with the private sector. I.e. there is no overall change in the net financial assets of the public sector even though these operations do create new “outside” money ex-nihilo. Such operations when undertaken with private banks in fact change the composition of private sector financial assets (swapping reserves for T-bonds) and do not add to the supply of private bank issued money. Fed policies such as “Quantitative Easing” are often mistakenly referred to as “money printing”, but we must be very specific in using such terminology as it can often be misleading.”
So… generally speaking… the FED swaps assets with the private actors and it is the private banking system that increases the money supply through credit expansion …yes?
How is all this talk of expectations any different than the confidence fairy?