The Fed and policy: Temporary but not permanent
Via Arnold Kling at Econlog we see this paper regarding the impact on Fed policy. It is an interesting paper in an economic history sense, I would suggest reading it. However, the passage I want to focus on is the same one Arnold mentioned:
First, spending and pricing decisions are assumed to be based on long-term assessments of real income and real rates of return. Second, changes in monetary policy can only change real interest rates temporarily. Ultimately, the forces of productivity and thrift determine them, not changes in nominal magnitudes on the central bank balance sheet. Combining the two propositions implies that the Federal Reserve’s interest rate policy, as long as it stays within the narrow range of experience, would not be expected to have a significant or long-lasting imprint on markets or activity.
This is a great result. It suggests that the central banks ability to change the “structure” of the economy, or make any long lasting changes to economic conditions, is negligible. Without any “long-run costs” of Fed policy this suggests that monetary policy CAN be used to stabilise activity in the very short run – so it reforces the view that a central bank should look at “smoothing the economic cycle” by keeping underlying inflationary pressures near a certain target.
This is consistent with the orthodox way of viewing monetary policy. However, interestingly Arnold Kling states that this paper is something he agrees with, but it “puts (him) at odds with Scott Sumner and John Taylor, among many others.” – people who are also part of the orthodoxy.
I believe that the issue here is that people are talking past each other a little – in terms of strict monetary policy, the views that Scott Sumner and (originally) John Taylor focused on were short-run, and as a result they were interested in the stabilisation role of monetary policy. Kling appears to have ignored the idea of the short-run to focus on the relevant view of the long-run – something we can’t do in the face of price/wage stickiness.
Now I agree with Arnold that many people give the idea that central banks can create miracles FAR too much weight. I think that central banks should not be involved with structural policy, or if they are it NEEDS to be separated from their stabilisation role for the sake of transparency – but this issue is separate from the focus on thinkers like Sumner.
If one starts with the definition that monetary economics is all about the way the quantity, price, and terms and conditions of nominal debt contracts affect an economy, the second proposition seems odd, unless it incorporates the idea that bad central bankers are ultimately fired (or their terms are not renewed after 10 years).
It seems odd because there doesn’t seem any reason why a determined central bank could not set nominal interest rates at whatever level it wanted for an extended period of time. Since real interest rates are not self-correcting to the level of nominal interest rates (eg low nominal interest rates generate inflation which causes even lower real interest rates), it would appear possible for a central bank to make local currency real interest rates depart from a long run average rate for long periods of time. Of course, it cannot make people enter contracts using these interest rates, so the real volume of nominal debt contracts may contract; but there doesn’t seem any reason why a central bank could not persist with very high or very low real interest rates for a long period of time, except that it decides not to because of loss of reputation.
One can make this idea concrete. Suppose a central bank decided to lend as much base money (legal tender) to banks at zero nominal interest rates as the banks desire. This will be inflationary; and real interest rates will be negative. The world has had several such experiences in the past. Negative real interest rates do not affect the return to capital, but they (a) provide an incentive to borrow in local denominated debt contracts and (b) provide an incentive for potential lenders to eschew local denominated debt in favour of foreign currency debt or equity positions. Again, this appears to be what happens in high inflation countries. As a net result, firms find it difficult to raise debt finance from agents other than central-bank funded banks, and the economy has a long term inflation problem that can only be cured by axing the central bank staff responsible.
I have much more sympathy with the first proposition, “spending and pricing decisions are assumed to be based on long-term assessments of real income and real rates of return”, but if it is possible to issue nominal debt contracts at real interest rates that are much lower than the real rate of return one would think this is stimulatory as firms undertake more investments than otherwise. This surely is how an interest rate based (rather than a credit-rationing based) monetary policy is meant to work: central bank fiddlers induce a gap between the price of new debt contracts and (a) the real rate of return on new investments and (b) the return and thus second hand price of old debt contracts or equity contracts, in order to stimulate or slow down the economy. At least that is how Fisher described the process a century ago, and he didn’t get much wrong.
This issue is important for New Zealand, not just because we have had very high real interest rates for a very long time (at a huge cost to the economy, given the net NZ dollar debt position), but because the issue is not whether the central bank can influence activity and inflation but whether it does it well. This is ultimately an empirical question, one that NZ policy makers shy away from in favour of the settled theoretical debate as to whether it is possible for monetary policy to be beneficial. I suspect the reason they prefer to address the second question is because they would not like the answer to the empirical question, and prefer to hope that around the corner there is a period where monetary policy is implemented in a manner which generates results that are good as we would like.
Andrew
Hi Andrew,
“If one starts with the definition that monetary economics is all about the way the quantity, price, and terms and conditions of nominal debt contracts affect an economy, the second proposition seems odd”
My impression is that the question of whether real interest rates are independent of monetary policy in the long-run isn’t clear – theoretically they shouldn’t, but the evidence just isn’t clear cut.
I agree with you here that this is an empirical question – but of course I would add the priviso that any policy recommendations on the basis of an empirically observed fact need to be consistent with theory/set of causal reasoning for the observation.
“This issue is important for New Zealand, not just because we have had very high real interest rates for a very long time (at a huge cost to the economy, given the net NZ dollar debt position), but because the issue is not whether the central bank can influence activity and inflation but whether it does it well. This is ultimately an empirical question, one that NZ policy makers shy away from in favour of the settled theoretical debate as to whether it is possible for monetary policy to be beneficial.”
I think this is an excellent point – there is a fundamental different between what “could” happen and what “does” happen. That is, after all, where the idea of public choice theory and government failure stemmed from.
Talking about the benefits of an “independent central bank” are one thing, but the next step would be to analyse the institutional structure of the Bank – not to just then let it slide.
However, isn’t there an incentive for some people outside the central bank to do work on this? Surely producing work that shows that monetary policy has been costly would garner a lot of attention and put pressure on the bank, so the incentives in academia must be there.