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Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.
To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation.
This lead a few bloggers to questions his sanity: Employment, Interest and Money (I), Angry Bear (I), Economist's View (I, II, III), Nick Rowe (I, II), and even Paul Krugman (I). Surprisingly, Kocherlakota has few defenders: Steve Williamson (I) and only a few comments in the posts mentioned above.
Kocherlakota is clearly taking about a long run. And if the Fed wants to maintain low nominal interest rates, it can only do so, again this is a steady state, by have a negative inflation rate. This is not only the Fisher equation, but also the result of countless monetary models whose optimal monetary policies are the Friedman rule. In fact it is damn difficult to avoid the Friedman rule even in models with price rigidities. And remember, Kocherlakota was taking about the long run, and in the long run, money in neutral. Not superneutral, though, as the Friedman rule shows.
6 comments:
So, according to the Friedman rule, deflation would actually be good. Why has no central bank then pursued such an objective?
That is not the point. The point is that Kocherlakota is appealing to a steady-state result that is well established in theory and makes plenty of sense. He does not say it is optimal.
All the critics understand long-run superneutrality of money. We all understand that for every long run equilibrium, there exists another long run equilibrium in which the nominal interest rate, inflation rate, and money growth rate, are all one percentage point higher. But if the Federal Funds Rate is your instrument, and the Fed raises it, permanently, you won't ever get to that long-run equilibrium; you will move away from it. We all understand that problem with stability, NK doesn't.
If NK were right, there would be no zero lower bound problem. Want higher inflation, to prevent the current risk of deflation? Just raise the FFR.
Instead, we want to lower the FFR, temporarily, to get higher inflation. Then when inflation does increase, and expected inflation increases too, we raise the FFR to the new long-run equilibrium, a la Fisher. But we can't, because of the zero lower bound.
It's like the bus driver mixing up the brake and gas pedal.
The dispute is about the direction of causation. We all agree that, in the long run, if the Fed wishes to have a zero interest rate, it must follow a deflationary policy. Kocherlakota seems to argue that, by choosing to keep the interest rate at zero, the Fed will produce deflation. (This is how I interpret the phrase "must lead to". And that interpretation is supported by Kocherlakota's subsequent statement, "If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation.") And that is simply wrong. No matter how long you try, you cannot bring about a long-run equilibrium simply by acting as if the equilibrium is already here.
Assume a Taylor rule. Right now, the low inflation rate and the large output gap indicate that the nominal interest rate should be low.
Then, assume the following doomsdayish scenario: The Fed realizes that it is powerless with current tools, or the drop in the path of GDP is there to stay. Thus it reduces potential output to current output. The Taylor rule then tells you should increase interest rates.
But politicians claim this is foolish and want to keep low interest rates. The Fed then says, as Kocherlakota, OK, but then you will have deflation. Thus the new inflation objective is deflationary. This is credible and expectations are deflationary (one could argue they are not far from that right now).
You have your Kocherlakota steady state without much transition. What would be wrong with that scenario, apart from the fact that it entails an abdication of the Fed?
In your scenario, the Fed actually has to say it is targeting deflation. I'm willing to believe that such a statement might be credible. I'm not, however, willing to believe that the Fed could make a credible commitment to deflation inadvertently (at least not without temporarily raising interest rates in the process), which is what Kocherlakota seems to be arguing. I acknowledge that the Bank of Japan has inadvertently made a credible commitment to deflation, but it had to raise interest rates a couple of times in order to do so. The only way Kocherlakota's argument works is if people somehow intuitively know the Fed's intentions, despite the fact that those intentions deviate from all their prior public statements.
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