I put off reading this post for 47 days because it seemed boring. But once I found the right time, it was incredibly informative and world-opening. THANK YOU MATT, KEEP IT UP
I don’t think the nz argument makes sense. If nz signaled it intended to reduce the value of its currency it’s true that the market would rapidly adjust to do that. But if the nz govt proceeded to not actually follow up with any actions to make that permanent then it would bounce back up again surely. And the effect would be smaller next time because people wouldn’t trust them to act. I think the expectations can accelerate things through anticipation. But the fundamentals still need to change. Otherwise the fed would never have to actually do anything. It could just keep
Matt, I almost always agree with you. And you have some really good insights here. But I fear you are forgetting some stuff you definitely know about monetary policy theory history. Wow that's a lot of noun modifiers.
I agree with you that the expectations are important, and perhaps more important than the hydraulic effects. But you seem to *totally* discount hydraulics based on the experience since ~2007 when there are pretty solid hydraulic-compatible explanations. Any decent read of Keynes and Hayes would tell you the hydraulic monetary forces would lose effectiveness when you hit the zero bound. See for example Paul Krugman's last couple columns, especially the one where he goes fully Tanya Harding's ex on Milton Friedman's kneecaps. His point, and Hayes', and indeed Friedman's is that in normal times monetary policy does work hydraulically, at least to an extent. It's certainly likely that there's an expectation component there too, but it seems pretty clear that when we aren't off in weird places, the Fed's concrete actions work about how we'd expect.
We live in interesting times.
For most of the time since 2007 we've been at the zero bound. Now, suddenly, we are not.
Keynes' answer was simply "when you hit the zero bound you just have to do fiscal policy." Hayes more or less just put a lot of math underneath that without disagreeing. Friedman went and claimed that we should *never* have to use fiscal policy, and that view has borne out....poorly. I think Krugman would tell you it works mostly hydraulically until it doesn't, and then you have to do fiscal stimulus...and whatever the Fed can do psychologically would be welcome too. He certainly was appreciative of Draghi's "whatever it takes" sabre-rattling, as I'm sure you were (and I was). But those are answers for when you're on the other side of the street. Now that we're in inflationary territory, that doesn't really apply.
How you get off the mat of the zero bound is not well established. But I don't think you get to do it purely with expectations. One way or another the balance sheet will be unwound...the true question is how to do it without blowing up the economy. Here is where you have your best insights and I don't really disagree with your prescription. But I think it's important to recognize that the hydraulic effects likely are in fact in play.
NZ/Australian dual citizen here. Both had high inflation in the 1980s. NZ went fine r am independent central bank with a hardass governor, Don Brash. He got inflation down but at huge cost to the real economy and it took four years. Australia went for a more moderate approach with a focus on balancing sectoral interests (the PM, Bob Hawke, invited the top 200 CEOs and union leaders to Canberra to agree to moderate price and wage increases, supported by the RBA. Inflation also came down but with less real economy shock. At the end of the process Australia was left with much higher productivity and wages than NZ, a differential that has remained to this day. I think Jay Powell is a good choice for America - pragmatic, not too theoretical.
Bottom line both matter., but as Volker demonstrated ultimately it's the hydraulic version that backs up expectations.
Also, when the next crisis hits, it's really helpful if you don't already have ultra low interest rates because that makes it much harder for the Fed to do it's job.
Moreover, there are other factors besides those that you just mentioned. For example, the velocity of money has been falling for years. Which is most likely one reason we didn't get a lot of inflation over the last decade. Basically banks were just sitting on the extra cash not loaning it out and creating demand.
That didn't happen this time because it was paired with many trillions of additional government spending.
Matt's statement that "the hydraulic view is wrong" seems impossible. The expectations of future performance depends on the hydraulic view having some kind of impact. It is after all the expectation that interest rates will be low in the future. I could buy that the overall impact of Fed decisions is dominated by the setting of expectations. Otherwise it seems a bit like the Fed is just pushing a rope.
If the Fed were selling microchips instead of money itself, the expectations model would seem just normal.
When your microchip supplier raises prices, of course that's also a signal that they *will* raise prices in the future, so long as similar conditions continue. So you cut back where you can on your business plan to use their microchips.
When the Fed raises the price of money (raises interest rates), that's also a signal that they *will* raise the price of money in the future, and you cut back on your business plans for depending on easy money.
The catch is that the Fed, unlike your microchip supplier, isn't limited by a single chip manufacturing line but by the entire economy's tendency to inflation. That seems a lot harder to anticipate.
One thing to note is that qualitative easing basically conjures money into existence; the fed buys stuff using money it creates. As a consequence, the amount of USD in existence (M0) has increased 83% since Feburary 2020 [1], which is kind of nuts! For months, people have been blaming various mechanisms for inflation (the price of rental cars if factored in! ports are slow! need more truck drivers!), but the amount of money in existence has nearly doubled in the last two years. It would be a major trick if there weren't significant inflation. (In fact, M0 given that M0 increased by ~40% per year, prices increasing by 5% per year seems pretty tame.) I don't see that much need in looking for hidden mechanisms for higher inflation.
I never said it was destiny. I'm well aware that even the macro 101 formula has more variables in it. However, I'd submit that the great recession was the trick, and 2020-present is more in line with what you should reasonably expect.
I would say 2020-present is a very short window in which a whole lot of crazy things happened. As such I don't think it's a good idea to rework your models based on that experience.
Even if you accept the dubious proposition that BBB is “paid for”, we are still looking at trillion dollar budget deficits indefinitely. The monetary policies need to accommodate a trillion dollars a year in federal borrowing will be inflationary (though it may be reflected in may be reflected in asset inflation rather than consumer prices).
What does the BBB have to do with those "trillion dollar budget deficits indefinitely" exactly? It doesn't make a meaningful impact to the deficit in any year. Yeah, we run deficits that have lots of digits. We also have a big economy. Trillion is a word that causes heart palpitations and at some point we're gonna have to get over it. BBB total spending is something like 1% of GDP over its 10 year window. And I'm talking about the spending, not the deficit impact which is very likely negative. It's just not significant if you have an appropriate frame of reference.
You're like my dad complaining that GOOG lost $40 yesterday and I'm like "that's like half a percent shut up pop." Go do some arithmetic and knock off the fear mongering.
My point was that we already have built in trillion dollar deficits even without considering BBB. And, as has been widely discussed, BBB ends most of its programs after a few years so that the ten year budget impact looks relatively benign while obviously hoping and assuming that once started, these programs will be politically impossible to terminate. And if you think deficits don't matter, you are in good company - from Dick Cheney and Donald Trump to Bernie and AOC.
Respectfully disagree with Matt. QE kept interest rates low which sent money into stocks better returns, also drove up home prices by lowering mortgage costs.
But are you contending that there are no consequences to endless deficit spending?
Which did not reduce anyones quality of living and therefor is not inflation. Low interest rates make bond funds worth less, do you think that equals deflation?
Calling economics the dismal science was just plain wrong. The dismal pseudo-science would be more apt and the dismal Astrology even more so. Is there another field of human endeavor,besides perhaps Philosophy, that is populated by really brilliant people who don't agree on anything? Including even basic definitions such as what is inflation and how should you measure it? Yet I remain interested in the subject in much the same way as I would rubberneck an impending calamity. Parenthetically I was perfectly aware of the Volcker disinflation strategy. It was contagious. And I graduated from engineering in the middle of it. Not only were there not jobs but my student loan agreements pegged my interest rate at prime plus one. So, here in Canada, that was 22 percent. Oh Joy!
In the course of graduate studies I was introduced to the subject of solving or modeling multi-variable non-linear differential equations. My head still aches to think about it. Which is why I am not unsympathetic to what economists are trying to accomplish. Which brings me to your bipolar view of hydraulic vs managing expectations. Well obviously both are valid views. Which one, temporarily, is the dominant term in the equation you are trying to solve at any given time. Figure that out and maybe you could do an asymptotic approximation of how to weight these factors. It will never be one or the other.
Somebody finally realized that even 3% inflation is wildly unpopular.
I put off reading this post for 47 days because it seemed boring. But once I found the right time, it was incredibly informative and world-opening. THANK YOU MATT, KEEP IT UP
Finally. I have been trying hard to understand monetary policy more, and this is a great primer.
I don’t think the nz argument makes sense. If nz signaled it intended to reduce the value of its currency it’s true that the market would rapidly adjust to do that. But if the nz govt proceeded to not actually follow up with any actions to make that permanent then it would bounce back up again surely. And the effect would be smaller next time because people wouldn’t trust them to act. I think the expectations can accelerate things through anticipation. But the fundamentals still need to change. Otherwise the fed would never have to actually do anything. It could just keep
Signaling
I expected an ironic hydraulic concrete pun somewhere in there. Perhaps that was what you were going for.
V=C/r is not a religious totem. You bet against the Fed (and Paul Krugman) at your peril.
Matt, I almost always agree with you. And you have some really good insights here. But I fear you are forgetting some stuff you definitely know about monetary policy theory history. Wow that's a lot of noun modifiers.
I agree with you that the expectations are important, and perhaps more important than the hydraulic effects. But you seem to *totally* discount hydraulics based on the experience since ~2007 when there are pretty solid hydraulic-compatible explanations. Any decent read of Keynes and Hayes would tell you the hydraulic monetary forces would lose effectiveness when you hit the zero bound. See for example Paul Krugman's last couple columns, especially the one where he goes fully Tanya Harding's ex on Milton Friedman's kneecaps. His point, and Hayes', and indeed Friedman's is that in normal times monetary policy does work hydraulically, at least to an extent. It's certainly likely that there's an expectation component there too, but it seems pretty clear that when we aren't off in weird places, the Fed's concrete actions work about how we'd expect.
We live in interesting times.
For most of the time since 2007 we've been at the zero bound. Now, suddenly, we are not.
Keynes' answer was simply "when you hit the zero bound you just have to do fiscal policy." Hayes more or less just put a lot of math underneath that without disagreeing. Friedman went and claimed that we should *never* have to use fiscal policy, and that view has borne out....poorly. I think Krugman would tell you it works mostly hydraulically until it doesn't, and then you have to do fiscal stimulus...and whatever the Fed can do psychologically would be welcome too. He certainly was appreciative of Draghi's "whatever it takes" sabre-rattling, as I'm sure you were (and I was). But those are answers for when you're on the other side of the street. Now that we're in inflationary territory, that doesn't really apply.
How you get off the mat of the zero bound is not well established. But I don't think you get to do it purely with expectations. One way or another the balance sheet will be unwound...the true question is how to do it without blowing up the economy. Here is where you have your best insights and I don't really disagree with your prescription. But I think it's important to recognize that the hydraulic effects likely are in fact in play.
Speak loudly and carry a small stick
NZ/Australian dual citizen here. Both had high inflation in the 1980s. NZ went fine r am independent central bank with a hardass governor, Don Brash. He got inflation down but at huge cost to the real economy and it took four years. Australia went for a more moderate approach with a focus on balancing sectoral interests (the PM, Bob Hawke, invited the top 200 CEOs and union leaders to Canberra to agree to moderate price and wage increases, supported by the RBA. Inflation also came down but with less real economy shock. At the end of the process Australia was left with much higher productivity and wages than NZ, a differential that has remained to this day. I think Jay Powell is a good choice for America - pragmatic, not too theoretical.
Bottom line both matter., but as Volker demonstrated ultimately it's the hydraulic version that backs up expectations.
Also, when the next crisis hits, it's really helpful if you don't already have ultra low interest rates because that makes it much harder for the Fed to do it's job.
Moreover, there are other factors besides those that you just mentioned. For example, the velocity of money has been falling for years. Which is most likely one reason we didn't get a lot of inflation over the last decade. Basically banks were just sitting on the extra cash not loaning it out and creating demand.
That didn't happen this time because it was paired with many trillions of additional government spending.
Matt's statement that "the hydraulic view is wrong" seems impossible. The expectations of future performance depends on the hydraulic view having some kind of impact. It is after all the expectation that interest rates will be low in the future. I could buy that the overall impact of Fed decisions is dominated by the setting of expectations. Otherwise it seems a bit like the Fed is just pushing a rope.
If the Fed were selling microchips instead of money itself, the expectations model would seem just normal.
When your microchip supplier raises prices, of course that's also a signal that they *will* raise prices in the future, so long as similar conditions continue. So you cut back where you can on your business plan to use their microchips.
When the Fed raises the price of money (raises interest rates), that's also a signal that they *will* raise the price of money in the future, and you cut back on your business plans for depending on easy money.
The catch is that the Fed, unlike your microchip supplier, isn't limited by a single chip manufacturing line but by the entire economy's tendency to inflation. That seems a lot harder to anticipate.
One thing to note is that qualitative easing basically conjures money into existence; the fed buys stuff using money it creates. As a consequence, the amount of USD in existence (M0) has increased 83% since Feburary 2020 [1], which is kind of nuts! For months, people have been blaming various mechanisms for inflation (the price of rental cars if factored in! ports are slow! need more truck drivers!), but the amount of money in existence has nearly doubled in the last two years. It would be a major trick if there weren't significant inflation. (In fact, M0 given that M0 increased by ~40% per year, prices increasing by 5% per year seems pretty tame.) I don't see that much need in looking for hidden mechanisms for higher inflation.
[1] https://fred.stlouisfed.org/series/BOGMBASE
Please take a look at the same numbers from 2007-2014 and report back. Monetary base is not destiny. (sorry for the deletion just got dates messed up)
I never said it was destiny. I'm well aware that even the macro 101 formula has more variables in it. However, I'd submit that the great recession was the trick, and 2020-present is more in line with what you should reasonably expect.
I would say 2020-present is a very short window in which a whole lot of crazy things happened. As such I don't think it's a good idea to rework your models based on that experience.
Good column.
Even if you accept the dubious proposition that BBB is “paid for”, we are still looking at trillion dollar budget deficits indefinitely. The monetary policies need to accommodate a trillion dollars a year in federal borrowing will be inflationary (though it may be reflected in may be reflected in asset inflation rather than consumer prices).
What does the BBB have to do with those "trillion dollar budget deficits indefinitely" exactly? It doesn't make a meaningful impact to the deficit in any year. Yeah, we run deficits that have lots of digits. We also have a big economy. Trillion is a word that causes heart palpitations and at some point we're gonna have to get over it. BBB total spending is something like 1% of GDP over its 10 year window. And I'm talking about the spending, not the deficit impact which is very likely negative. It's just not significant if you have an appropriate frame of reference.
You're like my dad complaining that GOOG lost $40 yesterday and I'm like "that's like half a percent shut up pop." Go do some arithmetic and knock off the fear mongering.
My point was that we already have built in trillion dollar deficits even without considering BBB. And, as has been widely discussed, BBB ends most of its programs after a few years so that the ten year budget impact looks relatively benign while obviously hoping and assuming that once started, these programs will be politically impossible to terminate. And if you think deficits don't matter, you are in good company - from Dick Cheney and Donald Trump to Bernie and AOC.
Not that the rest of this comment isn't also ridiculous but, there is no such thing as asset inflation!!!!!
https://www.slowboring.com/p/asset-price-inflation-is-not-a-thing
Respectfully disagree with Matt. QE kept interest rates low which sent money into stocks better returns, also drove up home prices by lowering mortgage costs.
But are you contending that there are no consequences to endless deficit spending?
Which did not reduce anyones quality of living and therefor is not inflation. Low interest rates make bond funds worth less, do you think that equals deflation?
Calling economics the dismal science was just plain wrong. The dismal pseudo-science would be more apt and the dismal Astrology even more so. Is there another field of human endeavor,besides perhaps Philosophy, that is populated by really brilliant people who don't agree on anything? Including even basic definitions such as what is inflation and how should you measure it? Yet I remain interested in the subject in much the same way as I would rubberneck an impending calamity. Parenthetically I was perfectly aware of the Volcker disinflation strategy. It was contagious. And I graduated from engineering in the middle of it. Not only were there not jobs but my student loan agreements pegged my interest rate at prime plus one. So, here in Canada, that was 22 percent. Oh Joy!
In the course of graduate studies I was introduced to the subject of solving or modeling multi-variable non-linear differential equations. My head still aches to think about it. Which is why I am not unsympathetic to what economists are trying to accomplish. Which brings me to your bipolar view of hydraulic vs managing expectations. Well obviously both are valid views. Which one, temporarily, is the dominant term in the equation you are trying to solve at any given time. Figure that out and maybe you could do an asymptotic approximation of how to weight these factors. It will never be one or the other.
You should consider reading some economists.