With so many important issues out there like who got canceled and what books are available at school libraries in San Antonio, throwing some monetary policy red meat to the base is at best a distraction.
Timely post! I've been looking for something like this.
Reading your description of the expectations theory, it sounds like it could be viewed as an extension of the hydraulic view rather than an alternative, i.e. the hydraulic view is right, but usually expectations move the market before the hydraulic mechanisms do. If the hydraulic view were entirely incorrect and the mechanisms had no effect, then there would be nothing for anyone to build expectations on, right?
Yes, I was confused as well. If hydraulic mechanisms genuinely wouldn't work, then it's like nuclear deterrence except where nuclear bombs are a just a made-up technology to scare us.
I think it’s both. Basically the hydraulic view is theoretically correct but you never get to it use it because the expectations view always preempts it. So hydraulic view is theoretically correct but the expectations view practically. This is why Bernanke said in the past “QE does not work in theory but works in practice”.
Matt said this. "Of course if it turns out to be a huge fake out, that undoes the impact. If Powell were constantly screwing around and bullshitting people, eventually everyone would tune him out. But a credible central banker moves markets with his words as well as his deeds, and the moving of markets is the essence of how the banker does his work."
If your title was an experiment in low expectation-setting, it worked because I didn’t think this was boring at all.
Like much else about our world, it’s both fascinating and terrifying to think the entire economy might be yet another figment of our imaginations; like government or the idea of God, it only works if we believe it works. On that note, I am happy that most people are in the hydraulic camp- it’s the only reason the expectation camp might actually be right.
Yes it sounds less like these are really two competing theories, than that the hydraulic theory is in fact correct, as Volker showed, but normally expectations make it unnecessary for central bankers to prove the point, as long as everyone believes they can.
One thing Matt didn’t mention is monetary policy accommodates fiscal policy. aid the Fed couldn’t buy bonds with newly created money, there would be more risk of a default and our government would wear the same chains as the smaller EU members.
Government doesn't only work because we believe it works. It works because men with guns can (and will) come to your house shoot your dog, and maybe you to if you don't comply
Your opinion above of what Powell should be saying right now reminds me a lot of what I think you've been less explicitly suggesting the FDA/CDC should be saying about the pandemic. In other words...speak very frankly and clearly about what you're going to do and don't try to get clever about saying something that you hope will get the outcome you want without ticking anyone off or saying something controversial. I completely agree.
I think that a lot of institutional habits were ingrained two or three generations ago when communications technology was worse and the general level of education in the population was much lower and it made more sense for agency leaders to just try and speak ex cathedra to the public.
You haven’t been to the Fayette County Table Tennis club. The number of conspiracy theories and utter bullshit you hear from quasi affluent suburbanites is depressing.
There are vastly more well educated people today than 50 years ago, by which I mean more people who can understand/run regressions, have a solid understanding of economic and political history, can comment intelligently on Slow Boring, etc. This group still isn’t much more than 5% of the population. Plenty of people with degrees from good colleges have no idea what an r squared is. Plenty of superior court judges are ignorant of basic economics.
There’s a much bigger chattering class than before and even a metro like Atlanta probably has several thousand sophisticated people whom one could engage meaningfully on the issues of the day. However, this enlightenment hasn’t trickled down that far.
There are plenty of degrees where knowledge of R^2 is not particularly useful. Additionally, you can understand an awful lot of statistics and still have no need of it. If I was going to teach a 1 semester statistics for normies, I am not sure I would bother with R^2.
Agree. These organizations shouldn't attempt crazy bank shot ideas. People who have money and health on the line are likely to look at the details and will be harder to fool. Actions should do what it says on the tin, and organizations should just state their reasoning. "We're raising rates to lower inflation" "Masks work, but we're saving our supply for healthcare workers" Most people aren't that dumb, and everyone appreciates being treated like adults.
You cannot say to the general public, "Masks work, but we're saving our supply for healthcare workers," because 0.1% of your audience ignores your advice and buys masks, you are out of luck(and so are your healthcare workers).
Greetings from Turkey, where President Erdogan is definitely making the central bank follow neo-Fischerian policies. Of course the low interest rates are making inflation worse rather than better, but they're making the currency collapse even faster than the domestic price level rises, so it makes for an amazingly cheap vacation.
Would just like to say that I was one of your readers who clicked on and actually read your monetary policy columns in Slate/Vox and that was a primary reason for me subscribing. And I'd much rather read about monetary/housing/transportation policy here than yet another column about Democrats' messaging problems (yes yes, I know it's necessary to read about that too... just that the balance seems to have tipped way too far in that direction).
Yeah, this also reminded me of the good ole days when Paul Krugman’s columns were enlightening and unconventional takes on economic fundamentals instead of cranky old hippie politics like they are now.
Krugman long ago abandoned economics for political punditry. His economic analyses of the past 15 years start with who is in the White House, and his conclusions follow from that point.
Except for that minor detail that he's been right the whole time.
Minor exception of his panic post immediately after the 2016 election that he made mea culpa for within a week. But seriously...his description of the future US economy has been spot on since 2007 at least. Disagree with Krugman on comments threads at no peril. Disagree with it with your money at...your money's peril.
Couldn't agree more, Marie... I usually like Krugman and he's right more often than he's wrong (and even admits mistakes on occassion) but I feel like he's taken it upon himself to refute the Brooks/Stephens/Douthat bloc and that veers too often into crankiness.
Yeah, this is a much more fair complaint. He's not shy about the politics..."conscience of a liberal" and all. Not like he's hiding it. But that whole time he's still been way more accurate in his predictions than any peer I could name. And it's not for nothing that the same timeframe involves politics being not really unclear. If you aren't on the side of the liberals right now............
Usually the posts on inflation here make sense, but this one is off the mark. The debate isn't about whether central banks *can* affect economic conditions by changing expectations. It's about whether central banks *should* try to implement monetary policy by changing expectations.
In basically any macroeconomic model, expectations about future interest rates affect current demand. If the central bank can make a credible announcement to cut rates in the future, then the economy will be stimulated in the present. When it comes time to actually cut rates, the central bank does so through "hydraulic" methods.
The disagreement among economists is whether the central bank's ability to control expectations is a scalpel or a machete. That is, if the central bank announces a 2% cut in the future, will people actually believe the cut will be exactly 2%?
The misconception about the expectations debate leads to some confusion throughout the rest of the piece.
1. Of course, everyone knew that long-term bond prices depend on expectations of tapering in 2013. The Fed was simply wrong about how much tapering the market expected, and they tapered more than markets thought, inadvertently causing the taper tantrum. This experience argues against implementation of monetary policy by expectations, not in favor of it.
2. The expectations-vs-hydraulics debate has nothing to do with whether central banks have to cause a recession in order to head off inflation. A well-calibrated interest rate hike in the present can suppress demand just the right amount today in the same way as a well-calibrated change in future expectations. The question is how easy it is to calibrate each intervention.
3. In the NZ example, the claim is that the central bank never actually needs to intervene as long as it announces an intervention ahead of time. Of course, if the central bank goes around announcing interventions it never implements, people will stop believing those announcements.
4. The Volcker disinflation again argues against expectations-driven monetary policy rather than in favor of it. During the 70s, the Fed repeatedly tried to assure markets that inflation was transitory and that it would hike rates when necessary. This didn't magically stop inflation because the Fed didn't actually succeed in changing expectations. Volcker had to rebuild credibility by actually raising rates.
It seems to me that you first do expectations, and if that changes behavior and the economy, then you don't need to follow through. If it doesn't, then you execute the hydraulics option and do whatever tapering/rate increases you need to to achieve the desired effect.
Like the Fed is a floor wax *and* a dessert topping.
It’s silly to ask if the fed *should* use expectations. the expectations channel is always operating. Your proposed fine tuned interest rate changes in the moment also after expectations. This seems to me to be the ‘hydraulic v expectations’ debate Matt is describing. In the expectations camp we say expectations are almost aways the primary factor. Volcker is the exception that proves the rule bc expectations of inflationary policy were so strong after decades of pro growth consensus that he was forced to make bigger hydraulic moves than we would expect would be necessary to overcome inflation ‘all else equal’.
I thought MY's point was that you don't say, "We're hiking rate .5% on XX date and every subsequent quarter for two years," to set expectations but instead say, "We're going to start hiking rates on XX date and continue until inflation gets down to YY%". Then, because people expect you to hiking rates until inflation goes down to your target level, they change their behavior in ways that reduces demand which in turn reduces inflation. As a result, when you start hiking rates, you don't have to do it as many times much because behaviors have already begun to change.
So per your point 3, you do something, and what you do is still consistent with what you announced. But because you did a good job setting expectations, the intervention isn't as severe was the 'hydraulic model' would suggest.
Wish I had read this one before writing my own econ history book, probably way below somewhere. Yeah, this is a both situation not an either-or. You provide expectations about future hydraulics. If the expectations worked better than expected or if some other stuff changes, maybe you don't have to follow through hydraulically. Meeting the targets is the best credibility.
nice article. and admirable humility. I told you immediately upon publishing your list of predictions around this time a year ago that your inflation priors were unlikely to be correct,
I think its admirable that you have changed your tune on this especially for the reason you listed: being a monetary policy dove has been one of your foundational views for over a decade now and has always served you well (I have generally been of the same persuasion)
I am not an expert, but I think you are conflating a few things here. One is how "traditional monetary policy" works (i.e. adjusting the federal funds rate) vs. how "quantitative easing" works.
My sense is the hydraulic mechanism of traditional monetary policy is pretty well understood. Higher federal funds rates increases borrowing costs to banks, so interest rates on other lending products go up, reducing demand for credit, reducing the money supply and slowing overall demand in the economy. [That the bond market (or stock market) doesn't move in lockstep with Fed actions doesn't really disprove this - capital markets "price in" all sorts of inputs including economic growth, inflation expectations, etc. so this is not a reliable indicator of anything here.]
QE is a much more novel tool, only having been invented in Japan 20 years ago and introduced in the US during the financial crisis, and is basically a way to get around the zero interest rate bound of traditional monetary policy. They hydraulics of this are much less well understood because there is so much less history here! And importantly unwinding QE has never been part of an inflation management strategy because the US, Japan and other markets where QE has been used have not seen robust inflation until now. I think experts disagree on 1) the extent to which QE has a big effect, 2) how that effect actually works, and 3) what would happen if it unwinds.
Beyond that distinction, I am also not clear how "coordinating expectations" can actually manage inflation. I agree keeping people confident that you will both manage inflation and support growth will keep economic activity high by providing the illusion (or reality) of stability, but that is a different problem than convincing people to slow down demand just a bit to ease off inflation without triggering a recession. Most economic actors are not making spending or borrowing decisions based on an expectation of 3% vs 2% GDP growth... they are looking at the cost of credit vs an opportunity in front of them. The hydraulic mechanism explains how to slow growth pretty straightforwardly, and I'm not sure I understand what the "expectations-led" mechanism would be.
"Most economic actors are not making spending or borrowing decisions based on an expectation of 3% vs 2% GDP growth... they are looking at the cost of credit vs an opportunity in front of them."
It seems to me that part of "an opportunity in front of them" is anticipated future demand. A slower future economy means less future demand. Why wouldn't that lead to less investment?
It depends on the borrower. For some your scenario makes sense - e.g. a company thinking of taking a loan to build a new manufacturing plant. Even then though, broad macro inputs are only one factor of many considerations and the interest rate on the loan will have a much more direct impact than a modest difference in expected macro growth.
For many borrowers this consideration does not enter at all. Shoppers putting purchases on their credit card, homeowners looking at refi opportunities, people looking at how much car they can afford, all are going to be far more sensitive to the cost of financing than a subtle change in macro expectations.
Again, to be clear, if the fed expectations channel here is "we are going to cause a recession to cut off inflation" I think that will have an effect on all these behaviors... it's the dampening middle ground where a recession is avoided that I don't understand.
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.
I loved this post Matt! A very clear explanation of some tricky ground and I agreed with almost all of it.
However, one thing I found striking is that you seemed to be on the same page as Scott Sumner (whose book I'm currently reading) on almost everything until you got to fiscal policy. I was expecting you to take the Sumnerite position that monetary policy is so powerful that fiscal policy is rarely necessary or helpful. But instead you take the opposite view that the power of monetary policy makes it ok to overshoot on fiscal policy and then backtrack.
Is the issue here that you think expectations-based monetary policy is powerful most of the time but not in the most extreme circumstances? Or that it's powerful always in theory but political constraints occasionally prevent it from being powerful enough in practice? Or that you just aren't worried about debt levels so you see no real downside to throwing fiscal policy into the mix when a lot of stimulus is needed?
I took Macroeconomics in 1984 as an undergraduate econ major at Univ of Illinois from a prof named Case Sprenkle. Sprenkle showed up to lead the review for his final exam totally blotto and announced that "Macroeconomics is dead". I think what he meant was that all that M-1, M-2 and Laffer Curve (hydraulic) stuff wasn't predictive that the Fed can control the economy and inflation by levering interest rates and money supply.
Today it's clear, however, that levering expectations is the name of the game. That's where the modern MMT folks get it wrong. Sure, you can print as much money as you want, but if people believe that the government can print money to buy whatever it wants, why would they ever agree to pay taxes? Inflation is the economy killer and it's all about expectations.
It's really incredibly difficult to figure out what the MMT folks are saying. But the idea that inflation is the only constraint on a sovereign's deficit isn't only held by MMT. That's a statement that Hayes or Keynes would have been all the way onboard for, and is consistent with most of the saltwater models.
MMT's reliance on accounting identities leads me to believe it puts forth the hydraulic view. I think what Brian is saying is that if MMT were ever widely accepted as what the Fed/Congress were doing, it would throw off expectations in a disastrous way
I mean you could also argue that the continuation of Bernanke, Yellen and now Powell is that they preemptively stopped inflation, and now with Powell flipping during the pandemic we now have it.
Personally I think BOTH views are right, and the hydraulic view is what makes the perceptions view work.
I think of Fed policy as driving a car with an underpowered engine, brakes that sometimes don't engage right away, and a flakey speedometer.
To make things worse, you can't tell for sure if you're driving on a flat road, climbing a mountain, or descending a steep downhill. Also, you can't know what road grade you'll face around the next bend.
Now try to keep the car going 55 mph constantly and without error.
With so many important issues out there like who got canceled and what books are available at school libraries in San Antonio, throwing some monetary policy red meat to the base is at best a distraction.
Wondering how many of the likes _didn't_ read this as sarcasm....
The promise of “slow, boring” is why i signed up for this newsletter and I’m glad you’re keeping that promise.
The boards are still hard...
Timely post! I've been looking for something like this.
Reading your description of the expectations theory, it sounds like it could be viewed as an extension of the hydraulic view rather than an alternative, i.e. the hydraulic view is right, but usually expectations move the market before the hydraulic mechanisms do. If the hydraulic view were entirely incorrect and the mechanisms had no effect, then there would be nothing for anyone to build expectations on, right?
Yes, I was confused as well. If hydraulic mechanisms genuinely wouldn't work, then it's like nuclear deterrence except where nuclear bombs are a just a made-up technology to scare us.
I think it’s both. Basically the hydraulic view is theoretically correct but you never get to it use it because the expectations view always preempts it. So hydraulic view is theoretically correct but the expectations view practically. This is why Bernanke said in the past “QE does not work in theory but works in practice”.
Matt said this. "Of course if it turns out to be a huge fake out, that undoes the impact. If Powell were constantly screwing around and bullshitting people, eventually everyone would tune him out. But a credible central banker moves markets with his words as well as his deeds, and the moving of markets is the essence of how the banker does his work."
If your title was an experiment in low expectation-setting, it worked because I didn’t think this was boring at all.
Like much else about our world, it’s both fascinating and terrifying to think the entire economy might be yet another figment of our imaginations; like government or the idea of God, it only works if we believe it works. On that note, I am happy that most people are in the hydraulic camp- it’s the only reason the expectation camp might actually be right.
Yes it sounds less like these are really two competing theories, than that the hydraulic theory is in fact correct, as Volker showed, but normally expectations make it unnecessary for central bankers to prove the point, as long as everyone believes they can.
Yep- insert “why not both?” little girl GIF here 🤷🏻♀️
Describing topics as "boring", almost sarcastically, is classic nerd bait.
One thing Matt didn’t mention is monetary policy accommodates fiscal policy. aid the Fed couldn’t buy bonds with newly created money, there would be more risk of a default and our government would wear the same chains as the smaller EU members.
*If the Fed
Government doesn't only work because we believe it works. It works because men with guns can (and will) come to your house shoot your dog, and maybe you to if you don't comply
Government works because you *believe* men with guns will come shoot your dog if you don’t comply ;)
Well there's enough evidence out there to make me a believer
Your opinion above of what Powell should be saying right now reminds me a lot of what I think you've been less explicitly suggesting the FDA/CDC should be saying about the pandemic. In other words...speak very frankly and clearly about what you're going to do and don't try to get clever about saying something that you hope will get the outcome you want without ticking anyone off or saying something controversial. I completely agree.
I think that a lot of institutional habits were ingrained two or three generations ago when communications technology was worse and the general level of education in the population was much lower and it made more sense for agency leaders to just try and speak ex cathedra to the public.
You haven’t been to the Fayette County Table Tennis club. The number of conspiracy theories and utter bullshit you hear from quasi affluent suburbanites is depressing.
There are vastly more well educated people today than 50 years ago, by which I mean more people who can understand/run regressions, have a solid understanding of economic and political history, can comment intelligently on Slow Boring, etc. This group still isn’t much more than 5% of the population. Plenty of people with degrees from good colleges have no idea what an r squared is. Plenty of superior court judges are ignorant of basic economics.
There’s a much bigger chattering class than before and even a metro like Atlanta probably has several thousand sophisticated people whom one could engage meaningfully on the issues of the day. However, this enlightenment hasn’t trickled down that far.
"Plenty of people with degrees from good colleges have no idea what an r squared is"
Sounds like that college if failing to properly prepare their students.
There are plenty of degrees where knowledge of R^2 is not particularly useful. Additionally, you can understand an awful lot of statistics and still have no need of it. If I was going to teach a 1 semester statistics for normies, I am not sure I would bother with R^2.
But now we have Twitter, with polarization and epistemic closure positively correlated with increasing levels of education, so it's all good.
Agree. These organizations shouldn't attempt crazy bank shot ideas. People who have money and health on the line are likely to look at the details and will be harder to fool. Actions should do what it says on the tin, and organizations should just state their reasoning. "We're raising rates to lower inflation" "Masks work, but we're saving our supply for healthcare workers" Most people aren't that dumb, and everyone appreciates being treated like adults.
You cannot say to the general public, "Masks work, but we're saving our supply for healthcare workers," because 0.1% of your audience ignores your advice and buys masks, you are out of luck(and so are your healthcare workers).
We were anyway. The mask hoarders weren’t fooled, healthcare workers ended up having to use homemade cloth masks anyway.
Greetings from Turkey, where President Erdogan is definitely making the central bank follow neo-Fischerian policies. Of course the low interest rates are making inflation worse rather than better, but they're making the currency collapse even faster than the domestic price level rises, so it makes for an amazingly cheap vacation.
Would just like to say that I was one of your readers who clicked on and actually read your monetary policy columns in Slate/Vox and that was a primary reason for me subscribing. And I'd much rather read about monetary/housing/transportation policy here than yet another column about Democrats' messaging problems (yes yes, I know it's necessary to read about that too... just that the balance seems to have tipped way too far in that direction).
Yeah, this also reminded me of the good ole days when Paul Krugman’s columns were enlightening and unconventional takes on economic fundamentals instead of cranky old hippie politics like they are now.
Krugman long ago abandoned economics for political punditry. His economic analyses of the past 15 years start with who is in the White House, and his conclusions follow from that point.
Except for that minor detail that he's been right the whole time.
Minor exception of his panic post immediately after the 2016 election that he made mea culpa for within a week. But seriously...his description of the future US economy has been spot on since 2007 at least. Disagree with Krugman on comments threads at no peril. Disagree with it with your money at...your money's peril.
Couldn't agree more, Marie... I usually like Krugman and he's right more often than he's wrong (and even admits mistakes on occassion) but I feel like he's taken it upon himself to refute the Brooks/Stephens/Douthat bloc and that veers too often into crankiness.
Yeah, this is a much more fair complaint. He's not shy about the politics..."conscience of a liberal" and all. Not like he's hiding it. But that whole time he's still been way more accurate in his predictions than any peer I could name. And it's not for nothing that the same timeframe involves politics being not really unclear. If you aren't on the side of the liberals right now............
Usually the posts on inflation here make sense, but this one is off the mark. The debate isn't about whether central banks *can* affect economic conditions by changing expectations. It's about whether central banks *should* try to implement monetary policy by changing expectations.
In basically any macroeconomic model, expectations about future interest rates affect current demand. If the central bank can make a credible announcement to cut rates in the future, then the economy will be stimulated in the present. When it comes time to actually cut rates, the central bank does so through "hydraulic" methods.
The disagreement among economists is whether the central bank's ability to control expectations is a scalpel or a machete. That is, if the central bank announces a 2% cut in the future, will people actually believe the cut will be exactly 2%?
The misconception about the expectations debate leads to some confusion throughout the rest of the piece.
1. Of course, everyone knew that long-term bond prices depend on expectations of tapering in 2013. The Fed was simply wrong about how much tapering the market expected, and they tapered more than markets thought, inadvertently causing the taper tantrum. This experience argues against implementation of monetary policy by expectations, not in favor of it.
2. The expectations-vs-hydraulics debate has nothing to do with whether central banks have to cause a recession in order to head off inflation. A well-calibrated interest rate hike in the present can suppress demand just the right amount today in the same way as a well-calibrated change in future expectations. The question is how easy it is to calibrate each intervention.
3. In the NZ example, the claim is that the central bank never actually needs to intervene as long as it announces an intervention ahead of time. Of course, if the central bank goes around announcing interventions it never implements, people will stop believing those announcements.
4. The Volcker disinflation again argues against expectations-driven monetary policy rather than in favor of it. During the 70s, the Fed repeatedly tried to assure markets that inflation was transitory and that it would hike rates when necessary. This didn't magically stop inflation because the Fed didn't actually succeed in changing expectations. Volcker had to rebuild credibility by actually raising rates.
As you say - expectations setting only works because "hydraulic" methods work.
It seems to me that you first do expectations, and if that changes behavior and the economy, then you don't need to follow through. If it doesn't, then you execute the hydraulics option and do whatever tapering/rate increases you need to to achieve the desired effect.
Like the Fed is a floor wax *and* a dessert topping.
This is 106.8% right!
It’s silly to ask if the fed *should* use expectations. the expectations channel is always operating. Your proposed fine tuned interest rate changes in the moment also after expectations. This seems to me to be the ‘hydraulic v expectations’ debate Matt is describing. In the expectations camp we say expectations are almost aways the primary factor. Volcker is the exception that proves the rule bc expectations of inflationary policy were so strong after decades of pro growth consensus that he was forced to make bigger hydraulic moves than we would expect would be necessary to overcome inflation ‘all else equal’.
I thought MY's point was that you don't say, "We're hiking rate .5% on XX date and every subsequent quarter for two years," to set expectations but instead say, "We're going to start hiking rates on XX date and continue until inflation gets down to YY%". Then, because people expect you to hiking rates until inflation goes down to your target level, they change their behavior in ways that reduces demand which in turn reduces inflation. As a result, when you start hiking rates, you don't have to do it as many times much because behaviors have already begun to change.
So per your point 3, you do something, and what you do is still consistent with what you announced. But because you did a good job setting expectations, the intervention isn't as severe was the 'hydraulic model' would suggest.
Wish I had read this one before writing my own econ history book, probably way below somewhere. Yeah, this is a both situation not an either-or. You provide expectations about future hydraulics. If the expectations worked better than expected or if some other stuff changes, maybe you don't have to follow through hydraulically. Meeting the targets is the best credibility.
nice article. and admirable humility. I told you immediately upon publishing your list of predictions around this time a year ago that your inflation priors were unlikely to be correct,
I think its admirable that you have changed your tune on this especially for the reason you listed: being a monetary policy dove has been one of your foundational views for over a decade now and has always served you well (I have generally been of the same persuasion)
keep up the good work
I am not an expert, but I think you are conflating a few things here. One is how "traditional monetary policy" works (i.e. adjusting the federal funds rate) vs. how "quantitative easing" works.
My sense is the hydraulic mechanism of traditional monetary policy is pretty well understood. Higher federal funds rates increases borrowing costs to banks, so interest rates on other lending products go up, reducing demand for credit, reducing the money supply and slowing overall demand in the economy. [That the bond market (or stock market) doesn't move in lockstep with Fed actions doesn't really disprove this - capital markets "price in" all sorts of inputs including economic growth, inflation expectations, etc. so this is not a reliable indicator of anything here.]
QE is a much more novel tool, only having been invented in Japan 20 years ago and introduced in the US during the financial crisis, and is basically a way to get around the zero interest rate bound of traditional monetary policy. They hydraulics of this are much less well understood because there is so much less history here! And importantly unwinding QE has never been part of an inflation management strategy because the US, Japan and other markets where QE has been used have not seen robust inflation until now. I think experts disagree on 1) the extent to which QE has a big effect, 2) how that effect actually works, and 3) what would happen if it unwinds.
Beyond that distinction, I am also not clear how "coordinating expectations" can actually manage inflation. I agree keeping people confident that you will both manage inflation and support growth will keep economic activity high by providing the illusion (or reality) of stability, but that is a different problem than convincing people to slow down demand just a bit to ease off inflation without triggering a recession. Most economic actors are not making spending or borrowing decisions based on an expectation of 3% vs 2% GDP growth... they are looking at the cost of credit vs an opportunity in front of them. The hydraulic mechanism explains how to slow growth pretty straightforwardly, and I'm not sure I understand what the "expectations-led" mechanism would be.
"Most economic actors are not making spending or borrowing decisions based on an expectation of 3% vs 2% GDP growth... they are looking at the cost of credit vs an opportunity in front of them."
It seems to me that part of "an opportunity in front of them" is anticipated future demand. A slower future economy means less future demand. Why wouldn't that lead to less investment?
It depends on the borrower. For some your scenario makes sense - e.g. a company thinking of taking a loan to build a new manufacturing plant. Even then though, broad macro inputs are only one factor of many considerations and the interest rate on the loan will have a much more direct impact than a modest difference in expected macro growth.
For many borrowers this consideration does not enter at all. Shoppers putting purchases on their credit card, homeowners looking at refi opportunities, people looking at how much car they can afford, all are going to be far more sensitive to the cost of financing than a subtle change in macro expectations.
Again, to be clear, if the fed expectations channel here is "we are going to cause a recession to cut off inflation" I think that will have an effect on all these behaviors... it's the dampening middle ground where a recession is avoided that I don't understand.
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.
I loved this post Matt! A very clear explanation of some tricky ground and I agreed with almost all of it.
However, one thing I found striking is that you seemed to be on the same page as Scott Sumner (whose book I'm currently reading) on almost everything until you got to fiscal policy. I was expecting you to take the Sumnerite position that monetary policy is so powerful that fiscal policy is rarely necessary or helpful. But instead you take the opposite view that the power of monetary policy makes it ok to overshoot on fiscal policy and then backtrack.
Is the issue here that you think expectations-based monetary policy is powerful most of the time but not in the most extreme circumstances? Or that it's powerful always in theory but political constraints occasionally prevent it from being powerful enough in practice? Or that you just aren't worried about debt levels so you see no real downside to throwing fiscal policy into the mix when a lot of stimulus is needed?
I took Macroeconomics in 1984 as an undergraduate econ major at Univ of Illinois from a prof named Case Sprenkle. Sprenkle showed up to lead the review for his final exam totally blotto and announced that "Macroeconomics is dead". I think what he meant was that all that M-1, M-2 and Laffer Curve (hydraulic) stuff wasn't predictive that the Fed can control the economy and inflation by levering interest rates and money supply.
Today it's clear, however, that levering expectations is the name of the game. That's where the modern MMT folks get it wrong. Sure, you can print as much money as you want, but if people believe that the government can print money to buy whatever it wants, why would they ever agree to pay taxes? Inflation is the economy killer and it's all about expectations.
But isn't that exactly what the MMT folks are saying? "Inflation is the only constraint on the ability of a sovereign to run a deficit"?
It's really incredibly difficult to figure out what the MMT folks are saying. But the idea that inflation is the only constraint on a sovereign's deficit isn't only held by MMT. That's a statement that Hayes or Keynes would have been all the way onboard for, and is consistent with most of the saltwater models.
MMT's reliance on accounting identities leads me to believe it puts forth the hydraulic view. I think what Brian is saying is that if MMT were ever widely accepted as what the Fed/Congress were doing, it would throw off expectations in a disastrous way
I mean you could also argue that the continuation of Bernanke, Yellen and now Powell is that they preemptively stopped inflation, and now with Powell flipping during the pandemic we now have it.
Personally I think BOTH views are right, and the hydraulic view is what makes the perceptions view work.
Terrible news I thought CPI numbers were going to be 6.9% Y/Y.
I think of Fed policy as driving a car with an underpowered engine, brakes that sometimes don't engage right away, and a flakey speedometer.
To make things worse, you can't tell for sure if you're driving on a flat road, climbing a mountain, or descending a steep downhill. Also, you can't know what road grade you'll face around the next bend.
Now try to keep the car going 55 mph constantly and without error.