Unfortunately, the Fed doesn’t get to decide the path of interest rates. It looks like they do, but that’s a cognitive illusion. The bond market determines the path of interest rates, reflecting factors such as global credit markets, as well as NGDP growth and the level of NGDP in the US.
I am fond of Winston Churchill’s remark about someone who “stumbles across the truth, but then picks himself up as if nothing happened.”
That is what I feel took place here. I think that the implication of the quoted sentences is that it is the bond market, not the Fed, that is in control. As I write in the Book of Arnold, the Fed is just another bank. It has no more ability to “target” macroeconomic variables than does Citibank. Of course, Citibank is free to set a ridiculous interest rate for its on loans and deposits, and so is the Fed. And if the Fed set a ridiculous rate on reserves (right now negative 1 percent would be ridiculous, as would positive 5 percent) lots of crazy things would happen. With a negative rate on reserves, cash would dominate reserves as an asset. With a rate of 5 percent, reserves would dominate pretty much any loan as an asset.
But leave aside such hypotheticals. The Fed is not the macroeconomic driver it is made out to be.
The question I’ve been mulling how to ask recently is can they control short-term prices (perhaps through leverage) and through expert timing (or some other mechanism) affect path dependencies?
It has no ability to target real variables. It has every ability to target nominal variables because its notes are the unit of account. How can you possibly be confused about this?
Does nominal affect real?
btw, are you a market monetarist?
Yes, nominal affects real, through things like money illusion, price stickiness, ability to plan, changing the value of existing contracts, etc, etc, etc.
In other words it affects it in very complicated nonlinear ways. Nominal does not affect real in any way that is powerful and predictable enough for the fed to target a real variable like GDP.
However, it is predictable that if the fed targets a reasonable nominal variable like NGDP, things will turn out better than if the fed targets an unreasonable variable like the price of legos.
Minis the part about NGDP, I think Arnold means basically the same thing you are saying and what Scott Sumner says at the link.
As for the NGDP part, that of course isn’t entirely nominal.
> As for the NGDP part, that of course isn’t entirely nominal
Huh? NGDP is measured in nominal dollars. It is entirely nominal. You could imagine not-entirely nominal variables like NGDP + RGDP, but I can’t imagine what use they would be.
Ha! I knew you were a market monetarist.
The conclusion doesn’t follow the premise. The fed can probably determine the direction of nominal variables, but that is a far cry from being able to target them.
I’m not sure what you mean by the difference is between “being able to control the direction”, and “being able to target”.
Are you saying there’s a limit to how precisely the fed can control a nominal variable? If so, I agree, though judging by the success of inflation targeting since it was instituted, it looks like the fed can target nominal variables well enough to be useful. It could probably do a lot better than that by using market forecasts and level targeting, but we won’t know that for sure unless they try.
Or are you saying that there is some asymptote where the fed is no longer able to create inflation? If so, hahahahahhahaha look at Zimbabwe and tell me that again with a straight face.
Re: As I write in the Book of Arnold, the Fed is just another bank.
The Fed has a printing press.
The Fed is just another bank, except it can print the Book of Arnold.
Dr. Kling: I’m still not sure you’ve ever understood the monetarist model; you talk like you think the Keynesian model is the only one in town (indeed, like you think monetarists *are* Keynesians, except for their policy prescriptions). I think you should do some more studying and understand how monetarists think the quantity of money affects the real path of the economy, so you’ll understand how someone can both believe that it does and that the Fed lacks the ability to determine interest rates (other than its own discount rates).
Jonathan Cast:
I’m not speaking for Dr. Kling here, but I suspect I may “suffer” from the same lack of understanding of the monetarist model you reference as applicable to him. So perhaps I should do some more studying as well.
But I’m not exactly pathetically ignorant either. So before I ask you for a recommendation of where I should start studying the monetarist model, I should give you some idea of my pre-conceived notions, based on what seems to be portrayed as the monetarist model:
You reference, “… the quantity of money affects the real path of the economy”. You also state, “… the Fed lacks the ability to determine interest rates (other than its own discount rates).”
I agree wholeheartedly with both of those statements, as stated! (So perhaps I’m a “monetarist” after all.)
Of course the quantity of money affects the path of the economy. The thing is though, the quantity of money is not the only thing that affects the path of the economy. Nor is the quantity of money the economy in and of itself, as Scott Sumner seems to want me to believe. He advocates the Fed (or somebody) just “print up” an increase in the quantity of money until NGDP looks “pretty” – with “pretty” being defined by Sumner as somewhere between 4% and 5% NGDP growth rate. As compelling as that might sound for Sumner and others (after all, who doesn’t want robust GDP growth?), I don’t consider just making NGDP look “pretty” by way of the expedient of adding more money a worthy macroeconomic goal in and of itself. As Dr. Kling has said (and I concur), “the U.S. economy is not just a GDP factory.”
I also agree that the Fed doesn’t have the ability to determine interest rates other than its own. I would also quickly add that the Fed doesn’t even have the responsibility of determining interest rates other than its own. I suspect that is the issue that Dr. Kling (and I, and others) have always known, but Scott Sumner apparently has just “stumbled upon” – the point of this post by Dr. Kling.
So where should I begin my study of the monetarist model to improve upon my understanding? Any recommendations?
I am pretty sure that I understand the monetarist model. I am also quite sure that you do not understand my objection to it. In brief, I would say that:
1. The public decides what is money. We use plastic as money, we use paypal as money, we use money market funds as money, etc. The central bank does not control the supply of money that we actually use.
2. Central banks by themselves do not cause high inflation. High inflation is a fiscal phenomenon. When the government runs out of cheap credit but still runs a deficit, it starts printing money in great quantities, and that leads to high inflation.
3. The central bank controls its own balance sheet. But a private bank also controls its own balance sheet, and that does not determine macroeconomic performance. Unless the government is running an unsustainable deficit, everything the central bank does with its balance sheet can be accommodated by the private sector without any effects on long-term interest rates, inflation, or other macro variables.
on 1: The public uses those things as media of exchange and stores of value. It does not use them as units of account. Paypal, bank deposits, and money market funds promise to be redeemable in base money. Base money does not promise to be redeemable in any other financial asset. This is a critical distinction and it’s central to the monetarist story. I don’t see how you can address any objection to monetarism without dealing with this distinction.
on 2: but the causality runs entirely through the central bank. What would happen if the central bank chose not to inflate away the debt? The treasury would default on the debt.
I feel I’m making progress toward reconciling the views of two people for whom I have a great deal of respect. Here are two thought experiments that will help in this endeavor:
1) Suppose the Fed increased interest on reserves from 0.25% to 8% tomorrow and simultaneously began a program to sell few trillion of the assets on it’s balance sheet and announced a new inflation target of 0%. What does the Book of Arnold predict will happen to inflation over the next two years?
2) Suppose the Fed cut the interest rate on reserves to -2%, announced a plan to buy an unlimited amount of financial assets until a market based forecast of NGDP 5 years from now reached $22.5T (5% year over year growth). What does the Book of Arnold predict will happen to NGDP over the next two years?
The Fed’s ability to influence nominal variables in the short run is, I think, pretty well established, both theoretically and empirically. The mechanism underlying this has been quite well-described by Nick Rowe in his alpha/beta bank series (asymmetric convertability), if you care to read.
In fact, I would say that it is specifically the “cognitive illusion” that Scott mentions that allows the Fed to influence (though not control) the short-run path of interest rates…though I’m sure Scott would reply that the path and level of interest rates are an epiphenomenon generated by the Fed’s control of base money. And that there is no particular reason to focus on the particular variable.
In the same vein, MMTers focus heavily on the cognitive illusion of chartalism to motivate a positive value for legal tender…at least in the Wray model.
In the end, I certainly believe that the Fed has the power to steer the nominal economy. I believe this because others believe this, and that makes it true. That’s a far cry from saying that the Fed has iron clad control over the economy. I would also say that the Fed has the power and means to hit any nominal variable it wanted…unless we are running out of 1s and 0s…
The fact that the Fed has missed its inflation target for umpteen quarters in a row strikes me as an important anomaly for those who believe in the power of the central bank over nominal variables. I know that the believers have an explanation, which is that the Fed could have hit its target but instead it just kept botching things. While that explanation can placate a believer, it does not win over a skeptic.
I would agree IF the FOMC’s statements sounded more like this: “we will continue to make monetary policy more accommodative until market based forecasts of future inflation fall in line with our target.” Instead, all the Fed talks about is how badly it looks forward to raising interest rates in the future. The Fed says it has a 2% inflation target, but it’s actions and statements are consistent with those coming from a group of people who disagree about how the economy works but are basically ok with the status quo as long as inflation is not more than 2%.