John Cochrane’s Monetary Thought Experiment

He writes,

The Fed or Treasury could easily say that the yield difference between TIPS and Treasuries shall be 2%. (I prefer 0, but the level of the target is not the point.) Bring us your Treasuries, say, and we will give you back 1.02 equivalent TIPS. Give us your TIPS, and we will give you back 0.98 Treasuries. (I’m simplifying, but you get the idea.) They could equivalently simply intervene in each market until market prices go where they want. Or offer nominal-for-indexed swaps at a fixed rate.

Scott Sumner enthuses,

Excellent. And so Neo-Fisherism has now arrived where David Glasner, Bill Woolsey, Bob Hetzel, Milton Friedman and I were a few decades back. Target the market forecast.

The idea is to pin down expected inflation at 2 percent. I gather that Cochrane figures that actual inflation will then converge to expected inflation. I am not so sure. Suppose that “expected inflation” (defined as the spread between the interest rates on the 5-year nominal Treasury and the five-year TIP) is 2 percent but actual inflation is running at 1 percent for the indefinite future. What sort of arbitrage is available? Go long the spread and short everything in the CPI?

I think that the error is in thinking in terms of “the” rate of interest. There are many different rates of interest. The five-year nominal Treasury and the give-year TIP are just two of them. If the Fed pegs the spread between the two, I am not sure that has any consequences for the other interest rates in the economy. In particular, as I see it, there is nothing to ensure that actual inflation converges to the targeted spread.

If you’re new to this blog, I take an outlier point of view, which is that the Fed is not important for the macro economy. Walrasian economists needed something to pin down the nominal price level, so they nominated the money supply. I instead take the view that money and inflation are largely social conventions. Extreme measures by the government can change these social conventions. Otherwise, in my view, the belief in the power of the Fed is a superstition. This superstition is best maintained if the Fed’s actions are mysterious. If the Fed were to follow a transparent rule, I think that the superstition would be exposed for what it is.

10 thoughts on “John Cochrane’s Monetary Thought Experiment

  1. Arnold,

    You write most inspiringly:

    “[T]he Fed is not important for the macro economy” – but then I wonder, is the Fed not very influential, perhaps capable of skewing incentives and disturbing price finding in important markets, being in this way negatively “important for the macro economy”?

    “[M]oney and inflation are largely social conventions” – what is it about their being “social conventions” that makes the Fed impotent? Can’t “money and inflation be social conventions” AND the Fed at the same time be “important for the macro economy?”

    Are theories wrong according to which the Fed has a momentous role to play in (macro-economically significant) financial crises (like the Great Depression)?

    Has prudent central bank policy of an interventionist type (in principle or historically) no significant influence on the macro economy?

    Under which circumstances might the Fed be macro-economically important?

    I think, your outlier view is fascinating, and even if there were nothing to it – which I doubt – it would represent a most enriching heuristic challenge, which invites the thoughtful to ask questions with great potential for usefully novel answers.

    Where can I find posts/an article in which you spell out your outlier view?

    • I think one of the best books on the subject is Fischer Black’s “Business Cycles and Equilibrium” the first chapter really elucidates the essence of “money.” other chapters specifically address the passive nature of the Fed.

      • Paul,

        Thank you very much for the hint.

        I have not read Fischer Black for decades, it surely will be a new experience after all these years.

        Unforgeable, the three days that I spent with Fischer and Merton Miller, both being guests of a conference I had helped organise (on the occasion of the opening of the German Options and Futures Exchange, then DTB, now Eurex). A year later Merton received his Nobel prize; we used to joke that it was due to his participating in our conference, and an anthology based on the speeches we gave at the conference.

        Fischer was so intense, during our discussions he made me feel like standing right next to a buzzing pylon – never before or after have I met a person whose thinking could be felt physically.

        I was deeply touched when I learned of the untimely death of Fischer, in 1995. Just imagine what contributions he might have added to his impressive work had he had another 20 or 30 years to live.

  2. I can see belief in the Fed as all powerful may be too much, but do you really want to say the Fed has never, can never, cause a recession, or that Fed actions are just expressions of the market? (In the latter case, they could still be valuable as an indicator even if not as cause, though given self fulfillment, would still seem somewhat powerful)

  3. I think a different statement is more important than the outlier view of the powers of the Fed (though it supports the idea that the powers of the Fed are more limited than sometimes supposed.)

    To wit: “I think that the error is in thinking in terms of “the” rate of interest.”

    And in particular, “THE” rate of interest a relative few large money center institutions charge each other is only vaguely coupled to the real availability and costs of credit elsewhere in the economy. I personally take the view that entire array of interest rate instruments at hand for the Fed are too far decoupled from the real economy to make refined intervention possible.

    Yes, they could try to drive interest rates very high and perhaps shut down the economy, or do some extreme thing to cause hyperinflation, but to actually have a solid purposeful intervention seems very difficult. Just as it’s vastly easy to kill a cancer patient than to cure them.

  4. I have some trouble with this too.
    Lets say the Fed wanted more inflation. How can it get more inflation? By losing the inflation bet and paying off the Goldmann Sachs with ink and paper. But Goldmann Sachs is likely to turn the paper into real growth, not inflation.

    Can the Fed bet with Congress?. Currently, the Fed eans all its incoming paper from Congress, then just returns the money. So if it made any bet with Congress, it would br neutral.

    One last scenario is that the Fed bet Goldman Sachs on disinflation. We get inflation, Goldman Sachs gives the ink and paper to the Fed and the Fed turns it over to Congress, who then converts real growth into inflation, but way after that bet.

    No, I think the Fed’s best strategy is to have a six month debate about the word ‘considerable’, and let Goldman Sachs handle the fiat.

  5. The notion that the Fed can change social conventions by extreme measures, but not small ones, deserves more elaboration. If you accept the monetarist (market monetarist?) view that anticipated money debasement appears as inflation, then the size of Fed movements depends upon its built in market credibility. But if you believe that the Fed can debase money, and you add some level of rational expectations, then the Fed should be able to change social conventions in nominal terms.

  6. “What sort of arbitrage is available? Go long the spread and short everything in the CPI?”

    Pretty obviously, you could arbitrage nominal and inflation-hedged futures contracts for commodities. If the spread between Treasuries and TIPS is 2%, but the spread between nominal and inflation-hedged dollar-denominated futures contracts for oil is persistent at 1%, then you just arbitrage away and make your fortune. Except obviously, markets adjust, so the spread between nominal and inflation-hedged futures contracts for every commodity becomes 2%. And that will feed through into the “real” economy, and so CPI inflation will be pushed up to 2%.

  7. Even if no arbitrage opportunity exists, why would anyone buy a TIPS in your scenario when they get a 1% higher real rate of return on the nominal treasury? They wouldn’t of course so this would put pressure on security prices that the Fed would offset by expanding the money supply until… So in your scenario either investors are just ignorant of a better opportunity or no amount of money printing can increase inflation from 1% to 2%. So which do you think it is?

    Also, you’re skepticism about one interest rate affecting another is really puzzling. Surely there is some substitutability between different bonds.

  8. We live in a world of semi-free banking. There is a regulated banking sector and a largely invisible unregulated sector. The actions of the Fed can best be analyzed from a micro-economic perspective. They can subsidize the regulated sector and they can burden the regulated sector. This they can do within narrow limits for short periods of time.

    There is little the Fed can do to improve the economy. They can, on the other hand, mismanage the regulated sector to a degree that the economy is damaged. They may also be able to step in when the unregulated sector panics and financial intermediation breaks down on a massive scale.

    The Fed does not control interest rates, the price level, aggregate demand, money or employment except under extreme and rare circumstances.

    This has not always been the case. But it is the case today due to globalization, the dollar’s reserve currency status and technology.

    Bad money drives out good. Setting the spread between TIPS and non-TIPS is like fixing the coinage ratio between silver and gold. One or the other product will dominate the market outside of specialty sectors.

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