Saturday, November 22, 2014

Is market monetarism wrong because the market is wrong?

That title will probably get me in trouble. The other candidate was "Are incorrect models a source of excess volatility?", but that was boring. 

First here's the background reading. James Hamilton at econbrowser put up a post earlier this month I've only now read. In it there was a very interesting graph:

Movement of 10-year treasury on news of additional QE. Source James Hamilton at

My reaction was "that's a big, sudden shift ... wait, wha?!?"

The 10-year treasury is not impacted by QE as I rather decisively showed in the data here, so why should it drop on news of additional QE? Hamilton continues: "But over the next few days, the yield started climbing back up. By the end of April, the 10-year yield was higher than it had been before the Fed’s announcement." Hamilton then suggests and disproves that this was due to inflation expectations. The best answer seems to be that the market was wrong and then randomly drifted back to where it should be. [See diagram at the bottom of this post.]

[As an aside, market inflation expectations are also wrong.]

Note that I've discussed the idea that markets might not know what they are doing about a year ago to explain a set of observations from Scott Sumner about interest rates; the first two are here:
  1. Moves toward easier money usually lower short term rates. The effect on long term rates is unpredictable.
  2. Moves toward tighter money usually raise short term rates. The effect on long term rates is unpredictable.
The market appears to think monetary expansion lowers interest rates. However in the information transfer model (ITM) if inflation is high (the IT index 'kappa' is low), monetary expansion will lead to higher interest rates though the income/inflation effect. If inflation is low (kappa is high), then monetary expansion will lead to lower interest rates since the income/inflation effect is muted. I then explained Sumner's rules like this:
  1. Markets like what they think is easier money, but the long run depends on whether the information transfer index is high or low. 
  2. Markets don't like what they think is tighter money, but the long run depends on whether the information transfer index is high or low.
If the market knew how monetary expansion impacts interest rates, then we wouldn't get things like the incorrect adjustment in the graph at the top of this post.

Another potential area where the market appears to be in error is in exchange rates. The immediate response to expansionary policy in Japan and the Eurozone were a falling Yen and Euro ... but the Euro should rise if the supply of Euros expands because relative demand for currency explains the behavior of exchange rates, thus more Euros means more demand for Euros.

There are two takeaways from this:

  • Since "the market" appears to have something like a monetarist view, immediate market responses to news should confirm e.g. Scott Sumner's model. The Fed announces QE, and the market expects a rise in the stock market, lower interest rates, a fall in the dollar and a return to target inflation. The market moves are taken as evidence that the Fed hasn't "run out of ammunition". However, in the long run, the economy moves back towards the ITM trends ... and you get pieces from Sumner like this: Were market monetarists wrong about Japan?
  • If the market frequently moved in the wrong direction in particular venues, that would become a source of excess volatility. I'm not saying all venues! There are many where things where the market appears to get things right. However, there are excess volatility problems in exchange rates (mentioned above) and stocks [pdf].

Regarding the stocks, James Hamilton closes his post with a question about whether the rise in the Nikkei on news of QE from the BoJ will last. If stocks rise on what the market believes is good macro news, then if that belief is incorrect and the news should be considered neutral (e.g. QE) from the correct model, then there will be excess volatility and market moves should be discounted [1].

This also implies that market monetarism won't work. No matter the market expectations set by forward guidance or NGDP targets, they won't lead to the desired outcomes unless the underlying model is correct. You could guide inflation and NGDP with the ITM if it is correct -- but then if the ITM is correct, only certain values of NGDP growth and inflation are attainable.

Schematic drawing. Market belief in purple and the correct model in orange. The market considers neutral news to raise the given price, overshoots and returns to the original price.
[1] These are theoretical musings, and the ITM may well be wrong. Actually, the ITM does not as yet predict when the prices should return to trend (the market can be irrational far longer than you can remain solvent). So if you lose money shorting the Nikkei based on this low-traffic blog by a non-economist, it's your own fault.

Monday, November 17, 2014

Because empirical success

I've occasionally had discussions with some commenters, most recently Philippe on this thread, that such and such explanatory variable can't possibly be used to explain what I'm trying to explain because it doesn't make sense to that commenter. In the recent case, Philippe suggested that it didn't make sense that physical currency (the currency component of the monetary base, which I call M0) was an explanatory variable for inflation. Philippe suggested other forms of money that should matter for inflation, like M1 or central bank reserves.

You could probably put the brief back and forth between Nick Rowe and myself in the previous few posts into this framework, except in that case I'm disagreeing with Nick by saying expectations (the explanatory variable) can't explain the price level or inflation. Nick suggests that expectations (and central bank targets or guidance) are an explanatory variable, while I'm saying expectations do not explain much more than the most recent NGDP and M0 numbers.

Maybe the information transfer model is wrong and expectations and M1 matter for inflation. Whatever model you have, though, it can't be too different from the ITM. Why? Because empirical success. Here are the information transfer model results for the price level and inflation. First, here they are for the core PCE measure:

And here are the results for core CPI:

This is more empirically successful than any economic model of inflation that has ever been published. The P* model from the Federal Reserve was comparable in the 1990s, but choked on new data. Maybe the ITM will choke on new data, too. However, time and data will tell, not theoretical arguments. The details of the model are all written down in the "for beginners" posts linked on the sidebar of this blog. Have a go yourself! All of the data I've used is from FRED (except the Japanese monetary base data, which is from here).

Also note that the fact that both fits are good means that core PCE and core CPI inflation are not independent measures. The information transfer model describes them both equally well given the data we have, so there is no telling which is the "real" measure of inflation. What is interesting is that this observation follows regardless of whether you believe the information transfer model or not. The ITM fit to each measure implicitly defines a global transformation you can perform to turn CPI data into PCE data meaning that PCE = f(CPI) so that any property of CPI can be mapped to a property of PCE. The next time you see an economist chide someone for confusing the two measures, you can come to the rescue with the retort: there is no economically meaningful difference in PCE or CPI inflation. It's like the fact that there is no physically meaningful difference in measuring distances in kilometers or miles.

And it's not like the model for the US is a fluke; here is Japan:

The empirical accuracy doesn't mean various theoretical criticisms of the information transfer model are prima facie wrong; it just means they should be discounted (i.e. given a low prior probability of being correct) unless they are accompanied by a model of comparable empirical success. Or as I said to Philippe:
The benefit of using M0 as the explanatory variable for inflation is that it gives an incredibly accurate model. If you have done [sic] better model that uses M1 or MB that explains the price level, I'm interested in hearing about it! But if you're just making hand waving arguments without any empirical evidence, that seems like a step backwards from the ITM.
The ITM doesn't just do inflation -- the interest rate model is pretty good too:

If you're of the opinion that the Fed's expansion of reserves will result in inflation, that people's expectations matter, or even that human decisions and behavior matter in a macroeconomic system at all, I'd first like to see some lines going through some data points.

Update 7:30pm MST, for Nick's comment below: 

Both of the error results for the PCE and CPI inflation models above have approximately zero mean. First, PCE inflation error:

Second, CPI inflation error:

Tuesday, November 11, 2014

In which I irritate Nick Rowe (again)

I am currently on travel for work (again) so light updates this week, but I thought I could irritate Nick Rowe some more. He has a new post up where he shows how police could regulate the speed of drivers without actually pulling anyone over:

I took on two other analogies before here:

... and my critique is similar this time.

The speed limit analogy would make sense if we all had NGDP/inflation meters/pedals. However, since many of the influences that go into NGDP or inflation are beyond our control, it's hard for individuals to target them.

A restaurant owner can't have her patrons enjoy the food 1% more while paying 3% more (to hit 2% inflation, including quality adjustments). She can't help it if suddenly her chief ingredients become cheaper and competition forces her to reduce prices ... This has been happening in the computer industry for awhile now, with actual deflation in the tech sector price level.

That's the gist of the linked post; here's some new stuff.


A tiny tweak to the behavior model turns the speed limit equilibrium into a boom-bust cycle. If the police don't pull anyone over (and no one is being seen being pulled over), people will start to speed more often and the police will start having to pull people over (concrete steps). Eventually enough people are pulled over (or witness such events) that leads back to the zero-enforcement scenario. Which leads to speeding and the cycle begins anew.

In the economic version, you'd see central bank targets start to lose their effectiveness, followed by concrete steps.


You can get the same speed limit equilibrium without expectations. In an ideal gas the velocity of particles follows a maxwell Boltzmann distribution with average speed ~ kT. Nothing actually acts on the molecules to achieve this at the micro level -- the effect of the cops in this case is an emergent entropic force that does not exist for individuals.


If Inflation and demand don't actually exist at the micro level, then the speed limit analogy doesn't make any sense at all. We can't measure our individual speed much like an individual molecule doesn't have a temperature. There is nothing to expect! You can't get tickets for going "undefined" ...

[This is not a very good post. BTW I'm writing it in a hotel room down the street from the St Louis Fed with one finger on my iPad, hence the picture above.]

Sunday, November 9, 2014

The information transfer model and the econoblogosphere

Paul Krugman has a post up that criticizes the "neo-Fisherite" view. Oddly I completely agree with his post, yet I wrote a post about agreeing with John Cochrane's post, which Krugman calls the "highest level" of  Keynesian denial. It might be confusing as to exactly where I or the information transfer model (ITM) stands.

I wrote two posts in the past that illustrate a bit of how the ITM fits in with both the history of macroeconomic thought and the debate around the current crisis. Actually, the ITM can help explain the history of macroeconomic thought. At its heart, the ITM says Paul Krugman is always right, but not necessarily for the right reasons. Anyway, this is a post fleshing that statement out with a bit more detail in fun, easy to read listicle format.

First, let me say that the ITM has a critical parameter κ (kappa, basically named after the parameter in this paper by Fielitz and Borchardt), called the information transfer index. In short, it represents the relative size of information chunks received by the supply and transmitted by the demand. Anything you say about the information transfer model has a caveat depending on the value of κ. There are two major κ regimes, and they're not very far apart numerically. When κ ~ 0.5, the ITM reduces to the quantity theory of money (and is similar to the AD/AS model with monetary offset). When κ is larger, getting towards κ ~ 0.8 to 1.0, the quantity theory stops being a good approximation to the ITM and the IS-LM model becomes a better approximation. The details are linked at this post

The thing is that κ can change over time and is different for different countries. That ends up muddling things a bit so I end up agreeing with Scott Sumner, Nick Rowe, Paul Krugman, David Glasner, or John Cochrane on various occasions and disagreeing with them on other occasions.

One additional detail is that the ITM says that κ tends to rise as economies get bigger and can only be reset by changing the definition of money or a monetary policy regime change. Hence you can consider old/advanced economies as generally having larger κ while younger emerging economies have lower κ. This is not always true, but can be a good guide. With that bit of background, on with the listicle!

I personally think the way expectations are used in macroeconomics make the field unscientific. They appear to be important in microeconomics (and game theory) -- and I have no particular problem with the way they are used there. However, mainstream macroeconomics does not appear to have any kind of constraints on what form expectations take, and hence allow anything to happen in a model. This reaches an almost absurd level with e.g. Nick Rowe's insistence that if a central bank is credible with its NGDP (or inflation) target, the economy will reach that NGDP (or inflation) target ... without the central bank actually having to do anything (besides 'be credible'). I've encountered many other theories and papers in my short few years of studying economics that effectively assume the conclusion through expectations. One economist called these chameleon models (although the author does not specifically call out expectations as the source ... however the questionable assumptions in economic models are typically about expectations or human behavior).
That aside, in the information transfer model, 'expectations' as such take the specific form of probability distributions over market variables (they parameterize our ignorance of the future). Since these distributions always differ from the actual probability distributions (we do not have perfect foresight), they represent information loss and hence a drag on economic growth (relative to perfect foresight). Additionally, prices are not only lower than they would be if we knew the actual probability distribution of market variables, but frequently lower than if we parameterized our ignorance as maximal (which is what the information transfer model does).
The monetary base
The monetary base is directly related to short term interest rates in the ITM. However, only the currency component of the monetary base (I've called it M0 as they have in the UK in the past) has any impact on inflation and then only when κ is closer to 0.5. Monetary base reserves have little to do with inflation ... except in the sense that movements in reserves can sometimes cause movements in the currency base.
Liquidity trap
The ITM model has a lot of similarities with the liquidity trap when κ ~ 1.0 -- I've called it the "information trap". Monetary policy does not have strong impact -- neither raising nor lowering interest rates, nor expanding nor contracting the currency base. The "information trap" differs from the modern liquidity trap in that it doesn't have to happen at the zero lower bound (ZLB) ... it is more like Hawtrey's credit deadlock or Keynes original liquidity trap that didn't have to happen at the ZLB. 
The ITM is, in a sense, identical to Paul Krugman's mental model (or what seems to be his mental model) if you replace "normal times" with κ ~ 0.5 and "liquidity trap" with κ ~ 1.0.
The Phillips curve
This sounds reasonable, but doesn't appear to have a strong signal in the data using the ITM. The two variables (inflation and unemployment) have a complicated relationship and the ITM doesn't describe the fluctuations leading to unemployment -- unemployment seems to be the result of, for lack of a better set of words, irrational panic that could only be modeled by modeling human behavior.
(New) Keynesianism
Essentially, the ITM is well-approximated by the ISLM model when κ ~ 1.0, but not when κ ~ 0.5. So the ITM is sometimes Keynesian inasmuch as the ISLM model is Keynesian. New Keynesianism is based on the expectations-augmented Phillips curve. Given what I've said about expectations and the Phillips curve above, you can guess that the ITM probably doesn't agree with new Keynesian methodology. This isn't to say the models are wrong or won't outperform the ITM against data -- just that methodologically they represent completely different viewpoints. 
Also, since in the US κ has been close to 1.0 both today and during the 1920s-30s, the ITM basically says Keynesianism has been the right theory at those times ... as Paul Krugman says, our world today (and Japan in the 90s) represents the return of depression economics.
(Market) Monetarism
If you take out the expectations piece (the "market" in market monetarism) ... and instead of M2 or MB use M0 ... and give a specific form for the velocity of money, the ITM basically agrees with monetarism ... when κ ~ 0.5. That is to say that Milton Friedman was (almost) right about the US during the 1960s and 70s (but wrong about Japan and the Great Depression). Scott Sumner and Nick Rowe are also right about the 1970s. Additionally, κ < 1.0 for Canada, Australia, China, Russia and Sweden (currently), so monetarism gets those right. However monetarists frequently try to appeal to data from these countries to prove their point about the US, Japan or the EU; in the ITM this is comparing apples and oranges.
Neo-Fisherite model
The only two things that the ITM has in common with this idea/model is that lower interest rates run you into low inflation faster than higher interest rates, and, if κ gets too large, the dependence of the price level on M0 (currency base) becomes an inverse relationship ... i.e. deflationary monetary expansion (as evidenced by Japan). This latter mechanism will lead to even lower interest rates over time.
However! An economy with a constant rate of inflation and a constant interest rate is impossible (unless RGDP grows at an increasingly exponential rate), and the mechanism has nothing to do with expectations, but rather is closely related to the liquidity trap. This makes it different from the typical neo-Fisherite view.
Fiscal policy
Debt-financed fiscal policy always boosts NGDP as it represents an independent process from economic growth. It also raises interest rates (aka 'crowding out'). However, when κ ~ 0.5, if the central bank is targeting inflation or NGDP, fiscal policy will fail to produce inflation (or NGDP) due to monetary offset (q.v. Scott Sumner). When κ ~ 1.0, then there is no monetary offset and the impact on interest rates is minimal. Again this view almost perfectly matches up with Paul Krugman's views, except that "liquidity trap conditions" mean κ ~ 1.0.
(My personal politics on this issue say that even if e.g. unemployment insurance negatively impacted NGDP, we should still do it because we are human beings not heartless automatons optimizing economic variables.)
Coordination failures
David Glasner and Nick Rowe have several posts that present the idea that coordination failures are the cause of recessions (Nick Rowe tends to put the onus on monetary policy, while David Glasner does not). The ITM motivates the idea that coordination causes the recession in the first place (i.e. people en masse becoming pessimistic about the economy) and that the economy does not naturally re-coordinate (create the 'inverse coordination' of the original pessimism) in order to undo that loss in NGDP. That re-coordination would require resources (e.g. debt financed fiscal policy) comparable to the original NGDP loss ... basically the idea that government spending should approximately equal the output gap per Keynesian analysis.
Other ideas?


Saturday, November 8, 2014

More goodness from Nick Rowe

It's a beautiful Saturday here in Seattle, so I'll make this quick (and somewhat out of order). Nick Rowe has new post up where he puts a few ideas very clearly:
Nominal demand can fall, but it can't fall to zero, unless the stock of base money falls to zero too. And central banks can stop it falling to zero, ZLB or not.
This is basically what happens in the information transfer model -- the existence of money means that the economy can't deviate too far from the NGDP-M0 path without some randomly irrationally exuberant people stepping in and cleaning up.
So any Neo-Wicksellian model with a ZLB must have currency in the model implicitly, even if it's not there explicitly.

Something of a side note on this one: I think that ZLB comes from the existence of money -- an asset that pays a 0% nominal interest rate; that's how it enters implicitly. If you think the ZLB is important, you're implicitly assuming currency. (I think that is the traditional economics answer.)

This next one is a long one:
If the central bank permanently raises the nominal interest rate, will this result in higher or lower inflation? If you tell me what permanently raising the nominal interest rate does to the base money supply growth rate, I can answer your question. If it causes the base money growth rate to increase permanently, like in John Cochrane's model, then inflation will increase. If it causes base money growth to decrease, then inflation will decrease. Tell me how the central bank raises interest rates, and what it is doing with base money growth when it does this. 
So why not just change the question? Ask what happens to inflation and nominal interest rates if the central bank permanently increases the money growth rate? Inflation and nominal interest rates will eventually increase too. What happens to inflation and nominal interest rates immediately is a little more complicated. It depends on whether prices and inflation are sticky, and on how quickly expectations adjust and people learn that the increase is permanent.
This is what I tackled in these two posts:

And yes, the result is complicated, but it doesn't have to do with expectations or the ZLB (I have explicit money in this model, not implicit, so the ZLB is not relevant), but rather the relative size of the monetary base and the size of the economy. There is a way to translate expectations into this measure if you like expectations more.

Friday, November 7, 2014

Assume a (neo-Fisherite) can opener

Nick Rowe tries to explain the paper [pdf] from Schmitt-Grohe and Uribe. I think I have a shorter version: Schmitt-Grohe and Uribe simply assume their result. They invented a new "lack of confidence shock" with different dynamics that leads directly to the result -- 'confidence' is directly proportional to the nominal interest rate so a higher interest rate brings inflation up and a lower interest rate brings inflation down. Basically, if the central bank sets a higher interest rate in a liquidity trap then people think the economy is going to improve, and, voilà, expectations of improvement lead to improvement.

Now I am interested in the neo-Fisherite view where low interest rates lead to lower inflation -- the information transfer model (ITM) gives that result. However the result in the ITM follows from trying to fit data from before the liquidity trap happened -- it doesn't assume different inflation dynamics in a liquidity trap.

In which I agree with John Cochrane (again)

A rising in nominal interest rate leading to a dip in inflation followed by increased inflation.
When John Cochrane says it -- Noah Smith is all twitterpated and Nick Rowe is moony-eyed; when I say it -- Noah deletes the comment from his blog post [no link, naturally] and Nick calls me warped. So it goes.

Anyway, Cochrane put out a working paper the other day that's set the econoblogosphere alight and Tom Brown asked for a response from me. I'll just work from the most recent post from Cochrane. I'm a little surprised at how much I've been agreeing with him lately.

The subject this time? The neo-Fisherite rebellion. I'm not fully a neo-Fisherite, but I'm sympathetic to many of the ideas and mechanisms.

There are two major ideas Cochrane considers:

1. Raising nominal interest rates can result in inflation.

He allows that it might cause a bit of deflation before and then result in inflation. I pretty much showed that, depending on the path of policy, this is what happens in the information transfer model. I discuss it in this post where I tried to reproduce the results as Stephen Williamson:

One of the graphs from that post is at the top of this post. Of course, as I mention in the post on Williamson, something gets in the way: the fact that there is no stable result with a permanent increase in interest rates. Guess what Cochrane' second consideration is?

2. If the Fed permanently pegs interest rates, is inflation stable or unstable in the long run?

I mentioned in the link on Williamson above that there is no stable path of the economy with a permanent increase in interest rates in the information transfer model. In this older post, I show that in order to have an economy with some constant interest rate and some constant inflation rate, you must have an economy with an increasing RGDP growth rate:

Cochrane also puts together a list of ideas that have been "demolished" ...
... MV = PY. Sorry, we loved you. But when reserves go from $50 billion to $3 trillion and nothing at all happens to inflation -- or at most we're arguing about percentage points -- it has to go out the window.
This is exactly what I've said here two days before:

There still is an equation of exchange, but the real equation is log P ~ k(Y, M) log M where k is a function.
... Keynesian deflationary spirals. Just as much as monetarists worried about hyperinflation, Keyensians' forecast of a deflationary spiral just didn't happen.
For this one, I'd say read any post on this blog about inflation. The price level is a function of M and NGDP, and doesn't depend (in the long run) on the expectations involved in the spiral. The only way deflation can happen is either though directly affecting M. In Sweden, the central bank decided to take some currency out of circulation -- and got deflation. In Japan there's a different effect; the currency in circulation has expanded so much that the average information content of each Yen is falling, resulting in deflation.
... The Philips curve. Unemployment went to levels not seen since the great depression; the output gap went to 10 percent and ... inflation moved less than one percent.
Unemployment and inflation trends are pretty unrelated, first here:

And in a more recent update here:
Fiscal stimulus... well, we'll take that up another day.
Given Cochrane's priors, I think he'll say it doesn't have a positive effect (at least). But if he comes with the answer that's right (ha!) rather than the one he likes, let me tell you what that answer should be -- at least according to the information transfer model.

Fiscal policy has an impact when monetary policy doesn't, such as in a liquidity trap (or generally when the monetary base is large relative to the size of the economy). The two "forces" are orthogonal in a liquidity trap and are closer to parallel when the quantity theory of money applies.

It's pretty amazing that all this comes from some simple considerations stemming from the idea of money transferring information.