Friday, September 20, 2013

Interest rates and monetary policy or: Never reason from a price change

Scott Sumner has a great post up today. Great, in the sense that he lays out with some clarity how he sees interest rates (I will call these rules S1 - S4):
  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.
  3. Extremely easy money policies (hyperinflation) almost always raise interest rates.
  4. Vice versa. [Which I have taken to mean "Extremely tight money policies (disinflation) almost always lower interest rates".]
But his immediate reaction (as well as Yglesias's) to the immediate reaction to the Fed's guidance that it won't start "tapering" violated his maxim to never reason from a price change.

So what does the information transfer model say about monetary policy and interest rates? I will make a list like Sumner did, but the interesting piece comes in when you recognize that markets don't know about the information transfer model. Hence the market reaction to easier money is always lower rates, but the long run depends on whether you are in a high information transfer (IT) index regime or not:
  1. If the IT index is high, increases in the monetary base lowers interest rates (increasing MB causes NGDP to stay the same or drop slightly, decreasing NGDP/MB ~ r). Markets will also shift to lower rates as MB is increasing (perception of easier money).
  2. If the IT index is high, decreases in the monetary base raises interest rates (decreasing MB causes NGDP to stay the same or increase slightly, increasing NGDP/MB ~ r). Markets will also shift to higher rates as MB is decreasing (perception of tighter money).
  3. If the IT index is low, increases in the monetary base will raise interest rates (increasing MB causes NGDP to increase more, increasing  NGDP/MB ~ r). Markets will initially shift to lower rates as MB is increasing (perception of easier money) but the equilibrium will drift to higher rates over the long run.
  4. If the IT index is low, decreases in the monetary base will lower interest rates (decreasing MB causes NGDP to drop, decreasing NGDP/MB ~ r). Markets will initially shift to higher rates as MB is decreasing (perception of tighter money) but the equilibrium will drift to lower rates over the long run.
High and low IT index is dependent on how close the economy is to the information trap criterion, and some of the reasoning can be understood from these two posts. I will call these rules I1 - I4. Let's review Sumner's rules in the light of the information rules:
  1. Moves toward easier money usually lower short term rates. The effect on long term rates is unpredictable. This is because this case includes both I1 and I3. Markets like what they think is easier money, but the long run depends on whether the information transfer index is high or low. 
  2. Moves toward tighter money usually raise short term rates. The effect on long term rates is unpredictable. This is because this case includes both I2 and I4. 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.
  3. Extremely easy money policies (hyperinflation) almost always raise interest rates. This is rule I3. Sumner is basically recalling the 1970s here when the information transfer index was low. However this does not apply during the 1930s or since 2008. Sumner rationalizes this by saying money during the 1930s and 2010s is tight (see next rule) despite the massive increases in the monetary base (the increase is expected to vanish ... eventually).
  4. Extremely tight money policies (disinflation) almost always lower interest rates. This is rule I4. Sumner believes this is the situation in the 1930s, the 1980s and now (his views are consistent with the information transfer model if the IT index is always low). Rule I4 only applies if the IT index is low, which works in the 1980s, but is incorrect in the 1930s and since 2008 since the IT index is high. We do not have "tight" money that is leading to low interest rates, we are in a liquidity trap which happens at low interest rates and monetary policy is ineffective: money is neither tight nor loose.
Another way to see this is by eras:
  • The 1930s: Sumner says S4 explains. I say I1 explains. (We disagree on whether the Fed could intervene.)
  • The 1970s: Sumner says S3 explains. I say I3 explains. (We agree inflation was a monetary phenomenon.)
  • The 1980s: Sumner says S4 explains. I say I4 explains. (We agree that monetary policy brought inflation under control.)
  • The 2010s: Sumner says S4 explains. I say I1 explains. (We disagree.)
I think this is also a good place to place to compare and contrast the information transfer model with two other views of our current situation:
Scott Sumner believes the current situation is like the US in the 1930s and Japan. Money is tight and the Fed could create expectations that allow economic growth but it is failing. Fiscal stimulus will be offset by continued Fed failure (and would be unnecessary if the Fed stopped failing). 
Paul Krugman believes the current situation is like the US in the 1930s and Japan. Monetary policy is ineffective at the zero lower bound (a liquidity trap). The Fed could create expectations that allow economic growth but it is almost impossible for the Fed to do credibly. Fiscal stimulus will boost the economy because the Fed has no traction to offset it. 
The information transfer model shows the current situation is like Japan [1]. Monetary policy is ineffective when the base becomes too large relative to NGDP (an information trap). The Fed cannot generate inflation via expansionary monetary policy nor expectations of expansionary monetary policy unless they abandon targets [2]. Fiscal stimulus could [3] boost the economy because the Fed has no traction to offset it (monetary policy shifts are orthogonal to NGDP shifts). [1]
I hope I was fair to the viewpoints of Sumner and Krugman. Overall the information transfer view is more similar to Krugman, but does not include the ability to leave the liquidity trap via expectations (the central bank credibly promising to be irresponsible). However there is a possibility to leave the trap by generating accelerating inflation (see footnote [2]) by, say, printing money without regard to macroeconomic targets (inflation, NGDP growth) and giving it to people. I guess this is credibly promising to be irresponsible. The key is that the central bank has to stop receiving information from the economy and reacting to it. This may have been what happened in the 1940s. As you can see from the following graph the ratio of NGDP to the MB grew significantly (inflation rates reached 15-20%) which would have significantly decreased the IT index:



I've gone a little off the original subject of interest rates and monetary policy. I think I will devote a future post to this hyperinflation exit picture of the Great Depression and what it could mean for today.
[1] If this phase transition picture is correct, then a) the situation is like the 1930s as well and b) the only likely solution to our current problems is to create a phase transition/redefine money (e.g. leaving the gold standard and WWII in the 1940s, or potentially the accelerating inflation -- see [2] below). The modern equivalent may be switching to electronic money. I am uncertain of these conclusions and monetary reset may be easier than it seems from the only available case in the data. 
[2] Hyperinflation/accelerating inflation will still leave us without a monetary policy that functions with targets. We would just have another recession in the future as the Fed tried to stop inflation. The key question is whether this will leave us at a higher NGDP/MB ratio or not. NGDP grows faster than MB as long as the IT index is below 1 (at IT index = 1 they grow at the exact same rate). Therefore engaging in accelerating inflation can move us to lower IT index. Low inflation targets will move us back towards higher IT index causing the cycle to start anew. 
[3] I haven't worked it out in detail, but it seems that the primary mechanism for fiscal stimulus failing is monetary offset and that is impossible in a information/liquidity trap. In fact, fiscal stimulus may have offset the negative impact of monetary stimulus in an information trap.

1 comment:

  1. The sentence "Markets like what they think is tighter money, but the long run depends on whether the information transfer index is high or low." should read "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." Copy and paste error.

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