Tuesday, September 25, 2007

What Has Been Learned about Monetary Policy?

While this may not be a question that comes up in day-to-day conversation, for those of us who teach economics, it provides a touchstone on what we know and teach. This is particularly applicable for those of us who have students who are amateur Fed-watchers, either through predilection or involvement in programs like the Fed Challenge.

Fed Governor Mishkin presented a paper at a Deutsche Bundesbank conference on monetary policy. The entire paper is probably more than you would share with your students - it's over 40 pages with references and charts. The first 13 pages (15 in the pdf file) include nine key principles about monetary policy developed over the past 50 years. And for those of us teaching, they are worth reviewing.

1. Inflation is always and everywhere a monetary phenomenon. (This is important for students to understand in order to make choices in the civic as well as economic arena.)

2. Price stability has important benefits. (This is important for students to understand that price stability ultimately affects other aspects of the economy, and is worth pursuing.)

3. There is no long-run trade-off between unemployment and inflation. (This is important to understand that anyone offering that as a policy solution is attempting to "pull the wool" over their eyes. This has civic education aspects.)

4. Expectations play a crucial role in the determination of inflation and in the transmission of monetary policy to the economy. (It is important to understand that inflation can feed on itself, and sound policy can reduce that tendency. Again, this has some civic education aspects.)

5. Real interest rates need to rise with higher inflation, i.e. the Taylor Principle. (It is important to understand that there is a connection between real rates, monetary policy and inflation outcomes.)

6. Monetary policy is subject to the time-inconsistency problem. (This is important to understand that adjusting policy to short-term needs can make long-term outcomes harder to achieve.)

7. Central bank independence helps improve the efficiency of monetary policy. (This is important to understand the potential for problems when monetary policy is directed by objectives that are not economic. This also has civic education aspects. See #6.)

8. Commitment to a nominal anchor is central to producing good monetary policy outcomes. (This is important because there remains much debate about the issue of inflation-targets for several central banks, not the least of which is the Federal Reserve.)

9. Financial frictions play an important role in the business cycle. (This is important to understand that information is vital to a well-functioning economy and financial sector; and that business cycle fluctuations can cause information imbalances that have the potential to make matters worse.)

Those are my "take-aways." You may disagree and feel free to debate. You can access the paper and look at each in greater depth. To what extent does your teaching reflect these learned lessons?

3 comments:

Mike Fladlien said...

thanks for the link to the paper...because of your involvement with the fed challenge, i began to look at the fischer rule and the fed reaction function...i admit, i need more work on those subjects, but they are mentioned in your blog...i am always confused why at the econ 101 level we have to teach the phillips curve...isn't the phillips curve a medium-run outcome?

Tim Schilling said...

Actually, everything I've read is that Phillips Curve is a short-term trade-off. And I suspect that with the increased availability of information, and the ability of markets of all kinds to internalize policy changes, it's getting shorter.

Flow5 said...

(1) Ben S. Bernanke
Chairman and a member of the Board of Governors of the Federal Reserve System. Chairman of the Federal Open Market Committee, the System's principal monetary policymaking body.

At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as provisional and subject to revision as the facts demand. Thus, policy must be flexible and ready to adjust to changes in economic projections.

2) European Central Bank (ECB) Central Bank for the EURO

The transmission mechanism is characterised by long, variable and uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy actions on the economy and price level…

3) Janet L. Yellen, President and CEO of the Federal Reserve Bank of San Francisco

You will note that I am casting my statements about the stance of policy and the outlook in very conditional terms. I do this because of the great uncertainty that surrounds these issues. Frankly, all approaches to assessing the stance of policy are inherently imprecise. Just as imprecise is our understanding of how long the lags will be between our policy actions and their impacts on the economy and inflation. This uncertainty argues, then, for policy to be responsive to the data as it emerges, especially as we get within range of the especially as we get within range of the desired policy setting.

(4) Thomas M. Hoenig
President of Federal Reserve Bank of Kansas City

Monetary policy must be forward-looking because policy influences inflation with long lags. Generally speaking a change in the Federal funds rate may take an estimated 12-18 months to affect inflation measures….But the course of monetary policy is not entirely certain. & will depend on how the economy evolves in the coming months.

(5) William Poole*
President, Federal Reserve Bank of St. Louis

However inflation is measured, economists agree that monetary policy has at most a minimal influence on the rate of change in the price level over relatively short time periods—months, quarters or perhaps even a year. Central banks are responsible for medium- and long-term inflation—such inflation, as Milton Friedman wrote, is a monetary phenomenon that depends on past, current and expected future monetary policy. As a practical matter, the medium- to long-term likely is a period of two to five years.

(6) Robert W. Fischer – President Dallas Federal Reserve Bank
November 2, 2006:
"In retrospect [because of faulty data] the real funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer than it should have been. In this case, poor data led to policy action that amplified speculative activity in housing and other markets. The point is that we need to continue to develop and work with better data."

(7) Governor Donald L. Kohn

I think a third lesson is humility--we should always keep in mind how little we know about the economy. Monetary policy operates in an environment of pervasive uncertainty--about the nature of the shocks hitting the economy, about the economy’s structure, and about agents’ reactions. The 1970s provide a sobering lesson in the difficulty of estimating the level and rate of change of potential output; these are quantities we can never observe directly but can only infer from the behavior of other variables.

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First, there is no ambiguity in forecasts. In contradistinction to Bernanke (and using his terminology), forecasts are mathematically "precise” (1) nominal GDP is measured by monetary flows (MVt); (2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits, demand deposit turnover) that matters; (3) “money” is the measure of liquidity; & (4) the rates-of-change (roc’s) used by the Fed are specious (always at an annualized rate; which never coincides with an economic lag). The Fed’s technical staff, et al., has learned their catechisms;

Friedman became famous using only half the equation, leaving his believers with the labor of Sisyphus.

The lags for monetary flows (MVt), i.e. proxies for real GDP and the deflator are exact, unvarying, respectively. Roc’s in (MVt) are always measured with the same length of time as the economic lag (as its influence approaches its maximum impact; as demonstrated by a scatter plot diagram).

Not surprisingly, commercial bank "free" legal reserves (their roc’s) corroborate/mirror both lags for monetary flows (MVt) –-- their lengths are identical.
The lags for both monetary flows (MVt) & "free" legal reserves are indistinguishable.

Consequently it has been mathematically impossible to miss an economic forecast. There are no inaccuracies, just some non-conforming & unavailable data.

This is the “Holy Grail” & it is inviolate & sacrosanct.

The BEA uses quarterly accounting periods for real GDP and deflator. The accounting periods for GDP should correspond to the economic lag, not quarterly. They should represent a rolling moving average.

Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP. Note: roc’s in nominal GDP can serve as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.

Because of monopoly elements and other structural defects which raise costs and prices unnecessarily and inhibit downward price flexibility in our markets (housing being most notable), it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 percentage points.

In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.

Some people prefer the devil theory of inflation: “It’s all OPEC’s fault.” This approach ignores the fact that the evidence of inflation is represented by actual prices in the marketplace. The "administered" prices of OPEC would not be the "asked" prices were they not “validated” by (MVt).
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Dr. William Poole: The depreciation of the dollar is something that is not explicable. And the way I like to phrase this – I like to put my academic hat back on. If you look at academic studies of forecasts of the exchange rates across the major currencies, you find that the forecasts are simply not worth a damn.

Your best forecast of where the dollar is going to be a year from now is where it is now. There is no model that will beat that simple model. And people have dug into this over and over again. Obviously, you can make a ton of money if you were able to have accurate forecasts.

No one has been able to come up with a forecasting methodology that will make you a lot of money. And you can’t make money under the forecast that the dollar is the same as it is right now a year from now. I can go a step beyond that though – and this is what I think is really interesting.

The academic literature is also full of papers trying to explain exchange rate fluctuations after the fact – after you have all the data that you can put your hands on – data that you can’t accurately forecast, but data that after you get your hands on it might logically explain the fluctuations of currency values. And those models aren’t worth a damn either.

We cannot explain the fluctuations of currencies after they have occurred even with all the data that we can dig out. And therefore, to me, it’s completely unsupported idle speculation not only to make the forecast but to talk about why the dollar has behaved as it has.

I know the financial pages and the traders love to talk about that, but I would challenge any of them to construct a model that would stand up to a peer review journal in economics or finance. The models just aren’t that good.”

A post-event question from a Bloomberg reporter: “I was hoping you could elaborate a little bit on the implications of the weakness in the dollar right now… whether implications on inflation or just the economy in general.”

“I don’t see any implications for inflation, at least with the magnitude of the depreciation that we’ve seen so far. The evidence is that – there’s a literature that looks at what’s called “pass through” – pass through of changes in domestic prices. And the evidence is that the pass through coefficient has gotten small and smaller.”

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If the world's largest economy ($13b+) has a contraction in its economy, imports will fall, & export driven countries will suffer, exacerbating the negative flow of funds, and any currency crisis.

Forecasting results:

Mexico crisis 2/17/1982 (not identified) - Peso was pegged

Listed below, currency crisis that were predictable & preventable
(1) Black Monday Oct 19 1987 (same day)
(2) Mexico Peso crisis Dec 1994 (2 months early) Peso was pegged
(3) U.S. dollar fall in Mar. 1995 (same month)
(4) Asian financial crisis July 1997 (one month late) - without primary time series
(5) Russian financial crisis 1998 (same month)
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Yea for these, our sterling pieces, all of pure Athenian mold -- ARISTOPHANES, THE FROGS

Monetary flows (MVt) peaked Oct. 1974 (the stock market bottom)
Monetary flows (MVt) peaked Oct. 1982 (1 month after the stock market bottom).
(MVt)'s lag for long-term rates peaked Sept. 1981 (this century's peak in long-term interest rates).
Monetary flows (MVt) peaked in Jun 1984 (the stock market bottom).

1 option trade beat Prechter's trading championship record with his 200+ trades

Lags are not coterminous, e.g., the stock market bottom of 1982 was identifiable a year and ½, earlier

Go, presently inquire, and so will I, where money is. --- THE MERCHANT OF Venice

1938-1940 roc's in "free" legal reserves pulled us out of the depression.
1951 (Korean War) had the highest roc’s in inflation & in "free" legal reserves since WWII.
1973 had the highest roc's in inflation & the highest roc's of "free" legal reserves ever.
1979-1980 had the highest rates of inflation & the highest roc's of "free" legal reserves ever.
“Black Monday" Oct. 19, 1987, coincided with the sharpest and fastest peak-to-trough decline in the roc for real GDP since 1915.
The stock market's 1QTR top in 2000 coincided with a +3.24 (roc) in Dec. 1999, which reversed to -.32 in Feb 2000. An historic reversal.

Feb 27 coincided with the sharpest decline in 1) the absolute level of "free" legal reserves, & 2) & an historically large peak-to-trough reversal of roc’s for proxies on real GDP & the deflator.
Contrary to the pundits the stock market slide did not start overseas. The stock market collapse & gold's down draft were home grown. The

The policy rule is ex-post. (e.g, Taylor Rule).
Bank debits & "free" legal reserves are ex-ante.

http://fraser.stlouisfed.org/docs/MeltzerPDFs/bogsub020538.pdf

Member Bank Reserve Requirements; Feb, 5, 1938. “In 1931 this committee recommended a radical change in the method of computing reserve requirements, the most important features of which were…”(2) uniform percentage requirements against the volume of deposits of both types and in all classes of cities; and (3) requirements against debits to deposits.”