Cochrane’s inconsistencies

I just came across a couple of weeks old post from John Cochrane’s blog. Cochrane seems to be very upset about the calls for easier monetary policy in the euro zone. Let’s just say it as it is. Even though Cochrane is a professor at the University of Chicago he is certainly not a monetarist. It is sad how the University of Chicago has totally abandoned its proud monetarist traditions.

Here is Cochrane:

“As you might have guessed, I think it’s a terrible idea (Cochrane refers to a weakening of the euro engineered by easier monetary policy)…The biggest reason is the vanity that you can do it just once. “Devalue and inflate the currency” is hardly a new idea. Portugal, Italy, Spain, and Greece lived on a cycle of continual devaluation and inflation until they joined the Euro.  Going on the Euro was a hard won transformation to precommit to get off this cycle. “

Hence, Cochrane thinks easier monetary policy is very evil. However, in the in the comment section Cochrane states the following:

“I like a price level target. I view money as a set of units for value, and I don’t think the government artfully devaluing the meter and kilo to give shopkeepers a boost is a good idea, any more than fooling with inflation to do so, even if it does “work,” at least once. I’m less of a fan of NGDP targets, and the link from interest rates to price level is pretty tenuous…More coming, a comment isn’t the place for an entire monetary-fiscal program.”

Again you would think that Milton Friedman would be screaming from economist heaven about Cochrane’s odd references to the “tenuous” link between the price level and interest rates – as if interest rates are telling us much about monetary policy. Anyway, note that Cochrane says he likes a price level targeting regime. Fine with me. Then why not endorse Price Level Targeting for the euro zone professor Cochrane?

The graph below shows the euro zone GDP deflator and a 2% trend path for prices. The 2% path is of course what the ECB would be targeting if it implemented a Price Level Target as supported by Cochrane. Now have a look at the graph again and tell me what the ECB should do now if it was a Price Level Targeter?

The graph is very clear: Monetary policy is far too tight in the euro zone and as a result the actual price level is far below the pre-crisis 2% path level.

If Professor Cochrane was consistent in his views then he would obviously conclude that the ECB’s failed monetary policies are keeping the euro zone price level depressed, but I am afraid he did not even care to study the numbers.

Cochrane should obviously be calling for massive monetary easing in the euro zone. Milton Friedman would do so.

I can only again say how sad it is that the University of Chicago professors continue to disregard the economics of Milton Friedman.

PS I hope I am wrong about the University of Chicago so I would be happy if my readers would be able to find just one staffer at UC that is actually a monetarist. Ok, I would be happy if you could just locate a student at UC who has read anything Milton Friedman had to say about monetary theory.

PPS I really do not like this kind of attack on what other economists are writing on their blogs. However, as an admirer of Milton Friedman the continued indirect badmouthing of Friedmanite monetarism by the present day University of Chicago professors upsets me a great deal.

—–

Related posts:

See here on another University of Chicago professor who doesn’t care about Milton Friedman.

Another post on why the ECB should target the GDP deflator rather than HICP.

Guest post: Why “Integral” is wrong about Price Level Targeting (by J. Pedersen)

I have always said that my blog should be open to debate and I am happy to have guest posts from clever and inlighted economists (and non-economists) about monetary matters. I am therefore delighted that my good friend and colleague Jens Pedersen (I used to be his boss…) has offered to write a reply to “Integral’s” post on price level targeting versus NGDP level targeting. Jens who recently graduated from University of Copenhagen. His master thesis was about Price Level Targeting.

Jens, take it away…

Lars Christensen

Guest post: Why “Integral” is wrong about Price Level Targeting

by Jens Pedersen

The purpose of this comment is two-fold. First, I argue that ”Integral” in his guest post ”Measuring the stance of monetary policy through NGDP and prices” is wrong when he concludes that the Federal Reserve has done a fine job in achieving price level path stability and by this measure does maintain a tight stance on monetary policy. Second, I present a way of evaluating the Fed’s monetary policy stance based on the theory of optimal monetary policy.

“Integral” assumes that the Federal Reserve has targeted an implicit linear path for the price level since the beginning of the Great Moderation. Following Pedersen (2011) using the deviation in the price level from a linear trend (or the deviation in nominal GDP) to evaluate the stance of monetary policy needs to take into account the potential breaks and shifts in the trend following changes in the monetary policy regime. Changes in the monetary policy committee, changes in the mandate, targets etc. may lead to a shift or break in the targeted trend. Hence, the current implicit targeted trend for the price level (or nominal GDP) should correctly be estimated from February 2006 to take into account the change in president of the FOMC, or alternatively take account of this possible shift or break.

Changing the estimation period changes the conclusions of “Integral’s” analysis. Below, I illustrate the deviation in the log core PCE index from the estimated linear trend over the period 2006:2-2006:12. As the figure show Fed has significantly undershoot its implicit price level target and has not achieved price level path stability during the Great Recession. Currently, the price level gap is around 3% and increasing. Hence, looking at the deviation in the price level from the implicit price level trend does indeed suggest that monetary policy should be eased.

Following, Clarida et. al. (1999), Woodford (2003) and Vestin (2006) optimal monetary policy is a dual mandate which requires the central bank to be concerned with the deviation in output from its efficient level and the deviation in the price level from its targeted level. The first-best way of evaluating Fed’s monetary policy stance should be relative to the optimal solution to monetary policy.

However, this method requires a clear reference to the output gap. Common practice has been to calculate the output gap as the deviation in real output from its HP-filtered trend. This practice is by all means a poor consequence of the RBC view of economic fluctuations. Theoretically it fails to take account of the short run fluctuations in the efficient level of output. Empirically it does a poor job at estimating the potential output near the end points of the sample.

Fortunately, Jordi Galí in Galí (2011) shows how to circumvent these problems and derive a theoretical consistent output gap defined as the deviation in real output from its efficient counterpart. The efficient level of output corresponds to the first-best allocation in the economy, i.e. the output achieved when there are no nominal rigidities or imperfections present. Galí further shows how this output gap can be derived using only the observed variables of the unemployment rate and the labour income share.

The chart below depicts the efficiency gap in the US economy. Note, that this definition does not allow positive values. It is clear from the figure that at present there is significant economic slack in the US economy of historic dimension. The US output gap is currently almost 6.5% and undershoots its natural historical mean by more than 1.5%-points.

Hence, the present price level gap and output gap reveal that the Federal Reserve has not conducted optimal monetary policy during the Great Recession. Furthermore, the analysis suggest that Fed can easily increase inflation expectations by committing to closing the price level gap. This should give the desired boost to demand and spending and further close the output gap.

References:

Clarida, et al. (1999), “The Science of Monetary Policy: A New Keynesian Perspective”

Galí (2011), “Unemployment Fluctuations and Stabilization Policies: A New Keynesian Perspective”

Pedersen (2011), “Price Level Targeting: Optimal Anchoring of Expectations in a New Keynesian Model”

Vestin (2006), “Price Level Targeting versus Inflation Targeting

Woodford (2003), “Interest and Prices”

Guest blog: Why Price-Level Targeting Pareto Dominates Inflation Targeting (By David Eagle)

Guest blog: Why Price-Level Targeting Pareto Dominates Inflation Targeting

– And a Bizarre Tale of Blind Macroeconomists

By David Eagle

Some central banks throughout the world, including the Central bank of Canada and the Federal Reserve, have been considering Price-Level Targeting (PLT) as an alternative to Inflation Targeting (IT). In this guest blog, I present my argument why PLT Pareto dominates IT.  My argument is simple, and one that many readers will consider so obvious that they would expect most monetary economists to be already aware of this Pareto domination.

Please read the following quotation from Shukayev and Ueberfeldt (2010):

Various papers have suggested that Price-Level targeting is a welfare improving policy relative to Inflation targeting. … Research on Inflation targeting and Price-level Targeting monetary policy regimes shows that a credible Price-level Targeting (PT) regime dominates an Inflation targeting regime.

Reading the above quotation indicates that economists already know that PLT Pareto dominates IT.  However, there is a bizarre twist to this literature, which we will discuss later in this blog.  I ask you to continue patiently reading and trust that the ending to the blog will be well worth the journey, even to market monetarists who oppose both PLT and IT.

In my last guest blog for The Market Monetarist, I discussed what I called the Two Fundamental Welfare Principles of Monetary Economics.  The First Principle concerned the Pareto implications when nominal GDP (NGDP) changes, but real GDP (RGDP) does not.  The Second Principle concerned the Pareto implications when RGDP changes, but NGDP does not.  Since PLT and IT have the same Pareto implications when RGDP changes, but NGDP does not; let us focus on the First Principle.  To do so, assume an economy where RGDP is known with perfect foresight; then the First Principle always applies.

A Nominal-Loan Example – Initial Expectations

Let us again consider a long term nominal loan.  This time, I will explain my argument with an example.  For this example, assume a €200,000 nominal mortgage with a 7.2% p.a. interest rate, compounded monthly, and a term of 15-years, and fixed, fully amortizing nominal monthly payments.  The monthly payment would then be a nominal €1820.09.  Let us assume that individual B borrowed the €200,000 from individual A.   The €1820.09 is the nominal amount B must pay A each month.

Let us also assume that both A and B expect inflation to be 2.4% p.a., compounded monthly, during this period.  They therefore built that expected inflation rate into their 7.2% p.a. negotiated nominal interest rate.[1]   Please note that in Finance, we second-naturedly convert per annum rates to per month rates when the rate is compounded monthly.  Thus, the 7.2% p.a. is actually 0.6% per month, and the 2.4% p.a. inflation rate is 0.2% per month.  While this monthly compounding adds an extra step and a source of confusion, I believe the gain in the realism of the example is worth it.

If inflation is the 2.4% p.a. expected rate, then the real value of the monthly payment at time t will equal 1820.09/(1.002)t where t is the number of months from the loan’s origination.  Since both A and B expect the inflation rate to be 2.4% p.a., compounded monthly, their expected real value[2] of this monthly loan payment at time t will be 1820.09/(1.002)t

As I discussed in my second guest blog on the Market Monetarist, PLT and IT have the same effect on the economy as long as the central bank is successful at meeting its target, whether that target is a price-level target or an inflation target.  Let us assume that under IT, the central bank’s inflation target is 2.4% p.a., whereas under PLT, the central bank’s price-level target at time t is 100(1.002)t.  Hence, under both PLT and IT, the central bank’s initial price-level trajectory is 100(1.002)t.

Scenarios of Missing the Target

When PLT and IT differ is when the central bank misses its target.  Suppose inflation on average over the first year turns out to be 1.2% p.a. instead of the expected  2.4% p.a (both rates are compounded monthly).  To be more clear given the monthly compounding issue, the central bank’s initially trajectory of the price level at one year (or at time t=12 months) was 100(1.002)12 = 102.43; however, the actual price level at one year turned out to be 100(1.001)12 = 101.21.  Under PLT, the central bank will try to return the economy to its initial price-level target of 100(1.002)t.  However, under IT, the central bank would shift its price-level trajectory to 101.21(1.002)t-12, which is less than the initial price-level trajectory of 100(1.002)t.  This is the phenomenon we call price-level base drift, which is caused by the central bank under IT letting bygones be bygones and merely aiming for future inflation to be consistent with its inflation target; the central bank under IT does not try to make up for lost ground.

The real value of the nominal loan payment at time t=12 when the actual inflation rate turns out to be1.2% 1820.09/1.00112 = €1798.39, which is greater than the expected nominal loan payment of €1776.97.

On the other hand, assume that the inflation rate on average over the first year was 3.6% p.a. rather than the targeted 2.4% p.a. This means that the actual price level at one year turned out to be 100(1.003)12 = 103.66.  Under PLT, the central bank would have tried to return the economy to its initial price-level target of 100(1.002)t.  However, under IT, the central bank would shift its price-level trajectory to 103.66(1.002)t-12, which is greater than the initial price-level trajectory of 100(1.002)t.

The real value of the nominal loan payment at time t=12 when the actual inflation rate was 3.6% instead of 2.4% is 1820.09/1.00312 = €1755,83, which is less that the initially expected value of €1776.97.

Comparing Actual to Expectations Beyond 12 Months

Because we are talking about four different scenarios, let PLT and IT represent PLT and IT when the inflation rate on average for the first year turns out to be 1.2% rather than 2.4%.  Let PLT+ and IT+ represent PLT and IT when the inflation on average for the first year turns out to be 3.6% rather than the expected 2.4%.  Under all four scenarios, assume that starting in at time t=24, which is 2 years after the loan began, the central bank is able to perfectly meet is price-level trajectory whether under PLT or IT and it does so for the remaining of the 15 years.

Under these assumptions, the real value of the monthly payment under PLT starting at time t=24 will be the same as expected because the central bank will get the price level back to its preannounced price-level target.  However, when the actual inflation rate for the first year turned out being 1.2%, the real value of the nominal monthly payment under IT would be 1820.09/((1.001)12(1.002)t-12) for t≥24 under the assumption the central bank (CB) then meets its target.  On the other hand, when the actual inflation rate for the first year turned out being 3.6%, the real value of the nominal monthly payment under IT would be 1820.09/((1.003)12(1.002)t-12) for t≥24 assuming the CB then meets its target.

The table below shows how the actual real values of these nominal loan payments compare to A and B’s original expectation under all four scenarios.

Note: This table only reports the payment at the end of each year.

That PLT Pareto dominates IT should be obvious from the table.  Under PLT, the central bank (CB) tries to get the real value of nominal loan payments to be back to what borrowers and lenders initially expected.  In other words, under PLT, the CB tries to reverse its mistakes.  Under IT, the CB makes its mistakes permanent.  Note that in the table under PLT, the real value of the nominal loan payments are as expected from time t=24 months on.  However, under IT, the real value of the nominal loan payments are either 1.21% less than expected when the CB fell short of its target, or 1.19% higher than expected when the CB overshot its target.  Clearly, both risk-averse borrowers and risk-averse lenders will be better off with the temporary deviations from expectations under PLT than under the permanent deviations under IT.

Kicking Borrowers or Lenders When They are Down

John Taylor referred to the price-level basis drift as the CB “letting bygones be bygones.”  After writing this blog, I have another view:  I view IT as meaning that when the CB hurts either borrowers or lenders because it is unable to meet its target, then the CB turns around and kicks that down borrower or lender again and again to make them suffer for the duration of their loan.  I have long opposed IT, but writing this blog makes me oppose it even more.  Why cannot other economists see IT for the Pareto damaging regime it is?

The issue of why PLT Pareto dominates IT is simple.  The risk to borrowers and lenders is not inflation risk; it is price-level risk.  To minimize price-level risk, we should not minimize inflation, we should minimize the deviation of the price-level from its expected value.  As such, when a central banking missing its target, it should not keep kicking those suffering from the CB’s past mistakes; the central bank should not make that miss permanent as in IT, but rather the CB should try to reverse that damage as it will try to do under PLT.  Hence PLT Pareto dominates IT.

The Bizarre Tale of the Blind Economists

Thank you all for bearing with me through my argument.  However, from the quote by Shukayev and Ueberfeldt, you knew that the economic profession already knew this.  After all, this is obvious.  (Lars, drink something before you read on; we don’t want your blood to boil too much.)

However, the argument that I gave is not the argument that the literature that Shukayev and Ueverfeldt cited.  That literature did not use the Pareto criterion; it used a loss function that included inflation.  (Yes, Lars, that xxxx loss function again.)

What the literature starting with Svenson (1999) found is that paradoxically when the central bank is trying to minimize a loss function involving inflation, it may actually be better able to do that through PLT than with IT.  That is what Shukayev and Ueverfeld (2010) meant when they said that the literature had found PLT welfare dominates IT.  That literature was referring to “welfare” as defined by their ad hoc loss function, not by their applying the Pareto criterion to the well being of borrowers and lenders.

Economists have been blinded from the obvious by their ad hoc assumption of a loss function involving inflation.  This bizarre twist to this literature is an example of the dangers that economists’ prejudices can enter into their ad hoc loss functions, causing them to miss the obvious.  In this case they have missed the obvious impacts on individual borrowers and lenders of PLT vs. IT.

Of course, there are other targeting regimes than just PLT and IT, but this blog focused on those two.  In my future writing, I plan to explain why NGDP level targeting Pareto dominates NGDP growth rate targeting, although the logic of that is really the same as I have just discussed; we just allow RGDP to vary so that the Second Fundamental Principle of Monetary Economics also applies.

Also, think about how the “kick them while they are down” characteristic of IT is relevant to the aftermath of the Financial crisis concerning the sovereign debt issues in Europe and the debt burdens on mortgage borrowers in the U.S. and elsewhere.  I guess I have to be careful here as I might be accused of starting riots.

References

Eagle, David and Dale Domian (2011), “Quasi-Real-Indexed Mortgages to the Rescue,” working paper delivered at the Western Economic Associating Meetings in San Diego, CA, http://www.cbpa.ewu.edu/~deagle/WEAI2011/QRIMs.doc

Shukayev, Malik and Alexander Ueberfeldt (2010).  “Price Level Targeting: What Is the Right Price?” Bank of Canada Working Paper 2010-8

Svensson, Lars E O, 1999. “Price-level Targeting versus Inflation Targeting: A Free Lunch?,”

Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(3), pages 277-95, August.

© Copyright (2012) by David Eagle


[1] The traditional Fisher equation states that i @ r + E[π] where i is the nominal interest rate, r is the real interest rate, and π is the inflation rate.  A more exact relationship we use in Finance is (1+i)=(1+r)(1+E[π) where these rates are per compound period, in this case per month.  According to the approximate and traditional Fisher equation, the real interest rate would be 4.8%, which equals the 7.2% nominal rate less the 2.4% expected inflation (the more precise Fisher equation using the monthly rates concludes the real rate will be 4.79%).

[2] You may note that the real value of the monthly nominal payment is expected to decline over time.  In the mortgage literature, this is known as the “tilt effect” (See Eagle and Domian, 2011).


Pedersen on Price Level Targeting

My good colleague Jens N. Pedersen has today successfully defended his master thesis at the Department on Economics at the University of Copenhagen.

 Jens’ thesis should be of interest to Market Monetarists.

 Here is a bit from the introduction of Jens’ thesis “Price Level Targeting –  Optimal anchoring of expectations in a New Keynesian model”:

 “The recent experience of the Financial Crisis has highlighted the potential drawbacks of a policy targeting the changes and not the level of the prices. When the zero lower bound on the nominal interest rate binds, the inflation target presents a lower constraint on the real interest rate because inflation expectations are anchored at the target. Following the crisis, a number of major central banks have been forced to keep the policy rate close to zero and in the mean time use unconventional tools to keep monetary policy effective. Price level targeting, however, presents the optimal way of anchoring expectations by increasing inflation expectations in a deflationary environment and vice versa. This improves monetary policy in general and in a zero interest rate environment, which keeps the conventional interest rate operating procedure effective. This thesis attempts to study, how the central bank can optimally utilise the expectational channel, when setting monetary policy, by announcing a price level target. The investigation will take on both a theoretical and an empirical stand point. The theoretical part of the thesis revisits the arguments for and against adopting price level targeting. The empirical part of the thesis attempts to evaluate the optimality of monetary policy by inspecting the statistical properties of the price level.”

I am grateful to Jens for always challenging some of my views on monetary policy and Jens is always an excellent sparring partner not only on monetary issues but also on such interesting subjects as sportometrics and fine dining.

So dear readers please have a look at Jens’ excellent thesis. And to Jens – Congratulations! It is well-deserved and you can truly be proud of your thesis.

 

 

Bank of Canada is effectively targeting the price level

Last week the Bank of Canada and Canadian government announced – not overly surprising – that it will continue its 2% inflation targeting regime.

This is a slight disappointment to Market Monetarists, but that said maybe the BoC is not really having a inflation targeting. In fact research show that BoC effectively has been targeting the price level rather than inflation.

This at least is the conclusion in a IMF paper from 2008. Here is the abstract:

“One of the pioneers of inflation targeting (IT), the Bank of Canada is now considering a possibility of switching to price-level-path targeting (PLPT), where past deviations of inflation from the target would have to be offset in the future, bringing the price level back to a predetermined path. This paper draws attention to the fact that the price level in Canada has strayed little from the path implied by the two percent inflation target since its introduction in December 1994, and has tended to revert to that path after temporary deviations. Econometric analysis using Bayesian estimation suggests that a low probability can be assigned to explaining this behavior by sheer luck manifesting itself in mutually offsetting shocks. Much more plausible is the assumption that inflation expectations and interest rates are determined in a way that is consistent with an element of PLPT. This suggests that the difference between IT as it is actually practiced (or perceived) and PLPT may be less stark than what pure theoretical constructs posit, and that the transition to a full- fledged PLPT regime will likely be considerably easier than what was previously thought. The paper also shows that inflation expectations are a major driver of actual inflation in Canada, which makes it easier to keep inflation close to the target without large output costs.”

HT Jens Pedersen

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