Home > macro, monetarism > A threat is credible if you want to do in the future what you say you will do in the future

A threat is credible if you want to do in the future what you say you will do in the future

Matt Yglesias had an interesting post last Friday that I think nicely encapsulates a common confusion about monetary policy at the zero-lower bound (ZLB).   The key issue is that when nominal interest rates are zero, the Fed mainly controls the real interest rate (its main policy lever) by controlling the expected inflation rate.   The issue starts with a famous quote from Krugman that the Fed must credibly promise to be irresponsible.   In effect, Matt is telling us that this is not the problem it seems, to quote him:

The paradoxical formulation is this: If the Federal Reserve would raise its inflation target, that would boost growth. But once the growth is in place, maybe the Fed would prefer to not have the extra inflation. So if people think the Fed would responsibly backtrack in the face of success, then the expectations-management strategy won’t work. So how can the Fed promise to be irresponsible in the future? Then we start talking about delivering monetary policy statements while drunk or wearing a Hawaiian shirt.

In fairness, he is responding to some “prominent left-of-center voices” who may or may not be getting something wrong.   I have no idea who these voices are, or precisely what they are saying.  What I am saying is that this is exactly wrong, wrong, and in very dangerous ways wrong:

The non-paradoxical formulation is that the responsible way to behave is to live up to your promises. If a bunch of serious-looking public officials say “we promise not to raise short-term interest rates unless inflation goes above 5 percent or unemployment falls below 6 percent” then precisely because they have a reputation for seriousness people will doubt that they would throw their reputations away by backing out of their commitment.

The problem is that credibility, in this context has roughly zero, nada, nothing to do how “responsible” anyone is perceived and very little to do with psychology of any sort.   To start, I’ll let Krugman (from that Japanese paper I linked to above) knock this down and then comment.   Krugman first,

The central new conclusion of this analysis is that a liquidity trap fundamentally involves a credibility problem–but it is the inverse of the usual one… In a liquidity trap, the problem is that the markets believe that the central bank will target price stability, given the chance, and hence that any current monetary expansion is merely transitory.

There are really several separate effects here.   First, the Ben Bernanke cannot commit his future self to do any actions that he will not in fact want to do when in fact it comes time for him to do them.   Having solved the unemployment problem by promising future inflation, Ben will in fact want to reduce the size of his balance sheet and undo any asset purchases long before the feared inflation actually arrives.

The second issue is the financial issue.   It is generally known by investors that once unemployment is under control, Ben will return to his usual inflation-fighting self.   They’ll be counting on it.   If they know what the Fed will do, then these investors have an arbitrage opportunity which undoes the Fed work purchasing assets.

Finally, there is an issue about the distribution of beliefs about what the Fed will actually do, call this the expectations issue (see Morris and Shin for an example of the kind of model I have in mind).   The more investors there are who are “pessimistic” about the Fed’s “resolve” (because of the first two problems) the more likely that there will be a critical mass of investors who bet against the Fed in a kind of self-fulfilling prophecy.   The Fed has unlimited resources when dealing in domestic currency (which is not an issue in the Morris and Shin paper), but that does not mean that the Fed has unlimited resolve to walk into a room and beat everyone up like Chuck Norris until they cooperate.

The Fed is big, but the “market” is much, much bigger.   The revealed preference of the central banks of the world is that they don’t like inflation, and also that they don’t like over-large balance sheets.   The market knows this.

I’ve generally assumed that this is one of the major rationales for market monetarists to target levels instead of rates.   Nevertheless, market monetarists in practice often minimize these issues.   Yet changing targets is “credible” in a way that Ben Bernanke being a Responsibly Responsible VSP, or even an Evans-style flexible inflation target, just aren’t–the Fed’s threat of higher inflation in the future will be credible if higher inflation in the future is part of the Fed’s optimal policy response in the future.   End of story.

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Categories: macro, monetarism
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