Saturday, November 8, 2014

Scott Sumner shares my input on Monetary Offset

Scott Sumner argues that since the monetary authority is the last mover in targeting the nominal economy, fiscal cyclical policy is mostly neutered.  If the Fed is targeting a certain nominal production level or inflation level and the government institutes fiscal policy intended to increase nominal economic activity, then the Fed will offset that policy in order to remain on target.  If the Fed wouldn't offset fiscal policy stimulus, then the question is why wasn't the Fed creating more stimulus to begin with?  The zero lower bound isn't a reason.  I have found that the Fed has been able to influence forward inflation and interest rate expectations at the zero lower bound.  Here is a recent study coming to the same conclusion.

At any rate, Scott has posted some comments I made about the issue.  Click on the link for the full story.  The short version is that we can see monetary offset in the Fed transcript from September 2008.

In fact, I suspect that, on a policy like Emergency Unemployment Insurance (which was first implemented in this cycle by President Bush in June 2008), the modelers at the Fed probably model the policy as stimulative.  So, there is a double whammy effect of monetary offset.  Someone like Janet Yellen sits down at the FOMC meeting and she looks at the models from the Fed quantitative staff, which reflect perceived additional fiscal stimulus, and thinks, "Hey, things aren't so bad.  We don't have to be as accommodative as I thought."  Then, bringing her own intuition to the meeting, she notes that the unemployment rate is probably overstated because of the recently instituted emergency unemployment insurance.  We would normally expect rising unemployment to be disinflationary, but since it is likely exaggerated by the effects from EUI, we can kind of figure that the labor market is doing better than the unemployment rate would suggest.

So, EUI might cause Fed modelers to point to a more hawkish policy and then the FOMC adds their own additional hawkish twist.

In actuality, Janet Yellen was right that EUI probably caused higher unemployment, but this probably called for more dovish policy.

Here is a fiscal policy that could be contractionary, but that leads to an exaggerated monetary offset that is also contractionary.

8 comments:

  1. Excellent blogging. Moreover, tight money does not improve structural impediments. In fact, most interest groups hold on even tighter to their structural impediments in a recession.

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  2. TravisV here.

    Bonnie Carr isn't quite sure about your interpretation of Yellen:

    http://dajeeps.wordpress.com/2014/11/09/did-janet-yellen-pass-judgment-on-the-unemployed-in-september-2008

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    1. I commented at her site. Scott was having some fun, but I agree his polemics probably added more heat than light.

      I think the problem with the offset language is that it depends on what you hold constant when you look at her comment. I think this is a place where Morgan Warstler's point about NGDP is right. If we had NGDP targeting, it would be clear that EUI leads to less real production and more inflation.

      In the transcript, if we use a constant NGDP framework, Yellen is saying that we are targeting inflation. EUI has caused unemployment to rise. Higher unemployment is a sign of lower production, but while we would normally associate it with lower inflation, since some of it is a product of EUI, we should still expect to meet our inflation target even though unemployment is higher. Thus, we will hit the inflation target without further accommodation.

      Yellen would probably not agree with that framing, but I don't see how one could logically deny it.

      The offset is that fiscal policy caused her to increase her inflation expectations at any given unemployment rate, so she was slightly less likely to be accommodative.

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  3. To me, this discussion highlights the critical importance of level targeting and accountability for past mistakes. An error such as the one you point out (exaggerated monetary offset) is less of a problem in a level-targeting world, no?

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    1. I agree. It's interesting how much pushback the NGDPLT idea gets.

      PS. I noticed a comment you posted at themoneyillusion on the post that linked to my recent stuff on profits and compensation, which I replied to after the post had probably exited your peripheral attention.

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  4. TravisV here.

    "Lawler on D.R. Horton: Net Orders Jump as Increased Incentives Continued; Expects Big Increase in Unit Sales, Flat Home Prices Next Year"

    http://www.calculatedriskblog.com/2014/11/lawler-on-dr-horton-net-orders-jump-as.html

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    1. Very interesting. I would expect that the conditions which could lead to increased sales would also lead to increased prices. Homebuilders have shot up over the past few days on this improved sales outlook. I'm going to have to dig into the conference call transcripts and see if I can figure out the story.

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