Marcus Nunes Was Right

by: Scott Sumner

More than three years ago Marcus Nunes did a post taking on two of my favorite macroeconomists, Robert Hall and Greg Mankiw. It hardly seems like a fair fight, as Marcus is merely an amateur market monetarist down in Brazil. And yet, I'll show that Marcus was correct in both disputes. In a January 2012 post, Marcus quotes from a Ryan Avent post. Here's Ryan:

This time around, Mr. Hall addressed the point head on. He noted that in a liquidity trap, the real rate of interest was simply equal to the negative inflation rate. In other words, if the Fed's nominal rate is at 0% and the inflation rate is 2%, then the real rate of interest is -2%. If a -3% real interest rate is necessary to clear the economy, then all that's needed is a higher rate of inflation-3% rather than 2%. Mr. Hall noted that this was an important point because potentially the Fed could have an enormously helpful impact on the economy simply by raising inflation just a little. And here's where things got topsy-turvy. Mr. Hall argued that (my bold):

  1. A little more inflation would have a hugely beneficial impact on labour markets,
  2. And a reasonable central bank would therefore generate more inflation,
  3. And the Federal Reserve as currently constituted is, in his estimation, very reasonable; therefore
  4. The Federal Reserve must not be able to influence the inflation rate.

Both Ryan Avent and Marcus Nunes thought Hall was wrong. So did I. I could have given dozens of reasons. Bernanke said the Fed could do more. The Fed had not done the things Bernanke recommended the Japanese do. The market's response to QE rumors. The difference between central banks that did QE and those that didn't. Since this time we have lots more evidence, such as the Abe policy in Japan, which has pushed the yen from 80 to 125/dollar. Despite the recent dip due to falling oil prices, Japanese inflation since 2013 is significantly higher than before.

But even if that was all wrong, we can still be 100% certain that Hall was completely incorrect. Indeed it's not even a debatable point anymore. Why? I hope it's obvious to everyone by now. Hall is wrong because the Fed plans to raise interest rates later this year, even though they expect inflation to continue running below 2%. So the Fed does not want to raise its inflation target to 3%. Period. End of debate.

[Isn't it wonderful when economic debates get resolved with 100% certainty! It happens so rarely.]

Now on to the next victim, Greg Mankiw. Here he quotes Mankiw discussing the condition of the economy in early 2012, in light on Mankiw's own version of the Taylor Rule:

Not surprisingly, the rule recommended a deeply negative federal funds rate during the recent severe recession. Of course, that is impossible, which is why the Fed took various extraordinary steps to get the economy going. But note that the rule is now moving back toward zero. As Eddy points out, "At the current inflation rate, the unemployment rate needs to drop to 8.3% from the current 8.5% for the model to signal positive rates. We're getting close."

To be fair to Mankiw, he doesn't explicitly say the Fed should raise rates when unemployment falls to the low 8% range, even if inflation stayed about the same. There's some wiggle room. So let me just say that I think the vast majority of readers would have assumed that Mankiw was stating that policy implication with approval.

In any case, we now know that tightening monetary policy in early 2012 would have been a big mistake. Actual unemployment has fallen rapidly to 5.4%, and inflation remains well below the 2% target. Furthermore, inflation is expected to remain below target for an extended period, while unemployment is expected to keep falling. Tightening policy in 2012 would have been a mistake, even if you were a hawkish Fed policymaker who would prefer to ignore unemployment and focus like a laser on their 2% inflation target.

In contrast, the ECB did raise rates a few months before the Nunes post, and we now know that the result was disastrous.

The bottom line here is that the Taylor Rule (in any form) is not a reliable instrument rule. That's not to say that the Taylor Principle is without value - I think it contributed to the successful Fed policy of the Great Moderation period. But as a rigid instrument rule it simply doesn't work.

PS. In my tradition of "burying the lede", let me point to a comment left by Julius Probst:

Yesterday, Larry Summers held a speech at DIW Berlin here in Germany, talking about secular stagnation.
He mentioned that bond markets expect low trend real growth rate in the years to come, low inflation rates and low interest rates - all of that is true in my opinion and I think that the FED is much too optimistic expecting long-term interest rates at 4% in a few years. It won't happen.

I got to ask Larry Summers a question whether he favors more aggressive monetary stimulus - he does - and whether he favors a different monetary target.

He was against a 4% inflation target, but he favored a NDGP target !!!! I think that might have been the first time he did so in public ? At least the first time I know about it.

The same with me, I'd never heard that he favored NGDP targeting. Maybe I backed the wrong horse in the Fed race last year. Oh well. I'd appreciate it if someone could send a link as soon as possible. With endorsements by Woodford, Romer, McCallum, Frankel, DeLong, Krugman (sort of), Bullard, and now Summers, there is obviously strong momentum toward NGDP targeting among the macro elite. So much for the silly view that MM ideas are becoming less popular. (Of course I'm not claiming that our blog posts actually caused any of these conversions, just that our policy ideas are getting more popular.)