The Brad DeLong - Bennet McCallum Debate

Over at The Economist there is an interesting debate taking place between Brad DeLong and Bennet McCallum.  They are responding to the following statement: this house believes that a 2% inflation target is too low.  The idea behind this statement is that with a higher inflation rate the targeted short-term nominal interest rate would be higher and thus less likely to hit the 0% bound.  Brad DeLong endorses this view.  He sees the 0% bound as a real constraint on monetary policy and wants to avoid it.  Bennet McCallum challenges it.  He argues that monetary policy is not powerless at the 0% bound and there are real costs with going to a higher inflation target.

A key issue to resolving this debate  is how binding the 0% bound is for monetary policy.  My own view is that it is not truly a binding constraint, but only a self-imposed one because of the way monetary policy is normally conducted.  Conventional monetary policy targets a short-term nominal interest rate.  So when the 0% bound is reached monetary authorities have to switch over to their "unconventional" monetary policy bag of tricks.  But it doesn't have to be this way.  Imagine if the Fed targeted the price level at a 2% growth rate and didn't use the federal funds rate as its instrument.  It simply adjusted the monetary base to hit the price level target and communicated very clearly its goals to the public. Assume that as part of this communication the Fed said it would do whatever is necessary to hit its target, including buying other assets than just t-bills if the need arose.



In that setting it is hard to imagine why the 0% bound on the short-term interest rate would ever matter.  First, the 0% bond would rarely be reached because nominal expectations would be well anchored.  Second, even if it did, say because of a major aggregate demand shock that caused deflation, the price level target would require significant catch-up inflation that would lower the expected path of real interest rates presumably enough to restore full employment. Over the long-run there would be price level stability as the price level returned to trend and 2% growth.  Thus, the 0% bound would not matter and there would be no need for permanently higher inflation.

On the catch-up inflation scenario above, something similar happened during the 1933-1936 period.  FDR communicated clearly that he wanted the price level to return to its pre-crisis level and backed up his talk with the devaluation of the gold-content of the dollar and deciding not to sterilize gold inflows. (See Gautti Eggertson and this for more.)  Short-term rates were at the 0% bound at this time too. Nonetheless, this monetary easing sparked a remarkably robust recovery that was unfortunately cut short. 

What all this means is that we can have our cake and eat it too.  If the Fed were too adopt an explicit price level target and vow to hit it no matter what (i.e. engage in other asset purchases if necessary), then Brad DeLong would get some higher-than-normal catch-up inflation and Bennet McCallum would not have to worry about a permanently higher inflation rate.  Better yet, if the Fed were to adopt a nominal GDP level, then DeLong and McCallum wold get all the above benefits plus the fact that the Fed would not be responding inappropriately to aggregate supply shocks.

P.S. See the recent posts by Josh Hendrickson and myself on why the 0% bound typically is not enough to create a liquidity trap.

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Brad DeLong, Jim Grant, and Milton Friedman

Brad DeLong and Jim Grant debate whether the Fed should do QE3.  DeLong makes the case for QE3 and invokes Milton Friedman in support of his view:

We have seen something like this--but worse--twice before: the Great Depression, and Japan's lost decades. A collapse in trust in the solvency of financial institutions induces the hoarding cash as part of the safe-asset tranche of portfolios. The economy's cash disappears from the transactions money stock--and so, for standard monetarist reasons, spending declines and unemployment rises... Expansionary monetary policy even at the zero lower bound via quantitative easing is what Milton Friedman recommended for the Great Depression and for Japan. 

That's what Friedman would be recommending were he with us today--keep doing rounds of quantitative easing until we get the economy's transactions cash balances and the flow of spending back to normal levels.

So did Milton Friedman actually recommend doing successive rounds of quantitative easing until nominal spending returns to normal levels? Let's have Milton Friedman speak for himself.  Here is an excerpt from a Q&A following a 2000 speech he delivered at the Bank of Canada (my bold below). 

David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero,  monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?

Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.

During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?”

It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.

The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.

So yes, Milton Friedman did call for buying longer-term securities until a robust recovery takes hold.  He also notes that policy interest rates can be a poor indicator of  the stance of monetary policy.   I suspect, however, that Friedman would have preferred that such a monetary stimulus program be done in a more systematic manner than that of announcing successive, politically costly rounds of QE.  Imagine how much easier all of this would have been had the Fed announced a level target from the start and said asset purchases will continue until the level target was hit.  There would have been no need to announce the large dollar size of the asset purchases up front that attracts so much criticism.  There would also have been no need to announce successive rounds of QE that make it appear the previous rounds did not work.  More importantly, it would have more firmly shaped nominal expectations in a manner conducive to economic recovery.  The question is what type of level target would Friedman have supported?  This 2003 WSJ article indicates he might have liked a nominal GDP level target.

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