In recent years, I have been depressed by the state of macroeconomic research. I find many new research papers almost unreadable. Perhaps this reflects the fact that my own work is increasingly out of the mainstream. New Paper by Tom Holden It encompasses many of the themes I have emphasized. Even better, the paper is very well written (a rarity for a macro theory paper) and is due to be published in a very prestigious journal. Econometrica.
Before discussing Haldane’s paper, I want to be clear that I am not saying that he necessarily agrees with my macroeconomic views — he takes a New Keynesian approach while I’m a Monetarist, he advocates inflation targeting while I prefer NGDP targeting — but in some important respects we ultimately arrive at the same conclusions, even if we got there by different paths.
Consider the following vaguely monetarist-sounding argument:
In this model, only monetary policy shocks affect inflation. Of course, if the model has nominal rigidities, monetary shocks can affect real variables. But as long as the central bank follows these rules, these real perturbations do not feed back into inflation. The causal relationship is from inflation to real variables, not the other way around. We can understand inflation without worrying about the rest of the economy.
This is consistent with causality running from inflation to the output gap, and not the other way around. Similarly, Miranda Agrippino and Ricco (2021) find that while a contractionary monetary policy shock immediately reduces the price level, its effect on unemployment emerges more slowly, again suggesting causality running from inflation to unemployment, and not the other way around.
In the traditional Keynesian model, causation runs from real shocks (increased physical purchases and increased employment) to nominal outcomes (rising wages/prices). Milton Friedman thought causation ran from nominal shocks (money and inflation) to real effects (increased employment and output). Both views on causation are consistent with the correlation observed in studies of the Phillips curve, but the monetarist interpretation tends to lead people to push harder for monetary policy as the primary stabilization tool.
Haldane’s inflation stabilization policy proposals are as follows:
Unlike previous Taylor rule proposals, Haldane envisions deriving the real interest rate from fixed-income inflation-protected securities, or “TIPS.”
I have previously argued that economists place too much emphasis on public inflation expectations, and that the key to successful monetary policy is to stabilize the expectations of financial market participants.
The only expectations that matter are those of participants in the nominal and real bond markets. It is much more reasonable to assume that financial markets will lead to prices that are consistent with rational expectations than to assume the rationality of households more generally.
This is all like music to me. Here’s another gem:
The real interest rate rule also has a second source of robustness: it does not require the aggregate Phillips curve to be maintained. The slope of the Phillips curve has no effect on inflation dynamics. If the central bank has no interest in output, it does not need to know what the slope of the Phillips curve is, or even whether it is being maintained. It also does not matter how firms form their inflation expectations. Because the Fisher equation and monetary rules fix inflation, irrational firm expectations can affect output fluctuations, but inflation dynamics remain unchanged.
I have also argued against using the Phillips Curve for monetary policy. I favor anchoring market expectations for NGDP, while Haldane suggests anchoring market expectations for inflation. But the basic approach is the same: anchor market expectations for a nominal macro target variable. Don’t try to manipulate the Phillips Curve.
I believe that a successful monetary policy regime is one that is nearly perfect. Financial offset Haldane also mentions other demand-side factors, such as fiscal stimulus paid for by tax cuts. Haldane takes monetary offsets a step further because he proposes inflation targeting. The policy rule he proposes therefore also offsets supply-side effects on inflation, although he later argues (correctly) that policymakers may want to adjust the target in the event of a supply shock.
In my work I have been a strong critic of the view that monetary policy works by changing interest rates, at least in the Keynesian sense of affecting the economy through changes in both nominal and real interest rates. I have run various thought experiments in which prices are flexible and the effects of monetary policy on nominal aggregates cannot arise from changes in real interest rates. Haldane makes a similar argument.
A more fundamental question in monetary economics is: “How does monetary policy work?” The traditional answer is that price rigidities cause nominal interest rate changes to lead to real interest rate changes. But this cannot be a transmission mechanism when prices are flexible, because real interest rates are exogenous. It also cannot be a transmission mechanism under real interest rate rules, because real interest rate changes are irrelevant. In these cases, monetary policy works only through the Fisher equation link between nominal interest rates and expected inflation. We find that the dynamics under real interest rate rules are qualitatively very similar to those under traditional rules, so it would be surprising if monetary policy worked in a fundamentally different path under traditional rules. Rather, this suggests that the main path of monetary policy in the New Keynesian model is through the Fisher equation, which is present even when prices are flexible. Rupert and Šustek (2019) draw the same conclusion based on the observation that in a New Keynesian model including capital, contractionary (positive) monetary shocks can lower real interest rates.
I think the monetary tightening shock is actually Lowered In 2008, real interest rates rose, but at the same time NGDP fell, causing a deep recession.
In the 1980s, many economists, including Earl Thompson, Robert Hall, David Glassner, Robert Hetzel, and myself, proposed policies that effectively targeted financial market expectations of inflation or (in my case) the NGDP growth rate, and Haldane suggests that his real interest rate rule is in that tradition.
Furthermore, previous studies, such as Hetzel (1990) who proposes using the spread between nominal and real bonds to guide monetary policy, and Dowd (1994) who proposes targeting the price of futures contracts with the price level, have a similar flavor to the real interest rate rule, and these rules effectively use expected inflation as an instrument of monetary policy.
Predictive targeting has also been proposed by Hall & Mankiw (1994) and Svensson (1997), among others.
I have previously suggested that the Fed’s interest rate target should be adjusted daily instead of every six weeks.
Keep in mind that while in traditional monetary policy, nominal interest rates are roughly constant between monetary policy committee meetings, this may not be the case in this case. The central bank’s trading desk would need to continually adjust the level. This is a departure from current operating procedures, but there is no reason why keeping the TIPS spread roughly constant would be any more difficult than keeping interest rates roughly constant, thanks to the real-time observability of the real interest rate through inflation-linked securities.
I have argued that this should be decided by the central bank. strategy Monetary policy objectives (price targeting or nominal GDP targeting, level targeting or growth rate targeting) are determined based on market expectations, but market expectations should be used to actually implement policy. Haldane concludes his paper with a similar observation:
We have presented a practical implementation design for a real interest rate rule with a time-varying short-term inflation target. The proposal preserves the central bank’s board’s crucial role in choosing the desired inflation trajectory. Only the technical decision of how to set interest rates to reach that trajectory is left to the rule. The rule does not incorporate politically sensitive views about the slope of the Phillips curve or the costs of inflation. Also, the rule can be implemented using assets for which there are already liquid markets, such as nominal and real long-term bonds or inflation swaps.
my Recent BooksIn this article, I have avoided the issue of “uncertainty” (i.e. the possibility of multiple equilibrium points) as I have no expertise in this. However, based on what I have read, it seems to be a bigger problem with interest rate targeting than with price-stabilizing monetary regimes such as the gold standard or fixed exchange rate regimes. I suspect uncertainty is less of a problem with real interest rate rules, since the TIPS spread is similar to the CPI futures contract, and therefore stabilizing the TIPS spread is similar to targeting the price of the CPI futures contract. With the gold standard, uncertainty is avoided because the gold price is visible and controllable in real time. The same can be said about the CPI futures contract price. If this is inaccurate, please correct me in the comments section.
While I support NGDP targeting, I think Haldane was wise to frame his proposal as an inflation-targeting regime. Unlike NGDP expectations, there is already a deep and liquid TIPS market, and real-world central banks have chosen inflation targeting over NGDP targeting. Framing the proposal as an inflation-targeting regime is the best way to orient real-world policymakers toward a broader goal that targets market expectations of the goal variable.
