In recent years I have become depressed by the state of research in macroeconomics. I find many new research articles almost unreadable. Perhaps this reflects the fact that my own work is increasingly outside the mainstream. I was therefore very pleasantly surprised when I a new article by Tom Holden which encompasses many of the themes I have emphasized. In fact, the article is extremely well written (unusual for an article on macro theory) and appears in the very prestigious journal Econometrics.
Before I discuss Holden’s article, I want to be clear that I am not suggesting that he necessarily agrees with my general view of macro. He uses more of a New Keynesian approach, while I am a monetarist, and he advocates inflation targeting, while I prefer NGDP targets. But at a number of important points we end up in the same place, even though we arrive there via different routes.
Consider the following statements, which sound vaguely monetarist:
In this model, only monetary policy shocks affect inflation. If there is nominal rigidity in the model, monetary shocks can obviously have an impact on real variables. But as long as the central bank follows a rule like this, these real distortions have no feedback on inflation. The causal link runs from inflation to real variables, and not the other way around. We can understand inflation without worrying about the rest of the economy. . .
This is consistent with the causal link only running from inflation to the output gap, and not in the opposite direction. Similarly, Miranda-Agrippino & Ricco (2021) find that a contractionary monetary policy shock causes an immediate decline in the price level, while the effects on unemployment manifest themselves more slowly. This again suggests that the causal link runs from inflation to unemployment, and not the other way around.
In the traditional Keynesian model, the causal link runs from real shocks (more physical purchases and more hiring) to nominal outcomes (higher wages/prices). Milton Friedman saw the causal relationship as running from nominal shocks (money and inflation) to real effects (more jobs and production). ). Both views of causality are consistent with the correlations observed in Phillips Curve studies, but the monetarist interpretation tends to push people more toward monetary policy as the main stabilization tool.
Here is Holden’s policy proposal to stabilize inflation:
Unlike previous Taylor Rule proposals, Holden plans to derive real interest rates from inflation-indexed bonds, or “TIPS.”
In the past, I have argued that economists focus too much on the public’s inflation expectations, and that the key to successful monetary policy is stabilizing the expectations of financial market participants. Here’s Holden:
The only expectations that matter are the expectations of participants in the nominal and real bond markets. It is much more reasonable to assume that financial markets lead to prices consistent with rational expectations than to assume the rationality of households in general.
This all sounds like music to my ears. Here’s another gem:
Real interest rate rules also have a second source of robustness: they do not require an aggregate Phillips curve to hold. The slope of the Phillips curve cannot influence the dynamics of inflation. If a central bank isn’t concerned about output, it doesn’t even need to know whether the Phillips curve is holding, let alone what its slope is. It also doesn’t matter how companies form inflation expectations. The Fisher equation and the monetary rule keep inflation fixed, so while non-rational business expectations may influence output fluctuations, they will not change inflation dynamics.
I have also argued against the use of the Phillips Curve in monetary policy. I favor stabilizing market expectations of the NGDP, while Holden proposes stabilizing market inflation expectations, but the underlying approach is the same: stabilizing market expectations of a nominal macro target variable. Do not attempt to manipulate the Phillips Curve.
I have emphasized that any successful monetary policy leads almost to a complete policy monetary compensation of other demand-side factors, such as tax incentives financed by tax cuts. Holden goes even further with monetary compensation as he proposes an inflation target. His proposed policy rule therefore also compensates for supply-side influences on inflation, although he later (correctly) argues that policymakers may want to adjust their target in the face of supply shocks.
In my own work I have strongly criticized 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 come up with several thought experiments where prices are flexible and the effects of monetary policy on nominal aggregates cannot possibly arise from changes in real interest rates. Holden makes a similar claim:
An even more fundamental question of monetary economics is: “how does monetary policy work?” The traditional answer holds that fluctuations in nominal interest rates lead to fluctuations in real interest rates, due to persistent prices. But this cannot be the transmission mechanism with flexible prices, because the real rates are then exogenous. It also cannot be the transmission mechanism under a real interest rate rule, since real interest rate movements are then irrelevant. In these cases, monetary policy works solely through the Fisher equation, which relates nominal interest rates to expected inflation. Since we will see that the dynamics under a real interest rate rule are qualitatively so similar to the dynamics under a traditional rule, it would be surprising if monetary policy under a traditional rule operated through a fundamentally different channel. Instead, this suggests that the most important channel of monetary policy in the New Keynesian models is the one present even under flexible prices, via the Fisher equation. Rupert & Šustek (2019) draw the same conclusion based on the observation that contractionary (positive) monetary shocks can lower real interest rates in New Keynesian models with capital.
I have argued that there is in fact a contractionary monetary shock reduced real interest rate in 2008, but also cut the NGDP, causing a severe recession.
In the 1980s, a number of economists, including Earl Thompson, Robert Hall, David Glasner, Robert Hetzel, and myself, proposed policies that would effectively target financial market forecasts of inflation or (in my case) NGDP growth. Holden suggests that his real interest rate rule is in that tradition:
Moreover, in older work, Hetzel (1990) proposes using the spread between nominal and real bonds to guide monetary policy, and Dowd (1994) suggests targeting the price of futures contracts at the price level. This has the same flavor as a rule on real interest rates, as these rules essentially use expected inflation as a tool of monetary policy.
Prediction targeting has also been proposed by Hall & Mankiw (1994) and Svensson (1997), among others.
In the past, I have suggested that the Fed’s interest rate target should be adjusted daily, not every six weeks. Here’s Holden:
Note that although under conventional monetary policy nominal interest rates are approximately constant between meetings of the monetary policy committees, this may not be the case here. . . . The central bank’s trading department should be able to adjust the level continuously [interest rates] . . . While this is a departure from current operating procedures, there is no reason to maintain this policy [TIPS spreads] approximately constant should be more difficult than holding [interest rates] approximately constant. This is due to the real-time observability of [real interest rates] through inflation-protected bonds.
I have argued that central banks should set the course strategy of monetary policy (i.e. whether to target prices or NGDP, and whether to target levels or growth rates), while market expectations should be used to actually implement policy. Holden concludes his article with a similar observation:
We have presented a design for the practical implementation of a real interest rate rule with a time-varying short-term inflation target. Under this proposal, central bank boards retain the crucial role in choosing the desired inflation path. Only the technical decision on how to set rates to achieve that path is delegated to the rule. The rule does not include politically sensitive views on the slope of the Phillips curve or the costs of inflation. And the rule can be implemented with assets for which a liquid market already exists: nominal and real long-term bonds, or inflation swaps.
In my recent book, I have avoided the issue of “indeterminacy” (i.e. multiple possible equilibria), an issue on which I have no expertise. However, based on what I have read, it seems to be a bigger problem with targeting interest rates than with monetary regimes that stabilize a price, such as the gold standard or a fixed exchange rate regime. I suspect that indeterminacy is less of an issue with a real interest rate rule because TIPS spreads are analogous to a CPI futures contract, and therefore stabilizing TIPS spreads is akin to targeting the price of a CPI futures contract. A gold standard avoids indeterminacy because gold prices are visible and controllable in real time. The same applies to the prices of CPI futures contracts. If this is wrong, please correct me in the comments section.
While I am in favor of NGDP targeting, I believe Holden is wise to frame his proposal as an inflation targeting regime. Contrary to NGDP expectations, we already have deep and liquid TIPS markets, and real-world central banks have opted for an inflation target over an NGDP target. Framing the proposal as an inflation-targeting regime is the best way to move real-world policymakers toward the broader goal of focusing on market expectations of the target variable.
