In recent years, I have been depressed by the state of macroeconomics research. I find many new research papers are almost unreadable. Perhaps this reflects the fact that my own work is increasingly out of the ordinary. So I was very surprised to see a Tom Holden’s new paper which includes many of the themes I have been emphasizing. Even better, the paper is very well written (rare for a major theory paper) and will appear in a well-respected journal. Econometrica.
Before discussing Holden’s paper, let me be clear that I am not suggesting that you agree with my general macro view. He is more of a New Keynesian approach while I am a monetarist, and advocates inflation targeting while I favor NGDP targeting. But on a few important points we end up in the same place, even if we get there by different routes.
Consider the following claims, which sound like a lot of money:
In this model, only monetary policy shocks affect inflation. Of course, if there is nominal stability in the model, financial shocks may affect real volatility. But as long as the central bank follows a rule like this, this real disturbance has no answer in terms of inflation. The causality runs from inflation to real variables, not the other way around. We can understand inflation without worrying about the whole economy. . .
This is consistent with the causality from the money supply to the output gap, not the other way around. Similarly, Miranda-Agrippino & Ricco (2021) find that a contractionary monetary policy shock causes a rapid drop in the price level, while the effects on unemployment are less pronounced. Again, this suggests that causation runs from inflation to unemployment, not the other way around.
In the traditional Keynesian model, causation runs from nominal shocks (more physical purchases and more employment) to nominal effects (higher wages/prices.) Milton Friedman saw causation from nominal shocks (money and inflation) to real effects (more jobs and output) . . Both theories of causation are consistent with the correlations observed in Phillips Curve studies, but the definition of money tends to move people more toward monetary policy as the primary stabilization tool.
Here is Holden’s policy proposal to stabilize inflation:
Unlike previous Taylor Rule proposals, Holden envisions deriving the real interest rate from inflation-indexed bonds, i.e. “TIPS”.
In the past, I have argued that economists focus too much on the public’s expectations of inflation, and that the key to successful monetary policy is to stabilize the expectations of financial market participants. Here’s the Holden:
The only important expectation is that of participants in the common and real bond markets. It is more reasonable to assume that financial markets lead to prices consistent with rational expectations than to assume the prudence of households in general.
All this music is in my ears. Here is another gem:
The real rate laws also have a second source of robustness: they don’t need an integrated Phillips curve to hold. The slope of the Phillips curve has no effect on the power of inflation. If the central bank doesn’t care about output, it doesn’t even need to know if the Phillips curve is up, let alone down. And it doesn’t matter how firms form inflation expectations. The Fisher equation and the law of money reduce inflation, so although unrealistic corporate expectations may affect output volatility, it will not change the dynamics of inflation.
I also argued against using the Phillips Curve in monetary policy. I favor stabilization of market expectations of NGDP, while Holden proposes stabilization of market inflation expectations, but the underlying approach is the same—stabilization of market expectations of capital diversification. Don’t try to fake the Phillips Curve.
I have emphasized that any effective monetary policy policy leads to near-perfect inflation financial decline in other aspects of demand, such as the fiscal stimulus of tax cuts. Holden goes even further with monetary offset, as he proposes an inflation target. So his proposed policy framework also removes supply-side influences on inflation, although he later says (correctly) that policymakers may wish to adjust targets in the event of a supply shock.
In my work, I have strongly criticized the idea that monetary policy works by changing interest rates, at least in the Keynesian sense of influencing the economy through changes in both nominal and real interest rates. I created a variety of hypothesis tests in which prices are flexible and the effects of monetary policy on nominal interest rates cannot be reflected in changes in real interest rates. Holden makes a similar claim:
An even more important question in monetary economics is “how does monetary policy work?”. The traditional response includes movements in general rates that lead to movements in real prices, due to sticky prices. But this cannot be a method of transmission under variable prices, since then the real prices are outside. And it will not be a method of transmission under the law of real ratio, since then the movement of real ratio is not important. In these cases, monetary policy works mainly through the Fisher equation link between minimum rates and expected inflation. As we will see that the dynamics under the real rate law are very similar to the dynamics under the traditional law, it would be surprising if monetary policy works through a very different channel under the traditional law. Instead, this suggests that the main channel of monetary policy in new Keynesian models is the one that exists even under variable prices, with the Fisher equation. Rupert & Šustek (2019) reach a similar conclusion based on the observation that contracted (positive) financial shocks can lower real prices in New Keynesian models of capital.
I have argued that financial shocks are actually being shortened has been lowered real interest rates in 2008, but also reduced NGDP—causing deflation.
During the 1980s, a number of economists including Earl Thompson, Robert Hall, David Glasner, Robert Hetzel and myself proposed policies that would effectively target the financial market’s forecast of inflation or (in my case) NGDP growth. Holden suggests that his rule of true rank lies in that tradition:
Additionally, in an older work, Hetzel (1990) proposes to use the spread between nominal and real bonds to guide monetary policy, and Dowd (1994) proposes to guide the price of futures contracts to the price level. This has a similar flavor to the real rate system, as these rules effectively use expected inflation as a monetary policy tool.
The direction of prediction has also been suggested 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 6 weeks. Here’s the Holden:
Note that while under conventional monetary policy, nominal interest rates are unlikely to change between monetary policy committee meetings, this may not be the case here. . . . The central bank’s trading desk may need to continue adjusting this rate [interest rates] . . . Although this is a departure from current operating procedures, there is no reason to hold back [TIPS spreads] almost constant should be harder than holding [interest rates] almost always. This is due to the real-time observation of [real interest rates] with inflation-protected bonds.
I have argued that central banks should decide strategy of monetary policy (that is, whether it is targeting prices or NGDP, and whether it is targeting rates or growth rates), and market expectations should be used to initiate policy action. Holden concludes his paper with a similar observation:
We have presented a design for the implementation of the real rate rule with a variable short-term inflation target. Under the proposal, central bank boards retain the key role of choosing the desired inflation path. It is only a technical decision on how to set the standards to achieve that method that is passed on to the law. The law does not embed politically sensitive assumptions about the slope of the Phillips curve or the cost of inflation. And the rule can be applied using assets that already have a liquid market: either nominal and real maturity bonds, or inflation.
In mine the latest book, I have moved away from the issue of “indeterminism” (ie multiple possible equilibria), which is a problem in which I have no expertise. Based on what I’ve read, however, it seems to be a bigger problem with interest rate pegs than with price-stabilizing monetary regimes, such as a gold standard or a fixed exchange rate. I suspect that uncertainty is not a problem with the real rate rule because the TIPS spread is the same as the CPI futures contract, and hence fixing the TIPS spread is the same as targeting the price of the CPI futures contract. The gold standard avoids uncertainty because gold prices are visible and controllable in real time. The same is true for CPI futures contract prices. If this is wrong, please correct me in the comment section.
While I like the NGDP guidance, I believe Holden is wise to frame his proposal as an inflation targeting regime. Unlike NGDP expectations, we already have deep and liquid TIPS markets, and the world’s central banks have chosen to focus on inflation rather than NGDP insights. Formulating the proposal as an inflation control regime is the best way to move real-world policymakers toward the broader goal of targeting market expectations for policy variability.
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