In recent years I have become depressed by the state of macroeconomic research. I find many recent research papers almost unreadable. This may reflect the fact that my own work is increasingly outside the mainstream. So I was very pleasantly surprised to see a new article by Tom Holden which embraces many of the themes I have highlighted. Better still, the article is extremely well written (unusual for an article on macroeconomic theory) and will be published soon in the very prestigious journal Econometrics.
Before I get to Holden’s paper, I want to make it clear that I do not mean to imply that he necessarily shares my overall view of macroeconomics. He tends to adopt a neo-Keynesian approach, whereas I am a monetarist, and he advocates inflation targeting, whereas I prefer nominal GDP targeting. But on a number of important points, we arrive at the same point, even if we arrive there by different paths.
Consider the following statements, which seem vaguely monetarist:
In this model, only monetary policy shocks affect inflation. Of course, if the model has nominal rigidity, monetary shocks can have an impact on real variables. But as long as the central bank follows a rule like this, these real disturbances have no feedback on inflation. The causality goes 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 the fact that causality only runs from inflation to the output gap, and not in the opposite direction. Similarly, Miranda-Agrippino and Ricco (2021) find that a contractionary monetary policy shock causes an immediate decline in the price level, while the impacts on unemployment materialize more slowly. Again, this suggests that causality runs from inflation to unemployment, and not the other way around.
In the traditional Keynesian model, causality runs from real shocks (increased physical purchases and hiring) to nominal outcomes (increased wages and prices). Milton Friedman saw causality running from nominal shocks (money and inflation) to real outcomes (increased employment and output). Both views of causality are consistent with the correlations observed in Phillips curve studies, but the monetarist interpretation tends to bias people toward monetary policy as the primary stabilization tool.
Here is Holden’s policy proposal to stabilize inflation:
Unlike previous Taylor rule proposals, Holden considers deriving the real interest rate from inflation-indexed bonds, i.e. “TIPS.”
In the past, I have argued that economists place too much emphasis on public expectations about inflation and that the key to successful monetary policy is to stabilize the expectations of financial market participants. Here is what Holden says:
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 lead to prices consistent with rational expectations than to assume the rationality of households in general.
This is all music to my ears. Here’s another gem:
Real 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 have any impact on inflation dynamics. If a central bank does not care about output, it does not even need to know whether the Phillips curve holds, much less its slope. Nor does it matter how firms form their inflation expectations. The Fisher equation and the monetary rule capture inflation, so while firms’ irrational expectations may affect 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 for nominal GDP, while Holden advocates stabilizing market expectations for inflation, but the underlying approach is the same: stabilize market expectations for the nominal macroeconomic target. Don’t try to manipulate the Phillips curve.
I have stressed that any successful monetary policy regime leads to almost complete disintegration. monetary compensation Holden goes even further with monetary compensation, since he proposes an inflation target. Thus, the monetary policy rule he proposes also compensates for supply-side influences on inflation, although he later argues (correctly) that policymakers may wish to adjust their target in the event of supply shocks.
In my own work, I have been a strong critic of the idea that monetary policy works by changing interest rates, at least in the Keynesian sense of influencing the economy through changes in nominal and real interest rates. I have created various thought experiments in which prices are flexible and the effects of monetary policy on nominal aggregates cannot come from changes in real interest rates. Holden makes a similar claim:
An even more fundamental question in monetary economics is “how does monetary policy work?” The traditional answer implies that movements in nominal rates lead to movements in real rates, because of price stickiness. But this cannot be the transmission mechanism under flexible prices, because real rates are then exogenous. Nor can it be the transmission mechanism under a real rate rule, because movements in real rates are then irrelevant. In these cases, monetary policy works exclusively through the Fisher equation link between nominal rates and expected inflation. Since we will see that the dynamics under a real rate rule are qualitatively so similar to the dynamics under a traditional rule, it would be surprising if monetary policy worked through a fundamentally different channel under a traditional rule. Instead, this suggests that the main channel for monetary policy in New Keynesian models is the one also 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 rates in New Keynesian models with capital.
I have argued that a contractionary monetary shock lowered real interest rates in 2008, but it also lowered nominal GDP, creating a severe recession.
During the 1980s, a number of economists, including Earl Thompson, Robert Hall, David Glasner, Robert Hetzel, and myself, proposed policies to effectively target financial market expectations of inflation or (in my case) nominal GDP growth. Holden suggests that his real rate rule is in this tradition:
Moreover, in older work, Hetzel (1990) proposes to use the spread between nominal and real bonds to guide monetary policy, and Dowd (1994) proposes to target the price of futures contracts to the price level. This approach resembles a real rate rule, because these rules effectively use expected inflation as an instrument of monetary policy.
Forecast targeting has also been proposed by Hall and Mankiw (1994) and Svensson (1997), among others.
In the past, I have suggested that the Fed’s target interest rate should be adjusted daily, not every six weeks. Here’s what Holden said:
It should be noted that while under conventional monetary policy nominal interest rates are roughly constant between meetings of the monetary policy committee, this may not be the case here. . . . the central bank’s trading desk may need to continually change the level of (interest rates) . . . While this is a departure from current operating procedures, there is no reason why keeping (TIPS spreads) roughly constant should be more difficult than keeping (interest rates) roughly constant. This is because of the real-time observability of (real interest rates) via inflation-protected bonds.
I have argued that central banks should determine the strategy of monetary policy (i.e. whether to target prices or nominal GDP, and whether to target growth levels or rates), while market expectations should be used to implement policy. Holden concludes his article with a similar observation:
We have presented a model for the practical implementation of a real rate rule with a time-varying short-term inflation target. Under this proposal, central bankers retain the crucial role of choosing the desired inflation path. Only the technical decision about how to set rates to achieve that path is delegated to the rule. The rule does not incorporate any politically sensitive views on the slope of the Phillips curve or the costs of inflation. And the rule can be implemented using assets for which there is already a liquid market: either long-dated nominal and real bonds or inflation swaps.
In my recent bookI have avoided the issue of “indeterminacy” (i.e. multiple possible equilibria), which is a topic in which I have no expertise. From what I have read, however, it seems to be a bigger problem with interest rate targeting 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 a problem with a real rate rule because TIPS spreads are analogous to a CPI futures contract, and so 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 is true for CPI futures prices. If this is incorrect, please correct me in the comments section.
While I support nominal GDP targeting, I think Holden is right to frame his proposal as an inflation targeting regime. Unlike nominal GDP expectations, we already have deep and liquid TIPS markets, and real-world central banks have opted for inflation targeting over nominal GDP targeting. Framing the proposal as an inflation targeting regime is the best way to bring real-world policymakers closer to the broader goal of targeting market expectations about the target variable.
