Here’s Nick Rowe:
I have been arguing with John Cochrane and Steve Williamson over whether central banks announcing higher nominal interest rates is inflationary or deflationary. The very fact that economists are arguing about that very basic question tells us something important about central banks’ using nominal interest rates as a communications strategy: it sucks. This is a point that economists like Scott Sumner and I have been making for some time. Do low nominal interest rates mean monetary policy is loose or tight? It depends.
Obviously I agree, but I want to be careful that we don’t overstate its suckiness (is that a word?) There is no question what central banks mean by higher interest rates, ceteris paribus. They are signaling contractionary intent. And there is no question that markets interpret it that way. So what is the problem? Ceteris is rarely paribus. Suppose the economy is weakening and the markets believe the Wicksellian equilibrium interest rate has fallen by more than 50 basis points. For instance, December 2007. The Fed announces a 25 basis point rate cut. The stock market crashes. Why? Because policy became more contractionary (if you are a MM or a thoughtful NK), or policy became expansionary at a slower rate than needed (if you are a normal person or a sloppy NK.)
That is the ambiguity that Nick refers to. Of course Williamson was postulating something much more counterintuitive, that even a larger than expected fed funds (or IOR?) rate cut could have a contractionary impact on expected inflation (relative to a smaller rate cut.)
In fairness to the Keynesians, the monetary base has the same problem as interest rates. A huge increase in the base could be expansionary (Zimbabwe) or it could reflect a lower NGDP trend growth rate (Japan.)
Nonetheless, the base is better that interest rates because interest rates also have the zero bound problem, which makes policymakers mute when nominal interest rates are zero. That’s why they turn to QE as their communication strategy.
Of course NGDP futures targeting is better than either option. To summarize:
1. Interest rates:
Lousy at communicating policy stance, zero bound problem in communication.
2. The monetary base:
Lousy and communicating policy stance, no zero bound problem in communication.
3. NGDP futures prices:
Good at communicating policy stance, no zero bound problem in communication.
Can you guess which policy instrument I favor?
PS. In this post Arnold Kling argues that monetary policy is endogenous. Actually it’s both exogenous and endogenous. The “partly exogenous” is an implication of the strong disputes that break out within central banks, the differing reaction function between central banks, the differing reaction functions within a central bank over time, and the market response to unexpected central bank actions.
Markets react strongly to monetary shocks—for good reason.
Kling also makes this comment:
Perhaps a few key Wall Street gurus interpreted the announcement as good news, because of (1) or because they are devoted followers of Scott Sumner or because of the meds they were on or whatever.
The easiest explanation is that markets aggregate information better than any individual, including me. That’s why I look to markets for interpretation, and why market monetarism keeps outperforming alternative models of the economy, such as those that predicted QE would be highly inflationary, or that the austerity of 2013 would sharply slow growth in the US.