Trevor Chow on machetes and scalpels

Trevor Chow has a long post that provides one of the best summaries of macroeconomics that I have ever read. Highly recommended. Another great post demystifies the money creation process—essential reading for helping people recover from MMT.

Here I’d like to respond to a different Chow post, however, one that looks at the following question:

Can monetary policy control the path of nominal GDP? I have no idea anymore and am wildly confused, so this is an attempt to tell a few just-so stories and see how they land.

Disclaimer: This is wildly wildly wildly speculative, especially story E.

Chow presents 5 options, one of which expresses my preferred view:

Story C

1. The Fed is the monopoly supplier of base money

2.The value of base money is defined as its the purchasing power/exchange rate

3. The Fed can set the value of base money in terms of assets i.e. 1/price of assets

4. The Fed can set the price of assets

5. NGDP depends on the price of assets

6. The Fed can set nGDP

This is a Market Monetarist story and it adds some details to the Old Monetarist hot potato story. Empirically, the entire literature on the Quantity Theory (think McCandless and Weber etc.) suggests that central banks can control nominal quantities.

Then Chow challenges the theory:

But Trevor, central banks don’t actually do this. I have no doubt that if a central bank went about buying everything it could get its hands on by printing money, their prices would get bid up. But the fact that a massive increase in base money would raise nominal quantities does not mean central banks can control nGDP on a meaningful level under its ordinary practices. The ability to wield a machete is no evidence that one can utilise a scalpel.

This is a question I frequently get asked, and I have two related responses:

1. Massive increases in the monetary base (Japan, Switzerland, etc.) are not policies I am trying to get enacted; rather they are policies that I am trying to avoid. The thought experiment about a “whatever it takes” approach to money creation is aimed at convincing skeptics that monetary policy is capable of raising nominal aggregates as high as you like. I hope and believe that my preferred policy would result in less base money creation than actual real world central banks have generated in developed countries.

My claim confuses people because they assume that if we’ve done X% money creation and fallen short of our nominal targets, then we’d have to do more than an X% increase to hit the target. Actually, the demand for base money as a share of GDP is inversely related to the trend rate of NGDP growth. A commitment to do whatever it takes to achieve higher NGDP growth rates actually allows us to do less than otherwise, if credible.

2. Chow would probably say he understands all of that, but still is concerned about the machete/scalpel issue. How do we calibrate the whatever it takes approach? How do we avoid overshooting? How do we make policy a scalpel, not a machete?

The key is to target a variable that responds in real time to monetary policy. That might be an asset price. For instance, the Singapore central bank targets exchange rates. They set the exchange rate at the level expected to lead to macroeconomic equilibrium. No one worries about a zero lower bound for exchange rates. In a perfect world, I’d have the Fed target NGDP futures prices.

In the imperfect world that we live in, I’d have the Fed target its internal forecast of NGDP or the price level, and then construct a real time internal forecast that is a weighted average of asset market prices and model-based forecasts. And that’s roughly what the Fed actually does, at least when policy isn’t hamstrung by an unwillingness to do “whatever it takes”. Fed VP Richard Clarida recently stated that his forecasts combine market and non-market forecasts:

Market- and survey-based estimates of expected inflation are correlated, but, again, when there is divergence between the two, I place at least as much weight on the survey evidence as on the market-derived estimates.

Thus imagine a forecast that is 50% TIPS spreads and 50% model-based inflation forecasts. That hybrid forecast will respond in real time to changes in monetary policy. Do whatever it takes to keep that forecast on target.

PS. If you are having trouble understanding how the Bank of Japan can achieve much higher inflation, it helps to use the following two questions to pinpoint where your skepticism lies:

  1. Do you believe the Bank of Japan would be unable to peg the yen at 1000yen/US$, as compared to the current 110 rate?
  2. Or do you believe that an exchange rate of 1000 yen to the dollar would fail to create lots of inflation?

And if central banks are unable to peg nominal exchange rates, then how did Bretton Woods work?

PPS. Actually, the machete/scalpel issue is a much bigger problem for fiscal policy, which comes in huge discrete chunks despite wide disagreement as to the size (or stability) of the fiscal multiplier.

HT: Basil Halperin


Clarida, Richard.  “Models, Markets, and Monetary Policy.”  In Strategies for Monetary Policy.  Edited by John Cochrane and John Taylor.  2020.  Hoover Institute Press.