17 April 2016

Believe it or not, NK models are not Market Monetarist

Today on Twitter, Nick Rowe deployed a couple of the tricks his commonly like to use when arguing against New Keynesians who think (rightly) that the NK model suggests that, when the Wicksellian natural rate is negative, fiscal stimulus is 1) warranted and 2) will not be offset by the central bank.

Notably, Nick said
"accommodate fiscal stimulus" = "no longer trying to target 2% inflation"
Assume NK [is] true. Current BoC r > ZLB > ELB (as defined by BoC)
 Of course, Nick should know (from numerous posts in which I have written about this same issue) that the New Keynesian IS curve implies that expansionary fiscal policy raises the natural real interest rate, which means that, if inflation is currently below target, fiscal stimulus can raise it to target without requiring an appropriately sized interest rate cut (which may not be possible).

This is where the biggest fault in Nick's argument is -- he suggests that, as long as the nominal interest rate is currently above the zero lower bound (or the 'effective lower bound'), a New Keynesian central bank can keep inflation on target. Essentially, he is arguing that, since the current interest rate set by the Bank of Canada is above zero, the Wicksellian natural rate (defined as the interest rate at which inflation is on target) must be above zero.

This assumption is just plain wrong, but I will slightly alter Nick's actual argument into something that I think is much better (and probably what he meant, but was unable to articulate given Twitter's stringent limits on tweet length). In a New Keynesian model, the central bank can raise the Wicksellian natural rate by deliberately setting future nominal interest rates lower than they otherwise would be (this is called forward guidance). Because of this, all a central bank need do to keep current inflation on target is to lower the path of the nominal interest rate.

Now the argument makes a lot more sense; Nick is suggesting that 1) the Bank of Canada is responsible for inflation being below target because they refuse to use forward guidance and 2) since inflation is exactly where the Bank of Canada wants it, fiscal policy will simply be offset.

The issues that I have with this argument are two-fold:

First, the regime I just described on behalf of Nick is not consistent with an inflation targeting regime because the central bank is supposed to deliberately raise future inflation above target in order to put current inflation on target. This is what forward guidance does in New Keynesian models and, as such, represents an important break from actual inflation targeting.

Second, the empirical failure of forward guidance is well documented and is commonly referred to as the 'forward guidance puzzle.' For instance, Del Negro et al. 2012 note that "[DSGE models] appear to deliver unreasonably large responses of key macroeconomic variables to central bank announcements about future interest rates ... Carlstrom et al. (2012b) shows that the Smets and Wouters model would predict an explosive inflation and output if the short-term interest rate were pegged a the ZLB between eight and nine quarters" [1].

Thus, not only is forward guidance not consistent with keeping inflation on target in the medium term, it is probably nowhere near as effective at raising the Wicksellian natural rate as basic DSGE models would suggest which severely limits my edited version of Nick's original argument. As it turns out, the Bank of Canada is probably either self-constrained by a refusal to do an adequate amount of forward guidance or otherwise constrained by a lack of effective tools to raise the natural rate up to a level at which inflation would be on target. In this case, it is perfectly reasonable to suggest that not offsetting loose fiscal policy is not inconsistent with the Bank of Canada's inflation target.

[1] Del Negro, Marco & Giannoni, Marc & Patterson, Christina, 2012.
"The forward guidance puzzle,"
Staff Reports 574, Federal Reserve Bank of New York, revised 01 Dec 2015.

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