Permazero

St. Louis Fed President Jim Bullard gave a very interesting paper at the Cato monetary conference, with this great title.

Jim starts with this great picture. It's a simulation of the standard three equation new Keynesian model as we go from 2% interest rate to zero. This is an upside down version of the first graph in my "Do higher interest rates raise or lower inflation." (Blog post) But Jim makes a new and insightful point with it, that had not occurred to me.

Jim reads this as an account of what happened in 2008, not (my) tentative prediction for what might happen in 2016 in the other direction. It's compelling: The Fed lowers rates. This boosts output (black line) over what it would otherwise be, overcoming the horrendous negative shocks to the economy from a financial crisis. Inflation gently declines, which is also what inflation did after a one time shock in 2009, related to the output shock which the Fed was offsetting.

Jim then ties that together with my Figure 3 in an artful way. The same model that accounts well for slow disinflation in the recovery suggests that raising rates now, in the absence of other shocks, would just raise inflation and lower output.

Jim goes on to present some data averaged across a variety of countries. Here you see a pattern quite similar to the model's prediction. After recovering from the severe shock, inflation starts its gentle decline.

Like me, Jim is nervous about these conclusions. The data seem to be telling us that interest rate pegs are not unstable. The standard model turns out to have that prediction, but also predicts that raising interest rates, while lowering output as we have long been told, will just smoothly raise inflation. It's very hard to turn around decades of contrary doctrine -- that pegs are unstable, and raising rates lowers inflation. One should be nervous about such conclusions. Maybe inflation is, finally, just around the corner. So Jim makes very clear he's not yet recommending a rate rise to cause more inflation!

But one should also start thinking about what these conclusions mean if they are right, and Jim summarizes with a number of such implications. A few that seem especially important, with comment:

Third, longer‐run economic growth would still be driven by human capital accumulation and technological progress, as always, but without the accompanying stabilization policy as conventionally practiced from 1984‐2007. In principle, the economy would still be expected to grow at a pace dictated by fundamentals.

A little more bluntly, Japan-bashers cannot blame 20 years of poor growth on the zero bound. Nor should we worry that permazero will cause lower growth. (The other way around is much more likely: low marginal product of capital leads to low rates.) Japan's growth and inflation, like our own for the last seven years, has also been quite stable, raising the next question of just how much stabilization this policy was doing.

Fourth, the celebrated Friedman rule would arguably be achieved, so that household and business cash needs are satiated. In many monetary models this is a desirable state of affairs.

Yes!! Shout it from the rooftops.

Just what is so terrible about zero rates and very low inflation? Zero rates are the optimum quantity of money. They have financial stability benefits too. Banks sitting on huge piles of cash don't go under.

Conventional modeling has been treating the zero bound as a "trap," or a terrible outcome to be avoided. But it's a honey trap, at least in these models. The main complaint one could make is that they don't last, that they lead to spiraling deflation or hyperinflation. But the models said "trap" -- they last -- and the data seem to agree.

Fifth, the risk of asset price fluctuations may be high. In the New Keynesian model, the near‐zero interest rate policy with little or no response to incoming shocks is associated with equilibrium indeterminacy. This means there are many possible equilibria, all of which are consistent with rational expectations and market clearing. In a nutshell, a lot of things can happen. Many of the possible equilibria are exceptionally volatile. One could interpret this theoretical situation as consistent with the idea that excessive asset price volatility is a risk.

This is spot on. In the models, the trouble with the zero bound "trap" is not high unemployment, low growth, or spiraling inflation or deflation -- it has none of these. The problem is "indeterminacy," the possibility that inflation can bounce around a bit, each time returning stably back again. That's also what we seem to see, and it hasn't been a huge problem: We don't see any more inflation, output, or asset market volatility in the last 7 years than in the period before the crisis.

And this is a simple problem to solve in the theory. Add back the missing fiscal theory of the price level -- deliberately thrown out in the theory -- and you have determinacy again. In words, a jump to an alternative equilibrium requires that fiscal policy expectations also jump. If people's expectations of long-term fiscal policy are stable, then we have determinacy and no more volatility at the zero bound too.

Sixth, and finally, the limits on operating monetary policy through ordinary short‐term nominal interest rate adjustment in this situation would surely continue to fire a search for alternative ways to conduct monetary stabilization policy. The favored approach during the past five years within the G‐7 economies has been quantitative easing, and there would surely be pressure to use this or related tools.

I.e. in permazero, eventually markets get tired of reacting to whispers that the Fed might someday raise rates. Monetary policy overall becomes ineffective, leading central banks to try other levers. Which may not be such a great idea!