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Michelson-Morley, Occam, and Fisher: The Radical Implications of Stable, Quiet Inflation at the Zero Bound John H. Cochrane Hoover Institution, Stanford University April 30, 2017 1 / 27 Michelson-Morley; The long quiet ZLB 6 5 10Y Govt 4 3 Core CPI 2 1 Fed Funds 0 1996 I 1998 2000 2002 2004 2006 Reserves 2008 2010 2012 2014 2016 What happens at the ZLB? Nothing. 2 / 27 Core Monetary Doctrines / ZLB predictions What happens at ZLB? I Old K / adaptive E: ZLB → Deflation spiral. I (Friedman 68) i peg, or ZLB, or passive, is unstable. πt+1 = (λ > 1)πt + shocks. I I Taylor φ > 1 stabilizes. No Taylor, → spiral. NK/Rational E: ZLB → π is volatile; “Self-confirming fluctuations,” “sunspots.” I ZLB, peg, passive is stable but indeterminate. Et πt+1 = (λ ≤ 1)πt ; πt+1 = Et πt+1 + δt+1 . I I I Taylor φ > 1 makes unstable, hence determinate. φ < 1 volatility a core prediction. MV=PY: ZLB, i ≈ 0 is irrelevant. M $50b → $3,000b means hyperinflation. Velocity is “stable.” QE “injects liquidity.” 3 / 27 Adaptive/Old-Keynesian Spiral 2 i 0 vr Percent −2 −4 π −6 −8 −10 −12 −2 0 2 4 6 8 10 Time xt = −σ(it − πt−1 − vtr ); πt = πt−1 + κxt ; it = max[i ∗ + φ(πt − π ∗ ), 0] 4 / 27 Core Monetary Doctrines / ZLB predictions I Old K / adaptive E: ZLB → Deflation spiral. I (Friedman 68) i peg, or ZLB, or passive is unstable. πt+1 = (λ > 1)πt + shocks. I I Taylor φ > 1 stabilizes. NK/Rational Ex.: I ZLB → π is stable, but indeterminate hence volatile; Et πt+1 = (λ ≤ 1)πt ; πt+1 = Et πt+1 + δt+1 . I I I I At ZLB, model only pins down expected π. Unexpected π can be anything. “Sunspots.” φ > 1 makes π unstable, hence determinate. φ < 1 volatility a core prediction. MV=PY: ZLB, i ≈ 0 is irrelevant. M $50b → $3,000b means hyperinflation. V is “stable.” 5 / 27 Michelson-Morley; The long quiet ZLB 6 5 10Y Govt 4 3 Core CPI 2 1 Fed Funds 0 1996 I I 1998 2000 2002 2004 2006 Reserves 2008 2010 2012 2014 2016 Quiet, stable π at long period of i ≈ 0, φ << 1, huge M. No deflation spiral. No M/QE inflation. No sunspot volatility. No change in π dynamics. σ(π) lower? 6 / 27 US unemployment and GDP 10 Unemployment 8 6 4 Fed Funds 2 0 GDP Growth -2 1994 I 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Larger shock but same dynamics. Faster decline in u, lower σ(∆Y )? E (∆Y ) is too low, but is that monetary policy? 7 / 27 Japan 6 5 4 Percent 3 10Y Govt 2 1 Int rate 0 -1 Core CPI -2 1992 I I 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 20+ years at i ≈ 0 with no spiral, sunspot σ(π). Spiral fear understandable in 2001. 8 / 27 Europe 5 1 mo Euro Libor 4 Percent 3 2 Euro Core CPI 1 0 -1 2000 I 2002 2004 2006 2008 2010 2012 2014 2016 Lower rates ↔ lower inflation. 9 / 27 Michelson-Morley Michelson-Morley. Experiment: I Inflation can be stable, quiet, at ZLB, φ < 1. Even a peg. I Huge excess reserves paying market interest are not inflationary. I φ > 1 vs. φ < 1, ZLB, is not a key state variable for σ(π), dynamics. Implications I Old-Keynesian. No spiral. I New-Keynesian. No sunspots. I MV=PY. No hyperinflation. Next theory? New Keynesian + Fiscal Theory. ... 10 / 27 NK + FTPL ∞ X Bt−1 β j st+j = Et Pt j=0 Real value of gov’t debt = PV of primary surpluses ∞ X Bt Pt (Et+1 − Et ) = (Et+1 − Et ) β j st+1+j . Pt Pt+1 (1) j=0 Unexpected inflation = news about pv of surpluses / debt I Unexpected deflation ↔ debt worth more ↔ raise tax/cut spending. I (1) solves spiral, indeterminacy/sunspots. δt+1 = πt+1 − Et πt+1 ↔ fiscal policy. I i peg or φ < 1 can be stable (NK) and (now) determinate and quiet. I NK + FTPL is the only remaining pre-existing, simple, economic, theory consistent with stable, quiet inflation at ZLB, huge reserves. 11 / 27 Occam: The (Long) Paper What about... I Equations? A very simple transparent model. I Variations to rescue instability, indeterminacy, M? (A: epicycles.) I I I I I I I I Fiscal theory objections? I I I I I I I Really unstable but QE offset deflation spiral? NK Equilibrium selection from post-bound actions, not current φπt ? Really active NK, no one expected it to last? (A: Japan?) Peg still unstable/indeterminate? Really unstable but slow to emerge (sticky wages, velocity)? Reserves didn’t leak to M1, M2. (A: My point.) More general models? (A: don’t change stability, determinacy.) Large deficits, debt, Japan? (A: Low r . Not deficits, debt ↔ π.) Previous pegs, 1970/1980, other episodes? (A: Fiscal problems. “A peg can be stable.”) Why is σ(π) = σ(E fiscal policy) low? (“A peg can be quiet”) “Budget constraint,” debt repayment means passive fiscal? (A: No; off equilibrium modeling just like NK.) “Exogenous” surpluses? s = τ y ? s(P)? (A: No. Like dividends.) Test FTPL? (A: Test MV=PY? P = EPV(D)?) A: Today: I only claim NK+FTPL is possible, survives quiet ZLB test. I do not claim it proved, explains all tests, all history. 12 / 27 Fisher 13 / 27 Frictionless model 1.5 1.5 π, with fiscal shocks interest rate i 0.5 Percent response Percent response 0.5 inflation π 0 π, with fiscal shocks -0.5 inflation π 0 -0.5 -1 -1 -1.5 -3 -2 -1 0 1 2 3 -1.5 -5 -4 -3 I I -1 0 1 2 3 Model πt+1 − Et πt+1 I -2 Time Time I interest rate i 1 1 it = r + Et πt+1 , X = (Et+1 − Et ) β j st+j /(B/P) “Monetary policy” changes i with no change in fiscal {s}. Higher it raises πt+1 , immediately. Joint fiscal-monetary tightening can give a temporary π decline. Pricing frictions give a temporary negative π? ... 14 / 27 Effects of rate rise – Standard NK model with φ = 0 interest rate i i π x 1 0.8 inflation π 0.6 Percent response 0.4 0.2 0 -0.2 output gap x -0.4 -0.6 -0.8 -1 -4 -2 0 2 4 6 Time I xt = Et xt+1 − σ(it − Et πt+1 ); πt = βEt πt+1 + κxt . I Pricing frictions do not produce π decline. 15 / 27 Long term debt, fiscal theory, works Simple frictionless example. P∞ 6 j=0 Pt Price level, short term 4 (j) (j) Qt Bt−1 = Et ∞ X β j st+j j=0 2 Interest rate I Higher (future) i → lower Q. P level must fall. I Just like a fiscal shock. I Then i = r + E π inflation rises. I Paper: Merge with sticky prices → smooth temporary negative π response. 0 -2 Price level, long term -4 -6 2 4 6 8 10 12 14 16 / 27 The Answer for negative sign? P∞ j=0 (j) (j) Qt Bt−1 Pt ≈ Et ∞ X β j st+j j=0 Points in favor: I → QE (twist), forward guidance, and i policy are the same thing. I Works in totally frictionless model (money, prices). (+ frictions for realistic dynamics.) Warnings: I Only works for unexpected changes. Hard to justify systematic policy, “fine tuning.” I Positive in long run. Produces 1970 failed stabilizations, not standard 1980s story. (Without a fiscal change too.) I Nothing like any story told to undergraduates, FOMC. I → The answer is yes, but not for every question. Other approaches?.... 17 / 27 (Long) Paper: What about.. Variations that don’t work: I I Sticky prices Money U(c, M/P) I Only expected ∆i works. Won’t help VARs. Won’t work in IOER. Sign helps, but off by × 10 in size. I Temporary rates. I Backward-looking Phillips, or static IS. I Multiple equilibria, coincident or “passive” fiscal shocks. Active money/passive fiscal. I I I Same result with φ > 1. Solution conditional on i path (Werning). If it = it∗ + φ(πt − πt∗ ) = iˆt + φπt produce this equilibrium observed it , this is πt , xt . Standard solution of 3 equation model. 18 / 27 Paper: What about.. I More ingredients? I I I I Borrowing or collateral constraints, hand-to-mouth consumers, bounded rationality or irrational behavior, a lending channel; habits, labor/leisure, production, capital, variable capital utilization, adjustment costs, alternative models of price stickiness; informational, payments, monetary, financial, frictions; pricing or timing lags, alternatives to rational expectations (“reflective,” “k-step” expectations); non-Walrasian equilibrium, game theory,... A: Necessary as well as sufficient. The sign (and stability?) of M policy depends on soup, not simple economics. There is no honest simple story to tell undergrads, FOMC. Yes to frictions etc.! To understand size and dynamics on top of a simple model that gets sign and stability right. VAR evidence? (A: price puzzle, includes fiscal shocks; long term debt effect.) Bottom line: I There is no other simple, modern (rational expectations) theory, that delivers the traditional view that higher interest rates lower inflation, even temporarily. 19 / 27 Policy Summary: Evidence suggests, and NK+FTPL theory digests: I ZLB is stable, quiet. No deflation spiral, sunspots. I → Peg or passive φ < 1 too. I Large interest-paying reserves do not cause inflation. I Contrary classic doctrines were wrong. Summary: Implication I I Higher i can lead to higher π in the long run. (Neutrality.) Negative short run effect? No simple economic model for standard beliefs. (Only a fiscal / long-term debt channel.) Policy: (Consequence of stability, quiet) I Do not fear the ZLB, balance sheet! I We can live the Friedman rule; Huge reserves paying market interest. Or, better, the Treasury can issue reserves to the rest of us. No need to keep “bonds” illiquid for price level control. I 20 / 27 Optimal quantity of money/Balance sheet 21 / 27 Policy Policy: (Consequence of stability, quiet) I The Fed can keep a low peg. (Inflation then varies as r , r ∗ vary.) I (Wild) The Fed can target the spread between indexed and non-indexed debt, thus target expected inflation, and let the level of the real rate free to respond to market forces. (Expected CPI standard.) it = rt + Et πt+1 → Et πt+1 = it − rt I The Fed can guess r , r ∗ , vary interest rates i. → More stable inflation, output. Observe a Taylor-like rule. I The Fed can (try to) offset lots of shocks with time-varying rates/spread; fine-tune inflation / output path with complex DSGE. I Vs. leave it alone, like hot/cold shower. Old “fine tuning,” “rules vs. discretion,” planning vs. market debate continues. 22 / 27 Policy The Fed? Simple rules v. fine-tuning discretion continues. I Observed policy may not change much – Taylorish responses to output and inflation + temporary responses to shocks. I Foundations / strategy may change a lot. No more φ > 1 equilibrium selection. Fiscal anchoring. Balance sheet. I Monetary economics is now like regular economics! A simple S&D benchmark, then add frictions to taste. 23 / 27 Warnings Extrapolation warning: I NOT “lower rates to lower inflation” (Turkey, Brazil). I Must be ver persistent, credible, and with fiscal backing. (Our flight to quality came first.) FTPL warning: ∞ X 1 Bt−1 = Et st+j Pt Rt,t+j j=0 value of gov’t debt = pv of primary surpluses I Fiscal policy “anchoring” comes from expectations of eventual primary surpluses, and low real rates for government debt. I Low R, flight to quality, → low P. I Discount rates dominate valuation everywhere. I Low discount rates could evaporate quickly. (Greece, but ends in inflation.) 24 / 27 The End 25 / 27 Standard NK model with φ > 1 (Woodford) ρ = 0.9 ρ =1 2.5 2 i π 1.5 Percent (%) Percent (%) 2 1.5 1 0.5 0 i π 1 0.5 0 -0.5 -0.5 -1 0 2 vi -1 4 6 8 10 0 2 vi Time ρ = 0.50838 4 6 8 10 8 10 Time ρ = 0.3 0.8 0.5 0.4 Percent (%) Percent (%) 0.6 π 0.2 i 0 -0.2 -0.4 -0.6 π 0 i -0.5 -0.8 -1 0 2 vi -1 4 6 8 10 0 2 vi 4 Time 6 Time i it = φπt + vti ; vti = ρvt−1 + εit ; φ = 1.5 I Standard φ > 1 model is even more Fisherian! 26 / 27 Long term debt + fiscal theory + sticky prices P∞ (j) j=0 (j) Qt Bt−1 ≈ Et Pt ∞ X j Y j=0 k=1 1 1 + rt+k ! st+j ; rt = it − Et πt+1 Unexpected permanent rate rise 1 Inflation π ∆s=-4.47 Percent response 0 I Calibrated to 2014 US maturity structure. I More sticky → r rises, → PV declines → less effect. -1 ∆s=0.00 Output gap x -2 -3 Inflation, no r effect -4 -5 -3 -2 -1 0 1 2 3 4 5 6 7 Time 27 / 27