Friday, December 20, 2013

John Cochrane on the 1982 Fiscal Restraint ???

Has John Cochrane fallen off the cliff again with:
What if we got the sign wrong on monetary policy?
He is motivated by post from Stephen Williamson on Phillips curves and monetary policy that starts off sensibly enough. Even this die hard believer that Keynes had a point is willing to concede that Milton Friedman got a lot of things right. Williamson is even willing to note this:
If we think there is an episode where monetary factors were important, then we should see the Phillips curve over that period, as monetary shocks tend to move inflation and the unemployment rate in opposite directions in the short run. So, consider the period of time between fourth quarter 1980 and third quarter 1982, when Paul Volcker was using monetary policy to bring the rate of inflation down.
Williamson later notes what Irving Fisher taught us about the effect on nominal interest rates in the long-run:
So, over the long run, there's a clear positive correlation between the nominal fed funds rate and the pce inflation rate. Irving Fisher taught us that, in credit markets, borrowers and lenders care about real rates of return. Thus, there should be an inflation premium built into the observed nominal interest rate - if the inflation rate is higher, the nominal interest rate should be higher. This just compensates lenders for the decline in purchasing power they experience between the time a loan is extended and when it is paid back. Indeed, some mainstream models, including New Keynesian models (which are basically neoclassical growth models with sticky prices and wages) have the feature that the long-run real interest rate is a constant, determined by the subjective rate of time preference of the people who live in the model.
All of this seems fine until Williamson starts musing over this:
So, suppose I am Paul Volcker, and I'm faced with a situation at point A where the inflation rate is high and the nominal interest rate is high. The curve SRLE1 is the short-run tradeoff I face. I can reduce inflation in the short run by increasing the nominal interest rate, thus moving to B. But that won't work to reduce inflation in the long run, so after increasing the nominal interest rate, I have to begin reducing it.
At this point one might be best advised to stop reading as we old timers would cut in and say that the prolonged large out gap during the 1980’s was what was responsible for the dramatic reductions in inflation, which sort of became a semi-permanent feature of the US economy. But silly me had to read Cochrane’s take on this which included:
To be sure, I left the grand Volcker stabilization out of the picture here, where a sharp spike in interest rates preceded the sudden end of inflation. And to be sure, there is a standard story to explain negative causation with positive correlation. But there are other stories too -- the US embarked on a joint fiscal-monetary stabilization in 1982, then under the shadow of an implicit inflation target gradually lowered inflation and interest rates.
Did Cochrane and I live on different planets some 30 plus years ago? My recollection was that Reagan’s fiscal policy was quite stimulative working contrary to Voclker’s tight monetary policy. Which is why real interest rates during the 1980’s shot up dramatically and stayed high even as inflation and nominal interest rates fell. Yea – there are “other stories too”. Stories that don’t fit the reality of the period.


FRestly said...

You have this wrong,

"I can reduce inflation in the short run by increasing the nominal interest rate."

I can reduce the inflation rate by raising the short term interest rate faster than the markets can raise the long term interest rate. Meaning I can raise short term interest rates faster than banks can find borrowers at long term interest rates - destruction of credit intermediation.

Anonymous said...

"Which is why real interest rates during the 1980’s shot up dramatically and stayed high even as inflation and nominal interest rates fell."
The Fed made a conscious effort to raise the real interest rate. This video explains...