It’s been a while since we’ve read about the FOMC pushing on a string, but that string is getting renewed attention. Although there is broad consensus that monetary expansions lead to increased output and contractions lead to decreased output, in their new paper, “Gaussian Mixture Approximations of Impulse Responses and the Nonlinear Effects of Monetary Shocks,” Christian Matthes of the Richmond Fed and Regis Barnichon of Universitat Pompeu note there is little agreement on asymmetric and non-linear effects of monetary policy. (link below) That leaves two key questions unanswered. For the first, they employ the string metaphor—is a contractionary shock, pulling the string, more effective than an expansionary one, pushing the string? Second, how much does the state of the business cycle change the effectiveness of monetary policy?

The authors note that the standard approach to answering such questions, the use of Vector Autoregessions (VARS), is inherently flawed; such models are linear and cannot answer questions about asymmetrical shocks. Replacing VARS with Gaussian approximations (GMAs) the authors are able to estimate a moving average for the economy directly from the data, and then apply Gaussian basis functions in order to capture non-linear responses. Testing the GMA model against VAR results shows the former detects nonlinearities and estimates their magnitudes well.

And the string has it. On average, no matter how they identify monetary shocks, the contractionary ones have a “strong adverse” effect on unemployment, while expansionary ones have “little” effect. And the state of the business cycle does indeed play a role: when there is slack in the labor market, an expansionary shock has an expansionary effect, but in a tight labor market, an expansionary shock has no significant effect on unemployment, causing instead a “burst” on inflation. If the unemployment rate is 4%, an expansionary shock increases inflation by twice that suggested by VAR estimates. If the unemployment rate is 8%, there is no effect on inflation, probably because of downward wage rigidities. They note this is in line with the Keynesian narrative where a monetary authority working to expand an economy already operating above potential would achieve only higher inflation. (We discussed problems with how we measure potential, and its weak trajectory, in our last issue: we’re moving toward potential because the bar keeps falling.)

The authors suggest we employ their models to ascertain nonlinear effects of fiscal policy shocks. Indeed. A coherent fiscal policy would be such a shock in itself it might blow out the Gaussian models. But, joking aside, monetary policy has been pushing that lonesome string for a long time now, and if we want a more vibrant economy and the higher rates that come with that territory, we’d better try something else, something with some real pull.

https://www.richmondfed.org/publications/research/working_papers/2016/wp_16-08

How did that 2% inflation rate get sanctified? Neil Irwin of the New York Times once traced the origins of the totem back to Dan Brash, a former kiwi farmer who became governor of the Reserve Bank of New Zealand in 1988. Shortly after Brash took office, the NZ parliament mandated that the central bank pick an inflation target and granted it the political independence to meet it. Working with the nation’s finance minister David Caygill (successor to the legendary Roger Douglas, whose policy of aggressive market liberalization had worldwide influence), Brash settled on 2%. The idea spread to central bankers around the world.

Should there be such a target? The consensus of those who matter for such things seems to be yes, but one important dissenter was the current chair of the Fed, Janet Yellen. At FOMC meetings in 1995 and 1996, Yellen argued strongly against adopting a formal inflation target. In January 1995, she denounced a single-minded focus on inflation at the expense of real outcomes like employment and income growth. Underscoring the point, the said that “a wise and humane policy is occasionally to let inflation rise even when inflation is running above target.” Further, the costs of inflation targeting could be high: “Each percentage point reduction in inflation costs on the order of 4.4 percent of gross domestic product…and entails about 2.2 percentage-point-years of unemployment in excess of the natural rate.” For her, there was no proof that keeping inflation low improved economic performance, making those costs not worth paying.

She developed the point a year-and-a-half later, at the July 1996 meeting of the FOMC. She reiterated that very low inflation has no demonstrable economic benefit, other than perhaps reducing tax distortions, and those problems could be addressed legislatively without incurring the economic costs of disinflation. She also touted the flexibility afforded by slightly higher inflation: it made it easier for real interest rates to go negative when the economy needs stimulus, and it also disguised real wage cuts that might be necessary in response to demand shocks or to balance labor supply and demand across sectors. Of course, inflation in 1995 and 1996 was around 3%; she thought lowering that to 2% wouldn’t hurt much, but anything beyond that would be uselessly painful. But now even 2% might seem constraining with the ZLB having become a fact of life, and one that might endure.

In a speech to the American Economics Association’s annual meeting, Fed vice chair Stanley Fischer asked some important questions and provided few explicit answers. (He admits this himself; it’s not a reader’s uncharitable judgment.) Much of it is inspired by the zero lower bound (ZLB), but Fischer’s attention roams widely around from that starting point.

His first stop is the possibility that we’re moving towards a world with a “permanently lower long-run equilibrium interest rate,” aka r*. We’ve always been skeptical of that concept, for a number of reasons. You can’t see it, and every attempt to estimate it statistically winds up with different results. Maybe there are several points of equilibrium—a high-employment and a low-employment equilibrium, for example. Or maybe something as turbulent as a modern capitalist economy has no point that’s durably stable enough to deserve the name equilibrium.

But we don’t have seats on the FOMC, so we must bracket these concerns. A number of recent empirical efforts have found that r* is close to zero, and this empirical work has found theoretical support in Lawrence Summers’ argument that we are in a state of secular stagnation. When combined with low inflation, interest rates will spend a lot of time at or near the zero line, which makes life very difficult for central bankers.

What to do? One option is to raise the inflation target from the semi-official 2% to some unspecified higher level. To Fischer, this is risky business, and it seems to hold little appeal for him. Another possibility is to adopt negative interest rates—a strategy that some European countries have experimented with—but Fischer also finds this problematic, at least in the short term.

A third approach, about which Fischer says nothing negative (unlike most of his other propositions) is raising r* through expansionary fiscal policy. “In particular,” he observes, “the need for more modern infrastructure in many parts of the American economy is hard to miss. And we should not forget that additional effective investment in education also adds to the nation’s capital.” It might be possible to manipulate the yield curve, allowing short rates to rise for the sake of normal policy and money market functioning while keeping economically sensitive long rates down. That could be accomplished through continued long-term asset purchases by the Fed and a shortening of maturities by the Treasury.

Central bankers are expected to be discreet, and Fischer is well-practiced. But occupationally adjusted, he’s calling for a more stimulative fiscal policy to counter what could be a bout of long-term economic stagnation. There’s certainly room to boost public investment: as the graph on p. 5 shows, after depreciation, civilian public investment hasn’t been this low since the World War II mobilization.

Fischer stepped out of normal central bankerly discretion to endorse raising rates to prick an asset bubble, a controversial position in the trade. While he thought macro-prudential tools might be appropriate—capital requirements, or restrictions on loan-to-value ratios—the Fed doesn’t have the freedom to wield such tools that its foreign counterparts have. So, “if asset prices across the economy…are thought to be excessively high, raising the interest rate may be the appropriate step,” he concluded. One awaits the declassification of FOMC transcripts to see what Fischer is saying behind those big wooden doors—and how his colleagues are reacting.

Although Fischer said in the speech that r* was likely to stay low “for the policy-relevant future,” he disclosed on Wednesday that the markets are wrong if they’re only expecting two rate hikes this year. Of course, four quarter-point hikes would amount to just a single percentage point, which isn’t all that far from zero.