Monday Smackdown Watch: Robert Waldmann Defends Janet Yellen from Brad DeLong

Robert Waldmann: In Which I try to Defend Janet Yellen from Brad DeLong: “Fed Chair Janet Yellen said, among other things:

For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy. To support taking this step, however, I will need to see continued improvement in labor market conditions, and I will need to be reasonably confident that inflation will move back to 2 percent over the medium term. After we begin raising the federal funds rate, I anticipate that the pace of normalization is likely to be gradual. The various headwinds that are still restraining the economy…

The news is that “some point this year” means “not next month” A possible increase in June 2015 used to be discussed a lot.

Brad DeLong argues that raising rates “sometime this year” would be crazy… the speech includes no consideration of the risk of hitting the zero lower bound due to a shock after raising rates…. I’m going to go to a long boring comment. The main point, if any, is that a speech describing a sub-optimal plan for interest rates (as a function of future information) may be an optimal speech. But I also type about optimal control (both of us are trying to do math in our heads using plain English). I want to stress here that I think Brad is making a very important very valid point….

This is a public speech. I have a story for why she thinks it was optimal. It goes as follows:

1. Remember how the markets freaked out when we said we would taper QE3 ? We promised we weren’t going to raise the target federal funds rate and federal funds futures freaked fiercely. It is clear that lots of investors are just waiting for us to turn back into normal central bankers all of a sudden.

2. Sooner or later, we will have to raise the federal funds rate. There is a risk that investors will assume that we are going to turn into Trichet. This would be very bad. So we have to start now saying it won’t be a huge deal when we raise the target a bit.

I think she is saying: We aren’t going to do anything dramatic and scary. Don’t be scared by anything we do. Don’t panic.

It seems to me to be optimal control to say that. The instrument I am discussing is the speech not the federal funds rate.

Second there is the goal of also proving that she is not a raging reincarnation of Rudolf Havenstein. Repeated statements that even discussing raising rates is insane are accurate, but would infuriate powerful people. It is useful for Yellen to Clinton and say “I feel your desire to inflict pain.”

Third I don’t see why the rate increase is large when, finally, an increase is optimal…. Say the month of Austember is the one when it should raise the rate, In constrast during Stimember (the month before Austember) the target FF rate should be 0-0.25% . There must be two such months if 100% inflation is not optimal. From Stimember to Austember the only change is an 0.1% increase in the core inflation rate. This can have only a small effect on the marginal cost of inflation (which I consider trivial at 4% inflation) and also only a small effect on the expected present discounted cost of the future ZLB (being the value of the option to set interest rates below zero which we wish we had). All has changed little so the optimal federal funds rate can’t be high…. How can it be sensible to raise it to 1%?

It doesn’t jump: but when you have a steadily-improving economy then, relative to the no-ZLB bound, optimal control tells you to move late, and then move fast so that you coverage to the no-ZLB rate as the chance of hitting the ZLB again drops from high to near-zero: