Must-Read: Nick Rowe: Suppose the Bank of Canada targets 2% inflation…
Must-Read: More intellectual garbage pickup by the learned Nick Rowe on the stability of expectational equilibria in monetary economics. It’s a dirty job, and I’m glad he’s doing it rather than me. Me? I think this “literature” should never have started, because it requires ignoring that central banks issue not just forward guidance as to interest rates but an entire macroeconomic forecast including money-supply and monetary-base measures. So asking the question of what happens in a model in which the interest rate path is the only piece of information ever revealed by the central bank is rather… stupid…
: “Suppose the Bank of Canada targets 2% inflation, using a nominal interest rate instrument…
…Suppose the economy is humming along in full rational expectations equilibrium, with inflation at 2%, nominal interest rate at 3%, and nobody expects it to change. Now suppose the Bank of Canada suddenly and unexpectedly raises the interest rate to 4%…. Eventually the Bank of Canada’s memo gets published on the web. Here are four possible memos explaining why the Bank did what it did: 1) “Our new information/model shows demand is going to be much stronger than our old information/model says it was, and we need to raise real interest rates to prevent inflation rising above the 2% target.” 2) “We decided to increase the inflation target from 2% to 3%, figured expected inflation would rise very quickly to the new target, and didn’t want real interest rates to drop.” 3) “We’ve turned Swedish, and decided to raise the overnight rate to reduce asset prices, even if it means inflation drops below the 2% target temporarily.” 4) “The person responsible has been fired, and normal monetary policy will resume shortly.”
We are not going to get the same response across all 4 cases…. In Canada today, memo 1 is most plausible, but we can’t rule out memo 3 (or even memo 4)…. Neo-Fisherians… don’t mention memos at all, but are… assuming… memo 2. [But] what happens if memo 2 is in fact published on the web, but some people don’t get the memo?… And the people who did get the memo know that some fraction of the population won’t have got the memo, and will assume it’s memo 1?… The people who didn’t get the memo are going to cut their own spending (figuring someone else will spend more to make up for it and keep inflation on target). The people who did get the memo are going to figure out that the people who didn’t get the memo are going to cut their spending, and that nobody else will make up for it, so that demand will drop, and so output and inflation will drop. We can’t get the Neo-Fisherian result unless everyone gets the memo, and interprets the Bank of Canada’s action the same way. Ain’t gonna happen…