Tag: Narayana Kocherlakota

Must-read: Narayana Kocherlakota: “It’s Time to Make a Hard U-Turn”

Posted on by Brad DeLong

Must-Read: Narayana Kocherlakota: It’s Time to Make a Hard U-Turn.: “Market-based measures of long-term inflation compensation…

…have fallen persistently and dramatically since mid-2014. This decline means that the Federal Open Market Committee (FOMC)  is confronting a significant risk to its credibility. It must act aggressively in the near-term to eliminate this risk. 

It is true that there are two possible explanations for this decline in market-based measures of long-term compensation. The first explanation is that should be viewed as a transitory phenomenon, due to some mysterious (to me) interaction between the market for inflation-protected TIPS bonds and declining oil prices. The second is that the decline means that market participants believe that the FOMC will be unable or unwilling to keep inflation as high as 2% on a sustainable basis.  This interpretation seems a lot less mysterious to me, since the FOMC continues to tighten policy in the adverse of severe disinflationary headwinds (associated in part with the decline in oil prices). 

There’s no easy way to tell these stories apart in the data.  But this challenge is irrelevant for policymakers.  The first story simply tells policymakers to ignore the decline in longer-term breakevens. Because the first story makes no specific policy recommendation, policymakers can simply ignore the possibility that it is true.  (Things would be different if, for example, the first story argued in favor of tighter monetary policy.)

In contrast, as long we put the slightest weight on the second story of declining credibility being true, it matters considerably for policy.  The FOMC’s tightening cycle is systematically lowering longer-term inflation expectations generally, and especially during future recessions.   The erosion of credibility means that real interest rates will be higher whenever the Fed is at the zero lower bound in the future – and that means lower employment and prices in those times.  (You can start to see the potential for a self-fulfilling trap that has so many so concerned.)

All central bankers agree that, without anchored inflation expectations, a central bank cannot be effective at achieving its price and employment objectives.   That’s why the main mission of a central bank is to keep inflation expectations well-anchored.  The evidence continues to mount that the FOMC is failing at this task. The Committee needs to confront this significant credibility threat by reversing its tightening cycle quickly and decisively.

Graph 5 Year 5 Year Forward Inflation Expectation Rate FRED St Louis Fed

Must-read: Nick Rowe: “Neo-Fisherian Equilibrium with Upper and Lower bounds”

Posted on by Brad DeLong

Must-Read: At least this has produced some useful work in how to teach the ignorant today things about convergence to equilibrium that Frank Fisher, Tom Sargent, and many others knew very well back at the end of the 1970s:

Nick Rowe: Neo-Fisherian Equilibrium with Upper and Lower bounds: “Naryana [Kocherlakota]… [thinks] models should have relatively robust predictions….

If what happens in the limit is totally different from what happens at the limit, we have a problem…. If each boy racer had wanted to drive at 90% of the average speed, we get exactly the same Nash equilibrium, where they all drive at 0km/hr and stay in Ottawa, only now it’s a ‘stable’ equilibrium. We do not get multiple equilibria by adding an upper (or negative lower) bound to their speed. Any plausible equilibrium should be like that; it should be robust to minor changes in the boundary conditions. But if each boy racer wants to drive at 110% of the average speed, so driving at 0km/hr becomes an unstable equilibrium, adding boundary conditions creates new equilibria that are more plausible than the original unstable equilibrium, simply because they are stable….

We can see what Narayana is doing, when he considers a finite horizon version of the same game, as being like adding boundary conditions. If the game’s equilibrium is very fragile when you add or subtract or change those boundary conditions, there is something wrong with that equilibrium. We ought to get the same results in the limit as at the limit. If we don’t, we have a problem. Something like the Howitt/Taylor principle (or controlling a monetary aggregate or NGDP rather than a nominal interest rate) can convert an unstable equilibrium into a stable one.

Must-read: Narayana Kocherlakota: “Information in Inflation Breakevens about Fed Credibility”

Posted on by Brad DeLong
Graph 5 Year 5 Year Forward Inflation Expectation Rate FRED St Louis Fed

Must-Read: Narayana Kocherlakota: Information in Inflation Breakevens about Fed Credibility: “The ten-year breakeven refers to the difference in yields between a standard (nominal) 10-year Treasury and an inflation-protected 10-year Treasury (called TIPS)…

…The five-year breakeven is the same thing, except that it’s over five years…. The five-year five-year forward breakeven is defined to be the difference between the 10-year breakeven and the five-year breakeven… shaped by beliefs about inflation over a five year horizon that starts five years from now… conceptually… the sum of… 1. investors’ best forecast about what inflation will average 5 to 10 years from now, [and] 2. the inflation risk premium over a horizon five to ten years from now…. My own assessment is that both components have declined. But my main point will be a decline in either component is a troubling signal about FOMC credibility.  

It is well-understood why a decline in the first component should be seen as problematic for FOMC credibility. The FOMC has pledged to deliver 2% inflation over the long run…. A decline in the first component of breakevens signals a decline in this form of credibility…. A decline in the inflation risk premium means that investors… increasingly see standard Treasuries as being a better hedge…. But Treasuries are only a better hedge than TIPs against macroeconomic risk if inflation turns out to be low when economic activity turns out to be low…. [Thus] a decline in the inflation risk premium… reflects investors’ assigning increasing probability to a scenario in which inflation is low over an extended period at the same time that employment is low….

In the world of policymaking, no signal comes without noise.  But the risks for monetary policymakers associated with a slippage in the inflation anchor are considerable.   Given these risks, I do believe that it would be wise for the Committee to be responsive to the ongoing decline in inflation breakevens by reversing course on its current tightening path.

Question: Neel Kashkari to Replace Narayana Kocherlakota at the Minneapolis Fed?

Posted on by Brad DeLong

Can somebody remind me: where was Neel Kashkari in September 2008 on letting Lehman go into uncontrolled bankruptcy?