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Influencing the zeitgeist with a long and variable lag

Summary:
Jay Powell was asked about long and variable lags in monetary policy, and his answer caught my eye: You know, the question of long and variable lags is an interesting one. That’s Milton Friedman’s famous statement. And I do think that in this world where everything is — or the global financial connect— markets are connected together, financial conditions can change very quickly. And my own sense is that they get into — financial conditions affect the economy fairly rapidly, longer than the traditional thought of, you know, a year or 18 months. Shorter than that, rather. But in addition, when we communicate about what we’re going to do, the markets move immediately to that. So, financial conditions are changing to reflect, you know, the forecasts that we made and —

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Jay Powell was asked about long and variable lags in monetary policy, and his answer caught my eye:

You know, the question of long and variable lags is an interesting one. That’s Milton Friedman’s famous statement. And I do think that in this world where everything is — or the global financial connect
— markets are connected together, financial conditions can change very quickly. And my own sense is that they get into — financial conditions affect the economy fairly rapidly, longer than the traditional thought of, you know, a year or 18 months. Shorter than that, rather. But in addition, when we communicate about what we’re going to do, the markets move immediately to that. So, financial conditions are changing to reflect, you know, the forecasts that we made and — basically, which was, I think, fairly in line with what markets were expecting. But financial conditions don’t wait to change until things actually happen. They change on the expectation of things happening. So, I don’t think it’s a question of having to wait.

Matt Yglesias made the following comments, just five days prior to the Powell press conference:

But one problem with this view is that empirically when the Fed cuts its target interest raise or announces some new QE, bond yields sometimes go up rather than down.

One way to deal with this is to invoke Milton Friedman’s idea that monetary policy operates with “long and variable lags,” so you shouldn’t expect any immediate operation of the hydraulic mechanism. The long part could make sense, but long and variable suggests a flight away from inquiry and toward a kind of superstition. “Long and variable” means there is no empirical test of whether or not the mechanism is working. It takes time to operate, and there’s no way of knowing in advance how much time.

And I think it ultimately makes more sense to think of the whole thing as mostly a conjuring trick. A QE announcement can make rates go up because it is creating expectations of faster nominal growth in the future.

The really important thing, though, is that the bond market is not the only financial market. If traders all raise their expectations of nominal growth, the price of commodities and of stock shares will also rise. This generates wealth effects that can fuel spending. It also directly encourages investment in producing commodities and indirectly encourages investment in startups and tangible business equipment.

Now there are lags here, but they are lags in the sense that financial investments (the price of copper going up) happen faster than physical investments (because copper is more expensive now, the copper mines increase production). But the proximate mechanism is essentially instantaneous. If your goal in an inflationary environment is to reduce expectations of future nominal growth, then you can tell more or less immediately whether or not that happened by looking at financial markets. And critically, while doing things can and does influence expectations, so does talking about doing things.

I like that “superstition” remark. The final paragraph echoes the “no wait and see” point I used to make about policy initiatives.

PS. I hope Yglesias will forgive me if this unusually long quotation violates copyright rules, but I’m actually trying to send business his way. Powell already seems to be a subscriber.

PPS. When Abe took office at the beginning of 2013, Japan switched to easier money and tighter fiscal policy. A similar shift took place in the US at about the same time. NGDP growth sped up in both countries, clearly signaling that monetary policy is more powerful than fiscal policy. But The Economist has a new article out claiming that the lesson of the 2010s is that fiscal policy is more powerful than monetary policy.

Sometimes I feel like I’m just beating my head against the wall.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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