The recent post on a better liquidity trap noted Michael Woodford’s claim of elite stabilization power, especially in circumstances of extreme instability, for central-bank forward guidance. That message was delivered in his August 2012 talk at the Fed’s annual Jackson Hole symposium. Given that policymakers pay attention to Woodford, this week’s blog looks more closely at his assertion.
Woodford argued that, in the circumstances of zero-bound interest rates, both theory and evidence indicate that forward guidance provides relatively powerful stimulus. He believes it to be, for example, more effective than quantitative-easing. He is wrong. In the familiar story, his badly off-base conclusion results from relying on the coherent friction-adjusted dynamic stochastic general-market-equilibrium theory that has dominated mainstream macro thinking for decades.
Forward guidance. GEM scholars understand that Woodford’s debilitating problem in designing effective stabilization policy is that mainstream modeling, which he has significantly influenced, cannot coherently accommodate meaningful wage rigidity (MWR). It follows that interest-rate and inflation expectations exert, by default, dominating influences on investment spending, asset prices, and wages. It also follows that MWR existence that GEM modeling has derived from axiomatic preferences and technology substantially reduces the potency of Woodford’s forward-looking decisionmaking. Pure-profit expectations now dominate investment spending and asset pricing, with interest rates receding to a weak secondary status. Moreover, inflation catch-up dominates rational inflation expectations in periodic labor price adjustments in large, specialized establishments. (Chapters 4 and 6)
Woodford appears to be unaware of the centrality of an assumption implicitly used in his forward-guidance argument: the robust credibility of the Fed’s trend real-side (employment) objective, which is denoted by Ƈ in the GEM Project. (Chapters 6 and 10) That assumption, needed to make central-bank guidance effective, suppresses the powerful instability mechanics that generated the Great Recession. Woodford’s central bank is looking for how best to shape investor/lender expectations of what its policy, given the unfolding circumstances, will be. He believes that in a cyclical economy such well-informed decision-making will take advantage of lower interest rates and greatly help stabilize total spending.
In the GEM Project, however, agents confront a more complex array of choices. In circumstances of acute instability, the central bank’s trend real-side credibility is no longer given. Investor/lender concern about Ƈ, and therefore the immediate macro future, is rooted in uncertainty about the FOMC’s capacity and will to reverse collapsing nominal aggregate demand. Uncertain Ƈ induces rational investors/lender inaction, resulting in free-falling asset prices and destabilizing total-spending feedback. Prospects of depression are no longer trivial. (Chapter 6 and Annable and Schechter. “Modeling Extreme Instability”)
In Woodford’s world, the central Fed task is making sure that its communiqués fully capture its own forward-looking expectations and circumstance-specific stabilization strategy. In the GEM world, the central bank’s critical stabilization task is more fulsome: continually strengthening its demand-management toolkit, while broadly and effectively explaining those tools’ potency as well as the FOMC’s unshakable commitment to use them, quickly and in size, in future episodes of episodes of extreme instability. It is the real-side counterpart to the concerted post-stagflation effort, which Woodford helped design, of central banks to establish their low-inflation bona fides. Mainstream theorists need to recognize that maintenance of robust investor/lender Ƈ through the Lehman upheaval and beyond would have sharply reduced the 2008-09 welfare loss that resulted from the residential real-estate bubble and fraudulent subprime lending.
Quantitative easing. At Jackson Hole, Woodford was very skeptical of QE policies. Given that interest rates are always the policy focus in mainstream macro thinking, he framed QE as concentrating on unusual financial-market interventions (necessitated by zero-bound short rates) to reduce the real cost of capital, such as announcing a temporary increase in the inflation target. (Chapter 10)
In the GEM Project, QE is more broadly understood as the aggressive use of the Fed’s balance sheet to halt and reverse collapsing total spending. Taking guidance from his historian’s grasp of acute-instability mechanics during the Great Depression (Chapter 6), Bernanke’s determination to be the buyer/guarantor of last resort in frozen markets helped establish credible bottoms in asset markets, luring inactive investors and lenders back from the sidelines. The implicit policy focus was on Ƈ. Managing the zero-bound interest-rate environment to further reduce the real cost of capital played no significant role in the Fed’s successful campaign to save the economy from a devastating depression.
Final word. In an interview conducted by Clement (2014, p.16), Woodford described the December 2012 FOMC adoption of policy-change thresholds for unemployment and inflation as “a step in [my] direction. Not only was it an attempt to shape expectations by making official statements about future policy, but it was in line with what I had been arguing for in at least one important respect, which is that it was saying something about criteria for making future decisions as opposed to trying to announce the future policy settings themselves in advance.” I have no problem with Woodford’s pleasure that his advice is being listened to. But I caution the rest of us to understand that his advice is not all that important, especially with respect the difficult, critical policymaking issue of avoiding future Great Recessions. The GEM Project demonstrates that effectively preventing episodes of extreme instability requires robust investor/lender belief in the credibility of the trend real-side (high employment) objective of stabilization authorities. Woodford’s suggestions on forward guidance play at best a minor role in constructing robust Ƈ. His Jackson-Hole recommendations cannot inform a stand-alone solution.
Blog Type: New Keynesian Saint Joseph, Michigan