Scott Sumner, Tony Yates and Warren Mosler on Expectations

     Recently, Sumner and Yates had a debate on expectations. Sumner argues for the idea that monetary policy works with 'long and variable leads'-in contradiction to virtually all received economic theory-not least, of course, Milton Friedman.

    "Suppose you think of monetary policy in the way most people do—as open market operations that change the money supply.  In that case, there may actually be LEADS in monetary policy, i.e. the effect may occur before the cause.  A future money supply change may cause a current change in demand and output."

    "Those who are philosophically inclined may be a bit uncomfortable with the thought of effects occurring before causes.  “Wait” (I can just hear you saying) “it isn’t the future money supply change that causes a current change in spending, it is the CURRENT EXPECTATION of a change in future monetary policy, and future AD.”  OK, I’m willing to go along with that.  We should not describe changes in monetary policy in terms of current changes in the money supply, but rather expected future changes in the money supply.  And of course we also know that it isn’t just the money supply that matters, velocity is equally important.  So what really matters is changes in the expected future level of M*V, or NGDP.  It is changes in expected future NGDP that best characterizes changes in monetary policy, at least if we don’t want effects to occur before causes.  Of course that’s exactly what I have been arguing in my blog for 18 months."

   "And by the way, if we define monetary policy changes in terms of changes in expected future M*V (as we should), and if the fiscal multiplier is estimated under the assumption that monetary policy is held constant, then it is a truism that the expected fiscal multiplier is always precisely zero."

    http://www.themoneyillusion.com/?p=28775

   Tony Yates is not buying it:

   "Backing up, I don’t accept, of course, the premise of this line of thinking at all, that monetary and fiscal policy are perfect substitutes, and therefore that the former can be dispensed with.  But it’s worth bearing in mind that the logic gone through here works for fiscal policy too, both in the models, and in those attempts to identify shocks to fiscal policy today and in the future."

    "Sumner cites Woodford and Krugman as commenting on the potency of expectations, and uses this in support of his thesis that changing expectations changing things refutes the long and variable lags thesis.  But I am quite sure neither of them believe any such thing.  Estimated versions of Woodford’s model (for example, the original Rotemberg-Woodford model) behave just like my account above.  And Krugman is a firm believer in sticky prices, talking interchangeably between IS/LM and New Keynesian models.  Which behave just as I’ve explained above."

     "The only model I know where monetary policy has its entire effect instantaneously is the flexible price rational expectations monetary model.  And in this case there is no point in monetary stabilisation policy at all.  Money has no short-run effects on output.  Optimal policy in this model is to set rates at zero permanently, obeying the Friedman Rule.  If there are real frictions in this model, like financial frictions, there will still be a role for fiscal stabilisation, however."

     "I’m sure these mix-ups would get ironed out if MaMos stopped blogging and chucking words about, and got down to building and simulating quantitative models.  Talking of which…."

     https://longandvariable.wordpress.com/2015/02/27/market-monetarists-and-the-myth-of-long-and-variable-lags/

     Sumner, of course, got back to him:

     "In my view economists should forget about “building and simulating quantitative models” of the macroeconomy, which are then used for policy determination. Instead we need to encourage the government to create and subsidize trading in NGDP futures markets (more precisely prediction markets) and then use 12-month forward NGDP futures prices as the indicator of the stance of policy, and even better the intermediate target of policy.  It’s a scandal that these markets have not been created and subsidized, and it’s a scandal that the famous macroeconomists out there have not loudly insisted that it needs to be done."

    "If and when we get out of the Stone Age and have highly liquid NGDP and RGDP futures markets, then it would be much easier to explain my views on leads and lags. In that world a change in NGDP futures prices, not a change in the fed funds rate, represents a change in monetary policy. To be more specific:

     "I predict that whenever the 12-month forward NGDP futures prices starts falling significantly, near term NGDP would fall at about the same time, or soon after.  For instance, if we had had a NGDP futures market in 2008, then during the second half of the year you would have seen a sharp fall in 12 month forward NGDP futures.  At roughly the same time or soon afterwards current NGDP would have been falling. In contrast, if the Fed had moved aggressively enough to prevent 12-month forward NGDP prices from falling, then near term NGDP in late 2008 would have been far more stable.  I think that’s roughly consistent with Woodford’s view, although we may differ slightly on the lag between a change in 12-month forward NGDP expectations and a change in actual NGDP.  (Nor would he necessarily accept my views on the potency of monetary policy in 2008.)"

     http://www.themoneyillusion.com/?p=28775

     So the proof about long and variable leads would be apparent if we had a NGDP futures market? Would this market be one with Sumner's Rational Expectations? Yates seems even less impressed:

    "Scott Sumner replies on The Money Illusion here, including some priceless phrases about how his research found that there were in fact, no lags at all between monetary policy changes and their effects, and some other collectibles about there not being a NGDP futures market."

   So we have the libertarian Scott Sumner demanding the government come up with the NGDP futures market the market itself seems totally uninterested in. 

    Meanwhile. even his benefactor, Kevin Duda, admits that he has no idea of such a futures market would work. The knock on it by Mark Sanowski, et al. is that such a market would be too easy to game and that the data would be too noisy. 

    I asked a skeptical commentator at Money Illusion once why the futures market couldn't work as TIPs are a successful market. Here was 'Dervis'' answer:

   "TIPS are not “pegged”

  "Also, The transaction in any other future that I can think of (and I’ve traded most of them), does not result in creating an offsetting (if not greater) opposing transaction. i.e, If I sell a normal future, I know I am weakening a market and benefiting my initial position. Even if I do not sell the entire volume I desired to sell (the market moves away from me), it results in me being P+L positive on my initial transaction. As designed, a sale of an NGDP future results in my actually driving the market right into my face (sale of 1 creates 1,000 opposing me). If I am early, anyone else that sees what I saw (normally would be a benefit to me), again no longer benefits me, as their transactions also pushes the market back to the peg price, without me benefiting."

  "The final point of waiting to trade at the last minute, is essentially the same as if you asked me to early exercise an option with extrinsic value less than carrying cost."

 "With a gun to my head, I ask you to pull the trigger before I ever exercise an option inefficiently. Hell, I’d pull the trigger for you."

   http://www.themoneyillusion.com/?p=28674

   As someone who has traded options on equities I think I know what he means 

   For more on Sanowski's critique of NGDP futures see here. 

   http://diaryofarepublicanhater.blogspot.com/2012/07/now-its-scott-sumner-vs-mike-sanowski.html

   Sanwoski does say that he prefers an NGDP target to our current dual mandate whether the futures market would work or not-I've argued this myself. 

    http://monetaryrealism.com/why-500bn-and-not-500-quadrillion-i-bothered-to-do-the-math/

    As usual in that back and forth, Sumner didn't accept Sanowski as making friendly criticism but took hm as one of the bad guys-a 'hostile Keynesian.'

   One thing I'm glad to hear from Scott regarding Yate's post:

   "The post also speculates on my views on fiscal policy.  Just to be clear, I oppose attempts to force a balanced budget."

    http://www.themoneyillusion.com/?p=28775

    Ok, now Mosler. He criticizes the entire mainstream focus on expectations. 

    "But what we have is a government that doesn’t understand its own monetary operations, so, in America, the seven deadly innocent frauds rule. Our leaders think they need to tax to get the dollars to spend, and what they don’t tax they have to borrow from the likes of China and stick our children with the tab. And they think they have to pay market prices. So from there the policy becomes one of not letting the economy get too good, not letting unemployment get too low, or else we risk a sudden hyperinflation like the Weimar Republic in Germany 100 years or so ago. Sad but true. So today, we sit with unemployment pushing 20% if you count people who can’t find full-time work, maybe 1/3 of our productive capacity going idle, and with a bit of very modest GDP growth - barely enough to keep unemployment from going up. And no one in Washington thinks it’s unreasonable for the Fed to be on guard over inflation and ready to hike rates to keep things from overheating (not that rate hikes do that, but that’s another story)."

     "And what is the mainstream theory about inflation? It’s called “expectations theory.” For all but a few of us, inflation is caused entirely by rising inflation expectations. It works this way: when people think there is going to be inflation, they demand pay increases and rush out to buy things before the price goes up. And that’s what causes inflation. What’s called a “falling output gap,” which means falling unemployment for all practical purposes, is what causes inflation expectations to rise. And foreign monopolists hiking oil prices can make inflation expectations rise, as can people getting scared over budget deficits, or getting scared by the Fed getting scared. So the job of the Fed regarding inflation control becomes managing inflation expectations. That’s why with every Fed speech there’s a section about how they are working hard to control inflation, and how important that is. They also believe that the direction of the economy is dependent on expectations, so they will always forecast “modest growth” or better, which they believe helps to cause that outcome. And they will never publicly forecast a collapse, because they believe that that could cause a collapse all by itself."

    "So for me, our biggest inflation risk now, as in the 1970’s, is energy prices (particularly gasoline). Inflation will come through the cost side, from a price-setting group of producers, and not from market forces or excess demand. Strictly speaking, it’s a relative value story and not an inflation story, at least initially, which then becomes an inflation story as the higher imported costs work their way through our price structure with government doing more than its share of paying those higher prices and thereby redefining its currency downward in the process."

   This is an area where he-and any heterodox economic thinker-is outside the mainstream to the extent they believe that the primary cause of the 70s inflation was oil prices and not demand side. 

    Well we've seen energy prices fall hard since June, 2014 so I guess according to him there's no need for worry-and true enough, we scarcely have any inflation at all now and many more mainstream economists including those in policy circles and at CBs are concerned that inflation is too low. .