Monetary Policy's Jurassic Park Problem at the Zero Lower Bound

May 3, 2013Mike Konczal

Remember those scenes in Jurassic Park where everyone has to stand really still? The T-Rex finds the humans, but its dinosaur brain only senses movements, so as long as nobody moves an inch, they are safe. But if they even twitch, they are going to be ripped to shreds. Those scenes are great.

Last weekend, I wrote a piece for Wonkblog on monetary policy at the zero lower bound alongside austerity that got a great number of responses [1]. I want to respond to two points.

1. One thing I wanted to engage on, and a point I hope gets some additional comments in 2013, is that we had a major shift in “expectations” management at the zero lower bound with the Evans Rule. I think that this form of expectation management is a trial run for more serious moves like using a higher inflation target or a nominal GDP target to gain traction at the zero lower bound. So how has it gone, and how would we know?

I had thought a good measure of its success was whether short-term inflation would approach its 2 percent target, and whether or not it would go past. Other people, notably Matt O’Brien, had already flagged that 2 percent appeared to be a ceiling even with the Evans Rule in place.

Some seem to be abandoning the Evans framework entirely, such as Ryan Avent writing this week that “the Evans rule is consistent with prolonged, Japanese style stagnation.” [2] Others argue that a consistent nominal GDP with austerity is sufficient evidence to show that the Evans Rule worked.

I think this needs more exploration. We don’t often get a serious shift in expectations. That’s why I’m not sure how much the “gas pedal” from David Becksworth’s response is at play. Becksworth notes that the purchases in QE3 don’t automatically react to turbulence in the economy, and hopes that the Federal Reserve will buy more if the economy gets weaker. But if the expectations of where the Fed wants to end up are the real limiting factor for a robust recovery, why would a small change in purchases matter? This is partially why Greg Ip said the FOMC statement this week was “asymmetric,” even though the Fed said it might “increase or reduce” purchases: an increase is a small move, but a reduction is a genuine retrenchment.

2. Another point is that expectations are important. I want to push back on Ryan Avent implying I “knew what conclusions were going to be drawn before the experiment was ever run.” I actually turned more negative about the December announcement while researching the post. I spoke to several economists who supported the Evans Rule at the time to see where they stood months later. I heard from many that they were excited about the proposal at first, but that they thought the policy was undermined significantly by FOMC members’ comments in March.

What happened in March? As the Washington Post’s Ylan Q. Mui wrote in March, the Fed seemed split into two camps: “Hawks, who want to curtail quantitative easing programs because of the risks they create. And doves, who see evidence that they’re working well enough at stimulating growth that they might soon no longer be needed.” The Fed’s March minutes noted “that continued solid improvement in the outlook for the labor market could prompt the Committee to slow the pace of purchases beginning at some point over the next several meetings." Several economists I spoke with thought that this hurt the expansionary impact of monetary policy.

Watch this again in slow-motion: Aggressive monetary policy begins to expand the economy, or at least gives the impression the economy is expanding. Central bankers argue that this means that they can pull back quicker than expected. (They don’t pull back; they just say they will.) The expectations for future policy then collapse, because central bankers signal that it will end too soon. The economy then weakens, going back to where it started.

This is monetary policy in the style of those T-Rex scenes in Jurassic Park. The central bank says, “we are committing to extraordinary action,” and then everyone has to remain incredibly still for a long time. Just a random dovish member of the FOMC saying, “hey, maybe it’s working so well we should consider ending it early” is enough for dinosaurs to eat everyone the policy’s effectiveness in impacting expectations to collapse.

If you believe this is a serious problem for monetary policy, well, this is precisely the time inconsistency problem Krugman identified in the late 1990s for Japan. The neutrality of money will cause an expansion to push up either prices or output, provided markets believe that it is permanent and that the central bank won’t immediately rush to stabilize prices the moment it gets a chance. And if the comments in March show that central banks aren’t going to “credibly promise to be irresponsible” with the Evans Rule, how will they do it with 4 percent inflation?

Note that four months after the stimulus was passed, no Democrats would stand up and defend it. Yet the stimulus was carried out without a problem. Four months after the Evans Rule, it looked like Bernanke’s coalition was weakening, and that has major implications. The Wonkblog piece I wrote notes that the next step will have to be an explicit, permanent, new target. That would get around these issues about how permanent the monetary expansion will be. But if there’s barely enough support for the Evans Rule, it makes me worried we won’t get there anytime soon.

[1] Responses include: Scott Sumner, Matt Yglesias, Paul Krugman, Reihan Salam, Ryan Avent, David Becksworth, Uneasy Money, Ramesh Ponnuru, southofthe49th, as well as a communist anarchist critique at pogoprinciple which notes that my “post-Fordist national fascist state fiscal policy” is exhausted. And that while “Keynesians are playing checkers, the monetarists are playing three dimensional chess.” Hmmm.

[2] If the Evans Rule was a bust from the get-go, was all that 2012 energy put into trying to find clever ways of explaining “Delphic” versus “Odyssean” guidance language to a general audience a waste of time? Boo.

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