New Keynesians, Equations for a Conservatively Minded Central Banker and the Evans Rule

Ryan Avent laments the failure of government and Ben Bernanke forgetting what he knew about the Great Depression.  Tim Duy reads the Bernanke of 2003 and is even more depressed.  Having spent a day rereading some New Keynesian classics, I’m starting to get surprised by people being surprised.  So much energy over the past 30 years has been put on the idea that the central bank needs to be structurally conservative and always prioritize inflation-fighting.  As friend of the blog Andrew Bossie recently wrote, “Isn’t Ben Bernanke what the New Keynesians want?”

At this point there’s a pretty substantial critique of “Dark Ages” macroeconomics.  But there’s another critique that bubbles up from time to time among lefty economics bloggers and that’s how the New Keynesians, or those who would carry the light in the dark times, essentially left themselves unprepared to deal with a Great Depression-style event.

Take Kenneth Rogoff.  Rogoff is wondering why the Federal Reserve is too conservative and won’t tolerate going over the inflation target to help with the recovery and is trying to convince people otherwise.  But one of the first times I had encountered Rogoff’s work back as a graduate student was his classic 1985 paper that opens with the all-you-need-to-know statement: “Society can sometimes make itself better off by appointing a central banker who does not share the social objective function, but instead places ‘too large’ a weight on inflation-rate stabilization relative to employment stabilization.”  Sounds like right now, doesn’t it?

That individuals, institutional structures, rewards and the zones of acceptable discussion and policy would all focus on finding ways to emphasize inflation-fighting at the expense of employment and output is a key feature of the New Keynesian literature, from works like that through the big summaries and statements like 1999’s The Science of Monetary Policy: A New Keynesian Perspective.  This isn’t the dark ages economics.  Even for those who were trying to carry the light in dark economic theory times, a lot of energy was spent trying to figure out how to condition a central banker to be like a fire chief who hesitates in using the hose to put out a fire raging in an orphanage, lest some of the children drown.

I got to thinking about the 1985 paper as a result of Chicago Federal Reserve President Charles Evan’s speech The Fed’s Dual Mandate Responsibilities and Challenges Facing U.S. Monetary Policy (the speech really is that good, read it!).  Krugman quoted the following from the speech: “Imagine that inflation was running at 5 percent against our inflation objective of 2 percent. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market.”

It is important to understand what that means.  It isn’t just shorthand or a guess, there’s a series of equations with values and assumptions in them that we should unpack.  Look at this equation from the Science paper, which is a statement of  the goal of a central bank:

Evans uses a version of this equation in his paper.  Let’s rewrite that slightly more in line with how Evans uses it and then translate it to a general audience:

The Federal Reserve wants to balance between its inflation target and stabilizing output. Rogoff argued that, since we need a conservative, hawkish Federal Reserve, the λ variable needs to be added as a balance between the two goals.  It should be less than one, because as a result of an asymmetry of the two goals we need a Federal Reserve chairman who is more worried about inflation than output.

Evan then notes that it is “reasonably conservative to set λ equal to ¼” and that “Okun’s Law…says that a 1 percentage point gap between actual and potential output corresponds to a one half percentage point gap between unemployment and its natural rate.”  Turning from output to employment – remember the Fed’s mandate is employment – gives us a four on the outside (2 squared).

As Evans notes, since a conservative sets λ equal to ¼, and since 4*(1/4) is one, “we see that the conservative central banker attempts to minimize the equally weighted sum of squared inflation and unemployment deviations.”

So putting in some numbers, a 9% unemployment rate with a very high natural unemployment rate of 6% plus inflation checked is a loss of 9 ([2-2]^2 + [9-6]^2).  A 5% inflation rate with unemployment checked is a loss of 9 as well ([5-2]^2+[6-6]^2).

So when people say that our employment situation is as bad as if inflation was running at 5% they are looking at it from the point of view of a very conservative central banker who cares less about employment than inflation.  If you see the situation as I do, with a u* near 5 and a u near 10, as well as an actual need to penalize the central banker for bringing in too low inflation, then the score is even higher.

So what gives?  We can understand the FOMC dissenters in line with this equation.  If the Federal Reserve is even more conservative than a 0.25 value for λ, say if their value was arbitrarily near zero, then we can understand how they only care about inflation.  Another is that if you believe that the “natural rate” of unemployment, u*, is 9%, then there’s no problem to solve.  There’s evidence that the Fed dissenters believe these thoughts.  Another problem is if you see coming in under the inflation target as an opportunity to lock in disinflation rather than a problem for employment that you have an obligation to solve, then this equation doesn’t even make sense.  Here’s what locking in disinflation while U.S. wages stagnate looks like:

The fact that we have a dual mandate for the Federal Reserve isn’t a trivial matter.  And surveying the discourse amidst the Lesser Depression in this way calls even more forcefully for something like the Evans rule: the Federal Reserve should simply agree to keep interest rates at zero and tolerate 3 percent average inflation until unemployment is down to 7 percent.

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5 Responses to New Keynesians, Equations for a Conservatively Minded Central Banker and the Evans Rule

  1. Ken Houghton says:

    “This isn’t the dark ages economics.”

    To the contrary, NeoClassical and NeoKeynesian (Neo, in both cases meaning, “We want to forget that group) are exactly the Dark Ages–from the Greek (Classical) and Roman (Keynesian, or really Marshallian) Eras to a period of deliberate eschewing of Reason and Logic for the sake of a Higher Power (Rational Expectations; MicroFoundations as all there is).

    The only question is what will come next, and which Arabs, Indians, or Chinese will develop the system that gets us moving toward the Economics Reinassance. (That it will not happen in my lifetime, but may happen in yours, may be taken as implied.)

  2. Taryn H. says:

    I know this is academic since even 3% is out of the question, but Krugman argued back in the 90s re: Japan, basically, that you have to go big or it wouldn’t work.

    Maybe it doesn’t apply to us since we’re not experiencing deflation?

    Anyway, here’s Krugman –

    Rumors suggest that the Bank of Japan may actually be considering adopting some form of inflation targeting, with a positive upper bound. . . . I am not sure [they get it], because the numbers being floated are almost surely too low. . . . [T]he basic logic of a liquidity trap says that the choice facing a country in such a trap is between a significant positive rate of inflation and grinding deflation. There is no middle ground.

    The point is simple, but apparently hard to grasp. Suppose that the equilibrium real interest rate – the rate at which savings and investment, including net foreign investment, would be equal at full employment – is negative. . . . And suppose also that prices do not fall quickly in the face of unemployment. Then if the expected inflation rate is too small to allow a low enough real interest rate – if, for example, the economy “needs” a minus 3 real interest rate, and expected inflation is only 1 percent – the actual result will be an underemployed economy, and hence continuing slow deflation. This will soon mean that the inflation target loses credibility, and you are back where you started.

    So an inflation target can work only if it is high enough that, if believed, it would produce a strong enough economy to actually generate inflation. A target that is set too low is doomed to failure. . . .

  3. Taryn H. says:

    @ Ken

    “This isn’t the dark ages economics.” I think what Konzcal’s getting at is the fact that freshwater economists couldn’t even see the present crisis as a shortfall of demand and started making Treasury View, “crowding out” arguments. When Krugman refers to the Dark Ages of macroeconomics, he’s talking about the freshwater folks.

    But, even among those who do see the crisis in terms of demand, there were arguments for contractionary policies. This isn’t dark age economics, it has a different intellectual source.

    Mike points to some papers above (love the analogy about not putting out the fire because you’re worried about drowning the children inside – that’s a great analogy).

    I’ve actually thought about this a lot. Certainly, one argument you hear is that there was a generation of economists that was really impacted by stagflation and they just think of inflation as the worst danger (it appears Volcker is in this category).

    Something else that has occurred to me – but I really haven’t heard it – is that IMF austerity policies that were imposed in East Asia and Latin America became intellectually entrenched among banker types and that austerity package becomes a kind of one-size-fits-all policy advice for financial crises (maybe this explains why austerity is SO widespread – austerity is all the rage EVERYWHERE).

    Ultimately, I find it really mysterious – why did people who understood the problem to be a shortfall of demand not support expansionary policies?

    I does seem that those who were involved with Japan have argued for aggressive policy – Krugman, Woodford, Eggertsson, Adan Posen, Lars Svensson. And then also, Koo – who was directly involved with the Japanese crisis. But someone like say Rogoff – who sees the problem in terms of demand, but was not a Japan worrier – seems to approach it very differently. This might suggest that it’s something that was going on with New Keynesianism – which is certainly what the papers Mike cites above suggests.

  4. Bill Murray says:

    that austerity package becomes a kind of one-size-fits-all policy advice for financial crises

    This reminds me of an old joke about headaches, which in austerity terms would be

    A politician asks an economist for policy advice about a financial crisis.
    The economist recommends an austerity package. The politician thanks the economist and leaves.
    A little later, the economist asks himself, “I wonder if the politician wanted advice about how to end a financial crisis”

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