Michael Woodford: ‘I personally would have gone further but what [the Fed] did is definitely a step in the right direction.’

September 15, 2012

Michael Woodford is the John Bates Clark Professor of Political Economy at Columbia University. He received one of the first MacArthur "genius grants" and is considered the world's preeminent monetary economist. His paper at the central bank retreat in Jackson Hole, Wy. advocating a policy called "nominal GDP targeting" caused a stir in the profession and was commented upon by Fed chairman Ben Bernanke following the announcement of the latest round of quantitative easing Thursday. We spoke Friday. A lightly edited transcript of our conversation follows.

 

Dylan Matthews: What prompted you to write the Jackson Hole paper?

Michael Woodford: I’ve been writing about ideas closely related to that for quite a while. I didn’t specifically prefer to use that formalism of a nominal GDP target, which is why I’m not particularly associated with that specific proposal. What I’ve been writing about for quite a while, and there’s a lot of discussion of this in my 2003 book Interest and Prices and a lot of papers as well, is the desirability of committing to rules where there’s a nominal level variable rather than purely referring to the rate of growth of a nominal variable. The idea was that if the nominal growth in the economy undershoots or overshoots, either one, there should be a commitment to getting back to the target path, so we’ll target the rate of growth going forward. The idea that purely forward looking approaches are undesirable is something I’ve been emphasizing in various papers since the 1990s, and I’ve criticized various proposals that didn’t have that property.

I emphasized then that this was important if you got in a position where you couldn’t lower nominal interest rates below a certain rate. There was a lot of interest in this at that time because that was the case in Japan in the 1990s. I actually gave a paper (pdf) at Jackson Hole on the theme of the monetary policy in a low inflation environment in 1999. Everyone was sort of patting themselves on the back then, but worried about Japan. One of the issues that I talked about was that you were more likely to have this problem of hitting that lower limit, and if you did hit it, you would particularly want to commit to have higher inflation for a while to get back to this nominal level target. I wrote a paper (pdf) in 2003 for Brookings that was specifically about that mechanism.

We proposed what we called an "output gap adjusted price level target". The idea was to talk about a price level, as opposed to the inflation rate, but a corrected price level target where you add to it some multiple of the real output gap. In various models you could show there were ideal properties to this kind of proposal. But in only relatively special circumstances would that coincide with nominal GDP. I thought there was a strong case for having the nominal level variable, but not just a price index, to also take into account the level of real economic activity. But it’s not just real economic activity. It has to be corrected for potential growth. There are a lot of things to discuss about the ideal level of the target variable, but I was mostly arguing for the desirability of schemes that involved a level variable.

The thing about the Jackson Hole talk this year is that probably the most practical version of such a proposal that you can imagine the Fed adopting is an NGDP target. That is a compromise relative to the theoretical ideal. It’s worth asking what you could imagine the Fed actually going for, which is not going to be what, in an ideal world where everyone understood economics perfectly, you would want to do.

DM: The NGDP target idea seemed slightly different from your proposal in the Financial Times in 2010, which was more focused on higher inflation. 

MW: So they approached me asking for a comment on whether another round of quantitative easing was going to be a good idea, and I had to write something subject to the constraints of it being pretty short, and it was published under a title not chosen by me. They wanted to make it look like a direct challenge to Ben Bernanke. He was not mentioned in my text, but they inserted his name to make it seem like I was sticking my finger at Mr. Bernanke. It did not end up being exactly what I wanted to put out in the form in which it was put out, but I felt like I did have something to say about whether another round of quantitative easing would be worthwhile. I was trying to argue that adopting something like a targeting framework or at least more clear communication about what the ideal rule of policy are, instead of saying that.

For one thing, as I was saying, what you’d want is a target for an output gap adjusted price level. If you had fallen below then you would need to be maintaining an accommodative policy to get back up to that path, and the expectations that that would be a more expansionary policy. A forward-looking inflation target that talked about what you want the long run rate of inflation to be, regardless of whether you’ve fallen behind, is not the right way to think about things. It was never my preferred proposal to simply talk about the inflation target. It was a combination of the fact that I had to say what I had to say in a few paragraphs and the fact that the FT put a title on the piece about needing higher inflation which made it look like it was pushing the higher inflation target. That was probably not helpful at the time. I doubt the FOMC [Federal Open Markets Committee, which decides Fed policy] considered something that took that form. I got to write at greater length this year and I tried to express a more helpful proposal.

DM: One big advocate of an NGDP target, on his blog and elsewhere, has been Scott Sumner at Bentley University. Did he influence your thinking on this?

MW: I don’t think it affected me. This theme is one that I had been pushing extensively even before the current crisis, both for reasons that relate to my general views on monetary policy, and the fact that I had been giving talks on responding to the zero lower bound in this general situation. So I already had a well worked out view of that kind. I don’t think it changed my mind about the importance of the particular themes.

DM: You mentioned the debate about Japan in the late '90s. Ben Bernanke's views (pdf) on that as it was happening seem to be in tension with his conduct as a central banker. Do you remember disagreeing on that issue at the time?

MW: I think we had some points of agreement on that. We certainly talked about the issue then, because both he and I were interested in the Japanese situation and writing things about it. There was always some difference in emphasis in our preferred advice back then. He gave a lot of emphasis on the idea that purchases as such were the key, or at least that's something he would give a lot of emphasis to as opposed to being committed to particular targets. I thought future policy and the targets of future policy was the correct thing to talk about. He also talked about the desirability of commitments to keep interest rates low as a policy tool that could also be used but he never pushed it as hard as I would have pushed it. So there was probably some difference in preferred approach even then.

DM: One problem with making those commitments, though, is that Bernanke's term is up in 2014, so he may leave before mid-2015, the end-date of his commitment to keep rates low. Does that pose a problem?

MW: I think that’s an obvious issue. I think that it’s an advantage of the approach taken in the statement yesterday that it’s more plausible that the committee would continue with the policy that’s being announced. And that’s something that he announced in his press conference. He said there was a substantial consensus in the committee and he was confident for that reason that even if people were rotating on and off the committee, that future members would feel bound by what they're saying. By making the policy more contingent, rather than just announcing dates they were doing something, that in fact addresses the main concerns of the people who had been dissenters from the policy until now.

There were obviously disagreements within the committee until now about what to do. But if you see what the dissenters disagree with, it was with policies that go forward to a specific date in uncertain terms. The thing they were objecting to was the idea of announcing a date regardless of whether the economy picks up faster, and they were saying it was dangerous to make commitments when we don’t know what's going to happen. Maybe the economy will come roaring back, and that will be an inflationary policy. But on the other side, [Chicago bank President Charles] Evans, the main point of his dissent was that the policies were too limited by being tied to specific dates when we should be committed to maintain certain targets.

The statement was in fact trying to address some of the most obviously known points of disagreement within the committee about whether this was a sound commitment to be making or not. It was intended to be something where with a given rotation you could imagine the committee sticking with the policy. It’s obviously not an ironclad commitment. That was one of the concerns that Bernanke likely had in thinking about how to shape this policy. It was a good way to address that concern. I think it does mean something about policy beyond the current year and even beyond that. We know that who votes changes from year to year and we know there can obviously be changes in the personnel certainly when you go, but this could be maintained.

DM: When he was asked about your proposal, Bernanke's critique seemed to be that no one measure can capture the state of the labor market. How true do you think that is?

MW: I certainly understand the concern, and it’s an obvious concern. Whenever you talk about quantitative targets, this is an issue that’s raised and for obvious reasons. If you’re going to have to name a particular number it raises the question of whether that number is the right one. Any one statistic is not ideal. If they say Evans’ unemployment number, if they say unemployment has to go under 7 percent and they're saying specifically what they mean, I think there are important advantages of being more specific but someone could say, "How could you be sure with the unemployment rate having that specific numeric value?" This past month the unemployment rate ticked down because more people stopped looking for work. You could see that as a sign that things are worse in the labor market. That’s an example of how the unemployment rate is just one number doesn’t tell you the whole story.

That's obviously right. One number doesn’t tell you everything you care about. You don’t want to lock yourself into saying there’s only one statistic that says economic conditions have improved. But there are important advantages to being specific. When people read the language they went with, that didn’t include references to any specific variables that leaves a lot of ambiguity about how much is "substantially" and other things, it creates uncertainty about what exactly they're saying will happen. It leaves specific committee members much more wiggle room to say, "I didn’t agree to what you say I agreed to," because the wording is ambiguous.

I think those are big problems with vague formulations and I think there are important advantages to a more quantitative target but it’s always true that you’re always facing a tradeoff. You have to choose somewhere between not being vaguer than you have to be, but not being specific in a way that is specific and precise but wrong. I personally would have gone further but I think what they did is definitely a step in the right direction and I could certainly understand the conditions that would have lead them to not put numeric measures in it.

DM: Are there structural changes you'd want to see to the way the Fed works? The Bank of England, for instance, has a statutory inflation rate set by parliament and Barney Frank has proposed eliminating the role of regional banks in setting Fed policy. Are those good ideas?

MW: I think that the idea of the statutory target has advantages. The Fed itself earlier this year talked a little more specifically about what its policy targets are, what its interpretation of its mandate under the full employment act is, but I think there’s a disadvantage to having the Fed announce those things itself as opposed to the Bank of England, where the government assigns its targets and leaves it a lot of operational independence to achieve those targets. I think that system makes a lot of sense. It helps insulate the institution from the kind of political controversy that the Fed has been subject to, that it gets to decide on its own what's good for the economy. People say, "Who elected you, you have all this power!" There is an advantage to saying, "Congress should say what the goals are and leave the trained staff to figuring out the week by week and month by month actions needed to achieve those goals, but not decide what makes up the goals itself." I think there’s a lot to be said for that approach.

On the question of the structure of the committee itself, it’s a complicated question. There are some problems associated with its federal structure. Insofar as communication becomes a bigger part of policy, and it is becoming a bigger part, and the Fed has moved to saying more and more about what it thinks policy should be like, and they try to say more about the nature of their deliberations and the considerations behind policy and the considerations that are likely to be shaping future policy, it puts a strain on this system where the committee is made up of people who are distributed around the country and only see each other a few times a year. It’s a struggle to have a discussion and an articulate discussion that all members are part of, that is part of this strategy

I don’t think this means you need to cut out the regional bank chairs. They probably need to communicate more to do it. In the modern world there are lots of ways for people to talk without being in the same room. It probably isn't necessary to say that you only have a committee in Washington. They have to develop the procedures through which a conversation is going on between the members of the committee and their staffs throughout the country. But that’s something that can be solved. The obvious advantage, and one of the reasons the Fed was set up that way, is that you want people from around the country to have their concerns reflected, and if one part of the country is hurting you want Washington to hear that. There are economic interests throughout the country and a populist suspicion that the elites just don’t understand, and I think you do want to have a mechanism where someone is out talking to people in various parts of the country. The system we have does have that virtue, certainly, and the regional bank presidents are a big part of that.

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