The intuition for policy attenuation is that uncertainty about the effects of policy creates ex post policy errors that cause economic outcomes to differ from the policymaker’s intentions. The magnitude of the policy error is multiplicative in the policy action; that is, the larger the action, the greater the expected squared error. Therefore, the expected size of the policy error is affected by the size of the policy action, creating a bias toward muted policy actions.
Think of the shower-tuning analogy. Suppose the water is too cold. If you know exactly how the water temperature will change as you move the knob, you turn it quickly. If you are not sure how much the water temperature will change for a given amount of turning, you turn the knob more slowly, to avoid getting scalded.
Scott Sumner comments,
Williams misses the bigger picture, those “demand shocks” were contractionary Fed policy. More specifically they were caused by the failure of the Fed to do NGDP level targeting. The Fed set the wrong target in each year, and this caused the vast majority of the “demand shocks”. With a policy of NGDPLT along a five percent trend line, the recession would have been far milder, with unemployment probably peaking at 6 to 7 percent.
A digression for people of the concrete steppes. No, it wasn’t just “errors of omission”. After growing at 5 percent per year during the Great Moderation, the Fed brought growth in the base to a sudden halt from July 2007 to April 2008. Yet the Fed saw itself as a valiant knight fighting off recession by cutting the Fed funds rate, as if interest rates were a reliable measure of the stance of monetary policy. They aren’t. But even if they were, the Fed drove real interest rates sharply higher in the second half of 2008, a time when they weren’t at the zero bound. So there were plenty of affirmative actions taken by the Fed to drive us into a deep slump. BTW, the base isn’t a reliable indicator either, only NGDP expectations count.
Sumner thinks that the Fed ignored the temperature of the water and just stared at the knob.
Does anybody take Sumner seriously? His NGDP targeting seems like a horrible idea, as though the Fed could magically solve problems by printing more money and keeping NGDP growth at a constant rate, even if you’re getting there through inflation. I don’t know why people keep talking about the guy as though it’s a credible idea.
@Ajay: I take Sumner seriously. In his model expectations trump mechanical aspect of monetary policy. Under a Sumnerian regime the Fed would have printed far less money than it actually did. This is what Lars Christensen calls the ‘Chuck Norris Effect’ http://marketmonetarist.com/category/chuck-norris-effect/page/3/
As far as inflation is concerned, a moderate increase might be worthwhile, if that is the cost of keeping the nominal income of the ‘average economic agent’ growing at about the rate this agent forecasted in earlier periods. At any rate, the various inflation measures have been at post-war record lows since 2008, so its hard to imagine a sustained high inflation scenario under a 5% NGDP level path. At 5%, outright stagnation still lands you with GDP deflator inflation around the level of the late 80s.
The Buddhist would say that we have to accept the world for how it is, and in our world, debt contracts are in nominal terms and employers fire rather than cut wages. Thus nominal income, not dubious price indices, drive aggregate loan performance and employment.
The Fed effectively printed nothing, as almost all of the increase in reserves were electronic, so I don’t see how Sumner’d be any better. I don’t see why it’s so important to keep “the nominal income of the ‘average economic agent’ growing at about the rate this agent forecasted in earlier periods,” particularly through monetary policy. Sometimes expectations need to be readjusted, particularly after dumping trillions down the drain of a housing bubble.
I don’t see how you magically plan to hit that “5% NGDP level path” through monetary policy, but without inflation. Not all “debt contracts are in nominal terms,” many are tied to floating rates these days, like ARMs, nor do I see fired employees as something to always avoid. Yes, nominal income may drive a lot of loans and contracts, that’s no reason to monkey with those signals by inflating till the signal is meaningless.
Sumner strikes me as a snake oil salesman, peddling his particular nominal GDP-centric policy as some kind of cure-all. I think it’s snake oil.