Rational nerdiness vs macho bada$$ery in monetary policy From a terrific post by Andy Harless: Machismo is a type of commitment mechanism. If you're a perfectly rational nerd, people will always expect you to do the rational thing. You won't be able to make credible threats unless it would be rational to carry out the threat. And it seldom will be. After all, how often is it really rational to whoop someone's ass? On the other hand, if you're a tough, macho badass, people will always expect you to do the tough, macho badass thing. You'll always be able to make credible threats, because carrying out threats is always the tough, macho badass thing to do. And since the threats are credible, you mostly won't have occasion to carry them out. This principle has a traditional application to monetary policy. If your central banker is a perfectly rational nerd, he's going to let the inflation rate get too high, because he won't be able to make a credible threat to cause a recession. Obviously you want a tough, macho badass. You want the kind of central banker that likes to pick up small animals in his talons so that he can crush them to death and serve them for dinner. That theory made a lot of sense in the 1980"s, but the world has changed. The inflation rate hasn't been too high for 20 years. We are in the middle of a minor depression, and the way to get out of it is to threaten inflation. Tell people they had damn well better start doing something useful with their cash or else, as soon as you get a chance, you're going to make its purchasing power start evaporating. Of course, when the time comes, it won't be rational to carry out that threat. If you're a perfectly rational nerd, the threat won't be credible. So what kind of central banker do you want if you hope to get out of this depression? I love this terminology for discussing recent events, as the evolution of Fed policy since last September has been, in a sense, largely about reducing the tension between the need for macho badassery, and the wisdom of rational nerdiness. First a step back In May 2010 - before QE2, before Operation Twist, before 2 per cent was even an explicit goal, before QEternity, before the Evans Rule was enacted - Ben Bernanke was asked for his thoughts on the possibility of raising the inflation target from (a then-implicit) 2 per cent. He responded: We're not starting from scratch. The central banks of the world have, over many years now, established a great deal of credibility for inflation rates in the vicinity of about 2 per cent and it would be a very risky transition if we in any way reduce our commitment to a 2 per cent or approximate 2 per cent inflation target. We're not sure how expectations would react. It could be that 4 per cent would not be a stable equilibrium and that people would expect an even higher inflation rate after that. And last April, during an FOMC presser, Bernanke appeared to go a bit further when talking about the possibility of pursuing higher inflation for a time, though without necessarily changing the target: I guess the question is, does it make sense to actively seek a higher inflation rate in order to achieve a slightly increased reduction - a slightly increased pace of reduction in the unemployment rate? The view of the Committee is that that would be very reckless. We have - we, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable in that we've been be able to take strong accommodative actions in the last four or five years to support the economy without leading to an unanchoring of inflation expectations or a destabilization of inflation. To risk that asset for what I think would be quite tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do. At the time this drove me crazy. I thought it strange that credibility was always discussed in such binary terms (something that a central banker either has or doesn't have) rather than as a spectrum (something that a central banker can have more or less of). And along with many other "doves," I wondered why risking the loss of a little inflation-fighting credibility, of which the Federal Reserve already had heaps, wasn't worth gaining a bit more credibility on fighting unemployment, of which it had very little. Talking tough on inflation seemed pointless at best and counter-productive at worst. I was in the camp of those calling for the Fed to commit to acting "irresponsibly" into the future. An unambiguous declaration that higher inflation would temporarily be tolerated while unemployment declined seemed like a sensible idea. A few months later, in September, that's what Bernanke gave us, laying the groundwork for a full switch to a slightly altered version of the Evans Rule in December. This version dictates that rates will not be raised until either unemployment falls below 6.5 per cent or projected inflation for the next 1-2 years rises above 2.5 per cent - though these are thresholds and not hard rules. Why did it take so long? For decades, monetary policy had been conducted the way Harless describes above: a macho approach to low inflation was widely understood to be the one non-negotiable. The experience of the 1970s and early 1980s had cast a long shadow. This worked just fine so long as low inflation was also accompanied by relatively shallow recessions, and the Fed could not be accused of ignoring either half of its mandate. Indeed the unquestioned commitment to low inflation was thought to be among the main components of long-term stable growth. Everything changed in 2007, of course. This recession-and-recovery period obviously has differed from the prior two (the early 1990s and early 2000s) in the extent to which the Fed has failed to satisfy the unemployment half of its mandate, and for how long. Yet as indicated by the quotes above, the Fed was reinforcing its tough approach to inflation for years into an unemployment catastrophe during which inflation and inflation expectations were tame. For all the talk of the Fed's unconventional measures, it's worth remembering the primary aim and accomplishment of each: the special lending facilities and QE1 helped stabilise the financial system; QE2 stopped an aggressive disinflationary momentum; and Operation Twist gave a boost to the housing market. These measures may have been unconventional (and helpful), but none was meant to threaten the extant macho commitment to low inflation. The US economy has had several false starts since 2009, and it's likely that several tangled factors were responsible for their not lasting longer. It's reasonable to think that one of these factors was that the initial reflationary effects of these unconventional measures faded, because of doubts about the Fed's commitment to maintaining accomodative policy during a period of catch-up growth. If such growth threatened to generate above-target inflation, then monetary conditions could be expected to tighten. The rational-nerdy thing to do was to soften the macho commitment to inflation and commit to a temporary period of inflation-tolerance, thereby balancing the two sides of the mandate - but to do so while retaining credibility on both. But as Harless notes, ceding a little ground on one side could be interpreted as ceding all ground. Being a "macho badass" central banker means credibly committing to never cede ground. This seems to be what Bernanke feared when he said that pursuing higher inflation would be "reckless" - perhaps envisioning a future where unemployment had come down but the Fed was burdened without credibility. And after three decades, status quo bias is powerful. Naturally, the "dove-ish" counter-argument was that not committing to tolerance of higher inflation was itself also reckless. Prudence in one direction meant recklessness in the other, but recklessness of some sort could not be avoided. It was a matter of preference. (That's not to assert an equivalence between the inflation hawks and the doves. Given economic conditions, I think the dove-ish preference was the right one.) To use the slightly altered terms of Harless, you can have rational nerdery and macho badassery, but you can't have both. Or maybe you can? Yet an ideal monetary policy framework does include both. The rational nerdiness is there to correctly interpret economic conditions and diagnose the correct policy, while the macho badassery is needed to convince the markets and economic agents generally that the Fed will do what is necessary to carry out this solution, ie to influence expectations. This is difficult so long as embracing the former means giving up the latter. All of which has been a long windup to saying that the appeal of the Evans Rule, and if we ever get it, some variation of NGDP level targeting, is this: they institutionalise the macho badassery, which in a dual-mandate framework can only be applied to one of the two mandates. Not so with an Evans Rule or NGDP level targeting, where it can be applied symmetrically - because in each it is well understood when the "recklessness" towards either unemployment or inflation kicks in, and when it will end. And therefore it ceases to be reckless. The public doesn't have to guess, and the decisions over when and how to alter policy is based less on personnel (on whoever happens to be Fed chair and a voting FOMC member) and more on changes in economic conditions. Rather than having to talk tough on one part of a dual mandate or the other, and worrying about later having insufficient credibility when it is most needed, the central bankers are left mainly to correctly interpret those conditions. Credibility has already been built into the new framework. And the central bankers are left to be themselves: huge nerds.