Frequently Asked Questions for Central Banks Undershooting Their Inflation Target

If you are a cen­tral bank un­der­shoot­ing your in­fla­tion tar­get, please read this first be­fore post­ing a ques­tion about how to cre­ate more in­fla­tion.


Q. Help! I keep un­der­shoot­ing my 2% in­fla­tion tar­get!

A. It sounds like you need to cre­ate more money.

Q. I tried that, and it didn’t work!

A. How much money did you cre­ate?

Q. Five dol­lars.

A. Okay, now we know that five dol­lars wasn’t enough money. You need to cre­ate more.

Q. More than five dol­lars?

A. Right.

Q. I’ve heard that it’s very bad when gov­ern­ments cre­ate lots of money just so they can buy things. Prices sky­rocket, and soon no­body wants to hold on to the money any­more! That’s why we have stern and in­de­pen­dent cen­tral banks, to pre­vent too much money from be­ing cre­ated.

A. Yes, that’s a big prob­lem, all right! That prob­lem is the op­po­site of the prob­lem you ac­tu­ally have. It’s definitely true that if prices start go­ing up faster than you want, you should stop cre­at­ing money and maybe de­stroy some of the money you already made. But that is not the prob­lem you have right now. Your cur­rent prob­lem is that there’s too lit­tle money flow­ing through the econ­omy, mean­ing, not enough money to drive all the buy­ing of real goods and la­bor that could be ex­changed if your econ­omy had more money.

You know how hy­per­in­fla­tion hap­pens be­cause there isn’t enough real stuff and so the tons of new money are just com­pet­ing with other money to buy a limited amount of real stuff? One way of look­ing at your 2% in­fla­tion tar­get is that you’re sup­posed to cre­ate just enough money flow that it’s a lit­tle above what’s re­quired to an­i­mate all the trades your econ­omy can make. If there’s a lit­tle more money flow than the min­i­mum re­quired to an­i­mate all po­ten­tial trades, that money is com­pet­ing just a lit­tle with other money to buy stuff. Pro­duc­ing, say, around 2% in­fla­tion. That’s why your gov­ern­ment gave you an in­fla­tion tar­get that was low, but not su­per-low and not zero. Right now your econ­omy doesn’t have that much in­fla­tion, be­cause there isn’t enough money flow­ing and your econ­omy is failing to make all the trades it could make. That’s why ‘un­der­shoot­ing your in­fla­tion tar­get’ is as­so­ci­ated with a coun­try that feels sad and listless, with all the fac­to­ries and shops still there but peo­ple not hav­ing enough money to buy things from them, be­cause not enough cus­tomers are buy­ing from their own en­ter­prises. It’s very de­press­ing.

Q. Can I solve that prob­lem by be­ing a stern, in­de­pen­dent cen­tral bank that re­fuses to cre­ate more money?

A. No.

Q. How about if I sit down to lunch with some big banks and ask them to make more loans, maybe ac­com­panied by a sig­nifi­cant look where I have one eye­brow raised?

A. Even if they listened, I’d worry that ev­ery­thing in your econ­omy is cur­rently in equil­ibrium and other banks might make fewer loans once there were fewer loan op­por­tu­ni­ties left. Any­way—I’m just guess­ing here—did you maybe already try that?

Q. Yes.

A. And what hap­pened?

Q. It didn’t work. But that doesn’t mean it won’t work next time!

A. Your econ­omy, and the peo­ple in your econ­omy, are suffer­ing right now. You should be cre­at­ing more money right away, not let­ting in­no­cent peo­ple suffer while you ex­per­i­ment with weird al­ter­na­tives to ac­tion.

Q. But I don’t want to cre­ate more money!

A. Then you won’t get more in­fla­tion. If you want more in­fla­tion, you need to cre­ate more money.

Q. But I already printed five whole dol­lars and prices didn’t go up at all! They ac­tu­ally fell! I’m start­ing to won­der if print­ing money re­ally makes prices go up.

A. There were prob­a­bly some banks ex­plod­ing at the same time you were print­ing the five dol­lars, and the ex­plod­ing banks de­stroyed more than five dol­lars. Even though you’re the only en­tity that’s al­lowed to cre­ate your coun­try’s base money, banks also cre­ate a kind of vir­tual money when they make loans. This means that when a bank ex­plodes, it can de­stroy some vir­tual money. So even though you printed five dol­lars, the bank ex­plod­ing at the same time de­stroyed more than five dol­lars of vir­tual money, and the to­tal amount of money went down. That might be why prices didn’t rise. Or it might be more sub­tle, like peo­ple want­ing to hang onto the money they already have. That also de­creases the speed at which money changes hands, which means that there’s less effec­tive money per trans­ac­tion in the to­tal econ­omy, which puts down­ward pres­sure on the price of each trans­ac­tion.

Q. So there’s noth­ing I can do? That’s ter­rible! But I guess if there’s noth­ing I can do, it’s not my fault—

A. No, you can do some­thing! You just need to cre­ate even more money.

Q. (Grudg­ing sigh.) How much more money do you think might be enough?

A. Well, pre­dict­ing that is a very difficult job! There are all sorts of things that af­fect prices be­sides the amount of base money, like bank lend­ing rates. Now, all these other fac­tors merely af­fect the amount of base money that’s “enough”, they don’t mean that you could print in­finite money with­out in­creas­ing prices. Ideally, you’d cre­ate a pre­dic­tion mar­ket to fore­cast the effects of print­ing differ­ent amounts of money. But if you cre­ate some money and prices don’t in­crease, that definitely means you didn’t print enough.

Q. What if I print enough money to make prices rise, and they still don’t rise?

A. Then you were wrong about how much money was ‘enough’.

Q. That seems un­likely. Maybe I’m already do­ing the right thing, and it’s just go­ing to take a while to work, so I don’t need to change any­thing?

A. Sorry, but that’s a definite no! The weak form of the effi­cient mar­kets hy­poth­e­sis says you can’t have pub­li­cly pre­dictable price changes in a liquid mar­ket. If the price of your cur­rency was pre­dictably go­ing to drop later, peo­ple would short-sell it now, or just re­fuse to buy it at a price that would pre­dictably go lower. So if what you’re cur­rently do­ing, and any fu­ture ac­tions you’ve already an­nounced, aren’t already mak­ing prices higher, we already know it wasn’t enough. You can also check and see if the mar­ket is pric­ing in­fla­tion-ad­justed se­cu­ri­ties in a way that shows the mar­ket ex­pects in­fla­tion over the next few years. If they don’t, you’re do­ing some­thing wrong.

Q. But my ex­pert economists say that the peo­ple who price in­fla­tion-ad­justed as­sets are wrong, and there will be lots of in­fla­tion next year! In fact, I’m already start­ing to think about rais­ing rates now to pre­vent that, like a stern and in­de­pen­dent cen­tral bank should.

A. Is it pos­si­bly the case that your in-house ex­perts have been wrong ev­ery sin­gle time they pre­dicted more in­fla­tion than the mar­ket fore­cast, over the last fif­teen years or so?

Q. Yes, but that doesn’t mean they’ll be wrong this year!

A. I’m sorry, but it sounds to me like your ex­perts just don’t have the in­cen­tives to make cor­rect fore­casts. Or maybe they lack the sheer knowl­edge and com­pu­ta­tional power to make bet­ter fore­casts than the hedge-fund man­agers who can make billions and billions and billions of dol­lars if they pre­dict 1% bet­ter than the mar­ket. Although… I have to say, your in-house ex­perts be­ing wrong in the same di­rec­tion ev­ery year doesn’t sound quite so in­no­cent.

Q. But… my in-house ex­perts have ex­pen­sive suits! And cre­den­tials! Hedge-fund man­agers don’t have suits that nice, I bet.

A. Ac­tu­ally, they kind of do. More im­por­tantly, they’re paid liter­ally billions of dol­lars to get the an­swer right. Maybe your in-house ex­perts are tel­ling you what they think you want to hear. Maybe they’re just mak­ing the same in­no­cent mis­take re­peat­edly. But if you’ve already seen your in-house ex­perts be wrong lots of times be­fore, and they’re mis­taken in the same di­rec­tion ev­ery time, then you need to stop listen­ing to your in-house ex­perts when they pre­dict lots of happy in­fla­tion. You should pay at­ten­tion to the mar­ket fore­casts in­stead, be­cause highly liquid mar­ket prices al­most never change in a pre­dictable net di­rec­tion. When liquid prices change in a pre­dictable net di­rec­tion, it cor­re­sponds to free money! Lots of highly in­tel­li­gent or­ganisms in your fi­nan­cial ecol­ogy re­ally like to eat free en­ergy, and when they con­sume the free en­ergy it elimi­nates the di­rec­tional er­ror. Which usu­ally means liquid mar­kets aren’t re­peat­edly wrong in the same di­rec­tion, like your in-house ex­perts are. Right now, the mar­ket fore­cast is tel­ling you that you need to cre­ate more money if you want in­fla­tion.

Q. It does seem clear that I should lower rates to nearly zero at my meet­ing next month. That’s cre­at­ing more money, right?

A. Sorry, let me rephrase. The mar­ket has already guessed that you plan to lower rates at your meet­ing next month. If the mar­ket rate for in­fla­tion-ad­justed se­cu­ri­ties doesn’t already im­ply that they ex­pect in­fla­tion, it means they already don’t ex­pect you to cre­ate enough money. If the mar­ket doesn’t already ex­pect in­fla­tion, you need to cre­ate more money than they’re cur­rently ex­pect­ing you to cre­ate. If you’re wor­ried about a self-refer­en­tial cir­cu­lar­ity if you did start pay­ing at­ten­tion to the mar­ket fore­cast and the mar­ket re­al­ized that, you can just cre­ate a sep­a­rate pre­dic­tion mar­ket to di­rectly fore­cast the amount of money you’ll need. But right now, when you’re not pay­ing at­ten­tion to the mar­ket fore­cast, the situ­a­tion is clear—the mar­ket ex­pects your cur­rent be­hav­ior and com­fortable habits to fail, and you need to do more.

Q. But I can’t lower in­ter­est rates be­low zero!

A. First of all, yes you can, sev­eral coun­tries are try­ing it and noth­ing bad is hap­pen­ing to them. And sec­ond, you can always cre­ate money. Create new ones and ze­roes and in­ject them into the econ­omy. Never mind think­ing about in­ter­est rates. If you cre­ate enough money, prices will go up.

Q. What if I say I’ll print ten dol­lars and the mar­ket still thinks that’s not enough?

A. Create even more money. Look, imag­ine cre­at­ing a quadrillion dol­lars. Prices would go up then, right? I mean, a 12-year-old raised by gold­bugs could un­der­stand that part… uh, it’s pos­si­ble you might need to add a 12-year-old raised by gold­bugs to your ad­vi­sory staff.

Q. Just be­cause cre­at­ing enough money would make prices rise, doesn’t log­i­cally im­ply that if prices don’t rise then I haven’t cre­ated enough money!

A. Ac­tu­ally—

Q. Really hon­estly, I already cre­ated a large amount of base money! I’m not ly­ing, I re­ally made a lot! Doesn’t that mean I’m already be­ing su­per-loose with my policy? I just can’t un­der­stand how, with my base money sup­ply at a level of over nine dol­lars, you think my mon­e­tary policy is too tight.

A. The ab­solute amount of base money has no mean­ing apart from mon­e­tary ve­loc­ity. 1 trillion base dol­lars and a bank-lend­ing mul­ti­plier of 33 is more effec­tive money than 6 trillion base dol­lars and a bank-lend­ing mul­ti­pler of 4. That’s why cen­tral bank­ing isn’t as sim­ple as just in­creas­ing the base money sup­ply by 2% per year, or some­thing like that. In fact, there are pos­i­tive feed­back cy­cles which means that tar­get­ing a base money level can pro­duce wild in­sta­bil­ity. When money is be­com­ing more valuable, peo­ple try to hold onto it more, which slows down ve­loc­ity, which de­creases the effec­tive amount of money available per trans­ac­tion, which de­creases prices even more, which makes money even more valuable. Which in­creases the real bur­den of debt, which means that fewer peo­ple pay back their loans suc­cess­fully, which blows up banks and makes them more re­luc­tant to lend, which futher de­creases the money sup­ply, which fur­ther de­creases the money available to pay back debt. So as a cen­tral bank, you need to keep your eye on the amount of money be­ing spent and mov­ing around, not the amount of base money that ex­ists. If the amount of money spent and mov­ing around is go­ing down, or just in­creas­ing slower than it used to, you’re in trou­ble. And you need to do some­thing right away, be­cause of pos­i­tive feed­back cy­cles!

Q. I am do­ing some­thing! My in­ter­est rates are su­per-low right now. Peo­ple can take out loans su­per cheaply! Doesn’t that mean I’m already be­ing su­per-loose with my policy in a way that’s just bound to cre­ate lots of in­fla­tion start­ing, you know, any minute now?

A. Nope! Think about Free­do­nia, which is print­ing too much money and has 100% per year in­fla­tion. Would ten per­cent in­ter­est rates be ‘tight money’ there?

Q. Ten per­cent in­ter­est? That’s su­per-high!

A. Not in Free­do­nia! In Free­do­nia, if you have a com­pany that’s grow­ing five per­cent real growth ev­ery year, plus one hun­dred per­cent in­fla­tion, that cor­re­sponds to 105% nom­i­nal growth. In a coun­try like that, if you make a loan at ten per­cent nom­i­nal in­ter­est, it’s −90% real in­ter­est! Which is 95% be­low the rough vicinity of where we might find the Wick­sel­lian in­ter­est rate! And that’s su­per-in­fla­tion­ary! Con­versely, in Ja­pan where there’s near-zero in­fla­tion and lots of sav­ing and an ag­ing pop­u­la­tion, the Wick­sel­lian equil­ibrium in­ter­est rate is nega­tive-some­thing per­cent, so a nom­i­nal 1% per­cent in­ter­est rate might be a high rate of real in­ter­est that made for tight money and pro­duced more defla­tion. That’s why cen­tral bank­ing isn’t as easy as clamp­ing the nom­i­nal in­ter­est rate at three per­cent and hold­ing it there for­ever. In fact, if you clamp nom­i­nal in­ter­est at 3%, your cur­rency will in­evitably blow up into defla­tion or hy­per­in­fla­tion! Lower in­fla­tion makes a fixed nom­i­nal rate be tighter money which pro­duces an even lower price level. Higher in­fla­tion makes a fixed nom­i­nal rate be a lower real rate which cor­re­sponds to even cheaper money. Nom­i­nal in­ter­est-rate tar­get­ing as a con­trol in­stru­ment is kind of silly to be­gin with, hon­estly! It’s like try­ing to steer a car with a wob­bling, un­steady steer­ing wheel, where the same steer­ing-wheel po­si­tion might be point­ing the road-wheels in a differ­ent di­rec­tion ev­ery time the car goes an­other me­ter.

Q. All this sounds very com­pli­cated. Can I take a long time to think about what’s go­ing on, and maybe re­spond very timidly and weakly?

A. No! When your cur­rency is gain­ing value, it makes peo­ple more re­luc­tant to spend the cur­rency, which de­creases the effec­tively available sup­ply of the cur­rency, which in­creases the price of the cur­rency. When banks blow up and va­por­ize vir­tual money, or when banks be­come more re­luc­tant to make loans, it de­creases the money flow available to pay off all the loans in the sys­tem. When in­fla­tion goes lower, it in­creases the real in­ter­est rate rep­re­sented by the nom­i­nal rate you tar­get, which is tighter money, which puts fur­ther down­ward pres­sure on prices. Th­ese are pos­i­tive feed­back loops! You need to re­spond right away, be­fore the pos­i­tive feed­back gets out of con­trol. If you do noth­ing, the loops will blow up. If you do some­thing, but too lit­tle, they’ll blow up slower. You need to do enough to in­ter­rupt the pos­i­tive feed­back cy­cle!

Q. Like sharply rais­ing in­ter­est rates to com­bat in­fla­tion, be­fore peo­ple start try­ing to get rid of the money they’re hold­ing and it turns into hy­per­in­fla­tion?

A. Right! And if in­fla­tion was still spiral­ing out of con­trol, you’d raise in­ter­est rates fur­ther and, more im­por­tantly, cre­ate less money or even de­stroy some money! You’d have to do that right away be­fore things got even worse!

Q. Ex­actly! I’d raise rates as soon as I saw in­fla­tion com­ing, I wouldn’t wait for it to hap­pen. I’d be su­per-proac­tive!

A. Well, you’d raise rates if the mar­ket said too much in­fla­tion was com­ing. You wouldn’t listen to your in-house ex­perts who’ve been wrong in the same di­rec­tion ev­ery sin­gle time.

Q. I wouldn’t?

A. Any­way, you know how you need to be su­per proac­tive and alert to pre­vent too much in­fla­tion? This is the same situ­a­tion, only in re­verse.

Q. But… it’s just…

A. What is it?

Q. As a cen­tral bank raised in the mod­ern era, I just feel deeply bad in­side about in­fla­tion, you know? Even if I have to do it some­times, it feels dirty.

A. Yes, I’ve gath­ered that.

Q. I mean, back in the day, there were bad peo­ple who cre­ated a lot of new money, and heroes who stopped them. Even though no­body be­lieved in them, even though the world scorned them, even though lots of peo­ple were claiming that in­fla­tion had noth­ing to do with the money sup­ply and was caused by la­bor unions or some­thing, they still tight­ened mon­e­tary policy! I want to look in the mir­ror and see a hero, not a villain. Like the days of yore when Paul Volcker rode into bat­tle against in­fla­tion with Pres­i­dent Carter by his side like a loyal shield­bearer, and Carter nobly sac­ri­ficed him­self so Volcker could go on…

A. Those heroes were fight­ing a prob­lem that is the op­po­site of your prob­lem. They cor­rectly did the op­po­site of the thing you need to do. Or, on a meta-level, they did the meta-thing you need to do—they showed courage and con­vic­tion, pointed in the right di­rec­tion, even though some peo­ple were claiming that the cen­tral bank was pow­er­less to help.

Q. But what if I’m too coura­geous and then I over­shoot my in­fla­tion tar­get?

A. Both lab ex­per­i­men­ta­tion and macroe­co­nomic his­tory shows that price-set­ters are much more re­luc­tant to lower prices than raise prices. Em­ploy­ers and em­ploy­ees are much more re­luc­tant to lower wages than to raise wages. Most em­ploy­ers would rather fire one per­son than try to ne­go­ti­ate 5% salary cuts with 20 peo­ple who would all be de­mor­al­ized. On the other hand, if there’s enough nom­i­nal money com­ing in and the wage mar­ket is heat­ing up, they’re of­ten okay with giv­ing ev­ery­one 5% raises. This means that mak­ing your money policy slightly too tight does much more dam­age than mak­ing it slightly too loose, be­cause it’s a well-tested em­piri­cal fact that the peo­ple in­side the econ­omy have a much eas­ier time ad­just­ing to slightly higher money flow than slightly lower money flow.

Big defla­tion and big in­fla­tion both do enor­mous amounts of dam­age, and hy­per­in­fla­tion is worse be­cause it goes fur­ther and faster. But money that’s a lit­tle too tight does much more dam­age than money that’s a lit­tle too loose! So it’s re­ally im­por­tant that you cre­ate more money right now, and don’t worry so much about the pos­si­bil­ity of over­shoot­ing your in­fla­tion tar­get a lit­tle, es­pe­cially when you’ve un­der­shot your tar­get a lot up un­til now.

Q. But with all these dan­ger­ous pos­i­tive-feed­back cy­cles… what if prices sky­rocket? Just be­cause print­ing a quadrillion dol­lars would cre­ate hy­per­in­fla­tion doesn’t mean that there’s a smaller amount of money I can print to cause ex­actly 2% in­fla­tion! There could be non­lin­ear­i­ties in the mar­ket.

A. In­deed there are! So here’s what you do. In­stead of liter­ally print­ing cash, cre­ate elec­tronic money in your own ac­count that you then use to buy some­thing else. Buy an as­set you can sell back later, like gov­ern­ment bonds. That way, you’re cre­at­ing some new money now. But you keep the as­sets you buy with the new money. That way, you can sell back the as­set later to de­stroy the money af­ter ve­loc­ity picks up, or if you ac­ci­den­tally cre­ated too much.

Q. That sounds re­ally wob­bly to me. I’m afraid some­thing will go wrong, and that price lev­els will end up go­ing back and forth or maybe out of con­trol.

A. There are sev­eral tools you can use to pre­vent that! The most im­por­tant tool is to tar­get a price path. That means, in­stead of con­stantly try­ing to eye­ball the econ­omy and guess­ing in an ad-hoc way whether it has too much or too lit­tle money, you have a definite rule that says, “If in­fla­tion goes over 2%/​year then I will cre­ate less money and if in­fla­tion goes un­der 2%/​year I will cre­ate more money, and the fur­ther over or un­der the level it goes, the more money I’ll de­stroy or cre­ate.” And if peo­ple trust you’ll do that, they won’t ex­pect in­fla­tion to go much over or un­der 2%/​year, and they won’t value money any more or less than a long-run 2%/​year level im­plies.

Q. So ev­ery year I try for 2% in­fla­tion that year, and miss, and end up with 1% in­fla­tion in­stead, and then I do the same thing again next year? Sounds like a great policy to me! I’m already on the ball when it comes to that one!

A. No, no, no! If you’re do­ing that, you’re not ac­tu­ally tar­get­ing the path of any­thing! Let’s say a donut costs $1 this year, in year 0. At 2% in­fla­tion, it would cost $1.02 next year, and $1.04 in year 2, and $1.22 in year 10. Let’s say that you miss your in­fla­tion tar­get for this year and the donut ends up cost­ing $1.01 next year. If you just shrug and say, “Oh, well, I’ll try for 2% again,” then your new plan is for the donut to cost $1.03 in year 2, in­stead of $1.04. And $1.21 in year 10. As a re­sult of get­ting less in­fla­tion than you wanted, you changed your mon­e­tary tar­get to be tighter—you changed your mind and aimed to have a donut cost less in year 10, then you pre­vi­ously said a donut should cost in year 10. That’s ex­actly the sort of thing that pro­motes pos­i­tive feed­back loops!

Q. What do you mean, I’m tight­en­ing my mon­e­tary policy? I’m still say­ing “I want 2% per year in­fla­tion”, right?

A. Be­fore, the mar­kets ex­pected you to tar­get $1.22 per donut in year 10. Now they ex­pect you to tar­get $1.21. That’s a tight­ened mon­e­tary policy! And what’s much worse is if you do this ev­ery year, and the mar­kets rapidly re­al­ize that in real life the donut will only be $1.10 in year 10. Now the mar­ket ex­pects a much tighter mon­e­tary policy and they’ll con­sider money much more valuable than you say you want it to be. And peo­ple will hold onto even more money. Which will make you ‘miss’ your in­fla­tion ‘tar­get’ even more. Which will make you tighten fu­ture price tar­gets again, and so on.

Q. So what should I do in­stead? Tell ev­ery­one that I re­ally, re­ally want 2% in­fla­tion next year?

A. To tar­get the path or main­tain a level tar­get, if you get 1% in­fla­tion in year 0, you have to cre­ate even more money in year 1 to make up for the missed tar­get in year 0. Even if year 1 comes out to $1.01, you still have to tar­get $1.04 for year 2, $1.06 for year 3, and so on. That way, it doesn’t mat­ter as much if you over­shoot in one year, be­cause the stance of long-term mon­e­tary policy won’t have changed in re­sponse to that. The same the­ory also works for com­bat­ing hy­per­in­fla­tion—you just cre­ate less money next year, or de­stroy money, if you over­shoot. And if you stick to that policy, the mar­ket will rapidly come to ex­pect it, and they won’t value your coun­try’s cur­rency this year more or less than your long-term level tar­get says your cur­rency will be worth. The mar­kets will know you’ll put the path back on track, and the weak form of the effi­cient mar­kets hy­poth­e­sis says you can’t have pub­li­cly pre­dictable price changes. That’s the “ra­tio­nal ex­pec­ta­tions chan­nel” which is the sec­ond key to achiev­ing price sta­bil­ity. The third key is to use pre­dic­tion mar­kets on how much money you need to cre­ate, so you don’t cre­ate too much or too lit­tle in the first place. But that’s just ic­ing on the cake.

Q. But what if even try­ing to tar­get a nom­i­nal path still doesn’t work?

A. If you (1) cre­ate in­creas­ingly more or less money as you go un­der or over your nom­i­nal path tar­get, (2) show the mar­ket that you are fully com­mit­ted to that tar­get, and (3) use a pre­dic­tion mar­ket to tar­get the size of in­ter­ven­tion, then you will hit 2%/​year in­fla­tion, or 5%/​year NGDP growth, or con­stant gold prices, or any other sin­gle nom­i­nal price tar­get you choose. You could have your prices deflate by ex­actly 2% per year, not that you should, but you could, and the price level wouldn’t blow up over or un­der that. That’s the power of tar­get­ing a path! If you pick liter­ally any sin­gle nom­i­nal vari­able you want—the price of silver, the price of a me­dian hair­cut, liter­ally any­thing—and you pub­li­cly de­clare a tar­get price path and then con­sis­tently loosen when un­der the tar­get and tighten when over the tar­get, in­creas­ing the size of your ac­tion as you get fur­ther away from the path, and the mar­ket knows and be­lieves this, that price path will be achieved, pe­riod. I mean, you can’t say that a kilo of gold should have a con­stant price path of $1 be­cause you can’t af­ford to buy back and de­stroy enough dol­lars to make that be true. But that is the op­po­site of the prob­lem that you cur­rently have. You can­not run out of abil­ity to make prices go higher. Run­ning out of re­serves can pre­vent a cen­tral bank from en­forc­ing that its cur­rency have a min­i­mum value, but you can­not run out of ones and ze­roes when it comes to en­forc­ing your cur­rency’s max­i­mum value. Just sell more of the cur­rency!

Q. Okay, I could see firmly com­mit­ting on that policy up to cre­at­ing $15, but any more than that, and I’d have to give up.

A. Then the price will not be sta­ble. The mar­ket will know that if there’s enough defla­tion, you’ll print $15 and then give up. They can see that com­ing, so they’ll get ner­vous as soon as the price starts to drop. If the mar­kets think you’re not truly com­mit­ted, they’re very likely to test you. This is true even if you’re do­ing some­thing that ought to be im­pos­si­ble to fail at, like keep­ing a price high or putting a ceiling on your cur­rency’s value, be­cause mar­kets know that cen­tral banks of­ten get ner­vous and change their minds.

You’ve got to be ready to ac­tu­ally fol­low through! If you are truly com­mit­ted you can sta­bi­lize any one price path, but if you stop sta­bi­liz­ing the path, it stops be­ing sta­ble, and mar­kets can make billions of dol­lars if they can suc­cess­fully pre­dict when you’ll give up.

But re­mem­ber, you liter­ally can’t lose at keep­ing a nom­i­nal price high so long as your de­ter­mi­na­tion holds. Just hold down the trig­ger un­til the tar­get is de­stroyed or you run out of bul­lets, bear­ing in mind that you can­not run out of bul­lets.

Q. So I’d have to re­ally com­mit my­self? That’s scary! Well, I guess I could com­mit my­self and then change my mind later if it doesn’t work out. But what if I un­der­shoot my price path, print even more money next year, and still can’t hit my tar­geted price path?

A. Then you did not cre­ate enough money, god damn it. That’s what the pre­dic­tion mar­ket is for. But even then, if you’re con­sis­tently an em­bar­rass­ing 1% un­der the path, that’s a whole lot more sta­ble than un­der­shoot­ing your 2% in­fla­tion tar­get by a vari­able amount ev­ery year.

Q. What if I’m un­der­shoot­ing my price path by more and more each year?

A. In­crease the size of your ac­tion even faster as you get even fur­ther away from the tar­get path. Like, have your ac­tion in­crease as the square of the amount you missed, or some­thing like that. Bet­ter yet, tar­get the mar­ket fore­cast. Bet­ter yet, use a pre­dic­tion mar­ket to figure out how much money you need to cre­ate or de­stroy.

Q. What if no mat­ter how much money I print it still doesn’t change prices?

A. Then why is your gov­ern­ment even both­er­ing to col­lect taxes?

Q. I mean… couldn’t the prob­lem be that the money I cre­ate is stay­ing in bank ac­counts in­stead of do­ing any­thing?

A. Uh, aren’t you cur­rently pay­ing pos­i­tive in­ter­est on bank re­serves held at your cen­tral ac­count? If you think that’s the prob­lem you definitely should not be pay­ing pos­i­tive in­ter­est on re­serves.

Q. But pay­ing 0.25% in­ter­est on re­serves makes me feel bet­ter.

A. Why?

Q. I don’t know, it just does. Uh, maybe it causes my banks not to make stupid loans if they know they can at least get 0.25% in­ter­est by hold­ing the money in­side me?

A. I guess that’s pos­si­ble, and stupid loans are a prob­lem, but… if you do pay pos­i­tive in­ter­est on re­serves, that makes banks more re­luc­tant to lend and re­flects a tighter mon­e­tary policy. It changes the amount of money that’s ‘enough’. It means you’ll need to cre­ate even more, more money, when you’ve already been un­der­shoot­ing your in­fla­tion tar­get for sev­eral years run­ning. In­deed, some rel­a­tively wise cen­tral banks are charg­ing nega­tive in­ter­est on ex­cess re­serves.

Q. Why do you say they’re only rel­a­tively wise?

A. Be­cause if they were ab­solutely wise they’d have cre­ated enough money to cre­ate enough in­fla­tion that they wouldn’t need to charge nega­tive in­ter­est. But re­gard­less, pay­ing pos­i­tive in­ter­est on re­serves is kinda like trans­form­ing that cur­rency into a new kind of gov­ern­ment bond. It might be harm­less if you could print enough enough-money, but oth­er­wise it’s prob­a­bly not a wise thing to do, even if it makes you feel bet­ter. Think of it as a lux­ury re­served for good cen­tral banks that don’t un­der­shoot their in­fla­tion tar­get.

Q. Yeah… I’ve been won­der­ing if maybe my cur­rency is pretty much in­ter­change­able with gov­ern­ment bonds, now. Maybe when I buy gov­ern­ment bonds from the sort of peo­ple who own gov­ern­ment bonds in the first place, they just keep my cur­rency around and don’t buy any­thing else with it. Maybe I need to in­ject the money some­where else.

A. First, like many other prob­lems hav­ing to do with defla­tion, this hy­po­thet­i­cal prob­lem, if it ex­isted, would be one that you could solve with moar money. There is some amount of money cre­ation that overflows into the hands of peo­ple who can buy real things, that gets things mov­ing again and causes all the fac­to­ries to work at ca­pac­ity and peo­ple to be em­ployed and flows through all the trades that peo­ple can make.

Se­cond, it does seem du­bi­ous that the in­jec­tion site makes much of a differ­ence, be­cause de­mand for money is fun­gible, and if you add more money in one place it’s generic sup­ply that com­petes in a global pool of generic de­mand.

Third, if you think that’s the prob­lem, then for god’s sake stop pay­ing pos­i­tive in­ter­est on re­serves when you’re already un­der­shoot­ing your tar­get.

Fourth, if a wrong in­jec­tion site or fun­gi­bil­ity with bonds re­ally was the prob­lem, and you didn’t want to brute-force it with moar money, you could cre­ate money and buy a broad bas­ket of low-past-volatility equities that are easy to short-sell and hence cor­rectly priced. Or… well, op­ti­mal mon­e­tary policy is a lot sim­pler than op­ti­mal poli­tics, and I un­der­stand the lat­ter a lot less well than the former. But maybe you could make your cen­tral bankers put on suits, and go to your poli­ti­ci­ans with hat in hand, and humbly say, “I’m sorry, we screwed up and un­der­shot 8 years’ worth of pub­li­cly de­clared in­fla­tion tar­gets, and we need to give the mar­kets a sign that we’re se­ri­ous this time. Can you please let us send ev­ery cit­i­zen a check for $2000 just this one time?”

Q. My gov­ern­ment would never let me do that!

A. Are you sure? I’m not a gov­ern­ment my­self, but I kinda imag­ine that if you made your cen­tral bankers put on their best suits and tell the gov­ern­ment’s poli­ti­ci­ans that you just had to send all their vot­ers a bunch of free money—

Q. But that’s ex­actly the op­po­site of the way that cen­tral banks are sup­posed to be wiser and more pa­ter­nal than gov­ern­ments, and tell gov­ern­ments ‘no’ about fun things they’re not al­lowed to do! I’d never be able to look other cen­tral banks in the eye again!

A. Maybe you could com­pen­sate for the emo­tional dam­age by eat­ing a lot of choco­late or some­thing? It doesn’t seem like the same or­der of prob­lem as un­em­ployed peo­ple slowly sink­ing into de­spair.

And if you go to the leg­is­la­ture and ask them for the statu­tory au­thor­ity to mail cit­i­zens checks af­ter un­der­shoot­ing your in­fla­tion man­date for three years run­ning, the mar­kets will go “Oh holy poot, they mean it this time, let’s stop hoard­ing this cur­rency” and you won’t even have to mail the check.

Failing that? Bleep­ing do it. Think of it as declar­ing a coun­try-wide div­i­dend where ev­ery cit­i­zen gets an equal share of the new money needed to an­i­mate an econ­omy that ex­pands over time. I mean, I wouldn’t recom­mend mailing too many checks be­cause that re­ally would make it harder to de­stroy money later and pre­vent over­in­fla­tion. But it would tell the mar­kets you re­ally, hon­estly meant your new mon­e­tary stance of Bleep This Bleep­ing Un­der­in­fla­tion, I Own A Print­ing Press.

Q. Listen, you don’t un­der­stand how things are in my coun­try! My gov­ern­ment is full of poli­ti­ci­ans just look­ing for an ex­cuse to tear me to bits, and if I so much as asked to mail checks to peo­ple, they would! Frankly, I’m wor­ried that I couldn’t print as much money as you think I should, even if I wanted to.

A. Then I guess you’re not re­ally in in­de­pen­dent con­trol of your coun­try’s mon­e­tary policy, huh?

Q. That’s… harsh. Though, the thought of not be­ing blamed for any­thing does sound nice.

A. Well, to be clear, if you aren’t already print­ing all the money you can print, un­der what­ever poli­ti­cal con­straints, and promis­ing the mar­kets to print all the money you can print later un­til you reach a de­clared path tar­get, then you are to blame if you un­der­shoot your in­fla­tion tar­get. Un­til you’re do­ing that, you’re not do­ing ev­ery­thing you can; and what­ever level of money is flow­ing through your econ­omy, you did choose that par­tic­u­lar level and no higher, so you’re re­spon­si­ble for what­ever dam­age it does.

Q. But… you just don’t re­al­ize the ob­sta­cles here! What if other coun­tries don’t like me weak­en­ing my cur­rency rel­a­tive to their cur­rency? They’ll yell at me that I’m ex­port­ing my defla­tion to them!

A. If an­other coun­try thinks their cur­rency is too ex­pen­sive, they can print more of it.

Q. But that just ex­ports the defla­tion back to me. Isn’t this a zero-sum game?

A. No. If you both print more money, then your rel­a­tive ex­change rate stays the same and you both un­der­shoot your stated in­fla­tion tar­gets less pa­thet­i­cally ev­ery bleep­ing year af­ter year.

Q. But what if they re­fuse to print more money, and then blame me for adding to their defla­tion­ary pres­sures?

A. Then you can send them a recorded video mes­sage of you scream­ing at the top of your lungs that they should just print more money. No coun­try that has not phys­i­cally run out of ones and ze­roes has the right to blame any­one or any­thing else for their own cur­rency’s ex­cess value.

Q. Hm… I just re­al­ized, if they did make their cur­rency cheaper rel­a­tive to mine, they’d ex­port more goods to me, which could steal away jobs from my coun­try! Should I re­ally be re­mind­ing them of that?

A. That is not how Ri­cardo’s Law of Com­par­a­tive Ad­van­tage works. Imag­ine a world where no­body in­vests in other coun­tries or builds up for­eign cur­rency re­serves from year to year. In this world, ev­ery for­eign car has to be pur­chased with for­eign cur­rency that was ob­tained by sel­l­ing them a do­mes­tic com­puter in the same year. Right? So your rel­a­tive ex­change rate doesn’t af­fect the num­ber of com­put­ers you need to sell to buy a car—the price of for­eign cars in do­mes­tic com­put­ers. Con­versely, if a coun­try is sel­l­ing you cars and then just keep­ing some of your cur­rency in ware­houses while it slowly de­pre­ci­ates, then they’ll send you more cars than you ship com­put­ers to them, re­gard­less of rel­a­tive ex­change rates.

Q. Then you’re not ar­gu­ing that I should print lots of money to make my cur­rency cheaper so I can sell more things to for­eign­ers and make sure that I’m steal­ing their jobs in­stead of the other way around?

A. No! One, lots of the coun­tries try­ing to sell you things have me­dian in­comes much lower than yours, and I frankly don’t see how it could be any­thing but mus­tache-twirling car­toon villainy if I did ad­vise you how to thrive at their ex­pense. Two, that’s not how Ri­cardo’s Law of Com­par­a­tive Ad­van­tage works. And three, if be­ing able to get more cars by mak­ing com­put­ers and trad­ing them for cars, ac­tu­ally ‘de­stroyed jobs’, then com­bine har­vesters would also re­duce em­ploy­ment be­cause they pro­duced tons more grain and de­stroyed farm­ing jobs. If that was re­ally the way eco­nomics worked, then the 100-fold in­crease in agri­cul­tural pro­duc­tivity since the me­dieval era when 98% of the pop­u­la­tion was made up of farm­ers, would have caused only 3% of your pop­u­la­tion to have jobs to­day. The peo­ple in­side you are bet­ter off when they have more stuff, not when they need to do more work. Have you heard of the bro­ken win­dow fal­lacy?

Q. That’s where, if your econ­omy isn’t do­ing well, you just break a lot of win­dows, and then peo­ple have to re­pair their win­dows, which gives em­ploy­ment to glaziers, who spend their wages at bak­eries, who pay farm­ers, and the whole econ­omy is stim­u­lated and does bet­ter, right?

A. Well, that’s the fal­lacy. The prob­lem is that you’re not ac­count­ing for op­por­tu­nity costs. Break­ing a win­dow just means that you have to di­vert glass, la­bor, and money from other uses—the re­pair, and the money for the re­pair, aren’t mag­i­cal events that oc­cur with­out trad­ing off against any­thing else. Fur­ther­more, the idea that the town does bet­ter, just be­cause more money is be­ing spent, im­plies that there wasn’t yet enough money to an­i­mate all the trades that could be made. But if there’s not enough money to go around, so that money rather than glass­mak­ing ca­pac­ity is the limit­ing fac­tor on how many win­dows get made, then break­ing win­dows means that limit­ing-fac­tor money gets di­verted from some­where else!

I mean… the only way break­ing win­dows could ac­tu­ally add jobs, is if the econ­omy was be­ing limited by low money flow so there was spare glass­mak­ing ca­pac­ity and spare la­bor, and if the per­son pay­ing to re­pair the win­dows took the money out of an oth­er­wise in­ac­tive bank ac­count, and then the win­dows-re­pairer didn’t try to save more money later to make up for the loss. Not only would that hap­pen very rarely, but if it did hap­pen, it would mean you’d been asleep on your job! The only real benefit is com­ing from spend­ing down an oth­er­wise in­ac­tive bank ac­count to add money to a money-limited sys­tem! The whole pur­pose of your ex­is­tence is to make sure that the amount of glass flow­ing is bound by the amount of sand and heat available, not by there be­ing in­suffi­cient money to flow the other way.

The bro­ken win­dows fal­lacy is a fal­lacy, there isn’t some coun­ter­in­tu­itive way to make peo­ple be bet­ter off by break­ing their win­dows—or by out­law­ing clever har­vesters that pro­duce more grain with less la­bor—or by out­law­ing build­ing cars by send­ing other peo­ple com­put­ers in ex­change for cars—so long as you’re cre­at­ing enough money. But you shouldn’t be wor­ry­ing about which ex­act par­tic­u­lar places your econ­omy is al­lo­cat­ing its la­bor, or whether it’s more effi­cient to get cars by build­ing them from scratch ver­sus trad­ing com­put­ers for them. I mean, maybe there should be some part of your gov­ern­ment that wor­ries about things like run­away oc­cu­pa­tional li­cens­ing or real marginal tax rates ow­ing to benefit phase-outs, but not the cen­tral bank part!

Q. But my gov­ern­ment does keep tel­ling me to think about both in­fla­tion and jobs. That means I can’t put just in­fla­tion on a par­tic­u­lar tar­get path like you say, be­cause then I wouldn’t be think­ing about jobs too! I need to think about two things at once, which is why I have to use an ad-hoc policy and hold big im­por­tant meet­ings where I change my mind all the time. This dual tar­get also ex­plains why I’m always very wor­ried about over­shoot­ing 2% in­fla­tion even when em­ploy­ment has been drop­ping, and why I keep end­ing up with too lit­tle in­fla­tion and too lit­tle em­ploy­ment si­mul­ta­neously.

A. Yes, it’s bad when peo­ple are un­em­ployed. It’s very un­pleas­ant and it de­stroys real value. You want to min­i­mize that as much as you can. This gets us into an­other topic, which is that even tar­get­ing in­fla­tion at a 2%/​year level path isn’t all that great an idea. It’s bet­ter than try­ing to tar­get the amount of base money, sure. But you could still have some­thing bad hap­pen where peo­ple be­came more re­luc­tant to trade at the same time as a lot of money was de­stroyed. In that case you might end up with the same amount of to­tal ‘in­fla­tion’ per trade, even though there were idle fac­to­ries and peo­ple that you could put to work by cre­at­ing more money.

Q. So I should just make more money when­ever I eye­ball that I think my econ­omy is do­ing less than it could, but stop if in­fla­tion goes too high?

A. Hon­estly, that might be bet­ter than some of the other things you could be do­ing! Though it would be im­por­tant to only stop when the mar­ket said in­fla­tion was about to go too high, not when you were feel­ing a lit­tle ner­vous that it might go high later.

How­ever, there’s a sim­pler and more for­mal an­swer that ac­com­plishes the same thing and cre­ates much more sta­bil­ity. In­stead of tar­get­ing 2%/​year in­fla­tion, tar­get the to­tal amount of money chang­ing hands in your econ­omy and make that quan­tity go up by 5%/​year on a level price path. This quan­tity is called NGDP, or Nom­i­nal Gross Do­mes­tic Product.

Q. Huh, NGDP. I re­mem­ber hear­ing bad things about that mea­sure. Like, it’s a stupid mea­sure of my coun­try’s health, be­cause it doesn’t take into ac­count how a com­puter at the same price can be much more pow­er­ful. And peo­ple even try to in­clude mil­i­tary spend­ing into NGDP, and so on.

A. That’s okay! We’re not us­ing NGDP as a proxy mea­sure of how much fun your coun­try is hav­ing. We’re us­ing NGDP as ex­actly what it is, a mea­sure of the to­tal flow of money chang­ing hands.

When NGDP ac­cel­er­ates above trend, your coun­try’s mon­e­tary policy is too loose, and there’ll be too much money com­pet­ing for each trans­ac­tion. If NGDP drops be­low trend, your coun­try’s mon­e­tary policy is too tight, and there won’t be enough money for each trans­ac­tion.

And again, price-set­ters are re­luc­tant to lower their prices, of­ten much more so than peo­ple are re­luc­tant to pay in­creased prices—or price-set­ters are first in line to raise prices when they have mar­ket power, but try to be last in line to drop them. It’s not a ra­tio­nal-agent the­o­rem, but it’s definitely an em­piri­cally ob­served fact. So when NGDP drops, many trans­ac­tions will stop hap­pen­ing at all, which de­stroys the real value of the gains from trade, which is bad. By tar­get­ing NGDP, you’re tar­get­ing the flow of money di­rectly. It means that ev­ery shop­keeper knows that the coun­try as a whole will spend 5% more money next year, no mat­ter what else hap­pens. Now doesn’t that sound nice and sta­ble?

Q. What does that have to do with un­em­ploy­ment, though?

A. In most ways, NGDP is a mir­ror image of Nom­i­nal Gross Do­mes­tic In­come, the amount of money that ev­ery­one re­ceives to spend. Some economists sug­gest you should be tar­get­ing NGDI in­stead, be­cause it seems to be a more sta­ble es­ti­mate that gets ad­justed af­ter­wards less of­ten than NGDP es­ti­mates. But leav­ing that aside and just in­vert­ing the way we look at things, keep­ing NGDI on a level up­ward path en­sures that money-flow is available to pay ev­ery­one who wants to work. That’s the se­cret hid­den in­side the idea that when un­em­ploy­ment rises, you should cre­ate more money. What you’re re­ally do­ing is adding more wage-flow so that more peo­ple can be em­ployed. Think of NGDI as be­ing like a game of mu­si­cal chairs—all the peo­ple who are em­ployed need flow­ing money to pay them. So if there isn’t enough NGDI flow­ing through the sys­tem, some­body has to be­come un­em­ployed! That’s why sharp drops in em­ploy­ment track the graph for sharp drops in NGDP much more than they track the graph for lower in­fla­tion. So to make sure the econ­omy can steadily add as many jobs as it has room for, you tar­get the path of NGDI or the to­tal amount of money flow­ing, not ‘in­fla­tion’.

Q. But if I don’t tar­get in­fla­tion, won’t in­fla­tion go to­tally out of con­trol?

A. It would be very hard for that to hap­pen un­der an NGDP level tar­get­ing regime. If the to­tal amount of money flow­ing always in­creases at ex­actly 5% per year and re­turns to path from any level de­vi­a­tion, it’d be very hard for prices in the econ­omy to reg­u­larly go up at 10% per year. I mean, maybe you’re wor­ried that a speci­fied NGDP tar­get im­plies that there’d be twice as much money-flow per trans­ac­tion if half your coun­try’s res­i­dents died to a bio­eng­ineered su­per­plague—

Q. Yes! That would be very bad. Prices could dou­ble!

A. Then you can just tar­get NGDP per cap­ita—not per em­ployee, of course, but per in­hab­itant of the cur­rency area—and that would be fine too. That way you won’t get large amounts of in­fla­tion no mat­ter what hap­pens.

Q. Will that also pre­vent as­set bub­bles from form­ing? Some­times peo­ple blame me for that too.

A. Any as­set bub­ble that can hap­pen with 5%/​year NGDP growth is prob­a­bly one that would’ve hap­pened no mat­ter what you did. Plus, re­mem­ber, a cen­tral bank only has one price of money to con­trol, and it af­fects liter­ally ev­ery­thing in your coun­try. You should use that one lever to make sure that the coun­try as a whole will always spend 5% more money next year. So long as you do that, as­set bub­bles shouldn’t do much dam­age when they pop, and you prob­a­bly can’t even pre­vent them in the first place, and if you did try to mess with them and went off the NGDP level path to do so you’d be screw­ing up ev­ery­thing else. The way your coun­try’s se­cu­rity reg­u­la­tors can pre­vent price bub­bles is by mak­ing sure that an as­set class is very cheap and easy to short—that there’s no ob­sta­cles that add ex­pense or difficulty or un­cer­tainty to buy­ing put op­tions.

Not to men­tion, a lot of times when peo­ple yell ‘bub­ble’ the mar­ket goes up fur­ther be­fore it even­tu­ally goes down. Which is just an or­di­nary prob­lem of not know­ing whether an as­set is too high or too low, and you might not be any smarter about that than hedge-fund man­agers. But if an as­set price goes too high and peo­ple can ac­tu­ally tell, it’s of­ten be­cause there’s a sys­temic difficulty that makes short­ing the as­set too difficult or too ex­pen­sive.

Re­gard­less, all of that just shouldn’t be your con­cern. Just fo­cus on mak­ing sure that 5% more nom­i­nal money will be spent next year. If a price bub­ble can’t change that by in­flat­ing or burst­ing, it prob­a­bly can’t af­fect the rest of the econ­omy very much. And try­ing to ‘pop’ the price of one as­set class you think might maybe be a ‘bub­ble’, is definitely not worth the col­lat­eral dam­age of al­low­ing the whole coun­try’s NGDP to drop be­low trend, or the col­lat­eral dam­age of aban­don­ing your de­clared tar­get path.

Q. Okay, I’m not sure I be­lieve you about this ‘NGDP tar­get­ing’ busi­ness, but you’ve at least con­vinced me to try, you know, print­ing an amount of money that strikes me as in­sane. And you’d bet­ter be­lieve I am go­ing to buy back all those bonds and de­stroy this money the sec­ond this econ­omy starts to hy­per­in­flate… huh, that’s in­ter­est­ing.

A. What hap­pened?

Q. Prices went up 1.5% and un­em­ploy­ment got closer to its nor­mal level, though la­bor force par­ti­ci­pa­tion is still down… that means it’s now time to raise in­ter­est rates to above zero, right?

A. NO! Wait, what? What are you do­ing? You’ll choke off your re­cov­ery! Do you have any idea how badly the mar­kets have already re­acted sev­eral years ear­lier be­cause they already knew you would tighten mon­e­tary policy the in­stant there was any hint of re­cov­ery?

Q. But if I don’t raise in­ter­est rates now, I won’t have any room to cut in­ter­est rates later, if things get worse again—

A. Aaarg! Stop! That is not how in­ter­est rate tar­get­ing works!

Q. It’s not? I always thought that cut­ting the in­ter­est rate stim­u­lates the econ­omy. And it works, so far as I can tell. Back when things were bet­ter, I’d cut rates half a point and the econ­omy would go vsssh­hoooom just like press­ing the ac­cel­er­a­tor pedal on a car. But I can’t cut in­ter­est rates be­low zero, or, I mean, some peo­ple say I can, but I’m not sure I be­lieve them. So ob­vi­ously, if I might need to cut rates later in case of a re­ces­sion, I should raise the in­ter­est rate now when it won’t do much dam­age. That way I have room to cut it later!

A. NO. Don’t. That’s like stop­ping your an­tibiotic treat­ment in mid-course so you can ‘in­crease the amount of an­tibiotics later’ if you get sicker. It’s not just based on an in­stinc­tive brain-level mi­s­un­der­stand­ing of whether it’s ‘tak­ing an­tibiotics’ or ‘adding more an­tibiotics’ that is the effec­tive in­ter­ven­tion, it ac­tu­ally makes the dis­ease more re­sis­tant. Charg­ing 3% in­ter­est means a very differ­ent thing in terms of mon­e­tary policy, de­pend­ing on whether you’re in Ja­pan or Zim­babwe. In Zim­babwe, if you offer some­one a loan at 3% in­ter­est, it is a su­per-cheap loan. In Ja­pan, if you offer some­one a loan at 3% in­ter­est, it is an ex­pen­sive loan. Depend­ing on whether there’s more or less in­fla­tion, the same nom­i­nal in­ter­est rate on a loan can make the money cheap or ex­pen­sive. If you raise rates now, you’re tight­en­ing mon­e­tary policy, which brings the nat­u­ral in­ter­est rate down­ward, which in the fu­ture will make the same nom­i­nal in­ter­est rate tar­get rep­re­sent a tighter mon­e­tary policy.

Q. I’m not sure I un­der­stand.

A. If you raise rates now, in­fla­tion will be lower than it oth­er­wise would. Which means that if you later ‘drop’ fu­ture rates to 0.1% in case of a re­ces­sion, that fu­ture 0.1% in­ter­est rate will be less effec­tive and rep­re­sent less mon­e­tary stim­u­lus, than a rate of 0.1% would have rep­re­sented if you’d just held the rate con­stant to­day. You are not giv­ing your­self more am­mu­ni­tion be­fore you hit the ‘zero bound’. You are giv­ing your­self less am­mu­ni­tion be­fore you hit the ‘zero bound’, and also you’re chok­ing off your econ­omy’s nascent re­cov­ery.

Q. So you’re say­ing… rais­ing rates now will make the econ­omy weaker, so when I press the ac­cel­er­a­tor pedal later, it will be less effec­tive?

A. No, more like brak­ing changes the real dis­tance of the ac­cel­er­a­tor from the con­trol sys­tem’s zero, which isn’t the same as the ac­cel­er­a­tor’s phys­i­cal dis­tance from the floor mat.

Q. What?

A. I’m say­ing that you need to think in terms of the effect of an in­ter­est rate in­stead of the effect of an in­ter­est rate drop. If you raise in­ter­est rates now, a fu­ture nom­i­nal rate of 0.1% will be less pow­er­ful in an ab­solute sense later. So even though you’ll have the abil­ity to ‘drop’ in­ter­est rates later, you’ll be drop­ping it to a level of stim­u­lus that’s less pow­er­ful in an ab­solute sense, be­cause in­fla­tion will be lower af­ter you sig­nal a tight­ened mon­e­tary policy, so the real in­ter­est rate rep­re­sented by a fixed nom­i­nal rate will be higher and money will be more ex­pen­sive—

Q. I still don’t un­der­stand.

A. Look, just… you don’t need to ‘cre­ate more am­mu­ni­tion for later’ be­cause you can’t run out of am­mu­ni­tion. You can just cre­ate more ones and ze­roes if the econ­omy needs them, no mat­ter what the ‘in­ter­est rate’ looks like.

Q. But if I don’t raise in­ter­est rates now, I’ll be em­bar­rassed in front of the other cen­tral banks!

A. If you tighten rates now then you will have to keep rates even lower for longer and cre­ate even more money later be­cause in­fla­tion will go down and, worse, the mar­kets will have learned that you un­der­shoot your in­fla­tion tar­get. They will ex­pect overly-timid mon­e­tary policy in the fu­ture, which by the EMH (weak form) en­courages traders to hoard more of your cur­rency now and is a more con­trac­tionary mon­e­tary policy now.

If you’d cut rates fast enough in 2008, you could have kept the money flow from cra­ter­ing, and a 2% nom­i­nal in­ter­est rate would rep­re­sent a lower real in­ter­est rate than we have to­day. And then you wouldn’t have needed to do quan­ti­ta­tive eas­ing later on. Not to men­tion all the banks that wouldn’t have failed.

Well, it isn’t any differ­ent to­day. The more money you print now, the less you will be em­bar­rassed later. The more you tighten rates now, the longer you’ll have to keep them ‘em­bar­rass­ingly low’.

Q. But in­ter­est rates have already been low for so long! It doesn’t look good when I have to keep in­ter­est rates low for su­per-long! It sig­nals that I think my econ­omy is weak!

A. I’m sorry, but no­body be­lieves your pre­dic­tions about the econ­omy any more. They’ve seen you over­state your pre­dic­tions ev­ery year for a decade, and they have a mar­ket fore­cast to look at in­stead. Traders do care about how the cen­tral bank thinks the econ­omy is do­ing, but that’s be­cause ev­ery time you think the econ­omy is do­ing well, you tighten mon­e­tary policy and they want to fore­cast the re­sult­ing dam­age.

Q. But… if I raise in­ter­est rates by half a per­centage point, won’t it sig­nal that I think the econ­omy is do­ing re­ally well, and peo­ple will be­lieve me and perk up and the econ­omy will do bet­ter and stocks will rise?

A. Is that what ac­tu­ally hap­pened the last time you tried that?

Q. Well, no, but—

A. Look. You’re mak­ing your life more com­pli­cated than it needs to be. If you’re un­der­shoot­ing your tar­get path for in­fla­tion or for what­ever, cre­ate more money. Do not de­stroy money. Do not start un­do­ing your quan­ti­ta­tive eas­ing. Do not raise in­ter­est rates. Not for sig­nal­ing rea­sons, not to give your­self “am­mu­ni­tion for later”, not be­cause “in­ter­est rates have been low for too long”. Just don’t… tighten… policy when you’re still un­der­shoot­ing your tar­get. Any nom­i­nal vari­able you’re tar­get­ing, whether it’s in­fla­tion or NGDP, if you un­der­shoot the path, then loosen mon­e­tary policy. It’s not that com­pli­cated.

Q. Hey, I just thought of a clever idea. Maybe I can get my gov­ern­ment to bor­row more money and spend it. That way I can cre­ate less new money and still meet my in­fla­tion tar­get!

A. Please don’t. That will ac­com­plish liter­ally noth­ing ex­cept to cre­ate a huge bur­den of gov­ern­ment debt. If ev­ery dol­lar the gov­ern­ment spends is one less dol­lar you cre­ate, it has liter­ally zero net stim­u­la­tory effect on the econ­omy. If you think the econ­omy as a whole is spend­ing too lit­tle money, you should cre­ate more money. There is no rea­son the gov­ern­ment’s fis­cal policy should be in­volved. At all. Ever. There is no way your gov­ern­ment can push on money-flow by bor­row­ing a dol­lar to spend, that you, the cen­tral bank, can­not do at lower hu­man cost by cre­at­ing a tem­po­rary dol­lar from scratch. The only rea­son for a gov­ern­ment to buy a high­way is if the high­way is worth the money. Do­ing it for ‘stim­u­lus’ is com­pletely pointless if the cen­tral bank is effec­tively tar­get­ing in­fla­tion or any other nom­i­nal vari­able. Every dol­lar the gov­ern­ment bor­rows to spend, is one less dol­lar the cen­tral bank cre­ates to reach their nom­i­nal tar­get. If the ‘fis­cal mul­ti­plier’ is not zero, it means the cen­tral bank is not effec­tively tar­get­ing the price of any­thing and your pres­i­dent ought to be fired. Your in­fla­tion tar­get is your prob­lem and you shouldn’t try to shove it onto your gov­ern­ment.

Q. That’s cer­tainly an in­ter­est­ing poli­ti­cal stance, but…

A. Poli­ti­cal stance? It is an em­piri­cal state­ment about how money works. Re­mem­ber when there was this big, scary ‘se­quester’ that was sup­posed to sharply cut US gov­ern­ment spend­ing in the mid­dle of a re­ces­sion? The Fed­eral Re­serve scraped up some more courage, printed a cor­re­spond­ing amount of money, and noth­ing hap­pened. There was a nice lit­tle to-do where the Key­ne­si­ans pre­dicted eco­nomic dis­aster and the mar­ket mon­e­tarists said ‘Noth­ing will hap­pen so long as the Fed prints a cor­re­spond­ing amount of money’ and the mar­ket mon­e­tarists were ex­per­i­men­tally cor­rect. It was a clear-cut test of two com­pet­ing the­o­ries and the re­sults were also clear. If you are able to print more money when more money is needed, your gov­ern­ment can cut spend­ing with­out any mon­e­tary effects.

I mean, maybe you won’t get a new high­way and peo­ple’s cars will crash. But the part where the econ­omy crashes due to de­creased to­tal spend­ing is some­thing you can pre­vent by adding more money. In fact this will hap­pen au­to­mat­i­cally if the cen­tral bank is in a regime where they will re­spond in­cre­men­tally to in­cre­men­tal move­ment away from their price tar­get—

Q. Wait… hold on… god damn it, not again. I’m sorry, I need to put this con­ver­sa­tion on hold while I bail out one of my coun­try’s big banks.

A. What? Why would you do that? Wouldn’t that cre­ate a huge moral haz­ard?

Q. I know that! God, I know. But if I don’t bail out this bank, some other banks might fail too!

A. So?

Q. And some bro­ker­ages might fail! There’d be sys­temic con­ta­gion!

A. Okay…?

Q. And al­most ev­ery­one has their hands in some­one else’s pants! Our whole fi­nan­cial sec­tor could im­plode!

A. Truly, the tree of pru­dent in­vest­ment must be wa­tered from time to time with the blood of idiots. Shall we watch the fire­works to­gether? I’ll grab some pop­corn.

Q. No, see… it’s bad if lots of fi­nan­cial com­pa­nies go bankrupt! I’ve got to stop that from hap­pen­ing! It’s a dis­aster with banks in it, and I’m the Cen­tral Bank, so it must be my job to stop it!

A. Why do you even care? So a bunch of fi­nan­cial com­pa­nies go ker­plooey and va­por­ize the vir­tual money of some rich peo­ple who trusted other peo­ple wear­ing fancy busi­ness suits. How does that af­fect an av­er­age house­hold with two chil­dren? If any­thing, some suck­ers will have less cur­rency with which to buy yachts, and some of the steel and con­crete could go into mak­ing toys for the chil­dren in­stead. On a more ab­stract level, your rich-sucker in­sti­tu­tions would have less cur­rency with which to make mediocre in­vest­ments, and the eco­nomic ca­pac­ity thus freed up could go into good in­vest­ments in­stead.

Q. Such a huge fi­nan­cial dis­aster would have catas­trophic effects on the real econ­omy! The com­pany that em­ploys the par­ents at a hair­cut shop wouldn’t be able to get a loan to make pay­roll! The rich peo­ple who were buy­ing hair­cuts from them will lose a bunch of money on the stock mar­ket and be un­able to af­ford hair­cuts!

A. That would be a prob­lem of not enough money flow­ing, an in­stance of the prob­lem class where the econ­omy still has a bunch of fac­to­ries but peo­ple don’t have enough money to buy things. You can pre­vent this prob­lem by cre­at­ing more money.

Look, you don’t even need to think about the de­tails! Just ig­nore all the the­atrics and keep out­putting what­ever amount of money the pre­dic­tion mar­ket says is nec­es­sary to keep the to­tal money flow, or Nom­i­nal Gross Do­mes­tic Product, on a level path tar­get of 5% per year. I mean, if your coun­try’s whole fi­nan­cial sec­tor is melt­ing down, the pre­dic­tion mar­ket is prob­a­bly go­ing to tell you to cre­ate a lot of money, but that’s okay.

Um, it is ad­mit­tedly true that this is re­ally, re­ally not the time to flinch from print­ing any re­quired amount of money. You only want the bad banks to go bankrupt, not for all the banks to go bankrupt be­cause there isn’t enough money in the en­tire sys­tem to pay off even the non-stupid loans—that lat­ter part re­ally is your job to pre­vent.

Q. Do you have any idea the size of dis­aster we’d be risk­ing?! What if the new money doesn’t reach peo­ple fast enough!?

A. If mar­ket fore­casts start to in­di­cate that the real econ­omy might be about to tank, I guess you could ask the leg­is­la­ture for the statu­tory au­thor­ity to mail your cit­i­zens checks. If it’s re­ally go­ing bad that fast, you can use di­rect de­posit, even. I think the poli­ti­ci­ans would let you do it un­der those con­di­tions… right? I guess you’d have to be pretty sure they’d let you do it.

Q. Even if the gov­ern­ment did let me do it, are you se­ri­ously tel­ling me that as a cen­tral bank, I should watch my coun­try’s en­tire fi­nan­cial sec­tor just burn to the ground?

A. Not the en­tire sec­tor. A bunch of peo­ple who made bad in­vest­ments lose their shirts. If you were in a con­ta­gion en­vi­ron­ment where lots of banks were lend­ing to bad in­vestors or cre­at­ing com­pli­cated deriva­tives with other banks who were, then lots of peo­ple lose their shirts. The good banks who stayed vir­tu­ous pick up the slack us­ing all that new money you’re cre­at­ing—tem­porar­ily, un­til ve­loc­ity picks up—and a few years later, ev­ery­one’s in­vest­ing more wisely.

As a cen­tral bank you have one job, to reg­u­larize the to­tal flow of money through the econ­omy. You make sure there’s enough money in the to­tal sys­tem for peo­ple to pay off good loans. You make sure that the fam­ily with two kids has enough money in hand to pay for gro­ceries.

As a cen­tral bank, you have one su­per­power—the ab­solute abil­ity to con­trol the path of any one nom­i­nal vari­able. Use that power to promise ev­ery shop­keeper that the coun­try will spend 5% more money next year. Promise ev­ery em­ployee that the coun­try will have 5% more nom­i­nal in­come to flow into wages, promise ev­ery hon­est bank that there will be 5% more money flow to pay back loans to pro­duc­tive en­ter­prises. And then tell your too-big-to-fails to go hang!

You might need to sell a lu­dicrously huge amount of cur­rency to keep money flow on-path if over fifty per­cent of your fi­nan­cial sec­tor is burn­ing mer­rily to the ground, es­pe­cially if this is the first time you’re do­ing this and peo­ple are scared your de­ter­mi­na­tion will break. And then, as good banks start to take over the loan-mak­ing ca­pac­ity, you’ll need to buy back a lot of that lu­dicrously huge amount of cur­rency. But that’s all you need to do.

Q. This sounds re­ally scary! I’d rather take a bunch of ad-hoc half-mea­sures and throw enor­mous amounts of money at a bunch of to­tal bas­tards and cre­ate ter­rify­ing amounts of moral haz­ard just to avoid the tem­po­rary cleans­ing fire that would have cleaned a lot of gunk out of the sys­tem and maybe even re­duced in­equal­ity!

A. Well, you cer­tainly won’t be alone if you go that route.

Q. How can you just say that I should let a huge amount of vir­tual money go up in smoke while tem­porar­ily cre­at­ing enough new money to pre­vent real-world dis­rup­tion? How can I let so many banks fail when ev­ery­one with more than $250,000 in­vested at a bad bank will only have $250,000 left plus what­ever per­centage of the bank’s other as­sets were re­cov­er­able, with a com­pen­sat­ing amount of new money be­ing tem­porar­ily added some­where else to level the to­tal money flow through the econ­omy?

A. It’s sim­ple! You just de­clare an NGDP path tar­get, set up a pre­dic­tion mar­ket, tell an in­tern to do what­ever the pre­dic­tion mar­ket says, and then go on va­ca­tion for the rest of your life as a cen­tral bank!

Q. This is mad­ness!

A. Mad­ness? This… is… mar­ket mon­e­tarism!


Origi­nally posted to so­cial me­dia on Fe­bru­ary 11, 2016.