This put up is from a set of feedback I gave on the NBER Asset Pricing convention in early November at Stanford. Convention agenda right here. My full slides right here. There was video, however sadly I took too lengthy to jot down this put up and the NBER took down the convention video.
I used to be requested to touch upon “Downward Nominal Rigidities and Bond Premia” by François Gourio and Phuong Ngo. It is a very good clear paper, so all I might assume to do as discussant is reward it, then transfer on to larger points. These are actually feedback about entire literatures, not about one paper. One can admire the play however complain concerning the sport.
The paper implements a model of Bob Lucas’ 1973 “Worldwide proof” statement. Costs are much less sticky in excessive inflation international locations. The Phillips curve extra vertical. Output is much less affected by inflation. The Calvo fairy visits each evening in Argentina. To Lucas, excessive inflation comes with variable inflation, so folks perceive that worth adjustments are largely mixture not relative costs, and ignore them. Gourio and Ngo use a new-Keynesian mannequin with downwardly sticky costs and wages to precise the concept. When inflation is low, we’re extra typically within the more-sticky regime. They use this concept in a mannequin of bond threat premia. Instances of low inflation result in extra correlation of inflation and output, and so a distinct correlation of nominal bond returns with the low cost issue, and a distinct time period premium.
I made two factors, first about bond premiums and second about new-Keynesian fashions. Solely the latter for this put up.
This paper, like lots of earlier than it, provides just a few substances on high of an ordinary textbook new-Keynesian mannequin. However that textbook mannequin has deep structural issues. There are recognized methods to repair the issues. But we frequently construct on the usual mannequin, somewhat than incorporate recognized methods or discover new methods to repair its underlying issues.
Drawback 1: The signal is “flawed” or at the least unconventional.
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The fundamental signal is flawed — or at the least counter to the usual perception of all coverage makers. Within the mannequin, larger rates of interest trigger inflation to leap down instantly, after which rise over time. Everybody on the Fed uniformly believes that larger rates of interest trigger inflation to go nowhere instantly, after which gently decline over time, with “lengthy and variable lags.”
Larry Ball pointed this out 30 years in the past. The conduct comes straight from the forward-looking Phillips curve. Decrease output goes with decrease inflation, relative to future inflation. I.e. inflation rising over time.
To be clear, possibly the mannequin is true and the beliefs are flawed. It is superb that a lot modeling and empirical work has gone in to massaging principle and information to evolve to Milton Friedman’s 1968 proclamation of how financial coverage works. The “lengthy and variable lags” particularly are a hassle to fashionable economics. If costs are going up tomorrow, you increase costs right now. However that is for one more day. This mannequin doesn’t behave the best way most individuals assume the financial system behaves, so if you are going to use it, at the least that wants a serious asterisk.
Effectively, we all know methods to repair this. You possibly can see that sneaking lagged inflation into the Phillips curve goes to be a giant a part of that.
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Christiano Eichenbaum and Evans, 20 years in the past, produced a extensively cited mannequin that “fixes” this drawback. It has loads of substances. Most of all, it assumes that wages and costs are listed. Companies and employees that do not get tapped by the Calvo fairy to vary their worth or wage nonetheless increase by noticed inflation. This provides a Phillips curve with lagged inflation. Furthermore, in preferences, funding, and this Phillips curve, CEE modify the mannequin to place development charges rather than ranges. (Extra evaluation in a three half collection on new-Keynesian fashions right here.)
Nice. However discover that neither Gourio and Pho nor just about anybody else builds on this mannequin. We cite it, however do not use it. As an alternative, 20 extra years of NK theorizing research totally different extensions of the essential mannequin, that do not resolve the central conundrum.
Drawback 2: Fed induced explosions
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The usual new-Keynesian mannequin says that if the Fed holds rates of interest fixed, inflation is steady — will go away by itself — however indeterminate. There are a number of equilibria. The usual new-Keynesian mannequin thus assumes that the Fed intentionally destabilizes the financial system. If inflation comes out greater than the Fed needs, the Fed will lead the financial system to hyperinflation or hyper deflation. Underneath that menace, folks leap to the inflation that the Fed needs to see.
However the Fed does no such factor. Central bankers resolutely state that their job is to stabilize the financial system, to convey inflation again from wherever it’d go. Regardless of 1000’s of papers with new-Keynesian equations written at central banks, if anybody have been ever to actually describe these equations within the introduction, “we assume that the central financial institution is dedicated to answer inflation by hyperinflation or deflation to be able to choose from a number of equilibria” they might be laughed out of a job.
As an alternative, we go on with the identical mannequin and its underlying extensively counterfactual assumption about coverage.
Drawback 3: The match is horrible
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A mannequin consists of a set of equations, with the factor you wish to decide (say, inflation) on the left, the financial causes described by the mannequin on the fitting, plus “shocks,” that are issues your mannequin cannot seize. Within the rationalization half, there are parameters ((sigma, beta, kappa, phi)), that management how a lot the issues on the fitting have an effect on the issues on the left.
The match of new-Keynesian fashions is often horrible. In accounting for financial variables ((x_t,) (pi_t, ) (i_t ) right here), the error phrases ((varepsilon)) are a lot bigger than the mannequin’s financial mechanisms (the (x,) (pi) on the fitting hand aspect). Forecasts — predicting (pi), (x) forward of time — is worse. For instance, the place did inflation come from and why did it go away? Anticipated inflation hasn’t moved a lot, and the financial system simply plugged alongside. A lot of the rise and fall of inflation got here from inflation shocks.
Associated, the match of the fashions is about the identical quantity of horrible for various values of the parameters. Which means the parameters are “poorly recognized” if recognized in any respect. That implies that the mechanisms of the mannequin — say, how a lot larger rates of interest decrease output, after which how a lot decrease output impacts inflation — are weak, and poorly understood.
Partly this is not typically observed as a result of we acquired out of the behavior of evaluating fashions by match within the Nineteen Eighties. Most fashions are evaluated, as I confirmed above for CEE by matching choose “recognized” impulse response capabilities. However as these response capabilities additionally clarify small variances of output and inflation, it is doable to match response capabilities effectively, but nonetheless match the information badly, i.e. match the information solely by including huge shocks to each equation.
I do not know of fine fixes right here. Quaint ISLM fashions had comparable issues (See Sims 1980). However it’s a incontrovertible fact that we simply ignore and go on.
The Phillips curve is a central drawback, which has solely gotten worse recently. Unemployment was excessive and declining all through the 2010s, with steady inflation. Inflation got here with excessive unemployment in 2021. And inflation fell with no excessive actual rates of interest, no unemployment, and powerful development in 2022-2023. However what’s going to substitute it?
So the place are we?
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Macro is surprisingly un-cumulative. We begin with a textbook mannequin. Individuals discover some shortcomings and recommend a repair. However somewhat than incorporate that repair, the following paper provides a distinct repair to the identical textbook mannequin. One would assume we might comply with the trail on the fitting. We do not. We comply with the trail on the left.
That is frequent in economics. The true enterprise cycle literature adopted a lot the identical path. After the King Plosser Rebelo stochastic development mannequin turned the usual, folks spent a decade with one extension after one other, every effectively motivated to repair a stylized truth. However by and huge the following paper did not construct on the final one, however as an alternative provided a brand new variation on the KPR mannequin.
Posteriors comply with priors in keeping with Bayes’ rule, in fact. So one other means of placing the statement, folks appear to place a reasonably excessive prior on the unique mannequin, however do not belief the variations in any respect.
Wę want a digestion. Which of the brand new substances are dependable, sturdy, and belong as a part of the brand new “textbook” mannequin? That is not straightforward. Dependable and sturdy may be very arduous to search out, and to steer folks. There are such a lot of to select from — CEE’s smorgasbord, capital, monetary frictions, heterogeneous brokers, totally different expectation formation tales, totally different pricing frictions, and so forth. What is the minimal straightforward set of those to make use of?
A part of the difficulty lies in how publishing works. It is almost inconceivable to publish a paper that removes outdated substances, that digests the mannequin right down to a brand new textbook model. The rewards are to publishing papers that add new substances. Even when, like CEE, everybody cites them however would not use them.
I’ve requested many economists why they construct on a mannequin with so many recognized issues, and why they do not embody recognized fixes. (Not simply fiscal principle!) The reply is often, sure, I find out about all these issues, however no one will hassle me about them since each different paper makes the identical assumptions, and I have to get papers revealed.
I went on a little bit of a tear right here as I referee plenty of nice papers like this one. Each a part of the paper is nice, besides it builds on a mannequin with huge flaws we have recognized about for 30 years. It feels unfair to complain concerning the underlying mannequin, because the journal has revealed and can publish 100 different papers. However at what level can we, collectively, scream “Cease!”
The brand new-Keynesian mannequin has been the usual mannequin for an astonishing 30 years. None of ISLM, monetarism, rational expectations, or actual enterprise cycles lasted that lengthy. It is much more superb that it’s so unchanged in all this time. It’s undoubtedly time for a greater textbook model of the mannequin! Perhaps it is a plea for Woodford, Gali or one of many different NK textbook authors, which significantly better command of all of the variations than I’ve, to bless us a brand new textbook mannequin.
Or, maybe it is time for one thing completely new.
That is not fiscal principle per se. Fiscal principle is an ingredient, not a mannequin. You possibly can marry it to new-Keynesian fashions, as I, Leeper, Sims, and others have executed. However you may also marry it to outdated ISLM or anything you need. Given the above, possibly there is not an current modification however a brand new begin. I do not know what that’s.
(My feedback even have some comparable feedback about time period premiums and the way to consider them, however this put up is lengthy sufficient.)
Replace:
The previous is a VAR with excessive frequency measurement of the financial coverage shock. And..
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| Supply: Miranda-Agrippino and Ricco |
The worth degree in addition to the inflation price can leap down instantly when the rate of interest rises! (I feel the graph plots the extent of CPI, not development price.) That is even stronger than the baseline mannequin by which the value degree, being sticky, doesn’t transfer, however the inflation price jumps on the rate of interest rise.
The latter is a pleasant theoretical paper. It provides loads of the CEE assumptions. I overstated an incredible deal that others haven’t used these substances. They’re utilized in these “medium scale” fashions, simply not in “textbook” fashions. Nevertheless, it removes listed costs and wages with purely ahead trying Phillips curves. It provides intermediate items nevertheless. This makes costs adjustments work by way of the community of suppliers including fascinating dynamics, which has at all times struck me as an important ingredient. And…
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| Supply: Phaneuf, Sims ,and Victor |
The primary estimate is the darkish line. Right here you see a mannequin with the traditional response: inflation doesn’t transfer on influence, and will increase a while after the rate of interest rise.