Visions of grandeur. Or analyzing data with 3D lenses!

I could never understand the focus on annualized quarterly growth rates! On that score we´ve been getting a lot of this sort of comment:

GDP registered its best six-month stretch since 2003 in the period ending Sept. 30, Commerce Department data out Tuesday showed.

The resurgent growth alongside steady labor market improvements this year suggest the economy is on solid footing despite uncertainty abroad. GDP has now expanded for two straight and 19 of the past 21 quarters. Those 63 months of only briefly interrupted growth stretch out longer than the post-World War II average of 58 months for recoveries.

But some come quickly “down to earth” and say:

But strip out some of the quarterly volatility and the economy’s performance remains unspectacular.

For the short four year period following the gutter of the “Great Recession”, this is the contrast between viewing data with 3D and “normal” lenses:

3D Lenses

Both have the same average (2.2%) but the volatility of annualized growth is more than 3x greater.

Don´t forget that it was from focusing attention at the volatile component of headline CPI/PCE that led the Fed to fear inflation “getting out of hand” back in 2008! We all know (and feel) the consequences.

From “The Long Boom” to “The Long Depression”

In their recent “Monetary Policy When the Spyglass Is Smudged”, San Francisco Fed researchers Early Elias and co-authors start off:

It would be a mistake to characterize the Great Recession as simply a run-of-the-mill economic downturn, only larger in magnitude. In the post-World War II era the United States experienced both deep recessions and episodes of financial turmoil, but not since the Great Depression had the U.S. economy suffered both simultaneously. The degree of economic dislocation has been considerable, greatly altering the long-term structure of the economy and the outlook.

Economists are still grappling with this new economic order and how to refine their thinking. Not surprisingly, implementing policy in such an uncertain economic environment has been specially challenging. This Economic Letter examines how this new environment has made traditional measures of economic performance harder to interpret. The tool we use to communicate these policy challenges is the well-known Taylor rule.

I thought to myself: Instead of writing about the difficulties in measuring “economic slack” in this “new economic order”, why didn´t they spend some time trying to understand the reason for the joint occurrence of “deep recession and financial turmoil”?

In his recent “How the Fed Got Huge”, Jeffrey Rogers Hummel contrasts Friedman´s “money view” with Bernanke´s “credit view”. In which case:

Instead of a sharp increase in Fed-created money that would have calmed the panic and then been quickly reversed, we got targeted bailouts with almost no impact on the effective money supply, despite all the chatter about “quantitative easing.”

The Long Boom description of the post 1984 economy was coined by John Taylor in 1998 and followed the Fed´s “Taylor Rule-based” monetary policy. Later it was renamed by Stock and Watson “The Great Moderation”. The “Long Depression”, likewise, could aptly be called “The Mediocre Moderation”.

In charts, both the “Long Boom” and “Long Depression” and the associated behavior of monetary policy reflected in the “high” and “low” paths of NGDP.

Long Boom Depression_1

The moment the Fed went all-in for the bail-outs the rest of the economy tanked. It´s not as Hummel has it, “with almost no impact on the effective money supply”, but with a very large negative impact, even stronger than it appears given that money demand was increasing fast!

Long Boom Depression_2

So I was very saddened to read my friend and fellow MM Lars post “The story of a remarkably stable US NGDP trend”, where he wraps up on a very depressing note:

I have earlier argued that the development in NGDP looks as if the Federal Reserve has had a 4% NGDP level target since Q3 2009. In fact at no time since 2009 has the actual level of NGDP diverged more than 1% from the 4% trend started in Q3 2009 and right now we are basically exactly on the 4% trend line. This is remarkable especially because the Fed never has made any official commitment to this target.

With market expectations fully aligned to with this trend and US unemployment probably quite close to the structural level of unemployment I see no reason why the Fed should not announce this – a 4% NGDP level target – as its official target.

PS I might join the hawks soon – if the trend in NGDP growth over the last couple of quarters continues in the coming quarter then we will move above the 4% NGDP trend and in that sense there is an argument for tighter monetary conditions.

PPS I am not arguing that monetary policy was appropriate back in 2009 or 2010. In fact I believe that monetary policy was far too tight, but after six years of real adjustments it is time to let bygones-be-bygones and I don’t think there would be anything to gain from a stepping up of monetary easing at the present time.

It´s not, I think, a question of easing (or, as he says, “soon joining the hawks”) but of changing market expectations by a regime change (an NGDP Level Target). Market expectations, being “putty-putty” (not “putty-clay”), will very quickly adapt!

Update: More “slack measuring” at Econbrowser:

There is a lot of discussion of how economic slack is fast disappearing, and I expect a lot of push on this view, given continued rapid growth in GDP as reported in today’s second release for 2014Q3. This view seems counter to (1) the CBO estimate of potential GDP and (2) the slow pace of inflation. My suggestion is that there remains a substantial amount of slack out there.

I like the idea of “given continued rapid growth in (R)GDP. In fact RGDP growth has been “monotonously” slow, clocking an average 2.2% since Q2 2010!

“All quiet on the E. Front”

There´s absolutely nothing new on the economic front! So why there´s so much talk about “policy normalization” (i.e. increase in rates)?

Since the economy “pulled-up” from the “gutters” of the “Great Recession” a “mediocre moderation” has established itself. It´s growth all right, which is more than the EZ, for example, can flaunt. But in this case, doing better than the Jones´ is not the appropriate yardstick! It only self-serves the US policymakers.

All Quiet_1

Maybe the persistent drop in the unemployment rate over this period is “side-tracking” monetary policy makers. Inflation below target is “good” and if unemployment is reaching “full employment” the time is nearing for “us” to act!

All Quiet_2

Earlier this year, before the quarter1 GDP release, the NGDP Indicator was pointing to growth remaining close to 4%. At the time so was Justin Irving´s real time NGDP forecast, but now it´s down a notch!

Remembering Ronald Reagan, Federal Budgets And Inflation-Fighting. John Cochrane Fights Economic History Again?

A Benjamin Cole post

Some say Allan Meltzer, the right-wing economist, Carnegie Mellon professor, and author of the well-regarded A History of the Federal Reserve is an acerbic fellow. Maybe so.

Nearly forgotten today, a younger version of Meltzer served as an Acting Member of President Ronald Reagan’s Council of Economic Advisers in 1988-9. Ten years after his stint on the CEA, Meltzer recounted the Reagan Days (1981-1989), in a piece entitled, Economic policies and actions in the Reagan administration.

Meltzer’s chastising study reads in part—

“Uncertainty and lack of a coherent monetary policy were not limited to 1981-82. During the years 1984-87, the Reagan administration shifted from a freely fluctuating exchange rate to encouraging dollar devaluation first by talk and then, in 1986, by increasing money growth. These actions were followed by a decision at the Louvre in January 1987 to set a band for the exchange rate against principal currencies. Within a few months, the dollar was overvalued relative to the agreed-upon rates, so maintenance of the band required increased money growth in Germany and Japan and lower money growth in the United States. The band required higher interest rates. Between July and October 1987 interest rates on long-term U.S. government bonds increased approximately 25 percent (from 8 1/2% to about 10 1/2%). When anticipations of further increases in interest rates contributed to a rather dramatic decline of prices on the world’s stock exchanges, the administration shifted its position again. The dollar declined about 8 to 10 percent below the presumed bottom of the previous band.

It is difficult to find a consistent pattern, much less a coherent policy, in these shifts within less than one year from efforts to force devaluation by raising money growth and lowering market interest rates to a program of stabilizing exchange rates, lowering money growth, and raising interest rates and then to a program of lowering interest rates and allowing the dollar to fall. The shifts suggest an extremely short-term focus….” (boldface added.)

From Meltzer’s perspective, the Reaganauts stomped on the monetary brakes in 1981, then once inflation slipped towards 5%, they gunned the accelerator again. Thereafter, they had an incoherent policy.

Okay, monetary policy was a mess, by Meltzer’s lights, although the curious placement of monetary policy within the Reagan Administration, and not within Chairman Paul Volcker’s somewhat independent Federal Reserve, is puzzling. Meltzer seems to imply Reagan called the shots, and Volcker complied. As in Fed Chairman Arthur Burns’ compliant dance with President Nixon.

But what about Reagan’s fiscal policy?

Here, Meltzer is again the scold.

“Why did the Reagan administration choose to run deficits that are large relative to previous peacetime experience in the United States? One possibility is that the deficits were not anticipated. This is improbable….”

Meltzer concludes the Big Reagan Deficits stemmed from increased spending, as tax receipts as a fraction of GDP stayed within historical ranges.

As a final slap, Meltzer also concludes Reagan “did very little to implement a deregulation policy. If we include protectionist actions affecting imports with deregulation, the Reagan administration’s record on deregulation is poor.”

Meltzer is a tough, even acid critic. But John Cochrane, University of Chicago scholar? Not so much.

Enter John Cochrane

Today Cochrane hails the Reagan-Volcker Team as Dynamic Duo Inflation-Busters.

At first blush, this is puzzling; Cochrane’s recent “Neo-Fisherite” stance declares the Fed can fight inflation by lowering interest rates, which sets off lower inflationary expectations—and voila!  You get lower inflation.

In the comments section of his blog, I asked Cochrane about the accepted Fed Chairman Paul Volcker story, that an indomitable Volcker mightily raised rates and thereby broke the back of inflation.

That is not a Neo-Fisherite story line.

Cochrane replied, “The 1980s were a classic joint fiscal-monetary contraction….Tax reform, growth, led to large surpluses that paid off a handsome present to bondholders, and paid for a decade of high interest costs. Many monetary tightenings have failed without this fiscal support.”

No doubt, the reader is thinking, “What the beans is Cochrane thinking about? Reagan ran red ink like water over Niagara!”

Cochrane has a nifty definition of federal surplus that is kin to what business people would call an “operating budget.” That is, what is the profit or loss a business makes on operations, before debt payments. Cochrane’s point is that Reagan ran an operating surplus, also called a primary surplus—taxes were greater than operating outlays.

It is an interesting vessel of an idea, the only problem it also leaks water like Niagara. The Reagan deficits were so vast that even without debt payments The Gipper ran rivers of red ink.

FEDERAL BUDGET

Year   Net Interest Payments    Deficit

1981                   $68.8                  $  79.9 billion

1982                   $85.0                  $128.0

1983                   $89.8                  $207.8

1984                   $111.1                $185.4

1985                   $129.5                $212.3

1986                   $136.0                $221.2

1987                   $138.6                $149.7

1988                   $151.8                $155.2

2000                   $222.9                +$236.2

Well, Reagan came close to a balanced operating budget in 1988, but no cigar, and most of his Presidency was a gathering ocean of red ink, even his primary budget.

The year 2000, btw, was President Clinton’s last year in office, in which he ran an operating surplus, or primary surplus, of $459.1 billion. One might ponder if any organization ever in history ran such a large operating gain.

Economic History

Cochrane has been pushing a Neo-Fisherite stance, but too often he seems to run headlong into a granite wall of opposing empirical and historical facts.

As Meltzer points out, there was no coordination, or joint contraction, of fiscal and monetary policy in the Reagan Administration; Reagan ran big deficits and Volcker raised interest rates to the moon in 1980.

By luck or otherwise, inflation cracked quickly to under 5%, so Volcker eased up, as is seen in sliding interest rates and bulging M1 and M2 supplies in the 1980s. Meanwhile, Reagan kept running huge deficits.

This is not a Neo-Fisherite story. Monetary policy erratically eased and was joined at the hip with big federal deficits after 1981.

The Real Story

But the real story remains lost to Cochrane, and others, I fear.

The first real story is that the U.S. economy has evolved over the decades to one that is much less inflation-prone than the 1960s and 1970s. The last gasp of inflation was in the early 1980s, when Volcker slay it.

Now, Big Labor is dead, Big Steel too, Big Telecommunications, Big Oil, Big Autos, Big Anything.

International trade has exploded, reducing supply side bottlenecks and the possibility that an economy can “overheat.” The Wal-Mart import-a-rama scheme is the norm.

Americans would have to buy a lot of cars to allow global automakers to engage in price gouging. More than they could ever buy. Multiply that example a thousand times over, in every product category.

Meanwhile, top marginal tax rates have been cut in half, while financial, telecommunications and transportation industries have been deregulated. Capital is everywhere, gluts of it.

The Internet has made sourcing easy and global, and simultaneously opened local markets—second and grey-market goods are easily traded now.

The real story is inflation is dead.

The second real story is the one Market Monetarists know: A central bank that fixates on inflation or interest rates is not doing its job, which is properly focused on economic growth. Oh, that?

Yes, that. A central bank best obtains a good result on that by trying to keep nominal GDP growth on a steady growth path.

I guess that is just too easy.

PS: On May 6, Meltzer penned an op-ed in The Wall Street Journal to the effect that “Never in history has a country that financed big budget deficits with large amounts of central-bank money avoided inflation. Yet the U.S. has been printing money—and in a reckless fashion—for years.”

Inflation will wreck America, suggests Meltzer.

Some things never change.

In a perpetual “state of readiness”

And still failing miserably!

That´s the story of the ECB:

FRANKFURT—European Central Bank President Mario Draghi sent a strong signal Friday that the central bank is ready to “step up the pressure” and expand its asset-purchase programs if inflation fails to show signs of quickly returning to the ECB’s target.

“We will continue(!) to meet our responsibility—we will do what we must[“whatever it takes”, again?] to raise inflation and inflation expectations as fast as possible, as our price stability mandate requires of us,” Mr. Draghi said in a speech to a banking conference.

If(!) on its current trajectory our policy is not effective enough to achieve this, or further(!) risks to the inflation outlook materialize, we would step up the pressure and broaden even more the channels through which we intervene, by altering accordingly the size, pace and composition of our purchases,” Mr. Draghi said.

Readiness

 

“Nothing ado about inflation”

There was very little said about today´s CPI release. Funny that when inflation remains below target we don´t hear much, unlike earlier this year when it was thought that inflation was climbing towards the 2% target!

The Fed targets PCE inflation, which on average comes about 0.4 points below CPI inflation. The charts below give a pretty good indication that inflation has not been a problem for quite some time, particularly if you track the Core versions of the indices, which take out the noise from things like oil and commodity shocks!

Nothing Ado_1

Nothing Ado_2

The final chart illustrates how (CPI) long-term inflation expectations have behaved. Interesting to note that before the crisis hit, both the TIPS and Cleveland Fed measures of expected inflation were quite similar. I have no idea why that changed after 2008, but maybe they are “joining-up” again.

Nothing Ado_3

The charts seem to indicate that what the Fed has wanted for some time is really to keep inflation within a 1%-2% (1.4%-2.4%) band for the Core PCE (Core CPI). And they are doing a damn fine job, no matter what else is (not) happening!

The Federal Justice System is a lot better at parsing evidence!

In economics you usually get “hung juries”.

Parsing Evidence_0Two examples:

1A. Labor market slack is “low”

Alan Krueger, former chairman of President Barack Obama’s Council of Economic Advisers and a professor at Princeton University, wrote an influential paper earlier this year arguing the long-term jobless face such unusual challenges in finding work that policy makers should count them out when trying to gauge potential unused capacity in the labor market – also known as slack—and its effect on inflation pressures.

“Overall, there is little evidence in the cross-state data that the long-term unemployed exert less pressure on wages,” the five New York Fed researchers counter, referring to people out of work for more than six months. “This finding, as well as the differences between the labor market outcomes of long-term unemployed workers and nonparticipants, suggests that the long-term unemployed should not be dismissed when considering labor market slack.”

1B. Labor market slack is “high”

New York Fed: “The results suggest that there is little difference in how long-term and short-term unemployment affect wages, and as a consequence, the long-term unemployed shouldn’t be dismissed when evaluating labor market slack,” the New York Fed authors say.

  1. From Board of Governors we “learn” that Recessions permanently lower RGDP:

The economic collapse in the wake of the global financial crises (GFC) and the weaker-than-expected recovery in many countries have led to questions about the impact of severe downturns on economic potential. Indeed, for several major economies, the level of output is nowhere near returning to pre-crisis trend (figure 1). Such developments have resulted in repeated downward revisions to estimates of potential output by private- and public-sector forecasters. In addition, this disappointment in post-recession growth has contributed to concerns that the U.S. economy, among others, is entering an era of secular stagnation. However, the historical experience of advanced economies around recessions indicates that the current experience is less unusual than one might think. First, output typically does not return to pre-crisis trend following recessions, especially deep ones. Second, in response, forecasters repeatedly revise down measures of trend.

But maybe that´s not what the evidence shows, at least for the US. In the chart below we observe that the 3.3% trend growth formed in the 1870-1928 period remained true going forward. Even after the “Great Depression” real output returned to the original trend level path! Under Bernanke´s watch RGDP dropped well below trend and shows no signs of returning to it (actually it is growing at a rate significantly below (2.2%) the trend rate (3.3%).

Parsing Evidence_1

The next chart shows the more recent (from start of the “Great Moderation”) behavior of RGDP relative to the “centenary trend”.

Parsing Evidence_2

The Bernanke´s Fed failure is starker in the more recent version of the chart.

The last chart indicates the “culprit” was the Fed by first allowing NGDP (because of oil price-inflation worries) to deviate persistently from trend and then tumble.

Parsing Evidence_3

Policymakers seem to be making the best efforts, for the first time in at least one century and a half, to keep real output permanently below trend, and increasingly so!

The Fed´s “two-step” dance

From today´s Minutes:

The information on economic activity received since the staff prepared its forecast for the September FOMC meeting was close to expectations, and therefore, the staff’s projection for real GDP growth over the remainder of the year was little revised. However, in response to a further rise in the foreign exchange value of the dollar, a deterioration in global growth prospects, and a decline in equity prices, the staff revised down its projection for real GDP growth a little over the medium term.

Even with the slower expansion of economic activity in this projection, real GDP was still expected to rise faster than potential output in 2015 and 2016, supported by accommodative monetary policy and a further easing of the restraint on spending from changes in fiscal policy; in 2017, real GDP growth was projected to step down toward the rate of potential output growth. As a result, resource slack was anticipated to decline steadily, albeit at a slightly slower rate than in the previous projection, and the unemployment rate was expected to gradually improve and to be at the staff’s estimate of its longer-run natural rate in 2017.

The staff’s forecast for inflation this quarter and early next year was reduced in response to further declines in crude oil prices, but the forecast for inflation over the medium term was only a touch lower. Consumer price inflation was projected to be lower in the second half of this year than in the first half and to remain below the Committee’s longer-run objective of 2 percent over the next few years. With resource slack projected to diminish slowly and changes in commodity and import prices anticipated to be subdued, inflation was projected to rise gradually and to reach the Committee’s objective in the longer run.

Pathetic!

Expansion of economic activity is expected to be slower but RGDP was still expected to rise faster than potential in 2015-16!

Resource slack is expected to diminish slowly. This seems inconsistent with RGDP expected to rise faster than potential!

They say 2% inflation is years away!

And they think monetary policy is supportive!

To repeat a chart from yesterday´s post, monetary policy is supportive if by supportive you mean it is successful in keeping the economy in a depressed state (of (too) low real growth, (too) low inflation and low employment).

But even that will look good if the Fed engages in the “two-step”!

Two Step

The unending (and frustrated) search for inflation

In The Risks to the Inflation Outlook SF Fed researcher Vasco Cúrdia writes:

Figure 1 shows that the median inflation forecast is not expected to return to the FOMC target of 2% until after the end of 2016. The uptick in inflation in the first half of 2014 could lead one to believe inflation is finally on the path back toward its target. However, inflation has shown similar patterns several times before and each time the uptick has never lasted very long. According to this model, we should not see inflation begin to recover more firmly until around the end of 2015.

The model explains that persistent effects from the financial crisis are the main reason inflation is expected to remain low for so long. The financial crisis disrupted the credit market, leading to underinvestment and underutilization of resources in the economy. This slowed the economic recovery and pushed inflation down more than 2 percentage points, according to the model.

In contrast, the model suggests monetary policy pushed inflation up by 0.8 percentage point. This is expected to fall to zero by the end of 2016. Comparatively speaking, monetary policy appears to be far from causing excessive inflation under present circumstances.

Frustrated Search_1

It´s much more straightforward than that. It all boils down to how the Fed handles nominal spending (NGDP). The set of charts illustrate for different periods.

The 1970s harbored the “Great Inflation” because the Fed “manned” NGDP growth on an upward trend. Things get “shaky” when an oil shock hits, but the inflation trend is basically determined by the NGDP growth trend.

Frustrated Search_2

The 2001 recession saw NGDP growth fall way below the trend growth level. When the Fed became “smart” it decreed “forward guidance”, letting everyone know that spending growth would be such as to take NGDP back to the trend level.

Frustrated Search_3

Going into the “Great Recession” the Fed gets “confused” by the oil price shock and lets NGDP growth slide (and then tumble) down, bringing both real output AND inflation down with it!

Frustrated Search_4

The recovery starts off with the Fed introducing QE1. The NGDP “airplane” takes off, but “levels-off” long before reaching the previous “height”.

Frustrated Search_5

So that, at the new lower “cruise level”, we get “phony” nominal stability, which is associated with lower RGDP growth and lower inflation, sometimes temporarily disturbed by oil (supply) shocks.

Frustrated Search_6

Bottom line: If the Fed does not “recalibrate” the “plane´s height”, and accelerates towards it, inflation will simply not get back to target!

John Cochrane Defiantly Takes On Economic History

A Benjamin Cole post

As I predicted, the right-wing has gone past its fixation on absolutely dead prices as an economic cure-all and moral imperative, to the even-better nirvana of…deflation.

I wish I was making this up.

But comes now University of Chicago scholar John Cochrane, path-breaking with stalwart allies such a FOMC member Charles Plosser, that deflation is an economic elixir, not a sign of stagnation. Cochrane authored a recent The Wall Street Journal op-ed genuflecting to southerly price drifts.

I just don’t get it.

Recent Economic History

Okay, let’s look at the United States, 1982-2007. That’s a 25-year stretch, and recent too. In 1982 the U.S. GDP was $5,865.9 billion. It rose to 13,206.4 billion in 2007 (both figures in 2005 dollars).

That is a real increase of 125.1%, or an annual compounded rate of 3.3% real, for 25 years running, with all the imperfections and structural impediments that the U.S. economy has.

In the real world, the U.S. economy performed well 1982-2007. That is not debatable.

The rate of inflation? In the 25-year period prices rose 114.8%, so the inflation rate was about 3% a year. Except for 1982, inflation was always below 6% and, and only twice below 2% in the 25 years. In other words, moderate inflation in the 2% to 4% range was the norm. It worked.

For most of that period of prosperity, moderate inflation was accepted across the political spectrum. And why not?

Japan

There was a modern nation that passed through deflation, which regular readers know was Japan. From 1992 to 2012, Japan had mild deflation.

Looking to the St Louis Fred series, we have to go with 1990 to 2011 figures (due to data discontinuations), and we find Japan had a real annually compounded GDP growth of less than 1%, or 0.91%, through that 21-year period.

Japan’s real growth rate was one-third of that of the United States, when we compare their mildly deflationary period (1990-2011) to the mild-to-moderately inflationary period (1982-2007) of the United States.

If you are old enough, you remember in the 1980s when Japan was hailed for its lack of structural impediments, for its cooperation of government and business that created the biggest business boom of all history. By the 2000s, some economists said it was structural impediments holding Japan back.

In fact looking at the yen’s exchange rate and deflation, it seems much more likely the Bank of Japan held Japan back.

Upshot

Cochrane is correct in some regards; mild deflation does not coincide with recession, only with very, very sluggish real growth. Yes, the U.S. can probably go to mild deflation, and it will only look somewhat slower than 2008-2012. If you have a sinecure at an academic institution, maybe that is fine.

But Cochrane ignores the bigger picture: Robust growth is associated with moderate inflation.

In the end, based on recent and cogent historical experience, it comes down to this: Should we forego trillions of dollars of real output just to bring a subjective index of prices (CPI or PCE) to a dead halt, or even into deflation territory?

Why?