50 years of US growth and inflation history from a Market Monetarist perspective

One defining characteristic of market monetarism is that, contrary to convention, the level of the target Fed Funds (FF) rate is not a good indicator of the stance of monetary policy. MM´s prefer to gauge the stance of monetary policy directly from the behavior of nominal spending (NGDP).

Let me first backtrack and present the conventional view.

In 2001 Gregory Mankiw wrote the chapter on “Monetary Policy in the 1990s” for the NBER panel on “Economic Policy in the 1990s”. In that article, Mankiw argued that during the 1990s – characterized by reduced volatilities in both real output growth and inflation, a.k.a. “Great Moderation – monetary policy had been more effective due to the fact that, different from what had until then been usual, it reacted more strongly to inflation.

Mankiw puts up a Taylor-type rule which he estimated for the 90s (the “good monetary policy” period). The difference to the traditional “Taylor rule” is that Mankiw has the Fed reacting to the rate of inflation and unemployment, without any concern for the “output gap” or the “natural real interest rate”. That´s probably an advantage because you are dealing only with observable variables available in real time (although subject to revisions) and on a monthly instead of quarterly frequency.

To see if and how monetary policy in the 90s was different from other periods (decades), Mankiw calculates the FF Target rate based on the “rule” and compares to the actual FF rate.

The chart shows how the “rule” rate and actual rate compare over the 1958-2008 period (before the FF rate was lowered to “zero”). The chart also shows the behavior of inflation (PCE-Core) over the same time span.

The result is qualitatively the same as that obtained from the application of the “popular” Taylor-rule. In the 1990s inflation came down and remained low and stable because the Fed set the FF rate according to the rule. Note that in the late 1950s and first half of the 1960s, the result is the same: inflation remains low and stable because the FF rate also followed the rule closely.

During the second half of the 60s and throughout the 70s, the rule rate is consistently above the actual FF rate. The result: money growth is excessive and the result, as expected, is high and generally rising inflation.

The period from 2001 to 2005 is contentious. The FF rate remains consistently below the rule-rate (period in which monetary policy was branded “too easy”, with rates remaining “too low for too long”), nevertheless inflation, contrary to the late 60s, remains low and stable. Now, if the rule is set so that it is the “correct” rate given the Fed´s dual mandate, why didn´t inflation (and unemployment) diverge from their levels in the 1990s?

And looking at the more recent period, the actual FF rate remains below the rule rate all the way to the “Great Recession”. Should rates have been even higher?

From a market monetarist perspective, looking at the behavior of nominal spending (NGDP) to gauge the stance of monetary policy, we get more consistent results.

The chart shows NGDP and trend for 1954 to 1969. Observe that inflation takes off after nominal spending rises above trend. That´s consistent with the information from the chart comparing the FF rate with the rule rate.

Into the 1970s, nominal spending shows a rising and volatile trend, clearly inconsistent with low and stable inflation but quite consistent with the observation of high, rising and volatile inflation.

I skip the “Volcker Adjustment” period (1979.IV to 1986.IV). The objective was to bring inflation down. That was mostly done through forcefully bringing down the level of nominal spending relative to the previous trend by constraining spending growth. Inflation was successfully “conquered” at the cost of an initially high level of unemployment.

The next chart shows that during the so called “Great Moderation”, NGDP remained close to its trend level. As in the 50s and early 60s, inflation was low and stable. In 2008 NGDP tumbles below trend, the opposite move from what happened in the second half of the 60s when NGDP rose above trend.

In the chart above we can see that NGDP goes initially above trend in the late 90s and then drops below trend in the first years of the 00s. The chart below gives a clearer picture, showing the NGDP “gap” (the difference between actual spending and the trend level.

The late 90s were “trying” times for monetary policymakers. In the second half of the decade productivity growth accelerated. That has the effect of bringing down both inflation and unemployment. That´s an “unusual” combination for all those versed on Phillips Curve macro. No wonder people like Krugman and Steven Roach (at the time Morgan Stanley´s chief-economist) in 1997/98 were shouting that the Fed was behind the curve. Furthermore, there were the shocks from the Asia Crisis in 1997/98, the Russia Crisis and LTCM in 1998, the “fear of Y2K in 1999, the terrorist attack and corporate shenanigans in 2001, not to mention the Bush wars.

Initially, Greenspan “kept his cool” but in the end relented and interest rates went first down and then up. The result was NGDP instability. Interesting that according to market monetarist principles, when NGDP dropped below trend it signaled that monetary policy had tightened, so that bringing rates down after 2001 was the “correct” policy. And rates stayed down until NGDP started the “recovery journey” towards trend. But as seen in the first chart comparing the FF rate with the rule, rates were “too low”. I have more confidence in the NGDP indicator for the stance of policy.

The obvious question now is: Why, with spending crashing, didn´t inflation fall and even turned into deflation? After all, didn´t it go up and kept climbing after spending rose above trend in the 60s and “ballooned” in the 70s?

The difference is this time around the Fed is a credible inflation/deflation fighter. In 2002 didn´t Bernanke as Fed governor made the famous “Deflation, making sure “it” doesn´t happen here” speech?

A better understanding of the implications of stabilizing spending along a level path is provided by the panels below.

The first panel shows NGDP growth and volatility during selected periods. The “Great Moderation” witnessed a marked spending stabilization. It´s clear that Bernanke lost that difficult “conquest”.

The second panel shows inflation and its volatility over the same periods. Although spending stability was lost, the same cannot be said for inflation.

The third panel shows that real growth stability was also forsaken more recently.

What this implies is that nominal spending stability is a necessary condition for real growth stability, but inflation stability can be obtained without nominal spending stability, as long as spending is below the “adequate trend level”, i.e. remains depressed.

In the 60s, the obsession with unemployment led to the “Great Inflation”. Now, the obsession with inflation has given us the “Great Recession”, which I prefer to call “Bernanke´s Depression”.

To bring inflation down, Volcker had to constrain nominal spending growth. Conversely, to bring unemployment down, Bernanke has to increase spending growth. And that could be done with minimum suffering and no inflation collateral effects IF a level target is specified for nominal spending. In the latest FOMC meeting the step was in the right direction but it was only a “baby step” and, as prone with babies their steps are quite unstable, so they can easily fall before getting to their desired destination!

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15 thoughts on “50 years of US growth and inflation history from a Market Monetarist perspective

  1. Not only is Marcus Nunes the best grapher in economics, he may be the best economic historian.

    I would call him a “national treasure” except he lives in Brazil.

    But thanks to the Internet, we can all enjoy Nunes, as citizens of the world!

  2. Benjamin, I replied to you twice on Glasner’s blog, but got blocked both times, despite David assuring me that he thought my posts were fine. So I’ll post my reply from “Uneasy Money” to you here:

    Benjamin, I’m basically a Caplanian about politics. I think those with strong tribal affiliations will vote the way they do, and the rest will vote based on their mood at election time. The will punish the incumbent if their personal situation is worsening at that time, and/or if the latest media reporting gives them an impression of a worsening society. And vice versa if things seem to be improving at that moment. Note that this is not the same as Robin Hanson’s strategy of penalizing/rewarding presidents for the overall change in your own circumstances only (which you know most about) since the beginning of the presidential term. I think the latest job figures will show an improvement thanks to the Fed’s new move, without people having dropped out of the labor force (perhaps 0.5%). And then Obama will win.

    Besides, I believe in market forecasts. And Intrade has Romney at 67% http://www.intrade.com/v4/markets/contract/?contractId=743474
    And then there’s this:

    http://www.bloomberg.com/news/2012-09-17/today-mitt-romney-lost-the-election.html

  3. Ditto on the brilliance.
    I am curious about this part: “The obvious question now is: Why, with spending crashing, didn´t inflation fall and even turned into deflation?” Sorry, if I missed the connection but I thought that disinflation was the problem with wages/unemployment and major assets like houses. Or is the meaning of that question more nuanced, like why didn’t 2008 end up like the Great Depression?

    • You just answered your own question Bonnie – disinflation is different from inflation. And even that disinflation has averaged less than a percentage point – so that even economists who might have entertained an essay at an outcomes-based determination of the stance of monetary policy would have seen inflation not too low, and decided that monetary policy was not to blame. No one thinks to look at NGDP, except us – and Bernanke.

  4. Pingback: 50 years of US growth and inflation history from a Market Monetarist perspective (Beware, "charts may bite" « Economics Info

    • flow5, so monetary policy worked well (most of the time) during their tenure because they were embued by the Holy Spirit? Yes, sometimes they “tightened” MP. First to bring AD to a lower trend level under Volcker and then by a few “mistakes” committed by Greenspan. If you´re doing things right (keeping NGDP close to the trend path), if you have to “tighten” MP is because previously you made the mistake of “loosening” it.

  5. The money supply could never be managed by any attempt to control the cost of credit (i.e., thru interest rates pegging governments, or thru “floors”, “ceilings”, “corridors”, “brackets”, etc).

  6. Saturos:

    Everything you say is true. But it is also true that in US politics, a lifetime is one month. The GOP specializes in attack politics, especially in the last month of campaigning. It may be the Romney team is different, or just incompetent.

    I repeat, there has been suspicious voting patterns in two recent elections, in Ohio and Florida.

    Indeed, I do not believe in conspiracies, but I have read that the exit polls vs. actual results in the 2000 and 2004 US elections were sometimes different enough that in a Third World country it would have been considered grounds to conclude the election was fraudulent.

    Kerry won the exit polls in 2004 by a wide margin. Something is either very wrong with the exit polling or the elections. One of the Kennedy clan wrote a long, long story on Ohio, for I think Rolling Stone, asserting fraud there in the 2004 election. It was a compelling piece, as i recall.

    I enjoy your commentary, and if you would like to send me a note, I am at 7continents7@gmail.com. I live in rural Thailand with wife and family, so intellectual conversations have become a rarity–and that from a guy who used to live in Los Angeles! I see you live in Perth, a city I wanted to migrate to for a long time, as I imagined it was like Los Angeles, only before LA became so developed.

    Good luck in all regards, and thank you for notching my commentaries!

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