The Phillips Curve still lurks underneath FED thinking

Minnesota Fed Neel Kaskari published today “Why I dissented”, to explain the reasons for his dissent in the latest FOMC Meeting. His dissent has a dovish slant, but does not differ materially from the consensus view. In short, the relationship between inflation & unemployment, known as the Phillips Curve, is still very much alive in the Fed´s decision-making process:

“I strongly support the new Statement on Longer-Run Goals and Monetary Policy Strategy¹ that the Federal Open Market Committee has adopted. It incorporates the lessons we have learned from the prior recovery and gives the Committee sufficient flexibility to make up for periods of low inflation in order to achieve our dual mandate goals.

However, I voted against the FOMC’s September 16, 2020, policy statement because, while I believe the statement is a positive step forward in putting those lessons into practice, I would have preferred the Committee make a stronger commitment to not raising rates until we were certain to have achieved our dual mandate objectives.

The 2015 tightening cycle

To explain my rationale for seeking stronger forward guidance, I first must review what I learned from the recent tightening cycle that began in 2015. That policy tightening was predicated on the Committee’s view that the labor market was reaching maximum employment and therefore inflation was around the corner.

When I first became an FOMC voter, I dissented against all three of the Committee’s rate hikes in 2017 because, as I wrote then: “We are still coming up short on our inflation target, and the job market continues to strengthen, suggesting that slack remains.” ²

Recently, Governor Brainard commented: “had the changes to monetary policy goals and strategy we made in the new [monetary policy strategy] been in place several years ago, it is likely that accommodation would have been withdrawn later, and the gains [to the labor market] would have been greater.” ³

We misread the labor market and, as a result, the tightening cycle that we embarked upon was not optimal to achieving our dual mandate goals of maximum employment and stable prices.”

In recent years, we have repeatedly believed we were at or beyond maximum employment only to be surprised when many more Americans reentered the labor market or chose not to leave, increasing the productive capacity of the economy without causing high inflation. To me, maximum employment is the point at which the labor market is just tight enough to deliver 2 percent inflation in equilibrium.”

The highlighted segments indicate the close connection the Fed, even its more dovish members, see continue to exist between unemployment and inflation.

This is not surprising. In March of this year, Marco Del Negro, from the New York Fed, and coauthors presented a paper for discussion with reference to the New Statement on Longer-Run Goals titled “What´s up with the Phillips Curve:

Inflation has been largely disconnected from business cycle ups and downs over the past 30 years.  This puzzling observation is one more reason why the Federal Reserve should consider adopting a systematic monetary policy strategy that reacts more forcefully to off-target inflation—whether too high or too low.”

In What’s Up with the Phillips Curve?, the authors note that inflation in the United States has remained remarkably stable since 1990, even in the face of pronounced cycles in economic activity.  For example. the unemployment rate has fallen from a 25-year high of 10 percent in 2009 during the Great Recession to near 50-year lows of at or under 4 percent over the past two years.  But U.S. inflation hasn’t responded much to the steep drop in joblessness and remains somewhat short of the Fed’s 2 percent inflation target.

They don´t think monetary policy has been the major factor:

Changes in the conduct of monetary policy appear to have played some role in inflation stability in recent decades, but they cannot be its principal explanation, the authors suggest.

Their leading candidate for the driver of inflation stability is a reduced sensitivity of inflation to cost pressures—such as those associated with wage movements—or, in economic parlance, a decline in the slope of the Phillips curve.  This could be due to many structural forces—such as the increased relevance of global supply chains, heightened international competition, and other effects of globalization.

So, they recommend Average Inflation Targeting (AIT):

A flat Phillips Curve requires the monetary authority to work harder to stabilize inflation:  Unemployment needs to get lower to bring inflation back to target after a recession,” the authors write.  They use an econometric model to explore how monetary policy should adapt, examining, for example, a strategy known as average inflation targeting—one of several strategies the Federal Reserve has been evaluating during a public review of its monetary policy framework.

It´s a pity the Fed ignored much better advice, some from people advocating NGDP Level Targeting.

The panel below, covering the post Great Recession “Longest Expansion” provides interesting pointers.

  1. A stable NGDP growth is associated with falling unemployment (and stable inflation)
  2. When NGDP growth falls (below its average growth), unemployment stabilizes (stops falling) and when NGDP growth rises above its average growth, unemployment falls faster.
  3. The Fed´s juggling of the FF rate does not seem to connect to either inflation or unemployment (with unemployment falling “faster” during the period the FF was on the rise). That was more likely because NGDP was growing more.

FOMC members would do well to read and reflect on a recent paper by Alan Cole of the Senate´s Joint Economic Committee titled “A stable monetary policy to connect more americans to work”:

“The best anchor for monetary policy decisions is nominal income or nominal spending—the amount of money people receive or pay out, which more or less equal out economy-wide. Under an ideal monetary regime, spending should not be too scarce (characterized by low investment and employment), but nor should it be too plentiful (characterized by high and increasing inflation).

While this balance may be easier to imagine than to achieve, this report argues that stabilizing general expectations about the level of nominal income or nominal spending in the economy best allows the private sector to value individual goods and services in the context of that anchored expectation, and build long-term contracts with a reasonable degree of certainty. This target could also be understood as steady growth in the money supply, adjusted for the private sector’s ability to circulate that money supply faster or slower.

Bottom Line:

The Fed´s new strategy may just be a tweak on its old strategy in order to “accommodate” a belated realization that the Phillips Curve is (or has become) flat!

How´s the Fed doing in the make-up department?

The Fed´s new Statement on Longer-Run Goals and Monetary Policy Strategy is all about “making-up”; be it about inflation below target or unemployment shortfalls.

The Fed is not changing its ultimate mandate, which is to balance price stability with maximum employment. However, it has announced that it will no longer preemptively slow down the economy if the labor market begins to look tight and it will treat its 2% inflation target as an average.

Why the new statement? According to Lael Brainard, since the end of the “Great Recession” the US economy has been in a “new normal”. Three things characterize “new”:

  1. The equilibrium interest rate has fallen to low levels, which implies a large decline in how much we can cut interest rates to support the economy.
  2. Underlying trend inflation appears to be somewhat below the Committee’s 2 percent objective, according to various statistical filters.
  3. The sensitivity of price inflation to labor market tightness is very low relative to earlier decades, which is what economists mean when they say that the Phillips curve is flat.

How does that compare with the “old normal” (Great Moderation)?

  1. The equilibrium or neutral interest rate was never a concern. It averaged 2.3%, close to the 2% John Taylor pinned it at in his 1993 Taylor-rule. Since the end of the GR it has averaged 0.3%.
  2. In the “old normal”, core PCE inflation averaged 2.1%, almost exactly the 2% that was the implicit target at the time. During the “new normal”, it has averaged 1.6%.
  3. The “low sensitivity of price inflation to labor market tightness was already low relative to previous decades. For example, speaking in 2007, Bernanke 2007 said:

“…many studies of the conventional Phillips curve find that the sensitivity of inflation to activity indicators is lower today than in the past (that is, the Phillips curve appears to have become flatter);1 and that the long-run effect on inflation of “supply shocks,” such as changes in the price of oil, also appears to be lower than in the past (Hooker, 2002).

The “new normal” mindset leads to comments such as these:

“Monetary policy is really good for playing defense,” said Adam S. Posen, president of the Peterson Institute for International Economics. “But not for playing offense.”

“If the Fed is relatively weak in its ability to end recessions, why do its actions get so much attention during times of economic crisis? Mostly because the actions of Congress (dominated for the past decade by the Republican caucus in the Senate) have been either too weak or outright damaging during these crises. For example, in the weak recovery from the Great Recession of 2008-2009, austerity imposed by a Republican-led Congress throttled growth, even as historically aggressive actions by the Fed tried (only partly successful) to counter this fiscal drag.”

That´s interesting because during the “Great Inflation” of the 1970s, Fed Chair Arthur burns thought the Fed could not play defense, but under the right circumstances, it could be good at playing offense!

Arthur Burns:

“Another deficiency in the formulation of stabilization policies in the United States has been our tendency to rely too heavily on monetary restriction as a device to curb inflation…. severely restrictive monetary policies distort the structure of production. General monetary controls… have highly uneven effects on different sectors of the economy.”

Burns did not consider monetary policy to be the driving force behind inflation. He believed that inflation emanated primarily from an inflationary psychology produced by a lack of discipline in government fiscal policy and from private monopoly power, especially of labor unions. It followed that if government would intervene directly in private markets to restrain price increases, the Federal Reserve could pursue a stimulative monetary policy without exacerbating inflation.

The new and old normal share characteristics:

  1. In both cases, NGDP growth, RGDP growth and inflation were stable, albeit at lower rates in the new normal
  2. Phillips Curve thinking was the wrong mindset in both cases. It was a very costly mistake in both instances.

The question that naturally comes up is “what led us from one state to the other”?

The two states are illustrated by the behavior of aggregate nominal spending (NGDP).

In both, NGDP is stable along a level path. We can infer that those paths and associated growth rates were chosen, (were not accidental). The same goes for the inflation rate that averaged a stable 2.1% in the old normal and 1.6% in the new.

The transition from one state to the other took place in 2008-09. In the chart below, we see that both NGDP and money supply growth tanked and inflation shifted down from 2% to 1%.

The Fed never tried to make up for the drop in NGDP and inflation, resuming expansion along a lower level path and lower rates.

The next chart zooms in on the “new normal” chart shown in the first picture above. To explain the recent behavior of nominal spending (NGDP), I use the QTM (Quantity Theory of Money).

According to the QTM, MV=Py, to keep nominal spending (Py) growing at a constant rate, money supply (M) has to offset changes in velocity (V).

The chart shows five regions. In region 1, the Covid19 surprise increased the demand for money (velocity falls). Since the money supply barely changed, NGDP drops. In region 2, the Covid19 shock intensifies the demand for money (velocity drops more). Although money supply growth rises, it does so by less than required to keep NGDP at least stable. In region 3, velocity stabilizes while money supply growth increases. NGDP rises. In region 4 money still grows somewhat, but so does velocity, with the result being a further rise in NGDP.

In region 5, which covers the latest data point (July), we see that money growth stabilizes. Velocity, however, rises somewhat so NGDP increases but at a slower rate.

Maybe the Fed was influenced by the large number of articles and op-eds decrying that the unprecedented rates of money growth would lead to an inflationary boom down the road. In any case, money growth stopped rising. In that case, the rise in NGDP was fueled only by the small rise in velocity.

It appears, therefore, that we face a situation not of excessively strong money supply growth, but once again, although for very different reasons, a case of “not enough money”. For NGDP to rise back to the “new normal” trend, money growth will have to increase more, unless velocity rises faster,

The danger is that the Fed will not make up fully for the drop in NGDP, starting on a “new-new normal”, characterized by an even lower level of aggregate nominal spending. The new target of getting inflation to average 2% will also remain a distant dream…

Brainard´s “New Normal” is Old

Lael Brainard´s speech on the Fed´s new “longer-run goals and strategies makes reference to a “New Normal”: [I only highlight her references to the labor market]

“The new statement on goals and strategy responds to these features of the new normal in a compelling and pragmatic way by making four important changes.

First, the statement defines the statutory maximum level of employment as a broad-based and inclusive goal and eliminates the reference to a numerical estimate of the longer-run normal unemployment rate.6 The longstanding presumption that accommodation should be reduced preemptively when the unemployment rate nears the neutral rate in anticipation of high inflation that is unlikely to materialize risks an unwarranted loss of opportunity for many Americans.

Third, the statement highlights an important change in the Committee’s reaction function. Whereas previously it sought to mitigate deviations of employment and inflation from their targets in either direction, the Committee will now seek “to mitigate shortfalls of employment from the Committee’s assessment of its maximum level and deviations of inflation from its longer-run goal.” This change implies that the Committee effectively will set monetary policy to minimize the welfare costs of shortfalls of employment from its maximum and not preemptively withdraw support based on a historically steeper Phillips curve that is not currently in evidence and inflation that is correspondingly much less likely to materialize.

… Beyond that, had the changes to monetary policy goals and strategy we made in the new statement been in place several years ago, it is likely that accommodation would have been withdrawn later, and the gains would have been greater.”

What she really shows is that the post Greenspan FOMC has continuously misinterpreted the economy.

The panel below clearly illustrate that during the 1990s and early 2000s (before the Great Recession), a stable growth rate for nominal spending (NGDP) was what was required to keep the rate of unemployment on a downward trend while inflation either fell or remained low & stable.

The same remains true for the post GR period.

When the Fed makes a big monetary policy mistake and allows nominal spending to tank, the consequences are also big. This was the case in the monetary-led Great Recession. NGDP tanks while unemployment balloons. Inflation dropped by 50% (from 2% to 1%).

Four years ago (Sept 16) Lael Brainard made a speech with the title: “The New Normal and what it means for Monetary Policy”. One of the key features of the New Normal was:

  1. Labor Market Slack Has Been Greater than Anticipated
    Second, and related, although we have seen important progress on employment, this improvement has been accompanied by evidence of greater slack than previously anticipated. This uncertainty about the true state of the economy suggests we should be open to the possibility of material further progress in the labor market. Indeed, with payroll employment growth averaging 180,000 per month this year, many observers would have expected the unemployment rate to drop noticeably rather than moving sideways, as it has done.

The next chart zooms in on 2016 to indicate the “cause” of the sideways move in unemployment. You easily see it was due to the excessive drop in NGDP growth from the 4% average that prevailed in the 2010 – 2019 period. The same happened 20 years before. The Fed should have picked on this “pattern” some time ago! As seen in the previous charts, once NGDP growth picks up again, unemployment resumes the down trend.

So, using new words for the “target” – AIT – and new words for the “reaction function” – shortfalls – will likely change very little.

When danger looms, the NGDP-LT dog barks, the other dogs stay silent

David Beckworth brings attention to this interview with James Bullard where it he implies that the new AIT framework is equivalent, or approximates NGDP-LT.

That´s not true. The Great Recession was the result of the Fed “downgrading” the NGDP target level, and then continuing to practice NGDP-LT at a lower trend path (accompanied by a lower growth rate). However, AIT (or IT, or PLT) continued on the same trend path as before.

The charts illustrate. Until 2006, all those “targets” were “observationally equivalent”. You wouldn´t know if the Fed was targeting the average PCE core inflation, the PCE core price level or PCE core inflation. It could also be targeting NGDP at a particular level and growth rate.

From that point on, the NGDP-LT dog began barking to remind the Fed that it was being “derailed”. The other dogs remained on the path so the Fed, who never imagined that the overall nominal stability it had successfully attained (Great Moderation) was due, not to targeting inflation, average inflation or the price level, but to targeting NGDP at a particular trend path, was stunned by the depth of the recession.

A “new” and lower trend path for NGDP was followed after the shock, and that´s why the economy has been nominally stable since the end of the GR. Unfortunately, it is a “depressed” level of nominal stability. Given the new AIT framework, we risk, as I argued here, to “depress” the economy further following the Covid19 shock!

Irony alert: The Fed has been doing AIT for three decades!

As I will show, it has also been doing NGDP-LT, albeit with a “variable” Level Trend. It´s amazing that it took them one and a half years to come up with a framework that had been in place for so long!

The chart below shows that the core PCE has closely followed the trend (estimated from 1992 to 2005). The trend reflects a 1.8% average inflation, not the 2% average target, but close.

To illustrate the fact that the Fed has effectively been practicing AIT, I zoom in on two periods (outside the estimation interval) to show an instance of adjustment from above and one from below.

Even now, after the Covid19 shock, it is trying to “make-up”!

The “other Policy framework” the Fed has been “practicing” with for over three decades is NGDP Level Targeting.

The set of charts below show how NGDP has evolved along the same trend during different periods.

The following chart zooms in on 1998 – 2004 and shows that the Fed first was excessively expansionary (reacting to the Asia & Russia +LTCM crises) and then “overcorrecting” in 2001-02 before trying to put NGDP back on the level trend, which it did by 2004. Many have pointed out that the Fed was too expansionary in 2002-04, blaming it for stoking the house bubble and the subsequent financial crisis. However, the only way the Fed can “make-up” for a shortfall in the level of NGDP is for it to allow NGDP to grow above the trend rate for some time!

As the next to last chart shows, 2008 was a watershed on the Fed´s de facto NGDP-LT framework. As shown in the chart, in June 2008 the Fed “gave up” on the strategy, “deciding” it would be “healthier” for aggregate nominal spending (NGDP) to traverse to a lower level path and lower growth rate.

If you doubt that conjecture, read what Bernanke had to say when summarizing the June 2008 FOM Meeting.

Bernanke June 2008 FOMC Meeting:

“I’m also becoming concerned about the inflation side, and I think our rhetoric, our statement, and our body language at this point need to reflect that concern. We need to begin to prepare ourselves to respond through policy to the inflation risk; but we need to pick our moment, and we cannot be halfhearted.”

He certainly got what he wished for.  As the next chart indicates from the end of the Great Recession to just prior to the Covid19 shock, NGDP was spot on the new lower trend path alongside a reduced growth rate.

The Covid19 shock tanked NGDP. This was certainly different from what happened in 2008. Then, it was a monetary policy “choice”. Now, it was virus related. The other thing is that at present, instead of being worried about inflation being too high or risking getting out of control, the fear is with inflation being too low.

That worry, which has been evident for some time, led that Fed to unveil a new monetary policy framework, AIT, for average inflation targeting. As I argued before, this framework has been in place for decades!

The last chart above indicates that monetary policy is “trying” to make-up for the drop in NGDP from the “Great Recession Trend” it was on. We also saw that the Core PCE Index is on route to get back to its decades-long trend.

Given that inflation is a monetary phenomenon, these two facts are related. For inflation to go up (as required to get the price level back to the trend path) NGDP growth has to rise. However, many FOMC members are squeamish. We´ve heard some manifest that they would “be comfortable with inflation on the 2.25% – 2.5% range”.

The danger, given the presence of “squeamish” members, is there could come a time when the Fed would reduce NGDP growth before it reached the target path. Inflation would continue to rise (at a slower, “comfortable”, rate) and reach the price path while, at the same time, the economy remains stuck in an even deeper “depressive state” (that is, deeper than the one it has been since the Fed decided in 2008).

That is exactly what happened following the Great Recession. NGDP growth remained stable (at a lower rate than before) and remained “attached” to the lower level path the Fed put it on.

These facts show two things:

  1. To focus on inflation can do great damage to the economy. For example, imprisoning it in a “depressed state”.
  2. Since the Fed has kept NGDP growth stable for more than 30 years, and freely choosing the Level along which the stable growth would take place, the implication is that it has all the “technology” needed to make NGDP-LT the explicit (or just de facto) monetary policy framework. As observed, that framework is perfectly consistent with IT, AIT or PLT!

A “simple solution” to the Fed´s new AIT framework

The first thing to note is that inflation is not a price phenomenon (don´t reason from a price change is relevant here), but a monetary phenomenon.

For example, changes in relative prices (due to an oil price shock, for example) will only turn into inflation (a continued increase in all prices), if monetary policy allows it to happen (as we´ll see contrasting the 70s with the last 30 years.

Another point I´ll make is that the price index the Fed should target is the PCE Core index. Why? Because the headline index is much more volatile and, like in 2008, will lead the Fed astray.

The first chart shows that over a long period (60 years in this case) both the Core & Headline index show the same thing.

If you break the 1960 – 2020 period by decades, you´ll note that the core index functions as an “upper bound” to the headline index. The next chart shows two examples. The first from the high inflation 1970s and the second from the low inflation 1990s.

The next charts show the two in the form of year over year rate of change – inflation – and the corresponding behavior of nominal spending (NGDP) growth. Note that rising inflation (both for the headline & core indices) only happens when monetary policy, as gauged by NGDP growth, is on a rising trend. Relative prices do change but only with overall prices going up.

During the low and stable core PCE inflation period, the headline PCE inflation wonders up and down, buffeted by the price shocks (mostly oil). For this low inflation period, the average headline PCE inflation is 1.8, with a standard deviation (volatility) of 0.86. The average for core PCE inflation is the same 1.8, but with a standard deviation less than half that (0.41). So it´s much better to target the low volatility index.

What does the Fed face at present? The next chart shows that the core PCE index has hugged closely to a 1.8% trend path since 1993. This trend path was established from the data to 2006, before the upheavals of the Great Recession. Fourteen years later, even after the effects of the Covid19 shock, the index hasn´t deviated from the path.

If the Fed manages to keep the core PCE index following this path going forward, in ten years’ time, the index will reach Scott Sumner´s “magic number” of 135 (Ok, he means the headline index, but I´ve argued that´s a bad index to target and anyway, the core index is an upper bound on the headline index).

How to do that? Basically, don´t invent new benchmarks. Take what you have and do the best with it. Moreover, the best the Fed can do is what has been proven adequate for a long time, to wit, keep NGDP growth stable. The Fed can improve on that by not making the mistakes it made in 2001 and particularly in 2008, as the charts below indicate.

Now, NGDP is still far below the trend path it followed from the end of the Great Recession. The Fed´s first order of business is to make monetary policy expansionary enough to take NGDP back to that trend path. Once (if?) that´s done, the Fed should pursue a monetary policy that allows NGDP to grow close to the 4% rate it averaged from 2010 to 2019.

With that, the core price level will be close to 135 in 10 years’ time.

If only monetary policy in 2008 had been what it was in 2020.

Many like to compare the Covid19 contraction with the Great Depression. In addition to the nature of the two contractions being completely unrelated, while in the first two months of the Covid19 crisis (from the February peak to the April trough) RGDP dropped 15%, it took one year from the start of the Great Depression for RGDP to drop by that amount.

Although the Covid19 shock has also no common element with the Great Recession, a comparison between the two is instructive from the monetary policy point of view. This is so because the Great Recession was the “desired outcome” of the Fed´s monetary policy. Bear with me and I´ll try to convince you that is not a preposterous statement.

Motivated by the belief that the 2008-09 recession originated with the losses imposed on banks by their exposure to real estate loans and propagated through a consequent breakdown in the ability of banks to get loans to credit-worthy borrowers, government, the Fed and regulators intervened massively in credit markets to spur lending.

Bernanke´s January 13, 2009 speech “The crisis and the policy response” summarizes that view:

“To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally.”

Bernanke´s “credit view” of the monetary transmission process is well established. Two articles support that view.

His flagship 1983 article is titled “Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression.”

“…we focus on non-monetary (primarily credit-related) aspects of the financial sector–output link and consider the problems of debtors as well as those of the banking system. We argue that the financial disruptions of 1930-33 reduced the efficiency of the credit allocation process; and that the resulting higher cost and reduced availability of credit acted to depress aggregate demand.

His 1988 primer “Monetary Policy Transmission: Through Money or Credit?

“…The alternative approach emphasizes that in the process of creating money, banks extend credit (make loans) as well, and their willingness to do so has its own effects on aggregate spending.”

For details on the Fed´s credit market interventions (with the purpose of reducing spreads, which to the Fed is a sign of credit market dysfunction), see chapter 15 of Robert Hetzel´s “The Great Recession

“The answer given here is that policy makers misdiagnosed the cause of the recession. The fact that lending declined despite massive government intervention into credit markets indicated that the decline in bank lending arose not as a cause but as a response to the recession, which produced both a decline in the demand for loans and an increase in the riskiness of lending.

In their effort to stimulate the economy, policy makers would have been better served by maintaining significant growth in money as an instrument for maintaining growth in the dollar expenditures [NGDP growth] of the public rather than on reviving financial intermediation

The charts below attest to that fact insofar as spreads began to fall, the dollar exchange rate began to depreciate and the stock market began to rise, only after the Fed implemented quantitative easing (QE1) in March 2009.

The purchase of treasuries by the Fed was what “saved the day”, not the array of credit policies that had been implemented for several months prior. Note, however, that the monetary policy sail was only at half-mast. On October 2008, the Fed had introduced IOER (interest on reserves), so that the rise in the monetary base from all the Fed´s credit policy would not “spillover” into an increase in the money supply. (The rise in the reserve/deposit (R/D) ratio in fact more than offset the rise in the base, so money supply growth was negative).

What QE did was to increase the velocity of circulation. With that, spending (NGDP) growth stopped falling and then began to rise slowly. As the next chart shows, the Fed (due to inflation worries) never allowed NGDP growth to make-up for the previous drop, “calibrating” monetary policy to keep NGDP growth on a lower trend path and lower growth rate.

Skipping to 2020, when the Covid19 shock hit, NGDP tanked. With spreads rising, the Fed again, now under Jay Powell (who must have learned “creditism” from his time with Bernanke), quickly announced a large batch of programs to intervene in credit markets to sustain financial intermediation.

While in the U.S., it was all about “closing spreads”, in Europe the sentiment was the opposite:

Christine Lagarde (March 12): “We are not here to close spreads”

Laurence Meyer (March 17): “The Fed is here to close spreads”

In “Covid19 and the Fed´s Credit Policy”, Robert Hetzel writes:

“…When financial markets actually did continue to function, Chairman Powell claimed that it was because of the announcement effect that the programs would become operational in the future…”.

Looking at the charts for the period, we again observe that spreads fell (markets functioned) when monetary policy – through open market operations, with the Fed buying treasury securities – becomes expansionary. The difference, this time, is that the monetary policy sail was at “full mast”, so that money supply growth rose fast.

Compared to the post 2008-09 period, NGDP reversed direction in a V-shape fashion (data on monthly NGDP to June from Macroeconomic Advisers). This time around, it seems the Fed is set in making-up for the lost spending, returning NGDP to the trend level that prevailed from 2009 to 2019.

Going forward, once the economy fully reopens the Fed will have to make clear that monetary policy will the conducted to maintain nominal stability (i.e. NGDP cruising along the trend level path it was on previously). Given the degree of fiscal “overkill” that has been practiced, the Fed will have to resist pressures to maintain an overly expansionary monetary policy to relieve fiscal stress through inflationary finance.

The workings of the monetary ‘thermostat’ during the Great Depression

George Selgin is writing a series on “The New Deal and Recovery”. In the Intro (where you find links to the five ‘chapters’ written so far), he summarizes:

“I believe that the New Deal failed to bring recovery because, although some New Deal undertakings did serve to revive aggregate spending, others had the opposite effect, and still others prevented the growth in spending that did take place from doing all it might have to revive employment.”

I want to show in this post the monetary policies that resulted from all the “actions” or policy decisions taken during the 1929-1941 period. The details of those decisions are the subject of Selgin´s series. As he points out:

I´m not opposed to countercyclical economic policies, provided they serve to keep aggregate spending stable, or to revive it when it collapses.”

In short, that statement is all about the workings of the thermostat. To recap, Friedman´s thermostat analogy as an explanation for the Great Moderation says:

“In essence, the newfound stability was the result of the Fed (and many other Central Banks) stabilizing nominal expenditures. In that case, from the QTM, according to which MV=PYthe Fed managed to offset changes in V with changes in M, keeping nominal expenditures, PY, reasonably stable.

The two charts below summarize the behavior of aggregate nominal spending (NGDP) and the associated real aggregate output that resulted during the four “stages” of the Great Depression

If anything, 1929 shows what happens when the thermostat brakes down. When velocity drops (money demand rises) deep and fast, if instead of offsetting that move in velocity money supply tanks, aggregate nominal spending collapses, and so does real output.

The next chart reveals what happened during 1929 and early 1933, the first “stage” of the GD.

In the next Chart, we observe the power of monetary policy. With the thermostat set to “heat-up” the economy (with money supply growth reinforcing the rise in velocity, the opposite of what happened in 1929-33). Going off gold in March 1933 played a major role.

Going into Stage III we see a “reversal of fortune”, with monetary policy quickly tightening (culprits here are the gold sterilization policy by the Treasury & increase in required reserves by the Fed). In “The New Deal and Recovery Part IV – The FDR Fed, George Selgin writes:

“…instead of taking steps to ramp-up the money stock, Fed officials became increasingly worried about…inflation! Noticing that banks had been storing-up excess reserves, they feared that a revival of bank lending might lead to excessive money growth, and therefore refrained from contributing directly to that growth. Then, finding a merely passive stance inadequate, they joined forces with the Treasury to offset gold inflows. These steps were among several that contributed to the “Roosevelt Recession” of 1937-8…”

Stage IV coincides with the end of gold sterilization and ensuing expansionary monetary policy.  The military spending that began in 1940 to bolster the defense effort gave the nation’s economy an additional boost. This worked through the rise in velocity while money growth remained stable.

How did the price level behave through the different stages? The next chart gives the details. Stage I witnessed a big drop in prices (deflation). In Stage II the process stopped and reversed somewhat. Stage III indicates why the Fed worried about inflation and in Stage IV we see the effect on prices of the “defense effort”. Even so, by the end of 1941, the price level was still significantly below the July 1929 level!

After Covid19, inflation?

Recently, manifestations about rising inflation following the Covid19 have increased substantially. Two recent examples illustrate, with both appealing to the QTM:

  1. The quantity theory of money today provides – as it always has done – a theoretical framework which relates trends in money growth to changes in inflation and nominal GDP over the medium and long term.

A condition for the return of inflation to current target levels is that the rate of money growth is reduced back towards annual rates of increase of about 6 per cent or less.

2. The quantity theory of money, the view that the money supply is the key determinant of inflation, is dead, or today’s mainstream  tell us. The Federal Reserve is now engaged in a policy that will either put the nail in the quantity theory’s coffin or restore it to the textbooks. Sadly, if the theory is alive and wins out, the economy is in for a very rough ride.

All those that appeal to the QTM to argue, “Inflation is coming”, forget that in 1971 Milton Friedman published in the JPE “A monetary theory of nominal income”, in which he argued for using the quantity theory to derive a theory of nominal income rather than a theory of either prices or real income.

There he asks; “What, on this view will cause the rate of change in nominal income to depart from its permanent level [or trend level path]? Anything that produces a discrepancy between the nominal quantity of money demanded and the quantity supplied, or between the two rates of change of money demanded and money supplied.”

A little over two decades later, in 2003, Friedman popularized that view with his “The Fed´s Thermostat” to explain the “Great Moderation”:

“In essence, the newfound stability was the result of the Fed (and many other Central Banks) stabilizing nominal expenditures. In that case, from the QTM, according to which MV=PY, the Fed managed to offset changes in V with changes in M, keeping nominal expenditures, PY, reasonably stable. Note that PY or its growth rate (p+y), contemplates both inflation and real output growth, so that stabilizing nominal expenditures along a level growth path means stabilizing both inflation and output.

How does that square with the evidence? To illustrate we look at two periods, the “Great Inflation” of the 70s and the “Great Moderation” (1987 – 2005).

During the “Great Inflation”, it seems the Thermostat broke down and the “temperature” kept rising above “normal”. During the “Great Moderation”, it appears the Thermostat worked just fine, keeping the “temperature” close to normal levels at all times.

How does the stability of the trend level path for nominal spending (NGDP) translate to the growth rate view? In the next charts, we observe that during the “Great Inflation” the “temperature” oscillated on a rising trend, while during the “Great Moderation” it was much more stable with no trend.

If the Thermostat is working fine, according to Friedman stabilizing nominal expenditures along a level growth path means stabilizing both inflation and output.

The next charts show that is the observed outcome.

On average, real growth is similar in both periods, while the volatility (standard deviation) of growth is 50% (1.3 vs 2.6) lower.

Note that price & wage controls work like putting a wet cloth on the patient´s forehead to reduce fever, as doctors did in the Middle Ages! As soon as you take away the wet cloth, temperature rises.

An interesting takeaway gleaned from the results following the application of Friedman´s Fed Thermostat, is that the 70s was no “stagflationary decade” as pop culture has it. It was just the “inflationary decade”.

It also shows that comments as the one below are plainly wrong:

“We are right to fear inflation. The 1970s was a colossal disaster and economists still can’t even agree on what exactly went wrong.”

Having understood the meaning and usefulness of “Friedman´s Thermostat”, we can use it to explain what happened after Bernanke took over as Chair in January 2006.

“Dialing down” the economy

AS the chart shows, when Bernanke began his tenure as Fed Chair, initially he kept nominal spending (NGDP) evolving close to the trend level path. Around mid-2007, he began to worry about the potential inflationary effects of low unemployment (4.4%, below their estimate of the natural rate) and rising oil prices.

At that point, money demand was on a rising trend (falling velocity) due to the uncertainties flowing from the financial sector problems that were brewing (remember the “start date” of the financial crisis was August 07 when two funds from Paribas were closed for redemption) and money supply growth was “timid”. As a result, nominal spending began to fall below trend.

In mid-08, the FOMC became very concerned about inflation. After all, in the 12 months to June 08 oil prices doubled. Bernanke´s summary of that meeting discussions is unequivocal evidence that the Fed´s goal was to “dial down” the Thermostat (or “cool”) the economy!

FOMC Meeting June 2008 (page 97):

“My bottom line is that I think the tail risks on the growth and financial side have moderated. I do think, however, that they remain significant. We cannot ignore them. I’m also becoming concerned about the inflation side, and I think our rhetoric, our statement, and our body language at this point need to reflect that concern. We need to begin to prepare ourselves to respond through policy to the inflation risk; but we need to pick our moment, and we cannot be halfhearted. When the time comes, we need to make that decision and move that way because a halfhearted approach is going to give us the worst of both worlds. It’s going to give us financial stress without any benefits on inflation. So we have a very difficult problem here, and we are going to have to work together cooperatively to achieve what we want to achieve.”

Before that meeting, the fall in nominal spending below trend was likely the result of unintended mistakes in the calibration of the thermostat, in the sense that the increase in money supply failed to fully offset the fall in velocity. During the second half of 2008, however, money supply growth decreased sharply, especially after the Fed introduced IOER in October. That certainly qualifies as “premeditated crime”!

The 2008-09 recession (dubbed “Great”) is more evidence for the relevance of the “Thermostat Framework” spelled out by Friedman. It was the conscious “dialing down” of the thermostat by the Fed, not the house price bust or the associated financial crisis, that caused the deep recession.

The charts below illustrate the impact of the “dialing down of the thermostat” by the Fed.

What comes next, however, puts the “Thermostat Analogy” in “all its glory”, in addition to dispelling the notion made popular by Carmen Reinhart and Kenneth Rogoff that this recovery was slow because it followed a financial crisis.

In short, once the economy was “cooled”, the Fed never intended to “warm it up” to the previous trend level path, keeping the thermostat working fine for the lower temperature the Fed desired.

The implications of a well-functioning thermostat are evident in the charts below.

1 Nominal spending is kept stable along a (lower) level path

2 Both real output and inflation are stabilized (also at a lower rate)

The next chart (which makes use monthly NGDP from Macroeconomic Advisers) shows what happened following the Covid19 “attack”.

This is not like 2008. This time around, the Fed had no hand in the outcome. The virus came out of left field and “crunched” both the supply and demand “armies”, leading to a sudden “drop shock” in nominal spending.

Money demand jumped (velocity tanked). The next chart shows that the Fed reacted in the right way, with a lag, given the surprise attack.

The economy faces a health issue with mammoth economic consequences. The thermostat dialed the temperature down “automatically” and will likely maintain the “cooler temperature” while the virus is “active”. All the Fed can do is work to ensure the temperature does not fall even more. Given the latest data available (May), it appears the Fed is managing to “hold the fort”.

What the inflacionistas worry is with the aftermath, after the virus loses relevance. They argue the massive rise in the money supply observed so far ensures an inflation boom in the future.

As the thermostat analogy indicates, you have to take into account the behavior of velocity (money demand). So far, even with the “Federal Reserve pouring money into the economy at the fastest rate in the past 200 years”, what we observe is disinflation!

How will the Fed behave once the virus loses relevance? Will it set the thermostat at the previous temperature (previous trend level path)? In other words, will it make-up for the losses in nominal spending incurred during the pandemic, or not?

In this post, David Beckworth argues that there is no evidence the Fed plans to undertake a make-up policy, concluding:

“So wherever one looks, make-up policy is not being forecasted. Its absence does not bode well for the recovery and underscores the urgency of the FOMC review of its framework. I really dread repeating the slow recovery of the last decade. So please FOMC, bring this review to a vote and give make-up policy a chance during this crisis.”

After the Great Recession, the Fed chose not to “make-up”. The chart illustrates

What will it be this time around?

If the Fed undertakes a make-up policy, inflation will temporarily rise (just as it temporarily fell when the thermostat was dialed down). The impossible dream I have is that the Fed not only makes up for the virus-induced loss, but also partly for the loss incurred by its misguided policy of 2008!

As always, the inflation obsession will the greatest barrier the Fed will face. No wonder more than 40 years ago James Meade warned that inflation targeting was “dangerous”.

Toying with business cycle dating

In this year´s ASSA Annual Meeting in January, Christina & David Romer (R&R) presented “NBER Business Cycle Dating: Retrospect and Prospect”:

“…Our most substantial proposal is that the NBER continue this evolution by modifying its definition of a recession to emphasize increases in economic slack [Deviations from potential output and/or unemployment] rather than declines in economic activity…”

“…Throughout the paper, we make use of Hamilton´s (1989) Markov switching model as a framework for investigating and assessing the NBER dates. Though judgement will surely never be (and should not be) eliminated from the NBER business cycle dating process, it is useful to see what standard statistical analysis suggests and can contribute.”

On page 32, they move to Application: The implications of a two-regime model using slack for dating US business cycle since 1949:

“We have argued that a two-regime model provides insights into short-run fluctuations. And we have argued for potentially refining the definition of a recession to emphasize large and rapid increases in economic slack rather than declines in economic activity. Here, we combine the two approaches by applying Hamilton´s two-regime model to estimates of slack and exploring the implications for the dating of postwar recessions.”

According to R&R (page 34):

“The largest disagreement between the two regimes estimates using slack and the NBER occurs at the start of the Great Recession. The NBER identifies both 2008Q1 and 2008Q2 as part of the recession (with the peak occurring in 2007Q4), while our estimates (see table 1) put the probability of recession as just 21% in 2008Q1 and 43% in 2008Q2.”

Table 1 Economic Performance going into the Great Recession

Quarter NBER Date

In Recession?

Agreement of 2-Regime Model Shortfall of GDP from Potential Unemployment minus Nat Rate
2007Q4 No 97% -0.6% 0.6%
2008Q1 Yes 21% 4.2% 0.9%
2008Q2 Yes 43% -0.2% 1.4%
2008Q3 Yes 91% 3.9% 2.7%

It is somewhat confusing! The 2-Regime model only “fully” agrees with the NBER that the economy was in a recession from 200Q3. The GDP gap roams all over the place, while the unemployment gap is increasing consistently over time.

Although R&R suggest the NBER emphasize measures of slack, those measures are very imprecise. This is clear given the CBO systematic revisions of potential output in the chart below.

Since I´m “toying” with dates, I´ll try using the NGDP Level target yardstick to see what it says about the Great Recession. (Useful recent primers on Nominal GDP Level Targeting are David Beckworth and Steve Ambler).

In the years preceding the Great Recession, there were many things happening. There was the oil shock that began in 2004 and gathered force in subsequent years. There was the bursting of the house price bubble that peaked in mid-2006 and, from early 2007, the problems with the financial system began, first affecting mortgage finance houses but soon extending to banks, culminating in the Lehmann fiasco ofSeptember 2008.

The next chart  the oil and house price shocks.

The predictable effect of an oil (or supply) shock is to reduce the real growth rate and increase inflation (at least that of the headline variety). The charts indicate that was what happened.

The chart below shows that when real growth fell due to the supply shock, real output (RGDP) dropped below the long-term trend (“potential”?). Does this mean the economy is in a recession? If that were true, the recession would have begun in 2006!

In that situation, how should monetary policy behave? Bernanke was quite aware of this problem. Ten years before, for example, Bernanke et al published Systematic Monetary Policy and the Effects of Oil Price Shocks”. (1997)

In the conclusion, they state:

“Substantively, our results suggest that an important part of the effect of oil price shocks on the economy results not from the change in oil prices, per se, but from the resulting tightening of monetary policy. This finding may help to explain the apparently large effects of oil price changes found by Hamilton and many others.”

In the chart below, we observe that during his first two years as Chair, Bernanke seems to have “listened to himself” because NGDP remained very close to the target level path all the way through the end of 2007.

With NGDP kept on target, the effects of the supply shock are “optimized”. Headline inflation, as we saw previously will rise, but if there is little or no change in NGDP growth, core measures of inflation will remain contained.

During the first quarter of 2008, NGDP was somewhat constrained. This likely reflects the FOMC´s worries with inflation. RGDP growth dropped further, but during the second quarter of 2008, the Fed seemed to be trying to get NGDP back to trend. RGDP growth responded as expected and core inflation remained subdued.

At that point, June 2008, it appears Bernanke reverted to focus almost singly on inflation, maybe remembering what he had written 81/2 years before in What Happens when Greenspan is gone? (Jan 2000):

“U .S. monetary policy has been remarkably successful during Alan Greenspan’s 121/2 years as Federal Reserve chairman. But although President Clinton yesterday reappointed the 73-year-old Mr. Greenspan to a new term ending in 2004, the chairman will not be around forever. To ensure that monetary policy stays on track after Mr. Greenspan, the Fed should be thinking through its approach to monetary policy now. The Fed needs an approach that consolidates the gains of the Greenspan years and ensures that those successful policies will continue; even if future Fed chairmen are less skillful or less committed to price stability than Mr. Greenspan has been.

We think the best bet lies in a framework known as inflation targeting, which has been employed with great success in recent years by most of the world’s biggest economies, except for Japan. Inflation targeting is a monetary-policy framework that commits the central bank to a forward-looking pursuit of low inflation; the source of the Fed’s current great performance; but also promotes a more open and accountable policy-making process. More transparency and accountability would help keep the Fed on track, and a more open Fed would be good for financial markets and more consistent with our democratic political system.”

This is evident in his summary of the FOMC Meeting June 2008 (page 97), where Bernanke says:

“My bottom line is that I think the tail risks on the growth and financial side have moderated. I do think, however, that they remain significant. We cannot ignore them. I’m also becoming concerned about the inflation side, and I think our rhetoric, our statement, and our body language at this point need to reflect that concern. We need to begin to prepare ourselves to respond through policy to the inflation risk; but we need to pick our moment, and we cannot be halfhearted. When the time comes, we need to make that decision and move that way because a halfhearted approach is going to give us the worst of both worlds. It’s going to give us financial stress without any benefits on inflation. So we have a very difficult problem here, and we are going to have to work together cooperatively to achieve what we want to achieve.”

From that point on, things derailed and a recession becomes clear in the data. It appears the NGDP Level Targeting framework agrees with Hamilton´s 2-regime model that the recession was a fixture of 2008Q3.

If NGDP had not begun to tank in 2008Q3, a recession might, later, have been called before 2008Q3, but it would never have been dubbed “Great”, more likely being short & shallow.

The takeaway, I believe, is that the usual blames placed on the bursting of the house price bubble, which led to the GFC and then to the GR is misplaced. Central banks love that narrative because it makes them the “guys who saved the day” (avoided another GD) when, in fact, they were the main culprits!

PS: The “guiltless” Fed is not a new thing. Back in 1937, John Williams (no relation to the New York Fed namesake), Chief-Economist of the Fed, Board Member and professor at Harvard (so unimpeachable qualifications, said about the 1937 downturn:

If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn. It makes a bad record and confused thinking. I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground. There is no good reason now for a major depression and that being the case there is a good chance of a non-monetary program working out and I would rather not muddy the record with action that might be misinterpreted.