Inflation – “Headline” & “Core”

There has been a lot of discussion recently on “measures” of inflation. The popular debate usually revolves around the particular “index” which the Fed should target or use as an indicator of future inflation. Should the Fed look at “headline” inflation or at “core” inflation?

Just to give a few (of many available) examples, in a recent post Steve Williamson concludes:

I don’t see anything solid that justifies the Fed’s focus on core inflation measures. Indeed, one could, I think, make a better case for looking at headline inflation measures.

In a NYT op ed, Laurence Meyer, former Fed governor writes:

So in the ’70s, increases in food and gas prices affected both core and overall inflation. Some believe this is still the case today. But it isn’t. Since the inflationary era ended in the early ’80s, the Fed has earned a reputation for keeping inflation in check. For more than a decade, the markets have operated under the assumption that in the long term inflation will be stable. This means that spikes in food and energy prices do not get translated into expectations of higher inflation down the road and thus do not lead to a general increase in prices, today or tomorrow. In light of the evidence, the Fed is right to pay more attention to core inflation than to overall inflation when making decisions about interest rates.

Both Williamson and Meyer refer to a technical article available at the Federal Reserve Board, that observes:

In the 1970s and early 1980s, movements in overall prices and prices excluding food and energy prices both contained information about the trend; in recent data, the trend is best gauged by focusing solely on prices excluding food and energy prices.

Where does that leave us? The first thing to note is that inflation is not about particular prices but about the overall price level – both “headline” and “core”. Being defined as a “continuing rise in the price level”, we should expect that inflation would be characterized by very similar moves in ALL prices over a sufficiently long period of time. The figure below shows that´s exactly what happens.  Over more than 40 years, the price level, both of headline and core prices, and both either defined by the CPI or the PCE (deflator of consumption prices) have increased by similar amounts.

One characteristic of the inflation process is that it has become much less persistent. That´s an indication that inflation has been tamed. In other words, a higher inflation “today” does not indicate that inflation will also be high “tomorrow”. This characteristic is shown on the figures below – which show the autocorrelation of inflation, i.e. the degree to which inflation “today” is correlated with inflation in different points in months past – both for the CPI and PCE indices, for the period 1968 – 80 (“Great Inflation”) and for the years after 1992.

The “key” to the discussion about if the Fed should “ignore” “headline” inflation is, as found by the Federal Reserve Board article cited above, that over the past two decades the trend is better gauged by “core” prices. This is visually clear in the following pictures.

We observe that for both the CPI and PCE indices, the “taming” of inflation means there´s no more “trend” to inflation, i.e. headline price changes are mostly “noise” and therefore should not “guide” monetary policy.

As an addendum, I submit that the crisis has shown that “targeting” inflation is not ideal. First there´s the problem of choice of index – and a case can be made that the steep drop in nominal spending after mid 2008 is due to the Fed “paying attention” to “headline” inflation. Second, the fact that inflation was tamed was not due to central banks “targeting” inflation. In fact, many countries, the US included, experienced “price stability” even with without being a formal “inflation targeter”. The inflation AND output stability derived from the fact that nominal spending was stabilized. When nominal spending dropped steeply after mid 2008, “targeting” inflation constrains actions to take nominal spending up, as the intense debate about the “danger” of inflation, even among FOMC members, indicates.

What would the “cynics” have done?

This is the picture of headline and three core measures of the CPI inflation. The “cynics” are peddling the headline for target. Let´s assume they are correct to do so. In 2008 it appears from the FOMC statements that the Fed was very worried with the headline numbers. The rest of the story we know well.

So in 2009 they would have brought rates down. But wait, rates were already at zero…so there´s nothing MP could do (and to appease their conscience, unemployment was deemed “structural”).

Recently headline has climbed above the magic 2% so the vultures are out in droves.  Wait there´s more. Among the “cynics”, the biggest cynic – Kocherlakota – does not appeal to the headline number. He says that IF MP was adequate at the end of 2010 with core rates between 0.6% and 0.8%, MP should be prepared to tighten now that core inflation is between 1.2% and 1.5%

If you make the assumption that at the end of 2010 that policy was appropriately accommodate, so neither too loose nor too tight, then you see core inflation go up by 50 basis points over the course of 2011, the usual response to that we know from 20 years of thinking about monetary policy or even more is to raise the target rate by even more than that increase in observed inflation. So that would mean you should raise your target rate by more than 50 basis points. The usual number is a 1.5 coefficient that Taylor has, so that would be 75 basis points. So this is saying that if you take monetary policy as being appropriate, just right at the end of 2010, then at the end of 2011 if you see this increase in inflation you should be responding to it by raising rates.

Given the state of the economy, inside a deep “hole” out of which it is only beginning to do a “sideways crawl”, MP was certainly not appropriate!

On the other side are the “doves” – Yellen, Evans and Dudley – which don´t get as much press.  Bernanke, in the middle has a tough balancing act ahead of him. And still in “cold storage” the nomination of Peter Diamond for Fed governor.

Cynics galore

Tim Duy has a post – On the logic of inflation hawks. There´s not much “logic”, it´s pure cynicism. On this matter I think Kocherlakota gets “The Greater Cynic” Prize. A review of some of his recent manifestations:

August 17 2010

Of course, the key question is: How much of the current unemployment rate is really due to mismatch, as opposed to conditions that the Fed can readily ameliorate? The answer seems to be a lot. I mentioned that the relationship between unemployment and job openings was stable from December 2000 through June 2008. Were that stable relationship still in place today, and given the current job opening rate of 2.2 percent, we would have an unemployment rate of closer to 6.5 percent, not 9.5 percent. Most of the existing unemployment represents mismatch that is not readily amenable to monetary policy.

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

March 25 2011

The bubble collapse has no impact on unemployment or output, given sufficiently accommodative monetary policy.

March 31 2011

If you make the assumption that at the end of 2010 that policy was appropriately accommodate, so neither too loose nor too tight, then you see core inflation go up by 50 basis points over the course of 2011, the usual response to that we know from 20 years of thinking about monetary policy or even more is to raise the target rate by even more than that increase in observed inflation. So that would mean you should raise your target rate by more than 50 basis points. The usual number is a 1.5 coefficient that Taylor has, so that would be 75 basis points. So this is saying that if you take monetary policy as being appropriate, just right at the end of 2010, then at the end of 2011 if you see this increase in inflation you should be responding to it by raising rates.

Other cynics include Bullard, Andolfatto and Steve Williamson, all “surveyed” in this post. Lacker is well reviewed by Tim and appears to be intent on “grabbing the prize” from Kocherlakota. I reproduce some of Tim´s graphs and complement them with additional ones that cover Lacker´s “hope for more unemployment “.  From Lacker, a beautiful tour de force. Watch how he switches from core to headline inflation with “effortless ease”:

In the last cycle, the economy began to grow more rapidly at the end of 2003. Although energy prices showed growth spurts, unemployment had not yet begun to fall and the core inflation measure that excludes energy and food prices was still just 1-½ percent. As a result, many forecasters expected inflation to diminish, and the FOMC kept the funds rate at a very low level well into 2004. Instead of falling, overall inflation soon rose to 3 percent, where it stayed, on average, through the end of the expansion in 2007. Core inflation averaged 2-¼ percent over that horizon. With hindsight, I think it is fair to say that policymakers overestimated the extent to which high unemployment would keep inflation from accelerating, and as a result, waited too long to withdraw monetary stimulus. Four years of 3 percent inflation may not have been the worst of all possible outcomes, but I do not consider it a success. I hope we do better this time. In particular, I believe we need to heed the lesson of the last recovery that inflation is capable of rising even if the level of economic activity has not returned to its pre-recession trend.  

The picture follows.

Tim puts up the graph for one commodity price representative – Crude materials for further processing. I add another two price indices in the “commodity” category: The PPI-all commodities and the CRB from the Commodity Research Bureau. Common to all three is the “take off” after 2001. In this post I argued that that pattern was due to the ballooning Chinese imports, heavy in commodities – that increased by a factor of 7 from 2001 to 2010 – following its membership in the WTO in December 2001. Mr Lacker, in order to avoid the rise in headline prices, think about expelling China from the WTO! The Fed can´t do anything about it. Worse, when it tried to do so in 2008 – remember that your colleague Richard Fischer voted for a rate increase as late as the August 2008 FOMC meeting – things got out of hand, to put it mildly.

Mr. Lacker, you say that the economy began to grow more rapidly in late 2003. Yes, you are correct. As the following picture shows that was due to the fact that nominal spending began to rise sufficiently strongly in order to close the “gap”, which it did by the end of 2005. It is clear why unemployment fell from that point. In other words, monetary policy was correct. Your idea would have made things worse, probably anticipating the start of the “Great Recession”.

This last picture indicates the depth of the “hole” the economy is in and you seem eager to “tighten” monetary policy. I´m sorry to say, but you most certainly do not deserve a place at the FOMC.

The crisis from an AD perspective

(Note: This piece was written in November 2009 as “notes to myself” when I decided to write up a story based on NGDP targeting and see if it fitted the “facts”. I believe the illustrations help in understanding the story. Judge the results for yourselves)

Rarely a day goes by without a new analysis on the “cause” of the crisis. A lot of the discussion on this topic is centered on the importance of the role that the elements on the “most wanted” list of suspects played. Those include:

The excess savings in emerging markets (savings glut),

Expansionary monetary and fiscal policies in the advanced economies,

The securitization of finance,

The underestimation of aggregate risks,

The fall in loan underwriting standards,

The errors made by rating agencies,

Regulatory failure,

The aggressive tactics behind mortgage loans,

The public policies related to homeownership.

Most likely, all the “suspects” share some degree of guilt. However, this is not of much help if the goal of the “finger pointing game” is to provide lessons for the future. For example, if the public policies related to the mortgage market and home ownership had not been adopted, maybe the aggressive mortgage loan tactics, the fall in loan standards, the degree of securitization and even the underestimation of risks would have evolved differently.

From another angle, and this enticed a defense by Bernanke in the recent AEA meetings in Atlanta, many analysts attach a high weight to monetary policy “errors” that would have occurred between 2002 and 2004, when “interest rates were kept too low for too long”. This conclusion follows from examining the Taylor Rule for calibrating the FF rate by the Fed illustrated in figure 1.  Since the FF (Fed Funds) rate remained significantly below the rate required by the “Rule” (FF-TR), monetary policy is interpreted as being “too easy”, contributing to the increase in the demand for mortgage loans and the consequent unsustainable (“bubble”) rise in house prices.

Apparently, as shown in figure 2, this view has merit since there appears to be a close correlation between the FF rate and the 30 year mortgage rate. During 2002 – 2004 the fall and subsequent stability at the 1% level of the FF rate “pulled” the mortgage rate downwards, a fact that may have contributed to the increase in house demand (which was already being driven by the public policies – homeownership incentives – adopted for the sector). 

As figure 3 indicates, the “contribution” of the “easy” monetary policy to the “bubble” in house prices may not have been as significant as envisaged by many. Looking again at figure 2 we observe that the mortgage rate remains low even after the FF rate begins to rise in mid 2004. On the other hand, we note from figure 3 that house prices had been rising for some years prior to the rate reduction and continued to climb after the FF rate began to rise, with the peak in prices being reached two years later in mid 2006.  This fact (FF rates increasing and long rates stable) was codified by Greenspan as a conundrum. One “solution” to the conundrum that became famous was provided by Bernanke in 2005, going by the name of savings glut (meaning the “excess” of savings in emerging markets whose positive current account balance – reserve accumulation – was reinvested in US Treasury Bills), in practice blocking one of the transmission channels of MP.

If figures 1 and 2 constitute evidence in favor of those that point to failures in monetary policy for the development of the “bubble” in house prices, the bursting of which is a root cause of the crisis, figure 3 throws some doubts on this narrative since the behavior of house prices doesn´t change during the period of “low” rates.

Critics accuse Greenspan of being a “bubble blower”. Since this was certainly not his explicit objective, what motivated the Fed to adopt an “easy” monetary policy in the first half of the last decade? To understand the FOMC´s actions we have to appeal to the Fed´s dual mandate: “Price stability (interpreted as a “low” inflation (2%)) and maximum employment”.

Figures 4 and 5, illustrate what the Fed was “seeing” at that moment. Between 2001 and 2003, following the 2001 recession, inflation was below its “target” and falling while the rate of unemployment was in a clear rising trend. In November 2002 Bernanke, at the time a Fed governor, delivered his famous speech: “Deflation: Making sure “it” doesn´t happen here”.

A passage in the speech clearly indicates what was going on in the minds of those responsible for monetary policy: “That this concern is not purely hypothetical is brought home to us whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation–a decline in consumer prices of about 1 percent per year–has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors”.

Note on the figures that FF only began to rise after inflation reached the “target” and unemployment was on clear down trend.

Figures 4 and 5 sort of exculpate Greenspan and the Fed since the policy implemented was the correct one given the Fed´s dual mandate.

These two opposing views – one based on Taylor Rules, that indicates that monetary policy was “easy”; the other, given the Fed´s mandates, indicates that policy was correct – lead me to think, especially in light of the crisis that manifested itself further down the road, if the objective (inflation target, even if only implicit in the case of the US) and the instrument (FF rate) of monetary policy are robust.

There are calculations of the Taylor Rule indicating that the FF rate should now be -5%. Having reached its zero lower bound, however, the FF rate cannot be manipulated any longer. There remains the perception that at the time it is most needed, monetary policy becomes powerless with “fiscal stimulus” remaining the only alternative to get the economy back on its feet.

On the other hand, the use of an interest rate as the instrument of policy creates confusion regarding the stance of policy. “Low” rates are confused with an “easy” monetary policy (MP) and “high” rates with a tight MP stance. Japan, for example, has kept its “FF” rate close to zero for many years, but Japanese MP cannot be called “easy”. Between April and September 2008 the FF rate was kept at 2%. As experience has shown, far from indicating that MP was “easy”, this “low” rate reflected a “tight” MP stance!

The Inflation Targeting (IT) regime also gives rise to some problems. By definition the IT regime requires that MP be symmetric. If inflation is below target MP has to be manipulated to bring inflation back on target. Conversely, MP has to constrain inflation when it is above the target.

However, while we may think of inflation above target as being “bad”, a fall in inflation below target (or even some deflation) is not necessarily something “malign”. The problem, as perceived from the Bernanke quote above, is that even a moderate deflation can be damaging. This happens due to the fact that he, as well as many others, has in mind the events surrounding the Great Depression when MP errors resulted in deflation and a steep fall in real output (RGDP).

That deflation is not necessarily harmful is illustrated in figure 6 which shows what was happening in the US economy in the last quarter of the 19th century.  While RGDP increased at an average rate of 3.8%, prices fell at 1.3% on average. Note that this is something quite different from the Japanese experience over the last 20 years.

The arguments above may be indicating that an IT regime may not be ideal. In the second half of the 1980´s several researchers, notably Bennett McCallum, with the purpose of devising “rules” for MP, discussed the idea that MP should be geared to maintaining stability in aggregate nominal expenditures (aggregate demand (AD)). This “search for rules” ended up being won by the proponents of the IT regime, with the interest rate (the FF rate in the US case) being the “instrument” of policy.

One of the effects of the ongoing crisis, characterized by an abrupt and steep fall in AD as will be seen below, was to bring back the discussion of what should be the target of MP. To the proponents of the view that the Central Bank should have as its objective the stability of AD, this is the “key” to macroeconomic stability – national or global.

For this group, shocks to AD are the true source of macroeconomic volatility while inflation is just a symptom of those shocks. Just like in medicine, symptoms may be related to different causes, so that prescribing the correct treatment is not trivial. In this sense inflation (a symptom) may be difficult to interpret: is inflation high (low) due to a positive (negative) shock to AD or to a negative (positive) supply (or real) shock? In situations of this kind, the prescribed “medicine” may not be the right one.

Figure 7 provides an illustration. The figure depicts the essence of a basic Dynamic Aggregate Demand/Aggregate Supply (AD/AS) model. The vertical axis denotes inflation while RGDP growth is depicted on the horizontal axis. The AD growth curve AD1 represents nominal expenditures growing at the rate of 5%. Along the AD1 curve the product of inflation and RGDP growth is 5%. The long run AS line LAS1 represents the growth of potential RGDP, which has been about 3% for the US over the last 50 years. The long run AS is vertical to reflect the fact that in the long run AS is determined by real factors. In the short run, however, the AS curve SAS1 is positively sloped due to temporary rigidity of prices and wages.   The dynamics of the level of RGDP and prices is illustrated in figure 8.  In the graphical model (fig. 7) the initial point is at a to which is associated an RGDP growth of 3% and an inflation rate of 2%. Let us suppose that the economy experiences a real, or productivity shock that permanently raises the level of potential RGDP (fig. 8). In this case the economy goes from point a to point b where RGDP growth  increases to 4% and inflation falls to 1% with AD growth remaining at 5%.

To associate the model to real world events, some may recall that in the second half of the 1990´s there was a heated discussion about if the Fed was “behind the curve”. Several analysts, among them Paul Krugman, accused the Fed of being complacent with inflation by not raising the FF rate when RGDP growth was “clearly” above “potential’.

Greenspan would reply that the US economy was going through a period of higher productivity growth (a positive supply shock), that had temporarily increased the sustainable rate of output growth, something that did not call for an increase in the FF rate.

Note that in time the economy returns to point a with growth falling back to 3% and inflation moving back to 2%. The level of RGDP is permanently higher and the price level will be permanently lower.

This will be the outcome if the Fed keeps the growth of AD at 5%. However, if it strives to keep inflation at 2% after it falls to 1% as a result of the positive supply shock, increasing AD growth to AD2 the economy will move from point b to point c. Since at point c the economy will be growing above its potential, inflation pressures will appear so that AD will have to be constrained (FF will increase) in order to keep inflation on target. In this case RGDP and employment volatility will certainly be higher than if the Fed had operated to keep AD growth stable.

Panel 1 below depicts the theory described in the simple model (figures 7 & 8) above. While growth in the US economy was higher than what was considered “normal” by analysts, being  the result of a higher rate of productivity growth, a fact that few other than Greenspan noted, the FF rate was stable and AD growth remained close to its average of a little more than 5%. After 1997, however, when inflation fell below the “target”, the Fed reduced the FF rate. AD went on to grow more than 7%.

At this point RGDP growth climbs to close to 5% while inflation remains below “target”. Note that the trend growth of productivity is maintained over the period, indicating that the fall in inflation was the predictable outcome of positive supply shocks.

From reacting to an inflation below “target” reducing the FF rate in 1998, the Fed than reacts to an RGDP growth considered “exuberant”. So, when the unemployment rate falls below 4% in 1999 the Fed caved in to “popular demand” and raised the FF rate.

Panel 2 describes what happened next.

The main point to note is the strong reversal of AD growth. Inflation remains below the target and productivity growth remains strong. RGDP growth falls towards zero with 2001 being officially defined as a recession year.

AD instability after 1998 is associated with Fed actions. First the Fed reacted to a below target rate of inflation and then, in the opposite direction, reacted to an exuberant RGDP growth rate. This is indicative that an IT regime has an important flaw that manifests itself when the economy experiences supply shocks (also called real or productivity shocks).

Furthermore, we cannot discard the fact that a Fed induced AD instability also has consequences for asset prices. This is shown in figures 9 & 10 where we observe the strong positive correlation between AD growth and the NASDAQ and S&P stock indices.

Note that the NASDAQ more than doubled between mid 1998 and early 2000 while the S&P rose by a little over 30%. This difference in the behavior of the two market indices is related to the fact that the NASDAQ, composed of technology stocks, was also influenced by the “productivity stories” of the time. Thus, what became known as a “bubble” was to a significant degree a reflection of AD instability.

So, if MP were to focus on stabilizing AD growth (level targeting), in addition to preserving macroeconomic stability it would also contribute to avoiding the appearance of “bubbles” in asset prices!

As was observed in figures 4 and 5, following the 2001 recession inflation remained low and unemployment high and rising with both reflecting the robust growth in productivity shown in Panel 2. Panel 3 describes how things unfolded in the 2002-05 period.

Expansion in AD only stabilizes (at the high rate of 7%) when inflation is brought back to “target”, the rate of unemployment is consistently falling and RGDP growth resumes its long run rate of about 3%.

As observed in figure 7 which illustrates the simple Dynamic AD/AS model, if MP is successful in keeping AD growth stable, the system adjusts while volatility remains low. If the Fed manipulates AD, influenced in turn by an inflation below target and then influenced by RGDP growth above potential, the system also adjusts – in the sense that inflation returns to target and growth to potential – but the shocks to AD resulting from these manipulations impart an undesired high level of volatility to the system, also affecting asset prices with spillovers (through wealth effects) to the real economy.

Given its size, events in the US economy have significant impact on the global economy. Figure 11 shows the behavior of AD (nominal expenditure growth) in the US over the last 50 years. It is relatively straightforward to associate this behavior to the periods that became known as “The Great Inflation” and “The Great Moderation”.

Figure 12 shows the similarity of the AD behavior in a group of 24 countries in the OECD. In the 1960´s and 1970´s the focal variable was the unemployment rate. During the Kennedy-Johnson administrations AD shocks, from MP and Fiscal Policy (FP), parted a positive bias to AD growth.

In the 1970´s, characterized by negative supply shocks (notably oil prices), increases in AD to compensate for the negative effects of the shocks on unemployment and RGDP growth resulted in high and rising inflation.

Panel 4 illustrates the “final sprint” to the crisis. As indicated in figure 3, in mid 2006 house prices began to fall. From this moment the delinquency rate began to grow affecting the health of important financial institutions. A few (New Century Financial, for example) went broke already at the beginning of 2007.

Notable, however, is the fact that between 2006 and mid 2008 AD growth was kept relatively stable and close to the trend path. Therefore, in spite of the crisis, the adjustments in the economy were able to proceed in an “orderly fashion”.

Observe in figures 13 and 14 that between 2006.II and 2008.II employment change was mostly positive and the unemployment rate remained stable. Something very different happens after 2008.II when AD “dives”, becoming negative for the first time since WWII. The change in employment is strongly negative and the unemployment rate shoots up.

Figures 15 and 16 help explain why it so happens that between mid 2006 and mid 2008 employment didn´t “dive” and the unemployment rate didn´t “soar”. With nominal spending growth (AD) relatively stable, resources flowing out of the residential construction sector were, among other, relocated to the export and non residential construction sectors.

Only when AD “melts” is that a significant cyclical problem manifests itself. From this moment on the drop in economic activity is generalized and no “compensations” are possible.

It is interesting to note how many analysts see things in a completely different light. In a recent column in the Washington Post, for example, Alan Blinder who was a governor and vice chairman of the Fed (1994-96) and like Bernanke is a Princeton University professor writes that while between mid 2007 and mid 2008 Fed actions fell short, following the Lehman blow-up “the Fed deserves extremely high marks for its work since then. It has hit the bull’s-eye regularly under very trying circumstances”.

When it is said that the Fed regularly got it right at the same time that AD “melts down” something must be very wrong with people’s perceptions.

What is lacking is an explanation for the steep drop in AD. Once again the fact can be connected to the IT regime. Since early 2006 commodity prices were rising. In early 2007 oil prices joined in the fray, with price more than doubling in the next twelve months. Figures 17 and 18 illustrate.

Panel 4 showed that core inflation remained stable (even if slightly above target). The Fed feared that commodity and oil price increases would “infiltrate” the price system and push core inflation upwards.

The crisis gained the headlines in early August 2007 when three funds in Bank Paribas were closed for redemption. In the September FOMC meeting, in a gesture of “appeasement”, the Fed began a process of FF reduction. Nevertheless in every meeting after that the Fed always showed that it was very concerned with the risk of a rise in inflation. In the April 2008 meeting the FF rate was set at 2% and remained at that level until early October, when the “panic” set in.

In the August 2008 FOMC meeting, when commodity and oil prices had already turned down the Fed showed a very hawkish stance. One of the participants voted for an immediate increase in the FF rate and the release after the meeting indicated that the next move in the rate would likely be up! In the September 16 meeting, 24 hours after the collapse of Lehman and a few hours after receiving the news that industrial production had dropped by 1% in August, the Fed maintained the FF rate at 2% and reaffirmed its concern with inflation.

The Fed´s inflation fighting credibility – and the manifestations in the sequence of releases after meetings – indicated that the growth of nominal spending (AD) would be reduced in the future. Just like inflation expectations are an important determinant of present inflation, the same happens with AD growth.

The negative supply shock (from oil and commodity prices) and an IT regime meant that if the Fed strives to keep inflation at the “target” level it will contract AD growth. Given the Fed´s credibility, nobody doubted that that would happen. No wonder it did…

The financial crisis was certainly made worse by the expectation of a contraction in AD, and contributed  to increase the economy´s “melt-down” rate.

I wonder in what kind of world we would be living today if 20 years ago the group that argued for the stabilization of AD growth (level targeting) as the rule to be followed by MP had won the debate over those that proposed IT with the interest rate as the policy “instrument”. Quite likely we would be experiencing much less “fiscal stimulus” with all its attendant risks.

As an end-note, Bernanke knows very well how to conduct MP at the ZLB. In a paper presented in 1999 (check Japanese Monetary Policy – A case of self-induced paralysis in the “Suggested Reading” list) he gave very useful advice to Japan (including “price level targeting”, a variant of AD targeting). One wonders why he did (and does) not take his own advice.

No consensus on inflation

Steven Williamson has a post – “Core Inflation” – where, maybe unconsciously, he shows that inflation targeting is “dangerous”. From his conclusion:

To say how a central bank should be responding to particular observed price movements, we need some solid theory concerning the welfare effects of inflation, how monetary policy affects inflation, and some solid measurement to tell us about the quantitative effects. I don’t see anything solid that justifies the Fed’s focus on core inflation measures. Indeed, one could, I think, make a better case for looking at headline inflation measures.

He´s surely being provocative, but is essentially saying that “looking at inflation can be bad for your health”. I wholeheartedly agree with that. But I don´t agree that we need a “solid theory…”. We already have that. And as I´ll try to show, it was exactly because the Fed failed to heed to the “solid theory” in 2008 that a “normal” recession became “Great”. People tend to think of inflation as a “price phenomenon”. As the link to the Plosser speech in his post shows, that´s WRONG:

Some fear that the strong rise in commodity and energy prices will lead to a more general sustained inflation. Yet, at the end of the day, such price shocks don’t create sustained inflation, monetary policy does. If we look back to the lessons of the 1970s, we see that it is not the price of oil that caused the Great Inflation, but a monetary policy stance that was too accommodative. In an attempt to cushion the economy from the effects of higher oil prices, accommodative policy allowed the large increase in oil prices to be passed along in the form of general increases in prices, or greater inflation…

Below I show a set of pictures (once again) that perfectly illustrates that when monetary policy is accommodative you get a rising trend for nominal spending growth accompanied by highly volatile (no trend) in real GDP growth. Conversely, when nominal spending growth is stable (no trend), real GDP growth is also stable. The story behind the “Great Moderation” was clearly one associated with a stable nominal spending growth path, which contrasts quite clearly with the rising nominal spending trend of the “Great Inflation” years.

The figures below show that during an inflationary period – increases in all prices – no price is “sticky”. The figures depict the behavior of “sticky” and “flexible” headline CPI.

During the “Great Inflation” years, up to 1979, both sets of prices move together. Note that you still get relative price changes, but within an inflationary process. The disinflation from 1980 to 1983 is also characterized by simultaneous movements in both sets of prices. The picture is very different during the post 1984 years. “Flexible” prices move a lot (and even fall – deflation), while “sticky” price changes are relatively low and stable. Stability was achieved not because the Fed was targeting “inflation” (be it from sticky or flexible prices) but because, in practice, it kept nominal spending evolving along a stable growth path.

And how did he do that? From the quantity theory, the Fed managed to keep MV stable by offsetting movements in velocity (V) with opposite movements in money (M). The next figures illustrate this point in recent years, in two situations characterized by rising “flexible” price inflation. The first, shown in green bars on the inflation graph above, corresponds to the final period of Greenspan at the Fed helm – 2004-05. The second, shown in yellow depicts the 2007-08 period.

In the first period, money growth closely offsets velocity (money demand) changes. In the second period we observe that after mid 2008, the fall in velocity (rise in money demand) is accompanied by a fall in money growth. From the QTM, the only outcome possible is a fall in nominal spending (PY=NGDP)!

The next graph shows this is exactly what happened, with nominal spending dropping way below “trend”. After that point (mid 2008) the recession that began in late 2007 turned “Great”. As this post shows, that´s the point that marked the soar in unemployment, the plunge in employment and the strong contraction in non residential investment and all measures of spending.

This last point connects well with Williamson´s smack down post on Christina Romer´s op ed at the NYT this weekend. According to CR:

the elevated unemployment rate appears to reflect mainly cyclical factors, particularly a lingering shortfall in consumer spending and business investment and that: This diagnosis suggests that the appropriate remedy is to stimulate demand.

To which SW responds:

So, how can Romer state with any confidence that consumer spending and business investment have fallen short of what they should be? She does not say. Where is the empirical evidence? What is this demand that we are trying to stimulate?

To which I respond: “Steve, look at the pictures” and at the way monetary policy erred!

Update: The whole discussion about which “inflation” just won´t go away. Today two FOMC voting memebers, Yellen and Evans, respectively made a speach and released a paper on the subject. Just goes to show how precarious is the IT “thing”. Better to read and reflect on the Scott Sumner and Beckworth analysis – suggesting that the Fed move to NGDP level targeting. The references are linked to on the “Suggested Readings” on the right side bar under the titles: “The Case for NGDP targeting” – S. Sumner, and “How to Narrow the Fed´s Mandate” – D Beckworth.

Update (4/14): The discussion about the “ideal inflation” to target expands further:

This is St Louis Fed chief Bullard:

Of course, if the evidence shows that core PCE is not the best measure to focus on for policy purposes, exploring other options may make sense. One alternative measure could include all components but put less weight on those that have highly volatile prices. Such a measure would avoid systematically excluding certain prices and would more accurately reflect consumers’ expenditures. Additionally, studies have shown that other existing “core” measures, such as PCE trimmed-mean or PCE weighted-median inflation, may be better predictors of headline PCE inflation than core PCE.2 In the end, the policymakers’ goal is to use the inflation measure that helps them achieve low and stable headline inflation in the long run.

And here is Andolfatto, a VP (Research) at the St Louis Fed:

What, if anything, justifies looking at price indices that strip out components of the index? A cynical view is that the Fed may prefer core to headline because it evidently makes the Fed’s performance look better (in terms of keeping inflation low). This cynical view conveniently ignores the fact that headline inflation is frequently below core.

Perceptions differ from reality

Usually the view is that monetary stimulus like quantitative easing works by reducing long term rates. Even Bernanke has said so in his efforts to explain the process when QE2 was launched in early November. So when long term interest rates rose many took that to mean that QE2 had failed.

So it was surprising to read Roger Farmer´s piece in the FT/Economists Forum today saying that:

Central bankers are in unfamiliar territory. Before 2007, there was a consensus that monetary policy could not influence the term structure of interest rates by changing the composition of its balance sheet. That consensus has been shattered by the success of strategies that are widely perceived to have brought down long-term interest rates and generated a boom in world stock markets.

I wonder if he looks at the data! But his perception is predicated on the “fetish” of the interest rate transmission channel, and it is the “fall” in long term rates that has generated the boom in stocks! In any case, as David Beckworth, among others, frequently argues:

What is not true is that a successful monetary stimulus program will be defined by sustained low long-term interest rates.  A successful monetary stimulus by definition would lead to a robust recovery.  Though this would be initially associated with lower interest rates, the robust recovery should ultimately lead to higher interest rates.  Given the forward looking nature of markets, just the expectation of an increase in economic activity should put upward pressure on current interest rates. 

The data indicate that David´s view is the correct one. The figures show that during QE1 long term rates went up (and stayed up), stocks rose and inflation expectations turned positive after dropping into negative territory in late 2008.  QE1 ended prematurely and long term rates, stocks and inflation expectations fell!

Talk of another bout of monetary stimulus (QE2) in late August 2010 during the Jackson Hole gathering was enough to reverse trends. So QE2 was not the failure many envisaged, but it is not a resounding success either. Bernanke would have done much better to take the opportunity to establish a new target, preferably a nominal spending level target. But he opted to remain locked inside the IT straightjacket which now has gotten the hawkish members of the FOMC all excited and arguing for an early termination of the program.

DeLong asks the right question…

And gets to the answer convincingly. A few days ago, he was concerned with the “anatomy of slow recoveries”. Now he asks himself “How did we get here”? And the answer jumps at him:

I thought that the Federal Reserve had the power and the will to stabilize the growth path of nominal GDP. He was not called “Helicopter Ben Bernanke” for no reason. When demand for currently-produced goods and services is crashing because households and businesses find themselves desperately short of the safe, liquid vehicles of appropriate duration in which they want to park their wealth and so are not-spending in order to build up their safe, liquid, appropriate duration asset holdings, it is the job of the central bank–and of the Treasury through banking policy, and perhaps of the Treasury through fiscal policy–to fix it and give the private sector the financial assets it wants. No excess demand for financial assets, and by Walras’s Law there can be no deficiency of demand for currently-produced goods and services and labor in general.

Skipping a paragraph:

Demand management worked in spite of a number of large shocks from the mid-1980s to the mid-2000s. Black Monday in 1987. The S&L crisis of 1990. The Mexican peso crisis of 1994. The East Asian crisis of 1997. The Russian state bankruptcy. LTCM. The collapse of the dot-com boom. Assorted Brazilian, Turkish, Argentinian, and other episodes. In all these the Federal Reserve, without breaking a sweat, intervened strategically in financial markets to successfully build a firewall between financial panic and distress on the one hand and effective demand for goods, services, and labor on the other. And so we all began writing papers on the “Great Moderation.”

And more:

But I don’t think I was wrong because the government does not possess the power. I think I was wrong because the government does not possess the political will to do what ought to be done and the technocratic clarity of thought to understand what strategic interventions in financial markets are likely to work and what ones are likely to simply be wastes of money.

To which Nick Rowe gives the perfect appraisal in the comment section:

One thing I think is missing is this: how much of the failure of political will was really due to the New-Keynesian/Neo-Wicksellian perspective? “What the central bank does is set the nominal rate of interest, and so when the nominal rate of interest hits zero, it can do no more”?

You are a historian of thought (inter alia). You have read stuff that wasn’t published yesterday. Most economists haven’t. They found it very hard to think outside that “monetary policy is setting the interest rate” box. They couldn’t communicate monetary policy outside that box.

It was less a failure of political will than an atrophy of thought about monetary policy. The grandchildren of Tobin and Friedman’s marriage had invested all their inheritance in a single asset — The Federal Funds rate.

Update: Scott Sumner reminds me that once upon a time DeLong did not believe in the efficacy of MP to get the economy back on it´s feet. In this letter to the editor from 2009 he comments on DeLong´s views at the time.

Some dogs just bark and some just bite

The ECB barks and bites! It raised rates (“bit”) this week as it had indicated it would do (“barked”) despite economic weakness all over the place. Oh! Yes, headline inflation is a bit over the limit, mostly due to commodity prices. But everyone knows Germany frightens easily on that score.

The countries that were “bit” will have to “mend” their “wounds” by themselves, mostly by deflating, instead of rising wages in Germany doing most of the “healing”.

Below is the graph for unit labor costs in a group of countries. Note that ULC did not rise only in the periphery, but also in large counties like France as well as in small countries like the Netherlands, both outside the “periphery”.

So it´s not just a question of “competiveness” – a very imprecise concept – but maybe more importantly, a question of the wide gap between savings and investment in Germany, which is the factor determining its current account surplus. The figure below contrasts the saving investment balance of Germany and France.

What transpires is quite illogical. On the one hand, Germany believes its customers should “keep buying”, but stop “irresponsible borrowing”! It simply cannot be done. On the other, the ECB is “making policy” only for Germany, at the same time making it harder for it to “sell”.

DeLong´s “Anatomy of a Slow Recovery”

According to DeLong:

The obvious hypothesis to explain why the current US recovery – like the previous two – has proceeded at a sub-par pace is that the speed of any recovery is linked to what caused the downturn. A pre-1990 recession was triggered by a Fed decision to switch policy from business-as-usual to inflation-fighting. The Fed would then cause a liquidity squeeze and so distort asset prices as to make much construction, sizable amounts of other investment, and some consumption goods unaffordable (and thus unprofitable to produce). The resulting excess supply of goods, services, and labor would cause inflation to fall.

This “anatomy” analysis is not new. After the 1990/91 recession there were also “concerns” about the changing nature of the recovery process.

For example, in the summer 1992 issue of Challenge Magazine, Robert Brusca, chief economist at The Nikko Securities Co., wrote a long piece titled Recession or Recovery?

“… by all historical standards there should be a strong recovery (following the 1990/91 recession). But the economy is now so uncertain, we could be in for a triple-dip recession rather than a recovery…” and there follows several pages of comparative statistics on the behavior of all kinds of economic variables following a recession, with the conclusion being that since the economy had not yet shown the strong rebound that historically follows a recession, his view was that the recession had not yet ended, “appearing to be the longest since the Great Depression” (at about the time the article was published, the official date for the end of the recession was put at March 1991).

Also, in the Fall 1992 issue of The Federal Reserve Bank of Minneapolis Quarterly Review, David Runkle (a senior economist in the research department) wrote: “… the current recovery is the weakest in the post war period in all measures of economic activity. This means that the current recovery is most appropriately viewed as a continuation of a long period of below average growth”.

The “this time is different” view is correct, but not for the reasons stated. Also, the “pathology” of the current situation is very different from the previous two.

The figures below provide a good illustration.

The first set of figures show real growth (RGDP) and nominal spending growth (NGDP) for two periods (1954 – 1983 and 1987 – 2007).

It´s straightforward to understand the worries shown by both Brusca and Runkle in the early 1990´s. By that time the growth process had changed, with the swings in economic activity – both nominal and real – becoming much more subdued. The recessions of 199/91 and 2001 are “short & shallow”, a pattern very different from what went on in the previous decades. Both the “busts” and the “booms” were much more contained. Trend real growth was essentially constant (around 3.3%) over the two stretches. But it is understandable that Brusca and Runkle should feel “frustrated” by the “weakness” of the recovery. Notable also is the relative stability of nominal spending growth from 1987 to 2007. During the 1950´s through the early 1980´s there is a clear rising trend in nominal spending. As the set of figures on inflation show, this imparted a growing trend to inflation, which disappears during 1987 – 2007. In this case, the “inflation-fighting” focus of the Fed is a “full-time concern” and not conducted by “switching on and switching off” the “control button”.

DeLong focuses on the unemployment rate. The next figures show the time series of unemployment for the same two periods. The rise in inflation ´that began in the late 1960´s is accompanied by rising and volatile unemployment. This volatility is greatly reduced during 1987 – 2007 and the fall in unemployment during this period shows similar persistence to that observed during the expansion of the 1960´s (from 1961 to 1969).

The important policy difference in the two periods is found in the growth of nominal spending, upward trending for most of the first period and evolving along a stable growth path in the second. In essence this “strategy” helped contain the propagation of shocks, stabilizing both inflation (at a low level) and real growth.

So we arrive at the current predicament. It´s not a question of slow recovery but the almost complete absence of one. And why is that so? The figures below repeat the previous ones for the 2008 – 10 stretch.

Nominal spending growth was significantly negative (something that had not happened since events during the Great Depression). Real growth plunged deeper than at any time in the post war period and inflation almost disappeared. With the opening up of such a big “hole” there´s no way unemployment will not skyrocket.

Monetary policy did it and monetary policy can pull the economy back to a reasonable level path. But the “memory less” nature of inflation targeting constrains appropriate actions by the Fed so the most we can expect is a very slow crawl back to a “place which will still be short of where we once were”.



Round and round…

Krugman and Taylor keep “jabbing” at each other about investment and unemployment and the role of government. So I don´t mind showing again that the slump that began in mid 2008 (not end 2007) is a direct consequence of monetary policy mistakes. And not the so called “mistakes of 2002-04” that Taylor keeps harping on, but the big mistake, reminiscent of 1929 that the Fed made in 2008.

Krugman never tires of saying that the ZLB makes all the difference (and evokes the 1921 recession (here) to argue that “conservatives” are dead wrong to use it as an example of the benefits of government keeping its “distance”).

As usual I go about showing arguments through a set of pictures.

The first shows the already standard indicator that after mid 2008 the Fed allowed nominal spending, that had evolved along a stable growth path during the “Great Moderation”, to “fall off a cliff”, something that had last happened in 1938.

Why did this happen? As we´ll see, it wasn´t the housing bust and the financial crisis that ensued, but the fact that monetary policy tightened significantly (despite the low level of interest rates – 2% from April to October 2008). The following picture shows that up to mid 2008, money supply increased to offset the fall in velocity (rise in money demand). But after that point money supply growth and velocity fall together.

To me this is the most compelling explanation for the “debacle” that followed. As seen in the next picture, residential construction employment peaked in early 2006.

But total nonfarm employment kept rising only dropping after mid 2008.

Unemployment was only 5.3% in mid 2008, after which point it “skyrocketed”.

The same pattern is seen in private investment. First, residential investment peaks at the end of 2005.

But nonresidential investment keeps chugging along up until, you guessed, mid 2008.

House prices (case-Shiller National) is shown next.

Prices peaked in early 2006. By mid 2008 prices had already dropped by 15%. But the economy was still standing! Also note that house prices began rising in mid 1997 (that´s an interesting story on its own) and just kept on going during the “low rate” period.

What was the government (at all levels) doing? The following pictures show government purchases (consumption and investment) and government expenditures on transfers and subsidies.

Both had increased somewhat (1 and 1.5 percentage points, respectively) between end 2006 and mid 2008. After that point government purchases increases another 1 percentage point while “automatic stabilizers” increase transfers and subsidies by almost 3 percentage points of GDP.

So what made the recession acquire the moniker “Great”? Monetary Policy mistakes!

I wonder what Milton Friedman would say if he were around. Maybe this will help find out:

Between 1980 and 2005, as the world embraced free market policies, living standards rose sharply, while life expectancy, educational attainment, and democracy improved and absolute poverty declined. Is this a coincidence? A collection of essays edited by Balcerowicz and Fischer argues that indeed reliance on free market forces is key to economic growth. A book by Stiglitz and others disagrees. I review and compare the two arguments.