From Bullard´s presentation it comes out that “Inflation Targeting is Rotten”

On the evening of May 18 James Bullard, President of the St Louis Fed and FOMC voting member, made a speech to the “Money Marketeers of New York University” titled: Measuring Inflation: The Core is Rotten. From the introduction:

In my remarks tonight I will argue that many of the old arguments in favor of a focus on core inflation have become rotten over the years. It is time to drop the emphasis on core inflation as a meaningful way to interpret the inflation process in the U.S. One immediate benefit of dropping the emphasis on core inflation would be to reconnect the Fed with households and businesses who know price changes when they see them. With trips to the gas station and the grocery store being some of the most frequent shopping experiences for many Americans, it is hardly helpful for Fed credibility to appear to exclude all those prices from consideration in the formation of monetary policy.

In critiquing the “volatility argument” for core inflation Bullard says:

Recent experience offers something to ponder in this regard. While many think that the recent financial crisis provides an illustration of the merits of the focus on core inflation, I do not see it that way at all. During the second half of 2008 and into 2009, headline inflation measured from one year earlier fell dramatically and in fact moved into negative territory. This was a signal—one among many, to be sure—that a dramatic shock was impacting the U.S. economy. Inflation was not immune to this shock. The FOMC reacted appropriately with an aggressive easing of monetary policy. Yet the movements in core inflation during this chilling period were far more muted and sent much less of a signal that action was required.

That´s interesting, because one of the reasons for the steep fall in headline inflation in the second half of 2008 was the tight monetary policy the Fed had adopted since late 2007 to counteract the rise in oil and commodities. And contrary to what Bullard argues, the Fed did not react with an aggressive easing of monetary policy, because it was exactly beginning in the second half of 2008 that nominal spending plunged to an extent not experienced since the 1930´s! Clearly, the level of the Fed Funds rate is a very imprecise indicator of the stance of monetary policy. In his dismissal of the “relative price” argument, Bullard states:

The key relative price changes in today’s global economy are for energy and other commodities. Crude oil prices, in particular, are substantially higher in real terms than they were a decade ago and constitute a significant fraction of global expenditure. It is often asserted that energy prices cannot increase indefinitely; that a one-time rise in energy prices only temporarily contributes to inflation; and therefore that it makes sense to ignore such changes. However, the logic of relative prices suggests that if households are forced to spend more on energy consumption, then they have to spend less on the consumption of all other goods, thereby putting downward pressure on all other prices (and all other expenditure shares) in the economy. Ignoring energy prices would then understate the true inflation rate, as one would be focusing only on the prices facing downward pressure because of changing relative prices.

Let´s take a look at some pictures. The following graph shows, from the Atlanta Fed Inflation Project, the behavior of headline inflation – both of the flexible and sticky components.

What stands out is the fact that during the “Great Inflation” of the 1970,s, the “sticky components” became unstuck! That´s what we mean by inflation: a continuing rise in all prices. The following figure shows that it is hard to distinguish between the sticky Headline CPI depicted in the previous graph and the Core CPI.

What transpires is that a relative price change can take place within an inflationary process like during the 1970´s or not, like during the last decade. Over the last several months we´ve been hearing all sorts of arguments for and against targeting headline inflation. That should give us pause regarding inflation targeting because if even policy makers cannot agree on the appropriate target, something is definitely wrong with the concept (maybe it´s “rotten”).

I believe that disagreement provides the most compelling case for a change in target. It turns out that a nominal spending target can explain both the rising inflation of the 1970´s as well as the stable and low inflation after the mid 1980´s up to 2007. It also explains why the “Great Moderation” was lost beginning in 2008.

In the next picture, the rising inflation of the 1970´s is the result of the increasing nominal spending trend followed by the Burns Fed to accommodate the rise in energy and commodity prices. If Burns had acted differently and adopted a contractionary monetary policy in the face of those shocks, he would have imparted a decline in nominal spending, exactly what Bernanke did in 2008! So much for Bullard´s suggestion of targeting headline inflation.

The next figure shows that the stable nominal spending growth up to 2007 is associated with the low and stable inflation of the period (note that real growth was also stable).

The next two pictures indicate that stability was lost when the Fed allowed nominal spending growth to first fall below trend and then plunge.

Maybe it’s time to seriously discuss the nominal spending target proposals that have been put forth by different researchers, including Mankiw, Hall and McCallum in addition to Scott Sumner and David Beckworth, over the last 25 years.

“Conservative hypocrisy” – (a follow-up on the previous post)

This article from the WSJ is revealing:

A growing number of House Republicans are expressing doubt about the need to raise the federal debt ceiling by Aug. 2, as the Treasury Department insists is necessary, sharply raising the political and economic stakes as congressional leaders try to secure a deal to raise the nation’s borrowing limit.

“When you say the drop-dead day is going to be August, I question that,” said Rep. Tom Rooney (R., Fla.). “I’ll believe it when I see it.”

The danger is that by the time Mr. Rooney “sees it” it will be too late to contain the potential damage.

Question: Where were the “conservatives” when the debt ceiling was raised 7 times during the Bush presidency (with the 7th coming in just two months after the 6th)? Note that between 2002 and 2006, when the debt limit was raised four times, it was an “all republican” government.

Where were the “conservatives” when the “going was good”?

As soon as the CPI numbers are announced “hysteria flourishes”. Ron Paul, given his position as chair of the House committee that oversees monetary policy, may be considered the “representative conservative agent”. After Bernanke´s recent press conference following the April FOMC meeting, he stated:

A “staged press conference will not be enough to stop the growing demand for real Fed transparency,” said Paul, adding that “the American people want real answers about Fed bailouts, lending to foreign banks, and most of all inflation.”

The Congressman vowed to press ahead with his efforts to audit the Fed, and to continue to expose Bernanke’s deliberate devaluation of the dollar, which Paul urges is paving the way for “hyperinflation and the destruction of our currency.”

As the figures show the “inflation fetish” is downright ridiculous. But we know it´s not about inflation at all…

Steve Chapman takes the histrionics seriously:

“The Bernanke policy of printing money is setting the stage for mass inflation,” claims former House Speaker Newt Gingrich. Rep. Ron Paul, R-Texas, decries “the inflation all Americans suffer due to the Fed’s relentless monetary expansion.” Former Sen. Rick Santorum, R-Pa., fears not just inflation but “potentially hyperinflation.”

The claim has a surface plausibility. If the money supply is growing and prices are rising, what more evidence do we need? But first impressions, in this case, are badly misleading.

Inflation is not a price phenomenon

It never ceases to amaze me the “ignorance” about inflation, even from people that should know better. In the WSJ, Kathleen Madigan writes: “Link between weak dollar, inflation is eroding”:

Exchange rates are a hot topic as the U.S. and China hold their third annual round of the Strategic and Economic Dialogue this week. The link between a weaker dollar and prices is also gaining in importance because the Federal Reserve is coming under fire about inflation pressures in light of rising commodity costs. The Fed says the effect of such cost increases are “transitory.” Businesses and consumers aren’t so sure.

The figures show the absence of any link between the trade weighted value of the dollar and inflation (CPI Core) in different moments over the last 10 years.

In the latest Economic Synopses released by the St Louis Fed, veteran researcher Daniel Thornton proposes to test the hypothesis that the FOMC focuses on core inflation measures because “in light of the volatility of food and energy prices, core inflation has been a better forecaster of overall inflation in the medium term than overall inflation itself has been over the past 25 years”. He concludes:

This essay notes that the evidence that core inflation is a better predictor of future headline  inflation is mixed and presents the results of a simple test of the proposition that core inflation is a better predictor of future headline inflation than headline inflation. The essay concludes by showing that over periods of interest to consumers, the difference in the loss of purchasing power reflected by the core and headline measures is economically relevant.

The following picture shows that over a long period of time (last 40 years) the headline CPI and Core CPI have increased by the same factor. Their “paths” have differed sometimes markedly. Those are moments of significant relative price changes (in the 70´s or over the last seven or eight years). The point to note is that relative price changes can take place within an overall inflation process (the 70´s) or not (more recent period).

During the 70´s the Fed (Burns) compensated the negative oil and commodity shocks with expansionary monetary policy (increase in nominal spending). As Friedman had said in 1968, the result would only be more inflation without gains in output or reductions in unemployment. And that´s exactly what happened.

In 2008, paying attention to headline prices, the Fed (Bernanke) indicated that nominal spending would be contracted. Given the environment (financial crisis) this was tantamount to “rubbing salt in the wound”. Nominal spending crashed and the recession became “Great”.

Not to worry. As long as policymakers are focused on “inflation”, the economy will not revive, but many will be “happy” because “prices have remained stable”.

According to Kocherlakota:

In remarks that closely tracked a speech he gave last week, the head of the smallest regional Fed bank said he sees core inflation rising by year’s end to 1.5 percent, still short of the Fed’s informal 2 percent target, but nearly double the rate last year.

If that forecast pans out, “The Fed would then be closer to its price stability mandate – and so should ease the pressure on the monetary gas pedal,” he said. “My recommendation in this scenario would be to raise the target fed funds rate by 50 basis points,” he told the Forecasters’ Club of New York.

The Economist debate – motion could be more interesting

The Economist has a live debate going on since last week. The “motion”:

This house believes that a 2% inflation target is too low.

Brad DeLong defends the motion while Bennett McCallum argues against. Ryan Avent, of The Economist, moderates. In this second round, rebuttals, Andy Harless is a featured guest and ends up siding with DeLong. According to Andy (emphasis mine):

As a practical matter, stability is the main advantage cited for a low-inflation regime. We are comfortable with 2% inflation, but higher rates could be a slippery slope, as in the 1960s and 1970s. And even if we do not slide down the slope, its potential existence will make people nervous, be a drag on the economy and produce excessive volatility. Yet that does not seem to have been a major problem from 1983 to 1991, when the Fed successfully maintained a stable inflation rate in the 4-5% range. If economic stability is our goal, the real resilience provided by a higher inflation rate should trump the illusory comfort provided by a lower one.

The figure below shows that between 1992 and 2007 (just before the economy capsized) there was some gain in real output (RGDP) stability relative to 1983-91. Maybe that´s not the most relevant point Andy is trying to make. He´s saying that the lower inflation (1.5% to 2.5%) provides an “illusory comfort”, so it´s possible that there would be a welfare gain from a higher (4% to 5%) inflation.

The next figure shows the hatching down of inflation over the periods that Andy mentions. Given all the excitement about proposals of higher “inflation targets”, maybe inflation is considered a “reverse addiction” type of “good”. Addictive goods are those that once you get more of it you won´t settle for less. With inflation it might be that once you get less of it you just won´t settle for more, regardless…

Ryan comes to the “rescue” with some pointed remarks on the rebuttals. Notably (my emphasis):

It seems to me that the discussion is focusing on two key questions. The first is to just what extent the zero bound binds. Both debaters acknowledge that the Fed is not entirely helpless when interest rates fall to zero. Ben Bernanke has gone a bit further, suggesting that the Fed’s quantitative easing policy is not qualitatively different from interest-rate reductions. The less of a constraint zero is, the weaker the case is for a higher target. But we should also be careful not to ignore either the psychology or the political economy of the nominally independent central bank. If the zero bound does not actually bind, then some other factors have constrained monetary responses in the wake of the Great Recession and, earlier, in Japan: culture, politics, or something else. If central banks are systematically reluctant to take extraordinary steps even when additional expansion is technically possible, then the zero bound may be a real constraint, whatever the models say.

I believe these remarks show how useless the debate on inflation really is. In addition to the difficulties in defining the proper measure of inflation, it indicates that we should not discuss “symptoms” like inflation. In medicine, for example, sometimes a low fever can be a very bad sign, while a high fever may not be too worrisome; it all depends on the underlying causes of those fevers. That´s what should be discussed.

In Ryan´s remarks, identifying the “something else” is what´s important to “free” monetary policy. In a post several weeks ago, I defined the “something else” – the factor that is constraining monetary responses – as the “obsession bound”; the fact that “come hell or high water” an inflation (even if not a “target”) higher than 2% is “taboo”.

Maybe the “motion” should have been: “Instead of inflation, what should monetary policy target”?

I´m in the camp that favors targeting nominal spending, level targeting. Some at the Fed, including Bernanke in the case of Japan, have proposed a Price Level Target (PLT). In the present case it would be infinitely better than IT, but could be misguiding in the case of productivity (or real) shocks.

Taylor defends “TR”

Recently I posted an exceedingly long piece criticizing interest rate targeting, so I won´t go over that. But John Taylor insists in thinking that his namesake rule is the world´s 8th wonder, being the cause of all evil when it was “discarded”.

His latest post draws on a new study that questions justifications for quantitative easing. According to Taylor:

Proponents of Quantitative Easing frequently cite—inappropriately in my view—the Taylor Rule as support, saying that the rule calls for a federal funds rate as low as minus 6 percent, well below the zero bound. But in various pieces over the past year, such as Taylor Rule Does Not Say Minus 6 Percent, I have argued the contrary. If you simply plug in current inflation and output (gap) you will find that the interest rate is above zero with the policy rule coefficients I originally derived. But QE II proponents change the coefficients. Frequently they use a higher coefficient on output (around 1.0) rather than the lower coefficient (0.5) which I originally recommended. The higher coefficient on output gives a much lower interest rate now and is thus used by proponents of quantitative easing.

A new paper by Alex Nikolsko-Rzhevskyy and David Papell provides important evidence relevant to this debate. They show that, if history is any guide, the higher coefficient would lead to inferior economic performance compared with the original coefficient I recommended.

The operative words are: “if history is any guide”. Unfortunately history ceases to be a guide when you create a “whole new world”. And that´s exactly what the Fed did when it allowed nominal spending (AD) to completely “derail” (to paraphrase Taylor´s “Getting off track”). The “interest rate tweaking”, harmless enough when the economy was “on track”, proves quite useless, no matter the “parameter values” you plug in, when a derailing takes place. At this point the “target” should be to put the “train” back on the “track”. For that a new set of “tools” is required. But the main thing to do is “define the target”. And obviously since you´ve veered far “off track” when you “derailed”, a “level target” should be your goal. Until you get back “on track”, forget about “targeting rates”. They´ll only succeed in keeping you (far) away from the right “track”.

“Photograph shown at the inquest”


Papell summarized the argument in this econobrowser guest post:

Variants of Taylor rules with larger output gap coefficients, which do produce negative interest rates, cannot be justified by historical experience. The Taylor rule does not provide a rationale for quantitative easing.

Organize your thoughts on Eurozone troubles

Some very recent pieces, all pointing in the direction of rising “troubles” for the eurozone:

1. Paul De Grawe on Governance of a fragile eurozone

2. Irish Times on Ireland´s road to ruin

3. Der Spiegel on Greek “exiting maneuvers”  

4. Tyler Cowen on “Invasion of the zombie banks

5. The Weekly Standard on “The coming euro crack-up

6. (Update 5/09) The Finns opine.

Tyler Cowen has a nice “Game theory” summary:

…if any one euro zone country were to start exiting the euro, there would be bank runs on the other fiscally ailing countries. The richer European Union nations know this, and so they are toiling to keep everyone on board. But that conciliatory approach creates a new set of problems because any nation with an exit strategy suddenly has enormous leverage. Ireland or Portugal [or Greece!] need only imply that without more aid it will be forced to leave the euro zone and bring down the proverbial house of cards. In both countries, aid agreements already are seen as a “work in progress,” and it’s not clear that the subsequent renegotiations have any end in sight, because an ailing country can always ask for a better deal the following year.

Jobs, where are you? – 2 (“Please come back”)

Catherine Rampell has a nice graph that well illustrates the “depth” of the problem.

The following pictures could help assuage the worries of those that see inflation everywhere, and actually believe that “expansionary” monetary policy could harm employment by stoking inflation.

The  pictures, depicting all the recessions since 1981, give out one clear information: until nominal spending growth is strong enough to close the “spending gap”, employment does not rebound. Also, higher spending catch-up growth does not ignite inflation.

The picture for the 2007 recession shows that given the size of the drop in spending, the “hole” to be closed is much bigger, and spending growth is far short of what is needed. But many are worried about inflation!

This editorial from the WAPO is really saying: “sorry all you unemployed, but that´s life”

The main point is that unemployment remains well above what it should be; the longer this persists, the more we risk a “new normal” of structural unemployment, which is a fancy term for elevated human suffering and snowballing economic waste. We dare not let this happen. The question, though, is how to generate the new jobs.

Big new fiscal and monetary stimulus is probably not the answer. Federal spending and tax cuts over the past three years, coupled with the Federal Reserve’s easy money policy — including the controversial $600 billion second phase of balance sheet expansion known as QE2 — kept unemployment from rising out of control. The government’s support was truly massive: Even before QE2 and the December 2010 payroll tax cut, the economy had received four times more fiscal and monetary stimulus (as a share of gross domestic product) than in all nine post-1953 recessions combined, according to a J.P. Morgan analysis. But the federal deficit is already huge at 10 percent of GDP, and increasing it substantially could trigger a bond market revolt that would abort the recovery. Indeed, fiscal consolidation is probably necessary to long-term job growth.

Jobs, where are you?

From the Fed Statement (April 27):

Information received since the Federal Open Market Committee met in March indicates that the economic recovery is proceeding at a moderate pace and overall conditions in the labor market are improving gradually.

From David Leonhardt in the NYT (May 6):

The job market continues to improve, which is certainly welcome news. But the pace of improvement remains modest. Unfortunately, that’s the typical pattern in the wake of a financial crisis.

From Paul Krugman (May 6):

It’s not as if our political class is feeling complacent. On the contrary, D.C. economic discourse is saturated with fear: fear of a debt crisis, of runaway inflation, of a disastrous plunge in the dollar. Scare stories are very much on politicians’ minds.

Yet none of these scare stories reflect anything that is actually happening, or is likely to happen. And while the threats are imaginary, fear of these imaginary threats has real consequences: an absence of any action to deal with the real crisis, the suffering now being experienced by millions of jobless Americans and their families.

The Krugman quote is a much better reflection of reality than utterances that “conditions in the labor market are improving gradually” or “the job market continues to improve”.

And the “unfortunately, that´s the typical pattern in the wake of a financial crisis” is the biggest cop-out, that plays right into the hands of the Fed, by “absolving” monetary policy from responsibility.

I make one basic assumption: The Fed has a good measure of control over nominal magnitudes.

The 3 pictures show nominal spending and it´s trend level and employment (Non Farm) over the three recessions that took place during the so called “Great Moderation”. In each picture the start date is the quarter the recession officially began. The dotted brown line indicates the quarter the recession officially ended while the green dotted line marks the maximum employment loss. (Note: The trend is the same over all periods)

In the 1990/91 recession – that contained elements of a financial crisis associated with the S&L debacle – the maximum loss in employment was 1.3 million (1.2% from peak). But we observe that nominal spending remained very close to trend, which resulted in a strong employment rebound.

Following the 2001 recession, nominal spending dropped significantly below trend. The loss in employment reached 2.7 million (2.1% from peak). But once spending growth increased enough to take spending back to trend employment growth turned strongly positive.

The present situation is “unique” in the sense that nominal spending – something over which the Fed has control – did not just “drop”. It “tanked”! No mystery why employment loss reached 8.6 million (6.2% from peak).

The “improvement” in the job market is peddled as “welcome news”. It´s not, only serving as a reminder how dire the labor market situation really is . And things in the labor market will remain bleak as long as nominal spending remains far below any reasonable trend level, running the risk of turning a “cyclical” event into a “structural” problem.

Update: After examining different organs (sectors) of the economy, Karl Smith concludes:

So given the real potential for a construction turn around and the likely healing of state and local government the jobs trajectory looks fairly good.

Question: Why doesn´t the “whole body” feel that?

A “simple” answer

To Eric Rosengren´s of the Boston Fed question:

How Should Monetary Policy Respond

to Price Increases Driven by

Supply Shocks?

There´s a ´”simple” answer: Get the economy back to a reasonable nominal spending trend level and than keep spending growing at a suitable constant rate (before the economy fell off the cliff, that rate was around 5%).

With the economy evolving along that level target, you don´t react to either price increases due to things like “oil shocks” or to price decreases due to “positive productivity shocks”, you just keep spending growing at the chosen rate along the trend target.  If the economy falls below it monetary policy strives to pull the economy back up and vice versa, if the economy goes above the trend path. The Central Bank will get “high marks” just by “protecting” the economy from unwanted “demand shocks” – the only type of shock that the Fed can control.

That´s for the future. Given the present modus operandi, confusion reigns, starting with the definition of inflation itself!

Inflation is best defined as a “sustained increase in ALL prices”, a monetary, not a real or price phenomenon. But people tend to worry about particular prices.  So when the “stripping” out of volatile prices from consideration takes place, technically correct if what you are interested in is the trend of inflation, the media starts “howling” and the consumer feels he´s being duped by the monetary authorities. And that´s why Rosengren had to deliver the speech I linked to.

William Gavin of the St Louis Fed just came out with a note that shows that “headline” CPI inflation is “gasoline powered”. The figure below, cloned from his note, shows that just by “stripping” gasoline prices from “headline” inflation, “headline” and “core” inflation show almost no difference. Nice to know, but so what?

As the next picture indicates, gas prices at the pump are “fueled” by oil prices at the wellhead. Going one step further back you naturally ask: what´s fueling prices at the wellhead? Is it “supply” or “demand”? Probably a bit of both. Again, for the Fed and monetary policy, so what?

Reminds me of the Bank of England back in 1999 worrying about a surge in house prices in the south east region of the country (the London-Calais corridor) and if that warranted a rise in rates. Later it became known that the (temporary) rise in home prices was due to French immigrants escaping higher marginal (50% higher) tax rates in France!

But the fundamental question remains unanswered: Why did patterns (valid for most commodities) changed dramatically after 2001? I don´t know if I´m right, but I think China in the WTO (December 2001) must be an important part of the answer.

Update: It appears many Fed presidents/officers decided to speak about the same thing on the same day. This is John Williams of the San Francisco Fed on the subject of “inflation” (and it´s nuances):

Higher gasoline prices are at the top of the list of factors that have been a drag on the economy and will continue to be so for some time. Over the past year, the price of gas at the pump has jumped by about a third. This takes money out of the pockets of consumers and reduces their ability to make other purchases. In addition, the jump in energy prices raises uncertainty, saps confidence, and makes both consumers and businesses more cautious about spending. Indeed, consumer confidence, as measured by surveys of households, remains mired near its recessionary lows.

Let me now turn to inflation. Here are some of the questions we need to ask at this juncture: What is the current inflation situation? What are the underlying forces driving prices? What are the prospects for inflation in the medium term? And what is the appropriate response of Federal Reserve monetary policy?