“1997 – the origin”

I like this quote from an old John Taylor post:

If the Fed had not kept interest rates so low when inflation was rising and the economy was growing in the 2002-2005 period, then we would have avoided much of the boom and the bust which eventually caused the devastating increase in unemployment.

He clearly identifies the “cause” of the crisis as being due to the Fed keeping “rates too low for too long”. Those low rates then fomented the house price bubble which, when the crash came along, gave rise to the “financial crisis”. And as is “well known”, a financial crisis requires a drawn out “healing” process.

Taylor is right in arguing that the crisis was due to monetary policy errors, only, as I´ll try to show, not the one he imagines.

The next picture shows that house prices (Case-Shiller) “took off” in 1997, long before the “too low for too long” period. Coincidently, 1997 was the year that Congress approved legislation exempting taxes on capital gains on the sale of primary residences every two years. Given the other conditioning factors encapsulated in the incentives to homeownership (that propelled subprime financing), this change in the tax rule is surely an important factor behind the observed house price rise. The process “snowballed” and, as usually happens with snow, it “melts”.

The year 1997 also witnessed a fact that defied the “conventional wisdom”: the simultaneous drop in inflation and unemployment. The next picture illustrates the “event” that left analysts “perplexed”.

The third piece of “evidence” is depicted in the next pictures, showing that productivity growth trended strongly up…and real growth surged to more than 4%!

So we had falling inflation and unemployment and strong productivity and real growth.

The following picture shows that in the context of a Dynamic AS/AD model that outcome is to be expected.

The “productivity shock” shifts the AS curve down and to the right, with the economy moving from point a to point b. Real growth picks up (unemployment trends down) and inflation falls.

But as David Glasner just reminded us, inflation targeting can have perverse effects. With inflation dropping below target, the Fed put on its “inflation targeter hat” and “jacked up” spending growth, taking the economy to point c.

The next two pictures show that the Fed erred in reacting to a productivity shock and destabilized the economy which up to that point was evolving along a stable level growth path.

In the quarters that followed the “excessive growth of AD”, the Fed became queasy about the inflationary potential of a “too low” rate of unemployment and went on to “contract AD”. This “queasiness” was already being felt for some time by many analysts, among them Paul Krugman who wrote in 1997 that:

Most economists believe that the US economy is currently very close to, if not actually above, its maximum sustainable level of employment and capacity utilization. If they are right, from this point onwards growth will have to come from increases either in productivity (that is, in the volume of output per worker) or in the size of the potential work force; and official statistics show both productivity and the workforce growing sluggishly. So standard economic analysis suggests that we cannot look forward to growth at a rate of much more than 2 percent over the next few years. And if we – or more precisely the Federal Reserve – try to force faster growth by keeping interest rates low, the main result will merely be a return to the bad old days of serious inflation.

Other AD shocks – the internet crash, 9/11 and the accounting scandals (Eron et al., that affected “confidence”) also influenced and amplified the “contractionary” monetary policy. As the next figure shows, inflation remained below “target” throughout the period. So, in order to bring the economy back to its trend level, the Fed acted as it should (contrary to Taylor´s argument).

And note that throughout those years, be it with AD growing above trend or contracting, house prices “kept on rising” (figure 1 above), weakening the thesis that it was caused by a “too easy” monetary policy.

The pictures below show the “shape” of monetary policy. “Contractionary” in 1999 and during 2001-2003, with both velocity and money supply falling.

Expansionary in 2005, when it managed to bring AD back to the level trend.

How has Bernanke fared? In 2006/07, despite the fall in house prices and in residential construction, monetary policy did a reasonable job in offseting changes in velocity and kept the economy  chugging along close to its trend level.

But in 2008/09 he “lost his touch” and MP turned highly contractionary, certainly worsening the “financial crisis”.

According to Nick Rowe, “Recession/Depression is always a monetary phenomenon”. So no mystery that the “recession” ended in mid 2009. That was the time that monetary policy became “accommodative” (in the sense of offsetting movements in velocity (money demand)).

But the point is that that´s not enough to get the economy (spending) climb out of the “ravine” into which it fell. For that you would have to get the “shape” observed in 2005!

In his recent post, John Taylor is not sure about the meaning of the recent increase in money supply. Could it be indicating more inflation to come? Or is it telling us that things are getting “worse” because money demand is rising? Given the state of the economy he should have shown “no doubts”!

And tomorrow we have the much expected Bernanke speech at Jackson Hole. I´m pessimistic.

“Bleak Friday”?

Which view will Bernanke embrace?

1. From the Economist:

OVER a decade ago a frustrated Ben Bernanke, then an economics professor at Princeton University, called for Japanese central bankers to show some “Rooseveltian resolve” and to act more boldly as total nominal demand in Japan was “growing too slowly for the patient’s health”. He might have been delivering a stern advance warning to himself in his current job as head of America’s Federal Reserve. Judged by its record on inflation, the usual yardstick, the Fed is performing fairly well. But judged by the criterion Mr Bernanke had used for the Japanese economy in the late 1990s, something has gone badly wrong. America’s nominal gross domestic product—GDP before adjusting for inflation—collapsed during the recession and is now nearly 12% below where it would be if its pre-recession trend had continued.

The slump in nominal GDP has had pernicious effects. It has raised both public and private debt burdens, since the ability of households, firms and governments to service their debt depends upon their nominal incomes and revenues. The gap between the performance of inflation and that of nominal GDP is so big that some economists, such as Scott Sumner of Bentley University, are dusting off an old idea. They are calling for central bankers to switch targets. Rather than directing monetary policy to hit inflation targets (as they have done for the past 20 years) central bankers should take aim at nominal GDP (or NGDP).

2. From today´s GaveKal daily: What will Bernanke say?

But the most important reason to expect Ben Bernanke not to be excessively dovish at Jackson Hole is the panic-buying mentioned above. Indeed, if one of the problems today is that investors are now plowing into grossly overvalued safe havens like gold, CHF, Yen, etc., it makes no sense for the Fed to encourage this through further US$ debasement. Instead, it is increasingly obvious that what the US economy needs is for the world to have more faith in the Dollar.?

Putting it all together, the odds have to be that tomorrow’s speech ends up being a repeat of the last FOMC communique (which after all was only three weeks ago and already included a big monetary surprise-the 2-year virtual ZIRP promise). If so, then Friday should be a big day for the Dollar (upside) and oil, gold and bonds (downside).?This may have already started in the past 24 hours. In our view this combination would give equities a short-term boost, since the immediate problem for the equity markets today is not the lack of growth, nor even the problems in Europe (as daunting as these problems are), but the collapse of confidence in US economic management and politics.

 

Some “get it”, some “don´t”

By “get it” I´m referring to getting monetary policy “right”, meaning that the Central bank does not let aggregate nominal spending (NGDP) stray for long far off trend. David Beckworth picked up on an article by Ambrose Evans-Pritchard in the Telegraph and wrote this post, arguing that Central Banks still have much ammunition. If so, those that “used it” should have managed to keep NGDP close to trend and those that didn´t use…bad luck!

The figures describe 4 examples. Two that “didn´t” and two that “did”.

“Didn´t

“Did”

The LEVEL of economic activity is key

From the last FOMC statement:

“The Committee now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting and anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, downside risks to the economic outlook have increased.”

Note that the FOMC believes the unemployment rate will fall only “gradually”, mostly because the expected pace of “recovery” has slowed!

From NY Fed President William Dudley :

Some of the weakness in economic activity in the first half of the year was due to temporary factors such as the hit to household income from higher food and energy prices, and supply chain disruptions following the tragic earthquake in Japan. These restraining forces have abated and thus, we should see stronger growth in the second half. But it is clear that not all of the weakness was due to these one-time factors—and in light of this, I have revised down my expectations for the pace of recovery going forward.

And from Cleveland Fed President Sandra Pianalto:

My latest forecast is for the economy to grow at a rate of about 2 percent this year, and about 3 percent in each of the next two years. Our economy has to grow at about a 2-1/2 percent clip just to absorb new labor force entrants and to keep the unemployment rate from rising.

Only growth, growth and growth! And mostly expectations of growth below previous trend! Importantly, growth is being revised down by both the Fed and private forecasters!

The economy has SHRUNK and those guys seem comfortable with that. If so, the following pictures indicate that employment will be PERMANENTLY lower (and the rate of unemployment PERMANENTLY higher, unless the labor force continues to shrink, which is “false good news”).

The pictures indicate that when spending falls below trend employment goes down (and unemployment up) reversing only after spending picks up enough to bring it back to the trend LEVEL.

Update: Robert Gordon is very “pessimistic”:

  • The spending decomposition shows that fiscal policy has failed in that the government spending sector has made the output gap shortfall worse, not better.
  • The double-hangover theory helps to explain why monetary policy is impotent, no matter how much quantitative easing is attempted.

“Uncertainty”

That´s a word we´ve being hearing a lot lately. It´s viewed by many as the major “cause” of all ills. In the last paragraph of his “Accounting for the Great Recession” Lee Ohanian, a good representative of this view writes:

Uncertainty, in fact, may be a primary reason why the recession deepened and persisted into 2009, well after the worst of the financial crisis. High uncertainty raises the value of delaying decisions in many economic models, which can depress economic activity. Recent and ongoing research on the impact of uncertainty on economic activity suggests that it can indeed induce recessions; in one forthcoming theoretical article, for example, uncertainty about the accuracy of government pronouncements regarding macroeconomic strength can lead households to reduce the labor hours they supply.

But that begs the question: What gave rise to the “uncertainty”? The “uncertainty” is seen as emanating from the panoply of “interventions” by the government to “support” the economy. This portion of Greg Ip´s article for the WAPO is a good summary:

Liberals and conservatives in the United States have long differed on how much the government should meddle in individual markets, whether for energy or health care. But they have largely agreed that the government should have at least some role in smoothing out the ups and downs of the business cycle — what economists call “macroeconomic stabilization,” that is, containing inflation in good times and boosting employment in bad.

But this is the consensus that many Republicans in effect now reject. In their view, the government has no more role meddling in the business cycle than in any other market. “Many of our problems can be traced to a misguided belief by politicians that the American economy is something that can be controlled or micromanaged or influenced positively by government intervention and borrowing,” House Speaker John Boehner (R-Ohio) said in a speech in May. He went on to explain that “for job creators, the ‘promise’ of a large new initiative coming out of Washington is more like a threat. It freezes them. … The rash of ‘stimulus’ legislation passed by Congress in recent years has been one of those obstacles.”

Lee Ohanian writes that:

The 2007-09 U.S. recession differed considerably from earlier post-World War II recessions both in the behavior of key variables like output, consumption, investment and labor as well as in the possible factors that might account for fluctuations observed in these variables.

It sure did differ. But an “X-ray” can easily pinpoint where the “cancer” is located. The set of pictures below show the post-World War II growth in aggregate nominal spending, the rate of inflation (Headline CPI to 1957 and Core CPI thereafter) and the rate of unemployment.

I divide the 63 year history portrayed in five “periods”, each having particular “characteristics” which are briefly described in the pictures. The driving force of the whole process is naturally the growth of aggregate spending. It is likely, therefore, that that´s where we are likely to find the “tumor”. And that´s easily done. For the first time in the post-War history, in 2008 the growth of aggregate spending turned negative!

But what “caused” the tumor? It´s no good prescribing treatments (interventions) when the “doctors” cannot agree on a diagnosis (“cause”), since the “side-effects” of inappropriate treatment may well “kill” the patient.

One interesting aspect is that the “tumor” showed up right after the twenty years from 1987 to 2007 that the “economic organism” was the “healthiest” –showing low/declining inflation, declining unemployment and pretty stable nominal and real spending growth – a period that got nicknamed (by Bernanke himself, I think) “Great Moderation”. It appeared that, finally, economists had learned how to do “stabilization policy”. The next picture illustrates.

The irony is that Bernanke took the helm of the Fed after a stint as Fed Governor and head of the CEA, having been the person that many years before had described what the Fed “should do” once Greenspan was gone!

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.

Fast forward 10 years.

Bernanke´s October 15, 2010 speech is a “landmark”:

Although the attainment of price stability after a period of higher inflation was a landmark achievement, monetary policymaking in an era of low inflation has not proved to be entirely straightforward. In the 1980s and 1990s, few ever questioned the desired direction for inflation; lower was always better. During those years, the key questions related to tactics: How quickly should inflation be reduced? Should the central bank be proactive or “opportunistic” in reducing inflation? As average inflation levels declined, however, the issues became more complex. The statement of the Federal Open Market Committee (FOMC) following its May 2003 meeting was something of a watershed, in that it noted that, in the Committee’s view, further disinflation would be “unwelcome.” In other words, the risks to price stability had become two-sided: With inflation close to levels consistent with price stability, central banks, for the first time in many decades, had to take seriously the possibility that inflation can be too low as well as too high.

At another point of the speech:

Overall, my assessment is that the bulk of the increase in unemployment since the recession began is attributable to the sharp contraction in economic activity that occurred in the wake of the financial crisis and the continuing shortfall of aggregate demand since then, rather than to structural factors.

From these passages I surmise:

  1. Bernanke is a die-hard inflation targeter (and symmetrically so)
  2. Bernanke puts great weight on the “credit channel” of monetary policy

To him the “financial crisis” (meaning Lehman) started it all (and would have been much worse if the Fed hadn´t come out with all the “cannons” to “save the day…and the banks”).

On the day he made the speech, Stephanie Flanders of the BBC wrote:

Ben Bernanke declared war today – not on China, but on the possibility of deflation. He knows that a vicious cycle of slow growth, stagnant or falling prices and high unemployment poses a much greater threat to America’s way of life than China’s silly exchange rate.

And less than 20 days later, QE2 began.

But that´s the problem. Bernanke does not see the inconsistency of targeting inflation (avoiding deflation) and stabilizing the economy after a monetary error has been made and the previous stability jeopardized, giving way to the “Bernanke Depression”!

For him it was the “financial crisis”. But I subscribe to the “monetary disorder” that came about in mid 2008 when Bernanke and the Fed obsessed with “headline inflation” kept monetary policy “tight”. Remember that the FF rate was set at 2% at the April 2008 FOMC meeting and stayed at that level until October!

House prices began to fall in 2006 and problems with important financial institutions began taking place in early 2007. The date for the start of the financial crisis was “set” as early August 2007.

The start of the recession was set by the NBER as December 2007. At that moment, unemployment was 4.8%. By the second quarter of 2008 it was still “only” 5.3%, after which it climbed fast to a bit more than 10%.

The panel below provides evidence for the “monetary disorder” view of the recession (and worsening of the financial crisis).

During 2006-07, despite falling house prices and problems with residential construction employment and financial institutions, monetary policy was “stabilizing”, with money supply growth offsetting the decline in velocity (increase in money demand). The result was that nominal spending, which had returned to its trend level in late 2005 (see the Spending & Trend picture above) kept growing at its trend rate of around 5%. In 2008 the Fed, obsessed with rising oil and commodity prices, restrained money growth at the same time that velocity was falling fast! The result, as expected, was a steep drop (the steepest since 1938) in aggregate spending. The fast increase in unemployment and worsening of the financial crisis were the almost inevitable consequences.

By December 2008, interest rates were down to “zero” and all the talk was that monetary policy had run out of ammo. Even Bernanke said that fiscal policy had to come to the rescue to help prop up the real economy. The “divisions” and “distortions” only accentuated, helping give rise to the “tea party” movement and the “debt ceiling great debate”.

All in all a very sad and hurtful ending to the “Great Moderation”. And soon we´ll likely have a new expression in the economic lexicon: “downward-sticky unemployment rate”!

But many will argue it´s “structural”.

The “takeaway”: After more than 10 years of papers, conferences and speeches on the topic of “monetary policy in a low inflation environment”, policy makers should have learned that “inflation targeting can be hazardous to the economy´s health”. In 1933 FDR “adopted” a “price level target”. It was of great help, immediately reversing the downward trend in prices and economic activity. Bernanke could do even better by announcing a “spending level target (NGDP). Unfortunately, the odds are about 40 to 1 against it!

Update: From Jim Hamilton:

I would suggest that the more important and achievable goal for the Fed should be to keep the long-run inflation rate from falling below 2%. The reason I say this is an important goal is that I believe the lesson from the U.S. in the 1930s and Japan in the 1990s is that exceptionally low or negative inflation rates can make economic problems like the ones we’re currently experiencing significantly worse. By announcing QE3, the Fed would be sending a clear signal that it’s not going to tolerate deflation, and I expect that would be the primary mechanism by which it could have an effect. Perhaps we’d see the effort framed as part of a broader strategy of price level targeting.

He suggests “PLT”, but what really should be done is “stop talking about inflation/deflation”.

Governor Perry vs The FT

We all know what Governor Perry said about Bernanke and the Fed. The Financial Times recommends the exact opposite:

In the Bavarian region of Chiemgau, Germany, local shoppers can pay for their würstsalat lunch with brightly coloured Chiemgauer notes. Invented by an economics teacher in 2003, the money loses 2 per cent of its value every three months, funding the scheme, but also providing a helpful incentive to spend.

A similar plan for the US, some sort of tax on notes and coins, is just one of the more radical ideas being tossed around as a way for Ben Bernanke, the Federal Reserve chairman, to revive a sagging US economy.

But, as the world’s central bankers prepare to head for their mountainside retreat in Jackson Hole, Wyoming, next weekend, it is becoming increasingly clear that Mr Bernanke needs to take some more radical form of action.

The announcement on August 9 that short term interest rates would remain close to zero into 2013 prompted the S&P 500 to rise for six days, but also served to reinforce the danger posed by a long stagnation.

Interest rates are already so low that businesses and consumers may come to expect years of stagnation ahead. If so, the US will have become like Japan, in its 17th year of deflation.

So the essential thing is that the Fed does act. By explaining the tools available at Jackson Hole last year, Mr Bernanke prepared investors for the bond buying that followed, injecting confidence into markets that itself formed part of the stimulus.

For if the Fed’s next measures are to work as the effects of QE2 fade, markets must still believe that the Fed has power to influence the economy by use of its balance sheet. The longer that Mr Bernanke waits to act, the greater the risk that his power evaporates.

It may be too late already, in which case perhaps only a gamble in the mould of the Bavarian schoolteacher remains: set a timetable for rates to rise, making it expensive not to borrow, and encouraging immediate spending.

HT Samuel Kinoshita

Everything DOWN, but inflation UP

And IF the Fed only cares about inflation, and avoiding deflation…we´re in a stalemate!

Scott Sumner has a post about “passivity” in the 1930´s and ends it on a “positive” note:

Thankfully we can learn from their mistakes.

I´m not so sure. And reading this David Glasner post makes me wonder “how stupid can you be”?

After administering a pro-forma slap on the wrist to Texas Governor Rick Perry for saying that it would be treasonous for Fed Chairman Bernanke to “print more money between now and the election,” The Wall Street Journal in today’s lead editorial heaps praise on the governor for taking a stand in favor of “sound money.”  First there was Governor Palin, and now comes Governor Perry to defend the cause of sound money against a Fed Chairman who, in the view of the Journal editorial page, is conducting a massive money-printing operation that is debasing the dollar.

And what about the RISE in inflation that was emphasized in the news today:

The inflation report comes amid mixed signals for the economy and worries about a weaker U.S. outlook. The Fed could be constrained from taking further stimulative action—such as buying more bonds to keep long-term borrowing rates low—if inflation measures stay above its informal target of close to 2%.

Let us look at the “face” of the so called “constraint”. From the Atlanta´s Fed Inflation Project, the figure below shows the headline CPI and it´s flexible and sticky components. The sticky component has the greater weight and works to “cushion” the high volatility of the flexible prices. Sticky price inflation is still way below what it was before the recession began in late 2007.

The picture below shows alternative measures of core CPI inflation. Again, they are far below the experience prior to 2008 and mostly below the “magical” 2% threshold.

And alternative measures of inflation expectations indicate they are on the way down! First the inflation expectation curve from the Cleveland Fed shows that with the end of QE2 the whole curve has shifted down.

And the 10 year inflation expectations using the TIIPS market has drpped steeply since the beginning of this month. The FOMC statement, indicating the possibility of another “round of monetary stimulus”, had a short “shelf live”, with today´s market outcomes enticing a large drop in inflation expectations.

The only “constraint” is the “stupid passivity” of those responsible, with the Fed on the very top of the list.

And the Economist writes the “epitaph”:

If the shortfall in GDP relative to trend in each year since 2007 is totted up, America has suffered a cumulative loss of $4 trillion, equivalent to a stunning $13,000 for each person. Stockmarkets and newspapers will cheer when growth rates eventually pick up, but most of the income that has been lost since the crisis began will never be recouped.

“Recession probability game”

I find it funny (in a macabre way) that many forget that the country is languishing in a “depression” so that data releases (industrial production, for example, UP 3.7% from a year ago) that would be cause for celebration in “normal” times are really “depressing in the present state!

And to keep the flow of Fed president pronouncements going, one from the Atlanta Fed president Lockhart:

“Slow growth doesn’t lock in a recession,” advises Dennis Lockhart, president of the Atlanta Fed. “In fact, some recent data we have on hand – retail sales and initial unemployment claims, for example – seem to contradict the direst predictions.”

Apparently the new baseline is “the direst prediction”!

Update: Jim Hamilton seems “satisfied” with “We´re still standing” (or, “not dead yet”)!:

There’s still plenty to worry about, and deep anxiety by consumers and investors can be both an indicator of bigger problems ahead as well as a cause of a downturn in its own right. But for the time being, the real economy seems to be continuing its recent pattern of unsteady growth.

Another “dissenter”

From a Bloomberg interview with St Louis Fed president Bullard:

St. Louis Federal Reserve Bank President James Bullard, who was the first Fed policy maker to urge the round of bond purchases that started last year, said the central bank isn’t signaling a third stimulus program with its commitment to keep rates near zero through mid-2013.

“The most likely outcome for the U.S. economy is still that the economy continues to grow at a moderate pace through the second half of the year,” Bullard said late yesterday in a telephone interview. “If the economy is substantially weaker than expected, we could take more action, especially if it was coupled with a renewed deflation risk.”

“Substantially weaker than expected”? Last I heard the FOMC, like private analysts, have done nothing other than “downgrade forecasts”. How much more “downgrading” Bullard thinks is necessary before the FOMC takes action?

And note the reference to “renewed deflation risk”. As I argued previously, that “risk” seems to be the “guiding light” of the FOMC! So forget about high unemployment or the general state of “economic depression”. The Fed remains unmoved by those “trivialities”.

Update: And there´s more from Bloomberg:

Charles Plosser, president of the Federal Reserve Bank of Philadelphia, said the Fed will probably need to raise interest rates before mid-2013 and that policy makers should have waited to see how the economy performed before pledging to hold rates at record lows for two years.

Plosser said that it wasn’t clear that the economy needed additional stimulus, especially given rising inflation and a decline in the unemployment rate since November to 9.1 percent. (Why, may I ask, not “and a rise in unemployment since March?)

“We’re reacting too quickly here,” he said. “A little patience might be a good idea.”

As a parent would say to his child: “My patience has limits”!

Update2 And there´s even more. This time from Dallas Fed Fischer mixing up “structural” (i.e long run growth) issues with stabilization issues:

The Fed has “refilled” the tanks needed to fuel economic expansion and it isn’t wise to signal further accommodation, the Fed official said.

Update3 And a “Hitchkockian” twist to Plosser´s “wish” for higher rates from Scott Sumner in a comment to my comment:

Marcus, Plosser’s to blame for the low rates. If Plosser really wants higher rates, he should argue for monetary stimulus. Instead he’s acting like a Japanese central banker. How’d that work out in Japan?

HT Rafael

More “ghosts from the past”

Here´s a short post by Scott Sumner:

Herbert Hoover succeeded in reversing the Depression during early 1931.  During the first 4 months of 1931, industrial production in the US rose slightly, after plunging sharply throughout 1930.  Then bad luck hit.  The German-Austrian agreement of late March poisoned relations with France.  Then the Austrian bank Kreditanstalt failed in May.  Then German banks came under pressure, then the German currency.  Then the British currency.  The crisis kept moving from one country to another.  People sought gold as a safe haven, and the value (or purchasing power) of gold increased.  More deflation set in.  The severe recession of 1930 turned into the Great Contraction.

Here’s Obama yesterday:

At a town hall meeting on his campaign-style tour of the Midwest, President Obama claimed that his economic program “reversed the recession” until recovery was frustrated by events overseas.

Hoover wasn’t able to print gold, but can be blamed for supporting the Fed’s tight money policies.  Obama can’t print dollars, but can be blamed for not moving aggressively to put people at the Fed who understand the need for more dollars.

Given the subsequent magnitude of the fall it´s pretty hard to detect a “reversal”. But shortening the sample makes the “reversal” visible between January and April 1931. And then the problems in Europe hit…

But the “problems” in Europe were still there, and aggravated, two years later, but that didn´t stop FDR taking on the “monetary policy reins” and establishing a “Price Level Target” (PLT), in an economy that had seen spending plunge for more than three years and, much like now, in the throes of deleveraging from the excesses of the twenties! Things turned around immediately. Soon after, NIRA was a spoiler, but that´s another story…

Does “personality” have anything to do with the “outcome”? I don´t know, but in the modern world of “rules” maybe it shouldn´t. But let´s do a quick check.

Over the last 32 years, since 1979, the Fed has had three chairmen. Volker to 1987, Greenspan to January 2006 and Bernanke since then.

Volker strived, successfully to “squeeze” inflation out of the system. He was very blunt and direct. To him, unusual for a Fed chairman after the Burns experience and further back in time the Eccles Fed during the depression, inflation, behold, was a monetary phenomenon!

Greenspan “picked up the baton” and managed to lower inflation further and keep it relatively stable, even in the face of some severe shocks during his 19 year term. But Greenspan was very different from Volker. He was never very explicit or even clear about anything. Maybe he was brilliant, or just lucky. Maybe a bit of both. He talked about “appropriate monetary policy” – make of that what you want. The fact is that he presided over the “Great Moderation”, and handed over to Bernanke an economy back on its long term level path in terms of nominal aggregate spending (NGDP), from which it had deviated, first above and then below, during the 1998-2004 period. The figure below illustrates.

And then we get Bernanke, apparently the most “qualified” Fed Chairman ever. With him we also get the “Little Depression”, an astounding failure of monetary policy. Not in the league of the failure of 1930-32, but certainly comparable to the monetary failure of 1937, when the Eccles Fed, afraid of the rise in commodity prices – although that was consistent with FDR´s “Target” – adopted a restrictive MP. In 2008, Bernanke, “intimidated” by the rise in commodity prices also kept MP tight, and this is so despite the low (2%) level of the FF rate!

Ironically, back in January 2000, more than two years before becoming a Fed Governor, Bernanke coauthored a piece in the WSJ titled: “What happens when Greenspan is gone”? In that piece he set out the principles that should guide the Fed to keep and improve upon the gains obtained under Greenspan. The principles were “transparency”, clear “communication” and, to make those principles operational, the adoption of an explicit inflation target:

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.

From his writings and presentations, most will agree that Bernanke is a “rabid” inflation targeter. From his Japanese monetary policy paper (“a case of self induced paralysis) and his 2002 speech as Fed Governor “Making sure “it” doesn´t happen here”, I gather that he´s also “terrified” of deflation (natural for someone so deeply versed in the Great Depression).

He truly believes that “targeting inflation” will bring “economic nirvana” and that if due to a weak economy, for example, inflation crosses the “Rubicon” that separates inflation from deflation, QE has to be applied. But his only concern is to avoid deflation, so as soon as that danger subsides, QE stops. There´s no concern for real economic activity, because keeping inflation within the bounds of the “target” is the only thing that matters.

After the statement from the last FOMC meeting that “quantified” the expression “extended period” and the last paragraph where he expressed thoughts very similar to what he said last year at the Jackson Hole conference, hinting at QE2, the markets geared to the real possibility of a Q3 announcement. But, unfortunately the “QE drive” is losing “power”. The markets will more and more see it as an “anti deflation pill”, not something that will drive the economy “upward”.

Follow your stated “principles” Ben and communicate, clearly and transparently a new framework for MP, preferably one based on a target level for nominal spending (NGDP Target). After all, following more than 10 years of papers and conferences about “Monetary Policy in a Low Inflation Environment”, I gather many feel that the MP framework has to change (or adapt). My advice: Stop “pressing switches on and off” and, like the Nike logo, “Just do it”. And instead of “the problems in Europe” adversely affecting the US, it might be that the US will “positevely affect Europe”!