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

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

Let me first backtrack and present the conventional view.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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