Stop talking about inflation – It´s dangerous and misleading

If there is something that radically changes when a recession described by a fall in aggregate demand (or NGDP) takes place it is the concept of inflation. In situations of economic normality – full employment and capacity utilization – inflation is something undesirable in that it increases interest rates, discourages savings and induces distortions in the allocation of capital.

However, in the present situation characterized by a high rate of unemployment and aggregate demand far below an adequate level, it is said that the economy needs more inflation! Suddenly, a higher inflation or, more precisely, an increase in inflation expectations becomes something “good” for the unemployed and for economic growth.

It is not surprising, therefore, to witness a great confusion in the discussions, not only in the media but also among FOMC members themselves. For example, in all the eight FOMC meetings of 2010 Thomas Hoenig, president of the Kansas City Fed, cast a dissident vote. That was a record!

The concept of inflation is confusing. It is certainly important, but what is its correct measure? The chart below shows some of the differences by comparing the deflator for personal consumption expenditures (PCE) in its “headline” and “core” versions. The “core” version excludes from the “headline” index the volatile components such as food and energy.

Maybe the best that can be done is to altogether stop talking about inflation and, more importantly, not take it into consideration during the FOMC meetings to establish monetary policy. Instead of inflation, the goal, or target of monetary policy should be the growth of nominal spending along a determined growth level path.

There are several advantages to adopting a NGDP level target:

  • If the goal is to stabilize aggregate demand monetary policy does not prompt undesired fluctuations in real output in the case of real (or supply) shocks.
  • It allows the widening of the focus of policy to take into account monetary aggregates, asset prices, yields, etc., thus diverting the obsessive attention dedicated to interest rates, which tend to be a poor indicator of the stance of monetary policy, revealing a more clear picture of the economy´s health.
  • As many prices are sticky, a fall in nominal spending doesn´t immediately show up in the inflation numbers. Therefore, the behavior of nominal spending is a better indicator of monetary shocks than inflation indicators such as the CPI or the PCE. On the other hand, if a significant price shock takes place – a jump in oil prices, for example – the “headline” inflation indices are going to rise. With policymakers focused on inflation, especially on “headline” inflation, they will miss the underlying weakening of the economy. This is, for example, what happened in 2008 as I illustrate.

As the chart shows, the oil shocks of 2003-06 and 2007-08 were of similar magnitude.

In both instances “headline” inflation went up. More so on the occasion of the second oil shock, maybe because it was more concentrated in time and because it came on the heels of the previous one.

Note that while the FF rate was on the rise during the first shock it was falling during the second, with the FF rate being lower in early 2008 (3.2%) than in late 2005 (4%). Nevertheless, monetary policy was tighter in 2008 than in 2005. Why do I commit such “blasphemy”?  Just note what was happening to nominal spending on the two occasions.  The chart below shows that, despite the oil shock, while in 2005 nominal spending remained on the trend associated with the “Great Moderation”, in 2008 it dropped below before tanking in the second half of the year.

So, ignoring nominal spending and concentrating on confusing and conflicting inflation signals, the Fed, in effect, tightened monetary policy.

Furthermore, since in the last decades all the talk was about reducing and controlling inflation, to start talking about increasing inflation or inflation expectations sounds very strange and leaves everyone confused. It seems, therefore, that from a “public relations” perspective it also sounds better to talk about increasing nominal incomes or spending!

Update: This piece in the WSJ is a case in point (HT:Patricia Stefani):

The double think, deception and distortion of the cold-war era looks like it’s being reproduced today. Except, unlike then, when it was state trying to manipulate state, now it’s central banks manipulating individuals and markets.

Nowhere is this more clear than with respect to inflation. Central bankers are trying to convince people that they will turn a blind eye to inflation in order to cut people’s very high preferences for holding cash and liquid assets. These extreme liquidity preferences are, according to standard economic thinking, causing a deficit in demand.

Unfortunately, the same central banks spent the past three decades convincing people that they will do whatever it takes not to allow a repeat of the rampant inflation that made the 1970s an economic wasteland.

What to do?

The world of monetary policy is in dire need of a revamp!

From Grover Cleveland at Pileus:

Fisher gives us something to think about in terms of the limits of monetary policy, the problem of the Fed’s dual mandate, and the need to get our fiscal house in order.

From Gillian Tett at the Financial Times:

The crucial problem, as Fisher noted with such unusual clarity this week, is that the psychology of this is still so uncertain.

…Anyone who feels tempted to start celebrating the recent share price rally, in other words, would do well to read Fisher’s bold speech – and then take a long, deep breath.

Commenting on Gillian Tett, Scott Sumner had this to say:

“Bold”  ”Powerful” “Unusual clarity” I’m intrigued, given that Fisher seems perversely proud of the fact that he’s become one of the world’s most powerful economic policymakers, despite not being an economist.

But I find it interesting that some months ago Pileus did not one, but two posts on Market Monetarism and NGDP targeting!

John Taylor takes another stab at giving a structural bias to the ongoing weak economic performance

John Taylor discriminates between the 1983-85 and the 2009-12 expansions. The first he calls “economic expansion” while he refers to the second as a “regulatory expansion”. To him that is the best explanation for the very different economic performances in the two expansions.

Taylor puts up this comparative Real GDP growth chart:

And argues the difference can be adequately explained by the next chart which shows the number of number of federal workers engaged in regulatory activities (a proxy for the “production” of regulations) in the years before and during both recoveries:

Who knows, maybe the following comparative chart showing the growth in Nominal GDP in the two periods does a better job at explaining the wide difference in Real GDP growth observed.

Taylor puts up another chart showing the growth in federal workers engaged in regulatory activities for the past 50 years. Note that except during the 1980-85 period, it´s mostly increasing. The increase in the first half of the 1990´s, for example, didn´t stop the economy from growing, remembering that the 1990s registered the longest period of economic expansion in the nation’s history.

In any case regulation affects mostly the “supply side” and may improve, or impair, long run potential growth but it´s monetary policy that has the largest effect on the cyclical behavior of the economy. And I believe the Nominal GDP growth comparison best illuminates the important differences in real economic behavior during the two periods.


It´s a horrible post – Sowing the Wind – but the irony is that it is illustrated with the cover of Robert Hetzel´s great book – The Great Recession: Market Failure or Policy Failure – obviously without acknowledgement.

It concludes thus:

It must be realized that the damage inflicted on the economy by reckless monetary and fiscal policies cannot be fixed by further aggressive monetary pumping and by lifting people’s confidence in the Fed’s policies. What is needed to revive the economy is to stop the Fed and to cut government outlays to the bone.

It´s all in the timing – It was not the financial crisis but the drop in NGDP that´s responsible for deleveraging

Garett Jones elaborates on a post by Eli Dourado:

In fact, it looks like households are paying a lot more than required.  Here’s the Flow of Funds ratio of total household and nonprofit liabilities over GDP.  The Great Deleveraging is proceeding apace, and unless that’s all debt forgiveness and bankruptcy, debt payments appear to be higher than the monthly minimum: But I don’t think monthly debt payments are the main way that balance sheets matter.  After all, when people pay down debt that money goes to somebody else–a lender–who can decide how best to invest the repaid cash. Instead, I argue that net worth matters, because net worth makes you trustworthy.  Households with high net worth can borrow at leisure and at low rates; households with high net worth can sell an underwater house and take a $10,000 hit, invest money in a new business, borrow to put the kids through college.  They can borrow and invest easily because they have something to offer, because they can put skin in the game. You know the old song about how freedom’s just another word for nothing left to lose?  High net worth families don’t have a lot of freedom…and that’s why bankers love them. So what’s happened to net worth since the financial crisis?  I think you know:

The last time we were at this level of net worth [Update: for more than a couple of quarters] was in the late 90’s.  A lot of high net worth families–the kind that bankers love to see walking through the door–have somehow disappeared in the last few years.

The last paragraph is a bit of a stretch. What´s “off place” are the two wide swings in the net worth ratio since the mid-90s.

As the chart below shows, these are clearly linked to, first the stock market gains of the second half of the 90s, and then to the second upswing in stock prices and concomitant increase in house prices between 2003 and 2006/07. The point after which NGDP tanked is signaled by a red dot in the charts. Observe that by that time the net worth ratio had completed most of its fall.

Note, however, that even with much lower net worth household could still borrow. That dries up only after nominal spending tanks!


Additional evidence is provided by the unemployment rate. It also only skyrockets when spending takes a plunge. That´s when the recession turned into depression!


HT: Saturos

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!

“The more (does not always mean) the merrier”

Tim Duy has an important post where he worries that the economy does not overcome the ZLB before the next recession. His post builds on David Beckworth´s argument that the Fed did not cause (as popularly thought) the low level of the structure of interest rates, but rather, and this distinction is important, the Fed is responsible for that outcome.

The Fed´s responsibility arises from its lack of adequate action. The charts show that every time the Fed took action “stuff” happened, usually in the form of increases in interest rates, inflation expectations and the stock prices.


The point is that those actions were only that: “actions” and not a well specified “strategy” for monetary policy like, for example, the specification of a NGDP Target Level. As soon as the “actions” petered off, all variables reversed direction.

A very negative consequence of this “on” & “off” sequence is that – and Bernanke confirms – that monetary policy cannot induce the necessary changes in the economy (essentially an initially higher growth rate of nominal spending) on its own, requiring the assistance of fiscal policy. And Duy´s worry leads him to write:

I am getting a little nervous that we will not lift off from the zero bound before the next recession hits. Or maybe the attempt to lift the economy off the zero bound is the trigger of that recession. In either case, I am thinking it would be very bad to be still at the zero bound when that recession hits. So I am wondering what is the equilibrium path that returns the US economy to a normal interest rate environment. Furthermore, can the Fed push the economy to such a path by itself, or is fiscal cooperation required? I don’t have answers to these questions, but my suspicion is that the job would be easier with coordinated fiscal and monetary policies.

In the 1960s, monetary policy was “served” as a complement to fiscal policy. Now, the suggestion is that the roles be reversed, with fiscal policy complementing monetary policy, with the view being “the more the merrier”. But even if that can be construed as a “positive”, it won´t roll today (see this from a group of well-known and well-connected economists).

In my view the problem is Bernanke´s “risk aversion” leading to a succession of “baby steps” being taken when the situation requires bolder moves. And in the end, when the new, slightly bolder, action again falls short the “blame” can always be put on the fact that “fiscal help” was not forthcoming.

The Fed´s unassertiveness

After showing charts of breakeven inflation expectations and of several commodity prices, James Hamilton concludes:

Can the Fed’s announcement really do all that? There were similar initial moves following QE1 and QE2, which later were reversed as the market realized that no, this really wasn’t going to turn the U.S. into another Zimbabwe. Bernanke himself seems to have pretty modest expectations:

The policies that we have undertaken have had real benefits for the economy that they have provided some support, that they have eased financial conditions and helped reduce unemployment. All that being said, monetary policy as I’ve said many times is not panacea, it is not by itself able to solve these problems. We are looking for policymakers in other areas to do their part. We will do our part and we will try to make sure that unemployment moves in the right direction but we can’t solve this problem by ourselves.

And says:

That’s my view as well. I think the correct interpretation of QE3 is that the Fed has unambiguously signaled that it’s not going to re-run the Japanese experiment to see what happens when the central bank stands by and watches wages and prices fall even while unemployment remains very high. The Fed can and will keep U.S. inflation from falling much below 2%, and that may help a little. Investors should expect that, and not a whole lot more.

Seems that the 2% upper limit more or less stands! Avoiding a re-run of Japan should really not be a concern. If it is, “G.H.U”!

And later, when the initially expected doesn’t happen, the justification will be that help from policymakers in other areas (fiscal stimulus) was not forthcoming.

Recommended reading, from Bill Woolsey:

Michael Woodford was asked if he had been influenced by Scott Sumner, and he said no.

I believe him.
On the other hand, where has Woodford been for the last four years?

I think the answer is obvious–way, way up there in his ivory tower.

Apparently, in his own mind, Woodford is a longtime advocate of gap-adjusted price level targeting.   Nominal GDP targeting, according to Woodford, is a similar, though less than optimal, simplistic alternative.

I just pray that all the association that has been made with MM principles from the FOMC announcements will be quickly forgotten.

Jeffrey Lacker, the lone dissenter

Federal Reserve Bank of Richmond Jeffrey Lacker, “striked” and disagreed with ALL FOMC decisions. In particular, he believes the actions:

  1. Likely to push inflation up
  2. Unlikely to help boost growth or reduce unemployment
  3. Unemployment held back by real impediments, unaffected by monetary policy

Exactly four years ago Lehmann collapsed. That was already a consequence – not, as many believe, a cause – of the collapse in NGDP expectations. Since then, the Fed has focused on keeping the financial sector afloat, a direct reflection of Bernanke´s “credit view” of the crisis. Consequently, the economy has been left “rolling in the deep” of the “hole” it was allowed to fall into.

According to Scott Sumner the Fed has made progress exchanging “arrows” for “small caliber handguns” in its efforts to combat the crisis, but is still a long way from deploying the “big guns”. But Lacker wants to restrict the Fed to the use of “kitchen knives”!

In the 1960s, policymakers were willing to use every weapon in the arsenal to bring and then keep unemployment down. The result was the “Great Inflation”. Now, thankfully ever fewer Fed members (Lacker is the “lone wolf” among the voting members but there are a few others who are not voting this year) shun the use of more powerful weapons.

I believe the weapons chosen:

1.  Making the size of QE conditional on actual progress on the jobs/inflation front.

2.  Promising to keep policy expansionary for an extended period, even after the economy has recovered.

Are still not adequate, in particular given the “size of the problem” that has been allowed to grow for several years.

It may help to compare how a big recession brought about to “cure the inflation sickness” was managed in the early 1980s and the management of a much bigger recession brought about by “errors of omission” in the late 2000s.




In the 1980s, the Fed strived to put nominal spending (NGDP) on a sustainable level trend path. It succeeded and the “GM” (“Great Moderation”) followed suit. This time around, until now there´s not been much (any?) success. Hope we can avoid a “GJ” (“Great Japanization”)

Expectations metamorphosis – what does it signal?

Back in March I put up this chart:


After taking a look at today´s Cleveland Fed “inflation expectations curve”, I just couldn´t resist the analogy with the Nike logo. As the saying goes, “Just do it”.

Unfortunately, despite encouraging signs mentioned by David Glasner the logo is “melting”. The latest inflation expectations curve, released together with the monthly CPI, shows the whole curve is down from three months ago.

And three months on the logo not only continued to “melt”, but “flipped”. This is the chart for the month of June/12:

And another three months on, the Nike logo changes into an “isoquant”, closely resembling the kind seen in the “Production Theory” section of micro texts.

After falling continuously, the short end of the inflation expectations curve “jumps” after June, with the long end remaining subdued. This transformation may be reflecting the chatter over the summer on the likelihood of “additional Fed action”. The behavior of the stock market, which reverses direction at the same time, is consistent with this conjecture.

I´m now curious to see the “mutation” which will show up next month. If the commitment pledged at the last FOMC meeting is believed, we should see the long end of the inflation expectations curve shift up, with the whole curve once more resembling a “Nike logo”, only at a higher level relative to the older ones. Riskier assets would remain attractive.

Will check back in a month.