An unstoppable wave?

Maybe, when even international bureaucrats start talking about NGDP targeting.

From Kemal Davis (former Turkish Economic Minister, VP of the World Bank and present VP of the Brookings Institution):

On December 12, US Federal Reserve Chairman Ben Bernanke announced that the Fed will keep interest rates at close to zero until the unemployment rate falls to 6.5%, provided inflation expectations remain subdued. While the Fed’s governing statutes, unlike those of the European Central Bank, explicitly include a mandate to support employment, the announcement marked the first time that the Fed tied its interest-rate policy to a numerical employment target. It is a welcome breakthrough, and one that should be emulated by others – not least the ECB.

There is no recent example, however, of a major central bank setting a numerical employment target. This should change, as the size of the employment challenge facing the advanced economies becomes more apparent. Weak labor markets, low inflation, and debt overhang suggest that a fundamental re-ordering of priorities is in order. In Japan, Shinzo Abe, the incoming prime minister, is signaling the same set of concerns, although he seems to be proposing a “minimum” inflation target for the Bank of Japan, rather than a link to growth or employment.

In a more global context, none of this is to dismiss the longer-term dangers of inflation. In most countries, at most times, inflation should be kept very low – and central banks should anchor inflation expectations with a stable long-term target, although the alternative of targeting nominal GDP deserves to be discussed.

Yes, better late than never! Let the wave rise and sweep everyone like a tsunami.

Note: Jeff Frankel elaborates further on the theme.

HT Patricia Stefani

Bernanke: The man who disregards his own advice

Bernanke´s now (in)famous 1999 paper on Japanese monetary policy was a blueprint for what he should but did not do when NGDP crashed after mid-2008. But there´s more.

In 1997 Bernanke (with Mark Gertler)wrote “Systematic Monetary Policy and the Effects of Oil Price Shocks”. Their conclusion:

Bernanke Advice_0

If only Bernanke had heeded his own advice and had not tightened policy…

But the oil-monetary policy nexus is not ‘common knowledge’, explaining why Bernanke might have forgotten about his result. In 2009, no less than Jim Hamilton, an ‘oil shock specialist’ wrote:

Suppose you knew in 2007:Q3 what GDP had been doing up through that date and could know in advance what was about to happen to the price of oil. What path would you have then predicted the economy to follow for 2007:Q4 through 2008:Q4?

The answer is given in the diagram below. The green dotted line is the forecast if we ignored the information about oil prices, while the red dashed line is the forecast conditional on the huge run-up in oil prices that subsequently occurred. The black line is the actual observed path for real GDP. Somewhat astonishingly, that model would have predicted the course of GDP over 2008 pretty accurately and would attribute a substantial fraction of the significant drop in 2008:Q4 real GDP to the oil price increases.

Bernanke Advice_01

And concludes:

Eventually, the declines in income and house prices set mortgage delinquency rates beyond a threshold at which the overall solvency of the financial system itself came to be questioned, and the modest recession of 2007:Q4-2008:Q3 turned into a ferocious downturn in 2008:Q4. Whether we would have avoided those events had the economy not gone into recession, or instead would have merely postponed them, is a matter of conjecture. Regardless of how we answer that question, the evidence to me is persuasive that, had there been no oil shock, we would have described the U.S. economy in 2007:Q4-2008:Q3 as growing slowly, but not in a recession.

So, was it the oil shock or monetary policy ‘enhancing’ the oil shock that was responsible for the “greatness” of the recession?

Two back to back moments allow us to test the hypothesis. The charts show oil prices from 2004 to 2006 (Jan 2004=1) and from 2007 to 2008 (Jan 2007=1). If oil is determinant, as argued by Hamilton, the recession should have happened much sooner.

Bernanke Advice_1

How did monetary policy differ in the two periods?

From a standard dynamic AS/AD model we know that following a negative supply shock (rise in oil price), real output growth falls and inflation rises. If nominal spending growth (NGDP growth) stays constant we go to point 2 in the chart below. Nevertheless, if monetary policy is contractionary and tries to curb the rise in inflation by restraining NGDP (AD) growth, inflation will fall somewhat but real output growth will fall further, taking the economy to point 3.

Bernanke Advice_2

The real world counterpart is observed in the following charts, which depict nominal and real output growth in the two periods.

Bernanke Advice_3

While under Greenspan NGDP kept ‘chugging’ along at a ‘constant’ rate, under Bernanke, with the FOMC ‘terribly worried’ about the possible inflationary consequences of the oil price rise, monetary policy soon turned contractionary and NGDP growth quickly began to fall. (Corroborating evidence: In the transcripts of the June 08 FOMC meeting we read that participants felt that the next move in rates would be up!).

And what about inflation. I use the core PCE variety that ‘strips-out’ the oil price effect.

Bernanke Advice_4

By not abiding to his own advice, Bernanke allowed monetary policy to contract, which concomitant with rising oil prices and falling home prices was the coup de grace for both the real and financial sides of the economy.

I must mention that in one single point Bernanke acted true to form and in accordance with the results of his research. His unwavering belief in the credit channel of the transmission of monetary policy were behind his successful efforts in propping-up the financial sector. Pity this research effort was the one that gave out the least convincing results!

Note: Images are built from perceptions, not fact. The FT compares Bernanke with James Dean in “Bernanke – the Rebel with a cause” and says his latest move is genuinely radical!

Jeffrey Frankel does it again

While enjoying the warm weather of Zanzibar, off the coast of Tanzania, Jeffrey Frankel has come out, once again, in defense of NGDPLT targeting.

But this time I want to criticize one point he makes in an otherwise almost flawless piece:

A nominal-GDP target’s advantage relative to an inflation target is its robustness, particularly with respect to supply shocks and terms-of-trade shocks. For example, with a nominal-GDP target, the ECB could have avoided its mistake in July 2008, when, just as the economy was going into recession, it responded to a spike in world oil prices by raising interest rates to fight consumer price inflation. Likewise, the Fed might have avoided the mistake of excessively easy monetary policy in 2004-06 (when annual nominal GDP growth exceeded 6%).

The bold sentence above indicates that he forgot, temporarily, that it´s supposed to be a LEVEL target, not a GROWTH target (although if you are on target the growth rate of NGDP should be ‘constant’). Saying that monetary policy was excessively easy in 2004-06, because NGDP growth exceeded 6%, is a mistake even some bona fide market monetarists entertain. And the bad part about it is that it gives credence to those like John Taylor, among others, who point to the “easy” monetary policy over that period (“rates too low for too long”) as an important cause of the housing bubble and bust and the ensuing “Great Recession”.

I´ll try to show, through some charts, that that´s very far from the ‘truth’, and that monetary policy in 2004-06 was ‘exactly right’ (in the sense that it brought NGDP back to the target level.

The first chart shows the NGDP gap between 2001 and 2006. The reason for the dotted line over mid-2003 will become clear soon.

Jeff Frankel_1

The only way NGDP can climb back to trend, as it did by early 2006, is if NGDP grows temporarily above the trend growth rate (about 5% at the time).

Jeff Frankel_2

The question is: Why did it happen after mid-2003? The answer lies in the Fed having been successful in its forward guidance policy (something which it has been trying to repeat of late, and now adding thresholds, without much success).

In the May 2003 FOMC meeting there were already indications that monetary policy could change.

In the next FOMC meeting, in June, unknown at the time to the general public, Vincent Rinehart (Director of the Board´s Division of Monetary Affairs) made a presentation called Conducting Monetary Policy at Very Low Short-Term Interest Rates”. The post- meeting statement read:

The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome substantial fall in inflation exceeds that of a pickup in inflation from its already low level. On balance, the Committee believes that the latter concern is likely to predominate for the foreseeable future.

This signaled that a change in policy was likely in the near future. That came about in the next FOMC meeting, in August 2003. The post-meeting statement said:

The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.

Interestingly, at the top of Reinhart´s alternatives for monetary policy at low rates was this one:

Encouraging investors to expect short rates to be lower in the future than they currently anticipate.

Although the FF rate didn´t change, remaining at 1%, the new words, more recently labeled forward guidance, did the trick!

Interestingly, as the next charts show, all that we want to see happen now happened then.

Real growth went up significantly and unemployment began a solid downtrend.

Jeff Frankel_3

Long term Treasury rates and the S&P 500 stock index reversed direction.

Jeff Frankel_4

And medium term (5 years) inflation expectations also stopped falling and began to rise.

Jeff Frankel_5

Rising NGDP and NGDP expectations did the “trick”. Later, Bernanke´s Fed let NGDP and NGDP expectations drop and then tank. Now, the only way to reverse the situation is to adopt, like the UK is on the way to do, an explicit NGDP-Level Target. But that will likely require a change in leadership, which is set to happen in early 2014.

Shrinking Inflation Expectations

From Richard (“Inspector Clouseau”) Fisher:

Dallas Fed President Richard Fisher said Friday on CNBC he opposed the Federal Open Market Committee‘s recent decision on employment thresholds and that he was extremely concerned that it would become increasingly difficult to exit the Fed’s accomodative monetary policy.

“We are at risk of what I call a ‘Hotel California’ monetary policy, referring to the Eagles’ song, where we can check out any time we want from this program, but we can never leave” due to an engorged balance sheet, he said.

I looked at the Cleveland Fed today´s release of their measure of inflation expectations. This is what I found.

Shrinking Expectations

Just imagine those are representations of short-run supply curves!

Seems that a lot of spending growth can be conjured before the 2.5% inflation threshold is reached.

Whither the Taylor-rule?

Via Saturos I went to Mankiw´s blog which published a note by Larry Ball. Larry “fiddles” with parameter values on the Taylor-rule and arrives at whatever conclusion he wants. So much for the usefulness of Taylor-rules.

But what got me thinking was his last paragraph:

It is not clear whether the Fed’s announcement of future dovishness will have significant effects today. The efficacy of announcements about future monetary policy is unproven.

It´s not “unproven” because it has worked in the past. I´m thinking of 2003 in particular and the statement of the August FOMC meeting which said:

The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.

And even though the FF rate remained at 1%, the economy turned up.

More details on this can be seen in this post.

But now, more than “forward guidance-cum-thresholds” was needed. Guess what?

Meanwhile in a parallel universe…

Even though Ben Bernanke has not yet begun to fight:

…for five years running, the Fed under Chairman Ben S. Bernanke has had a remarkable track record of moving creatively, aggressively, and quickly to try to ease policy and get the U.S. economy on track — usually more creatively, more aggressively, and more quickly than those (surely NOT market monetarists) who spend their days watching the Fed thought possible.

Over the last two years, Bernanke and his colleagues at the Fed have been flummoxed that, years after the crisis and despite extraordinary interventions by the Fed, the U.S. economy has seemed stuck in a rut, unable to grow fast enough to accelerate back to full employment. Across Washington and at many of the world’s other central banks, there was a sense of fatalism: The economy has suffered a crushing blow. More stimulus — monetary, fiscal, whatever — won’t work. All we can do is sit on our hands and hope for the best.

Further down we read:

Bernanke and the Federal Open Market Committee weighed the arguments of economists supporting “nominal GDP targeting,” but rejected a full-bore push in a direction that seemed to them risky and unworkable. But they took to heart some crucial insights from advocates of that approach, particularly around the importance in a central bank shaping expectations to influence the economy.

NGDPT “risky and “unworkable”? He should talk to Mark Carney who just lay down what, according to some, is a monetary policy strategy blueprint for when he takes over the BoE next June.

On the importance in a central bank shaping expectations…Bernanke has full knowledge. What he´s terribly afraid is of people coming to expect higher inflation. That´s why the inflation threshold is capped at 2.5%!

And at the end:

Bernanke made his career studying the errors of central bankers in the Great Depression and then in 1990s Japan, arguing consistently that more forceful monetary policy would have jolted those economies out of their troubled state. He has acted as if on a mission to avoid becoming one of those central bankers who were, in his view as an academic, culpable for unnecessary misery heaped upon their people.

He studied all right…but didn´t pass the exam!

I´m of the view that he has been pretty blazé about the whole thing, not acting as if on a mission.

And Carney says that guidance-cum-thresholds is the “end of the road”, they “exhaust the guidance options available”. “If yet further stimulus were required the policy framework itself would likely have to be changed”.  And that will only happen if someone else replaces Bernanke in 2014.

Bernanke should read Beckworth & Ponnuru

Federal Reserve Chairman Ben Bernanke said if the country falls off the fiscal cliff, the economy will be damaged in way the Fed can’t control.

 “I don’t think Federal Reserve has tools to offset the effect…we’d have to temper the expectations of what we can accomplish.” said Mr. Bernanke, who coined the phrase fiscal cliff for the looming tax hikes and government spending cuts set to begin in 2013.

Mr. Bernanke said that while the Fed could increase asset purchases “a bit,” it can’t offset fully the effects through added stimulus.

Here´s B&P:

There are indeed reasons to fear falling off the cliff. Scheduled increases in taxes on capital formation, for example, would do long-term damage to the economy. The Keynesian nightmare about the cliff is overwrought, however, because the Federal Reserve has the power to avert it. For that matter, Congress could cut spending much more deeply than it is now considering without risking a recession — at least if the Fed acts appropriately.

The point should be easy to grasp if you imagine a central bank that has a 2 percent inflation target that it hits every year. Under those circumstances, neither fiscal stimulus nor austerity can change levels of inflation or output. If a stimulus inflated the economy, the central bank would just deflate it again to hit its target. If austerity shrank the economy, the central bank would re-inflate it. The total amount of economic activity would not change (although how much of it was directed by private-sector actors would).

The same conclusion — that changes in the federal budget position cannot affect the size of the economy overall — follows if the central bank substitutes a nominal-spending target for an inflation target and hits it every year. In the real world, of course, central banks do not hit their targets perfectly. They do, however, have the power to come close, which means that fiscal policy cannot have a large effect if they are trying.

NGDP-LT: “A target for all seasons”

When reconverting to Catholicism in order to ‘upgrade’ from being King of Navarre to become King of France, Henry IV is alleged to have said: “Paris vaut bien une messe” (Paris is well worth a Mass). Now, anticipating his move from Governor of the Bank of Canada to Governor of the Bank of England, Mark Carney “indicates” he would be willing to “renounce” IT and “embrace” NGDP-LT (where LT stands for “Level Target”).

And he states the reason (my bolds):

From our perspective, thresholds exhaust the guidance options available to a central bank operating under flexible inflation targeting.

If yet further stimulus were required, the policy framework itself would likely have to be changed. For example, adopting a nominal GDP (NGDP)-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add “history dependence” to monetary policy. Under NGDP targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP.

And why would he be willing to contemplate a “conversion” from his IT ‘faith’ (even if of the flexible variety) to NGDP-LT?

The charts below give an indication. In the UK, nominal spending had progressed very close to trend. It´s fall ‘from grace’ has been very significant. In Canada not as much. Chart 4 in Mark Carney´s speech clearly states that ‘bygones are not bygones in NGDP-LT, so an effort to get back the economy back close to trend is warranted.

Mark Carney_1

Carney further states:

However, when policy rates are stuck at the zero lower bound, there could be a more favorable case for NGDP targeting. The exceptional nature of the situation, and the magnitude of the gaps involved, could make such a policy more credible and easier to understand.

Of course, the benefits of such a regime change would have to be weighed carefully against the effectiveness of other unconventional monetary policy measures under the proven, flexible inflation-targeting framework.

The optimistic me reasons that´s just Mark Carney not wanting to be too blunt and scare the “faithful”. I´m certain that if NGDP-LT is proven justified under an “Exceptional nature” it can easily be generalized to be justified in any situation, or in “all seasons”.

Just yesterday I published a post dealing with research that found that “Even central bankers get the new-job jitters”:

In central bank parlance, new officials are more likely to act like “hawks,” policy makers who are relatively more worried about inflation getting out of control. Policy “doves,” meanwhile, are sometimes more concerned about other economic problems, such as unemployment, and can be willing to let prices rise temporarily.

Luckily Mark Carney is not a “new official”. He´s moving from one ‘Governorship’ to another and, hopefully, giving advance notice of his preferred strategy for the new job (the other actors involved, in particular PM David Cameron better start the ‘conversion ball’ rolling).

Obviously, the British press had a field day. My preferred headline was from the BBC:

Mark Carney suggests targeting economic output

Mark Carney, who will take over as governor of the Bank of England next year, has suggested targeting economic output instead of inflation.

They make it sound like a fait-accompli.

PS. Bernanke, take notice. Mark Carney has just told you guidance-cum-thresholds will not cut it for the US.

Scott Sumner, Lars Christensen, Britmouse and Nick Rowe have posts.

The “causes” are always real, never monetary

Keynes said “In the long run we´ll all be dead”. Unfortunately our descendants will be very much alive, maybe living miserably…

Chess Masters, Entrepreneurs and Economists weigh in. But they´re all talking about dreary prospects for the long run. But so did Thomas Malthus more than 300 years ago. And so did the Club of Rome 50 years ago. It appears that human ingenuity “solves” the long run problem. It seems much harder to “solve” the short-run cyclical one!

From the FT:

There is a fierce debate over the origins of the disappointing economic growth seen in advanced economies. On one side there is former world chess champion and political activist Garry Kasparov and internet entrepreneur Peter Thiel, while on the other, there is Kenneth Rogoff, a Harvard economist.

Mr Rogoff, who authored This Time is Different: Eight Centuries of Financial Folly(2009) with Carmen Reinhart, argues that the systemic financial crisis is the root cause of the prolonged economic slump in the western world. In their research, Mr Rogoff and Ms Reinhart found economic growth following a systemic financial crisis to be about a full percentage point below trend growth.

Mr Kasparov and Mr Thiel, on the other side, disavow Mr Rogoff’s claim that the collapse of advanced-country growth is the result of the financial crisis. In their view, the flailing western economies reflect stagnating technological development and innovation, and without radical changes in innovation policy, advanced economies are unlikely to see any prolonged pickup in productivity growth.

Robert Gordon of Northwestern University espouses an even more dire view, suggesting that the 250 years of rapid technological progress that followed the Industrial Revolution may prove to be the exception, rather than the rule.

As usual, the “luck of the draw” is determinant

Even central bankers get new-job jitters.

In their first year or two after taking office, newly appointed monetary policy makers are more likely to act tough on inflation. That’s especially true in countries where an independent central bank has a specific inflation target, according to a new paper by Matthias Neuenkirch, an economics professor at RWTH Aachen University in Germany.

In central bank parlance, new officials are more likely to act like “hawks,” policy makers who are relatively more worried about inflation getting out of control. Policy “doves,” meanwhile, are sometimes more concerned about other economic problems, such as unemployment, and can be willing to let prices rise temporarily.

Let´s see. In his first FOMC (March 2006) meeting as Chairman, Bernanke kept ‘Greenspan´s language’:

The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance.

But in his second FOMC meeting (May 2006) there was a ‘hawkish’ change:

The Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information.

And the ‘hawkish’ tone increased during 2006, with added worries about ‘elevated’ readings on core inflation and high levels of resource utilization.

This went on throughout 2007. At the October 2007 FOMC meeting worries about the oil price increase was added to the list.

During 2008 there were several dissents, sometimes two in a meeting, favoring an increase in rates. From April 08 to September 08 the FF rate stayed put at 2%.

The charts illustrate.

Fear of Inflation

So maybe, if Greenspan had stayed another couple of years, the “Great Recession” would have been just a “Run-of-the-Mill Recession”.