Not so fast, Ed

Ed Dolan has an interesting post: “Latest Economic Growth Data Give Cheer to Market Monetarists, or, What is the NGDP Gap and Why do we Care?”, where he writes:

After that long digression, let’s take a look at the recent behavior of NGDP to see why the latest data will be a relief to market monetarists. Let’s start with a chart that shows the levels of actual and potential NGDP during the Great Recession. (The chart uses a version of potential NGDP calculated by the Congressional Budget Office. Some economists might quibble with the CBO methodology. Instead, we could estimate potential NGDP by simply extrapolating its historical trend. That trend would track a little above the CBO measure, but it would not greatly change the general picture.) As the chart shows, actual NGDP plunged well below potential in 2008, opening a big negative output gap. Since about 2010, the lines have run almost parallel. The gap has stubbornly failed to close. Dolan_1 We can get a clearer picture by switching to a chart that plots the gap directly. There was clear progress from the bottom of the recession in mid-2009 until late 2010, when it briefly touched the -3 percent mark. The gap then widened again, not getting back to under -3 percent for a full year. After renewed gains in 2011, it again widened. By Q2 2013, the gap was still larger than it had been five quarters before. Only with the latest revision of the data for Q3 2013 has it closed to less than -2 percent. Dolan_2

His use of the CBO measure of potential NGDP is what makes the story weak. And it is not, as Ed says, that “it would not greatly change the general picture.” It does and significantly so.

The next charts track back Ed´s to 1987 and I include the equivalent charts based not on the CBO measure of potential NGDP but on the NGDP trend. This trend was estimated from 1987 to 1997 and projected forward (for the reasons why, see here).


The first thing to note is that, in the CBO potential case, almost all of the time the actual level of NGDP is above the potential level (equivalently, the NGDP gap to potential is almost always positive). Something quite different comes out of the story told using the estimated trend. But why should I prefer the “trend” to the “potential”?

For starters, if the gap had really been consistently positive, inflation should have risen. Nevertheless it fell. And so did unemployment (the reverse of a stagflation scenario). Some of this was due to the positive productivity shock that took place from about 1993 to 2003. Some of it is likely due to the fact that Greenspan had high credibility and managed to keep NGDP close to trend.


Interestingly even the likes of Krugman were worried that the Fed was “behind the curve” so that inflation would soon show its ugly face. Writing in mid-1997, Krugman says:

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.

Greenspan certainly perceived long before Krugman (and most analysts) that productivity growth had increased, so that the expansion should be free to “roll on”. But later, reacting to the Russia crisis (and LTCM) he allowed NGDP to climb above trend. In trying to bring it down he undershot the trend. Interest rates were brought the extremely low level of 1% but it was only when forward guidance was introduced in mid-2003 that the economy began to climb back to trend.

And it was back to trend when the baton was passed on to Bernanke. As an inflation targeting obsessive-compulsive, he quickly lost it!

Quite likely the present gap relative to the “Great Moderation trend” is exaggerated. Likely there has been some reduction in the trend level path (maybe also in the trend growth rate). But even so, the gap is still far wider than the one indicated by comparison to potential NGDP from the CBO.

The “Great Inflation” is being revisited

I have a standard quip: “The obsession with the unemployment rate in the 1960s (slowly) gave rise to the Great Inflation of the 1970s” and “the obsession with (nonexistent) inflation in 2007/08 (quickly) gave rise to the Great Recession”.

It appears that Fed policy following the Great Recession has brought back memories of the Great Inflation. Two recent books are noteworthy:

Remembering Inflation” by Brigitte Granville of Queen Mary College, University of London, Princeton University Press 2013. You can get the gist of her argument right at the preface where she writes:

“On August 19,2010, the Financial Times published an article titled “Needed: A New Economic Paradigm”, by Joseph Stiglitz. “In that article, Stiglitz wrote”:

Bad models lead to bad policy: central banks, for instance, focused on the small economic inefficiencies arising from inflation, to the exclusion of the far, far greater inefficiencies arising from dysfunctional financial markets and asset price bubbles”.

“Some readers may have been impressed by this disparagement of efforts to bear down on inflation. For me it clearly signaled that the time had come for remembering inflation. For even if the successful pursuit of low inflation in many countries since the 1980s was accompanied by failures in other areas of policy that contributed to the financial and economic shocks that crystallized in the US credit markets and burst upon the world in 2007-08, even worse outcomes could result in the future from forgetfulness about the costs of inflation”.

The other recently published book:

Michael D. Bordo and Athanasios Orphanides, editors, The Great Inflation: The Rebirth of Modern Central Banking. Chicago: University of Chicago Press, 2013

Has been informatively reviewed by Robert Hetzel:

The first point to make is that the preface understates the value of the book.  The preface promotes the book with the observation that high inflation is costly and policy makers need to learn not to repeat the experience.  True enough, the incentive to adopt price controls when faced with high inflation came close to setting the United States on a path leading to state control of the economy and away from free enterprise.  However, the book is far more than a morality tale for central bankers.  The long, stumbling process of learning engaged in by central banks about operating in a regime of fiat money provides the kind of experiments that economists require in order to identify shocks.  When it comes to these experiments, the period known as stop-go monetary policy and as the Great Inflation is “as good as it gets.”

I´ll just note this point from Hetzel´s review:

Given the Blinder-Rudd explanation of the Great Inflation that exonerates the Fed from any blame, the discussion of monetary policy in Japan and Germany is especially interesting.  Takatoshi Ito (“Great Inflation and Central Bank Independence in Japan”) contrasts monetary policy before and during the two inflation shocks of the 1970s, the first in 1973-1974 and the second in 1979-1980.  He argues that expansionary monetary policy in the early 1970s had already created high inflation before the first shock.  In the second episode, monetary restraint led to only a short-lived, moderate increase in inflation.  In a similar spirit, Andreas Beyer, Vitor Gaspar, Christina Gerberding, and Otmar Issing (“Opting Out of the Great Inflation: German Monetary Policy after the Breakdown of Bretton Woods”) credit a monetary policy, which started in the mid-1970s, with a firm nominal anchor for price stability as a source of nominal and real stability relative to other countries.  They especially emphasize the role of money targets as a commitment device for aligning inflationary expectations with the goal of price stability.

Macroeconomists cannot run controlled experiments, but they can do a much better job of identifying and elucidating the extraordinary range of experiments that central banks have delivered. The Great Inflation is a terrific example.

I am fascinated by the “Great Inflation” and will post more on it over the weeks and months ahead (after reading the new books and going over others that were written at the time – like Blinder´s Economic Policy and The Great Stagflation (1979) and Ekstein´s The Great Recession(!) (1978)).

In the meantime check the charts below in light of Hetzel´s paragraph on monetary policy in Japan and Germany.

First the commodity and oil shocks. Note that the commodity shock began more than one year before the oil shock.

Great Inflation_1

From the inflation chart, note that Japanese inflation took off at the time of the commodity shock so that by the time the oil shock happened inflation in Japan was already above 15%. Note also that the second oil shock in 1979 had little impact on Japanese and German inflation, in contrast with what happened in the US.

Great Inflation_2

Now compare the behavior of monetary policy in the three countries, here represented by the growth in NGDP.

Great Inflation_3

It´s not hard to see the reason Germany had the lowest inflation outcome and that by changing monetary policy Japan, unlike the US, mostly avoided the inflationary impact of the second oil shock.

“Extended Insurance”

  1. The Fed has never been comfortable with QE3
  2. Many thought that QE ineffective
  3. Bernanke felt compelled to clear the path for Yellen

But it has boosted “Forward Guidance” to make up (or more than make up) for the “taper”.

According to the “outlook”, interest rates are likely to remain down into 2016 because inflation will likely still be below the Fed´s target.

Taper On_1

The Fed would always say, about its securities purchases:

Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

As the chart shows (weekly data) that never happened:

Taper On_2

And that´s  (according to Scott Sumner) “A classic example of how interest rates tell us very little about the stance of monetary policy.”

The stock market has mostly been on an uptrend:

Taper On_3

And as David Beckworth illustrates, the QE + Forward Guidance group has performed significantly better than the Euro group (and better the more QE+FG):

Taper On_4

Just imagine if the Fed had been clear on its communications, something it could have accomplished by stating a level target for NGDP!

“12 blind mice”

I liked this opening:

After a financial crisis he didn’t see coming, Ben Bernanke steered the U.S. away from a potentially devastating panic. Yet five years later, the recovery he helped engineer with extraordinary policies remains frustratingly weak.

He didn´t see it coming because the Fed was the agent provocateur. They were blindsided by a headline inflation polluted by oil and commodity price shocks. By allowing nominal spending to tank, the Fed reaped the worst financial crisis in many decades.

And if monetary policy is as accommodative as the Fed argues, why has the recovery been so meek?

Now, to “clear the way” for his successor, Bernanke starts off the taper…

The Pending Federization of Stanley Fischer?

A guest post by Benjamin Cole

Slated to be No. 2 at the Fed is Stanley Fischer, former central bank kingpin in Israel, where he amassed an enviable record of guiding the Mideast state through the global Great Recession with only a scrape or two.

Though he espouses adjustable inflation-targeting more than the locally preferred shooting for steady increases in nominal GDP (Market Monetarism), who knows?—it may amount to the same thing in practice.

That is to say, one central banker may say, “Inflation is too low, and we need to be a little flexible anyway, let’s do $85 billion a month in QE,” and the next may say, “NGDP is too low, let’s do $85 billion a month in QE.”

In practice, the same policy, despite all the complicated arguments behind each approach.

We can hope that Fischer is, at least, not peevishly fixated on obtaining microscopic rates of inflation, or even zero inflation, an idea now zealously touted by such monetary thinkers as John Cochrane of University of Chicago or Charles Plosser, the Philly Fed bank chief. With the PCE deflator at 1 percent, the stiff-necked “no inflation” crowd has near-guttural blood-lust to savage that last yet initial digit, economic growth be damned.

But Hopes May Be Dashed

So, Fischer may offer hope for a more growth-oriented Fed policy—but remember, the Market Monetarist community has been long disappointed with current Fed Chief Ben Bernanke, who wrote so intelligently about the Great Depression in the United States, and even more cogently about the recession-deflation quagmire that has been Japan since 1992

In short, Bernanke—as an academic—told the Bank of Japan to print money and buy bonds, and keep doing it until results were in hand, much as Milton Freidman did in his 1998 seminal piece, “Reviving Japan,” written for the Hoover people at Stanford.

Market Monetarist don Scott Sumner more than once has lamented that Bernanke the academic has been AWOL or even MIA as Fed leader.

Why Bernanke the Changeling?

As an independent public agency (self-financing at that) the Fed has been fortifying and ossifying an institutional culture since it won formal independence in 1951. Starting in the 1980s the Fed began muscling up, by hiring a small army of on-staff PhD economists and a serious support staff, holding conferences and developing powerful ties to academia and industry publications. With perhaps 700 economists at HQ or at the 12 branches, the Fed dominates the craft.

As early as the 1990s, Milton Friedman complained that the Fed was “stifling” debates about monetary policy. Wrote Friedman in a letter, “having something like 500 economists is extremely unhealthy. As you say, it is not conducive to independent, objective research. You and I know there has been censorship of the material published. Equally important, the location of the economists in the Federal Reserve has had a significant influence on the kind of research they do, biasing that research toward noncontroversial technical papers on method as opposed to substantive papers on policy and results….”

In a sense, the basics of Fed culture were fired like clay in an oven in the triumphant 1980s days of Fed Chairman Paul Volcker, when he successfully tightened the money supply and busted inflation, then in low double-digits. Volcker left the Fed ring in 1987 hailed as a champ—forgotten today is that inflation as Volcker departed was about 5 percent, and people were happy with that.

Brandishing the Volcker escutcheon, the Fed seized its defining moment of glory to craft and hone an exalted mission statement—the brave if genteel protector of price stability, as opposed to, say, the spendthrift weaklings in US Congress or the White House.

It is into this Fed culture that Fischer will find himself enveloped, and into which Bernanke entered, never to be seen again in his original incarnation.

Indeed, all over the developed world, major central banks become independent, and have become fixated on inflation, from the ECB to the Bank of Japan.

Teams of organizational theorists and sociologists might be able to explain this obsession, but suffice it to say central bank staffs probably do not have a lot in common with bar operators, real estate developers or entrepreneurs. It would be unfair to say bankers have a fetish for currency or secretly genuflect to gold.

There is also the reality that central banks know they can flatten inflation—the Bank of Japan did it, and operationally crushing inflation is easy to do. A smart public agency defines the goalposts down and close enough that scoring is easy. “Our only job is price stability,” has a nice ring, and then everyone can go home at 5 pm, no worries.

In contrast, managing monetary policy so that inflation is moderate but there is prosperity—that takes skill, judgment and nerve, and a thick skin.

It must be conceded that with a dual mandate, the inflation-hysterics will ever bash the Fed, while others will chant for more growth. To agree to a dual mandate is to enter the ring against two boxers, for an infinite number of rounds.

Central banking types, in their wing-tipped shoes, are not fond of stepping into crossfires. Indeed, the recent Fed  embracing of a third mandate—to “prevent bubbles”—is perhaps but a scrim to reduce the emphasis on prosperity, and to effectively get to a single anti-inflation mandate.

The Big Question: So will Stanley Fischer succumb to the global and Fed central banker cult of immaculate price stability?

The Good News

The good news is that Fischer is 70 (an alter cocker, look it up) and has already been a central banker, meaning (we hope) he perhaps will not be intimidated by the marbled hall, large eagle statues and glorified mission statements and exalted prerogatives of the Fed—nor its rising predilection to seek a single mandate, legally or in practice, of straitjacketing inflation to infinitesimal levels.

As an Israeli, my guess is that Fischer has a thick skin, as in rhinoceros epidermis.

So shooting for dual mandates and taking heat from both sides should be easy for him. But mostly, let us hope Fischer brings a practical, Israeli settler perspective to his job: “Inflation, schmaflation, people need to live and prosper too.”

Mr. Coeure doesn´t have a “heart”

But Mr, Coeure should if he were guided by the sound of his name!

Coeure told a journalist club on Monday night that the ECB was ready to act, but that the euro zone was not edging towards a dangerous fall in prices.

“Inflation prospects are consistent with our objective, so I don’t see need to use spectacular measures, such as U.S.-style large-scale asset purchases,” Coeure said, adding that the ECB can buy government bonds as long as it does not do so for the purpose of financing governments.

But the Frenchman added that the ECB would keep a close eye on price developments and would be ready to act, if needed. At the same time, there was no evidence of deflation taking root.[in Greece it´s down to -2.9%!)

“We have not even taken the first step towards deflation, that would be the de-anchoring of inflation expectations.” [Old Japan, here I come!]

Commenting further on the inflation outlook he said that inflation would accelerate gradually to the ECB’s target.

“Staff forecasts say the inflation will gradually recover and will come back towards 2 percent in 2015 and presumably back to 2 percent at some later point, but not so long after the expiration of the forecasts.”

Earlier this month, the ECB released new staff economic projections that forecast inflation of 1.3 percent for 2015. [Where is he getting his information?]

To show how “heartless” he is:

Turning to the ECB’s forward guidance, Coeure said this was based solely on the inflation outlook and the ECB would not refrain from hiking rates if inflation was seen rising above target. The euro zone central bank broke in July with its tradition of never pre committing, stating that it expected to keep interest rates low for an extended period of time.

“We are not on that line, not at all, we will not change our reaction function,” Coeure said. [He draws the gun fast with his “right hand” but is terribly slow with “his left hand”!]

HT Patricia Stefani

Hope fades!

Rereading Carney´s speech from December of last year, it was not as “revolutionary” or even novel as I and several people thought at the time:

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.19 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 (Chart 4).

Bank of Canada research shows that, under normal circumstances, the gains from better exploiting the expectations channel through a history-dependent framework are likely to be modest, and may be further diluted if key conditions are not met.  Most notably, people must generally understand what the central bank is doing – an admittedly high bar.20

However, when policy rates are stuck at the zero lower bound, there could be a more favourable 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.21

Gone more or less unnoticed was a speech he had given much earlier at the BIS in February 2012:

In exceptional circumstances, including the zero lower bound, NGDP could work. But he also said it could be terrible:

In the worst case, if nominal GDP targeting is not fully understood or credible, it can, in fact, be destabilizing.


NGDP-level targeting may thus merit consideration as a temporary unconventional monetary policy tool. But NGDP targeting does not, in our view, amount to a complete policy framework. What is needed is a robust framework that remains appropriate and well understood under any circumstances.

Almost two years later he is even more ‘unexciting’: In a speech today he says:

The Ghost of Christmas Yet to Come suggests that it is unlikely that equilibrium interest rates will return to historically normal levels any time soon. This prospect puts a premium on macro-prudential policies and financial reforms to manage the associated risks without abandoning the need to keep interest rates in line with the equilibrium level. [let´s be plumbers!]

So while it is unsurprising that the ideas behind secular stagnation are being revived, it would be a mistake to rush to a more extreme macroeconomic response. There is a long history of pessimism in economics, from Thomas Malthus through Alvin Hansen to Robert Gordon. Such worries have proven misplaced in the past and skepticism is warranted now. Don’t forget that the US economy is more than 13 times larger than when Hansen first formulated his ideas. [History is on our side, so let´s be patient]

Similar performance must again be possible. Central banks are playing a catalytic role to help deliver it but their contribution will ultimately be limited. The most important drivers of long term prosperity will be measures taken by others to increase the growth of supply, particularly those that reinforce an open, global economy. Such good deeds will truly merit the goodwill of all men and women.

“The Ghost of Christmas Yet to Come suggests that it is unlikely that equilibrium interest rates will return to historically normal levels any time soon”. Translation: Things are going to be quite bad for a long time” and: unfortunately, “our contribution will ultimately be limited”!

I remember when almost everyone thought that Greenspan was the most powerful man on the planet!

A current account deficit in Japan is a good sign!

From the WSJ: “Japan May Soon Start Losing Wealth”

Japan may still be the world’s largest creditor nation, but it is likely to starting losing some of its wealth within the next couple of years, as its broadest trade measure lurches closer to its first annual deficit in more than 30 years.

Japan has posted a current account surplus every year since 1981, on the back of its strong exports and overseas investment income.

Analysts point to the declining competitiveness of Japanese manufacturing sectors, such as electronics. More innovation is taking place overseas, such as the iPhoneand smartphone technology in general, prompting Japanese consumers to spend more on imported items than on domestic products.

Currently helping to mask (!) the severity (!) of the situation — at the balance of payments level at least — is the huge influx of foreign money into the Japanese stock market [why would that be?]

In October, foreigners were net buyers of Japan stocks to the tune of ¥814.8 billion. In November, their net buying reached a whopping ¥2.6 trillion, the biggest since April, amid continued hopes for Abenomics — Prime Minister Shinzo Abe’s bold pro-growth policies. The inward flow of money helped boost the volatile capital account, which together with the current account comprises the balance of payments. The overall capital account recorded a surplus of ¥407.3 billion.

There is a mercantilist streak in those analyzing the external situation of a country. “To sell is good, buying bad!”

And those trends have materialized at the same time that the yen/USD has been on a rising trend for a whole year, something almost unheard of since 1971 when Nixon closed the “Gold Window”, with stocks following along for the ride!.


Japan is no longer the “carry trade” vehicle. It has become THE trade!

The world would be a boring place without the “fiscal stimulus debates”!

From Wouter Den Haan of the LSE:

In the community of academic macroeconomists, the crisis has made it very fashionable to work with Keynesian models, especially models in which a lack of demand deepens crises and possibly even prevents a recovery. Several “fresh-water” macroeconomists, who traditionally focus on the supply side, are now considering animal spirits and demand shocks. In fact, quite a few macroeconomists argue that austerity has such a strong negative effect on gross domestic product (GDP) that it would increase the ratio of government debt to GDP.

This is remarkable. From the early eighties until the onset of the financial crisis, macroeconomic textbooks taught us that fiscal policy is not effective in dampening business cycles. These days there are many new models that would give politicians justification to engage in fiscal stimulus, at least in the current circumstances. Interestingly, politicians have pretty much ignored these views, except during the initial phase of the financial crisis.

Britain’s coalition government definitely has done this, but this restraint is not limited to conservative politicians who prefer small governments. This is ironic. One of the traditional reasons that macroeconomists gave against the use of fiscal policy to affect business cycles is that the profligacy and unreliability of politicians would mean that fiscal policy would be hard to implement sensibly. These days, academic macroeconomists want to spend and politicians do not.

Even Paul sows confusion about the power of fiscal stimulus

Paul Krugman in 1998:

It seems to be part of the folk wisdom in macroeconomics that this is in fact how the Great Depression came to an end: the massive one time fiscal jolt from the war pushed the economy into a more favorable equilibrium. However, Christina Romer contends that most of the out- put gap created during 1929-33 had been eliminated before there was any significant fiscal stimulus. She argues that the main explanation of that expansion was a sharp decline in real interest rates, which she attributes to monetary policy (although most of the decline in her estimate of the real interest rate is actually due to changes in the inflation rate rather than the nominal interest rate). Indeed, Romer estimates that for most of the recovery period ex ante real rates were sharply negative, ranging between -5 and – 10 percent.

My point is that the end of the Depression, which is the usual, indeed perhaps the sole, motivating example for the view that a one-time fiscal stimulus can produce sustained recovery, does not actually appear to fit the story line too well. Much, though by no means all, of the recovery from that particular liquidity trap seems to have depended on inflation expectations that made real interest rates substantially negative.

But in 2011 he embraces the “folk wisdom”:

As regular readers know, I’ve pointed out that World War II ended the Great Depression. Then critics say, how could war, a destructive activity, do anything good? I answer that when the economy is in a liquidity trap, there are a lot of perverse consequences. And then the critics declare that I’m a warmonger.

For a countervaling view see here:

In his 2008 book, The Return of Depression Economics and the Crisis of 2008, Paul Krugman writes: “The Great Depression in the United States was brought to an end by a massive deficit-financed public works program, known as World War II.”

Update: Another Paul (Samuelson), who believed the war had ended the GD, (naturally) predicted in 1943:

“The final conclusion to be drawn from our experience at the end of the last war is inescapable—were the war to end suddenly within the next 6 months, were we again planning to wind up our war effort in the greatest haste, to demobilize our armed forces, to liquidate price controls, to shift from astronomical deficits to even the large deficits of the thirties—then there would be ushered in the greatest period of unemployment and industrial dislocation which any economy has ever faced.”

HT Becky Hargrove