More “debate” with Mian and Sufi´s “House of Debt”

Recently I´ve been having a “debate” with Atif Mian and Amir Sufi (A&A)(here, here). Now they write “Monetary Policy and Secular Stagnation”:

The Federal Reserve directly controls the short-term interest rate. But what it really tries to target is inflation and its expectations. The Fed’s goal is to achieve the target of 2% inflation in the long-term, and its preferred price index is the core personal consumption expenditure price index that excludes the volatile food and energy sectors (or core PCE for short). So how has the Fed performed in achieving its target of 2% inflation in the past 15 years?

And show a version of this chart:

The chart above plots the implied core PCE index if inflation had met its 2% target (red line), and the actual core PCE index (blue line) starting from 1999.  The blue line is consistently below the red line, the gap has only diverged further since the Great Recession. The cumulative effect is that today the price level is 4.7% below what it should have been had the Fed achieved its long-run target.

They´re quite right to say that what the Fed “really tries to target is inflation and its expectations”. But until very recently (January 2012) that was just an “implicit” target. In fact, Greenspan was staunchly against making any target explicit. That was Bernanke´s pet project. What the Fed said it wanted was “low and stable” inflation.

The other thing wrong with A&A´s argument is that they are discussing a “Price Level Target (PLT) and surely that was not what the Fed was targeting, even implicitly. A PLT differs from an Inflation Target (IT) in that while in the former bygones are not bygones, in the latter they are.

A&A continue misleading their readers:

The divergence between target and actual inflation is all the more striking given the elevated rate of unemployment during the sample period. We have discussed in a previous post how the post-2001 and post-2009 recoveries were “jobless” – a recovery in output but not much in employment. The Fed has a dual mandate – inflation targeting and maximizing employment. It is traditionally believed that there is a trade-off between the two and a higher level of unemployment permits the Fed to go beyond its 2% inflation target (this is the famous Taylor rule). Yet the Fed has failed to achieve its target inflation despite high unemployment rates.

To say the level of unemployment was “elevated” during the sample period is very misleading. For the 1999-07 period the average rate of unemployment was a very low by historical standards 4.9%, only going up strongly when the crisis hit. And PCE-Core inflation averaged 1.9% in 1999-07, therefore very close to the 2% implicit target rate! [Note: In my posts “debating” A&A linked to above, I have shown what really caused the jobless recovery after the 2001 recession as well as the job loss recovery in the present cycle]

They go on:

It is hard to fault the Fed for not trying – it brought short term rates to zero for an extended period of time, and bought trillions of dollars in bonds. Yet the gap between the red and blue lines continued to diverge.

The Fed’s difficulty in maintaining a 2% target is not just about the Great Recession. The divergence started in the 2000′s despite the Fed keeping nominal rates quite low by historical standards. In fact the only period when the blue line runs parallel to the red (implying a 2% rate of inflation for a while) is the 2004-2006 period when the economy witnessed an unprecedented growth in credit.

Their blog (and forthcoming book) is called “House of Debt”, so debt has to figure prominently in their argument. But as the chart shows, the debt/GDP ratio begin to rise strongly in 2000 (not 2004) and continued going up until 2007. Note that all the debt increase is explained by mortgage debt. For that one should look to the distorted incentives mostly provided by the government´s homeownership policy.

But it´s interesting that they note that prices picked up in 2004-06. That was not because of an “unprecedented growth in debt” but because with the Fed adopting forward guidance in August 2003, monetary policy became more expansionary and allowed nominal spending (NGDP) to climb back to trend after the nominal instability that marked the 1998-03 period. The chart illustrates:

A&A conclude:

What we are witnessing is the limit of what monetary policy alone can do. Sometimes there is a tendency to assume that the Fed can “target” any inflation rate it wishes, or that it can target the overall price level – the so-called nominal GDP targeting. The evidence suggests that the Fed may not be so omnipotent.

We are witnessing no such limit. What we are witnessing are the unsatisfactory effects of an Ad Hoc and timid stance of monetary policy (indicated by the lack of convergence of nominal spending towards trend). A&A also make the mistake of saying that PLT is the same as NGDPLT. As the first and last chart show, they´re not!