The “timidity” is embedded in the model

Krugman´s take on Abenomics:

…Now, even in this case you can get traction if you can credibly promise higher inflation, which reduces real interest rates. But what does it take to credibly promise inflation? Well, it has to involve a strong element of self-fulfilling prophecy: people have to believe in higher inflation, which produces an economic boom, which yields the promised inflation.

But a necessary (not sufficient) condition for this to work is that the promised inflation be high enough that it will indeed produce an economic boom if people believe the promise will be kept. If it isn’t, then the actual rate of inflation will fall short of the promise even if people believe in the promise – which means that they will stop believing after a while, and the whole effort will fail.

Here’s the picture I put up this morning:

Timidity Trap_1

On one side we have a hypothetical but I think realistic Phillips curve, in which the rate of inflation depends on output and the relationship gets steep at high levels of utilization. On the other we have an aggregate demand curve that depends positively on expected inflation, because this reduces real interest rates at the zero lower bound. I’ve drawn the picture so that if the central bank announces a 2 percent inflation target, the actual rate of inflation will fall short of 2 percent, even if everyone believes the bank’s promise – which they won’t do for very long.

So you see my problem. Suppose that the economy really needs a 4 percent inflation target, but the central bank says, “That seems kind of radical, so let’s be more cautious and only do 2 percent.” This sounds prudent – but may actually guarantee failure.

Who knows, after so many years of mild deflation and little real growth if someone came along ‘promising’ 4% inflation we would likely witness “mass suicide!”

I believe Japan´s authorities certainly made life more difficult by focusing on inflation. In Krugman´s ‘model’ that comes out very clearly so you can go to the ‘bad equilibrium’ (inflation too low and so also too low output).

Now, keep the ‘2% inflation target’ but change the model. Instead of having a model where everything ‘flows through interest rates’ (whereby higher expected inflation lowers the real interest rate and increases spending), we have a dynamic AS/AD model. Instead of (real) output on the horizontal axis we have real output growth. The Phillips Curve becomes the short-run aggregate supply curve (SRAS) and the AD curve is a rectangular hyperbola whereby all points along it represent the same rate of AD growth.

The adapted chart shows that to get to 2% inflation the BoJ has to increase the rate of AD growth through permanent injections of money. In this model, the BoJ´s credibility derives from observable facts. If the BoJ increases the growth rate of AD purposefully, it will necessarily hit the inflation target. Note that at that point real output growth will also have risen.

Timidity Trap_2

By then, the Japanese economy will be ‘out of the swamp’ so a new set of monetary policy rules and targets (the monetary regime) can be chosen. Hopefully they´ll try NGDPLT!

Look at the “real Mcoy”

Calculated Risk (Bill McBride) reposts (with updated comments) a piece from January 2013 in which he expressed “a few thoughts on the next recession”:

In addition to paying attention to incentives, we also have to be careful not to rely “heavily on the persistence of trends”. One of the reasons I focus on residential investment (especially housing starts and new home sales) is residential investment is very cyclical and is frequently the best leading indicator for the economy. UCLA’s Ed Leamer went so far as to argue that: “Housing IS the Business Cycle“. Usually residential investment leads the economy both into and out of recessions. The most recent recovery was an exception, but it was fairly easy to predict a sluggish recovery without a contribution from housing.

So right now I expect further growth for the next few years (all the austerity in 2013 concerns me, especially over the next couple of quarters as people adjust to higher payroll taxes, but I think we will avoid contraction). [CR Update: We avoided contraction in 2013!] I think the most likely cause of the next recession will be Fed tightening to combat inflation sometime in the future – and residential investment (housing starts, new home sales) will probably turn down well in advance of the recession. In other words, I expect the next recession to be a more normal economic downturn – and I don’t expect a recession for a few years.

That´s a perfect example of looking at components of Aggregate Demand (AD) to gauge the state of the economy. Why not look directly at the “most comprehensive measure of AD” – NGDP?

By not doing that he throws out that “it was fairly easy to predict a sluggish recovery without a contribution from housing”!

Not so. It was fairly easy because NGDP growth did not make up any of the level shortfall from the crash.

In fact, growth in residential investment has even returned to levels that prevailed before the crisis. But that´s unlikely to be sustained because NGDP growth is still below the pre-crisis level which indicates there´s still a wide spending gap.

We may not experience a recession, but we´re still “living inside a depression”. And beware the “inflation obsession”. It could certainly push us deeper.


What did the Fed signal about inflation?

In the words of Cardiff Garcia:

She [Yellen] doesn’t think inflation will threaten to breach the 2 per cent level so long as unemployment is “quite high”.

This could be read either hawkishly or dovishly.

The potentially hawkish interpretation is described by Tim Duy, who notes that such language reinforces the implicit, extant policy of 2 per cent as an inflation ceiling rather than a target.

The dovish reading is that if she doesn’t think this tradeoff is likely to be an issue, then it’s because she also thinks there is more labour slack than the unemployment rate is communicating — and therefore it’s unlikely that inflation will climb to its target even as the labour market improves.

But Narayana Kocherlakota didn´t like any of that because, according to him:

Mr. Kocherlakota emphasized that he thought the Fed needed to be aggressive in signaling to the public that it won’t tolerate inflation running below its 2% objective for a long time. The Fed’s preferred measure of inflation is now closer to 1%.

“We’re targeting 2%. We should be taking purposeful steps—that we’re describing clearly and articulating—to address that issue,” he said.

The Fed has a precise numerical inflation target- 2% – but feels a “winner” if inflation is persistently below!

Update: Jim Pethokoukis has reproduced an “award winning” comment by Robert Brusca, the last part of which reads:

The Fed continues to see lower rates of unemployment than it was projecting in the past. But the Fed’s own projections of growth are being trimmed. How does the unemployment rate make this accelerated progress? It’s all due to the magic of demographics. The Fed is relying on a continuation of a process it really does not understand and did not anticipate. It is willing to PLAN to raise rates on the notion that this process will continue. Who says the Fed ain’t got religion?

The Fed has not told you using its fabled transparency that this is the process by which unemployment rates will drop faster. Janet Yellen registers deep concern about all sorts of labor market characteristics but she is stopping QE which is the one thing the Fed was doing that might have helped. Moreover, the Fed is planning to raise the fed funds rate with inflation below target and expected to remain below target. Fed policy amounts to hoping that demographics will reduce the rate of unemployment faster. … While Janet urges you to ignore ‘the Dots’ I urge you to shred the Fed statement and to look only at ‘the Dots’ and the other projection materials. They describe the lay of the land and conditions where the Fed really plans to live. The statement is a cover story.

The “appropriate monetary policy” to tackle the Long Term Unemployment problem

At the Brookings Conference the Krueger et al paper – “Are the Long-Term Unemployed on the Margins of the Labor Market?” – made waves, being mentioned, summarized and commented in a large number of posts.

One year ago I did a post on the topic of long term unemployment which I titled “Chilling”, and that, I think, is the best description possible.

In this post, my point of departure is the very last words from the Krueger et al paper´s conclusion:

Some may wish to draw macroeconomic policy implications from our findings. Only time will tell if inflation and real wage growth are more dependent on the short-term unemployment rate than total unemployment rate. To us, the most important policy challenges involve designing effective interventions to prevent the long-term unemployed from receding into the margins of the labor market or withdrawing from the labor force altogether, and supporting those who have left the labor force to engage in productive activities.

Overcoming the obstacles that prevent many of the long-term unemployed from finding gainful employment, even in good times, will likely require a concerted effort by policy makers, social organizations, communities and families, in addition to appropriate monetary policy.

“Appropriate monetary policy” was an expression that at one time Greenspan used with some frequency to “calm markets”. When he used it the meaning was: “Trust me to get things right”. But Krueger et al don´t give it any particular meaning. Maybe they are just hinting that they support a continued Fed policy of low interest rates.

Given that the game has changed to bets on the date rates will start to move up, there´s not much hope there. In fact, the big problem is that the Fed has no monetary policy regime in place. The Fed is in practice groping in the dark. Not being able to say so they say things like “we  will monitor “a wide range of information” on the job market, inflation and the economy before approving any rate increase.”

As Scott Sumner argues:

Changes in aggregate demand impact housing, retail sales, industrial production, business investment and exports.  Those are all components of RGDP.  Aggregate demand also affects prices.  Both RGDP and prices are components of NGDP.  So in a sense NGDP is the most comprehensive measure of AD.  It’s the total dollar value of all spending on all domestically produced final goods and services.

Would NGDP (something the Fed could closely control) have any bearing on long term unemployment? Let´s appeal to our visual senses.

The chart shows NGDP growth and the long term unemployment rate (LTU) for the past 60 years. Note that in the 1950s NGDP growth bounces quite a bit. Long term unemployment “bounces” in close tandem and in the opposite direction.


Beginning in the mid-1960s and extending to the late 1970s we have a strong upward trend in NGDP growth (that was the age of the Great Inflation). Note, however, that long term unemployment remains relatively low and that happens despite some serious supply shocks (oil and commodity prices).

The Volcker “war on inflation” brings down NGDP growth. Long term unemployment jumps but quickly comes back to “normal” levels.  And throughout the Great Moderation from the mid-1980s the pattern is the same. LTU goes up during and immediately following recessions (shaded areas) but comes down to “normal” levels (around 10%).

In the 2001 cycle the Fed tightened excessively and before the positive effects on LTU from the Fed´s correction could be completed the Great Recession came about…

The next chart singles out the post 1985 period which encompasses both the Great Moderation and the Great Recession that follows it.

There´s a close correspondence between LTU and the NGDP gap. For example, the 1991 recession came about when the Fed worked to close the positive NGDP gap that had opened up. For most of the rest of the decade NGDP evolved close to its trend level path (“zero” gap) and LTU decreased continuously.


The excessive monetary tightening in the early 00s clearly shows up in NGDP falling below trend and in the rise in LTU, but in mid-2003 the Greenspan Fed (through “appropriate monetary policy”) moved to correct the error, bringing NGDP back to trend. LTU immediately backs down.

But then Bernanke came along and by adopting a rigid IT focused monetary policy – clearly the wrong policy for a country that had long before “conquered” the inflation beast and had the alternative of introducing an explicit NGDP targeting monetary regime – aborted the fall in LTU.

Later, by letting NGDP fall into the abyss, it caused the massive rise in LTU. And by not moving to close the gap it has maintained LTU at record high levels with all the economic and human costs that entails.

I wish Kevin Sheedy´s paper on “The case for NGDP targeting” also presented at the Brookings Conference had made more of a splash. It would help make clear the “solution” to the problem tackled in Krueger´ paper!

Simply and cogently argued

Kevin Sheedy of the London School of Economics makes a strong case for NGDP targeting: “Debt and Incomplete Financial Markets: A Case for Nominal GDP Targeting”.

From the abstract:

Financial markets are incomplete, thus for many households borrowing is possible only by accepting a financial contract that specifies a fixed repayment. However, the future income that will repay this debt is uncertain, so risk can be inefficiently distributed. This paper argues that a monetary policy of nominal GDP targeting can improve the functioning of incomplete financial markets when incomplete contracts are written in terms of money. By insulating households’ nominal incomes from aggregate real shocks, this policy effectively completes financial markets by stabilizing the ratio of debt to income. The paper argues the objective of replicating complete financial markets should receive substantial weight even in an environment with other frictions that have been used to justify a policy of strict inflation targeting.

Inflation Über Alles

James Pethokoukis notes:

Judge the new Fed chair’s debut as you will, but the bottom line is that Fed policymakers now expect rates to be a bit higher in 2015 and 2016 than they did previously. Also of note: The Fed de facto downgraded the efficiency of the US economy as seen in its projection of reduced GDP growth and unemployment. These changes suggest, from the Fed’s perspective, more structural weakness in labor markets and an economy that, the WSJ’s Justin Lahart explains, “generates more inflation at a lower rate of growth — a notion reinforced by the Fed’s stepped-up expectation of when it will be time to raise rates.” Despite the decline in labor force participation and the share of adults working, the Yellen Fed is suddenly concerned about the inflation risk of tight labor markets.

When you are lost you have only a vague idea of where you are and no idea whatsoever of where to go. To keep the kids in your party (which is lost in the woods) calm you sing “lullabies” to them.

Yellen´s “lullaby” is to reinforce the FOMC´s worries with inflation. They feel “safe” when stressing inflation. When the FOMC obsessed with that fictional monster back in 2008 we know what happened. But never mind, that´s all they can do after having put “blinders” on!

Update: And the “inflation exclusivity” is not just a purview of the Fed. The BoE also has its equivalents. This from Martin Weale, a BoE MPC member:

Mr. Weale’s remarks suggest that if the U.K. economy continues to improve then he may favor moving earlier to contain inflation than other members of the committee.

Monomania at The Federal Reserve? Or Just Dementia? Inflation: If You Can’t Find it With A Microscope, Then Use a Telescope

A guest post by Benjamin Cole

Would the United States Federal Reserve (and some economists) prefer which of these two scenarios:

  1. About 1.5 percent inflation, and about 1.5 percent growth for the next 10 years, or
  2. About 3 percent inflation, and 3 percent real growth for the next 10 years.

Sad but true, the Federal Reserve—at least that part of it expressed by the policy-making Federal Open Market Committee (FOMC)—would pick the first scenario.

The second scenario is a policy-buster, ushering in a sustained rate of inflation perhaps double the Fed’s “true” inflation ceiling, now about 1.5 percent.

Where does 1.5 percent, come from? David Beckworth, of the Macro and Other Market Musings blog, points out even Fed projections of inflation now fall below 2 percent, and yet the Fed is…complacent.

And a 3 percent inflation rate is beyond the pale.

So, by default the Fed would choose Scenario No. 1.

Yes, it is nuts.

It Gets Nuttier

Does anyone on the FOMC (with the possible exception of Narayana Kocherlakota, Minneapolis Fed President) even ponder if the 1.5 percent scenario is the lesser choice?

Perhaps the sentiments of the FOMC are summed up by Dallas Fed President Richard Fisher, who stated, “I consider inflation an evil spirit that rots the core of economic prosperity and must never, ever be countenanced.”

True, Fisher made that remark in the early 1980s when inflation soared out of control in the United States…actually, Fisher made that statement in 2009. In Japan. Yes, Japan. A nation in a deflationary quagmire.

But then not to be outdone, FOMC member Charles Plosser, the Philly Fed Bank chieftain, rhapsodized late last year about falling prices. “It’s not obvious a period of mild deflation is such a bad thing,” Plosser said at the Cato Institute.

If not by Microscope, Then by Telescope

Okay, so inflation is dead now, maybe at 1 percent, but trending down. It has been trending down for 30 years.

A central banker might fear ZLB-land. If they followed a trend-line with their finger, on a graph.

No matter. Some FOMC board members like to bring out telescopes and quaver about fleeting and marginally raised long-term inflationary expectations, for a period beginning five years from now, in the TIPS market (Treasury Inflation-Protected Securities).

“Distant inflation expectations from the TIPS market seem to suggest that investors do not completely trust the Fed to deliver on its 2 percent inflation target,” intoned James Bullard, St. Louis Fed Bank president, in a speech in Memphis, on October 5, 2012.

The “five-year forward break-even rate,” which then projected the pace of price increases starting in 2017, was at 2.77 percent on Oct. 2, 2012—and that is based on the CPI, which trends perhaps 40 or 60 basis points higher than the PCE deflator, upon which the Fed is supposed to key.

In short, Bullard was sounding the klaxons when the TIPS market suggested that in five years hence the rate of inflation might be 20 or 30 basis points above the 2 percent Fed target. A target that is supposed to be an average, not a ceiling.

The ironic upshot?

Now that same five-year forward TIPS break-even rate is down to 1.80 percent, starting in 2019.

In other words, the market expects the Fed to undershoot its 2 percent target, perhaps by 40 to 60 basis points, even five years from now.

Contrition at the Fed?

Will Bullard start warning about the need to boost monetary expansionism to get the TIPS market back to 2 percent inflation expectations? Well…most recently he is quoted as saying he expects inflation to start cooking again.

“There is no generally accepted explanation for the low inflation readings,” Bullard said in January of this year.

Were it not so serious, Bullard’s comment would be comical. Usually, very low inflation and interest rates are credited to, or blamed on, tight monetary policy. Oh, that?

But I like Bullard. When I tried to make it into the bigs as a pitcher, I had an ERA of 13.19 in double A. Often I wondered how the other teams scored so many runs.

Leaning Too Hard

As Marcus Nunes has so clearly chronicled in this blog, the Fed was too single-minded in trying to promote growth in the 1970s and early 1980s. Inflation rose into double-digits (though never close to hyperinflation). Back then, Fed Chief Arthur Burns felt inflation would not respond to monetary policy due to structural rigidities in the U.S economy.

Burns was wrong, as famed Fed Chairman Paul Volcker would show.

But Burns looks like a pillar of circumspection and balance compared to the cloistered, insulated monomaniacal Fed of today.

Today, our Fed and much of economics profession has drifted into a type of dementia, in which an obsession about inflation passes for analysis, while the purpose of macroeconomic policy—real, sustained growth—is lost in the verbiage.

It makes me nostalgic for Arthur Burns. You know, at least his heart was in the right place.

Monetary Policy becomes a “dating game”!

It´s become all about the date the FOMC will lift rates for the first time. When Yellen carelessly mentioned “Fall” and “six months”, it became October for the end of the taper and April for the first rate hike.

As Hilsenrath points out, there´s not even “much conviction”:

Ms. Yellen didn’t sound at all like a lady with much conviction on that six-month timeframe either. She was asked how long the Fed might wait to raise interest rates after the bond-buying program ends. The Fed’s official policy statement says it will wait for a “considerable time,” but what does that mean? Here is what she said:

“This is the kind of term it’s hard to define, but, you know, it probably means something on the order of around six months or that type of thing. But, you know, it depends. What the statement is saying is it depends what conditions are like. We need to see where the labor market is. How close are we to our full employment goal? That will be a complicated assessment, not just based on a single statistic. And how rapidly are we moving toward it? Are we really close and moving fast? Or are we getting closer, but moving very slowly? … Inflation matters here, too [an afterthought?]. And our general principle tries to capture that notion. If we have a substantial shortfall in inflation, if inflation is persistently running below our 2 percent objective, that is a very good reason to hold the funds rate at its present range for longer.”

But inflation has been running persistently below the 2% target for 5 years and is even going lower over the past two years.

In fact, monetary policy is not discussed at all, only interest rates are mentioned and on that score it´s about guessing the “date”.

In a recent post Scott Sumner wrote something which perfectly reflects what´s going on:

Unfortunately, we don’t have a coherent policy regime. We don’t know what the Fed is trying to do to NGDP. More importantly, we don’t know what they’ll do if they fail. That is an important part of a regime. Will they act as they did in 2008-09? Or will they have learned something, and act more appropriately (with some catch-up.) I hope it’s the latter, but the honest truth is that we simply don’t know.

During the Great Moderation we could at least infer that the Fed strived to maintain nominal stability (keep NGDP on a stable level path). Shocks happen, mistakes are made, but the important thing, as shown in the charts, is that “corrections” take place. But when you “open the gates of hell” you may feel all you have to do is “guesstimate” the date rates will began to climb!

Gates of hell

Inane comments

Gavyn Davies writes that it is likely that wages will emerge as the indicator that matters most for the FOMC.Even though we still have huge unemployment, we’re actually running out of employable workers, and a dangerous acceleration in the pace of wage increases is already underway.

Tim Duy writes that the path of rates currently expected by policymakers assumes a great deal of slack.  As a consequence, indications that slack is less than expected will tend to move forward the timing of the first rate hike and, perhaps the pace of subsequent tightening. Typically, the Fed tightens policy ahead of inflationary pressures, which, in practice, has meant hiking rates around the time wage growth bottoms out. Historically, the Fed tightens before wages growth accelerates much beyond 2%.

Robin Harding writes that the argument that the Fed should overshoot on inflation is wrong.

Tim Duy writes that wage acceleration tends to occur as unemployment approaches 6%.

The charts tell an interesting story.

Gates of hell

A few pointers:

During the productivity shock period unemployment and inflation come down. Wage growth increases.

After 1998, maybe influenced by the fall in inflation below “target” and/or the Russia Crisis (LTCM), the Fed allows NGDP to rise more than warranted (positive NGDP Gap). Inflation moves back to “target” but the Fed “tightens” excessively (negative NGDP gap opens). Unemployment climbs, wage growth subsides and inflation remains “tuned on target”.

Next step: Forward Guidance. And the “sky turns blue again”. Unemployment falls, wages rise and inflation stays “tuned on target”.

Then Bernanke comes along with his “rigid” IT script and soon the “Gates of Hell” open up!

Nowhere in that “dashboard” can you find a wage-inflation story!

A “Dove dissent”

There was some anticipation that the likes of Richard Fisher and Charles Plosser would push against the “for a considerable time” part of the statement. But no and surprise, this time we had a dove dissent, with (“born again”) Narayana Kocherlakota believing the “5th paragraphweakens the credibility of the Committee’s commitment to return inflation to the 2 percent target from below and fosters policy uncertainty that hinders economic activity:

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.

And he´s right! Inflation has been moving in the wrong direction and so has NGDP growth as the table below indicates. (Inflation is PCE-Core and NGDP is the monthly estimate from Macro Advisers)

Dove dissent

It seems that the FOMC has to work harder!

Note: During Yellens Press Conference there was a “scare moment” brought about by the words “next fall” (to end the asset purchase) and “six months” (april 15) (to begin the rate rise sweepstake). The Dow dropped 150 points.

Update (March 21): Kocherlakota explains his dissent