The Fed´s “two-step” dance

From today´s Minutes:

The information on economic activity received since the staff prepared its forecast for the September FOMC meeting was close to expectations, and therefore, the staff’s projection for real GDP growth over the remainder of the year was little revised. However, in response to a further rise in the foreign exchange value of the dollar, a deterioration in global growth prospects, and a decline in equity prices, the staff revised down its projection for real GDP growth a little over the medium term.

Even with the slower expansion of economic activity in this projection, real GDP was still expected to rise faster than potential output in 2015 and 2016, supported by accommodative monetary policy and a further easing of the restraint on spending from changes in fiscal policy; in 2017, real GDP growth was projected to step down toward the rate of potential output growth. As a result, resource slack was anticipated to decline steadily, albeit at a slightly slower rate than in the previous projection, and the unemployment rate was expected to gradually improve and to be at the staff’s estimate of its longer-run natural rate in 2017.

The staff’s forecast for inflation this quarter and early next year was reduced in response to further declines in crude oil prices, but the forecast for inflation over the medium term was only a touch lower. Consumer price inflation was projected to be lower in the second half of this year than in the first half and to remain below the Committee’s longer-run objective of 2 percent over the next few years. With resource slack projected to diminish slowly and changes in commodity and import prices anticipated to be subdued, inflation was projected to rise gradually and to reach the Committee’s objective in the longer run.


Expansion of economic activity is expected to be slower but RGDP was still expected to rise faster than potential in 2015-16!

Resource slack is expected to diminish slowly. This seems inconsistent with RGDP expected to rise faster than potential!

They say 2% inflation is years away!

And they think monetary policy is supportive!

To repeat a chart from yesterday´s post, monetary policy is supportive if by supportive you mean it is successful in keeping the economy in a depressed state (of (too) low real growth, (too) low inflation and low employment).

But even that will look good if the Fed engages in the “two-step”!

Two Step

The unending (and frustrated) search for inflation

In The Risks to the Inflation Outlook SF Fed researcher Vasco Cúrdia writes:

Figure 1 shows that the median inflation forecast is not expected to return to the FOMC target of 2% until after the end of 2016. The uptick in inflation in the first half of 2014 could lead one to believe inflation is finally on the path back toward its target. However, inflation has shown similar patterns several times before and each time the uptick has never lasted very long. According to this model, we should not see inflation begin to recover more firmly until around the end of 2015.

The model explains that persistent effects from the financial crisis are the main reason inflation is expected to remain low for so long. The financial crisis disrupted the credit market, leading to underinvestment and underutilization of resources in the economy. This slowed the economic recovery and pushed inflation down more than 2 percentage points, according to the model.

In contrast, the model suggests monetary policy pushed inflation up by 0.8 percentage point. This is expected to fall to zero by the end of 2016. Comparatively speaking, monetary policy appears to be far from causing excessive inflation under present circumstances.

Frustrated Search_1

It´s much more straightforward than that. It all boils down to how the Fed handles nominal spending (NGDP). The set of charts illustrate for different periods.

The 1970s harbored the “Great Inflation” because the Fed “manned” NGDP growth on an upward trend. Things get “shaky” when an oil shock hits, but the inflation trend is basically determined by the NGDP growth trend.

Frustrated Search_2

The 2001 recession saw NGDP growth fall way below the trend growth level. When the Fed became “smart” it decreed “forward guidance”, letting everyone know that spending growth would be such as to take NGDP back to the trend level.

Frustrated Search_3

Going into the “Great Recession” the Fed gets “confused” by the oil price shock and lets NGDP growth slide (and then tumble) down, bringing both real output AND inflation down with it!

Frustrated Search_4

The recovery starts off with the Fed introducing QE1. The NGDP “airplane” takes off, but “levels-off” long before reaching the previous “height”.

Frustrated Search_5

So that, at the new lower “cruise level”, we get “phony” nominal stability, which is associated with lower RGDP growth and lower inflation, sometimes temporarily disturbed by oil (supply) shocks.

Frustrated Search_6

Bottom line: If the Fed does not “recalibrate” the “plane´s height”, and accelerates towards it, inflation will simply not get back to target!

John Cochrane Defiantly Takes On Economic History

A Benjamin Cole post

As I predicted, the right-wing has gone past its fixation on absolutely dead prices as an economic cure-all and moral imperative, to the even-better nirvana of…deflation.

I wish I was making this up.

But comes now University of Chicago scholar John Cochrane, path-breaking with stalwart allies such a FOMC member Charles Plosser, that deflation is an economic elixir, not a sign of stagnation. Cochrane authored a recent The Wall Street Journal op-ed genuflecting to southerly price drifts.

I just don’t get it.

Recent Economic History

Okay, let’s look at the United States, 1982-2007. That’s a 25-year stretch, and recent too. In 1982 the U.S. GDP was $5,865.9 billion. It rose to 13,206.4 billion in 2007 (both figures in 2005 dollars).

That is a real increase of 125.1%, or an annual compounded rate of 3.3% real, for 25 years running, with all the imperfections and structural impediments that the U.S. economy has.

In the real world, the U.S. economy performed well 1982-2007. That is not debatable.

The rate of inflation? In the 25-year period prices rose 114.8%, so the inflation rate was about 3% a year. Except for 1982, inflation was always below 6% and, and only twice below 2% in the 25 years. In other words, moderate inflation in the 2% to 4% range was the norm. It worked.

For most of that period of prosperity, moderate inflation was accepted across the political spectrum. And why not?


There was a modern nation that passed through deflation, which regular readers know was Japan. From 1992 to 2012, Japan had mild deflation.

Looking to the St Louis Fred series, we have to go with 1990 to 2011 figures (due to data discontinuations), and we find Japan had a real annually compounded GDP growth of less than 1%, or 0.91%, through that 21-year period.

Japan’s real growth rate was one-third of that of the United States, when we compare their mildly deflationary period (1990-2011) to the mild-to-moderately inflationary period (1982-2007) of the United States.

If you are old enough, you remember in the 1980s when Japan was hailed for its lack of structural impediments, for its cooperation of government and business that created the biggest business boom of all history. By the 2000s, some economists said it was structural impediments holding Japan back.

In fact looking at the yen’s exchange rate and deflation, it seems much more likely the Bank of Japan held Japan back.


Cochrane is correct in some regards; mild deflation does not coincide with recession, only with very, very sluggish real growth. Yes, the U.S. can probably go to mild deflation, and it will only look somewhat slower than 2008-2012. If you have a sinecure at an academic institution, maybe that is fine.

But Cochrane ignores the bigger picture: Robust growth is associated with moderate inflation.

In the end, based on recent and cogent historical experience, it comes down to this: Should we forego trillions of dollars of real output just to bring a subjective index of prices (CPI or PCE) to a dead halt, or even into deflation territory?


Zimbabwe: “Show-case” for “Neo Fisherites”

Lately, Nick Rowe has given a lot of time and thought to get a handle on “Neo Fisherism”. I think that at the end of his latest post on the subject he nails it:

I am of the view that the Bank of Canada targets 2% inflation (or NGDP or whatever), and it adjusts the nominal interest rate (or base money or whatever) to hit that target, and its actions affect its profits, and those profits affect the government’s spending and taxation decisions. In the long run, the government adjusts its budget to be consistent with the Bank of Canada’s actions. Not vice versa. We saw that adjustment in 1995.

Zimbabwe, under Mugabe, is different. The guy with the AK47 chooses how much currency you print for him to spend, even though he does give you a bond in return. And the higher the price level the more currency he wants you to print for him. Raising the nominal rate of interest on bonds lets you sell more bonds and withdraw currency from circulation, but also means you must print currency even faster to pay the higher interest. Because the guy with the AK47 is going to make you print enough additional currency to pay the interest on the bonds he issued. That’s a Neo-Fisherite world.

The “show-case” for Market Monetarists is quite different (and much more palatable). You can choose from things like the “Great Moderation” or Australia´s quarter century absence of recession!

Keynes returns. In fact, he should be “sanctified”…

´´´so that economists could claim having a patron saint taken from their ranks!

Peter Temin and David Vines make a contribution to that effort in Why Keynes is important today:

Ricardian Equivalence is a theory that concludes that any expansion of public spending will be offset by an equal and opposite decline in private spending. The theory is based on a few important assumptions. It assumes forward-looking consumers who adjust their current spending in anticipation of future taxes to pay for the spending. Under these conditions, any increase in current spending leads consumers to anticipate a rise in future taxes and decrease their current spending to save for this.

This theory dominates current macroeconomic discussion. It fits into the form of current macroeconomics that assumes not just forward-looking consumers, but flexible prices as well. And if a Keynesian suggests fiscal policy in current conditions, a modern economist is likely to invoke Ricardian Equivalence.

Remembering the past

Keynes faced exactly this opposition in 1930. He was a member of the Macmillan Committee convened by the British government to analyse the worsening economic conditions of that time. His recommendation for increased government spending – what we now call expansive fiscal policy – was opposed by Norman and other representatives from the Bank of England. They did not invoke Ricardian Equivalence because it had not yet been formulated; instead they simply denied that increased government spending would have any beneficial effect.

Keynes opposed this view, but he did not have an alternate theory with which to refute it. The result was confusion in which Keynes was unable to convince a single other member of the Macmillan Committee to support his conclusions. It took five years for Keynes to formulate what we now call Keynesian economics and publish it in what he called The General Theory.

He based his new theory on several assumptions, two of which are relevant here. He assumed that consumers are only forward-looking part of the time, being restrained by a lack of income at other times, and that many prices are not flexible in the short run wages in particular are ‘sticky’. These assumptions give rise to involuntary (Keynesian) unemployment which expansive fiscal policy can decrease.

Which theory is relevant today? We know that wages are sticky – countries in Southern Europe have found it impossible to implement requests from their creditors that they reduce wages swiftly. And we know that not all private actors in the economy are forward-looking. Before the crisis, borrowing and spending increased in ways that could not be sustained;  now consumers are not spending and business firms are not investing even though interest rates are close to zero.

Those are the conditions described by Keynes in which expansive fiscal policy works well. They also are the conditions in which monetary policy does not, even though modern macroeconomic policymakers came to rely entirely on monetary policy for stabilisation. There is a disconnect between the needs of current economies and theories of current macroeconomists.

Doomed to repeat it?

What to do? In many applied disciplines, like medicine, practitioners go back to basics when the facts change. If their current practice fails to produce the desired result, they search their armamentarium for others.  If their assumptions prove wrong, they look for more appropriate ones. But not modern macroeconomists – they say we must simply endure what they call secular stagnation.

This is an unhappy prediction. Monetary policy does not work today; instead, this is the perfect time for fiscal policy. There are immediate needs to repair roads and bridges, rebuild energy grids, and modernise other means of travel. Expansive Keynesian fiscal policy will benefit the economy in both the short and long run.

A quarter century ago, however, Peter Temin teamed up with Barrie Wigmore to write “The end of one Big Deflation”:

This paper provides a new account of the recovery from the Great Depression in the second quarter of 1933. Our argument is that President Roosevelt established a new macroeconomic policy regime shortly after his inauguration in March 1933 that altered expectations and stimulated investment. The key to this change was Roosevelt´s devaluation of the dollar and the resulting rise in farm prices and incomes….

So monetary policy was effective at a time (Great Depression) where the economic situation was an order of magnitude worse than today? What made Temin change his mind?

Interestingly, Cassel had explained, before the fact, both how a country could get into a Great Depression AND how it could come out of it. “Going into and getting out of” was the consequence of monetary policy!

I think economists should look for their “patron saint” elsewhere!

Deflation targeting @2%

“Neo Fisherite” John Cochran writes in the WSJ “Who’s Afraid of a Little Deflation?”:

According to the conventional worldview, the economy is inherently unstable. Central banks control inflation the way you balance an upside-down broom, with interest rates on the bottom and inflation on top. Central banks have to actively move interest rates around to keep inflation and deflation from breaking out. And if they want more inflation, they must temporarily move interest rates the wrong way, let the inflation increase, and then move quickly to stabilize it.

Hence the zero-bound worry. When interest rates hit zero and the Fed can’t move the broom handle any more, the top of the broom must topple into deflation. Except we hit the zero bound, and almost nothing happe

“The danger now is inflation,” warned University of Chicago economist and Paul Ryan dinner companion John Cochrane in 2009. He warned of this again in 2010.

And again in 2012(“Inflation Should Be Feared”).

Inflation has stayed very low. And look, here is John Cochrane in today’sWall Street Journal editorial page, no longer warning of inflation. Now he is arguing that deflation might be coming, but it’s not so bad.

Yes, that is Professor Cochrane tearing down the goalposts and moving them several miles back.

ned. Maybe the economy isn’t so inherently unstable and in need of constant guidance after all.

Bottom line? Relax. Every few months we hear a new “biggest economic problem” from which our “policy makers” must save us. Wait for the next one.

Maybe being 1990-2012 Japan is every country´s dream (except Japan´s)!

Update: And here´s Jonathan Chait on John Cochrane the “inflacionista”:

“The danger now is inflation,” warned University of Chicago economist and Paul Ryan dinner companion John Cochrane in 2009. He warned of this again in 2010.

And again in 2012(“Inflation Should Be Feared”).

Inflation has stayed very low. And look, here is John Cochrane in today’sWall Street Journal editorial page, no longer warning of inflation. Now he is arguing that deflation might be coming, but it’s not so bad.

Yes, that is Professor Cochrane tearing down the goalposts and moving them several miles back.


“Improved” Fed Communication means “you´re free to speak your mind” (and the consequences be damned)

Volker still remembers a thing or two:

“The fate of the Federal Reserve can’t depend on the accuracy of the forecasts it makes two years ahead,” he said. Offering up forecasts with greater frequency and details–the Fed now does this on a quarterly basis–simply demonstrates to the public “more frequently the forecasts aren’t that accurate.

Fed guidance that has at points pointed to calendar-date expectations of rate increases, as well as official guidance that rates will stay very low for a long time to come, are ultimately unproductive, he said. “If you make it precise in terms of interest rates, then the market begins working against you,” and any disconnect between what the Fed promised and what it’s delivering can cause market trouble, he said.

Mr. Volcker also said that officials, other than the Fed leader, are talking too much these days and making it harder for the central bank leader to deliver a coherent message about the policy outlook.

It seems like “it’s kind of reaching a peak” for officials speaking out, Mr. Volcker said. He zeroed in on the rising tide of officials’ dissenting votes at Fed meetings in recent years.

“You can dissent if you feel strongly enough,” Mr. Volcker said. “But unless you are willing to do that with some restraint you probably shouldn’t be in the Federal Reserve.

Playing safe (and absolving the Fed)!

Mark Thoma comments on this piece from the Fed Board of Governors: “Potential Output and Recessions: Are We Fooling Ourselves?”:

The economic collapse in the wake of the global financial crises (GFC) and the weaker-than-expected recovery in many countries have led to questions about the impact of severe downturns on economic potential. Indeed, for several major economies, the level of output is nowhere near returning to pre-crisis trend (figure 1). Such developments have resulted in repeated downward revisions to estimates of potential output by private- and public-sector forecasters. In addition, this disappointment in post-recession growth has contributed to concerns that the U.S. economy, among others, is entering an era of secular stagnation. However, the historical experience of advanced economies around recessions indicates that the current experience is less unusual than one might think. First, output typically does not return to pre-crisis trend following recessions, especially deep ones. Second, in response, forecasters repeatedly revise down measures of trend.


Contrary to early research on deterministic versus stochastic trends, it appears the US economy followed a deterministic RGDP trend path, in which case after being buffeted by shocks the economy went back to trend. One of the charts follows:

Unit Root

At the end the authors consider:

Although these calculations are simple, they raise deeper questions about the impact of recessions on trend output. The finding that recessions tend to depress the long-run level of output may imply that demand shocks have permanent effects. The sustained deviation of the level of output from pre-crisis trend points to flaws in the way the economics profession models the recovery of output to economic shocks and raises further doubts about the reliance on measures of output gaps to determine economic slack. For policymakers, the results also point to the cost of recessions, especially deep and long ones, and provide a rationale for strong and rapid policy responses to economic downturns.

Not to be upstaged Mark Thoma adds:

One note: I want to emphasize that “the results also point to the cost of recessions, especially deep and long ones, and provide a rationale for strong and rapid policy responses to economic downturns.” An important question is how much of the permanent effect can be avoided with a correct and timely policy response — something we surely did not get with fiscal policy in the most recent episode.

And I add: Something we didn´t get from monetary policy either!

Bad decisions follow from bad analogies

In “Wall Street Has Decided It’s Time For The Fed To Raise Interest Rates” we read:

US workers are quitting their jobs like crazy.

On Thursday, the latest JOLTS report from the BLS showed that the quit rate for US workers rose to 2% in September, with total job quits rising to 2.8 million, a six-year high.

And the read-through on quits is this: workers will quit their job if they are more confident they can find another one.

In a note following that announcement, Chris Rupkey, chief financial economist at MUFG, wrote that the Fed’s statement implied it had “capitulated” and became willing to admit that there is real strength in the economy and the labor market, despite inflation that remains below the Fed’s 2% target.

And in an email following Thursday’s JOLTS report, Rupkey reiterated this stance, writing:

“Fed Chair Yellen has famously pointed to the Quits Rate also in these Jolts data. If you feel secure enough to quit your job then the economy must be pretty good. Well, the Quits Rate jumped in September to 2.8 million people from 2.5 million in August. The number of Quitters out there in the economy, you know who you are, is just the same now as it was back in 2004 when the Fed started normalizing interest rates.” 

The point is that in 2004 the Fed started to “normalize” interest rates because NGDP was back on trend. It certainly doesn´t look like that now, even assuming a lower trend level. Also note that quits and hires started moving up when NGDP began to rise in mid-2009. In short, there´s a lot of “Quits & Hires” to take place before we get close to anything that could be called “normal”.

Quits & Hires

HT Travis V

In the land of the blind,” the one-eyed country is king”

Every country wants to be top-of-the-heap. It would be funny if it weren´t tragic!

In the US:

When Jack Lew took over at Treasury a little less than two years ago, the rest of the world was still blaming the U.S. for triggering the worst global financial crisis in generations. Today, the U.S. is doing better than nearly any other advanced economy.

So the Treasury secretary feels comfortable in doing a little boasting (“We have created more jobs since the pre-crisis peak than Europe and Japan combined”) and in offering some be-more-like-us economic advice to Germany and Japan.

The “be-more-like-us” parody goes around. That´s exactly what Germany “advises” to her “minions”.

Jack Lew doesn´t grasp that the US is a little ahead because it´s monetary policy has been somewhat better, although that may be about to end.