Back in April 1997, while still a ‘freshman’ Fed Board member, Laurence Meyer gave a milestone speech at the Forecasters Club of New York. For the first time, I think, a board member provided a detailed account of his decision process framework.
One month earlier, the FOMC had changed (raised) interest rates for the first time since having reduced it in February 1996.
I am going to offer some interpretations of the outlook as a context for the recent policy action by the Federal Reserve and explain how I view this action as part of a prudent and systematic strategy for monetary policy. The Forecasters Club of New York is an ideal forum for me to offer this commentary because, in my view, the recent policy action must be understood not in terms of where the economy has been recently, but rather in terms of the change in the forecast, a change in expectations about where the economy likely would be in six or twelve months in the absence of a policy change.
Despite the sharpness and force of the Phillips Curve/NAIRU model, it can be difficult to implement in practice. Still, this relationship was about the most stable tool in the macroeconomists’ tool kit for most of the past 20 years; those who were willing to depend on it were likely to be very successful forecasters of inflation, and the record speaks for itself on this score. Nevertheless, the combination of the 7-year low in the unemployment rate and 30-year low in inflation was a surprise to those using this framework. The challenge is to understand why we have been so fortunate…
So, what was going on and what did come about? The charts illustrate.
Inflation had been stable while unemployment was trending down. Almost immediately following the speech, the fall in unemployment increased and inflation ‘shot down’!
The more convincing story behind this fact was the productivity increase that was taking place (helped out by the steep drop in oil prices following the Asia crisis, although this did not have much effect on core prices). Anyway, such positive supply shocks reduce inflation and increase growth (reduce unemployment).
In short, contrary to Meyers (and most in the FOMC) view, there was no ‘dangerous’ increase in resource utilization.
The rate increase was of the “one and done” kind. Much later, following the Russia/LTCM event in August 1998, rates were reduced.
The next chart indicates that NGDP was evolving close to trend, growing close to 5.5%. When Russia/LTCM happened, the growth in AD was increased. This turned out to be excessive. We know that because it ignited a cycle to nominal spending that first went too high and later was brought down too low, only being stabilized again towards the end of Greenspan´s tenure in early 2006!
The “too much nominal growth” leg is seen in the next chart, which indicates that money growth more than offset the fall in velocity, especially following Russia/LTCM.
Jumping to the present, apparently nothing has changed because now we read:
Federal Reserve officials might raise interest rates soon because they have a theory: Falling unemployment pushes up prices and wages, requiring tighter credit to keep inflation in check.
David Altig, research director at the Atlanta Fed is quoted:
We haven’t lost faith in the framework described by Mr. Phillips and his successors, that a tight labor market generates higher inflation, said David Altig, research director at the Atlanta Fed. But the numbers that you would plug into that framework and the exact levels at which the pressures begin to emerge, we’re not so clear on those.
In economics, it´s interesting to observe how some things, especially those that require “estimation”, become “gospel” and, despite their suspicious origins, never go away, being endlessly “reestimated”.
When Modigliani and Papademos (yes, the same one who later became head of the Central Bank of Greece and then its Prime Minister) “invented” NAIRU (NIRU at the time) in a BPEA paper in 1975, their clear aim was to downplay “monetarism” and argue for monetary expansion expansion based on the fact that NAIRU/NIRU was above its “non accelerating rate”:
At this point the analysis confronts a widely held concern, encouraged by at least some monetarists, that such a rapid rate of growth and sudden acceleration of the money supply , would unfavorably influence prices and inevitably set off a new round of inflation.
Our analysis indicates that such concerns are unfounded; it implies that inflation systematically accelerates only when unemployment falls below NIRU, and the M1 growth that we expect will be needed as component of a policy package aimed at approaching NIRU from above over the next two years.
We all know how that turned out!
Today, New York Fed chief Dudley apparently moved markets by saying:
From my perspective, at this moment, the decision to begin the normalization process at the September FOMC meeting seems less compelling to me than it was a few weeks ago,” he said.
But he also said:
Responding to a question about whether a Fed move will come in a subsequent 2015 FOMC meeting, Dudley said he “really” hopes to raise rates this year, but “let’s see how the data unfold before we make any statements about exactly when that might occur.”
And I say: I really hope a large rock will fall on my head this year!