“The Way We Were”

Antonio Fatás writes “The missing lowflation revolution”:

It will soon be eight years since the US Federal Reserve decided to bring its interest rate down to 0%. Other central banks have spent similar number of years (or much longer in the case of Japan) stuck at the zero lower bound. In these eight years, central banks have used all their available tools to increase inflation closer to their target and boost growth with limited success. GDP growth has been weak or anemic, and there is very little hope that economies will ever go back to their pre-crisis trends…

… Now we have learned that either all central bankers are as incompetent as the Bank of Japan in the 90s or that the phenomenon is a lot more natural, and likely to be repeated, in economies with low inflation, more so when the natural real interest rates is very low…

My own sense is that the view among academics and policy makers is not changing fast enough and some are just assuming that this would be a one-time event that will not be repeated in the future (even if we are still not out of the current event!).

The comparison with the 70s when stagflation produced a large change in the way academic and policy makers thought about their models and about the framework for monetary policy is striking. During those years a high inflation and low growth environment created a revolution among academics (moving away from the simple Phillips Curve) and policy makers (switching to anti-inflationary and independent central banks). How many more years of zero interest rate will it take to witness a similar change in our economic analysis?

Fatás succinctly lays out the problem. Interestingly, since the late 1990s, many have been concerned about “Monetary Policy in a Low Inflation Environment”, among them, Bernanke himself! For those interested, I provide a nontechnical essay from 2001 (with references within).

Apparently, when “push comes to shove”, it was all forgotten!

For the past seven years, Market Monetarists, under the guidance of Scott Sumner have proposed a monetary regime change. The new regime would have the Fed (and other central banks) level target nominal GDP.

In a sense, this proposal simply involves making explicit something that was only implicit during the “Great Moderation”, being, in fact, responsible for that outcome. That´s good, because it won´t be a “shot in the dark”. We´ve been there.

Over the past seven years, people who never thought themselves as “market monetarists” have come out in favor. For example, Christina Romer, a former Obama head of the CEA and Harvard professor Jeffrey Frankel. Even Simon Wren-Lewis, a pillar of the New Keynesian school, is coming around to the idea.

There is however, one lose end. There´s a view that over the past five years, after partially recouping from the “Great Slump”, the economy lives through a “Great Moderation 2.0”. Unfortunately, the “GM 2.0” is also viewed as the “Great Stagnation”.

This is where the “Level Target” attached to “NGDP Targeting” comes in. To make the idea clear, I put up a set of charts that compare the “golden age” of the “GM 1.0”, the five years from 1992.IV to 1997.IV with the five years of the “GM 2.0”, from 2010.III to 2015.III.

Level Problem_1

Houston, we have a LEVEL problem!

Another point: Fatás mentions the change among academic economists, who moved away from the Phillips Curve. Now, we have academics in the Fed, like Yellen and Fischer, moving back to Phillips Curve thinking, while not abandoning inflation targeting.

Note that the unemployment rate at present is the same low rate of unemployment as in 1997, while inflation, both in 1997 and today are below the target level. In both instances, unemployment fell together with inflation!

However, the unemployment then and now are not comparable magnitudes. Just look at the very different behavior of labor force participation in the two periods.

Level Problem_2

Although the level of NGDP growth is important, the fundamental level question concerns the level of NGDP, more than its growth rate. This comes out shockingly clear in the next chart. As Fatás mentions in his post:

The fact that a crisis can be so persistent and that cyclical conditions can have such large permanent effects on potential output.

Would lead us to say that, after 7 years, the original trend may not be attainable any longer. However, a trend level between today´s level and the level that prevailed all the way to 2007 may be feasible.

Level Problem_3

The way we were


His Excellency, the Model, suggests…

The Federal Reserve Board released an updated version of its large-scale model on the U.S. economy that may hold clues into why policy makers pivoted at their meeting earlier this week toward a December interest-rate increase.

The revised inputs and calculations on Friday suggest the economy will use up resource slack by the first quarter of 2016, according to an analysis by Barclays Plc, and that also indicates Fed staff lowered their near-term estimate for how fast the economy can grow without producing inflation — a concept known as potential growth…

…In the current model, “the long-run growth rate is two-tenths lower” at 2 percent, Barclays said. FOMC participants forecast the economy’s long-run growth rate at 2 percent in September.

The unemployment rate stood at 5.1 percent in September, and the Fed model assumes little change from that level, dipping to a low of 4.8 percent in a forecast horizon that extends to 2020, according to Barclays. FOMC officials estimated full employment — or the level of the unemployment rate consistent with stable prices — at 4.9 percent last month…

…The model, known as FRB/US and updated periodically, is a series of calculations put together by Fed staff that sketch out how broad measures of the economy would change based on a set of defined parameters. The staff also constructs a bottom-up forecast for policy makers before each FOMC meeting. U.S. central bankers use the models and forecasts as reference points, not sole determinants of their decision-making.

This is nothing short of fantastic!

For the past five years, since partially recovering from the “Big Slump” of 2008-09, real output (RGDP) has been crisscrossing the “potential” growth rate. On the last view, it seems to be dying to undercrosss it! From the behavior of NGDP growth, it will likely “manage” that over the coming quarters.

FRB-US Model_1

Meanwhile, unemployment has taken a dive, but that has not put upward pressure on any measure of inflation, that has been “relenting” (and doing so long before the oil price drop since mid-2014).

FRB-US Model_2

Maybe the future will be significantly different from the recent past, with, for example, low unemployment finally pressuring inflation according to the Fed´s preferred Phillips Curve assumption in the model, given that real growth is (and has been for a long time) at “potential”.

However, before putting a lot of faith in these forecasts, what is the model´s “record of accomplishment”?

The tables below start with the first “Forecast Material” from April/11. Then from March/13, March/14 and the latest from Sept/15. In parenthesis, the realized value for the year. You immediately notice the “one-sided” errors of the forecasts, which mostly over forecast growth, unemployment and inflation!


RGDP Unemploym. PCE PCE-Core
2011 3.2 (1.6) 8.6 (8.5) 2.5 (2.5) 1.5 (1.5)
2012 3.4 (2.2) 7.8 (7.9) 1.6 (1.9) 1.5 (1.9)
2013 3.9 (1.5) 7.0 (6.7) 1.7 (1.4) 1.7 (1.5)


RGDP Unemploym. PCE PCE-Core
2013 2.6 (1.5) 7.4 (6.7) 1.5 (1.4) 1.6 (1.5)
2014 3.2 (2.4) 6.9 (5.6) 1.8 (1.4) 1.9 (1.5)
2015 3.4 (?) 6.3 (?) 1.9 (?) 2.0 (?)


  RGDP Unemploym. PCE PCE-Core
2014 2.9 (2.4) 6.2 (5.6) 1.7 (1.4) 1.5 (1.5)
2015 3.1 (?) 5.8 (?) 1.8 (?) 1.8 (?)
2016 2.8 (?) 5.4 (?) 1.9 (?) 1.8 (?)


RGDP Unemploym. PCE PCE-Core
2015 2.1 5.0 0.4 1.4
2016 2.3 4.8 1.7 1.7
2017 2.2 4.8 1.9 1.9
2018 2.0 4.8 2.0 2.0

Notice how they have been “downgrading” their growth and unemployment forecast over time, but not fast enough to catch up with “reality”. Notice how their inflation forecasts will always move towards the target. They must be greatly frustrated!

I certainly wouldn´t bet the house on the model´s robustness (or precision)!

We continue to “think”, “see”, “expect”, such and such will “pick up”, “climb”, “rise”, as…

That´s the conventional phrase structure most used by the Fed, the media and analysts.

The latest example, concerning the release of the employment cost index today:

“We continue to think that compensation will pick up as the labor market tightens, but there has been limited evidence of firming wage inflation so far in the various measures that we track.”

Everything that some “think” will “pick up” is in fact going down!


Unheeded Lesson

After doing their usual GDP autopsy in “It May Sound Disappointing But It’s Not!”, Thomas Cooley and Peter Rupert write:

It is clear that the U.S. economy is continuing to grow. That consumption and basic investment are strong is a sign that the domestic fundamentals are pretty strong. Real disposable personal income increased by 3.5%. Declines in the energy sector have held back investment in non-residential structures and equipment and that doesn’t promise to improve in the near future…

… There is a growing chorus of people who believe that they are doing unseen harm by not normalizing monetary policy. There will be a couple more employment reports and the second estimate of Q3 GDP before the next FOMC meeting in mid-December, so time and data will tell!

Now for the unheeded lesson: GDP=C+I+G+(X-M)=Grossly Deceptive Partitioning:

When I discuss the effect of monetary stimulus on aggregate demand with other economists, I notice that they often want an explanation couched in terms of the major components of GDP.  I find this very frustrating, as this approach does more to conceal than illuminate…

… Macroeconomics should be about aggregates, not components of spending.  Yes, changes occurring in the various components of GDP can impact interest rates, and thus velocity.  And if monetary policy is inept (i.e. doesn’t offset changes in velocity) that can impact nominal spending, but it certainly isn’t the most illuminating way of looking at the issue.  It’s like trying to explain changes in the overall price level by modelling changes in the nominal price of each good—theoretically possible, but a waste of time.

And what are the aggregates saying? They are reflecting the visible harm monetary policymakers are making through tightening monetary policy by “word of mouth”!

Echoing Friedman, Bernanke once said: To gauge the stance of monetary policy, look at what´s happening to nominal spending (NGDP or Nominal Final Sales, for that matter) and inflation.

And the message is clear!

Pill to swallow

Thirty years and counting, but reasoning doesn´t change!

Maybe this “analytical calamity” comes from “price and quantity-based” reasoning.

In 1984 Alan Reynolds wrote “Mainstream Voodoo Revisited”:

The quality of public debate on economic issues is rapidly degenerating to the level of intellectual barbarism. Contradiction has become the mark of sophistication, evidence is dismissed as irrelevant, and “experts” are defined as anyone who advised the government during some economic catastrophe. Indolent journalists lean on an imaginary consensus, claiming that “most economists agree” about this or “Wall Street worries” about that.

Most economists are said to be concerned that a growing economy must raise interest rates, which will prevent the economy from growing. The solution, it seems, is for the Fed to raise interest rates to slow the economy, so that interest rates can fall and thus speed up economic growth…

And concludes

Economic policy has never before been so thoroughly dominated by ever-changing economic theories and forecasts. Economists who can’t predict the next month now propose to fine-tune the 1989 budget or the 1986 inflation rate. There is a panicky political impulse to fix things that are not broken and ruin things that were almost fixed. Always, the rationale is that “most economists agree” that “something” must be done. If economists were actually guilty of believing half of the strange ideas that are attributed to them, it would be safer to base economic policy on astrology.

An increase in the FF target rate is “a pill that must be swallowed”!

One think I know is that I will have fun reading comments on the GDP release. For example, “GDP Waves Yellow Flag at the Fed”:

The hope is that the inventory swing is just temporary, and that GDP will soon be moving along at a strong enough clip that the economy will have no problem swallowing a rate increase. The concern is that businesses cut inventories because they are worried that the global slowdown will hurt them, and that those qualms will affect their hiring decisions.

The GDP figures might mask what’s happening with demand, but sometimes the mask matters.

Unfortunately, it´s not masking anything. Final nominal sales (FSDP) follows closely on the heels of nominal spending (NGDP). They´re both chasing “zero” growth!

And while the Fed has confidence that inflation will “move towards target”, it has moved away and stayed away. Furthermore, with (“unmasked”) demand weakening by the quarter, there´s no chance it will do so!

Pill to swallow

GDP Release: “The Ship is Slowly Sinking”

By staying pat on the FF rate, but constantly saying they “would like to begin to normalize policy” this year, Janet & Friends are in effect enlarging the hole that will eventually sink the ship!

Why have they been procrastinating for so long? As history attests (here, here see notes below)), the Fed is terribly afraid of being accused of having sunk the ship. They just don´t see that they are doing exactly that, so far in “slow motion”!

Boat Leaking



At the November 1937 FOMC meeting John Williams, a Harvard professor, member of the Fed board and its chief-economist said:

We all know how it developed. There was a feeling last spring that things were going pretty fast … we had about six months of incipient boom conditions with rapid rise of prices, price and wage spirals and forward buying and you will recall that last spring there were dangers of a run-away situation which would bring the recovery prematurely to a close. We all felt, as a result of that, that some recession was desirable … We have had continued ease of money all through the depression. We have never had a recovery like that. It follows from that that we can’t count upon a policy of monetary ease as a major corrective. … In response to an inquiry by Mr. Davis as to how the increase in reserve requirements has been in the picture, Mr. Williams stated that it was not the cause but rather the occasion for the change. … It is a coincidence in time. … If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn. It makes a bad record and confused thinking. I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground.


It seems “being afraid” is in their DNA. This is Tim Geithner in 2008:

The argument that makes me most uncomfortable here around the table today is the suggestion several of you have made—I’m not sure you meant it this way—which is that the actions by this Committee contributed to the erosion of confidence—a deeply unfair suggestion.

But please be very careful, certainly outside this room, about adding to the perception that the actions by this body were a substantial contributor to the erosion in confidence.

What to target? It’s only rational to use expectations of nominal output growth

A James Alexander post

Twitter is great. It gets to the nub of issues quickly. No messing.

Every time I propose NGDP Targeting the heavyweight sophisticates immediately come back like here and here.  with “you can’t target that because of the huge revisions”. It got me thinking about what these twitterati would target.

Inflation: anyone’s guess

The inflation target is perhaps the worst of all. There is little agreement about which inflation rate to choose. Rightly so. It’s way more complex than facile economic commentators think.

  • Should the rate be the one faced by the average consumer? The average consumer is a tricky concept to start with, as we all know. Perhaps the median consumer?
  • Core inflation, excluding volatile items like food and energy? No small debate there! And lives depend on it as central banks often seem to regard high headline inflation inflation as a justification for raising rates, trumping core rates. And then low headline inflation rates are somehow to be ignored and instead a focus on core inflation, or even core inflation expectations a very long way out.
  • Housing costs are 30-40% for the average consumer. And they are very sticky. Incorporating “inflation” in those housing costs is immensely tricky, either tracking sticky prices like rent, and of then of course separating out changes to the quantity and quality of what is rented. Or, even worse where there are a lot of homeowners, you need to measure inflation in imputed rent (ie the purely inflationary element of the theoretical benefit homeowners get from owning their homes, again stripping out those pesky quality and mix changes). the UK ONS has been criticised for not measuring housing inflation properly, but it is hard to do.
  • Or should expected inflation be used? Perhaps this has the benefit of never needing to be revised. But there are numerous versions of expected inflation. Short, medium and long term. Consumers expectations, business expectations. These are very different in the UK at the moment. Or market-implied expectations? But expectations of what? CPI, RPI, Core CPI, the deflator? And here we have some genuine issues about reliability anyway, as neither the government or the central banks don’t like it they don’t really focus on helping improving the efficiency of this market. The table from the BoE August report  illustrates the “pick a number” problem.

JA Tweeterati

A better inflation measure is the deflator, but …

If we really want to improve national well-being we need more output, more wealth, so the inflation rate that really needs to be divined is the output deflator: how we move from nominal value of output to real output, stripping out inflation. Then somehow target not having too much of that sort of inflation.

That deflator is not an easy measure either. The same hedonistic challenges apply, i.e. how does the quality of output change over time. The same mix effect causes huge challenges as economies are both complex and highly dynamic. Eighty percent of most modern economies produce services, not goods. Inflation in service sector output is no easy thing to measure, e.g.

  • Housing output from existing houses (10% of a modern economy by value added)?
  • Output from the government in terms of schools, hospitals/defence and bureaucrats (about 5% each)?
  • Distribution (15% of a modern economy)?
  • To say nothing of banking, insurance, legal services, IT, pointless celebrities, etc, etc.

An excellent essay by Geoff Tily of the UK’s ONS demonstrated the challenges of measuring either service sector output and its deflator.

UK CPI is the least reliable measure to target: it’s never even gets revised!

Laughably, in the UK the Consumer Price Index is targeted by the Bank of England. This index is a political and contractual one, as it used to set welfare and pension increases, the return on index-linked bonds, for inflation swaps, and often in wage negotiations. Some clever people think it is reliable because it is never revised. This is a really foolish argument. The lack of revisions demonstrates its political and contractual importance, but also proves it is not a reliable measure of what is happening in the economy. Only economic measures that get revised are reliable as they demonstrate a proper respect to the difficulties of measuring macroeconomic variables. No respectable professional macroeconomist should use it in any model of how the economy works.

Output is the way to go, but expectations not the rear-view mirror

So what about targeting output? Well the clever people spot the problem. It is often revised. Partly due to revisions of the physical output, partly due to revisions of nominal output (by value), partly due to the deflator, partly due to mix changes, methodological changes, even mistakes. Revisions are the output number’s strength, not it’s weakness. It is constantly improved upon, unlike the joke macro number of the UK CPI.

Critics are right that targeting a number that gets revised is a problem, but that is why you should look through the problem and target expectations for the number. If there is a rationale for targeting inflation expectations, it can be applied to output too. Expectations can’t get revised, they are updated, and do influence actual behaviour. If output growth is expected to be robust people will act differently to if they expect it to be poor. Historic price numbers or output numbers are the rear-view mirror. You can’t drive by looking behind you.

There are a host of subsidiary numbers that could be targeted like wages, employment, business surveys etc., but none provides the full picture of a dynamic economy, and are all flawed for that reason. Perhaps nominal wage growth could be targeted as that is at the heart of the problem of macroeconomics, unemployment being caused by downwardly sticky wages during a turndown in aggregate demand. I feel just targeting nominal wages might be a bad thing as it could end up being gamed or rather indexed, but it is worth thinking about.

A word about unemployment targeting

Employment, or rather unemployment, could be targeted. But just look briefly at the almost endless debates about labour force participation rates, especially in the US; about the quality of the employment, especially in the  UK; or about the real number of unemployed, especially in countries with large informal economies and easy unemployment registration. Unemployment is not the answer. Perhaps, expectations of unemployment?

Derivatives of output, like output per head, or output per hour (ie productivity) could be targeted but these obviously suffer from the challenge of first measuring real output reliably. In addition, I am not sure how or who would target expectations of output per head or per hour.

Real output or nominal output?

And there is the final measurement challenge. If measuring nominal output is tough and measuring the deflator is tough, measuring a derivative of the two is more than doubly tough (RGDP=NGDP/Deflator).

I know that some chunks of RDGP are measured by measuring actual stuff produced. Officials do gather data on the oil pumped out of the wells, the cars coming off the production line, or bushels of wheat from the farms. But extraction industries, manufacturing and agriculture are a very small fraction of any economy these days – even in an industrial powerhouses like Germany.
So, which output number should be targeted, a real or a nominal one? Both.

  • Governments (or rather “society”) should target (be concerned with) real output, the creation of wealth.
  • Central banks should target expectations for nominal output (NGDP), i.e. the value of the real output measured in money terms – assuming a steady growth in nominal output is a good thing, which most people do.

The balance between nominal growth and real growth, inflation, can then be left for society to figure out.

The last exit!

Since there´s only one meeting left, “how long” had to become “next meeting”. The parsed statement:

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining [how long to maintain this] whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation.

There´s been no material change in the statement. They just wanted to keep the “this year” option on the table. But it won´t be exercised.

Things change but they don´t budge from the view that inflation will settle near the target!


Inflation is anticipated to remain near its recent low level in the near term but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.

Four years ago:

The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate as the effects of past energy and other commodity price increases dissipate further. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

And they consistently get it wrong!

Last Exit_1

Four years ago, oil prices had climbed from $40 in mid-09 to near $100 in November 11 when the meeting took place. With oil prices stable after the steep climb, inflation did not settle near the target, it kept falling!

Now they parrot-like repeat the meme that the downward pressure on inflation of the fall in oil prices will dissipate.

It won´t, because the Fed has been tightening monetary policy for more than one year, as indicated by the NGDP monthly growth rate (from Macro Economic Advisers). That´s one of the reasons oil prices fell to begin with!


Please, give the Fed a timeless rule

In an interesting post “A kink in the Phillips curve”, Nick Bunker finishes off:

The graph shows the relationship between wage growth for production and non-supervisory workers, and the employment rate for prime-age workers six months prior. It clearly shows that when the labor market is tighter (when the employment rate is higher), wage growth is stronger.

Time Invariant Rule1

In other words, the underlying idea of the wage Phillips curve still stands. It’s just a matter of using measures that fit the time.

As Matt Phillips (no relation to William presumably) points out in his Quartz piece on the curve, the labor market has changed quite a bit since the mid-1970s. He points specifically to the decline in the unionization rate, which is a sign of the decreasing bargaining power of labor in the economy. A 5 percent unemployment rate when labor is relatively much stronger, for example, is very different from a 5 percent unemployment rate when labor is on the back of its heels. Changes in the labor market might be a reason why increases in wages and salaries don’t pass through to overall inflation as much as we might have thought. Back when labor had more bargaining power, wage hikes would bite more into profits and therefore spur companies to raise prices. Now companies have more of a cushion, so a similar wage increase won’t necessarily lead to as strong of a price increase.

Context appears to very much matter. Policymakers will always need to create rules of thumb to help them make sense of an incredibly complex economy. But those rules need to be updated as the world changes.

That´s all very nice, but is it useful? In other words, can´t we come up with a “rule of thumb” that is “timeless”?

The NGDP-LT growth rule may qualify. In the chart below, I use the same graphic strategy, but instead of charting wage growth and the prime-age employment population ratio, I substitute wage growth for NGDP growth.

Time Invariant Rule2

It appears that what´s driving both the employment ratio and wage growth is NGDP growth. While during the “Great Moderation” (“GM”), NGDP growth evolved along a stable level path, by letting NGDP growth crash in 2008-09, the Fed afterwards put it on a lower path, which is why I name it the “False GM”.

The coincidence of the fall in the employment ratio to the crash in NGDP growth makes the argument that the fall in the employment ratio is mostly due to structural/demographic factors hard to swallow.

In his post, Nick Bunker says “but those rules need to be updated as the world changes”. He´s referring to adopting a modified Phillips Curve (PC) concept. Unfortunately, that likely won´t help. Over the last 50 years, no relation has been more modified, refined and specified than the PC, and it still doesn´t work!

As I argued in another post, it is time to abandon “estimation” and do some “experimentation”. The chart gives a clear pointer: try putting NGDP growth on a higher path. The result will likely be a higher labor force participation and higher wage growth. If it is done right, inflation getting “out of hand” shouldn´t be a worry!

The chart below shows how the Fed was successful in bringing the NGDP growth path down to conquer inflation and reap the Great Moderation. Now it has to do the opposite and make the red band look more like the green band!

Time Invariant Rule