“We´re almost there” – A narrative

For the past two years, the Fed has insisted that the time for “policy normalization” has come.

At the very start of this year, none other than Vice Chair Fischer said that four rate hikes in 2016 were “in the ballpark”. We´re almost halfway through the year and nothing has yet happened, and it appears the “highly touted” June hike is “off the table”, and July has become much less likely.

It seems that the Fed has no idea about the monetary policy it is actually practicing. So, let´s help them find out!

Go back a quarter century and picture the 1990-91 recession. That episode came to be called “strategic disinflation” (“SD”). When you look at the chart, you see that inflation in both its “headline” and “Core” guises came down permanently.

How did the Fed do it?

What it did was to significantly lower NGDP growth. Thereafter it sanctioned NGDP growth at a lower level than before the “SD”. That level was stable and kept NGDP evolving very close to a level trend path. Inflation came down and stayed down!

The next chart tells the whole story.

In the late 1990s, monetary policy was first too expansionary and then, too contractionary, But the Fed managed to put things right, i.e. put NGDP back on trend. Throughout, inflation remained contained.

Note that headline PCE inflation fluctuates widely to the beat of oil and commodity shocks but core inflation remains subdued throughout.

Then we arrive at the Bernanke/Yellen Fed. It appears that for reasons that are hard to explain, inflation, once again became a “big issue”. The 2008 Transcripts are clear on that point. If you read the June 2008 Transcript, which takes place just before NGDP tanks, you find that:

The tightening expected over the next year is not anticipated to begin soon. As shown in exhibits 23 and 24, options on federal funds rate futures contracts currently imply that market participants expect that the FOMC will stand pat at both this and the August FOMC meetings. Although considerable tightening is priced in over the next year, this is not unusual at this stage of the monetary policy cycle.

Exhibit 11 presents the near-term inflation outlook. As you can see in the top left panel, the recent data on consumer prices have come in a little lower than we had expected at the time of the April Greenbook. As shown on line 3, core PCE prices rose only 0.1 percent in April, and based on the latest CPI and PPI readings, we expect an increase of 0.2 percent in May. As a result, we have marked down our estimate of core PCE inflation in the second quarter by 0.3 percentage point, to an annual rate of 2 percent. Total PCE prices (line 1) have risen at a substantially faster pace than core prices; but here, too, the current-quarter forecast is a little lower than in our previous projection, both because of the lower core inflation and because the sharp increases in oil prices have been slow to feed through to finished energy prices.

Despite this recent news, we expect inflation to rise sharply over the next few months. In part, this reflects our judgment that core prices were held down in the first half by some factors that will not persist into the second half. In addition, as shown to the right, we expect increases in food and energy prices to push up the twelve-month change in the total PCE price index more than 1 percentage point over the next several months, to about 4½ percent.

Regarding inflation, every single participant with the possible exception of Mishkin, showed grave concern. This is reflected in Bernanke´s summary:

My bottom line is that I think the tail risks on the growth and financial side have moderated. I do think, however, that they remain significant. We cannot ignore them. I’m also becoming concerned about the inflation side, and I think our rhetoric, our statement, and our body language at this point need to reflect that concern. We need to begin to prepare ourselves to respond through policy to the inflation risk; but we need to pick our moment, and we cannot be halfhearted. When the time comes, we need to make that decision and move that way because a halfhearted approach is going to give us the worst of both worlds. It’s going to give us financial stress without any benefits on inflation. So we have a very difficult problem here, and we are going to have to work together cooperatively to achieve what we want to achieve.

The last thing I’d like to say is on communications. Just talking about communications following this meeting, I’d like to advise everyone, including myself, to lean, not to lurch. That is, we are moving toward more concern about inflation, but we still have concerns about economic growth and financial markets. We should show that shift in emphasis as we talk to the public, but we should not give the impression that inflation is the entire story or that we have somehow decided that growth and financial problems are behind us, because they are not. So if we can convey that in a sufficiently subtle way, I think we will prepare the markets for the ultimate movements that we’re going to have to make.

Unfortunately, and that was to be expected, the “public” gathered that inflation, if not the entire story, was the major part. In the Minutes of that meeting we read that “likely the next move in interest rates will be up”!

Was the downshift in NGDP an error or was it the outcome of an explicit strategy? In 1990, the Fed wanted to bring inflation down permanently, and did. In 2008, you could think that the Fed was again very concerned with inflation. In fact, it appears that it thought that the ongoing trend level of NGDP was “too high”, risking a loss of inflation control. That view is consistent with the facts. After bringing NGDP growth down forcefully (deep into negative territory for the first time since 1937), the Fed never allowed it to go back to the “long-term trend level”, like it had done after the inflation adjustment of the early 1990s, or after the policy mistakes of the late 1990s, early 2000s.

Note that the Fed closely controls nominal spending (NGDP) growth. It´s smack on the trend level path the Fed wishes it to be.

The next chart helps to explain why the Fed has been “worrying”. Having kept NGDP at the “desired” level, potential NGDP is converging to that level. In the chart we see the original trend path from 1998, the CBO estimated potential from January 2007 and the latest estimated level from January 2016, together with actual NGDP.

“Slack” is fast diminishing (if you believe the CBO potential calculations). Not surprisingly the Fed is getting nervous, and worried that inflation will soon be “pressured”.

What it misses is that the near zero level of the policy interest rate is the outcome of its “decision” to keep NGDP at a low level path. If it starts “promising” to hike rates, NGDP will fall below the desired path (as seems to be happening since mid-2014 with NGDP growth trending down). This “survey results” is interesting:

By not having a clear idea of the monetary policy it is pursuing (keep NGDP on a stable low trend path), the Fed thinks, because the policy rate is “too low”, that it is being “highly accommodative”. What that conceptual error implies is that the Fed is locked inside a “loop”, well described thus:

What it needs to do is break away from the “loop”. It can do that by explicitly stating that NGDP is on the desired path, in which case interest rates will “forever remain very low”, or, it can recognize that 8 years ago it made a big mistake and explicitly target a higher level of NGDP, which will force a temporarily higher NGDP growth rate, which will be accompanied by an increase in interest rates!