The Fed, by tightening, is reducing “slack”!

Speaking at a conference in Beijing, Boston Fed President Eric Rosengren said it has been appropriate to be patient about normalizing interest rates, given that growth “has continued to underwhelm.” But the Fed’s mandated goals – stable prices and maximum sustainable employment – are likely to be achieved relatively soon, and “keeping interest rates low for a long time is not without risks.”

As a result, important questions confront monetary policymakers in the United States, including when and how quickly to continue normalizing interest rates.

Why are they so worried if inflation, as measured by the PCE-Core has remained below the 2% target level for almost the whole time since end-2008, even if “full employment” is all around us?


What they don´t realize is that “slack” has been diminishing because they are keeping the economy ever more subdued. The idea of “potential” is risible because actual NGDP seems to be the strongest determinant of “potential” NGDP.

In the chart you can see that while for the years prior to 2013 potential NGDP in the latest vintage (August 2016) was revised slightly up, compared to the 2011 vintage (the earliest available in Alfred), for the past two years it was revised down significantly.



Now, note that´s exactly the period during which NGDP growth has tumbled down, the outcome of all the tightening talk going on at the FOMC!


Squint, and the picture will look better

Back in Jackson Hole:

HILSENRATH: Dennis Lockhart, president of the Federal Reserve Bank of Atlanta. We’re here in Jackson Hole, talking about the economy. So give us your read: How is the U.S. economy doing right now?

LOCKHART:I think the U.S. economy is expanding at a modest pace. The second quarter (gross domestic product) number—which was 1.1 (percent annual rate of growth), just revised slightly yesterday—I think overstates the slowdown or a slowdown. We have been looking through that number to an account in the GDP accounts called real final sales, which is GDP less inventory.

And what we see there is a better picture and a more consistent picture over the last few quarters. So I think the economy is chugging along, and I’m not one who is interpreting the headline GDP number as somehow suggesting that we have slowed from what was already a slow expansion.

The picture over the past two years strongly contradicts Lockhart: The economy has been slowing for the past two years.


That´s not surprising because all those measures of aggregate nominal activity give out the same information over long periods.


PS I remember that a couple of years ago, some were favoring GDI. At the time GDI was higher than the other measures…But then again:

ABSTRACT  The two official measures of U.S. economic output, gross domestic product (GDP) and gross domestic income (GDI), have shown markedly different business cycle fluctuations over the past 25 years, with GDI showing a more pronounced cycle than GDP. This paper reports a broad range of results that indicate that GDI better reflects the business cycle fluctuations in true output growth. Results on revisions to the estimates, and correlations with numerous other cyclically sensitive variables, are particularly favorable to GDI. The most recent GDI data show the 2007–09 downturn to have been considerably worse than is reflected in GDP.

The Fed’s logic is faulty but may yet end up with the right answer

A James Alexander post

The last blog post was a great analysis of the last thirty years of US monetary policy as the Fed focused on Core PCE inflation and unemployment and for most of the time accidentally got NGDP growing on target. When the Fed switched rigidly to focusing on its own projections for Core PCE things started to go awry, both with unemployment and NGDP.

Still focusing on those projections since 2009 it has got things right in fits and starts only. Unemployment has ever so gradually returned to 5%, a record slow recovery. That said, there is still tons of labor market slack as evidenced by the participation ratios, ultra-low nominal wage growth and low quit rates. These factors mean there is very little productivity growth as the labor market is so lacking in energy. Core PCE keeps missing Fed projections of a return to 2%.

This troubled but not yet terrible situation is summed up by, actually caused by, the dreadful growth rate and level of NGDP.

So why does the Fed want to raise rates?

Trying to put myself in the mind of the average FOMC member I came up with this “logic”, although it is not logical – perhaps because it reflects so many competing views and not just one human brain:

1. The Fed wants to raise rates to give it the room to cut them when the data goes bad – even though we know the data will go bad due to the raising of rates, or the constant threat of raising rates.

2. The Fed is thus stuck as it really doesn’t want to:

a. use negative rates because the banks, insurance companies, money market mutual funds and savers will complain very loudly;


b. do more/wider QE because too many politicians, internet Austrians/goldbugs, alt-right, progressives, socialists, etc. will all            complain about the Fed creating winners and losers “and may require legislation” as Yellen said;


c. do helicopter money, defined here as directly new-money financed fiscal expenditure as it is bound to run up against any unaltered Core PCE inflation target projections

3. While the Fed needs rate-cutting firepower it is unlikely to have been able to raise before the data goes really bad

4. So the Fed has to look at more innovative alternatives than negative rates or more/wider QE. Thus it is tentatively looking at a higher inflation target or even level targets for inflation or nominal growth, instead as a sort of last resort back-up plan.

The Fed is causing this confusion becausthe logic is confused. It has the wrong targets and they are both causing and storing up trouble. Changing the targets would be the right thing to do, even if for all the wrong reasons.


The Great (Monetary) Unraveling

In “Years of Fed Missteps Fueled Disillusion with the Economy and Washington”, Jon Hilsenrath gives his contribution to the “Great Unraveling” series. He starts off writing:

In the past decade Federal Reserve officials have been flummoxed by a housing bubble that cratered the financial system, a long stretch of slow growth they failed to foresee and inflation persistently undershooting their goal. In response they engineered unpopular financial rescues, launched start-and-stop bond buying and delayed planned interest-rate boosts.

“There are a lot of things that we thought we knew that haven’t turned out quite as we expected,” said Eric Rosengren, president of the Federal Reserve Bank of Boston. “The economy and financial markets are not as stable as we previously assumed.”

In the 1990s, a period known in economics as the “Great Moderation,” it seemed the Fed could do no wrong. Policy makers and voters saw it as a machine, with buttons officials could push to heat or cool the economy as needed. Now, after more than a decade of economic disappointment, the central bank confronts hardened public skepticism and growing self-doubt about its own understanding of how the U.S. economy works.

For anyone seeking to explain one of the most unpredictable political seasons in modern history, with the rise of Donald Trump and Bernie Sanders, a prime suspect is public dismay in institutions guiding the economy and government. The Fed in particular is a case study in how the conventional wisdom of the late 1990s on a wide range of economic issues, including trade, technology and central banking, has since slowly unraveled.

During the Great Moderation, the Fed did do wrong. It just didn´t fail utterly! I believe the chart tells a convincing story.

Great Monetary Unraveling_1

Note that during the Great Moderation – the Greenspan years – NGDP growth was relatively stable. In 1990-91, the story is the Fed engineered a “strategic Disinflation”, with inflation coming down from the 4% level to 2%. In 2000-02 the Fed, worried about the low (4%) rate of unemployment and what it would do to inflation, erred, allowing NGDP growth to fall significantly. This mistake was subsequently corrected.

In level terms we see that NGDP remained close to its “target level”.

Great Monetary Unraveling_2

In the first two years of his mandate, Bernanke managed to keep NGDP close to its “target level”. Inflation remained very close to target and unemployment low and stable.

Great Monetary Unraveling_3

The follow-up in 2008-09, however, was a disaster. The Fed allowed NGDP growth to take a beating. The result was a massive increase in unemployment (given wage stickiness) with inflation dropping below target.

Great Monetary Unraveling_4

This outcome is very closely linked to the Fed´s renewed obsession with the likelihood of inflation shooting up on the heels of an oil shock. This is somewhat surprising given that 10 years earlier, in 1997, Bernanke and co-authors had published a paper “Systematic Monetary Policy and the Effects of Oil Price Shocks” (now gated), which was summarized by Business Insider in March 2011, at the time the ECB was considering hiking rates because of the oil price rise.

Earlier we mentioned a Ben Bernanke paper from 1997 titled, Systematic Monetary Policy and the Effects of Oil Price Shocks and while the full thing is definitely worth a read, we have a breakdown for you right here.

CNBC is talking about it today, too, in light of the ECB’s talk of higher rates.

The thesis is that it is central bank monetary policy in reaction to oil price spikes that creates economic downturns, not the oil price spike itself.

On the other hand, a rate hike ends up causing problems for years, reducing output.

The implication of this is that Federal Reserve Chair Ben Bernanke has no interest in raising rate for a commodity or oil spike, so long as prices remain within Fed range, because it has a damaging impact on output that could send unemployment higher.

In 2008, however, the Bernanke Fed was very worried about the inflationary impact of oil. Although the Fed didn´t raise rates (they didn’t lower them either between April and September 2008), all the FOMC talk, as gleaned from the 2008 Transcripts, was about the risk of inflation and how the next rate move would likely be up!

“Fed talk” is monetary policy, and it gets transmitted through the expectations channel. You get the idea about how monetary policy was severely tightened during 2008, in addition to looking at the behavior of NGDP growth, that tanked, by looking at how the dollar strengthened, how the stock market plunged, and how long-term interest rates dropped.

Great Monetary Unraveling_5

In mid-2009 the economy began to recover, with NGDP growth reversing course. QE1 had a positive impact.

Great Monetary Unraveling_6

During this policy easing, the dollar fell while stocks and long-term bond yields rose.

Great Monetary Unraveling_7

For some reason, by mid-2010 the Fed decided that “enough was enough”. QE1 ended and NGDP growth was stabilized initially at 4%. In other words, unlike after the 2000-03 when NGDP fell below trend but was brought back to trend, this time around the Fed decided that a lower trend path was the way to go.

Great Monetary Unraveling_8

For the past two years, even with inflation remaining below target, through its raise hike talk the Fed has been tightening monetary policy. NGDP growth is coming down, the stock market has remained sideways while the dollar has boomed, oil prices have tanked and long-term bond yields are coming back down. It seems the Yellen Fed is guided by the unemployment rate.

Great Monetary Unraveling_9

It is, therefore, not surprising that the level chart for the Bernanke/Yellen period contrasts sharply with the one observed during the Greenspan years ( I would have imagined that would give useful pointers for the “design of a new monetary framework”)

Great Monetary Unraveling_10

The Jackson Hole Conference had an encouraging title: “Designing Resilient Monetary Policy Frameworks for the Future”. Unfortunately, they mostly talked about the nuts & bolts of policy implementation. Furthermore, while Yellen signalled one rate rise this year, her number 2 Stan Fischer said he “roots” for two. And Bullard said once in the next two years!

It was certainly a missed opportunity for the Fed to regain some modicum of credibility.

Blissful Ignorance

Janet Yellen:

And, as ever, the economic outlook is uncertain, and so monetary policy is not on a preset course. Our ability to predict how the federal funds rate will evolve over time is quite limited because monetary policy will need to respond to whatever disturbances may buffet the economy. In addition, the level of short-term interest rates consistent with the dual mandate varies over time in response to shifts in underlying economic conditions that are often evident only in hindsight.

For these reasons, the range of reasonably likely outcomes for the federal funds rate is quite wide–a point illustrated by figure 1 in your handout. The line in the center is the median path for the federal funds rate based on the FOMC’s Summary of Economic Projections in June.1 The shaded region, which is based on the historical accuracy of private and government forecasters, shows a 70 percent probability that the federal funds rate will be between 0 and 3-1/4 percent at the end of next year and between 0 and 4-1/2 percent at the end of 2018.2

The reason for the wide range is that the economy is frequently buffeted by shocks and thus rarely evolves as predicted. When shocks occur and the economic outlook changes, monetary policy needs to adjust. What we do know, however, is that we want a policy toolkit that will allow us to respond to a wide range of possible conditions.

The range of reasonably likely outcomes for the FF rate is so wide it´s useless.

Blissful Ignorance

One property NGDP targeting (in fact NGDP LEVEL Targeting) is that it is the appropriate framework for “all seasons”, i.e. you don´t need to keep tinkering with monetary policy. In addition to keeping the central bank from mishandling supply shocks, it keeps the central bank from generating demand shocks, which throws both inflation and real growth in the same direction, up as during the “Great Inflation” and down as in the “Great Recession”.

We will, we won´t

The Fed may have cried wolf a few too many times recently. But investors should remember that in the original parable, the wolf did show up eventually. The time to start preparing for higher rates is now.

How best to prepare? By level targeting NGDP.

Cry Wolf

Many, however, have gone “stark mad”. Steve Williamson is a case in point:

…if a central bank wants to hit a higher inflation target, it has to set nominal interest rates higher, on average. So, in the course of transitioning to a higher inflation target, the central bank must, at some time, have to raise nominal interest rates in order to produce higher inflation. But then, it must be true that, if the central bank has an inflation target of x%, and inflation is persistently y%, where y < x, then the central bank must raise its nominal interest rate target.

Since the Fed is so keen in doing exactly that, it should try it. If it doesn´t work, just blame St Louis Fed VP Steven Williamson!

Yellen: “We will keep plodding”

In her opening remarks at Jackson Hole:

…my primary message today is that I expect monetary policy will continue to play a vital part in promoting a stable and healthy economy. New policy tools, which helped the Federal Reserve respond to the financial crisis and Great Recession, are likely to remain useful in dealing with future downturns. Additional tools may be needed and will be the subject of research and debate. But even if average interest rates remain lower than in the past, I believe that monetary policy will, under most conditions, be able to respond effectively.

Unfortunately, that is not happening. As illustrated in the charts, monetary policy has been overly tight, with a brief respite.


Why they don´t perceive this and make a real effort to overhaul the monetary policy framework is beyond comprehension!


The Jackson Hole 2016 gathering just started. The Conference Title is Designing Resilient Monetary Policy Frameworks for the Future.

However, the session directly linked to the Conference Theme – Evaluating Alternative Monetary Frameworks – is a letdown of massive proportions.


10:55 a.m. Evaluating Alternative Monetary Frameworks 
Author: Ulrich Bindseil 
Head of Directorate General Market Operations
European Central Bank
Discussants: Jean-Pierre Danthine
Paris School of Economics
Simon Potter 
Executive Vice President, Markets Group Federal Reserve Bank of New York

Ulrich Bindseil: 12 years ago he wrote…ending:

If the Fed would have been fully independent from the US Government at least directly after WW1, it would probably have had far less incentives to deny the validity of well established central bank technique, namely that short term interest rates are the operational target of monetary policy.”

Jean Pierre is a Finance person and Simon Potter is an econometrician (time series) and forecaster.

Hope I get pie in the face!

While they discuss about economy “overheating”, the economy is “overcooling”

Stan Fischer:

The Federal Reserve’s governors are debating what is going on in the U.S. economy and how to set policy, the Fed’s No. 2 official said on Thursday.

“The issue of overheating of the economy is being discussed within the Fed board,” Fed Vice Chair Stanley Fischer told a room of labor activists who met with Fed officials to press them not to raise interest rates.

“Everything that’s being argued here is being argued in the board as well,” said Fischer.

But reality “stinks”!


If 2% is not enough, don´t double it

According to the Economist:

…How might these problems be fixed? One possibility is simply to raise the inflation target to, say, 4%. Credibly enacted, that ought to alleviate the risk of impotence. If investors and consumers believe inflation will reach 4%, nominal interest rates should eventually rise to 5% or so even if real rates stay low. But rich-world central banks have undershot their targets for so long they may struggle to persuade the public to expect higher inflation. And a higher target would still leave central banks with a dilemma when economic growth and inflation diverge. Neither would it make up for big misses.

A more radical option is to move away from targeting inflation altogether. Many economists (and this newspaper) see advantages in targeting the level of nominal GDP, the total amount of spending in the economy before adjusting for inflation. A nominal-GDP target would allow for temporary variations in inflation. Downturns would be tempered by an expectation of protracted stimulus later on to make up lost ground. In better times, a rise in real GDP would provide the lion’s share of the required nominal-GDP growth and inflation could drift lower.