Irony alert: The Fed has been doing AIT for three decades!

As I will show, it has also been doing NGDP-LT, albeit with a “variable” Level Trend. It´s amazing that it took them one and a half years to come up with a framework that had been in place for so long!

The chart below shows that the core PCE has closely followed the trend (estimated from 1992 to 2005). The trend reflects a 1.8% average inflation, not the 2% average target, but close.

To illustrate the fact that the Fed has effectively been practicing AIT, I zoom in on two periods (outside the estimation interval) to show an instance of adjustment from above and one from below.

Even now, after the Covid19 shock, it is trying to “make-up”!

The “other Policy framework” the Fed has been “practicing” with for over three decades is NGDP Level Targeting.

The set of charts below show how NGDP has evolved along the same trend during different periods.

The following chart zooms in on 1998 – 2004 and shows that the Fed first was excessively expansionary (reacting to the Asia & Russia +LTCM crises) and then “overcorrecting” in 2001-02 before trying to put NGDP back on the level trend, which it did by 2004. Many have pointed out that the Fed was too expansionary in 2002-04, blaming it for stoking the house bubble and the subsequent financial crisis. However, the only way the Fed can “make-up” for a shortfall in the level of NGDP is for it to allow NGDP to grow above the trend rate for some time!

As the next to last chart shows, 2008 was a watershed on the Fed´s de facto NGDP-LT framework. As shown in the chart, in June 2008 the Fed “gave up” on the strategy, “deciding” it would be “healthier” for aggregate nominal spending (NGDP) to traverse to a lower level path and lower growth rate.

If you doubt that conjecture, read what Bernanke had to say when summarizing the June 2008 FOM Meeting.

Bernanke June 2008 FOMC Meeting:

“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.”

He certainly got what he wished for.  As the next chart indicates from the end of the Great Recession to just prior to the Covid19 shock, NGDP was spot on the new lower trend path alongside a reduced growth rate.

The Covid19 shock tanked NGDP. This was certainly different from what happened in 2008. Then, it was a monetary policy “choice”. Now, it was virus related. The other thing is that at present, instead of being worried about inflation being too high or risking getting out of control, the fear is with inflation being too low.

That worry, which has been evident for some time, led that Fed to unveil a new monetary policy framework, AIT, for average inflation targeting. As I argued before, this framework has been in place for decades!

The last chart above indicates that monetary policy is “trying” to make-up for the drop in NGDP from the “Great Recession Trend” it was on. We also saw that the Core PCE Index is on route to get back to its decades-long trend.

Given that inflation is a monetary phenomenon, these two facts are related. For inflation to go up (as required to get the price level back to the trend path) NGDP growth has to rise. However, many FOMC members are squeamish. We´ve heard some manifest that they would “be comfortable with inflation on the 2.25% – 2.5% range”.

The danger, given the presence of “squeamish” members, is there could come a time when the Fed would reduce NGDP growth before it reached the target path. Inflation would continue to rise (at a slower, “comfortable”, rate) and reach the price path while, at the same time, the economy remains stuck in an even deeper “depressive state” (that is, deeper than the one it has been since the Fed decided in 2008).

That is exactly what happened following the Great Recession. NGDP growth remained stable (at a lower rate than before) and remained “attached” to the lower level path the Fed put it on.

These facts show two things:

1. To focus on inflation can do great damage to the economy. For example, imprisoning it in a “depressed state”.
2. Since the Fed has kept NGDP growth stable for more than 30 years, and freely choosing the Level along which the stable growth would take place, the implication is that it has all the “technology” needed to make NGDP-LT the explicit (or just de facto) monetary policy framework. As observed, that framework is perfectly consistent with IT, AIT or PLT!

A “simple solution” to the Fed´s new AIT framework

The first thing to note is that inflation is not a price phenomenon (don´t reason from a price change is relevant here), but a monetary phenomenon.

For example, changes in relative prices (due to an oil price shock, for example) will only turn into inflation (a continued increase in all prices), if monetary policy allows it to happen (as we´ll see contrasting the 70s with the last 30 years.

Another point I´ll make is that the price index the Fed should target is the PCE Core index. Why? Because the headline index is much more volatile and, like in 2008, will lead the Fed astray.

The first chart shows that over a long period (60 years in this case) both the Core & Headline index show the same thing.

If you break the 1960 – 2020 period by decades, you´ll note that the core index functions as an “upper bound” to the headline index. The next chart shows two examples. The first from the high inflation 1970s and the second from the low inflation 1990s.

The next charts show the two in the form of year over year rate of change – inflation – and the corresponding behavior of nominal spending (NGDP) growth. Note that rising inflation (both for the headline & core indices) only happens when monetary policy, as gauged by NGDP growth, is on a rising trend. Relative prices do change but only with overall prices going up.

During the low and stable core PCE inflation period, the headline PCE inflation wonders up and down, buffeted by the price shocks (mostly oil). For this low inflation period, the average headline PCE inflation is 1.8, with a standard deviation (volatility) of 0.86. The average for core PCE inflation is the same 1.8, but with a standard deviation less than half that (0.41). So it´s much better to target the low volatility index.

What does the Fed face at present? The next chart shows that the core PCE index has hugged closely to a 1.8% trend path since 1993. This trend path was established from the data to 2006, before the upheavals of the Great Recession. Fourteen years later, even after the effects of the Covid19 shock, the index hasn´t deviated from the path.

If the Fed manages to keep the core PCE index following this path going forward, in ten years’ time, the index will reach Scott Sumner´s “magic number” of 135 (Ok, he means the headline index, but I´ve argued that´s a bad index to target and anyway, the core index is an upper bound on the headline index).

How to do that? Basically, don´t invent new benchmarks. Take what you have and do the best with it. Moreover, the best the Fed can do is what has been proven adequate for a long time, to wit, keep NGDP growth stable. The Fed can improve on that by not making the mistakes it made in 2001 and particularly in 2008, as the charts below indicate.

Now, NGDP is still far below the trend path it followed from the end of the Great Recession. The Fed´s first order of business is to make monetary policy expansionary enough to take NGDP back to that trend path. Once (if?) that´s done, the Fed should pursue a monetary policy that allows NGDP to grow close to the 4% rate it averaged from 2010 to 2019.

With that, the core price level will be close to 135 in 10 years’ time.

If only monetary policy in 2008 had been what it was in 2020.

Many like to compare the Covid19 contraction with the Great Depression. In addition to the nature of the two contractions being completely unrelated, while in the first two months of the Covid19 crisis (from the February peak to the April trough) RGDP dropped 15%, it took one year from the start of the Great Depression for RGDP to drop by that amount.

Although the Covid19 shock has also no common element with the Great Recession, a comparison between the two is instructive from the monetary policy point of view. This is so because the Great Recession was the “desired outcome” of the Fed´s monetary policy. Bear with me and I´ll try to convince you that is not a preposterous statement.

Motivated by the belief that the 2008-09 recession originated with the losses imposed on banks by their exposure to real estate loans and propagated through a consequent breakdown in the ability of banks to get loans to credit-worthy borrowers, government, the Fed and regulators intervened massively in credit markets to spur lending.

Bernanke´s January 13, 2009 speech “The crisis and the policy response” summarizes that view:

“To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally.”

Bernanke´s “credit view” of the monetary transmission process is well established. Two articles support that view.

His flagship 1983 article is titled “Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression.”

“…we focus on non-monetary (primarily credit-related) aspects of the financial sector–output link and consider the problems of debtors as well as those of the banking system. We argue that the financial disruptions of 1930-33 reduced the efficiency of the credit allocation process; and that the resulting higher cost and reduced availability of credit acted to depress aggregate demand.”

His 1988 primer “Monetary Policy Transmission: Through Money or Credit?”

“…The alternative approach emphasizes that in the process of creating money, banks extend credit (make loans) as well, and their willingness to do so has its own effects on aggregate spending.”

For details on the Fed´s credit market interventions (with the purpose of reducing spreads, which to the Fed is a sign of credit market dysfunction), see chapter 15 of Robert Hetzel´s “The Great Recession”

“The answer given here is that policy makers misdiagnosed the cause of the recession. The fact that lending declined despite massive government intervention into credit markets indicated that the decline in bank lending arose not as a cause but as a response to the recession, which produced both a decline in the demand for loans and an increase in the riskiness of lending.

In their effort to stimulate the economy, policy makers would have been better served by maintaining significant growth in money as an instrument for maintaining growth in the dollar expenditures [NGDP growth] of the public rather than on reviving financial intermediation”

The charts below attest to that fact insofar as spreads began to fall, the dollar exchange rate began to depreciate and the stock market began to rise, only after the Fed implemented quantitative easing (QE1) in March 2009.

The purchase of treasuries by the Fed was what “saved the day”, not the array of credit policies that had been implemented for several months prior. Note, however, that the monetary policy sail was only at half-mast. On October 2008, the Fed had introduced IOER (interest on reserves), so that the rise in the monetary base from all the Fed´s credit policy would not “spillover” into an increase in the money supply. (The rise in the reserve/deposit (R/D) ratio in fact more than offset the rise in the base, so money supply growth was negative).

What QE did was to increase the velocity of circulation. With that, spending (NGDP) growth stopped falling and then began to rise slowly. As the next chart shows, the Fed (due to inflation worries) never allowed NGDP growth to make-up for the previous drop, “calibrating” monetary policy to keep NGDP growth on a lower trend path and lower growth rate.

Skipping to 2020, when the Covid19 shock hit, NGDP tanked. With spreads rising, the Fed again, now under Jay Powell (who must have learned “creditism” from his time with Bernanke), quickly announced a large batch of programs to intervene in credit markets to sustain financial intermediation.

While in the U.S., it was all about “closing spreads”, in Europe the sentiment was the opposite:

Christine Lagarde (March 12): “We are not here to close spreads”

Laurence Meyer (March 17): “The Fed is here to close spreads”

In “Covid19 and the Fed´s Credit Policy”, Robert Hetzel writes:

“…When financial markets actually did continue to function, Chairman Powell claimed that it was because of the announcement effect that the programs would become operational in the future…”.

Looking at the charts for the period, we again observe that spreads fell (markets functioned) when monetary policy – through open market operations, with the Fed buying treasury securities – becomes expansionary. The difference, this time, is that the monetary policy sail was at “full mast”, so that money supply growth rose fast.

Compared to the post 2008-09 period, NGDP reversed direction in a V-shape fashion (data on monthly NGDP to June from Macroeconomic Advisers). This time around, it seems the Fed is set in making-up for the lost spending, returning NGDP to the trend level that prevailed from 2009 to 2019.

Going forward, once the economy fully reopens the Fed will have to make clear that monetary policy will the conducted to maintain nominal stability (i.e. NGDP cruising along the trend level path it was on previously). Given the degree of fiscal “overkill” that has been practiced, the Fed will have to resist pressures to maintain an overly expansionary monetary policy to relieve fiscal stress through inflationary finance.