Is the new Monetary Policy Framework (AIT) an improvement?

Unlikely. Also, it´s likely not worse and suffers from the same shortcoming of inflation targeting, being based on the false premise of the existence of a Phillips Curve. I plan to show, hopefully convincingly, that the New Keynesian model (the centerpiece of which is the New Keynesian Phillips Curve) is grossly unsuitable for monetary policy analysis.

The FOMC has “chosen” to pursue an AIT framework. Why? Because it is a suggestion that flows directly from a New Keynesian model where the interest rate is constrained by the zero-lower- bound (ZLB).

The oldest reference to AIT I found was a Working Paper from 2000, published in 2005. The Phillips Curve is the driving force of the model (despite the economy being far from the ZLB at the time. Probably the reason was the uncertainty regarding the value of the NAIRU).

JMCB October 2005 (WP version 2000):

The analysis of this paper demonstrates that when the Phillips curve has forward-looking components, a goal for average inflation-i.e., targeting a j-period average of one-period inflation rates-will cause inflation expectations to change in a way that improves the short-run trade-off faced by the monetary policymaker.

The other papers proposing AIT are all from 2019-20, when the Fed was revising its framework.

Two examples

Thomas M. Mertens and John C. Williams June 28, 2019

We use a simple New Keynesian model as a laboratory for our analysis. The economy is governed by a Phillips curve that links inflation to a supply shock, the output gap, and expected future inflation and an IS-curve that links the output gap to a demand shock, the ex ante real interest rate, and expectations of the future output gap.

In “What´s up with the Phillips Curve”, we learn that:

It used to be, when the economy got hot and pushed unemployment down, inflation rose as businesses charged higher prices to meet higher wages and other increased costs.

Changes in the conduct of monetary policy appear to have played some role in inflation stability in recent decades, but they cannot be its principal explanation, the authors suggest. 

Their leading candidate for the driver of inflation stability is a reduced sensitivity of inflation to cost pressures—such as those associated with wage movements—or, in economic parlance, a decline in the slope of the Phillips curve

A flat Phillips Curve requires the monetary authority to work harder to stabilize inflation:  Unemployment needs to get lower to bring inflation back to target after a recession,” the authors write.  They use an econometric model to explore how monetary policy should adapt, examining, for example, a strategy known as average inflation targeting

Joseph Gagnon of the PIIE recently described it thus:

Economies around the world have languished in the flat region of a kinked Phillips curve. Any level of unemployment above the natural rate keeps inflation constant. CBs need to aggressively push unemployment down into the steep region.

 

The ECB is also revising its framework, but in Europe, the Phillips Curve concept is not as explicit as in the US, though it clearly lurks behind the models.

ECB Working Paper April 2020:

Following a large recessionary shock that drives the policy rate to the lower bound, a central bank with an AIT objective keeps the policy rate low for longer than a central bank with a standard inflation targeting objective, thereby engineering a temporary overshooting in future inflation that helps to mitigate the decline of output and inflation at the lower bound via the expectations channel.

In a recent speech, Charles Evans, president of the Chicago Fed said:

Describing the stance of policy against a moving and unobservable benchmark is another complicated communications challenge.

He was referring to the “neutral interest rate”, but the same communication problems arise regarding the two other famous “moving and unobservable benchmarks”, to wit, the natural rate of unemployment (or NAIRU) and potential output.

Such comments are not new, although they were more of a “what to decide” problem rather than a “communication challenge”.

In the FOMC meeting of December 1995, Greenspan noted wryly:

“Saying that the NAIRU has fallen, which is what we tend to do, is not very helpful. That’s because whenever we miss the inflation forecast, we say the NAIRU fell” (p. 39).

Seven months later, in the July 1996 meeting Thomas Melzer, president of the St Louis Fed commented:

“Whenever we get to whatever the NAIRU is, people decide it is not really there and it gets revised lower.  We get to what people thought would be the NAIRU, we do not see wage pressures, and we assume that the NAIRU must be lower. So it keeps getting revised down.” (p. 61)

There were also the strong believers in the Phillips Curve. This comment from Laurence Meyer in the February 1999 FOMC meeting is an example:

When I think about the inflation process and the inflation dynamic, I always point to two things: excess demand and special factors. I don’t know any other way to think about the proximate sources of inflation. When I think about excess demand, I think about NAIRU. If we eliminate NAIRU and that concept of excess demand, it moves us into very dangerous territory with monetary policy.

I would remind you that in the 20 years prior to this recent episode, the Phillips curve based on NAIRU was probably the single most reliable component of any largescale forecasting model. It was very useful in understanding the inflation episode over that entire period. Certainly, there is greater uncertainty today about where NAIRU is, but I would be very cautious about prematurely burying the concept. (pg 118)

In the same meeting, Edward Boehne, president of the Philadelphia Fed said:

As far as NAIRU is concerned, my personal view is that it is a useful analytical tool for economic research but that it has about zero value in terms of making policy because it bounces around so much that it is very elusive. I would not want our policy decisions to get tied all that closely to it, especially when most of the NAIRU models have been so far off in recent years. (pg 116)

A few months later, in the June 99 FOMC meeting, William Poole, president of the St Louis Fed observed:

I certainly count myself among those who believe that the Phillips curve is an unreliable policy guide. What that means is that the predictive content for the inflation rate – and I’ll emphasize the “predictive” – of the estimated employment gap or GDP gap, however you want to put it, seems to be very low. (pg 106)

One year later, in the June 2000 meeting Poole “nailed down” the problem:

The traditional NAIRU formulation views the wage/price process as running off a gap–a gap measured somehow as the GDP gap or the labor market gap. And the direction of causation goes pretty much from something that happens to change the gap that feeds through to alter the course of wage and price changes.

I think there is an alternative model that views this process from an angle that is 180 degrees around. It says that in an earlier conception, either through a determination of a monetary aggregate or through a federal funds rate policy, monetary policy pins down the price level or the rate of inflation and, therefore, expectations of the rate of inflation. Then the labor market settles, as it must, at some equilibrium rate of unemployment. Where the labor market settles is what Milton Friedman called the natural rate of unemployment. But the causation goes fundamentally from monetary policy to price determination and then back to the labor market rather than from the labor market forward into the price determination. I certainly view the causation in that second sense.

I think it is the willingness of the Federal Reserve to stamp out signs of rising inflation that ultimately pins down expectations of the price level and the inflation rate. Now, the labor market has been clearing at a level that all of us have found surprising. But I don’t think that necessarily has any particular implication for the rate of inflation, provided we make sure that we are willing to act when necessary. (pg 61).

Interestingly, six months earlier, Richard Clarida (who is now Vice Chair of the Fed Board and led the framework Review Process), Gali and Gertler published “The Science of Monetary Policy” in the Journal of Economic Literature. On page 1665 we read:

It is then possible to represent the baseline model in terms of two equations: an “IS” curve that relates the output gap inversely to the real interest rate; and a Phillips curve that relates inflation positively to the output gap.

Which is the opposite of Poole´s “direction of causation”. Unfortunately, this is the view that survived and prevailed, for 20 years later, as seen at the beginning of this post that is the model Mertens & Williams use to, inter alia, promote AIT.

In between those times, Narayana Kocherlakota, president of the Minneapolis Fed wrote “Modern Macroeconomic Models as Tools for Economic Policy” in 2010:

“…I am delighted to see the diffusion of New Keynesian models into monetary policymaking. Regardless of how they fit or don’t fit the data, they incorporate many of the trade-offs and tensions relevant for central banks.”

Just like the NAIRU, potential output is “constantly changing”, so the “output gap” is elusive, therefore worthless for monetary policy analysis. The chart below shows that, either from below or from above, potential output is always “chasing” actual output.

In the 1990s, inflation was initially falling before remaining low and stable. Therefore, by the dictates of the NK model, there was no output gap to contend with. The solution: Revise potential output up until it converges to actual output.

The opposite occurs in the 2010s. With inflation stable (not falling), the output gap (actual minus potential) could not be negative. Therefore, potential undergoes downward revisions until it converges to actual output.

In summary, Greenspan got it exactly right in the June 2002 FOMC Meeting:

A lot of people out there are asking why we can’t come up with something simple and straightforward. The Phillips curve is that, as is John Taylor’s structure. The only problem with any one of these constructs is that, while each of them may be simple and even helpful, if a model doesn’t work and we don’t know for quite a while that it doesn’t work, it can be the source of a lot of monetary policy error. That has been the case in the past. (pg 20)

One of the reasons monetary policy errors occur, apart from using bad models for policy purposes, is that most policymakers think the policy rate well defines the stance of monetary policy. The set of charts below try to dispel that view, indicating that NGDP growth much better reflects the stance of monetary policy.

Instead of thinking narrowly of the Fed goal as “price stability”, think more broadly as the Fed having the goal of providing “nominal stability”. Nominal stability means a stable growth of aggregate nominal spending (NGDP). To get that result, it must be that money supply growth closely offsets changes in velocity (the inverse of money demand).

Note, in the first chart, that unemployment stops falling or rises (somewhat or a lot), when NGDP growth falls a little (bars 1 & 4), significantly (bar 2) or majestically (bar 3). Given sticky wages, the unemployment rate is ‘determined’ by the wage/NGDP ratio. The bigger the drop in NGDP, the higher the wage/NGDP ratio rises and so does unemployment. Therefore, with NGDP growing at a stable rate, unemployment falls ‘monotonically’.

As William Poole put it: “…Then the labor market settles, as it must, at some equilibrium rate of unemployment. Where the labor market settles is what Milton Friedman called the natural rate of unemployment.

Guided by the NAIRU/Phillips Curve framework, however, as soon as unemployment falls to levels consistent with their view of NAIRU, and not wanting to wait to see the “white of the inflation eyes” (which is what they now say they want to do with AIT), the Fed doesn´t allow the unemployment rate to “settle”, and tightens monetary policy. This comes out very clearly in the chart above.

In the next chart we see that interest can fall with unemployment rising, rise with unemployment falling and other combinations.

This statement from Board Member Brainard has a ‘true’ part and a ‘false’ part:

[True] The longstanding presumption that accommodation should be reduced preemptively when the unemployment rate nears the neutral rate in anticipation of high inflation that is unlikely to materialize risks an unwarranted loss of opportunity for many Americans.

[False] Beyond that, had the changes to monetary policy goals and strategy we made in the new statement been in place several years ago, it is likely that accommodation would have been withdrawn later, and the gains would have been greater. [Here she´s referring to the lift-off that began in December 2015]

To complete my reasoning, the next chart shows the complete absence of correspondence between unemployment and inflation over the last three decades.

In the June 2002 FOMC meeting, Board Member Gramlich and Presidents Minehan & Broaddus were thinking correctly. They

thought the poorer performance of the Phillips curve was a result of the Fed’s success in reducing and stabilizing inflation – with inflation low and inflation expectations more firmly anchored, there was a less reliable relationship between the output gap and inflation.

It is unfortunate that the Fed quickly forgets what it learned. Members change and so do theories, views and biases.

Firstly, they deny the view that the magnitude of the 2008/09 crash was the result of an unbelievably bad monetary policy. Then they argue that monetary policy is limited in its capacity to reverse the error. Narayana Kocherlakota in the FOMC Transcript from January 2012 is a good example:

If I am right in my forecast, the Committee will need to be careful to keep in mind the limitations of monetary policy. We will face ongoing political pressures to use monetary policy to try to jump from the new normal back to the old normal. That’s simply not the role of monetary policy. You cannot move an economy from one long-term normal to another long-term normal. What monetary policy can do is to enhance economic stability by facilitating an economy’s adjustment to macroeconomic shocks. (pg 141)

As the chart below indicates, you can only move it down!

And so we come to 2020 and the Covid19 shock. This was both a supply (health) shock and a demand (monetary) shock.

The monetary shock is illustrated in the charts below. The fall in velocity was sudden and sharp, but the Fed reacted quickly to begin to reverse the situation. Unfortunately, having chosen an ‘useless’ framework for monetary policy, it appears to be faltering, risking not only a complete loss of credibility because average inflation will persist indefinitely below 2% (like it has for the past 30 years), but also condemning the economy to evolve along an additionally depressed path!

As Peter Ireland put it recently:

The time to do something is when the time is right. The time is right for nominal GDP level targeting.

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