“Forensic evidence that Bernanke drove the car off the road”

Since Bernanke began blogging I have complained that he doesn´t go to the “heart of the matter”. That is, recognize that the Fed, under his command, bungled.

In fact, the mess-up is likely due to his “love affair” with inflation targeting, with that “love” manifesting itself at the worst possible moment, because the rise in headline inflation that occurred at the time was the result of a negative supply shock, which should not have unduly worried the “lover”.

Bernanke has a deep knowledge of economic history, so he knew about the thought process on economic stabilization that evolved over the decades since the early 1970s. To recall, on becoming chairman of the Fed, Volker challenged the Keynesian orthodoxy which held that the high unemployment high inflation combination of the 1970´s demonstrated that inflation arose from cost-push and supply shocks – a situation dubbed “stagflation”.

Volker´s challenge placed inflation as the FOMC´s top priority. He also brought to the fore of policy discussions the ideas developed during the previous 12 years – since Friedman´s address to the 1967 AEA meetings – on the importance of inflation expectations.

To Volker, the policy adopted by the FOMC “rests on a simple premise, documented by centuries of experience, that the inflation process is ultimately related to excessive growth in money and credit”.

This view, an overhaul of Fed doctrine, implicitly accepts that rising inflation is caused by “demand-pull” or excess aggregate demand or nominal spending.

Now, why is this new “doctrine” consistent with the observed increase in economic stability?

Given the cost-push “doctrine” on the inflation of the 1970´s, the Fed would compensate the fall in AS with an increase in AD, an expansionary monetary policy. This followed from the perceived flatness of the SAS curve below potential output. Since this was a flawed doctrine, over time we should observe trend growth in AD (or nominal expenditures).

Volker, on the other hand, believed that inflation was the result of excessive AD. So nothing more natural than to assume that the Fed should increase its responsiveness to the growth in nominal spending. How would this change in “doctrine” (from regarding inflation as a “cost-push” to “demand-pull” phenomenon) show up in the data?

Recall that under the cost-push “doctrine” the Fed would react vigorously to negative output gaps making policy expansionary, so nominal spending would grow. Under the new “doctrine” the Fed doesn´t react much to supply shocks since a negative supply shock, for example, would decrease real output an increase prices with little effect on nominal spending, but would react vigorously to AD or nominal spending shocks.

Therefore, under the new “doctrine”, policy would make AD growth stationary, in which case AD growth will not show a rising trend as under the cost-push “doctrine”. The chart illustrates.

Forensic Evidence_1

The main difference between the two “doctrines” is not the change in the Fed´s responsiveness to inflation as argued by, among others, John Taylor and Bernanke, but the changed responsiveness to aggregate demand or nominal income growth. A collateral effect of the change in “doctrine” shows up in the reduction and stabilization of inflation and decreased volatility in real output.

The Fed never explicitly targeted anything – inflation or nominal income (AD) growth – but implicitly you could say it targeted nominal AD along a 5.5% growth path growth with Volcker and Greenspan.

The chart below provides, to my mind, compelling evidence about the change in doctrine and its stabilizing consequences. One implication is that during all this time, “Inflation Targeting” was just a red herring!

Forensic Evidence_2

And the biggest victim of the “red herring” was Bernanke himself. Since forever he has been a great defender of the “IT modus operandi”, and exactly when he put it in practice he “pushed the car off the road” and got a “depression” as the result. Later, by making the “red herring” @2% official policy target, he showed he was clueless about the true cause of the monetary policy foul-up!

Now, Bernanke obfuscates!

In his latest post Bernanke takes on the WSJ editorial “The Slow-Growth Fed?”:

The unemployment rate is a better indicator of cyclical conditions than the economic growth rate, and the relatively rapid decline in unemployment in recent years shows that the critical objective of putting people back to work is being met. Growth in output has been slow, despite solid job creation, because productivity gains have been slowperhaps as the result of the financial crisis, which hammered new business formation and investment in research and development, perhaps for other reasons. But nobody claims that monetary policy can do much about productivity growth. Where it can be helpful is in supporting the return to full employment, and there the record has been reasonably good. Indeed, it seems clear that the Fed’s aggressive actions are an important reason that job creation in the United States has outstripped that of other industrial countries by a wide margin.

The WSJ also argues that, because monetary policy has not been a panacea for our economic troubles, we should stop using it. I agree that monetary policy is no panacea, and as Fed chairman I frequently said so. With short-term interest rates pinned near zero, monetary policy is not as powerful or as predictable as at other times. But the right inference is not that we should stop using monetary policy, but rather that we should bring to bear other policy tools as well. I am waiting for the WSJ to argue for a well-structured program of public infrastructure development, which would support growth in the near term by creating jobs and in the longer term by making our economy more productive. We shouldn’t be giving up on monetary policy, which for the past few years has been pretty much the only game in town as far as economic policy goes. Instead, we should be looking for a better balance between monetary and other growth-promoting policies, including fiscal policy.

In “The Fed´s Lullaby”, I said that the Fed was happy with satisfying “the other mandate”! Note that BB doesn´t mention inflation!

“Growth in output has been slow, despite solid job creation, because productivity gains have been slowperhaps as the result of the financial crisis”. Not so subtly he says “it was not my (the Fed´s) fault. However, that argument doesn´t stand up to scrutiny.

The panel below puts productivity and unemployment side by side for the following periods: 1983.I – 1995.1; 1995.II – 2003.IV; 2004.I – 2014.IV.

Note that productivity growth rises when unemployment increases (as expected). That´s not so evident for 1995.2 to 2003.IV because throughout this time productivity was booming. Nevertheless, there´s a big difference in productivity growth between 1995.II – 2000.IV at 2.5% and 2001.I – 2003.IV, when unemployment was on the rise, at 3.6%.

BB Obfuscates_1

Note also that between late 1992 and early 1995 (top row) productivity growth was nonexistent, and lower than what has been observed since early 2011, nevertheless real GDP remained close to trend (see RGDP & Trend chart).

What Bernanke still fails to address after having blogged for one month is WHY the Fed, under his command, allowed a depression to materialize. If he had only acknowledged early on after 2008 the mistake of letting nominal spending (NGDP) tank he would have “guessed” the solution. Long-term real growth is not the province of the Fed. The best the Fed can do to allow the economy to “flourish” at the highest level is to maintain nominal stability, a task in which it failed miserably. It´s no good and no use now calling for “a better balance between monetary and other growth promoting policies”, whatever that means.

BB Obfuscates_2

As George Selgin wrote today, it may be late in the game to regain much of what was lost because:

You see, unlike some economists, although I’m happy to allow that an increase in the Fed’s nominal size, which is roughly equivalent to a like increase in the monetary base, is neutral in the long run, I don’t accept the doctrine of the neutrality of increases in the Fed’s relative size.  I believe that Fed-based financial intermediation is a lousy substitute for private sector intermediation, and that as it takes over, economic growth suffers.  The takeover is, in other words, financially repressive.

Which means that the level of spending is, after all, not the only relevant indicator of whether the Fed is or isn’t going in the right direction.  Another is the real size of the Fed’s balance sheet relative to that of the economy as a whole, which measures the extent to which our central bank is commandeering savings that might otherwise be more productively employed.  Other things equal, the smaller that ratio, the better.

And there, folks, is the rub.  If you want to know the real dilemma facing the FOMC, forget about the CPI, oil prices, and last quarter’s weather.  Here’s the real McCoy: NGDP growth is too low.  But the Fed is too darn big.

Yes, Bernanke, by your misguided policies you´ve made the Fed too big AND mostly useless!