Brainard´s “New Normal” is Old

Lael Brainard´s speech on the Fed´s new “longer-run goals and strategies makes reference to a “New Normal”: [I only highlight her references to the labor market]

“The new statement on goals and strategy responds to these features of the new normal in a compelling and pragmatic way by making four important changes.

First, the statement defines the statutory maximum level of employment as a broad-based and inclusive goal and eliminates the reference to a numerical estimate of the longer-run normal unemployment rate.⁶ 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.

Third, the statement highlights an important change in the Committee’s reaction function. Whereas previously it sought to mitigate deviations of employment and inflation from their targets in either direction, the Committee will now seek “to mitigate shortfalls of employment from the Committee’s assessment of its maximum level and deviations of inflation from its longer-run goal.” This change implies that the Committee effectively will set monetary policy to minimize the welfare costs of shortfalls of employment from its maximum and not preemptively withdraw support based on a historically steeper Phillips curve that is not currently in evidence and inflation that is correspondingly much less likely to materialize.

… 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strategy we made in the new statement been in place several years ago, it is likely that accommodation would have been withdrawn later, and the gains would have been greater.”

What she really shows is that the post Greenspan FOMC has continuously misinterpreted the economy.

The panel below clearly illustrate that during the 1990s and early 2000s (before the Great Recession), a stable growth rate for nominal spending (NGDP) was what was required to keep the rate of unemployment on a downward trend while inflation either fell or remained low & stable.

The same remains true for the post GR period.

When the Fed makes a big monetary policy mistake and allows nominal spending to tank, the consequences are also big. This was the case in the monetary-led Great Recession. NGDP tanks while unemployment balloons. Inflation dropped by 50% (from 2% to 1%).

Four years ago (Sept 16) Lael Brainard made a speech with the title: “The New Normal and what it means for Monetary Policy”. One of the key features of the New Normal was:

2. Labor Market Slack Has Been Greater than Anticipated
   Second, and related, although we have seen important progress on employment, this improvement has been accompanied by evidence of greater slack than previously anticipated. This uncertainty about the true state of the economy suggests we should be open to the possibility of material further progress in the labor market. Indeed, with payroll employment growth averaging 180,000 per month this year, many observers would have expected the unemployment rate to drop noticeably rather than moving sideways, as it has done.

The next chart zooms in on 2016 to indicate the “cause” of the sideways move in unemployment. You easily see it was due to the excessive drop in NGDP growth from the 4% average that prevailed in the 2010 – 2019 period. The same happened 20 years before. The Fed should have picked on this “pattern” some time ago! As seen in the previous charts, once NGDP growth picks up again, unemployment resumes the down trend.

So, using new words for the “target” – AIT – and new words for the “reaction function” – shortfalls – will likely change very little.

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.

Fed´s usefulness is waning

According to Bernanke:

In general, with policymakers sounding more agnostic and increasingly disinclined to provide clear guidance, Fed-watchers will see less benefit in parsing statements and speeches and more from paying close attention to the incoming data. Ultimately, the data will inform us not only about the economy’s near-term performance, but also about the key parameters—like y*, u*, and r*—that the FOMC sees as determining that performance over the longer term.

 

The Fed Will Fail

A Benjamin Cole post

House prices feed heavily into U.S. inflation rates as measured, and as pointed out by Kevin Erdmann of the excellent blog Idiosyncratic Whisk, there is hardly inflation at all but for housing costs.

The matters little for U.S. Federal Reserve officials or the gaggle of inflationistas who monomaniacally jibber-jabber about prices. At every juncture, monetary policy is about the perils of inflation and the need to raise rates.

But, as noted by many, from here the Fed cannot tighten its way to higher long-term interest rates. The United States is in that monetary zone long ago noted by Milton Friedman: Interest rates are low as a consequence of tight money.

The present-day reality is this: Easy money for years on end does not lead to sub-2% 10-year US Treasuries, which we see in the market now.

And Fed policy gets more confounding.  If the Fed raises rates, it will only succeed on the short-end of the curve. As money is already tight, long-term rates will sag, and that includes long-term mortgage rates.

Okay, so lower long-term mortgages rates, ceteris paribus, lead to higher house prices and thus higher rents, as rents are tried to house prices.

Of course, the real solution to high housing costs in the United States is twofold, involving aggressive upzoning or dezoning of property in high-cost cities, and a looser money policy and extension of credit to home-building industries and buyers.

An aggressive pro-growth monetary policy might actually result in prosperity and higher long-term rates. Oddly enough, the higher mortgage rates might somewhat depress house prices and related rents, which feed into reported inflation.

As it stands, there is little the Fed can do about property zoning, which is a local prerogative. At the last Fed shindig in Jackson Hole, every panel discussion was about inflation, but none mentioned property zoning. I would call this a blind-spot, but that would suggest the Fed has eyes.

In any event, the U.S. property-owning class in each city seems content to zone out competition, and is politically powerful. In the real world, prosperity in the United States will incur moderate inflation, in large part due to housing costs.

The Fed’s chosen solution is to prevent prosperity, but that is a central banker’s fix and not a good one. The Fed’s better recourse from here is to shoot for higher long-term growth and interest rates, and moderate inflation, by any means necessary, including helicopter drops.

Of course, the best course is targeting NGDPLT.

The Fed is likely to enter the next recession with interest rates near the zero-bound and inflation dead. Then what?

Markets to Fed: “Stop talking nonsense”

A James Alexander/Marcus Nunes post

The FOMC statement today clearly tried hard to tell the market that the economy was improving,  signaling the “door is open for a September hike”!

“The labor market has “strengthened,” the Federal Open Market Committee said after its two-day meeting. That was brighter than the FOMC’s assessment six weeks ago, when the central bank said the pace of improvement in jobs growth had “slowed.” Moreover, officials described household spending as having been “growing strongly,” and economic activity as expanding at “a moderate rate.” That marked a mild upgrade from June, when the Fed said household spending had strengthened and economic activity appeared to have picked up.”

But … since mid-2014, the Fed’s own Change in Labor Market Conditions is still weakening, if a bit less than earlier in the year. Household spending in nominal terms is still awful, even if lowflation means real spending looks OK. NGDP growth is also sliding down. We know that money illusion means people certainly won’t feel better and low nominal growth does no favors  to productivity growth. The Price Pressures probability, calculated by the St Louis Fed, also shows price pressure is absent.

Today’s FOMC statement followed on from the transparent spinning we spotted last week by the Fedborg.

In fact, three bits of data that came out today were all weaker than expected all in different areas of the economy: durable goods, pending home sales and stronger oil inventories. A “moderate rate” of expansion is just plain wrong.

The markets certainly reacted quickly, first seeing a rise in the USD and bond yields before shock kicked in that the Fed had lost touch with reality and both the USD and bond yields fell. Technically the first impact is the liquidity impact of tighter money followed by the Fisher effect of longer term expectations driving prices.

The feedback loop we identified  in monetary policy seems to be working very quickly these days, hours, minutes. In fact, it is on the way to collapsing to a single point: “Whatever the FOMC says, there will be no tightening”!

If talk matters, why not change the subject matter?

Timothy B Lee summarizes thus:

This pattern — the Fed talking about imminent interest rate hikes but then delaying them due to disappointing economic performance — has been playing out for a couple of years. A lot of commentators simply treat it as bad luck, with the Fed as a mere spectator. But that misunderstands what’s going on.

In reality, the Fed’s constant chatter about raising rates is itself an important cause of the economy’s sluggish performance. Markets and business leaders pay close attention to Fed statements. When Yellen signals that higher interest rates — and, consequently, slower growth — are imminent, companies respond by cutting investment spending. The result is a self-defeating feedback loop.

Imagine if, from today, the Fed instead of “rate normalization”, began to talk about “spending level normalization”. Quite likely, a self-reinforcing feed-back loop would take hold. Instead of “slumming” we might just start “going somewhere”!

“Headwinds”: Code for “Fed”

Ms. Yellen has said headwinds are holding back the economy. Right! The Fed is working full-time to that end. And, if they continue their quixotic search for the “neutral rate”; if they continue to believe inflation will climb to target sometime in an unknown future date; if they continue to believe the labor market is “strong”; they will be surprised to see the fed funds rate remaining unchanged for “years to come”!

The FOMC is content playing “loves me, loves me not”, not with daisies, but with data

And never realizes that it´s not the Fed who´s “data dependent”, but it´s the data that is “Fed-dependent”!

So they frequently have to go through some contortionism, like this “tongue-twisting” comment from Atlanta´s Dennis Lockhart: 

The [employment]report was not a sign that the economy was slowing, he said. It could be the “natural slowing” in job creation as the economy gets closer to full employment, he said.

Parrots at the FOMC

Repeat after me:

1. “economy getting close to full employment”
2. “inflation will soon climb to 2%”

So that you can then say:

3. “a rate hike will take place soon”

In the not-so-distant future, people will realize that the “gradual normalization” strategy for monetary policy was a most stupid choice!

One of the reasons is that it “keeps out evidence”, in particular evidence that wouldn´t be consistent with their view of necessary “normalization”.

Two pieces of evidence available to policymakers contest their “mantra” about employment and inflation.

The Kansas City Fed calculates a Labor Market Conditions Indicator. The chart shows that for the past two years the changes have trended down and lately have turned negative.

The St Louis Fed calculates a Price Pressure Measure:

Policymakers usually want to know—to the extent possible—the probability that inflation over the next four or eight quarters will exceed the inflation target.

To help policymakers, financial market participants, and others who have an interest in assessing future inflation probabilities, the Federal Reserve Bank of St. Louis has developed an index called the price pressures measure (PPM).³ The PPM measures the probability that the expected inflation rate (12-month percent changes) over the next 12 months will exceed 2.5 percent.

And here´s the chart with the probabilities since January 2012 when the 2% target became official.

Contrary to what the “Parrots” chant, the probability that inflation will exceed the target going forward, has been diminutive!

Unfortunately, the “gradual normalization” strategy ignores all that!

The “Overly Optimistic” Fed

In “Reluctant Parties: The Fed and the global economy”, Gavyn Davies writes:

To judge from last week’s surprisingly hawkish FOMC minutes, which I had not expected, the Fed seems to be reverting to type (see Tim Duy). Many committee members have downplayed foreign risks and have returned to their earlier focus on the strength of the domestic US labour market, which in their view is already at full employment.

In his column today for Bloomberg View, Kocherlakota writes:

This kind of uncertainty — about which goals will define the Fed’s policies — is not healthy. Consumers and businesses can’t make good decisions if they don’t have a strong enough sense of how the central bank will act in any situation. Fed officials must have — or be given — a much clearer set of shared objectives for managing the economy.

To wrap up, commenter Bill sent me “Why the Unskilled Are Unaware: Further Explorations of (Absent) Self-Insight Among the Incompetent”:

People are typically overly optimistic when evaluating the quality of their performance on social and intellectual tasks. In particular, poor performers grossly overestimate their performances because their incompetence deprives them of the skills needed to recognize their deficits. Five studies demonstrated that poor performers lack insight into their shortcomings even in real world settings and when given incentives to be accurate. An additional meta-analysis showed that it was lack of insight into their own errors (and not mistaken assessments of their peers) that led to overly optimistic estimates among poor performers. Along the way, these studies ruled out recent alternative accounts that have been proposed to explain why poor performers hold such positive impressions of their performance.

I just became more pessimistic!