James Bullard and the case of the ‘wandering regimes’

In London, recently, St Louis Fed president James Bullard restated the Bank´s ‘new view’:

The St. Louis Fed had been using an older narrative since the financial crisis ended. That narrative has now likely outlived its usefulness, and so it is being replaced by a new narrative. The hallmark of the new narrative is to think of medium- and longer-term macroeconomic outcomes in terms of regimes. In this new narrative, the concept of a single, long-run steady state to which the economy is converging is abandoned, and is replaced by a set of possible regimes that the economy may visit. Regimes are generally viewed as persistent, and optimal monetary policy is viewed as regime dependent. Switches between regimes are viewed as not forecastable.

Unfortunately, Bullard gets it wrong. It is not monetary policy that is regime dependent but regimes that are monetary policy dependent. In other words, the Fed is not passive, but instrumental in building regimes.

History is very clear on that point.

In the 1960s, monetary policy worked double-shift to build the high inflation (“Great Inflation”) regime that blossomed in the 1970s.

According to Arthur Okun, Council of Economic Advisers (CEA) staff member (1961-62), member (1964-67) and Chairman (1968-69):

The stimulus to the economy also reflected a unique partnership between fiscal and monetary policy. Basically, monetary policy was accommodative while fiscal policy was the active partner. The Federal Reserve allowed the demands for liquidity and credit generated by a rapidly expanding economy to be met at stable interest rates

Throughout the 1970s, Fed Chairman Arthur Burns conducted monetary policy in such a way as to entrench the “Great Inflation” regime. According to Burns:

We are in the transitional period of cost-push inflation, and we therefore need to adjust our policies to the special character of the inflationary pressures that we are now experiencing. An effort to offset, through monetary and fiscal restraints, all of the upward push that rising costs are now exerting on prices would be most unwise. Such an effort would restrict aggregate demand so severely as to increase greatly the risks of a very serious business recession.

In his view, monetary policy could at most mitigate the unemployment effects of supply shocks. No wonder nominal spending growth showed a rapidly rising upward trend all through the 1970s. High and rising inflation was the consequence.

Later, Paul Volcker worked hard to change the regime. In his first FOMC meeting as Chairman in 1979, Volcker “defined his moment” by asserting:

Economic policy has a kind of crisis of credibility. As a result, dramatic action to combat inflation would not receive public support without more of a crisis atmosphere.

I define the seven-year period going from the fourth quarter of 1979 to the fourth quarter of 1986 as the “Volcker Transition.” That is when the US economy transitioned from a high inflation and high volatility regime, to one characterized by more-stable real output and lower and steadier rates of inflation. The result of the Volcker Transition is the “Great Moderation” that extends, under Greenspan, from 1987 to 2007.

Bernanke´s misguided monetary policy, heavily influenced by fears of inflation from oil price shocks, broke the spell. The outcome was the “Great Recession” regime, quickly followed by the “Great Stagnation” regime.

This is a good place to introduce another Fed Bank that does not capture the fact that monetary policy is vital in determining the regime. Four years ago, Liberty Street, the blog of the New York Fed wrote The Great Moderation, Forecast Uncertainty, and the Great Recession:

The Great Recession of 2007-09 was a dramatic macroeconomic event, marked by a severe contraction in economic activity and a significant fall in inflation. These developments surprised many economists, as documented in a recent post on this site. One factor cited for the failure to anticipate the magnitude of the Great Recession was a form of complacency affecting forecasters in the wake of the so-called Great Moderation. In this post, we attempt to quantify the role the Great Moderation played in making the Great Recession appear nearly impossible in the eyes of macroeconomists.

And concludes:

 In sum, our calculations suggest that the Great Recession was indeed entirely off the radar of a standard macroeconomic model estimated with data drawn exclusively from the Great Moderation. By contrast, the extreme events of 2008-09 are seen as far from impossible—if unlikely—by the same model when the shocks hitting the economy are gauged using data from a longer period (third-quarter 1954 to fourth-quarter 2007). These results provide a simple quantitative illustration of the extent to which the Great Moderation, and more specifically the assumption that the tranquil environment characterizing it was permanent, might have led economists to greatly underestimate the possibility of a Great Recession.

From reading Bullard, that´s exactly what you would get because:

The upshot is that the new approach delivers a very simple forecast of U.S. macroeconomic outcomes over the next two and a half years. Over this horizon, the forecast is for real output growth of 2 percent, an unemployment rate of 4.7 percent, and trimmed-mean personal consumption expenditures (PCE) inflation of 2 percent. In light of this new approach and the associated forecast, the appropriate regime-dependent policy rate path is 63 basis points over the forecast horizon.

The chart below comprises the period considered by Liberty Street. Note that in the late 50s, the relatively small and brief negative NGDP growth was sufficient to thump RGDP growth, even harder than the supply shocks of the 70s or the tightening of spending during the Volcker Transition.

Wandering Regimes

According to Robert Lucas (Econometric Policy Evaluation, a critique, 1976), forecasts are regime dependent. So, if you change policy, you change the regime (and also the forecasts).

Liberty Street estimates the model across regimes, so that the Great Recession becomes “far from impossible”.

I identify the Great Stagnation regime as a low volatility regime. That characteristic (low vol) is shared with the Great Moderation regime. But that is very misleading. Once you take into account the different nominal and real growth rates in the two periods, you understand how “sub-optimal” the present regime is!

The Tables below illustrates for the 2010-2016 and 1992-1997 (halcyon days of the Great Moderation).

NGDP 2010 – 2016 1992 – 1997
Growth (% YoY) 3.7% 5.6%
Standard Deviation 0.7 0.7
RGDP
Growth (% YoY) 2.1% 3.5%
Standard Deviation 0.6 0.8
CPI Core
% YoY 1.5% 2.1%
Standard Deviation 0.4 0.5

Certainly a steep price to pay for having inflation a bit below target!

“The Way We Were”

Antonio Fatás writes “The missing lowflation revolution”:

It will soon be eight years since the US Federal Reserve decided to bring its interest rate down to 0%. Other central banks have spent similar number of years (or much longer in the case of Japan) stuck at the zero lower bound. In these eight years, central banks have used all their available tools to increase inflation closer to their target and boost growth with limited success. GDP growth has been weak or anemic, and there is very little hope that economies will ever go back to their pre-crisis trends…

… Now we have learned that either all central bankers are as incompetent as the Bank of Japan in the 90s or that the phenomenon is a lot more natural, and likely to be repeated, in economies with low inflation, more so when the natural real interest rates is very low…

My own sense is that the view among academics and policy makers is not changing fast enough and some are just assuming that this would be a one-time event that will not be repeated in the future (even if we are still not out of the current event!).

The comparison with the 70s when stagflation produced a large change in the way academic and policy makers thought about their models and about the framework for monetary policy is striking. During those years a high inflation and low growth environment created a revolution among academics (moving away from the simple Phillips Curve) and policy makers (switching to anti-inflationary and independent central banks). How many more years of zero interest rate will it take to witness a similar change in our economic analysis?

Fatás succinctly lays out the problem. Interestingly, since the late 1990s, many have been concerned about “Monetary Policy in a Low Inflation Environment”, among them, Bernanke himself! For those interested, I provide a nontechnical essay from 2001 (with references within).

Apparently, when “push comes to shove”, it was all forgotten!

For the past seven years, Market Monetarists, under the guidance of Scott Sumner have proposed a monetary regime change. The new regime would have the Fed (and other central banks) level target nominal GDP.

In a sense, this proposal simply involves making explicit something that was only implicit during the “Great Moderation”, being, in fact, responsible for that outcome. That´s good, because it won´t be a “shot in the dark”. We´ve been there.

Over the past seven years, people who never thought themselves as “market monetarists” have come out in favor. For example, Christina Romer, a former Obama head of the CEA and Harvard professor Jeffrey Frankel. Even Simon Wren-Lewis, a pillar of the New Keynesian school, is coming around to the idea.

There is however, one lose end. There´s a view that over the past five years, after partially recouping from the “Great Slump”, the economy lives through a “Great Moderation 2.0”. Unfortunately, the “GM 2.0” is also viewed as the “Great Stagnation”.

This is where the “Level Target” attached to “NGDP Targeting” comes in. To make the idea clear, I put up a set of charts that compare the “golden age” of the “GM 1.0”, the five years from 1992.IV to 1997.IV with the five years of the “GM 2.0”, from 2010.III to 2015.III.

Level Problem_1

Houston, we have a LEVEL problem!

Another point: Fatás mentions the change among academic economists, who moved away from the Phillips Curve. Now, we have academics in the Fed, like Yellen and Fischer, moving back to Phillips Curve thinking, while not abandoning inflation targeting.

Note that the unemployment rate at present is the same low rate of unemployment as in 1997, while inflation, both in 1997 and today are below the target level. In both instances, unemployment fell together with inflation!

However, the unemployment then and now are not comparable magnitudes. Just look at the very different behavior of labor force participation in the two periods.

Level Problem_2

Although the level of NGDP growth is important, the fundamental level question concerns the level of NGDP, more than its growth rate. This comes out shockingly clear in the next chart. As Fatás mentions in his post:

The fact that a crisis can be so persistent and that cyclical conditions can have such large permanent effects on potential output.

Would lead us to say that, after 7 years, the original trend may not be attainable any longer. However, a trend level between today´s level and the level that prevailed all the way to 2007 may be feasible.

Level Problem_3

The way we were

The Depression´s “Great Moderation”

It´s always interesting to see that not many perceive the low growth of this ‘recovery’ as clear evidence that the economy is in a depression (not a “Great” one, but one nevertheless).

The chart provides an illustration:

Depressions´ Great Moderation_1

At the WSJ Jon Hilsenrath writes about his (and the markets´) befuddlement in Why the Economy—and the Fed—Keeps Getting Knocked Off Track:

The peril of a slow-growing economy is that even small disturbances can knock it off stride, a reality now bedeviling the U.S.

A slew of soft economic reports in recent days has led Wall Street analysts to again reduce their estimates of U.S. growth. It now looks possible U.S. output will nearly be flat for the first half of 2015, and might even contract on average over the first half. J.P. Morgan economists see a growth rate of just 0.5% for the first half.

This softness, which is likely to constrain the Federal Reserve as it eyes when to raise short-term interest rates, is befuddling many economists who just months ago pointed to signs the U.S. economy was kicking into a higher gear. Many of the economy’s underlying fundamentals still look strong: companies are hiring, and incomes and wealth are rising. Interest rates are low and supportive of growth while government fiscal policy—a drag early in the recovery—has become neutral.

A variety of indicators, though, tell a different story. The Federal Reserve on Friday reported U.S. industrial production contracted in April for the fifth straight month, down a seasonally adjusted 0.3% from the month before. A University of Michigan index of consumer sentiment also droppedSoft April retail-sales data and dismal trade numbers, both on Wednesday, had already led analysts to reduce their estimates of growth.

“Economies, like bicycles, are more stable when growing at moderate speed than when growing slowly,” said Lawrence Summers, a Harvard University economics professor and former Obama administration economics adviser, in an interview. A slow-growing economy “is one moderate sized shock away from recession.”

……………………………………………………………………

The U.S. economy has actually been less volatile than normal since the recession ended in mid-2009, according to James Stock, a Harvard University economics professor who coined the term “Great Moderation” to describe the steady growth rates of previous decades.

Deviations in growth from one quarter to another have been no larger in this recovery than they were in the three recoveries preceding the past recession, he said. Moreover, deviations in growth from one year to the next in this recovery have actually been half as large as they were during the three previous recoveries.

Yet he sees a risk if economic turbulence grows.

“If you are growing at a low level, you are going to be more vulnerable to those major shocks than you would be if you were growing at 3.5% or 4%,” he said. “This is a major challenge for policy.”

Because interest rates are already near zero—in part because of the slow growth rate—the Fed doesn’t have room to cut them in response to a downturn if one actually does occur.

The thing is that most talk about “Great Moderation” as something only pertaining to growth, forgetting about the associated level.

The chart below illustrates why the ongoing “Great Moderation” is consistent with a depressed economy. The chart describes in ‘phase space’ the degree to which growth ‘spreads out’ (is volatile).

Depressions´ Great Moderation_2

It is clear that real growth volatility is significantly lower during the ongoing ‘recovery’, than it was during the original “Great Moderation”. If you discard the low growth of the 2001 recession, real growth at present has been far lower than real growth in 1992 -07.

If you look at the first chart above, you see why we are in a depression. During the “Great Recession”, real output contracted and extremely low growth thereafter has not directed it back to trend.

The next chart describes in ‘phase space’ the behavior of nominal growth (NGDP or nominal spending growth). It is even more stable now than before, but note that at present, the growth rate is not much different from the nominal growth rate observed during the 2001 recession.

Depressions´ Great Moderation_3

The big question is; if the Fed has the ability (and note that for decades nominal growth was very volatile) to provide nominal growth stability (that translates into real growth stability), why can´t it also do it at a non-depressed level?

In other words, if it can keep nominal growth chugging along at a ‘constant’ rate, why can´t it temporarily increase that rate so that the economy will climb out of the ‘hole’ it´s in?

It´s certainly not because interest rates are at the ZLB. As Watson puts it, rates are near zero in part because (nominal) growth has been so low. For goodness sake, then, increase the nominal growth rate!

Unfortunately, Janet & Friends prefer to speak about “policy normalization”, meaning increasing the FF target rate. They would do much better if they switched to a target level for nominal spending.