How´s the Fed doing in the make-up department?

The Fed´s new Statement on Longer-Run Goals and Monetary Policy Strategy is all about “making-up”; be it about inflation below target or unemployment shortfalls.

The Fed is not changing its ultimate mandate, which is to balance price stability with maximum employment. However, it has announced that it will no longer preemptively slow down the economy if the labor market begins to look tight and it will treat its 2% inflation target as an average.

Why the new statement? According to Lael Brainard, since the end of the “Great Recession” the US economy has been in a “new normal”. Three things characterize “new”:

  1. The equilibrium interest rate has fallen to low levels, which implies a large decline in how much we can cut interest rates to support the economy.
  2. Underlying trend inflation appears to be somewhat below the Committee’s 2 percent objective, according to various statistical filters.
  3. The sensitivity of price inflation to labor market tightness is very low relative to earlier decades, which is what economists mean when they say that the Phillips curve is flat.

How does that compare with the “old normal” (Great Moderation)?

  1. The equilibrium or neutral interest rate was never a concern. It averaged 2.3%, close to the 2% John Taylor pinned it at in his 1993 Taylor-rule. Since the end of the GR it has averaged 0.3%.
  2. In the “old normal”, core PCE inflation averaged 2.1%, almost exactly the 2% that was the implicit target at the time. During the “new normal”, it has averaged 1.6%.
  3. The “low sensitivity of price inflation to labor market tightness was already low relative to previous decades. For example, speaking in 2007, Bernanke 2007 said:

“…many studies of the conventional Phillips curve find that the sensitivity of inflation to activity indicators is lower today than in the past (that is, the Phillips curve appears to have become flatter);1 and that the long-run effect on inflation of “supply shocks,” such as changes in the price of oil, also appears to be lower than in the past (Hooker, 2002).

The “new normal” mindset leads to comments such as these:

“Monetary policy is really good for playing defense,” said Adam S. Posen, president of the Peterson Institute for International Economics. “But not for playing offense.”

“If the Fed is relatively weak in its ability to end recessions, why do its actions get so much attention during times of economic crisis? Mostly because the actions of Congress (dominated for the past decade by the Republican caucus in the Senate) have been either too weak or outright damaging during these crises. For example, in the weak recovery from the Great Recession of 2008-2009, austerity imposed by a Republican-led Congress throttled growth, even as historically aggressive actions by the Fed tried (only partly successful) to counter this fiscal drag.”

That´s interesting because during the “Great Inflation” of the 1970s, Fed Chair Arthur burns thought the Fed could not play defense, but under the right circumstances, it could be good at playing offense!

Arthur Burns:

“Another deficiency in the formulation of stabilization policies in the United States has been our tendency to rely too heavily on monetary restriction as a device to curb inflation…. severely restrictive monetary policies distort the structure of production. General monetary controls… have highly uneven effects on different sectors of the economy.”

Burns did not consider monetary policy to be the driving force behind inflation. He believed that inflation emanated primarily from an inflationary psychology produced by a lack of discipline in government fiscal policy and from private monopoly power, especially of labor unions. It followed that if government would intervene directly in private markets to restrain price increases, the Federal Reserve could pursue a stimulative monetary policy without exacerbating inflation.

The new and old normal share characteristics:

  1. In both cases, NGDP growth, RGDP growth and inflation were stable, albeit at lower rates in the new normal
  2. Phillips Curve thinking was the wrong mindset in both cases. It was a very costly mistake in both instances.

The question that naturally comes up is “what led us from one state to the other”?

The two states are illustrated by the behavior of aggregate nominal spending (NGDP).

In both, NGDP is stable along a level path. We can infer that those paths and associated growth rates were chosen, (were not accidental). The same goes for the inflation rate that averaged a stable 2.1% in the old normal and 1.6% in the new.

The transition from one state to the other took place in 2008-09. In the chart below, we see that both NGDP and money supply growth tanked and inflation shifted down from 2% to 1%.

The Fed never tried to make up for the drop in NGDP and inflation, resuming expansion along a lower level path and lower rates.

The next chart zooms in on the “new normal” chart shown in the first picture above. To explain the recent behavior of nominal spending (NGDP), I use the QTM (Quantity Theory of Money).

According to the QTM, MV=Py, to keep nominal spending (Py) growing at a constant rate, money supply (M) has to offset changes in velocity (V).

The chart shows five regions. In region 1, the Covid19 surprise increased the demand for money (velocity falls). Since the money supply barely changed, NGDP drops. In region 2, the Covid19 shock intensifies the demand for money (velocity drops more). Although money supply growth rises, it does so by less than required to keep NGDP at least stable. In region 3, velocity stabilizes while money supply growth increases. NGDP rises. In region 4 money still grows somewhat, but so does velocity, with the result being a further rise in NGDP.

In region 5, which covers the latest data point (July), we see that money growth stabilizes. Velocity, however, rises somewhat so NGDP increases but at a slower rate.

Maybe the Fed was influenced by the large number of articles and op-eds decrying that the unprecedented rates of money growth would lead to an inflationary boom down the road. In any case, money growth stopped rising. In that case, the rise in NGDP was fueled only by the small rise in velocity.

It appears, therefore, that we face a situation not of excessively strong money supply growth, but once again, although for very different reasons, a case of “not enough money”. For NGDP to rise back to the “new normal” trend, money growth will have to increase more, unless velocity rises faster,

The danger is that the Fed will not make up fully for the drop in NGDP, starting on a “new-new normal”, characterized by an even lower level of aggregate nominal spending. The new target of getting inflation to average 2% will also remain a distant dream…

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!

After Covid19, inflation?

Recently, manifestations about rising inflation following the Covid19 have increased substantially. Two recent examples illustrate, with both appealing to the QTM:

  1. The quantity theory of money today provides – as it always has done – a theoretical framework which relates trends in money growth to changes in inflation and nominal GDP over the medium and long term.

A condition for the return of inflation to current target levels is that the rate of money growth is reduced back towards annual rates of increase of about 6 per cent or less.

2. The quantity theory of money, the view that the money supply is the key determinant of inflation, is dead, or today’s mainstream  tell us. The Federal Reserve is now engaged in a policy that will either put the nail in the quantity theory’s coffin or restore it to the textbooks. Sadly, if the theory is alive and wins out, the economy is in for a very rough ride.

All those that appeal to the QTM to argue, “Inflation is coming”, forget that in 1971 Milton Friedman published in the JPE “A monetary theory of nominal income”, in which he argued for using the quantity theory to derive a theory of nominal income rather than a theory of either prices or real income.

There he asks; “What, on this view will cause the rate of change in nominal income to depart from its permanent level [or trend level path]? Anything that produces a discrepancy between the nominal quantity of money demanded and the quantity supplied, or between the two rates of change of money demanded and money supplied.”

A little over two decades later, in 2003, Friedman popularized that view with his “The Fed´s Thermostat” to explain the “Great Moderation”:

“In essence, the newfound stability was the result of the Fed (and many other Central Banks) stabilizing nominal expenditures. In that case, from the QTM, according to which MV=PY, the Fed managed to offset changes in V with changes in M, keeping nominal expenditures, PY, reasonably stable. Note that PY or its growth rate (p+y), contemplates both inflation and real output growth, so that stabilizing nominal expenditures along a level growth path means stabilizing both inflation and output.

How does that square with the evidence? To illustrate we look at two periods, the “Great Inflation” of the 70s and the “Great Moderation” (1987 – 2005).

During the “Great Inflation”, it seems the Thermostat broke down and the “temperature” kept rising above “normal”. During the “Great Moderation”, it appears the Thermostat worked just fine, keeping the “temperature” close to normal levels at all times.

How does the stability of the trend level path for nominal spending (NGDP) translate to the growth rate view? In the next charts, we observe that during the “Great Inflation” the “temperature” oscillated on a rising trend, while during the “Great Moderation” it was much more stable with no trend.

If the Thermostat is working fine, according to Friedman stabilizing nominal expenditures along a level growth path means stabilizing both inflation and output.

The next charts show that is the observed outcome.

On average, real growth is similar in both periods, while the volatility (standard deviation) of growth is 50% (1.3 vs 2.6) lower.

Note that price & wage controls work like putting a wet cloth on the patient´s forehead to reduce fever, as doctors did in the Middle Ages! As soon as you take away the wet cloth, temperature rises.

An interesting takeaway gleaned from the results following the application of Friedman´s Fed Thermostat, is that the 70s was no “stagflationary decade” as pop culture has it. It was just the “inflationary decade”.

It also shows that comments as the one below are plainly wrong:

“We are right to fear inflation. The 1970s was a colossal disaster and economists still can’t even agree on what exactly went wrong.”

Having understood the meaning and usefulness of “Friedman´s Thermostat”, we can use it to explain what happened after Bernanke took over as Chair in January 2006.

“Dialing down” the economy

AS the chart shows, when Bernanke began his tenure as Fed Chair, initially he kept nominal spending (NGDP) evolving close to the trend level path. Around mid-2007, he began to worry about the potential inflationary effects of low unemployment (4.4%, below their estimate of the natural rate) and rising oil prices.

At that point, money demand was on a rising trend (falling velocity) due to the uncertainties flowing from the financial sector problems that were brewing (remember the “start date” of the financial crisis was August 07 when two funds from Paribas were closed for redemption) and money supply growth was “timid”. As a result, nominal spending began to fall below trend.

In mid-08, the FOMC became very concerned about inflation. After all, in the 12 months to June 08 oil prices doubled. Bernanke´s summary of that meeting discussions is unequivocal evidence that the Fed´s goal was to “dial down” the Thermostat (or “cool”) the economy!

FOMC Meeting June 2008 (page 97):

“My bottom line is that I think the tail risks on the growth and financial side have moderated. I do think, however, that they remain significant. We cannot ignore them. 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. When the time comes, we need to make that decision and move that way because a halfhearted approach is going to give us the worst of both worlds. It’s going to give us financial stress without any benefits on inflation. So we have a very difficult problem here, and we are going to have to work together cooperatively to achieve what we want to achieve.”

Before that meeting, the fall in nominal spending below trend was likely the result of unintended mistakes in the calibration of the thermostat, in the sense that the increase in money supply failed to fully offset the fall in velocity. During the second half of 2008, however, money supply growth decreased sharply, especially after the Fed introduced IOER in October. That certainly qualifies as “premeditated crime”!

The 2008-09 recession (dubbed “Great”) is more evidence for the relevance of the “Thermostat Framework” spelled out by Friedman. It was the conscious “dialing down” of the thermostat by the Fed, not the house price bust or the associated financial crisis, that caused the deep recession.

The charts below illustrate the impact of the “dialing down of the thermostat” by the Fed.

What comes next, however, puts the “Thermostat Analogy” in “all its glory”, in addition to dispelling the notion made popular by Carmen Reinhart and Kenneth Rogoff that this recovery was slow because it followed a financial crisis.

In short, once the economy was “cooled”, the Fed never intended to “warm it up” to the previous trend level path, keeping the thermostat working fine for the lower temperature the Fed desired.

The implications of a well-functioning thermostat are evident in the charts below.

1 Nominal spending is kept stable along a (lower) level path

2 Both real output and inflation are stabilized (also at a lower rate)

The next chart (which makes use monthly NGDP from Macroeconomic Advisers) shows what happened following the Covid19 “attack”.

This is not like 2008. This time around, the Fed had no hand in the outcome. The virus came out of left field and “crunched” both the supply and demand “armies”, leading to a sudden “drop shock” in nominal spending.

Money demand jumped (velocity tanked). The next chart shows that the Fed reacted in the right way, with a lag, given the surprise attack.

The economy faces a health issue with mammoth economic consequences. The thermostat dialed the temperature down “automatically” and will likely maintain the “cooler temperature” while the virus is “active”. All the Fed can do is work to ensure the temperature does not fall even more. Given the latest data available (May), it appears the Fed is managing to “hold the fort”.

What the inflacionistas worry is with the aftermath, after the virus loses relevance. They argue the massive rise in the money supply observed so far ensures an inflation boom in the future.

As the thermostat analogy indicates, you have to take into account the behavior of velocity (money demand). So far, even with the “Federal Reserve pouring money into the economy at the fastest rate in the past 200 years”, what we observe is disinflation!

How will the Fed behave once the virus loses relevance? Will it set the thermostat at the previous temperature (previous trend level path)? In other words, will it make-up for the losses in nominal spending incurred during the pandemic, or not?

In this post, David Beckworth argues that there is no evidence the Fed plans to undertake a make-up policy, concluding:

“So wherever one looks, make-up policy is not being forecasted. Its absence does not bode well for the recovery and underscores the urgency of the FOMC review of its framework. I really dread repeating the slow recovery of the last decade. So please FOMC, bring this review to a vote and give make-up policy a chance during this crisis.”

After the Great Recession, the Fed chose not to “make-up”. The chart illustrates

What will it be this time around?

If the Fed undertakes a make-up policy, inflation will temporarily rise (just as it temporarily fell when the thermostat was dialed down). The impossible dream I have is that the Fed not only makes up for the virus-induced loss, but also partly for the loss incurred by its misguided policy of 2008!

As always, the inflation obsession will the greatest barrier the Fed will face. No wonder more than 40 years ago James Meade warned that inflation targeting was “dangerous”.

PS Update to the last chart above with data to August 20. The “bad outcome” seems to be transpiring!

Contrasting Inflation Targeting with NGDP Level Targeting

Given the recent increase in the number of articles or blog posts on NGDP level targeting (see, for example, here, here, here or here), I thought it would be useful to post an essay I wrote at the end of 2014 that compared NGDP-LT to inflation targeting. The piece is empirical, but I think the visual evidence is compelling,

Which is more reliable-1

Independent Fiat-Money Central Banks and ITs: A Toxic Combination

A Benjamin Cole post

The woeful record of independent fiat-money central banks and inflation targets is one of nearly universal economic asphyxiation. Everywhere on the globe where a central bank has an IT, one sees inflation below targets, deflation and anemic growth.

Right to it:

  • The Reserve Bank of Australia has an inflation target of 2% to 3%, but with inflation at 1% the RBA is below target. Growth is subpar—and this is the best of the lot.
  • Thailand has a1.5% inflation band around 2.5% IT, and has no inflation and subpar growth.
  • The People’s Bank of China has a 4% IT, and a 1.8% inflation rate. The nation is about at half of real growth rates when inflation was close to target.
  • The ECB has a 2% IT, and is in deflation perma-gloom
  • Japan has a 2% IT, and is in deflation perma-gloom.
  • The Bank of England has a 2% IT, and a 0.3% inflation rate. Growth is subpar.
  • Singapore has exchange-rate target on currencies that are ruled by ITs. The city-state nation most recently posted 0.3% QoQ growth and is in deflation.

Calling Inspector Clouseau

I see a pattern!

For that matter the Fed has a 2% IT on the PCE, often misperceived as a 2% ceiling on the CPI (perhaps even by FOMC officials). The Fed is below target and real growth in the U.S. microscopic. What a surprise!

Should not the macroeconomic topic of the day be,  “Why are global central banks nearly universally falling below their ITs while mired in slow growth?”

At this late date, why does anyone think an IT is a good idea? Where has an IT worked (with the possible exception of the RBA’s IT-band, a slightly less worse idea than an strict IT).

The sooner fiat-money central banks kill off ITs the better. They have not worked. Is that not reason enough?

Yes, NGDPLT’s would be better.

The oddity: For decades, there has been long-winded sermons on the risks of fiat-money central banks, one reason they were made independent. The premise, even in present-day literature, is that central banks have been loose, are loose, and want to be loose, to serve sinister statist-inflationist goals and populist madmen.

The reality? Independent fiat-money central banks have universally asphyxiated commerce through tight money.

How else to explain gathering global deflation and slow growth?

When will macroeconomic orthodoxy accept the reality?

Appearances can be deceiving

To many, the economy is strong enough to sustain a jolt of higher rates. Richmond´s Jeff Lacker is a case in point:

The U.S. economy appears strong enough to warrant significantly higher interest rates, Richmond Federal Reserve Bank President Jeffrey Lacker said on Friday.

Lacker, who is not a voting member of the U.S. central bank’s rate-setting committee this year, said he still favors raising rates sooner than later and that the Fed’s last policy meeting in July would have been a “good time” to tighten policy.

Speaking to a group of economists in Richmond, Lacker argued that a range of economic analysis suggests the Fed’s benchmark overnight interest rate – the federal funds rate – is currently too low.

“It appears that the funds rate should be significantly higher than it is now,” he said in the speech.

As the chart shows, for the past 23 years, inflation (PCE-Core) has been ‘cornered’.

Appearances Deceiving_1

What we dearly miss is some of the robust growth the economy experienced during the Greenspan years (1987 – 2005)

Appearances Deceiving_2

If 2% is not enough, don´t double it

According to the Economist:

…How might these problems be fixed? One possibility is simply to raise the inflation target to, say, 4%. Credibly enacted, that ought to alleviate the risk of impotence. If investors and consumers believe inflation will reach 4%, nominal interest rates should eventually rise to 5% or so even if real rates stay low. But rich-world central banks have undershot their targets for so long they may struggle to persuade the public to expect higher inflation. And a higher target would still leave central banks with a dilemma when economic growth and inflation diverge. Neither would it make up for big misses.

A more radical option is to move away from targeting inflation altogether. Many economists (and this newspaper) see advantages in targeting the level of nominal GDP, the total amount of spending in the economy before adjusting for inflation. A nominal-GDP target would allow for temporary variations in inflation. Downturns would be tempered by an expectation of protracted stimulus later on to make up lost ground. In better times, a rise in real GDP would provide the lion’s share of the required nominal-GDP growth and inflation could drift lower.

If interest rates “disappear”, Central Banks lose their relevance!

In Central Bankers’ Main Challenge: Staying Relevant – Decline in the natural interest rate gives authorities less ammunition to counteract economic shocks, Grep Ip writes:

When central bankers gather this week in Jackson Hole, Wyo., they will be consumed not with some pressing crisis in the global economy but by an existential threat to their relevance.

The threat stems from the realization that the sluggish economic growth that has prevailed since 2009 may be here to stay. If so, then so are today’s low interest rates.

For more than 8 years they´ve been shooting themselves in the foot, refusing to abandon their inflation target framework and the associated interest rate targeting (which now they desperately want to “normalize”).


Unwittingly, Conor Sen demolishes inflation targeting

Conor Sen discusses inflation:

Those who argue that the U.S. Federal Reserve should keep interest rates low typically point to the same piece of evidence: The central bank’s preferred measure of inflation remains below its 2 percent target, suggesting that the economy still needs stimulus.

What they ignore is that during the dot-com and housing booms of the 1990s and 2000s, this logic would have led to bigger bubbles — and bigger busts.

Stop right there.

That´s the best argument against inflation targeting!

In the late 1990s and early 2000s, the economy was buffeted by (positive) productivity shocks. That increases RGDP growth and reduces inflation. If the fall in inflation induces the Fed to adopt a more expansionary monetary policy, the result will be nominal instability.

But those were not straightforward times. Other relevant shocks were taking place. There was the Russia/LTCM shock of 1998, the oil shock of 1999 and Y2K (1999), terrorist attack (9/11/2001), the Eron et al also in 2001. In 2003-08 there were also back to back significant negative oil shocks.

Instead of gauging the stance of monetary policy by the up´s and down´s of the Fed Funds rate, you should look at the behavior of NGDP relative to trend.

The chart puts the NGDP Gap (the behavior of NGDP relative to its trend path) and PCE Core inflation.

C Sen_1

It seems that in its reactions to those shocks, the Fed initially “oversupplied” money between 1998 and 2000 and then, “undersupplied” money between 2001 and 2003. During most of that period, inflation remained below “target” because the positive supply shock was preponderant.

Then Conor Sen writes:

The bursting of the subprime bubble was particularly disastrous, forcing the Fed and Congress to take extraordinary measures to keep the financial system afloat and contain the economic damage. One can only wonder how much worse the episode would have been — and whether Congress would have found the political will to pay for even bigger bailouts — if the Fed had further fueled the boom by conducting even looser monetary policy. We should be glad the bubble got no bigger than it did.

He couldn´t be more wrong. What happened is that with the end of the productivity boom and the reemergence of a strong negative supply (oil) shock, core inflation ticked above the then implicit inflation target between 2005 and 2007.

But that was enough to bring on the inflation paranoia, which is quite evident in the 2008 FOMC Transcripts.

The result was that in 2008 monetary policy was severely tightened, with NGDP taking a deep and prolonged dive.

Now, you could ask: Why didn’t inflation become deflation? It certainly was on the way to that, but in 2009 the Fed reversed course and put NGDP growth back into positive territory. The chart illustrates.

C Sen_2

Something interesting to note: Since the crisis, core inflation has not behaved differently from what it did during 1997-2004, remaining mostly below target.

The difference is that now, instead of a productivity boom, we´re having a productivity slump. Inflation should be higher. It isn´t because NGDP growth has remained on a much lower path than before.

However, likely because the NGDP level path has been so much lower, opportunities for productivity enhancement investments have been rare. This has important feed-back effects and may be the main reason for the appearance of “feelings” of “Great Stagnation”.

At the end, Conor Sen confirms “inflation” as the proper target. But one that should be complemented by other indicators

Of course the Fed has to focus on inflation in making its monetary policy decisions. But officials should keep in mind that core PCE is not the only measure, and factor in other indicators such as employment and the behavior of asset markets. If they do so, the case for removing stimulus in the near future will look a lot stronger.

Life for the Fed and for the market would be much simpler if, instead of an elusive “inflation target”, the Fed targeted a trend level path for NGDP, much like it implicitly did from 1987 to 2007.

HT David Beckworth

Inflation targeting as voodoo economics

A James Alexander post

My last post was on the need to change the 2% inflation target to higher one or, better still, switch to  NGDP growth targeting. However, by even talking about inflation I feel it is easy to get sucked into a black hole of nonsense chatter about a concept so hard to practically measure.

Nominal GDP (as measured by the value of output, total income or total expenditure) is the reality. Real GDP is a highly artificial construct. And inflation is also a highly artificial construct, the mere residual between the reality of actual Nominal GDP and the artificial Real GDP. It is necessary to calculate some version of inflation to get from real Nominal GDP to artificial Real GDP.

To create a Real GDP figure the statisticians are meant to collect a huge number of price indices for each product, and then deflate the real or actual nominal value of output (ie sales) to derive a supposedly inflation-free “real” but artificial output figure.

Although they collect all these price indices they don’t create indices for the changing quality of each product. They should do. The price indices are thought of as “inflation”, but that is because of the assumption that the inflationary element of prices changes more quickly than quality or nature of the goods and services change. But how do we know? Has it been tested? Has it even been thought about in any methodical manner. I don’t think so. Occasionally, hedonistic or quality changes are incorporated into the price indices, but in a highly haphazard way. Statisticians do track changes in the basket of goods and services via surveys or by observing actual patterns of expenditure but can’t track changes in the nature of service – like a switch from learning on the job to learning at college, or a switch from spending on alcohol to spending on a gym, vice to virtue.

Of course, any quality or nature indices would create huge debates. But the price indices are largely meaningless without them. How can price inflation be observed without as much monthly effort going in to assessing the quality and nature of the product or service being tested.

Entertainment is the classic example, 15% of the CPI basket. The switches from street entertainers, to theatres, to movie theatres, to black and white television, to colour television, to broadband internet all involved major changes in product quality and very often the fundamental nature of the service. The pure inflation element may be able to be measured from one week to the next, but quality and nature also move ahead rapidly.  Transport, another 15%, is the same as walking gave way to horse drawn transport, to railways, to motor vehicles, to aircraft, to not travelling but having people and products brought to you virtually. The cost is not then transport but the cost of the broadband connection. Restaurants and hotels, 10% of the basket, change in quality all the time. Housing provokes similar questions.

I am not denying it is quite hard to compile NGDP as it has one or two theoretical issues itself: the final vs intermediate consumption issue, the issue of how to value self-owned housing or the scale of the informal economy. But RGDP has the exact same issues, plus the massive issue of divining pure inflation from changes in quality and nature.

Paul Krugman likes to throw the “voodoo economics” tag around when non-mainstream economists come up with ideas, but what should be done when mainstream economics has formed a consensus   around a very silly idea like inflation targeting.

The 2% target is voodoo upon voodoo

On top of the targeting of inflation, seemingly out of thin air a 2% target was created. It was possibly invented because the long run real growth has often been calculated as around 3%. So a 2% inflation seemed a nice balance. Not more than real growth, but not too close to zero and risking deflation. Not too high as to upset the current bunch of Republicans, the Germans, the famous Japanese housewives, or …? William Dudley of the NY Fed recently gave as a reason that it meant most people in their 30 year working lives would see a doubling of prices. Assuming inflation can be so precisely calculated, so what? Why not no change or quadrupling? What difference can it make?

Why has inflation targeting appeared to have worked?

There is much discussion about the “divine coincidence” that while targeting inflation, central bankers actually targeted the output gap. And during the Great Moderation got monetary policy more or less right. The “output gap” is an even more tricky theoretical concept.

NGDP Targeting is so sensible, so simple. It does not rely on any theoretical concepts to target like inflation, RGDP or another voodoo upon voodoo concept like the gap between artificially-created RGDP and where the artificial RGDP should be, theoretically speaking.

Some have suggested that central bankers were implicitly targeting NGDP growth. Well, maybe. If they were, it came very unstuck in 2007-08 when they seemed blinded by high headline inflation, and were very slow to react to falling actual NGDP growth and crashing NGDP growth expectations.