A “simple solution” to the Fed´s new AIT framework

The first thing to note is that inflation is not a price phenomenon (don´t reason from a price change is relevant here), but a monetary phenomenon.

For example, changes in relative prices (due to an oil price shock, for example) will only turn into inflation (a continued increase in all prices), if monetary policy allows it to happen (as we´ll see contrasting the 70s with the last 30 years.

Another point I´ll make is that the price index the Fed should target is the PCE Core index. Why? Because the headline index is much more volatile and, like in 2008, will lead the Fed astray.

The first chart shows that over a long period (60 years in this case) both the Core & Headline index show the same thing.

If you break the 1960 – 2020 period by decades, you´ll note that the core index functions as an “upper bound” to the headline index. The next chart shows two examples. The first from the high inflation 1970s and the second from the low inflation 1990s.

The next charts show the two in the form of year over year rate of change – inflation – and the corresponding behavior of nominal spending (NGDP) growth. Note that rising inflation (both for the headline & core indices) only happens when monetary policy, as gauged by NGDP growth, is on a rising trend. Relative prices do change but only with overall prices going up.

During the low and stable core PCE inflation period, the headline PCE inflation wonders up and down, buffeted by the price shocks (mostly oil). For this low inflation period, the average headline PCE inflation is 1.8, with a standard deviation (volatility) of 0.86. The average for core PCE inflation is the same 1.8, but with a standard deviation less than half that (0.41). So it´s much better to target the low volatility index.

What does the Fed face at present? The next chart shows that the core PCE index has hugged closely to a 1.8% trend path since 1993. This trend path was established from the data to 2006, before the upheavals of the Great Recession. Fourteen years later, even after the effects of the Covid19 shock, the index hasn´t deviated from the path.

If the Fed manages to keep the core PCE index following this path going forward, in ten years’ time, the index will reach Scott Sumner´s “magic number” of 135 (Ok, he means the headline index, but I´ve argued that´s a bad index to target and anyway, the core index is an upper bound on the headline index).

How to do that? Basically, don´t invent new benchmarks. Take what you have and do the best with it. Moreover, the best the Fed can do is what has been proven adequate for a long time, to wit, keep NGDP growth stable. The Fed can improve on that by not making the mistakes it made in 2001 and particularly in 2008, as the charts below indicate.

Now, NGDP is still far below the trend path it followed from the end of the Great Recession. The Fed´s first order of business is to make monetary policy expansionary enough to take NGDP back to that trend path. Once (if?) that´s done, the Fed should pursue a monetary policy that allows NGDP to grow close to the 4% rate it averaged from 2010 to 2019.

With that, the core price level will be close to 135 in 10 years’ time.

The workings of the monetary ‘thermostat’ during the Great Depression

George Selgin is writing a series on “The New Deal and Recovery”. In the Intro (where you find links to the five ‘chapters’ written so far), he summarizes:

“I believe that the New Deal failed to bring recovery because, although some New Deal undertakings did serve to revive aggregate spending, others had the opposite effect, and still others prevented the growth in spending that did take place from doing all it might have to revive employment.”

I want to show in this post the monetary policies that resulted from all the “actions” or policy decisions taken during the 1929-1941 period. The details of those decisions are the subject of Selgin´s series. As he points out:

I´m not opposed to countercyclical economic policies, provided they serve to keep aggregate spending stable, or to revive it when it collapses.”

In short, that statement is all about the workings of the thermostat. To recap, Friedman´s thermostat analogy as an explanation for the Great Moderation says:

“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=PYthe Fed managed to offset changes in V with changes in M, keeping nominal expenditures, PY, reasonably stable.

The two charts below summarize the behavior of aggregate nominal spending (NGDP) and the associated real aggregate output that resulted during the four “stages” of the Great Depression

If anything, 1929 shows what happens when the thermostat brakes down. When velocity drops (money demand rises) deep and fast, if instead of offsetting that move in velocity money supply tanks, aggregate nominal spending collapses, and so does real output.

The next chart reveals what happened during 1929 and early 1933, the first “stage” of the GD.

In the next Chart, we observe the power of monetary policy. With the thermostat set to “heat-up” the economy (with money supply growth reinforcing the rise in velocity, the opposite of what happened in 1929-33). Going off gold in March 1933 played a major role.

Going into Stage III we see a “reversal of fortune”, with monetary policy quickly tightening (culprits here are the gold sterilization policy by the Treasury & increase in required reserves by the Fed). In “The New Deal and Recovery Part IV – The FDR Fed, George Selgin writes:

“…instead of taking steps to ramp-up the money stock, Fed officials became increasingly worried about…inflation! Noticing that banks had been storing-up excess reserves, they feared that a revival of bank lending might lead to excessive money growth, and therefore refrained from contributing directly to that growth. Then, finding a merely passive stance inadequate, they joined forces with the Treasury to offset gold inflows. These steps were among several that contributed to the “Roosevelt Recession” of 1937-8…”

Stage IV coincides with the end of gold sterilization and ensuing expansionary monetary policy.  The military spending that began in 1940 to bolster the defense effort gave the nation’s economy an additional boost. This worked through the rise in velocity while money growth remained stable.

How did the price level behave through the different stages? The next chart gives the details. Stage I witnessed a big drop in prices (deflation). In Stage II the process stopped and reversed somewhat. Stage III indicates why the Fed worried about inflation and in Stage IV we see the effect on prices of the “defense effort”. Even so, by the end of 1941, the price level was still significantly below the July 1929 level!

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”.

The usefulness of underlying, or core, rates

It is the case, instead, of not missing the trees for the forest. The case for core inflation, for example, is well established, but not always understood. The charts below show that sometimes the qualitative information given by “trees & forests” or core and headline rates is the same, but at other times, “trees & forests” look very different.  In 2007-08, the Fed took drastic and wrong actions because it only looked at the “forest” and missed the “health of the trees”.

The next chart shows the effect of the “sudden drop shock” brought on by Covid19. With economic activity “dumped”, temporary lay-offs skyrocketed.

Temporary lay-offs have since decreased, bringing headline unemployment down. Should we be “thrilled” by the falling headline unemployment, or are we missing the more durable effects of the wild swings in temporary lay-offs? In effect, these lay-offs may increase again following the pick-up in infections since the last data collection period for the employment report.

In order to have a better understanding of what´s happening to the trend in unemployment, we have to strip-out this highly (and distorting) volatile element. Our measure of core unemployment includes those called marginally attached (which are not in the labor force but want to work) and excludes those defined as on temporary lay-offs. In practice, it defines core unemployment by subtracting temporary lay-offs from the U-5 definition of unemployment.

The chart below shows that for most of the time, headline & core unemployment gave out the same information about unemployment.

Since the Covid19 “sudden drop shock”, however, they diverge “majestically”.

The underlying or core unemployment trend trend reversed direction in July. Hopefully this reversal will be confirmed with the data for August.

Do you believe in miracles?

From the WSJ:

“At a time when the global economy is doubting itself in the face of Brexit, the U.S. consumer is emerging with a smile on his face,” said Gregory Daco, head of U.S. macroeconomics at Oxford Economics.

I find it hard to see much reason for smiles! That´s not what the data show. The chart indicates that nominal consumption expenditure growth has come down over the past two years. The basic reason is the Fed tightening of monetary policy through the “rate hike talks”. On a smoother basis (12-month growth), it has fallen and has remained reasonably flat.

Miracle_1

The chart below clearly illustrates that consumption is depressed! Both the spending level and the trend growth are below what they were. Maybe Gregory Daco is mistaking “open mouth” for “smile”!

Miracle_2

What about the Fed´s inflation mandate? The Fed does not understand what inflation means! Sometimes they think it´s the “oil price”, sometimes the “foreign exchange” and sometimes, “other stuff”.

The fact is that for the past 20 years “inflation” has not been a problem. And given the (low) growth rate of spending, inflation will blossom only through a miracle!

Miracle_3

The inflation bogeyman

Calculated Risk (Bill McBride) presents this chart

Inflation Bogeyman

And remarks:

Using these measures, inflation has been moving up, and most of these measures are at or above the Fed’s target (Core PCE is still below).

OMG! None of them are above the Fed´s target because none of them are targets, other than the PCE (advised by the much less volatile PCE-Core), which is below target!

And aren´t we lucky that none of those other measures of inflation are the target. Quite likely the outcome of yesterday´s FOMC Meeting would have been very different (and much more painful too!).

PS In addition to those measures of inflation, the Cleveland Fed also provides (CPI) inflation expectations. The chart shows how the 5 and 10 yr expected inflation have behaved for the past two years, since the Fed began the rate rising mantra!

Inflation Bogeyman_1

Inflation: A Schizophrenic Target!

In the US, many, like Blanchard and Krugman, have for long advocated a higher inflation target as a means of getting the economy ‘moving’.

However, if the Fed, just as the ECB, BoE or BoJ are having a hard time pushing inflation up to the 2% target, why should a higher target “solve” the problem?

Australia, on the other hand seems to be ‘flirting’ with the opposite tack: reduce the inflation target:

The RBA is likely to indicate that it remains wedded to the target, stressing that there is a high degree of flexibility for policy that goes with it.

But the target doubters argue that if low inflation is entrenched, there seems little sense in promoting a target that won’t be achieved without driving interest rates still lower and inviting financial sector stresses in the process. In other words, why risk the fallout from a domestic housing bubble by obsessing over a price target that global forces are keeping out of your reach?

Funny how central banks all over are quick to say they´re “powerless”. That´s just like a “forger” saying that he has no money to buy a new car!

What central banks miss is that inflation is low, not because of “structural” (or entrenched) reasons, but because they are conducting monetary policy to make it so!

Australia provides a good example of good monetary policy that has more recently turned bad.

The chart shows that since the IT regime was adopted, inflation has clocked 2.5% on average, for either the headline or core measures. That´s exactly the center of the 2% to 3% target band.

Australia IT Change_1

Meanwhile, monetary policy was mostly good, keeping NGDP evolving close to a level target path.

Australia IT Change_2

For the past two years, however, the RBA has been “sleeping at the helm”. NGDP has deviated systematically from the “target level”.

Australia IT Change_3

So, it´s not at all surprising that inflation, in either guise, is also trending below the target band!

Australia IT Change_4

The “solution” is not to have a higher or lower inflation target, but to “get a grip” on nominal spending (NGDP). If the RBA says it´s “powerless” to do so, bring in a “master forger” like Gideon Gono, the former head of Zimbabwe´s central bank.

Why talk about the “living” when they´re handsomely compensated to elucubrate about the “dead”?

Walking dead_0

My partner James Alexander sent me something that gave me this idea…

And the “dead”, as you may have surmised, is Inflation!

As the chart depicting (from the Atlanta Fed Inflation Project) the flexible and sticky CPI YoY inflation makes very clear, inflation has been dead for at least a quarter century.

Walking dead_1

What the chart makes clear:

  1. An inflationary process, like during the “Great Inflation” of the 1970s, is characterized by increases in both the flexible and sticky components of the CPI (or any other price index)
  2. When you have price shocks like in the 00s, where between 2003 and 2008 oil shocks were prevalent, the flexible components “swing along” while the sticky components “stay put”. That´s the outcome when the Fed is successful in maintaining nominal stability (satisfactory NGDP growth along an adequate trend path).
  3. When, as in 2008, the Fed, suddenly fearful of price shocks that disturb the flexible components, engineers a massive demand shock (deep drop in NGDP) to quench “inflation”, the result is a long depression! Note that even the sticky prices are affected!

To justify their handsome remuneration, our sages at the Fed keep “talking-up” a problem that has long been dead. Much easier than worry about the (sometime barely) living!

Group-think within and amongst central banks

A James Alexander post

A new book has just been released on problems with central banks. The best chapter looks like the one on group-think. John Taylor, one of the book’s editors describes it thus:

 “Kevin Warsh’s (ex-FOMC member) report on the lack of effective deliberations at the FOMC is one of the most surprising parts of the book. In his commentary Peter Fisher notes Warsh’s refreshing candor, and uses it to jump off on a critique of policy committees, including the unwillingness of committee members to change priors when presented with new arguments or data.”

It is not just within central banks that we see such group-think. Loretta Mester, a current FOMC member gave a speech this week drawing comfort that all central banks saw an uptick in inflation just around the corner.

JA Inflation_1

JA Inflation_2

We have already commented on just how happy central banks are with their current monetary stance, they are all on target with their central projections for inflation. Meanwhile, in the real world, anaemic economic growth is the result of low nominal growth, and recession is always and only a few active monetary tightenings away.

They just can’t see the group-think, either within their central banks or amongst them.

“Misdemeanor”

And a serious one when perpetrated by the IMF´s Chief-Economist with colleagues who write: Oil Prices and the Global Economy: It’s Complicated:

Even though oil is a less important production input than it was three decades ago, that reasoning should work in reverse when oil prices fall, leading to lower production costs, more hiring, and reduced inflation. But this channel causes a problem when central banks cannot lower interest rates. Because the policy interest rate cannot fall further, the decline in inflation (actual and expected) owing to lower production costs raises the real rate of interest, compressing demand and very possibly stifling any increase in output and employment. Indeed, those aggregates may both actually fall. Something like this may be going on at the present time in some economies. Chart 3 is suggestive of a depressing effect of low expected oil prices on expected inflation: it shows the strong recent direct relationship between U.S. oil futures prices and a market-based measure of long-term inflation expectations.

Misdeamenor_1

…Our claim is simply that when an oil importer’s macroeconomic conditions warrant a very low central bank interest rate, a fall in oil prices could move the real interest rate in a way that runs counter to the positive income effect.

But the “causation” they allude to, from oil prices to expected inflation is just a figment of their collective imagination!

If they only looked at a longer time period (beginning in 2003 when the inflation expectation became available), they would have difficulty establishing even a simple correlation.

Misdeamenor_2

What you do notice in the chart above is that oil prices and inflation expectations fall in tandem when there is a negative demand shock. That´s very clear in 2008/09. More recently, since mid-2014, there the Fed has also tightened monetary policy – a negative demand shock. The tightening was initially expressed through Fed words and has been reflected in NGDP growth slipping, expected one year ahead FF rate rising, the dollar index rising (dollar appreciation) in addition to the oil price fall, among other indications of monetary policy tightening!

Misdeamenor_3