“The Impossibility Theorem”

When your argument centers on interest rates and inflation, you´re bound to arrive at a wrong conclusion.

That´s happened to Ryan Avent´s article “No Exit – Global financial integration is tying central banks hands”, where he concludes:

The balance of risks suggests the Fed should tolerate rising inflation. A faster pace of increase in wages and prices would be a healthy development for the American economy. Inflation has been below 2% for four years; exceeding that level would affirm the Fed’s claim that 2% is a symmetrical target for inflation, rather than a ceiling. A temporarily higher inflation rate might be an annoyance for some Americans, but it is preferable to imploding portfolios and a risk of recession.

Even though Ms Brainard prevailed in March, the debate is sure to continue. The Fed is bound to raise rates again at some point, as inflation rises. Another torrent of mobile capital will then flood in, perhaps swamping the Fed’s attempts to go its own way. The world should brace for more financial storms.

There will be no “rising inflation” as long as the central bank constrains nominal spending (NGDP) growth (that´s the “impossibility theorem”). And if there´s no increase in inflation there will be no need, under the Fed´s operating procedure, to raise interest rates.

The chart indicates, with monthly data on a year over year basis, that from 1993 to 2006 NGDP growth averaged 5.5%; RGDP growth averaged 3.4% (exactly the same average as from 1947 to 1992) and Core-PCE inflation averaged 1.8% (just shy of the implicit (at the time) 2% target.

RA Havoc

From 2007 to the present, NGDP growth averaged only 2.9%; RGDP growth averaged 1.3% while Core-PCE inflation averaged 1.6%.

In the more recent period average 1.6% inflation is just equal average NGDP growth minus average RGDP growth (for the pre 2007 period while average inflation was 1.8%, NGDP growth minus RGDP growth was 2.1%. This may reflect the occurrence of a real positive (productivity) shock in the earlier period, which increases RGDP growth and reduces inflation, under a stable NGDP growth regime).

Much has been said about a supposed fall in “potential output”. I tend to believe that a significant part of that is due to the “demand downgrade”.

Anyway, what Ryan Avent should be writing about is not how an inevitable increase in rates will cause havoc, but how the markets are telling (not constraining, mind you) the Fed that it´s on the wrong track. If only the Fed would talk about a NGDP level target…

No Inflation In Texas: A Lesson There? We Miss Inspector Clouseau

A Benjamin Cole post

It is too bad in some regards that Richard “Inspector Clouseau” Fisher, the former president of the Federal Reserve Bank of Dallas, in no longer ensconced in that position. For one, he was always great copy. For seconds, he was one of the most infallible reverse indicators of Post War Era, and economic soothsayers could bet against a Fisherian proclamation with a rare calm.

Alack and alas, Fisher was replaced by Robert Kaplan in September, who so far seems content to avoid huge and regular public embarrassments.

Some may remember a jaw-dropping press conference Fisher held October 9, 2014 in the fair city of Dallas, where he proclaimed Texas wage inflation was a threat, soon to possibly envelop the nation—“there are concerns about getting it (wage growth) under control,” Fisher said. The former Dallas Fed Chief seemed especially agitated that wages were rising faster than prices, enough so to call reporters into his office.

BC Texas

Well, as we see from the chart above, inflation, even as measured by the CPI (which tends to overstate inflation), Dallas sunk into deflation after the Fisher proclamation. Sheesh, the CPI for Dallas was headed south even as Fisher spoke. The chart for Houston, the Lone Star state’s other big city, looks much the same.

A Serious Lesson?

Okay, taking potshots at Fat-Target Fisher is always good for a laugh, but is there a more-serious lesson in all of this? Probably. Texas boomed and did not suffer inflation.

Now, some will say, “Oh sure, but Texas can import labor, capital and services from surrounding states.”

But the U.S. imports goods, services, capital and labor from the world. More demand would result in more supply. See Texas. Besides, global supply lines are glutted with product and commodities.

If a seven-year national recovery, magnified in the red-hot energy state of Texas, results in deflation in Dallas, should the U.S. Federal Reserve continuously go weak at the knees whenever unemployment skates near 5%?

Probably not.

P.S. Housing

Fans of Kevin Erdmann, author of blog The Idiosyncratic Whisk, know that Dallas is what Erdmann defines as an open city, one in which housing can be readily built. Many of America’s largest and glamour cities, such as Los Angeles, San Francisco, New York, Boston, Seattle etc., have criminalized robust housing construction. Not only those cities, but surrounding suburbs and towns—building high-rise condos anywhere along the Southern California coast, from liberal Santa Monica to conservative Newport Beach, is not done.

The U.S. economy has structural impediments, and housing is a big one. Still, the Fed may wish to ponder if suffocating the national economy to avoid some housing inflation is a good trade-off.

Stanley Fischer speaks with forked tongue

A James Alexander post

In a speech this week Stanley Fischer, Vice Chair of the Fed, insisted on the existence of the Phillips Curve. It made little sense.

  1. Inflation and unemployment: Estimated Phillips curves appear to be flatter than they were estimated to be many years ago–in terms of the textbooks, Phillips curves appear to be closer to what used to be called the Keynesian case (flat Phillips curve) than to the classical case (vertical Phillips curve). Since the U.S. economy is now below our 2 percent inflation target, and since unemployment is in the vicinity of full employment, it is sometimes argued that the link between unemployment and inflation must have been broken. I don’t believe that. Rather the link has never been very strong, but it exists, and we may well at present be seeing the first stirrings of an increase in the inflation rate–something that we would like to happen

If, after more than 50 years since it’s invention the curve may be still be flat or horizontal then it would seem to non-economists that it is time to move on. He made many jokes and recalled many  supposedly wise sayings, but one appeared to me to demonstrate why the profession of economics is held in such disrepute.

But Paish also warned us that forecasting was difficult, and gave us the advice “Never look back at your forecasts–you may lose your nerve.” I pass that wisdom on to those of you who need it.

It seems to typify economics as a profession, never let your theories be tested. Real scientists would say if your forecasts are consistently proven wrong then your models are wrong.

The final comment in that Inflation and Unemployment section is what struck me as particularly disingenuous. How does the Fed demonstrate that they want to see the inflation rate increase? By actively tightening monetary policy in December 2015?  By having so publicly forecast and fretted about a rise in inflation for months beforehand, thus passively tightening monetary policy? It appears that Fischer says he wants something but all his actions and his fretting tells the market that he doesn’t actually want it.

Fischer’s Fed has consistently forecast a return to higher inflation as unemployment has fallen. It hasn’t happened, it will never happen if the Fed insists on tightening any time 2% is approached, either in real time or more importantly in the Fed’s own forecasts for inflation.

His attitude to inflation was quite revealing when he was asked in the Q&A, about 42 minutes in, whether raising the inflation target to 4% was a good idea.

He immediately responded by talking about other countries’ hyperinflation experiences. Great. Scare tactics. ‘If you touch the 2% target all hell would break loose.’ Really?

Then he worried about too much indexation at higher rates of inflation and how hard it was to undo that indexation once embedded. A fair point, but not very relevant in a free market economy. Indexation is a supply side issue, and not really one for central bankers to address, though they may have to react to it once it is established.

He then said that 2% is  about right, “clearly here”, according to Greenspan’s definition of not having people having to think about the rate of inflation in their daily work. And “4% is the other side of the line”. Is there really such a difference? Was the average of 2.5% PCEPI throughout the Great Moderation so bad?

And lastly he mentioned the “credibility problem of changing targets in mid-stream, because that’s easy”. It’s easy, perhaps because it’s right.

In a section on the ZLB and the effectiveness of monetary policy he stated:

Empirical work done at the Fed and elsewhere suggests that QE worked in the sense that it reduced interest rates other than the federal funds rate, and particularly seems to have succeeded in driving down longer-term rates, which are the rates most relevant to spending decisions.

The Fed has claimed that is the reason they did QE, to bring down longer-term rates, but they keep missing the Fisher effect. If QE is really working then it is raising longer term rates, reflating the economy. Fischer and the Fed have a truly massive blind spot here, one that makes their policy making hard to understand in the markets.

And that is what we saw when QE was working, and growth expectations rising, longer-term rates were rising too, not falling. From an old post:

JA Stan Fischer

At least Lael Brainard, on the same day, spoke  more sense. Is there a generational debate at the Fed? The old guard of inflation hawks and those younger types more in touch with the lack of prosperity in the US. We hope so, although age shouldn’t be the main gauge for hawkishness. There are lots of older Market Monetarists too!

CPI trending higher, NGDP growth lower – monetary policy must go easy

A James Alexander post

The echoes of 2008 became stronger last week as both headline and core US inflation as measured by the CPI rose faster than expected. It is a very dangerous cocktail when the claque sees inflation yet nominal growth expectations are weak. It caused the Great Recession when central banks misread the situation. Hopefully they will have learned their lesson, but the current tightening bias of the Fed doesn’t give us much confidence.

Go to Twitter and enter “core CPI” and you’d see a welter of inflation hawks trumpeting the now clear upward trend in CPI. These were typical:

“John P. Hussman‏@hussmanjp

Not to bust anyone’s NIRP bubble, but while YOY CPI inflation is 1.34% due to food & energy, YOY core inflation rose to 2.22% in January.

Michael Ashton‏@inflation_guy

I did NOT realize until just now that this month’s 0.29% rise in core CPI was the highest m/m since 2006.

Carl Quintanilla‏@carlquintanilla

Beating estimates in past 2 wks: * core CPI * core PPI * hourly wages * retail sales * Ind. Prod


It is hard to disagree with the charts over the short-term.


The longer term is a bit different, of course.


But does it mean the Fed should take act? The markets decided the new information content from the CPI data was virtually nil.

Why were markets so calm?

 1. The Fed looks at the far superior Personal Consumption Expenditure price index or deflator. It is composed of the dozens of individual price index estimates used to deflate nominal spending to derive a supposedly “real” level of spending for each category of goods and services purchased. Compiling these indexes is a task fraught with pitfalls. At least PCE uses actual data on expenditure rather than the CPI surveys of consumer expenditure as a starting point. It also includes items bought on behalf of consumers by their employers like healthcare and insurance. It also estimates the financial benefit of services not paid for, like banking.

PCE has historically run 0.5% lower than CPI and been far less prone to volatility. The PCE deflator much more quickly captures substitution effects, as consumers switch purchases from higher priced goods and services to lower ones, or like today (probably) switching spending from energy and goods sectors in deflation to housing, healthcare and education – increasing the pace of service sector inflation? Looking just at the service sector will be very misleading.

The housing element of CPI remains a minefield as Kevin Erdmann constantly reminds us. Artificial shortages abound and have significant effects. Artificial demand in education thanks to state-subsidised loans  also leads to price pressure, and we all know about restrictive practices in medicine.

 2. The Fed has made it clear since the market turbulence that it caused will be incorporated into its future actions.

 3. Nominal growth is still horribly weak. Core CPI may be trending up but nominal Personal Consumer Expenditure, i.e. not deflated, remains stuck in a 3% trend – down from the 4%-5% trend achieved towards the end of QE3 when nominal spending peaked at 4.96% in August 2014.

 I remain unconvinced that PCE will move up meaningfully towards any higher trend in CPI. Nominal growth, historic and expected, remains just too low. And, of course, active monetary policy is clearly biased towards tightening.

And here we may get a horrible echo of 2008 where nominal growth expectations are flat or falling but the claque of inflation hawks is fretting about cost-push inflation. The Fed should ignore the claque and laser-lie focus on nominal growth expectations, but will they?

The other echo of 2008 comes from the accounting identity that if inflation really is rising and nominal growth really is weakening then the counterpart has to be in weakening RGDP and weakening productivity. And this is precisely what we are seeing. RGDP is weak and so is productivity.

I am a bit more more sanguine about productivity, even if arithmetically it is shown to fall. It may not be falling as the deflator may be too high, underestimating real growth, and thus productivity growth. Why is this?

First, because it is so fiendishly difficult to directly measure productivity, especially in our service-sector dominated world. There are hardly any detailed temporal or cross-border studies of productivity by industry segment, just windy, useless, macro level stuff by country. Output of physical stuff is relatively easy to measure in both nominal and real terms, as long as the quality of the stuff doesn’t change too much: a bushel of wheat, a barrel of oil, a table. But think of a college degree, a cable subscription or a visit to the dental hygienist and things get trickier.

Quality issues are very, very tricky to gauge. It should be for economic historians and politicians to argue about the quality of the nominal growth, the balance between real and inflation within the nominal figure.

Second, it will have got very difficult with the rise of the web to really figure out what is happening to the real economy. It is important to figure it out, but is really hard. Diane Coyle wrote this thought-provoking piece on Digitally Disrupted GDP recently:

 Digital technologies are having dramatic impacts on consumers, businesses, and markets. These developments have reignited the debate over the definition and measurement of common economic statistics such as GDP. This column examines the measurement challenges posed by digital innovation on the economic landscape. It shows how existing approaches are unable to capture certain elements of the consumer surplus created by digital innovation. It further demonstrates how they can misrepresent market-level shifts, leading to false assessments of production and growth.

Third, we think it will rise once the nominal economy begins to run hot again. Why should businesses invest to economise on labour when labour is so plentiful? Why should businesses invest when sales are so weak and expected to remain so?

Fed Chair Janet Yellen Defends 3% Inflation Floor; Says Lower Target Requires Cutting Structural Impediments

A Benjamin Cole post

February 11, 2016, Washington, D.C.—Defiantly defending the U.S. Federal Reserve’s 3% inflation floor, Fed Chair Janet Yellen’s swatted away questions from U.S. Senators who said lower rates of inflation could be obtained safely.

The “public and representatives have embraced thickets of structural impediments to growth,” retorted Yellen. “For the economy to scrape through to minimally acceptable rates of GDP growth requires a bedrock of 3% inflation. Below that floor threatens stall speed, and financial instability.”

Yellen noted “the joke is that it takes an Act of Congress to get housing built in many cities of America—and that is what I am saying: Congress has to turn some screws to boost housing production is key metropolitan regions.” Without that, asserted Yellen, housing inflation will also boost general inflation numbers, even in a slack economy.

The Fed Chair tried to unruffle Senatorial feathers by pointing out that many structural impediments are state and local government sacred cows, such as property zoning, occupational licensing, and the near-universal criminalization of push-cart vending.

“But I have to tell this body that many federal structural impediments, be they rural subsidies and the USDA, or the SSDA and VA disability programs, the minimum wage, the ethanol fuel program, or the $1 trillion in annual national security outlays, are impediments to a freer economy that could grow more rapidly at lower rates of inflation,” Yellen explained. “The real path to lower rates of inflation lies in Congress.”

Yellen again tried to smooth matters with Senators by reminding them of the “bad old days” when the U.S. was characterized by unionization, limited foreign trade, and regulated rates in transportation, including trucking, airlines and railroads. “Back then Chairman Paul Volcker accepted a 5% rate of inflation,” reminded Yellen, speaking of the 1980s Fed Chief. “And you know what Vocker thought of inflation.”

In conclusion, Yellen pointed the economic struggles in Japan and Europe, two economies that have sunk into persistent deflation and slow growth. “It may be ungracious of me to say so, but it was only the Fed’s decision in 2008 to target and forcefully obtain rates of inflation well above 3% that kept us from sinking into the deflationary stalls we have seen since in Europe and Japan,” said Yellen. “The $7 trillion of QE was controversial but effective; the resolve and credibility of the Fed was affirmed; and we have never looked back.”

Lo and behold! Feldstein needs to see it in a “wide screen”

Here´s Feldstein:

´…the Fed is planning a path for short-term interest rates that is likely to raise the rate of inflation too rapidly in the next two years. The December FOMC minutes show that members expect to have a negative real federal-funds interest rate until sometime in 2017, much too low for an economy already at full employment. The danger is that very low interest rates in this environment would lead to a higher rate of inflation and higher long-term rates. The Fed could prevent that faster rise in inflation by increasing the federal-funds rate more rapidly this year and next. …

The Fed needs to recognize that its employment goals have essentially been reached and that the inflation rate will reach its target of 2% in the foreseeable future. The economy would be better served by a more rapid normalization of short-term interest rates.

The “Cinemascope” version:

Feldstein once more

PS David Glasner has more details:

…In the absence of evidence that the Fed is affecting inflation expectations, it is a blatant and demonstrable fallacy to maintain that the Fed is forcing interest rates to deviate from equilibrium values that would, but for Fed intervention, otherwise obtain. No doubt, there are indeed many assets that are overpriced, but, for all Professor Feldstein knows, there are just as many that are underpriced.

So Professor Feldstein might really want to take to heart a salutary maxim of Ludwig Wittgenstein: Whereof one cannot speak, thereof one must be silent.

Lacker, the Blind hawk

According to him:

Inflation is likely to move back to the U.S. central bank’s 2% annual target in the “near-term,” said Richmond Fed President Jeffrey Lacker, on Thursday. “After the price of oil bottoms out, I would expect to see headline inflation move significantly higher,” Lacker said in a speech to the Chamber of Commerce in Raleigh, N.C.

Lacker is a hawk on the Fed’s interest rate committee, having dissented at the Fed’s September and October meetings in favor of an increase in interest rates. He is not a voting member of the Fed policy committee this year.

His visual capacity is nil! What would he think after looking at a chart like this?

Blind Hawk

Between 2001 and 2008, oil prices went up by a factor of 6. Headline inflation went up but core inflation was very well behaved, staying close to “target”.

Between December 2008 and January 2011, oil went up by a factor of 4, and remained at that high level for the next 37 months. Headline inflation quickly moved below target before tanking with the drop in oil after early 2014. Meanwhile, core inflation was significantly below target for most of the last seven years.

He thinks oil price is the driver of inflation, when it only determines the swings in headline inflation. That misguided thinking has already brought much grief!

Think instead that monetary policy determines trend inflation, and look at core inflation as “trend inflation”. In that case, if you are “hawked” on headline inflation you will be “busy”, but will also do a lot of harm!

Like a first year medical student, John Williams is focused on “cadavers”

  1. All eyes are on inflation

The Fed is looking for signs that it’s meeting its dual mandate of stable inflation and maximum employment as it charts the course for rate increases. Price pressures have remained below the Fed’s 2 percent goal since 2012, and Williams made it clear while talking to reporters that they’ll be his focus this year.

“The big question mark in 2016 to me is really on this inflation front,” Williams said Monday, noting that questions about labor market slack probably would be resolved as the job situation continues to improve. If “global growth slows, and global inflation falls, and that pushes the dollar up, that’s clearly a scenario that would cause us to take longer to get to our inflation goal, and I think would call for a little bit more accommodation.”

The inflation ECG (again)

Patient Dies

And everything points to a Fed that has been tightening (opposite of accommodative) since mid-2014!


NGDP Growth




Dollar Index


Funny thing: Williams believes the “cadaver” will “stand-up” (one day sometime in the future)


When the patient dies

The ECG of a dead person shows straight line. Straight line refers to absent electric signals in the heart. However, sometimes ECG shows some irregular and abnormal drawings that may be due to injected drugs like atropine and adrenaline. So, clinician should wait till the ECG is straight before declaring the patient is dead.

Patient Dies

But we´re told it will soon “ressurect”

Tim Duy´s prophecies

Prophecy #5:

5.) Inflation will accelerate. I think 2016 will be the year that economic resources become sufficiently scarce to push inflation back to the Fed’s target. I know this may seem like a wildly optimistic call given the persistence of low inflation during this cycle.

I would say TD is very optimistic!


My question: How can resources become “sufficiently scarce” if nominal spending growth is going down?


That´s another example of the “hare chasing the fox”, meaning it is “potential output” that is in pursuit of actual output!

Fox & Hare_2