Is the new Monetary Policy Framework (AIT) an improvement?

Unlikely. Also, it´s likely not worse and suffers from the same shortcoming of inflation targeting, being based on the false premise of the existence of a Phillips Curve. I plan to show, hopefully convincingly, that the New Keynesian model (the centerpiece of which is the New Keynesian Phillips Curve) is grossly unsuitable for monetary policy analysis.

The FOMC has “chosen” to pursue an AIT framework. Why? Because it is a suggestion that flows directly from a New Keynesian model where the interest rate is constrained by the zero-lower- bound (ZLB).

The oldest reference to AIT I found was a Working Paper from 2000, published in 2005. The Phillips Curve is the driving force of the model (despite the economy being far from the ZLB at the time. Probably the reason was the uncertainty regarding the value of the NAIRU).

JMCB October 2005 (WP version 2000):

The analysis of this paper demonstrates that when the Phillips curve has forward-looking components, a goal for average inflation-i.e., targeting a j-period average of one-period inflation rates-will cause inflation expectations to change in a way that improves the short-run trade-off faced by the monetary policymaker.

The other papers proposing AIT are all from 2019-20, when the Fed was revising its framework.

Two examples

Thomas M. Mertens and John C. Williams June 28, 2019

We use a simple New Keynesian model as a laboratory for our analysis. The economy is governed by a Phillips curve that links inflation to a supply shock, the output gap, and expected future inflation and an IS-curve that links the output gap to a demand shock, the ex ante real interest rate, and expectations of the future output gap.

In “What´s up with the Phillips Curve”, we learn that:

It used to be, when the economy got hot and pushed unemployment down, inflation rose as businesses charged higher prices to meet higher wages and other increased costs.

Changes in the conduct of monetary policy appear to have played some role in inflation stability in recent decades, but they cannot be its principal explanation, the authors suggest. 

Their leading candidate for the driver of inflation stability is a reduced sensitivity of inflation to cost pressures—such as those associated with wage movements—or, in economic parlance, a decline in the slope of the Phillips curve. 

A flat Phillips Curve requires the monetary authority to work harder to stabilize inflation:  Unemployment needs to get lower to bring inflation back to target after a recession,” the authors write.  They use an econometric model to explore how monetary policy should adapt, examining, for example, a strategy known as average inflation targeting…

Joseph Gagnon of the PIIE recently described it thus:

Economies around the world have languished in the flat region of a kinked Phillips curve. Any level of unemployment above the natural rate keeps inflation constant. CBs need to aggressively push unemployment down into the steep region.

 

The ECB is also revising its framework, but in Europe, the Phillips Curve concept is not as explicit as in the US, though it clearly lurks behind the models.

ECB Working Paper April 2020:

Following a large recessionary shock that drives the policy rate to the lower bound, a central bank with an AIT objective keeps the policy rate low for longer than a central bank with a standard inflation targeting objective, thereby engineering a temporary overshooting in future inflation that helps to mitigate the decline of output and inflation at the lower bound via the expectations channel.

In a recent speech, Charles Evans, president of the Chicago Fed said:

Describing the stance of policy against a moving and unobservable benchmark is another complicated communications challenge.

He was referring to the “neutral interest rate”, but the same communication problems arise regarding the two other famous “moving and unobservable benchmarks”, to wit, the natural rate of unemployment (or NAIRU) and potential output.

Such comments are not new, although they were more of a “what to decide” problem rather than a “communication challenge”.

In the FOMC meeting of December 1995, Greenspan noted wryly:

“Saying that the NAIRU has fallen, which is what we tend to do, is not very helpful. That’s because whenever we miss the inflation forecast, we say the NAIRU fell” (p. 39).

Seven months later, in the July 1996 meeting Thomas Melzer, president of the St Louis Fed commented:

“Whenever we get to whatever the NAIRU is, people decide it is not really there and it gets revised lower.  We get to what people thought would be the NAIRU, we do not see wage pressures, and we assume that the NAIRU must be lower. So it keeps getting revised down.” (p. 61)

There were also the strong believers in the Phillips Curve. This comment from Laurence Meyer in the February 1999 FOMC meeting is an example:

When I think about the inflation process and the inflation dynamic, I always point to two things: excess demand and special factors. I don’t know any other way to think about the proximate sources of inflation. When I think about excess demand, I think about NAIRU. If we eliminate NAIRU and that concept of excess demand, it moves us into very dangerous territory with monetary policy.

I would remind you that in the 20 years prior to this recent episode, the Phillips curve based on NAIRU was probably the single most reliable component of any largescale forecasting model. It was very useful in understanding the inflation episode over that entire period. Certainly, there is greater uncertainty today about where NAIRU is, but I would be very cautious about prematurely burying the concept. (pg 118)

In the same meeting, Edward Boehne, president of the Philadelphia Fed said:

As far as NAIRU is concerned, my personal view is that it is a useful analytical tool for economic research but that it has about zero value in terms of making policy because it bounces around so much that it is very elusive. I would not want our policy decisions to get tied all that closely to it, especially when most of the NAIRU models have been so far off in recent years. (pg 116)

A few months later, in the June 99 FOMC meeting, William Poole, president of the St Louis Fed observed:

I certainly count myself among those who believe that the Phillips curve is an unreliable policy guide. What that means is that the predictive content for the inflation rate – and I’ll emphasize the “predictive” – of the estimated employment gap or GDP gap, however you want to put it, seems to be very low. (pg 106)

One year later, in the June 2000 meeting Poole “nailed down” the problem:

The traditional NAIRU formulation views the wage/price process as running off a gap–a gap measured somehow as the GDP gap or the labor market gap. And the direction of causation goes pretty much from something that happens to change the gap that feeds through to alter the course of wage and price changes.

I think there is an alternative model that views this process from an angle that is 180 degrees around. It says that in an earlier conception, either through a determination of a monetary aggregate or through a federal funds rate policy, monetary policy pins down the price level or the rate of inflation and, therefore, expectations of the rate of inflation. Then the labor market settles, as it must, at some equilibrium rate of unemployment. Where the labor market settles is what Milton Friedman called the natural rate of unemployment. But the causation goes fundamentally from monetary policy to price determination and then back to the labor market rather than from the labor market forward into the price determination. I certainly view the causation in that second sense.

I think it is the willingness of the Federal Reserve to stamp out signs of rising inflation that ultimately pins down expectations of the price level and the inflation rate. Now, the labor market has been clearing at a level that all of us have found surprising. But I don’t think that necessarily has any particular implication for the rate of inflation, provided we make sure that we are willing to act when necessary. (pg 61).

Interestingly, six months earlier, Richard Clarida (who is now Vice Chair of the Fed Board and led the framework Review Process), Gali and Gertler published “The Science of Monetary Policy” in the Journal of Economic Literature. On page 1665 we read:

It is then possible to represent the baseline model in terms of two equations: an “IS” curve that relates the output gap inversely to the real interest rate; and a Phillips curve that relates inflation positively to the output gap.

Which is the opposite of Poole´s “direction of causation”. Unfortunately, this is the view that survived and prevailed, for 20 years later, as seen at the beginning of this post that is the model Mertens & Williams use to, inter alia, promote AIT.

In between those times, Narayana Kocherlakota, president of the Minneapolis Fed wrote “Modern Macroeconomic Models as Tools for Economic Policy” in 2010:

“…I am delighted to see the diffusion of New Keynesian models into monetary policymaking. Regardless of how they fit or don’t fit the data, they incorporate many of the trade-offs and tensions relevant for central banks.”

Just like the NAIRU, potential output is “constantly changing”, so the “output gap” is elusive, therefore worthless for monetary policy analysis. The chart below shows that, either from below or from above, potential output is always “chasing” actual output.

In the 1990s, inflation was initially falling before remaining low and stable. Therefore, by the dictates of the NK model, there was no output gap to contend with. The solution: Revise potential output up until it converges to actual output.

The opposite occurs in the 2010s. With inflation stable (not falling), the output gap (actual minus potential) could not be negative. Therefore, potential undergoes downward revisions until it converges to actual output.

In summary, Greenspan got it exactly right in the June 2002 FOMC Meeting:

A lot of people out there are asking why we can’t come up with something simple and straightforward. The Phillips curve is that, as is John Taylor’s structure. The only problem with any one of these constructs is that, while each of them may be simple and even helpful, if a model doesn’t work and we don’t know for quite a while that it doesn’t work, it can be the source of a lot of monetary policy error. That has been the case in the past. (pg 20)

One of the reasons monetary policy errors occur, apart from using bad models for policy purposes, is that most policymakers think the policy rate well defines the stance of monetary policy. The set of charts below try to dispel that view, indicating that NGDP growth much better reflects the stance of monetary policy.

Instead of thinking narrowly of the Fed goal as “price stability”, think more broadly as the Fed having the goal of providing “nominal stability”. Nominal stability means a stable growth of aggregate nominal spending (NGDP). To get that result, it must be that money supply growth closely offsets changes in velocity (the inverse of money demand).

Note, in the first chart, that unemployment stops falling or rises (somewhat or a lot), when NGDP growth falls a little (bars 1 & 4), significantly (bar 2) or majestically (bar 3). Given sticky wages, the unemployment rate is ‘determined’ by the wage/NGDP ratio. The bigger the drop in NGDP, the higher the wage/NGDP ratio rises and so does unemployment. Therefore, with NGDP growing at a stable rate, unemployment falls ‘monotonically’.

As William Poole put it: “…Then the labor market settles, as it must, at some equilibrium rate of unemployment. Where the labor market settles is what Milton Friedman called the natural rate of unemployment.

Guided by the NAIRU/Phillips Curve framework, however, as soon as unemployment falls to levels consistent with their view of NAIRU, and not wanting to wait to see the “white of the inflation eyes” (which is what they now say they want to do with AIT), the Fed doesn´t allow the unemployment rate to “settle”, and tightens monetary policy. This comes out very clearly in the chart above.

In the next chart we see that interest can fall with unemployment rising, rise with unemployment falling and other combinations.

This statement from Board Member Brainard has a ‘true’ part and a ‘false’ part:

[True] The longstanding presumption that accommodation should be reduced preemptively when the unemployment rate nears the neutral rate in anticipation of high inflation that is unlikely to materialize risks an unwarranted loss of opportunity for many Americans.

[False] Beyond that, had the changes to monetary policy goals and strategy we made in the new statement been in place several years ago, it is likely that accommodation would have been withdrawn later, and the gains would have been greater. [Here she´s referring to the lift-off that began in December 2015]

To complete my reasoning, the next chart shows the complete absence of correspondence between unemployment and inflation over the last three decades.

In the June 2002 FOMC meeting, Board Member Gramlich and Presidents Minehan & Broaddus were thinking correctly. They

thought the poorer performance of the Phillips curve was a result of the Fed’s success in reducing and stabilizing inflation – with inflation low and inflation expectations more firmly anchored, there was a less reliable relationship between the output gap and inflation.

It is unfortunate that the Fed quickly forgets what it learned. Members change and so do theories, views and biases.

Firstly, they deny the view that the magnitude of the 2008/09 crash was the result of an unbelievably bad monetary policy. Then they argue that monetary policy is limited in its capacity to reverse the error. Narayana Kocherlakota in the FOMC Transcript from January 2012 is a good example:

If I am right in my forecast, the Committee will need to be careful to keep in mind the limitations of monetary policy. We will face ongoing political pressures to use monetary policy to try to jump from the new normal back to the old normal. That’s simply not the role of monetary policy. You cannot move an economy from one long-term normal to another long-term normal. What monetary policy can do is to enhance economic stability by facilitating an economy’s adjustment to macroeconomic shocks. (pg 141)

As the chart below indicates, you can only move it down!

And so we come to 2020 and the Covid19 shock. This was both a supply (health) shock and a demand (monetary) shock.

The monetary shock is illustrated in the charts below. The fall in velocity was sudden and sharp, but the Fed reacted quickly to begin to reverse the situation. Unfortunately, having chosen an ‘useless’ framework for monetary policy, it appears to be faltering, risking not only a complete loss of credibility because average inflation will persist indefinitely below 2% (like it has for the past 30 years), but also condemning the economy to evolve along an additionally depressed path!

As Peter Ireland put it recently:

The time to do something is when the time is right. The time is right for nominal GDP level targeting.

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!

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.

If only monetary policy in 2008 had been what it was in 2020.

Many like to compare the Covid19 contraction with the Great Depression. In addition to the nature of the two contractions being completely unrelated, while in the first two months of the Covid19 crisis (from the February peak to the April trough) RGDP dropped 15%, it took one year from the start of the Great Depression for RGDP to drop by that amount.

Although the Covid19 shock has also no common element with the Great Recession, a comparison between the two is instructive from the monetary policy point of view. This is so because the Great Recession was the “desired outcome” of the Fed´s monetary policy. Bear with me and I´ll try to convince you that is not a preposterous statement.

Motivated by the belief that the 2008-09 recession originated with the losses imposed on banks by their exposure to real estate loans and propagated through a consequent breakdown in the ability of banks to get loans to credit-worthy borrowers, government, the Fed and regulators intervened massively in credit markets to spur lending.

Bernanke´s January 13, 2009 speech “The crisis and the policy response” summarizes that view:

“To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally.”

Bernanke´s “credit view” of the monetary transmission process is well established. Two articles support that view.

His flagship 1983 article is titled “Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression.”

“…we focus on non-monetary (primarily credit-related) aspects of the financial sector–output link and consider the problems of debtors as well as those of the banking system. We argue that the financial disruptions of 1930-33 reduced the efficiency of the credit allocation process; and that the resulting higher cost and reduced availability of credit acted to depress aggregate demand.”

His 1988 primer “Monetary Policy Transmission: Through Money or Credit?”

“…The alternative approach emphasizes that in the process of creating money, banks extend credit (make loans) as well, and their willingness to do so has its own effects on aggregate spending.”

For details on the Fed´s credit market interventions (with the purpose of reducing spreads, which to the Fed is a sign of credit market dysfunction), see chapter 15 of Robert Hetzel´s “The Great Recession”

“The answer given here is that policy makers misdiagnosed the cause of the recession. The fact that lending declined despite massive government intervention into credit markets indicated that the decline in bank lending arose not as a cause but as a response to the recession, which produced both a decline in the demand for loans and an increase in the riskiness of lending.

In their effort to stimulate the economy, policy makers would have been better served by maintaining significant growth in money as an instrument for maintaining growth in the dollar expenditures [NGDP growth] of the public rather than on reviving financial intermediation”

The charts below attest to that fact insofar as spreads began to fall, the dollar exchange rate began to depreciate and the stock market began to rise, only after the Fed implemented quantitative easing (QE1) in March 2009.

The purchase of treasuries by the Fed was what “saved the day”, not the array of credit policies that had been implemented for several months prior. Note, however, that the monetary policy sail was only at half-mast. On October 2008, the Fed had introduced IOER (interest on reserves), so that the rise in the monetary base from all the Fed´s credit policy would not “spillover” into an increase in the money supply. (The rise in the reserve/deposit (R/D) ratio in fact more than offset the rise in the base, so money supply growth was negative).

What QE did was to increase the velocity of circulation. With that, spending (NGDP) growth stopped falling and then began to rise slowly. As the next chart shows, the Fed (due to inflation worries) never allowed NGDP growth to make-up for the previous drop, “calibrating” monetary policy to keep NGDP growth on a lower trend path and lower growth rate.

Skipping to 2020, when the Covid19 shock hit, NGDP tanked. With spreads rising, the Fed again, now under Jay Powell (who must have learned “creditism” from his time with Bernanke), quickly announced a large batch of programs to intervene in credit markets to sustain financial intermediation.

While in the U.S., it was all about “closing spreads”, in Europe the sentiment was the opposite:

Christine Lagarde (March 12): “We are not here to close spreads”

Laurence Meyer (March 17): “The Fed is here to close spreads”

In “Covid19 and the Fed´s Credit Policy”, Robert Hetzel writes:

“…When financial markets actually did continue to function, Chairman Powell claimed that it was because of the announcement effect that the programs would become operational in the future…”.

Looking at the charts for the period, we again observe that spreads fell (markets functioned) when monetary policy – through open market operations, with the Fed buying treasury securities – becomes expansionary. The difference, this time, is that the monetary policy sail was at “full mast”, so that money supply growth rose fast.

Compared to the post 2008-09 period, NGDP reversed direction in a V-shape fashion (data on monthly NGDP to June from Macroeconomic Advisers). This time around, it seems the Fed is set in making-up for the lost spending, returning NGDP to the trend level that prevailed from 2009 to 2019.

Going forward, once the economy fully reopens the Fed will have to make clear that monetary policy will the conducted to maintain nominal stability (i.e. NGDP cruising along the trend level path it was on previously). Given the degree of fiscal “overkill” that has been practiced, the Fed will have to resist pressures to maintain an overly expansionary monetary policy to relieve fiscal stress through inflationary finance.

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=PY, the 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!

Toying with business cycle dating

In this year´s ASSA Annual Meeting in January, Christina & David Romer (R&R) presented “NBER Business Cycle Dating: Retrospect and Prospect”:

“…Our most substantial proposal is that the NBER continue this evolution by modifying its definition of a recession to emphasize increases in economic slack [Deviations from potential output and/or unemployment] rather than declines in economic activity…”

“…Throughout the paper, we make use of Hamilton´s (1989) Markov switching model as a framework for investigating and assessing the NBER dates. Though judgement will surely never be (and should not be) eliminated from the NBER business cycle dating process, it is useful to see what standard statistical analysis suggests and can contribute.”

On page 32, they move to Application: The implications of a two-regime model using slack for dating US business cycle since 1949:

“We have argued that a two-regime model provides insights into short-run fluctuations. And we have argued for potentially refining the definition of a recession to emphasize large and rapid increases in economic slack rather than declines in economic activity. Here, we combine the two approaches by applying Hamilton´s two-regime model to estimates of slack and exploring the implications for the dating of postwar recessions.”

According to R&R (page 34):

“The largest disagreement between the two regimes estimates using slack and the NBER occurs at the start of the Great Recession. The NBER identifies both 2008Q1 and 2008Q2 as part of the recession (with the peak occurring in 2007Q4), while our estimates (see table 1) put the probability of recession as just 21% in 2008Q1 and 43% in 2008Q2.”

Table 1 Economic Performance going into the Great Recession

Quarter	NBER Date In Recession?	Agreement of 2-Regime Model	Shortfall of GDP from Potential	Unemployment minus Nat Rate
2007Q4	No	97%	-0.6%	0.6%
2008Q1	Yes	21%	4.2%	0.9%
2008Q2	Yes	43%	-0.2%	1.4%
2008Q3	Yes	91%	3.9%	2.7%

It is somewhat confusing! The 2-Regime model only “fully” agrees with the NBER that the economy was in a recession from 200Q3. The GDP gap roams all over the place, while the unemployment gap is increasing consistently over time.

Although R&R suggest the NBER emphasize measures of slack, those measures are very imprecise. This is clear given the CBO systematic revisions of potential output in the chart below.

Since I´m “toying” with dates, I´ll try using the NGDP Level target yardstick to see what it says about the Great Recession. (Useful recent primers on Nominal GDP Level Targeting are David Beckworth and Steve Ambler).

In the years preceding the Great Recession, there were many things happening. There was the oil shock that began in 2004 and gathered force in subsequent years. There was the bursting of the house price bubble that peaked in mid-2006 and, from early 2007, the problems with the financial system began, first affecting mortgage finance houses but soon extending to banks, culminating in the Lehmann fiasco ofSeptember 2008.

The next chart  the oil and house price shocks.

The predictable effect of an oil (or supply) shock is to reduce the real growth rate and increase inflation (at least that of the headline variety). The charts indicate that was what happened.

The chart below shows that when real growth fell due to the supply shock, real output (RGDP) dropped below the long-term trend (“potential”?). Does this mean the economy is in a recession? If that were true, the recession would have begun in 2006!

In that situation, how should monetary policy behave? Bernanke was quite aware of this problem. Ten years before, for example, Bernanke et al published “Systematic Monetary Policy and the Effects of Oil Price Shocks”. (1997)

In the conclusion, they state:

“Substantively, our results suggest that an important part of the effect of oil price shocks on the economy results not from the change in oil prices, per se, but from the resulting tightening of monetary policy. This finding may help to explain the apparently large effects of oil price changes found by Hamilton and many others.”

In the chart below, we observe that during his first two years as Chair, Bernanke seems to have “listened to himself” because NGDP remained very close to the target level path all the way through the end of 2007.

With NGDP kept on target, the effects of the supply shock are “optimized”. Headline inflation, as we saw previously will rise, but if there is little or no change in NGDP growth, core measures of inflation will remain contained.

During the first quarter of 2008, NGDP was somewhat constrained. This likely reflects the FOMC´s worries with inflation. RGDP growth dropped further, but during the second quarter of 2008, the Fed seemed to be trying to get NGDP back to trend. RGDP growth responded as expected and core inflation remained subdued.

At that point, June 2008, it appears Bernanke reverted to focus almost singly on inflation, maybe remembering what he had written 81/2 years before in What Happens when Greenspan is gone? (Jan 2000):

“U .S. monetary policy has been remarkably successful during Alan Greenspan’s 121/2 years as Federal Reserve chairman. But although President Clinton yesterday reappointed the 73-year-old Mr. Greenspan to a new term ending in 2004, the chairman will not be around forever. To ensure that monetary policy stays on track after Mr. Greenspan, the Fed should be thinking through its approach to monetary policy now. The Fed needs an approach that consolidates the gains of the Greenspan years and ensures that those successful policies will continue; even if future Fed chairmen are less skillful or less committed to price stability than Mr. Greenspan has been.

We think the best bet lies in a framework known as inflation targeting, which has been employed with great success in recent years by most of the world’s biggest economies, except for Japan. Inflation targeting is a monetary-policy framework that commits the central bank to a forward-looking pursuit of low inflation; the source of the Fed’s current great performance; but also promotes a more open and accountable policy-making process. More transparency and accountability would help keep the Fed on track, and a more open Fed would be good for financial markets and more consistent with our democratic political system.”

This is evident in his summary of the FOMC Meeting June 2008 (page 97), where Bernanke says:

“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.”

From that point on, things derailed and a recession becomes clear in the data. It appears the NGDP Level Targeting framework agrees with Hamilton´s 2-regime model that the recession was a fixture of 2008Q3.

If NGDP had not begun to tank in 2008Q3, a recession might, later, have been called before 2008Q3, but it would never have been dubbed “Great”, more likely being short & shallow.

The takeaway, I believe, is that the usual blames placed on the bursting of the house price bubble, which led to the GFC and then to the GR is misplaced. Central banks love that narrative because it makes them the “guys who saved the day” (avoided another GD) when, in fact, they were the main culprits!

PS: The “guiltless” Fed is not a new thing. Back in 1937, John Williams (no relation to the New York Fed namesake), Chief-Economist of the Fed, Board Member and professor at Harvard (so unimpeachable qualifications, said about the 1937 downturn:

“If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn. It makes a bad record and confused thinking. I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground. There is no good reason now for a major depression and that being the case there is a good chance of a non-monetary program working out and I would rather not muddy the record with action that might be misinterpreted.”

Two presidents and a governor

A James Alexander post

In the last day of public comments by FOMC members before the whole committee entered purdah the market was treated to three separate statements.

1. Kashkari

First off was Neel Kashkari. He knows little about monetary economics and it showed he hasn’t bothered to find out anything since his appointment. He should take this course for starters. At least is he is enthusiastic and inquisitive.

In a blog post entitled “Nonmonetary Problems: Diagnosing and Treating the Slow Recovery” he rather airily dismissed the idea that the slow recovery was due to poor monetary policy. He tasked his economics team at the Minneapolis Fed with building on some random thoughts of Greg Mankiw in a New Times op-ed. Mankiw came up with five, Kashkari and his team added two more, I think.  I have read so many of the secular stagnation theses and other ad hoc nostrums I go a bit bored.

What was not seriously discussed was monetary policy. He did at least mention raising the inflation target, moving to a level target or even NGDP targeting. But he then spoilt these promising thoughts with this incredible statement:

“However, there are significant downside risks with these policy recommendations [raising the IT, LT of NGDPLT] that I believe must be carefully considered before being adopted. First, the Federal Reserve is struggling to hit its current target of 2 percent and has come up short for four years. Market forecasts and expectations about our ability to hit 2 percent have fallen. If we announced a new higher target, it isn’t clear why anyone would believe that we could hit it. The Federal Reserve’s credibility could be weakened.“

The trouble is, the Fed has buckets of credibility. Despite “struggling to hit its current target” it ended QE in 2014, threatened all through 2015 to raise rates and did so in December. And then the Fed projected four more 25bps hikes in 2016 and around eight more within two years or so. What on earth effect does Kashkari think all that actual and clearly threatened firepower have on inflation expectations? No wonder the inflation data the Fed is so dependent upon keeps disappointing.

Still Kashkari is a lot more dovish than his two peers in the Kansas (George) and San Francisco (Williams) Feds, and will swing the average vote much more dovish in 2017 when it is his turn to vote.

2. Lockhart

The president of the Atlanta Fed is a bit on the hawkish side, but mostly a bit of a tease. He said nothing of note in his speech and ended a bit dovish, but teasingly so:

“Among these—and I will close on this note—are, first, what is the right policy setting given an outlook of getting to full employment and price stability relatively soon—in the next couple of years? And, if 1.6 percent inflation and 4.9 percent unemployment were all you knew about the economy, would you consider a policy setting one tick above the zero lower bound still appropriate? These are some of the questions on my mind as I approach the next few meetings. I think circumstances call for a lively discussion next week.”

3.Brainard

This was the big one. The speech worried markets on Friday 9th September when it was announced, especially after a litany of hawkish regional Fed presidents reiterating their inane and extremely tired views on the coming hyperinflation unless rates were raised soon.

The markets need not have worried. Brainard echoed many of the very sensible comments made by her governor colleague Tarullo.

“1. Inflation Has Been Undershooting, and the Phillips Curve Has Flattened … With the Phillips curve appearing to be a less reliable guidepost than it has been in the past, the anchoring role of inflation expectations remains critically important. On expected similar to realized inflation, recent developments suggest some reasons to be concerned more about undershooting than overshooting. Although some survey measures have remained well anchored at 2 percent, consumer surveys have moved to the lower end of their historical ranges and have not risen sustainably“

The other four sections were all pretty sensible:

2. Labor Market Slack Has Been Greater than Anticipated …the unemployment rate is not the only gauge of labor market slack, and other measures have been suggesting there is some room to go … 

3. Foreign Markets Matter, Especially because Financial Transmission is Strong  …In turn, U.S. activity and inflation appear to be importantly influenced by these exchange rate movements. In particular, estimates from the FRB/US model suggest that the nearly 20 percent appreciation of the dollar from June 2014 to January of this year could be having an effect on U.S. economic activity roughly equivalent to a 200 basis point increase in the federal funds rate

[but whose fat finger caused the USD appreciation?] …

4. The Neutral Rate Is Likely to Remain Very Low for Some Time … Ten years ago, based on the underlying economic relationships that prevailed at the time, it would have seemed inconceivable that real activity and inflation would be so subdued given the stance of monetary policy. To reconcile these developments, it is difficult not to conclude that the current level of the federal funds rate is less accommodative today than it would have been 10 years ago. Put differently, the amount of aggregate demand associated with a given level of the interest rate is now much lower than before the crisis

[OK, this is really confused. Interest rates are not monetary policy, expected nominal growth is. High rates mean money is or was easy, low rates mean it is or was tight] …

5. Policy Options Are Asymmetric… From a risk-management perspective, therefore, the asymmetry in the conventional policy toolkit would lead me to expect policy to be tilted somewhat in favor of guarding against downside risks relative to preemptively raising rates to guard against upside risks.”

And then we get what seems to be a highly encouraging trend, seen first with John Williams, but repeated by Neel Kashkari today, a nod to alternative policy options:

“There is a growing literature on such policy alternatives, such as raising the inflation target, moving to a nominal income target, or deploying negative interest rates.15 These options merit further assessment. However, they are largely untested and would take some time to assess and prepare. For the time being, the most effective way to address these concerns is to ensure that our policy actions align with our commitment to achieving the existing inflation target, which the Committee has recently clarified is symmetric around 2 percent–and not a ceiling–along with maximum employment.”

The last point echoes what we have identified coming from the Bank of England, that 2% is not necessarily a ceiling, although the Fed is not yet saying that about projected inflation.

There is no mea culpa, that the Fed has caused the inflation undershooting by excessively tight monetary policy but, hey, we can’t have everything just yet.

And all this is going to be evaluated in the “months ahead”. Read my lips: no September, November or even December rate hike. A good news day!

“Heads or Tails”

From a recent Vox post: “The tail that wags the economy: The origin of secular stagnation”:

The Great Recession has had long-lasting effects on credit markets, employment, and output. This column combines a model with macroeconomic data to measure how the recession has changed beliefs about the possibility of future crises. According to the model, the estimated change in sentiment correlates with economic activity. A short-lived financial crisis can trigger long-lived shifts in expectations, which in turn can trigger secular stagnation.

The typical post-WWII recession has a distinct trough, followed by a sharp rebound toward a stable trend line. Following the Great Recession, however, this rebound is missing. The missing recovery is what Summers (2016) and Eggertsson & Mehotra (2014) call ‘secular stagnation’ (see also Teulings and Baldwin 2014).

And show a version of this chart

Why did the dysfunction in credit markets impact the real economy for so long? Many explanations for the real effects have been advanced, and these are still being compared to data (e.g. Gertler and Kiyotaki 2010, Brunnermeier and Sannikov 2014, and Gourio 2012, 2013). Existing theories about why the crisis took place assume that the shocks that triggered it were persistent. Yet such shocks in previous business cycle episodes were not so persistent. This differential in persistence is just as puzzling as the origin of the crisis. What most explanations of the Great Recession miss is a mechanism that takes some large, transitory shocks and then transforms them into long-lived economic responses.

Perhaps the fact that this recession has been more persistent than others is because, before it took place, it was perceived as an extremely unlikely event. Today, the question of whether the financial crisis might repeat itself arises frequently. Financial panic is a new reality that was never perceived as a possibility before.

I believe there´s a simpler and more direct explanation – or mechanism – consistent with the changes in “beliefs, expectations or sentiment” which, in addition to helping understand the fall in productivity growth, is also consistent with the post war history of the behavior of RGDP depicted in the chart above.

That alternative explanation relies on observing that what is manifestly different in the present cycle is the behavior of monetary policy, if you understand monetary policy to be the main determinant of aggregate nominal spending (NGDP).

My strategy divides the post war period (actually the period after 1953, to avoid complications from the immediate post war years and the period of the Korean War) in four parts. The “low inflation” 1950s and early 1960s, the “rising-high inflation” of the late 1960s to the early 1980s, the “falling-low inflation” years from the mid-1980s to 2006, and the “Great Recession/Great Stagnation/Too Low Inflation” years thereafter.

In this story, it´s not “the tail that wags the economy”, but the “hydra-head” of the FOMC, who wields close control of aggregate nominal spending in the economy.

The panel depicts NGDP and RGDP during the four episodes. All corresponding charts have the same scale and they cover the period from the peak of the cycle to 28 quarters from the trough (which is the time span since the Great Recession ended in June 2009).

From looking at the behavior of NGDP and the associated behavior of RGDP during the episodes, it becomes clear why we´re living a Great Stagnation. For the past 60 years, monetary policy has never been this tight! That´s the mechanism that transforms transitory shocks into long-lived economic responses.

And on the productivity implications of inadequate AD growth, this was tweeted by Adam Tooze:

Keynes on the aggregate demand context necessary for rapid productivity growth

The genius that was Milton Friedman

Going back over old posts, I found one from 6 years ago that covered Milton Friedman. That was in Portuguese, and here I have more.

This is taken from the Q&A following Friedman´s Keynote Address at a Bank of Canada Conference in 2000. Here´s Friedman, on the hot topics of today: The Euro, Inflation Targeting operated primarily through interest rates, and Japan

Michael Bordo: Do you think the recent introduction of the euro will lead to the formation of other common-currency areas?

Milton Friedman: That’s an extremely interesting question. I think that the euro is one of the few really new things we’ve had in the world in recent years. Never in history, to my knowledge, has there been a similar case in which you have a single central bank controlling politically independent countries.

The gold standard was one in which individual countries adhered to a particular commodity—gold—and they were always free to break or to leave it, or to change the rate. Under the euro, that possibility is not there. For a country to break, it really has to break. It has to introduce a brand new currency of its own.

I think the euro is in its honeymoon phase. I hope it succeeds, but I have very low expectations for it. I think that differences are going to accumulate among the various countries and that non-synchronous shocks are going to affect them.

Right now, Ireland is a very different state; it needs a very different monetary policy from that of Spain or Italy. On purely theoretical grounds, it’s hard to believe that it’s going to be a stable system for a long time. On the other hand, new things happen and new developments arise.

The one additional factor that has come out that leads me to raise a question about this is the evidence that a single currency—currency unification— tends to very sharply increase the trade among the various political units. If international trade goes up enough, it may reduce some of the harm that comes from the inability of individual countries to adjust to asynchronous shocks. But that’s just a potential scenario.

You know, the various countries in the euro are not a natural currency trading group. They are not a currency area. There is very little mobility of people among the countries. They have extensive controls and regulations and rules, and so they need some kind of an adjustment mechanism to adjust to asynchronous shocks—and the floating exchange rate gave them one. They have no mechanism now. If we look back at recent history, they’ve tried in the past to have rigid exchange rates, and each time it has broken down. 1992, 1993, you had the crises. Before that, Europe had the snake, and then it broke down into something else. So the verdict isn’t in on the euro. It’s only a year old. Give it time to develop its troubles.

(Note: and the troubles developed)

Malcolm Knight: Countries with a flexible exchange rate need a nominal target for monetary policy to anchor expectations. Do you feel that inflation targeting provides a useful nominal target?

Milton Friedman: As I mentioned earlier, I think it’s a good thing to have a nominal target, to say that you’re not going to try to fine-tune, and to indicate what you aren’t going to do.

The problem I have is this: the current mechanism for all of the central banks who are inflation targeting is a short-term interest rate—as in the United States—in all of the central banks.

We know from the past that interest rates can be a very deceptive indicator of the state of affairs. A low interest rate may be a sign of an expansive monetary policy or of an earlier restrictive policy. And similarly, a high rate may be a sign of restriction, of trying to hold things down; or it may be a sign of past inflation.

The 1970s offer the classical illustration in which there were high interest rates that were reflecting the Fisher effect of inflation expectations. So I’m a little leery of operating primarily, or almost primarily, via interest rates. But, I think that having a given inflation target is a good objective. The question is, how long will you be able to keep it?

David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero, monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?

Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.

The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.

Federal Reserve Bankers Victoriously Declare Defeat!

A Benjamin Cole post

Speaking in Beijing a few days ago, Chicago Federal Reserve Bank President Charles Evans said economic stagnation is the new normal and so he sees slow inflation, interest rates and growth for far as the eye can see. Ergo, there is nothing for the Fed to do.

Eric Rosengren, Boston Fed President, reviewed the same outlook, but added that rate hikes will be needed soon, as the U.S. economy, particularly commercial real estate, could “overheat.”

Overheat?

Again, here is a telling graph:

For Q1 2016, the index of hours worked nationally in the United States private sector was 112.3. It was 110.2 in Q2 2007, and 109.2 in Q2 2000. That is 16 years of essentially no employment growth in the United States.

This is overheating?

And look at the 1990s—strong employment growth, and sustained. Yet inflation was moderate throughout the decade.

Presently, the PCE core is reading 1.6% YOY. As Marcus Nunes has pointed out repeatedly on these pages, nominal GDP growth has been falling in recent years.

Conclusion

There remains a premise in central banker and monetary circles that fiat-money central banks have been “easy” (perhaps for decades) or “accommodative,” and have done all they can do, sometimes wreaking destruction in their path.

So now it is time for central bankers to victoriously declare defeat.

Central bankers contend that by being so easy for so long, they have driven the developed world into deflation, or close to it.

So now, raising rates makes sense.