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.

NAIRU: The “Holy Grail”

Tim Duy, the quintessential “Fed Watcher”, has a detailed discussion of the FOMC Minutes: This Is Not A Drill. This Is The Real Thing.  He then gives his thoughts, the last of which summarizes them:

E.) Of all the divisive points above, I think the most important is the debate over the level of full employment. The ability of the doves to slow the pace of subsequent rate hikes will hinge on their willingness to push for below NAIRU unemployment to alleviate underemployment.

Which puts the Fed in a very bad light, square in the Phillips Curve camp, with the long discredited NAIRU being the “holy grail” in determining Fed policy!

Beliefs are to be held forever

And Chairwoman Yellen has forever held the belief that Phillips Curve/NAIRU is the “best inflation indicator”.

In his Final Thoughts on September, Tim Duy writes:

I expect the Fed will ultimately pledge allegiance to the Phillips curve. I think they believe that stable inflation is incompatible with sub-5% unemployment if short term interest rates remain at zero. Hence, they will signal that the first rate hike is imminent.

While a BoG member in 1996, she teamed up with PC/NAIRU other big fan Laurence Meyer:

Dec/96 FOMC Transcript:

L Meyer:

A second justification for policy change would be the conviction that we are already below NAIRU and not likely to move back to it quickly enough to prevent an uptick in inflation. This is basically the staff forecast, and my view has been and continues to be that this is the most serious risk factor in the outlook. Yet, we get stuck in place because we continue to be confronted by the reality of stable to declining core inflation in the face of this prevailing low unemployment rate. So, we wait for additional data to resolve our doubts. The risk of waiting, judging from the modest rise in inflation in the staff forecast, is not very great. Still, it is probably worthwhile noting that in all of the five private-sector forecasts that I looked at, there are increases in core inflation over the next year or two. That is a pervasive tendency that just about everybody is worried about. I think we need to keep that in mind.

J Yellen

To my mind, labor markets are undeniably tight. You remarked last time, Mr. Chairman, that we should be careful not to lull ourselves into a false sense of security about incipient wage pressures by reading too much into that suspiciously low third-quarter ECI, and I agree with that. So, I still feel that we need to avoid complacency about the potential for inflationary pressures to emerge from the labor market down the road.

Sometime later, now as head of President Clinton´s CEA we read:

Yellen CEA  Report 1998

This chapter’s analysis of macroeconomic policy and performance concludes that the economy should continue to grow with low inflation in 1998. The chapter begins with a review of macroeconomic performance and policy in 1997, to show in some detail where the year’s growth came from and how inflation remained so tame. The second section examines the important question of whether our understanding of inflation and our ability to predict it have changed in significant ways. This question is part of a broader inquiry into whether the economy has changed in such fundamental ways that standard analyses of how fast it can grow without inflation need to be replaced with a new view. The conclusion reached here is that no sea change has occurred that would justify ignoring the threat of inflation when the labor market is as tight as it is now;

In a few hours we´ll know if beliefs changed!

A mindset cast in bronze

Back in April 1997, while still a ‘freshman’ Fed Board member, Laurence Meyer gave a milestone speech at the Forecasters Club of New York. For the first time, I think, a board member provided a detailed account of his decision process framework.

One month earlier, the FOMC had changed (raised) interest rates for the first time since having reduced it in February 1996.

Meyer writes:

I am going to offer some interpretations of the outlook as a context for the recent policy action by the Federal Reserve and explain how I view this action as part of a prudent and systematic strategy for monetary policy. The Forecasters Club of New York is an ideal forum for me to offer this commentary because, in my view, the recent policy action must be understood not in terms of where the economy has been recently, but rather in terms of the change in the forecast, a change in expectations about where the economy likely would be in six or twelve months in the absence of a policy change.

………………………………………………………………………

Despite the sharpness and force of the Phillips Curve/NAIRU model, it can be difficult to implement in practice. Still, this relationship was about the most stable tool in the macroeconomists’ tool kit for most of the past 20 years; those who were willing to depend on it were likely to be very successful forecasters of inflation, and the record speaks for itself on this score. Nevertheless, the combination of the 7-year low in the unemployment rate and 30-year low in inflation was a surprise to those using this framework. The challenge is to understand why we have been so fortunate…

So, what was going on and what did come about? The charts illustrate.

Inflation had been stable while unemployment was trending down. Almost immediately following the speech, the fall in unemployment increased and inflation ‘shot down’!

Meyer97_1

The more convincing story behind this fact was the productivity increase that was taking place (helped out by the steep drop in oil prices following the Asia crisis, although this did not have much effect on core prices). Anyway, such positive supply shocks reduce inflation and increase growth (reduce unemployment).

In short, contrary to Meyers (and most in the FOMC) view, there was no ‘dangerous’ increase in resource utilization.

The rate increase was of the “one and done” kind. Much later, following the Russia/LTCM event in August 1998, rates were reduced.

Meyer97_2

The next chart indicates that NGDP was evolving close to trend, growing close to 5.5%. When Russia/LTCM happened, the growth in AD was increased. This turned out to be excessive. We know that because it ignited a cycle to nominal spending that first went too high and later was brought down too low, only being stabilized again towards the end of Greenspan´s tenure in early 2006!

Meyer97_3

The “too much nominal growth” leg is seen in the next chart, which indicates that money growth more than offset the fall in velocity, especially following Russia/LTCM.

Meyer97_4

Jumping to the present, apparently nothing has changed because now we read:

Federal Reserve officials might raise interest rates soon because they have a theory: Falling unemployment pushes up prices and wages, requiring tighter credit to keep inflation in check.

David Altig, research director at the Atlanta Fed is quoted:

We haven’t lost faith in the framework described by Mr. Phillips and his successors, that a tight labor market generates higher inflation, said David Altig, research director at the Atlanta Fed. But the numbers that you would plug into that framework and the exact levels at which the pressures begin to emerge, we’re not so clear on those.

In economics, it´s interesting to observe how some things, especially those that require “estimation”, become “gospel” and, despite their suspicious origins, never go away, being endlessly “reestimated”.

When Modigliani and Papademos (yes, the same one who later became head of the Central Bank of Greece and then its Prime Minister)  “invented” NAIRU (NIRU at the time) in a BPEA paper in 1975, their clear aim was to downplay “monetarism” and argue for monetary expansion expansion based on the fact that NAIRU/NIRU was above its “non accelerating rate”:

At this point the analysis confronts a widely held concern, encouraged by at least some monetarists, that such a rapid rate of growth and sudden acceleration of the money supply , would unfavorably influence prices and inevitably set off a new round of inflation.

Our analysis indicates that such concerns are unfounded; it implies that inflation systematically accelerates only when unemployment falls below NIRU, and the M1 growth that we expect will be needed as component of a policy package aimed at approaching NIRU from above over the next two years.

We all know how that turned out!

Today, New York Fed chief Dudley apparently moved markets by saying:

From my perspective, at this moment, the decision to begin the normalization process at the September FOMC meeting seems less compelling to me than it was a few weeks ago,” he said.

But he also said:

Responding to a question about whether a Fed move will come in a subsequent 2015 FOMC meeting, Dudley said he “really” hopes to raise rates this year, but “let’s see how the data unfold before we make any statements about exactly when that might occur.”

And I say: I really hope a large rock will fall on my head this year!