Brainard´s “New Normal” is Old

Lael Brainard´s speech on the Fed´s new “longer-run goals and strategies makes reference to a “New Normal”: [I only highlight her references to the labor market]

“The new statement on goals and strategy responds to these features of the new normal in a compelling and pragmatic way by making four important changes.

First, the statement defines the statutory maximum level of employment as a broad-based and inclusive goal and eliminates the reference to a numerical estimate of the longer-run normal unemployment rate.6 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.

Third, the statement highlights an important change in the Committee’s reaction function. Whereas previously it sought to mitigate deviations of employment and inflation from their targets in either direction, the Committee will now seek “to mitigate shortfalls of employment from the Committee’s assessment of its maximum level and deviations of inflation from its longer-run goal.” This change implies that the Committee effectively will set monetary policy to minimize the welfare costs of shortfalls of employment from its maximum and not preemptively withdraw support based on a historically steeper Phillips curve that is not currently in evidence and inflation that is correspondingly much less likely to materialize.

… 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strategy we made in the new statement been in place several years ago, it is likely that accommodation would have been withdrawn later, and the gains would have been greater.”

What she really shows is that the post Greenspan FOMC has continuously misinterpreted the economy.

The panel below clearly illustrate that during the 1990s and early 2000s (before the Great Recession), a stable growth rate for nominal spending (NGDP) was what was required to keep the rate of unemployment on a downward trend while inflation either fell or remained low & stable.

The same remains true for the post GR period.

When the Fed makes a big monetary policy mistake and allows nominal spending to tank, the consequences are also big. This was the case in the monetary-led Great Recession. NGDP tanks while unemployment balloons. Inflation dropped by 50% (from 2% to 1%).

Four years ago (Sept 16) Lael Brainard made a speech with the title: “The New Normal and what it means for Monetary Policy”. One of the key features of the New Normal was:

  1. Labor Market Slack Has Been Greater than Anticipated
    Second, and related, although we have seen important progress on employment, this improvement has been accompanied by evidence of greater slack than previously anticipated. This uncertainty about the true state of the economy suggests we should be open to the possibility of material further progress in the labor market. Indeed, with payroll employment growth averaging 180,000 per month this year, many observers would have expected the unemployment rate to drop noticeably rather than moving sideways, as it has done.

The next chart zooms in on 2016 to indicate the “cause” of the sideways move in unemployment. You easily see it was due to the excessive drop in NGDP growth from the 4% average that prevailed in the 2010 – 2019 period. The same happened 20 years before. The Fed should have picked on this “pattern” some time ago! As seen in the previous charts, once NGDP growth picks up again, unemployment resumes the down trend.

So, using new words for the “target” – AIT – and new words for the “reaction function” – shortfalls – will likely change very little.

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.

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.

NGDP really does drive RGDP: YoYs vs QoQs

A James Alexander post

If you are sensible about macroeconomics then you must be highly skeptical of macroeconomic data. You must focus on trends in data and not on any point data. Looking at quarterly figures you would ideally want to use Year on Year growth rates. You don’t want to be confused by “noise” from estimated seasonal adjustments, early data releases based on incomplete inputs, or just simple errors.

Obsessed with looking for the very latest trends the US habit of annualizing Quarter on Quarter growth rates seems particularly mad, and maddening. By all means report actual QoQ growth rates but don’t annualize them. The actual growth rate is QoQ non-annualized, even if a very small number.

In a perfect world of perfect data annualizing QoQ might make a bit more sense, especially if you were a central bank trying to maintain the stability of nominal growth. Rapid swings in QoQ growth rates might be a bit of a warning that your policy might be wrong. It would also matter more on the downside than the upside as too fast nominal growth causes little damage and is relatively easily corrected.

The Fed worries about having to suddenly “slam on the brakes” to prevent overheating and thus causing too rapid a slowdown, but this just smacks of bad driving habits. In any case, economies don’t crash from growing too fast but from having the brakes “slammed on”. Brakes can be gently applied and calm economies down, any confident driver will tell you that.

On the downside, however, real economic damage can be caused by either braking when you should have your foot on the accelerator, or failing to spot the car has run out of fuel. Either of these things happening while you are managing nominal growth can cause recessions involving high unemployment and real lost output. So, if your speed gauge suddenly drops it may be just a temporary problem with the speedometer, the road surface or traffic, but it may also indicate a more fundamental problem. Average speed or YoY growth is the long run goal but near term deviations to the downside should be watched closely.

JA QoQ

In the third quarter of 2003 NGDP hit a high of 9.3% YoY growth. Annualized QoQ ran at 5.3%. From that YoY high point NGDP growth gradually trended down and down, hitting 4.4% in fourth quarter of 2007, with QoQ annualized hitting 3.2%.

The Great Crash in NGDP QoQ in First Quarter 2008

In the first quarter of 2008 NGDP continued to trend down on a YoY basis to a worrying low 3.1%, but on a QoQ annualized basis it had crashed to a negative 0.5%. Of course, the YoY rate should have been ringing alarm bells from a few quarters, especially the drop below trend in 1Q08, but it was also “caused” by the negative QoQ reading  – a shrinking nominal economy, or deflation.

Since the end of the recession in 2009 we know NGDP has been too low, growing at between 2.5%-4.5% YoY. But we have also seen some really wild swings in QoQ annualized growth rates. These have ranged from a low of 0.2% in first quarter 2011 to a high of 6.7% in second quarter 2014. Despite the usual seasonal adjustments there appears to be a high degree of seasonality still in the data. Many have commented  on the RGDP apparent seasonality, with the first quarter often being the weakest and the second quarter the strongest. But there appears far worse seasonality in the NGDP data. The “first quarter weakness/second quarter strength” phenomenon is very, very visible in the QoQ annualized figures.

More intriguingly, the second quarter strength in 2015 needs to be beaten by some heavy margin in order for the base effect not to drag down YoY growth even more heavily than the already slowing trend. In fact, QoQ NGDP growth in the current second quarter needs be a record-busting 7.8% if  both the current Atlanta Fed GDPNow projection of 1.8% QoQ annualized RGDP is right and the GDP deflator maintains its current level of 1.3%. It may happen, of course, but seems highly unlikely given three monetary policy indicators.

  1. Although in some sense the doves on the FOMC are in the ascendancy, it is only delaying “normalization”. The Fedborg’s drive to raise rates seems inexorable.
  2. Monetary policy has been tightening passively since the end of QE3 and actively in December 2015.
  3. The US monetary base has been shrinking since the start of the year at roughly -3% YoY.

If NGDP drives RGDP then a print of 4% QoQ, for example, in the second quarter NGDP and a stable deflator of 1.3% would imply a negative -2% QoQ annualized print for RGDP.  The YoY trends for RGDP and NGDP would still be downwards but positive at 1.4% and 2.7% respectively.

The market will not like the big negative print in RGDP. Of course, on the way to it being reported there would have to be many surveys and data points suggesting that result and the two major public “nowcasts” from Atlanta Fed and New York Fed would be flashing red alerts. The actual market response would then be dependent on the expected response of the FOMC. I would expect it to be slow to react and certainly not do enough, but predicting the reaction is not at all easy.

I have no idea if NGDP QoQ annualized will drop to 4% in the second quarter, but it doesn’t seem implausible given first quarter trends and the stance of monetary policy. It could be an interesting couple of months.