Money “Front & Center”

This is a note to my long time readers that I have earlier this year moved my blogging to Substack.

At Substack, posts are called newsletters, and so no one has any doubt about the focus of my newsletter, I´ve named it “Money Fetish”.

Below a link to my latest “post”. Hope you like it and subscribe (free) to receive my newsletters in your e-mail box. Feel free to browse past issues.

Thanks to all


Does the “Monetary Theory of Nominal Income” stand scrutiny?

Fifty years ago, Milton Friedman published in the JPE “A Monetary Theory of Nominal Income”. I highlight two passages from the paper.

Correspondence of the Monetary Theory of Nominal Income with Experience

I have not before this written down explicitly the particular simplification I have labelled the monetary theory of nominal income—though Meltzer has referred to the theory underlying our Monetary History as a “theory of nominal income” (Meltzer 1965, p. 414). But once written down, it rings the bell, and seems to me to correspond to the broadest framework implicit in much of the work that I and others have done in analyzing monetary experience. It seems also to be consistent with many of our findings.

One finding that we have observed is that the relation between changes in the nominal quantity of money and changes in nominal income is, almost always, closer and more dependable than the relation between changes in real income and the real quantity of money or between changes in the quantity of money per unit of output and changes in prices.

This result has always seemed to me puzzling, since a stable demand function for money with an income elasticity different from unity led us to expect the opposite. Yet the actual finding would be generated by the monetary approach outlined in this paper, with the division between prices and quantities determined by variables not explicitly contained in it.

…On still another level, the approach is consistent with much of the work that Fisher did on interest rates…In particular the approach provides an interpretation of the empirical generalization that high interest rates mean that money has been easy, in the sense of increasing rapidly, and low interest rates that money has been tight, in the sense of increasing slowly, rather than the reverse.

A few pages later in Short-Run Adjustment of Nominal Income, Friedman writes:

For monetary theory, the key question is the process of adjustment to the discrepancy between the nominal quantity of money demanded and the nominal quantity of money supplied…The key insight of the quantity-theory approach is that a discrepancy will be manifested primarily in attempted spending, thence in the rate of change in nominal income.

Put differently, money holders cannot determine the nominal quantity of money, but they can make velocity anything they wish.

What, on this view, will cause the rate of change in nominal income to depart from its permanent value? Anything that produces a discrepancy between the nominal quantity of money demanded and the quantity supplied, or between the two rates of change of money demanded and money supplied.

In symbols, the equation of exchange (in growth form) says that M+V=P+y, with M being money supply growth, V velocity growth, P inflation and y real output growth.

By “ignoring” the division between prices (P) and quantities (y), we are only concerned with aggregate nominal spending growth (or NGDP). In this way, an “appropriate monetary policy” is one that maintains nominal stability (or a stable growth of nominal spending). In other words, an “appropriate monetary policy” is one in which money supply growth offsets changes in velocity to keep NGDP growth stable.

As I´ll show later, it is not just the stable growth rate of NGDP that matters, but also the Level Path of spending along which that growth takes place. That´s the reason Market Monetarists favor NGDP-Level Targeting as the central bank´s framework.  

Before going ahead, I think it is useful to put the Monetary Theory of Nominal Income in context.

Traditional versions of monetarism, still followed today, assume velocity is stable. With that assumption, the equation of exchange in growth form is written (to an approximation) as M=P+y or M-P=y so that statements such as:

“In a large body of work with a number of colleagues Friedman demonstrated that inflation was “always and everywhere a monetary phenomenon”, meaning that it arose over extended periods only when the quantity of money increased more rapidly than the quantity of goods and services.

Are not valid.

When Friedman concluded that money holders cannot determine the nominal quantity of money, but they can make velocity anything they wish, he was led to the view that the relation between changes in the nominal quantity of money and changes in nominal income is, almost always, closer and more dependable than the relation between changes in real income and the real quantity of money or between changes in the quantity of money per unit of output and changes in prices.

The other contender, New Keynesianism, is a way of analyzing the economy with a mere three equations, none of which refers to the quantity of money. A “two line summary” would be:

In New Keynesian analysis, monetary policy (interest rate policy) determines real GDP, which in turn determines inflation via a Phillips curve.

[Notes: In what follows, for the money supply, I consider the Divisia M4 index, a very broad measure of the money supply. The data are available at the Center for Financial Stability and a good discussion of the indices construction and usefulness for monetary policy is “Getting it Wrong”, by William Barnett. For inflation, I consider the headline PCE in order to take account of supply shocks such as oil prices. For unemployment, I use the Core version, which does not consider “temporary layoffs”. That´s a fixture of the “Covid19 pandemic”, with the two measures, core & headline unemployment, showing little difference for all other periods. For details, see here.]

To check if the Monetary Theory of Nominal Income stands up to scrutiny, I analyze several periods over the last 30 years. For each period, the top chart shows the “outcome” of M+V=P+y(NGDP), while the bottom chart shows what happened to “pieces” of the economy; RGDP(y), Inflation(P) and unemployment.

The first chart covers the 1990s.

Monetary policy was quite good. In the top chart, we observe nominal income (NGDP) growth was stable, with some sign of instability occurring when money supply growth did not adequately offset velocity changes.

In the bottom chart, RGDP growth “mimicked” nominal income growth. The unemployment rate fell almost continuously and inflation remained low (close to “target”). Towards the end of the period, inflation falls. That´s due to the occurrence of two positive supply shocks; the fall in oil prices following the Asia crisis 0f 1997/98 and the rise in productivity growth from 1997.

It appears that a monetary policy geared to keeping NGDP growth on a stable path gives out “good results”.

The second chart illustrates the more “confusing” follow-up period.

When the Asia crisis and Russia crisis (remember LTCM?) were “solved”, oil prices began to rise. In 1999 and for most of 2000, monetary policy kept NGDP growth stable. For that interval, RGDP growth remained stable and robust and unemployment still fell somewhat.

The combination of low unemployment and rising inflation signaled red flags to the Fed. Velocity fell significantly while money supply growth was “timid” in offsetting it. NGDP growth fell strongly, from about 5.5% to close to 2%. The effect on RGDP growth of the negative supply shock was magnified and unemployment rose.

 With monetary policy succeeding in stabilizing NGDP growth (around 4%), unemployment remains higher but stable. Around mid-2003, the Fed becomes more expansionary adopting “forward guidance”. Velocity rises (and money supply growth does not offset it). NGDP growth climbs to the 5% range, RGDP growth picks up and unemployment begins to fall. The end of the oil surge and the recession of 2001 had brought inflation down, and it remained low & stable after that.

The next chart covers the last years of the Great Moderation”, the last two years of Greenspan´s and the first months of Bernanke at the Fed´s helm

Contrary to many that view this period as an example of “bad” (expansionary) monetary policy, I believe monetary policy was close to “perfect”, especially given the fact that it coincides with the first leg of a persistent negative oil shock that extended to mid-2008.

The Dynamic AS/AD model tells us that, because of a negative supply shock, real growth falls and inflation rises. That´s exactly what happens as observed in the lower chart. In the top chart, however, monetary policy remains geared to providing nominal stability (stable NGDP growth).

With that, unemployment remains on a downtrend. I bet Claudia Sahm felt excited by that outcome shortly before she joined the Fed in 2007.

Unfortunately, in early 2006, Bernanke took over from Greenspan, and Bernanke has a “visceral” fear of inflation. The next chart shows that soon after, NGDP growth drops a notch and unemployment stops falling.

With inflation rising and unemployment low, in early 2008 the Fed tightens monetary policy (reflected in monetary expansion falling short of the fall in velocity). Unemployment begins to increase and the fall in RGDP growth is magnified.

At the closing of this period, it´s almost as if the Fed realizes its mistake and loosens monetary policy somewhat. The unemployment rate, however, does not have time to react because the Fed, scarred of inflation due to oil price increases tightens massively, as seen in the chart below.

The evidence for that comes from Bernanke himself:

Bernanke June 2008 FOMC Meeting (page 97):

“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.”

The Great Recession of 2008/09 is on. NGDP growth and RGDP growth sink while inflation goes from 4% to -1% and unemployment shoots up from 6% to 10%.

The next chart, in my mind, is the most compelling evidence for the monetary theory of nominal income approach.

By early 2010, NGDP growth was back to 4% YoY, with NGDP growth averaging 4% over the next 10 years. That was not due to interest rates remaining at the ZLB until December 2015, but to the fact that money supply growth adequately offset velocity changes to maintain stable NGDP growth.

The bottom chart shows that with nominal stability consolidated, the unemployment rate enters a long period of decline going from 10% to less than 4% before the pandemic began. RGDP growth was very stable around the average of 2.2% and headline inflation remained low and stable, averaging 1.6%.

But, and there´s always a “but”, those 10 years comprise a vivid example of the importance of the level path along which nominal stability occurs.

The chart below illustrates, showing that after the Great Recession, the economy evolved very stably along a much lower nominal income level.

Over the years, the rate of unemployment has become not just a gauge of the health of the labor market but the most common yardstick policymakers use to assess the health of the economy as a whole.

Some have argued that the historically low rate of unemployment attained is testament to the strength of the economy. Unfortunately, that´s not so. When you look at the determinants of the unemployment rate, the employment population ratio and labor force participation, you see that the post Great Recession economy is much “weaker” than the pre GR economy.

Labor force participation provides a measure of the “excitement” conveyed by the labor market. The “low” level of nominal income has “muted” that “excitement”.

Almost one year ago, the pandemic hit. The next chart shows the steep & deep fall in velocity (remember, money holders can make velocity whatever they wish). This time, monetary policy reacted quickly to stop the bleeding.

As the next chart shows, however, monetary policy still falls short of what´s needed, so that the level of NGDP remains below, and even distancing itself from the already low level that prevailed after the Great Recession.

As the pandemic withers with mass vaccination, the demand for money will fall (velocity will rise). The Fed will have to offset this rise in velocity in order to stabilize the growth of nominal income (NGDP). It will also have to choose a level path, hopefully higher than the one it travelled for the 10 years to early 2020!

As the NGDP growth rises to reach a higher-level path, some of that rise could reflect (temporarily) higher inflation. Despite the Fed having adopted Average Inflation Targeting (AIT), a higher inflation will most likely cause “nervousness” at the Fed. That´s probably why, more than 10 years ago, Scott Sumner wrote:

I don’t propose to abolish the phenomenon of inflation, but rather the concept of inflation.  And to be more precise, price inflation, which is what almost everyone means by the term.  I want it stripped from our macroeconomic theories, removed from our textbooks, banished into the dustbin of discarded mental constructs.

Bits & Pieces

The “bits” are the components of the equation of Exchange in growth form:

M+V=P+Y, where

M is the growth rate of money supply, V the growth of velocity (the inverse of money demand), and P+Y the growth of aggregate nominal spending, or NGDP growth.

For the past few months, many look at the high (unprecedented) growth of M illustrated in the chart and say an increase in inflation is just around the corner.

However, when you look at the V “bit”, you see that velocity growth crashed

In fact, money supply growth has fallen short of money demand growth. That becomes clear when you put those two pieces together and add the NGDP growth “piece”.

Notice that before the Covid19 shock, money supply growth adequately offset velocity changes to keep NGDP growing at a stable rate close to 4%.

When the pandemic hit, velocity tanked while money supply growth lagged behind. More recently, money supply growth has been sufficient, given velocity, to keep NGDP moving at sub-zero temperatures.

Hard to imagine that “heat” (inflation) can be generated by a “thermostat” dialed-down to such low temperatures!

Now for the “pieces”. Those refer to the labor market, more specifically to the construction of the unemployment rate. Two “pieces” stand out. The chart shows that data for workers on temporary layoff and for those marginally attached were distorted by the pandemic.

Last June, Jed Kolko devised a “core rate of unemployment” that considers those two anomalies. From the unemployment level he subtracts workers on temporary layoff and adds marginally attached workers (those not in the labor force but prepared to work). The adding permits to count as unemployed those workers that were not able to get their job back after being laid-off.

The chart shows that until the pandemic hit, headline and core unemployment were closely attached, so the core rate now gives us a less misleading view of the unemployment rate.

A zoom of the picture indicates that the discrepancy between the headline and core rates are closing, so shortly we may go back to looking just at the conventional (headline) data.

We can play around with the “bits & pieces”. The next chart shows that the drop in aggregate spending (NGDP) growth in 2020 was much steeper & deeper than what happened in 2008/09. Nevertheless, core unemployment rose much less now than in 2008/09.

Note that in both instances, unemployment stops rising when NGDP growth reverses direction. The question remains, however, about why the huge difference in the behavior of unemployment.

One reason might be the suddenness of the drop in spending. While it took only 4 months for spending to fall from peak to trough, in 2008/09 it took 21 months. Real variables like employment take time to adjust. That still doesn´t explain why unemployment didn´t keep rising even after spending reversed direction.

What guides unemployment is not just the behavior of nominal spending but, more importantly, the ratio of wages to nominal spending (NGDP). The next chart indicates that the rise in the ratio of wages (average hourly earnings) to NGDP jumped from trough to peak in just 2 months and then dropped rapidly, even while NGDP growth was still falling. The 2008/09 story is very different.

The explanation for the (surprising) observation of a relatively small rise in unemployment in spite of a large fall in spending is evident in the next chart, which shows that wages fell in absolute terms, leading to the quick reversal in the wage/NGDP ratio and thus containing the rise in unemployment. In 2008/09, wages rose continuously.

To wrap up, the next picture shows the “end result” of the “bits” (the outcome of monetary policy trying to adequately offset changes in velocity, but failing at present) which helps define the “shape of the pieces” (core unemployment & payroll employment in this case).

Where we observe that faltering monetary policy leads to unemployment not falling and employment being constrained.

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.

The Longest Expansion: A post mortem

According to the NBER´s Business Cycle Dating Committee (BCDC), the expansion that began in June 2009 ended in February 2020, having lasted 128 months, eight months more than the March 1991 – March 2001 expansion.

A comparative analysis of these two long expansions should be useful. I´ll fudge the dates of the 1991 – 2001 expansion, extending it to the end of the next cycle that began in November 2001 and ran through December 2007. The only reason behind this extension is to bring out the importance of a stable level path of NGDP. [Note: The 2001 recession was more like a growth retrenchment, with year-on-year real growth never turning negative. Also, the popular rule of thumb of negative real growth in two successive quarters never materialized].

What separated these two long expansions was the deep and longest post war recession that went on from December 2007 to June 2009 (18 months), being known as the Great Recession.

The main statistics (average over periods) for the two expansions is illustrated below:

The charts are telling. In order to have all the data on a monthly basis, for RGDP & NGDP I use the monthly estimates of those variables (available from January 1992) provided by Macroeconomic Advisers.

The first panel illustrates the behavior of NGDP & RGDP relative to the Great Moderation trend level path.

During the first expansion, both NGDP & RGDP hug close to the trend for much of the time. During 1998-03, there is some instability in NGDP, which is mirrored in RGDP instability. Note that towards the end of the first expansion, although NGDP remains close to trend, RGDP falls significantly below trend. What is going on?

In the second expansion, both NGDP & RGDP remain on a stable level trend path that has been permanently lowered! Later I will examine the ‘transition’ from the high to the low trend path brought about by the Great Recession.

The next panel shows the behavior of prices, both the headline and core versions of the PCE during the two expansions.

During the first expansion, both headline & core prices remained close to the 2% trend line from 1992. Towards the end of this expansion, just as RGDP fell below trend, headline PCE rises above trend. The fall in RGDP growth & rise in inflation implied by those moves is consistent with predictions of the dynamic AS/AD model in the case of a supply (oil price in this case) shock.

During the second expansion, after 2014, when oil prices dropped significantly, headline PCE shifted down and never “recovered”. Core PCE has remained significantly below the 2% trend and has risen at a rate below 2%.

The real and nominal output growth panel (and the price panel) indicate the two expansion phases were characterized by nominal stability. The differing characteristic is that during the recent long expansion, nominal stability followed a lower trend level path with lower growth.

To see how the economy transited from the “high” to the “low” path, I examine the details of the last years of the first expansion.

Those years were marked by oil shocks. As the dynamic AS/AD model tells us, growth slows and inflation rises. The best monetary policy can do in those instances is to keep aggregate nominal spending (NGDP) growth stable along the level trend path.

As the next charts indicate, the results are ‘model consistent’. An oil shock happened:

As predicted by the model, RGDP dropped below trend (real growth fell) and headline PCE shifted up (headline inflation increased):

NGDP, however, remained close to the trend level path, while Core PCE remained below the 2% level path, with core inflation remaining subdued:

The fall in real growth and the rise in headline inflation were the unavoidable consequence of the oil shock. Apparently, both Greenspan during his last year as Fed Chairman and Bernanke during his first two years as Chairman recognized this fact, keeping monetary policy on an ‘even keel’ (evolving close to the trend level path).

After that point, things unraveled. In the first six months of 2008, oil prices climbed an additional 44%. Headline PCE (and inflation) followed suit.

It is rare that a policymaker has the chance of putting his academic knowledge into practice. In 1997, Bernanke, with co-authors Gertler & Watson, published a paper titled:

“Systematic Monetary Policy and the Effects of Oil Price Shocks”. 

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.”

At that point, June 2008, monetary policy was “crunched”, with NGDP growth turning negative! No wonder the “effects of the oil price changes became large”, and the recession became “Great”.

The problem, I believe, is that Bernanke´s mind became increasingly focused on inflation. In that same year (1997) he had published a paper (coauthored with Frederick Mishkin) titled:

Inflation Targeting: A New Framework for Monetary Policy?

At that time he was still “flexible”, concluding that IT “construed as a framework for making monetary policy, rather than rigid rule, has a number of advantages…”

It seems “rigidity” set in because eleven years later, concluding the June 2008 FOMC Meeting, Bernanke states:

 “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.”

Bernanke´s timing could not be worse because at that point, June 2008, a recovery appeared to be incipient. The rest, as they say, is history. The economy never recovered so the “longest expansion” should never be hailed or become a paradigm.


As the charts below indicate, the US economy has always recovered from deep recessions, even from the “Great Depression”. By recovery, I mean that the economy climbs back to where it should have been if not for the recession/depression. As the bottom right chart indicates, the economy never recovered from the Great Recession.

A big problem is that monetary Policy is “guided” by unobservable variables. The concept of “potential” output, for example, says that if real output is above “potential”, monetary policy should be tightened, because otherwise inflation will rise. Conversely, if real output is below “potential”, monetary policy should be loosened, otherwise inflation will fall.

The fact is that when guided by unobservable variables, monetary policy becomes a “matching game”.

The charts below indicate that when actual output is above the initial estimate of “potential”, “potential” output is systematically revised up until it “matches” actual output. The opposite happens when actual output is below initial estimates of “potential”. Note that in the first case, inflation, instead of rising was falling and remained low thereafter, while in the second case it remained low throughout.

This imparts a tightening bias to monetary policy. In the “longest expansion”, this bias proved “mortal”.

PS: Note that I make no mention of the house price bust or financial troubles, usually pinned as “causes” of the Great Recession. I believe those were minor actors in the “movie”. The “movie was a box-office bust” because monetary policy, the “leading actor”, forgot its lines!

Getting down to business

A James Alexander, Benjamin Cole, Justin Irving, Marcus Nunes post

After a six-year run, during which Historinhas helped spread the Market Monetarist approach, this blog will undergo a metamorphosis, becoming NGDP-Advisers. The blog will continue but be augmented by new products that will be available via subscription.”.

In watching the U.S. and global economy since 2008 (and before) it has become obvious there is a dearth of financial advice that is informed by Market Monetarism, or even close attention to nominal gross domestic product (NGDP).

A recent Economist magazine study of the International Monetary Fund’s national economic forecasts from 1999 to 2014 found, “Over the period, there were 220 instances in which an economy grew in one year before shrinking in the next.  In its April forecasts the IMF never once foresaw the contraction looming in the next year.” Not once! Something is wrong in economic forecasting.

NGDP-watching is not a forecasting cure-all. However, Historinhas and the Market Monetarists have time and again been proven right on macroeconomic matters when the establishment was wrong. When old-school monetarists feared hyperinflation from unconventional easing measures, Market Monetarists correctly saw the real risk was still tight money. When Keynesians predicted recession from cuts in government spending during the 2013 US fiscal cliff episode, Market Monetarists anticipated the monetary offset and were proven right. When central banks in Europe raised interest rates in 2011, Market Monetarists called this for the debacle that it became.

It is time to bring these insights from the world of blogging, into the realm of macro forecasting, time to unseat the hopeless “experts”.

The bedrock of our approach is a healthy fear of market efficiency, though our approach still has important advice for investors. Many have missed historic bond rallies since 2008, so certain were established advisers that an inflationary surge, or even hyperinflation, was pending. Equity investing is equally tricky.

Central bank monetary policy sometimes feels like a game of blackjack, random. Time and again in its history, the Fed has tried to tighten (in recent years), or loosen (in earlier eras), yet been beaten back when markets question their view of economic reality. It is hard to forecast how stubborn a central bank will be in such situations and when it will inevitably buckle, but our approach frames the issues correctly, allowing all investors to understand where their risk lies.

At NGDP Advisers, we hope not only to continue our examination of the global economy, but also to recognize realities and advise accordingly. We’ll yell from the cliff tops ‘what should be’, but we’ll also help you get ready for what ‘will be’.

Please join us at, the best is yet to come. The Historinhas blog will stay up but dormant, and recent and all future posts will be freely available here 

Kashkari should have joined the Treasury, not the Fed!

The title of his speech is revealing: Nomonetary Problems: Diagnosing and Treating the Slow Recovery, where he says:

I must acknowledge up front that most of the policy prescriptions I will identify are outside the scope of monetary policy. Monetary policy is largely doing what it can to support a robust recovery, and what remains are fiscal and regulatory policies. If we are able to apply our research expertise to identify potential solutions, I believe it is appropriate to do so and then leave it to other branches of government to decide whether or not to pursue them

If, as he says “I joined the Federal Reserve because I want to help tackle the most important economic policy challenges we face as a country”, he´s wasting his time at the Fed!

The view of central bankers that the problems they face are “nonmonetary” is prevalent. Just to give one example (among many):

Throughout the “Great Inflation” Arthur Burns argued that inflation was a nonmonetary phenomenon (Unions, Oligopolies, Oil Producers, etc.).

Now, the view remains the same “throughout the “Great Stagnation”!

Lael, a “courier pigeon”?

Last month, John Williams wrote an “out-of-the-mainstream” letter. He was quickly reined in and three days later “toed the line”.

Now, we are told that Lael Brainard will give a speech in Chicago on September 12:

One of the most influential Fed doves has announced that she will speak on Monday, Sept 12 on the US economy in Chicago at noon local time (1 pm ET).

The location is the Chicago Council on Global Affairs and they say she will discuss “the economic outlook for the United States and monetary policy implications” and will be in conversation with Michael Moskow, who was CEO of the Chicago Fed.

Maybe it’s been in the works for a while, maybe she’s been dispatched to reel in hike expectations for September 21. Either way, that’s going to be a critical speech.

The fact that she´s regarded as an “influential dove” increases the “likelyhood” of a September hike if she so indicates. It will certainly be interesting to read.

The “Guessing Game” Goes On

Caroline Baum had a nice piece yesterday: “The Fed’s baffling fascination with unreliable information”:

The idea of relying on expectations as a means to an end always seemed more viable in theory than in practice. So I was glad to find some support for my reservations from the economics community: specifically, a blog post by William Dupor, an economist at the Federal Reserve Bank of St. Louis, on the subject of inflation expectations.

Titled “Consumer Surveys, Inflation Expectations and the FOMC,” Dupor notes that “survey-based measures of inflation expectations” are mentioned in each of the statements released at the conclusion of the last 12 meetings of the Federal Open Market Committee. (My search revealed a reference to “survey-based measures of inflation expectations” in both FOMC statements and minutes dating back to January 2014.)

Perhaps it’s a coincidence, but market-based measures of inflation expectations set a near-term peak in January 2014 and have been declining ever since, much to the Fed’s consternation.

I always viewed the inclusion of survey measures as a case of confirmation bias: It gave policy makers the answer they wanted to hear. It allowed them to dismiss the sharp decline in market-based measures of inflation expectations, derived from the spread between nominal and inflation-indexed Treasuries, as a distortion due to liquidity preferences. Based on survey measures, they could take comfort that monetary policy was on the right track.

Now, the Fed clings to the labor market. This Bloomberg piece is telling:

An overlooked line in Federal Reserve Chair Janet Yellen’s speech last week could hold the key to whether Friday’s U.S. jobs report clinches an interest-rate increase this month.

While the focus was on Yellen’s statement that the case for an interest-rate increase “has strengthened in recent months,” she followed with new language that the central bank’s decisions depend on the degree that data “continues to confirm” the outlook. That, and other recent remarks by Fed officials, suggest that job gains need to be merely solid — rather than extraordinary — to warrant raising borrowing costs for the first time in 2016.

If what you want is “comfort”, go lie in the sun, but don´t pin your hopes on irrelevant information.

If ‘push comes to shove’ tomorrow, sell stocks, buy dollars and, maybe with a short delay, buy 10-year bonds