“Looking for Wally when there are many Wallies”

That well describes the challenges faced by monetary policymakers according to this piece from Bloomberg Business “Are we tight yet? The Fed´s problem in finding the neutral rate”:

Federal Reserve officials just aren’t sure how much stimulus their zero-interest-rate policy is providing.

At issue is the level of the so-called natural, neutral or equilibrium rate of interest, which is the borrowing cost — adjusted for inflation — that keeps the economy at full employment with stable prices.

Economists from the academic world and even within the central bank are vigorously airing differing views on where the rate lies in the aftermath of the worst recession since the Great Depression. The uncertainty is yet another reason for Fed officials to go slowly as they begin raising interest rates for the first time since 2006.

According to this older piece from Brueguel:

What’s at stake: The natural rate of interest is a key ingredient in the recent discussion of secular stagnation, and more generally in New-Keynesian models of the Great Recession. But the concept is often poorly understood, in part because the term refers to different things for different people.

A couple of examples:

Richard Anderson writes that the Swedish economist Knut Wicksell based his theory on a comparison of the marginal product of capital with the cost of borrowing money. If the money rate of interest was below the natural rate of return on capital, entrepreneurs would borrow at the money rate to purchase capital (equipment and buildings), thereby increasing demand for all types of resources and their prices; the converse would be true if the money rate was greater than the natural rate of return on capital.

Axel Leijonhufvud writes that Erik Lindahl (1939) and Gunnar Myrdal (1939) refined the conceptual apparatus, in particular by introducing the distinction between ex ante plans and ex post realizations and thereby clarifying the relationship between Wicksellian theory and national income analysis.

And there are several others.

In short, the Fed is faced with an “estimation” problem. To make that clear, think of a Taylor-Rule for setting the Fed Fund (FF) rate:

Looking for Wally_1

The circles around the level of “potential output” (y*) and the level of the natural rate (NR) represent the “uncertainty” about their estimated values.

For example, San Francisco Fed senior economist Vasco Cúrdia argued in a paper published earlier this month that the equilibrium rate may have dropped so much that “monetary conditions remain relatively tight despite the near-zero federal funds rate.” He provides a chart which indicates that at present the “natural rate” could be anywhere from -3% to 6%!

Looking for Wally_2

Similar uncertainty surrounds the value of “potential” output.

In essence, facing the “estimation” problem, the situation of monetary policy makers is well captured by this picture!

Looking for Wally_3

An alternative, to try to overcome the “estimation” problem would be for the Fed to try some “experimentation”.

That has happened before. In March 1933, in the depths of the Great Depression, President Roosevelt decided to “innovate” and free the economy from the “gold standard shackles”, delinking from gold. The effect was immediate as illustrated below.

More recently, in the heights of the Great Inflation, Paul Volcker also decided to innovate:

On Oct. 6, 1979, the Federal Open Market Committee—under the leadership of Paul Volcker—made a decision that would come to be known as a key moment in U.S. economic policymaking, a turning point in the history of the Federal Reserve that would forever alter central banking. And those are the understatements.

A defining moment may shape the direction of an institution for decades to come. In the modern history of the Federal Reserve, the action it took on October 6, 1979, stands out as such a milestone and arguably as a turning point in our nation’s economic history.(A Greenspan)

So, what did the FOMC do? It made a short-term change in the method used to conduct monetary policy, from making adjustments in the federal funds rate to containing growth in the monetary aggregates. (Yes, the Fed now targets the funds rate again—the 1979 change was reversed in 1982—but more on that in a minute.) This meant the Fed would focus on controlling the amount of reserves provided to the banking system, which would ultimately limit the supply of money.

By many, that “experiment” was seen as a failure. Nevertheless, judging by the results it worked, in that inflation was permanently brought down.

In what follows I´ll give a “liberal” interpretation of the experimentation, based on NGDP. The interpretation is not so farfetched because the NGDP targeting concept was extensively discussed both by the Volcker Fed in 1982 and by the Greenspan Fed in 1992.

The first charts show how rising core inflation was the outcome of a rising NGDP growth. The follow up shows that by “downsizing” NGDP growth inflation was brought down.

Looking for Wally_4

This was followed by Greenspan´s “consolidation” in 1987-92 and almost “smooth sailing” from then to the end of his mandate in January 2006. These last two periods came to be known as the “Great Moderation”.

Looking for Wally_5

I interpret the “experiment” as trying to find first the level and then the stable growth path for NGDP. As the next chart shows, by 1987 the Fed had “hit” on the NGDP level and from then onwards NGDP growth rate was stabilized, i.e. kept close to the trend path.

Looking for Wally_6

There were “mistakes” along the way, notably in 1998-03, when NGDP first rose above trend and then fell below, but by the end of 2005, NGDP was back on trend.

Looking for Wally_7

Soon after taking the Fed´s helm, Bernanke allowed NGDP to begin once more to fall below trend. This was magnified in 2008, probably because of the Fed´s exclusive focus on headline inflation, which was being propelled by an oil and commodity price shock. In an environment where the financial system was “wounded”, allowing NGDP to crumble is mortal!

Looking for Wally_8

At present we have the opposite situation of the 1970s. Instead of high/rising inflation due to rising NGDP growth, we have low/falling inflation due to low/falling NGDP growth. So this time around it may be fruitful to devise an NGDP based experiment in reverse. Try to establish a higher level of NGDP that when attained is “consolidated” through a stable NGDP growth rate.

This “experimentation” would be much more helpful than spending time on “estimation” of the “natural rate of interest” or the “potential level of output”.

PS In the comments, bill writes:

“I need to go see the correlation between corporate spreads and NGDP growth. I think those spreads have been widening which I take as a good sign that the market expects less than optimal choices by the Fed in the near future.”

The chart shows how the recent fall in NGDP growth has been accompanied by a rise in less than stellar bond spreads over 10yr treasuries:

Looking for Wally_9

A monetary story alternative to Krugman´s fiscal story

Paul Krugman writes “Did The Fed Save The World?”:

Bernanke’s basic theme is that the shocks of 2008 were bad enough that we could have had a full replay of the Great Depression; the reason we didn’t was that in the 30s central banks just sat immobilized while the financial system crashed, but this time they went all out to keep markets working. Should we believe this?

It’s not a hard story to tell — and I very much agree with BB that pulling out all the stops was the right thing to do. You don’t play games at such times.

But I’m not persuaded that the real difference between 2008 and 1930-31 (which is when the Depression turned Great) lies in central bank action, or related bailouts.

It’s true that the 30s were marked by a big financial disruption; one measure (which I learned from Bernanke’s academic work) is the soaring spread between slightly risky corporate bonds and government debt:

Alternative to Krugman story_1

But there was also a big financial disruption in 2008-2009, in fact comparable in size by this measure:

Alternative to Krugman story_2

So really, was putting a limit on the financial crisis the reason we didn’t do a full 1930s? Or was it something else?

And there is one other big difference between the world in 2008 and the world in 1930: big government. Not so much deliberate stimulus, although that helped, as automatic stabilizers: the U.S. budget deficit widened much more in 2007-2010 than it did in 1930-33, even though the slump was much milder, simply because taxing and spending were much bigger as a share of GDP. And that budget deficit was a good thing, supporting demand at a crucial time.

Again, Bernanke and company were right to step in forcefully. But I’d argue that the fiscal environment was probably more important than monetary actions in limiting the damage.

The charts below allow for a different narrative.

Alternative to Krugman story_3

Notice that the “financial disruption” in the Great depression only began 15 months into the economic contraction, being responsible (“propagating”) the second stage of the contraction. When did it end? When FDR delinked from gold and NGDP turned around.

The “financial disruption” in the Great Recession was “front loaded”, with financial disruptions beginning even before the start of the recession. What seems to have “propagated” the financial disruption after mid-2008 was the Fed allowing NGDP to “shrink”. The fact that the “financial rescue services” quickly went into action helped avoid another dive in NGDP as happened in 1931. In other words, “propagation” this time around was avoided. When did the “financial disruption end? When, in addition to rescuing finance houses, the Fed introduced QE1 in March 2009.

Just like FDR´s action in 1933, Bernanke´s action in 2009 reversed the course of “fate”, only in Bernanke´s case, the action was excessively timid.

The main point, however, is that in this version of the comparative stories the “fiscal actor” (big government) does not get to go on stage!

Update: Elsewhere someone called geerussell commented:

Those charts just show the central bank doing its job. In the 1930s by abandoning the gold standard to provide the necessary accommodation. In 2009 by furnishing liquidity and avoiding rate spikes. In doing so they don’t crowd big government off the stage, they keep the stage from collapsing so the show can go on.

If the central bank is doing its job in accommodation though, it can’t “do more” and whether anything happens on the stage or not depends on degree to which the government steps up with the necessary spending and this chartdetermines the pace and quality of NGDP recovery.

The version of his chart is on top:

fiscal-mon story

Despite increasing fiscal stimulus in 2007-09, the real economy is tanking together with nominal spending. When NGDP growth turns up, so does RGDP growth. And note that despite increasingly contrationary fiscal policy in 2011-14, RGDP growth hums along at a stable rate, dancing to the tune of stable NGDP growth.

Bernanke: “The man in the ‘irony’ mask”

To my mind, Bernanke is the living embodiment of irony. Irony has followed him closely through the last few decades. Below a small but diverse sample.

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.

He was what happened, and he did exactly what he said should be done. Was it a success? To be kind, not so much.

Systematic MP and the effects of oil price shocks (June/1997):

Substantively, our results support that an important part of the effect of oil price shocks on the economy results not from the change in oil price per se, but from the resulting tightening of monetary policy.

This finding may help explain the apparently large effects of oil price changes found by Hamilton (1983) and many others.

Soon after becoming Chairman of the BoG an oil shock materialized. What did Bernanke do? He forgot about his “findings” and tightened monetary policy (constraining NGDP growth (see below)).

On Milton Friedman´s 90th Birthday (Nov 2002):

Once Roosevelt was sworn in, his declaration of a national bank holiday and, subsequently, his cutting the link between the dollar and gold initiated the expansion of money, prices, and output.

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

He did it, albeit at a much smaller scale. Why? Because he acted on his “knowledge” of the “credit channel”. From his 1983 article Non-Monetary Factors of the Financial Crisis in the Propagation of the Great Depression:

A second possibility is that banking panics contributed to the collapse of output and prices through nonmonetary mechanisms. My own early work (Bernanke, 1983) argued that the effective closing down of the banking system might have had an adverse impact by creating impediments to the normal intermediation of credit, as well as by reducing the quantity of transactions media.

That was what propagated the depression. By “saving” the banks, Bernanke´s Fed “cut-off the propagation mechanism”, leaving only the deleterious effects of the monetary policy mistakes.

What were those mistakes? An idea comes from On the legacy of Milton and Rose Friedman´s Free to Choose (2003):

As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as wellThe real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth

The absence of a clear and straightforward measure of monetary ease or tightness is a major problem in practice. How can we know, for example, whether policy is “neutral” or excessively “activist”?

Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation

Unfortunately, he preferred to concentrate on inflation, and worse, the headline variety, which was being buffeted by the oil and commodity price shocks! Apparently, inflation is not always a good indicator of the stance of monetary policy.

Japanese Monetary Policy: A case of self-induced paralysis (Dec 1999):

Before discussing ways in which Japanese monetary policy could become more expansionary, I will briefly discuss the evidence for the view that a more expansionary monetary policy is needed. As already suggested, I do not deny that important structural problems, in the financial system and elsewhere, are helping to constrain Japanese growth. But I also believe that there is compelling evidence that the Japanese economy is also suffering today from an aggregate demand deficiency. If monetary policy could deliver increased nominal spending, some of the difficult structural problems that Japan faces would no longer seem so difficult.

It is true that current monetary conditions in Japan limit the effectiveness of standard open-market operations. However, as I will argue in the remainder of the paper, liquidity trap or no, monetary policy retains considerable power to expand nominal aggregate demand. Our diagnosis of what ails the Japanese economy implies that these actions could do a great deal to end the ten-year slump.

Japan is not in a Great Depression by any means, but its economy has operated below potential for nearly a decade. Nor is it by any means clear that recovery is imminent. Policy options exist that could greatly reduce these losses. Why isn’t more happening? To this outsider, at least, Japanese monetary policy seems paralyzed, with a paralysis that is largely self-induced. Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work. Perhaps it’s time for some Rooseveltian resolve in Japan.

Twelve years later, “Rooseveltian Resolve” was asked of him by Christina Romer in

Dear Ben: It’s Time for Your Volcker Moment (2011):

For evidence that adopting the new target could help fix the economy, look at the 1930s. Though President Franklin D. Roosevelt didn’t talk in terms of targeting nominal G.D.P., he spoke of getting prices and incomes back to their pre-Depression levelsAcademic studies suggest that this commitment played an important role in bringing about recovery.

President Roosevelt backed up his statements. He suspended the gold standard and let the dollar depreciate. He got Congress to pass New Deal spending legislation and had the Treasury monetize a large gold inflow.The result was an end to deflationary expectations , leading to the most impressive swing the country has ever seen from horrible contraction to rapid growth.

Would nominal G.D.P. targeting work as well today? There would likely be unexpected developments, just as there were in the Volcker period. But the new target would have a better chance of meaningfully reducing unemployment than any other monetary policy under discussion.

Because it directly reflects the Fed’s two central concerns — price stability and real economic performance — nominal G.D.P. is a simple and sensible target for long after the economy recovers. This is very different from Mr. Volcker’s money target, which was abandoned after only a few years because of instability in the relationship between money growth and the Fed’s ultimate objectives.

Desperate times call for bold measures. Paul Volcker understood this in 1979. Franklin D. Roosevelt understood it in 1933. This is Ben Bernanke’s moment. He needs to seize it.

Romer´s article was published Oct 29/11. Just 3 days later, the FOMC met. They discussed NGDPT, but rejected it and 2 months later Bernanke realized his longtime dream: IT became official @2%!

Again he forgot. This time his advice to Japanese monetary authorities. Final irony: when was inflation last at 2%? On the month (Jan/12) 2% became the target!

Mask of Irony

BB makes me sick!

On the day that his book “Courage to Act” will be released, he writes an op-ed at the WSJ “modestly” titled How the Fed Saved the Economy – Full employment without inflation is in sight. The central bank did its job. What about everyone else?

For the first time in nearly a decade, the Federal Reserve is considering raising its target interest rate, which would end a long period of near-zero rates. Like the cessation of large-scale asset purchases in October 2014, that action will be an important milestone in the unwinding of extraordinary monetary policies, adopted during my tenure as Fed chairman, to help the economy recover from a historic financial crisis. As such, it’s a good time to evaluate the results of those measures, and to consider where policy makers should go from here.

He chooses to compare with Europe:

It is instructive to compare recent U.S. economic performance with that of Europe, a major industrialized economy of similar size. There are many differences between the U.S. and Europe, but a critical one is that Europe’s economic orthodoxy has until recently largely blocked the use of monetary or fiscal policy to aid recovery. Economic philosophy, not feasibility, is the constraint: Greece might have limited options, but Germany and several other countries don’t. And the European Central Bank has broader monetary powers than the Fed does.

Europe’s failure to employ monetary and fiscal policy aggressively after the financial crisis is a big reason that eurozone output is today about 0.8% below its precrisis peak. In contrast, the output of the U.S. economy is 8.9% above the earlier peak—an enormous difference in performance. In November 2010, when the Fed undertook its second round of quantitative easing, German Finance Minister Wolfgang Schäuble reportedly called the action “clueless.” At the time, the unemployment rates in Europe and the U.S. were 10.2% and 9.4%, respectively. Today the U.S. jobless rate is close to 5%, while the European rate has risen to 10.9%.

And wraps up with a bromide:

It is encouraging to see that the U.S. economy is approaching full employment with low inflation, the goals for which the Fed has been striving. That certainly doesn’t mean all is well. Jobs are being created, but overall growth is modest, reflecting subpar gains in productivity and slow labor-force growth, among other factors. The benefits of growth aren’t shared equally, and as a result many Americans have seen little improvement in living standards. These, unfortunately, aren’t problems that the Fed has the power to alleviate.

The crappiest of ideas

That´s the ‘dot plot’, conceived by the “Transparency Committee” headed by Janet Yellen while a Governor at the Board.

Interestingly it came ‘on line’ for the first time in January 2012 at the same time inflation hit the target. Since then inflation has mostly trended down. It has done so even while oil prices remained high. Naturally, when oil prices tumbled in mid-2014, headline inflation followed suit.

Dot Plot_1

However, by the time the first dot plot was released in January 2012, the Fed was no longer expecting to chart an exit from stimulus soon. The economy had taken a turn for the worse; in fact, additional bond-buying was on the horizon.

Then-Fed Chairman Ben Bernanke consequently downplayed the dots, a tradition that Janet Yellen continued when she assumed leadership of the Fed at the beginning of last year. At times, the chart—with its 17 disparate projections of the future path of policy—can conflict with the unified message the committee is trying to send.

In her first press conference as Fed chair in March 2014, Yellen told reporters “one should not look to the dot plot, so to speak, as the primary way in which the committee wants to or is speaking about policies to the public at large.”

Over the last several quarters, however, the dots have come back down, suiting Yellen’s message that the pace of tightening to follow what would be the Fed’s first rate increase in nearly a decade will be gradual.

So Yellen has turned back to the dots as “Exhibit A” for investors. During her press conference in June of this year, she pointed to it repeatedly when asked about the central bank’s likely course.

Other signs of utter confusion

Dudley in August:

“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,” Dudley told a news conference Wednesday at the New York Fed.

I really do hope that we can raise interest rates this year, because that would be a sign that the U.S. economic outlook is good and that we’re actually on track to achieve our dual mandate objective,” Dudley said.

Dudley today:

Federal Reserve Bank of New York President William C. Dudley said the central bank will “probably” raise interest rates later this year despite uncertainties over global growth.

Unemployment in the U.S. has fallen to its lowest level in more than seven years, making it harder for the Fed to justify interest rates near zero. Inflation, however, has remained well below the Fed’s target. It was 0.3 percent in the 12 months through August, as measured by the Fed’s preferred gauge of price movements.

Dudley said inflation probably would move back toward the target over time, and that 2 percent was “the right target.”

With the biggest confusion being the view that monetary policy has been accommodative:

“We’ve had so many years of accommodative policy, I think the market is losing faith in the Fed,” said Priya Misra, the head of global interest-rate strategy in New York at TD Securities, one of the 22 primary dealers that trade with the central bank. “You’re not really seeing the impact of policy end up in inflation.”

Which completely misses the logic that “you’re not really seeing the impact of policy end up in inflation” exactly because monetary policy has been anything BUT accommodative!

Looking back, during the Greenspan years monetary policy worked fine. Greenspan was the “anti-transparency”:

 “I know you think you understand what you thought I said but I’m not sure you realize that what you heard is not what I meant”.

Nowadays we feel like it´s more like a take on George Santayana´s:

Having lost sight of our objectives, we redoubled our efforts.”

Forget interest rates as providing the stance of monetary policy, and look instead at NGDP growth and inflation (remembering that the rising dollar and falling commodity and oil prices are consequences or symptoms of monetary tightening).

For more than one year monetary policy has been tightening, but the Fed thinks it´s highly accommodative!

Lars Christensen has a good post – Yellen is transforming the US economy into her favorite textbook model:

When I listen to Janet Yellen speak it leaves me with the impression of a 1970s style keynesian who strongly believes that inflation is not a monetary phenomena, but rather is a result of a Phillips curve relationship where lower unemployment will cause wage inflation, which in turn will cause price inflation.

And what that model is doing is to tighten monetary policy!

They should know better. In 2003, Bernanke wrote:

The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman  . . . nominal interest rates are not good indicators of the stance of policy . . .  The real short-term interest rate . . . is also imperfect . . .  Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation.

And those indicators of the stance of monetary confirm that the Fed is tightening the screws, with NGDP growth and inflation going down.

Stance of policy_1

A spillover effect of the monetary policy tightening is the appreciation of the dollar and the fall in commodity and oil prices.

Stance of policy_2

But the geniuses at the FOMC reason from a price change and argue that the fall in inflation is a consequence of the fall in oil prices and appreciation of the dollar, and when these effects dissipate, inflation will climb towards the 2% target!

With that caliber of central bankers, no wonder things are a mess.

When the Fed ran out of luck!

I think that coincided with Bernanke taking over from Greenspan.

Let´s back track to a speech by Governor Laurence Meyer from June 2001, six months before he left the Board of Governors after serving for almost five years.

In “What happened to the New Economy?” he writes:

In 1995, the growth rate of the gross domestic product was close to the prevailing estimate of trend, the unemployment rate was close to the prevailing estimate of the non-accelerating inflation rate of unemployment (NAIRU), and inflation was modest. I am reviewing this bit of recent history just to set the stage for my arrival on the Board of Governors in mid-1996. What did the challenges facing monetary policy look like, and what did they turn out to be? The contrast is remarkable.

When I joined the Board, the statement I made at my very first Federal Open Market Committee (FOMC) meeting was that, although economic performance had been very good–perhaps the first-ever soft landing–it would be a challenge to sustain that performance, and we certainly shouldn’t expect it to get any better. Without a doubt, that was my worst forecast.

In fact, as you all know well, the economy’s performance did improve, dramatically, over the next four years. I have often described the ensuing reaction of the FOMC. First, we celebrated. Second, we gracefully accepted a share of the credit. Third–and in terms of time expended, this swamped all the others–we struggled to understand why performance had turned out to be so exceptional and what this explanation implied for the appropriate conduct of monetary policy. In the private sector, I learned that if you made a bad forecast, clients were more forgiving if, as a result, they ended up richer than they expected rather than poorer. So we struggled to understand the unexpected performance at the same time that we were accepting accolades for our contribution to the outcome, if not for our forecasting acumen.

And, importantly:

One reason that I am beginning with this nostalgia is to focus on the exceptional performance of 1996 through mid-2000 and take your minds off the more recent travails of the economy. But I certainly understood that the time would come when monetary policymakers would find it challenging to keep the economy on a favorable course–as we had been briefly challenged in 1998. Indeed, last October, I said a transition to slower growth was likely already under way.

The charts illustrate the economy´s performance (in terms of real growth, unemployment and inflation) during the four years plus the “more recent travails” alluded by Meyer.

Fed out of luck_1

The next chart depicts the market monetarist stance of monetary policy (NGDP growth). The 1998 “challenge”, for example, was the brief “tightening” of monetary policy reflecting the “Phillips Curve” view that above trend growth and below NAIRU unemployment called for “action”. Greenspan quickly reversed the “wrong” decision, claiming (correctly) that productivity had increased, something that pulls down inflation and increases real growth.

Fed out of luck_2

Meyer (and the FOMC) thought they “got it”, but clearly didn´t, because a couple of years later, maybe reacting to the “tech crash”, they cranked up monetary policy. The increase in headline inflation was a reflection of the rise in oil prices (which had fallen considerably on the heels of the Asia crisis), while the rise in core reflected the monetary policy expansion. The consequent monetary “tightening” (despite the FF rate being forcefully lowered since early January 2001) was responsible for the “travails”!

They never “guessed” that the nominal stability that prevailed was responsible for the good outcome (stable real growth, low unemployment and low & stable inflation).

How did things progress to the end of Greenspan´s term?

Things remained “bad” for another couple of years. Real growth low (below trend), unemployment on the rise and inflation “too low”.

Fed out of luck_3

Despite the FF rate being lowered to 1% the economy didn´t react. That changed when the Fed announced “forward guidance” in August 2003. NGDP growth picks up, and so does RGDP. Unemployment begins to drop and inflation climbs back to “target”.

Fed out of luck_4

Enters Bernanke

His obsession with inflation targeting leads him to forget about overall nominal stability. The Fed´s reaction to real (oil) shocks, in an environment weakened by financial sector difficulties, leads to an almost unprecedented drop in nominal spending (NGDP).

Fed out of luck_5

Fed out of luck_6

But the Fed feels it´s on “top of things”, never giving up its Phillips Curve/NAIRU “analytic framework”, and with unemployment falling persistently, there´s just no way inflation won´t soon begin the climb to the 2% “ceiling”!

But that´s what they´ve been saying for more than one year, revising down their estimate of NAIRU as unemployment falls, first below 6.5%, then 6%, then 5.5% and now at 5.1%, even while inflation remains falling (at least “dormant”).

Now we´ve had a rate hike “on the table” and “off the table” for several months. Our old friend from the Board Laurence Meyer, back as a private forecaster, calls the Fed to “pull the trigger”, which leads me to think he still “doesn´t get it”!

Board Members show themselves to be completely at a loss. This recent interview by San Francisco Fed president John Williams is standard fare.

From Jeremy Stein we get a paper where in the abstract we read (HT Evan Soltas):

“Here’s how the problem works, as per Stein and Sunderam. Say the central bank decides internally that its long-term target for the policy rate is too low. Because the central does not want to shock the bond market with a big change, it moves gradually. But markets aren’t stupid. Understanding policy inertia, they infer from small moves in the short run what will happen in the longer run. As a result, the effort to avoid shocking the bond market doesn’t work, essentially because a small hike today has more informational content about future hikes. The central bank becomes trapped by its own inertia rather than doing what it thinks would be best for the economy.”

The problem is that the Fed has for a long time shown that it has no idea about what would be best for the economy!

Why let the system burn to begin with?

NEW HAVEN, Conn.—Former Federal Reserve Chairman Ben Bernanke and former Treasury Secretaries Henry Paulson and Timothy Geithner gathered last week in an auditorium to reflect on their response to the 2008 financial crisis. Their audience: A global group of government officials who might have to respond to the next one.

The closed-door reunion last week, which marks the trio’s first joint panel discussion since they left office, is part of a new effort at Yale University to update the playbook for dealing with financial panics. The scholars are calling it a “New Bagehot,” referring to Walter Bagehot, author of a famous 1873 book, “Lombard Street,” that central bankers still use as a guide for crisis management.

Mr. Geithner, who helped organize the gathering, called it “a master class in financial crises for the firefighter, focused on the very practical craft of making choices in the fog of war in the midst of a panic.” Rather than looking at how monetary policy or regulations might prevent a crisis, this class addresses another, less commonly asked question, he said: “What do you do when the system is burning?”

It seems they really want to divert attention from their monetary policy shortcomings!

Bernanke´s Baseball Metaphor?

His latest post:

Saturday’s game also reminded me of one of the reasons that I like baseball so much. No other sport provides such a detailed record of performance, covering thousands of games and players back to the nineteenth century. That means that every game takes place in a rich historical context. In that context, Max Scherzer wasn’t pitching against the Pittsburgh Pirates; he was pitching against a standard of achievement established over decades. Thus, a one-sided baseball game on a hot and humid Saturday afternoon in Washington became a game that I and the other 41,000 fans there will always remember.

Bernanke´s “monetary policy pitch” was also memorable, but for negative reasons! He´s the “post-war champion” in the “worst pitch in the Nominal Spending category”!

BBs MetaphorThe outcome: Little real growth, low employment and below target inflation. A “triple crown” achievement!

Bernanke´s “amnesia” caused the depression

Here´s what Bernanke knew long before becoming Fed chairman:

Bernanke (with Gertler & Watson) 1997 (on oil shocks)

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.

Bernanke 1999 (on Japan)

Needed: Rooseveltian  Resolve

Franklin D. Roosevelt was elected President of the United States in 1932 with the mandate to get the country out of the Depression. In the end, the most effective actions he took were the same that Japan needs to take—- namely, rehabilitation of the banking system and devaluation of the currency to promote monetary easing. But Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and to experiment—-in short, to do whatever was necessary to get the country moving again. Many of his policies did not work as intended, but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done.

Bernanke 2003 (on Friedman)

As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth

The absence of a clear and straightforward measure of monetary ease or tightness is a major problem in practice. How can we know, for example, whether policy is “neutral” or excessively “activist”?

Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation

The charts show the facts he confronted and actions taken after becoming chairman.

Amnesia_1

Amnesia_2

In June 2008 he “forgot” about his views on interest rates as an indicator of monetary policy and thought monetary policy was easy because the FF rate was “only” 2%! At that time the FOMC let it be known that the next rate move would likely be UP!

He “forgot” that the impact of an oil shock in the real economy resulted from the tightening of monetary policy, the stance of which was better indicated by nominal spending growth rather than the interest rate.

When the crash materialized due to the errors above, he “forgot” to adopt the “Rooseveltian Resolve” he had suggested to the BoJ!

PS: Scott Sumner once again reminds us that “Inflation doesn´t matter (NGDP growth does)