The “emptiness” of the Fed´s monetary policy

Dean Baker writes: “As talk grows of a June interest rate increase, where’s the data to support it?”:

Weak data had convinced many that the Federal Reserve was unlikely to raise interest rates in June, but in recent days multiple Fed policymakers have suggested that an increase should be on the table in the near future. What’s unclear is why.

Little new data have emerged to suggest that the economy is much better than it was six or nine months ago. Since interest rates were raised in December, in fact, the pace of economic improvement has slowed almost to a stall.

All that´s true, but Dean shouldn´t be surprised because the monetary strategy in place has absolutely nothing to do with the underlying economy, being guided only and exclusively by what they call “Gradual Normalization” (of interest rates, obviously).

And “gradual” cannot mean just once a year, but at least a couple of times. Remember that early this year the sages thought four times was a “good definition of gradual”!

Update: In addition to “empty” the Fed´s strategy (program) is infeasible because there´s a loop that doesn´t allow it to “terminate”:

 [market-strengthening -> Fed tightening talk -> market weakening -> Fed backing off -> market strengthening -> Fed tightening talk -> … ]

And a loop that needs breaking in order to achieve sustainable and stable growth – by a shift away from inflation targeting and towards nominal income growth targeting.

Central Banks are never to blame. That´s as true if inflation is too high/rising or too low/falling!

That´s what I gather from this Dean Baker piece in Beat the Press:

A Washington Post piece on the Fed and the presidential elections told readers:

“A strong economy tends to boost the party currently in power, which is why President Nixon installed confidante Arthur Burns as head of the Fed in 1970, urging him to keep interest rates low to stoke the job market. The result was a decade of runaway inflation that was tamed only by a painful recession.”

This is a very strong and implausible claim. The inflation in the 1970s was fueled in large part by two huge rises in the price of oil. The first was associated with an OPEC oil embargo directed against the United States, which led to a quadrupling in the price of oil between 1973 and 1974. The second was associated with the Iranian revolution, which essentially stopped Iran’s oil exports. At the time, Iran was the world’s second largest oil exporter. There was also a sharp surge in food prices associated with massive sales of wheat to the Soviet Union in 1973.

I refer the reader to Robert Hetzel´s classic article “Arthur Burns and Inflation”:

How did Burns view macroeconomic policy as an economist? Most generally, Burns had a credit view of monetary policy. That is, monetary policy worked through its influence on the credit market. However, monetary policy was only one factor affecting credit markets. At times, in its influence on inflation, monetary policy could be overwhelmed by other factors.

More specifically, Burns had a real or nonmonetary view of inflation. That is, inflation could arise from a variety of sources other than just money. He believed that a central bank could cause inflation by monetizing government deficits but did not attribute inflation to that source in the early 1970s. Instead, he attributed it to the exercise of monopoly power by unions and large corporations.

If conventional monetary policy weapons were powerless to deal with these forces, then perhaps direct controls might work. Accordingly, President Nixon imposed wage and price controls August 15, 1971. The experience with such constraints offered a tailor-made experiment of Burns’s views.

The controls worked as intended in that they held down wage growth and the price increases of large corporations (see Kosters [1975]). Nevertheless, inflation rose to double digits by the end of 1973. So Burns attributed inflation to special factors, such as increases in food prices due to poor harvests and in oil prices due to the restriction of oil production. However, special factors are by nature one-time events. In 1974, inflation should have fallen as the effect of these one-time events dissipated, but it remained at double-digit levels that year. Burns then blamed inflation on government deficits. Although those deficits were small in 1973 and 1974, Burns was able to make them look larger by adding in the lending of government-sponsored enterprises like the Federal National Mortgage Association.

For Burns, the source of inflation changed regularly. He believed this view only reflected the complexity of a changing world. As a consequence, he did not have a model of inflation that could be contradicted by experience.

The chart gives an illuminating overview

  1. Inflation began to rise long before the oil shock of 1973. The effect of Nixon´s price controls is evident.
  2. Who can say that a large part of the decision of oil producers (dominated by Saudi Arabia) to restrain supply and increase prices was not a reaction to (a) the persistent rise in US inflation which began in 1965, given that oil was priced in dollars and (b) to the strong dollar depreciation that took place after Nixon closed the gold window in August 1971?

Dean Baker Burns_1

Note that both PCE Headline and PCE Core (which excludes food and energy) rose in tandem throughout the 1970s.

This, for example, does not happen during 2003-08 when there was an oil shock of comparable magnitude to the one in the 1970s. Note, especially, that headline inflation climbs somewhat and fluctuates to the beat of oil prices, while core inflation remains low and stable. That´s a very different picture from the 1970s. Who´s responsible?

Quite likely the Fed, who, under Volker and Greenspan had learned that inflation is a monetary phenomenon and that the Fed controls it through its control of nominal spending (NGDP) growth.

The chart below shows the behavior of NGDP growth.

Dean Baker Burns_2

Trending up during the “Great Inflation”, pulled down during the “Volcker Adjustment”, nominal stability during the “Great Moderation” which was lost under Bernanke, giving rise to the “Great Recession”.

Interesting bit:

Burns had a “credit view” of monetary policy. Presided over the “Great Inflation”.

Bernanke also had a credit view of monetary policy. Presided over the “Great Recession”

What´s Yellen´s view? Apparently a “Phillips Curve view” of monetary policy. The “GR” is still ongoing, maybe she´ll contribute to deepen it!

Needed, a central banker with a “monetary view” of monetary policy!

So many culprits!

That´s what you get when you do GDP component analysis. Sounds smart but is utterly useless:

Macroeconomics should be about aggregates, not components of spending.  Yes, changes occurring in the various components of GDP can impact interest rates, and thus velocity.  And if monetary policy is inept (i.e. doesn’t offset changes in velocity) that can impact nominal spending, but it certainly isn’t the most illuminating way of looking at the issue.  It’s like trying to explain changes in the overall price level by modelling changes in the nominal price of each good—theoretically possible, but a waste of time.

Dean Baker says:

The biggest risk is that a set of bad events elsewhere in the world could cause the trade deficit to deteriorate further.

According to Brookings:

Hutchins’ Fiscal Impact Measure shows sluggish government spending contributed to weak fourth quarter GDP growth.

Bernanke himself once said:

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…”

If you follow Bernanke´s lead, this is what you see


Clearly not what you could call a “stable monetary background”.