When Monetary Policy is Guided by “Ghosts”

One of the arguments for acting sooner rather than later on monetary policy is that if the slack disappears, inflationary expectations will surge.

This is an implication of Orphanides latest “Short-sighted monetary policy and fear of liftoff”:

Monetary policy operates with long and variable lags. According to some Fed models, the maximum effect is around two years after a policy action. The Fed has been adding accommodation with quantitative easing up until less than a year ago, which will continue to stimulate the economy and push inflation upward well into 2016.  Policy needs to be pre-emptive. The degree of policy accommodation should be reduced to avoid an overheated economy which would surely destabilise inflation and make a recession more likely (for a more detailed exposition, see Orphanides 2015).

We have all these “unseens” informing monetary policy. The fact is that they are useless. No one knows (or sees) the natural rate, be it of interest, unemployment or output. Furthermore, the uncertainty around their estimates is huge!

To account for that “ignorance” it has become standard to appeal to long and variable lags. However, what if instead of lags, monetary policy operates with leads.

For example, Orphanides says: “The Fed has been adding accommodation with quantitative easing up until less than a year ago, which will continue to stimulate the economy and push inflation upward well into 2016.”

What if we find that even before the end of the taper in October 2014, monetary policy was being “tightened”, despite interest rates remaining at the ZLB?

How could we know? Certainly not by looking at “ghosts” like “slack” or “natural rates”. Bernanke himself has said that to gauge the stance of monetary policy you should look at things such as NGDP growth or inflation.

And those gauges tell us that for more than one year monetary policy has not been “easy” or “accommodative”, quite the opposite!

One-year ahead NGDP growth expectations and medium and long-term inflation expectations are all trending down.

Orphanides Accomodative_1

So are actual NGDP growth and inflation!

Orphanides Accomodative_2

Update: Want to see more evidence of policy tightening? Here goes.

Commodity prices are on a downshute while the dollar is reaching for the stars!

Orphanides Accomodative_3

Today, Lars Christensen tweeted this as “book of the day“. To grasp the evidence given upstairs, it is highly reccommended.Orphanides Accomodative_4

The Fed´s “Lullaby”

Fed Lullaby_1

The FOMC met concurrently with the release of the GDP report. Despite the far below expectations result the Fed remains steadfast:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Although growth in output and employment slowed during the first quarter, the Committee continues to expect that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate. The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.

They sure expect a lot! Given the realizations of the past five years, I wonder how far they can extend their expectations!

Since the Fed is miles from practicing anything that could resemble an appropriate monetary policy, it will be surprising if their expectations are ever realized!

Some relevant pictures:

Fed Lullaby_2

Note: FSDP = Final Sale of Domestic Product (excludes inventory change)

Fed Lullaby_3

Nothing to worry about because “we are close to satisfying our other mandate”!

Fed Lullaby_4