The scourge of the “star Trinity”

The trinity is comprised of the “star variables” y*, u*, and r*, which denote, respectively, potential output, natural rate of unemployment and neutral interest rate.

According to Bernanke:

Changes in policymakers’ estimates of these variables thus reflect reassessments of the economic environment in which policy must operate.

DeLong is more forceful:

The only way to resolve the question in a satisfying way is to test it: to push the economy beyond the estimated potential growth rate and see if inflation rises…. Bernanke argues that Fed officials are willing to be a little patient with the economy, to see whether running it a little hot brings more workers into the labour force and encourages productivity-enhancing investments. It certainly seems clear to me that overshooting is the right way for the Fed to err….

But I am less confident than Mr Bernanke in the Fed’s openness to overshooting. It did not exactly intend to run the unemployment rate experiment that demonstrated how wrong its previous projections had been…. Now, the Fed looks all too willing to revise down its GDP growth projections without ever really testing them…. There is far too little radicalism at the Fed. It risks making permanent a low-growth state of affairs which is largely a consequence of its own excessive caution.

It gets worse. In “Fed Officials Challenge Decades of Accepted Wisdom on Inflation”, we read:

Nalewaik suggests that a return to a world in which inflation expectations and actual inflation become more tightly linked, as they were before the mid-1990s, may not be in the cards.

As Nick Rowe tweeted, if the Fed´s inflation target is credible, as it has been for more than 20 years, there should be no correlation between expected and actual inflation. This is an application of Friedman´s “Thermostat”. In 2003, Friedman gave the simplest explanation for the “Great Moderation” with his “thermostat analogy”. In essence, the new found stability was the result of the Fed (and many other Central Banks) stabilizing nominal expenditures. In that case, from the QTM, according to which MV=PY, the Fed managed to offset changes in V with changes in M, keeping nominal expenditures, PY, reasonably stable. Note that PY or its growth rate (p+y), contemplates both inflation and real output growth, so that stabilizing nominal expenditures along a level growth path means stabilizing both inflation and output.

The thermostat analogy come out very clearly in the panel below.

Star Trinity

While monetary policy was loose and NGDP growth was trending up, the outcome was runaway inflation.

To get inflation down, Paul Volcker experimented with NGDP growth, bringing it down.

While the Greenspan Fed kept NGDP growth at an adequate stable level, the Bernanke/Yellen Fed first depressed NGDP and then kept it growing at an inadequate level. That fact is sufficient to explain both the “sluggish” recovery and “too low” inflation.

If only the Fed could forget about the “star trinity” and experiment with NGDP growth, the main determinant of the economic environment…

Instead, they get “desperate

Central bankers and governments must come up with new policies to buffer their economies against persistently low interest rates that threaten to make future recessions deeper and more difficult to avoid, a top Federal Reserve official said on Monday.

Setting higher inflation targets, tying monetary policy directly to economic output, instituting government spending programs that automatically kick in during economic downturns, and boosting investment in education and research are all policies that should be considered, San Francisco Fed President John Williams said.

Much later, the “Great Inflation” was pinned on poor monetary policy. How long will it take to blame monetary policy for the “repressed economy” since 2008?

The conflicting conclusions from these “old” arguments are still present today!

Alan Blinder (2009)

From the end of 2002 to the middle of 2008, the US economy was in the throes of a significant oil price shock. The dollar price of oil rose fivefold, with spot prices briefly hitting $145/barrel. Even adjusting for inflation, the rise in oil prices was stunning. At their peak, real oil prices stood about 50% above their previous record high – reached following the second OPEC oil shock of 1979-80. (After hitting its 2008 peak, the price of oil fell rapidly, tumbling over the past six months into the $30-$50/barrel range.)

Although the recent run-up in oil prices is comparable in magnitude to the first two OPEC shocks, its effects on the economy seem to have been very different. Textbook accounts of the 1970s and early 1980s blame “supply shocks” (which included sharp rises in the price of food as well as oil) for the prolonged periods of both high unemployment and high inflation, or “stagflation,” that followed.

By contrast, the most recent increase in oil prices appeared to have very little effect on the expansion that followed the 2001 recession. (While the US economy did enter a recession at the end of 2007, this was widely attributed to the collapse in consumer and business confidence that attended the subprime crisis and subsequent financial panic.) Similarly, core consumer price inflation – inflation excluding food and energy prices – was relatively stable over this period, which again contrasts sharply with the earlier episodes.

One interpretation of the experience of the past several years is that it vindicates “revisionist” views of the role played by oil shocks (and other supply shocks) in precipitating the stagflation of the 1970s. According to this view – variants of which have been propounded by DeLong (1997), Barsky and Kilian (2002), and Cecchetti et al. (2007) – the root cause of the abysmal macroeconomic performance from 1973 to 1983 was poor monetary policy, not the oil shocks.

Jim Hamilton (2009)

The implication that almost all of the downturn of 2008 could be attributed to the oil shock is a stronger conclusion than emerged from any of the other models surveyed in my Brookings paper, and is a conclusion that I don’t fully believe myself. Unquestionably, there were other very important shocks hitting the economy in 2007-08, first among which would be the problems in the housing sector. But housing had already been subtracting 0.94% from the average annual GDP growth rate over 2006:Q4-2007:Q3, when the economy did not appear to be in a recession. And housing subtracted only 0.89% over 2007:Q4-2008:Q3, when we now say that the economy was in recession. Something in addition to housing began to drag the economy down over the later period, and all the calculations in the paper support the conclusion that oil prices were an important factor in turning that slowdown into a recession.

Let´s consider Jim´s arguments first: There´s no doubt, just imagining a dynamic AS-AD model that a price shock increases inflation and reduces real output, so Jim´s conclusion is not special. But the strength of the oil price effect on real output is predicated on how the Fed reacts to the shock.

If the Fed reacts to the rise in inflation by contracting nominal spending (NGDP), real output is going to decrease more than if the Fed kept nominal spending “constant”. This is clearly seen in the following graph, representing a dynamic AS-AD model, where point 1 is the initial state and points 2 and 3 represent, respectively, the states following the oil price shock and the oil shock cum contraction in AD:

When will MP take blame_1

There´s an interesting experiment to be made. In 2003-2006 the economy was buffeted by an oil price shock that was even stronger (higher percent price increase) than the one that occurred in 2007-08. This is shown in the charts below.

When will MP take blame_2

As the next charts indicate, in the 2003-06 period NGDP growth was kept stable, so that RGDP growth was only little reduced. This was not the case in 2007-08. In the later period, the Fed remained so worried about inflation that it kept contracting NGDP and that´s the reason a “run of the mill recession” became “Great”!

When will MP take blame_3

Going back to Blinder, he´s very off hand about the “Great Recession”. Unlike the 1970s, he thinks it had nothing to do with monetary policy. Maybe that reflects his concentration on the inflation side of the ledger!

I wonder if it will take another 25 or thirty years for someone to say “the root cause of the abysmal macroeconomic performance from 2008 onwards was extremely poor monetary policy, (not the oil shocks, subprime crisis and ensuing financial panic)