The Great (Monetary) Unraveling

In “Years of Fed Missteps Fueled Disillusion with the Economy and Washington”, Jon Hilsenrath gives his contribution to the “Great Unraveling” series. He starts off writing:

In the past decade Federal Reserve officials have been flummoxed by a housing bubble that cratered the financial system, a long stretch of slow growth they failed to foresee and inflation persistently undershooting their goal. In response they engineered unpopular financial rescues, launched start-and-stop bond buying and delayed planned interest-rate boosts.

“There are a lot of things that we thought we knew that haven’t turned out quite as we expected,” said Eric Rosengren, president of the Federal Reserve Bank of Boston. “The economy and financial markets are not as stable as we previously assumed.”

In the 1990s, a period known in economics as the “Great Moderation,” it seemed the Fed could do no wrong. Policy makers and voters saw it as a machine, with buttons officials could push to heat or cool the economy as needed. Now, after more than a decade of economic disappointment, the central bank confronts hardened public skepticism and growing self-doubt about its own understanding of how the U.S. economy works.

For anyone seeking to explain one of the most unpredictable political seasons in modern history, with the rise of Donald Trump and Bernie Sanders, a prime suspect is public dismay in institutions guiding the economy and government. The Fed in particular is a case study in how the conventional wisdom of the late 1990s on a wide range of economic issues, including trade, technology and central banking, has since slowly unraveled.

During the Great Moderation, the Fed did do wrong. It just didn´t fail utterly! I believe the chart tells a convincing story.

Great Monetary Unraveling_1

Note that during the Great Moderation – the Greenspan years – NGDP growth was relatively stable. In 1990-91, the story is the Fed engineered a “strategic Disinflation”, with inflation coming down from the 4% level to 2%. In 2000-02 the Fed, worried about the low (4%) rate of unemployment and what it would do to inflation, erred, allowing NGDP growth to fall significantly. This mistake was subsequently corrected.

In level terms we see that NGDP remained close to its “target level”.

Great Monetary Unraveling_2

In the first two years of his mandate, Bernanke managed to keep NGDP close to its “target level”. Inflation remained very close to target and unemployment low and stable.

Great Monetary Unraveling_3

The follow-up in 2008-09, however, was a disaster. The Fed allowed NGDP growth to take a beating. The result was a massive increase in unemployment (given wage stickiness) with inflation dropping below target.

Great Monetary Unraveling_4

This outcome is very closely linked to the Fed´s renewed obsession with the likelihood of inflation shooting up on the heels of an oil shock. This is somewhat surprising given that 10 years earlier, in 1997, Bernanke and co-authors had published a paper “Systematic Monetary Policy and the Effects of Oil Price Shocks” (now gated), which was summarized by Business Insider in March 2011, at the time the ECB was considering hiking rates because of the oil price rise.

Earlier we mentioned a Ben Bernanke paper from 1997 titled, Systematic Monetary Policy and the Effects of Oil Price Shocks and while the full thing is definitely worth a read, we have a breakdown for you right here.

CNBC is talking about it today, too, in light of the ECB’s talk of higher rates.

The thesis is that it is central bank monetary policy in reaction to oil price spikes that creates economic downturns, not the oil price spike itself.

On the other hand, a rate hike ends up causing problems for years, reducing output.

The implication of this is that Federal Reserve Chair Ben Bernanke has no interest in raising rate for a commodity or oil spike, so long as prices remain within Fed range, because it has a damaging impact on output that could send unemployment higher.

In 2008, however, the Bernanke Fed was very worried about the inflationary impact of oil. Although the Fed didn´t raise rates (they didn’t lower them either between April and September 2008), all the FOMC talk, as gleaned from the 2008 Transcripts, was about the risk of inflation and how the next rate move would likely be up!

“Fed talk” is monetary policy, and it gets transmitted through the expectations channel. You get the idea about how monetary policy was severely tightened during 2008, in addition to looking at the behavior of NGDP growth, that tanked, by looking at how the dollar strengthened, how the stock market plunged, and how long-term interest rates dropped.

Great Monetary Unraveling_5

In mid-2009 the economy began to recover, with NGDP growth reversing course. QE1 had a positive impact.

Great Monetary Unraveling_6

During this policy easing, the dollar fell while stocks and long-term bond yields rose.

Great Monetary Unraveling_7

For some reason, by mid-2010 the Fed decided that “enough was enough”. QE1 ended and NGDP growth was stabilized initially at 4%. In other words, unlike after the 2000-03 when NGDP fell below trend but was brought back to trend, this time around the Fed decided that a lower trend path was the way to go.

Great Monetary Unraveling_8

For the past two years, even with inflation remaining below target, through its raise hike talk the Fed has been tightening monetary policy. NGDP growth is coming down, the stock market has remained sideways while the dollar has boomed, oil prices have tanked and long-term bond yields are coming back down. It seems the Yellen Fed is guided by the unemployment rate.

Great Monetary Unraveling_9

It is, therefore, not surprising that the level chart for the Bernanke/Yellen period contrasts sharply with the one observed during the Greenspan years ( I would have imagined that would give useful pointers for the “design of a new monetary framework”)

Great Monetary Unraveling_10

The Jackson Hole Conference had an encouraging title: “Designing Resilient Monetary Policy Frameworks for the Future”. Unfortunately, they mostly talked about the nuts & bolts of policy implementation. Furthermore, while Yellen signalled one rate rise this year, her number 2 Stan Fischer said he “roots” for two. And Bullard said once in the next two years!

It was certainly a missed opportunity for the Fed to regain some modicum of credibility.

Give the Fed a new compass. We´re going in the wrong direction

According to the news:

Friday’s employment report clears the way for the Federal Reserve to raise short-term interest rates by a quarter-percentage point at its Dec. 15-16 policy meeting, ending seven years of near-zero interest rates.

The Fed can reasonably well control nominal spending (NGDP) growth. Stable NGDP growth at the appropriate level well defines what good monetary policy is supposed to look like.

If that´s true, when NGDP growth falters, things like employment growth will register the “punch”, just as it will “blossom” when monetary policy pulls NGDP growth up. Stable NGDP growth goes hand-in-hand with stable employment growth (only thing is if NGDP level falls short, so will the level of employment)

Examples from the mid-1990s and early 2000s show the Greenspan years. For the last ten years, we have been under Bernanke and Yellen. The pictures are illustrative. (The montlhy NGDP numbers come from Macroeconomic Advisers)

Throughout the period, inflation was not a problem. By the mid-1990s, it had reached the “low and stable” target of the time. Ironically, after the numerical 2% target was set in January 2012, inflation has languished, but is still “low and stable”!

Employ Report 11-15_1

Employ Report 11-15_2

But if you zoom in on the past 15 months, things seem “fishy”. For all the Fed´s “communication”, the truth is that they have been tightening policy. NGDP growth is coming down which was shortly followed by decreasing employment growth. Won´t even mention inflation.

Employ Report 11-15_3

To wrap up, where´s the much touted wage growth-inflation nexus so cherished by some at the FOMC?

Employ Report 11-15_4

Great harm might be on the way!

PS If you don´t believe me about the “beauty” of stable nominal spending, believe George Selgin:

a central bank that allows the overall volume of spending to collapse has blown it, no matter how much emergency lending it undertakes.  Indeed, to the extent that a central bank engages in emergency lending while failing to preserve aggregate spending, it may be guilty of compounding the damage attributable to the collapse of spending itself with that attributable to a misallocation of scarce resources in favor of irresponsibly-managed firms.

Greenspan´s last 10 years and Bernanke/Yellen´s first Decade

Greenspan´s first 10 years

No visible difference in the behavior of inflation, which remained closer to “target” during Greenspan´s last decade.

There´s a big difference in the behavior of unemployment, much lower during Greenspan´s tenure.

The defining difference is in the behavior of nominal spending (AD or NGDP) growth, which translates into a significant difference in the growth of real output.

Note than in 2001, when Greenspan allowed NGDP growth to drop below trend, unemployment goes up and stays up until NGDP growth returns to trend. In 2008, unemployment soars when NGDP growth tanks and becomes negative. The yellow bar shows that when NGDP growth stops falling, unemployment “levels off”, beginning to fall when NGDP growth becomes positive once again.

Unfortunately, the Fed this time around chose an inadequate level of spending growth. The result is that the economy got stuck in a “Great Stagnation”, defined by a level of real output and employment well below the previous trend level!

To get out of this trap, the monetary policymakers have to start thinking outside the “interest rate box”! From all the nonsense we hear from them, that is not likely.

“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

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!

“Forensic evidence that Bernanke drove the car off the road”

Since Bernanke began blogging I have complained that he doesn´t go to the “heart of the matter”. That is, recognize that the Fed, under his command, bungled.

In fact, the mess-up is likely due to his “love affair” with inflation targeting, with that “love” manifesting itself at the worst possible moment, because the rise in headline inflation that occurred at the time was the result of a negative supply shock, which should not have unduly worried the “lover”.

Bernanke has a deep knowledge of economic history, so he knew about the thought process on economic stabilization that evolved over the decades since the early 1970s. To recall, on becoming chairman of the Fed, Volker challenged the Keynesian orthodoxy which held that the high unemployment high inflation combination of the 1970´s demonstrated that inflation arose from cost-push and supply shocks – a situation dubbed “stagflation”.

Volker´s challenge placed inflation as the FOMC´s top priority. He also brought to the fore of policy discussions the ideas developed during the previous 12 years – since Friedman´s address to the 1967 AEA meetings – on the importance of inflation expectations.

To Volker, the policy adopted by the FOMC “rests on a simple premise, documented by centuries of experience, that the inflation process is ultimately related to excessive growth in money and credit”.

This view, an overhaul of Fed doctrine, implicitly accepts that rising inflation is caused by “demand-pull” or excess aggregate demand or nominal spending.

Now, why is this new “doctrine” consistent with the observed increase in economic stability?

Given the cost-push “doctrine” on the inflation of the 1970´s, the Fed would compensate the fall in AS with an increase in AD, an expansionary monetary policy. This followed from the perceived flatness of the SAS curve below potential output. Since this was a flawed doctrine, over time we should observe trend growth in AD (or nominal expenditures).

Volker, on the other hand, believed that inflation was the result of excessive AD. So nothing more natural than to assume that the Fed should increase its responsiveness to the growth in nominal spending. How would this change in “doctrine” (from regarding inflation as a “cost-push” to “demand-pull” phenomenon) show up in the data?

Recall that under the cost-push “doctrine” the Fed would react vigorously to negative output gaps making policy expansionary, so nominal spending would grow. Under the new “doctrine” the Fed doesn´t react much to supply shocks since a negative supply shock, for example, would decrease real output an increase prices with little effect on nominal spending, but would react vigorously to AD or nominal spending shocks.

Therefore, under the new “doctrine”, policy would make AD growth stationary, in which case AD growth will not show a rising trend as under the cost-push “doctrine”. The chart illustrates.

Forensic Evidence_1

The main difference between the two “doctrines” is not the change in the Fed´s responsiveness to inflation as argued by, among others, John Taylor and Bernanke, but the changed responsiveness to aggregate demand or nominal income growth. A collateral effect of the change in “doctrine” shows up in the reduction and stabilization of inflation and decreased volatility in real output.

The Fed never explicitly targeted anything – inflation or nominal income (AD) growth – but implicitly you could say it targeted nominal AD along a 5.5% growth path growth with Volcker and Greenspan.

The chart below provides, to my mind, compelling evidence about the change in doctrine and its stabilizing consequences. One implication is that during all this time, “Inflation Targeting” was just a red herring!

Forensic Evidence_2

And the biggest victim of the “red herring” was Bernanke himself. Since forever he has been a great defender of the “IT modus operandi”, and exactly when he put it in practice he “pushed the car off the road” and got a “depression” as the result. Later, by making the “red herring” @2% official policy target, he showed he was clueless about the true cause of the monetary policy foul-up!

Krugman is frequently inconsistent

Krugman misses a step in “Democratic Booms

But does this say anything about the presidents in question? Both the Reagan expansion and the Clinton expansion had much more to do with Federal Reserve policy than anything coming from the White House, and Obama’s macroeconomic policy has been hamstrung by GOP opposition almost from the beginning. There are presidents, and sometimes there are job booms when they are president, but the booms aren’t their doing.

If the Reagan and Clinton expansions had much more to do with Volcker and Greenspan, why not conclude that the dismal Obama economy has much more to do with Bernanke and Yellen than with “Obama´s macroeconomic policy being hamstrung by the GOP opposition”?

Update: Krugman´s “inconsistency” derives from the fact that he believes in a ‘liquidity trap’ which makes monetary policy impotent. So it would be up to Obama and fiscal policy. But that´s “hamstrung by GOP opposition”