It´s good when something works both in practice and in theory!

For the past several years, market monetarists have promoted the change from inflation targeting to NGDP level targeting. The analysis was mostly empirical, a fact that made some “wrinkle their nose”. A new model based paper arrives at the same conclusion:

The design of monetary policy has been the subject of a voluminous and influential literature. In spite of widespread discussion in the press and policy circles, the normative properties of nominal GDP targeting have not been subject to scrutiny within the context of the quantitative frameworks commonly used at central banks and among academic macroeconomists.

The objective of this paper has been to analyze the welfare properties of nominal GDP targeting in comparison to other popular policy rules in an empirically realistic New Keynesian model with both price and wage rigidity. We find that nominal GDP targeting performs well in this model. It typically produces small welfare losses and comes close to fully implementing the flexible price and wage allocation. It produces smaller welfare losses than an estimated Taylor rule and significantly outperforms inflation targeting.

It tends to perform best relative to these alternative rules when wages are sticky relative to prices and conditional on supply shocks. While output gap targeting always at least weakly outperforms nominal GDP targeting, the differences in welfare losses associated with the two rules are small.

Nominal GDP targeting may produce lower welfare losses than gap targeting if the central bank has difficulty measuring the output gap in real time. Nominal GDP targeting always supports a determinate equilibrium, whereas output gap targeting may result in indeterminacy if trend inflation is positive.

Overall, our analysis suggests that nominal GDP targeting is a policy alternative that central banks ought to take seriously.

There are a number of possible extensions of our analysis. Two which immediately come to mind are financial frictions and the zero lower bound. Though our medium scale model includes investment shocks, which have been interpreted as a reduced form for financial shocks in Justiniano et al. (2011), it would be interesting to formally model financial frictions and examine how nominal GDP targeting interacts with those.

Second, our analysis abstracts from the zero lower bound on nominal interest rates. It would be interesting to study how a commitment to a nominal GDP target might affect the frequency, duration, and severity of zero lower bound episodes.

On the last sentence, MM´s have little doubt that, when undertaken, the study will also corroborate their view that the frequency, duration and severity of ZLB episodes would essentially disappear!

Central Banks Play An Old Flyboy Trick

A Benjamin Cole post

In the last few decades, the globe’s major central banks have collected under various exalted “fighting inflation” banners, while seeking independence from democratic control which, we are told, would lead to hyperinflationary holocausts.

To be sure, inflation has receded from double digits in the early 1980s, to zero (long ago in Japan, btw).

Today, one major central bank targets no inflation and explicitly disclaims responsibility for robust economic growth, as in the case of the European Central Bank. Another major central bank, the U.S. Federal Reserve Board, has set a ceiling of 2% on inflation (perhaps really 1.5%), regardless of other outcomes.

Central banks want a simple one-dimensional mission—like old flyboys, more on that later.

The results of central bank tunnel vision are a disaster for Western economic growth and employment, as Japan found out long ago.

We Have One Job Only

Today’s bloodless central banker staffers, divorced from economies (they live on sinecures) and free of democratic control, have chosen to define their performance by an easily accomplished mission: price control. Central banks know they can kill inflation, and rather handily. See Japan, see Europe, and even see the United States. This is a fool’s game: Tighten enough, and inflation dies. Mission success, self-defined.

This reminds me of 1960s U.S. astronauts, those brave media darlings of the pioneering Mercury and Gemini missions. Early on, each mission had a number of experiments for astronauts to perform, and if the tests were not performed, or botched under time pressures, the mission was chided, or even said to “fail” on some points.

The astronauts rebelled. “We will do one test per flight,” they said. Assured success. The flyboys were better at self-preservation and PR than NASA officials. Besides astronauts were old test pilots—they had been through this drill before, with earthbound engineers asking for complicated tests while they piloted temperamental new aircraft. But the flyboys knew they were in the pilot’s seat.

Central bankers, like flyboys, know they are in the pilot’s seat (limited democratic oversight) and have chosen their one mission, that of price control.

Prosperity? That is somebody else’s concern.

Economic Growth

Unfortunately for millions of businesses, citizens and employees, central banks do play a role in demand and prosperity, in modern developed nations. Yes, every modern nation has structural impediments, and every nation should cut back structural impediments.

But central banks should make monetary policy for the facts on the ground, not in utopia. Modern nations have militaries and social welfare, and corrupt tax codes and endless fat in government. They always will.

Recent history strongly suggests a modern economy needs moderate inflation to prosper. See Japan 1992-2012 (deflation, very slow growth), or the U.S. in the boomy 1990s, with average 3% inflation.

Central banks should not be allowed to pull an old flyboy trick. They need to take responsibility for economic growth as well as keeping inflation moderate.

Yes, a complicated mission, but necessary.

“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!

Ben´s blogging has generated more heat than light so far

So far the former and wannabe Fed Chairmen crossed swords over the irrelevant and misguided concepts of GSG & SS. (I´ve given those things some thought here and here).

With big dogs growling at each other, Krugman simply could not help butting in (really to show he had been there before). And for very obvious reasons he ends up giving each a “bone”:

There’s been a really interesting back and forth between Ben Bernanke and Larry Summers over secular stagnation. I agree with most of what both have to say. But there’s a substantive difference in views, in which Bernanke correctly, I’d argue, criticizes Summers for insufficient attention to international capital flows – but then argues that once you do allow for international capital movement it obviates many of the secular stagnation concerns, which I believe is wrong.

As it happens, the role of capital flows in the logic of liquidity traps is an issue I tackled right at the beginning, back in 1998; and I’ve been trying to work out how it plays into the discussion of secular stagnation, which is basically the claim that countries can face very persistent, quasi-permanent liquidity traps. So I think I may have something useful to add here.

Start with Bernanke’s critique of Summers. The most persuasive evidence that the US may face secular stagnation comes from the lackluster recovery of 2001-2007. We experienced the mother of all housing bubbles, fueled by a huge, unsustainable rise in household debt – yet all we got was a fairly unimpressive expansion by historical standards, and little if any inflationary overheating. This would seem to point to fundamental weakness in private demand. But one reason for the sluggish growth in demand for U.S.-produced goods and services was a huge trade deficit, the counterpart of huge reserve accumulation in China and other emerging markets. So Bernanke argues that what Summers sees as evidence of secular stagnation actually reflects the global savings glut.

The 2001-2007 recovery is not evidence, let alone persuasive, of secular stagnation. Krugman is on the right track when he says this “would seem to point to fundamental weakness in private demand.” But at the last minute he veers off in the wrong direction by making the fundamental mistake of “reasoning from a (GDP) component change” (a close cousin of “reasoning from a price change”).

A huge trade deficit somewhere is always the counterpart of a huge reserve accumulation elsewhere. The important reasoning is to discover why this came about when it did and if it might be related to other stuff (such as the US housing boom). For an explanation, read here (below the fold).

If “movements in GDP components” had not distracted Krugman he would probably have found out that the post 2001 recession recovery was slow up to mid-2003, being due to the tightness of monetary policy, despite fast falling interest rates.

When the Fed made monetary policy more expansionary in mid-2003 by adopting forward guidance (FG), despite interest rates remaining put, the recovery took off, with nominal spending rising back to trend. Interestingly, many see this strong growth in nominal spending as reflecting a “loose/easy” monetary policy. Grave mistake. Faster NGDP growth was necessary to take nominal spending to trend. Monetary policy was “just right”!

At that point, unemployment begins to fall and core inflation rise towards the “target” level.

Bernanke had the bad luck to take over almost concomitantly with the peak in house prices. Initially house prices fell only a little, increasing the speed of fall after financial troubles erupted in some important mortgage finance companies.

Unfortunately, the Fed was exceedingly focused on headline inflation, fearful of the oil price rise. Interest rates remained elevated, only being reduced after August 2007, when three funds from Bank Paribas folded. However, the pace of interest rate reduction was deemed too slow by the market. In the December 11 2007 FOMC Meeting, for example, the markets were negatively surprised by the paltry 25 basis points reduction in the FF rate. On that day the S&P fell 2.5% and the 10 year TB yield dropped 17 basis points.

Rate reductions stopped in April 2008 (only resuming in October, after Lehman!). In the June 2008 FOMC, it came out that the next move in rates was likely up!

With all this monetary tightening, nominal spending decelerated and then fell at an increasing rate. One casualty was Lehman! The rest is history!

Give me a break and let´s stop talking “Gluts” and “Stagnations”. Bernanke would do much better if he starts shinning some light and blog about how monetary policy could really have been much better! Will he be daring?

The charts illustrate the story

Gluts & Stagnations_1

Gluts & Stagnations_2

Gluts & Stagnations_3


Matt O´Brien thinks it´s the opposite in “Larry Summers and Ben Bernanke are having the most important blog fight ever

MM Heresy: Is IT Band Targeting Better Then NGDPLT? Unmeasurable Means Unmentionable?

A Benjamin Cole post

Could it be that a looser IT band is a better policy target than NGDPLT?

What if a nation can measure prices and thus relative slack reasonably well, but real-time estimates of even nominal GDP are worsening guesses?

Moreover, what if much of what makes urban life agreeable—better parks, clean air, pleasing sidewalks, good schools, low crime, leisure time—is not even captured by GDP? And the world is going urban.

And then add to the mix the perhaps exploding role of the off-the-books grey markets in the United States, unrecorded?


The amount of cash in circulation in the U.S. has exploded to $4,200 per resident, doubling in the last 10 years. The response of U.S. economists, who obviously never worked in a small business in Los Angeles, is that, “Well, the Benjamin Franklins are all offshore doing drug deals.”

Anyway, Edgar Feige, University of Wisconsin cash-scholar, says 75% of cash is onshore and in grey markets. That $3k for every man, woman, child and transgender in America. And growing rapidly.

As Feige says, “the growth of unreported income has the insidious effect of corrupting the reliability of primary data used for most macroeconomic analysis.”

Unmeasurables And Thus Unmentionables

Measuring GDP? Consider the Los Angeles of 1975 vs. that of 2015. One was a poison gas chamber, a permanent scrim that occluded close neighbors, and the latter has winter air in which one can sight Mt. Baldy 75 miles distant.

Crime rates at record lows, too.

No show on GDP, however.


Surely, a looser NGDPLT target is better than the Fed’s sub-2% monetary IT noose.

But, if the public is un-teachable on NGDPLT (or more likely, the profession), then perhaps taking a page from the Reserve Bank of Australia and its 2% to 3% IT band is a good idea.

Just goose the IT up a bit to 2.5% to 3.5%. There is no sense in permanently losing real growth for some  chump reductions in inflation.

Fed: “limited and tentative”

Robert Samuelson writes “Where is the Federal Reserve headed?”:

Yellen recognizes the dismal choices and strives to cultivate confidence as a way of blunting the conflicts. At her recent news conference, she emphasized that the Fed, though it wants the freedom to tighten policy, will not be hurried into premature or sharp rate increases. Even after the initial change, she said, “our policy is likely to remain highly accommodative.” Money will continue to be cheap. Investors need not make market-disruptive changes in their portfolios.

So far, this soothing strategy has succeeded. Whatever happens, there remains a larger historic question: How did an agency that seemed so powerful and commanding in one era become so limited and tentative in the next?

I not only liked but also loved the “limited and tentative” description.

I believe Samuelson´s question has a simple and straightforward answer. It happened when the Fed, after the change of guard from Greenspan to Bernanke, forsook nominal stability to pray at the altar of inflation targeting.

That this would happen if Bernanke got the job was inevitable. In January 2000, long before even becoming a Fed Governor, let alone its Chairman, Bernanke wrote (with Mishkin and Posen) an op-ed in the WSJ titled “What happens when Greenspan is gone?”:

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.

On the last sentence on “transparency and accountability”, one would think exactly the opposite happened from reading this op-ed at the WSJ today:

The calls in Washington to “audit” the Federal Reserve are not for a narrow, bean-counting review of the institution’s financial statements. The audit’s goal is more fundamental: to assure that the checks and balances in a democratic government also apply to central bankers. It means figuring out how our elected representatives can effectively oversee unelected monetary “experts.”

If Bernanke had only understood that Greenspan in practice had been (more or less) committed to nominal stability, understanding that real, or supply, shocks should be treated carefully, he wouldn´t have let nominal spending tank in 2008.

However, Bernanke should have understood because in a 1997 paper with Mark Gertler and Mark Watson, they concluded:

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 mentions Japan as an exception to the success of inflation targeting. He missed an important lesson there because Japan was, in fact, the first victim of an “no holds barred” IT regime. To make a long story short, after the inflation explosion in Japan in the mid-1970s (when inflation reached 25%), inflation became Japan´s public enemy #1. An inflation target was never made explicit but every housewife in the land new that the BoJ pursued “price stability”.

With that background, in 1989, when the Ministry of Finance introduced the first installment of the consumption tax, prices jumped. Immediately the BoJ clamped nominal spending. This was repeated after the second installment in 1997, with even more dire consequences!

In short, Bernanke´s “best bet” was the wrong bet. Instead of “powerful and commanding” the Fed became “limited and tentative”. But the solution presents itself clearly. Have the Fed pursue an explicit NGDP Level Target. Very quickly it will once again become “powerful and commanding” and the “instrument rules” advocates like John Taylor will have to change their tune! More significantly still, Krugman´s “liquidity trap” meme will fade!

We Do Not Like Inflation

A Benjamin Cole post

Market Monetarists and other have been exasperated beyond measure by certain Federal Open Market Committee members’, and thus the Federal Reserve’s, peevish fixation on inflation.

We ponder why the Fed undershoots even its dubiously low 2% (on the PCE no less) inflation target for years on end, or why it even matters that much if inflation is 2% or 3%. In the vernacular of the blog-street, WTF?

In reply, anti-inflationists drag out the Weimar Republic, or cite the now-aging numbers-and-formulas-laden texts of Robert Lucas, in which Lucas pulled out all the stops, and at one point suggested that a 10% rate of inflation might be associated with a 1% decrease in GDP growth.

But we are not even close to 10% inflation now and have not been in decades, and moreover an economist in 2009 from Boston College re-ran Lucas numbers, fitted Lucas’ Nobel Prize-winning “log-log” data to more-recent observations, and concluded the cost to economic growth of inflation was much less than Lucas had calculated. Lucas empirical observations were an artifact of the times. See here.

Meanwhile, the NY Fed, in 1997 reported that lost output “is quite low for inflation rates less than 10 percent, remaining below 0.10 percent of GDP. Only when inflation rises to above 100 percent do these costs become appreciable, climbing above 1 percent of GDP .”

This is the Great Bogeyman? 0.10% of GDP?

Not that I have 100% faith in the Boston College or Fed NY efforts either. Economic models always, and I mean always, find what the model-makers want, left-, right- or upside-down wing.

So Why Is The Fed Talking Tightening When Inflation Remains Below Target?

It is not about macroeconomics.

We have that from Bob McTeer, a former FOMC (1991-2004) member, so he has some insights that bloggers and academics do not.

McTeer wrote recently on his interesting blog, “My opposition to inflation targeting was not very sophisticated. I simply though of inflation as bad and didn’t want to officially condone it.”

McTeer continues, “Frankly, I’ve been surprised at the apparent general acceptance of the goal of two percent inflation by the talking heads on financial TV. I’m not surprised at its support from the academic community. I would have thought that the talking heads would take a less sophisticated position, as I did.”

And finally McTeer says, “This is guesswork on my part, but I really doubt that members of the FOMC really want two percent inflation. Extrapolating from my own thinking on the subject, I’ll bet they would prefer one percent inflation, or even lower…. What I really want, and I’ll bet many of them agree with me, is not two percent inflation, but no deflation.”

Well, McTeer is wrong on that last one. Charles Plosser, Philly Fed President has rhapsodized about deflation.

I Hate Inflation Too

Of course, no one likes inflation, as all of us seem vulnerable to the fear that when prices going up, the price we charge for goods and services will not—unless we actively raise our prices.

And there is yet a vast socio-business nicety afloat that salves business relations, and that is that we are not trying to profit off one another. No one sends a letter to clients to the effect, “I am raising prices as I want to make more money, and thus I am charging you more. I am even aware some of you have no ready options, so I am gouging you while I can.”

It is bad socio-business form to raise prices, and most of us prefer not to. Even asking the boss for a raise can be a very dicey matter. How about, “Since you are short-handed now, I figured it is good time to demand a raise.”

Instead we send letters about how “inflation has gone up, so our charges must, alas, also. We fought against it for so long, but are compelled….blah, blah, blah.”

Monetary Policy

So, we do not like inflation. But are human social emotions the right way to make monetary policy?

What is the point of having a central bank with the power to print or “unprint” money—fiat currency—if that power is used only to tighten a monetary noose around the economy’s neck?

And I ask the question again: What is better: Economy #1 with 3% annual growth and 3% inflation; or Economy # 2 with 2% real growth and 2% inflation?

The Fed would tell you that Economy #2 meets policy objectives. Think about that. The Fed is within policy objectives in Economy #2, no matter how long that goes on, but not when in Economy #1, even for one minute.

After all, we do not like inflation.

It seems the Fed has forgotten, once again, that inflation is a monetary phenomenon!

And so is disinflation…

With the results for the PCE deflator out we get the headline: “U.S. Inflation Undershoots Fed’s 2% Target For 33rd Straight Month”! The chart from the day the Fed made the 2% target official:

PCE Jan 15

The arguments the Fed uses today echo those of 40 years ago, only this time with inflation “below the line”:

Back in the 1970s, inflation was due to oil prices, Unions and Oligopolies. If I read Yellen correctly, she thinks, lower than target inflation is due to oil, import prices and second round effects of oil!

Fed Chairwoman Janet Yellen last week told lawmakers that “recent softness” in inflation largely reflects the plunge in oil prices since mid-2014. Prices for energy goods and services tumbled 10.4% in January from the prior month and were down 21.2% from a year earlier, according to Monday’s report.

Ms. Yellen acknowledged slower growth in nonenergy prices as well, which she said partly reflects “declines in the prices of many imported items” and “perhaps also some pass-through of lower energy costs into core consumer prices.”

In “Lessons from the Great Inflation”, Robert Hetzel writes:

[T]his common understanding of the nature of the Phillips curve and activist policy rested on two basic assumptions.

First, inflation is a nonmonetary phenomenon. That is, inflation springs from a variety of real factors rather than from the failure of the central bank to control money creation.

[T]he second basic assumption was that policymakers understood the structure of the real economy sufficiently well to pursue an unemployment objective.

The French are correct: “Plus ça change, plus ça reste le même c’est pareil”!