Appearances can be deceiving

To many, the economy is strong enough to sustain a jolt of higher rates. Richmond´s Jeff Lacker is a case in point:

The U.S. economy appears strong enough to warrant significantly higher interest rates, Richmond Federal Reserve Bank President Jeffrey Lacker said on Friday.

Lacker, who is not a voting member of the U.S. central bank’s rate-setting committee this year, said he still favors raising rates sooner than later and that the Fed’s last policy meeting in July would have been a “good time” to tighten policy.

Speaking to a group of economists in Richmond, Lacker argued that a range of economic analysis suggests the Fed’s benchmark overnight interest rate – the federal funds rate – is currently too low.

“It appears that the funds rate should be significantly higher than it is now,” he said in the speech.

As the chart shows, for the past 23 years, inflation (PCE-Core) has been ‘cornered’.

Appearances Deceiving_1

What we dearly miss is some of the robust growth the economy experienced during the Greenspan years (1987 – 2005)

Appearances Deceiving_2

The FOMC is content playing “loves me, loves me not”, not with daisies, but with data

Love me love me not_1

And never realizes that it´s not the Fed who´s “data dependent”, but it´s the data that is “Fed-dependent”!

So they frequently have to go through some contortionism, like this “tongue-twisting” comment from Atlanta´s Dennis LockhartLove me love me not_2

The [employment]report was not a sign that the economy was slowing, he said. It could be the “natural slowing” in job creation as the economy gets closer to full employment, he said.

Jeffrey Lacker strongly mis contextualizes

In a recent interview, Jeffrey Lacker, when answering the question “So why haven’t we seen faster inflation?” said:

… the historical evidence suggests that there’s some lag before things accelerate as you reduce slack significantly. In 1966-67, we had unemployment at 5 percent, we pushed it to 4, and it was 1967 and 1968 when inflation took off. So there was a significant lag in the way that relationship seems to have worked in the past.

That only shows the degree of his ignorance about economic contexts. As Arthur Okun, an important player throughout the 1960s, and the economist that “invented” the concept of “potential output” reminisces:

“The strategy of economic policy was reformulated in the sixties. The revised strategy emphasized, as standard for judging economic performance, whether the economy was living up to its potential rather than merely whether it was advancing…the focus on the gap between potential and actual output provided a new scale for the evaluation of economic performance, replacing the dichotomized business cycle standard which viewed expansion as satisfactory and recession as unsatisfactory. This new scale of evaluation, in turn, led to greater activism in economic policy: As long as the economy was not realizing its potential, improvement was needed and government had a responsibility to promote it.

The objective was to promote brisk advance in order to make prosperity durable and self-sustaining…The adoption of these principles led to a more active stabilization policy. The activist strategy was the key that unlocked the door to sustained expansion in the 1960s”.

Furthermore, to the economists at the CEA:

The stimulus to the economy also reflected a unique partnership between fiscal and monetary policy. Basically, monetary policy was accommodative while fiscal policy was the active partner. The Federal Reserve allowed the demands for liquidity and credit generated by a rapidly expanding economy to be met at stable interest rates.

However, as Okun recognized:

The record of economic performance shows serious blemishes, particularly the inflation since 1966. To some degree, these reflect errors of analysis and prediction by economists; to a larger degree, however, they reflect errors of omission in failing to implement the activist strategy”.

Funny how often policymakers and commenters fall prey to the “it wasn´t enough” argument, in this case not “activist enough” or, more recently, “the 2009 fiscal stimulus wasn´t big enough” or was “reversed too soon”.

The above is far from being a description of the present context.

I think these points from Ryan Avent´s “Simple rules of thumb” are very relevant to the present context (just as they would have been 50 years ago). They are also consistent with my preference for “experimentation” instead of “estimation” (of all the “naturals” – interest rate, unemployment, output) to which much time and effort is devoted mostly in vain!

4) We know what an economy with way too much demand looks like. It has high and accelerating inflation.

5) We know what an economy with way too little demand looks like. It has high unemployment and deflation.

6) Within those two extremes, it can be tricky to identify exactly where an economy stands: how close or far away from potential output it is.

7) Both too much and too little demand are economically costly, but history suggests that too little demand is far more economically costly and politically risky than too much demand. So policy should err on the side of too much demand rather than too little.

How does “now” compare to the 1960s? For one thing, demand (NGDP) is growing at a relative trifling rate. The charts also indicate that the unemployment rate doesn´t add anything to the story, especially because the unemployment numbers are just not comparable.

Rules of Thumb_1

What happened between those two extremes? Following the 1960s, nominal aggregate demand growth (NGDP) took off at a rising rate (the scale in this chart is different from the others). Inflation was also up with spikes reflecting the oil shocks of the decade that reduced real growth and increased unemployment. Later, during the age of the “Great Moderation”, demand growth was just about right; inflation remained low and stable (with swings reflecting supply shocks).

Rules of Thumb_2

The images are telling us that the FOMC would be much more productive if, instead of eternally grumping about inflation, it moved on to experiment with level targeting nominal aggregate demand (NGDP).

Jeffrey Lacker, a “serial dissenter”

With his vote on Thursday, Mr. Lacker becomes tied for seventh place in the number of dissents among Fed officials during the central bank’s century-long existence, according to information from the St. Louis Fed. He has voted no 14 times, matching Darryl Francis, the St. Louis Fed president, from 1966 to 1976. [Note: Considering only Regional Fed Presidents, who vote much less often, he and Francis are # 2]

Lacker has been a FOMC participant since 2004. Although he´s tied with Darryl Francis, their inflation environment couldn´t be more different!

Lacker serial dissenter

Maybe his goal is to be #1! In the pursuit of that goal he´s already setting-up another dissent:

The Federal Reserve could get enough new information by its late October policy meeting to spur officials to raise short-term interest rates then, Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, said in an interview with The Wall Street Journal on Wednesday.