The Fed has more than just “some explaining” to do

Narayana Kocherlakota writes “The Fed Has Some Explaining to Do”:

My forecast is that the Fed will remain reluctant to raise rates until inflationary pressures are much stronger, at which point it will feel compelled to move at a faster pace than four times per year. This is similar to Chicago Fed President Charles Evans’s suggestion that the central bank should wait to raise rates until core inflation reaches 2 percent. If prices start rising at that rate, the Fed will be right to put a lot more weight on inflationary concerns than on downside risks.

Charles Evans’ suggestion has been practiced in the past.

Back in mid-2003, when inflation was far below 2%, the Fed adopted forward guidance (“FG”). In the Minutes of the August 2003 meeting we read:

The Committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.

In January 2004, the message changed to:

With inflation quite low and resource use slack, the Committee believes that it can be patient in removing its policy accommodation.

In May 2004, in the meeting before the first rate hike, the message became:

With underlying inflation still expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.

The chart illustrates the period:

The FF Target rate started moving up when core inflation reached 2%, just like Charles Evans suggests at present.

However, note that at the time, NGDP was somewhat below the trend level path. The chart indicates that forward guidance was sufficient to take it back to trend, with core inflation at 2%

Unfortunately, at present, the environment is very different. Today, NGDP is way below the original trend level, in which case, even if (big if) inflation is brought closer to 2%, the level of nominal spending will still remain far below any reasonable trend path.

To “ignite” the economy, and lift it from the depressed state it´s in, the best alternative is not to keep “fiddling” with interest rates, but to change the target to an NGDP Level target.

The Fedborg pushes for rate rises but, instead, will send them down

A James Alexander post

Jon Hilsenrath at the Wall Street Journal is an excellent journalist. He often scoops his peers by getting people to talk to him off the record. His main line is into anonymous Fed staffers in Washington – aka the Fedborg.

The Fedborg is the consensus of backoffice staff who have tirelessly argued for “normalization” of monetary policy, i.e. raising rates to historical norms despite massive evidence that inflation and nominal growth are miles below healthy historical norms. The Fedborg seems to believe that preservation of financial stability is more important than prosperity. The fact that time and again this elevation of financial stability over prosperity leads to financial instability seems to keep eluding them.

Hilsenrath’s story “Fed Officials Gain Confidence They Can Raise Rates This Year“  in today’s WSJ probably moved markets. The yield curve shifted up a handful of basis points and the USD rose too – the index rose 30bps from 96.70 to 97.00

A rate increase could come as early as September if economic data hold firm

… Officials are almost certain to leave rates unchanged when they meet July 26-27, according to their public comments and interviews with officials. But the message in their post meeting policy statement could be that the economy is on a more solid footing than appeared to be the case when they last gathered in June, setting the stage for raising rates if the data hold up in the months ahead …

Such a message would get the attention of traders in futures markets, who see low chances for the Fed moving as early as September. In early June, traders on the Chicago Mercantile Exchange placed a probability of greater than 60% that the Fed would raise short-term rates by at least a quarter percentage point by its September policy meeting, according to the CME. The probability dropped sharply after a weak May jobs report and the June 23 Brexit vote and was just 12% on Monday.

As Hilsenrath weaves into his story, public comments by various hawkish regional governors have been again trying to talk up more rate rises than the market expects. But the chatter has had very little impact.

New news

So the un-named “officials” have given Hilsenrath his scoop. The officials have upped the ante and tried to get the market to take the regional governors more seriously.

The Fedborg is not at all happy that it keeps getting overruled by more sensible regional governors in alliance with more sensible permanent Fed members like Lael Brainard. So, the Fedborg stoops to spin pressuring markets and the sensible governors alike. We hope that the they will fail again, but what really needs to happen is a Kocherlakota “house cleaning” of these back office experts and their replacement with more rounded, sensible, evidence-based, pro-prosperity types. Or they could just recognise their errors and stop pushing financial stability that results in financial instability.

Although in the short term the Fed can often influence rates in the way they wish ultimately it depends on the market. The market ultimately will send rates down if the Fed tries to raise them now.

The “Overly Optimistic” Fed

In “Reluctant Parties: The Fed and the global economy”, Gavyn Davies writes:

To judge from last week’s surprisingly hawkish FOMC minutes, which I had not expected, the Fed seems to be reverting to type (see Tim Duy). Many committee members have downplayed foreign risks and have returned to their earlier focus on the strength of the domestic US labour market, which in their view is already at full employment.

In his column today for Bloomberg View, Kocherlakota writes:

This kind of uncertainty — about which goals will define the Fed’s policies — is not healthy. Consumers and businesses can’t make good decisions if they don’t have a strong enough sense of how the central bank will act in any situation. Fed officials must have — or be given — a much clearer set of shared objectives for managing the economy.

To wrap up, commenter Bill sent me “Why the Unskilled Are Unaware: Further Explorations of (Absent) Self-Insight Among the Incompetent”:

People are typically overly optimistic when evaluating the quality of their performance on social and intellectual tasks. In particular, poor performers grossly overestimate their performances because their incompetence deprives them of the skills needed to recognize their deficits. Five studies demonstrated that poor performers lack insight into their shortcomings even in real world settings and when given incentives to be accurate. An additional meta-analysis showed that it was lack of insight into their own errors (and not mistaken assessments of their peers) that led to overly optimistic estimates among poor performers. Along the way, these studies ruled out recent alternative accounts that have been proposed to explain why poor performers hold such positive impressions of their performance.

I just became more pessimistic!

Currency War: It won´t happen

Kocherlakota writes “Bring On the Currency War”:

The U.S. government seems concerned about what will happen if other big nations push down the value of their currencies against the dollar. Actually, it could be good for the global economy.

Ahead of this week’s meeting of finance ministers from the Group of Seven developed nations, Treasury Secretary Jacob Lew has warned that the U.S.’s counterparts — the three largest euro-area nations plus Canada, Japan and the U.K. — might undermine global growth if they engage in policies that cause their currencies to depreciate against the dollar. In my view, his concerns are misplaced.

That´s an obvious point, just look what happened to the countries that devalued (delinked from gold) in the early 1930s, but:

1. The US has selectively (and Japan in the 1980s is the “representative” example) over time “warned” countries about letting their currencies depreciate against the dollar.
2. The US position as a “monetary superpower” indicates that it dictates to a large extent the world´s currency “configuration”.

The charts below show, through some examples, how US monetary policy has ‘shaped’ the broad dollar index over time.

Whenever US monetary policy is tightened (measured by an enlargement of the NGDP ‘gap’ relative to the “Great Moderation” trend, or a narrowing if coming from above), the dollar appreciates relative to a broad basket of currencies. If US monetary policy is “eased” (measured by the NGDP ‘gap’ narrowing, or enlarging if from above trend), the dollar depreciates.

Now, Japan is in the news. Actually, it´s described as “Elephant in the Room at This Week’s G-7 Is Sure to Be the Yen”:

When finance chiefs and central bankers from the Group of Seven countries gather this week at a hot springs resort in northern Japan, the official agenda has them focusing on ways to revitalize global growth and crack down on cross-border tax evasion.

Left off the discussion list is one of the most pressing concerns for the host nation: how to counter a 10 percent surge in the yen that’s squeezing an economy unable to escape a cycle of expansion and contraction. Cries for sympathy are likely to fall on deaf ears, given the tailwind corporate Japan got in the first years of the Abe administration from the currency’s sharp depreciation.

As the chart indicates, Abenomics was successful from inception because the expansionary monetary policy undertaken by Abe/Kuroda managed to depreciate the Yen by more than the Broad Dollar Index.

But more recently, while Japan´s monetary policy has faltered, the US has relented on “tightening” (although this seems to have changed as indicated by the Minutes released yesterday). That was a “deadly” combination from Japan´s perspective.

In short, Japan did it to itself! If the US “tightening bias” is resumed and Japanese monetary policy makers rethink their strategy, the Yen will again depreciate. If the FOMC “lightens-up” again, as it did earlier this year, Japan´s monetary policy will have to be even “braver”!

Japan doesn´t need a higher inflation target, but a sufficiently high NGDP Level Target

In his Bloomberg View article today, Narayana Kocherlakota writes “A Possible Cure for Japan’s Low Inflation”:

Suppose, for example, that the Bank of Japan had announced a target of 4 percent in March 2013. Actual inflation over the past three years would probably have been higher — teaching wage-setters and price-setters that if they want to avoid costly mistakes, they’d better pay attention to what the central bank says will happen. Having built up that credibility, the central bank could then more easily guide expectations to its long-run goal of 2 percent.

Before Abe, Japan had an implicit 0% inflation target. By establishing an explicit 2% target, things should have worked out as Kocherlakota argues. But they didn´t! Does that mean that if you really want 2% inflation you should target 4%? Doesn´t sound reasonable.

As the chart indicates, Japan´s problems began when the BoJ allowed NGDP to stagnate. It appears it would be much more effective for Abe/Kuroda to stipulate that the BoJ would “not rest” until nominal spending (NGDP) had reached the stated level, from which it would henceforth grow at a specified rate.

“This crazy world…is coming undone”

Or, and this from a prominent former FOMCer Narayana Kocherlakota, “When Discredited Policies Make Sense”:

Presidential candidates Donald Trump and Bernie Sanders have proposed policies that run counter to literally centuries of economic thought. In the current environment of extremely low interest rates and low inflation, however, they might make more sense than most economists recognize.

The Federal Reserve faces a big challenge: It wants to get inflation up to its 2-percent target, but so far its stimulus efforts have failed to reach that goal. So there’s a good chance it will keep interest rates low, even if inflation pressures pick up a bit. This likely passivity of monetary policy creates a highly unusual situation, in which certain much-discussed economic initiatives could have an unusually positive effect.

So, monetary policy has been “passively” tightening. Market Monetarists agree with that. Kocherlakota hopes (in vain) that monetary policy will remain “passive”, but in “stimulating fashion”.

For example, he argues:

• Increasing the minimum wage. What if Congress decided to increase the federal minimum wage by 10 percent a year over the next five years? Typically, economists would be concerned about the impact on employment: Higher wages might lead businesses to employ fewer workers. With monetary policy out of the picture, though, the move might actually help. The expectation of higher wages would cause consumers to expect more inflation over the next few years, leading them to buy more goods and services now, before prices went up. To meet this added demand, businesses would have to boost production and hiring.

Similar reasoning for other ‘favorited” measures:

Increasing import tariffs, and Imposing restrictions on immigration.

Recognizing that:

The Fed’s response is crucial in all these cases. Typically, the central bank reacts to increases in inflation by raising interest rates sharply — a move that would choke off any demand that the policy measures might generate. With inflation running well below target, however, it’s appropriate for the Fed to hold rates low even if it sees a modest increase in inflationary pressures. It’s this subdued reaction function that allows the policy initiatives to have more positive effects.

It´s the sort of argument that will be eagerly embraced by the “End the Fed crowd”!

Title

Unintentionally, Kocherlakota makes a strong case for NGDP Level Targeting

In “Blackouts and the Burden of Uncertainty”, he writes:

From the mid-1980s through 2008, central banks had the tools, the will, and the knowledge to protect the economy from sharp swings in the demand for goods and services. They raised interest rates to head off surges, and lowered rates to prevent severe slumps. As a result, households and businesses could count on an economy in which aggregate demand grew relatively steadily. Nobody had to think about, or plan around, the possibility of persistent shortfalls in prices and employment.

That has changed. Since 2008, central banks haven’t been able or willing to defend against a sharp and highly persistent fall in aggregate demand. They have used much of their toolkit, and seem reluctant to employ the tools that remain. As a result, the flow of demand has become uncertain.  Market participants and others are focused on what could go wrong, and how central banks might — or might not — respond.

Before 2008, global aggregate demand was like electricity in the U.S. — just something in the background that everyone could count on. After 2008, it became like electricity in India — desperately needed, but subject to random and persistent shortages. Just as the uncertainty of electricity provision hobbles India’s economy, the uncertainty of aggregate demand impairs the global economy. To reduce uncertainty and promote higher growth, both systems need overhauls.

How should the world overhaul its system for providing aggregate demand? To me, this is the key question facing macroeconomists today. Answering it will require a big change in the discipline. Before 2008, most macroeconomists studying the U.S. and Europe largely ignored the possibility of long-lasting shortfalls in demand. This may (at least arguably) have been appropriate for most questions of interest before 2008. Now, however, they need different models and approaches to understand the effects of aggregate-demand uncertainty, and figure out how best to eliminate it.

The chart gives a visual of Kocherlakota´s ‘allegations’.

Note that during 1985 – 2007, NGDP (Aggregate Demand) growth was very stable (comparatively). In other words, “Before 2008, global aggregate demand was like electricity in the U.S. — just something in the background that everyone could count on.”

But note, after 2007 NGDP growth was initially quite unstable, “running off at high speed” through the Southwest corner of the “stability compound”. Contrast that with NGDP “running off at high speed through the Northeast corner of the “stability compound” in 1970 -84. While the 1970s defined the “Great Inflation”, the 2008-09, by symmetry, characterized a strong disinflation period. In 1985 – 07, aggregate demand growth is contained wholly within the “stability circle, and we had the “Great Moderation”.

Again note that contrary to Kocherlakota´s musings, after the “recovery” from the Great Recession was established in early 2010, what we observe is a very stable aggregate demand growth and not random and persistent shortages”.

However, given the low level of NGDP and it´s rather low average growth, the post 2010 period could be called “Depressed Great Moderation”!

From that perspective, again contrary to Kocherlakota, there´s no need to “overhaul the system for providing aggregate demand”, and also no “big change in the discipline” is required.

It is clear that the Fed can target NGDP growth at a stable rate. After all that´s what it did from 1985 to 2007 and from 2010 to 2015. What´s missing now is the definition of an adequate NGDP level and the most promising growth rate along that level path.

If that´s done the economy will, once again, prosper in a state of nominal stability.

This epitomizes what´s wrong with the post-Greenspan Fed

Trying to sell the view that all´s calm and quite in the “Kingdom of Denmark”, Jon Hilsenrath writes “The Decline of Dissent at the Fed”. The caption of Hilsenrath´s piece is “In an interview, the new centrist in Dallas backs slow rate hikes, as officials with dissenting views have departed”, where we read:

The Fed needs to keep raising short-term interest rates to diminish risks to the economy and markets of “excessive accommodation,” Mr. Kaplan told the Journal on Monday. However, fragile and interconnected financial markets, slow global growth, and the perils of driving the economy back into recession all mean the Fed can’t move aggressively, he said.

“We want to try to normalize [interest rates] as fast as we can,” Mr. Kaplan said in a Dallas office stuffed with memorabilia from his home state of Kansas and with management “how to” books he wrote at Harvard. “But we have to be patient and gradual.”

Yes, dissent has diminished. They´re all of the same view, having embraced the monetary policy framework that Kocherlakota has aptly named “gradual accommodation”.

The only divergence is in the definition of “gradual”. To some it means “start in April”. To others it means we can “hang on to what we´ve got” for a while longer!

Fools all!

Update: The new meaning of dissent: Difference in desired speed of “normalization”

Contrasting views on negative rates

By two former central bankers.

Narayana Kocherlakota writes:

So, going negative is daring but appropriate monetary policy.   But it is a sign of a terrible policy failure by fiscal policymakers.

The reason that the FOMC has to go negative is because the natural real rate of interest r* (defined to be the real interest rate consistent with the FOMC’s mandated inflation and employment goals) is so low.   The low natural real interest rate is a signal that households and businesses around the world desperately want to buy and hold debt issued by the US government.   (Yes, there is already a lot of that debt out there – but its high price is a clear signal that still more should be issued.)  The US government should be issuing that debt that the public wants so desperately and using the proceeds to undertake investments of social value.

But maybe there are no such investments?  That’s a tough argument to sustain quantitatively.  The current market real interest rate – which I would argue is actually above the natural real rate r* – is about 1% out to thirty years.  This low natural real rate represents an incredible opportunity for the US. We can afford to do more to ensure that all of our cities have safe water for our children to drink.  We can afford to do more to ensure that our nuclear power plants won’t spring leaks.  We can afford to do more to ensure that our bridges won’t collapse under commuters.

These opportunities barely scratch the surface.  With a 30-year r* below 1%, our government can afford to make progress on a myriad of social problems.  It is choosing not to.

If the government issued more debt and undertook these opportunities, it would push up r*.  That would make life easier for monetary policymakers, because they could achieve their mandated objectives with higher nominal interest rates. But, more importantly, the change in fiscal policy would make life a lot better for all of us.

William Poole writes:

It won’t work. Negative central-bank interest rates will not create growth any more than the Federal Reserve’s near-zero interest rates did in the U.S. And it will divert attention from the structural problems that have plagued growth here, as well as in Europe and Japan, and how these problems can be solved.

Part of the impetus behind a central bank’s negative interest-rate policy is a desire to devalue the currency. With lower market interest rates, holders of euros, for example, may sell them to flee to countries with higher interest rates—driving down the euro’s exchange rate, boosting European exports and growth. But it is impossible for every country in the world to depreciate its currency relative to others. If the European Central Bank hopes to force euro depreciation against the yen and the Bank of Japan hopes to force yen depreciation against the euro, one or both of the central banks will fail.

Where central banks can help is by identifying the structural impediments to growth and recommending a way forward. In the U.S., Congress should force the Federal Reserve to come clean about why growth has been so slow. The forthcoming congressional monetary policy oversight hearings—Feb. 10 for the House Financial Services Committee and Feb. 11 for the Senate Banking Committee—are the right place to explore what is wrong with the U.S. economy.

These committees ought to insist that the Fed, with its large and expert staff, present relevant studies by mid-June, in time for the annual oversight hearings in July. At the July hearings, the Fed can discuss its research. Academic and other experts can offer their analysis of the Fed’s findings. Instead of vague Fed statements about “headwinds,” the nation deserves solid empirical work on the problem.

Note, however, that both appeal to monetary policy to correct fiscal/structural failures! NK, for example, did much better in a previous post:

The Committee needs to change its basic policy framework.  Monetary policy is not about targeting the level and volatility of interest rates. The FOMC needs to have a framework in which the fed funds rate (and its other tools) are much more responsive to its medium-term forecasts of inflation and employment shortfalls.  Markets would then have to adjust to the possibility that interest rates might have to change rapidly, at any time and in either direction, if the FOMC believes that change is necessary to achieve its macroeconomic objectives more rapidly.

The story behind the “scariest jobs chart ever”

Bill McBride (Calculated Risk) posts Update: “Scariest jobs chart ever” where he presents a version of this chart

And writes:

This graph shows the job losses from the start of the employment recession, in percentage terms, compared to previous post WWII recessions.  Since exceeding the pre-recession peak in May 2014, employment is now 3.5% above the previous peak.

Note: I ended the lines for most previous recessions when employment reached a new peak, although I continued the 2001 recession too.  The downturn at the end of the 2001 recession is the beginning of the 2007 recession.  I don’t expect a downturn for employment any time soon (unlike in 2007 when I was forecasting a recession).

By choosing to break with the way he presented the chart originally, with lines ending when the previous employment peak was reached, he ‘pollutes’ the chart, and detracts attention from an interesting characteristic.

Note that the 2001 Employment Recession is one of the shallowest, only less so than the 1990 Employment Recession; but the second most persistent, only less so than the present Employment Recession.

Interesting question that comes up from eyeballing the chart:

What accounts for the depth and persistence of the employment recessions?

The short answer: monetary policy, whose stance is well described by the growth of NGDP.

The chart below is a powerful illustrator.

The 1981 employment recession was deep. The fall in NGDP growth was high. The objective of monetary policy at the time was to bring inflation down significantly. It came from double digit rates to the 3%-4% range. The intensity of the employment pick-up is commensurate with the strength of the rise in NGDP growth.

In the 1990 cycle, monetary policy was slightly less tight than in the 2001 cycle and NGDP growth increased sooner, making the 1990 cycle a little less deep and less persistent than the 2001 cycle.

The 2007 cycle is the clincher, and “living proof” of the responsibility of monetary policy in generating the “Great Recession”. Note that for the initial months/quarters since the cycle peak, the fall in employment during the 2007 cycle was par with the fall in employment in the 1990 and 2001 cycles. As should be expected, the behavior of NGDP growth during this stage was very similar in the three cycles.

But suddenly the Fed makes the second largest error since its inception in 1913. The massive drop in NGDP growth, which remains for an “eternity” in negative range, “destroys” employment. The timid monetary pick up, both in relative and absolute terms, fully explains the persistence of the employment recession in the present cycle.

Decades in the future, when the history of the last 30 years will be written by dispassionate researchers, one interesting footnote will surely describe the “NK Trip”, where NK does not stand for “New Keynesian”, but for Narayana Kocherlakota and will show that the “last step” in the “trip” completely denies the “first step”. Furthermore, the “ingredients” deemed important in the stories told today: the house price boom & bust, “greedy bankers”, “spindrift consumers”, will be seen as bit players, in part victims of the monetary “mayhem” brought on by the Fed!