Will it be enough if there are no rate hikes in 2016?

Janet Yellen and the Federal Reserve are on another planet:

That’s the message from global investors who are sending the Fed a big distress call to come back to earth.

The Fed is still predicting four interest rate hikes this year, but the market now forecasts zero hikes in 2016.

The closely watched Fed Futures market now has a nearly 60% probability of no rate hikes at all this year.

It’s a dramatic U-turn from only a month ago when the market was pricing in a 75% probability the Fed would increase rates at least once in 2016.

New York Fed Dudley said:

New York Fed President William C. Dudley said in an interview with Market News International that policy makers are “acknowledging that things have happened in financial markets and in the flow of the economic data that may be in the process of altering the outlook for growth and the risk to the outlook for growth going forward.”

Only “may be”? Much more is needed, especially since lately we´ve had the Fed and the ECB/BoJ pulling in opposite directions. Some policy coordination would greatly increase their productivity!

I believe that even if there are no rate hikes in 2016, that will not be near enough to get the economy “unstuck”!

What´s needed is a reversal of nominal growth expectations that translates into a reversal of actual nominal growth. For the past year and a half, this has been sliding down and if the Fed remains hostage to its policy framework of “gradual normalization” underpinned by “Phillips Curve thinking”, the outcome will be dire!

Fed Wrong

Tony Yates on Kocherlakota

In his further comments on Stan Fischer´s presentation at the AEA meeting, Kocherlakota writes:

Why has r* fallen so much and stayed so low, despite signs of improvement in the economy?  One reason is the diminished credibility of central bank objectives.

The Fed (and other central banks) have fallen short of their inflation and employment goals for many years, and are expected to do so for several more years to come.  The public’s beliefs about Fed long-run capabilities and objectives are evolving in response to these misses.  It should not be surprising that the Fed’s extended misses with respect to its objectives are fueling expectations of similar future extended misses – and are one factor that is pushing down on r*.

This analysis seems like yet another argument against the plan to continue to tighten monetary policy.  Doing so only serves to prolong the Fed’s long undershoot with respect to inflation and (more arguably) with respect to employmentThe additional erosion of credibility will create still more downward pressure on r*. (Note: r*   stands for the neutral rate of interest).

To which Tony Yates responds:

On Twitter last night, commenting on Stanley Fischer’s contribution to a panel at the American Economic Association meetings in San Francisco, outgoing FOMC member Kocherlakota expressed his scepticism about the wisdom of raising the inflation target.

However, credibility worriers also need to remember [and here I don’t finger Prof Kocherlakota for failing to] that in some respects raising the inflation target may improve the credibility of monetary policy and reduce inflation uncertainty.

By persisting with the current 2 per cent target, the Fed and other central banks risk further long episodes at the zero bound, and further protracted periods in which inflation is substantially below target [in the UK headline inflation has been about 0 for a year now], and corresponding uncertainty about whether the central bank can ever regain control over inflation.  If setting a higher target means reduced time at the zero bound, then it most surely means better inflation control, and enhanced ‘credibility’, in the sense of the reputation for competence and inflation forecasts that would follow from inflation turning out to be closer to the new, higher objective.

Nowhere does Kocherlakota mention a higher inflation target. That´s TY´s pet project. In any case, if the Fed does not seem to be able to hit the 2% target, how can we presume a 4% target is not only achievable but also enhances credibility!

Inflation is determined by monetary policy. If instead of associating monetary policy with interest rate policy (which becomes “ineffectual” at the ZLB) you associate monetary policy with NGDP growth relative to a stable trend path, you get nominal stability. In that case you not only avoid the ZLB but you get stable (and credible) inflation and stable RGDP growth.

Over more than 20 years prior to 2008, the Fed succeeded in obtaining nominal stability. That comes out clearly in the chart below where, particularly between 1993 and 2007 NGDP growth is quite stable (low growth dispersion). That stability (around a trend growth path) was lost in 2008 and the appropriate level path has not been regained.

Kocherlakota-Yates_1

Core inflation, which particularly during the 1993 – 2007 period had remained close to 2%, fluctuating due to real (productivity) shocks, since 2008 has mostly been below the 2% target.

Kocherlakota-Yates_2

Just like the 1970s showed that a rising NGDP growth path is inflationary, the last several years have shown that too little inflation results from too low NGDP growth (at a low trend path).

What that tells me is that it is high time to stop talking and worry about inflation and try to regain the lost nominal stability that the US economy enjoyed prior to 2008. Best way to achieve that is for the Fed to set an NGDP Level Target.

Kocherlakota, the “turncoat”!

In “All hail Kocherlakota”, Scott Sumner asks:

I’ve also said the Fed should cut rates now.  Indeed I’ve said just about everything Kocherlakota says here. How did Kocherlakota ever get appointed to the Fed? They need to screen candidates more carefully.

Oh! They were good at screening! Kocherlakota became president of the Minneapolis Fed in October 2009. Less than one year later he made a speech that absolved the Fed:

Of course, the key question is: How much of the current unemployment rate is really due to mismatch, as opposed to conditions that the Fed can readily ameliorate? The answer seems to be a lot. I mentioned that the relationship between unemployment and job openings was stable from December 2000 through June 2008. Were that stable relationship still in place today, and given the current job opening rate of 2.2 percent, we would have an unemployment rate of closer to 6.5 percent, not 9.5 percent. Most of the existing unemployment represents mismatch that is not readily amenable to monetary policy.

In that same speech he “founded” the Neo Fisherite school of economic thought when he said:

if the Fed Funds rate was kept at zero the appearance of deflation was only a question of time!”

The people who screened him just never imagined he could be so “ungrateful”! By 2013, Kocherlakota was saying:  “Fed has not lowered interest rates enough”:

The Federal Reserve has not done enough to lower U.S. borrowing costs to boost economic growth, a top Fed official said on Friday, citing his outlook for overly low inflation and overly high unemployment over the next two to three years.

Since the Great Recession, workers and businesses are seeking safer assets, even as the supply of assets perceived as safe dwindles, Minneapolis Fed President Narayana Kocherlakota told a group convened by the University of Chicago Booth School of Business.

“The increase in asset demand, combined with the fall in asset supply, implies that households and firms spend less at any level of the real interest rate-that is, the interest rate net of anticipated inflation,” he said in prepared remarks.

Steven Williamson, for example, was angered by Kocherlakota´s “about face”:

As for the contributions of Kocherlakota to monetary policy, I think it’s fair to say that he has set us back rather than pushing us forward. Case in point is his latest speech.

The FOMC really needs more Kocherlakota types, people that recognize mistakes or that can simply change their minds (“when the facts change”).

 

The unemployment controversy

Five years ago, Kocherlakota dismissed the power of monetary policy to bolster employment:

Kocherlakota in August 2010

What does this change in the relationship between job openings and unemployment connote? In a word, mismatch. Firms have jobs, but can’t find appropriate workers. The workers want to work, but can’t find appropriate jobs. There are many possible sources of mismatch—geography, skills, demography—and they are probably all at work. Whatever the source, though, it is hard to see how the Fed can do much to cure this problem. Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.

Three years later (September 2013) his view changed completely:

First, I will show you data that depict the painfully slow pace of recovery in the U.S. labor market. Second, I will show you data that demonstrate that there is considerable monetary policy capacity with which to address this problem.

Now, New York Fed William Dudley parrots Kocherlakota in 2010:

The New York Fed president was in western New York for a routine district visit, his third to Rochester in the past five years. In remarks kicking off his one-day tour, Mr. Dudley highlighted structural imbalances in the labor market, saying they can’t be resolved with monetary policy alone.

He said there is a growing mismatch between employers’ needs and job seekers’ skills or locations, and that monetary policy couldn’t substitute for the workplace development programs that are needed to fix them.

 “Monetary policy can help labor markets recover by providing incentives for firms to invest and grow,” Mr. Dudley said. “However, monetary policy cannot by itself solve skill mismatches that may exist in the economy. These frictions must be addressed in other ways.”

The point that Kocherlakota grasped two years ago is that monetary policy, by “capping aggregate spendinghas not been providing incentives for firms to invest and grow.