Beliefs are to be held forever

And Chairwoman Yellen has forever held the belief that Phillips Curve/NAIRU is the “best inflation indicator”.

In his Final Thoughts on September, Tim Duy writes:

I expect the Fed will ultimately pledge allegiance to the Phillips curve. I think they believe that stable inflation is incompatible with sub-5% unemployment if short term interest rates remain at zero. Hence, they will signal that the first rate hike is imminent.

While a BoG member in 1996, she teamed up with PC/NAIRU other big fan Laurence Meyer:

Dec/96 FOMC Transcript:

L Meyer:

A second justification for policy change would be the conviction that we are already below NAIRU and not likely to move back to it quickly enough to prevent an uptick in inflation. This is basically the staff forecast, and my view has been and continues to be that this is the most serious risk factor in the outlook. Yet, we get stuck in place because we continue to be confronted by the reality of stable to declining core inflation in the face of this prevailing low unemployment rate. So, we wait for additional data to resolve our doubts. The risk of waiting, judging from the modest rise in inflation in the staff forecast, is not very great. Still, it is probably worthwhile noting that in all of the five private-sector forecasts that I looked at, there are increases in core inflation over the next year or two. That is a pervasive tendency that just about everybody is worried about. I think we need to keep that in mind.

J Yellen

To my mind, labor markets are undeniably tight. You remarked last time, Mr. Chairman, that we should be careful not to lull ourselves into a false sense of security about incipient wage pressures by reading too much into that suspiciously low third-quarter ECI, and I agree with that. So, I still feel that we need to avoid complacency about the potential for inflationary pressures to emerge from the labor market down the road.

Sometime later, now as head of President Clinton´s CEA we read:

Yellen CEA  Report 1998

This chapter’s analysis of macroeconomic policy and performance concludes that the economy should continue to grow with low inflation in 1998. The chapter begins with a review of macroeconomic performance and policy in 1997, to show in some detail where the year’s growth came from and how inflation remained so tame. The second section examines the important question of whether our understanding of inflation and our ability to predict it have changed in significant ways. This question is part of a broader inquiry into whether the economy has changed in such fundamental ways that standard analyses of how fast it can grow without inflation need to be replaced with a new view. The conclusion reached here is that no sea change has occurred that would justify ignoring the threat of inflation when the labor market is as tight as it is now;

In a few hours we´ll know if beliefs changed!

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!

A mindset cast in bronze

Back in April 1997, while still a ‘freshman’ Fed Board member, Laurence Meyer gave a milestone speech at the Forecasters Club of New York. For the first time, I think, a board member provided a detailed account of his decision process framework.

One month earlier, the FOMC had changed (raised) interest rates for the first time since having reduced it in February 1996.

Meyer writes:

I am going to offer some interpretations of the outlook as a context for the recent policy action by the Federal Reserve and explain how I view this action as part of a prudent and systematic strategy for monetary policy. The Forecasters Club of New York is an ideal forum for me to offer this commentary because, in my view, the recent policy action must be understood not in terms of where the economy has been recently, but rather in terms of the change in the forecast, a change in expectations about where the economy likely would be in six or twelve months in the absence of a policy change.


Despite the sharpness and force of the Phillips Curve/NAIRU model, it can be difficult to implement in practice. Still, this relationship was about the most stable tool in the macroeconomists’ tool kit for most of the past 20 years; those who were willing to depend on it were likely to be very successful forecasters of inflation, and the record speaks for itself on this score. Nevertheless, the combination of the 7-year low in the unemployment rate and 30-year low in inflation was a surprise to those using this framework. The challenge is to understand why we have been so fortunate…

So, what was going on and what did come about? The charts illustrate.

Inflation had been stable while unemployment was trending down. Almost immediately following the speech, the fall in unemployment increased and inflation ‘shot down’!


The more convincing story behind this fact was the productivity increase that was taking place (helped out by the steep drop in oil prices following the Asia crisis, although this did not have much effect on core prices). Anyway, such positive supply shocks reduce inflation and increase growth (reduce unemployment).

In short, contrary to Meyers (and most in the FOMC) view, there was no ‘dangerous’ increase in resource utilization.

The rate increase was of the “one and done” kind. Much later, following the Russia/LTCM event in August 1998, rates were reduced.


The next chart indicates that NGDP was evolving close to trend, growing close to 5.5%. When Russia/LTCM happened, the growth in AD was increased. This turned out to be excessive. We know that because it ignited a cycle to nominal spending that first went too high and later was brought down too low, only being stabilized again towards the end of Greenspan´s tenure in early 2006!


The “too much nominal growth” leg is seen in the next chart, which indicates that money growth more than offset the fall in velocity, especially following Russia/LTCM.


Jumping to the present, apparently nothing has changed because now we read:

Federal Reserve officials might raise interest rates soon because they have a theory: Falling unemployment pushes up prices and wages, requiring tighter credit to keep inflation in check.

David Altig, research director at the Atlanta Fed is quoted:

We haven’t lost faith in the framework described by Mr. Phillips and his successors, that a tight labor market generates higher inflation, said David Altig, research director at the Atlanta Fed. But the numbers that you would plug into that framework and the exact levels at which the pressures begin to emerge, we’re not so clear on those.

In economics, it´s interesting to observe how some things, especially those that require “estimation”, become “gospel” and, despite their suspicious origins, never go away, being endlessly “reestimated”.

When Modigliani and Papademos (yes, the same one who later became head of the Central Bank of Greece and then its Prime Minister)  “invented” NAIRU (NIRU at the time) in a BPEA paper in 1975, their clear aim was to downplay “monetarism” and argue for monetary expansion expansion based on the fact that NAIRU/NIRU was above its “non accelerating rate”:

At this point the analysis confronts a widely held concern, encouraged by at least some monetarists, that such a rapid rate of growth and sudden acceleration of the money supply , would unfavorably influence prices and inevitably set off a new round of inflation.

Our analysis indicates that such concerns are unfounded; it implies that inflation systematically accelerates only when unemployment falls below NIRU, and the M1 growth that we expect will be needed as component of a policy package aimed at approaching NIRU from above over the next two years.

We all know how that turned out!

Today, New York Fed chief Dudley apparently moved markets by saying:

From my perspective, at this moment, the decision to begin the normalization process at the September FOMC meeting seems less compelling to me than it was a few weeks ago,” he said.

But he also said:

Responding to a question about whether a Fed move will come in a subsequent 2015 FOMC meeting, Dudley said he “really” hopes to raise rates this year, but “let’s see how the data unfold before we make any statements about exactly when that might occur.”

And I say: I really hope a large rock will fall on my head this year!

New “con game” in town: Naming dots!

Here’s How Quickly Yellen Wants to Raise Interest Rates, According to a Former Fed Policy Maker:

In what’s become known as the “dot plot,” Fed officials earlier this month showed the public their best estimates for where the central bank’s policy rate will be over the next few years. It’s valuable information for investors who are desperate to know how quickly borrowing costs will rise in the U.S. What makes things tricky is that these dots are anonymous, and no one’s views matter more than the chair’s.

Enter Meyer, who was a Fed governor from  1996 to 2002 and is now senior managing director at Macroeconomic Advisers. He’s taken a stab at guessing which dots belong to whom (scroll down for the chart). He estimates that Yellen in June foresaw a single rate hike this year. That would make her dot one of five at 0.375 percent, which is below the median of her fellow Federal Open Market Committee participants.

Meyer also expects her to change her view by September, by which point he expects to see an economy on stabler footing.

Con Game

In Does the Fed finally realize forward guidance is folly? Caroline Baum thinks this is a waste of time:

In the last two weeks, three Federal Reserve officials have said or implied that the first rate increase could take place in September. The reaction? The September federal funds futures FFU5, +0.01%   set a new contract high of 99.83, an implied yield of 0.17%.

Just imagine what Fed officials must be thinking…

Fed Chairman Janet Yellen: “What part of September don’t they understand? In the old days, the Fed said almost nothing, or leaked it to The Wall Street Journal. Fed watchers had to deduce our stance from open-market operations. Yet traders were quick to tell their underlings: Don’t fight the Fed. Now we basically tell everyone what we are going to do and when, and the response is: So what?”

Fed Vice Chairman Stanley Fischer: “Perhaps it’s because we keep moving the goal posts. Sometimes we use a date for guidance. Other times it’s a threshold. Once our thresholds are breached, we have to hide behind a mish-mash of indefinite words, such as “considerable time” or “patient.” What exactly does that mean?”

Yellen: I think it’s very clear what we mean.

Fischer: Yes, it’s clear that we don’t know when we are going to raise rates, by how much and at what intervals. That’s what is clear. How could we be expected to know that given the nature of a rapidly changing global economy? As I said before I joined the Fed, and refrained from public comments to that effect since: ‘You can’t expect the Fed to spell out what it’s going to do. Why? Because it doesn’t know.’”

And concludes:

If policy makers want to understand why markets are ignoring the likelihood of an imminent increase in interest rates, look to the ever-changing nature of the guidance. Say what you mean, mean what you say, and realize that some things are best left unsaid.

Where does the FOMC get these ideas?

We all know that Janet & Friends are trigger-happy, dying for a plausible excuse to begin the so-called “rate lift-off”. We also know that the labor market is the “star of the play”, being groomed to be the signal that will open “heaven´s gate”!

The “grooming” has changed “styles”. Initially it was 6 to 6.5 “inches” and over the past couple of years has been “trimmed” down to 5 to 5.2 “inches”.

How do they know that´s the “in style”? They don´t, really. They thought it was also “in” almost 20 years ago when Janet was not yet the Head-dresser. In 1997, together with like-minded “fashion guru” Laurence Meyer, she was advising Greenspan that he should raise rates because unemployment was too low! Larry described the “hair style” in detail in April 1997. You can easily see that the playbook today is the exact same:

I am a strong and unapologetic proponent of the Phillips Curve and the NAIRU concept. Fundamentally, the NAIRU framework involves two principles. First, the proximate source of an increase in inflation is excess demand in labor and/or product markets. In the labor market, this excess demand gap is often expressed in this model as the difference between the prevailing unemployment rate and NAIRU, the non-accelerating inflation rate of unemployment. Second, once an excess demand gap opens up, inflation increases indefinitely and progressively until the excess demand gap is closed, and then stabilizes at the higher level until cumulative excess supply gaps reverse the process.

There is a third principle that I subscribe to, which, though not as fundamental as the first two, also plays a role in my forecast and in my judgment about the appropriate posture of monetary policy today. Utilization rates in the labor market play a special role in the inflation process. That is, inflation is often initially transmitted from labor market excess demand to wage change and then to price change. This third principle may be especially important today because, in my view, there is an important disparity between the balance between supply and demand in the labor and product markets, with at least a hint of excess demand in labor markets, but very little to suggest such imbalance in product markets.

Despite the sharpness and force of the Phillips Curve/NAIRU model, it can be difficult to implement in practice. Still, this relationship was about the most stable tool(!) in the macroeconomists’ tool kit for most of the past 20 years; those who were willing to depend on it were likely to be very successful forecasters of inflation, and the record speaks for itself on this score. Nevertheless, the combination of the 7-year low in the unemployment rate and 30-year low in inflation was a surprise to those using this framework. The challenge is to understand why we have been so fortunate. But, it should also be noted that monetary policy has responded appropriately to this surprise. That is, monetary policy has been careful not to be tied rigidly to a constant estimate of NAIRU. Instead, in my view, monetary policymakers have, in effect, implicitly adjusted their estimate of NAIRU to reflect the incoming data; this might be viewed as following a procedure like the time-varying parameter estimation technique applied by Robert Gordon and others.

We were all very lucky that Greenspan didn´t “buy” their suggestion at the time. Unfortunately, now Janet is the Head-dresser, and has enticed others who appear to be like-minded, or that have come on board simply because that´s the best bet available to “open heaven´s gate”.

Look at their “drawing-board”:

Janet´s Salon_1

You can easily understand why the first “style” was 6 to 6.5 “inches”. That´s the unemployment point below which wages began to rise. However, that was during the years before the Fed messed-up, when it strived to keep nominal spending on an “even keel”.

When it did mess up, although unemployment rose, wage growth didn´t budge for quite some time (the flat part of the blue line). That´s evidence for wage stickiness!

When wage growth finally dropped, it´s growth remained about the same even though unemployment was falling. As required by the “playbook”, Janet is adjusting (“trimming”) her estimate of NAIRU to reflect incoming data.

Now we are at the April 2015 point (red). Janet´s view is that if unemployment crosses the “Rubicon”, wages will “take-off”. How fast they have no idea. I do.

Given the level and the rate at which nominal spending has been growing (4% and likely falling), wage growth will likely increase very little.

Why all the anxiety about the impact of wage growth on inflation? It´s a fixed and longstanding image in Janet´s head. Ordinary mortals’ can´t see it!

Janet´s Salon_2

What will happen? More likely they´ll keep “trimming” the NAIRU estimate “to reflect incoming data”.