Yellen´s unchanging beliefs

The pity is that they are wrong beliefs! From the September 1996 FOMC:

I believe that a very solid case can also be made for raising the federal funds rate at least modestly, by 25 basis points, on the grounds that the unemployment rate has notched down further, the decline in labor market slack is palpable, and the odds of a rise in the inflation rate have increased, whatever the level of the NAIRU and the associated level of those odds. I believe I am echoing Governor Meyer in saying that I favor a policy approach in which, absent clear contra-indications, our policy instrument would be routinely adjusted in response to changing pressures on resources and movements in actual inflation.

She clearly belongs in the “accelerationist” camp recently defined by Justin Wolfers, where the other camp is the “inflation targeters”, to which Bernanke belonged:

What does this mean for the Fed? It’s too simple to characterize the current debate as one between hawks who dislike inflation and doves who are more concerned about unemployment. Rather, the main divide may be between accelerationists worried that rising wage growth signals an economy at full capacity, versus inflation targeters, who argue that weak wage growth signals that unemployment remains too high. And in the next few weeks, we’ll find out who’s winning that argument.

How did things work out in 1996 and what´s the scenery now?

After Yellen´s “solid case” for a modest rate rise in September 1996, wage growth continued to increase, unemployment continued to fall and so did inflation!

After the July 2014 FOMC Meeting, when it became clear that QE3 was about to close (taper would begin in October), unemployment continued to drop, but notice that wage growth and inflation turned “south”.

Yellens Beliefs

Justin Wolfers post is titled “Is the Economy Overheating? Here’s Why It’s So Hard to Say”. I prefer to ask: Is the Economy Overcooling”?

Friedman and Bernanke agree that interest rates are a bad indicator of the stance of monetary policy (which controls the economy´s “temperature”). It is much better, according to Bernanke, to look at what´s happening to NGDP and inflation.

According to those metrics, in 1996 the economy´s “temperature” was about right, with NGDP growth on a stable path. Now, for the past year, NGDP growth has been falling, indicating that the economy´s “temperature” has been dropping!

By clinging to her “Phillips Curve Faith”, the odds that Yellen´s Fed will make a big mistake in the foreseable future are rising!

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!

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”.

What would we be hearing from the Fed if, instead of 0.3% headline 1.4% core, we had 2.9% headline 1.7% core?

Any doubt they would raise rates immediately (through a Conference Call)? However, that was the combination that existed in September 2011 (“9/11”), when QE3 was still to come!

Today both headline and core are far from target, but Yellen is all the time “justifying” the need for a rate increase soon:

“Policy makers cannot wait until they have achieved their objectives to begin adjusting policy,” Fed Chairwoman Janet Yellen said last week in a speech:

“I would not consider it prudent to postpone the onset of normalization until we have reached, or are on the verge of reaching, our inflation objective.”

The “heartbeat” of nominal and real growth has not changed during this time, remaining close to 4% and 2.2%, respectively year on year.

Yellen´s Fetish_1

Overall, both measures of inflation have been well below target for most of the time since 2008.

Yellen´s Fetish_2

What has changed is unemployment, which has dropped from 9% in September 2011 to 5.5% in February 2015 and is getting “dangerously close” to her latest “estimate” of NAIRU (5% – 5.2%)!

Yellen´s Fetish_3

She should remember James Tobin, her thesis adviser at Yale who, on the year she was awarded her PhD, 1971, wrote “Living with Inflation”. Only now she wants to change that a bit and push for “Living without inflation”!

So I find Tony Yates´ “insistence” on raising the inflation target “romantically naïve”!

An elusive target is no target at all!

For some time the big monetary policy discussion revolved around a single word: “Patience”. And the word had a clear “sell date” once it was removed: Two FOMC Meetings. That was certainly a problem for the Fed who hates being “tied-up and gagged”. Everyone, without exception, expected the “word” to be removed at today´s FOMC Meeting, eagerly anticipating what would replace it.

The Statement “clears it up”:

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. Consistent with its previous statement, the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. This change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range.

The “sell date” has gone; the Fed has” untied and ungagged” itself! It also has lowered once more the unemployment threshold that would more clearly indicate an interest rate move was imminent. For those with a short memory, that threshold has been 7%, lowered to 6.5%, lowered again to 6%, and under Yellen, a NAIRU faithful, it has been put in the 5.2% to 5.5% range, which has now been lowered to the 5% – 5.2% range!

Fed officials have marked down considerably their view of the “Nonaccelerating inflation rate of unemployment,” or Nairu.

The new central tendency of the long run unemployment rate is 5 to 5.2%, down from 5.2% to 5.5%. Ms. Yellen told WSJ’s Jon Hilsenrath this may explain why so many FOMC members have marked down their path of interest rate increases: it implies more slack in the economy, less inflation pressure and a need for easy policy for longer.

Yellen´s “NAIRU faith” shows up clearly:

The Fed’s forecasts today contained a shallower path for interest rates going forward. Instead of increasing rates at 0.25% at every meeting, the median interest rate estimate from the Fed calls for only 7 increases over the course of the next 14 meetings.

Asked why, Ms. Yellen cited two factors underlying the slow rise of rates:

1) Inflation has come in further below the Fed’s target than they expected, and that calls for lower rates to bring it back.

2) The Fed has lowered its estimates of the normal rate for the unemployment rate. That means, the unemployment goal is a little bit further away than previously estimated. That too calls for somewhat lower interest rates, she said.

Later this year, with inflation remaining far below target, and unemployment continuing to fall as it has for the past 5 years, the “new range” for Yellen´s “beloved NAIRU” will be put at the 4.5% – 5% range. At this rate, in a few years’ time, Yellen will start believing 4% unemployment is the “real thing”!

Patience Gone_1

Maybe that´s possible, not because it is Yellen´s target, but because the Fed will have (re)learned how to conduct an “appropriate monetary policy”, that is, a monetary policy that maintains nominal stability at the appropriate level of activity.

Patience Gone_2

Adrift, but with an attitude!

Simon Wren-Lewis characterizes the “adrift”:

The third interpretation about why central banks are doing nothing is there is nothing they can do. Quantitative Easing seems to have come to a permanent halt either because it has stopped having a useful effect, or because policy makers fear it is having undesirable consequences. Under this interpretation the inflation target loses credibility not because the private sector no longer believes policy makers’ stated objectives, but because they no longer believe they have the means to achieve them. 

This possibility is the one that should really be worrying central banks right now. It is a scenario that is quite consistent with what is currently happening, and it puts at risk central bank credibility in a most fundamental way. Quite simply, central bank credibility is destroyed because people believe they have lost the ability (rather than the will) to do their job, and there is very little central banks can do to get it back because of the ZLB. This is what should be giving central banks nightmares. Strangely, however, they seem to be sleeping just fine.

To “compensate” they put on an “attitude”. To show they´re “active” the Fed has elected employment/unemployment as the “informant” on the “appropriate monetary policy” (or interest rate juggling). Note that, as late as 2009, with unemployment climbing fast towards 10% and inflation – both headline and core – dropping like a stone, they mostly talked about inflation during the FOMC Meetings. Now that they are “adrift”, they scramble to get “support” from the labor market!

Interestingly, 40 years ago Franco Modigliani with Lucas Papademos invented NAIRU (initially NIRU) – Non Accelerating Inflation Rate of Unemployment (Non Inflationary Rate of Unemployment) to argue from the “opposite extreme”. In their case, unemployment was far above NAIRU, therefore monetary policy could be expansionary without igniting an increase in inflation:

On the basis of these and other considerations, we conclude that a conservative interim unemployment target for mid-1977 is 6 percent. Achieving this target will require a growth of output of at least 17 percent over the next two years. Of this total, more than half should be achieved in the first year, to allow the growth rate to abate as the ultimate target is approached. Taking into account the price implications of this growth path, we conclude that in the first year money income should grow at an annual rate above 15 percent. From this it is argued that even if the primary stimulus to recovery comes from fiscal policy, as seems necessary to ensure an early and vigorous revival, the money supply will have to increase for a while at a rate well above 10 percent. There is wide concern that such a sharp acceleration in the money supply would have an unfavorable effect on the rate of inflation. But we allay this concern by showing that the evidence is clearly inconsistent with any influence of money on inflation outside of its indirect effect through its contribution to the determination of aggregate demand and employment.

How did things pan out? The chart below indicates that unemployment, which was above 8% when Modigliani & Papademos wrote, came down slowly, as did inflation. However, when NGDP growth accelerates, unemployment falls faster towards the 6% “target” but inflation begins to rise long before the “target” is reached.


In early 2012, when the Fed introduced the 2% inflation target, unemployment was, as in 1975, above 8%. Given that inflation was sliding below the 2% target the Fed “stipulated” that 6% unemployment would indicate the time was ripe for rates to begin to rise! What´s this fixation on 6% unemployment (understood to be the NAIRU level)?

Nevertheless, with unemployment falling towards “target” but with inflation continuing to drop, the Fed “reestimated” NAIRU at something between 5% and 5.5%. As of today, we are at the top of the “NAIRU band”, but inflation is still moving slowly down! Note, importantly, that differently from the 1970s, NGDP growth has remained stable (shy of 4%), a rate of spending growth that is consistent with higher than target inflation only if trend (potential) real output growth is below 2%. By insisting on keeping the economy at a “depressed” level of activity, low trend growth may in fact become “reality” (or the “new normal”). The Fed will then feel vindicated in raising rates, while the “New Fisherians” will feel vindicated in seeing higher rates hand in hand with higher inflation!


In the 1970s, “targets” for unemployment got us into inflationary troubles. Now, “targets” for unemployment will get us into “stagnation” troubles. My good friend Benjamin Cole clearly prefers the former!

Update: Krugman has something useful to say on the NAIRU “controversy”:

I very much hope that Fed staff remembers the 1990s. Circa 1994 it was widely believed, based on seemingly solid research, that the NAIRU was around 6 percent; but Greenspan and company decided to wait for actual evidence of rising inflation, and the result was a long run of job growth that brought unemployment below 4 percent without any kind of inflationary explosion. Suppose they had targeted the presumed NAIRU instead; they would have sacrificed trillions in foregone output, plus all the good things that come from a tight labor market.

The chart illustrates:


Here,also, NGDP growth is stable (not at the 4% range but at the 5.5% range). Inflation remains low and even falls (productivity shock) and the 6% NAIRU estimate was completely irrelevant!

San Francisco Fed John Williams is sanguine

Mr. Williams was quite upbeat about the U.S. economic outlook in an interview with Fox News Channel, echoing remarks made to The Wall Street Journal Thursday.

Citing broad-based employment gains in both low- and high-wage sectors, Mr. Williams said he believes the U.S. unemployment rate, currently at 5.7%, will fall to 5% by the end of this year. That’s a level consistent with full employment, which Fed officials see as the lowest rate of joblessness that doesn’t generate undue inflation.

“We’re seeing lots of positive developments,” Mr. Williams said. “There are lots of signs of a good consumer spending trajectory.”

Asked about U.S. inflation, which has been undershooting the Fed’s 2% target for nearly three years, Mr. Williams was also sanguine. He said the recent hit to consumer prices had been primarily driven by plunging energy costs, adding he expects inflation to stabilize and return to the central bank’s 2% goal over the next couple of years.

Let´s parse him:

The data does not show 5% unemployment as the lowest rate of joblessness that doesn´t generate undue inflation (unless by “undue” he means any positive rate of inflation)

Parsing Williams_1

Where does he see the “good consumer spending trajectory”?

Parsing Williams_2

Inflation has been falling ever since the 2% target became official, irrespective of oil prices remaining high or, more recently, falling!

Parsing Williams_3

Medium and long-term inflations expectations have remained below target throughout and are now plunging!

Parsing Williams_4

Maybe Williams is looking at things upside-down!


When Modigliani and Papademos “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 a component of a policy package aimed at approaching NIRU from above over the next two years.

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”.

No surprise, then, that forty years later, Robert Gordon wrote “The Phillips Curve is Alive and Well: Inflation and the NAIRU During the Slow Recovery”:

The triangle model shows that the puzzle of missing deflation is in fact no puzzle. It can estimate coefficients up to 1996 and then in a 16-year-long dynamic simulation, with no information on the actual values of lagged inflation, predict the 2013:Q1 value of inflation to within 0.50 of a percentage point. The slope of the PC relationship between inflation and unemployment does not decline by half or more, as in the recent literature, but instead is stable. The model’s simulation success is furthered here by recognizing the greater impact on inflation of short-run unemployment (spells of 26 weeks or less) than of long-run unemployment. The implied NAIRU for the total unemployment rate has risen since 2007 from 4.8 to 6.5 percent, raising new challenges for the Fed’s ability to carry out its dual mandate.

Maybe John Williams is a fervent adept!