Like a first year medical student, John Williams is focused on “cadavers”

3. All eyes are on inflation

The Fed is looking for signs that it’s meeting its dual mandate of stable inflation and maximum employment as it charts the course for rate increases. Price pressures have remained below the Fed’s 2 percent goal since 2012, and Williams made it clear while talking to reporters that they’ll be his focus this year.

“The big question mark in 2016 to me is really on this inflation front,” Williams said Monday, noting that questions about labor market slack probably would be resolved as the job situation continues to improve. If “global growth slows, and global inflation falls, and that pushes the dollar up, that’s clearly a scenario that would cause us to take longer to get to our inflation goal, and I think would call for a little bit more accommodation.”

The inflation ECG (again)

And everything points to a Fed that has been tightening (opposite of accommodative) since mid-2014!

Pointers:

NGDP Growth

ISM

Dollar Index

Funny thing: Williams believes the “cadaver” will “stand-up” (one day sometime in the future)

When your tank is almost empty and the engine is gasping, fill it up with a better grade fuel

To me this was the best part of the Minutes, the only real forward-looking one; the rest was the usual BS!:

A lower long-run level of r* [natural real rate of interest] would also imply that the gap between the actual level of the federal funds rate and its near-zero effective lower bound would be smaller on average.

A smaller gap might increase the frequency of episodes in which policymakers would not be able to reduce the federal funds rate enough to promote a strong economic recovery and rapid return to maximum employment or to maintain price stability in the aftermath of negative shocks to aggregate demand.

Some participants noted that it would be prudent to have additional policy tools that could be used in such situations.

Better think hard and choose carefully, if only to avoid falling into another trap. Unfortunately, from the wording, it seems they don´t grasp the fact that if there is something the Fed can avoid, or at least minimize the effects, are shocks to aggregate demand.

Fed leaders don´t pay attention to staff research. Sometimes they don´t even pay attention to themselves

Recently, I asked “Why have such a large research staff if their findings are ignored”?, with Janet Yellen in the “title role”.

Let´s go down to the level of Fed presidents.

First, Bullard has made several recent speeches again calling for tightening……….because you never know when inflation finally is going to appear.  But contrast his call for tightening against this new research from his own staff:

The figure shows the PPM constructed from our preferred specification since January 1995.5 Since the mid-1990s, there have been four periods—broadly speaking—when the PPM exceeded a probability of 0.5 (that is, 50 percent). Inflation was highest in the mid-2000s and the PPM exceeds 0.5 for several months during this period.

But during this most recent business expansion, with inflation averaging less than 2 percent, the PPM averages well under 0.5. As of October 2015, the PPM predicts a zero percent probability that PCEPI inflation will average more than 2.5 percent over the next 12 months.

The PPM is another instrument that policymakers and financial market participants can add to their tool kit to monitor the near-term outlook for inflation. The Federal Reserve Bank of St. Louis will regularly update the PPM shortly after the release of the monthly PCEPI.

Let´s not quibble, understand “0% probability” as meaning extremely low probability.

Next, San Francisco Fed president John Williams (who doesn´t pay attention to himself):

Now that the United States is closing in on full employment and inflation is likely to rise to target levels, the “next step” should be to start gradually increasing rates, a top U.S. central banker said on Saturday.

“I do think it makes sense to gradually remove the policy of accommodation that helped get the economy to where we are,” San Francisco Federal Reserve Bank President John Williams told the Arizona Council on Economic Education.

He must have forgotten the very recent update on his own research “Measuring the Natural Rate of Interest Redux”, which shows it has been negative for the past three years (see Fig 5)! How, then, under his criteria, can policy be accommodative?

“Looking for Wally when there are many Wallies”

That well describes the challenges faced by monetary policymakers according to this piece from Bloomberg Business “Are we tight yet? The Fed´s problem in finding the neutral rate”:

Federal Reserve officials just aren’t sure how much stimulus their zero-interest-rate policy is providing.

At issue is the level of the so-called natural, neutral or equilibrium rate of interest, which is the borrowing cost — adjusted for inflation — that keeps the economy at full employment with stable prices.

Economists from the academic world and even within the central bank are vigorously airing differing views on where the rate lies in the aftermath of the worst recession since the Great Depression. The uncertainty is yet another reason for Fed officials to go slowly as they begin raising interest rates for the first time since 2006.

According to this older piece from Brueguel:

What’s at stake: The natural rate of interest is a key ingredient in the recent discussion of secular stagnation, and more generally in New-Keynesian models of the Great Recession. But the concept is often poorly understood, in part because the term refers to different things for different people.

A couple of examples:

Richard Anderson writes that the Swedish economist Knut Wicksell based his theory on a comparison of the marginal product of capital with the cost of borrowing money. If the money rate of interest was below the natural rate of return on capital, entrepreneurs would borrow at the money rate to purchase capital (equipment and buildings), thereby increasing demand for all types of resources and their prices; the converse would be true if the money rate was greater than the natural rate of return on capital.

Axel Leijonhufvud writes that Erik Lindahl (1939) and Gunnar Myrdal (1939) refined the conceptual apparatus, in particular by introducing the distinction between ex ante plans and ex post realizations and thereby clarifying the relationship between Wicksellian theory and national income analysis.

And there are several others.

In short, the Fed is faced with an “estimation” problem. To make that clear, think of a Taylor-Rule for setting the Fed Fund (FF) rate:

The circles around the level of “potential output” (y^*) and the level of the natural rate (NR) represent the “uncertainty” about their estimated values.

For example, San Francisco Fed senior economist Vasco Cúrdia argued in a paper published earlier this month that the equilibrium rate may have dropped so much that “monetary conditions remain relatively tight despite the near-zero federal funds rate.” He provides a chart which indicates that at present the “natural rate” could be anywhere from -3% to 6%!

Similar uncertainty surrounds the value of “potential” output.

In essence, facing the “estimation” problem, the situation of monetary policy makers is well captured by this picture!

An alternative, to try to overcome the “estimation” problem would be for the Fed to try some “experimentation”.

That has happened before. In March 1933, in the depths of the Great Depression, President Roosevelt decided to “innovate” and free the economy from the “gold standard shackles”, delinking from gold. The effect was immediate as illustrated below.

More recently, in the heights of the Great Inflation, Paul Volcker also decided to innovate:

On Oct. 6, 1979, the Federal Open Market Committee—under the leadership of Paul Volcker—made a decision that would come to be known as a key moment in U.S. economic policymaking, a turning point in the history of the Federal Reserve that would forever alter central banking. And those are the understatements.

A defining moment may shape the direction of an institution for decades to come. In the modern history of the Federal Reserve, the action it took on October 6, 1979, stands out as such a milestone and arguably as a turning point in our nation’s economic history.(A Greenspan)

So, what did the FOMC do? It made a short-term change in the method used to conduct monetary policy, from making adjustments in the federal funds rate to containing growth in the monetary aggregates. (Yes, the Fed now targets the funds rate again—the 1979 change was reversed in 1982—but more on that in a minute.) This meant the Fed would focus on controlling the amount of reserves provided to the banking system, which would ultimately limit the supply of money.

By many, that “experiment” was seen as a failure. Nevertheless, judging by the results it worked, in that inflation was permanently brought down.

In what follows I´ll give a “liberal” interpretation of the experimentation, based on NGDP. The interpretation is not so farfetched because the NGDP targeting concept was extensively discussed both by the Volcker Fed in 1982 and by the Greenspan Fed in 1992.

The first charts show how rising core inflation was the outcome of a rising NGDP growth. The follow up shows that by “downsizing” NGDP growth inflation was brought down.

This was followed by Greenspan´s “consolidation” in 1987-92 and almost “smooth sailing” from then to the end of his mandate in January 2006. These last two periods came to be known as the “Great Moderation”.

I interpret the “experiment” as trying to find first the level and then the stable growth path for NGDP. As the next chart shows, by 1987 the Fed had “hit” on the NGDP level and from then onwards NGDP growth rate was stabilized, i.e. kept close to the trend path.

There were “mistakes” along the way, notably in 1998-03, when NGDP first rose above trend and then fell below, but by the end of 2005, NGDP was back on trend.

Soon after taking the Fed´s helm, Bernanke allowed NGDP to begin once more to fall below trend. This was magnified in 2008, probably because of the Fed´s exclusive focus on headline inflation, which was being propelled by an oil and commodity price shock. In an environment where the financial system was “wounded”, allowing NGDP to crumble is mortal!

At present we have the opposite situation of the 1970s. Instead of high/rising inflation due to rising NGDP growth, we have low/falling inflation due to low/falling NGDP growth. So this time around it may be fruitful to devise an NGDP based experiment in reverse. Try to establish a higher level of NGDP that when attained is “consolidated” through a stable NGDP growth rate.

This “experimentation” would be much more helpful than spending time on “estimation” of the “natural rate of interest” or the “potential level of output”.

PS In the comments, bill writes:

“I need to go see the correlation between corporate spreads and NGDP growth. I think those spreads have been widening which I take as a good sign that the market expects less than optimal choices by the Fed in the near future.”

The chart shows how the recent fall in NGDP growth has been accompanied by a rise in less than stellar bond spreads over 10yr treasuries:

Getting smart. Second step: Accelerate the process!

In “Why So Slow? A Gradual Return for Interest Rates”, Vasco Cúrdia of the San Francisco Fed writes:

Short-term interest rates in the United States have been very low since the financial crisis. Projections of the natural rate of interest indicate that a gradual return of short-term interest rates to normal over the next five years is consistent with promoting maximum employment and stable inflation. Uncertainty about the natural rate that is most consistent with an economy at its full potential suggests that the pace of normalization may be even more gradual than implied by these projections…

…The natural rate of interest is the real, or inflation-adjusted, interest rate that is consistent with an economy at full employment and with stable inflation. If the real interest rate is above (below) the natural rate then monetary conditions are tight (loose) and are likely to lead to underutilization (overutilization) of resources and inflation below (above) its target.

……………………………………………………………………………..

… This Letter suggests that the natural rate of interest is expected to remain below its long-run level for some time. This implies that low interest rates over the next few years are consistent with the most efficient use of resources and stable inflation. The analysis also finds that the output gap is expected to remain negative even after the natural rate is close to its long-run level. Additionally, there is considerable uncertainty about both the short-run dynamics as well as what level should be expected in the longer run. All these considerations reinforce the possibility that interest rate normalization will be very gradual.

Want to accelerate the process, instead of “waiting for Godot”? Either introduce negative IOR or, better, do level targeting, like a Nominal Spending Target Level.

How? Illustration follows:

After all, the Fed has for more than 20 years “chosen” the level and growth rate of nominal spending. In 2008 it made a big error, but since than it has pretty much chosen the level and growth rate. By choosing a new trend level and “target date”, it would define the transitional growth.

When “mumbling with great incoherence” beats “clarity”

Ben Bernanke inaugurated his blog. In the introductory post he writes:

When I was at the Federal Reserve, I occasionally observed that monetary policy is 98 percent talk and only two percent action. The ability to shape market expectations of future policy through public statements is one of the most powerful tools the Fed has. The downside for policymakers, of course, is that the cost of sending the wrong message can be high. Presumably, that’s why my predecessor Alan Greenspan once told a Senate committee that, as a central banker, he had “learned to mumble with great incoherence.”

And in the June 2008 FOMC meeting he spoke “clearly”:

My bottom line is that I think the tail risks on the growth and financial side have moderated. I do think, however, that they remain significant. We cannot ignore them. I’m also becoming concerned about the inflation side, and I think our rhetoric, our statement, and our body language at this point need to reflect that concern. We need to begin to prepare ourselves to respond through policy to the inflation risk; but we need to pick our moment, and we cannot be halfhearted. When the time comes, we need to make that decision and move that way because a halfhearted approach is going to give us the worst of both worlds. It’s going to give us financial stress without any benefits on inflation. So we have a very difficult problem here, and we are going to have to work together cooperatively to achieve what we want to achieve.

The last thing I’d like to say is on communications. Just talking about communications following this meeting, I’d like to advise everyone, including myself, to lean, not to lurch. That is, we are moving toward more concern about inflation, but we still have concerns about economic growth and financial markets. We should show that shift in emphasis as we talk to the public, but we should not give the impression that inflation is the entire story or that we have somehow decided that growth and financial problems are behind us, because they are not. So if we can convey that in a sufficiently subtle way, I think we will prepare the markets for the ultimate movements that we’re going to have to make.

Unfortunately, and that was to be expected, the “public” gathered that inflation, if not the entire story, was the major part. In the Minutes, of that meeting, released 3 weeks later, we read that “likely the next move in interest rates will be up”!

Any wonder NGDP tanked after that?

Bernanke follows that introductory post with the first post, which is all about how the Fed has to pursue an “imaginary number”, the natural interest rate!