Is there an NGDP Targeting bandwagon rolling here? Maybe

A James Alexander post

As recently as the late July John Williams, “an influential centrist” FOMC member and President of the San Francisco Fed, was mouthing the usual threats that have become so common about implementing more rate rises than the market expects:

“The Federal Reserve could raise interest rates up to two times before year end, a top Fed official said on Friday as he downplayed data that showed the U.S. economy grew far less than expected in the last quarter.”

Since then we have had a flurry of comments and speeches suggesting the Fed was engaged in a re-think of its monetary policy. Heck, as we said yesterday, just look a the title of the upcoming Jackson Hole Symposium: Designing Resilient Monetary Policy Frameworks for the Future  .

Now President Williams in a sort of official blog post seems to have completely changed his tune:

“Second, inflation targeting could be replaced by a flexible price-level or nominal GDP targeting framework, where the central bank targets a steadily growing level of prices or nominal GDP, rather than the rate of inflation. These approaches have a number of potential advantages over standard inflation targeting. For one, they may be better suited to periods when the lower bound constrains interest rates because they automatically deliver the “lower for longer” policy prescription the situation calls for (Eggertsson and Woodford 2003).

In addition, nominal GDP targeting has a built-in protection against debt deflation (Koenig 2013, Sheedy 2014). Finally, in a nominal GDP targeting regime, a decline in r-star caused by slower trend growth automatically leads to a higher rate of trend inflation, providing a larger buffer to respond to economic downturns. Of course, these approaches also have potential disadvantages and must be carefully scrutinized when considering their relative costs and benefits.

In stressing the need to study and consider new approaches to fiscal and monetary policy, I am not advocating an abrupt reversal of course; after all, you don’t change horses in the middle of a stream. And in monetary policy, “abrupt” and “disrupt” have more than merely resonance of sound in common. But now is the time for experts and policymakers around the world to carefully investigate the pros and cons of these proposals.”

It’s a shame he doesn’t mention Scott Sumner, the tireless campaigner for NGDP Targeting, but the blogosphere knows where the idea has come from even if a Federal Reserve President can’t be open about the fact.

But a Federal Reserve President who concludes by quoting Machiavelli probably knows a lot more about successful politicking than a mere blogger once of Bentley University.

“Conclusion – Economics rarely has the benefit of a crystal ball. But in this case, we are seeing the future now and have the opportunity to prepare for the challenges related to persistently low natural real rates of interest. Thoroughly reviewing the key aspects of inflation targeting is certainly necessary, and could go a long way towards mitigating the obstructions posed by low r-star. But that is where monetary policy meets the boundaries of its influence. We’ve come to the point on the path where central banks must share responsibilities. There are limits to what monetary policy can and, indeed, should do. The burden must also fall on fiscal and other policies to do their part to help create conditions conducive to economic stability.

Policymakers don’t often cite Machiavelli, but in this instance, the analogy is potent (and, perhaps, a portent). In The Prince, fortune is compared to a river; in times of turbulence it wreaks havoc, flooding and destroying everything in its way. But in calm and sedate weather, people can build dams and stem the tide of destruction. In other words, we can wait for the next storm and hope for better outcomes or prepare for them now and be ready.”

Yesterday we said that there had been little obvious reaction in markets. Well, today there has been a little more. Specifically in the USD, which weakened overnight on the back of the “influential centrist” changing his views. Bond markets do not agree as the yield curve remains flat and low. Bonds seem to be responding more to a perception of incipient economic weakness than a revolution in monetary policy. As true Market Monetarists will only know there has been a revolution when the Fisher effect (aka expectations effect) swamps the liquidity effect as bond prices crash in anticipation of higher nominal GDP growth.

The scourge of the “star Trinity”

The trinity is comprised of the “star variables” y*, u*, and r*, which denote, respectively, potential output, natural rate of unemployment and neutral interest rate.

According to Bernanke:

Changes in policymakers’ estimates of these variables thus reflect reassessments of the economic environment in which policy must operate.

DeLong is more forceful:

The only way to resolve the question in a satisfying way is to test it: to push the economy beyond the estimated potential growth rate and see if inflation rises…. Bernanke argues that Fed officials are willing to be a little patient with the economy, to see whether running it a little hot brings more workers into the labour force and encourages productivity-enhancing investments. It certainly seems clear to me that overshooting is the right way for the Fed to err….

But I am less confident than Mr Bernanke in the Fed’s openness to overshooting. It did not exactly intend to run the unemployment rate experiment that demonstrated how wrong its previous projections had been…. Now, the Fed looks all too willing to revise down its GDP growth projections without ever really testing them…. There is far too little radicalism at the Fed. It risks making permanent a low-growth state of affairs which is largely a consequence of its own excessive caution.

It gets worse. In “Fed Officials Challenge Decades of Accepted Wisdom on Inflation”, we read:

Nalewaik suggests that a return to a world in which inflation expectations and actual inflation become more tightly linked, as they were before the mid-1990s, may not be in the cards.

As Nick Rowe tweeted, if the Fed´s inflation target is credible, as it has been for more than 20 years, there should be no correlation between expected and actual inflation. This is an application of Friedman´s “Thermostat”. In 2003, Friedman gave the simplest explanation for the “Great Moderation” with his “thermostat analogy”. In essence, the new found stability was the result of the Fed (and many other Central Banks) stabilizing nominal expenditures. In that case, from the QTM, according to which MV=PY, the Fed managed to offset changes in V with changes in M, keeping nominal expenditures, PY, reasonably stable. Note that PY or its growth rate (p+y), contemplates both inflation and real output growth, so that stabilizing nominal expenditures along a level growth path means stabilizing both inflation and output.

The thermostat analogy come out very clearly in the panel below.

Star Trinity

While monetary policy was loose and NGDP growth was trending up, the outcome was runaway inflation.

To get inflation down, Paul Volcker experimented with NGDP growth, bringing it down.

While the Greenspan Fed kept NGDP growth at an adequate stable level, the Bernanke/Yellen Fed first depressed NGDP and then kept it growing at an inadequate level. That fact is sufficient to explain both the “sluggish” recovery and “too low” inflation.

If only the Fed could forget about the “star trinity” and experiment with NGDP growth, the main determinant of the economic environment…

Instead, they get “desperate

Central bankers and governments must come up with new policies to buffer their economies against persistently low interest rates that threaten to make future recessions deeper and more difficult to avoid, a top Federal Reserve official said on Monday.

Setting higher inflation targets, tying monetary policy directly to economic output, instituting government spending programs that automatically kick in during economic downturns, and boosting investment in education and research are all policies that should be considered, San Francisco Fed President John Williams said.

Fed´s usefulness is waning

According to Bernanke:

In general, with policymakers sounding more agnostic and increasingly disinclined to provide clear guidance, Fed-watchers will see less benefit in parsing statements and speeches and more from paying close attention to the incoming data. Ultimately, the data will inform us not only about the economy’s near-term performance, but also about the key parameters—like y*, u*, and r*—that the FOMC sees as determining that performance over the longer term.


Implication of Lael Brainard´s conclusions

Much like she did before the last FOMC meeting, Lael Brainard advises caution, concluding:

A variety of evidence suggests that the longer-run neutral rate is lower now than it has been historically, and that the very low shorter-run neutral rate may adjust to it very slowly, due to a combination of weaker foreign demand growth, greater risk sensitivity as a result of the crisis, higher risk premiums for productive investment, and lower growth in potential output.

The lower neutral rate means the normalization of the federal funds rate is likely to follow a more gradual and shallower path than in previous cycles, although the actual path will be determined by economic conditions.

It also implies that the likelihood of the federal funds rate hitting the zero lower bound will be persistently greater than it has been previously, which could make it more difficult to achieve our objectives of full employment and 2 percent inflation. With the nominal neutral interest rate lower than in the past, and with policy options being more limited if conditions deteriorate than if inflationary pressures accelerate, the asymmetry in risk-management considerations counsels a cautious and gradual approach.

If she listened to herself, she would conclude that what needs “normalization” is not the federal funds rate but the level and growth rate of nominal spending (NGDP).