Unwittingly, Conor Sen demolishes inflation targeting

Conor Sen discusses inflation:

Those who argue that the U.S. Federal Reserve should keep interest rates low typically point to the same piece of evidence: The central bank’s preferred measure of inflation remains below its 2 percent target, suggesting that the economy still needs stimulus.

What they ignore is that during the dot-com and housing booms of the 1990s and 2000s, this logic would have led to bigger bubbles — and bigger busts.

Stop right there.

That´s the best argument against inflation targeting!

In the late 1990s and early 2000s, the economy was buffeted by (positive) productivity shocks. That increases RGDP growth and reduces inflation. If the fall in inflation induces the Fed to adopt a more expansionary monetary policy, the result will be nominal instability.

But those were not straightforward times. Other relevant shocks were taking place. There was the Russia/LTCM shock of 1998, the oil shock of 1999 and Y2K (1999), terrorist attack (9/11/2001), the Eron et al also in 2001. In 2003-08 there were also back to back significant negative oil shocks.

Instead of gauging the stance of monetary policy by the up´s and down´s of the Fed Funds rate, you should look at the behavior of NGDP relative to trend.

The chart puts the NGDP Gap (the behavior of NGDP relative to its trend path) and PCE Core inflation.

C Sen_1

It seems that in its reactions to those shocks, the Fed initially “oversupplied” money between 1998 and 2000 and then, “undersupplied” money between 2001 and 2003. During most of that period, inflation remained below “target” because the positive supply shock was preponderant.

Then Conor Sen writes:

The bursting of the subprime bubble was particularly disastrous, forcing the Fed and Congress to take extraordinary measures to keep the financial system afloat and contain the economic damage. One can only wonder how much worse the episode would have been — and whether Congress would have found the political will to pay for even bigger bailouts — if the Fed had further fueled the boom by conducting even looser monetary policy. We should be glad the bubble got no bigger than it did.

He couldn´t be more wrong. What happened is that with the end of the productivity boom and the reemergence of a strong negative supply (oil) shock, core inflation ticked above the then implicit inflation target between 2005 and 2007.

But that was enough to bring on the inflation paranoia, which is quite evident in the 2008 FOMC Transcripts.

The result was that in 2008 monetary policy was severely tightened, with NGDP taking a deep and prolonged dive.

Now, you could ask: Why didn’t inflation become deflation? It certainly was on the way to that, but in 2009 the Fed reversed course and put NGDP growth back into positive territory. The chart illustrates.

C Sen_2

Something interesting to note: Since the crisis, core inflation has not behaved differently from what it did during 1997-2004, remaining mostly below target.

The difference is that now, instead of a productivity boom, we´re having a productivity slump. Inflation should be higher. It isn´t because NGDP growth has remained on a much lower path than before.

However, likely because the NGDP level path has been so much lower, opportunities for productivity enhancement investments have been rare. This has important feed-back effects and may be the main reason for the appearance of “feelings” of “Great Stagnation”.

At the end, Conor Sen confirms “inflation” as the proper target. But one that should be complemented by other indicators

Of course the Fed has to focus on inflation in making its monetary policy decisions. But officials should keep in mind that core PCE is not the only measure, and factor in other indicators such as employment and the behavior of asset markets. If they do so, the case for removing stimulus in the near future will look a lot stronger.

Life for the Fed and for the market would be much simpler if, instead of an elusive “inflation target”, the Fed targeted a trend level path for NGDP, much like it implicitly did from 1987 to 2007.

HT David Beckworth

Are bond yields low?

In a recent post, Scott Sumner argues that they are not particularly low conditional on NGDP growth.

The chart shows that for a long time bond yields have been falling together with the fall in inflation expectations (from the Cleveland Fed), which were converging to the 2% “target”.

Falling Idol_1
Since the Great Recession ended , however, there has been a disconnect, with the yield continuing to fall while inflation expectations, although below target, have remained stable.

This disconnect can be attributed to the low growth of NGDP which, after tanking in 2008 has never “tried” to get back on the “saddle”. The chart illustrates.

Falling Idol_2

Once the recovery began in mid-2009, NGDP growth accelerated. After mid-2010 it “tapered off”. So there would be no “catch-up” growth. The NGDP growth chart illustrates.

Falling Idol_3

With inflation expectations below target and expectations of low nominal and real growth going forward, there´s no reason for yields to rise! And so they fall. Notice that the start of the rate hike talk in mid-2014 clinches the “low nominal growth-low inflation-falling yield” scenario.

Falling Idol_4

PS Tim Duy has a good post. On John Williams:

Williams gives his view of the disconnect between financial markets and the Fed:

In term of the private-sector forecasts, I think it’s very hard to fully understand what the Fed’s decision-making is given that we haven’t done many active policy steps in the last few years. I mean we did obviously as I mentioned the asset purchases during that period, but since we’ve ended that, we talked a lot about raising rates, we’ve given a lot of “dot plots” about raising rates, we did one rate increase in December, but then it has been over six whole months since then, and – I try to put myself in the shoes of a private sector forecaster – one of the hard things to do is kind of see what is our reaction function. What is it that is driving our decision?…

…Right now we’re just in a situation where there is just not a lot of data on actual actions because, for various reasons we’ve held off a long time on our first rate increase and then we held off so far on a second rate increase.

This I think is wrong; lack of action is a policy choice as much as action. Williams seems to think the only useful information about the Fed’s reaction function comes when the Fed changes rates. This implies that holding policy steady conveys no information. I would argue that steady policy is in fact signaling the Fed’s reaction function, and hence, in combination with the data flow, financial market participants are concluding that the Fed will continue at a glacial pace regardless of what the “dots” say. Indeed, I would say that financial market participants are signaling that the Fed’s stated policy path would be a policy error, an error that they don’t expect the Fed to make. I guess you could argue that the market doesn’t think the Fed understands it’s own reaction function. And given the path of policy versus the dots, the market appears to be right.

Do you believe in miracles?

From the WSJ:

“At a time when the global economy is doubting itself in the face of Brexit, the U.S. consumer is emerging with a smile on his face,” said Gregory Daco, head of U.S. macroeconomics at Oxford Economics.

I find it hard to see much reason for smiles! That´s not what the data show. The chart indicates that nominal consumption expenditure growth has come down over the past two years. The basic reason is the Fed tightening of monetary policy through the “rate hike talks”. On a smoother basis (12-month growth), it has fallen and has remained reasonably flat.


The chart below clearly illustrates that consumption is depressed! Both the spending level and the trend growth are below what they were. Maybe Gregory Daco is mistaking “open mouth” for “smile”!


What about the Fed´s inflation mandate? The Fed does not understand what inflation means! Sometimes they think it´s the “oil price”, sometimes the “foreign exchange” and sometimes, “other stuff”.

The fact is that for the past 20 years “inflation” has not been a problem. And given the (low) growth rate of spending, inflation will blossom only through a miracle!


Where were 99% of UK economists in August 2015?

James Alexander post 

It is reported that 90% of UK economists are in favour of the UK remaining in the EU. They have carefully considered the costs and benefits of the UK leaving and mostly decided the economic loss is great, up to 8% of RGDP by 2030 – or around 0.5% per year for the next 14 years.

Yet right here, right now the UK is currently losing 1% of RGDP per year from tight monetary policy pressuring NGDP growth to below 3%. But there are no round-robin letters from these economists, no blog campaigns, no nothing.

In August 2015 we warned that UK NGDP had fallen to below 3% in 2Q15 driven by a rapidly shrinking growth in the GDP Deflator, indicative of near deflationary conditions.

Back then the Governor of the Bank of England was clearly warning that tight money was ahead. It had the effect of reducing NGDP growth further. There was virtual silence from these 90% of economists, except for one or two notable, mostly overseas macro-economists, like Danny Blanchflower.

The weak trend in RGDP fuels concern about the management of the economy and adds fuel to the Brexit flames. Similar trends occur in other countries: weak NGDP, weak RGDP, protest movements.

Market Monetarists are clear, below trend growth in NGDP will drag down RGDP. We would like to measure expectations for NGDP growth but that is tough. Longer term government bond yields are not a bad proxy and they are low and going lower in the UK despite Brexit fears about potential credit downgrades caused by Brexit. Of course, global slowdown fears could be trumping UK credit rating fears, but this would still put those latter fears into perspective, i.e. no big deal for the UK’s credit rating or at least for the consequences of downgrades.

Since the 2Q15 slowdown in NGDP the situation has mostly worsened and dragged down RGDP. Trend growth in NGDP was 5.3% in the UK 1992-2007 and trend growth in RGDP nearly 3%. Since 2010 NGDP and RGDP growth have averaged 3.8% and 1.8% respectively.  Every time RGDP has moved it appears to have been dragged up or down by NGDP. With NGDP growth averaging 2.4% over the last four quarters we would expect RGDP to be dragged down from its below 2% current level to closer to 1%.

JA 99%_1

The charts below give a more striking view of the depression caused by misguided monetary policy. The same outcome can be seen in the US and Eurozone, indicating that even monetary policy mistakes have become “sinchronized and globalized”!

JA 99%_2

Because of the neglect of NGDP growth by the Bank of England under the targets set by the UK Government, RGDP growth is running perhaps 1% or more below trend. This figure compares with the 0.5% below trend that could result if the worst fears of 90% of UK economists are realised.

Yet there is a deafening silence on this current disaster and a very loud campaign about Brexit. These UK economists and their claque in the press and social media should be ashamed of themselves.

“We´re almost there” – A narrative

For the past two years, the Fed has insisted that the time for “policy normalization” has come.

At the very start of this year, none other than Vice Chair Fischer said that four rate hikes in 2016 were “in the ballpark”. We´re almost halfway through the year and nothing has yet happened, and it appears the “highly touted” June hike is “off the table”, and July has become much less likely.

It seems that the Fed has no idea about the monetary policy it is actually practicing. So, let´s help them find out!

Go back a quarter century and picture the 1990-91 recession. That episode came to be called “strategic disinflation” (“SD”). When you look at the chart, you see that inflation in both its “headline” and “Core” guises came down permanently.

Almost There_1

How did the Fed do it?

What it did was to significantly lower NGDP growth. Thereafter it sanctioned NGDP growth at a lower level than before the “SD”. That level was stable and kept NGDP evolving very close to a level trend path. Inflation came down and stayed down!

Almost There_2

The next chart tells the whole story.

Almost There_3

In the late 1990s, monetary policy was first too expansionary and then, too contractionary, But the Fed managed to put things right, i.e. put NGDP back on trend. Throughout, inflation remained contained.

Almost There_4

Note that headline PCE inflation fluctuates widely to the beat of oil and commodity shocks but core inflation remains subdued throughout.

Then we arrive at the Bernanke/Yellen Fed. It appears that for reasons that are hard to explain, inflation, once again became a “big issue”. The 2008 Transcripts are clear on that point. If you read the June 2008 Transcript, which takes place just before NGDP tanks, you find that:

The tightening expected over the next year is not anticipated to begin soon. As shown in exhibits 23 and 24, options on federal funds rate futures contracts currently imply that market participants expect that the FOMC will stand pat at both this and the August FOMC meetings. Although considerable tightening is priced in over the next year, this is not unusual at this stage of the monetary policy cycle.

Exhibit 11 presents the near-term inflation outlook. As you can see in the top left panel, the recent data on consumer prices have come in a little lower than we had expected at the time of the April Greenbook. As shown on line 3, core PCE prices rose only 0.1 percent in April, and based on the latest CPI and PPI readings, we expect an increase of 0.2 percent in May. As a result, we have marked down our estimate of core PCE inflation in the second quarter by 0.3 percentage point, to an annual rate of 2 percent. Total PCE prices (line 1) have risen at a substantially faster pace than core prices; but here, too, the current-quarter forecast is a little lower than in our previous projection, both because of the lower core inflation and because the sharp increases in oil prices have been slow to feed through to finished energy prices.

Despite this recent news, we expect inflation to rise sharply over the next few months. In part, this reflects our judgment that core prices were held down in the first half by some factors that will not persist into the second half. In addition, as shown to the right, we expect increases in food and energy prices to push up the twelve-month change in the total PCE price index more than 1 percentage point over the next several months, to about 4½ percent.

Regarding inflation, every single participant with the possible exception of Mishkin, showed grave concern. This is reflected in Bernanke´s summary:

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 we read that “likely the next move in interest rates will be up”!

Was the downshift in NGDP an error or was it the outcome of an explicit strategy? In 1990, the Fed wanted to bring inflation down permanently, and did. In 2008, you could think that the Fed was again very concerned with inflation. In fact, it appears that it thought that the ongoing trend level of NGDP was “too high”, risking a loss of inflation control. That view is consistent with the facts. After bringing NGDP growth down forcefully (deep into negative territory for the first time since 1937), the Fed never allowed it to go back to the “long-term trend level”, like it had done after the inflation adjustment of the early 1990s, or after the policy mistakes of the late 1990s, early 2000s.

Note that the Fed closely controls nominal spending (NGDP) growth. It´s smack on the trend level path the Fed wishes it to be.

The next chart helps to explain why the Fed has been “worrying”. Having kept NGDP at the “desired” level, potential NGDP is converging to that level. In the chart we see the original trend path from 1998, the CBO estimated potential from January 2007 and the latest estimated level from January 2016, together with actual NGDP.

Almost There_5

“Slack” is fast diminishing (if you believe the CBO potential calculations). Not surprisingly the Fed is getting nervous, and worried that inflation will soon be “pressured”.

What it misses is that the near zero level of the policy interest rate is the outcome of its “decision” to keep NGDP at a low level path. If it starts “promising” to hike rates, NGDP will fall below the desired path (as seems to be happening since mid-2014 with NGDP growth trending down). This “survey results” is interesting:

Almost There_6

By not having a clear idea of the monetary policy it is pursuing (keep NGDP on a stable low trend path), the Fed thinks, because the policy rate is “too low”, that it is being “highly accommodative”. What that conceptual error implies is that the Fed is locked inside a “loop”, well described thus:

Cry Wolf_1

What it needs to do is break away from the “loop”. It can do that by explicitly stating that NGDP is on the desired path, in which case interest rates will “forever remain very low”, or, it can recognize that 8 years ago it made a big mistake and explicitly target a higher level of NGDP, which will force a temporarily higher NGDP growth rate, which will be accompanied by an increase in interest rates!

UK NGDP growth not playing to Osborne/Carney tune

A James Alexander post

UK NGDP growth was released today together with the second estimate of RGDP figures. NGDP picked up slightly to 2.5% YoY. We had earlier shown a similar trend using Nominal GVA data. The very messy and subsequently revised figures from 3Q and 4Q last year now show two quarters of a very low 2.2% YoY growth.

NGDP growth was very poor before Brexit concerns and has, if anything, now picked up slightly as those concerns have increased. Rather ironic given all the scaremongering – perhaps the GBP weakness helped ease the concerns.

Carney solemnly swore that there had been no government interference forcing the Bank of England to take its strong anti-Brexit stance. We believe him. All the ruling elites of both the UK and the Rest of the World are taking the same view. They are not at the sharp end of the woeful nominal growth that constantly drags down real growth. Above everything they prefer governments to be remote from the public and in the hands of self-selected technocrats who should be trusted to do the right thing.

The evidence from the UK is that Carney is failing badly. “Remain” economists remain surprised by the strength of the Brexit support despite all their best efforts. Well, they should look at nominal growth and not be so surprised. Mainstream macro-economists fail in so many ways, but none more so in their relaxed attitude to low Aggregate Demand (aka NGDP) growth. The Brexit debate is a sideshow compared to this abdication of responsibility.

Carney and his political master George Osborne should have been alarmed at the trend of nominal growth in the UK. Even if Brexit concerns are not preventing a small rise in nominal growth the rate is still far too low.


Carney still believes that the next move is up in interest rates, so cementing a policy of passive monetary tightening. When he strongly repeated his view this week, Sterling rose strongly. Just great. It’s not clear if all his Monetary Policy Committee agree with him but they don’t seem brave enough to speak out much.

In recent exchanges over Brexit Carney looks like a very hard man to cross. His responses to Jacob Rees Mogg in Parliamentary questions over the BoE’s anti-Brexit stance were a cross between Tony Blair and Bill Clinton. About right as he has passed from wannabe Canadian politician to global stage-trotter. He has become the model of a very modern hawkish central banker more concerned about fighting non-existent inflation threats than doing his upmost to help create prosperity. This is a shame.

We had high hopes back in the day he openly talked about NGDP Targeting. If he had to face an electorate worried about prosperity perhaps he would change his tune. It probably wouldn’t have much effect given the little impact it seems to have on his boss, Osborne.

Euro Area 1Q16 NGDP growth not so bad, better to come

A James Alexander post

We have already posted about our optimism for Euro Area economic growth due to the very strong growth in Base Money fuelled by the ECB’s “shock and awe” QE programme. We know it could be so much easier and so much better if they simply moved to properly flexible inflation targeting, price-level targeting or better still, NGDP level targeting. Unfortunately, central banks the world over just don’t seem brave enough to break with their peers on the issue. 2% projected inflation is the ceiling, de facto in the US, UK and Japan, de jure in the Euro Area.

However, out of the US, UK and Euro Area only in the latter is QE still growing strongly, and we remain encouraged by the plans for more.

While it will still be a few weeks until Eurostat releases 1Q16 NGDP figures we can estimate the result using those individual countries that have reported NGDP for 1Q16 like Germany and France plus the next four largest countries that have reported RGDP and “inflating” the figure to NGDP using their average GDP deflator over the past four quarters. It won’t be precisely right, but it will be good enough to get a feel of the first quarter trend.

The biggest six Euro Area countries account for 87% of Euro Area GDP and their estimated 1Q16 NGDP growth was 3.0% YoY, an uptick from the 2.9% seen in 4Q15. It is not quite as strong as the US at 3.2% YoY, but encouraging and actually in line with the longer run average. It was actually a really strong (for the Euro Area) 3.7% QoQ annualised – and the highest figure since 1Q11. But QoQ figures are noisy and we wouldn’t like the ECB to get any funny ideas about the strength of NGDP growth, especially as we know what followed 1Q11!


NGDP growth was driven by the strong NGDP growth figure for Germany at 4.1% YoY that helped offset a deceleration to 2.3% for France. Spain is still growing above 4% YoY and even Italy managed to maintain a decent result at 1.7%.

We could dwell on the mistakes of the past, the twin Trichet disasters of 2008 and 2011, and the failure of Draghi “to do what it takes” in 2013 when he let the TLROs run off with no replacement, thus crashing Base Money growth. But bygones are bygones. Now looking at current trends in QE and the effect on Base Money we are more encouraged and pleased to see the impact on Euro Area NGDP despite significant market and German scepticism. We are Market Monetarists but sometimes the markets can be rather obtuse, in my opinion. Still, all views are welcome and it’s what makes a market after all.

What´s the good having weapons & ammo if you don´t have a target to aim at?

Anatole Kaletsky reviews proposals for central bank action in “Central Bank´s Final Frontier?”:

Have central bankers run out of ammunition in their battle against deflation and unemployment? The answer, many policymakers and economists writing for Project Syndicate agree, is clearly No.

“Monetary policymakers have plenty of weapons and an endless supply of ammunition at their disposal,” says Mojmír Hampl, Vice-Governor of the Czech National Bank. The real issue is not whether more powerful monetary instruments are still available, but whether using them is necessary – or even threatens to do more harm than good.

And he goes on to consider all the different “calibers” of ammo Central Banks have at their disposal, from interest rates, including the negative variety, QE and Helicopter Money (HM), not forgetting the fiscal help that could be extended by the Treasury Departments.

But what is the use of having “weapons & ammo”, be it QE, negative rates or HM, if there is no goal or target to “point and shoot” at?

In other words, if you don´t have a goal or target, i.e. a destination, how can you “steer” the economy?

For the 1990 – 2007 period, the Fed managed to keep NGDP growing quite close to a trend level path. Maybe that was the implicit target. There were misses, sure, but they tended to be corrected and were nothing that compares to what happened in 2008.

Weapons & Ammo_1

Throwing the economy into a recession that became “great” and quickly turned into another (or ‘lesser’) depression was, I believe, the work of extremely bad monetary policy that had become “fanatically concerned” with headline inflation.

Weapons & Ammo_2

All the “ammo”, or “strategies”, adopted and ‘talked about’ have succeeded only in keeping NGDP growing at a rate below the previous trend and have not made any attempt to get NGDP closer to the previous trend level. But that would only be possible if the Fed had an explicit NGDP level target.

Since mid-2014, in fact, it appears that NGDP growth is falling even further behind, which is consistent with the tightening bias the FOMC has shown since the end of QE3 was in sight.

The target the Fed has, the 2% IT, has not only lost credibility but mostly works to constrain any attempt that might be made to get spending up, because the “2% target cannot be breached”!

What does and does not make sense?

In “Explaining the last 10 years”, Simon Wren-Lewis starts off:

The Great Recession was larger than any previous post WWII recession. But that is not what it will be mainly remembered for. Unlike previous recessions, it appears to have led to, or coincided with, a permanent reduction in the productive potential of the economy relative to previous trends.

According to measures of potential output put out by the CBO, the coincidence is clear, with a marked kink in the level of potential output occurring concomitant with the “Great Recession”. If that´s true, as the chart shows the economy has essentially closed the “gap”.

Greater Depression_1

However, according to a deterministic trend, estimated from 1955 to 1997 and projected forward, the “gap” has been rising given that real output growth, after dropping hard during the “GR” has never “bothered” to grow sufficiently to close the “gap”.

Greater Depression_2

The first case indicates that the apostles of the “Great Stagnation” thesis have a point. The second view says that the economy is, in the words of Brad Delong from almost 2 years ago, in a “Greater Depression”:

First it was the 2007 financial crisis. Then it became the 2008 financial crisis. Next it was the downturn of 2008-2009. Finally, in mid-2009, it was dubbed the “Great Recession.” And, with the business cycle’s shift onto an upward trajectory in late 2009, the world breathed a collective a sigh of relief. We would not, it was believed, have to move on to the next label, which would inevitably contain the dreaded D-word.

But the sense of relief was premature. Contrary to the claims of politicians and their senior aides that the “summer of recovery” had arrived, the United States did not experience a V-shaped pattern of economic revival, as it did after the recessions of the late 1970s and early 1980s. And the US economy remained far below its previous growth trend.


A year and a half ago, those who expected a return by 2017 to the path of potential output – whatever that would be – estimated that the Great Recession would ultimately cost the North Atlantic economy about 80% of one year’s GDP, or $13 trillion, in lost production. If such a five-year recovery began now – a highly optimistic scenario – it would mean losses of about $20 trillion. If, as seems more likely, the economy performs over the next five years as it has for the last two, then takes another five years to recover, a massive $35 trillion worth of wealth would be lost.

When do we admit that it is time to call what is happening by its true name?

Simon Wren Lewis goes on to indicate that:

If we stick to the more plausible idea that this is all somehow the result of the financial crisis and recession, we can again split explanations into two types: those that focus on the financial crisis and argue that crises of this type (rather than other types of recession) impact on potential output, and those that look at the impact of the recession itself. The distinction is important in understanding the impact of austerity. If the length and depth of the recession has permanently hit potential output, as Fatas and Summers suggest, then the cost of austerity is much greater than we could have imagined.

But I believe that´s the wrong focus. The charts show that the economy was “suffocated” not by austerity, but from a highly inadequate monetary policy, as indicated by the behavior of aggregate spending or NGDP.

Greater Depression_3

Greater Depression_4

And that wrong-headed monetary policy remains in place today!