Someone has been listening

And that someone is in far-away Australia, a country that has avoided recession for a quarter century. Things started going wrong for the past few years, when it ignored its NGDP level target and started worrying about home prices.

Read this: The new RBA governor should target [nominal] growth, not inflation:

If you had told Australians 10 years ago that official interest rates would fall to 1.5 per cent, many would have jumped for joy.

Aside from homeowners, Australians are not feeling much joy these days. This is despite the lowest interest rates in 70 years, low inflation, economic growth close to normal and the unemployment rate – though not ideal – still lower than it was during the Sydney Olympics.

So why are we feeling so miserable? The reason is that most Australians’ incomes are going nowhere.

Wages are growing at recessionary levels, profits for small and medium-sized businesses are flat and the budget deficit constrains government spending.

Overall, Australia’s “nominal” growth rate –  the growth in actual money in our pockets – has fallen from 7 per cent per annum in the decade before the GFC to only 2 per cent today.

A large part of it is also due to the out-of-date inflation target that the Reserve Bank of Australia has been tasked with hitting.

A better option would be for the RBA to target a reasonable rate of growth in Australia’s nominal GDP.

In other words, we should replace the RBA’s existing inflation target with a nominal GDP target.

Stronger growth in nominal GDP would provide workers and businesses with greater means to pay their debts, hire more staff and invest in new plant and equipment.

Amen

HT Virgílio

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.

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.

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

What happens when you let NGDP Drop below the trend level target?

You go the “(un)conventional” way:

The Reserve Bank of Australia has drafted an emergency playbook to follow the world’s major central banks in embracing extreme monetary policy as global interest rates stumble to historic lows and the Australian dollar stays stubbornly high.

Until mid-2014, Australia was doing nicely. In the past two years, however, it began worrying about asset bubbles:

Addressing members of the Committee for Economic Development of Australia (CEDA) lunch in Adelaide, he said monetary policy aimed at encouraging business investment and generating employment amid global economic weakness was in danger of creating a housing bubble in Australia.

And continued to do so one year on:

The Reserve Bank of Australia’s surprise decision to defer its widely anticipated April rate cut for at least another month might have been influenced by the increasingly pricey housing market, which it regards as posing a real “dilemma”.

According to UBS, in March the ratio of Australian dwelling prices-to-disposable household incomes equalled – and is presently surpassing – the previous record of 5.3 times set back in September 2003. And they predict it will climb further.

The policy interest rate has been lowered significantly. So what? That only means that monetary policy has been tight, something easily gleaned from the behavior of NGDP growth and inflation.

 

What Australia should do is try to get NGDP back on trend, which has served it well.

Southern Blues

Why do problems emanate in the South, even if you discount Greece (Deep South)? For the purposes of this post, South comprises France, Italy, Spain and Portugal, respectively the second, third and fourth largest Eurozone economies. North considers Germany (the largest EZ economy), Belgium, Netherlands and Austria.

In 2006, spending (NGDP) in the South was 28% higher than in the North. Today, it is only 14% higher! These eight economies make up 91% of Eurozone NGDP, both in 2006 and today.

In a recent post, Scott Sumner wrote:

Let me try to head off some comments that might talk about individual countries. As far as the ECB is concerned, the health of individual countries (including Germany) is TOTALLY irrelevant. What matters is the Eurozone as a whole, where monetary policy has been and is still far too tight.

But what we seem to have is a two-speed Eurozone: The “do-well” North and the “flailing” South. The charts indicate that the ECB monetary policy has “discriminated” against the South. That could be indicating that the South does not satisfy the conditions to be part of the monetary union. In that case, problems will only get worse with time!

Speaking up for the Euro Area

A James Alexander post

Our fellow Market Monetarists seem to be struggling a bit with making sense of the enormity of the post-Brexit market moves. It’s actually a curse sometimes being a Market Monetarist and having to take wild market moves seriously, or having to interpret them. NGDP Futures markets make sense, little else does.

Sure, the swing from 90/10 probability for Remain at 10pm on the 23rd to 0/100 certainty of Leave two hours later was pretty extreme. The huge swings in markets on the news could be seen as the “pure” reaction to the news, but then again what were markets actually pricing from one moment to the next. All sorts of stuff.

And once you start trying to analyse market moves in the following days you start to open the Pandora’s box of analysing thousands of things. And you actually then have to start looking at movements prior to the Brexit news, or anticipation of that news, and all the other thousands of things that influence market movements.

The Brexit issue has been hanging around the UK, Europe and the world for many, many years. The future of the EU and the Euro Area, likewise. It is tangled up with geo-politics: the Russia question, the breakdown of the Middle East, relations with Turkey. Is the EU a superpower? Is it the EU vs the US. Is it the G7 vs the RoW? Brexit throws all these things up in the air, and thousands more. Ask any International Relations undergrad.

One part of the jigsaw is Euro Area monetary policy. Scott Sumner today tries to make sense of all the market movements and says, without irony:

“the rest of Europe needs to take this very seriously.  Right now, almost no plausible amount of monetary stimulus from the ECB would be excessive.  It’s pedal to the metal time.”

Of course the rest of Europe needs to take this very seriously, very seriously indeed. Does he suppose it isn’t? There are lots of issues to consider, thousands, in fact. Sure the EU and the ECB are dysfunctional, but tell us something new. Is it more or less dysfunctional than the US at the moment? Maybe, maybe not.

Sumner appears to have slightly lost the plot when he talks of monetary stimulus. There are some facts out there already. The ECB is undertaking huge monetary stimulus already if he means QE or negative rates. Currently, the Euro Area is seeing 40%+ YoY Base Money growth. The ECB is committed to its current and recently expanded programme for at least 18 months. Target interest rates are solidly below zero.

What Sumner may mean is changing the targets, rather than ever bigger tools. If he does mean that, then he should say it. We have been arguing here for months that the ECB should either raise its inflation ceiling or far better, switch to NGDP level targeting.

Strangely, things aren’t too bad on the NGDP growth as we have documented.  As the chart indicates, as the US began tightening monetary policy in mid-2014 through the “rate hike talk”, we see US NGDP growth trending down. The opposite is observed in the EZ countries.

The stimulus is working slowly, but could work so much better if the targets were changed.

“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.

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!

The next chart tells the whole story.

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.

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.

“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:

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:

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!

Where´s that “Viking Spirit”

They don´t go out on raids any longer! Actually, they have pretty much been constrained to remain very close to the 7.46038 (DKr/EUR) “parallel”. Whenever they try to “break-out”, even a little, especially to the “south”, they are “reminded” to “come back”, lest the wrath of Odin will damn them!

Periodically, they try. Last February:

The currency slid after a report by Reuters said the central bank was willing to use capital controls if necessary to defend the peg, citing Hans Joergen Whitta-Jacobsen, the head of the Economic Council, an independent body of academics known as the “Wise Men.” In a follow up interview with Bloomberg, Whitta-Jacobsen said he has never advised the government or the central bank to impose capital controls.

The central bank would never unilaterally break the rules that Denmark abides by inside the European Union, he said. The earlier comment to other media was “a way of expressing that the central bank would go very far and do whatever it takes” to save the peg, he said.

Reports from today:

The man overseeing the world’s longest period of negative interest rates says any funds betting against the currency peg he’s defending will ultimately lose money.

“Last year the central bank made a profit on movements in the market,” most of which came from currency trades, Governor Lars Rohde said in an interview at the Danish central bank in Copenhagen on Thursday. “Someone must have been doing the opposite trade.”

But for others, the guarantee from the central bank is enough. “We don’t have any krone hedges and never have had any because we have full confidence in the central bank’s ability to defend the peg,” Kasper Ullegaard, who oversees all fixed-income investment at Sampension, which has $38 billion in assets, said by phone.

Lower Bound

As governor of Denmark’s central bank, Rohde oversees a monetary policy institution that has kept its rates below zero for the better part of almost four years. He has even said that market estimates that Denmark’s policy rate might not go positive until 2019 may well be right.

The experience has provided the lesson that minus 0.75 percent is not the lower bound, Rohde said. We also know that negative rates work much in the way that positive rates function, and there’s no collapse in monetary logic once one passes zero, he said. And though the ability of negative rates to revive inflation is questionable, the policy’s impact on exchange rates seems clearer. Denmark won praise from the International Monetary Fund for its successful peg defense last year.

If only they had chosen to better “peg” (target). Wouldn´t it be great to hear that same guy saying “we have full confidence in the central bank´s ability to keep NGDP on target”.

Very un-Vikingly they outsourced their monetary policy, the economy´s “blood vessels”, to the guys in Frankfurt. While the ECB was doing a good job, keeping the “vessels” unclogged, they were also doing great. But, as soon as the ECB “messed-up”, they suffered from trying to keep the currency peg “whole”.

What a waste.

Moral of the story: Don´t try to bet against stupidity!

Australia falling prey to bad (interest rate oriented) monetary policy

In recent news we read:

Australians must urgently confront the danger that the Reserve Bank of Australia is nearing the very limits of its powers and risks stumbling into the same zero-interest rate trap that has neutered European and Japanese central banks, say two high-profile economists.

Saul Eslake, one of the nation’s most experienced economists, and the ANZ Bank’s top analyst, Richard Yetsenga, say the examples of major central banks around the world don’t provide much hope that ever-more intensive monetary policy stimulus can resurrect inflation.

“The evidence is that even aggressive monetary policy action doesn’t seem to be driving up inflation, so far,” Mr Yetsenga told AFR Weekend.

Calls for a national debate on the eve of the Federal election about how the central bank operates come after the Reserve Bank issued the weakest inflation outlook since introducing its 2-3 per cent target range in the early 1990s. It also comes a day after Phillip Lowe was announced as the replacement for RBA Governor Glenn Stevens.

“Aggressive monetary policy action”? Quite the opposite. Australia weathered the international crisis of 2008-09 because, differently from most other central banks, it managed to avoid letting NGDP to fall below trend, quickly reversing the initial fall in spending, as the two charts indicate.

By identifying the stance of monetary policy with the level of its policy rate, it has allowed NGDP growth to fall continuously, and that has taken the level of spending below the long-term trend.

Meanwhile, inflation has fallen somewhat below the 2%-3% target range, something that is not novel. Since the start of the “IT” regime in 1992 Australia´s inflation, both headline and core measures of the CPI, have averaged 2.5%, and that´s certainly a most satisfactory outcome.

The RBA´s goal should be clear. Work to put NGDP back on the level trend it was at!

The Fed & the Unemployment Rate

Yellen on labor market (Sept 2015):

As I said, although we’re close to many participants and the median estimate of the longer-run normal rate of unemployment, at least my own judgment – and this has been true for a long time – is that there are additional margins of slack, particularly relating to very high levels of part-time involuntary employment, and labor force participation that suggests that at least to some extent the standard unemployment rate understates the degree of slack in the labor market.

“But we are getting closer. The labor market has improved. And as I’ve said in the past we don’t want to wait until we’ve fully met both of our objectives to begin the process of tightening policy given the lags in the operation of monetary policy.”

In fact, she´s a long way from meeting both objectives! No one has any doubt about the distance we are from the 2% inflation target. On the other hand, with unemployment down to 4.9%, many could assume that we´re even “overstepped” it!

The best way to look at the unemployment rate is to analyze it from the perspective of its two constituents: The employment population ratio (EPR) and the labor force participation rate (LFPR).

That´s because the unemployment rate (UR) is, by definition, equal to [1-(EPR/LFPR)]*100. Therefore, a rise in the EPR, normally associated with a robust economy, will reduce the unemployment rate. On the other hand, a rise in the LFPR, something also usually associated with a growing economy (controlling for demographic factors, that change slowly), will increase the unemployment rate.

From this perspective, even in a strong economy the rate of unemployment could be rising (a little at least) if the rise in LFPR is higher than the rise in the EPR.

The charts below make the importance of looking at the rate of unemployment together with its determinants clear.

In the “Golden 60s” and in the “roaring 90s”, we see the unemployment rate falling with rising EPR and LFPR, with the EPR rising faster than the LFPR.

Over the last 10 years, and especially since 2008, we see unemployment first jumping from the steep drop in the EPR and then monotonically falling with the fall in the LFPR together with a reasonably level EPR.

The suddenness of the fall in the EPR and coincident falling trend of the LFPR is difficult to ascribe to sudden and big demographic changes. But they are consistent with the initially gradual and then sudden drop in NGDP growth, which even turned significantly negative (a rare event indeed).

It doesn’t look like that the labor market has in some sense, improved. What is more likely is that the perverse monetary policy of the last several years has changed its nature, maybe through hysteresis effects.

That has been the outcome of the Fed´s policy framework, which Kocherlakota aptly named “gradual normalization”. That policy framework has been instrumental in providing monetary policy tightening!

To undo the hysteresis effect on the labor market the Fed has to change the policy framework. The best alternative, and one that would do the most to reverse those effects, is for the Fed to establish a higher nominal spending target. To reach it, nominal spending growth (NGDP) would be temporarily higher, providing the right incentives for an increase in both the EPR and LFPR.

“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: