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.

The Fed wastes time “star trekking”!

While the Fed goes “star trekking”, nominal stability is forsaken. As Bernanke argues, the FOMC´s forecast of the “star variables” – y*, u*, and r* – which, respectively, denote potential real output, natural rate of unemployment and the neutral interest rate, variables over which the Fed has no control, have been systematically downgraded. His table illustrates:

Star Trek_1

And Bernanke concludes:

FOMC communications also have been affected by the recent revisions in the Fed’s thinking. It has not been lost on Fed policymakers that the world looks significantly different in some ways than they thought just a few years ago, and that the degree of uncertainty about how the economy and policy will evolve may now be unusually high. Fed communications have therefore taken on a more agnostic tone recently. For example, President Bullard of the St. Louis Fed has recently proposed a framework which implies that, in most circumstances, economic forecasters can do no better than to assume that tomorrow’s economy will look like today’s. Other participants, noting earlier failures of forecasting, have argued that (for example) policy should not react until inflation has actually risen in a sustainable way, as opposed to being only forecast to rise. 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.

To argue that you should all but ignore the Fed is certainly very confusing!

Meanwhile, the people at Gavekal are on the right track when they write:

We were fortunate enough to have Nancy Lazar, from Cornerstone Macro, in our office today and she emphasized a very important point: nominal GDP is ultimately what really matters.

Nominal growth is what drives corporate revenue, and in turn, drives business spending. Because businesses are the backbone of any economy, trends in nominal GDP greatly impact inflation, wage growth, consumer spending, capex and interest rates to name just a few macro economic variables.

When the first release of 2Q GDP came out in late July, we noted how the 10-year annualized change in GDP had fallen to just 2.94%, which is the lowest growth rate on record going back to 1957. In the subsequent charts below we see how this structural decline in nominal GDP is reverberating through other parts of the economy.

There´s a better way to see the importance of nominal stability – the appropriate level and growth rate of nominal GDP (NGDP). In the panel below, which charts NGDP growth at time t against growth at time t+1, we see that what came to be called “Great Moderation”, characterized by stable real growth and stable and low inflation, was a period in which NGDP growth was stable and evolving along a stable trend level path.

Star Trek_2

During the “Great Inflation” we see that NGDP growth was excessive and upward trending. At present (“Great Stagnation”), after trending down, NGDP growth has once again come back into the “stability circle”. However, NGDP growth is “too low” and is evolving along a trend path that is also too low. In fact, as the chart below indicates, it appears that since 2014 NGDP growth is even veering off from this lower path.

Star Trek_3

No surprise, then, that “Fed communications have taken on a more agnostic tone”. As Bernanke argues: “It has not been lost on Fed policymakers that the world looks significantly different in some ways than they thought just a few years ago.” And what´s different is of Bernanke´s own making when, as Fed Chairman, he let NGDP (something which the Fed can closely control, in contrast to the “star variables”) drop significantly. But since they don´t know “what´s different”, stay tuned for more Fed mistakes going forward!

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.


Tim Duy´s prophecies

Prophecy #5:

5.) Inflation will accelerate. I think 2016 will be the year that economic resources become sufficiently scarce to push inflation back to the Fed’s target. I know this may seem like a wildly optimistic call given the persistence of low inflation during this cycle.

I would say TD is very optimistic!


My question: How can resources become “sufficiently scarce” if nominal spending growth is going down?


That´s another example of the “hare chasing the fox”, meaning it is “potential output” that is in pursuit of actual output!

Fox & Hare_2


His Excellency, the Model, suggests…

The Federal Reserve Board released an updated version of its large-scale model on the U.S. economy that may hold clues into why policy makers pivoted at their meeting earlier this week toward a December interest-rate increase.

The revised inputs and calculations on Friday suggest the economy will use up resource slack by the first quarter of 2016, according to an analysis by Barclays Plc, and that also indicates Fed staff lowered their near-term estimate for how fast the economy can grow without producing inflation — a concept known as potential growth…

…In the current model, “the long-run growth rate is two-tenths lower” at 2 percent, Barclays said. FOMC participants forecast the economy’s long-run growth rate at 2 percent in September.

The unemployment rate stood at 5.1 percent in September, and the Fed model assumes little change from that level, dipping to a low of 4.8 percent in a forecast horizon that extends to 2020, according to Barclays. FOMC officials estimated full employment — or the level of the unemployment rate consistent with stable prices — at 4.9 percent last month…

…The model, known as FRB/US and updated periodically, is a series of calculations put together by Fed staff that sketch out how broad measures of the economy would change based on a set of defined parameters. The staff also constructs a bottom-up forecast for policy makers before each FOMC meeting. U.S. central bankers use the models and forecasts as reference points, not sole determinants of their decision-making.

This is nothing short of fantastic!

For the past five years, since partially recovering from the “Big Slump” of 2008-09, real output (RGDP) has been crisscrossing the “potential” growth rate. On the last view, it seems to be dying to undercrosss it! From the behavior of NGDP growth, it will likely “manage” that over the coming quarters.

FRB-US Model_1

Meanwhile, unemployment has taken a dive, but that has not put upward pressure on any measure of inflation, that has been “relenting” (and doing so long before the oil price drop since mid-2014).

FRB-US Model_2

Maybe the future will be significantly different from the recent past, with, for example, low unemployment finally pressuring inflation according to the Fed´s preferred Phillips Curve assumption in the model, given that real growth is (and has been for a long time) at “potential”.

However, before putting a lot of faith in these forecasts, what is the model´s “record of accomplishment”?

The tables below start with the first “Forecast Material” from April/11. Then from March/13, March/14 and the latest from Sept/15. In parenthesis, the realized value for the year. You immediately notice the “one-sided” errors of the forecasts, which mostly over forecast growth, unemployment and inflation!


RGDP Unemploym. PCE PCE-Core
2011 3.2 (1.6) 8.6 (8.5) 2.5 (2.5) 1.5 (1.5)
2012 3.4 (2.2) 7.8 (7.9) 1.6 (1.9) 1.5 (1.9)
2013 3.9 (1.5) 7.0 (6.7) 1.7 (1.4) 1.7 (1.5)


RGDP Unemploym. PCE PCE-Core
2013 2.6 (1.5) 7.4 (6.7) 1.5 (1.4) 1.6 (1.5)
2014 3.2 (2.4) 6.9 (5.6) 1.8 (1.4) 1.9 (1.5)
2015 3.4 (?) 6.3 (?) 1.9 (?) 2.0 (?)


  RGDP Unemploym. PCE PCE-Core
2014 2.9 (2.4) 6.2 (5.6) 1.7 (1.4) 1.5 (1.5)
2015 3.1 (?) 5.8 (?) 1.8 (?) 1.8 (?)
2016 2.8 (?) 5.4 (?) 1.9 (?) 1.8 (?)


RGDP Unemploym. PCE PCE-Core
2015 2.1 5.0 0.4 1.4
2016 2.3 4.8 1.7 1.7
2017 2.2 4.8 1.9 1.9
2018 2.0 4.8 2.0 2.0

Notice how they have been “downgrading” their growth and unemployment forecast over time, but not fast enough to catch up with “reality”. Notice how their inflation forecasts will always move towards the target. They must be greatly frustrated!

I certainly wouldn´t bet the house on the model´s robustness (or precision)!

“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:

Looking for Wally_1

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%!

Looking for Wally_2

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!

Looking for Wally_3

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.

Looking for Wally_4

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”.

Looking for Wally_5

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.

Looking for Wally_6

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.

Looking for Wally_7

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!

Looking for Wally_8

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:

Looking for Wally_9

Jim Paulsen Of Well Capital Management Becomes Defeatist

A Benjamin Cole post

The supply side of the United States economy can only grow by 2% a year, and so the U.S. Federal Reserve and Wall Street are “making a big mistake” in assuming the domestic economy “cannot overheat,” said Jim Paulsen, chief investment strategist, Well Capital Management on May 21 to CNBC.

In fact, there is the threat “you’re going to aggravate costs, [and] push interest rate pressures,” Paulsen warned.

It is hard to know where to begin with Paulsen’s analysis.

Global Supply Lines

First, can Paulsen name a single industry that is supply-constrained, that is now rationing output by price? If so, I want Paulsen to name that industry, so I can buy a related ETF.

Paulsen also ignores that the U.S. supply side has globalized since the 1970s. If more steel, autos, computers or architectural services are demanded in the U.S., the supply side is international. Surely, Paulsen cannot believe there is not 2% more capacity in global supply lines (most of which are begging for business, btw)?


Unit labor costs in the U.S. are up 5.8% in the last eight years, and labor income as a fraction of business income declining in the U.S. for decades. Maybe this will change, but for now labor costs are nearly deflationary.

Interest rates?

The Economist magazine recently reported there is $12 trillion in cash sitting in U.S. banks and money market funds, earning nearly zero percent interest. And Bain & Co. is predicting capital gluts as far as the eye can see, at least for the rest of this decade. How do you get higher interest rates with capital gluts?

Housing-Maybe A Worry

People in expensive single-family detached neighborhoods do not like sky-rise condos with ground-floor retail erupting next door. In a nutshell, this explains why the U.S. may have housing inflation from time to time. Local housing markets may in fact be supply-constrained. Whether such local regulations lead to national inflation, or should determine central-bank monetary policy is an interesting question. Probably, the Fed just has to live with a little inflation from this quarter.


The main economic problem remains a lack of aggregate demand, in the United States, and globally. Not only that, it sometimes takes a round of inflation to stimulate supply—think oil markets, or even housing markets. The route to greater supply is paved by inflation. Life is not perfect, and that is another example thereof.

So, the Fed should print more money.