One small step for supply-siders, a giant leap for Wren-Lewis?

A James Alexander post

Market Monetarists have often been a bit frustrated with Simon Wren-Lewis’ Keynesian over-concern with the obstacle of the Zero Lower Bound. Having flirted  with NGDP Targeting a few years ago he went off the idea. It is great to see him both attacking  the idea of raising rates, in fact suggesting a cut in rates, and also returning to support NGDP Targeting:

“Good policy should not just look at the most likely outcome, but also at risks. At the moment there is a significant risk that we may be losing a huge amount of resources because of a tepid recovery. To cover that risk, we should cut rates now. The worst that can happen if this is done is that rates might have to rise a little more rapidly than otherwise in the future, and inflation might slightly overshoot the 2 per cent target. Inconvenient, but not very costly.

If we fail to cover that risk, there is a non-trivial probability that in three years’ time inflation will still be well below target and we will all be asking why on earth everyone in 2015 was talking about an interest rate increase.”

“If the Bank of England had adopted a NGDP target, as many have recommended, the MPC would be tearing their collective hair out right now trying to stimulate the economy. There would be zero talk of interest rate increases. So there seem to be just two possibilities. Either NGDP targeting is nuts, or monetary policy has slowly gone off the rails by focusing on CPI inflation alone.”

Unfortunately, there is still little room for the UK to cut rates as they are obviously very close to the the ZLB, unless the MPC goes down the negative rate road. Perhaps Wren-Lewis is just paving the way for a reopening of his campaign for more big government fiscal policy – he has never proposed tax cuts as a form of fiscal policy as far as I have read. Is this because his anti-market, anti-supply side, bias blinds him? I don’t know. But this bias needs to be overcome for NGDP Targeting to be really effective.

At or around the ZLB central banks have to be very clear just how far they will go with unconventional monetary policy in order to achieve their targets. But the key issue is how the markets, and thus the wider economy, understand what the central bank is really targeting.

Actual NGDP is a tricky thing to target as the numbers inevitably come out after the event, and accurately many months after the event. It could be too little, too late if central banks only look at incoming data. They must look forward, to set the flight path they want to be on.

Better to work with the market and target the market’s expectations for future NGDP. At the moment these expectations can only be seen indirectly through market implied inflation rates, longer term bond yields, equity markets and exchange rates. Consensus macro forecasts are almost worthless with their constant reversion to mean, usually using the same discredited macro models used by the central bank’s themselves. Market prices are far more reliable as a guide to the future as real money is at stake rather than just the reputations of a lot of rent-a-mouths.

It would be best for central banks to help launch an NGDP Futures market as Scott Sumner has argued. This small but imaginative step by a supply-side macroeconomist brought together Friedman’s classic monetarism with the new insights of rational expectations.

It would be even greater if Wren-Lewis too could make this step and work with rational expectations to achieve successful monetary policy and growth, rather than being so skeptical about the market all the time. For a Keynesian like Wren-Lewis this would be a giant leap, but it is a necessary one.

Good-bye, so long, farewell?

In a recent post Scott Sumner muses:

For the past few years I’ve been suggesting that the labor force participation rate is not going to bounce back.  Commenters have insisted that the workers were just “discouraged”, and that they’d come back in and start looking for jobs when the labor market got somewhat better.

Today the unemployment rate fell to 5.1%.  If that’s not the natural rate, it’s pretty close. Close enough so that if you really wanted a job you should at least be looking by now.  And yet the Labor force participation rate is 62.6%, the lowest level since the 1970s. No, I’m afraid the discouraged workers are gone for good.  Indeed the Fed wants to tighten now to prevent the job market from overheating!

In the next post he asks:

What is the total number of months during the Ford, Carter, Reagan and Bush I administrations, plus the first term of Clinton, when the unemployment rate was lower than today?

Answer:  1

(March 1989, when it was 5.0%)

Come on discouraged workers, get out there and start looking!

Nevertheless, taking a longer view, below several instances (many more in the 60s and 90s) of unemployment below 5.1% and the corresponding YoY core pce inflation:

Nov/66: 3.6% – 3.1%

Nov/73: 4.8% – 4.8%

Mar/89: 5.0% – 4.5%

Apr/00: 3.8% – 1.7%

May/07: 4.4% – 2.0%

Now: 5.1% – 1.2%

However, it is disturbing to see, as shown in the chart below, that monetary policy failures (letting NGDP growth drop significantly, or even tank) has permanent real effects, in this case causing a permanent drop in the labor force participation rate (even considering only prime-age workers). And the Fed Borgs think more “tightening” is needed!

So long Farewell_1

Therefore, saying that 5.1% unemployment is indicative of a “tight” labor market is nonsense! What is “tight” and remains “tight” is monetary policy.

The following chart indicates that higher employment growth could be forthcoming with higher nominal spending growth. Unfortunately, the Borgs don´t seem willing to experiment!

So long Farewell_2

Title Song


Taper Tantrum 2: Monetary policy is too tight right now

A James Alexander post

“Too tight?” Sounds ridiculous when you listen to 99% of commentators and conventional economists or look at such “obvious” facts as ultra-low interest rates and all the QE, past and present. But why we should listen to conventional macroeconomists is anyone’s guess when they were so dismally useless in spotting the crisis in 2008. Never have so many experts been proved so lacking in expertise.

Only a handful of got the story straight, most prominent was Scott Sumner, a professor at an obscure US college, but also a University of Chicago PhD in Economics. His version of monetarism, christened Market Monetarism was publicised on his blog. And, of course, Marcus Nunes here at Historinhas.

Sumner spotted that nominal growth expectations were falling in 2007 as the housing market in the US and elsewhere came off the boil. Rather than stay committed to maintaining a smooth path of nominal growth, central bankers moved to a tightening bias for monetary policy dazzled by high headline inflation. Their actions, or rather their inactivity, turned stalling growth into a banking crisis and a recession.

The confusion is caused because interest rates, QE and current monetary policy are trapped by the central banks’ love affair with Inflation Targeting. Markets are smart, they are forward-looking, expectations-driven. The “Market” in Market Monetarism.  If the central bankers start fretting about inflation the markets know that rate rises and active monetary tightening is around the corner and respond by buying government bonds, buying the currency and selling equities – all in expectation that the monetary authorities will act sooner rather later. The reaction thus becomes the policy. The central bank action when it comes, if expected, is not accompanied by much market reaction. ‘Buy the rumour, sell the fact’, as any finance professional will tell you on day one.

Hence, we have endless speculation about what the authorities are planning. And in times of stress or uncertainty about the economy, doubled and redoubled attention. The “taper tantrum” was a great example of this. We are probably having a second, “taper (or tightening) tantrum” right now.

Many conventional macroeconomists still cling to the notion of “long and variable lags” before the impact of changes in monetary policy have an impact. One top UK economics prof even names his popular blog  after it. They could not be more wrong. Markets do the heavy lifting, the signalling, the changed expectations, instantaneously. The rest is history, or rather the inevitable playing out of those expectations in terms of high or low inflation, or rather high or low nominal growth. Of course, expectations can change as central bankers shift their views but often they get stubborn, with disastrous consequences.

What we are seeing now is the very long and slow recovery from the Great Recession being threatened precisely because that recovery finally appears to have gathered enough pace to see some modest nominal wage growth, partly due to unemployment having fallen to pre-recession lows.

What both Market Monetarists and markets cannot grasp is why this should lead to active monetary tightening. All monetary theory says that you should tighten when nominal growth is too rapid, too far above trend. There is no conceivable data in the US or UK to show we are at above trend growth. Yet the very same central banks who so messed up in 2007-08 are on the verge of doing it again. Markets can see this and are reacting badly, correctly.

Alan Blinder thinks the interest rate trajectory defines the stance of monetary policy

Michael Darda to Scott:

Alan Blinder in today’s WSJ, arguing, as some Fed officials have, that it’s not the start/timing of the initial rate hike/tightening that matters, it’s the trajectory. This is just incredibly wrongheaded in virtually every respect. If the Fed is overlooking a passive tightening in monetary/financial conditions and a concomitant drop in the eq. short rate and then compounds it by actively tightening instead of easing, the “trajectory of short rates” will be very shallow indeed. The “path” of short rates was “only” 25 bps in Japan in 2000, “only” 50 bps in Japan in 2006/7 and “only” 50 bps in the EZ in 2011. And the outcomes were all consistent with monetary policy failure.

Memo to Blinder: Never reason from an interest rate path.

Scott comments:

This is a very important point. In the three episodes mentioned by Darda, the trajectory of interest rates was extremely flat, after the initial increase. And yet in all three cases monetary policy was far too contractionary, and in all three cases the country (or region) again fell back to the zero rate boundary. The Fed may avoid that mistake, but it won’t be because a flat interest rate trajectory means easy money. I’d guess that about 90% of interest rate movements reflect the condition of the economy, and 10% reflect Fed policy.

Blinder’s right that the future path of policy is very important, but wrong in assuming that the future path of interest rates tells us anything useful about the future path of policy.

Which reminded me of 1993-95, At that time, the Fed chose a “steep” path for the FF target rate. Was policy “tight”?

The nominal side:


Where it is hard to assign a “policy role” to the FF rate. After all, inflation fell while the FF rate was “dead” and stopped falling when the FF rate increased rapidly!

Now look at what went on with NGDP. It is clearly much more relevant to what happened to inflation.

The real side:


RGDP growth and the fall in unemployment pick up when NGDP growth rises (despite the rise in the FFT) . What the Fed successfully did was to put the nominal economy back on track after the 1990/91 recession and importantly, with a permanently lower rate of inflation. The real economy says “thanks”!

Note: Apparently, the Fed was also successful in “tracking” the equilibrium interest rate!

What´s wrong with macro (and the Fed) in two short sentences

From Scott Sumner:

Why then are they planning on raising interest rates?  They seem to be relying on flawed NK models that suggest tight labor markets cause higher inflation.  And they notice that unemployment has recently fallen to 5.3%, and may decline further.

But these NK models are simply wrong; low unemployment does not cause inflation.  Rather unexpectedly high inflation (when caused by demand shocks) causes low unemployment. And monetary policy drives inflation.   The NK models have causation reversed.  The Fed is acting like a bystander waiting for the economy to bring inflation on line, whereas actually the Fed determines inflation.  But to do so they need to ease monetary policy when they are likely to fall short of their target.

Going visual:

Wrong with macro and Fed
You can get many combinations of inflation and unemployment, depending on the shocks that hit the system. For example, in the mid and late 90s, a combination of a positive productivity shock, for a while accompanied by a negative oil price shock, is behind falling inflation and unemployment. In the early 00s, a negative demand shock (Fed mistake) which brought NGDP growth down was accompanied by rising unemployment, while inflation didn´t move much at all.

In 2008-9, a very strong negative demand shock (the Fed again) brings inflation forcefully down and unemployment jumps.

Although they appear not to like being bystanders, monetary policy makers act as if they were. But they are “restless”, especially since many of them have never had the chance to increase interest rates. With that, they begin to “see things” (like an economy that´s “picking up” bringing inflation in its wake!)

With a low and stable NGDP growth that would be quite a feat!

Almost five years later, they are very likely to pull a “Trichet trick”. And we well know the consequences.

Failed Fiscalist Forecasts

A Mark Sadowski post

The subject of the United States “fiscal cliff” as a test of monetary policy offset at the zero lower bound in interest rates has recently come up yet again. Russ Roberts brought it up here.

Simon Wren-Lewis responds here.

To which Scott Sumner replies here.

For what it’s worth, here’s my two cents worth. I’ve said some the following before in more than one place, but this time I’ll try and be even more complete and explicit.

To begin with, the sequester was only a small part of the U.S. fiscal consolidation that took place in 2013. The “sequester” refers to the automatic spending cuts in particular categories of outlays that were initially set to begin on January 1, 2013, as a result of the Budget Control Act (BCA), and were postponed by two months by the American Taxpayer Relief Act of 2012 (ATRA) until March 1. ATRA also addressed the expiration of certain provisions of EGTRRA and JGTRRA (the “Bush Tax Cuts”), the 2-year old cut to payroll taxes (the “Payroll Tax Holiday”) and federal extended unemployment insurance. An increase in income tax rates applicable to high income tax payers, an increase in the payroll tax, and a continuation of federal extended unemployment insurance went into effect on January 1, 2013.

In short, the sequester only refers to the spending cuts that went into effect on March 1, 2013 and does not include the two major tax increases that went into effect on January 1, 2013. Based on the CBO’s November 2012 analysis of the “fiscal cliff”, and adjusting for the late start of the sequester, the tax increases that went into effect constituted  approximately 70% of the budgetary effect of going over the “cliff”. This is why analyses such as these are far less than fully satisfactory.

Furthermore, none of the forecasts concerning the effects of fiscal consolidation, by either the CBO, or the major private forecasters, referred to annual 2013 RGDP growth. They all referred to quarterly RGDP growth in 2013 or to year on year RGDP growth in 2013Q4. This because this is the more reasonable measure when the question is what impact a budgetary change starting at or near the beginning of a given year will have on subsequent growth. The Q4/Q4 measure is approximately the average of the four quarterly growth rates following the budgetary change, whereas the Year/Year annual measure is essentially a weighted average of the previous and current year’s quarterly growth rates. In this particular instance 3/8ths of the weights in the Year/Year measure come from quarters that occurred before even a single act of the federal fiscal consolidation went into effect on January 1, 2013. For more on why the Q4/Q4 measure might be preferred to the Year/Year measure in this case, see this for example.

The CBO’s last full economic forecast of 2012 (which came out just weeks before QE3 was announced) called for 0.5% year on year decrease in RGDP in 2013Q4 assuming all of the projected fiscal tightening went into effect (Table 2-1).

The previously mentioned November 2012 CBO analysis of the effects of the fiscal cliff states that eliminating all of its components would result in year on year RGDP growth in 2013Q4 being 2.9 percentage points higher (Figure 1). This implies that the CBO was forecasting that year on year RGDP growth would be 2.4% in 2013Q4 without any of the components of the fiscal cliff.

A careful reading of the CBO’s estimates from November 2012 indicates that the fiscal consolidation (the 2% payroll tax increase, the high income tax increase and the sequester) should have subtracted 1.4 points from year on year RGDP growth through 2013Q4.

Figure 1 shows that the CBO were estimating that extending the reduction in the payroll tax and extending emergency unemployment benefits would increase year on year RGDP growth by 0.7 points in 2013Q4 (line five). Footnote 15 on page 11 indicates that approximately 80% of the budgetary effect of this component was due to the reduction in the payroll tax. Assuming the fiscal multiplier for the reduction in the payroll tax and emergency unemployment benefits is about the same, the economic effect of not extending the reduction in the payroll tax thus was about 0.56% of RGDP (i.e. 80% of 0.7 points).

Also, Figure 1 suggests that the economic effect of not extending lower tax rates for those with high incomes (the difference between line three and line four) is 0.1% of RGDP. The increase in income tax rates applicable to high income tax payers that went into effect under ATRA was actually somewhat smaller than what the CBO estimates were assuming, but probably not significantly enough to make it worth refining any further.

And lastly, Figure 1 shows that the CBO were estimating that eliminating the defense and nondefense spending reductions (i.e. the “sequester”) would increase year on year RGDP growth by 0.8 points in 2014Q4 (the sum of lines one and two). But the implementation of the sequester was delayed by two months. A crude adjustment to this figure may be obtained by reducing it by one sixth (two out of 12 months) or to about 0.67% of RGDP.

The sum of these three components totals about 1.4% of RGDP. Combining the CBO’s estimated effect of the three components of the fiscal cliff that actually did go into effect, with the CBO’s implied forecast in the absence of any of the components of the fiscal cliff of 2.4% RGDP growth, results in a forecast of 1.0% year on year increase in RGDP in 2013Q4.

A similar thing applies to the major private forecasters. (Sorry, no links, but some of this can probably still be googled.) The effect of the fiscal consolidation (again, the 2% payroll tax increase, the high income tax increase and the sequester) according to Bank of America, IHS Global Insight, Moody’s, Goldman Sachs, Morgan Stanley, Macroeconomic Advisers and Credit Suisse ranged from 1.0% to 2.0% of GDP, with the average estimate being about 1.6%. The baseline forecast (i.e. the RGDP growth without any components of the fiscal cliff) prior to the beginning of 2013 of these same seven private forecasters was for year on year RGDP growth of 2.0% to 3.5% in 2013Q4 with the average forecast being about 2.7%. Thus the average forecasted year on year RGDP growth in 2013Q4 adjusted for fiscal consolidation was about 1.1%. This is almost exactly the same as the CBO forecast that I’ve teased out above.

We now know that year on year RGDP growth in 2013Q4 was 3.1%, or significantly higher than what the CBO was forecasting, and higher than what most of the major private forecasters were estimating would occur without any fiscal consolidation at all.

Or, in plain English, taking into account the monetary policy offset, the fiscal multiplier still appears to be zero, even at the zero lower bound in interest rates.

Revisionist Thoughts: Was Australia just luckier than most?

This post was motivated by Scott Sumner´s musings about Australia: Australia´s Great Stagnation:

It looks like the Great Stagnation has hit even Australia.  In an earlier post I pointed out that Australian NGDP rose at a 6.5% rate from 1996:2 to 2006:2.  Then we had the Global Financial Crisis, and Australian NGDP growth slowed to . . . er . . . it stayed at 6.5% from 2006:2 to 2012:2.  No tight money and no recession in Australia.

Some important facts about Australia:

1 NGDP and Trend

Revisionist Thought_1

2 RGDP & Trend

Revisionist Thought_2

Notice that when NGDP climbs above trend, RGDP falls below trend!

Zooming in (circles explained later)

Revisionist Thought_3

Revisionist Thought_4

What explains the counterintuitive fact that RGDP falls below trend at the same time commodity prices take off?

Revisionist Thought_5

The rise in NGDP translates into a rise above target in core inflation.

Revisionist Thought_6

The 200 basis points increase in the cash rate (equivalent to the Fed´s FF rate) just goes to show that interest rates are bad definers of the stance of monetary policy. Despite the increase in the cash rate, inflation and NGDP were moving up, indicating monetary policy was “too easy”!

Revisionist Thought_7

With Australia being a commodity exporter, another way to gauge the stance of monetary policy is by comparing the move in the exchange rate to the dollar and commodity prices. Monetary policy is “just right” if a rise in commodity prices is accompanied by an appreciation of the Aussie Dollar (USD/A$) and a fall in commodity prices goes hand in hand with a depreciation of the exchange rate.

The chart below shows that in 2004-07 monetary policy was too loose, consistent with NGDP climbing above trend (and inflation increasing). Monetary policy was tightened in 2011-13, consistent with NGDP converging to trend and inflation decreasing (see circles in NGDP & Trend chart above).

Revisionist Thought_8

At present, NGDP is back on trend (actually just a “whisker” below it). What happens next? Will Australia go the way of Sweden, Israel and Poland, or will it get “smart”?

In the case of Sweden things started unraveling when the Riksbank decided to “prick” a housing “bubble”. According to the FT:

Sweden’s central bank has been lambasted by critics for trying to use interest rates to combat signs of a housing bubble. It lifted rates in 2010 and 2011 as it publicly worried about what it saw as high household debt levels.

In the case of Israel, it may not be coincidence that NGDP began a systematic deviation from trend when Ms Flug took over at the Bank of Israel. Maybe she prefers the role of Finance Minister:

Speaking at a Calcalist conference, Governor of the Bank of Israel said today, “Exceeding the 3% fiscal deficit target will expose the Israeli economy to significant risk and will be liable to harm us citizens. We must show responsibility and take into account the consequences of our decisions over time. Israel’s structural deficit, the deficit not subject to one-time shocks, is already one of the highest in the western world.”

This is what happened:

Revisionist Thought_9

In the case of Poland, it took three years, but in late 2011 Poland finally botched up and went the way of the majority of countries, letting NGDP fall way below trend. They didn´t (correctly) react to the 2007-08 oil price rise, like the US, UK, EZ, etc. and fared well, but didn´t resist when oil prices picked up again in 2010-11, when, among the initial group, only the ECB was dumb enough to react.

Revisionist Thought_10

By talking about house prices, the RBA is tempting the “fate” that hit Sweden and Israel. Scott links to an article in a subsequent post:

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”.

This, unfortunately, has been going on for some time. Last September, RBA Governor Glenn Stevens was warning of bubble risk in the current low interest rate environment:

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 the next chart compares two “bubbles”.

Revisionist Thought_11

Please, Governor Stevens, start thinking smart!

Even a Great Stagnation requires planning!

In a recent post, Nick Rowe gives a short reply to DeLong´s long post:

Suppose you lived in a world where, whenever the price level fell/rose by 1%, the central bank responded by decreasing/increasing the base money stock by the same 1%. A world like that would not have a long-run Omega point, from which some present equilibrium can be pinned down by back propagation induction.

That’s the sort of world we live in, under the inflation targeting regime. A drunk doing a random walk does not have a destination, from which we can infer his route by working backwards. His long run variance is infinite.

Stop arguing about whether a market macroeconomy is or is not inherently ultimately self-equilibratingIt’s a stupid question. It depends. It depends on the monetary regime.

Instead, let’s solve the stupid question by adopting a nominal level path target.

It´s even worse. If you don´t plan, i.e. provide a “destination” for it, even a “Great Stagnation” becomes “random”!

The charts illustrate.

Destination Required_1

Destination Required_2

The first shows why the “Great Moderation” happened. The “destination” was the trend level path, to which the economy returned after monetary policy mistakes dislodged it. Observe what many called a period of “too low for too long” rates doesn´t look like that at all!

In the second chart, we note that after the Fed pulled the economy down, it has been satisfied in keeping it down, i.e. “depressed”. It could come out and say that that´s the path (“destination”) it wants it to follow. But no, by saying it´s about time to “tighten” policy, it is implying that the path might be even lower. Is it A? Is it B? The truth is no one knows!

It certainly does not appear to be X!

Related: David Glasner, Scott Sumner

Recently, Scott Sumner visited the St Louis Fed. It wasn´t for naught!

Today Bullard comes out of the closet with a euphemism:

The Federal Reserve should consider new policy options, including directly targeting a non-inflation-adjusted level of economic growth, after more than six years of sustained monetary easing failed to spur a boom, Federal Reserve Bank of St. Louis PresidentJames Bullard said Thursday.

“It’s time to question the current theory and explore other models about what’s going on at the zero lower bound,” Mr. Bullard said, referring to the Fed’s zero-rates policy that has been in place since December 2008.

Mr. Bullard was presenting new research conducted with three other economiststhat he says shows “the monetary authority may credibly promise to increase the price level…to maintain a smoothly functioning credit market.”

The model could be “broadly viewed as a version of nominal GDP targeting,” the paper says, referring to a policy in which a central bank would set a target for gross domestic product growth without an inflation adjustment. The idea would be to signal to markets and the public that the Fed is serious about generating a recovery, thereby spurring investment and spending.

John Williams cannot think “outside the box”

He can only think in terms of interest rates. Since that´s pegged at “near zero levels” he feels lost:

Policy rules also wouldn’t have done much for the Fed in recent years with interest rates pegged at near zero levels, Mr. Williams said in the text of a speech prepared for delivery before an audience at Chapman University in Orange, Calif. These rules would have argued for something not easily done, and that would have been for the Fed to have pushed short-term rates deeply into negative territory, he said.

Mr. Williams said the problem policy rules have with zero interest rates is probably not over. The use of unconventional policy stimulus like bond buying and other tools “are very likely to occur again in the future,” and rule-based policy-making will have nothing to contribute in such a scenario, he said.

Scott Sumner has just written a post that tries to understand the “stance” of monetary policy, and ends thus:

People are constantly telling me that my “tight money” theory of the 2008 recession is loony.  But I am never provided with any good reasons for this criticism.  I have no doubt that there are hundreds of macroeconomists who are much smarter than I am, but I do occasionally wonder if my profession is somewhat lacking in imagination.

Lack of imagination is exactly what John Williams (and his colleagues) exudes!