Tony Yates on Kocherlakota

In his further comments on Stan Fischer´s presentation at the AEA meeting, Kocherlakota writes:

Why has r* fallen so much and stayed so low, despite signs of improvement in the economy?  One reason is the diminished credibility of central bank objectives.

The Fed (and other central banks) have fallen short of their inflation and employment goals for many years, and are expected to do so for several more years to come.  The public’s beliefs about Fed long-run capabilities and objectives are evolving in response to these misses.  It should not be surprising that the Fed’s extended misses with respect to its objectives are fueling expectations of similar future extended misses – and are one factor that is pushing down on r*.

This analysis seems like yet another argument against the plan to continue to tighten monetary policy.  Doing so only serves to prolong the Fed’s long undershoot with respect to inflation and (more arguably) with respect to employmentThe additional erosion of credibility will create still more downward pressure on r*. (Note: r*   stands for the neutral rate of interest).

To which Tony Yates responds:

On Twitter last night, commenting on Stanley Fischer’s contribution to a panel at the American Economic Association meetings in San Francisco, outgoing FOMC member Kocherlakota expressed his scepticism about the wisdom of raising the inflation target.

However, credibility worriers also need to remember [and here I don’t finger Prof Kocherlakota for failing to] that in some respects raising the inflation target may improve the credibility of monetary policy and reduce inflation uncertainty.

By persisting with the current 2 per cent target, the Fed and other central banks risk further long episodes at the zero bound, and further protracted periods in which inflation is substantially below target [in the UK headline inflation has been about 0 for a year now], and corresponding uncertainty about whether the central bank can ever regain control over inflation.  If setting a higher target means reduced time at the zero bound, then it most surely means better inflation control, and enhanced ‘credibility’, in the sense of the reputation for competence and inflation forecasts that would follow from inflation turning out to be closer to the new, higher objective.

Nowhere does Kocherlakota mention a higher inflation target. That´s TY´s pet project. In any case, if the Fed does not seem to be able to hit the 2% target, how can we presume a 4% target is not only achievable but also enhances credibility!

Inflation is determined by monetary policy. If instead of associating monetary policy with interest rate policy (which becomes “ineffectual” at the ZLB) you associate monetary policy with NGDP growth relative to a stable trend path, you get nominal stability. In that case you not only avoid the ZLB but you get stable (and credible) inflation and stable RGDP growth.

Over more than 20 years prior to 2008, the Fed succeeded in obtaining nominal stability. That comes out clearly in the chart below where, particularly between 1993 and 2007 NGDP growth is quite stable (low growth dispersion). That stability (around a trend growth path) was lost in 2008 and the appropriate level path has not been regained.

Kocherlakota-Yates_1

Core inflation, which particularly during the 1993 – 2007 period had remained close to 2%, fluctuating due to real (productivity) shocks, since 2008 has mostly been below the 2% target.

Kocherlakota-Yates_2

Just like the 1970s showed that a rising NGDP growth path is inflationary, the last several years have shown that too little inflation results from too low NGDP growth (at a low trend path).

What that tells me is that it is high time to stop talking and worry about inflation and try to regain the lost nominal stability that the US economy enjoyed prior to 2008. Best way to achieve that is for the Fed to set an NGDP Level Target.

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Broadbent shows BoE going after the wrong target: the real economy

A James Alexander post

I had some hopes for fresh thinking due to the “outsider appointment” status of the Bank of England’s new’ish Deputy Governor for Monetary Policy Ben Broadbent. He wasn’t part of the clique around Mervyn King and the long-serving staffers like Paul Tucker the previous Deputy Governor who so messed up UK monetary policy in 2007-09.

His latest speech shows him falling into the very messy and confusing place, where central bankers love to be Kings of Discretion rather than Rule Abiding Good Citizens. He is so busy patting himself and his colleagues on the back for ignoring above target CPI in 2011-13 that he can’t see the damage he is causing and about to cause today.

We love teasing you, it makes us feel important

But he starts of by setting himself a pointless problem and then digs an enormous hole as an answer, partially digs himself out but then proves when you are in a hole you should stop digging.

 The previous Governor of the Bank, Mervyn King, once referred to what he called the “rich seam” of MPC communication. Rich or not, it’s certainly a wide seam: MPC members each give several speeches a year; we publish minutes of every meeting, now supplemented with a Monetary Policy Summary; every quarter we publish a 50-page Inflation Report that summarises the MPC’s collective view of the economic outlook and includes our latest forecasts; every Report is followed by a session in front of parliament’s Treasury Committee. Yet, from all this, the outside world seems increasingly interested in only one particular nugget: the MPC’s central inflation forecast two years ahead.

The answer is simple: the Monetary Policy Committee sets monetary policy based on their forecast of inflation two years away. Inflation is always said by the Governor and his colleagues to be on target or off target by this “medium term” forecast. Of course, we all watch the forecast, that’s the world the BoE has created. The idiotic thing is that the forecast depends on the ever-so-slightly-circular market-implied BoE interest rate forecast, as created itself by nods and winks from the BoE.

The problem is that the “data” is very stubborn and near term inflation refuses to rise in line with the forecasts to allow the BoE to follow its desired rate normalisation path.

This is because their simple Philips Curve model of the world is wrong. Some would like to see the model and the results it produces, but for Market Monetarists it wouldn’t tell us much we don’t already know about their “slack theory” of inflation.

Slack being taken up does not lead to wage pressure and so does not lead to price pressure. Aggregate Demand, or rather aggregate nominal spending, drives prices up and that pulls wages up. And aggregate nominal spending is set by NGDP growth expectations. For all Broadbent’s protestations of the BoE having a flexible inflation target, the market is a better prophet.

The market can see the BoE’s obsession with the mid-point of its two-year out inflation forecast. But there really is no need to actually raise rates if the BoE is on target with its target as we said a few weeks ago. The market will anticipate the rises in rates and cool-off its expectations accordingly. This cooling-off acts as a break on nominal spending growth, in turn causing inflation to never rise as expected by the BoE. We are thus stuck in a self-defeating loop.

“Long and variable lags” the standard cop out of  today’s bankrupt monetary economists.

Broadbent sets up three scenarios in the face of a “cost shock” sending inflation up by 2% to 4%. The second question he asks is how to get it down. Quickly. Slowly. Or, weirdly, “Drunkenly”? Actually, methods don’t matter, the fact that it must be brought down is all important. It’s not a flexible target, it’s still a 2% target. It is merely a flexible amount of time to bring it back to 2%. And it is gradually squeezing the life out of the recovery. It’s not too late to react, and the BoE probably will, just in time, but their reaction time is too slow.

Shouldn’t the policy horizon simply be the shortest time delay between changes in interest rates and their impact on consumer prices? Well one problem is that one can’t be entirely sure about what that delay is. As a famous economist once said, monetary policy seems to operate with “long and variable” lags.

It is funny how Milton Friedman is wheeled out repeatedly for this hoary old chestnut. He was really on to scare politicians and policymakers out of trying to fine-tune the economy. Friedman was probably just wrong on this point, as rational expectations theory has shown and the markets demonstrate day in day out by reacting immediately to unexpected changes in monetary policy, and to unexpected inaction in monetary policy to changes in the economic outlook. It is hard to see why it has gained status as a near religious truth.

Interestingly, when Milton Friedman said lots of other things he gets ignored or ridiculed, especially by Keynesians when it comes to his supply-side views on economics. More importantly, he also said that often you can’t tell the stance of monetary policy by the level of interest rates. He also ridiculed the idea of cost-push inflation.

Didn’t they do well?

I think this had real relevance at the time I joined the MPC, in mid-2011. At that time … After a tepid recovery there was still plenty of spare capacity in the economy. Companies said they were operating well below capacity; unemployment was still high. But thanks to a series of cost shocks, including the big depreciation of sterling’s exchange rate 2-3 years earlier, inflation was nonetheless well above target.

In response, the MPC … took a more balanced approach. As I tried to explain in a speech I gave later that year, the MPC had arguably tolerated the (then) high rate of inflation for longer than it might have done because the real side of the economy was so weak.

It signalled this choice more explicitly in early 2013. Following a further depreciation in the currency, rises in administered prices and the prospect of continued weak growth in productivity, inflation was thought “likely to remain above target for much of the forecast period”. But “attempting to bring inflation back to target sooner…would risk derailing the recovery” and it was therefore “judged appropriate to look through the temporary, albeit protracted, period of above-target inflation”.

Was it so difficult in 2011 to look through headline CPI? Look at core inflation back then.

JA Broadbent_1

And the more appropriate measure to steer the economy, the GDP Deflator, was running at or below 2%. Of course, RGDP was certainly weak and falling. And the combination of the two, NGDP, was also weak and falling. In 2013, there was some modest recovery but we know how the BoE is currently squashing that with all its contractionary talk of rate rises sooner rather than later.

JA Broadbent_2

 Quoting Svensson only when it suits, but are they symmetrical?

I don’t think this was so exceptional. There is no inflation-targeting monetary authority that behaves so rigidly as to attempt to offset all shorter-term shocks to inflation, no matter the effects on the variability of interest rates and output. As the economist Lars Svensson puts it, “in practice, inflation targeting is always ‘flexible’, because all inflation-targeting central banks not only aim at stabilizing inflation but also put some weight on stabilizing the real economy”.

While it is great to see the magpie Broadbent quoting Svensson what would Svensson be saying right now about the UK? Is he saying that now the UK is near “full capacity” and there is no need to get inflation back to target? I don’t think so. I think he’d be warning of the dangers of Japanese-style deflation, not fussing about when the next rate rise would be like Carney, or teasing the market, Broadbent-style, about the way to read or not to read the BoE’s intentions.

Broadbent indicates that the BoE is not targeting inflation but real variables

What is the BoE really up to? Well, actually, it appears to be trying to steer the real economy, and I’m not sure that’s their job or that it is possible. In three charts from his speech Broadbent shows the correlation between economic variables and average votes on the MPC to change rates.

JA Broadbent_3

The strongest, in fact the only meaningful, correlation is with real economic variables (Chart 3). But the real economy is a residual between nominal growth and inflation. And that is not a central bank job as all textbooks and mission statements will tell you.

They are not trying to steer inflation (Chart 2). This is good, because that is very tricky trying to steer the residual between real and nominal growth, even though it is what they should be doing according to their mission statement. So, sort of bad, too.

They are also not steering a form of NGDP (Chart 4, I think). This is bad as that is what they can actually steer, aggregate UK demand or nominal spending. And by not looking at NDGP they make big mistakes, causing instability in RGDP. They missed the rapidly declining NGDP in 2Q08 and appeared unconcerned by 3Q08, half-heartedly focusing, instead, on the banking crisis they had caused. Then, they are shamefully guilty of the four successive quarters of negative NGDP from 4q08 onwards with its appalling impact on RGDP, unemployment and lost growth.

They need to pay attention now as NGDP shows a bad trend in the UK, declining to 3.4% in 2Q15 and looking lower again in 3Q15. Broadbent needs to wake up and stop this somewhat smart-alec self-congratulatory lecturing.

UK Socialists show interest in NGDP Targeting, BoE proxy moans

A James Alexander post

Scott Sumner is both warming up to Bernie Sanders and getting excited by growing signs of acceptance for Market Monetarism. In the UK we seem to be getting both things in the one package.

Writing in the Financial Times our new, “hard-left socialist”, senior opposition spokesman on finance, Shadow Chancellor of the Exchequer John McDonnell, has said he is interested in NGDP Targeting.

McDonnell has created a group of leading, if left-leaning. macro-economists to advise him on macro-economic policy. Their first job is to lead a review of the Inflation Targeting mandate of the Bank of England. The group includes many names familiar to Market Monetarists like Adam Posen, David Blanchflower and Simon Wren-Lewis. We know them because of their willingness to debate about NGDP Targeting and even broadly accept it as at least partially useful – though they all prefer active fiscal policy at the ZLB over what they consider to be unconventional monetary policy.

“The last time the Treasury tweaked the MPC’s remit was in 2013, when George Osborne, chancellor, clarified that the committee need not force inflation back to the target by the fastest possible route if a slower one would be better for growth. We will consider whether such trade-offs should be formalised. And we will look at more radical ideas, such as introducing a target for nominal gross domestic product — a suggestion Mr Carney broached in 2012.”

This is great news.

The diehards at the Bank of England won’t like it. An initial response from one of the leading UK economist who often represents mainstream BoE views was distinctly lukewarm.

Tony Yates even addressed himself to the NGDP Targeting idea:

“I’ve blogged a lot about this before, and haven’t the heart to repeat it here.  Very briefly.  Growth targets would not make a whole lot of difference.  Levels targets rely on being a rational expectations nutcase, and even then would probably be incredible.”

The attack on Rational Expectations is the oddest thing. It’s not clear what his problem with RE really is. It’s very hard to figure out. Yates is clearly a clever guy, but like most central bankers and their supporters, they distrust markets and prefer discretion. Yates seems to think that elite central bankers sitting around a table with lots of different models, lots of data and super-smart intuition is better than clear rules. We only need to ask how that worked out in 2008 to see what was wrong: internal politics, confusion and hopeless or downright counter-productive signalling. To recognise that central bankers were the prime cause of the recession is a step too far for the self-same central bankers and their proxies.

From an earlier anti-NGDP Targeting piece Yates demonstrates clearly the knots he ends up tying himself in when thinking about RE:

“Policymakers at the BoE used an RE model, but when they thought it was relevant, would often adjust forecast profiles by hand afterwards to try to offset what they thought were the effects of rational expectations.  (Highly unscientific and hopelessly imprecise in doing it this way, but well-intended).  However, whether central banks assume RE or not, it’s not a good defence of a regime that it works well in a false world those central banks happen to believe in.”

Who’s the nutcase?

Update. Excellent blog from Ben Southwood at the Adam Smith Institute.

UK academic economists should (and need to) work with markets not ignore them

A James Alexander post

Tony Yates has directed me to take a course in monetary economics. It seems like it would last a year at least. I would then be better able to understand the deep and meaningful research that tackles the Market Monetarist questions posed by me in a comment on his blog:

“Most of them are discussed at length in the applied monetary econ literature. Many not resolved conclusively. If someone paid me to do this, I would take you through it all, but it would take a couple of terms to take you through it. But don’t fire them thinking that somehow these are great mysteries central bank economists aren’t already thinking about, and that aren’t already dealt with in frameworks they are given and how they are applied. They are.”

For what it’s worth, I did take the shorter, but still challenging course on Scott Sumner’s blog, as well as slogging through a BSc Econ more than a few years ago.

I think Yates’ course might be interesting but would it really help me with my questions.. The blogsphere is alive with debate on them and sometimes academic papers are referred to, but most seem unsatisfactory in one way or another.

Anyway, would they help answer this question: Would you ever create a model that included occasional, but deeply random tightening and loosening of monetary policy by central banks?

To this one he answered: “Yes, if you thought central banks faced measurement error in real time, or changes in committee membership that meant changes in the preferences of the median committee voter. Have a look. Large literature on just that.”

However, this misses the point somewhat. It is not just a “measurement error in real time” that markets are dealing with. They want to know: What is the Fed or the BoE trying to measure? What are they targeting? These are deeper questions than mere “measurement error”.

And why have central banks picked 2% as the inflation target? Where is the rigorous model on that? Where is the academic model for that 2% becoming a ceiling?

The market understands all this confusion, or as Yates’ sweetly put it “many [questions are] not resolved conclusively”. The markets actively try to sum it all up in prices, in real time. Yates et al’s beloved “long and variable lags” are merely the arithmetical part of the markets’ realtime NPV calculations.

So why not use that market consensus, on the state of the economy (aka “real time measurement error”) and the state of mind of the central banks (aka “changes in committee membership that meant changes in the preferences of the median committee voter”),  to steer monetary policy. That is, use targeting of market forecasts for NGDP Level Growth?

Why the fear of markets?

It’s a real puzzle. I suspect many academic economists, UK ones especially, under-rate the market because they are so far removed from it. Most have final salary pension schemes, or presumably like Yates, also Bank of England/civil service like gold-plated, index-linked, unfunded ones. They think they have no direct stake in the markets and end up being dismissive of the whole thing.

I would recommend they go and sit and ponder the £5bn deficit in the academics’ own pension scheme and worry about how to fund those far-off liabilities, the ones linked to future inflation and future interest rates and many, many other assumptions about the future. And find investments that can deliver against those assumptions in a low-risk, low volatile way, via real financial and other assets. It’s tough.

Great and serious minds worry about this question. UK academic economists seem oblivious, yet their financial future rests on their fund making the right investments. On forecasting how markets will turn out. It’s not just an academic exercise but a real one. Markets are for real people like you, too, not just speculators.

Of course, maybe they expect the government to nationalise the university scheme like it did with the UK Post Office, take the assets, reduce the public sector debt and just add yet more unfunded liabilities onto the state sector balance sheet. Or rather off the balance sheet. Nationalisation would reduce some risks as it would provide a state guarantee. But what will the guarantee be worth it in 30 years time given the restrictions already starting to be imposed? Not trying to worry you guys or anything.

Never reason from a liquidity crisis

A James Alexander post

Tony Yates tips his hat with more respect that in previous posts towards NGDP Targeting.

Re-reading his earlier “silly” post I was struck by this comment he made in reply to some of the commenters:

“NGDP targeting would not have helped avoid the financial crisis. That was caused not by bad monetary policy, but by bad financial regulation policy”.

He was picked up on this by both Andy Harless and one other, but Yates kept mum. Why?

I suspect he can’t go there because his long time at the Bank of England turned him into something of an apologist for his alma mater. Benjamin Cole has complained here about the same sort of thing in the US.

Dan Davies, another sometime Bank of England employee and sometime apologist, has written very insightfully about the demarcation lines between the elite macroeconomists at the Bank of England and everyone else, in particular the grubby lot doing banking regulation. [Apologies to readers but I can’t find the link … it may have been an e-mail from when he was a banker]. They were always regarded as second-raters. Yates unconsciously reinforces that in his website bio:

“I worked for 20 years at the Bank of England in its Monetary Analysis directorate, the part of the Bank devoted to the setting of monetary policy.”

He has to make it very clear that it wasn’t in the lower ranked parts of the central bank, inhabited by dumb financial regulators, who failed to control those smart but evil guys at the banks.

But if it weren’t the banks or their regulators who caused the crisis then who was to blame? Yates and the all too numerous academics who move in, out and around the central banks have too much at stake to hold their hands up and take the blame. They can’t face the embarrassment. But it was them.

And this is probably the reason we hear so little criticism of the Bank of England’s monetary policy or that of the Fed or the ECB in precipitating the 2008 and 2011 crises. They really are “all in it together”. And like any good trades union, united they stand divided they fall.

Well paid bankers make easy villains yet the liquidity crisis that brought them low was a central bank failure.

Yates pompously suggests Market Monetarists should stop writing and go and create some mathematical models, but if I were to put in a function for “catastrophic failure by central banks to stick to targeting core CPI and in fact actively tighten policy or threaten to do it in the face of falling NGDP expectations” how would that go down?

I suspect I wouldn’t get much funding from Yates and his cronies who stuff the academic funding bodies or see it published in one of the hundreds of central bank academic journals. It may be wordy to call most modern macro a closed shop, but it’s true.

If Yates can so easily toss off populist comments that it was all caused by evil commercial bankers and useless regulators then there is plenty to argue about over the internet.

The FOMC, “money” and Acrobat reader

A James Alexander post

My last blog might have got a little carried away with analogies. The import might thus have been lost of my killer quote from what Yates called the “classic survey from 1999 … [where] … there has been a torrent of work since, reconfirming this basic message” of how monetary policy has to operate.

While this paper by Christiano, Eichenbaum and Evans does not support Yates view of long and variable lags view it also asserted the centrality of the growth rate of money as the central test of monetary policy.

“To actually implement a particular monetary policy rule, the growth rate of money must (if only implicitly) respond to current and past exogenous shocks in an appropriate way.”

It’s funny but I had not really thought that this would have been controversial today. I thought it was just a statement of the bleedin’ obvious. What else is monetary policy other than the supply of money? It’s what a central bank does.

Yet read Yates and there is no money supply in his model. Wierd or what? I was then musing worriedly like the rest of the world about just what the FOMC were really on about in the extensive minutes published of their July meetingThe ones that when published on August 19th triggered the latest global sell-off.

They read just like any competent economic survey or macro investment report on the state of the economy. “On the one hand this, on the other hand that”, etc, etc, perhaps a bit overlong. Actually way too long. TBH I gave up and skimmed after the first two thousand words or so.

But then I thought, hey, this is the supreme monetary authority of the world  what do they say about the growth rate in the money supply, their key weapon in implementing monetary policy as stated by Yates’ “classic survey”. Well, I was not going to read the whole 8000 words when I have Acrobat’s word search function.

(To be fair the first 600 words or so is a list of the eighty, yes 80 attendees at the discussions of what was partly a joint meeting of the Fed’s Board of Governors and the FOMC and all their official titles. The list includes three “Economists” and six “Associate Economists”. Perhaps this might be another post as everyone knows that discussion meetings with more than 6 or so people are completely pointless. And also presents very serious issues with keeping any sensitive matters secret, again limiting discussion.)

My word search didn’t seem to work. There was no mention of the money supply. There were only two mentions of money at all, both as in “money market interest rates”. I tried “monetary conditions”, but no joy.

“Monetary” came up frequently, as in the two “Deputy Directors of the Monetary Affairs Division” (plus one Assistant Director), the Division’s two Senior Advisers (plus one plain Adviser), one Associate Director (plus his deputy), one Project Manager, one Section Manager and, of course, their own Senior Economist. I guess if the actual Director had been there too the room might not have been big enough.

“Monetary policy” came up a lot too – sadly mostly in the context of the “normalization” of it, and we know that only means one thing – tightening.

I then had to re-skim the 8000 words to see if the discussion on monetary conditions or the money supply was somehow encoded elsewhere. But no, it wasn’t. Nothing. Nada. If anything monetary conditions, at a stretch, seemed to be associated with whatever the interest level was: a low rate means easy money, without actually looking at the growth rate of the money supply itself.

It’s a sad thing that on the verge of a momentous policy decision to start actively tightening, sorry, normalizing, monetary policy there is no discussion or investigation whatsoever into actual monetary conditions. As I said, weird or what?

Monetary policy has, of course, been actually tightening as the debate has heated up – witness the carnage in markets, and well, the zero growth in the money supply.

Oh, and as you survey your stock market investments, don’t forget they tell you nothing about the effect of monetary policy, it only operates with long and variable lags.

Show me the money

A James Alexander post

I am not a wonk, and barely an expert. This is a bit wonkish, but still worth reading for the non-expert. Mark Sadowski inspired it!

In Tony Yates’ reply to my earlier post he cited two academic studies that would presumably show me that what financial markets know to be true, was in fact false.

Yates and the “long and variable lags” brigades who flourish inside our central banks and elite universities remind me of quack doctors in the world before the discovery of the circulation of blood. They prescribe remedies for which they have no agreed scientific basis, but don’t really get tested because if the the patient recovers they win, if the patient dies it was because the disease was proven uncurable. We only find out the effects of their hit and miss cures at the end of the treatment.

For anyone wanting a quick read on just what a mess modern, consensus, macroeconomics is in the Wikipedia entry on the standard paradigm. “New Keynesian” reads like a discussion between two competing schools of seventeenth century apothecaries. No-one has a clue, but they definitely know the other side is wrong.

Modern doctors prescribe cures to which they generally know the results. Start this course of drugs now and in a certain period of time you will be cured. Setting the course is everything. If doctors didn’t know ibuprofen stopped most headaches they wouldn’t prescribe it. The long and variable lag from the taking the pill to the headache going is completely irrelevant.

Curiously, the first paper Yates cited (Christiano, Eichenbaum and Evans) is actually in agreement with the supposedly “utopian” Market Monetarists. It’s hard to know why Yates brings it up, but thanks anyway. The paper contains a crucial quote:

“To actually implement a particular monetary policy rule, the growth rate of money must (if only implicitly) respond to current and past exogenous shocks in an appropriate way. This is true even when the systematic component of policy is thought of as a relationship between endogenous variables, like the interest rate, output and inflation.”

Put simply, monetary policy changes have to act quickly on money, on the money side of the economy itself (the MV bit of MV=PY). If it isn’t acting, or expected to act, it isn’t working.

Market Monetarists say you can tell if it is working instantaneously by looking to see if the size of the money economy is expected to grow. Scott Sumner’s great contribution is to suggest a “money economy” growth futures market, or NGDP futures market. It would be the equivalent of all the best medical brains putting their money where their mouth was, or reputations on the line. Doctors in medicine do this today, everyday, by earning money through proven, successful treatments. Setting courses, more or less knowing the results – not much waiting around to watch the long and variable lags. They act with confidence in the outcomes of the courses they set.

In the absence of futures markets we are forced have to use somewhat unsatisfactory substitutes like market forecasts of inflation (in the US TIPS spreads), or other forward-looking instruments like stock market indices and bond yields, or FX rates that incorporate the expectations of one currency’s inflation prospects vs another (amongst other things).

The market’s reaction is the policy. When the market reacts to unexpected data points or new news in FOMC speeches, decisions, leaks, minutes, etc, then that tells us how the policy is changing. Immediately. Instantaneously. With no lag. Unexpected silences from the Fed in the face of big market moves can also be telling, as now. It is harder to interpret than unexpected news, but it is still there.

Yates directed me to his own co-authored paper but it seems as weird as most modern macro in that it has no role for money. The equivalent of those quack doctors working without knowledge of the circulation of the blood. When writing about monetary policy with such authority as Yates and so many macroeconomists like him, the plain man would expect money to figure in their highly technical models of the economy, but it doesn’t. No wonder Yates and so many central banks like the Fed, the BoE, the ECB who use the same moneyless-model have proven so hopelessly wrong during the crisis. Their model is literally and metaphorically bankrupt due to the absence of the key measure of monetary policy, money or the money economy itself.

 

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.

The 2002-04 period in the limelight once again

Tony Yates:

It’s highly contestable that the Fed set too-loose monetary policy in the early 2000s.  Bernanke made a stern and convincing case in favour of what they did while still Fed chair.  He pointed out that if you substituted inflation for forecast inflation in the Taylor Rule, for which a convincing case can be made that one should, you find that Fed policy was not too loose.  Specifically, rates were so low because the Fed were worried about deflation, and the zero bound.  They had watched what they saw as slow and weak Bank of Japan monetary policy, and had seen its consequences, and were doing what they could to avoid that experience being repeated.

David Beckworth in the comment section of Yates´post:

I would note that one of the largest surges in U.S. productivity growth occurred between 2002-2004. This was a well publicized development and raised trend productivity growth as seen in consensus forecasts at the time. All else equal, this development would imply a higher natural interest rate and lower inflation. Ironically, following a Taylor Rule-like reaction function can cause monetary policy to be too easy given these developments. It is more pronounced when the Taylor Rule uses forecasted inflation.

George Selgin, Berrak Bahadir and I build upon these papers and others by showing how the 2002-2004 productivity surge lured the Fed into complacency during the housing boom. We do not say it was the only cause for the boom or that the easing was intentional, but only that it failed to properly handle the productivity surge. And that is how it contributed to the boom.

In addition, David Beckworth has a post on the topic:

George Selgin, Berrak Bahadir, and I recently published an article that lends support to John Taylor’s view of Fed policy during this time. It received some pushback from Scott Sumner who is sympathetic to both the saving glut and secular stagnation views. At the same time, Tony Yates provided a critique of John Taylor’s argument on the financial crisis that was heartily endorsed by Paul Krugman. So the debate over the Fed policy during this period continues.

A little over 4 years ago, I did a lengthy post on this topic under the title “BERNANKE´S GSG HYPOTHESIS: A COP-OUT”. In that post I gave a coherent explanation of why house prices took off in late 1997 (long before the period of interest rate being “too low for too long”).

In their paper, BBS put a lot of emphasis on the productivity surge, a fact that tends to lower inflation and increase real GDP growth, so that if the Fed reacts to the fall in inflation below target by “loosening” monetary policy, it will cause instability.

I want to tell an alternative story, the conclusion of which is that monetary policy in 2002-04, particularly after mid-2003 was, to use an expression favored by Greenspan, the “appropriate monetary policy”.

The model behind the story is the dynamic aggregate demand-aggregate supply model, and the stance of monetary policy is defined by NGDP relative to trend. If NGDP is above trend monetary policy is “easy”, if it´s below trend, monetary policy is “tight”.

As the pictures illustrate, the “problem” began in late 1997. At that point, productivity started to increase above trend (a positive productivity shock). At the same time, oil prices fell, impacted by the fall in demand following the Asia crisis. From the vantage point of the US, this is also a positive supply shock. As a result, inflation fell way below “target”. Meanwhile, monetary policy became “easy”, with NGDP rising above trend (as did RGDP).

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In 2001, monetary policy tightened, with NGDP falling back to trend. However, the tightening was excessive, with NGDP falling below trend (as does RGDP, which contradicts Beckworth´s argument that the economy was “overheating during the housing boom”).

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From late 2001, a positive productivity shock was accompanied by a negative oil shock. After late 2003, it appears that the negative supply shock from rising oil prices was stronger than the positive supply shock from productivity. This is consistent with inflation picking up.

At that point it appears that the easing of monetary policy – forward guidance – guiding NGDP back to trend coupled with a slight leftward shift in the aggregate supply curve resulted in inflation moving back closer to target.

As the house price chart shows, throughout 1997 – 2005, house prices were on the rise. That story is quite separate from the monetary policy story. From late 1997 to late 2004, the Fed lost and regained nominal stability. It was left to Bernanke´s Fed to lose it “majestically”!

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What would we be hearing from the Fed if, instead of 0.3% headline 1.4% core, we had 2.9% headline 1.7% core?

Any doubt they would raise rates immediately (through a Conference Call)? However, that was the combination that existed in September 2011 (“9/11”), when QE3 was still to come!

Today both headline and core are far from target, but Yellen is all the time “justifying” the need for a rate increase soon:

“Policy makers cannot wait until they have achieved their objectives to begin adjusting policy,” Fed Chairwoman Janet Yellen said last week in a speech:

“I would not consider it prudent to postpone the onset of normalization until we have reached, or are on the verge of reaching, our inflation objective.”

The “heartbeat” of nominal and real growth has not changed during this time, remaining close to 4% and 2.2%, respectively year on year.

Yellen´s Fetish_1

Overall, both measures of inflation have been well below target for most of the time since 2008.

Yellen´s Fetish_2

What has changed is unemployment, which has dropped from 9% in September 2011 to 5.5% in February 2015 and is getting “dangerously close” to her latest “estimate” of NAIRU (5% – 5.2%)!

Yellen´s Fetish_3

She should remember James Tobin, her thesis adviser at Yale who, on the year she was awarded her PhD, 1971, wrote “Living with Inflation”. Only now she wants to change that a bit and push for “Living without inflation”!

So I find Tony Yates´ “insistence” on raising the inflation target “romantically naïve”!