The Fed must be happy. The employment numbers “confirm their view”!

From the WSJ “Economists react”:

“For the [Federal Open Market Committee], the unexpected 292,000 jobs added in December, and the upward revisions to October and November, will bolster their case for four rate hikes this year. Markets are desperate for good news, and now have it, but it comes with a caveat because better employment growth means the Fed will raise rates faster.” —Beth Ann Bovino, Standard & Poor’s Ratings Services

From Bill Gross:

The Fed does believe that jobs and the unemployment rate is critical to future inflation over the medium term,” Gross said. “So the three or four Fed steps that Stan Fischer and Janet Yellen seem to confirm are probably on track, at least in their verbiage.”

They are right. That´s the way the Fed thinks. But it is dangerous and wrong! Insisting on the mistake will likely lead to another recession. Larry Kudlow (HT Lars Christensen) also rants on the Fed´s mistaken view.

Fed should not make policy based on labor: Kudlow

Some illustrations for the past 22 years will help identify the mistake.

The first chart shows no connection between unemployment and inflation. While unemployment has “travelled widely”, core inflation has remained low and stable (on average below the 2% target)

Fed Happy_1

Note how inflation and unemployment reacted to the productivity shock of the late 1990s. Note also how the negative AD shock of 2008 affected unemployment and inflation.

Many at the FOMC like to appeal to “special causes” for the low inflation. A favorite is oil prices. However, the next chart shows that while oil prices have “jumped & tumbled”, core inflation has remained subdued.

Fed Happy_2

Note that in 2007-08 the economy was buffeted by both a negative AD shock and a negative supply (oil) shock. In that case both the AD curve and AS curve shift to the left. This solves the “puzzle” frequently mentioned of “why didn´t inflation fall even more”. The negative AS shock “supported” inflation. However, the negative AD shock was so strong that it ended up “annulling” the supply shock, with oil prices tumbling, at which point inflation dropped.

And Lacker is worried about an “inflation conundrum” (title has changed)!

Now, let´s look at things from a NGDP perspective.

Fed Happy_3

Much better, I think. The productivity shock after 1997 reduced unemployment and inflation. Keeping monetary policy (NGDP growth) steady was key to the outcome. However, in 1999/00, NGDP growth was a bit excessive and the reaction resulted in too much tightening. In 2003-05, the mistake was corrected, with unemployment falling and inflation remaining close to target.

Bernanke reacts to the oil shock by tightening monetary policy (allowing NGDP growth to fall unadvisedly (“let´s ball drop”). The mistake was compounded by “losing the ball”, after which the “net was permanently lowered” i.e. NGDP growth never rose sufficiently to take spending to the previous trend level.

Additional information is provided by the NGDP growth, RGDP growth and oil prices:

Fed Happy_4

During the first leg of the oil shock in 2002-05, monetary policy was “expansionary”, to offset the previous “tightening”. Note from the second chart from the top, that inflation remained well behaved. Despite the oil shock, real output growth rebounded. Bernanke “dropping the ball”, combined with the second leg of the oil shock, strongly decreased real growth. When the “ball was lost”, real growth tanked. The price of oil tumbled as a result of the strongly negative AD shock.

The oil shock effect on output was something about which Bernanke had written in 1997, concluding:

Substantively, our results support that an important part of the effect of oil price shocks on the economy results not from the change in oil price per se, but from the resulting tightening of monetary policy.

This finding may help explain the apparently large effects of oil price changes found by Hamilton (1983) and many others.

He certainly proved his point in 2007-08!

What the above discussions tells me is that monetary policy should not be informed by the rate of unemployment, what´s happening to oil prices or whatnot. A focus on NGDP growth relative to a “desired trend path” is all that´s needed.

The Fed seems to be making the same error again, this time by focusing on unemployment instead of oil prices.

Ever since the NGDP growth “net” was brought (insufficiently) up in 2010 and until mid-2014, trend NGDP growth was close to 4%. Since then, it has trended down dangerously:

Fed Happy_5

So it´s not at all surprising to see real and financial indicators also going south. Just to give two examples; the Institute of Supply Management diffusion index (ISM) and long term inflation expectations from the 10 year breakeven.

Fed Happy_6

If these trends continue, and the Fed seems set on keeping them going, the likelihood of a recession will be increasing as the year progresses.

Update: Stephen King gets it right:

Conventional wisdom suggests lower oil prices should provide a shot in the arm for the global economy. In current circumstances, however, lower oil prices may simply be providing over-enthusiastic central bankers with an opportunity to shoot themselves in the foot.

Cautionary advice from a former Fed Staffer

In Why It’s Still Too Early for the Fed to Start Raising Interest Rates, Andrew Levin writes:

The Federal Reserve has signaled that it will begin raising short-term interest rates at its Dec. 15 meeting. The Federal Open Market Committee has maintained its federal funds rate target close to zero for seven years, and it has frequently described the removal of monetary policy accommodation as “normalization.” So many will infer from this decision that the Fed judges the economy to be sufficiently close to “normal” to warrant the onset of tightening. Yet current economic conditions are not consistent with this action, and starting the tightening process now would pose substantial risks to the Federal Reserve’s statutory goals of maximum employment and price stability.


All of these considerations indicate that, instead of starting to remove monetary accommodation, the Federal Reserve should maintain its current policy stance until the employment shortfall has declined further and core inflation is moving definitively back toward its target.

He´s right. It´s nothing like Blinder´s “Be calm and carry-on”. Everyone should really be concerned that the Fed is likely to badly blunder once again, something that has been going on for almost a decade!

Levin makes comparisons to the 1990 and 2001 recessions, and the “tightening” that followed on the steps of the recoveries, where by tightening he means the rate “lift-offs” that took place.

The panel below shoes how dismal the Fed´s performance has been since Bernanke took the helm, which he passed on to Yellen early last year.

Compared to the 1990/91 recession, the 2001 recession was mild, more like a growth recession. Nevertheless, the recovery was protracted because the Fed “held spending growth back”.

Note that despite a comparative strong spending rebound following the 1990/91 downturn, inflation kept going down and twenty years ago reached the “gotcha (2%) level”. Since then, it has much of the time stayed below that threshold.

After managing to depress spending to an extent not seen since 1937/38, the Fed has been quite casual in bringing it back, actually stopping the process “short”.



Given the economy´s depressed state that resulted from the momentous monetary blunder, many feel that the “reserve cavalry” has to come to the rescue!

Greenspan´s last 10 years and Bernanke/Yellen´s first Decade

Greenspan´s first 10 years

No visible difference in the behavior of inflation, which remained closer to “target” during Greenspan´s last decade.

There´s a big difference in the behavior of unemployment, much lower during Greenspan´s tenure.

The defining difference is in the behavior of nominal spending (AD or NGDP) growth, which translates into a significant difference in the growth of real output.

Note than in 2001, when Greenspan allowed NGDP growth to drop below trend, unemployment goes up and stays up until NGDP growth returns to trend. In 2008, unemployment soars when NGDP growth tanks and becomes negative. The yellow bar shows that when NGDP growth stops falling, unemployment “levels off”, beginning to fall when NGDP growth becomes positive once again.

Unfortunately, the Fed this time around chose an inadequate level of spending growth. The result is that the economy got stuck in a “Great Stagnation”, defined by a level of real output and employment well below the previous trend level!

To get out of this trap, the monetary policymakers have to start thinking outside the “interest rate box”! From all the nonsense we hear from them, that is not likely.

Jeffrey Lacker strongly mis contextualizes

In a recent interview, Jeffrey Lacker, when answering the question “So why haven’t we seen faster inflation?” said:

… the historical evidence suggests that there’s some lag before things accelerate as you reduce slack significantly. In 1966-67, we had unemployment at 5 percent, we pushed it to 4, and it was 1967 and 1968 when inflation took off. So there was a significant lag in the way that relationship seems to have worked in the past.

That only shows the degree of his ignorance about economic contexts. As Arthur Okun, an important player throughout the 1960s, and the economist that “invented” the concept of “potential output” reminisces:

“The strategy of economic policy was reformulated in the sixties. The revised strategy emphasized, as standard for judging economic performance, whether the economy was living up to its potential rather than merely whether it was advancing…the focus on the gap between potential and actual output provided a new scale for the evaluation of economic performance, replacing the dichotomized business cycle standard which viewed expansion as satisfactory and recession as unsatisfactory. This new scale of evaluation, in turn, led to greater activism in economic policy: As long as the economy was not realizing its potential, improvement was needed and government had a responsibility to promote it.

The objective was to promote brisk advance in order to make prosperity durable and self-sustaining…The adoption of these principles led to a more active stabilization policy. The activist strategy was the key that unlocked the door to sustained expansion in the 1960s”.

Furthermore, to the economists at the CEA:

The stimulus to the economy also reflected a unique partnership between fiscal and monetary policy. Basically, monetary policy was accommodative while fiscal policy was the active partner. The Federal Reserve allowed the demands for liquidity and credit generated by a rapidly expanding economy to be met at stable interest rates.

However, as Okun recognized:

The record of economic performance shows serious blemishes, particularly the inflation since 1966. To some degree, these reflect errors of analysis and prediction by economists; to a larger degree, however, they reflect errors of omission in failing to implement the activist strategy”.

Funny how often policymakers and commenters fall prey to the “it wasn´t enough” argument, in this case not “activist enough” or, more recently, “the 2009 fiscal stimulus wasn´t big enough” or was “reversed too soon”.

The above is far from being a description of the present context.

I think these points from Ryan Avent´s “Simple rules of thumb” are very relevant to the present context (just as they would have been 50 years ago). They are also consistent with my preference for “experimentation” instead of “estimation” (of all the “naturals” – interest rate, unemployment, output) to which much time and effort is devoted mostly in vain!

4) We know what an economy with way too much demand looks like. It has high and accelerating inflation.

5) We know what an economy with way too little demand looks like. It has high unemployment and deflation.

6) Within those two extremes, it can be tricky to identify exactly where an economy stands: how close or far away from potential output it is.

7) Both too much and too little demand are economically costly, but history suggests that too little demand is far more economically costly and politically risky than too much demand. So policy should err on the side of too much demand rather than too little.

How does “now” compare to the 1960s? For one thing, demand (NGDP) is growing at a relative trifling rate. The charts also indicate that the unemployment rate doesn´t add anything to the story, especially because the unemployment numbers are just not comparable.

Rules of Thumb_1

What happened between those two extremes? Following the 1960s, nominal aggregate demand growth (NGDP) took off at a rising rate (the scale in this chart is different from the others). Inflation was also up with spikes reflecting the oil shocks of the decade that reduced real growth and increased unemployment. Later, during the age of the “Great Moderation”, demand growth was just about right; inflation remained low and stable (with swings reflecting supply shocks).

Rules of Thumb_2

The images are telling us that the FOMC would be much more productive if, instead of eternally grumping about inflation, it moved on to experiment with level targeting nominal aggregate demand (NGDP).

Yellen´s unchanging beliefs

The pity is that they are wrong beliefs! From the September 1996 FOMC:

I believe that a very solid case can also be made for raising the federal funds rate at least modestly, by 25 basis points, on the grounds that the unemployment rate has notched down further, the decline in labor market slack is palpable, and the odds of a rise in the inflation rate have increased, whatever the level of the NAIRU and the associated level of those odds. I believe I am echoing Governor Meyer in saying that I favor a policy approach in which, absent clear contra-indications, our policy instrument would be routinely adjusted in response to changing pressures on resources and movements in actual inflation.

She clearly belongs in the “accelerationist” camp recently defined by Justin Wolfers, where the other camp is the “inflation targeters”, to which Bernanke belonged:

What does this mean for the Fed? It’s too simple to characterize the current debate as one between hawks who dislike inflation and doves who are more concerned about unemployment. Rather, the main divide may be between accelerationists worried that rising wage growth signals an economy at full capacity, versus inflation targeters, who argue that weak wage growth signals that unemployment remains too high. And in the next few weeks, we’ll find out who’s winning that argument.

How did things work out in 1996 and what´s the scenery now?

After Yellen´s “solid case” for a modest rate rise in September 1996, wage growth continued to increase, unemployment continued to fall and so did inflation!

After the July 2014 FOMC Meeting, when it became clear that QE3 was about to close (taper would begin in October), unemployment continued to drop, but notice that wage growth and inflation turned “south”.

Yellens Beliefs

Justin Wolfers post is titled “Is the Economy Overheating? Here’s Why It’s So Hard to Say”. I prefer to ask: Is the Economy Overcooling”?

Friedman and Bernanke agree that interest rates are a bad indicator of the stance of monetary policy (which controls the economy´s “temperature”). It is much better, according to Bernanke, to look at what´s happening to NGDP and inflation.

According to those metrics, in 1996 the economy´s “temperature” was about right, with NGDP growth on a stable path. Now, for the past year, NGDP growth has been falling, indicating that the economy´s “temperature” has been dropping!

By clinging to her “Phillips Curve Faith”, the odds that Yellen´s Fed will make a big mistake in the foreseable future are rising!

Yellen is bemused

Yellen Bemused_1

“We want to raise rates. But how can we do that if inflation expectations, contrary to my beliefs, is falling together with unemployment?”

If she only looked at what´s happening with the “guiding light”, she would, not only understand what´s happening but would know how to solve the “conundrum”.

Yellen Bemused_2

By not “seeing the light”, she gives an opening to discussions such as this at the FT: “What if rates never rise?”:

Readers might recall that it is barely a month since the FT devoted a week to a series called “When Rates Rise”. Things have moved on since then. The Federal Reserve decided not to raise rates, as once widely expected, last month. And after pronouncements from various Fed governors in the past week, the markets are asking a new question.

Maybe our next series needs to be titled: “What If Rates Never Rise?

The Fed is getting exactly what it wants…

…And they must be pretty dumb if they think otherwise! They talk about “normalizing” monetary policy as if there could be any other understanding that they want to put rates up. What does the market do? It pushes longer rates down!

For more than one year, ever since “the time is coming talk” began, the economy has been weakening. In that sense, the “TT” (“Tightening Tune”) strategy is working.

This is another example showing that the level of the FF rate does NOT define the stance of monetary policy. As seen in the chart, NGDP growth has been trending down for more than one year, which defines the stance of monetary policy much more precisely.

Converging on 3

So I find it surprising that people who should know better feel baffled:

Chairperson Yellen’s remarks on September 24 mentions again that they could (expect to?) raise rates by the end of the year:

Most FOMC participants, including myself, currently anticipate that achieving these conditions will likely entail an initial increase in the federal funds rate later this year, followed by a gradual pace of tightening thereafter. But if the economy surprises us, our judgments about appropriate monetary policy will change.

The last sentence in the Yellen quote once again provides an out for the Fed not to do anything.

The bigger question is whether the economy is in a sustained recovery or have we hit a rocky spot giving the Fed further pause? That said, a return to normal monetary policy that begins to eliminate some of the distortions caused by several years of zero interest rates would seem to be beneficial and it is surprising that the FOMC did not see it that way.

Man, what do you mean by “not doing  anything”? As I just argued, the Fed is in “tightening mode”. By actually raising rates they will be in “economy strangulation mode”!

Scott Sumner says:

Get ready for the new normal—3.0% NGDP growth—it’s coming soon.

As the chart above shows, we may be there already! Worse, if the Fed continues with the “TT” Strategy, it will bring it even lower.

PS Remember, in the “limit”, if there´s no labor force, there´s 0% unemployment!

Déjà Vu

“As we write, the money is even on whether the Fed´s Open Market Committee will choose to push up the Fed funds rate at its meeting tomorrow, or perhaps after the election in November. With unemployment at a seven-year low of 5.1%, the Street´s priests are warning that higher inflation is around the corner unless the economy makes the autumnal sacrifice of a pre-emptive rate hike.” WSJ, 23 Sept. 1996

What happened?

The Fed did not raise rates at the September FOMC meeting (nor after the November election). It did a “one and done” in March 97.

And below inflation and unemployment.

Deja vu

Preparing spirits for another “postponement”!

First, the unemployment goalpost was at the 6.5% mark, then at 6%, falling to 5.5% before being revised to 5%.

With that, the “fatidic” date moved from mid-2014 to early 2015 to June 2015, to September 2015. But that will probably be changed again:

Next week, Federal Reserve officials publish new quarterly forecasts, and all eyes are going to be on where they set the job market’s Goldilocks rate.

That’s the estimated unemployment level officials figure is neither too high nor so low that it starts to drive wages and prices higher. To quote Goldilocks, it’s “just right.”

Fed officials in March estimated this “natural rate” of unemployment at 5 percent to 5.2 percent. Unemployment stood at 5.5 percent in May. A new paper by Fed board staff shakes up this view by suggesting the number could be as low as 4.3 percent.

Moving Goalpost

It´s long past the time the Fed changed its “tune-up”!

The Fed should get smart and stop ‘targeting’ unemployment

It´s such a bad ‘target’ that the Fed has been compelled to move the target frequently over the past couple of years, all the way from 6.5% to 5%-5.2%!

According to The Economist:

One key indicator to assess the health of this is America’s unemployment rate. But this may be less useful now than it once was. Although the number of jobless Americans has fallen, the share of the working-age population in the labour force has also dropped considerably, from 66% before the financial crisis to less than 63% now. Temporary factors have affected the statistics, but much of the change has been driven by structural factors, such as retirement of the baby-boomer generation and rising college enrollment. These developments may explain why, as the unemployment rate has fallen from 10% in 2009 to 5.4% today, the Fed’s target long-run unemployment rate has also declined, from 6% in 2013 to just 5.2% at present.

But what alternative indicators are there? Fed officials have drawn on a number of other economic indicators, such as labour-force participation rate or wage growth, to assess the level of remaining slack in the economy. Another approach is to estimate the number of Americans currently on the sidelines who could be coaxed into rejoining the labour market if conditions improve. Researchers at the Fed and the IMF have estimated that a stronger jobs market could boost the labour-force participation rate by as much as 0.75 of a percentage point, which is equivalent to about 1.9m workers. This would suggest that America’s true unemployment rate may be nearer 6.6% than the official figure of 5.4%.

Economists say that fixed-investment volumes may also be a better indicator. Back in 2011, John Taylor of Stanford University pointed out that since the early 1990s, unemployment rates have been lower in America during periods of high investment spending. For each percentage point increase in the investment share of GDP, unemployment falls by between 0.5 to 1.5 percentage points. But in recent months, the relationship between the two has weakened. Today, fixed-investment levels would predict an unemployment rate of roughly 6.5%, much more than the official 5.4% figure. There could be as many as 2m “missing” unemployed Americans excluded from the data the Fed uses to set interest rates. When the economy is so fragile, that’s not good news.

The alternative indicators arrive at almost exactly the same ‘true’ unemployment rate, which is quite a bit higher than the official figure. However, given it is itching to raise rates, the Fed is sticking to it´s guns. Unless, once again, they will feel compelled by reality to reduce the target!

Why is there a correlation between the share of private investment and the unemployment rate? There´s no causality here, it´s just that both magnitudes react to economic prospects. The “fallen chalice” chart below depicts this correlation. It also tells us that during the recovery(!) phase of the past five years, unemployment has reacted quite a bit more strongly, indicating something could be “fishy” in it´s measurement.