Give the Fed a new compass. We´re going in the wrong direction

According to the news:

Friday’s employment report clears the way for the Federal Reserve to raise short-term interest rates by a quarter-percentage point at its Dec. 15-16 policy meeting, ending seven years of near-zero interest rates.

The Fed can reasonably well control nominal spending (NGDP) growth. Stable NGDP growth at the appropriate level well defines what good monetary policy is supposed to look like.

If that´s true, when NGDP growth falters, things like employment growth will register the “punch”, just as it will “blossom” when monetary policy pulls NGDP growth up. Stable NGDP growth goes hand-in-hand with stable employment growth (only thing is if NGDP level falls short, so will the level of employment)

Examples from the mid-1990s and early 2000s show the Greenspan years. For the last ten years, we have been under Bernanke and Yellen. The pictures are illustrative. (The montlhy NGDP numbers come from Macroeconomic Advisers)

Throughout the period, inflation was not a problem. By the mid-1990s, it had reached the “low and stable” target of the time. Ironically, after the numerical 2% target was set in January 2012, inflation has languished, but is still “low and stable”!

Employ Report 11-15_1

Employ Report 11-15_2

But if you zoom in on the past 15 months, things seem “fishy”. For all the Fed´s “communication”, the truth is that they have been tightening policy. NGDP growth is coming down which was shortly followed by decreasing employment growth. Won´t even mention inflation.

Employ Report 11-15_3

To wrap up, where´s the much touted wage growth-inflation nexus so cherished by some at the FOMC?

Employ Report 11-15_4

Great harm might be on the way!

PS If you don´t believe me about the “beauty” of stable nominal spending, believe George Selgin:

a central bank that allows the overall volume of spending to collapse has blown it, no matter how much emergency lending it undertakes.  Indeed, to the extent that a central bank engages in emergency lending while failing to preserve aggregate spending, it may be guilty of compounding the damage attributable to the collapse of spending itself with that attributable to a misallocation of scarce resources in favor of irresponsibly-managed firms.

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!

Why have such a large research staff if their findings are ignored?

Yellen earlier this year:

“We will be looking at wage growth” as a signal of inflation though “I wouldn’t say either that that is a precondition to raising rates.” [Translation: I´ll raise them anyhow!]

Results over two decades for the general theme: Are wages useful in forecasting inflation?



Researchers have extensively studied how wage data might help predict future price inflation. The overall conclusion of the literature is that wages generally provide less valuable insight into future prices than some other indicators. In fact, models that do not incorporate wages often result in superior inflation forecasts.

In 2000:

Concluding Observations

The cost-push view of the inflation process that is implicit in the expectations augmented Phillips curve model assigns a key role to wage growth in determining inflation. In this article, I evaluate this role by investigating empirically both the presence and stability of the feedback between wage growth and inflation during the U.S. postwar period, 1952Q1 to 1999Q2. The results indicate that wage growth does help predict future inflation over the full sample period considered here.

However, this finding is very fragile, and it appears in the full sample because the estimation period includes the subperiod 1966Q1 to 1983Q4 during which inflation steadily accelerated.

Wage growth does not help predict inflation in two other subperiods, 1953Q1 to 1965Q4 and 1984Q1 to 1999Q2, during which inflation remained low to moderate.

In contrast, inflation always helps predict wage growth, a finding that is both quantitatively significant and stable across subperiods. These results thus do not support the view that wage growth has been an independent source of inflation in the U.S. economy.

In 1996:


Many analysts have heralded the slow growth of unit labor costs during recent years as a harbinger of continued low inflation. In this article, we investigate the usefulness of labor costs as a predictor of inflation. Earlier studies have focused on in-sample causality tests. Our in-sample causality tests indicate that, during the pre-1980 period, wage growth did have information content for future core inflation (CPIC) but not overall CPI inflation. During the post- 1980 period, however, this information content has disappeared.

Additionally, we find that the evidence of inflation causing wage growth is quite robust across samples.

In contrast with earlier studies, we also investigate out-of-sample forecasts of inflation using labor costs in an error-correction model. Out-of-sample forecasts offer the ultimate test of whether wages help predict future inflation. For recent years, the out-of-sample forecasting exercises offer no evidence that wage growth contributes to any reduction in forecast errors compared with univariate autoregressive models of inflation. Therefore, when assessing future inflation developments, these results suggest that policymakers and analysts should put little weight on recent wage trends.

Please, give the Fed a timeless rule

In an interesting post “A kink in the Phillips curve”, Nick Bunker finishes off:

The graph shows the relationship between wage growth for production and non-supervisory workers, and the employment rate for prime-age workers six months prior. It clearly shows that when the labor market is tighter (when the employment rate is higher), wage growth is stronger.

Time Invariant Rule1

In other words, the underlying idea of the wage Phillips curve still stands. It’s just a matter of using measures that fit the time.

As Matt Phillips (no relation to William presumably) points out in his Quartz piece on the curve, the labor market has changed quite a bit since the mid-1970s. He points specifically to the decline in the unionization rate, which is a sign of the decreasing bargaining power of labor in the economy. A 5 percent unemployment rate when labor is relatively much stronger, for example, is very different from a 5 percent unemployment rate when labor is on the back of its heels. Changes in the labor market might be a reason why increases in wages and salaries don’t pass through to overall inflation as much as we might have thought. Back when labor had more bargaining power, wage hikes would bite more into profits and therefore spur companies to raise prices. Now companies have more of a cushion, so a similar wage increase won’t necessarily lead to as strong of a price increase.

Context appears to very much matter. Policymakers will always need to create rules of thumb to help them make sense of an incredibly complex economy. But those rules need to be updated as the world changes.

That´s all very nice, but is it useful? In other words, can´t we come up with a “rule of thumb” that is “timeless”?

The NGDP-LT growth rule may qualify. In the chart below, I use the same graphic strategy, but instead of charting wage growth and the prime-age employment population ratio, I substitute wage growth for NGDP growth.

Time Invariant Rule2

It appears that what´s driving both the employment ratio and wage growth is NGDP growth. While during the “Great Moderation” (“GM”), NGDP growth evolved along a stable level path, by letting NGDP growth crash in 2008-09, the Fed afterwards put it on a lower path, which is why I name it the “False GM”.

The coincidence of the fall in the employment ratio to the crash in NGDP growth makes the argument that the fall in the employment ratio is mostly due to structural/demographic factors hard to swallow.

In his post, Nick Bunker says “but those rules need to be updated as the world changes”. He´s referring to adopting a modified Phillips Curve (PC) concept. Unfortunately, that likely won´t help. Over the last 50 years, no relation has been more modified, refined and specified than the PC, and it still doesn´t work!

As I argued in another post, it is time to abandon “estimation” and do some “experimentation”. The chart gives a clear pointer: try putting NGDP growth on a higher path. The result will likely be a higher labor force participation and higher wage growth. If it is done right, inflation getting “out of hand” shouldn´t be a worry!

The chart below shows how the Fed was successful in bringing the NGDP growth path down to conquer inflation and reap the Great Moderation. Now it has to do the opposite and make the red band look more like the green band!

Time Invariant Rule

The Employment Report is consistent with a “low altitude & slow speed” economy

The first chart describes the “low flying/slow speed” economy

Low Altitude & Speed_1

The others are a consequence!

Low Altitude & Speed_2

Update: One risk of “slow speed” is that the economy may “stall”. Justin Wolfers blogs :

This morning’s disappointing employment report confirms what an array of economic indicators has been suggesting for some time: The economy is slowing.


The latest readings of this index underscore the fact that, on average, the sum of economic data released so far through 2015 has tended to be worse than expected.

I like to think of this as an index that tells economists how much they need to change their minds, and in what direction. And it says that it is time to revisit earlier optimism, and to warn about the possibility that the recovery may be at risk of stalling.

Update 2: The lagging indicator nature of the labor market is consistent with this quote:

“The recovery’s not as robust as was assumed,” said Megan Greene, chief economist at John Hancock Asset Management. “The jobs data is finally catching up to the rest of the indicators.”

“The Great Excuse”

For the past five years the economy has been depressingly boring. But we have to understand that FOMC members must feel that by keeping interest rates at “zero” for more than 6 years, they have not been doing any “work”. As such they are restless and “trigger happy”.

Some pointers:

US Federal Reserve Chair Janet Yellen’s premium on consensus may lead to a Fed decision she has not yet endorsed, as a near-majority aligns in favor of a possible June interest rate hike.

Seven of the Fed’s 17 members have now said that they at least want the option of a June tightening on the table, or have pushed in general for an earlier increase amid an expectation that wages and inflation would turn higher.

By contrast, there is a dwindling core of officials who say publicly that the US economy and labor markets in particular still have a long way to go — just four Fed members have in recent weeks clearly said that rate hikes would not be appropriate until much later in the year or even into next year.

The five members of the Fed’s Washington-based board of governors, including Yellen, have spoken less definitively, although governors including Jerome Powell have said that they expected strong job growth to continue. Not all of the seven who point to June vote this year on the Fed’s 10-member policy setting committee, but all participate in policy discussions.

Tim Duy´s “Bottom Line:

“Patient” is out. Tough to justify with unemployment at the top of the Fed’s central estimates of NAIRU. Pressure to begin hiking rates will intensify as unemployment heads lower. The inflation bar will fall, and Fed officials will increasingly look for reasons to hike rates rather than reasons to delay. They may not want to admit it, but I suspect one of those reasons will be fear of financial instability in the absence of tighter policy. June is in play.

And this is what they have faced ever since the economy came out of the throes of the “Great Recession” five years ago:

Great Excuse

What´s behaving “differently”? Clearly the unemployment rate, so that becomes the “compass”. It suits Yellen, a devotee of the Phillips Curve and its NAIRU variant!