Inflation targeting as voodoo economics

A James Alexander post

My last post was on the need to change the 2% inflation target to higher one or, better still, switch to  NGDP growth targeting. However, by even talking about inflation I feel it is easy to get sucked into a black hole of nonsense chatter about a concept so hard to practically measure.

Nominal GDP (as measured by the value of output, total income or total expenditure) is the reality. Real GDP is a highly artificial construct. And inflation is also a highly artificial construct, the mere residual between the reality of actual Nominal GDP and the artificial Real GDP. It is necessary to calculate some version of inflation to get from real Nominal GDP to artificial Real GDP.

To create a Real GDP figure the statisticians are meant to collect a huge number of price indices for each product, and then deflate the real or actual nominal value of output (ie sales) to derive a supposedly inflation-free “real” but artificial output figure.

Although they collect all these price indices they don’t create indices for the changing quality of each product. They should do. The price indices are thought of as “inflation”, but that is because of the assumption that the inflationary element of prices changes more quickly than quality or nature of the goods and services change. But how do we know? Has it been tested? Has it even been thought about in any methodical manner. I don’t think so. Occasionally, hedonistic or quality changes are incorporated into the price indices, but in a highly haphazard way. Statisticians do track changes in the basket of goods and services via surveys or by observing actual patterns of expenditure but can’t track changes in the nature of service – like a switch from learning on the job to learning at college, or a switch from spending on alcohol to spending on a gym, vice to virtue.

Of course, any quality or nature indices would create huge debates. But the price indices are largely meaningless without them. How can price inflation be observed without as much monthly effort going in to assessing the quality and nature of the product or service being tested.

Entertainment is the classic example, 15% of the CPI basket. The switches from street entertainers, to theatres, to movie theatres, to black and white television, to colour television, to broadband internet all involved major changes in product quality and very often the fundamental nature of the service. The pure inflation element may be able to be measured from one week to the next, but quality and nature also move ahead rapidly.  Transport, another 15%, is the same as walking gave way to horse drawn transport, to railways, to motor vehicles, to aircraft, to not travelling but having people and products brought to you virtually. The cost is not then transport but the cost of the broadband connection. Restaurants and hotels, 10% of the basket, change in quality all the time. Housing provokes similar questions.

I am not denying it is quite hard to compile NGDP as it has one or two theoretical issues itself: the final vs intermediate consumption issue, the issue of how to value self-owned housing or the scale of the informal economy. But RGDP has the exact same issues, plus the massive issue of divining pure inflation from changes in quality and nature.

Paul Krugman likes to throw the “voodoo economics” tag around when non-mainstream economists come up with ideas, but what should be done when mainstream economics has formed a consensus   around a very silly idea like inflation targeting.

The 2% target is voodoo upon voodoo

On top of the targeting of inflation, seemingly out of thin air a 2% target was created. It was possibly invented because the long run real growth has often been calculated as around 3%. So a 2% inflation seemed a nice balance. Not more than real growth, but not too close to zero and risking deflation. Not too high as to upset the current bunch of Republicans, the Germans, the famous Japanese housewives, or …? William Dudley of the NY Fed recently gave as a reason that it meant most people in their 30 year working lives would see a doubling of prices. Assuming inflation can be so precisely calculated, so what? Why not no change or quadrupling? What difference can it make?

Why has inflation targeting appeared to have worked?

There is much discussion about the “divine coincidence” that while targeting inflation, central bankers actually targeted the output gap. And during the Great Moderation got monetary policy more or less right. The “output gap” is an even more tricky theoretical concept.

NGDP Targeting is so sensible, so simple. It does not rely on any theoretical concepts to target like inflation, RGDP or another voodoo upon voodoo concept like the gap between artificially-created RGDP and where the artificial RGDP should be, theoretically speaking.

Some have suggested that central bankers were implicitly targeting NGDP growth. Well, maybe. If they were, it came very unstuck in 2007-08 when they seemed blinded by high headline inflation, and were very slow to react to falling actual NGDP growth and crashing NGDP growth expectations.

Dudley is the markets man on the FOMC, a small mercy

A James Alexander post

The role of the President of the NY Fed is to be the lightning conductor of market sentiment to the FOMC. The NY Fed is the operating arm of the FOMC, conducting the open market operations. Because of this importance the President of the NY Fed gets a permanent vote at the FOMC, alongside the senior Fed staffers like Yellen and Fischer. What the NY Fed President says is important, often more so than the Vice-Chairman of the Fed, currently Fischer, or sometimes even than the Fed Governor themselves.

While Dudley has always physically looked uncomfortable passively tightening monetary policy and also actively doing so, he is incredibly loyal too. Twenty years at Goldman Sachs would have taught him that. He said nothing in public or officially dissented to any of the moves. Today we get this:

In addition, the weakening outlook for the global economy and any further strengthening of the dollar could have “significant consequences” for the health of the U.S. economy, William Dudley, president of the Federal Reserve Bank of New York, told MNSI in an interview.

“One thing I think we can say with more confidence is that financial conditions are considerably tighter than they were at the time of the December meeting,” said Dudley, a permanent voter on the Federal Open Market Committee, the Fed’s monetary policy arm.

“So if those financial conditions were to remain in place by the time we get to the March meeting, we would have to take that into consideration in terms of that monetary policy decision,” he said.

But how can he and his colleagues be so obtuse as to think that the tighter financial conditions are not a direct response to their own active tightening of monetary policy? It is this obtuseness, this stubbornness, that is of major concern, and makes monetary policy so unpredictable at times. Humans make errors

Predicting when the humans will recognise their errors, if ever, is all too subjective. When will the FOMC reverse course: the S&P hits 1500, unemployment at 8%, an inverted yield curve? All of them? We know they will change their minds, the question is whether market players can stay solvent until they do.

No wonder that the economy may be experiencing “super-hysteresis” effects

When someone like William Dudley, with a permanent vote on the FOMC, is capable of uttering so many empty words in a single sentence, the economy will continue to be damaged:

“We hope that relatively soon we will become reasonably confident that inflation will return to our 2 percent objective,” he said at Hofstra University. Dudley said it was “very logical” to expect that the Fed’s inflation and employment conditions would be met “soon,” allowing policymakers to “start thinking about raising the short-term interest rates.”

(Note: “super-hysteresis” effects refers to the impact of the great recession on both the level and growth rate of output, that would be permanently lowered)

HT James Alexander

By his own assessment, Dudley is saying the Fed has been a failure

On how monetary policy should be conducted, William Dudley concludes:

What is important for attaining the Federal Reserve’s mandated objectives is not that monetary policy is described in terms of a formal prescriptive rule, but rather that the FOMC’s intentions and strategy are well understood by the publicThis argues for clear communication through the FOMC meeting statements and minutes, the FOMC’s statement concerning its longer-term goals and monetary policy strategy, the Chair’s FOMC press conferences and testimonies before Congress, and speeches by the Chair and other FOMC participants. 

But it also is important that the strategy be the “right” reaction function.  This means a policy approach that responds appropriately to important factors beyond the two parameters of the Taylor Rule—the output gap estimate and the rate of inflation.

Interesting that each month a new “important factor” buts in!

Data dependency, the problem rather than the solution

A James Alexander post

Watching the recording of NY Fed Dudley’s market-moving live interview with the WSJ yesterday morning reminded me of a man caught in a trap.

When his interviewer, Jon Hilsenrath, rather melodramatically paused the interview after Dudley, a well-known dove, repeated the mantra about a likely rate rise before the end of 2015 the NY Fed chief looked quite alarmed.

The weirdest thing he said was that the US was “growing above trend”. If he really believes that it would be good to see some evidence. He didn’t bring up above trend growth in his June 2015 interview with the FT. So it is a new concern that he thinks growth is above trend now. Perhaps he was just thinking of the  upwardly revised 3.7% annualised growth 2q15/1q15 versus the (also upwardly revised) 0.6% annualised growth 1q15/4q14. If so, this seems incredibly short term and far too reliant on noisy qoq annualised growth rates – and certainly ignores falling NGDP growth.

Clearly, he was uncomfortable having to toe the line of his boss, Janet Yellen, who seems keenest on a 2015 rate increase. It didn’t look like he really believed in the rise but was simply being loyal. Admirable, but misguided. He should be his own man, but then if he was his own man he’d probably never have been appointed by the NY money-center banks to head the NY Fed.

The biggest issue was his constant refrain that he and the FOMC were “data dependent”. That they weren’t trapped by a calendar commitment to anything. But one of the data points that the FOMC talks up is financial market data. This presents a problem in the current environment of a threatened rate rise. The global economy is slowing, partly due to most of the non-US world having tied itself to US monetary policy, and the US economy is OK but not great. The markets recognise this troubling situation and so increasingly focus on the Fed’s monetary policy stance. And with the active tightening bias this causes more financial market turmoil, highlighted in real time during his interview. And so the financial data becomes worse, for a “data dependent” Fed.

The circularity of this seems to be lost on the FOMC. Dudley and the FOMC seem to think of themselves as observers half of the time rather than participants. It is a vicious circle, but one that could be broken out of if the Fed were to target  NGDP growth expectations instead – with an allowance for going over the target if there is some undershooting of the target in practice.

Obviously, the circle may not be quite so swiftly vicious if the FOMC really do keep to their data dependency, as financial markets will not let them actively tighten. That said, the slow strangulation will continue, and if the rest of the world has a crisis that does then infect US demand, then the FOMC will have to re-start QE or move to negative interest rates, things they seem really loathe to do – in the absence of altering the target of monetary policy to a much better monetary aggregate like NGDP.