Is the Fed behind the curve?

Quick follow-up to my previous post.  The 30-year T-bond yield just fell to 2.22%, the lowest ever.  Meanwhile Fed officials are itching to raise rates because the economy is in danger of overheating.

Is the Fed behind the curve?  Yes.  The real question is how many curves.  I say the Fed is just entering the first curve at Indy, while the asset markets are heading down the final stretch toward the finish line.  The markets get it—low NGDP growth and low nominal interest rates as far as the eye can see.  Let’s predict how long it will take the Fed to catch up with the markets. What do you think?

On another note, the Hypermind Q4 contracts concluded today.  The 4th quarter NGDP growth rate was 2.544%, which meant the contracts ended at 25.  I have heard about several winners.  And remember, you can’t lose any money at Hypermind.

For the last month we’ve been working on getting the Hypermind price embedded into this blog.  I guess it’s extremely difficult to do, given how long it is taking.  And iPredict should be up pretty soon.  I hope.  The frustrations of always having to wait for other people to act . . .

HT:  Brian Donohue

PS.  Ken Duda asked about the “audit the Fed” bill.  Does anyone know precisely what data the Fed critics want, that the Fed currently doesn’t provide?

The New Normal (Bill Woolsey wins)

In a post written 7 months ago I predicted that 3% NGDP growth would become the new normal:

It’s becoming increasingly clear that when the labor market recovers, RGDP growth will be very slow, maybe 1.2%.  Add in about 1.8% on the GDP deflator, and 3% NGDP growth looks like the new normal, assuming the Fed intends to stick with 2% PCE inflation targeting.  Bill Woolsey wins!!

The figures for 2014 were announced today.  NGDP growth was 3.70% (vs. 4.57% in the Year of Austerity.)  And RGDP growth was 2.48%, (vs. 3.13% in the Year of Austerity.)  Growth slowed because the Fed offset the easing of fiscal austerity with its own tapering, to prevent the economy from “overheating.”

The 3.7% figure suggests we are right on track for 3% trend NGDP growth.  Here’s why:

1.  Unemployment fell 1.1% in 2014.  Okun’s Law implies that output grew at about 2.2% above trend.  However recent Okun’s parameter estimates are a bit lower, so let’s say output grew about 1.5% above trend.

2.  Inflation in the GDP deflator was about 0.6% below the 1.8% that I expect.

If inflation rises by 0.6% and RGDP growth slows by 1.5%, then we are right at 2.8%.  Add in a couple tenths of a percent for people returning to the labor force.

The upshot is that with low NGDP growth we’ll have low interest rates, and we’ll hit the zero bound in every future recession.  If the Fed doesn’t give up its interest rate targeting regime, we’ll have a dysfunctional monetary policy going forward. Let’s hope they switch to an instrument with no zero bound (say the base, or NGDP futures prices.)  Alternatively, they could switch to level targeting.

Update:  I have a new post at Econlog showing how badly the CBO misforecast 2013.

Calomiris on Fed policy

Charles Calomiris suggests that the Fed will probably need to raise rates this year:

Furthermore, because the fall in energy prices is a positive supply shock, nominal GDP growth will not be reduced by the decline in energy prices; indeed, it is likely to accelerate going forward. That means real GDP growth will accelerate alongside nominal GDP growth. From the perspective of forward-looking inflation targeting, the Fed rightly understands that it needs to maintain its plan to begin to remove accommodation this year.

Overall it’s a thoughtful article, but I can’t help thinking that something is missing. First let’s review the difference between inflation and NGDP targeting.  If we use the equation of exchange:


You can think of the two regimes as offsetting velocity shocks, but responding differently to supply shocks.  Under strict inflation targeting, you shoot for 2% inflation no matter what.  Under flexible inflation targeting (such as the Fed’s dual mandate, or NGDP targeting), the Fed lets inflation rise and RGDP fall during a negative supply shock.  Calomiris correctly points out that in the near term it might make sense for the Fed to let inflation fall below 2%, and RGDP to accelerate, as long as NGDP is well behaved.

So far so good.  So what’s my nagging worry here?  My concern is that the Fed doesn’t seem to have the right REGIME in place.  So even if they handle the current oil price decline correctly, I’m not confident they will avoid the horrendous mistakes made in 2008-09, in the next recession.  To understand those mistakes let’s review three options:

1.  Stable inflation

2.  Countercyclical inflation (this is what the Congress, Calomiris and I all seem to prefer.)

3.  Procyclical inflation

You might be thinking; “Wait a minute, I don’t recall Congress asking for countercyclical inflation.”  Not explicitly, but it’s implicit in the dual mandate. Obviously the dual mandate rules out option #1, which ignores jobs.  Any loss function that worries about both inflation and jobs, will bias policy toward more stimulus when unemployment is high, and less stimulus when unemployment is low.  This means the Fed will face a “trade-off” and will tolerate slightly above target inflation when unemployment is higher than desired, and slightly lower than target inflation when unemployment is low.  Inflation should be countercyclical.

Let’s contrast this approach with its exact opposite.  Suppose Congress had instructed the Fed to target inflation at 2%, but, “while you are at it, try to be as cruel to the jobless as possible.  Create as much jobs market instability as possible, consistent with 2% inflation over time.”

Under that mandate (let’s call it the “cruel mandate”) the Fed would do a tight money policy when unemployment is above target.  Yes, they’d miss their inflation target on the low side, but that loss would be offset by the “benefit” that they’d receive from screwing the workers.  Under that sadistic policy they’d run a procyclical inflation rate, just the opposite of what they are currently supposed to do.

Now of course this is exactly what the Fed did in 2009, they ran inflation well below target during a period of 10% unemployment.  Defenders of the Fed will claim that this was unintentional.  I agree.  But it was also due to a flawed inflation targeting IT regime, which biases you toward procyclical inflation, especially at the zero bound.  And my fear is that that regime still is in place.

Let’s suppose the next 5 years are pretty good, and then we have another recession.   If you look at the next 5 years in isolation, the period would be a “boom” in a relative sense.  In that case Calomiris is quite right that the Fed should run inflation a bit below target right now.  But this policy only makes sense if it is offset by above target inflation during the high unemployment periods before and after the boom.  In fact, we did the opposite during 2009-13, and I fear we will again do the opposite in the next recession. I fear that instead of inflation rising in the next recession, (which would make Calomiris’s current recommendation appropriate, the Fed will let inflation fall, which will put us right back at the zero bound, and retrospectively make Calomiris’s proposed policy a mistake.

Robert Lucas emphasized that you need to think in terms of policy regimes, not day-to-day decisions.  I don’t care very much whether the Fed raises rates by a quarter point this year.  I care a lot whether they successfully make inflation rise during the next recession, or disastrously allow it to fall.

So what will it be; the pre-2008 dual mandate or a continuation of the post-2008 cruel mandate?

BTW, there are several options that could make the cruel mandate outcome less likely. One option is to raise the inflation target to 3% or 4%, to minimize the zero bound problem. A better option is NGDP level targeting, which also reduces the zero bound problem, at a lower inflation rate.  Best of all is NGDP futures targeting.  No zero bound problem.

HT  Ramesh Ponnuru

The Great Recession happened because we ignored Friedman’s ideas

Patrick Sullivan directed me to a Brad DeLong article on the lessons of the Great Recession:

And yet, as recommendable as Wolf’s proposals may be, little has been done to implement them. The reasons why are found in the second book: Hall of Mirrors, by my friend, teacher, and patron,Barry Eichengreen.

Eichengreen traces our tepid response to the crisis to the triumph of monetarist economists, the disciples of Milton Friedman, over their Keynesian and Minskyite peers – at least when it comes to interpretations of the causes and consequences of the Great Depression. When the 2008 financial crisis erupted, policymakers tried to apply Friedman’s proposed solutions to the Great Depression. Unfortunately, this turned out to be the wrong thing to do, as the monetarist interpretation of the Great Depression was, to put it bluntly, wrong in significant respects and radically incomplete.

The resulting policies were enough to prevent the post-2008 recession from developing into a full-blown depression; but that partial success turned out to be a Pyrrhic victory, for it allowed politicians to declare that the crisis had been overcome, and that it was time to embrace austerity and focus on structural reform. The result is today’s stagnant economy, marked by anemic growth that threatens to become the new normal.

I think this is exactly backwards.  But first let’s get one issue out of the way; Friedman’s proposed 4% rule for M2 growth might well have failed in 2008.  On the other hand, clearly that’s not what DeLong (and Eichengreen?) had in mind.  Monetarism in the sense of the k% rule has almost zero influence today.  If people are claiming that “monetarist” ideas contributed to the failed policy response in 2008-09, they are clearly thinking of monetary policy more broadly—that the Fed can and should steer the nominal economy, and that we should not rely of fiscal or regulatory solutions to problems that are essentially monetary.  So let’s review what happened in 2008:

1.  Two days after Lehman failed, the Fed met and decided the US faced a financial problem, not a monetary/AD problem.  Thus they decided not to ease monetary policy. A few weeks later the Fed decided to pump enormous quantities of liquidity into the banking system.  Under a normal (monetarist) policy regime, that liquidity would have driven short-term rates to zero and increased the broader money supply.  But the Fed did not want that to happen.  They explicitly tried to avoid easing monetary policy, even as they rescued the banks, by implementing a new device called “interest on reserves.”  Paying banks not to move the money out into the economy.  This kept rates above zero until mid-December, when the Fed finally threw in the towel and lowered rates to 0.25%, where they remain today.

2.  In 1997 Friedman warned the profession that they were confusing low interest rates with easy money.  In 2003 Bernanke echoed that warning.  In Frederic Mishkin’s final FOMC meeting (in 2008) he made a heartfelt plea to the Fed not to confuse low rates with easy money.  Unfortunately, over the next few years the Fed (and most of the rest of the profession) did exactly that, assuming that low rates meant an easy money policy.

3.  By March 2009, the data were coming in much worse than expected, and it was clear that monetary policy had been far too tight in 2008 (when we were not at the zero bound), producing the biggest drop in NGDP since the 1930s.  I recall DeLong once expressing dismay that the Fed would acquiesce to such a large drop in NGDP, and do little to repair the damage.  They finally did act in March, with the QE1 program, and a weak recovery began.  But they needed a much more aggressive program, either more QE, or lower IOR, or more aggressive forward guidance, or the sort of level targeting that Bernanke recommended the Japanese undertake in the early 2000s, or all of the above. But it wasn’t until late 2012, when the Fed saw the approaching fiscal austerity that they moved more aggressively on the QE/forward guidance front.  Since the beginning of 2013 the unemployment rate has been falling fast.

I see a profession that wrongly thought the Fed was out of ammo (something Friedman would have never assumed) that wrongly thought low rates meant easy money (something Friedman never would have done), that wrongly thought fiscal stimulus was the answer (something Friedman never would have done), that wrongly thought it was a financial crisis and not a monetary/AD crisis until it was too late (suggesting they put more weight on Bernanke (1983) than Friedman and Schwartz (1963).)

Actually Bernanke was trying to do more, but when the “Fedborg” is hopelessly confused, and when the broader economics profession is hopelessly confused, well then there’s only so much one mild-mannered former college professor can do.

The people most off base in 2008-09 were the conservatives.  Friedman’s voice was dearly missed.

PS.  I hope DeLong doesn’t get annoyed if I tease him on one point.  He calls Martin Wolf a “conservative British journalist” and then spends several paragraphs discussing all sorts of Wolf views on a wide range of issues.  The only common thread I found was that Wolf’s policy views seem consistently left-of-center, at least where there is a clear left/right split (the euro seems ambiguous.)  So why not say “formerly conservative British journalist?”

(That’s not to say Wolf doesn’t have some good suggestions.)

Investment flows and population growth

I saw an interview of Robert Shiller and Kenneth Rogoff at Davos, where they were asked about the sluggish level of investment in the US.  They spoke of a lack of animal spirits, lingering effects of the financial crisis, etc.  I wonder if we are underestimating the role of population growth.

For instance, suppose houses lasted forever.  In that case a permanent reduction of population growth from 2% to 1%/year would cut housing investment in half.  Even in a more realistic model, where a small fraction of houses are demolished each year, housing construction might fall by 20% or 30%.

It also seems to me that the working age population might be especially important, as they need workplaces, which are provided via new investment.  Here’s a graph of the US population from age 16 through 64:

Screen Shot 2015-01-28 at 2.10.21 PM

It looks to me as though working age population growth suddenly slowed down around the onset of the recession.  Because the most recent datum is November 2014, I went back seven years to November 2007. The total growth from 2007-14 was 3.63%.  For the seven years before that it was 9.61%.  For the seven years before that is was 9.15%, and from 1986 to 1993 it was 7.21%.

So in the late 1980s and early 1990s working age population was growing at about 1% per year.  Then growth sped up to well over 1% for 14 years.  Then when the recession began growth slowed to about 0.5%.  That seems significant.

Is it just the recession?  We are now seeing unemployment falling sharply, but growth seems to be declining even further, to just 0.31% in the last 12 months, far below the growth rates that America has seen for many generations.  And with rising disability rolls, presumably the number of non-disabled working age people is growing even more slowly.

Two theories:

1.  Boomer retirements.

2.  Less immigration.

I’d guess some of each–does anyone have the data?

Whatever the cause, this seems like it might be able to explain at least some of the sluggish investment and low interest rates.  And if it was just the recession, obviously yields on 10 year bonds would not be below 2%.  After all, unemployment is down to 5.6% and falling rapidly.  The past 10 years have been subpar, but cyclical factors can’t very easily explain low yields for the next 10 years.  On the other hand, if working age population growth continues to slow, then we’ll begin to look more like Japan—the country that first entered the low investment/low interest rate environment.

BTW, Check out my post on Keynesian economics and the 2013 austerity, at Econlog.

PS.  With the appreciation of the Swiss franc, shouldn’t the Davos meetings be moved to Innsbruck, which uses the now “worthless” euro.

PPS.  James in London directed me to an article showing that the SNB is itching to get back in there buying assets to hold down the value of the SF.  No surprise to readers of this blog.