Show us your target

John Taylor has been pressing the Fed to move toward a more rules-based approach.  I think Taylor is right on the big issue, although I don’t share his preference for using interest rates as a policy instrument.

I’ve always believed that the first step toward a rules-based approach is to clearly spell out the goal of monetary policy.  That should be an issue on which everyone on the FOMC agrees, once a decision has been made and voted on.  Unfortunately, the Fed has not done this.  The Fed’s policy goals are still shrouded in mystery.

The simplest solution would be for the Fed to set a univariate policy goal, say 2% PCE inflation or 4% NGDP growth.  Then spell out whether they favor growth rate targeting or level targeting.  Instead the Fed has chosen a dual target of 2% PCE inflation and unemployment close to the natural rate.  But what does that actually mean?  In order to make the goal clear, we need enough information to figure out whether previous policy was to expansionary or too contractionary.  Right now we lack that information.  Over the past 12 months, the unemployment rate has fallen to a level below the Fed estimate of the natural rate, while inflation has undershot their target.  So was the policy instrument setting 12 months ago too expansionary or too contractionary?  I don’t know, which is precisely the problem.

The Fed often objects that explicit policy rules are too simplistic, and that they need to take many data points into account, as the economy is quite complex.  OK, but that doesn’t excuse the lack of an explicit target, it just makes the target a bit more complicated.  So let’s discuss what a plausible Fed target might look like.

1.  For inflation, the Fed might worry about the distorting effects of oil price shocks.  In that case, they can use core PCE inflation, setting the target at two percent.

2.  The labor market is even more complicated.  The Fed might want to take account of both the standard U-3 unemployment rate, as well as the more comprehensive U-6.  Some would even add in the prime age labor force participation rate (PALFPR).  Here’s how a labor market indicator might look with those three variables:

Labor slack = U3 + 0.5*U6 + 0.1*(100% – PALFPR)

At the moment, U3 unemployment is 4.1% and U6 unemployment is 8.2%.  U6 is also roughly twice as volatile as U3.  The coefficient of 0.5 on the U6 rate is intended to give the two measures roughly equal weight.  The labor force participation rate is 81.8%, so 100% minus that rate is 18.2%.  I gave this variable a lower weight, because it’s partly cyclical and partly structural.  Monetary policy can only address cyclical changes.

Using these weights, my current measure of labor market slack is 4.1% + 0.5*8.2% + 0.1*18.2% = 10.02%

For simplicity, let’s suppose the Fed sets a target of 2% inflation and 10.0% labor market slack, using this formula.  (They could adjust that figure over time, as research on labor markets gave the Fed a better feel for the “natural rate” of labor market slack.)  Then the Fed would also want to create a set of “indifference curves”, each of which illustrates a set of outcomes that are equally suboptimal.  Unless I’m mistaken, that map would look like a target:

While I lack Jasper Johns’ skill as an artist, I think you get the point.  Interestingly, some conservatives get why inflation above 2% is bad, but are confused as to why below 2% inflation is a problem.  Some liberals get why high labor market slack is a problem, but don’t see why a tight labor market is a problem.  But if the Fed is serious about its targets, it should treat overshoots and undershoots of each variable as both being undesirable.  I.e., 3% unemployment is bad because it leads to future instability in the economy.  That doesn’t mean the indifference curves must be perfect circles, but they should at be least vaguely circular.

Of course I do not favor this dual variable policy goal; I favor something like 4% NGDP growth targeting, level targeting.  That looks like a point on a line, and is far easier to explain.  But even a complex target like inflation and labor market slack can be turned into a mathematical formula, which makes it possible to evaluate the effectiveness of Fed policy.

This is all the first step towards a Taylor-like policy rule.  The next step is to spell out an instrument rule.  You need to explain how and why you adjust the policy instrument.  If the instrument is the fed funds rate, Taylor would recommend something like the “Taylor Rule”, although he’s indicated that under his proposal the Fed would be free to choose its own rule, and even deviate on occasion if they spelled out why to Congress.  (Presumably he is thinking of extreme events, like the 2008 financial crisis.)  I’d use the monetary base as my instrument (it has no zero bound problem) and my rule would adjust the base according to trading in the NGDP futures market.  Whatever it takes.

PS.  Contrary to what you often read, Congress’s dual mandate does not require the Fed to adopt a complex dual variable policy goal.  NGDP targeting is 100% consistent with the Fed’s dual mandate, as it implicitly address both employment and inflation.  NGDP growth is inflation plus RGDP growth, and the latter variable is highly correlated with employment at cyclical frequencies.

PPS. After I drew up the graph, I realized that the horizontal axis should be called labor slack, not labor utilization.

The only real solution to Too Big To Fail

In a recent post I suggested that higher capital requirements might be called for if policymakers were unwilling to bite the bullet and remove moral hazard from our financial system.

The FT has a new article discussing a Treasury proposal to end Too Big To Fail, by setting up a new type of bankruptcy for big banks.  I wish them well, but remain skeptical.  In my view, the only way we’ll ever be able to remove moral hazard is with monetary policy reform.  If we can get to a policy of NGDPLT, then policymakers will no longer have to worry about the consequences of the failure of a big bank.  Unfortunately, that’s likely to take many decades, as we first need to implement the policy, and then see how it does during a period of financial distress.  Only then would policymakers begin to feel comfortable rolling back TBTF.  (And even then, special interest groups will try to keep it in place.)

PS.  The NYT has a new post showing that historians view Trump as being the worst President in American history.  That’s also my view.  Some people judge presidential performance by how the country is doing.  That’s about like judging my blogging based on how monetary policy is doing.  A couple posts I’d recommend are Yuval Levin explaining why Trump is not actually the President, in the conventional sense of the term.  He’s not qualified to be President, so day-to-day decisions are made by others.  Thus the GOP “deep state” wisely vetoed his recent attempt at crony capitalism, which would have re-regulated the coal and nuclear industry as a backdoor way of bailing them out.  The outcome was good, but Trump’s specific input into the process was destructive.  Matt Yglesias also has a good post, explaining why Trump is much more corrupt that even lots of left-of-center reporters assume.

PPS.  I have a new post on budget and trade deficits, over at Econlog.

$110 bills are still lying on the sidewalk

I have a new post on the Hypermind NGDP prediction market, over at Econlog.  I argue that it might be best if the market fails.

Even so, I’m encouraging people to participate.  The prize money for each contract is over $36,000, and it costs nothing to participate.  Where else in life can you win money with no risk of losing?

Only 321 people have participated in the first contract, which ends in April, and even fewer in the second, which ends at the end of April 2019.  At that rate, the average amount of winnings per participant will exceed $110.

I’d also encourage journalists to pay more attention to this market.  What other data point better describes the expected growth in aggregate demand over the next year?  Be specific.

 

 

Are hawks and doves simply confused?

I say yes.

Commenter BC tried to explain why it might be rational for some people to be hawks and others end up being doves:

I think of the dove and hawk designations as denoting the bias or errors that one makes in implementing discretionary policy. Doves tend to underestimate the likelihood that low inflation is “transitory” and overestimate the likelihood that high inflation is transitory and thus tend to overestimate the amount of stimulus needed when inflation is low and underestimate the amount of contractionary policy needed when inflation is high. Vice versa for hawks. One can also think in terms of expected future inflation, which is unobservable. Doves’ inflation expectations are persistently lower than hawks’ expectations. Thus, under the same current conditions, doves tend to advocate more stimulus than hawks.

While I concede this explanation might be true, I believe it quite unlikely.  If the dispute were merely a technical disagreement about how to forecast inflation, then hawkishness and dovishness would be 100% uncorrelated with political ideology.  But that’s clearly not the case.  Being hawkish is strongly correlated with being right of center, and dovishness is correlated with being left of center.  That tells me that hawks and doves are simply confused.

Elsewhere I’ve argued that in a world of 2% inflation targets it no longer makes any sense to be a hawk or a dove.  At one time those two terms did have a coherent meaning; hawks preferred a lower inflation rate than doves.  There was no inflation target at that time.  So in 1976, hawks and doves might have disagreed about setting the fed funds target at 7%, even as they agreed that this setting would likely lead to 6.2% inflation.  I believe these two groups continue to exist because they wrongly think we still live in a world where this disagreement has meaning.

We can have a world were the inflation rate is always exactly 2%.  Or we can have a policy that tries to push inflation above 2% during some periods and below 2% during other periods (my preference).  Hawkishness and dovishness have absolutely no role to play in either of those worlds.  Some doves seem to think it’s always possible to have an inflation rate that’s higher than expected, that is, policy can be consistently “expansionary”.  Some hawks wrongly believe the opposite outcome is possible.  They are simply confused.

Hawks were right that policy was too expansionary during the Great Inflation.  But they were wrong about policy during the Great Recession.  It’s wrong to be a hawk for the simple reason that it’s wrong to always favor a more contractionary policy.  That’s like always favoring turning the steering wheel in one direction.

Doves were right that policy was too tight during the Great Recession, but they are in danger of overstaying their welcome and continuing to advocate monetary stimulus at all times.  It makes no sense to always favor an expansionary policy, as we now know that expansionary policies are stimulative only to the extent to which policy is more expansionary than expected.

People should not be either hawks or doves; they should favor easier or tighter money based on whether AD is too low or too high to hit the central bank’s target.

That does not mean we can’t have ideological debates about the proper target of monetary policy.  We can and should have those debates.  (I favor NGDPLT, at roughly 4%).  But if three of the four people in the car have voted to go to Las Vegas, the fact that the driver prefers Taos is completely irrelevant.  The driver needs to steer the car towards Las Vegas.  (The driver can demand the four go see Penn and Teller instead of Britney Spears, as compensation for losing out on Taos.)

Again and again

Here’s Trump:

So many signs that the Florida shooter was mentally disturbed, even expelled from school for bad and erratic behavior. Neighbors and classmates knew he was a big problem. Must always report such instances to authorities, again and again!

Again and again?  So it’s not enough to report him to authorities once, you need to do it twice?  OK, whatever Trump says.  Here’s what happens when people take his advice:

The F.B.I. received a tip last month from someone close to Nikolas Cruz that he owned a gun and had talked of committing a school shooting, the bureau revealed Friday, but it acknowledged that it had failed to investigate.

The tipster, who called an F.B.I. hotline on Jan. 5, told the bureau that Mr. Cruz had a “desire to kill people, erratic behavior and disturbing social media posts,” the F.B.I. said.

The information should have been assessed and forwarded to the Miami F.B.I. field office, the bureau said. But that never happened. On Wednesday, Mr. Cruz, 19, killed 17 students and teachers at his former high school in Parkland, Fla., law enforcement officials said.

The tip about Mr. Cruz appeared to be the second in four months, after another person told the bureau about online comments from Mr. Cruz that he wanted to become “a professional school shooter.”

It’s not so much any single comment, it’s that there are hundreds of such comments.  On his best day in office, Trump says things that are more idiotic that the sort of silly things Obama said on his worst day in office.  Not once, but again and again and again.  Someone needs to report his erratic behavior to the authorities.