Archive for September 2011

 
 

What happens when an economist ignores what the markets are saying

Here’s Paul Krugman:

OK, the Fed moved. It was a bit stronger than expected “” and BB and company stood up to the GOP.

But seriously, they’re trying to use a water pistol to stop a charging rhino.

Stronger than expected?  By whom?

Another argument for market monetarism.

PS.  The water pistol is also a good metaphor for fiscal stimulus in a NGDP hurricane.

PPS.  The GOP wanted a stronger dollar, and they sure got it!

Memo to the Fed: We need a light at the end of the tunnel

The tunnel is low NGDP growth as far as the eye can see.  The evidence is low interest rates as far as the eye can see.  That looks like Japan.  The BOJ has failed to provide a light, and the results are clear.

What would be a light at the end of the tunnel?

LEVEL TARGETING.

There is zero justification for the Fed allowing a nominal recession to begin right now.  None.  If they do, history will judge them very harshly.

It may not happen, but the risk right now is unacceptably high.

Here’s Josh Hendrickson:

The biggest problem with current Federal Reserve policy is that it lacks any coherent direction or policy goal. Expectations matter. (Read Woodford, for heaven’s sake! This is supposed to be mainstream monetary theory.) For Fed policy to be successful, they need to outline an explicit goal for policy in the form of a target for nominal income and the price level and commit to using the tools at their disposal to achieve that goal. Random announcements of specific quantities of asset purchases provide no guidance and will not be effective. Temporary monetary injections are not successful for much the same reason that temporary tax cuts are not successful (see Weil, “Is Money Net Wealth?”, 1991). Without a coherent goal or strategy, monetary policy with all its fits and starts will continue to fail.

Here’s David Beckworth:

Still, I am not sure this new operation twist will pack much of a punch.  The reason being is that the Fed is once again adding monetary stimulus without setting an explicit target.

What I said on August 21st

See how this looks today:

So both Hamilton and Greg Mankiw have suggested a price level target with a 2% trend growth rate.  These are both highly respected moderates who don’t shoot from the hip like I do.  They both praise Bernanke.  I see this as a real test for Bernanke and the FOMC.  If the Fed won’t even do this little amount . . .   Something that would not require tearing up the (implicit) 2% inflation target and replacing with another number.  Something that would anchor the price level and remove any lingering fears of high inflation.  A policy that could be defended even if the Fed didn’t give a damn about unemployment at all, if the Fed lacked a dual mandate.  If they won’t even do that much, then the Fed will have abdicated all responsibility.

Even the Hamilton/Mankiw proposal would represent failure, relative to what the Fed would be expected to do if rates weren’t stuck at zero.  But at least it would be something (unlike Operation Twist, which seems like nothing to me.)

The TIPS markets show very clearly that investors have given up on the Fed.  There will be no level targeting (of prices or NGDP.)

Oil and money don’t mix

It occurs to me that oil shocks explain many of our monetary policy failures. 

Consider the recent crisis, which began in 2008.  Why didn’t the Fed cut interest rates in mid-September, 2008, the first meeting after Lehman failed?  Perhaps one reason was that they were actually considering raising rates in the previous meeting, and the ECB did raise rates at about the same time.  But why would they have considered higher rates, NGDP growth was quite slow in early 2008.  The economy had already been in recession for 6 month.  Yes, the Fed didn’t know we were in recession, because of data lags, but they surely knew growth was slow, and they knew the financial system was under great stress. 

The most likely explanation is headline inflation, which had been pushed sharply higher by surging oil prices during mid-2008.  By not cutting rates when the Wicksellian equilibrium rate was falling fast, they effectively tightened monetary policy, and the rest is history.

Now let’s look at late 2010.  Rumors of QE2 caused all the responses the Fed was looking for.  Inflation expectations rose (recall core inflation had fallen to 0.6%)  The dollar weakened.  Stocks soared.  Unemployment fell.  What’s not to like?  Apparently oil prices, which rose quite sharply. 

Let’s put aside the debate over how much of the increase in oil was QE2, how much was rising demand in developing countries combined with peak oil fears, how much was reduced Libyan production, etc.  The key point is that if the Fed pays attention to inflation at all, it should be increases in the price of stuff built with American labor.  They shouldn’t care about the inflation rate that matches some mythical “cost of living,” as the Fed can’t do anything about adverse supply shocks.  They should care about the inflation rate most correlated with macroeconomic stability, which is for stuff built in America.  Better yet, target NGDP growth.  Don’t let NGDP growth per capita fall sharply below the rate of growth in wages.  That means unemployment.

As soon as oil started rising the Fed came under attack, and they folded up like a $3 suit.  When the economy clearly was slowing in the spring of 2011, they went ahead with terminating QE2, and didn’t put any more effective program into effect. 

Imagine there’s no China.  (Or that Mao is still in charge, which is effectively the same assumption.)  In that case oil prices fall in the Great Recession, and don’t bounce back up.  In that case headline inflation doesn’t average 1% over the past three years; it averages 0% or less.  In that case the Fed doves are completely in charge, there is no good argument against stimulus.  Now think about how things have been different.  Inflation’s been just high enough to give the hawks an argument, weak as it is.  China does exist, and this thought experiment shows that China’s demand for oil has effectively sabotaged monetary policy.  That’s not China’s fault, we did it to ourselves.  We should have operated monetary policy as if China didn’t exist.  Instead we let Chinese demand for oil push us into a monetary policy that allowed a bit of inflation, but not nearly enough NGDP growth for full employment.

Ironically, in the 1970s oil caused the opposite problem–excessively expansionary policies.  Even before the 1973 oil shock inflation had begun to rise to excessive levels.  But after the oil shocks it was clearly way too high.  I’m just old enough to remember the constant reassurances from Keynesian economists that it was just a passing problem due to high oil prices.  It wasn’t caused by easy money.  The monetarists saw the 11% per year growth in M*V during 1972-81, and understood money was the problem.  Even without oil we had a major inflation problem, because RGDP only grows about 3%.  Eventually the Keynesians learned this lesson from the monetarists, and new Keynesianism was born.  Once again we need to teach a new generation of economists to ignore oil and focus on NGDP growth.  Let’s hope it doesn’t take a decade, like the last time.

HT:  I thank Statsguy for suggesting this post.  He probably would have done a better one.

Super long and variable lags?

For quite some time the old-style monetarists have been warning that all this “easy money” (what would Milton say!) will produce high inflation, with long and variable lags.  The recent passivity by the Fed has caused TIPS spreads to plummet in the last couple days.  Today for the first time that I can recall the 30 year TIPS spread fell below 2%.  Thirty years is a pretty long lag before that high inflation kicks in.

In fact, monetary policy works with leads, not lags.  Markets are plunging right now on expectations that future monetary policy will be tight, will allow NGDP growth to fall well below even the woefully inadequate 4% of this “recovery.”  The Fed has lost control of the nominal economy.

I hope all you hard money fans are happy—this is what hard money looks like.