The problem isn’t the recent decline in equity prices; the stock market tends to be more volatile than the underlying economy.  Nor is it the recent increase in the fed funds rates (2.4% isn’t very high in an economy growing at 5.5% in nominal terms.)  Rather, the problem is two-fold:

1. Unrealistic forward guidance, which ignores market forecasts.

2. Too much inertia in adjustments in the fed funds rate.

Elsewhere I’ve argued that the second factor may explain the strange absence of mini-recessions in postwar US history.  And this absence is really, really strange.  Just imagine how perplexed geologists would be if the Earth had no small earthquakes, only large ones.  What model could possible explain that? I’ve argued that the sluggishness in the response of interest rates might explain why it is that when we start to slide into a recession we never seem to stop halfway, with the unemployment rate rising by only 0.9 to 2.0 percentage points.

The fed funds rate is currently around 2.4%, and the market forecasts a rate of 2.3% out in July 2020.  That forecast is down sharply in recent months, although still not in recession territory.  Unfortunately, the Fed is forecasting two rate increases next year, and the markets seemed to react poorly to Powell’s attempt to explain this forward guidance.  Even worse, the Fed is often reluctant to change course, because of a perception that it reduces credibility.  Just the opposite is true.  The credibility that matters is the Fed hitting its macro targets, not its interest rate forecasts.

Earlier I suggested the following reform:  Each day, have every FOMC member email their preferred IOR rate, calculated to the nearest basis point.  Set the IOR at the median vote.  Tell the market that the rate will likely follow something close to a random walk, with an increase on one day often followed by a decrease the next.

Looking further ahead, my preference would be to have the Fed entirely cease its targeting of interest rates and let the market determine the appropriate rates.  Instead, the Fed would give the New York open market desk the following instructions:

1.  A range for one year NGDP growth–say 3.5% to 4.5%.

2.  Instructions for the New York Fed to take unlimited short positions on NGDP futures contracts at 4.5% and unlimited long positions at 3.5%.

3.  Instructions to do open market purchases and sales (with Treasury securities) in such a way as to avoid losses in their trading of NGDP futures contracts.

That’s all.  Let the market set interest rates; they are much better able to determine the appropriate fed funds rate.

OK Fed, you’ve got a landing. Now let’s make it “soft”.

PS.  As I contemplate the Fed’s current (flawed) policy regime, I feel sad and blue:

Tyler Cowen recently linked to an article on the Chinese industry of copying famous oil paintings. This is a detail from an oil painting I purchased in China, for about $15 dollars.  It hangs in my office.  In downtown LA, people spend thousands on paintings by hip new artists.  I can get better art in China for a tiny fraction of the price. You might argue that they aren’t really buying art, they are buying a story.  And “I support hip young artists” is more appealing than “I buy Chinese knockoffs of famous paintings.”  Fortunately, I don’t care what other people think of my taste in art.

Merry Xmas and Happy New Year

PPS.  You want a Christmas theme?  Here’s an even better painting (by Titian), recently restored to its former glory:

Over at Econlog, I have a post discussing the slowdown in US population growth, to 0.6% in 2018 (the slowest growth rate since 1937.)  A WSJ article also had some interesting data on state growth rates:

The footnote on Puerto Rico is rather striking, as its population fell by 4% last year.  That was partly due to hurricane Maria, but its population has been plunging for many years, down about 14% since 2010.  Who’s going to pay off that enormous debt, and will the last Puerto Rican please turn out the lights? Hawaii is also losing people, as are Mississippi and Louisiana.  So the “Sunbelt” phenomenon is more complex than advertised.

Other trends:

1.  Mormons have lots of kids.  The four fastest growing states are all in the top five in terms of percentage of the population that is Mormon, although only in Utah and Idaho are they numerous enough to dramatically impact population growth.  (The other top five Mormon state (Wyoming) is losing people.)

2.  Illinois has been losing about 40,000 people each year, while other Midwestern industrial states like Michigan and Ohio keep growing (albeit slowly).  What makes this surprising is that Illinois is dominated by one of the few Midwestern industrial cities to successfully reinvent itself.  Chicago has a thriving lakefront area full of high paying jobs, while Detroit, Flint, Cleveland, Akron and Dayton have languished.  This Illinois underperformance may reflect the extraordinary incompetence of the Illinois state government, which is driving the state toward a fiscal crisis.  Illinois is dominated by Cook County, which has a corrupt political culture.

3.  As recently as 2013, New York had more people than Florida.  Now Florida has 1.75 million more than New York.  Indeed 35% of US population growth now occurs in Florida and Texas.

4.  The sunny, oil-rich states that border Texas continue to do very poorly, either falling in population or growing much more slowly than the national average.  Texas probably benefits from a mixture of no state income tax, lax zoning, and business friendly regulations.  While other inland states also have cheap housing prices, Texas has cheap housing prices in big urban areas.

5.  It now seems like the lack of a state income tax doesn’t provide much gain to states without a big city, such as Alaska, Wyoming and New Hampshire.  The exception is South Dakota, which is doing modestly better than its neighbors.  In contrast, states with big cities and no state income tax (Texas, Florida, Nevada, Washington, Tennessee (on wages)) tend to grow faster than their neighbors.  I think that’s because the lack of a state income tax is especially attractive for the sort of high paid professionals that live in big cities.

6.  The recent federal tax reform will raise the effective top rate on the California state income tax from about 8% to 13.3%.  Many rich people (like me) will continue to choose California, due to its amenities.  But at the margin, a few more will make the switch to Austin or Seattle or Vegas.  California always used to grow faster than the US as a whole.  Even when whites started leaving for other states, the overall California population kept growing at a good clip due to international migration.  But now its growth rate (0.4%) has fallen below the national average.  Eventually, California may begin losing Congressional seats.

7.  Today, most of our population growth is in three areas.  The southeast (Raleigh to Miami), four big Texas metros, and the non-California west (the Denver/Seattle/Phoenix triangle.)

What are the odds that the world’s two richest guys would live in the same medium size city, in the only liberal state without a state income tax?

It will be easier to understand this post if you first read the previous post.  The Fed delivered two monetary shocks today.  The first occurred at 2:15pm, and caused yields on 2 and 5 -year bonds to increase.  The second occurred about 30 minutes later, and caused yields on 2 and 5-year bonds to fall back, and end the day slightly lower.  And yet both shocks seemed “contractionary” in some sense.  Obviously there are some very subtle distinctions here, which require an understanding of Keynesian and Fisherian monetary shocks. More specifically, the first shock was Keynesian contractionary and the second was Fisherian contractionary

At 2:15 the Fed raised its target rate as expected, and also indicated that another two rate increases are likely next year.  This announcement was a bit more contractionary than expected, especially the path of rates going forward.  As a result, 2 and 5-year yields rose, while 10-year yields fell on worries that the action would slow the economy, eventually leading to lower rates.

Later, the markets became increasingly worried that the Fed was not sufficiently “data dependent”, that it would plunge ahead with “quantitative tightening” and that the Fed stance on rates (IOR) would be too contractionary.  Watching the press conference, I had the feeling that Powell might have wanted to be a bit stronger in emphasizing that no more rate increases are a clear possibility, but felt hemmed in by his colleagues at the Fed.  But perhaps I was reading into it more than was there.  In any case, Powell said “data dependent”, but didn’t really sell the markets that he was sincere, or as sincere as the market would wish.  This monetary shock probably reduced NGDP growth expectations, and drove 2 and 5 year yields lower.

Do you see how utterly inadequate it is to talk about monetary policy in terms of interest rates?  Even the “sophisticated’ new Keynesian view that it’s the future path of rates that matters is nowhere near adequate.  The 2 and 5-year yields can go up with tightening, or they can go down with tightening.  Today they did a bit of both, within one hour.

If you insist on using Keynesian language, you might say the 2:15 action tightened primarily by raising expected future rates relative to the natural rate, by raising the expected path of the policy rate.  In contrast, the press conference impacted the gap by depressing the natural interest rate by depressing NGDP growth expectations.

PS.  The discussion on CNBC involved lots of people dancing around the “circularity problem”, i.e. the Fed looking at markets while the markets look at the Fed.

PPS. I laughed when a CNBC person suggested Trump might use the Fed as a “scapegoat”.  Hello, who appointed all the top Fed officials?  Has scapegoating the Fed ever worked for any President, even when they weren’t his appointees?

Update:  I forgot to mention Powell’s most interesting comment.  He says the Fed reappraisal of policy techniques planned for this summer in Chicago will look at the zero bound problem in monetary policy.  I view that as really good news.

Before today’s post, a few quick comments.  I have a piece on Trump’s “deregulation” policies at MarketWatch.  I have a Ted talk on public opinion at Econlog.

It’s clear to me that there is something seriously wrong with the field of monetary economics.  The profession got 2008-09 almost entirely wrong.  But it’s hard to pin down exactly where the problem lies.  After all, there are increasingly sophisticated models being developed by economists who are much smarter than me.  These models feature rational expectations, and all the other bells and whistles you might want. I regret their focus on interest rates and inflation, but that doesn’t fully explain the problem.  While I prefer to talk about money and NGDP, anything that I believe can be translated into New Keynesianism by referring to the gap between the natural rate of interest and the market rate.  So where’s the problem?

In my view, the problem lies in the interface between sophisticated theoretical models and a very crude discourse on monetary policy.  This monetary policy discourse is little changed from 90 years ago, and not at all informed by recent developments in theory.

John Hall directed me to a James Hamilton post that included this remark:

Zhang’s suggested solution begins with the observation by Gurkaynak, Sack and Swanson (2005) that the news revealed by a typical FOMC announcement is multidimensional. The Fed is typically both changing the current interest rate and signaling the changes that are in store for the future.

Here’s my hypothesis.  Monetary models suggest that monetary policy actions are multidimensional, while most of the discourse on real world monetary policy treats policy as one dimensional—easier or tighter money, lying along a single line.  This has led to the confusing debate between Keynesians and NeoFisherians, which I’ll return to later.

Once monetary theorists understood that monetary policy actions affected the entire future path of policy, the modeling problem became more difficult.  At this point they should have stopped basing their models on interest rates, as this variable creates all sorts of indeterminacy issues, or perhaps I should say makes these issues even harder to grapple with—they can also occur when using money itself.

To make things simpler, I’m going to boil the multidimensional theoretical models down to two dimensions—levels and growth rates.  Obviously things are more complicated than that, but it’s enough to make my point about the disconnect between monetary theory and the modern discourse on monetary policy.  I’m also going to work with some alternative monetary instruments, that is, alternatives to interest rates.

Let’s start with the monetary base.  Any change in monetary policy has two dimensions, a level shift and a growth rate shift.  Thus the Fed might immediately increase the base by 3%, but not change its expected growth path going forward, or they might keep the level of the base as is, but announce a faster growth path for the base.  In practice, most monetary policy shocks probably involve a bit of each.  You could plot them using a graph with the X axis being the immediate change in the level of the base, and the Y axis being the change in the expected growth rate of the base.

Elsewhere I’ve argued that Keynesian economics is basically about level shifts, and monetarism is basically about growth rate shifts.  But old monetarism is mostly gone, so I’ll instead describe these two dimensions of monetary policy as “Keynesian” and “Fisherian”.  No “neo” is necessary in front of Fisherian, for reasons that will later become clear.

Thus if the Fed suddenly announces a 3% rise in the base, and also announces that henceforth the growth rate of the base will be reduced by 1.8%/year, then the policy would be described as “Keynesian monetary stimulus and Fisherian monetary contraction.”  Terms like “easy money” and “tight money” are no longer sufficient in this multidimensional world.  And keep in mind that this multidimensional approach comes right out of modern monetary theory.  (Not “MMT”, I mean actual cutting edge monetary theory.)

Unfortunately, money demand shocks leave money as an unsuitable instrument for policy analysis.

I eventually plan to link this up to the Keynesian/NeoFisherian debate.  To do so, we’ll run through the exact same exercise, but this time using the exchange rate as the policy instrument.  (As is the case in Singapore, for instance.)  A Keynesian policy change is a one time adjustment in the exchange rate.  A Fisherian policy change is a change in the expected growth rate of the exchange rate.  In the Dornbusch overshooting model, an increase in the money supply causes a fall in interest rates (to levels below the alternative currency.) This leads to a one-time depreciation in the exchange rate.  But the interest parity condition implies that (with lower interest rates) the exchange rate is expected to appreciate relative to the alternative currency.   With Dornbusch overshooting the currency still depreciates in the long run; the Keynesian effect outweighs the Fisherian effect. But that need not be true in all cases.

In January 2015, Switzerland simultaneously appreciated its currency sharply, and dramatically cut interest rates.  The effect was a policy that was contractionary in both the Keynesian and Fisherian sense.  The Swiss franc immediately appreciated sharply, and was expected to continue appreciating over time (due to the low rates).  In a few cases, exactly the opposite occurs, usually in developing countries experiencing a crisis.  Thus places like Argentina or Indonesia might see their currency sharply depreciate in a crisis, and also see a huge rise in interest rates—which is a forecast of further depreciation (according to the interest parity condition.)  BTW, the interest parity condition does not hold perfectly true in the real world, but that’s not important for the points I’m making.  No macro model holds perfectly true—it’s a model, a stylized picture of reality.

When the US announced the QE of March 2009, the dollar plunged sharply and interest rates fell.  That was an example of Dornbusch overshooting, Keynesian monetary stimulus dominating Fisherian monetary contraction.  By “dominating”, I mean that in the long run the exchange rate ends up lower than before the shock, despite appreciating after the original overshoot lower.  It was easier money, in net terms.

Now let’s imagine the X/Y policy graph I described as a vast plain, with economists living on that featureless surface.  Some economists are only able to see things along the X-axis direction.  We’ll call these economists “Keynesians”.  They think lower interest rates represent easier money.  Others only see things along the Y-axis.  We’ll call these economists “NeoFisherians.”  They believe lower interest rates represent tighter money.   Others can see in two dimensions, we’ll call them “monetarists”.  They do not believe that interest rates tell us anything useful about the stance of monetary policy.

Comments and suggestions are welcomed.

PS.  I’d rather not use money or exchange rates as a monetary indicator, rather I’d prefer to rely on NGDP futures prices.  The level/growth rate distinction also applies there, but is complicated by the fact that NGDP responds slowly to shocks.  Thus unlike with exchange rates, “level shifts” actually take a bit of time.  Recall mid-2008 to mid-2009, which was a sort of level shift down in NGDP, of roughly 8% below trend.  Then the growth rate going forward also fell by about 1%, from 5% to 4%.

I happened to catch Rick Santelli on CNBC this morning, the first time I had seen him in years.  I recall he always used to complain about the zero interest rate/QE policies of the Bernanke/Yellen years, and indeed mocked the idea that easier money could somehow create growth when bad supply-side policies were holding the economy back.  And yet, now that unemployment is down to 3.7% and inflation is back up to 2%, he suddenly opposes a rate increase. I nearly spit out my coffee.

A number of people have recently asked me about what’s going on with all the conservative commenters suddenly opposing higher interest rates.  Didn’t they warn us a few years back that low rates were causing artificially high asset prices?  If so, wouldn’t we want to unwind these asset bubbles with slightly higher (albeit still extremely low) rates?

Steve Chapman pointed me to a Wall Street Journal piece by Stanley F. Druckenmiller and Kevin Warsh:

The time to be dovish was when the crisis struck and the economy needed extraordinary monetary accommodation. The time to be more hawkish was earlier in this decade, when the economic cycle had a long runway, the global economy ample momentum, and the future considerably more promise than peril.

I do recall lots of conservatives favoring a more hawkish policy in the early 2010s.  During most of this period, unemployment was in the 8% to 10% range and both inflation and inflation expectations were unusually low.  I would have thought that was the time to be more dovish, not more hawkish.  But let’s say I’m wrong and that Bernanke’s monetary stimulus was excessive, perhaps because it triggered high asset prices.  In that case, why would someone who had a hawkish view in the early 2010s now oppose interest rate increases, at a time when asset prices are even higher?

In the forlorn hope that I won’t be misunderstood, let me acknowledge two points:

1. There’s a very respectable argument that the Fed should not raise rates tomorrow.  That’s not what puzzles me.

2.  People have a right to shift their views on the Fed policy stance, indeed that’s appropriate when conditions change.  Thus in the early 2010s I thought Fed policy was clearly too tight, whereas now I think it’s about right, because we are close to their inflation and unemployment rate targets.

Many of my commenters are conservatives who oppose a rate increase tomorrow, but also thought money was too tight in the early 2010s.  That’s fine. What puzzles me is those who thought it was too loose when inflation was 1.5% and unemployment was 8%, but now think that the Fed is likely to make it too tight by pushing rates up to . . . 2.5%—at a time of 2% inflation and 3.7% unemployment.  What’s your model?

The elephant in the room is the head of political party with an elephant mascot—Trump.  He thought rates were too low before he became president, and now complains they are too high.  He thinks his trade war is a reason not to raise rates, even though he also claims that trade wars boost American GDP growth by bringing jobs home, which would actually be a reason to raise interest rates.  Of course, no thinking person takes Trump tweets at face value; it’s all politics.  But that raises an interesting question.  The bizarre flip flop of many conservative commenters regarding monetary policy occurred at roughly the same time as the Trump flip flop, which we all know reflected political considerations.

I don’t wish to impute bad motives to those I disagree with; indeed I’m probably missing something.  I eagerly await a coherent explanation of why a tighter policy was needed when the economy was severely depressed and asset prices were far lower than today, and 2.5% interest rates are excessive at a time when the economy is booming, inflation is back at 2%, and asset prices are far higher than in the early 2010s.

Again, I am not saying these conservatives are wrong today.  There are respectable arguments for not raising rates tomorrow.  I simply don’t understand the conservative model of monetary policy.  You may disagree with me, but when it comes to monetary policy I’m no moron.  I can generally teach even theories with which I disagree, and indeed I often taught the Keynesian model to my students.  But I wouldn’t even know how to explain modern conservative views on monetary policy to my students.  What is the model?

When I go to conservative monetary policy conferences, I hear one speaker after another rail against “discretion”.  But when I read modern conservative commentary on monetary policy, I’m confronted with policy judgments that seem far, far, far more discretionary than anything that came out of new Keynesian economics.  At least the new Keynesians favored targeting inflation at 2% and unemployment at the natural rate.  That’s not ideal, but it’s a sort of guidepost.

In contrast, consider this uber-discretionary set of claims:

In a first-best world, the Fed would have stopped QE in 2010. It might then have mitigated asset-price inflation, a government-debt explosion, a boom in covenant-free corporate debt, and unearned-wealth inequality. It might also have avoided sowing the seeds of future financial distress. Booms and busts take the Fed furthest from its policy objectives of stable prices and maximum sustainable employment.

So a tighter money policy in 2010 would have moved us closer to the “policy objectives of stable prices and maximum sustainable employment” because it would somehow prevent “booms and busts”?  Exactly how does that work?  I haven’t seen such fancy footwork since James Harden went up against the Utah Jazz.

And what happened to conservative support for the Taylor Rule?