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Conservative Keynesianism leads the Fed astray

From the Financial Times:

The Fed chair said she expected inflation to return to a 2 per cent annual rate over the next few years as temporary influences wane.

Why?  What will cause inflation to return to 2%?

Ms Yellen added that there were financial stability risks to holding rates at ultra-low levels for too long.

“Continuing to hold short-term interest rates near zero well after real activity has returned to normal and headwinds have faded could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability.”

Why would low rates encourage excessive risk taking?  And if they do, how does the Fed remedy that situation?  Do they raise rates for a couple years, at the cost of lower rates for a couple decades, or do they lower rates for a couple years, at the cost of higher rates for a couple decades?  Where is the model?  How do they get from here to there?

“Reducing slack along these other dimensions may involve a temporary decline in the unemployment rate somewhat below the level that is estimated to be consistent, in the longer run, with inflation stabilising at 2 per cent,” Ms Yellen said.

Allowing the unemployment rate to fall below its long-run level for a period could also have the benefit of “speeding the return to 2 per cent inflation”, Ms Yellen argued. It could have the extra positive of reversing some of the supply-side damage suffered by the US economy in recent years.

Since when has the Phillips Curve been a reliable model for predicting inflation?

Keynesianism is usually considered a “liberal” model.  That’s a bit misleading, as most conservative economists also use a Keynesian framework for analyzing the economy. They talk about the various sectors of the economy; consumption, government, net exports, etc.  They worry that monetary policy is ineffective at the zero bound.  They think inflation is caused by low unemployment.  They think low interest rates can lead to excessive risk taking.

In fact, except in the very short run, interest rates reflect the conditions of economy, not the stance of monetary policy.  Inflation is not caused by low unemployment, but rather by excessive NGDP growth.

The latest TIPS spreads have fallen to shockingly low levels:

5 Year TIPS spread  = 1.19%

10 year TIPS spread  = 1.50%

30 year TIPS spread = 1.69%

Recall that the Fed’s CPI inflation target is around 2.3% (give or take a few tenths.) These TIPS spreads call for monetary easing, or else the Fed may soon lose credibility.

Fortunately there is a ray of hope:

“Inflation may rise more slowly or rapidly than the committee currently anticipates; should such a development occur, we would need to adjust the stance of policy in response,” Ms Yellen said at the Philip Gamble Memorial Lecture University of Massachusetts, Amherst.

If this happens (and pretty I’m confident it will) then the Fed needs to do more than “adjust the stance of policy.”  The Fed needs to rethink its entire approach to policy. The Fed needs to define what they mean by “the stance of policy.”  The Fed needs to revisit past decisions, and figure out what they did wrong.  I hope they will look at what their critics have been saying.  Then the Fed needs to start setting the stance of policy at a position where the markets expect the Fed to succeed.

PS.  I understand the Fed has a dual mandate, and I don’t think it’s a big deal if they undershoot their inflation target for a couple straight years.  I do think it’s a big deal if they undershoot for a couple straight decades, as the Japanese have done, and the Europeans are doing.  I expect more from the Fed, especially as they’ve had the benefit of seeing what happened with other central banks, when they tried to raise rates above the Wicksellian equilibrium rate.


Question of the Day

What is the total number of months during the Ford, Carter, Reagan and Bush I administrations, plus the first term of Clinton, when the unemployment rate was lower than today?

Answer:  1

(March 1989, when it was 5.0%)

Come on discouraged workers, get out there and start looking!

The first step is admitting you have a problem

That is, the first step toward NGDP targeting.  Marcus Nunes has a new post that quotes a Jon Hilsenrath story in the WSJ:

JACKSON HOLE, Wyo.—Central bankers aren’t sure they understand how inflation works anymore.

Inflation didn’t fall as much as many expected during the financial crisis, when the economy faltered and unemployment soared. It hasn’t bounced back as they predicted when the economy recovered and unemployment fell.

The conundrum challenges much of what central bankers thought they understood about the world, as well as their ability to do their job. How will they know when to raise or lower interest rates if they’re unsure what causes consumer prices to rise and fall?

“There is definitely less confidence, a lot less confidence” about how inflation works,James Bullard, President of the Federal Reserve Bank of St. Louis, said in an interview here Friday.

The mysterious path of inflation during the crisis and post-crisis era is the main topic at the Federal Reserve Bank of Kansas City’s annual economic symposium here, where Fed officials, academics and global central bankers gather every August to discuss economic issues.

Inflation dynamics are more than an academic issue. Fed officials are considering whether to raise short-term interest rates from near zero, where they have been since December 2008. The Fed’s main sticking point is that inflation has run below its 2% target for 39 straight months. Inflation is lower than central bank objectives throughout the developed world, despite exceptionally low interest rates and other extraordinary measures aimed at driving it higher.

Before raising rates, Fed officials want to be confident inflation will rise to 2%. They have a theory it will. Unemployment is falling—reaching 5.3% in July—and slack in the economy appears to be diminishing. As supplies of labor and productive capacity become more constrained, officials believe wages and prices will rise.

So far, however, there are few indications that’s happening. The Commerce Department reported Friday that U.S. consumer prices rose 0.3% in July from a year earlier, well below the Fed’s goal. Stripping out volatile food and energy categories, officially measured inflation also runs below 2%.

The economy’s performance has “really challenged” the notion of a strong link between unemployment and inflation, Mr. Bullard said on the sidelines of the conference. The existence of such a link was also challenged in the 1970s, an era of high inflation and high unemployment.

Fortunately, there another nominal variable that still does track the business cycle very closely:

Screen Shot 2015-08-29 at 10.42.05 AMMarcus’s post also has some interesting graphs.

PS.  I have a new article on Milton Friedman and the euro, published in Reason magazine.  (Subscribers only, but why wouldn’t you already be a subscriber?)


Nick Rowe’s wisdom, New Keynesianism vs. NeoFisherism, and Fed incompetence, all explained in one 7 minute bicycle video

Here it is.

HT:  Tyler Cowen

Japan prediction from 2011, revisited

Back in 2011 most experts claimed there was nothing the Japanese could do to boost NGDP.  It was believed they were stuck in a liquidity trap.  Then in 2012 candidate Abe announced that he would implement a more expansionary monetary policy, including a 2% inflation target.  I suggested the policy would help, although they’d fall short of 2% inflation.  Mark Sadowski has a post showing the path of inflation.  (When Abenomics was announced in November 2012 the Nikkei was around 8700 and the yen at less than 80 to the dollar.)

Screen Shot 2015-08-20 at 11.34.31 AM

Mark also generously quoted from a 2011 post of mine that I’d forgotten about.

Just to be clear, it is quite possible (likely in my view) that Japan could get another 2% of RGDP by switching to a 3% NGDP target.  But it would be a one-time gain, as their labor market got less rigid.  Unemployment might fall to 2% or 3%, but trend growth shouldn’t change.

In fact, RGDP growth was 2.4% in the first year of Abenomics, and has been roughly zero since.  Recall that zero is the new trend growth for Japan, due to their rapidly falling working age population. Yes, I was a bit lucky, but as Napoleon once said “give me lucky generals.”  (or something vaguely like that, probably in French, not English.)

Marcus Nunes has a new post that quotes from the recent FOMC meeting:

There was push back against hesitating. A number of officials argued that a rate increase could convey confidence to the world about the economic outlook and that the Fed needed to move in acknowledgment of the progress the economy had already made toward normalcy.

Yes, tighter money from the Fed is just what global markets are looking for right now, to regain confidence.

You can’t make this stuff up.  While traveling I saw a story that the new President of the Dallas Fed is going to be a management professor.

PS.  I have a new post at Econlog.