Archive for October 2011


Gavyn Davies on the Fed meeting

Here’s Gavin Davies of the FT:

The startling recovery in risk assets in October – global equities rose by 11 per cent during the month - was triggered mainly by reduced pessimism on the eurozone’s debt crisis, but was probably also helped by easier monetary policy from several of the major central banks. As usual, the Federal Reserve has been in the vanguard of this action, and further measures are expected from the FOMC when it meets on  Tuesday and Wednesday.

There have been calls for major innovations, such as the introduction of a target for the level of nominal GDP, but the Fed has given little indication that it is ready for anything quite so drastic. Much more likely are some further modest steps to improve the communication of the Fed’s thinking on the future path of short rates, with the aim of keeping long rates as low as possible. And there might also be some more purchases of mortgage backed securities.

This certainly caught my attention, as there were three high profile endorsements of NGDP targeting recently; Romer, Krugman and Goldman-Sachs.  And there is only one person who was cited or linked to in all three statements.  I’m tempted to resurrect my connecting the dots post, but can’t really do so in good faith.  Davies is right; NGDP targeting is not going to be adopted at this meeting.  Indeed something that important ought to be widely debated first.  And that hasn’t yet occurred.  Still, I’d hope to see a mention that they are at least discussing the merits.

I do think Davies might be right about monetary stimulus chatter having some effect on equity prices recently, but I don’t see any firm evidence that would make that more than a conjecture.  In any case, any influence I have on that debate is an order of magnitude lower than the specific topic on NGDP targeting.

Davies continues:

Although the idea has merit, and may well be discussed by the FOMC in future, it is not likely to emerge from this week’s meetings.  Ben Bernanke has discussed many radical actions for monetary policy in the past, notably relating to Japan a decade ago, but I do not recall him ever giving much attention to a nominal GDP target.  He has consistently focused on the advantages of adopting a clear and consistent target for the rate of inflation (note, not the level of prices, but their rate of change, so past shortfalls would not need to be restored), and in a recent speech on 18 October he said the following:

“As a practical matter, the Federal Reserve’s  policy framework has many of the elements of flexible inflation targeting…The FOMC is committed to stabilising inflation over the medium term while retaining the flexibility to help offset cyclical fluctuations in economic activity and employment.”

A couple points.  Davies is right about Bernanke’s focus on inflation, but Bernanke actually has recommended the level targeting of prices.  Of course it was for Japan, not the US.  It’s too bad Bernanke has no interest in NGDP targeting, as it would achieve the objective laid out in that quotation far better than inflation targeting.  Indeed that Bernanke quotation is a textbook argument for NGDP targets.

He went on to argue that inflation targeting had proven its worth in stabilising inflation expectations in both directions in recent years, and he concluded as follows:

“My guess is that the current framework for monetary policy – with innovations, no doubt, to further improve the ability of central banks to communicate with the public – will remain the standard approach, as its benefits in terms of macroeconomic stabilisation have been demonstrated.”

If a 9% fall in NGDP below trend from mid-2008 to mid-2009, which led to massive and costly fiscal stimulus in the desperate hope it would prop up the very same aggregate demand that the Fed is supposed to be controlling is “benefits . . . demonstrated,” I’d hate to see a failed monetary policy.  And then there’s the sub-5% NGDP growth during the 27 month “recovery.”

Janet Yellen is particularly important here, since she is in charge of a Fed committee examining the matter. In her speech, she said:

“We have been discussing potential approaches for providing more information — perhaps through the SEP — regarding our longer-run objectives, the factors that influence our policy decisions, and our views on the likely evolution of monetary policy.”

The SEP is the Summary of Economic Projections, in which FOMC members give their outlooks for the main economic variables in the years ahead. It seems from Janet Yellen’s guidance that the Fed might decide to beef up this document so that it becomes more explicit about the nature of its long run inflation and unemployment objectives, and about the conditions underpinning its commitment to hold interest rates close to zero until mid 2013.

It is even possible that FOMC members might start to publish their entire expected path for short rates over future years, conditional on their economic forecasts. (Read my lips: no new rate hikes!”) The Chairman has explicitly pointed out that other central banks publish such projections of policy rates, which help influence market expectations of central bank policy.

The idea here would be to increase the confidence of the markets that short rates are intended to remain at zero for a very long time to come, which might in turn reduce long bond yields even further.  That would be useful in easing monetary policy slightly, but it cannot be expected to have very much effect when short rate expectations are already so low. More drastic options, like a target for the level of nominal GDP, will have to wait a while.

That doesn’t do much for me.  I’d say lower long term rates are more likely to be “evidence that monetary policy remains ineffective,” rather than “useful in easing monetary policy slightly.”  The Fed is still a long way from the point where it comes to grips with what actually needs to be done.  But at least they are searching for answers.

HT:  Richard W.

PS.  Joshua Lehner just sent me some interesting graphs comparing actual NGDP growth with Fed forecasts at different time horizons.  They obviously envision roughly 5% NGDP growth, and just as obviously aren’t doing level targeting.  Interestingly, he said the Fed stopped doing explicit NGDP forecasts in 2005, now it’s just RGDP and P.  That’s a bad sign.

Update:  Josh Lehner send me this post from his blog.

Can it get worse?

A few weeks ago there was some discussion about the prospects of a double dip.  I try to stay out of the fortune-telling business, as I don’t believe I or anyone else can predict the cycle better than markets.  But one line of reasoning that I found less than convincing was the argument that monthly car sales and monthly housing sales are already quite low.  And other parts of GDP aren’t that cyclical.  We know from the 1930s that things can get a lot worse.  If NGDP falls sharply, RGDP will also fall sharply.

But it’s only fair to point out that a month or two later those making the optimistic case (for avoiding the double dip) seem vindicated (knock on wood.)  If so, I’d point to another factor—monetary policy.

In the 1930s the Fed was incredibly passive; hence there was no floor on NGDP, or at least a very low floor.  Since 1982 the Fed has been following something close to a Taylor Rule.  As long as nominal rates are positive, markets have confidence that shocks won’t drive NGDP much lower.  Remember how bleak things seemed right after 9/11?  RGDP actually rose in the 4th quarter of 2001.

In my view there is still a floor on NGDP, even at zero rates, because the Fed still has some credibility.  But the floor is much lower than when rates are positive.  The upshot is that while there might be a mild downturn, I’d be shocked if we had a severe recession.  That’s not to say it can’t happen, but it would certainly be inconsistent with Fed behavior over the past couple of years, when they have used various unconventional stimulus tools when things looked especially bad.  I suppose my biggest fear would be a fast moving crisis, perhaps centered in Europe—with the Fed again letting bygones-be-bygones, and settling for growth rate targeting.

There’s no reason anyone should take any of my hunches seriously.  I didn’t predict the Great Recession until the markets did.  And if there’s another dip, I won’t predict it until the markets do.  All I’m saying is that visualizing the likely Fed response function is the most useful way to explore the possibility of a double dip, not whether various categories of RGDP “can’t go any lower.”

What we’re talking about when we talk about inflation

Some days I want to just shoot myself, like when I read the one millionth comment that easy money will hurt consumers by raising prices.  Yes, there are some types of inflation that hurt consumers.  And yes, there are some types of inflation created by Fed policy.  But in a Venn diagram those two types of inflation have no overlap.

So here’s my plan.  Beginning tomorrow, November 1st, I will ban all discussion of inflation from the comment section. I won’t respond to questions on inflation.  (God knows how Bob Murphy will react to this—something tells me it won’t make me look good.)

Before everyone starts whining, I am about to provide a substitute language for you to use, and tell you when to use it:

1.  Let’s start with the easiest type of inflation to consider, and the only one people really care much about—supply side inflation.  Suppose the AS curve shifts to the left because of a cutoff in oil production, crop failures, bad government tax and regulation policies, etc, etc.  Real GDP will fall, if we do nothing to aggregate demand.  And prices will rise.  People think it is the price rise that is making them worse off, but that’s an illusion; it’s really the drop in RGDP.  How do we know?  Because consider the case where the Fed responds with tight money, which shifts AD far enough to the left to prevent any inflation from the adverse supply shock.  In that case there are two possibilities; the drop in real GDP and real living standards would be just as bad (if money is neutral) or it would be even worse, if money isn’t neutral.  It is the fall in RGDP that is the key problem, and any price change is incidental to what’s really going on.  So if you ever envision an inflation problem that makes consumers worse off, please don’t call it “inflation,” call it “falling real incomes.”

2.  Now let’s turn to demand-side inflation, which either makes people better off in the short run (via higher RGDP, higher real incomes), or has no effect (if money is neutral.)  Here there are many cases to consider:

2.a.  Some argue that low inflation makes a liquidity trap more likely.  But as we can see by comparing Japan, China, and Hong Kong, mild deflation creates liquidity traps only when real growth is persistently low.  The problem isn’t low inflation, it’s low expected NGDP growth.  That’s because real interest rates are strongly correlated with real GDP growth, and of course expected inflation in nominal rates is perfectly correlated with the expected inflation component of NGDP growth.  So from now on please talk about the danger of low NGDP growth leading to a liquidity trap, not low inflation.  China had deflation in the late 1990s, but fast RGDP growth—hence no LT.

2.b.  This also applies to the phony tears people shed for the savers hurt by inflation.  Let’s assume savers buy long term nominal bonds.  Those bonds promise a fixed amount of money, at specified futures dates.  The standard argument is that inflation hurts savers by reducing their real return on bonds.  But savers don’t care about the nominal interest rate minus the inflation rate, they care about the nominal interest rate minus the per capita NGDP growth rate.  I’ll give you an example.  Years ago the British government indexed the initial starting point for retirement pensions to the cost of living, not average wages (as we do.)  The Thatcher reforms led to real increases in living standards iGn reat Britain, and so over time the living standards of retirees fell further and further behind living standards of the employed (who received nominal wages increases that exceeded inflation.)  Eventually the old-timers looked at the flashy lifestyles of their younger neighbors, and revolted.  The UK government was forced to change the indexing scheme.  People don’t care about real incomes they care about how they’re doing relative to their neighbors.  If NGDP rises faster than expected, then a bondholder is paid back a smaller share of national income than he anticipated when he bought the bond.  And that hurts.

2.c.  The Fisher effect applies to nominal interest rates minus NGDP growth, not minus inflation.  Some Keynesians fear that the Fed can’t stimulate the economy, because it finds it politically difficult to increase the expected rate of inflation.  But they don’t need to increase the expected rate of inflation, just the expected rate of NGDP growth (and the SRAS is pretty flat right now.)  When expected NGDP rises you get more investment whether firms expect more inflation, or more RGDP growth.  So just shoot for more nominal growth.

2.d.  Some people say inflation and deflation are bad because wages are sticky.  A sudden bout of deflation will raise real wages, and lead firms to lay off workers.  But that’s only true if the deflation comes from falling NGDP growth expectations.  Suppose it is the “good deflation,” produced by rising productivity.  Then if wages are sticky the deflation raises living standards.  This occurred during the 1927-29 boom, when the price level fell in America.  Of course that was followed by a “bad deflation,” sharply falling NGDP during 1929-33.  So rather than talk about good and bad deflation, let’s just talk about what we really mean, rising and falling NGDP.

2.e.  Some people think the Fed should target inflation.  When you mention oil shocks they say “well that’s an exception, I favor a flexible inflation target that allows prices to rise during supply shocks.”  OK, but then why not just target NGDP, so you don’t have to make exceptions?  Why totally confuse the public?

2.f.  One of the supposed costs of inflation is the excess tax on capital caused by the fact that capital gains taxes and taxes on interest are not indexed.  But that’s really a problem of high nominal returns on capital, not high inflation.  You say the two are correlated?  I say they’re even more correlated with NGDP growth.  So let’s talk about how rapid NGDP growth imposes inefficient tax burdens on capital.

2.g.  Menu costs?  Maybe, but it’s ambiguous, which is not enough to overcome my presumption for NGDP growth.  After all, many economists think the biggest menu costs apply to wages, which seem very hard to adjust.  Costly strikes result from attempts to adjust wages.  Or workers occupy the capital building in my hometown of Madison.  And wages are arguably more closely linked to per capita NGDP than inflation.  In early 2008 inflation rose rapidly while NGDP did not.  Wages remained well contained.

2.h.  The inflation tax from printing money?  It comes from the opportunity cost of holding cash, which is the nominal interest rate.  And the nominal interest rate depends on NGDP growth.  (I should add that it also depends on lots of other things, like economic slack and budget deficits.  But those other things are also “not inflation.”)

2.i.  Inflation can reduce the burden of the national debt?  No, NGDP growth reduces the burden of the national debt.  Does unexpected disinflation trigger debt crises?  No, it’s unexpected falls in NGDP that trigger debt crises.

To conclude:  If you are about to type the word “inflation,” please stop.  If you have in mind something that implies lower living standards, please type “falling real incomes.”  If it is a demand-side inflation (all the items in category 2 above) then type “NGDP growth” or “nominal income growth.”

So you have 12 hours to convince me to rescind this ban, before it goes into effect.  If you cannot come up with a scenario where I need the word “inflation,” then it will be banned.

Happy Halloween!

Can the Fed learn to speak a non-interest rate language?

I was reading a new book by Tim Congdon and came across this interesting quotation, discussing the flaw at the heart of New Keynesian economics:

In the New Keynesian schema, it [the interest rate] became in effect the only policy instrument, the factotum of macroeconomics.

Why did we have to end up with the worst possible policy instrument?  The only instrument that has a zero lower bound.  We could have chosen the monetary base, or the trade-weighted exchange rate, or the price on NGDP futures, or the TIPS spread, or the price of zinc.  But no, we had to pick nominal interest rates.

We ended up with a steering mechanism that locks up just when you most need it to work.  Even worse, central banks have so fallen in love with the mechanism that they can’t seem to shift to a different target.  Instead we end up with never-ending attempts to manipulate interest rates, even when short term rates have hit zero.  Promise to hold rates at zero for X number of years.  Or attempts to lower longer term rates.  Or to reduce interest rate risk spreads.

These proposals have a slightly pathetic quality, because (as Nick Rowe reminds us in this recent post) a policy that is expected to be successful will actually raise nominal rates.  So you have the Fed announcing that the goal of QE2 was to lower long term rates, and then when they start rising the Fed announces that the policy must be working.  It’s a wonder the Fed still has any credibility.  How’s this for communication?

WASHINGTON — The Federal Reserve made a rare promise on Tuesday to hold short-term interest rates near zero through at least the middle of 2013, in a sign that it has all but written off the chances of an expansion strong enough to drive up wages and prices. . . .

By its action, the Fed is declaring that it, too, sees little prospect of rapid growth and little risk of inflation. Its hope is that the showman’s gesture will spur investment and risk-taking by convincing markets that the cost of borrowing will not rise for at least two years.

The Fed’s statement, with its mix of grim tidings and welcome aid, contributed to wild market oscillations as investors struggled to make sense of the economy and the path ahead.  (emphasis added)

Well that will certainly whip up those animal spirits!

The zero rate bound doesn’t occur for variables like the monetary base.  Some Keynesians argue that this doesn’t matter; open market purchases become ineffective when rates hit zero, as one is merely swapping one asset for another.  But that’s not true, as a permanent increase in the base is inflationary.  And if the Fed had already been using the base, it would have been able to continue signaling future policy intentions as if nothing had happened.  In contrast, once rates hit zero the Fed can’t signal anything with changes in interest rates, because it can’t change interest rates.

Of course the New Keynesians also insist that interest rates are the transmission mechanism.  Not so.  When there’s a big apple crop, NGDP in apple terms soars.  No need to invoke interest rates.  Ditto for a big crop of Federal Reserve Notes.  And the mechanism that causes nominal shocks to have real effects is sticky wages and prices, not interest rates.  When I point out that rates hardly budged during the most expansionary monetary policy in US history, Keynesians start talking about rates falling relative to their Wicksellian equilibrium value.  Yes, but that’s pretty much true by definition, and true for any price.  If the Wicksellian equilibrium zinc price is the one consistent with 2% inflation, then the Fed can boost inflation above 2% if and only if it can raise zinc prices above their Wicksellian equilibrium.

The next meeting will be a big test for the Fed.  I don’t expect miracles, but I’d hope for at least some sign that they understand there’s nothing more they can do to generate recovery by fiddling with interest rates.  They need to indicate that they are at least attempting to communicate in some other language.

Most people seem to assume nothing major will be done until the three hawks leave in January.  In fact, Fed stimulus would be more credible if they could get at least one of the three to vote for it.  It seems to me that Kocherlakota offers the best hope.  At times he seems to indicate that he’s aware of the unemployment problem, but doesn’t like the lack of a nominal anchor in open-ended promises, such as two years of near-zero interest rates.  He might be willing to support stimulus, as long as there is an explicit promise to maintain prices or NGDP along a particular trajectory.  If I’m right, it’s quite possible that the fate of 100,000s of unemployed people might depend on what he decides.

It’s no way to run monetary policy.  We should have an explicit 5% NGDP target, and let the market set the money supply and interest rates.  But you go into recession-fighting with the Fed you have, not the Fed you wish you had.

McCallum on NGDP targeting

This is from a recent paper on NGDP targeting by Bennett McCallum:

I find it plausible that movements in nominal spending growth would be more closely and reliably related to central bank policy actions—primarily open market sales and purchases—than would movements in inflation and output separately.  If so, then the central bank that targets nominal GDP would not have to rely upon its models of the way in which nominal and real variables are related, that is, its model of the “Phillips curve” relationship.  That is a significant advantage, because the Phillips curve relationship is the component of quantitative (econometric) macroeconomic models for which professional understanding and agreement is, by far, the weakest.  Thus, if the central bank can manage nominal spending growth in a manner that does not involve conceptually the Phillips curve, it can conduct policy without use of that elusive relationship.  By contrast, if it focuses on inflation and real GDP separately, or on inflation alone, it cannot possibly avoid its use.

The point of view expressed in the preceding discussion is somewhat reminiscent of Milton Friedman’s approach to price-level determination, in which he famously depicts the central bank as choosing the supply of money in nominal terms while the private sector is choosing the quantity of money demanded in real terms.  The interaction of these choices then determines the price level—see Friedman (1987, pp. 3-4).  In the present application, the central bank determines the amount of spending in nominal terms, with the private sector’s behavior determining how much of any change in spending will be in terms of (real) output changes and how much will be in (nominal) price level changes.

I like the analogy with nominal money supply and real money demand, which I’ve always seen as the core of monetary economics.  Indeed my biggest beef with Keynesians is that they don’t see Friedman’s example as the core of monetary economics.  I also like the pragmatism in McCallum’s approach.  We really don’t have good Phillips Curve models.  I think this is partly because our data is worse than many assume, and is less closely related to the theoretically appropriate concepts than many macroeconomists assume.  For instance, one reason why deflation is bad is because it’s less profitable to produce output when prices fall (if wages are sticky.)  In that context it’s interesting that official CPI figures show housing prices up 7.5% over the past 5 years, and the Case-Shiller index shows housing prices down 32% over the past 5 years.  Which provides a better estimate of the incentive to construct new houses?  Which is the inflation number used in actual economic studies by real world macroeconomists?  It’s also much easier to measure the nominal output of the health care industry, the consulting industry, or the PC industry, than to separately measure the prices and outputs of those two industries.   And even if we had accurate data, the Phillips Curve would be highly unstable due to things like the recent extension of unemployment insurance from 26 weeks to 99 weeks.  But the data problems make it even worse.

Here McCallum expresses skepticism about level targeting:

From the foregoing it can be seen that one issue that arises in discussions of nominal GDP targeting is whether the targets should be expressed in terms of “level” or “growth-rate” measures.  For an example of the distinction, suppose that the chosen rate of growth of nominal GDP is 4.5% per year.  Suppose that in some year, however, the central bank misses that target by a full percentage point on the high side, yielding 5.5% growth consisting of (for example) 3.0 percent inflation and 2.5% real growth.  Should the central bank strive for the usual 4.5% growth in nominal GDP again in the following year?  Or should it decrease its growth target to 4.0%, aiming thereby to be back at the original path for the nominal GDP level at the end of the next year?  In other words, should the nominal GDP targets be set in terms of growth rates or growing levels?  In the latter case, the disadvantage will be that policy that decreases nominal growth below its usual target value may be excessively restrictive, whereas the former case leaves open the possibility of cumulative misses in the same direction for a number of periods, i.e., it permits “base drift” away from the intended path.  My position on this issue has been that keeping with the target growth rates will, if they are on average equal to the correct value over time, be unlikely to permit much departure from the planned path and so should probably be preferred.  This is not at all a universal point of view, however, among nominal GDP supporters.

In this recent post I explained one advantage of level targeting; the fact that it leads market participants to assist monetary policymakers.  Perhaps I’ve been overly influenced by the 2008 period, when the advantages of level targeting seem relatively large.  I would also point to Michael Woodford’s work on liquidity traps.  Woodford argues that level targeting is especially important when a central bank hits the zero bound (as he is even more skeptical about QE than I am.)  McCallum may be right that when the central bank is doing its job, growth rate targeting is as good as or even better than level targeting.  By “doing its job,” I mean targeting the forecast.  But given the spotty track record of real world central banks, it seems to me that level targeting has a great advantage over growth rate targeting, the ability to prevent very large and costly errors.  It seems inconceivable to me that NGDP would have fallen 9% below trend between mid-2008 and mid-2009, if markets had known that the Fed was engaging in level targeting of NGDP and would soon return the economy to the trend line.

PS.  In my previous post I probably created the impression that I entirely agree with Romer’s post.  Those who view me as an inflationist may be surprised to learn that I actually think her recommendation is a bit too expansionary.  In 2009 I favored going back to the old (pre-2008) trend line.  I still think that policy would be better than the status quo.  But any dating of a trend line is arbitrary unless the Fed has set an explicit target.  As time goes by more and more debt and wage contracts have been set based on post-2008 expectations.  So at this late date it might be more prudent to only go part way back.

And in a sense this discussion is purely academic.  My fear is that the Fed will do too little, not too much.  My recent discussion of aiming for 6% or 7% growth for a couple years, and 5% thereafter, is actually far more conservative than the Romer proposal, but also represents the outer limits of what the Fed would be willing to do.  More likely they’d just shoot for 5%, with no catchup at all.  The same discussion occurred during the Great Depression, when some advocated going half way back to pre-Depression prices, and others advocated going all the way back.  They only went half way back, but even that would have been enough for a quick recovery if the NIRA hadn’t raised nominal wages by over 20% in the late summer of 1933.

PPS.  David Beckworth also comments on McCallum’s paper.

PPPS.  Lars Christensen also comments on McCallum.