All is Lost

I just saw a film with that title, about a guy drifting around lost in the middle of the Indian Ocean on a small sailboat.  Today I’m going to show you just how contractionary current money policy actually is.  But not based on the Sumner/Bernanke “NGDP growth is the optimal way to measure the stance of policy” argument that almost no one seems to buy, (not even Bernanke.) No, I’m going to show you that policy is currently ultra-tight using the Fed’s own criteria.  I will show that the Fed is violating the law without even knowing it.  I will show that if you start with current policy, and make two changes that are each unambiguously expansionary, you end up with a policy that is so hawkish that it clearly violates the Fed’s dual mandate.

A few weeks back I did a post advocating that the Fed abandon one of the two thresholds in their forward guidance.  Many people misunderstood the post, because they misunderstand the guidance.  So let’s be clear:

The Fed promises not to raise rates as long as unemployment is above 6.5% and inflation is below 2.5%.  (That means they have the option of raising rates or not raising rates when unemployment is below 6.5% and/or inflation is above 2.5%.  It’s a negative promise, to refrain from something, not a promise to affirmatively do anything.)

I said drop the employment threshold.  At first glance you would think that is a hawkish move, as you ignoring more “dovish” part of the dual mandate. In fact, it’s just the opposite.  The scenarios where they would be allowed to raise rates become even fewer. Now they can raise rates when unemployment is 6% and inflation at 2%. Under my proposal they would not be able to do so.

After the post, Fed officials began discussing the possibility of lowering unemployment threshold to 6.0% or even 5.5%. That would be a move in the direction I recommended, but my proposal is obviously much more radical, and importantly much more dovish.

So I hope we can all agree that my proposal would be a substantial move in the dovish direction.  In today’s Wall Street Journal there is another proposal that would also make policy substantially more dovish:

Officials also have mixed views about the benefits of lowering the 6.5% unemployment threshold.

At a July meeting, for instance, they worried moving the threshold would hurt their credibility and undermine their effectiveness, according to meeting minutes. At a September meeting, minutes showed, some favored keeping the 6.5% threshold but explaining in more detail how long they would wait to raise rates after it was crossed. Fed officials have also considered adjusting their 2.5% inflation threshold to make clear they don’t want it below 1.5%.

Inflation is currently running at about 1.2%, hence a 1.5% inflation floor would immediately force the Fed to adopt a significantly more stimulative monetary policy. That’s another move that pushes policy in a substantially more dovish direction.

And where would we end up after the two changes discussed above? We would end up with a promise to keep inflation within a 1.5% to 2.5% range. In other words we would end up with a single mandate, 2% inflation target. At a time when unemployment is far above the Fed’s estimate of the natural rate of unemployment, focusing like a laser on 2% inflation becomes an ultra-hawkish policy. Indeed it would be a clear violation of the Fed’s dual mandate to address both inflation and employment. It would be clearly ignoring the employment side of the mandate.

Let me be clear that I am not saying that current Fed policy is as ultra-hawkish as the 2% inflation target that ignores unemployment, which I’ve just described. No, I’m not saying current Fed policy is that ultra-hawkish. I am saying it is far, far more hawkish than that. If I walked into an FOMC meeting and proposed the two changes discussed above, I’d be laughed out of the room. Richard Fisher would ask if I had just arrived from Zimbabwe. There is no way the Fed would even consider doing both of those changes at the same time. And yet if they did they would end up with a policy that is still so contractionary that it would be in violation of the law.

The Fed is currently so far from home that they don’t even know which way to go, just like Robert Redford on the middle of the Indian Ocean with his damaged sailboat.

Lost at sea.

PS.  Lot’s of people are asking me for comments on a new Fed paper that discusses NGDP targeting.  I’ve already addressed all the anti-NGDP arguments in my Mercatus paper on the subject, and dozens of blog posts.  I see no reason to respond to the same arguments over and over.  The rest of the profession needs to respond to the arguments that we (market monetarists) are making.  I don’t see them doing so.  It’s their job to catch up; we are way ahead of the consensus on this issue.

BTW, in addition to all the reasons already discussed for not worrying about NGDP revisions, the new Philly Fed estimates of “NGDPplus” provide another reason why data revisions are not a barrier to NGDPLT.

HT: Frank McCormick

Update:  I should add that things are slightly more complex than I suggested; the 1.5% to 2.5% channel has a little bit of price level “catch-up” built in for the current undershooting of 2%, so there is a small degree of price level targeting added on to inflation targeting.  But fundamentally it’s a 2% inflation target. It’s the Fed saying we’d like inflation above 1.5% and below 2.5%


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27 Responses to “All is Lost”

  1. Gravatar of Saturos Saturos
    7. November 2013 at 06:32

    Europe making same mistakes as Japan in 1990′s, IMF conference paper argues (don’t get your hopes up): http://blogs.wsj.com/economics/2013/11/07/europe-making-same-mistakes-as-japan-in-1990s/

  2. Gravatar of Andrew M Andrew M
    7. November 2013 at 06:37

    Regarding the PS paragraph,

    On the contrary, I think you have very good reasons to continue responding to same arguments over and over. Not doing so risks losing the current status of your operation. The rest of the profession does not need to respond to your (MM) arguments because they are still the majority and until that shift of power or common sentiment happens, we will still have to be the ones making noise. I caution you not to overlook the value of the repetition despite it undoubtedly becoming draining and at times intellectually uninteresting.
    My advice: Respond to the paper, crush it, be relentless, and continue to establish/retain dominance. Those who lack the insight, the infrastructure, and those who just aren’t quite there yet look to you for leadership and guidance. The ball is still in your court.

  3. Gravatar of jj jj
    7. November 2013 at 06:56

    Scott, a 2% inflation target is not precisely equivalent to a 1.5% floor and a 2.5% threshold giving them the option to raise rates.
    But I agree that in practice, the Fed would clearly act to raise rates at 2.5% inflation, so you’re essentially correct.

  4. Gravatar of Saturos Saturos
    7. November 2013 at 07:22

    Breaking: ECB drops rate by 25 basis points: http://www.bbc.co.uk/news/business-24851483

  5. Gravatar of Saturos Saturos
    7. November 2013 at 07:23

    Golden quote:
    “It is obvious that the ECB under president Draghi has become much more pro-active than under any of his predecessors.”
    Carsten Brzeski, ING analyst

  6. Gravatar of Doug M Doug M
    7. November 2013 at 08:42

    I would prefer it if they dropped the forward guidance altogether. They will be easy as long as it is in their interest to be easy.

  7. Gravatar of jknarr jknarr
    7. November 2013 at 09:36

    Scott, could policymakers (the Fed and Treasury together) in fact be working to maintain the status of the USD as the global reserve currency, rather than focussing on effective inflation/employment management?

    USD strength is a simple and reasonable hypothesis for existing tight money policies in the US. There are a lot of global economic interests at stake in the outcome, which are arguably bigger and more influential than the US voting public’s knowledge of the matter.

    Other countries have kept global-reserve-tight-money-strong-currency policies before, even in the face of domestic economic troubles: Britain in the 1920s, for instance.

    If this is a reasonable and entertainable hypothesis, how would it change your assessment of the Fed’s ignorance?

  8. Gravatar of Mark Mark
    7. November 2013 at 10:50

    “But fundamentally it’s a 2% inflation target. It’s the Fed saying we’d like inflation above 1.5% and below 2.5%”

    In Canada it’s called the ‘target range’ and it’s 1% to 3%.

  9. Gravatar of Vivian Darkbloom Vivian Darkbloom
    7. November 2013 at 11:26

    I believe this is the relevant FOMC language (from the June 2013 Press Release):

    “To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.”

    Scott has interpreted that as:

    “The Fed promises not to raise rates as long as unemployment is above 6.5% and inflation is below 2.5%.”

    That’s not an accurate summary. First, the Fed made no “promise”. In fact, when read as a whole, the entire statement is incredibly equivocal. Second, if we merely comment on the sentence regarding the inflation and unemployment rate, Scott’s sentence I quoted above should read *or* not “and”. (Scott’s subsequent parenthetical which changes this to and/or is more accurate but perhaps not sufficient to overcome the initial misstatement):

    (That means they have the option of raising rates or not raising rates when unemployment is below 6.5% and/or inflation is above 2.5%. It’s a negative promise, to refrain from something, not a promise to affirmatively do anything.)

    But, if you read all the FOMC statement quoted above, there is a lot more going on here. First, is the equivocal language “expects that” and “currently anticipates”—this is not my idea of making a “promise” (or giving “forward guidance”) whether that promise be “positive” or “negative”. They’ve given us some noncommittal language, and even that was taken back by essentially saying “well, we reserve the right to change our minds tomorrow”.

    And this:

    “inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

    So, we’re not talking about measurable recent inflation, but various measures of *projected* inflation on which very reasonable people can easily differ. The FOMC could easily change projections which makes this a very wishy- washy thing to make a “promise” dependent on.

    And then, there’s this:

    “In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.”

    OK, the message here seems to be that there are a whole lot of other factors we can consider besides the 6.5 percent unemployment rate and the projected 2.5 percent rate of future inflation.

    In short, the FOMC made absolutely no promises, positive or negative, although they may have raised some vague and unwarranted expectations. And, that may be precisely the problem.

  10. Gravatar of Mike Rulle Mike Rulle
    7. November 2013 at 12:50

    So, lets imagine there is a futures market for NGDP. Lets further imagine the Fed wants to target 5%, but the contracts are trading at implied growth of 3%. The contracts are not arbitragable, like a bond contract or equity contract. They are just an open bet. What does the Fed do? What can it do? Well, it can buy the contracts and bid up their price and the straight bet is on. Or, recognize it as a market signal and respond accordingly with action to change the markets expectations.

    But what is the action? Buy even more bonds? Give various conditional promises to keep interest rates at levels relative to achieving target NGDP? We now have $2 tril of ER and .00025 interest rates.

    What am I missing?

  11. Gravatar of Mike Rulle Mike Rulle
    7. November 2013 at 13:44

    Continuation of last post….

    It would seem the contracts would have to trade at the desired Fed rate—assuming the Fed wants to keep it at its target, as it can buy and sell. But this seems exogenous to the system to me. What is the Fed’s lever? A futures contract can trade at an expected value—–and yes that is good information. But if it trades below the target, what can the Fed do in action it cannot already do in practice or has not already done in practice?

    If it cannot do anything except express a wish—-relative to what it already can do—-why will the economy react to the wish?

    This has always been my basic question on NGDP.

  12. Gravatar of J J
    7. November 2013 at 14:14

    Vivian Darkbloom:

    With the switch from ‘and’ to ‘and/or’, these two statements are the same:

    “The Fed promises not to raise rates as long as unemployment is above 6.5% and inflation is below 2.5%.”

    “(That means they have the option of raising rates or not raising rates when unemployment is below 6.5% and/or inflation is above 2.5%. It’s a negative promise, to refrain from something, not a promise to affirmatively do anything.)”

    The event A=inflation below 2.5% and unemployment above 6.5%. In the first sentence, Scott says: if A, then Fed doesn’t raise rates. In the second sentence, Scott says: if not A, then the Fed may raise rates. This is entirely consistent with the quoted passage from the FOMC press release: “this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

    Both Scott and the FOMC are saying that if one of two (the FOMC lists three) conditions are met, then rates may be raised. Otherwise, rates will not be raised (Scott says promise and the FOMC says anticipate).

  13. Gravatar of Mike Freimuth Mike Freimuth
    7. November 2013 at 14:16

    Vivian,

    “the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, AND longer-term inflation expectations continue to be well anchored.”

    I don’t see how you are getting “or” out of this.

  14. Gravatar of Mike Freimuth Mike Freimuth
    7. November 2013 at 14:18

    Scott,

    I think you are making the same mistake that you (rightly) accuse readers of making about your previous post. Somewhere in here you seem to have turned “promise not to raise rates unless inflation is above 2.5%” into “promise to raise rates if inflation rises above 2.5%” in order to arrive at your 2% inflation target. It seems without making this additional change, they would still have leeway to run higher inflation if they wanted to focus on employment more.

  15. Gravatar of J J
    7. November 2013 at 14:18

    Mike Rulle,

    Many market monetarists have addressed your question. The futures contracts would be ‘arbitragable’. Suppose they always pay the risk-free rate minus 5% plus NGDP growth. If NGDP growth is expected to be under 5%, then there will be a net demand shortfall for NGDP futures contracts and the Fed will buy up the excess supply using printed money. The market will be in equilibrium when the cash injections used to buy up the excess supply push up NGDP expectations to 5%.

  16. Gravatar of Mike Freimuth Mike Freimuth
    7. November 2013 at 14:31

    Mike Rulle,

    I’m not completely versed in Scott’s NGDP futures scheme but just for fun let me take a stab at this.

    If the market were predicting the level of NGDP to be below target, it seems there are two things the FED could do. One would be normal OMO to try to get the market to adjust. It seems unlikely that the market would be completely deaf to changes in monetary policy. Another would be to simply buy up the contracts which were trading below the forecast. This would inject more base money and have a similar effect to OMO.

    I think that’s the beauty of it. The “lever” that one would normally expect to move the market (buying and selling) when the Fed does it, also should have the desired effect on NGDP. This would indeed be a one sided bet but that’s another added benefit. If the Fed loses the bet (NGDP comes in below forecast) they have to pay up which injects further base money. If they overshoot, they win and automatically suck money out.

    Of course, one imagines that in most cases the Fed would not have to take a very large position because who is going to want to take a one sided bet on NGDP against the very entity which controls NGDP. The phrase “don’t fight the Fed” would take on even more meaning.

  17. Gravatar of benjamin cole benjamin cole
    7. November 2013 at 16:01

    Excellent blogging. Richard Fisher is a menace to American prosperity. Alone, he has changed my views on freedom of speech.
    Seriously, FOMC members undermine already mushy Fed guidance.
    Do we need the Rube Goldberg designed, semi-secretive FOMC anymore?
    Better a Fed chief who serves at the President’s favor?

  18. Gravatar of Geoff Geoff
    7. November 2013 at 18:10

    “Inflation is currently running at about 1.2%”

    Hahahahahahahahahahahahahahahaha

  19. Gravatar of ssumner ssumner
    7. November 2013 at 18:36

    Saturos, I’m certainly all for structural reform in Europe, but yes, I was hoping for a bit more.

    Andrew, I suppose that’s good advice.

    JJ. You are right, which is why I added the update.

    Doug, If they dropped the forward guidance entirely the stock market would crash. That would be a bad idea.

    jknarr, Those theories give them too much credit. There is no plan, they are making it up as they go. I think reporters like Hilsenrath are exactly right, there are big splits and the changes of mind (i.e Kocherlakota, Bullard, etc) are genuine. It’s not some big secret plan.

    Vivian, You said;

    “That’s not an accurate summary. First, the Fed made no “promise”. In fact, when read as a whole, the entire statement is incredibly equivocal. Second, if we merely comment on the sentence regarding the inflation and unemployment rate, Scott’s sentence I quoted above should read *or* not “and”.”

    I disagree on both points. I think it is a promise, although I concede it’s not unequivocal. And it is “and” not “or.” If it was “or” the policy would be far more dovish—indeed more dovish than even I would favor.

    I agree they are targeting inflation expectations, not current inflation, which is exactly what they should be doing (albeit for NGDP, not inflation.)

    Mike, In the right margin there is a link to a paper on NGDP futures targeting that answers all your questions. They’d buy enough assets to move the NGDP futures price to 5%.

    Mike Freimuth, You said;

    “I think you are making the same mistake that you (rightly) accuse readers of making about your previous post. Somewhere in here you seem to have turned “promise not to raise rates unless inflation is above 2.5%” into “promise to raise rates if inflation rises above 2.5%” in order to arrive at your 2% inflation target. It seems without making this additional change, they would still have leeway to run higher inflation if they wanted to focus on employment more.”

    Technically you are correct, which explains my update. The point I was trying to make in the update was that the 2.5% can be seen as a sort of “level targeting” catch-up adjustment. Inflation is currently 1.2%, so the Fed is unhappy about this low rate, and wants to err a bit on the side of slightly above 2%. But that’s all consistent with a 2% inflation target, level targeting, and no unemployment mandate at all.

    But technically you are correct, I oversimplified slightly to make a point. I’d still say the gist of my post is correct. The policy I discuss (1.5% to 2.5%) would be pretty clearly a 2% inflation target, albeit with a slight catchup for the current undershoot.

  20. Gravatar of Saturos Saturos
    7. November 2013 at 23:33

    Ryan Avent also responds to the new Fed paper: http://www.economist.com/blogs/freeexchange/2013/11/monetary-policy

    I love how the Fed itself thinks it is moving closer to inflation targeting and or flexible inflation targeting, and rules based policy more generally, and ends its papers with streams of data – whilst completely ignoring its own performance as detailed in Scott’s post above.

  21. Gravatar of J.V. Dubois J.V. Dubois
    8. November 2013 at 00:46

    This is a very neat article again showing that FED is not ignoring dual mandate but that they also ignore even the hypotethical-and more hawkish single inflation mandate. The matters are worse with ECB.

    This is classical example of “Conjunction Fallacy” where people thing that additional details increase probability even though logic says otherwise. People generally think that sentence like “Bob owns a nice red Ferrari” is more probable then the sentence “Bob owns a car”.

    PS:Unfortunately this is nothing “new”. Similar to you I was horrified when reading Jon Hilsenrath story that shows FED is choosing monetary policy so it is not target of smirk remarks Wall Street like “QE-infinity”. It is beyond hawkish. It is plain stupid.

  22. Gravatar of Vivian Darkbloom Vivian Darkbloom
    8. November 2013 at 05:11

    Scott,

    I see now that your set up formulation added a “not”, so your original version “and” was correct. Mea culpa. Mea culpa. Mea maxima culpa. Forgive me Scott, for I have erred…

    On the other hand, your main statement, combined with the parenthetical attempted to have it both ways, so how could you possibly have been wrong? Of course, this is consistent as I see it with the Fed statement, it doesn’t commit them at all.

    I am, however, completely non-repentant on the issue of whether this constitutes a “promise”. If it is one, I guess we could put it in the category of “If you like your insurance policy you can keep it”, “I didn’t have sex with that woman” or “read my lips, no new taxes”. But, the FOMC’s statement has left them many more “outs” than these examples and as a result they are pretty much free to do whatever they want with minimum ex post rationalization. If one allows this degree of equivocation in a “promise” it renders any meaning normally inherent in that word nugatory.

    As far as “forward guidance” is concerned, I think for that to have any real effect, the “promise” inherent in that guidance has to be relatively clear and certain to be adhered to. That is, the FOMC’s “promise” should be one in the real sense. A “promise” should be a promise. I think that the fact that markets tend to move sharply, at least in the short term, on FOMC announcements is not only due to the fact that monetary policy has influence, but also due to the fact that the forward guidance on policy as a whole has not been clear. If guidance and the “promises” inherent therein were clear, markets would not be in the least surprised when minutes or policy actions are released.

    Here again, I think you have, or at least should have, common ground with folks like Taylor, who continuously argue for rule-based policy-making.

  23. Gravatar of Mike Rulle Mike Rulle
    8. November 2013 at 07:26

    To J, Mike F, and Scott

    Thanks for your replies. Scott, I had read it and read it again. I previously had the premise or logic backwards. You expect the market to initiate the action with the Fed, not as today, where the Fed initiates the action with the market. The market “becomes the Fed”, so to speak, as it relates to monetary policy. Is that broadly correct?

  24. Gravatar of Mike Rulle Mike Rulle
    8. November 2013 at 07:29

    Continuation

    I mean once the NGDP target has been set. What if the market wants a different target?

  25. Gravatar of Mike Rulle Mike Rulle
    8. November 2013 at 07:40

    To answer my own question it will engage in money supply counter effects. Will think more. No need to respond

  26. Gravatar of JohnB JohnB
    8. November 2013 at 08:11

    Nothing has discredited the Fed more than their forward guidance. “We’re gonna raise rates in 2011, no 2012, no 2013, no 2014,….”

    Drop the employment targeting and forward guidance and stick with an inflation target. Say “We’ll unwind QE3 if inflation gets above 2.5% and look to raise rates if inflation goes above 3%.”

    That should satisfy both the moderate hawks and doves. Of course, those against monetary central planning in the first place like myself aren’t going to like anything the Fed does besides disbanding so there’s no point in them trying to please everybody.

  27. Gravatar of ssumner ssumner
    8. November 2013 at 11:15

    Vivian, You said;

    “I think for that to have any real effect, the “promise” inherent in that guidance has to be relatively clear and certain to be adhered to.”

    I don’t agree. If I promise to go to a football game with someone, they expect me to carry out the promise, and plan on that basis. But they also know that if my wife needs to be rushed to the hospital to give birth I will not show up.

    You said;

    “On the other hand, your main statement, combined with the parenthetical attempted to have it both ways, so how could you possibly have been wrong?”

    Nope, my parenthetical statement is also correct, and does not conflict with the previous sentence. Read it again.

    Yup, I agree with Taylor that we need rules.

    Mike, Yes, the market becomes the Fed.

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