The Fed should listen to Jim Hamilton

You’re probably getting sick of me arguing that the Fed should be talking about how it’s trying to raise national income, not the cost of living.  Here’s Jim Hamilton making the same point:

The strength of this opposition [to QE2] may puzzle some within the FOMC. Traditionally, the Fed faced a trade-off between the goals of trying to keep both unemployment and inflation low. But at the moment, unemployment is painfully high by anybody’s standards, even as inflation is lower than the Fed feels is consistent with its goal of long-term price stability. Why is the Fed finding that persuading the public that inflation is too low is such a hard sell?

As Ben McCallum recently noted, regular Americans will tell you, of course inflation is still too high, because the price of X has gone up over the last year. Somehow the ability to process numbers that way fits naturally into our cerebral wiring, whereas averaging over all our purchases does not. There is also a deep-seated distrust of the official government measures of inflation. More fundamentally, many Americans think of inflation as an increase in the price of things they buy (which of course sounds bad), as opposed to an increase in the price of the things that they sell (which by itself is not that unpleasant). Perhaps the Fed should consider referring more to its desire to see wages and incomes growing more solidly, rather than its desire to see inflation higher.

In late 2008 when everyone was wringing their hands saying there’s nothing the Fed can do, Hamilton said something to the effect that; “If they can’t create inflation, let me have a shot at it.  I’ll show them how.”  (Not his exact words.)  He was right then and he’s right now.

PS.  Don’t say it would be deceptive advertising to switch from inflation to income.  The Fed isn’t trying to boost inflation, they are trying to boost national income.  For any given increase in NGDP they’d prefer to have less inflation and more real income growth.  I’d be like a anorexic sumo wrestler saying he was targeting a higher fat level by eating big meals.  No he’d be targeting more weight, and hoping that any weight gain is mostly muscle and only a little fat.

I’d love to see the looks on the faces of ad execs on Madison Avenue if Bernanke explained that he was trying to raise nominal spending and income, and thought the best way to communicate this fact to the public was by announcing the Fed was trying to raise the cost of living.  A future satirist will have lots of fun picking over the wreckage of this crisis.

Update:  Leigh Caldwell sent me the following from Time:

And that’s what those two little cute Bernanke bashing bears don’t seem to get. It’s not that the Fed is trying to prevent falling prices, or at least that’s not what they are most worried about when it comes to deflation. The price of iPhones, flat screens and other gadgets fall all the time, and that’s not a problem. The real thing that the Fed is worried about is wage deflation. When we all make less money we spend less, and it becomes even harder to pay back our debts. That’s an economic spiral that is very hard to get out of. And rising commodity prices make that spiral more likely, not less.

That’s slightly better than inflation, but still not really correct.  The Fed doesn’t want higher wages, they want higher incomes.  It is true that higher wages would be an indication that stimulus is working, but for any given increase in national income, higher wages mean fewer jobs.  What we really need is more income.

It’s ironic that having to respond to those two little bears is making the intelligentsia come over to my side.   My God! (pundit whacks hand on forehead) . . . it’s not inflation, it’s higher income that the Fed has actually wanted all along.


Tags:

 
 
 

28 Responses to “The Fed should listen to Jim Hamilton”

  1. Gravatar of Jon Jon
    27. November 2010 at 14:23

    Scott quotes Hamilton saying:

    As Ben McCallum recently noted, regular Americans will tell you, of course inflation is still too high, because the price of X has gone up over the last year. Somehow the ability to process numbers that way fits naturally into our cerebral wiring, whereas averaging over all our purchases does not.

    These people are stupid memes make me edgy. On the evidence, its pretty clear that inflation of goods has been high in the past ten years, much higher than the overall price target, and is still quite high. This is what people perceive, and they are right. See for instance: http://www.shadowstats.com/imgs/sgs-cpi.gif?hl=ad&t=

    But look, you do have to square that with nominal income statistics, bond yields, etc. Its fact now that our economy is service dominated. Service price inflation is definitely constrained by labor market slack and tracks changes in nominal wages. What this means it that the overall level of inflation is low but the price inflation of some categories of things is high–the notion that price inflation is only the common change in prices across _all_ goods has never been a correct or reasonable definition. Its perfectly rational that the price elasticity of certain goods can vary, and that as a consequence, in the short-run, prices of final goods and services behave differently under inflation generally.

    I suspect the difference here is who buys services versus who buys goods. The man on the street doesn’t buy a lot of services he buys a lot of goods. So any survey of people generally is going to be tilted toward the higher number because the income distribution is skewed. (See e.g., Table 1 of http://www.clevelandfed.org/research/commentary/2001/1101.pdf which shows a very strong inflation bias with income).

    Its just outrageous and wrong to take the attitude that inflation perceptions of the common man some how reflect an irrationality.

  2. Gravatar of W. Peden W. Peden
    27. November 2010 at 14:53

    Being a publicity officer for a central bank would be a great job. There would be all the intellectual stimulation of macroeconomic policy, combined with a chance to be creative and to deal with people more often than numbers.

    QE2 would have done better if it was marketed as a “Non-debt-increasing business recovery plan” or an “Anti-recessionary programme” or best of all an “Monetary Rebalancing Measure”.

    We’re not aiming to increase the cost of living, we’re aiming to address the madness of the past few years.

    Central bankers are one of the few groups in politics who label their plans in terms of means rather than outcomes. That’s very honest and academically scrupulous, but it also means that people have no idea WHY these policies are being done in the first place.

  3. Gravatar of Leigh Caldwell Leigh Caldwell
    27. November 2010 at 15:45

    Stephen Gandel at Time says roughly the same thing:

    http://curiouscapitalist.blogs.time.com/2010/11/25/thanksgiving-day-feast-another-sign-of-hyperinflation-or-not/

  4. Gravatar of Mark A. Sadowski Mark A. Sadowski
    27. November 2010 at 18:14

    The food component of the PCE peaked in November 2008 and fell a total of 2.0% by September of 2009. Then it rose modestly through April of 2010 (at about a 1.9% annual rate) but since April it has only risen at an annual rate of only 0.5%. The index is still 0.5% below the previous peak nearly 2 years ago. I perceive the modest rise it experienced late last year through early this year as a “dead cat bounce” after nearly a year of deflation.

    Similarly the energy component of the PCE peaked in July 2008. It plunged 36.2% by December 2008. Then it bounced back up 23.9% through January 2010. Since January it has risen at an annual rate of only 0.2%. It’s still off 20.5% from its previous peak over two years ago. Last year’s increase was another dead cat bounce.

    So both food and energy have plateaued this year after partially recovering from a drop.

    In short both food and energy (but especially energy) are volatile. They are dropped from core inflation precisely because they have a tendency to gyrate, often dramatically. So the real story about food and energy prices over the last three years is no story.

    And according to the Energy Information Administration gasoline is the same price at the pump it was in October 2007, three years ago.

    When inflation is as dead as it has been, how could nominal GDP growth generate anything other than real growth.

  5. Gravatar of scott sumner scott sumner
    27. November 2010 at 18:25

    Jon, Aren’t services something like 75% of our economy? It’s hard to believe the average person doesn’t buy many services. In any case, I don’t believe any inflation numbers, they all seem arbitrary to me.

    W. Peden, Yes, good point.

    Leigh, Thanks, I added an update with the quotation. I actually don’t think it was quite the same point I was making–but better than inflation.

    Mark, You’d think most macroeconomists would see things as you and I do. But most seem terrified that easier money would produce inflation, not growth. I have no idea why. Nor do I understand why stimulus is controversial now, but not back in 2007 when inflation was well above target.

  6. Gravatar of Jon Jon
    27. November 2010 at 19:48

    Scott: Of course, low income people buy services too, but do they buy as many? Clearly they do not because they internalize those activities under home production. The lawyer who bills 900/hr hires a maid to clean his house, a chef to cook his meals (maybe takeout), a gardener to care for his grounds, a nanny for his children, a driver for his car etc. This to be so because the marginal cost of the lawyer’s time is high and value of the services bought on the market comparably low–the reverse being true for the day laborer.

    My point is that people perceive inflation according to their market basket. So if the perception of inflation is income sensitive and the gini coefficient isn’t zero, then the average of a random sample of people will give an answer different from the GDP deflator.

    That was my point. Hamilton thinks people are clueless for not perceiving that inflation is ‘low’. I think people are individually rational for perceiving different amounts of inflation according to their market basket.

    So what does this mean for policy? In the short-run if inflation accelerates, its not wrong to perceive this as harmful. Even if in the long run there would be a benefit from a higher employment rate associated with returning to trend NGDP.

    But if you have a job, as most people do, isn’t your optimal policy low-inflation? We need a lot more unemployment before a high-inflation policy would be accepted.

    So high inflation is a bad sales pitch.

  7. Gravatar of Benjamin Cole Benjamin Cole
    27. November 2010 at 20:59

    In my small way, I have been trying to encourage the pro QE2 crowd to consider the language they use. I think this is a very important post by Sumner.

    The public is being swayed (or influenced) by reactionary right-wingers, and the cause of wrecking Obama or curiously related obsession/fetish with money/gold/inflation (even inflation of 1 percent and sinking).

    Pro QE2′ers should always talk about the need for QE2 to pull up economic output, and refer to non QE2′ers as the “Japan Wing” of the Fed, or the “Nipponists.”

    Talk about money as oxygen for a growing economy. Talk about the need for a boom to pay off debts. Talk about good times ahead if we can get QE2 up and running.

    Deflating wages would be bad; deflating property promises decades of sad-sack banks (see Japan).

    Keep pounding in this point: In Japan, property and equity markets have fallen 75 percent in 20 years. You want to speak Japanese in America? And who in Japan predicted 20 years of ruin in 1990?

  8. Gravatar of Charles R. Williams Charles R. Williams
    28. November 2010 at 04:39

    Price stability means 0% inflation before quality adjustments. People do not understand nonsensical statements like “inflation is below the 2% target that is consistent with price stability.” People do not understand why food and energy costs are irrelevant.

    People do not understand the bizarre preoccupation of certain economists with deflation, as if this where some mysterious black hole that we could drift into without the government crushing the economy.

    Speaking personally, the difference between 1% inflation and 3% inflation is the difference between a comfortable retirement and dying in poverty.

    The economy will move forward when the government stops propping up housing prices, propping up insolvent banks, propping up profligate state and local governments, stabilizes tax rates and backs off on its massive expansion of regulation into every nook and cranny of the American economy.

    The only thing preventing stagflation is this shortage of aggregate demand that obsesses certain economists.

  9. Gravatar of scott sumner scott sumner
    28. November 2010 at 08:46

    Jon, I’m not claiming people are dumb, that’s Hamilton’s argument. But I don’t really see your point. Service prices tend to rise much faster than goods prices, so if you are right the rich should perceive higher inflation. It’s also true that housing prices for the rich have risen much faster than housing prices for the poor.

    Benjamin. I agree.

    Charles, Even if the ideal rate of inflation is zero percent (and it might be), that has absolutely no bearing on the proper monetary policy right now. Even proponents of zero percent inflation think we need more expansionary policy right now, as a severe financial crisis is a horrible time to adopt a zero inflation target, especially when they went into the crisis with people expecting 2 to 3% inflation. I doubt that there is a single respected economist in the country who thinks a financial crisis is a good time to disinflate. It’s like saying that having cancer is a good time to lose some weight, after all obesity is a bad thing.

  10. Gravatar of Bill Woolsey Bill Woolsey
    28. November 2010 at 09:40

    Aside from the fact that 2 percent inflation isn’t 0 percent inflation, I do think the quality adjustments are a very serious problem in terms of perception.

  11. Gravatar of Bill Woolsey Bill Woolsey
    28. November 2010 at 09:57

    The best way to describe the policy is the most accurate–increase spending on goods and services. Sure, national income account shows that money expenditures equal the nominal value of ouput. And the nominal value of output equals nominal income.

    But it is a serious error to skip those two steps and jump to more money equals more income.

    The Fed is creating money so that people will have more income. It sounds to good to be true. It is too good to be true.

    The Fed is creating money so that people will spend more, firms will sell more, firms will produce more, and that will increase income. That is alot better than assuming an understanding of national income accounting.

    Income isn’t created by printing money. Income comes from producing goods and services. And the capacity to produce those goods and services is essential. But firms won’t produce what they cannot sell, and so adequate money expenditures are important too. And it is the Fed’s job to make sure there are adequate money expenditures.

    Of course, I agree that advocating higher inflation is bad PR, and really, just wrong. What puzzles me is how anyone can be so divorced from reality as to believe that the American people have agreed that 2% inflation is the same as price level stablity, and, more importantly, desirable.

    Why hasn’t the Fed come out and said that it is aiming at 2% inflation? Sure, there are some liberals in _Boston_ like Barney Frank who think that 2 percent inflation limits the Fed from lowering the unemployment rate when necessary, but there are many more people who would be offended to learn that the Fed is creating the inflation _on purpose._ In their world view, inflation is just one of those bad things that we cannot avoid. Why isn’t the unemployment rate zero? Well, I can explain why, but can you imagine seeing inflation in a similar way–it is an imperfect world. The cost of living just goes up?

    Isn’t it better than those folks continue to be blind rather than be told that the Fed is creating 2% inflation on purpose?

  12. Gravatar of Bill Woolsey Bill Woolsey
    28. November 2010 at 10:06

    Williams, you are assuming that the yields on your investments are the same regardless of inflation. Right?

  13. Gravatar of septizoniom septizoniom
    28. November 2010 at 15:35

    Have you ever read “Dying of Money” (1974–Jens O. Parsson)? What is your view of that book?

  14. Gravatar of Mark A. Sadowski Mark A. Sadowski
    28. November 2010 at 17:25

    Scott
    You wrote:
    “It’s ironic that having to respond to those two little bears is making the intelligentsia come over to my side.”

    Jim (Hamilton) thinks they’re bunnies. Scott thinks they are bears. I have it on good authority they are in fact dogs. (Check out xtranormal’s PAWZ “Pride-Puppy” 50 seconds in.)

    http://www.youtube.com/watch?v=8ERDt4weTIs

  15. Gravatar of Mark A. Sadowski Mark A. Sadowski
    28. November 2010 at 17:26

    In honor of a diversity of opinion here is the original video:

    http://www.youtube.com/watch?v=PTUY16CkS-k

    And the Sumner counterargument:

    http://www.xtranormal.com/watch/7687255/

  16. Gravatar of Morgan Warstler Morgan Warstler
    28. November 2010 at 22:15

    “No he’d be targeting more weight, and hoping that any weight gain is mostly muscle and only a little fat.”

    LOL. Watch your similes. If it isn’t muscle, it is better to skinny, which means VERY little extra for a anorexic.

    And since it works so well: the anorexic gets just a few more daily calories, and that tendency is no longer a disease it is a personal strength.

    Which means: You aren’t really arguing for weight, you are arguing for a “little less skinny.”

  17. Gravatar of Morgan Warstler Morgan Warstler
    28. November 2010 at 22:19

    “The real thing that the Fed is worried about is wage deflation.”

    No, they are worried about banks becoming insolvent, which according to their own data means:

    1. if rates go up, everyone underwater jungle mails, and banks die.
    2. if home prices fall below x%, they jingle mail and banks die.

    And then after thinking about those two things, they worry about wage deflation, etc.

  18. Gravatar of scott sumner scott sumner
    29. November 2010 at 08:01

    Bill , You said;

    “Income isn’t created by printing money. Income comes from producing goods and services. And the capacity to produce those goods and services is essential. But firms won’t produce what they cannot sell, and so adequate money expenditures are important too. And it is the Fed’s job to make sure there are adequate money expenditures.”

    Aren’t you confusing real and nominal income? I am talking about targeting nominal income, not real.

    Off topic, But I am starting to have second thoughts on the IOER/IORR distinction. You may be right that it should apply to all reserves. Otherwise two banks could just set up accounts in each others banks, and turn ERs into RRs anyway.

    I agree that some people think any inflation is a bad thing, but if they are only now complaining about it (and many have been silent for 2 decades, and are only now complaining) then they are incredibly naive. The price level has risen dramatically in recent decades, which means the Fed has been intentionally creating inflation for my entire lifetime. It’s amazing that people are only now waking up to that fact. Did they think the Fed had a zero inflation target? Haven’t they noticed the cost of living rising over time?

    septizoniom, No, what’s it about?

    Mark, They’re whatever you imagine them to be.

    Morgan, No, sumo wrestlers need a lot more weight.

  19. Gravatar of How Does Scott Sumner Really Feel About “Income”? How Does Scott Sumner Really Feel About “Income”?
    29. November 2010 at 08:07

    [...] (B) You have been arguing that we are in a recession because national income did not grow quickly enough, and so people’s plans are all screwed up. In fact you want Bernanke to stop talking about inflation and start talking about income. [...]

  20. Gravatar of septizoniom2 septizoniom2
    29. November 2010 at 09:45

    http://esocap.com/uploads/files/Dying%20of%20Money.pdf

  21. Gravatar of Jon Jon
    29. November 2010 at 13:36

    Scott: Yes you’re right, I think I’d better restrict my point to a statement that people have different market baskets and therefore would choose to estimate inflation differently and that choice would still be rational.

    Interestingly the WSJ just hit this note today.

    http://online.wsj.com/article/SB10001424052748704008704575638434255058278.html?mod=ITP_pageone_1

    Yet another example of discussion on themoneyillusion blog LEADing rather than FOLLOWing the MSM.

  22. Gravatar of Bill Woolsey Bill Woolsey
    29. November 2010 at 19:31

    I don’t think I am confusing real income and nominal income, and I know you are proposing to target nomnial income. But nominal income is what people earn, which depends on what they produce, which depends on what they expect to sell, which depends on what they actually sell. And that is what the Fed controls–money expenditures, which is the same as what firms sell.

    Now, explain to me exactly how the Fed controls what people earn?

    Personally, I have some doubts about the validity of aggregate income accounting, particularly profits on unsold goods.

    As for inflation, it is time to do some informal polling. Aside from friends, family, and the like, try the new undergraduates in the spring. (I get a substantial porpotion of my students who will say that the production of goods and services in the U.S. has stayed stable over the last 100 years. We will see how many answer, “we have had inflation over the years because that is the government wants inflation.” My guess is that it will be very few.

  23. Gravatar of Jon Jon
    29. November 2010 at 20:31

    Scott remarks:

    Off topic, But I am starting to have second thoughts on the IOER/IORR distinction. You may be right that it should apply to all reserves. Otherwise two banks could just set up accounts in each others banks, and turn ERs into RRs anyway.

    Yes, that’s fair. This occurred to me too that banks could lend back and forth to each other to create RR.

    But is this possible. I’m afraid I’m not a lawyer and do not thoroughly understand the regulations but the statute states:

    For purposes of this part, the following definitions apply unless otherwise specified:

    (a)(1) Deposit means:

    (vii) Any liability of a depository institution on any promissory note, acknowledgment of advance, bankers’ acceptance, or similar obligation (written or oral), including mortgage-backed bonds, that is issued or undertaken by a depository institution as a means of obtaining funds, except any such obligation that:

    (A) Is issued or undertaken and held for the account of:

    ( 1 ) An office located in the United States of another depository institution, foreign bank, Edge or Agreement Corporation, or New York Investment (Article XII) Company;

    Which suggests that funds borrowed from another bank, when on deposit are not funds subject to reserve requirements.

    Presumably this is done so that reserves may be lent from one bank to another but get taxed as reserves only once.

  24. Gravatar of Bill Woolsey Bill Woolsey
    30. November 2010 at 04:19

    Last I read about this, inter-bank deposits required 100 percent reserves. I suppose this does amount to a loan from the depositing bank to the bank receiving the deposit.

    The institutional framework was correspondent relationships. At one time, this was very important. Perhaps with all banks having direct access to the Fed, as opposed to member banks only clearing checks, receiving loans from the Fed, and the like, this regulation no longer exists.

    I oppose the existence of reserve requirements anyway, and also if there is to be negative interest on reserves, one of the paths by which it will solve the problem of monetary disequilibrium is by reducing the interest banks pay on deposits, perhaps making those negative as well. That reduces the demand to hold money. Of course, pushing those interest rates down to the point where it results in a currency drain is pointless. Which points to the nature of the problem–zero nominal interest hand-to-hand currency.

    Seeing negative interest rates on reserves as a way to punish banks to having too much excess reserves (is that redundant?) is wrongheaded. If the market clearing price (yield) is negative, then the actual price should be negative. Of course, the quantity of reserves can be increased by the Fed, and there are plenty of assets that have yields well above zero. But there is risk, including interest rate risk. Increase the quantity of base money adn the Fed’s revenues, but also its risk, or reduce the interest rate paid on reserves, and reduce its costs. But get a yield/quantity combination on reserves such that the demand to hold them with the flow of money expenditures on target equals the quantity. The zero-nominal bound on hand to hand currency puts a lower bound on how low the intereset rate the Fed pays can go (how negative) and so forces the Fed to increase the quantity and take more risk.

  25. Gravatar of scott sumner scott sumner
    30. November 2010 at 06:30

    septizoniom2, Can you summarize the main point?

    Jon, I’m planning a post on how the media follows this blog with a lag.

    Bill, I agree that the public fails to understand that the Fed controls inflation, I should have emphasized that I was referring to pundits, who bash the Fed for its supposedly inflationary policy, and yet ere silent when inflation was even higher in the 1980s and 1990s.

    My point was that nominal income and nominal expenditure are just two sides of the same coin (adjusting for depreciation and indirect business taxes.) So if the Fed controls one they control the other. I know you know this, so maybe I am still misinterpreting your argument.

    Jon, Thanks for that info on reserve regulations. I find this accounting stuff hard to wrap my brain around, so I’ll keep an open mind on the issue.

    Bill, Your comment on reserves makes a lot of sense, and I still have an open mind on the best way of doing this.

    One small point. Everyone talks about the risk to the Fed, but I view the Fed as part of a consolidated government balance sheet. Since the government is still a net borrower vis-a-vis T-securities, the government actually gains from an unexpected economic expansion that boosts i-rates. It lowers their net liability as the price of long term T-bonds falls. The real risk is that we end up like Japan, with the T-bonds being strong, but government revenues going down the toilet.

  26. Gravatar of septizoniom2 septizoniom2
    1. December 2010 at 09:19

    main point is that we don’t need inflation. we need a fairer return of value to labor. inflation actually long term concentrates wealth. then leads to collapse.

  27. Gravatar of Rod Everson Rod Everson
    1. December 2010 at 15:00

    Morgan Warstler wrote: “The real thing that the Fed is worried about is wage deflation.”

    No, they are worried about banks becoming insolvent, which according to their own data means:

    1. if rates go up, everyone underwater jingle mails, and banks die.
    2. if home prices fall below x%, they jingle mail and banks die.

    And then after thinking about those two things, they worry about wage deflation, etc.

    Morgan, I think you have hit the nail precisely on the head. The Fed is first and foremost concerned with the health of the banking system and the banking system is severely threatened by the overhang of underwater mortgages, an overhang that thus far is still growing.

    But it’s impossible to raise house prices by an amount sufficient to undo this situation without creating significant inflation because house prices far, far outran the general price level during the housing bubble. In short, losses will be incurred; it’s just a matter of who incurs them.

    While the Fed is no doubt hoping for a general rise in the price level (if for no reason other than the alternative, a general decrease, just makes the housing mess even messier,) their main strategy seems aimed at subsidizing bank earnings for as long as possible both by paying them interest on all reserves, excess and required, and by maintaining for as long as possible an interest arbitrage situation where the banks can borrow short and lend long at a profit.

    As you point out, higher short rates become a problem and deflation becomes a problem. For the banks, the best way out of this mess is to have time to accumulate the earnings necessary to survive the inevitable avalanche of “jingle mail” as you put it. Managing the money supply to attain any particular price level is now a secondary consideration to the Fed. Those who think they know how the general price level will be affected by current policy are deluding themselves, and that goes for both the deflationists and the inflationists. (both not real words, according to the spell checker, but what the heck) The Fed, under its current operating procedures, has no control over the amount of money in the system. The nearly $1 trillion in excess reserves tells you that. It will do what it will do; money, that is.

  28. Gravatar of scott sumner scott sumner
    2. December 2010 at 07:54

    septizoniom2, Thanks, I think I’ll pass on that.

Leave a Reply