Inflation doesn’t matter (NGDP growth does)

Simon sent me a new NBER paper on inflation by Coibion, Gorodnichenko and Kumar.  Here is the abstract:

We implement a new survey of firms’ macroeconomic beliefs in New Zealand and document a number of novel stylized facts from this survey. Despite nearly twenty-five years under an inflation targeting regime, there is widespread dispersion in firms’ beliefs about both past and future macroeconomic conditions, especially inflation, with average beliefs about recent and past inflation being much higher than those of professional forecasters. Much of the dispersion in beliefs can be explained by firms’ incentives to collect and process information, i.e. rational inattention motives. Using experimental methods, we find that firms update their beliefs in a Bayesian manner when presented with new information about the economy. But few firms seem to think that inflation is important to their business decisions and therefore they tend to devote few resources to collecting and processing information about inflation.

I can’t imagine why a firm would care about inflation.  On the other hand NGDP growth would be at least somewhat important, as it would be linked to the growth in revenue they could expect to earn, and also the growth in costs such as wages that they’d have to pay their workers.

Never reason from an oil price change

Back in late 2014, many pundits assured us that falling oil prices were bullish for the economy.  I countered that one should never reason from an oil price change.  The net effect is ambiguous.  As the following graph shows, industrial production had been rising fast in the period leading up to November 2014, but has been falling ever since.  GDP was almost flat in Q1, and the Atlanta Fed says growth will also be slow in Q2.

That does NOT mean falling oil prices hurt the economy, an equally unjustified assumption.  Rather it is monetary policy (NGDP growth) that drives short run changes in output.  NRFPC!

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Stance, shock, cause

OK, the title’s not as dynamic as Camille Paglia’s Break, Blow, Burn, but I’m only an economist.  Recently I’ve been trying to figure out several questions; including what do we mean by the stance of monetary policy, and what do we mean by a monetary shock?  I suspect that at some deep level these are actually the same question, much as I suspect, “Does free will exist” and, “Is there such a thing as personal identity?” are the same question.  This post is a reaction to some good comments I’ve received, and also an excellent new post by Nick Rowe.  Don’t expect any final answers here, go to Nick’s post for specifics on VAR models.

Let’s work backwards from “cause.”  Perhaps a monetary shock is a change in monetary policy that causes something or many things to happen.  But that forces us to examine the thorny issue of what do we mean by “cause?”  In a sense, monetary policy could be said to cause all nominal changes in the economy, and many real changes.  After all, under a fiat money regime there is always some alternative monetary policy that would have prevented a nominal variable from changing.  Thus if the price of zinc rises from $1.30 to $1.35 a pound, you could say the cause of the increase was the Fed’s refusal to use OMOs to peg the price of zinc at $1.30/oz.  I think we can all agree that this is not a very useful view of causation.  But this problem will creep in to some extent no matter how hard we try to pin down ’cause’.

Now let’s look at ‘stance’ and ‘shock’.  By now you are sick of me telling you that interest rates don’t measure the stance of monetary policy.  But why not?  And why can’t I provide a definitive definition, if I’m so sure interest rates are wrong? Let’s consider three groups of possible indicators:

1.  Interest rates and the monetary base

2.  Exchange rates and the monetary aggregates

3.  Inflation, NGDP growth and zinc prices

I’d like an indicator that always moves in one direction in response to a given change in the stance of monetary policy. That’s why I hate interest rates; tight money sometimes makes them rise, and sometimes makes them fall.  So we can’t look at interest rates and identify the stance of policy.  Ditto for the base, which might rise because we are monetizing the debt Zimbabwe style, or it might rise because we are accommodating a high demand for reserves at the zero bound, a la Japan since the late 1990s.  That’s not to say that we can’t assume a given nudge in rates or the base leaves policy predictably tighter than a few minutes earlier.  The problem is that we can’t look at rates or the base and tell whether policy is looser or tighter than 3 months ago, which makes it useless for projects like VAR studies.  Nor does it help to look at rates relative to the natural rate, as the natural rate is highly unstable, and hard to estimate.

The second group is better.  In general, tight money will appreciate the exchange rate and reduce M2.  But I’m not 100% sure that’s always true.  Is it possible that tight money could lead to expectations of depression, and that expectations of depression could lead to lower future expected exchange rates, and that this would reduce the current value of the currency?  Is it possible that tight money could lead to such uncertainty that people want to hold more M2, relative to other assets?

The last group seems safest, and the first two items in group #3 are also the indicators chosen by Ben Bernanke back in 2003.  I can’t imagine a case where tight money raises either inflation, NGDP, or zinc prices.  So at least in terms of direction of change, they seem completely reliable.  One can think of the CPI as measuring the (inverse of the) value of money.  That’s a nice definition of easy or tight money—changes in its purchasing power.  NGDP is slightly more ungainly, the (inverse of the) share of national income that can be bought with a dollar bill.

Unfortunately I’ve engaged in circular reasoning.  I’ve defined easy and tight money in terms of inflation and NGDP growth, because I believe they are reliably related to the stance of monetary policy.  But how do I know that the thing that causes NGDP to rise is easy money?  Here I don’t think we can escape the necessity of relying on theory.  Theory says that an unexpected injection of new money will have all the effects associated with easy money, such as temporarily lower interest rates, a depreciated currency, more inflation and NGDP growth.

If we define the stance of monetary policy in terms of inflation or NGDP growth, then it seems to me that it makes sense to think of “shocks” as policy actions that change the stance of monetary policy.  Thus if Fed actions moved expected GDP growth from 4% to 6%, you could say that monetary policy eased and a positive monetary “shock” occurred.  Vice versa if expected NGDP growth fell from 4% to 2%.

But lots of people aren’t going to like the implications of all this, or any of this, as there are deep cognitive illusions about distinctions between “errors of omission” and “errors of commission” that seem important (but in my view are not.) For instance, VAR studies could no longer disentangle monetary and demand-side fiscal shocks—-all changes in NGDP would be monetary shocks, by assumption.  There would be no difference between a change in M and a change in V, both would be monetary shocks.

If you try to flee back to your comforting notions of causality, they will fall apart under close inspections.  Suppose Russians hoard 5% of the US monetary base in 1991, and the Fed does not accommodate that increase, even though they easily could have done so.  Interest rates soar, V falls, and the US goes into recession.  What do the “concrete steppes” people say? Unfortunately they’d start arguing with each other.  The monetary base concrete steppes people would insist the Fed did not cause the recession, it was caused by Russian currency hoarding.  The base didn’t change.  The interest rate concrete steppes people would insist the Fed did an error of commission; they increased interest rates sharply and caused the recession.

Nor is it possible to fall back on “unexpected changes in interest rates.”  Suppose that prior to the Sept. 2008 FOMC meeting, markets had expected a huge negative monetary shock, which would occur because the Fed foolishly kept interest rates at 2%.  But instead (suppose) the Fed surprised us and avoided a negative monetary shock by cutting rates to zero and switching to NGDP level targeting.  There would be a huge negative surprise to interest rates, but no change in the stance of monetary policy, by the NGDP criterion.

Macroeconomics is riddled with unexamined assumptions about stances of policy, shocks, and causation.  It’s ironic that we use the term ‘stance’ as there’s no stable ground here to stand upon.  It’s like we’ve moved from a classical Newtonian world to a relativistic universe.  What’s is the stance of policy?  It depends where you are standing, how fast you are moving, what variables you are interested in, etc., etc.

People are constantly telling me that my “tight money” theory of the 2008 recession is loony.  But I am never provided with any good reasons for this criticism.  I have no doubt that there are hundreds of macroeconomists who are much smarter than I am, but I do occasionally wonder if my profession is somewhat lacking in imagination.

PS.  Going back to the opening paragraph, the answers are no and no.

If something can’t go on forever . . . it will

Occasionally I do post inverting Ben Herbert Stein’s famous observation:

If something can’t go on forever, it won’t.

Some of my commenters say things that are clearly not true, such as the claim that NGDP cannot keep growing at 5% forever.  Yet even economists can make those sorts of claims, as when they argue that Australia can’t keep running 4% of GDP current account deficits forever.  (I heard that when I lived there in 1991, and yes it can.)  Here’s an old FT article by Willem Buiter from January 2009, which is worth re-reading to get a sense of how even very smart people can misjudge which trends are unsustainable:

Some of the excess returns on US investment abroad relative to foreign investment in the US may have reflected true alpha, that is, true US alpha – excess risk-adjusted returns on investment in the US, permitting the US to offer lower financial pecuniary risk-adjusted rates of return, because, somehow, the US offered foreign investors unique liquidity, security and safety.  Because of its unique position as the world’s largest economy, the world’s one remaining military and political superpower (since the demise of the Soviet Union in 1991) and the world’s joint-leading financial centre (with the City of London), the US could offer foreign investors lousy US returns on their investments in the US, without causing them to take their money and run.  This is the “dark matter” explanation proposed by Hausmann and Sturzenegger for the “alpha” earned by the US on its (negative) net foreign investment position. If such was the case (a doubtful proposition at best, in my view), that time is definitely gone.  The past eight years of imperial overstretch, hubris and domestic and international abuse of power on the part of the Bush administration has left the US materially weakened financially, economically, politically and morally.  Even the most hard-nosed, Guantanamo-bay-indifferent potential foreign investor in the US must recognise that its financial system has collapsed.  Key wholesale markets are frozen; the internationally active part of its financial system has either been nationalised or underwritten and guaranteed by the Federal government in other ways. Most market-mediated financial intermediation has ground to a halt, and the Fed is desperately trying to replace private markets and financial institutions to intermediate between households and non-financial operations.  The problem is not confined to commercial banks, investment banks and universal banks.  It extends to insurance companies (AIG), Quangos (a British term meaning Quasi-Autonomous Government Organisations) like Fannie Mae and Freddie Mac, amorphous entities like GEC and GMac and many others.

The legal framework for the regulation of financial markets and institutions is a complete shambles.  Even given the dismal state of the legal framework, the actual performance of key regulators like the Fed and the SEC has been appalling, with astonishing examples of incompetence and regulatory capture.

There is no chance that a nation as reputationally scarred and maimed as the US is today could extract any true “alpha” from foreign investors for the next 25 years or so. So the US will have to start to pay a normal market price for the net resources it borrows from abroad. It will therefore have to start to generate primary surpluses, on average, for the indefinite future.  A nation with credibility as regards its commitment to meeting its obligations could afford to delay the onset of the period of pain.  It could borrow more from abroad today, because foreign creditors and investors are confident that, in due course, the country would be willing and able to generate the (correspondingly larger) future primary external surpluses required to service its external obligations.  I don’t believe the US has either the external credibility or the goodwill capital any longer to ask, Oliver Twist-like, for a little more leeway, a little more latitude.  I believe that markets – both the private players and the large public players managing the foreign exchange reserves of the PRC, Hong Kong, Taiwan, Singapore, the Gulf states, Japan and other nations – will make this clear.

There will, before long (my best guess is between two and five years from now) be a global dumping of US dollar assets, including US government assets.

Maybe eventually, but don’t hold your breath.

Hmmm, I wonder if it’s time again for one of my “Apocalypse Later” posts on how another year went by without the expected collapse of the Chinese economy.  I’ll take China’s 7% RGDP growth with all its “imbalances” over Brazil’s 0% growth.

PS.  There are lessons in Buiter’s erroneous forecast.  He lets emotion get in the way of cold hard logic.  I can see how people believed that after all its economic/foreign policy screw-ups the US deserved to get its comeuppance.  But life is not fair.

The WSJ Editorial Board, Paul Krugman and Simon Wren-Lewis

What do these strange bedfellows have in common?  Confusing employment shortfalls with productivity slowdowns. Here’s Ben Bernanke:

It’s generous of the WSJ writers to note, as they do, that “economic forecasting isn’t easy.” They should know, since the Journal has been forecasting a breakout in inflation and a collapse in the dollar at least since 2006, when the FOMC decided not to raise the federal funds rate above 5-1/4 percent.

[Memo to myself:  If I get into a debate with Bernanke, I need to expect to come out bloodied.  He’s been taking notes.]

Bernanke continues:

However, the WSJ editorialists draw some incorrect inferences from the FOMC’s recent over-predictions of growth. Importantly, they fail to note that, while the FOMC (and virtually all private-sector economists) have been too optimistic about growth, they have also been consistently too pessimistic about unemployment, which has fallen more quickly than anticipated. The unemployment rate is a better indicator of cyclical conditions than the economic growth rate, and the relatively rapid decline in unemployment in recent years shows that the critical objective of putting people back to work is being met. Growth in output has been slow, despite solid job creation, because productivity gains have been slow—perhaps as the result of the financial crisis, which hammered new business formation and investment in research and development, perhaps for other reasons. But nobody claims that monetary policy can do much about productivity growth. Where it can be helpful is in supporting the return to full employment, and there the record has been reasonably good. Indeed, it seems clear that the Fed’s aggressive actions are an important reason that job creation in the United States has outstripped that of other industrial countries by a wide margin.

Here’s where Krugman and Wren-Lewis come in.  Britain has done a very good job of creating jobs in recent years, much better than the US.  Unfortunately their RGDP growth rate has been poor, due to abysmal productivity growth (much worse than the US.)  Bernanke and I would say that this reflects supply-side problems.  Now in fairness Bernanke later mentions that infrastructure investments can boost growth in the long run (something I’m more skeptical about, at least if done by government.)  But of course when you look at how long it takes to do projects like Heathrow expansion of HR2 lines to Birmingham, it’s obvious these investments wouldn’t have effected productivity until many years in the future.  Yet somehow Krugman and Wren-Lewis seemed to think an AD shortfall in Britain caused by Conservative “austerity” killed output without killing jobs, sort of an economic reverse neutron bomb.  That doesn’t even make sense in the Keynesian model.  But then neither does the idea that fiscal stimulus can reduce the deficit by dramatically boosting growth.  We’ve now reached the point where Keynesian economics has “jumped the shark.”  Anything is possible, and one need not even be constrained by the (already rather heroic) assumptions of textbook Keynesianism.

OK, I’m letting my right wing tribalism get the better of me.  Rather than bashing two distinguished Keynesian economists, I ought to highlight the far more absurd arguments of the WSJ editorial page.  Here’s Bernanke:

For the second year in a row, the first-quarter Gross Domestic Product figures were disappointing. TheWall Street Journal, in an editorial entitled “The Slow-Growth Fed,” uses the opportunity to argue (again) for tighter monetary policy. The editorialists point out that the Federal Open Market Committee’s projections of economic growth have been too high since the financial crisis, which is true. Therefore (the WSJ concludes), monetary policy is not working and efforts to use it to support the recovery should be discontinued.

So since 2008 the Fed has mostly fallen short on both sides of its dual mandate, and hence the solution to the problem is tighter money—so that . . . . so that what?  So that we fall even further short of the inflation target?  What problem does tighter money solve?  I don’t get it.

And it’s not just on the right.  Today I got a newsletter from the Levy Institute, highlighting a paper suggesting that higher interest rates might boost growth.  OK, I could just barely envision a scenario where that is true. It’s very difficult, but not impossible.  Say the BOJ established a 100% credible forex regime where the yen depreciated 5%/year against the dollar, forever.  The interest parity effect would raise Japanese rates immediately and the yen depreciation would boost AD.  If that doesn’t work do 5%/month.  Yes, it’s possible.  But you read their explanations and they write as if central banks just moves rates around with a magic wand.  As if it doesn’t matter whether the higher rates are caused by easier money or tighter money. People write as if they didn’t notice what happened when Japan, the ECB and the Riksbank tried to exit the zero bound by raising rates.