Archive for the Category Monetary Policy


Josh Hendrickson on the Labor Standard of Value

If you asked me to name the five greatest works of macroeconomics during the 20th century, I might produce something like the following list (in chronological order):

1.  Fisher’s Purchasing Power of Money

2.  Friedman and Schwartz’s Monetary History

3.  Friedman’s 1968 AEA Presidential address

4.  The “Lucas Critique” paper

5.  Earl Thompson’s 1982 labor standard of value paper

(BTW, Krugman’s 1998 expectations trap paper might well make the top 10.)

Most economists would replace Thompson’s paper with something like the General Theory by Keynes.  In this post I explained why this 2 page never published paper that looks like something out of the Middle Ages is so important. (Please look at the link; the paper’s formatting is hilarious.)  Thompson’s student David Glasner did some excellent work on this idea in the late 1980s.

Josh Hendrickson has a new Mercatus paper which explains the logic behind the Thompson proposal.  Although Josh’s paper is very clear and well written, I can’t resist adding a few comments, as I fear that the extremely unconventional nature of Thompson’s idea might make it hard for some people to grasp the significance.

Josh starts off with an analogy to a gold standard regime, and then discusses the well-known drawbacks of that approach.  With a gold standard regime, any necessary changes in the real or relative price of gold can only occur through changes in the overall price level (or more importantly NGDP), which can be disruptive to the economy.

Here I’d like to emphasize the importance of the issue of sticky prices.  Adjustments in the overall price level can be costly because many nominal wages and prices tend to be sticky, or slow to change over time.  In contrast, gold prices are very flexible, changing second by second to assure that the gold market stays in equilibrium.  Under a gold standard, the nominal price of gold is fixed, and thus the ability of gold prices to quickly adjust is in a sense “wasted”.  Instead, we ask stickier prices to adjust when the real price of gold needs to change.

When reading Josh’s paper, try to keep sticky wages in the back of your mind.  Whenever the aggregate nominal wage level needs to adjust unexpectedly, some wages will be slow to change, and will be out of equilibrium for a certain period of time.  If there is downward wage inflexibility, especially a reluctance to cut nominal wages, then labor market disequilibrium can persist for years.

Normally, when we think of a government program aimed at fixing a price (gasoline, rents, etc.) we think of a market that is pushed out of equilibrium.  Nominal wage targeting is different.  Under Thompson’s proposed regime, individual nominal wages are still free to change, but monetary policy is adjusted until labor market participants do not want to change the aggregate average nominal wage rate.  In that case, the aggregate average nominal wage should stay at the equilibrium level (although of course individual wages might still occasionally move a bit above or below equilibrium.)

Under our current system, a sudden fall in nominal wage growth actually leaves the aggregate nominal wage too high, as some wages have not yet adjusted downwards.  We’d like to prevent that, by providing enough money so that the aggregate average nominal wage does not need to adjust.

My second comment has to do with the mechanism that Josh discusses:

Suppose that the central bank promised to buy and sell gold on demand at its current market price, but guaranteed that an ounce of gold would buy a fixed quantity of labor, on average. This is a promise to keep an index of nominal wages constant.

This approach is called indirect convertibility, a subject that Bill Woolsey discussed in a series of papers published in the 1990s.  I have a couple brief comments.  First, this sort of scheme need not involve gold at all.  Second it’s essentially a form of “futures targeting”, which is something I’ve done a lot of work on myself.  Indeed, this idea was independently discovered by numerous economists during the 1980s, but Thompson was the first.

If you are having trouble understanding the logic behind the indirect convertibility mechanism for a labor standard, think about the fact that aggregate wage data comes out with a lag, and hence you need to target a future announcement of the wage index.  To assure that monetary policy is set at a position where expected future wages are stable, you need a futures market mechanism where investors could profit any time aggregate wages are expected to move.  Their attempts to profit from wage changes nudge monetary policy back to the stance likely to keep average wages stable.

In addition, the specific proposal discussed by Josh involves a stable wage level, but given political realities it’s more likely the actual target would creep upward at 2% to 3%/year.

Also note that Josh argues that a labor standard is a vastly superior approach for achieving the goals of recent “job guarantee” proposals, put forth by progressives.  I agree.

PS.  I have a new Mercatus Bridge post discussing a WSJ article that called for monetary reform aimed at stable money.

PPS.  My recent post at Econlog on the usefulness of the yield spread got zero comments, which surprised me given all the recent focus on that variable.

Martin Feldstein on Fed policy

In a new WSJ piece, Martin Feldstein calls for higher interest rates. I don’t necessarily disagree with the need for somewhat higher interest rates, although I think we need to be very careful not to tighten policy too much.  But I do disagree with his reasoning:

But controlling inflation isn’t the primary reason for the Fed to keep raising the short-term interest rate. Rather, raising the rate when the economy is strong will give the Fed room to respond to the next economic downturn with a significant reduction.

This is wrong.  Raising interest rates reduces the Wicksellian equilibrium interest rate.  That gives the Fed less room to cut rates in the future.  The Fed does monetary stimulus by cutting rates below the equilibrium rate.  The lower the equilibrium rate, the less room there is to use conventional monetary stimulus.

That downturn is almost surely on its way. The likeliest cause would be a collapse in the high asset prices that have been created by the exceptionally relaxed monetary policy of the past decade.

This is wrong.  Downturns cannot be forecast.  Even if they could, they are not caused by high asset prices; they are caused by tight money.  And the recent high asset prices are not caused by easy money, because money has not been easy over the past decade.

It’s too late to avoid an asset bubble: Equity prices already have risen far above the historical trend. The price/earnings ratio of the S&P 500 is now more than 50% higher than the all-time average, sitting at a level reached only three times in the past century. Commercial real-estate prices also are extremely high by historical standards.

This is wrong—bubbles do not exist.  Past P/E ratios are not very useful in predicting asset prices.  If they were, P/E mutual funds would outperform ordinary funds.  Robert Shiller likes to use P/E ratios, and made some predictions about stock prices in 1996 and 2011.  The predictions did not turn out well.  Real estate prices are skewed by NIMBYism, and unusually low interest rates relative to NGDP growth.

The inevitable return of these asset prices to their historical norms is likely to cause a sharp decline in household wealth and in the rate of investment in commercial real estate. If the P/E ratio returns to its historical average, the fall in share prices will amount to a $9 trillion loss across all U.S. households.

Inevitable? If Martin Feldstein wants me to sign a contract to buy San Francisco property in 5, 10 or 15 years, at “historical norms” plus 10%, I’ll sign tomorrow.  Show me where the dotted line is.  Ditto for stocks.  I’ll buy stocks right now, to be delivered in 10 years, at “historical norms” plus 10%.  Does Feldstein want to sell those assets at that price?  After all, if prices fall to historical norms he’d make a 10% profit. Of course I’m not being serious—if I were in his shoes I wouldn’t want to waste time doing a deal with me; my point is for readers to think more deeply about what stuff is worth.

Large drops in household wealth are usually accompanied by declines in consumer spending equal to about 4% of the wealth drop. That rule of thumb implies that a $9 trillion drop in the value of equities would reduce consumer spending by about 2% of gross domestic product—enough to push the economy into recession. The fall in the value of commercial real estate would add to the decline of demand. And with consumer spending down sharply, businesses would cut back on their investment and hiring.

Drops in wealth do not necessarily cause a drop in spending; it depends on why wealth changes.  The stock market crash of 1987 did not impact consumer spending.  Where the two move together, it’s usually because a third factor such as the business cycle is causing both.  But if the Fed keeps NGDP growing at a steady rate (as in 1987), then an asset price drop is not likely to have much impact on consumer spending.  And even if consumer spending does drop, it’s not likely to push the economy into recession as long as the Fed keeps NGDP growing at a steady rate.  What matters is not consumer spending, it’s aggregate spending.

But significant monetary stimulus would be impossible to achieve if the short-term interest rate remains at the current 1.75%. And there is less room than ever for fiscal stimulus, as annual deficits will exceed $1 trillion by 2020 and federal debt will be greater than 100% of GDP by the end of the decade.

This is half wrong.  As Frederic Mishkin used to point out in his best selling monetary economics textbook, monetary policy remains “highly effective” at near zero interest rates.  However, Feldstein is right about fiscal policy.

That’s why it’s important for the Fed to raise the federal-funds rate to 4% over the next two years, which would allow it to cut the rate by at least three points when the next recession begins. Such a rate reduction might not be enough to prevent a recession within the next two years, but it would maximize the Fed’s positive influence on the economy.

It would be a huge mistake to raise rates so sharply (unless the economy got much stronger than I current expect.)  This might well trigger a severe recession, and in that case the equilibrium interest rate would fall sharply.  The Fed would actually have less room to cuts rates than they do right now, not more.

Feldstein’s views are very popular among conservative economists.  But I’m heartened to see that many younger economists and grad students are increasingly moving toward the market monetarist perspective, as events consistently back our interpretation and discredit the standard conservative view.  We are currently behind, but we’ll win in the long run.

PS.  I can’t even imagine what Feldstein would make of the past 27 years in Australia—they must be about to enter an enormous, humongous, stupendous, monumental, colossal, gigantic, titanic, vast, huge, bigly, Great Great Great Depression.  Check out David Beckworth’s post on house prices and debt in Australia, compared to the US.

HT:  Stephen Kirchner


The next five years

At the moment, monetary policy is boring.  But the next five years will be very interesting.  Take a look at this graph for the unemployment rate:

Screen Shot 2018-07-25 at 1.32.45 PMThere’s an interesting pattern there.  When the unemployment rate stops falling, we usually have a recession within about 18 months.

One exception is 1966.  During late 1966, it looked like we were entering a recession.  But the Fed put the pedal to the medal and we avoided a recession until the very end of 1969.

I feel fairly confident that the unemployment rate will stop falling within a couple of years.  I doubt it can go below 3%.  If so, we will enter a dangerous period for the economy.  The Fed will try to engineer a “soft landing”, but so far it’s had little luck. (And even if I’m wrong and unemployment falls to 2.5%, it merely puts off the day of reckoning by a year or so.)

In 1967, the Fed got so nervous that they pulled up on the steering wheel and never landed at all, soaring off into the Great Inflation of 1966-81.  In more recent cases we’ve had a hard landing into recession.

So is a low inflation soft landing impossible?  No.  The UK achieved a soft landing in 2001, and Australia hasn’t had a recession since 1991.  While a forecaster looking only at US data might say that a recession is extremely likely within the next 5 years, in my view the odds are closer to 50-50.

[Yes, that’s a wimpy forecast, where I can’t be “wrong”.  But that’s not the point of this post.  I make no claims to be able to forecast recessions.]

Past data is extremely misleading in macro, as the monetary regime is always evolving in response to previous mistakes.  The interwar period was not useful for predicting the postwar period, and the Great Inflation was not useful in predicting the Great Moderation, and the Great Moderation was not useful in predicting the Great Recession.  Subtle changes are always occurring.  Look how the business cycle has started stretching out since the 1950s.

Either of these two outcomes will be great for market monetarism:

1. If a recession occurs we can say, “See, we told you not to let NGDP growth plunge.  We told you inflation targeting was not reliable.”

2. If no recession occurs we can say, “See, we told you that if you keep NGDP growing at a steady rate you could moderate the business cycle.”

Of course if a recession occurs despite stable NGDP growth, then we’re screwed.

(BTW, David Beckworth has a new article in The Hill, on the prospects for Jay Powell adopting a monetary rule.)

Yes, it’s delusional to think our tiny band of MMs will get credit for a 14-year expansion.  Who would get (or “take”) credit?  I’m not quite sure . . .

Screen Shot 2018-07-25 at 2.20.42 PM

PS.  Read this hilarious article about what happened when Melania was caught watching CNN.  This is just 18 months in; imagine how wild things will be after another 6 years!

Should the Fed worry about dollar debts?

Here is the Financial Times:

The US Federal Reserve is often buffeted by fierce cross-currents but investors caution that balancing the strong domestic economy and rising turbulence in emerging markets — and now Europe — will require a particularly adept hand at the tiller this year.

Although Argentina and Turkey have been the focus for their own idiosyncratic reasons, Urjit Patel, India’s central bank governor, argued that emerging markets are suffering a broader bout of “upheaval” caused by the “double whammy” of the Fed’s balance sheet shrinkage and the US Treasury’s borrowing binge.

“Given the rapid rise in the size of the US deficit, the Fed must respond by slowing plans to shrink its balance sheet,” Mr Patel wrote in the FT on Monday. “If it does not, Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.”

Borrowers in emerging markets need to understand that interest rates are volatile.  If they cannot afford to repay dollar-denominated debts when the dollar is strong, then they shouldn’t be borrowing dollars in the first place.  Borrow in your local currency.

Worries about an EM debt crisis are not a good reason to refrain from raising the target interest rate.  On the other hand, the following is not a good reason to raise interest rates:

Indeed, given the robust US economic outlook, some analysts even caution that it runs the risk of overheating. The 10-year “breakeven” rate, a market measure of investors’ inflation expectations, remains above the Fed’s target 2 per cent at 2.07 per cent, despite recent declines, and inflation is expected to continue to accelerate into the summer.

Arrgggh!  I can’t believe that in 2018, respectable publications are still making this basic error.  The Fed does not target the TIPS spread at 2%, as that spread is based on CPI inflation, not the PCE inflation rate that is the actual target of Fed policy.  When CPI inflation is running at 2.07%, PCE inflation runs around 1.8%.

NOW you want more than 2% inflation?!?!?

Reading the Fed minutes can sometimes make me want to tear my hair out.  During the long recovery from the Great Recession, the Fed frequently told us that we could not do more stimulus due to the danger of inflation exceeding 2%.  The taper tantrum was caused by Fed hints that monetary tightening was on the horizon, motivated by a fear of higher inflation.  In 2015, the Fed began raising interest rates, with the goal of preventing inflation from overshooting 2%.

And now, with unemployment down to 3.9%, we are suddenly told that the Fed would actually welcome above 2% inflation?  This makes no sense at all.

It was also noted that a temporary period of inflation modestly above 2 percent would be consistent with the Committee’s symmetric inflation objective and could be helpful in anchoring longer-run inflation expectations at a level consistent with that objective.

Just to be clear, it’s perfectly fine to argue that the Fed should overshoot their 2% inflation target right now.  Thus a market monetarist might favor overshooting for “level targeting” reasons.  There are good arguments on both sides of that question, but it’s certainly a defensible argument.  However these MMs that favor overshooting were also favoring more monetary stimulus during the recovery from the Great Recession.

What’s not defensible is to have have opposed additional monetary stimulus during the recovery from the Great Recession, even as inflation was running well under 2%, and then now suddenly favor above 2% inflation.

Most business cycles are caused by procyclical monetary policy.  A monetary policy that causes inflation to run below 2% during periods of high unemployment and above 2% during booms is procyclical, and hence bad.  Why does the Fed have so much trouble understanding such a basic point?  I don’t get it.

I can already anticipate commenters talking about whether money is too easy or too tight without reference to the monetary REGIME.  That’s just stupid.  Monetary policy is not about whether the fed funds rate should be raised or lowered at a given meeting, it’s about what sort of policy regime you have.  The Fed still hasn’t figured out that a procyclical policy regime is destabilizing.  It’s the primary cause of the business cycle.

PS. I have a blog post at a new AEI symposium on how the US can best compete with China.