Stop talking about “real” demand

(A follow-up to yesterday’s post.)

Here’s Matt Yglesias:

This is not showing “demand”. Aggregate demand is a nominal concept, or it is meaningless. Back around 2008, real domestic final sales declined in Zimbabwe even as aggregate demand grew more than a million-fold.

This sort of graph merely shows quantity bought and sold. It says nothing about demand.

The problem with old-style monetarism

This should be a time of celebration for monetarists. While many conventional economists and market monetarists did not express much concern about inflation (until recently), more traditional monetarists like Bob Hetzel and Tim Congdon correctly warned that excessive money growth would trigger high inflation. And yet I don’t expect them to get much credit and I don’t expect a revival of monetarism. To see why, let’s look at the data:

Here I’d like to compare annual growth rates from 2019:Q4 to 2021:Q4:

Nominal GDP: +5.16%

PCE inflation: +3.33%

Real GDP: +1.56%

(They don’t quite add up because I used the PCE inflation index that the Fed targets, not the GDP deflator)

M2: +18.8% (December 2019 to December 2021)

Given the dramatic fall in immigration during Covid, the 1.56% RGDP growth is basically right on trend (per capita.) But the relatively normal growth in RGDP actually reflects two rather dramatic shocks, which roughly offset each other:

1. Excessive growth in aggregate demand. Nominal growth should have been no higher than 4%/year, and instead averaged over 5%. That pushed output above normal.

2. Supply chain problems related to early retirements and the switch from services to goods. That reduced output relative to trend.

These two factors roughly offset, leaving (per capita) output close to trend. The extra 1.16% in NGDP growth mostly led to higher than target inflation.

In some respects the situation is even worse than these figures suggest. NGDP growth was at an annual rate of 14.3% in 2021:Q4, confirming that monetary policy in the second half of 2021 was far too expansionary, as many traditional monetarists claimed. I expect the overheating problem to get even worse in 2022, as NGDP growth is likely to continue running at a rate that is well above 4%. Monetary policy is still too easy.

So why won’t monetarism make a big comeback? The problem here is that while monetarism was correct in a directional sense, the actual rise in inflation and NGDP was dramatically different from the growth in the monetary aggregates. (I used M2, but other aggregates also grew rapidly.) This reflects the fact that velocity slowed dramatically in 2020-21. M2 rose by over 41% over two years, while NGDP rose by barely over 10%. Thus it is still true that monetary aggregates are not a reliable guide to monetary policy. To judge whether money is too easy or too tight you need to look at expectations of NGDP growth.

Recent inflation figures look even worse. For instance, the PCE index is up 5.73% from November 2020 to November 2021. But that still means that someone who predicted 2% inflation this year was more accurate than someone who predicted 10% inflation. Is that how you think about forecast accuracy? Be honest.

I would call 2021 a marginal success for traditional monetarism. It supports the argument that the monetary aggregates provide some useful information that is not captured in conventional macro models. And while it’s still early, I am pretty confident that 2022 will provide another marginal success for traditional monetarism. We are in for another year of high inflation. So don’t take this post as a criticism of monetarism—its reputation should be higher today than a year ago.

Nonetheless, I don’t see enough evidence to support the claim that the monetary aggregates can play a decisive role in policy formation—velocity is too unstable. Markets saw what happened this time, and I’d expect the next time we get a surge in the monetary aggregates you’ll see that data better incorporated into market forecasts. Markets will decide how much weight to put on the aggregates.

Market forecasts are still the best guide to policy. Recall that market forecasts were far more useful than the monetary aggregates during the Great Recession.

PS. Hypermind predicted 8.1% NGDP growth, whereas the actual figure was 11.7%, which represents a spectacular failure of the Hypermind market. (Hypermind forecasters implicitly expected Q4 NGDP growth of roughly zero, instead it was 14.3%.) I suspect that there is a flaw in the way Hypermind reports its forecast, but I need to investigate further before I reach any conclusion. For the moment, I put more weight on TIPS spreads.

PPS. It’s not clear why the economy overheated in late 2021, but I suspect one reason is that the Fed abandoned its FAIT regime. There doesn’t seem to be any commitment to push inflation below 2%, as required by FAIT. Someone needs to ask Powell why that is.

PPPS. Greg Ip makes the common mistake of assuming that RGDP is a measure of aggregate demand. It isn’t. Nominal GDP measures aggregate demand. (Consider RGDP and NGDP in Zimbabwe.) This leads him to wrongly conclude that the high inflation wasn’t caused by excess demand. Supply problems certainly played a role, but so did excess demand.

A disappointing Powell press conference

Stocks fell by about 2.5% during Powell’s press conference, perhaps because the answers were more hawkish than expected. A few observations:

1. Powell was asked whether, in retrospect, the recent monetary and fiscal policy stance had been too expansionary. It seems clear that the answer is yes, but Powell indicated that we would have to wait 25 years for future historians to answer that question. This is nothing new; the Fed never blames itself for policy mistakes in real time.

2. At one point Powell suggested that if real wages rise by more than productivity, the result could be higher inflation. In my view, the real problem is nominal wages rising by more than productivity—specifically by more than 2% above the rate of productivity growth. Not sure why he’s focused on real wages, which have not been rising. Is his mistake based on some sort of Keynesian model? (Most of these fallacies seem to come out of Keynesian economics.)

3. The big decline in stocks occurred around the time of the first question, when Powell suggested that the balance sheet might be reduced, and also that the effect of balance sheet adjustments was much less important than the effect of interest rate changes. Lots of people believe the balance sheet is unimportant, and hence I was amused to see stocks fall sharply in response to Powell comments about something that is supposedly unimportant.

4. The second downshift in stocks occurred around 3pm, when Powell issued several comments that suggested he is worried about economic overheating (as he should be.)

5. Powell indicated that he now expects even higher inflation in 2022 than what he expected in December. The Fed is still behind the curve, indeed even further behind than in December. Monetary policy is getting even further off course.

PS. Over at Econlog, I discuss Powell’s strange response to a question on FAIT, where he seems to abandon the policy.

What does it mean to say that something is inflationary? (part 2)

Let’s try again. Here’s how I would answer the question: Is X inflationary?

1. Under successful inflation targeting, X is not inflationary.
2. Under successful NGDP targeting, X is inflationary if it reduces RGDP.
3. Under money supply targeting, X is inflationary if it reduces real money demand (perhaps due to higher V or lower Y)
4. Under interest rate targeting, X is inflationary if it raises the natural rate of interest.
5. Under a fixed exchange rate regime, X is inflationary if it raises the equilibrium real exchange rate.
6. Under the gold standard, X is inflationary if it raises the supply of gold or reduces the demand for gold.
7. Under a successful Taylor Rule, X is inflationary if it creates a negative output gap.

In these examples, X might be fiscal stimulus. It might be an increase in the minimum wage. It might be supply chain problems. it might be an oil shock. It might be an increase in monopoly power. It could be anything. And my answer is always the same. The answer depends on the monetary regime.

The seven answers above apply to any shock, of any type. If there’s war in the Ukraine, the list above gives you your answer. If the woke people take over America, the list above gives you your answer. If vaccines wipe out most of our population in three years (as some Republicans expect), the list above tells you the effect on inflation.

The answer always depends on the monetary regime.

This is frustrating to many people. We want a simple answer. We want to know the impact of X holding monetary policy constant. But I’ve just shown you seven different ways of holding monetary policy constant. Which one did you have in mind?

What does it mean to say that something is inflationary?

Tyler Cowen has a new post looking at the question of whether cryptocurrencies are inflationary. I’d like to take a stab at this question from another perspective.

Let’s start with the question of whether cryptocurrencies like Bitcoin are “money”. If you view Bitcoin as money, then it has been hyperdeflationary. Prices of goods and services in terms of Bitcoin have plummeted at a phenomenal rate over the past decade.

But that’s clearly not what people mean when they ask whether Bitcoin is inflationary. They are thinking of inflation in US dollar terms. In that case, asking whether Bitcoin is inflationary is sort of like asking whether gold, copper, or shares of Tesla stock are inflationary. So are they?

In the most simple possible model, crypto doesn’t seem to be inflationary because it doesn’t directly affect the dollar money supply. But what if it somehow boosts velocity? Is that possible?  

Crypto could theoretically cause market interest rates to rise, which would boost velocity. But if the Fed is targeting interest rates then this will not occur.

Crypto might raise the natural interest rate to a level above the policy rate, and hence boost inflation. This is actually the best theoretical argument for crypto being inflationary, but it is still rather implausible.

First, why wouldn’t the Fed offset this effect by raising the policy rate?  More importantly, why would crypto have any significant impact on the natural rate of interest? The total market value of cryptocurrencies is roughly $3 trillion, similar to Apple’s market value. People don’t typically ask if Apple stock is inflationary. They might ask if the stock market as a whole is inflationary, but not a single stock.

I suspect the confusion here comes from the fact that crypto is viewed as a form of “money” (it is often called “coins” or “currency”), and people wrongly think that monetary models of inflation are about money. They are not. Monetary models in macroeconomics are about the medium of account, the asset in terms of which goods and services are priced. Most cryptocurrencies are not media of account, and hence are not relevant to monetary models of the inflation, NGDP, etc. (And they aren’t even much of a medium of exchange.) As for stablecoins, I presume the Fed offsets their impact.

People often argue that monetary offset doesn’t work perfectly.  That’s obviously true, but the implication of this fact is frequently misinterpreted.  At times, the Fed is too expansionary (1970s, 2021) and at other times they are too contractionary (1930s, 2008-16).  But ex ante we don’t know what sort of mistake they will make, and hence a lack of monetary offset is not an argument for either an inflationary or a deflationary effect. 

Tyler spends a portion of his post discussing how crypto might affect aggregate demand, but I’m not persuaded by his reasoning.  He doesn’t tell us why this effect would lead the Fed to make a mistake in one direction or another.  The Fed knows about crypto.  Perhaps they overestimate its inflationary impact or perhaps they underestimate its inflationary impact.  I don’t know which is true, and I suspect that you don’t know either.

Perhaps Tyler is not thinking about monetary offset, rather he is viewing his analysis as a sort of input into Fed decision-making. Advice on how they might need to adjust policy from the baseline in response to crypto, in order to achieve effective monetary offset. But what is the baseline? There is no such thing as the Fed doing nothing. There is no baseline, except perhaps 2% inflation. But that merely assumes the answer! So what does it mean to talk about anything being inflationary? Holding what constant?