Pretty disappointing, but with one silver lining.  We pretty much know where the “Bernanke put” is, he drew a line at roughly 1% core inflation.  That means no more “depression economics.”  Let’s get costs down and we can get a faster economic recovery:

1.  Payroll tax cuts (at the margin, employer only.)

2.  Replace unemployment extended benefits with large lump sum payments to the unemployed.

3.  Temporary (two year) minimum wage cuts to $6.50.

Of course this won’t happen, but it would promote faster growth if it did.  They are things Obama could try.  Now for the speech:

Maintaining price stability is also a central concern of policy. Recently, inflation has declined to a level that is slightly below that which FOMC participants view as most conducive to a healthy economy in the long run. With inflation expectations reasonably stable and the economy growing, inflation should remain near current readings for some time before rising slowly toward levels more consistent with the Committee’s objectives.

Translation:  The Fed defines price stability as about 2% inflation, and it’s running around 1% (core inflation.)  Bernanke thinks that’s a bit lower than desirable.  But then there is also this:

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC. Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.

However, such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability.

Aaaargh!!  So which is it?  Is inflation too low, or not?

I wish those prominent economists calling for 4% inflation had followed my advice.  Call for level targeting.  Draw a 2% trend line for core inflation from September 2008.  We are now 1.4% below that trend line.  Shoot for getting back to trend.  I know that doesn’t sound like much stimulus, but given the slack in the economy it would actually take pretty fast NGDP growth to get 3.4% core inflation over 12 months.  Or 2.7% over 24 months.  You’ll never convince the Fed to change its inflation target to 4%, and there is no need to try.

But Bernanke definitely does understand the logic of the argument I have been making in recent posts:

First, the FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.

Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.  (italics added.)

Translation:  “Listen you inflation hawks, if things get even a tiny bit worse we will need more stimulus not just to boost growth, but to prevent further disinflation.”

I think we are already there, where more nominal growth is a win/win, and my hunch is that (to a lesser extent) Bernanke agrees.  After all, he basically said that in the first quotation I gave you, which I take to be his true feelings.  The hawks would never have said inflation is too low.  Bernanke is a patient man, but he is running out of patience.  Let’s hope the three new Board members push him hard this fall.

So if Bernanke wants to do more, why doesn’t he say so?  He explained why, if you read between the lines:

Central banks around the world have used a variety of methods to provide future guidance on rates. For example, in April 2009, the Bank of Canada committed to maintain a low policy rate until a specific time, namely, the end of the second quarter of 2010, conditional on the inflation outlook.4 Although this approach seemed to work well in Canada, committing to keep the policy rate fixed for a specific period carries the risk that market participants may not fully appreciate that any such commitment must ultimately be conditional on how the economy evolves (as the Bank of Canada was careful to state). An alternative communication strategy is for the central bank to explicitly tie its future actions to specific developments in the economy. For example, in March 2001, the Bank of Japan committed to maintaining its policy rate at zero until Japanese consumer prices stabilized or exhibited a year-on-year increase. A potential drawback of using the FOMC’s post-meeting statement to influence market expectations is that, at least without a more comprehensive framework in place, it may be difficult to convey the Committee’s policy intentions with sufficient precision and conditionality. The Committee will continue to actively review its communication strategy, with the goal of communicating its outlook and policy intentions as clearly as possible.

Translation:  We can’t communicate a clear objective because unlike in Canada and Japan, I can’t get those hawks to agree with my view of the appropriate “comprehensive framework.”  We will try to make our intentions as clear as possible, if we can ever agree on what they are.

[BTW, notice how in 2001 the BOJ promised to tighten policy as soon as inflation reached zero?  If you have deflation for years, and tighten the moment you hit zero (which was 2006) won’t you go right back into deflation?  The answer is yes.  So much for Paul Krugman’s theory that the BOJ is valiantly struggling to avoid deflation.]

What if more stimulus is needed, does the Fed have more ammo?

The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.

So Congress and the President are desperately looking for ways to boost demand, w/o ballooning the deficit.  The Fed has such tools, but sees no need to use them.  And what is the most likely tool?

A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve’s holdings of longer-term securities. As I noted earlier, the evidence suggests that the Fed’s earlier program of purchases was effective in bringing down term premiums and lowering the costs of borrowing in a number of private credit markets. I regard the program (which was significantly expanded in March 2009) as having made an important contribution to the economic stabilization and recovery that began in the spring of 2009. Likewise, the FOMC’s recent decision to stabilize the Federal Reserve’s securities holdings should promote financial conditions supportive of recovery.

I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed’s balance sheet would have to be weighed against potential risks and costs. One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions. In particular, the impact of securities purchases may depend to some extent on the state of financial markets and the economy; for example, such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high. The possibility that securities purchases would be most effective at times when they are most needed can be viewed as a positive feature of this tool. However, uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses.

Another concern associated with additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to execute a smooth exit from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might lead to an undesired increase in inflation expectations. (Of course, if inflation expectations were too low, or even negative, an increase in inflation expectations could become a benefit.) To mitigate this concern, the Federal Reserve has expended considerable effort in developing a suite of tools to ensure that the exit from highly accommodative policies can be smoothly accomplished when appropriate, and FOMC participants have spoken publicly about these tools on numerous occasions. Indeed, by providing maximum clarity to the public about the methods by which the FOMC will exit its highly accommodative policy stance–and thereby helping to anchor inflation expectations–the Committee increases its own flexibility to use securities purchases to provide additional accommodation, should conditions warrant.

Translation:  It worked last time (March 2009), there are a few minor problems, but we have addressed those problems.  He mentions other ideas like better communication and lower IOR, but you get the impression that he is much less enthusiastic about those ideas.  My guess is that he would only do a comprehensive stimulus with all three tools if things got really bad.  Actually things are really bad; I mean  if things got really, really bad.  If 3rd quarter NGDP growth comes in around 3% or lower, look for more QE in the fall (when the three new members are seated.)  BTW, I am less confident than Bernanke that QE worked last time.  But it is definitely better than nothing.

It didn’t take Andy Harless long to figure out what part 2 of this essay would look like.  Here’s his comment to part 1:

At the risk of giving away the punch line: structural unemployment is pretty much the same deal as an oil shock; it’s a reduction in aggregate supply. In both cases, employment eventually readjusts: in the structural case, because workers get retrained, relocated, &c; in the oil shock case, because product prices and productivity rise faster than wages so as to re-establish profit margins. In both cases, the adjustment happens faster if monetary policy accommodates: because there is more incentive to retrain and relocate workers; or because product prices rise more quickly.

The bottom line is that the Fed had been delivering 5% NGDP growth for decades, and no matter what caused the current crisis, they needed to continue delivering 5% NGDP growth.  This means that money has been far too tight since August 2008, even if most of the unemployment is structural.  I am reacting to statements like this from Narayana Kocherlakota:

Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.

There are so many things wrong with this that I hardly know where to begin:

1.  The structural theory is usually based on the fact that the housing bubble caused residential housing to become severely overbuilt by 2006, necessitating a sharp decline in construction jobs regardless of what the Fed did.  That’s true, but as this graph shows, almost all the decline in housing occurred BEFORE the severe phase of the recession started in August 2008.  (Almost halfway through the blue vertical band that starts in December 2007.)  So there was a structural loss of jobs after mid-2006, but it has little to do with the sharp rise in unemployment that only began two years ago.

2.  The sharp loss of jobs that did begin in August 2008 was associated with three areas mostly unrelated to sub-prime housing; manufacturing, commercial construction, and services.  All three of these turned down sharply precisely when NGDP started falling, i.e. when money got ultra-tight.

3.  The problem is not struggling with the re-allocation of construction workers into manufacturing, as manufacturing has also shed lots of jobs.

4.  It’s really not that hard to transform construction workers into factory workers.  For God’s sake in WWII we put housewives into factories!  And the average construction worker is far more skilled with heavy machines than the average housewife.

5.  The Fed has not provided the monetary stimulus required so that factories want to hire workers.  Volcker provided the monetary stimulus for factories to want to hire workers when he engineered 11% NGDP growth at an annual rate for the first 6 quarters of recovery in 1983-84.  We’ve been running 4% NGDP growth in the first 4 quarters, and we are now downshifting to 3%.  How can you get the 7.7% RGDP growth of the earlier recovery if NGDP is growing 3%?  Are we going to have a minus 4.7% GDP deflator?  When has an economy ever boomed with 5% deflation?  People who ask why the economy should not yet have adjusted to 1% inflation are asking completely the wrong question.  Even if we had adjusted, it would take 8.7% NGDP growth to get a Volcker-esque recovery.  It’s simple math.  What you are really asking is why isn’t inflation falling even further.  That’s a tougher question.  The 40% jump in minimum wages, and the 99 week unemployment extension probably made labor markets a bit less flexible that usual.  But overall what we are seeing is not that far out of the normal.  Both real GDP and inflation fell, with RGDP falling more sharply.  That’s pretty normal for steep recessions.

Now let’s return to Andy’s point.  Almost everyone agrees that the SRAS is upward sloping, even my critics.  After all, my critics claim the Fed blew up the housing bubble with easy money in 2003, and that can only occur if money is non-neutral.  This means that even if 100% of the current unemployment problem is structural, it is still true that monetary stimulus will boost employment.  And since inflation is still below target, and expected to remain below target, monetary stimulus would also improve the inflation situation.  It’s a win-win.  So when people say that structural problems argue against monetary stimulus, they aren’t just wrong, they are doubly wrong.

Part 2:  Stop searching for the Holy Grail of macro

Since David Hume, every bright young economist seems to want to take a stab at the problem of why nominal shocks have real effects (i.e. why the SRAS slopes upward.)  They’ve all failed.  It’s not that they haven’t come up with explanations; they’ve come up with plenty.  Bennett McCallum once listed ten versions of price stickiness.  Then there is wage stickiness.  And misperceptions.  And money illusion.  And that’s ignoring how the supply-side intersects with nominal shocks, as when governments extend UI to 99 weeks during recessions.

They sift through all sorts of micro-level data, develop macro stylized facts, and then try to connect them up with theory.  But they never get anywhere.  Maybe all theories are true to some extent, and the relative importance of each effect varies from one business cycle to another.  Milton Friedman once said that in 200 years we’ve only gone one derivative beyond Hume.  (We look at changes in inflation, rather than changes in the price level.)

So I get pretty discouraged when I read economists trying to sift through micro-level data about prices and labor markets, searching for the Holy Grail of the micro-foundations of recessions.  Hume explained our recession 200 years ago:

“If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.” David Hume “” Of Money

That’s right; Hume knew that if the Fed paid interest on bank reserves, encouraging them to lock up excess reserves, it was like a contractionary monetary policy.  Fed presidents would be better off spending more time reading Hume, and less time sifting through micro data that supposedly disproves “the” Keynesian model (as if there’s only one!)  The brightest minds of the profession have attacked the problem for 200 years, and they’ve all failed.  It’s a black box.  It is truly the Holy Grail of macroeconomics.

Please stop searching for structural patterns, and start boosting NGDP growth.

(PS:  I do agree that Obama’s economic policies are considerably less pro-growth than Reagan’s, but we could still be doing much better than we are.  “There’s a great deal of ruin in a nation.”  And again, those policies do not excuse the Fed allowing NGDP to suddenly fall 8% below trend.)

Nearly 2 years ago (in October 2008) I started running around like a chicken with its head cut off.  I talked to distinguished professors, wrote op eds, submitted papers to journals.  I haven’t stopped.  But the most common reaction at the time was:

1.  It’s not a monetary problem it’s a banking problem. 

2.  You can’t push on a string.

3.  Rates are already near zero.

4.  We need fiscal stimulus.

When NGDP is falling fast it is ALWAYS a monetary problem.  Two years later this awareness has seeped all the way down to the Drudge report.  Here are the top three headlines today:

Bernanke Under Pressure to Prop it Up!

Jackson Hole:  Speech, Speech . . .

Weak GDP Raises Stakes for Obama . . .

Now it’s not just one monetary crank, the whole world is looking to Bernanke to save us.  Can he fight off the arch-villain Fed hawks?  Stay tuned . . .

PS.  Yes, I over-dramatized a bit to make myself look good.  There were a few others like David Beckworth, Earl Thompson and Robert Hetzel.  And Jim Hamilton occasionally had some good things to say.  But in retrospect it is absolutely stunning how silent the profession as a whole was, at least on the need for monetary stimulus.  Better late than never.

My posts are too long, so I’ll break this up into two parts.

Consider the following policy options.  Assume a standard AS/AD model with some wage and price stickiness.

1.  An amoral monetary policy:

Let’s suppose central bankers cared only about keeping inflation at a steady rate of 2%/year.  They know that monetary policy also affects employment fluctuations, but they don’t care about workers.  Let’s call that policy “amoral.”

2.  An empathetic monetary policy:

Now let’s assume the central bank still prefers stable inflation of about 2%, but also wishes to avoid suboptimal employment fluctuations.  What should they do if unemployment rises to 10%, and many workers lose jobs because wages and prices are not completely flexible?  In that case the central bank must trade-off two goals; stable inflation and stable employment.  It will probably be optimal to allow slightly higher than 2% inflation, if the policy that does that (monetary expansion) also reduces unemployment in the short run.  So they might allow 3% percent inflation to reduce unemployment to 8%.

What if employment is too low?  Suppose NGDP has risen fast and companies are forcing workers on long term contracts to work lots of overtime.  They miss deer hunting season.  They are grouchy to their wives.  But they have no choice.  The Fed can reduce inflation slightly below 2% with tight money, and this will tend to push employment levels down closer to their optimal point.  That would be the amount of work that would occur if labor contracts had been negotiated with full knowledge of current levels of AD.

You may have noticed that this is roughly what NGDP targeting does, although there are many other versions of this general idea.

3.  A sadistic monetary policy:

Now suppose central bankers get pleasure from the suffering of workers.  They enjoy the thought of workers losing their jobs.  If unemployment hits 10%, what is the optimal policy response from the central banker’s perspective?  Recall that, other things equal, they prefer a steady inflation rate of 2%.  If unemployment hits 10%, they will want to make workers even a bit worse off with tight money.  This will result in lower than 2% inflation.  Perhaps 1%.  The lower inflation is bad from the central bank’s perspective, because they prefer a steady 2% rate.  But they are willing to pay the price of lower than desired inflation in order to get more unemployment–as they enjoy the suffering of workers.

This is just the standard economics of a trade-off between two goods; price stability and worker suffering.  A very simple model.

At this point the more astute readers may assume I am about to accuse the Fed of being a bunch of sadists.  Actually no.  Indeed I find the thought rather preposterous.  No matter how much you might dislike central bankers, they are not sadists.  I don’t even think they are amoral.

In addition, although the sadistic scenario seems to apply to the current policy situation, it actually fits almost every recession in my lifetime, in the US and many other industrial countries.  I could tell the same story about the BOJ or the ECB.

Instead, I’d like to argue that central bankers are a bunch of well-meaning (or at worst amoral) people who act like sadists because they have the wrong model in their heads.  They think that it is “natural” for inflation to fall during periods of high unemployment.  And we know that ‘natural’ means good.  After all, natural foods are good for you, aren’t they?  Why do they think low inflation is natural in a weak economy?  Because it almost always happens.  When it doesn’t happen, e.g. 1974, the event is viewed as bizarre.

Here’s the problem with their reasoning.  The reason inflation almost always falls during a weak economy is because the cause of a weak economy is almost always, at least partly, a reduction in M*V.  When M*V growth falls sharply, so does both inflation and real growth.  (I emphasize sharply, because this is less true of mild declines.)

This is why central bankers can sleep at night knowing that inflation is likely to be only 1% over the next year or two, they see that as a natural occurrence during a severe recession.

But I can’t sleep at night.  I see insufficient NGDP as the cause of the problem.  To me, a steady 5% growth in NGDP is “natural.”  If we had that, then inflation would rise when unemployment was high and output was low.  During an oil shock you might get a year of 1% real growth and 4% inflation.  During a tech boom you might get two years of 4% real growth and 1% inflation.  In the long run you’d get 3% real growth and 2% inflation.  When unemployment was high (oil shock) the Fed would push inflation higher than 2%.  That’s what’s normal for me.  What the Fed considers normal, I consider sadistic.  Not just this Fed, but earlier Fed’s, and foreign central banks as well.  If I knew there was 10% unemployment, I couldn’t sleep at night knowing the markets were predicting only 1% inflation, whereas the target was 2%.  I’d keep asking myself; “Why not do more stimulus?  We’d improve both the unemployment and inflation situations at the same time.”

At this point you’re saying to yourself; “But all this is because you are assuming sticky wages and prices are the problem, suppose it’s some sort of structural problems in the economy.  That changes everything.”  Actually, it doesn’t change anything, but that’s for the next post.

Here is Blinder:

– Interest on reserves. In October 2008, the Fed acquired the power to pay interest on the balances that banks hold on reserve at the Fed. It has been using that power ever since, with the interest rate on reserves now at 25 basis points. Puny, yes, but not compared to the yields on Treasury bills, federal funds, or checking accounts. And at that puny interest rate, banks are voluntarily holding about $1 trillion of excess reserves.

So the third easing option is to cut the interest rate on reserves in order to induce bankers to disgorge some of them. Unfortunately, going from 25 basis points to zero is not much. But why stop there? How about minus 25 basis points? That may sound crazy, but central bank balances can pay negative rates of interest. It’s happened.

Charging 25 basis points for storage should get banks sending money elsewhere. The question is where. If they just move money from their accounts at the Fed to the federal funds market, the funds rate will fall — but it can’t fall far. After all, it has averaged only 16 basis points since December 2008. If banks move the money into Treasury bills instead, the T-bill rate will fall. But even if it drops all the way to zero, that’s not a big change from its 12-month average of 11 basis points (for three-month bills). So charging 25 basis points is no panacea.

But suppose some fraction of the $1 trillion in excess reserves was to find its way into lending. Even if it’s only 10%, that would boost bank lending by 3%-4%. Better than nothing.

That’s what I keep saying—better than nothing.  Right now the Fed is giving us nothing.