Archive for September 2011


My slow response to Tyler Cowen’s quick response

Tyler Cowen reacted to the recent Fed decision.  I don’t understand several of his cultural references, but I’ll respond to at least some of his points:

I would put it thus: the Fed probably decided to do the best it could within political constraints and a framework of more or less stable prices.  Which won’t do much good at all.

They are certainly operating under political constraints, and what they’ve done last week certainly won’t help.  But I also think they’ve shown a lack of creativity.  In some ways their actions (QE and Twist) seem more radical that 2% inflation targeting, level targeting.  But the latter policy would actually be far more expansionary.  Both NGDP and RGDP would have to grow considerably faster than currently expected to get inflation up to 2% over the next 5 years (especially using the Cleveland Fed measure of expectations.)   Admittedly, even that policy would result in a sub-par recovery.  But how radical is it?  It would essentially mean the Fed is reneging on the employment mandate, and targeting prices only.  And we now live in a world where even that sort of conservative dream policy is viewed as being too stimulative.

1. The median voter hates price inflation.  Don’t blame Bernanke.

The median voter doesn’t understand inflation.  They don’t know the difference between supply-side inflation and inflation.  So it’s no surprise that “inflation” is unpopular.  Bernanke would be creating demand-side inflation, which raises the real incomes of Americans.  It’s an open question as to how unpopular that would be.  There’s no question that QE2 wasn’t all that popular.  But I’d make two points.  Obama was significantly more popular when QE2 was creating 200,000 jobs a month and reducing the unemployment rate, than he is now, with oil prices falling fast.  Second, part of the oil price increase under QE2 was Libya, which isn’t demand-side at all.

2. Today price inflation will accelerate real wage erosion, or at least is perceived so, who wants to take credit for that?

Demand-side inflation reduces real hourly wages (sometimes) but raises real annual incomes.  People care much more about real annual incomes than real hourly wages.  They want to work.  A president would much prefer real hourly wages falling and real incomes rising, rather than the reverse.

3. Core CPI is already going up at a rate of two percent and 3.8 percent for the broader bundle, at least for the time being.  Voters don’t know or care what is embedded in the TIPS spread, etc.

Lots of presidents have been highly popular with 2% core and 3.8% headline inflation.  Those are very typical inflation rates.  Not many have been popular with 9% unemployment for as far as the eye can see.  Voters do care about headline inflation, but it’s only averaged 1% over the past three years, and is expected to average about 1.4% over the next 5 years.  Headline inflation isn’t the biggest economic problem in America, unemployment is.  That’s why Obama is highly unpopular.  Plummeting house prices mean lower “inflation.”  Do a poll and find out how many voters see “inflation” that way; see how many actually welcome lower housing “inflation.”  For most voters inflation is the price of gas, period.

4. Some of the “inflationists” ignored supply-side factors and bottlenecks and didn’t see this price pressure coming.  That has thrown their entire analysis into doubt, unjustly probably but nonetheless.  In any case it is no longer the simple story where Q goes up first and only later does P rise.

I strongly agree here.  I’ve always argued that AD raises prices—there is no such thing as a flat SRAS.   And it does so right away, due to commodity prices.  The peak oil problem makes this even worse, as Tyler indicates.  The rising inflation is an embarrassment to demand-siders who have focused their analysis on the need for higher inflation and who buy into Keynes’s “bottleneck” theory of inflation, or NAIRU models.  FDR disproved those models when he generated rapid inflation in 1933.  On the other hand NGDP growth has been slowing from an already low level, so us market monetarists are seeing our predictions vindicated.  If you don’t generate robust NGDP growth, you CANNOT get a robust recovery.

Every now and then, you ought to conclude that what you see is what you get and that is because of the rules of the game.  When it comes to further monetary stimulus, I’m not sure there’s so much more to say.

Maybe not right now, but this policy will eventually fail.  And when it does we’ll be right back here debating the need for more monetary stimulus.  Eventually the Fed will do what it should have done in 2008-09, but after much needless suffering.  Just as eventually (in 1981) the Fed did the tight money policy it should have done in 1966.  And eventually (in 1933) it did the easy money policy it should have done in 1930.  That’s why pundits need to keep up the pressure, no matter how much it looks like we are losing.

PS.  At the request of some commenters, I added a link to my new NGDP paper on the right side of this blog, in the category “Quick intro to my views.”  I think it is the best place to see my policy views in one place.

The rhinoceros theory of the Fed.

Arnold Kling made an interesting comment about the Federal Reserve:

I can think of at least three reasons why the Fed is not pursuing expansion with more determination. First, current policy is much closer to optimal for banks than it is for the country as a whole. This suggests a Fed controlled by banks. Second, the Fed may be intimidated by those who oppose faster expansion. Third, the Fed is just very slow to change direction. One story for the 1970s is that the Fed kept under-estimating the shifts in the Phillips Curve and the increases in the natural rate of unemployment. It kept following inflationary policies because it was slow to adapt to reality. Similarly, it appears now that the Fed is slow to adapt to downward shifts in aggregate demand. It is adjusting gradually while conditions are deteriorating rapidly. In the 1970s, the Fed took too long to tighten, and now it is taking too long to loosen.

I disagree with the first point (tight money hurts banks—check out their stock prices), and agree with the second.  But it’s the third that intrigues me.

Suppose the Fed and ECB are big lumbering institutions, like the Catholic Church.  They develop a set of myths that guide them.  In the 1960s it was the myth that a bit higher inflation is actually a good thing, because of the Phillips Curve.  So from 1965 to 1981 inflation and inflation expectations moved relentlessly higher.  As early as 1968 Phelps and Friedman had shattered the idea of a stable Phillips Curve.  By the 1970s it was clear that inflation wasn’t buying lower unemployment.  But the Fed kept inflating.  Monetarist theory was a fringe idea, and the Fed is very much an establishment institution.  Only in 1981 (not 1979 as many wrongly believe) was there so much disgust with inflation, and such a widespread understanding of the natural rate hypothesis, that the Fed was able to reverse course and squeeze inflation out of the economy.  And when they made that decision in mid-1981 it happened really fast.  Monthly inflation rates quickly fell from 10% to 4%, and basically stayed low thereafter.  But even now I’m amazed that it took 16 years for them to realize they were on the wrong track.

So the Fed’s like a charging rhino that finds it hard to re-evaluate its trajectory and change direction.  How does that fit the recent history?

Although we think of the Great Moderation as having stable inflation, it’s not quite that simple.  Inflation has fallen from 4% in the 1982-89 period to 1% in the last three years.  And expected inflation has fallen even more sharply.  Here’s some estimates from the Cleveland Fed:

I used to have a sort of Whig view of the history of the Fed.  They did all sorts of really stupid things in the Great Depression and the Great Inflation, and then they finally found the right policy.  This led to low and stable inflation.  The last few years, and especially the last few days, have disabused me of that view.  Here’s an interesting excerpt from The New Republic article I cited in the previous post:

There is no doubt that predictable price levels are a necessary aspect of monetary credibility. But for many on the right, low inflation is not a matter of good policy, but an ideological dogma: inflation must always be fought, regardless of the state of the economy, and regardless what the data tell us. As Dallas Federal Reserve President and CEO Richard Fisher described it last summer, he was “committed to keeping inflation low and maintaining the credibility gained so painstakingly by former Fed Chairman Paul Volcker. I will remain steadfast in my resolve to keeping inflation low and stable.”

If Fisher was really for “stable” inflation, he’d be horrified that inflation has dropped to only 1% over the past three years.  But I have a feeling that Fisher is not horrified by this instability, this drop in inflation.  Instead, he seems to exalt in the never-ending fight against inflation.  The Volcker story is of course a myth.  He reduced inflation to 4% in 1982, and then stopped.  Why did he stop?  Because unemployment rose to 10.8%.  Something to do with the “Phillips Curve,” which the Volcker worshipers now insist doesn’t exist.  And then he made no further attempt to reduce inflation.  Only in the 1990s did inflation fall to the lower trajectory we now associate with the Great Moderation.  Volcker was content to allow 4% inflation, although he now argues that a return to 4% inflation would be awful. 

So the Fed has a new set of myths to replace the Phillips Curve.  And as a result of these myths they are gradually driving inflation expectations lower and lower.  They were supposed to stop at 2%, but it now seems that if low inflation is good, even lower inflation is better.  Look closely at the graph above and you’ll see expected inflation has fallen below 1.5%.  Some people at the Fed (like Chicago President Evans) would like to see more stimulus, even if it meant 3% inflation.  But the Fed is an institution with a momentum of its own, and it’s not clear that even Bernanke could turn it around (nor whether he wants to.) 

This won’t last forever.  Economists will eventually see that Fed policy is causing all sorts of damage to the economy–and the federal budget.  When that occurs another Volcker will finally call a halt to the “Great Disinflation.”  Let’s hope this time we finally get it right—5% NGDP growth, level targeting.

Update:  After I wrote this I realized my comments on the Phillips Curve seem inconsistent.  I was criticizing the idea of a long run trade-off, not the short run trade-off we saw in 1982.

PS.  No offense to rhinos, one of my favorite animals.  I like old things, and the rhino head reminds me a bit of what the dinosaurs must have looked like.  Any comments about their inability to change direction are not meant to be accurate, but merely reflect the way humans perceive them.

Mike Konczal on the importance of monetary policy

From The New Republic:

It is important that liberals engage conservatives on monetary debates. Since the 1970s, liberals have entirely ceded this aspect of the economic agenda.  Even now, calls from the left for more monetary action gain only a fraction of the support of arguments for fiscal stimulus. But the left needs to realize that there is no neutral position in monetary policy””even if President Obama’s jobs plan is passed, its effects can easily be canceled out if the Federal Reserve caves to the singular pressure being applied to it by inflation hawks.  (Italics added.)

And that would reduce the fiscal multiplier to zero, wouldn’t it?

Good article.  The only change I’d make is to; “if the Federal Reserve continues caving to the inflation hawks.”

HT:  Patrick Sullivan

Happy now?

During the last 4 months of 2010 and early 2011 I got a lot of grief from the inflation hawks.  Yes, QE2 seems to have lowered unemployment from 9.8% to 8.8% in 4 months, but they were having to pay more at the pump (I assume these commenters had jobs.)  They warned that it was devaluing the dollar, leading to high inflation.

Unfortunately, in today’s world oil market with Chinese demand pushing production to near capacity, any recovery in the US (even an expected recovery) will push oil prices significantly higher.  And of course Libya was an additional bit of bad luck.  Payback for the good karma of the 1990s.

But this isn’t “inflation” in the 1970s sense.  Back then wages rose rapidly and every time you went out to buy a new car it cost almost twice the previous one.  This is an increase in the relative price of an important commodity, which strongly affects the headline CPI for a few months.  Even worse, our insane ethanol policies cause it to bleed over a bit into food prices.

Well now the inflation hawks have gotten their way.   Oil fell into the high 70s today.  The Fed did something completely trivial on Wednesday, and basically washed its hands of the responsibility to keep NGDP at an adequate level.  Both inflation and employment are now forecast to be far below the Fed’s implicit target over the next 5 years, and they don’t seem willing to do anything about it.  BTW, according to the Cleveland Fed the TIPS spreads I often point to actually slightly overstate expected inflation; they have a more complicated formula that I don’t understand very well.  It shows 10 year inflation expectations below 1.4%.  Five year expectations are even lower.

So that’s our choice.  Do we want to keep gas nice and cheap for those who have jobs, or do we want an economic recovery for the millions whose lives are being ruined by this recession.

And I’m not sure that even those with jobs benefit from these policies.  Every time I save a few pennies at the gas pump I lose many thousands of dollars off my retirement fund.  Economics is not a zero sum game.  When millions are producing no output, almost everyone will suffer.

HT:  Thanks to Lars Christensen for the Cleveland Fed data.

Links to my views on money/macro

Here’s my long promised post that introduces my views to a wide range of issues.  I will occasionally update this post, adding links where appropriate.  Feel free to make suggestions, but understand I can’t add all suggestions without making it too cumbersome.

Let’s start with a (slightly simplistic) intro to my view of monetary economics

And an earlier attempt from 2009 (very long) to summarize my views in one blog post.

Also check out my FAQs.  (Contains suggestions about other authors.)

And why I don’t like the IS-LM approach

The best intro may be my recent magnum opus at National Affairs defending NGDP targeting:

And shorter versions at the Adam Smith Institute and National Review:

My Cato paper on how tight money caused the crash of 2008:

And a similar paper from The American

A blog post on NGDP futures targeting

And an academic paper on futures targeting

And my first paper ever, a 1989 paper on using NGDP futures (not really recommended, just to show I’ve been focused on this idea for a long time.)

Critiques of MMT here and here.

A post defending the EMH.

My views on methodology (one of my favorites.)

An early critique of the “liquidity trap.”  A longer and more recent version.

An example of the importance of rational expectations theory

Why the Keynesians are wrong about FDR’s high wage policy

Petition for Monetary Stimulus (March 2009)

The Great Danes blog post and academic paper (thoughts on culture, policy and neoliberalism.)

Conversations with Russ Roberts on monetary policy and growth and neoliberalism.  (Something to listen to on the exercise bike.)

And finally a post I’ve always liked, a odd sort of mixture of Tyler Cowen and Paul Krugman.

I’ll add lots more later, but I don’t want to overdo it.  I may substitute things as well.  I already slightly disagree with a few points in my early posts–but nothing major.