I’m thinking of adding a monthly feature to keep track of how the Fed is doing in terms of fulfilling its dual mandate.  Recall that the Fed tries to keep inflation close to 2.0% and unemployment close to about 5.6% (the Fed’s current estimate of the natural rate.)  One implication of the dual mandate is that they should try to generate above 2% inflation during periods of high unemployment, and below 2% during periods of low unemployment.

In July 2008 unemployment rose above 5.6%, and it’s averaged nearly 9% over the past 46 months.  So the Fed’s mandate calls for slightly higher than 2% inflation during this 46 month slump.  Last month I reported that the headline CPI had risen 4.6% in the 45 months since July 2008.  Now we have the May data, and the headline CPI has gone up 4.3% in the 46 months since July 2008.  So the annual inflation rate over that nearly 4 year period has fallen from a bit over 1.2%, to 1.1%.  BTW, NGDP growth has been the lowest since Herbert Hoover was in office.  Epic fail.

Some might argue; “Yes, the Fed’s fallen short, but no one can dispute that they’ve tried hard, they’ve run an extraordinarily accommodative monetary policy.”

They would be wrong.  That’s partly because Bernanke continually insists the Fed can do much more, but that the economy currently doesn’t need any more stimulus.   But the bigger problem is that money hasn’t been accommodative.

Here’s what Bernanke said in 2003:

The only aspect of Friedman’s 1970 framework that does not fit entirely with the current conventional wisdom is the monetarists’ use of money growth as the primary indicator or measure of the stance of monetary policy.  .  .  .

The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman .  .  . nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences . . .

The absence of a clear and straightforward measure of monetary ease or tightness is a major problem in practice. How can we know, for example, whether policy is “neutral” or excessively “activist”? I will return to this issue shortly.  .  .  .

Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman’s advice to heart.

When I started blogging I was the only person claiming Fed policy was actually very tight.  As far as I recall even the other market monetarists were not making that claim.  Even today, almost no highly respected economist will call Fed policy “tight.”  The press almost universally calls it “accommodative.”  Ben Bernanke himself calls it extraordinarily accommodative.  Yet none of that is true.  In 2003 Bernanke accurately described the difference between easy and tight money.  It’s a pity that even today virtually all of our elite macroeconomists (on both the left and the right) don’t understand how to recognize the stance of monetary policy.

Until we see the nature of the problem, what hope do we have in solving it?

PS.  Why do I keep repeating myself ad nauseum?  Because other economists won’t accept that I am right, nor will they tell me why I am wrong.

The Norseman who settled cold, barren, windswept Iceland over 1000 years ago were not wimps.  Modern Iceland is, genetically speaking, about 40% Celtic.  The Vikings apparently kidnapped lots of Irish brides on their way to Iceland.  So you wouldn’t expect modern-day Icelanders to wring their hands during an economic crisis and say “There’s nothing to be done.  If only we could debase our fiat currency, but we just don’t know how.”

Iceland was hit by a massive real shock in 2008 when their ponzi-like banking/real estate sector collapsed.  I find it hard to get any objective data on fiscal policy (in any country), but all the bloggers I read suggest that they opted for the only sensible policy; fiscal austerity.  Here’s the Financial Times:

The trick here? Sharp cuts in state spending, capital controls and a currency unit called the Krona..

And here’s Kevin Drum:

And state spending, although it went up in krona terms, was cut sharply in real terms.  Iceland isn’t really an anti-austerity poster child.

Nor is it a pro-austerity poster child.  Rather it’s a market monetarist poster child, as the following Paul Krugman post indicates:

From Statistics Iceland:

GDP is still below previous peak, but I think one could argue, much more so than in say America, that a significant part of that peak involved a Ponzi financial sector that isn’t coming back.

I think I was one of the first outsiders to notice that Iceland’s heterodoxy was yielding a surprisingly not-so-terrible post-crisis outcome.

[I’m picturing Bob Murphy reading this Krugman post and saying to himself; “Whoa, I don’t recall Krugman pointing out that the Latvian peak GDP should be ignored because it was just a frothy bubble after years of double digit growth.”]

The Financial Times reports that Iceland is doing so well that their central bank needs to raise interest rates.  They quote this report from the Icelandic Central Bank:

National accounts data for Q1/2012 are broadly in line with the Bank’s May forecast, which stated that GDP growth would continue to reduce the margin of spare capacity in the economy. The economic recovery is broadly based, and the growth in domestic demand is robust. Signs of recovery in the labour and real estate markets are steadily growing stronger.

Now you might wonder what all this has to do with market monetarism.  Recall that we are the ones claiming that Britain and the eurozone need to combine tight fiscal policy with monetary stimulus.  The tight fiscal policy addresses the looming debt crisis, and the monetary stimulus keeps AD (i.e. NGDP) growing at the sort of rate needed to keep the economy close to full employment.  Is there any evidence that Iceland did some monetary stimulus?  Here’s Kevin Drum:

Also worth noting: the Icelandic krona got devalued a lot. In 2008 a euro bought 90 krona. Today it buys 160 krona.

Iceland did almost everything right.  They stiffed the bank creditors to avoid aggravating the moral hazard problem, just like the textbooks recommend.  In the eurozone the bank creditors are being bailed out.  They relied of fiscal policy to address S/I and debt issues, and let monetary policy address AD, just as the New Keynesians were recommending in the 1990s.  In the eurozone they combined tight money with reckless deficits.  And now Iceland is growing fast and the eurozone is stagnating.

I do realize there are tricky issues involved when analyzing the GDP of a country with 310,000 people.  One big aluminum smelter could probably have an impact on GDP.  I’d focus on the fact that their GDP is up about 12% from 7 years earlier.  That’s not great, but they clearly aren’t in a depression.  I seem to recall that Britain’s GDP is flat over the past 7 years, and some of the weaker eurozone members have done even worse.

I realize that people will say that Iceland is special, it doesn’t count,  Just as Australia doesn’t count and Sweden doesn’t count and Poland doesn’t count and Israel doesn’t count and Argentina doesn’t count, and all those countries in the 1930s that just happened to start recovering after they left the gold standard don’t count.  But still, it’s one more data point.

Iceland is one of my favorite countries.  Here’s I’ll do a Cowen-style appreciation:

1.  Favorite Icelandic economist:  Gauti Eggertsson.

2.  Favorite Icelandic fiscal policy:  Their simple and flat income tax.  (Update: I’m told it’s no longer flat.)

3.  Favorite Icelandic pop stars:  Sigur Ros and Bjork

4.  Favorite Icelandic book:  The Sagas

5.  Blondes, blondes, blondes.  (spelling corrected.)

6.  Favorite Icelandic campaign commercial (indeed favorite campaign commercial from any country).

7.  Favorite Icelandic films:  Cold Fever, Children of Nature, The Seagull’s Laughter.

8.  Favorite Iceland trip:  My 2010 trip to the volcano, described in this post.

Update:  JJ sent me the following NGDP date for Iceland:

Don’t be fooled by the arithmatic scale, long term growth has been pretty steady.  Obviously short term growth sped up in the bubble years before the crisis, and then slowed sharply after 2007.  But if you look at the 7 year period from 1997 to 2004, it looks like NGDP rose from about 530 to 930 (up 75.5%) and then from 2004 to 2011 it rose from 930 to 1630 (up 75.3%.)  That’s an indication that long term NGDP is close to level targeting at around 8.3%/year. If NGDP had fallen after the 2007 peak (i.e. if they’d been fixed to the euro), then the real recession would have been much worse.  Unemployment is currently 6.6% in Iceland.

Commenters keep telling me that I’ll never get anywhere unless I stop doing what I’m doing and instead do blah, blah, blah.  Meanwhile the successes for market monetarism are piling up so fast I’m having trouble keeping up.  Just in the past few weeks.

1.  A groundswell in Japanese politics for a much more aggressive BOJ policy to offset the needed fiscal tightening, as their debt exceeds 200% of GDP.  Pure market monetarism.

2.  Paul Krugman bashing the ECB for not cutting rates below 1%.

3.  Minneapolis Fed President Narayama Kocherlakota endorses “target the forecast” via market prices.

4.  And today Jeffrey Frankel, a distinguished Harvard macroeconomists does a blog post endorsing NGDP targeting:

Monetary easing in advanced countries since 2008, though strong, has not been strong enough to bring unemployment down rapidly nor to restore output to potential. It is hard to get the real interest rate down when the nominal interest rate is already close to zero. This has led some, such as Olivier Blanchard and Paul Krugman, to recommend that central banks announce a higher inflation target: 4 or 5 per cent. (This is what Krugman and Ben Bernanke advised the Bank of Japan to do in the 1990s, to get out of its deflationary trap.) But most economists, and an even higher percentage of central bankers, are loath to give up the anchoring of expected inflation at 2 per cent which they fought so long and hard to achieve in the 1980s and 1990s. Of course one could declare that the shift from a 2 % target to 4 % would be temporary. But it is hard to deny that this would damage the long-run credibility of the sacrosanct 2% number. An attraction of nominal GDP targeting is that one could set a target for nominal GDP that constituted 4 or 5% increase over the coming year – which for a country teetering on the fence between recovery and recession would in effect supply as much monetary ease as a 4% inflation target – and yet one would not be giving up the hard-won emphasis on 2% inflation as the long-run anchor.

Thus nominal GDP targeting could help address our current problems as well as a durable monetary regime for the future.

5.  Today I also discovered an excellent new blog by Yichuan Wang.  I’d suggest reading the entire post, but here’s the last portion:

Thus, the econometric evidence comes somewhere in the middle. Yes, interest rate guidance can have an effect, but asset purchases have a large impact as well on a wide variety of interest rates because the purchases substantively change the expected future path of policy. This suggests that the two policies together would have a much stronger effect than either of them apart. I see this playing out in the following manner:

Limiting policy to a near-term interest rate commitment raises the possibility that the forward guidance describes the Fed passively tightening and keeping growth down. This forward guidance may be seen as Delphian. However, with asset purchases like QE, the Fed signals that it is committed to expansionary policy, which has first order effects on corporate bond yields and other asset prices. This additional policy action changes the original forward guidance from being Delphian to Odyssean. The Fed will be effectively saying, “We will pursue asset purchases that will push up inflation, but in spite of this inflation we will be keeping interest rates low”. This would break out of the indeterminacy on whether low interest rates are expansionary or contractionary. Quantitative easing might be normally seen as just a temporary injection of money, but forward guidance cements that injection in as permanent.

This interaction effect would offer the Fed much more ammunition with its current policies. It could help alleviate the concerns of the “concrete steppes” by using not-so-unconventional policies to shape expectations. Once the expectations are settled and we escape the zero-lower-bound, forward looking monetary policy shouldn’t be too difficult at all. This would be an example of the pragmatic monetary policy that could eventually transition to the end of history stabilization policy: a NGDP targeting regime.

So where does Mr. Wang teach?  Actually he’s another Evan Soltas, planning on attending college this fall.  What the heck has happened to our educational system since I attended high school in the early 1970s?  Did they add something to the drinking water?  I don’t recall any of my classmates doing this sort of sophisticated macro analysis.

The future’s so bright I now need to wear sunglasses while blogging.

PS.  If you scroll down to Yichuan’s May 31 post, you’ll see he’s also been able to unearth the worst song in the history of pop music.

When I was young the US had high inflation, and reports of lower than expected inflation was treated as very good news.  During the long “Great Moderation” the Fed kept NGDP growing at a fairly stable rate of about 5%.  In that environment low inflation was usually viewed as good news because it allowed for more real growth.  But now it’s become bad news:

NEW YORK (Reuters) – Stock futures extended declines after data showed retail sales dropped for the second straight month and U.S. producer prices fell sharply in May.

It was the sharpest decline in the PPI in three years.  If it was caused by more AS, it would be good news.  But the more likely cause is less AD, which might explain the weak retail sales numbers.  Of course David Glasner has provided much more systematic evidence of the way that low inflation has suddenly become bad news during the Great Recession.

People often ask how I can be so confident that market monetarist policies would help the economy.  It’s partly based on all the macro evidence that other economists look at, such as the fact that countries began recovering from the Great Depression when they left the gold standard, even though at the time most people felt monetary stimulus would not help, because the problems were “structural.”  But it’s partly because the markets themselves seem thoroughly market monetarist.  I find it almost comical the way reporters flounder around trying to explain Wall Street’s obvious preference for monetary stimulus.  They talk disparagingly of “another monetary fix” like the stock market was some sort of drug addict.  BTW, newspapers used the same “inflation is a drug” metaphor in the 1930s.  Both then and now reporters are forced to report the obvious fact that markets very much want more of the monetary stimulus that reporters insist will be useless–pushing on a string.

Just yesterday a strong stock market rally was kicked off by Charles Evans comments in favor of further Fed easing.  Just think about that, Evans is not even on the FOMC this year.  If even the tiniest hint of easy money can cause a big stock market rally, just imagine what a bold move by the Fed on June 20th would do!

It’s fashionable for both the left and the right to disparage stock market reactions, because the market is an unforgiving judge.  It’s not liberal or conservative, it’s pro-success.  It’s like a mirror held up to each economist’s pet theory, and the reflection is often very unflattering.  Conservative views that the problem is entirely structural—Wrong!  Liberal views that the Fed is out of ammo at zero rates—Wrong!   Most people can’t deal with reality, so they call the market “irrational.”  Sometimes markets do make mistakes, but it’s far more likely that the theory that conflicts with market reactions is wrong.

More than two years ago I did a post on Greece that is actually far more relevant today.  I’ll just summarize the post below, but I encourage readers who missed it to take a look.  Back in the early 1930s the war debts crisis was obviously causing problems for the US equity markets.  But the reason was unclear.  Was it because of  the fiscal or monetary implications of the crisis?  Then the US left the gold standard in April 1933 and the debt crisis suddenly stopped affecting Wall Street, despite the fact that it continued to have troublesome fiscal implications for the US.  The reason is obvious; the real problem was the monetary implications of the crisis.

I predict that if the ECB adopted 5% NGDP targeting (level targeting) tomorrow, the Greek crisis would continue, but it would no longer have a big impact on Wall Street.  The transmission mechanism is monetary.

Lot’s of people from Bernanke on down keep telling us that a recovery is just around the corner.  I’m an optimist by nature, so I want to believe it’s true.  But then I look at this:

HT:  John Thacker

Market monetarists have often pointed to the Fed’s pathetically weak response to the financial crisis of 2008.  For instance, the Fed met two days after Lehman failed in mid-September, and refused to cut their fed funds target (which was 2% at the time), citing an equal risk of recession and inflation.  In fact, the day of the meeting the 5 year TIPS spread was only 1.23%, which is roughly the actual inflation rate since that time.

Why did the Fed adopt such a tight money policy in 2008?  Because they were operating a backward-looking policy regime and inflation had been relatively high over the previous 12 months.  It’s like trying to drive a car by looking in the review mirror, and making adjustments when you are edging off the road.  In contrast, market monetarists want the Fed to look down the road, and steer to a point on the horizon.  We want the Fed to use market forecasts.  Now we have Narayana Kocherlakota making a similar argument:

Basic economics says that a policymaker should set a policy instrument so that, on the margin, there is no net benefit to altering it. But while the policymaker’s decision is necessarily made today, the resultant costs and benefits are realized only in the future. Therefore, the policymaker’s optimal choice is to set the policy instrument so that the outlook for the future marginal net benefit is zero. In this talk, I address the following question: How can the policymaker formulate the needed outlook for marginal net benefits? Policymakers often attempt to do so by using statistical models to forecast future marginal net benefits. I argue that policymakers can achieve better outcomes by basing their outlooks on risk-neutral probabilities derived from the prices of financial derivatives.

.   .   .

After presenting my general argument, I illustrate it using the example of a central bank that has a single mandate of targeting an inflation rate of pi_bar. Monetary policy operates with lags, and inflation is affected by shocks other than the central bank’s decision. Hence, the best that the central bank can do is to ensure that its medium-term outlook for inflation always equals pi_bar. My general argument implies that the appropriate outlook for the central bank is not a statistical forecast of inflation, but rather the risk-neutral expectation of inflation, calculated using risk-neutral probabilities. This risk-neutral expectation can be measured using inflation break-evens on assets like zero coupon inflation swaps or TIPS bonds. Hence, it is optimal for an inflation-targeting central bank to follow policies that ensure that inflation break-evens remain close to pi_bar.

I don’t have much to add, except to note that the Fed has a dual mandate, and thus would need a market forecast of the macro variable that would best correlate with their dual mandate.  If you have any suggestions for such a variable, please write Kocherlakota and tell him the Fed needs to create a futures market for that dual mandate indicator ASAP.

HT:  123

Update: Here’s an excellent Michael Darda interview on Bloomberg.tv.  He uses one of David Beckworth’s most effective graphs to show how the European debt crisis is fundamentally a monetary crisis.