Archive for June 2013


WSJ: Ignore unemployment. Ignore inflation. Ignore the markets.

It’s no surprise that the Wall Street Journal would want the Fed to ignore the plight of the unemployed.  After all, they want the Fed to focus like a laser on inflation.  Or they used to want that.  Now that the Fed’s favorite inflation index (PCE) is running 0.7% over the past 12 months, and 1.05% for core inflation, the WSJ no longer wants the Fed to target inflation.  How do I know?  Because they have a long editorial on monetary policy that doesn’t even mention inflation.  And they favor a tighter policy, whereas inflation targeting would obviously call for an easier policy.

Ever since the supply-side revolution of the 1980s, the WSJ has been enthralled by the “market signals” approach to policy.  Every time stocks rise on rumors of a capital gains tax cut, they say that’s proof that lower capital gains taxes are good for the economy.  And when stocks fall on news of some misguided Obama administration initiative, that shows the folly of socialism.  Or at least they used to believe that.  But now that the markets are clearly indicating that the Fed’s tapering plan is a big mistake, the WSJ sings a different tune:

This time, the Federal Reserve can’t afford to blink.

Since the financial crisis, the Fed has repeatedly found itself forced to respond to markets, rather than lead them. This has usually taken the form of sharp selloffs that demand the Fed ride to investors’ rescue.

During the bleakest crisis days, the Fed often had little choice but to give in. Now, as markets again throw a tantrum upon hearing the Fed may soon start scaling back, it must hold firm.

In fairness, David Reilly does admit that the Fed would need to step in if there were a major market meltdown.  But I read the entire piece and still don’t have a clue as to what variables he thinks the Fed should be targeting.

Every news editorial on the Fed should be written as follows:

1.  I believe the Fed should target X (which might be a weighted average of several variables.)

2.  Going forward, the Fed is likely to (hit, overshoot, undershoot) X.

3.  Therefore the Fed should (stay the course, tighten, ease) policy.

Most editorials fail to do this, but the WSJ piece is a particularly egregious example.

The Fed’s targeting inflation at 1%; it just doesn’t know it yet

It’s odd, but the best way to forecast price inflation is to look at wage inflation.  In the years leading up to the Lehman crisis wage inflation ran about 3.4% and price inflation (PCE core) ran around 2.4%.  The gap reflects productivity (and changes in the share of national income going to labor.)  Headline inflation reflects core inflation plus food and energy.  However food and energy are essentially unforecastable, at least if you look out more than a few months.  So core inflation is the best way to forecast headline inflation.  And core inflation is mostly wages, minus productivity gains.

For some reason core inflation slowed a bit less rapidly than wages over the past 4 and 1/2 years.  PCE core inflation has run about 1.4%, whereas wages are rising at a tad less than 2.0%.  But in the past 12 months the predictable pattern is coming into view.  PCE core inflation has dropped to 1.05% (the lowest ever recorded), which is roughly 1% under wage inflation.  Headline PCE inflation is down to 0.7%.

The following graph of average hourly wages tells you all you need to know about inflation since late 2008:

Screen Shot 2013-06-23 at 4.51.05 PM

You can clearly see the inflection point in late 2008, when the asset markets crashed.  Markets saw the huge disinflationary shock, but the Fed did not.  It takes a lot of unemployment to suddenly drive nominal hourly wage growth down to 2%.

The trend in nominal wage growth seems unlikely to change soon.  That means PCE core inflation will stay close to 1%, or a bit higher, and headline inflation will fluctuate unpredictably above and below 1%, because commodity prices are unforecastable.

The Fed will gradually become aware of the fact that money is too tight for it to hit its inflation target.  That will give the doves the upper hand, and if I didn’t believe in the EMH I’d tell my readers to buy long term bonds—I think rates will stay low for longer than the markets currently seem to assume.

It’s odd that James Bullard is the only FOMC member who sees what’s going on.

Marcus Nunes and Justin Wolfers express similar views.

PS.  I don’t own any bonds, I invest in stocks.

PPS.  The Fed’s mandate calls for it to adopt policies likely to lead to above 2% inflation during periods of high unemployment, and below 2% inflation during periods of low unemployment.  They don’t seem to understand their mandate.  Indeed they are acting exactly like a central bank would act if its mandate were stable prices and high unemployment.

The Keynesian blind spot

I’ve seen recent signs that the gap between Keynesians and market monetarists is narrowing.  David Beckworth reached out to fiscal advocates in a recent post, and Ryan Avent also tried to bridge the gap.  As you’d expect, Martin Wolf’s new piece in the NYR of Books ends up in a suitably ecumenical fashion:

The right approach to a crisis of this kind is to use everything: policies that strengthen the banking system; policies that increase private sector incentives to invest; expansionary monetary policies; and, last but not least, the government’s capacity to borrow and spend.

But I also see a huge blind spot in Wolf’s piece, which slants the results in a very revealing way.  Wolf provides a blow-by-blow account of how fiscal austerity slowed the recovery after 2010, and provides this graph to illustrate his points:

Screen Shot 2013-06-23 at 12.04.23 PM

A few comments.  Wolf uses RGDP, which combines the effects of supply and demand shocks.  He should use NGDP, since his argument relates to austerity.  If he had, the British performance would look far better than the eurozone performance.  Britain has bigger supply-side problems that many Keynesians acknowledge.  Also note that the second bar shows total growth over three years, thus even Germany has done poorly since 2010, worse than the US.

But here’s the big problem.  Wolf’s careful account of how austerity pushed the eurozone back into recession completely ignores the elephant in the room—the ECB’s sudden move toward tight money in 2011.  Indeed Wolf cites interest rate data that gives the casual reader a very misleading impression:

Why is strong fiscal support needed after a financial crisis? The answer for the crisis of recent years is that, with the credit system damaged and asset prices falling, short-term interest rates quickly fell to the lower boundary””that is, they were cut to nearly zero. Today, the highest interest rate offered by any of the four most important central banks is half a percent.

It’s really hard to imagine a more misleading description of ECB monetary policy over the past 5 years.  Yes, current ECB target rates are 1/2%, and they’ve been there for one month, i.e. for 2% of the past 5 years.  In 2011 the ECB was raising rates from 0.75% to 1.25% to slow the recovery, out of fear of inflation.  Had fiscal policy been more expansionary, monetary policy would have been even more contractionary.  Even Paul Krugman admits that fiscal stimulus is only effective when at the zero bound.  And the eurozone crisis occurred when the eurozone was not at the zero bound, indeed policy was being tightened in the most “conventional” fashion imaginable—higher short term interest rates.

Update:  Mark Sadowski corrected me–the ECB actually raised rates from 1.0% to 1.5% in 2011.

So fiscal austerity did not create the eurozone double dip recession; tight money did.  Still, I don’t want to be too hard on Mr. Wolf—he’s a great journalist and in a sense we are on the same side.  We both believe that weak AD (which I define as NGDP) is the core eurozone problem.  But the problem is not fiscal austerity, it’s austerity more broadly defined, an irrational fear of rising nominal spending.

Yichuan Wang has a nice post showing that many economists have misremembered (is that a word?) the events of late 2008.  At no time during the great NGDP crash of June to December 2008 was the Fed at the zero bound.  Money was too tight, but for eminently conventional reasons:

The zero lower bound didn’t always bind. For three months after Lehman’s collapse on September 15, 2008, the federal funds rate stayed above zero. In this period of time, the Fed managed to provide extensive dollar swaps for foreign central banks, institute a policy of interest on excess reserves, and kick off the first round of Quantitative Easing with $700 billion dollars of agency mortgage backed securities. Finally, on December 15, 2008, the Fed decided to lower the target federal funds rate to zero.

It is important to remember the sequence of these events. It is easy to think that the downward pressure on interest rates was the inevitable consequence of financial troubles. Yet the top graphic clearly contradicts this. Each of the dotted lines represents a FOMC meeting, and each of these meetings was an opportunity for monetary policy to fight back against the collapsing economy. The Fed’s sluggishness to act is even more peculiar given that there were already serious concerns about economic distress in late 2007. As, the decision to wait three months to lower interest rates to zero was a conscious one, and one that helped to precipitate the single largest quarterly drop in nominal GDP in postwar history. The chaos in the markets did not cause monetary policy to lose control. Rather, the Fed’s own monetary policy errors forced it up against the zero lower bound.

This is not to say those mistakes were purposeful. But in the high stakes game of central banking, even benign neglect can be dangerous. These failures in the last three months of 2008 can teach us many lessons about what should be done for future monetary policy. Only this way can we be more sure that careless mistakes won’t jeopardize the future path of monetary policy.

One of the first steps would be to switch to a nominal GDP target.

Yichuan then explains how NGDP targeting would improve Fed performance.  I also recommend this interesting Wang post, one of many I don’t have time to adequately discuss.  It tries to combine NGDP targeting with the Taylor Rule approach.

PS.  This post over at Free Exchange discusses a BIS report making an even worse mistake than Wolf:

CENTRAL banks are unable to repair banks’ broken balance sheets, to put public finances back on a sustainable footing, to raise potential output through structural reform. What they can do is to buy time for those painful actions to be taken. But that time, provided through unprecedented programmes of monetary stimulus since the financial crisis of 2008, has been misspent. Neither the public nor the private sector has done enough to reduce debt and to press ahead with urgent reforms. Yet only a forceful programme of repair and reform will allow economies to return to strong and sustainable growth.

That is the message from the Bank for International Settlements (BIS), the closest that central bankers have to a clearing-house for their views.

Nope, ECB policy was ultra-tight, especially in 2011.  That caused a eurozone NGDP growth collapse, and explains why so little progress has occurred on the debt front.

PPS.  Maybe this post was poorly named.  If there is a Keynesian blind spot, what do you call the BIS view?

From the blogosphere

I’ve been catching up on the blogosphere, after my recent trip to Milan.  Here are some good posts.

George Selgin on why free banking isn’t enough:

It follows that, because it leaves the base regime largely unaltered, a move from regulated to free banking today would not serve to eradicate inflation or otherwise guarantee monetary stability. Such a move would have led to improved stability a century or more ago, because it would have entailed depriving central banks of their role as currency suppliers: so long as gold and silver were economies’ final settlement mediums, to deprive central banks of their paper currency monopolies was equivalent to reducing if not eliminating altogether any tendency for other banks to treat central bank paper (or other central bank liabilities) as a reserve medium, and hence as what might be termed “pseudo” base money. The strict dichotomy of bank- and base-regime that applies today did not, in other words, pertain to specie-based monetary systems. Today, however, the strict dichotomy is quite valid; and this means that freedom of banking alone will no longer suffice to make our (or any) monetary system sound.

Something else is needed, then. And that something must of course consist of a reform of the base regime itself. Broadly two alternatives exist for such reform. These are: (1) the restoration of a base medium consisting of some form of specie, or perhaps of some other commodity; and (2) reform of the existing fiat regime.

And George Selgin on the need for monetary pragmatism:

Will merely insisting on the first-best solution suffice? I don’t think so. In the present context that would mean saying something like, “The Fed should freeze the monetary base; but that isn’t all: Congress should then wind it up, while allowing other banks complete freedom to meet the public’s monetary needs, including the freedom to issue their own notes. This would also require doing away with deposit insurance and…” etc. Even supposing one could elaborate the argument in a few sound bites, or that one could go on for hours, the obvious problem remains that the steps required would take months to accomplish even if they could be instantly and universally agreed upon. The answer, therefore, begs the question, “What should the Fed do in the meantime?” We remain more or less where we began.

Nor, as some commentators (myself included) have noted elsewhere, is saying that the Fed should do “nothing” any better. So long as it exists the Fed is, of necessity, doing “something.” So “nothing” here must actually refer to some particular Fed policy. Most often (I gather) it means that the Fed should refrain from any further lending or open-market activities, or from otherwise expanding its balance sheet. It amounts, in other words, to recommending that the Fed maintain a constant monetary base. But is asking the Fed to maintain a constant base really indicating any more principled opposition to monetary central planning than one indicates by calling upon it to alter the base by some particular amount, or by whatever it takes to achieve some particular target? I don’t see why. Indeed, what some have wrongly taken to be the more principled of the two alternatives seems to me to be hardly more principled, though rather less prudent, for it calls, not for the avoidance of monetary central planning, but for the implementation of a monetary central plan that is likely, according to “our” theory, to be particularly lousy. Nor will it do to say that the “keep the base constant” alternative is superior in that it might be proposed, not just as a suggestion for the present, but as a hard-and-fast monetary rule, for the same might be said concerning the suggestion that the Fed expand the base only when doing so serves to keep spending stable.

The option of recommending that the central bank “do nothing” is, by the way, precisely the one Hayek chose to take back in the early 1930s when, despite having recognized in print the desirability of a constant “money stream,” and despite the fact that the money stream had dried up dramatically, he campaigned against expansionary monetary policy. As he explained many years later, with regrets, Hayek’s reason for departing from his own theoretical ideal had to do, not with any slippery-slope considerations, but with his belief that allowing the collapse of demand to go on could be just the thing needed to wrench the British labor market free from labor unions’ stranglehold.** Still it is difficult to see why the results would have been any different if, instead of having opposed monetary expansion because he hoped by doing so to help thaw a rigid labor market, he did so on other political-economy grounds. To say that Hayek’s strategy backfired is putting it mildly, for it was not labor unions but Hayek’s own theoretical legacy that suffered.

Great stuff.

And here’s Matt Yglesias:

Here’s a good paragraph from Brad DeLong about why we’re not getting more oomph out of monetary policy (emphasis added):

The Federal Reserve’s announcement last December that it was switching from a time- to a state-based policy rule has not REPEAT NOT raised expectations of inflation over the next five, ten, or thirty years. Perhaps this is because Federal Reserve communicators have spent a lot of time telling people that the shift does not mean that the Federal Reserve will tolerate higher inflation. Perhaps it is for other reasons.

It is followed by a much less good paragraph about what this teaches us about the possible efficacy of monetary policy:

This is a powerful empirical piece of evidence that it is much harder to summon the Inflation Expectations Imp than economists like Greg Mankiw had thought. It is a point for the expansionary fiscalists in their debate with the expansionary monetarists.

We have empirical evidence of something here, but how can you read the italicized clause and conclude that it’s evidence of the difficulty of increasing inflation expectations? The Federal Reserve is telling people, explicitly, that they should not expect a higher level of inflation over the five-, 10-, or 30-year time horizon. To know whether it’s hard to raise inflation expectations, we would want to see what happens if the Fed told people they should expect a higher level of inflation over the five-, 10-, or 30-year time horizon.

Insofar as we have evidence of anything here, it seems to me that we have evidence that the Federal Reserve thinks it would be very easy to increase long-term inflation expectations, and that’s why they really want to be clear that the long-term inflation target hasn’t changed.

The fact is that we just don’t have very good empirical evidence in this field. The theory behind monetary dominance seems strong to me; if you forced me to choose, that’s the path I would choose. As a practical policymaker, I would try to hedge and do both.

And here’s Paul Krugman:

The main thing, I think, is to recognize that while we have our differences, the important thing is to try everything that might help. The greatest intellectual sin here is to care more about protecting your turf “” my answer is the only answer! “” than about the real economy that desperately needs every form of help we can deliver.

I agree, which is why I also advocate supply-side initiatives such as Christina Romer’s suggestion that we cut employer-side payroll taxes to boost employment.

And here’s Paul Krugman on the “taper.”

I know that the latest had overwhelming support on the FOMC; I’m surprised and a bit shocked by that, and worry that we may have seen incestuous amplification at work.

I really hope that the real economy recovers at a pace that makes my fears groundless. But if it doesn’t, I fear that the Fed has just done more damage than it seems to realize.

This is another reason why we should let markets run monetary policy.  They are less incestuous, or as James Surowiecki once argued, less prone to “group think.”

And here’s Ryan Avent:

I understand that the Fed is generally uncomfortable with unconventional monetary policy and has concerns about the side-effects from large-scale QE. That’s eminently reasonable. The trouble is that the Fed seems not to have learned that aiming to overshoot on the pace of employment growth and inflation is the safer, more conservative route. Overshooting maximises the chance that monetary policy will maintain its potency the next time trouble hits. Overshooting provides the best means to safely and quickly end growth in the balance sheet. Overshooting is the sustainable route to healthy increases in interest rates. But overshooting, the Fed has made entirely clear, is the one thing the American economy should not expect.

And at Marcus Nunes’s blog Mark Sadowski has another excellent post showing why monetary policy explains much more than fiscal policy.

And finally, what do tapirs think of the taper?

There’s lots more I plan to discuss, but that’s enough for now.

Welcome to the market monetarist world

We’ve been in a market monetarist world all along, but recent events have made that quite obvious.  I’d like to explain why in a slightly roundabout fashion.

Skeptics like George Selgin have occasionally asked why I think monetary stimulus is still needed.  After all, NGDP has been growing at about 4% rate for nearly 4 years, and you’d think wages and prices would have adjusted by now.

There are actually two different ways of thinking about this question:

1.  Figure out what is the optimal monetary regime, and then judge current Fed policy against that benchmark.

2.  Consider the Fed’s own announced goals, and then judge current policy against those goals.

I don’t have strong views on the optimal monetary regime.  I could see good arguments for a 3% growth NGDPLT regime, or a 5% growth NGDPLT regime.  And I can see good arguments for starting the clock in 2008 or 2013, or something in between.  If we started the clock in 2013, then a 3% NGDPLT regime would call for tighter money right now, and a 5% NGDP regime would call for easier money.

But in some ways it makes more sense to judge policy against the Fed’s own announced goals.  You might wonder why, given the Fed often fails to hit those goals.  The reason is that from 1983 to 2008 the Fed actually did a pretty good job of addressing its dual mandate.  And in the future they may also do a pretty good job.  That suggests that adhering to the mandate right now would reduce uncertainty and macroeconomic instability.   It does no good to tell the Fed to aim for zero inflation, or negative 1%, or positive 6%, if they will soon be aiming for 2% again.  We need stability, predictability.

So that raises the question of why they have recently failed, or indeed if they have recently failed.

And that’s where the recent success of market monetarism comes in.  For 4 years we’ve been battling on two fronts; trying to convince the profession that faster NGDP growth was needed, and trying to convince the profession that the Fed could deliver faster NGDP growth—indeed that the Fed was continuing to steer the economy at the zero rate bound.

And suddenly in the last few weeks it’s as if everything has become clear.  As if we’ve driven out of a dense fog into a sunny uplands, where the air is transparent.  Here’s the first sentence of a typical recent story:

The Federal Reserve almost entirely drove the markets this week.

Yes, and that doesn’t happen when an economy is in a liquidity trap.  But the bigger story was elsewhere.

Let’s start with the question of why we’ve done so poorly since 2008 if the Fed was following the same mandate (stable employment and roughly 2% inflation) as in 1983-2008.  Why is that policy not producing the good results of 1983-2008?  If there was any doubt as to the answer to that question, it’s been definitively dispelled by Bernanke’s recent press conference.  We aren’t getting good results precisely because the Fed is not acting in such a way as to implement their mandate.  Inflation is well under 2%, and likely to stay low, and the unemployment rate is far above the Fed’s estimate of full employment.  That means the Fed should further ease policy, and yet Bernanke just announced that they are likely to tighten policy, even if the economy continues along its current path.  During 1983-2008 they consistently adjusted their instruments in such a way as to hit their mandate.  Now they don’t.  They are failing because they’ve enacted the exact same policy mistakes that Ben Bernanke criticized the BoJ for making in earlier years.

The Fed has us just where they want us to be, and will adjust policy to keep us on the current path.  There were fears (even within the Fed) that monetary policy would be unable to offset the effects of fiscal stimulus.  Bernanke has recently dispelled those fears:

Bernanke said the quantitative-easing program could end in the middle of next year. The chairman was upbeat about the outlook, saying housing was strong and the recovery seemed to be brushing aside any headwinds from fiscal policy.

This is what a market monetarist world looks like.  The Fed is steering the nominal economy, bad outcomes (for AD) are due to bad Fed policy, and fiscal policy is ineffectual.  One of two things will happen over the next few decades:

1.  The Fed will keep NGDP growth fairly stable.

2.  The Fed will allow erratic fluctuations in NGDP growth.

In case one the market monetarists win.

In case two the market monetarists also win.  High NGDP growth will lead to excessive inflation, and we can say; “I told you so.”  A sharp fall in NGDP growth will lead to recession, and we can say; “I told you so.”

Unlike in 2008, the whole world is now watching NGDP.  No more excuses.  (OK, the whole world isn’t watching yet, but Michael Woodford is.)

From a purely selfish perspective, case one is actually the worst case.  If NGDP growth is stable then macro as we conceive it today (which is mostly a demand-side field) will disappear, and that means market monetarism will disappear.  Even worse, the residual problems (and there will be supply-side problems) will appear to be failures of market monetarism.  And we won’t have any useful advice to offer, other than “Money won’t solve that problem, nor will demand-side fiscal stimulus.” 

Why is the Fed adopting policies likely to cause it to fail?  I don’t know.  Commenter “James of London” links to people who spot the sinister influence of Jeremy Stein, who thinks the Fed should consider adding a third policy goal, financial market stability.  That might mean raising rates or ending QE even if other indicators suggest more stimulus is needed.  Who appointed this conservative to the Fed?  The same President who appointed 5 of the other 6 board members.  The President that supposedly thinks the economy needs more AD.  Thank God for regional Fed presidents like Bullard, Dudley, Evans, Rosengren, Kocherlakota, Williams, etc.

And where is Brad DeLong’s vitriolic ridicule when we need it most?

And sometimes the people are smarter than I am and done their homework. Then I have a very hard task indeed–and readers should understand that for them to bet on the correctness of my conclusions would not be to maximize expected value. Jeremy Stein is such a case.

As I understand Jeremy Stein’s view, it goes more or less like this:

[DeLong then presents Stein’s argument] . . .

It is Stein’s judgment that right now whatever benefits are being provided to employment and production by the Federal Reserve’s super-sub-normal interest rate policy and aggressive quantitative easing are outweighed by the risks being run by banks that are reaching for yield.

I do not know why this is Stein’s judgment. I do not know how I would go about making such a judgment.

Perhaps DeLong is saving up his insults for stupid conservatives that worry about bubbles and hence oppose monetary stimulus.  Conservatives that don’t teach at Harvard.  (Sorry if this is too snarky, the angel in my other ear is telling me I should praise DeLong for being civil.  And DeLong is smarter than he seems to think, certainly smarter than me.)

Even more amusing is that the same day Obama picked Stein he also nominated a former GOP administration official, to provide “balance” in order to get the two picks through the Senate.  And who is the blogger that has been talking about President Obama’s incompetence on monetary policy ever since 2009?

PS.  In the comment section there was lots of discussion of why real interest rates have recently risen sharply.  I find this issue to be really puzzling, but I think some people may have failed to pick up on the fact that I’ve always found this issue to be mystifying.  Consider that some of the previous US QE announcements seemed to lower bond yields, but later on bond yields rose during the actual QE program, as the economic outlook improved.  Or consider that the recent Japanese QE announcement seemed to initially lower bond yields, but then they rose sharply as the program raised inflation expectations.  Indeed you now have the following conventional wisdom:

1.  Japanese QE is raising inflation fears and raising bond yields.

2.  Fear of an end to US QE is raising bond yields.

Can both be right?  Do you see why I find this confusing?  Then add in the fact that some of the increase in US yields did occur after news of stronger than expected economic growth, but not all.  Some occurred after more contractionary than expected monetary policy announcements.

Some market monetarists are less enamored with the EMH than I am, and this sort of situation certainly works in their favor.  They can claim that the fall in bond prices is a due to a market failure, as investors don’t yet see that the tight money policy will slow growth, and eventually lead to lower bond yields.  Maybe, but then why call it “market” monetarism?

Of course if we had a NGDP futures market then all of these puzzles would be easily resolved.  No more mystery.  No need to speculate as to the possible existence of positive supply-shocks, etc.  But we aren’t willing to spend a few $100,000 on a prediction market that would vastly improve our knowledge base, our ability to conduct effective monetary policies.  And that’s the real mystery.