Five year TIPS spreads are at 1.5%.  Because the Fed targets PCE inflation, and because 2.0% PCE inflation is roughly equivalent to 2.4% CPI inflation, the Fed’s target is roughly a TIPS spread of 2.4%.  So 2014-19 inflation expectations are 0.9% below target.  Here’s Ryan Avent:

American markets are once again hunkering down for a bout of disinflation. Expectations for inflation over the next five years have fallen half a percentage point since July, to around 1.5%: a level at which the Fed has previously moved to begin new asset purchases.

It’s important to recall that the Fed has a dual mandate, so this fact doesn’t necessarily imply that money is too tight.  Later we’ll see that it is too tight, but let’s first consider the counterargument.

The Fed’s dual mandate covers both inflation and employment.  Thus the Fed should push inflation above their target when unemployment is high, and they should push inflation below target when the unemployment rate is low.  It seem likely that unemployment will be below average over the next five years, if only because it’s been above average for the previous six.  So it’s possible that money is not too tight.  Possible, but extremely unlikely.  Here’s Ryan again:

THE monetary economics of a world in which interest rates are close to zero are not especially mysterious. Stimulating the economy at that point requires central banks to raise expected inflation. Disinflation, by contrast, results in passive tightening, since the central bank can’t lower its policy rate and since the real interest rate is the policy rate less expected inflation. In this world, the downside risks are much larger than those to the upside. There is infinite room to raise interest rates if inflation runs uncomfortably high (one might even welcome that opportunity to push rates up as that would reduce the probability that rates would fall to zero again in future). But there is no room to reduce interest rates if inflation is running to low. That, in turn, forces central banks to use unconventional policy or run psychological operations to try to boost expectations. Central banks are not very good at those sorts of things.

Suppose that the Fed runs inflation at 1.5% over the next 5 years, and then we hit another recession.  In theory, the Fed should then push inflation much higher.  But as Ryan’s comment suggests, exactly the opposite is likely to happen.  The Fed will let inflation fall even below 1.5% in the next recession, and we’ll be in exactly the same position we are today.

This means that the real problem is not that money is too tight today (although it is) but rather that the entire monetary regime is flawed.  Level targeting of prices would be better (and is the no-brainer solution to the euro-crisis, given their fixation with inflation targeting.  But the ECB is not a no-brain, it’s a negative brain.)  Another solution is NGDP targeting.  Even better would be NGDP level targeting.  These are ways of moving away from the Fed’s current procyclical monetary policy.

Ryan’s comment also points to the danger of passive tightening.  Many people still have trouble with the notion that monetary policy could be tightening even as central banks “do nothing.”  But clearly they can (and this isn’t just a MM view, it’s also a New Keynesian view, and an old monetarist view.)

TravisV sent me an article indicating that the Fed is beginning to understand the situation:

St. Louis Fed President James Bullard told Bloomberg TV that the Fed should consider delaying the end of quantitative easing in response to tumbling inflation expectations.

His concern was tumbling inflation expectations. . . .

Bullard was basically echoing the concerns of San Francisco Fed President John Williams, who suggested the Fed may have to increase its asset purchase program.

I don’t always agree with Bullard, but to his credit his views are always data driven. He’s an important swing vote at the Fed, as he’s one of the moderates.

PS.  Once again, we’d have a much better idea of whether money is too tight if we had a NGDP futures market.  But the Fed isn’t willing to spend $2 million dollars to set up a subsidized prediction market that would provide useful forecasts, even as trillions of dollars of wealth (and lots of potential jobs) are being wiped out each week.  And the economics profession is equally apathetic. Over at Econlog I have a related post.

Update:  Mark sent me an excellent and somewhat related post from a few days back by Tim Duy.  He’d make these points even more forcefully today.  And take a look at the dovish shift in the FOMC next year.  I’d wouldn’t be at all surprised if there were no fed fund rate increases in 2015. Where are 4 votes for higher rates?  The real problem is the eurozone.

[Before starting this post, I’d like to thank Timothy Lee for his nice Vox.com post on the NGDP futures market project.]

I do sort of understand why people resist my claim that the Fed caused the Great Recession in the US.  After all, I’m asking people to believe several highly implausible claims:

1.  It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates.

2.  Other asset prices besides those on short-term debt instruments contain important information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms.

3.  Monetary policy can be highly effective in reviving a weak economy even if short term rates are already near zero.

Although I must say it’s odd that these points are so implausible, after all, they are taken word for word from Frederic Mishkin’s textbook, which was the number one monetary textbook in the US back in 2008.

But here’s what really confuses me.  You don’t even need to make these sorts of “implausible” claims to blame the ECB for the Great Recession (“Depression?) in the eurozone.  I was thinking of this when I heard David Wessel explain the eurozone’s possible triple dip recession on NPR this morning.  Basically he said (as far as I recall):

1.  The 2008-09 eurozone recession was caused by the ripple effects of the US housing crisis.

2.  The 2011-12 double-dip was caused by sovereign debt problems.

3.  The current slowdown and possible triple dip is caused by Russia/Ukraine.

Wessel’s a fine reporter, and it’s his job to express the conventional wisdom.  I have no doubt that he has done so.  But this view seems preposterous to me, on all sorts of levels.

It is possible for real shocks to get transmitted via trade and/or financial channels, even with sound monetary policies.  But even if the linkages are very close (as with the US and Canada), the secondary effects will be milder.  And they were milder for Canada (and would have been still less pronounced if the BOC had targeted Canadian NGDP.) The eurozone is far less closely linked to the US than is Canada (which sends 70% of its exports to the US.)  So the ripple effects should be much milder in the eurozone than Canada.

And even if you don’t buy anything I just said, there is a much bigger problem with the standard view.  It completely ignores the fact that the 2008-09 NGDP plunge in Europe began earlier than in the US and was actually deeper (a bit over 4% vs. a bit over 3% in the US.)

But it’s even worse; the eurozone was already in recession in July 2008, and eurozone interest rates were relative high, and then the ECB raised them further.  How is tight money not the cause of the subsequent NGDP collapse?  Is there any mainstream AS/AD or IS/LM model that would exonerate the ECB?  I get that people are skeptical of my argument when the US was at the zero bound.  But the ECB wasn’t even close to the zero bound in 2008.  I get that people don’t like NGDP growth as an indicator of monetary policy, and want “concrete steppes.”  Well the ECB raised rates in 2008.  The ECB is standing over the body with a revolver in its hand.  The body has a bullet wound.  The revolver is still smoking.  And still most economists don’t believe it.  “My goodness, a central bank would never cause a recession, that only happened in the bad old days, the 1930s.”

For God’s sake, what more evidence do people need?

And then three years later they do it again.  Rates were already above the zero bound in early 2011, and then the ECB raised them again.  Twice.  The ECB is now a serial killer.  They had marched down the hall to another office, and shot another worker.  Again they are again caught with a gun in their hand.  Still smoking.

Meanwhile the economics profession is like Inspector Clouseau, looking for ways a sovereign debt crisis could have cause the second dip, even though the US did much more austerity after 2011 than the eurozone.  Real GDP in the eurozone is now lower than in 2007, and we are to believe this is due to a housing bubble in the US, and turmoil in the Ukraine?  If the situation in Europe were not so tragic this would be comical.

And now we have a third possible murder, although at least this time the revolver is not smoking (they didn’t raise rates–it was errors of omission.)  Like the Pink Panther series of films, this story is beginning to move from classic comedy to utter farce.

(Whenever I do these posts I can’t get anyone to refute what I am saying.  How could they? But they don’t accept it either.)

PS.  Some commenters will always say; “if it’s monetary, how can Germany be booming?”  As if supply-side factors can’t explain regional variation in a demand slump.  In any case, German real GDP has risen by a grand total of 3% since the first quarter of 2008, vs. 7.5% in the US.  If Germany is booming, how would you describe the US?  And BTW, the recent monthly numbers look pretty good for the US, and horrible for Germany—they are the leading edge of the triple dip.

PPS.  Is there any more confusing database than Eurostat?  I’d expect more of the Iraqi central bank. 

Things are progressing quite nicely with iPredict, and I hope to be able to ask donors to send their checks out within a couple of days.  We have found a branch of Victoria University in the US, which is registered to accept donations that are tax deductible for Americans (I believe it’s called a 501(c)3 organization?)  Right now I am trying to determine exactly how much I will ask each person to contribute to that entity (i.e. what fraction of their original offer is needed.)  The money will all go to the iPredict NGDP markets.

Americans won’t be able to trade in iPredict, but another site I’ve been in communication with has listed a NGDP growth rate contract for the 3rd quarter of 2014 (a NGDP number that won’t be announced until October 30, 2014.)  This site is called “Hypermind,” and differs from other prediction markets in that traders do not put up their own money.  Instead their accounts are measured in “Hypermoney” (H), however at the end of a specified period the best performers do get monetary rewards, such as Amazon gift certificates. Here is the description of the new contract:

What will be the annualized growth rate of U.S. Nominal GDP in Q3 2014?

The value of each NGDPUS14Q3 share will be determined as follows:

10ℍ * (annualized 2014:3 rate of nominal GDP growth, expressed as a percentage)

Or: 0ℍ if nominal GDP falls in 2014:3.

Or: 100ℍ if the annualized nominal GDP growth exceeds 10% in 2014:3.

The final share price will be based on the “advance estimate” of nominal GDP growth. This nominal GDP announcement will occur at 8:30am on October 30, 2014. All of the information used to calculate the growth rate will appear in the BEA website, Table 1.1.5, line 1:

http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=3&isuri=1&903=5

The growth rate will be calculated in two steps. First the quarterly growth rate will be calculated, using October 30, 2014 estimates of both Q2 and Q3 nominal GDP:

QGR = (Nominal GDP in 2014:3 – Nominal GDP in 2014:2)/(Nominal GDP in 2014:2.

The quarterly growth rate will be annualized as follows:

Annualized nominal GDP growth equals [(1 + QGR)^4 – 1] * 100

Note that the annualized nominal GDP growth rate is expressed as a percentage (not decimal.) It is then rounded off to the nearest tenth of a percent.

For example, if nominal GDP grew from $17.328 trillion (in Q2) to $17.5 trillion in Q3, then the annualized growth rate (including compounding) would be 4.03%, rounded to 4%, and the final price of the NGDPUS14Q3 share would be 40ℍ.

Finally, beware that the Q2 estimate that will be used in the calculation is the one that will be published on October 30, which may be different from the current estimate of $17.328 trillion.

They also sent me the following description of Hypermind:

About Hypermind

————————

Hypermind is a US-based prediction market that features mostly geopolitical, political and economy/business questions. It is not a gambling venue because participation is free (play-money), but significant rewards are given out based on performance. Questions are grouped into contests that feature their own reward amounts, so one may choose to participate in all contests, or in just those that appeal to their narrow interests. Currently, the total reward amount in play is over $17,000.

Hypermind is a pure Continuous-Double-Auction market, with a trading engine similar to Intrade, except that there are no trading fees. Trading is zero-sum and frictionless. Contracts are priced [0,100] (in play money) with payoffs that can be continuous (e.g., vote-share) or binary (e.g., winner-take-all).

Participation to Hypermind is by invitation only. There are upwards of 500 participants, most of which have been recruited among the top traders in various prediction markets operated in France and the USA by NewsFutures and Lumenogic between 2000 and 2014. It is an elite panel of expert prediction traders recruited and rewarded solely based on performance. It is a highly educated group of professionals in all walks of life, with 65% Masters or Ph.D. degrees, and another 20% college degrees.

Proposal

————-

I propose to implement your NGDP contracts on Hypermind in a dedicated contest, or series of contests, featuring its own cash prize of an amount of your choosing. Hypermind will operate the market for free, so you only have to put up the prize money.

For distributing the rewards themselves, based on a performance ranking at the end of the contest, there are 2 possibilities: (1) you take care of it; (2) Hypermind takes care of it. In the second case, you would give us the money and we would distribute it, when the time comes, in the form of Amazon Gift Certificates. If Amazon GC is unpalatable to your traders, we can explore other forms of rewards – TBD.

For your readers to participate, they will have to register to the Hypermind website. This means providing personal information such as email address, name,  etc., and some basic demographic info such as education level, year of birth, gender, etc. But no financial or banking info of any kind. Since participation is invitation-only, they will first have to request an invitation, then they will receive an account activation link by email. Filling out the registration form just takes a minute.

Demo

———

The Nominal GDP 2014:3 contract that you specified is now live on http://hypermind.com (please use this exact address) with a dedicated contest featuring a minimal $126 prize (100 €). There is already some trading going on. But to check out this market, your readers will need to register to Hypermind first.  [I fixed the link]

They used Skype to show me the site, and it really is very easy to register, despite requiring two steps (request for invitation, then filling out a short form.) And of course no financial info needed.

I was thinking of starting off with 6 contracts at Hypermind; quarterly NGDP growth rates for 2014:3, 2014:4, 2015:1, 2015:2, and 2015:3, as well as an annual growth rate contract for 2014:4 to 2015:4.  There would be $1000 prizes for each quarterly market, and a $5000 prize for the one year contract. Total cost would be $10,000.  Unfortunately, everything in America is absurdly complicated.  In this case there is just one problem—there is no non-profit for donors to donate to. Hypermind is a for-profit entity. Does anyone know a method by which donors could contribute to this sort of experiment in a way that was tax deductible in the US and also 100% shielded from liability?  Or at the very least 100% shielded from liability?

The 2014:3 contract is already up and running, but we could obviously do much better with more than 100 euros in prize money.

Once I figure out what we are going to do with Hypermind, I’ll be able to tell each donor how much of their donation would be needed for iPredict.  If we can’t resolve this in a couple days, we may just go ahead with iPredict, and try to resolve Hypermind later.  My long term goal is to encourage Americans to trade NGDP at Hypermind, and non-Americans to trade NGDP at iPredict.

During the 1970s, the doves were consistently wrong, and for the most part denied they were wrong, even after the fact.  Inflation (they said) was caused by “non-monetary” factors.  Now we all know that was hogwash; NGDP was rising at 11% per year.  And non-monetary factors like oil shocks and strong unions have no impact on NGDP.

Since 2008 it’s been the exact opposite, the hawks have been consistently wrong.  There is no shame in being wrong, but it is shameful not to admit you were consistently wrong in the past, when the facts clearly suggest you were.  Oddly, Benn Steil and Dinah Walker now think it’s again the doves who are at fault.

Do Fed doves and hawks get their aviary classifications based on their cold, hard analysis of data, or is it the reverse – do they select data points to justify their dovish or hawkish perspectives?

The history of the Fed’s post-crisis focus on unemployment suggests the latter.  After June of 2013, as the figure above shows, the Fed’s estimate of the natural long-term unemployment rate begins declining in sync with the decline in the actual unemployment rate.  This suggests that FOMC members are lowering their estimates of the natural rate of unemployment to justify keeping interest rates at zero longer than they could if they stuck by their initial estimates, the 6% consensus upper bound of which is now above today’s actual 5.9% rate.

We cannot test this hypothesis directly, by checking each member’s estimate history, because the estimates are anonymous.  But we can check whether the phenomenon can be explained merely by a change of FOMC composition: it cannot. The distribution of participants’ estimates shows conclusively that some of them have indeed revised their estimates lower.  Given that these are supposed to be estimates of the long-term natural unemployment rate, this is more than curious.

With core PCE inflation, the Fed’s preferred inflation measure, running at 1.5%, still comfortably below the Fed’s 2% long-run target, there is little compelling reason to begin hiking rates immediately.  But given its upward trajectory from 1.2% at the start of the year, there is surely now reasoned cause for bringing forward the Fed’s old September 2012 calendar-guidance of zero rates through mid-2015 – which the Fed doves are still strongly wedded to.

Our observations suggest that monetary dovishness and hawkishness are often fixed states of mind, rather than artifacts of a consistent approach to data analysis.  If so, there is reason to fear that the Fed’s exit from monetary accommodation will be too late and too tepid – with the result being higher future inflation than the market is pricing in right now.

Obviously it’s possible they are right, but it seems extremely unlikely.  The doves have good reason to delay their estimate of the optimal time to raise rates; the markets are suggesting that we are not approaching the Fed’s multiple policy targets as quickly as the unemployment numbers would suggest.  If 5.4% really was the natural rate of unemployment, then there is no way the 5-year TIPS would be plunging rapidly below 2%, and the 10 year T-bonds would be 2.3%.  After all, we will be at 5.4% unemployment in about 5 months.  Once we fall below the natural rate, the standard model (i.e. the Fed’s model) says inflation should rise.  But there are no signs that inflation will rise.  Steil and Walker cite historical data, but market inflation expectations are much better.  It’s not a good idea to try to steer the car by looking in the rear view mirror.  It’s not wise to second guess market forecasts.

Unfortunately we lack a NGDP futures market, which would have made it much easier for me to make this argument.  The government and the economics profession deserve ridicule for the fact that this market does not exist.

I do agree with the first sentence of their final paragraph, and have a new post on that topic over at Econlog.  But I draw the opposite conclusion—it’s the hawks we need to fear.

This is me back in 2010:

The EMH is approximately true; indeed it’s almost impossible for me to imagine any other model of financial markets.  But it’s not precisely true, again, just as you’d expect.  After all, if the EMH were perfectly true then no one would have any incentive to estimate fundamental values.  We know people are imperfect and hence that any real world human institution, including markets, will be at least slightly imperfect.

A smart person like Eugene Fama should have been able to come up with both the EMH, and its limits, by just sitting in a room and thinking.  Much as David Hume got the QTM by imagining what would happen if everyone in England woke up one morning with twice as much gold in their purses.  Or Fisher’s theory of inflation and nominal interest rates.  Or Cassel’s purchasing power parity.  Or Friedman/Phelps’ natural rate hypothesis.  Or Muth and rational expectations.  Certain ideas are simply logical, and that’s why I have no doubt that despite all those economists on the left arguing the EMH has been discredited, it will still be taught in every top econ/finance grad program 100 years from now, whereas fiscal stimulus will be long gone from macro textbooks.

PS.  Why will fiscal stimulus be gone?  Because even Krugman admits it only makes sense at the zero bound.  And we are rushing headlong into a world of all electronic money-probably within 50 years.  There is no zero lower bound with electronic money, and hence the Taylor Rule is all you need.  Old Keynesian economics will vanish, leaving only new Keynesianism.