Archive for December 2015


Welcome to Woolsey world

Back in 2009, Bill Woolsey suggested that central banks target NGDP growth at 3%. Over the previous few decades, NGDP growth had averaged 5% in the US and closer to zero in Japan (at least since 1993.)  There was no reason to think that Woolsey’s suggestion would be taken seriously.  But now Woolsey may get his way.

The Economist reports that NGDP in Japan has risen by 3.1% over the past year.  What makes this especially impressive is that the growth rate of the working age population in Japan suddenly plunged sharply right as Abe was elected.  I.e., he faced “headwinds”. If Abe had continued the monetary policy regime of the previous few decades, NGDP growth would have fallen to negative 1%.  Matt Yglesias has a great post on Japan–pay particular attention to the working age population graph (falling fast), and the labor force participation rate graph (rising fast).

Meanwhile in the US, trend NGDP growth is falling close to 3%.  The Hypermind market predicts 3.2%, but that’s during an expansion year with falling unemployment. When the dust settles, I expect Europe to also average about 3%, or perhaps a bit lower.  And I think it’s likely that Japan will slip back below 3%.  Australia and Canada will be a bit above 3%.  These are the sorts of trend growth rates we saw under the gold standard, but in those days it was all real GDP growth. Now it’s mostly inflation.

So three percent is the new normal for NGDP growth, and also for 30-year bond yields in the US.  You might say, “5% is so 20th century.”

PS.  Of course that’s the developed world.  In the India/Indonesia/China triangle, where most people live, 6% real GDP growth is the new normal, while NGDP growth depends on inflation.

PPS.  Good to see the Peronists lose in Argentina—one down, two to go (i.e. Brazil and Venezuela.)

PPPS. I wrote this before the Venezuelan elections; it seems the socialists are on the way out there as well. As Vox recently pointed out, a country with Saudi-type oil reserves can’t provide its citizens with toilet paper.  Poverty levels are skyrocketing.  I hope the Brazilians don’t impeach their President; change should occur through elections.  Still it’s good to see Latin America moving away from the views of people like Jeremy Corbyn.

Sloppy thinking at The Telegraph (plus, I was wrong about Abenomics)

Today I’ll dissect a really sloppy article in The Telegraph:

To paraphrase Senator Everett Dirksen’s famous quote on the American military budget: a trillion here, a trillion there, and pretty soon you are talking about real money. Central banks may not have that much in common with the Army, but they are starting to fall into the same habit of spraying vast quantities of money at a problem, despite a troubling lack of evidence that it has any real impact.

Last week, the European Central Bank president Mario Draghi extended his quantitative easing programme, and drove interest rates even deeper into negative territory. And yet, despite the billion of euros printed, inflation across the eurozone resolutely refuses to pick up.

Central banks don’t spend money in the fiscal sense; they create money and swap it for other assets.

So the ECB adopts a tight money policy in 2011 and the eurozone goes into recession. Draghi then switches to a slightly more expansionary policy in 2013 and the economy begins to recover.  But because inflation is temporarily depressed by plunging imported oil prices, this somehow shows monetary policy is ineffective?  I don’t get it.

Here in the UK, the Bank of England is meant to generate price rises of 2pc a year, but Chelsea FC are hitting the back of the net more frequently this season than the Bank hits its inflation target. Likewise in Japan and the US, central banks are consistently missing their official targets for inflation. What is going on?

So exactly how badly are the central banks missing their targets?  By 10%? By 5%? By 1%?  It does make a difference, no one expected perfection.  After all, they were often 1% or 2% off during the Great Moderation.

Up until 2013 the BOJ was not trying to create inflation. Then they adopted a 2% inflation target.  Here’s what happened:

Screen Shot 2015-12-08 at 11.39.25 AMOver the past two years Japan has moved from a trend rate of 1% annual deflation to 2% annual inflation, using the GDP deflator.  (I wish they’d give us seasonalized data.)  That seems like a huge success to me.  What am I missing?

But what about unemployment?  Oh yeah, that just fell to the lowest rate since the golden days of the early 1990s:

Screen Shot 2015-12-08 at 11.43.41 AM

So they’ve hit their inflation target, and had huge success in lowering the unemployment rate. But isn’t that achieved by people exiting the labor force? Nope, just the opposite, Matt Yglesias recently pointed out that labor force participation in Japan is high and rising under Abenomics:

Screen Shot 2015-12-08 at 11.49.06 AMBut what about the CPI?  Yes, CPI inflation has been depressed recently by imported oil prices. That’s why the GDP deflator is a better indicator; it’s the price of domestically made goods matters for macroeconomic stability.  (Obviously I’d prefer NGDP.)

So Japan’s hit almost exactly 2% inflation on Japanese produced goods and services, after decades of steady 1% deflation.  Unemployment has fallen to a multi-decade low. Labor force participation is soaring.  And yet we are to believe that Abenomics has failed solely because Japanese motorists are suffering from dramatically cheaper imported oil, and as a result Japanese real wages are rising strongly?  This stuff is so silly I couldn’t make it up if I tried.  Whenever I read someone suggest that Abenomics has failed I immediately write them off as non-serious.

I was wrong about Abenomics.  I thought the monetary “arrow” would be a modest success, as they were on the right track but not doing enough.  In fact, so far the monetary arrow has been an overwhelming success, beyond almost anyone’s wildest dreams.  (The other two arrows are still in the quiver.)  I’m still expecting closer to 1% inflation over the next few years, but even that would be a huge success compared to recent decades.

But how about the US?  Haven’t we fallen short of 2%?  Yes, but the Fed is about to raise interest rates next week precisely because they think inflation is only temporarily depressed by falling oil prices, and that we are on track to 2% inflation when that shock passes.  (Yes, oil prices are still falling, but surely they can’t fall below zero.)

I suspect the Fed is too optimistic, but this has nothing to do with the impotence of monetary policy.  Even economists who think QE is 100% ineffective concede the Fed could choose to not raise interest rates in December, and that this would lead to higher inflation.  You might not like Fed policy, but the Fed believes inflation is right on track to being on target in a couple years.  I thought the silly blather about monetary policy ineffectiveness would stop once the Fed raised rates, but that doesn’t seem to be the case.

A new paper by the Bruegel Institute argues that central banks have lost their ability to control inflation. At the moment, that doesn’t matter very much, because prices are generally stable. But (and it’s a big “but”) if we can’t control inflation on the way down – and it appears we can’t – what makes us think we can control it on the way up? Once prices do finally tick up, it may turn out to be impossible to stop them. And that is worrying.

By now it should be clear to everyone that the ability of central banks to control inflation has disappeared. Take the eurozone to start with. The ECB has an official target of prices rising by 2pc a year.

Clear to everyone?  First one needs to present some evidence, and the author fails to do so.  He also gets the ECB’s inflation target wrong; it’s not 2%, it’s “below but close to 2%”.  Yes, the inflation rate is further below 2% than they’d like, but that partly due to the recent plunge in oil prices.  And why would central banks be unable to prevent rising inflation?  None of the theories that I know of that predict monetary policy impotence at the zero bound have any implication for preventing a rise in inflation.

Then again, it may be something more serious. In a recent paper for the Bruegel Institute, Gregory Claeys and Guntram Woolfe argue that central banks may have lost their ability to control inflation. They point out that globalisation and new technologies have already been shown to have had a powerful disinflationary impact right around the world: “The important question is whether these integration trends affect the transmission mechanisms of monetary policy and reduce the ability of central banks to fulfill their mandate.”

This isn’t just wrong, it’s doubly wrong.  Positive supply shocks don’t prevent central banks from hitting their inflation target.  Not in monetarist models. Not in New Keynesian models.  Not in Austrian models.  Not in any plausible fiat money model.  Even worse, to the extent that positive supply shocks hold down inflation, they do so by boosting output growth.  But growth has also been unusually low in recent years, not just in the US, but also globally.  Fast rising productivity due to globalization is the least of the world’s problems.

PS.  I have a post on Krugman/Cruz over at Econlog.

HT:  Caroline Baum

Kevin Drum on Fed policy during 2008

Here’s Kevin Drum:

I think you can argue that the Fed should have responded sooner and more forcefully to the events of 2008, but the problem with Cruz’s theory is that it just doesn’t make sense. Take a look at the chart on the right, which shows the Fed Funds target rate during the period in question. In April 2008, the Fed lowered its target rate to 2 percent. Then it waited until October to lower it again.

So the idea here is that if the Fed had acted, say, three months earlier, that would have saved the world. This ascribes super powers to Fed open market policy that I don’t think even Scott Sumner would buy. Monetary policy should certainly have been looser in 2008, but holding US rates steady for a few months too long just isn’t enough to turn an ordinary recession into the biggest global financial meltdown in nearly a century.

Actually, according to New Keynesian (NK) economic theory (not my theory) it certainly could be enough.  According to NK theory, when interest rates are positive the central bank controls the path of NGDP.  Notice that interest rates were positive throughout 2008 (until mid-December.)

Also, according to NK theory, you can’t look at the path of the fed funds target to figure out the path of monetary policy.  Ben Bernanke says you need to look at NGDP growth and inflation.

According to NK theory what really matters is the gap between the policy rate and the Wicksellian equilibrium rate. According to NK theory you’d expect the Wicksellian equilibrium rate to fall sharply in a housing crash/recession. And it did. According to NK theory that means Fed policy tightened sharply in 2008.  According to Vasco Curdia (a distinguished NK economist who has published papers with Michael Woodford) the policy rate rose far above the Wicksellian equilibrium rate in 2008.

In other words, according to NK theory Kevin Drum is wrong; policy got a lot tighter. Now we can debate what the Fed might have accomplished with various counterfactual policies, but there is no doubt that the actual policy became extremely tight in the second half of 2008.  Recall that in mid-year the Fed did not expect a severe recession, they thought the economy would grow between 2008 and 2009.  So something unexpected went wrong in the second half of 2008, and we know from high frequency output data that the sharp deterioration of the crisis preceded the intensification of the financial crisis in October.  Not for the first time, a crash in NGDP expectations led to a crash in asset prices, which led to the failure of highly leveraged banks.

Drum presents this graph:

Screen Shot 2015-12-06 at 2.23.14 PM

and then wrongly assumes it tells us something useful, that it helps us to understand how policy played out in 2008.  It does not.  Yes, the rate cuts of April and October made policy less contractionary on those days than if rates had not been cut, but it doesn’t tell us anything about the overall stance of policy, and how that stance evolved over the course of 2008.  As Frederic Mishkin says in his best-selling money textbook (and Ted Cruz agrees) for that you need to look at a wide range of asset prices.

Both the NK and MM models tell us that money got much tighter in the second half of 2008.  Ironically, Ted Cruz seems more aware that fact than many of his critics.

PS.  Notice that the Drum quote starts off, “I think you can argue. . .”  Drum’s being too polite here.  It’s like saying, “I think you can argue that the captain of the Titanic should have reduced the speed of the ship in the iceberg corridor.”  Yeah, I’d say so.

PPS.  On the other hand I wish more bloggers (including myself) were more polite, so no disrespect to Drum intended.

PPPS.  Over at Econlog I link to a great Tim Fernholz article (on Ted Cruz) in Quartz.


” . . . the FOMC chose to pursue a slow recovery.”

When I said this in 2009 I was way out on the fringe.  Today it’s almost become conventional wisdom.  And now we have a top Fed official admitting what market monetarists have known all along.  Here’s Narayana Kocherlakota:

So the FOMC was not forced to pursue a slow recovery because of constraints on its tools. Rather, the FOMC chose to pursue a slow recovery. In my view, this choice can be traced back to the Committee’s reliance on the Taylor Rule as a key baseline in its thinking. As we have seen, the Taylor Rule is specifically designed to constrain the response of the central bank’s target interest rate to inflation gaps and output gaps. Qualitatively, a desire for low interest rate variability would have important consequences for the FOMC’s perspectives on appropriate monetary policy in late 2009. To achieve a faster recovery, the FOMC would need to add more accommodation and/or slow the pace of its eventual removal of accommodation. Either option would increase the deviation between the time path of accommodation and its eventual long-run level.

The October 2009 Greenbook provides a more quantitative sense of how the Taylor Rule restricts the pace of economic recovery. In formulating its outlook, the staff assumed that, after (a delayed) liftoff in early 2012, the Committee’s future fed funds rate target choices would follow a rule that was close to that originally proposed by Taylor (1993).9 Given this model of Committee behavior, the staff’s outlook was that the unemployment rate would remain above its long-run level for nearly four years. The projected recovery was even slower with respect to inflation: It was expected to remain at or below 1.6 percent for at least the next five years.

To summarize: In the wake of the Great Recession, the FOMC and its staff treated the pre-2008 policy framework—that is, the Taylor Rule—as an important baseline. As we have seen, the Taylor Rule is grounded in an implicit penalty on deviations of short-term interest rates from their long-run levels. Because of that penalty, the rule required the Committee to seek a slow recovery in its dual mandate variables in order to return the short-term interest rate closer to its long-run level more rapidly. Put more bluntly, the Taylor Rule required the Committee to forgo the timely creation of hundreds of thousands—perhaps millions—of jobs in order to get interest rates back up to normal more rapidly.  

.  .  .

To be clear, there have been many prior suggestions about how to arrive at a better framework. Some observers have suggested that the FOMC should increase the inflation target, so as to have more policy space to deal with adverse demand shocks. Some observers have suggested that the FOMC should target the price level rather than the inflation rate. Still others have suggested that the FOMC should target the level of nominal income.

I see merit in all of these suggestions, and I welcome explorations of their consequences. But they represent large changes in the FOMC’s long-run goals. I will instead recommend a more minimal change in terms of the FOMC’s strategy—that is, how it seeks to pursue its current long-run goals. My recommendation is that the FOMC should adopt a policy framework that puts considerably more emphasis on returning the economy to its dual mandate objectives over the medium term. Such a framework would immediately imply that the FOMC should use a monetary policy reaction function that is a lot more responsive to the Committee’s best medium-term projections of inflation and output gaps.

What would be the benefits of this change in the FOMC’s strategic framework? I see two clear benefits. First, the FOMC’s choices would systematically return both inflation and output to desired levels more rapidly. There would be less persistence and less volatility in both inflation and output gaps. Second, the credibility of the FOMC’s inflation target would be enhanced. As noted earlier, in November 2009, the staff projected that, if the FOMC used the Taylor Rule after liftoff, inflation would remain at 1.6 percent or below for the next five years. This kind of outcome creates large downside risk to the credibility of the inflation target.

Those are the benefits: less variance in macroeconomic variables and enhanced credibility of the FOMC’s long-run inflation target. What would be the costs? The key cost is that, of course, the fed funds rate would be more variable around its long-run level. I have two comments about this putative cost. First, I don’t know of models in which such a cost is grounded in traditional welfare economics.10 The real interest rate is a key intertemporal price, and it may need to vary a lot to effect a desirable allocation of resources. According to models that are currently available, it would be welfare-reducing to smooth the fluctuations of this important price.

Second, and perhaps relatedly, my reading of the Federal Reserve Act is that Congress has not mandated that the FOMC seek to constrain the variability of its policy instruments. Congress has mandated that the Committee adjust its policy instruments as needed so as to achieve its macroeconomic objectives.11

To summarize my third and final point: The FOMC should strongly consider lowering its implicit penalty on interest rate variability relative to what was being imposed before the crisis. Doing so would lead the Committee to use a monetary policy reaction function that puts more weight on its forecasts of inflation and output gaps. Such a reaction function would automatically engender a more appropriate monetary policy response to severe downturns in inflation and employment such as those experienced during the Great Recession.


The theme of this speech is that the FOMC’s thinking about appropriate monetary policy in extraordinary times like late 2009 is heavily influenced by its policy framework during normal times. It should choose its new “normal” policy framework with this in mind. I have argued that the pre-2008 framework led the Committee to aim for a relatively slow recovery in inflation and employment in the wake of the Great Recession. I’ve recommended that, going forward, the Committee should use a reaction function that would be considerably more responsive to its best available forecasts of inflation and output gaps.

The U.S. House recently passed a measure, the Fed Oversight Reform and Modernization Act, that would enshrine the Taylor Rule as a key benchmark for monetary policy. Federal Reserve Chair Janet Yellen recently wrote in a letter12 to House leaders that the bill “would severely impair the Federal Reserve’s ability to carry out its congressional mandate to foster maximum employment and stable prices and would undermine ability to implement policies that are in the best interest of American businesses and consumers.”

My argument today gives a concrete example of Chair Yellen’s criticism. The FOMC did treat the Taylor Rule as a key benchmark for monetary policy during the early part of the recovery from the Great Recession. By doing so, we were systematically led to make choices that were designed to keep both employment and prices needlessly low for years.

Ultimately, if this legislation were to become law, it would force the Federal Reserve into the same kinds of choices in the wake of future adverse shocks. [Emphasis added]

Unfortunately, Kocherlakota is flat out wrong about the recent House bill, it does not “enshrine the Taylor Rule as a key benchmark for monetary policy”.  Not even close.  It asks the Fed to come up with an explicit monetary rule.  I suggest NGDPLT, target the forecast.

Otherwise a great speech, just outstanding.

HT:  TravisV, Julius Probst

Crazy like a fox

Over at Econlog I pointed out that Ted Cruz asked some rather market monetarist sounding questions to Janet Yellen, during her recent testimony in the Senate.  I think it’s fair to say Cruz easily came out ahead on the exchange.  But that doesn’t fit the press corps’ pre-conceived ideas of their relative expertise, and David Beckworth points out that the WSJ reporter who was live blogging the event initially thought Cruz had his facts wrong, especially the claim that the Fed tightened in the second half of 2008.

The Washington Examiner claims that Ted Cruz’s questions reflected some diverse intellectual influences:

Mundell, known as one of the intellectual architects of supply-side economics, said at a Reagan Foundation event in 2011 that tight money caused the financial crisis. “The Fed did some tightening, and the dollar started to soar,” Mundell told Wall Street Journal editorial page editor Paul Gigot.

The dollar rose by 10 percent between the Fed’s rate cut in April 2008 and the December meeting, against a broad range of currencies.

Furthermore, Cruz was right to note that the major declines in inflation and stock prices, both alternative indicators of monetary policy, occurred during the same period.

“Sen. Cruz basically gave a Market Monetarist critique of the Fed policy in 2008,” Western Kentucky University economist and former Treasury official David Beckworth, one of the economists cited by Cruz’s office, told the Washington Examiner. “The essence of this argument is that the failure of the Fed to respond properly in late 2008 turned an ordinary recession into the Great Recession. Ditto for the Fed’s response in 1929-33.”

That case was laid out in greater length in a 2009 study by Federal Reserve Bank of Richmond economist Robert Hetzel. In his paper, Hetzel wrote that “restrictive monetary policy rather than the deleveraging in financial markets that had begun in August 2007 offers a more direct explanation of the intensification of the recession that began in the summer of 2008.”

Hetzel argued that financial markets were “reasonably calm” as late as summer 2008. “The intensification of the recession,” he wrote, “began before the financial turmoil that followed the Sept. 15, 2008, Lehman bankruptcy.”

Widely overlooked was an exchange on interest on reserves (near the end), where Cruz again bested the Fed chair.  Cruz first asked how much interest had been paid since 2008.  Janet Yellen was not sure, but added:

.  .  . It is a critically important tool of monetary policy . . .

Cruz then asked:

So what has the impact been paying billions of dollars to those banks in the last seven years?

Yellen responded:

It’s helped us to set interest rates at levels that we thought were appropriate for economic growth and price stability.

To say this is misleading would be an understatement.   Everyone, including the Fed, agrees that raising the interest rate on reserves is a contractionary policy. The Fed sharply raised interest on reserves in October 2008. Just think about that. Now it’s true that the Fed was also doing some expansionary “concrete steps” during the same period. But Cruz was not asking about those other steps, he specifically asked about interest on reserves.

During 2009, Janet Yellen said, “we should want to do more.” She clearly meant that it would be better if interest rates were lower. That means that the (positive) interest on reserve program was actually moving the US economy farther away from the Fed’s economic growth and price stability objectives.

At the time, there was some concern about the stability of money market funds. Given the widespread adoption of negative interest on reserves in other countries, the Fed is no longer afraid of reducing IOR to zero, or even below. But concern over the stability of money market funds is very different from meeting the Fed’s economic growth and price stability objectives. There is no question that this policy has pushed the economy further away from those objectives, and Sen. Cruz was quite right to raise the issue with the Fed chair. It’s a pity she didn’t have a persuasive response.

A correct answer from Janet Yellen would have been.

1.  When we instituted IOR (at a time of 1.5% interest rates) we made a serious mistake.  As Ben Bernanke pointed out in his memoir, monetary policy was too tight during this period.

2.  We also erred in continuing the program in 2009, and after.  We thought that zero short-term rates were a threat to financial stability, and later discovered that this was not true.  In retrospect we neither should have initiated the program in late 2008, nor continued it after 2008.

Central banks are really good at admitting mistakes made by their predecessors (i.e. the Great Depression, the Great Inflation, etc.)  But they are not good at admitting mistakes that they themselves made.  That needs to change, which is why we need much more Fed accountability.  Senator’s Cruz’s questions were almost a model of what that accountability should look like.  The Fed needs to be much more upfront about admitting its mistakes.

Update:  George Selgin has an excellent new post that provides incisive analysis of how the Fed ended up sterilizing its monetary injections during 2008.

Update#2:  Chad Reese and I have a piece on policy rules in American Banker.

PS.  I doubt that either Paul Krugman or Ted Cruz would support a 4% NGDP target rule, level targeting.  Krugman might think it’s too low to deal with the zero bound problem.  But the level targeting factor would make a huge difference at the zero bound.  Senator Cruz might prefer something with a role for gold; I seem to recall he mentioned Bretton Woods at one point.  But I think he underestimates how much better NGDP targeting would be at making capitalism look good—making bailouts of auto companies and banks and fiscal stimulus seem unneeded.  If two people that far apart were to ever support NGDPLT, its momentum would be unstoppable.

PPS.  James Alexander has a very good post on the growing interest in NGDP targeting within the eurozone.

HT: Caroline Baum