The hawkish case

The future course of the economy always involves a bit of guesswork. But it seems to me that the following two claims are pretty likely to be true:

1. Over the past three years, monetary policy has been far too expansionary.

2. It is likely that monetary policy is still a bit too expansionary, although I have less confidence in that claim.

Here are some recent data points, starting with the Financial Times:

A “blowout” March retail sales report sparked a sell-off in US government debt and shook global currency markets on Monday, in the latest sign that the world’s largest economy may be running too hot to justify cutting interest rates.

US retail sales were much stronger than expected in March, as consumers kept spending despite uncertainty about the future path of interest rates. [Note the term “despite”]

Data from the US Census Bureau published on Monday showed that retail sales, which include spending on food and petrol, rose 0.7 per cent last month. Economists surveyed by Reuters had expected an increase of 0.3 per cent.

The figure for February was revised up from a rise of 0.6 per cent to one of 0.9 per cent, indicating resilient consumer spending earlier this year and providing further evidence of a reacceleration of economic growth.

That should read: Reacceleration of nominal economic growth.

Five-year TIPS spreads are back over 2.5%, and rising.

The Atlanta Fed nowcast for real GDP growth is up to 2.8%, implying continued strong nominal growth in Q1. You cannot control inflation without controlling nominal GDP.

Some people argue that the slowdown in “spot rents” will soon show up in CPI rents. Maybe so, maybe not. It depends on the future course of spot rents, as CPI rents still have a long way to go to catch up with previous increases in spot rents:

If spot rents now begin re-accelerating, then we’ll never get that promised slowdown in CPI rents. Multifamily housing construction is slumping, a bad sign.

I’m not suggesting that inflation cannot slow in the months ahead, as it is impossible to foresee turning points in the economy. Perhaps we’ll be in recession in late 2024. But I do believe the weight of evidence points toward an increased risk of inflation. Given that policy over the previous three years has obviously been way too expansionary, the Fed needs to err on the side of hawkishness (even at the risk of recession.) If you wonder “what’s so bad about 3% inflation”, then you haven’t understood a single thing I’ve said here over the past 15 years.

This is the point where economists discuss “what the Fed should do”, by which they mean where should they set the fed funds target. In my view, interest rates are not the right way to think about monetary policy, so I won’t recommend a particular rate setting. Instead, I’ll recommend making the policy regime more effective.

1. Stop being so clumsy. Right now, the Fed has a psychological aversion to unexpected changes in interest rates. Thus they’d rather not raise rates. But that psychological aversion is irrational, and it makes policy less effective. (I.e., it makes both a recession and an inflation overshoot more likely.) The Fed should adjust their fed funds target daily, to the closest basis point (say using the median vote of FOMC members.) The Fed funds target should look like other market prices, like a random walk. New information should not make people expect a different level of NGDP in 2025, rather new information should show up as the adjustment in the fed funds rate required to keep expected 2025 NGDP on target.

2. Switch to level targeting. The failures of the past three years have many causes, but one factor is of overriding importance. The Fed thinks in terms of growth rates, not levels. That radically increases uncertainty about the future path of NGDP, and largely explains the wild swings in the financial markets in response to seemingly trivial adjustments in Fed policy.

The Fed is not reacting to unexpected swings in aggregate demand, the Fed is creating unexpected swings in aggregate demand, through its clumsy interest rate targeting system and lack of level targeting.

Is African politics inferior to American politics?

The Financial Times has a story that points to some disturbing features of South African politics:

It is the kind of fervent devotion that has driven a wave of support for the former president [Jacob Zuma] ahead of a critical general election on May 29. Yet as recently as January, the 82-year-old African National Congress veteran appeared to have been cast into the political wilderness after he was suspended from the party he once helmed for launching “vitriolic attacks” against the leadership and backing a rival one.

So Zuma was a highly corrupt and semi-authoritarian president, who retired in disgrace. And now he’s launching a comeback at an age when most people are retired? And he’s launching “vitriolic attacks” against the establishment?

Zuma’s candidacy is being challenged over a criminal conviction and South Africa’s highest court has been asked to hear the matter. But that has simply fuelled his supporters, who have previously rioted on Zuma’s behalf and say the current charges are politically motivated. Some analysts fear Zuma may seek to discredit the electoral process if he is unable to contest.

Wait, he’s launching a comeback despite a political conviction? And his supporters rioted on his behalf? And people fear Zuma may try to discredit the election process? What’s wrong with Africa?

Zakhele Ndlovu, a politics lecturer at the University of KwaZulu-Natal, said Zuma’s appeal was primarily based on his image as a defender of the Zulu nation. This also played on a stereotype that many top ANC leaders have been Xhosas, South Africa’s second-biggest ethnic group.

You mean he appeals to his own ethnic group, and demonizes minorities? That’s horrible.

Jabulani Mkhize, who was one of those out canvassing for Zuma’s party in Durban’s informal settlement of Cato Crest on a hot afternoon this month, said “lives were better” when the former president ran South Africa.

“Zuma was a better president in terms of economic transformation . . . I’m talking about simple things, like even the bread was cheaper,” he said

Sure, things were mostly better. But are South African voters so stupid that they don’t understand that in the last few years of his administration Zuma put in place “populist” policies that pushed South Africa down to the road to ruin? Do they actually believe that his policies had nothing to do with the current inflation?

Zuma is no stranger to using court battles as political platforms, given his many years of fighting corruption allegations. . . . “He plays the victim card in the same way that so many populists play the victim card around the world,” said Richard Calland, a public law professor at the University of Cape Town.

The victim card? That’s unworthy of a great nation like South Africa. Africa’s most developed economy. That’s the sort of thing you’d expect in a banana republic. Perhaps Africans cannot handle democracy?

Seven! (Trump is on a roll)

In a recent post, I listed 6 ways that Trump intends to reduce inflation:

Trump has a 6-part plan to bring down inflation:

1. Favors NIMBY policies to prevent housing construction in the suburbs.

2. Expel all the illegal workers that pick our food and provide other key services.

3. Put heavy tariffs on imported food and other goods.

4. Have Medicare do less negotiation of drug prices.

5. Run super massive budget deficits.

6. Easy money.

Now Politico suggests that his advisors have found another method to add to the list:

Economic advisers close to former President Donald Trump are actively debating ways to devalue the U.S. dollar if he’s elected to a second term

Can anyone dispute that Trump’s plan to reduce inflation is brilliant? Can you name even one Nobel Prize winning economist who would be capable to devising this sort of multi-pronged anti-inflation program?

PS. Off topic, but I couldn’t resist linking to this tweet. At one level, the current campaign is appalling. But in the right frame of mind it can become lots of fun. There’s something sort of enjoyable about seeing Trump exposed as a complete idiot in front of the entire world. (At least until you think about the fact that he’ll soon have his finger on the nuclear trigger. And people worry about AI!)

I’m like that guy greedily cramming popcorn into his mouth as he watches a film about armageddon.

BTW, What do the people in the audience think as they listen to Trump ranting like a drug-addled homeless guy on the streets of LA? “There’s our next president!!”

Time to add the epicycles!

During the golden age of macroeconomics (roughly 1984-2007), many economists understood that interest rates were not monetary policy. After 2008, economists have been drifting back to old-school Keynesianism, with its emphasis on fiscal policy and interest rates.

For the umpteenth time, it makes no sense to talk about interest rates causing changes in other macro variables. To do so is to engage in reasoning from a price change. Interest rates can change for multiple reasons, and the effects of the rate change will depend on the underlying factors that caused rates to change.

Not surprisingly, this highly flawed approach has produced lousy results. The Financial Times reports that dissatisfaction with our current models has led to the search for alternatives:

Matthew Rognlie of Northwestern University says that more broadly, the Hank trend tapped into a “well of discontent” with older, simpler models. Those assume consumers respond very strongly to changes in interest rates, and hardly at all to changes in their income.

I cannot say I’m surprised by the fact that models that assume consumers respond to interest rate changes in a predictable way have not done well. Unfortunately, instead of scrapping the interest rate approach to macroeconomics (which I recommend in my recent book) economists are adding epicycles:

Hank [Heterogeneous Agent New Keynesian] models try to match real-life spending behaviour more closely, assuming a willingness to consume out of extra income roughly 10 times larger than in the older models.

That changes the emphasis when thinking about monetary policy transmission, away from the idea that greater rewards for saving encourage more of it. Other mechanisms could include an interest rate increase that hits people with variable-rate mortgages living hand-to-mouth, damping spending. Or an interest rate cut could stimulate investment, pumping up wages of people who are particularly likely to splurge, boosting consumption.

Another way that economists handle the failures of modern macro is by making the predictions more ambiguous, a technique used by successful astrologers. For instance, they can invoke those mysterious “long and variable lags”:

Despite including more detail, there are still areas where such models don’t seem to meet a reality check. They don’t capture the fact that individual spending can take a while to respond to an interest rate change.

High interest rates don’t reduce aggregate demand? You just wait. It must be those long and variable lags. The phrase “a while” is so much better than “6 months” or “18 months” or “30 months”. In early 2023, economists told us the recession was delayed because of long and variable lags. OK, but for how long? It’s already April 2024; is the recession coming soon?

Perhaps the following analogy would be useful: How do rising oil prices affect consumption, other things equal? That’s not even a question. Other things equal, oil prices never change. If oil prices rise due to reduced supply, then consumption falls. If oil prices rise because of increased demand, then consumption rises. But other things equal? What does that even mean?

If interest rates rise because of tight money, then aggregate demand may decline. If interest rates rise because of fiscal deficits or booming immigration or strong “animal spirits”, then aggregate demand may rise. It depends.

Doesn’t the Fed determine interest rates? Well, it has a target, which it moves up and down in response to what it perceives as changes in the equilibrium interest rate. But is it leading the market, or following?

No doubt the defenders of these models will insist that they’ve already incorporated all the various factors that move the equilibrium rate of interest. All I can say is that the proof is in the pudding—apparently we are still not able to model that “natural” rate with any degree of accuracy. As a result, we end up reasoning from a price change.

Monetary policy is not interest rates, it is the market forecast of future NGDP.

Bleak chic

Janan Ganesh has an piece in the FT entitled “The Rise of Bleak Chic”.

I don’t demand show trials or the ritual egging in public squares of people who were bearish on cities. There is no need for a mea maxima culpa from those who doubted if even the handshake, let alone the restaurant, would return. But let’s imagine that things were reversed: that we optimists were the ones proven wrong. We wouldn’t have been allowed to slink off like Homer Simpson into the hedge. There would have been recriminations. 

There is an asymmetry in public life. If you err on the side of optimism, it can dog you forever. Ask Francis Fukuyama. Erring the other way incurs much less cost. Ask . . . well, whom? Who is the reference point for incorrect pessimism? If a name doesn’t occur, it’s because we tend to let these things go.

In the past, I’ve made a similar argument about asset price “bubbles”. Those who wrongly suggest that high prices are the new normal are mercilessly criticized after the crash. People still cite Irving Fisher’s claim that stocks had reached a permanently high plateau in 1929.

[Actually, Fisher’s claim was probably reasonable. Stock valuations were not out of line in 1929, and the crash occurred because of a severe economic depression that almost no one forecast.]

In contrast, asset price bears get off almost scot-free when asset prices soar after inaccurate bearish calls.

After the 2006-09 house price crash, claims were made that housing prices at the peak were obviously excessive. (Kevin Erdmann was a notable exception.) By the late 2010s, that no longer looked to be the case. But even then, people would often single out a few places like Phoenix as being obviously overpriced in 2006. Yes, they argued, high prices in California and New York might be justified by restrictions on new construction, but surely there was no justification for the insanely high prices in Phoenix, which is surrounded by endless expanses of desert. Even I found it hard to explain what had occurred.

Well, if prices in Phoenix were obviously irrational in 2006, they are just as high today. In the graph below I presented the Case-Shiller index deflated by the price level—in nominal terms Phoenix houses are now much more expensive than in 2006.

People that assured us that high prices in 2006 were justified are ridiculed, while we ignore those who suggested that the low prices of 2009-13 were justified.

Bleak chic is just one of the many psychological flaws that contribute to belief in bubbles.