Commenter Michael Sandifer left this comment:

One key difference between the current period and ’66 is that inflation is tame.

He’s referring to our relatively low inflation:

Over the previous 6 years, unemployment has fallen from 8% to 3.7%.  Inflation has mostly stayed in the 1% to 2% range, occasionally dipping below 1%, and recently rising above 2%.

In contrast, here’s the picture as of mid-1966:

In this case, unemployment rose to a peak of 7% in 1961, then gradually trended down to 3.8% in mid-1966.  Inflation mostly stayed in the 1% to 2% range, occasionally dipping below 1%, and recently rising above 2%.

Hmmm, that sounds familiar.

I don’t expect the next 3 years to look anything like the late 1960s.  But if we are to avoid a repeat of the 1960s, it will not be because the current situation is radically different from 1966, it will be because we take steps right now to make sure than the future situation is radically different.  And that requires a dramatically less expansionary monetary policy that what the Fed adopted in 1966-69.

In the 1960s, the Fed tried to use monetary policy to drive unemployment to very low levels.  Let’s not make that mistake again.  Better to produce stable NGDP growth, and let unemployment find its own natural rate.

Stocks dropped sharply this morning.

In don’t view today’s decline in stock prices as being important.  In recent years, stocks have often plunged for a few days, and then recovered.  I put more weight on the level of stock prices, which is still quite high.  Thus I believe the macroeconomy is still in very good shape.

But there’s also something more interesting going on—bond prices have also been falling (i.e. higher yields):

“It’s always hard to judge at what point you hit an inflection point where the correlation between yields and stocks goes into reverse,” says Liz Ann Sonders, chief investment strategist at Charles Schwab & Co. “One of the markers to when that happens is typically when you move from a deflationary era or at least a deflationary mindset to more of an inflationary mindset.”

It’s potentially a big deal.

An enduring rupture in positive correlations — yields moving up along with stocks — would signal a break in the weak-growth, low-interest regime seen over much of the past decade. Markets driven by negative tandem moves — yields up, shares down — have tended to be in the grip of inflationary pressure or potential economic over-heating.

David Glasner did a very important study that found stock prices became positively correlated with TIPS spreads (inflation expectations) during the Great Recession, but not before.  This may have reflected the fact that market participants thought the US economy would benefit from a more expansionary monetary policy during the period of high unemployment and near-zero interest rates.  That assumption was correct in my view. If long-term bond yields and TIPS spreads start becoming negatively correlated with stocks, then presumably excessively tight money is no longer much of a problem.

That doesn’t mean money is now too easy.  In my view we are so close to optimal that it’s hard to be sure whether policy is appropriate or a tad too expansionary.  We’ll know better in a few years.  But certainly most of the data looks pretty good from a dual mandate perspective.

I’d encourage people not to think in terms of binaries, rather shades of grey.  Monetary policy has been gradually moving from much too tight, to slightly too tight, to about right.  We don’t know precisely where we are on the spectrum, but the trend it clear.  It’s also clear that current monetary policy is far more appropriate than policy in 2009, or 1979, or 1930.

I have three new pieces that just came out. At The Hill, I have an article that discusses wages:

On Friday, the government announced average hourly wage growth for October, which came in at an annual rate of 2.8 percent.

The case was similar in September, and the media reported that Fed officials may react by tightening monetary policy. Not surprisingly, this puzzles lots of people: Shouldn’t we welcome higher wages, especially after decades of sub-par wage growth?

The short answer is that we should welcome higher “real” wages, but the Fed does have reason to be concerned about higher “nominal” wages. . . .

It’s true that printing lots of money can lead to higher nominal wages. However, as workers in places like Mexico and Argentina have discovered, if productivity is stagnant, then large nominal pay raises do not translate into higher real wages.

The recent 2.8 percent average hourly wage growth doesn’t pose a large threat, but the Fed has good reasons to be wary of a steep upsurge in nominal wage growth.

At Mercatus, I have a new policy report discussing the Hypermind NGDP prediction market:

It is difficult to understand why it took so long for an NGDP prediction market to be created, as NGDP is probably the best single indicator of whether monetary policy is too expansionary or too contractionary. Given that the Fed has already expressed an interest in TIPS spreads, it likely would be equally interested in market forecasts of NGDP growth.

Had this market been in existence during 2008–2009, it might well have provided valuable signals to the Fed. After all, even Ben Bernanke admits that the Fed erred in September 2008, when it refused to cut its target interest rate from 2 percent right after Lehman failed. At the time, TIPS market expectations of inflation were much lower than Fed forecasts. But NGDP growth expectations are even more informative about the state of the economy than inflation expectations.

In the end, the Hypermind NGDP prediction market is a sort of demonstration project. One would hope that the Fed will set up its own (better-funded) NGDP futures market, which could help it to make more informed policy decisions. The cost would be trivial relative to the potential gains from more effective monetary policy.

At The Bridge, I have a piece pointing out that monetary policy is becoming increasingly accommodative:

Thus whether you judge policy solely by considering inflation, or both inflation and employment, you reach the same conclusion. Policy was too restrictive to hit both the Fed’s inflation target and its employment target during 2009-16, and policy is now relatively accommodative, with inflation above the two percent target and the unemployment rate below the 4.0 percent to 4.6 percent range that the Fed views as “full employment”.

The fact that monetary policy is increasingly accommodative does not necessarily imply it is too accommodative. The Fed needs to look beyond the current data and forecast the impact of its policy on the future condition of the economy. Inflation has recently been pushed up by a sharp rise in oil prices, and it’s possible that it may fall back below two percent during 2019. Even so, the balance of risks has recently shifted, and the long period of excessively restrictive monetary policy is over.

Some people are confused when I argue that excessive monetary ease right now could make a recession more likely.  Aren’t recessions caused by tight money?  Yes, but they are also caused by mistakes that lead the Fed to want to sharply slow NGDP growth.  And that sort of mistake is more likely to occur when policy has previously been too expansionary.

There is an especially large risk of recession when an excessively expansionary monetary policy coincides with a peak in the real side of the economy.  If inflation has been running above target at a time when real growth is robust, then there’s a danger than a slowdown in inflation will coincide with a slowdown in RGDP growth.

Here are a couple recent examples.  In 2000-01, RGDP growth slowed due to the end of the tech boom.  So why didn’t the Fed compensate with easier money, to keep NGDP growing fast enough to avoid recession?  Partly because in the second half of 2000, inflation (GDP deflator) was running at 2.4%.  By mid 2002 the inflation rate was down to about 1.5% (again using the GDP deflator.)  Thus NGDP growth slowed even more than RGDP growth.  The Fed took a real shock and turned it into an even bigger nominal shock.  It would have been easier for the Fed to adopt an aggressively expansionary monetary policy in 2001 if they had not already been experiencing above target inflation in late 2000.

The same set of events played out during the housing boom.  Once again, inflation rose above target.  When housing slumped, it was inevitable that RGDP growth would also slow.  But the Fed made things worse by causing inflation to slow even more sharply, especially in 2008-09.  And the cause of their mistake is pretty clear.  Because inflation had been running above target during the housing boom, they felt they had less leeway to adopt a highly expansionary monetary policy in 2008.

You can say these were mistakes by the Fed, and I’d agree.  My point is that this sort of mistake is more likely to occur when NGDP growth and inflation have been excessive during the previous boom.  Right now, the Fed forecasts 3.1% growth in 2018.  They think this is temporary, due to factors such as the recent tax cut.  They forecast growth slowing to 2% in 2020 and 1.8% in 2021.  At the same time, inflation (GDP deflator) is currently running at 2.5%.  It seems likely that inflation will also slow somewhat over the next couple years.  Put these two claims together and it’s not hard to imagine NGDP growth slowing rather sharply by 2020.  Especially if there is a “mistake”.  And interest rate pegging is a regime tailor made to produce procyclical mistakes.

Under the Fed’s dual mandate, the Fed should run inflation below target during booms and above target during recessions.  They have historically done the opposite, and this procyclical policy continues to this very day.  Now that we are booming, inflation is finally edging above 2%.  That makes a recession more likely.

I’m still not forecasting a recession, partly because I believe that recessions are unforecastable, and partly because current policy does not seem far off course.  For any given one or two year period, the most likely outcome is continued growth.  My point is that an excessively fast NGDP growth rate right now would make a recession in 2020 more likely, not less likely.  Jay Powell has his work cut out for him.

PS.  I cited the GDP deflator even though the Fed targets PCE inflation, because the GDP deflator inflation rate and the RGDP growth add up to NGDP growth.

PPS.  If there is a recession in 2020, who will deserve the most blame?  Perhaps those who now say, “Gee, let’s use monetary policy to see how tight a labor market we can produce.”  No, let’s use monetary policy to keep NGDP growing at 4% from now until the end of time.

Which of these statements is true:

1.  Tight labor markets are almost always followed by recessions within a year or two (1966 was an exception).

2.  Inverted yield curves are almost always followed by recessions within a year or two (1966 was an exception.)

3.  The US has never experienced an expansion lasting more than 10 years.

Actually, all three are true.  And none of the three have any necessary implication for current monetary policy. (Over at Econlog, I explain why I believe labor markets are currently tight.)

Suppose we took the first statement seriously.  If the labor market is getting tight, then the Fed might want to tighten monetary policy to get the labor market less tight.  After all, tight labor markets are often followed by recessions.  In contrast, if the yield curve inverted, then the Fed might want to loosen policy to avoid a recession.  And if the expansion has lasted for 9 years, then the Fed might want to simply throw in the towel, as history tells us that there is nothing that can be done.  A recession is inevitable in the near future.

In fact, history is not destiny.  It’s quite possible this expansion lasts for more than 10 years.  It’s quite possible that (as in 1966) a tight labor market doesn’t lead to a recession.  And its quite possible that (as in 1966) an inverted yield curve is not followed by a recession.  Unfortunately, we responded to the inverted yield curve of 1966 with an easy money policy, which created something even worse than a mild recession—the Great Inflation (which itself led to more severe recessions later on.)

History is no guide when the Fed is trying to achieve something that it has never achieved in all of American history—a soft landing.  So why am I so naive as to think this time is different?  Because Trump is President!  (Just kidding.)  One reason is because other countries have recently achieved soft landings.  Examples include the UK in the early 2000s and of course Australia.  Furthermore, the history of American monetary policy can be seen as a series of mistakes, and each time the Fed learns a lesson.  The Fed no longer creates 10% deflation.  They no longer create 10% inflation.  Now they must learn to avoid severe recessions.  I see no reason why they can’t succeed in that endeavor—Australia has already done so.

Update:  Let’s define ‘soft landing’ as at least three more years of growth once the labor market has become tight.

Undoubtedly the US will still experience the occasional mild recession.  But we can, should, and probably will do much better than in the past.  Recall that in the 1970s, people like me who claimed the Fed could control inflation were viewed by the Very Serious People as being hopelessly naive and utopian.  The VSPs are always behind the curve on monetary policy.  They don’t understand monetary theory, and hence rely on “history”.  But history is a very poor guide when it comes to monetary policy.

And if you insist on going with “history”, then don’t tell me what the Fed needs to do to avoid the next recession.  History says a recession is inevitable, within 9 months.

Meanwhile the NGDP prediction market is up to 5.2% growth, and the number is rising.  I’ll go with the prediction market over “history”.

PS.  I increasingly believe the Fed has (perhaps subconsciously) absorbed the most important lesson in monetary policy:

PPS.  Trump in 2014:

We need a President who isn’t a laughing stock to the entire World.

The entire world today at the UN:

Ha ha ha ha ha ha ha . . .