The Money Illusion is back!

Good news — there’s bad news.

The Money Illusion got off to a good start in early 2009. All I had to do is to point to the obvious fact that monetary policy was far off course.

By the mid-2010s, things got boring. I was beating a dead horse.

By the late 2010s, TMI hit rock bottom. Monetary policy became quite reasonable and I pivoted to moronic Trump bashing.

Now I’m back. Even better, I get to play a different role, a scarier bird.

It wasn’t until September 2008 that it dawned on me that monetary policy was clearly too contractionary, even though in retrospect policy had been too contractionary for several months. I assumed the Fed had an effective regime in place. It didn’t.

It wasn’t until late 2021 that it became clear to me that monetary policy was too expansionary, even though in retrospect policy had been too expansionary since mid-2021. I assumed the Fed had an effective regime in place. It didn’t.

[Memo to myself: Don’t assume the Fed has an effective regime in place.]

After FAIT was announced in August 2020, I made a forecast. Here’s the entire post:

The (PCE) price level will be 135.207 in January 2030

Or at least it better be.

Powell says there’s no strict mathematical formula; but it’s pretty obvious to me that the markets and pundits are going to hold the Fed accountable. People think in terms of decades, and this policy was announced in 2020. Thus markets will naturally see this a commitment for inflation to average 2% over the 2020s. Since the PCE price level was 110.917 in January of this year, it needs to be close to 135 in January 2030. A slight miss would not be a problem, but a big miss (say average inflation outside the 1.8% to 2.2% range) would be seen as a policy failure. The Fed would lose credibility.

I also have a post on the speech over at Econlog.

At the time, inflation had been running well below 2% since January. The 10-year TIPS spread was 1.72%, implying about 1.47%/year PCE inflation. Put the two together and the market was expecting the price level to be almost 6% too low at the end of the decade.

At that point I wasn’t too concerned, as I figured that Covid might be distorting markets. But many commenters complained that the Fed’s policy clearly had no credibility, and that they would obviously fail to raise average inflation up to 2%. Little did they know.

In April 2021, the PCE first moved above the 2% trend line from January 2020. The 10-year TIPS spread was 2.33%, implying 2.08% PCE inflation. Everything looked fine. Powell’s policy had worked.

But as I’ve pointed out in previous posts, all macroeconomic policies eventually fail. All of them. Nonetheless, this one failed sooner and more spectacularly than I anticipated.

We are two years down the road and can no longer use 10-year TIPS spreads. The 5-year TIPS spread is 3.48%, implying 3.23% PCE inflation. The 5-year, 5-year forward spread is 2.24%, implying 1.99% PCE inflation for those last three years of the 2020s. So the TIPS markets are expecting an extra 6.1% inflation (all in the next 5 years). But it’s even worse. The actual PCE is already 3.5% above the trend line from January 2020. Thus markets are expecting an extra 9.6% inflation over the 2020s, almost 1%/year. That would represent a major failure of FAIT.

[This is why we need level targeting. Think how much the point estimate of the PCE on January 2030 has changed over the past 18 months—from almost 6% below target to 9.6% above. That’s crazy. And it’s in 2030, so presumably it has nothing to do with Covid or supply bottlenecks]

In retrospect, I paid too much attention to Fed promises to target the average inflation rate. This January, Powell basically admitted that he had abandoned the FAIT policy, when he denied that a period of above 2% inflation needed to be offset by below 2% inflation in future years. Smarter observers like Bob Hetzel focused on how the language used by Fed officials echoed statements made in the 1960s and 1970s, when they also tried to “run the economy hot” to create jobs. (Kudos to Larry Summers and Tim Congdon as well.) I thought that happy talk was empty rhetoric to please the administration. I thought FAIT would be maintained. I was wrong.

The abandonment of FAIT will make the Fed’s job much harder, dramatically increasing the risk of recession. Because this policy was abandoned, inflation expectations have driven NGDP growth much higher in recent months than if markets had anticipated that the Fed would tighten enough to keep long run inflation at 2%. (Think of a loss of credibility as boosting velocity, if you wish.) Because the economy got so hot, it will take a much more contractionary policy than otherwise to bring it back down. It’s not about interest rates, it’s about the policy regime.

Here’s what I said last July, before I understood that the Fed had abandoned FAIT:

I don’t expect a recession to occur in the next few years, but recessions are almost impossible to predict. It’s more interesting to think about the sort of policy mistakes (were they to occur) that might lead to a recession within a few years.

One mistake would be an excessively tight money policy, which could trigger a recession in 2022 or 2023. That’s possible, but seems quite unlikely at the moment.

A slightly more likely scenario would involve excessively expansionary monetary policy, which drove wage growth to levels inconsistent with 2% inflation over the long run. To get the inflation rate back on target the Fed would then need a tight money policy, which might trigger a recession. . . .

Almost no one wants a recession in 2024. If we get one, it will be due to the misguided policies of people trying to help workers. They would overstimulate, and by 2023 the Fed would be forced to tighten to restore inflation credibility. I don’t think that’s the most likely case; rather it’s the most likely cause of a near-term recession should a recession occur.

Powell will need the skill of that airline pilot who landed the plane in the Hudson River to engineer a soft landing.



An NGDP targeting boomlet?

With all of the recent supply shocks, it’s increasingly obvious that inflation is the wrong target. Today I came across two articles advocating NGDP targeting. Ramesh Ponnuru has a piece in Bloomberg and Norbert Michel has a piece in Forbes.

In a recent article, Larry Summers links to this frightening graph showing soaring nominal wage growth:

He’s right, the Fed’s recent mistakes make a recession more likely.

There’s been a lot of discussion of inverted yield curves. Yield curve inversion implies a market forecast of lower future nominal interest rates. It can occur from expectations of slower real growth, slower inflation, as well as a number of other factors. The simplest model is to assume that yield curve inversion predicts slower NGDP growth.

On some occasions, such as 1966, 1981, and today, you would like to see substantially slower NGDP growth, even at the risk of recession. In other cases, a sharp slowdown in NGDP is undesirable, and a sign that monetary policy is too contractionary.

NGDP growth was over 11% over the past year, and will continue at well above trend for at least a few more quarters. I’d like to see NGDP growth fall below 4% in 2023, but not sharply below 4%. That’s much harder to do when the Fed has no credibility, Unfortunately, their recent abandonment of FAIT has cost them a lot of credibility.

It’s like the farmer said to the lost motorist, “First of all, I wouldn’t start from here.”

What Powell should say about wages

This Bloomberg headline caught my eye:

Powell Treads Tricky Path in Saying Wages Are Rising Too Fast

He’s right. Here’s how Powell should frame the issue:

1. Rapid real wage growth is good; it leads to higher living standards for average Americans.

2. Rapid nominal wage growth (relative to productivity growth) is bad, it generally implies high inflation.

3. The best way to promote higher real wages is through economic reforms that boost productivity.

Given our rate of productivity growth, the Fed needs to get nominal wage growth down to no more than 3%.

PS. Check out this FT headline:

Jay Powell channels his inner Paul Volcker with tough stance on US inflation

Tough? Did Volcker end the Great Inflation by raising interest rates from 0% to 0.25%?

Off topic, how about this FT headline and subhead:

Why I should have listened to Garry Kasparov about Putin

The chess grandmaster was dismissed when he warned about Russia. But he was right

Over the past decade, I’ve also noticed a lot of westerners in denial about Putin. Some even seem to idolize him.

Former US president Donald Trump posited that Russian president Vladimir Putin’s decision to invade Ukraine was driven by a desire to recreate the Soviet Union in which there was “a lot of love”.

So the war is Putin’s valentine to the Ukrainian people?

But he’ll appoint good people . . .

By “good people”, do you mean fascists?

I warned about him two years ago. (And read the comment section to that post.)

PS. He’s also an antisemite.

PPS. You want me to comment on the Fed? That’s what Econlog is for.

Taking the gloves off

Putin must be proud of the way that Trump is no longer making any attempt to hide his love of authoritarianism:

Bye bye civil service system. And don’t forget to purge all the state election certification officials. Especially that guy in Georgia who refused to come up with the extra 10,000 votes that Trump demanded.

And what impeccable timing for Trump. Propose abolishing civil service protections right as Putin is purging his government of the “deep state”, aka “people who oppose his insane policies”.

Meanwhile the president’s son is spreading Putin’s propaganda:

“It’s not a “war,” it’s a much needed cleansing,” wrote a member of a Telegram group called “Patriot Voices” that is popular with supporters of Trump. “Ukraine has a ton of US govt funded BioWeapons Labs that created deathly pathogens and viruses.”

Television pundits and high-profile political figures have helped spread the claim even further. Fox News host Tucker Carlson devoted segments on his shows on Wednesday and Thursday to promoting the conspiracy theory. On Wednesday, Donald Trump Jr. said conspiracy theories around the labs were proven to be a “fact” in a tweet to his 7.3 million followers.

Can’t wait until Trump’s “much needed cleansing” of the US in 2025. Should be fun.

Francis Fukuyama is more optimistic:

The invasion has already done huge damage to populists all over the world, who prior to the attack uniformly expressed sympathy for Putin. That includes Matteo Salvini, Jair Bolsonaro, Éric Zemmour, Marine Le Pen, Viktor Orbán, and of course Donald Trump. The politics of the war has exposed their openly authoritarian leanings.

Really? Who’s the current leader in the race for the 2024 GOP presidential nomination? Perhaps Americans actually favor an authoritarian leader. Not most Americans, just the minority necessary to elect Trump in our “democratic” system of government.

[BTW, I’ve criticized many of those authoritarians in my blog, along with jerks like Putin and Tucker Carlson. I’ve said Germany should not have shut down its nukes. I’ve said Russia was a bigger threat to world peace than China. I’ve favored a carbon tax. Dare I say, “I told you so”?]

And speaking of Tucker:

And people say that I’m a CCP stooge.

I’m starting to think that calling the US a banana republic is an insult to Honduras.