Fed has become tiresome

Regarding inflation, “temporary”, “transitory”, is the defining idea. Now, however, the Fed confesses that it´s understanding of inflation is imperfect.

…my colleagues and I currently think that this year’s low inflation is probably temporary, so we continue to anticipate that inflation is likely to stabilize around 2 percent over the next few years. But our understanding of the forces driving inflation is imperfect, and we recognize that something more persistent may be responsible for the current undershooting of our longer-run objective. Accordingly, we will monitor incoming data closely and stand ready to modify our views based on what we learn.

They could learn by looking at some simple charts.

The first suggests that their labor market slack or Phillips Curve view of inflation is misplaced.

Inflation can come down together with unemployment, unemployment can move up and down with inflation remaining flat, unemployment can rise a lot while inflation falls only a little. Finally, unemployment can tumble while inflation remains flat & low.

The second shows how unemployment is linked to nominal spending (NGDP) growth

Stable NGDP growth (at whatever positive level) is consistent with falling unemployment, just like a fall in NGDP growth, in the limit negative NGDP growth, is consistent with a rise in unemployment. The deeper the fall in NGDP growth, the stronger the rise in unemployment.

That´s a fixture of sticky wages.  With sticky wages, a fall in NGDP growth raises the Wage/NGDP ratio, thus raising unemployment. With NGDP growth stabilizing, the Wage/NGDP ratio comes down and so does unemployment.

Lesson for the Fed: By keeping NGDP growth stable, the Fed simultaneously keeps both inflation and unemployment low. Inflation is somewhat “excessively low” because NGDP growth is stable at an excessively low level (see second chart above).

The Fed, however, hasn´t learned the lesson. It keeps faulting “too low inflation” on “special (and temporary) factors”. In addition to the gyrations in oil, food and import prices, it recently faulted telecommunications and drug prices. That´s reminiscent of Arthur Burns, who in the 70s faulted “too high inflation” on, you guessed, oil, food, labor unions and oligopolies.

With many Fed officials convinced that the soft inflation numbers are transitory, even a weak employment report for September will not sway their desire to hike rates in December, especially if they can label it “transitory”, in this case due to the hurricanes.

The damage the Fed has been perpetrating over the past 11 years is depicted in the chart showing the ten-year average of per capita real output going back to 1880. For the 125 years from 1880 to 2005, the average was 2.2%. Since 2006, it has dropped to 1.1% and is going lower. With worries about an “overheating economy”, even an already hot one, the Fed is set in “deep-freezing” it.

With all this, talk of recession has increased. As Paul Samuelson once said, “economists have predicted nine of the past five recessions”. One of the most popular “recession predictors” is the inversion of the yield curve (10-yr-FF). However, there´s no “fail-safe” indicator/predictor. I would add that with the economy in “depression mode”, no known indicator/predictor will work.

There is, however, one fail-safe indicator in plain view and under the close control of the Fed. That is our indicator of the stance of monetary policy, to wit, the growth rate of nominal spending, or NGDP.

The panel below gives important information.

  • In the post war period, business cycles became much less daunting. From 1984, they became even less so.
  • The depth of recessions closely mirrors the strength of NGDP growth retrenchments. The Great Depression is the classic example. Even in cases where the driver of the recession was a negative supply shock (think oil prices in the 1970s) reduced NGDP growth magnified the recession.
  • The present cycle differs from other post war cycles in that NGDP growth turned significantly negative, giving rise to the deepest recession of the period.

The Economics Group at Wells Fargo published in September a research paper titled: Do We Need to Wait for a Yield Curve Inversion to Predict a Recession? No.

Briefly, the study indicates that, particularly in a low interest rate and inflation environment, the yield curve does not have to invert. All you need is that the FF rate touches/crosses the lowest level of the 10-yr Note in that tightening cycle, which began in December 2015.

The chart indicates that in this cycle, the minimum of the 10-yr note was 1.5%. With the FF rate now at 1.25%, one more hike and the “trigger” will be pulled. According to the study, this framework has predicted all recessions since 1955 with an average lead-time of 17 months.

Maybe. But the failure of recession predictions gives us pause. We are not only in a low interest rate inflation environment, but also in a “depression” environment, and this may change “conclusions”.

The next chart indicates that a recession takes place when NGDP growth falls “significantly” below its average, like in 1990-91. During this expansion, NGDP growth has averaged 3.8%. At this time, NGDP growth is “on average”. We´ll likely get a recession if NGDP growth drops below 2%.

The Fed is trying hard to get us there.


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