Faulty, but dangerous, reasoning

From “Fed-watcher” Tim Duy:

The Federal Reserve believes the economy currently operates close to if not a little beyond full employment. The unemployment rate fell to 4.1% in October, well below the Fed’s longer run estimate and the 4.4% low of the last cycle. And note the broader U-6 unemployment rate, which includes measures of underemployment, fell to 7.9%, the low of the last cycle.

By these metrics, conditions are fast approaching those the late-90’s. I believe the economy will sustain enough momentum to hit that point within the next six months.

We do not have much experience with an economy operating near full employment. This sounds odd, but generally the Fed kills the economy soon after reaching that point. Moreover, we do not have much recent experience with a full employment, low inflation economy. The tops of the last two cycles were fairly short-lived. Beyond that, I think you need to look at the late 60’s for a similar dynamic.

The tricky part for the Fed will be managing the slowdown of activity. Policymakers have had limited success at holding the economy near full employment for a sustained period of time. The risk is that the Fed forgets about policy lags and believing that the economy is not slowing quickly enough, tightens too much. This sets the stage for recession in late 2019 or 2020. That would still leave this as a record-breaking expansion.

Conditions in the late 1990s and now

In the 1990s, unemployment and inflation went down together. Despite unemployment being below the natural rate in the last four years of the 1990s cycle, inflation fell further and remained low.

At present, despite a long period of falling unemployment, inflation remained low and stable. Only recently, unemployment fell below the natural rate but inflation remains dormant. If inflation didn´t rise even a little while unemployment was falling dramatically, why should it rise now that the unemployment rate has more or less stabilized?

Therefore, Duy´s statement that “We do not have much experience with an economy operating near full employment…. Moreover, we do not have much recent experience with a full employment, low inflation economy”, is clearly false.

He asks us to “look at the late 60’s for a similar dynamic”. His “drink must have been spiked” because there´s no “similar dynamic”. What we get is a falling rate of unemployment that goes below the natural rate, just as in the 1990s, but inflation “soars”.

More than anything, this last chart explains why Yellen, Fischer & friends, who “came of age” in the late 1960s (Yellen PhD 1971, Fischer, PhD 1969) are firm believers in the Phillips Curve. Therefore, to them, falling/low inflation in the face of low unemployment is a “mystery”.

If inflation is not rising, it must be because temporary or transitory factors are at play.

From Yellen:

“A pricing war among mobile phone service providers has led to falling prices for cellphone plans, and prescription drug prices have made what appears to be a one-time drop”.

Bank of Canada Stephen Poloz “agrees”:

“One-off factors such as electricity rebates in Ontario, as well as the combination of abundant crop supplies and increased retail competition that have held down food prices, account for about two-thirds of this year´s shortfall.”

Interestingly, when inflation was on the rise in the 1970s, Fed Chairman Arthur Burns blamed it on oil prices, worker unions and oligopolistic firms!

To central bankers, monetary policy is synonymous with interest rate policy.

If instead you gauge monetary policy by what´s happening to nominal spending (NGDP) growth, there´s no more “mystery”. Either for the rising/high inflation of the second half of the 1960s (which was “delayed” due to the time it took for inflation expectations to “adapt”) for the falling/stable inflation of the 1990s or the low/stable inflation in the present cycle.

Tim Duy is right when he says, “believing that the economy is not slowing quickly enough, [the Fed] tightens too much. This sets the stage for recession in late 2019 or 2020.”

To us, “tightening too much,” means allowing NGDP growth to fall from the already low level. This is a clear possibility because they are looking at the wrong metric: the unemployment rate.

Maybe because he´s a Bernanke/Yellen fan, Tim Duy ends with a spin “…That would still leave this as a record-breaking expansion.”

When the truth lies more in calling it “the longest depression”!

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