The Fed´s unending search for “ammunition”

From Brad DeLong, who doesn´t think the economy is “solid”:

Economic developments over the past 20 years have taught – or ought to have taught – the US Federal Reserve four lessons. Yet the Fed’s current policy posture raises the question of whether it has internalized any of them.

The first lesson is that, at least as long as the current interest-rate configuration is sustained, the proper inflation target for the Fed should be 4% per year, rather than 2%. A higher target is essential in order to have enough room to make the cuts in short-term safe nominal interest rates of five percentage points or more that are usually called for to cushion the effects of a recession when it hits the economy.

If he thinks a higher inflation target is the way to go, he believes monetary policy can be much more expansionary.

Now from a FOMC voting member – Richmond Fed president Barkin – who thinks the economy is “solid” and the labor market is “strong” & “tight”:

In short, the labor market is really tight. And we all were taught that when the labor market is tight, companies raise wages. To date, however, wage growth has been modest.

Let’s turn to inflation. We’re coming off a fairly long stretch where inflation ran below the Fed’s 2 percent target. The numbers have firmed around our target in recent months, but it’s reasonable to ask why we’re not seeing more inflation, given not only the tightness of the labor market, but also commodity cost pressure in places like pulp, steel and oil.

…Given these challenges, I’m concerned about monetary and fiscal policymakers’ capabilities to provide an effective backstop in the next recession. But stronger underlying growth would address this concern. Stronger growth would allow the FOMC to raise rates higher without constraining the economy, giving us more ammunition when we need it.

The fact´s support neither DeLong nor Barkin.

One wants the nonstarter increase in the inflation target in order to accumulate “ammunition.” The other “hopes” growth will rise, “filling the ammunitions box”!

The real story behind the Fed´s travails shows where the “ammunition” is hidden.

The panel below concentrates on real output growth (RGDP), when that growth surpassed the recent “strong” 2018 Q2 2.8% growth YoY.

After the 2001 recession, RGDP growth weakens. That is the result of the succession of oil shocks during the period. According to the dynamic AS-AD model, a negative supply (real) shock reduces real growth and increases inflation.

The inflation part appears later. Going forward in the picture above, note that following the “Great Recession”, real growth seldom rises above the 2.8% “benchmark”. Observe also, that during the significant oil price drop (a positive supply shock), real growth “blossoms”, subsiding again when the shock dissipates.

The next chart depicts inflation (core PCE), for instances when it rises above the 2% target.

During the period of persistent oil shocks, core inflation rises, as predicted by the dynamic AS-AD model.

What should the Fed do in those situations? If it tightens monetary policy, it will contain inflation variability, but increase RGDP growth volatility. That being so, it should keep monetary policy (understood as NGDP growth) stable. As shown later, the Fed, “afraid” of inflation, tightened policy.

Observe that during the period the price of oil falls, inflation remains below target. In fact, it falls farther below target, reaching 1.2%.

The next chart shows the behavior of monetary policy (NGDP growth).

Note that after taking over at the Fed in January 2006, Bernanke tightened monetary policy, with NGDP growth falling significantly. As seen in the first chart, RGDP growth tumbles, falling to just 1.1% before tanking when the monetary screws tightened further going into the recession.

Also, note that during the quarters the price of oil drops, NGDP growth rises above the average for the post-recession period. That was sufficient to increase real growth somewhat, with inflation remaining down.

The fact is that the “ammunition” is “hidden” just below the Fed´s fingertips! To get the economy moving again, with adequate RGDP growth and close to target inflation, the Fed has to give up on the idea that monetary policy is synonymous with interest rate policy and that inflation targeting is the world´s eight wonder and define a target level for NGDP and its growth rate.

PS If you do not believe me, believe Larry Summers:

“If I had to choose one framework today, I would choose a nominal GDP target of 5 to 6 percent. And I would make that choice for two reasons. First, it would attenuate the issues around explicitly announcing a higher inflation target, which I think are a little bit problematic on political economy grounds.

Second, a nominal GDP target has an additional advantage in its implicit response to changing conditions. Arithmetically a nominal GDP target has the property that the expected rate of inflation rises as the expected real growth in GDP declines. This is desirable. If growth in underlying real GDP declines, neutral real interest rates are likely to decline as well. In this case allowing higher inflation to make possible even more negative real rates reduces the risk of policy impotence.”


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