UK monetary policy is too tight: easing required

Not quite the line you will see across most of the market or amongst so-called monetarist economists. In fact, implied by actual nominal growth and expectations for nominal growth monetary policy is too tight. Nominal GDP growth is running at 3.7% YoY and falling, while the best measure of inflation around, the implied GDP deflator is running just below 2%.

The screaming about the headline inflation rate derived from today’s CPI of 3% are totally missing the point. Consumer price inflation is not controllable by the central bank. It is a mere partial view of inflation, for consumers only and not well calculated, as it persistently misses quality or hedonic changes in purchasing patterns.

Central banks can only control Aggregate Demand, the sum of real growth and inflation, or nominal growth. With so many prices indexed to CPI and some insanely still indexed to the old, discredited, RPI (that runs around 0.5%-1.0% higher than the CPI) damaging rigidities and imbalances in the UK economy are inevitable.

While recent nominal growth has been decelerating, it could reasonably be expected to decelerate further as the uncertainty over the actual Brexit rises. Mark Carney pointed this out today and GBP rightly fell. The recovery in GBP recently has been very concerning for us as it indicated tightening monetary policy at the wrong time. Even better news is that the two new members of the MPC agree with Carney, and the foolish hawks now seem less powerful.

Amongst the hawks we know just how idiotic Ian McCafferty has been in the past, consistently calling for rate hikes whatever the economic reality, always fearing inflation around the corner. He´s the Esther George analog at the BoE.

Recent appointee Michael Saunders is a huge disappointment given his supposedly market background. One more example of finance people misunderstanding monetary policy.

Most disappointing of all has been the hawkish stance of the new’ish chief Economist Andy Haldane. Even if in September he did not vote for a rate rise, he caused massive anxiety when he broke with his boss in the 5-3 vote for no change in June. He is a Bank of England man and boy, has often showed some independent thinking about bank regulation and suchlike, but he seems a very old school believer in Phillips Curve nonsense when it comes to monetary policy.

At one point, Andy Haldane was considered a candidate to replace Mark Carney as Governor, not anymore. WeI hope that the former chief Economist of the Treasury and new MPC member, Dave Ramsden, will get the job. He is a government insider and knows the value of nominal growth. The formal answers to Parliament on his appointment to the MPC show a very healthy regard for the central importance of aggregate demand.

When Martin (Feldstein) Nailed His Theses On the Door Of the Federal Reserve—2009

When the famed Harvard macroeconomist Martin Feldstein nailed his theses to the door of the Federal Reserve on April 19, 2009, the great monetary theologian tellingly entitled his missive, Inflation is Looming On America’s Horizon.”

Feldstein foretold of a dark future. The “outlook for the longer term is more ominous. The unprecedented explosion of the U.S. fiscal deficit raises the specter of high future inflation.”

The federal H-bomb of red ink was nearly catastrophic on its own, warned Feldstein, but was being amplified by a floodtide of wanton Federal Reserve money-printing. “The link between fiscal deficits and money growth is about to be exacerbated by ‘quantitative easing,’ in which the Fed will buy long-dated government bonds.”

Feldstein hinted it was time to short bonds, and concluded, “It is surprising that the long-term interest rates do not yet reflect the resulting risk of future inflation.” At the time of his prognosticating, 10-year U.S. Treasuries offered a 4.97% yield.

Let us hope for the Feldstein family that Martin left the investing to someone else. The same 10-year Treasuries offer a 2.28% yield today.

In fact, as the always-perspicacious Kevin Erdmann of Idiosyncratic Whisk just pointed out, the CPI core sans housing was up 0.6% year-over-year in September, which is the lowest level for that metric in more than 50 years. The Fed’s preferred measure of inflation, the PCE core, is up 1.4% on 12 months at latest read.

Sadly, as chronicled by David Glasner’s Uneasy Money, Feldstein doubled and tripled-down on his view between 2008 and present, nailing more and more theses on the Fed’s door with every passing year.


As exemplified by Feldstein, the orthodox macroeconomics profession appears adrift, and worse, unwilling to reconcile observations with theory.

The least popular topic in conventional macroeconomics today is Japan, where the Bank of Japan has bought back 45% of the nation’s huge national debt; where the BoJ holds interest rates at 0% on 10-year government bonds; where the Bank of Japan charges negative interest on reserves; where government (like the U.S.) cannot balance the national budget; but (unlike the U.S.) where there are more job openings and than job seekers—and where inflation can’t reach 1%.


Obviously, what is “loose” or “tight” monetary policy needs to fully redefined, and what QE actually does need a solid rethink.

In the meantime, the counsel of Market Monetarists is probably the best. A central bank should aggressively and publicly pursue monetary policy so that nominal GDP rises to a higher trend level and then grows at a desired rate, perhaps a band between 4% and 5% annually. “Failure” would be falling below or above the band for more than a few months.

It is true that every developed nation has structural impediments that impede economic growth, and it is true those hurdles to growth should be lowered. It is sadly also true that Western democracies are largely incapable of doing so. For central banks to toss the growth ball into the lawmakers’ court is an abdication of responsibility.

The monetary theologians, such as Feldstein, have and would suffocate the economy in pursuit of their faiths. A better approach for a central bank is responsibly encourage growth with the economy and structural impediments we have.

PS. Apologies to our excellent Lutheran friends. Of course, it was Martin Luther who nailed his 95 theses on the door of the Castle Church in 1517, primarily to condemn the sale of indulgences.

Bernanke proposes a “temporary back-up” to inflation targeting

Bernanke has presented a paper at Brookings titled “Temporary price-level targeting: An alternative framework for monetary policy”:

Low nominal interest rates, low inflation, and slow economic growth pose challenges to central bankers. In particular, with estimates of the long-run equilibrium level of the real interest rate quite low, the next recession may occur at a time when the Fed has little room to cut short-term rates.

As I have written previously and recent research has explored, problems associated with the zero-lower bound (ZLB) on interest rates could be severe and enduring. While the Fed has other useful policies in its toolkit such as quantitative easing and forward guidance, I am not confident that the current monetary toolbox would prove sufficient to address a sharp downturn.

I am therefore sympathetic to the view of San Francisco Fed President John Williams and others that we should be thinking now about adjusting the framework in which monetary policy is conducted, to provide more policy “space” in the future. In a paper presented at the Peterson Institute for International Economics, I propose an option for an alternative monetary framework that I call a temporary price-level target—temporary, because it would apply only at times when short-term interest rates are at or very near zero.

After discussing and dismissing a higher Inflation Target and a permanent Price Level Target, Bernanke asks:

Is there a compromise approach? One possibility is to apply a price-level target and the associated “lower-for-longer” principle only to periods around ZLB episodes, retaining the inflation-targeting framework and the current 2 percent target at other times. 

The choice of a temporary alternative framework indicates, I believe, the level of attachment (addiction?) Bernanke has with the inflation-targeting framework.

The inflation target (IT) framework for monetary policy was first introduced in New Zealand, in 1990, quickly followed by Canada in 1991 and the UK in 1992, spreading out after that to several countries.

In all those countries, inflation had been on the high side, and the framework worked by “coordinating expectations”.

By the late 1990s, however, academics and policymakers began discussing “The conduct of monetary policy in a low inflation environment”. The first conclusion that should have been reached was “ditch IT”. Obviously, given the extended discussion, IT was not robust.

The worry was always about the danger of interest rates reaching the ZLB!

There is, however, a full-proof way of avoiding the ZLB while at the same time keeping inflation stable (in addition to stabilizing real output growth). That way is adopting an NGDP Level target.

I tell the story through a set of pictures.

In the first picture note several things.

First, the FF rate is a very poor indicator of the stance of monetary policy. It´s more like Friedman said: rising/high rates are a sign that monetary policy has been easy. Falling/low rates a sign that monetary policy has been tight.

Second, a rising trend for NGDP growth goes along with rising inflation and a falling trend of NGDP growth with falling inflation. A stable NGDP growth results, once the adjustment is complete, in low and stable inflation!

Three, in more than 60-year history, the ZLB happened once, in 2008. That´s because NGDP growth tumbled strongly into negative territory.

Four, when Greenspan made a mistake in early 2000s, letting NGDP growth fall significantly below trend, the FF rate went down to 1%. When he reversed the mistake and positioned NGDP back on trend, the FF rate went up.

Five, while the Fed is surprised that inflation has remained low despite the rate of unemployment having more than halved since 2010, they are also surprised that inflation didn´t fall significantly when unemployment more than doubled in 2008-10. What that indicates is that should give up on their Phillips Curve model of inflation. Unfortunately, they resist bravely!

Six, Inflation remains stable as long as NGDP growth is also stable, even if at a lower level than previously. The point here is that inflation has been low and stable for a quarter century. In other words, the Fed has unwavering credibility that inflation will remain low.

Seven, if you want to get the FF rate up and away from the ZLB, increase the rate of NGDP growth. Better, why not establish an NGDP growth (level) target? Much more reasonable than having a PLT in your “pocket” for temporary use when things go bad, as they do when you let NGDP fall way below trend.

The next pictures illustrate with levels of NGDP and RGDP. What gets impacted when the Fed is either excessively expansionary or contractionary, i.e. lets NGDP rise above or fall below trend, is real output.

And when things go terribly wrong, the effect is daunting.

What should the Fed do? By announcing a higher level target for NGDP, it will signal that NGDP growth will increase in the near term to reach the target. Will inflation rise “too much”? Probably not, just as it didn´t fall too much when NGDP tanked.

It will be wonderful to watch the “surprised faces” of many when they see RGDP growth picking up above the now thought low “potential” growth.

Once the target NGDP level is reached, keep it growing at a stable rate. Maybe something around 4%-4.5% will do the trick, keeping inflation low and stable and RGDP growth also stable.

No more “challenges imposed by low nominal interest rates, low inflation, and slow economic growth.”

With that, the NGDP level target as the framework of monetary policy will be explicit, not just implicit as during the Greenspan years. We´ll then stop confusing monetary policy with interest rate policy and will stop talking about inflation, especially given that inflation obsession was the proximate cause of the “Great Mistake” of 2008, and has been keeping the economy in the doldrums since.

The biggest advantage of an explicit level target for NGDP is that demand shocks are minimized (even eliminated) and the propagation of supply shocks are contained, something that troubles price level or inflation targeting.

Low wage growth is no mystery

The Fed wants to see wage growth pick up on the heels of a low unemployment rate so that inflation rises towards 2%.

That´s twisted logic, but never mind. The chart below, depicting a “wage Phillips Curve”, indicates that at low unemployment rates (unemployment below 6%, say), there´s a wide range of wage growth rates.

If the Fed favored a monetary model of inflation, instead of relying on the Phillips Curve/Slack framework, it would immediately understand why wage growth is low despite the low unemployment rate.

The chart below shows that nominal spending (NGDP) growth during this expansion is significantly lower than previously. Unemployment will drop as the wage/NGDP ratio falls, but wage growth will be subdued as long as NGDP growth is low.

The myth of “low inflation” debunked

Yellen and the Fed seem surprised that inflation remains below target even with unemployment at historically low levels.

With that view coming from the Fed we get pieces with “novel” titles such as

Even absurdly titled papers as one recently presented by former Board Member Tarullo:

The list is almost endless…

Why is that a concern today? Why wasn´t it a concern in the eleven years from 1994 to 2005.

In the eleven years from 1994 to 2005, PCE Core inflation averaged 1.8% annualized. Over the past 11 years from 2006 to 2017, the average has been 1.7%! What a difference one basis point makes.

One explanation that jumps out is that now the Fed has an explicit 2% inflation target. Before it was just “low and stable inflation”.

The Fed´s obsession with “price stability” is dangerous. James Meade said it explicitly is his Nobel Lecture 40 years ago:

Earlier I spoke of ‘price stability’ as being one of the components of ‘internal balance’. Yet in the outline which I have just given of a possible distribution of responsibilities no one is directly responsible for price stability.

To make price stability itself the objective of demand management would be very dangerousIf there were an upward pressure on prices because the prices of imports had risen or because indirect taxes had been raised, the maintenance of price stability would require an offsetting absolute reduction in domestic money wage costs; and who knows what levels of depression and unemployment it might be necessary consciously to engineer in order to achieve such a result?

He proposed instead that the Fed pursue nominal (NGDP) growth stability:

I have told this particular story simply to make the point that the choice between fiscal action and monetary action must often depend upon basic policy issues, which should certainly be the responsibility of the government rather than of any independent monetary authority.

Perhaps the best compromise is an independent monetary authority charged so to manage the money supply and the market rate of interest as to maintain the growth of total money income on its 5-per-cent-per-annum target path, after taking into account whatever fiscal policies the government may adopt.

The charts below provide compelling evidence for the pursuit of nominal stability by the Fed, with one proviso: it has to be a stable LEVEL path at an adequate level.

The charts are constructed to give a visual idea of the volatility of the different aggregates. The horizontal axis shows growth (quarter-on quarter) in quarter t, while the vertical axis shows growth in quarter (t+1).

During the so-called Great Moderation period, NGDP growth stability resulted in both RGDP growth stability and inflation stability. Note that inflation keeps falling until the economy adjusts to the stable level path of NGDP growth.

The importance of the “level” requirement becomes clear from looking at what has happened in the last seven years, after the crisis abated.

Nominal stability is once again the norm. NGDP growth (and RGDP growth) are even more stable than during the Great Moderation (their volatility is contained within a smaller circle).  Notice, however, that the trend level and trend growth rate of both NGDP and RGDP are significantly lower at present.

Average inflation has been a bit below the 2% target for the past 23 years, both when it was implicit and after it became explicit. That´s a fixture of nominal stability. What the Fed got wrong in 2008 was to lose that stability and then not engineering an economic recovery to put the economy back on (or near to) the previous trend level.

Inflation will be low and stable if NGDP growth is stable. Real growth will be the “victim” of too low NGDP growth. Just as the “Great Moderation” was the outcome of “appropriate monetary policy”, the “Long Depression” is the outcome of “misguided monetary policy”.

Endnote: Take a peek at what a “Long Depression” looks like and how it´s brought about.

The Fed Is Shrinking Its Balance Sheet—But Why?

The worldwide bond market tops $100 trillion, and we live in a world (as we are incessantly told) of global capital markets.  All told, there is more than $217 trillion in global debt outstanding, and that figure rises by many trillions every year, reports the Institute of International Finance.

The U.S. Federal Reserve, as widely reported, plans to start reducing its balance $4.5 trillion sheet, often described as massive or even “yuge.”

But it turns out due to rising piles of U.S. paper cash in circulation, there is not that much bond-selling the Fed can do. Indeed, as noted by former Fed chair Ben Bernanke, the Fed will soon have to keep a bare minimum of $2.5 trillion on the balance sheet just to accommodate paper cash in circulation.

So, that being the case, the Fed might be able unload $2 trillion or less over the next few years into a global debt market that tops $200 trillion.

And this Fed sale of bonds will accomplish what? Are there reasonable prospects the Fed bond sale will alter the global interest rate picture in one way or another?

One Concrete Result

There will be one concrete result: U.S. taxpayers will lose, as they will have to make up for the interest lost on the Fed bond hoard. The Fed now collects interest on its bonds, and largely shuffles that earned interest through to the U.S. Treasury. Ceteris paribus, a tax reduction for taxpayers.

Perhaps the better question is, “Why not add to the Fed bond portfolio?”

If one grants that the Fed is really part of the U.S. government, then the Fed buying of bonds unburdens U.S. taxpayers in terms of principle owned, and the interest earned can offset taxes.

As for inflation, the Bank of Japan owns about 45% of Japanese government bonds now, amount that rises near daily, and the Nippon disease is still borderline deflation, despite an official unemployment rate of 2.8%.

So, other than orthodoxy and convention, why not a larger Fed balance sheet?


One recent writer for Forbes posits that if the Fed begins to unwind the balance sheet, but is forced to stop due to negative market consequences, then “that has huge inflationary consequences.”

This may be a cousin idea to market monetarist David Beckworth’s idea that the Fed from the get go should have identified QE as permanent (and skipped interest on excess reserves, but that is yet another conversation).

These are interesting ideas, Beckworth’s certainly.

But here we are now, the Fed has a “large” balance sheet (though relatively smaller than the European Central Bank’s or the Bank of Japan’s) and inflation is below target.

In daily commerce, prices are set by supply and demand. Global and U.S. demand has been rising sluggishly, and many products are produced globally. How would manufacturers of smart-phones or automobiles charge more if the Fed stood still on its portfolio of bonds?

The Bank of Japan has never indicated it will ever sell its hoard of JGBs, and Japan is a long way from breaking out of deflation. Are the rules of macroeconomics different in Japan?


The Fed appears compelled by orthodoxy to sell off a couple trillion in bonds, even though its preferred measure of inflation, the core PCE, is running at 1.3% YOY in August, well below the Fed’s putative “average” target rate of 2.0%.

Moreover, a large component of measured inflation is coming from U.S. housing markets in which demand is not the problem, but supply.  The core CPI minus shelter index is up 0.88% YOY. In fact, core CPI minus shelter is at a lower rate now than any year since 1968—that is a far back as the FRED graph goes. A 50-year low-water market for inflation.

Yet the Fed insists on raising rates and selling bonds.

President Trump is correct to seek new leadership at the Fed.

By embracing the wrong framework, the Fed has difficulty understanding low inflation

Low inflation has bothered the Fed no end. Two years ago, Yellen “crunched” inflation in a speech titled Inflation Dynamics and Monetary Policy. She concludes:

I expect that inflation will return to 2 percent over the next few years as the temporary factors that are currently weighing on inflation wane, provided that economic growth continues to be strong enough to complete the return to maximum employment and long-run inflation expectations remain well anchored.

Most FOMC participants, including myself, currently anticipate that achieving these conditions will likely entail an initial increase in the federal funds rate later this year, followed by a gradual pace of tightening thereafter. But if the economy surprises us, our judgments about appropriate monetary policy will change.

Last week she discussed inflation again in Inflation, Uncertainty, and Monetary Policy. She´s still a “believer”, although it shows some “cracks”:

Based on analyses of this sort, 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.


To conclude, standard empirical analyses support the FOMC’s outlook that, with gradual adjustments in monetary policy, inflation will stabilize at around the FOMC’s 2 percent objective over the next few years, accompanied by some further strengthening in labor market conditions.

Neel Kashkari, reacting, has introduced “position papers” in the FOMC, writing My take on inflation:

Members of the Federal Open Market Committee (FOMC) are trying to understand why inflation and wage growth are low, despite the headline unemployment rate having fallen from a peak of 10 percent during the Great Recession to 4.4 percent today.

We would have expected a strong job market to lead to stronger wage growth and then higher inflation as businesses passed their increased costs on to customers. Yet that hasn’t happened.

He also writes:

I believe the most likely causes of persistently low inflation are additional domestic labor market slack and falling inflation expectations. This essay will explore the causes of the latter, falling inflation expectations, and I will argue that the FOMC’s policy to remove monetary accommodation over the past few years is likely an important factor driving inflation expectations lower.

While Yellen believes “gradual adjustments should continue”, Kashkari believes the policy to “remove accommodation” is to blame for the fall in inflation expectations.

As Kashkari shows, at least some measures of inflation expectations have fallen since the Fed began to signal a reduction in monetary accommodation three years ago.

Kashkari does not subscribe to the temporary/transitory view of low inflation, even though he embraces the same Phillips Curve/Cost/Gap framework as Yellen and much of the FOMC. The framework, however, is wrong and misleading.

These are the two ‘strands’ to the framework:

  1. Members of the Federal Open Market Committee (FOMC) are trying to understand why inflation and wage growth are low, despite the headline unemployment rate having fallen from a peak of 10 percent during the Great Recession to 4.4 percent today.
  2.  We would have expected a strong job market to lead to stronger wage growth and then higher inflation as businesses passed their increased costs on to customers.

Regarding the first ‘strand’, the chart indicates that falling/low unemployment has no implication for inflation.

In words, all combinations of unemployment and inflation are possible. You can have falling unemployment and inflation, rise & fall in unemployment alongside stable inflation, strongly rising unemployment with weak fall in inflation and strong drop in unemployment with stable inflation.

The second ‘strand’ reflects the cost-push view of inflation held by adepts to the Phillips Curve framework.

The chart below indicates that view is quite wrong. Look at the second half of the 1960s, the moment when inflation in the US began to travel up. In ‘region 1’, you have a strengthening labor market alongside rising inflation (what the P-C predicts). However, there´s no increase in wage growth.

During that period, inflation expectations were “dormant”. However, when inflation rises (doubles) and stays high, expectations adjust. When that happens, wages rise alongside inflation (‘Region 3) together with a strengthening labor market.

The next chart shows what happened in another period of strengthening labor market.

Throughout, the labor market strengthens. Wage growth also rises throughout but inflation falls. Towards the end of the period, unemployment falls faster. Wages rise more strongly and inflation falls further!

What explains those patterns? The next chart posits that nominal spending (NGDP) growth, a quantity under the Fed´s control, does a much better job of explaining the behavior of inflation.

Regions 1, 2 and 3 in the NGDP growth chart refer to the regions in the 1965 – 1969 chart. The pattern of initially rising then stable and again rising inflation is consistent with the behavior of NGDP growth.

Why, one may ask, does unemployment fall, wages rise and inflation falls in 1994 – 1997, if NGDP growth is lower and relatively stable in that period?

The answer is that the best the Fed can do for the economy is to achieve and maintain nominal stability (a stable rate of NGDP growth at an appropriate level). This will allow the economy to best ‘adapt’ to different circumstances, some positive, some negative (think, for example of a productivity shock – a positive supply shock like in 1994 – 1997 – or an increase in oil prices – a negative supply shock). Meanwhile, striving to maintain nominal stability, the Fed won´t ‘provoke’ nominal or demand shocks like in 1965 – 1969.

In summary, to understand inflation the Fed has to jettison its Phillips Curve/Cost/Gap theory of inflation. It misleads and leads to bad policy decisions.

That, however doesn´t seem likely. The framework is too entrenched in the minds of current monetary policymakers. Unless we´re lucky and, as Yellen indicated, they learn something and then “stand ready to modify our views based on what we learn.”

I sincerely hope they don´t go the way of the BIS (Bank for International Settlements, the “Central Bank of Central Banks). As recently suggested by Claudio Borio, head of the BIS Monetary & Economic Department:

Finally, if these hypotheses are correct, we may need to adjust monetary policy frameworks accordingly. As I shall explain, that would mean putting less weight on inflation and more weight on the longer-term real effects of monetary policy through its impact on financial stability (financial cycles).

If that idea comes to pass, “God help us”!

What have they done?

A frequent argument made by FOMC participants is that the Fed cannot wait too long to raise rates because that would increase the chances that the economy would “overheat”, pushing inflation above target.

Two examples:

Yellen (2015)

If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession.

Rosengren (2017)

Given the hot job market, “appropriate risk mitigation would argue for continued gradual removal of monetary accommodation, even though we are currently below the inflation target.”

Mr. Rosengren noted it was possible the jobless rate could fall below 4% and if it did, it would only increase the risk of economic overheating. Allowing that sort of jobless rate “would be a risk that would be unwise to take.”

Things are, in fact, quite the opposite. Over the past 10 years, the economy has “overcooled” and, given the Fed´s worry with “overheating”, it keeps “cooling down”.

To have a sense of where we´ve been and where we are, I look at the 10-yr average growth rate of per capita RGDP since 1880. The 10-yr average smooths out short run quirks in the data.

From 1880 to 2005, RGDP-PC growth averaged 2.2%, with a standard deviation (st dev) of 1.7. The st dev provides a measure of the variability, or volatility of the series.

Note that the 1880 – 2005 period encompasses several “crises”. For example, WWI, Great Depression, WWII, several recessions, some deep. Breaking the period up:

1880 – 1928 (to ‘avoid’ the Great Depression) growth averaged 1.8% with st dev of 1.1

1954 – 2005 (skipping WWII, the immediate aftermath and Korean War) growth averaged 2.1% with st dev of 0.6.

1984 – 2005 (the Great moderation) growth averaged 2.2% with st dev of 0.2

Note that during the sub periods, average growth was never far from the average for the whole period. Note also, how the volatility of growth fell over time, becoming very low during the Great Moderation.

Now, when we look at the last 10 years (2006 – 2016), we´re in for a big surprise.

2006 – 2016 (Great Recession + “Long Depression”) growth averaged 1.1%, or only half of the 125-yr average with st dev of 0.6.

The chart gives a poignant testimony.

The universal constant

Every few months after the FOMC Meeting, the Fed publishes the Summary of Economic Projections (SEP). An important component of the SEP is the long-run median of the FF rate, real growth rate, unemployment rate and inflation rate. Those are the rates the FOMC expects will prevail in the long run, or the rates towards which the economy will converge.

The charts compare the long-run median with the ongoing rates for those variables.

It´s notable that the rates expected to prevail over the long run have been systematically reduced. What is behind this one-way revision? Take, for example, the unemployment rate. Since the fall in the rate of unemployment has not driven inflation higher, as predicted by the Fed´s Phillips Curve view, the estimate of the long run (or natural) rate of unemployment has been lowered.

Note than when real GDP growth dropped below the long-run estimate (or potential), this rate was revised down. Now, the Fed says the economy is growing above “potential”, a “sign of strength”, signaling that inflation will converge to the 2% target.

Then there is the “universal constant” or the 2% inflation target. The core PCE rate better reflects the inflation trend, given that it “ignores” volatile components. The chart, in fact, suggests that 2% is not a symmetric target, but a ceiling!

With that, according to Joseph Gagnon, the Fed has bought into secular stagnation. The Fed doesn´t see that as the outcome of its policies. For example, with real growth above “potential”, the Fed believes it has to constrain growth further to avoid an undesirable rise in inflation…

‘Faith-based interest rate hiking’ – Understanding Yellen

It should be very worrying when we hear central bankers (Yellen) say things like:

“I will not say the committee clearly understands what are the causes of low inflation now”


“Our understanding of the forces driving inflation is imperfect.”

The present situation of low inflation is being touted “the mystery of the missing inflation. Maybe that´s why the Fed says it has an imperfect understanding.

According to their preferred model, with unemployment this low, inflation should be rising. The fact that it isn´t, makes it a mystery.

Yellen has faced that ‘mystery’ before. In her last months as a Board Member in 1996, she tried to nudge Greenspan into hiking rates. The reason being, you guessed, because unemployment was “too low”.

To recap:

Yellen – Aug 96

Now, suppose someone, and that someone is not I, firmly adheres to the view that the economy is currently operating at NAIRU and not below it. Can one point to anything in the recent pattern of wage and price behavior that would provide strong evidence against that view? Here I would agree with Governor Meyer; I think the answer is no.

On the other hand, historical evidence strongly suggests that NAIRU is higher than 5.4 percent, so it would be both dangerous and foolish to discount the possibility that the modest uptick in compensation that we are now seeing is the beginning of a process that, if left unchecked, will lead to gradually accelerating inflation.

Yellen – November 96

I agree with the staff that we may well be living on borrowed time and that inflation will eventually accelerate if the unemployment rate remains at its current level, as in the Greenbook forecast. Although I believe there is strong evidence that NAIRU has declined below 6 percent, it seems difficult to use the data in hand at this point to defend the proposition that it is as low as 5.2 percent.

Yellen – Dec 96

To my mind, labor markets are undeniably tight. You remarked last time, Mr. Chairman, that we should be careful not to lull ourselves into a false sense of security about incipient wage pressures by reading too much into that suspiciously low third-quarter ECI, and I agree with that.

So, I still feel that we need to avoid complacency about the potential for inflationary pressures to emerge from the labor market down the road. But while I think we cannot rule out the possibility that this long expansion is about to end with a period of stagflation and that that is a significant risk over the term of this forecast, that outcome is by no means a certainty.

This is what was going on around the meeting dates.

She could not rule out the “possibility that the long expansion was about to end with a period of stagflation”. What transpired was the exact opposite: robust real growth, falling unemployment, and falling inflation!

The obvious conclusion is that the labor market is an unreliable guide to monetary policy, and it seems Yellen´s faith in the Phillips Curve model is almost as big as the Pope´s in God!

Now, let me compare 1996-97 with 2015-17.

What do we see? Unemployment is on a downtrend, both then and now, although it is lower at present. Inflation is low in both instances, although a bit lower now. Real output growth is significantly lower now.

So it appears that low/falling unemployment is consistent with low/falling inflation, independently if real growth is ‘high’ or ‘low’.

I´ve already noted that the labor market is not a reliable guide to monetary policy. The reason being that unemployment adjusts to any (stable) nominal growth trend. Inflation does the same, which indicates that having an explicit inflation target may cause unwanted ‘friction’ if the stable inflation rate is below the target rate. Note that in 1996 there was no explicit inflation target, so the Fed was ‘happy’ with ‘low inflation’. Now it is worried about losing credibility.

The last chart solves the ‘mystery’. NGDP or nominal spending growth is relatively stable in both periods. That is consistent with low unemployment and inflation. However, the level of the stable nominal growth trend is much lower at present, explaining the much lower real growth rate.

In the presser following the FOMC September meeting, Yellen said: “if we conclude inflation drop not transitory, it would require an alteration in monetary policy.”

The successive appeals to temporary or transitory factors to ‘explain’ why inflation is low (despite low unemployment) over the past several years strain credulity (or the definition of transitory). More likely it´s Yellen´s way to justify clinging to her (misguided) faith.

What would the “alteration in monetary policy” look like? This chart, borrowed from David Beckworth, clearly shows why the economy is so “subdued” (kinder word then “depressed”).

In 2010, the Bernanke Fed interrupted the recovery, ‘blocking’ additional spending growth. That tells us that NGDP growth has to be pushed up. The ‘alteration’ in monetary policy would then ‘naturally’ lean toward establishing an NGDP Level Target.

Why was the recovery ‘interrupted’? With Bernanke being an ardent (‘faith’ again) inflation targeter, just as in 2008 he was afraid of the inflationary effects of the jump in oil prices, that may have happened again in 2010, especially given the similarity in oil price changes in both periods.

Why the recovery is not bolstered at present? Likely because Yellen is afraid of the inflationary effect of low unemployment. In that case, to the Fed, growth has to be constrained further!

Bottom line: OMG! That said, what does the Fed need? A ‘freethinker’.