The shape of a “late-cycle cyclical recovery”

That has been misdesignated “synchronized global recovery”. What we observe, however, is simply an “offset” to the previous slowdown.

The pattern shows up in the IMF´s world growth data.

It is also present in higher frequency global economic activity data – world industrial production & world trade. In both cases, the “recovery” seems to have run its course and danger, in the form of “trade wars” lurks ahead!

In the U.S., the pattern also shows up. I´ll posit that the process is driven by nominal spending (NGDP) growth, in other words, by monetary policy.

And is reflected in economic activity data such as industrial production and retail sales.

With the “recovery” appearing to be fading, the Fed´s newfound hawkishness flashes “amber lights.”

In fact, for the US & G7 economies, the FMI forecasts a slowdown in the coming years!

The sure-fire way of stabilizing the real economy or, “all roads lead to Rome”

At Vox, Walentin and Westermark write, “Stabilising the real economy increases average output”:

The intro:

The Great Recession has generated a debate regarding the potential effects on the long-run levels of output and unemployment of stabilising the real economy (e.g. Summers 2015). This issue takes on additional importance as the current economic situation in some countries, including the US, imply that there is a monetary policy trade-off between stabilising inflation and the real economy.

In particular, the unemployment level is low at the same time as inflation is low. More generally, the question at hand is whether policymakers, in particular central bankers, should try to stabilise the real economy, beyond taking into account how real factors affect inflation.

In this column, we will shed light on this question by summarising research indicating that stabilising the real economy raises the long-run level of output.


In sum, both empirical and theoretical arguments increasingly indicate that output and unemployment volatility reduces output and thereby impose substantial costs to society.

This is a solid argument in favour of policies that stabilise output and unemployment, in addition to inflation (see Lepetit 2017 for a quantitative treatment).

That said, we should not underestimate the various challenges that both fiscal and monetary policy face when attempting to stabilise the real economy.

For example, there are substantial practical difficulties in measuring what output trend or unemployment level the economy should optimally be stabilised around. Nevertheless, recent advances in economic modelling tilts the policy conclusion towards stabilising the real economy more than previous research has motivated.

Interestingly, in the late 1970s, John Taylor suggested an alternative set of options for policymakers to consider, one consistent with macroeconomic theory. These alternative options involve a tradeoff between the variability of output and the variability of inflation.

[Taylor, John B. “Estimation and Control of a Macroeconomic Model with Rational Expectations,” Econometrica, 47 (5), 1979, pp. 1267-86.]

In 2004, Bernanke gave a speech titled The Great Moderation. His conclusion:

The Great Moderation, the substantial decline in macroeconomic volatility over the past twenty years, is a striking economic development.

Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed.

I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well.

Moreover, because a change in the monetary policy regime has pervasive effects, I have suggested that some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks.

This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s.

What all the above quotes are saying is that the Fed should “calibrate” monetary policy to obtain both inflation and real growth stability. What they miss is that stabilizing both inflation and real growth is synonymous to stabilizing the nominal economy, i.e., NGDP!

Bernanke puts up a version of the chart below to illustrate the shift from the “Great Inflation” (GI) to the “Great Moderation” (GM).

The chart also indicates that the “Great Recession” (GR) entailed a loss of real growth stability, while inflation stability was maintained.

Does real world data conform to the idea that to stabilize both inflation and the real economy the Fed has to stabilize NGDP?

To illustrate I construct phase-space charts. These charts illustrate volatility (or variance) through a scatter plot of percent changes (in nominal and real growth, inflation and unemployment) at time t and time (t+1). The more closely together that dots are bunched, the lower that volatility or variance of changes.

The first panel depicts the volatilities during the “Great Moderation”. The ellipses delimit the range of variation for nominal and real growth, inflation and the unemployment rate.

The second panel shows what happened during the “Great Inflation” (GI). The ellipses are those obtained from the GM period. During the GI, while NGDP growth shows a rising trend, real growth is just more volatile, while inflation also shows a rising trend. Unemployment is generally higher and more volatile.

The next panel shows the GR period. Nominal growth “escapes” the “stability ellipse” through the southwest “door”. In other words, nominal growth tumbles. Real growth follows suite, while inflation remains “trapped” inside the stability ellipse, and close to the points that prevailed during 1994-05. Unemployment skyrockets.

Three observations:

  1. Does stabilizing the real economy increase average growth, as Walentin and Westermark argue? If that were so, you should expect that real growth during the GM would be higher than during the GI.

That, however, is not true. During the GM, average growth was 3.2%, with a standard deviation (volatility) of 1.4. During the GI, average growth was almost the same at 3.3% but volatility was double, 2.8.

  1. There doesn’t appear to be a trade-off between inflation and real growth stability. By abandoning nominal stability, the Fed may lose both inflation and real stability, like in the 70s, or just real stability as during the GR.
  2. Bernanke was confident that monetary policymakers would not forget the lessons of the 1970s. That was the problem, because thinking in terms of the wrong lesson, the Fed “forgot” that the real lesson was the one provided by the GM i.e., keep NGDP growth stable.

The last panel shows variances for the post GR period. Nominal stability was regained, leading to stability in the real economy (RGDP & unemployment) and inflation.

Note, however, that the stable growth of NGDP in the aftermath of the GR is significantly lower than the stable growth rate observed during the GM. The average growth of real output is also significantly lower. Meanwhile, inflation is equivalently low and stable while the unemployment rate has converged inside the GM ellipse.

That is why, despite positive and stable real growth, the economy appears sickly. This is where the idea of “level targeting”, as in NGDP-LT becomes important.

We saw that during the GR, NGDP growth tumbled. Thereafter, its growth remained too low (although stable) to bring NGDP to the previous level path. The level chart below illustrates.

The fact that monetary policy is conducted according to “imaginary numbers” (Potential output, Natural Rate of unemployment, Neutral Rate of interest), is “depressing”. For example, Atlanta Fed president Raphael Bostic recently argued against the Fed adopting an NGDP targeting framework because it is conditional on potential output.

In a recent speech, San Francisco Fed president John Williams says:

An important development of the past decade is that the trend growth rate today appears to be considerably slower than the growth trends we’ve previously seen in our lifetimes. This slower pace of growth is a reflection of a sharp decline in labor force growth and relatively slow productivity growth.

… Given that the current pace of growth is above trend, my view is that we need to continue on the path of raising interest rates. This will keep things on an even footing and reduce the risk of us getting to a point where the economy could overheat, and create problems that could end badly.

What Bostic and Williams are in fact saying is that we have to keep the economy depressed so as not to stoke inflation, additional Fed tightening, and recession!

The next panel is interesting, making clear the uselessness of the concept of potential output. During the GM, estimates of potential were systematically revised up to converge on actual output. Since the GR, potential output has been systematically revised down to converge on actual output. All the while, inflation first came down and then remained low and stable.

What if labor force and productivity growth are significantly determined by the “robustness” of real growth? Given that potential output appears “conditioned” on actual output, raising the level and growth rate of real output, through a higher level of NGDP and NGDP growth could do wonders for the economy.

That may have been what Yellen had in mind a couple of years ago when she conjectured about running the economy hot for a time. Unfortunately, she never tried.

Bottom line: “All roads lead to Rome” i.e., to NGDP level targeting.

Price Level targeting would not have avoided disaster in 2008

Raphael Bostic, Atlanta Fed president, is arguing for a change in the monetary policy framework, from inflation targeting (IT) to price level targeting (PLT) See here, here.& here.

What I want to show is that, although PLT differs from IT in that PLT has a “memory”, it suffers from the same weakness, i.e. it is sensitive to supply (for example, oil) shocks. In addition, I argue that an alternative monetary policy framework, NGDP level targeting, also has memory but does not suffer from the supply shock sensitivity of PLT.

Ten years ago, the FOMC was “laser focused” on inflation. In the June 2008 meeting, for example, we read in the transcript that:

Despite this recent news, we expect inflation to rise sharply over the next few months. In part, this reflects our judgment that core prices were held down in the first half by some factors that will not persist into the second half [the “transitory” argument was already a favorite]. In addition, we expect increases in food and energy prices to push up the twelve-month change in the total PCE price index more than 1 percentage point over the next several months, to about 4½ percent.

Regarding inflation, every single participant, with the possible exception of Mishkin, showed grave concern. This is reflected in Bernanke´s summary:

My bottom line is that I think the tail risks on the growth and financial side have moderated. I do think, however, that they remain significant.

We cannot ignore them. I’m also becoming concerned about the inflation side, and I think our rhetoric, our statement, and our body language at this point need to reflect that concern. We need to begin to prepare ourselves to respond through policy to the inflation risk; but we need to pick our moment, and we cannot be halfhearted. 

When the time comes, we need to make that decision and move that way because a halfhearted approach is going to give us the worst of both worlds. It’s going to give us financial stress without any benefits on inflation. So we have a very difficult problem here, and we are going to have to work together cooperatively to achieve what we want to achieve.

This is the picture:

Would the worry be different if instead of IT, the Fed pursued a PLT? The next picture shows probably not.

The reason for the rise in both inflation and the price level relative to trend was a strong and quick increase in oil price (an oil shock).

Ironically, the Fed´s worry about oil (and food) prices in June 2008 happened when those prices topped! In the first two charts, both inflation and the price level relative to trend drop significantly with the fall in oil prices.

Getting help from the Dynamic Aggregate Demand (AD)-Aggregate Supply (AS) model (DADAS)

That model tells us that when there is a supply shock, the AS curve shifts up and to the left, increasing inflation (or the price level relative to trend) and reducing real growth.

The first two charts above show that inflation and the price level increased on the heels of the supply shock depicted in the third chart. Chart 4 shows that real growth decreased.

In chart 3, we observe that after June 2008, oil prices dropped back to their initial value. This is a positive supply shock that, according to the DADAS model, would decrease inflation and increase real growth.

In charts 1 and 2 we see that inflation and the price level (relative to trend) fall. Real growth, however, plunges. That pattern is consistent with a massive negative AD shock.

The NGDP Level chart 5 shows that during the oil shock, NGDP dropped below the trend path. In other words, monetary policy was being tightened (although the FFR fell). Then, the Fed “cranks the monetary screws” and real growth and inflation plunge.

If the Fed had kept NGDP evolving close to trend, the recession would not become “great”. More importantly, the economy would not have remained depressed for the past 10 years.

As Scott Sumner put nicely:

Economists are beginning to understand that NGDP is the variable we should actually be concerned about. Instead of worrying about what might happen to inflation under NGDP targeting, we should consider what happens to NGDP if we insist on targeting inflation.

Interestingly, in 2004-06, the economy was also buffeted by an oil shock.

Variables behave in accordance with the predictions of the DADAS model:

Headline inflation rises (and falls when oil price drops)

And real growth falls.

The difference in the two episodes is evident in what happens to the unemployment rate.

In the early period, unemployment falls from the lofty level reached after the 2001 recession. In the latter period, unemployment begins to rise gently from a low level, and suddenly balloons.

The contrasting behavior of unemployment in a similar environment (oil price shock), is explained by the contrasting behavior of NGDP.

While in the early period NGDP remains close to the trend level path, in the latter period it slowly falls below trend before plunging.

Throughout those years, and despite the back-to-back inflation shocks, core PCE inflation remained tame, averaging a little below 2.1%.

Bottom Line: NGDP Level Targeting does not give rise to the very high social costs in terms of unemployment that can come from IT or PLT.

Monetary Policy Potpourri

  1. Monetary Policy Framework

Raphael Bostic, president of the Atlanta Fed has a three part (so far) series on Thoughts on a Long-Run Monetary Policy Framework.

His preferred framework is for the Fed to adopt price level targeting.

Bostic writes:

[f]ormer Fed chairman Alan Greenspan offered a well-known definition of what it means for a central bank to succeed on a charge to deliver price stability. Paraphrasing, Chairman Greenspan suggested that the goal of price stability is met when households and business ignore inflation when making key economic decisions that affect their financial futures.

I agree with the Greenspan definition, and I believe that the 2 percent inflation objective has helped us meet that criterion. But I don’t think we have met the Greenspan definition of price stability solely because 2 percent is a sufficiently low rate of inflation. I think it is also critical that deviations of prices away from a path implied by an average inflation rate of 2 percent have, in the United States, been relatively small.

Interestingly, as the chart shows, as soon as 2% target became explicit, the price level fell short of the target! In July 1996, when the FOMC discussed inflation targeting, and 2% was the “preferred number”, Greenspan alerted (page 72):

The discussion we had yesterday was exceptionally interesting and important. I will tell you that if the 2 percent inflation figure gets out of this room, it is going to create more problems for us than I think any of you might anticipate.”

A major problem with targeting the level of the headline PCE is that it is very volatile, being buffeted by things like oil shocks. The chart compares fluctuations in headline and core PCE.

Although the core PCE has progressed below the 2% trend path “forever”, before the 2% target became explicit no one bothered!

Instead of focusing on inflation, the Fed would have fared better if it had continued to keep nominal spending (NGDP) close to the trend level path. It would have “minimized” the disaster if, after letting nominal spending tank, it had resumed growth at the previous trend rate.

As Scott Sumner argues in The problem with central bankers’ inflation preoccupation:

High inflation is not a good indicator of the state of the economy, because it can either reflect excessive demand or a decrease in aggregate supply. In contrast, NGDP growth shows the increase in total spending in the economy — i.e. aggregate demand — and is an excellent indicator of whether the economy is overheating and needs monetary restraint.

In 2008, the Fed focused on the wrong indicator.

Inflation was distorted by soaring oil prices, and Fed policy during 2008 ended up being far too contractionary for the needs of the economy. As a result, NGDP fell by more than 3 per cent between mid-2008 and mid-2009, the worst performance since the 1930s.

A policy aimed at 4 per cent or 5 per cent NGDP growth would have likely led to above 2 per cent inflation during 2008-09, but that sort of problem is nowhere near as costly as 10 per cent unemployment.

  1. Immaculate Inflation & Inflation-Unemployment Link

Paul Krugman writes “Immaculate Inflation Strikes Again”:

[A]s Karl Smith pointed out a decade ago, the doctrine of immaculate inflation, in which money translates directly into inflation – a doctrine that was invoked to predict inflationary consequences from Fed easing despite a depressed economy – makes no sense.

In answer to comment, however, Karl Smith is more specific:

I haven’t put enough time into my posts to be very clear. I am apologize for that. However, my point is that whatever the ultimate cause of inflation, the proximate cause must be an increase in nominal demand or a decrease in supply.

As the nominal GDP chart above shows, the problem was a “permanent” drop in nominal spending (nominal demand).

Krugman then asks “Is there any relationship between unemployment and inflation?” And argues:

[T]he claim that there’s weak or no evidence of a link between unemployment and inflation is sustainable only if you insist on restricting yourself to recent U.S. data. Take a longer and broader view, and the evidence is obvious.

Consider, for example, the case of Spain. Inflation in Spain is definitely not driven by monetary factors, since Spain hasn’t even had its own money since it joined the euro. Nonetheless, there have been big moves in both Spanish inflation and Spanish unemployment.

“Definitely not driven by monetary factors…?” It´s always “risky” to discard monetary causes for inflation, even if, like Spain, the country is subject to “outside” monetary policy.

The panel below shows that unemployment patterns in Spain and the US are the same, and linked to what´s happening to NGDP (i.e. monetary policy).

Note that NGDP contracted much more strongly in Spain, with unemployment jumping higher.

Note also that unemployment begins to fall in both countries when NGDP stops falling and initiates a rising trend. The timing is significantly different in the two countries. Remember that in the EZ, Trichet applied the monetary screws once again in April and June 2011, with improvement only beginning after Draghi took over and promised “whatever it takes”. Meanwhile, in the US the Fed started QE in March 2009.

Krugman is definitely wrong. And while the Fed seems intent on guiding monetary policy by what´s happening to the unemployment rate, “success” will be elusive.

In contrast to the proverbial monkey, there are those that “see, hear & speak” inflation

From Goldman Sachs:

“During most of the post-crisis recovery, inflation risks have been subdued.

However, concerns with “overheating” and higher inflation are now being raised given a combination of strong global growth and diminishing economic slack, increasing labor market tightness, expansionary fiscal policy vs. only gradual normalization of monetary policy in the U.S., risks from trade protectionism / retaliation, and the potential for higher commodity spot prices as inventories continue to draw down,” writes Goldman Sachs strategist Michael Hinds.

“There’s really no question – inflation is rising.” –  @inflation_guy

His yardstick: The New York Fed “Underlying Inflation Gauge” (UIG)

“Underlying Inflation Gauge…first time over 3% since 2006.”

The New York Fed, however, has warned:

Recent analysis suggests the rise in the full-data-set UIG compared to the prices-only measure is being driven principally by survey measures of manufacturing and nonmanufacturing activity.

When you look at a “basket” of inflation indicators, only by introducing “survey measures of economic activity” you get an upward tilt in inflation.

Inflation is going to head up this year — on that there isn’t much debate.” Greg Ip:

If inflation turns up, economists have long assumed it would do so slowly, giving the Fed plenty of time to respond. But Michael Feroli of J.P. Morgan notes this assumption is built on models in which the world behaves in a predictable, linear way. In fact, he says, the world isn’t linear and inflation can change suddenly for unexpected reasons: it “is sluggish and slow-moving, until it isn’t.”

A case in point: in 1966, inflation, which had run below 2% for nearly a decade, suddenly accelerated to over 3%. Some of the circumstances echo the present: unemployment had slid to 4%, taxes had been cut and federal spending for the Vietnam War and Lyndon Johnson’s “Great Society” programs was surging.

“Consumer prices rising at a 2.1 percent rate could be toxic when combined with very low unemployment.” Tim Duy:

This persistent period of low unemployment feeds into the Fed’s forecast and comes out as faster inflation. The projections now show that central bankers expect inflation to surpass the target, rising to a high of 2.1 percent at the end of 2019.

In other words, the Fed is explicitly forecasting overshooting the inflation target. Policy makers could crank up the interest rate forecast to eliminate that overshooting but instead have chosen a less aggressive policy path. [If you call 0.1 overshoot, what do you call -1 or -0.5?]

Duy´s conclusion:

The Fed increasingly relies on a very flat Phillips curve even as unemployment rates head toward levels not seen in five decades. If there is a nonlinearity in the Phillips curve and inflation starts to pick up more aggressively, this bet is going to go sour quickly.

What both GI and Duy have in mind is a chart like the one below. With unemployment now quickly approaching 4% and, according to FOMC projections, expected to fall further, GI & Duy imagine a repeat of the 1960s, when the PC was flat until it wasn´t!

It´s discouraging when you see that the conventional wisdom still squarely believes inflation is an “unemployment phenomenon”, and that the Fed controls inflation by “nudging” the unemployment rate. Again from TD:

If Fed officials were determined to avoid an overshoot, they would need to act more aggressively to push unemployment up toward their estimate of the natural rate.

From GI:

The Federal Reserve is attempting in the next few years something it has never accomplished before: guide unemployment up without causing a recession. It faces high odds of failure–and little alternative path.

Many economists have to realize that the rising inflation in second half of the 1960s did not come about because of “too low” unemployment, but because monetary policy (indicated by NGDP growth) was in an expansionary roll. That´s certainly not true at present.

All that leads to one of the more “tongue-twisting” comments I´ve ever heard from a FOMC member:

Neel Kashkari:

Mr. Kashkari, in his comments Friday, said his support of the latest rate increase comes down more to defending the central bank’s credibility under a new chairman, rather than a shift in his fundamental outlook.

“If I had been sitting in the chairman’s seat, I would have raised rates because we told the markets we were going to raise rates,” Mr. Kashkari said. Boosting short-term rates “represented continuity with what the Federal Reserve said it was going to do.”

However, “we have a ways to go” before achieving the Fed’s job and inflation goals, and “there’s still some slack in the labor market,” Mr. Kashkari said. And on that front, “I don’t think the data itself supports rate increases at this point.”

The Fed Cowers From A Phantom

In February, more Americans entered the US labor than gained employment—and by a wide margin.

The good news is that a net 313,000 people found jobs in February, becoming productive, earning money and adding to GDP. There are 115.2 million employed in the US. That was the headline news.

The largely unreported news is that a net 806,000 people entered the U.S. labor force in February, causing a rise in the labor force participation rate. This is also good news—the more people who want to work the better.

Thus, the also largely unreported news is that in February labor markets actually loosened a little bit, with another half-million or so people nationally looking for work, but unemployed. The official unemployment rate remained at 4.1%.

Wage growth is still largely a no-show. Average hourly earnings edged up four cents, or 0.1%, to $26.75 in February, a slowdown from the 0.3% rise in January. That lowered the year-on-year increase in average hourly earnings to 2.6% from 2.8% in January.

Obviously, with wages rising at well under 3%, any productivity improvements greater than 1% will mean wages are not helping the Federal Reserve hit its putative 2% inflation target. While output per hour has been limited since 2008, it has been rising at greater than 1%. And with capital abundant, and sales and profits rising, we are seeing nascent signs on productivity gains—as we saw in the sustained economic recovery of the 1990s.

In economics, good news tends to breed good news.

No matter. The Fed has all but committed to three, and perhaps four, rate hikes in 2018.


The Fed contends that natural” rate of unemployment is 4.75%, and so it has targeted that level in medium-term forecasts. The nation may well wonder how the Fed intends to reach that particular goal.

Certainly, wage growth is a back-burner concern presently. More people are entering the US labor force, keeping job markets loose, certainly as defined by wage growth.

So…why doesn’t the Fed target a replay of the 1990s. Lots of job growth, low unemployment, lots of prosperity, and mild inflation?

Re-Remembering Milton Friedman And The Choppers

Milton Friedman remains a touchstone in macroeconomics, even for those who disagree with his policy prescriptions.

So it is unfortunate that one of Friedman’s serious stimulus proposals, that of money-financed fiscal programs, is generally recalled in connection with his bantering about “helicopter drops.”

But let’s go back, way back, to the Friedman’s 1948 paper “A Monetary and Fiscal Framework for Economic Stability,” published in the American Economic Review. In his article Friedman argued for a balanced national budget at full employment, but for deficits during recessions, and perhaps surpluses in boom times.  Friedman contended issuing debt to finance government outlays, rather than taxes, would be less deflationary and more stimulative than just raising taxes and outlays together. And importantly, he pointedly added that it is “still less deflationary to issue money,” than to issue debt.

It was only later, in 1969, that Friedman broached the topic of money-financed fiscal programs with the phrase “helicopter money,” perhaps in deference to the doctrinaire and PC-fault lines that were coming to define monetary policy, and which continue to straitjacket thinking to this day.

Modern Contexts

In 2003 Ben Bernanke, former Fed Chief, again raised the topic of money-financed fiscal programs, this time safely pondering Japanese and not American, prospects. Miles from home, the emboldened Bernanke was addressing the Japan Society of Monetary Economics, when he suggested, “Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt—so that the tax cut is in effect financed by money creation.”

More recently, Adair Turner, former chairman of the United Kingdom’s Financial Services Authority and former member of the UK’s Financial Policy Committee, has proposed the rather mangled analogy of “helicopter drops on a leash.”


More than 15 years after Bernanke addressed Japanese monetary policy thinkers, Japan is still below 1% inflation, though showing some signs of hope under Bank of Japan Governor Haruhiko Kuroda.

Europe’s real GDP is still below 2008 levels, while the United States has made some belated progress in the last 10 years, many citizens have seen a decade of substandard economic growth.  Wages are still in the doghouse.

Yet the conventional macroeconomics profession continues to insist that the “normal” primary tools of interest rates, budget deficits, and possibly quantitative easing are all that is needed, especially if married to consistent and clear PR jobs by central bankers.

The aversion to money-financed fiscal programs reminds me of the baseball manager who kept his .380 hitting clean-up batter benched, for those moments when he was really needed.

PS: Non-baseball fans, apologies. Akin to keeping the star football (soccer) striker on the bench until the fourth quarter.

The Fed makes-up reasons to justify their preferred actions

In her recent speech, Lael Brainard ends with the punchline:

In many respects, the macro environment today is the mirror image of the environment we confronted a couple of years ago. In the earlier period, strong headwinds sapped the momentum of the recovery and weighed down the path of policy. Today, with headwinds shifting to tailwinds, the reverse could hold true.

The charts indicate that there have been several instances of “mirror images” over the last 8 years.

The latest  “cycle” is characterized by the strongest headwind and the weakest tailwind.

That becomes more evident when you see that real consumption spending has not reacted at all to the “tailwind”.

No reason, therefore, to justify “hawkishness”.

She also says:

One of the striking features of the current recovery has been the absence of an acceleration in inflation as the unemployment rate has declined, a development that is consistent with a flat Phillips curve. Although wage gains have seen some recent improvements, they continue to fall short of the pace seen before the financial crisis.

However, we do not have extensive experience with an economy at very low unemployment rates and cannot be sure how it might evolve. In particular, we will want to remain attentive to the risk of financial imbalances.

The charts below show wage growth and inflation both for when unemployment is below (blue line) and above 5% (orange line).

Wage growth tends to be above average when unemployment falls below 5%. Inflation, however, “just doesn´t care”. What´s “remarkable” is that now, with unemployment far below 5%, wage growth is just as low, maybe even lower, than it was with unemployment over 5%! Inflation is no different.

The “innovation” in her speech, “justifying” a likely increase in the number of rate hikes, is that, even if low unemployment does not pull inflation, it might stoke “financial imbalances” (QED).

The “impossibility” of inflation

For the past 25 years, inflation (PCE-Core) has remained low and stable. Nevertheless, many are worried that inflation is about to “take-off”.

In a recent piece, Greg Ip writes, “Why an unpleasant inflation surprise could be coming”:

Inflation is going to head up this year — on that there isn’t much debate.

… If inflation turns up, economists have long assumed it would do so slowly, giving the Fed plenty of time to respond. But Michael Feroli of J.P. Morgan notes this assumption is built on models in which the world behaves in a predictable, linear way. In fact, he says, the world isn’t linear and inflation can change suddenly for unexpected reasons: it “is sluggish and slow-moving, until it isn’t.”

A case in point: in 1966, inflation, which had run below 2% for nearly a decade, suddenly accelerated to over 3%. Some of the circumstances echo the present: unemployment had slid to 4%, taxes had been cut and federal spending for the Vietnam War and Lyndon Johnson’s “Great Society” programs was surging. Deutsche Bank economists note the budget deficit jumped by more than 2% of gross domestic product between 1965 and 1968, similar to what they project between 2016 and 2019. Except in recessions, stimulus of this size “is unprecedented outside of these two episodes,” they said.

In his latest FOMC Watch, Tim Duy asks:

What is the realistically acceptable lower bound for unemployment?

When do officials become very uncomfortable?

The median unemployment rate forecast for the end of this year and next is 3.9 percent. The low of the central tendency of projections is 3.6 percent for 2019. Powell said the longer-run rate of unemployment may be as low as 3.5 percent.

The problem with all of these forecast is that all intents and purposes, a sustained unemployment rate much below 4 percent is basically uncharted territory. The last time the economy sustained such a low level was the late-1960s.

The late-1960s analogy is very interesting. Much has been written of the flat Phillips curve; for more than 20 years inflation concerns have proven overblown. Funny thing though – the Phillips curve was flat for much of the 1960’s as well. Right up until the end of the decade, when inflation quickly emerged – during a sustained period of below 4 percent unemployment. Fiscal stimulus came into play at that time as well.

Note that both Ip and Duy bring up the late 1960s as support to their “inflation may be coming” argument.

Tim Duy illustrates with a version of the chart below.

I have drawn a Phillips Curve for the 1960s. Greg Ip says that “as Michael Feroli of J.P. Morgan notes, this assumption is built on models in which the world behaves in a predictable, linear way. In fact, he says, the world isn’t linear and inflation can change suddenly for unexpected reasons: it “is sluggish and slow-moving, until it isn’t.”

The charts illustrate for the period. When unemployment falls below 4% in a sustained way, inflation picks up.

Since that time, unemployment has reached 4% a few times, but never dropped below that level in a sustained way. Now, however, there are forecasts of unemployment falling below 4% for a sustained period. Will history repeat?

Not necessarily (or even likely). What triggered inflation in the late 1960s was not the below 4% rate of unemployment, but the high and rising rate of NGDP growth, as the next chart indicates.

For the past quarter century, we have experienced relatively stable NGDP growth and no “above target” inflation. In the late 1990s, a positive supply (productivity) shock pulled inflation down. In 2008-09, a strong negative demand shock also pulled inflation down.

NGDP growth has been l ower than the previous trend since then, keeping inflation lower than target. Unemployment has fallen from 10% to 4.1% during this time, with no effect on inflation.

Even if unemployment falls sustainably below 4%, there will be no marked effect on inflation, unless NGDP growth takes off. Does anyone believe that is in the Fed´s plan?

Is the Truism, “Money Is Neutral in the Long Run,” Really True?

Surely, merely running a printing press disgorging fiat money cannot truly increase economic output.  It is a truism.

But what about historic examples of central banks policies and real economic output?

Milton Friedman blamed the Great Depression on tight money.

More recently, the 2008 Great Recession, which by some measures still results in crimped output, was caused by tight money.  Japan’s 20-year deflationary slog has been caused by tight money.

So, by historical example, many macroeconomists seem to agree bad monetary policy can crimp real output for decades at a time and can persist indefinitely, unless corrected, as may be the case today in Japan.

So what is the “long run”? More than 20 years?  And how many years does an individual have to be productive?

Moreover, if an economy is atrophied for 20 years, and then the monetary brakes are finally released, can the economy really regain the lost time or former projected levels of output? Have talented people left for other lands? Have working populations been made cynical? Have innovative industries collapsed and technologies stagnated? Are financiers scarred for another generation, and overly timid?  Have political leaders resorted to warmongering and xenophobia and not nation-building?


Okay, so a central bank can suffocate an economy, and perhaps for decades at a stretch.

But what about growth, the “pushing on a string” problem and all of that?

David Beckworth, of the excellent Macro Musings blog, recently ran this chart:

Yes, between 1940 and 1945, the monetary base more than tripled.

Real output exploded of course, as the U.S. geared up for and entered WWII. From 1940 to1945, real output more than doubled.

In one small example of the surge in real output between 1940 and 1945, more than 2,700 transport “Liberty Ships” were produced in US shipyards, often largely built by women employees.  In 1943, three Liberty ships were produced every day.

The much-touted truism is that “printing money cannot summon real goods and services out of thin air.”

Pray tell, just exactly how did the 2,700 Liberty Ships come to be?

Surely, from nearly nothing, the federal government—armed with its most-potent weapon, the money-printing press—summoned the Liberty Ships into being.  For the enemies of democracy, it was as the war-winning vessels were summoned out of thin air.

And the U.S. economy and technical and industrial base was permanently enlarged by the WWII binge-spending and money-printing.

Money is neutral? Really? In what practical sense is this true?

Modern Context

Of course, if a modern economy is running full-bore, then money-printing may be neutral, merely causing more inflation, and not boosting real output. Indeed, it is possible that excessive money printing could be injurious (not neutral!) by causing too much inflation, upsetting financiers and thus cramping real lending and output.

But in many modern contexts, what we see is developed economies operating at subpar levels for extended stretches, starved not for capital but for demand. And, when certain industries experience more demand than supply at present prices—such as the oil industry from time to time—what we have seen is capital pouring into the gap, and supplies surging.

We have also witnessed rising labor employment participation rates when the demand for labor is strong enough.

In short, demand creates supply.

That “money is neutral” is a difficult proposition in modern, developed economies.