The Reagan Deficits, Growth, Long-term Yields, Inflation & the Exchange Rate. Implications for today?

The tax cut signed in December and the two-year budget deal passed on February 9, which served to focus attention on trillion dollar deficits, have affected markets.

According to one analyst, reflecting the conventional wisdom:

What if you ask the man on the street? Say you were one of those local news programs and left your air-conditioned office and went out on the street and interviewed people randomly, and asked them: “Why is it bad when we run big deficits?

I assure you that not one person would be able to answer your question.

The answer, of course, is: it makes interest rates go up.

Is that so? Maybe not. Go back to the Reagan years. Initially, during the 1981-82 recession, the deficit increased to 6% of GDP. With the recession over and output rising strongly, the deficit remained high (4%-5% of GDP) and never went below 3%.

The long-term Treasury yield went lower throughout the period. So did inflation.

The dollar appreciated significantly against major currencies. That was reversed in 1985 with the “Plaza Accord”, an agreement between the governments of France, West Germany, Japan, the US and UK to depreciate the dollar in relation to the Deutsche Mark and Japanese yen by intervening in currency markets.

Forward to the present.

Following the signing of the tax cut in December 2017, long-term yields have gone up together with rising inflation expectations and falling dollar. The budget deal depreciated the dollar, increased inflation expectations and the 10-yr yield.

Growth has been tepid since the end of the 2007-09 recession, while inflation has remained “too low”. Is this combo about to change? Given the Fed´s “tightening stance”, that´s very unlikely. Downside risks are significant, which could bring a reversal in the inflation expectations and yield trend. A weak economy could contribute to keeping the dollar down.




“Just one of those things”

John Fernald, Robert Hall, James Stock and Mark Watson (JF, RH, JS, MW) write “The Disappointing Recovery in U.S. Output after 2009”.

The summary:

U.S. output has expanded only slowly since the recession trough in 2009, counter to normal expectations of a rapid cyclical recovery. Removing cyclical effects reveals that the deep recession was superimposed on a sharply slowing trend in underlying growth. The slowing trend reflects two factors: slow growth of innovation and declining labor force participation. Both of these powerful adverse forces were in place before the recession and, thus, were not the result of the financial crisis or policy changes since 2009.

The conclusion:

Some commentators have viewed the generally sluggish recovery from the deep U.S. recession of 2007–09 as a lingering consequence of financial and economic disruptions, perhaps reinforced by post-2008 regulatory changes. In this Letter, we find that neither of these are the main story of a slowing trend that, to an important extent, predated the recession. The seeds of the disappointing growth in output were sown before the recession in the form of slow productivity growth and a declining labor force participation rate.

Quantitatively, relative to the recoveries of the 1980s, 1990s, and early 2000s, cyclically adjusted output per person has grown about 1¾ percentage points per year more slowly since 2009. According to our analysis, about a percentage point of this is explained by the shortfall in productivity growth and about ¾ percentage point is explained by the shortfall in labor force participation. Other factors are small and offsetting.

Although the magnitude of the trend slowdown has surprised forecasters, the underlying forces were recognized before the recession. For example, Aaronson et al. (2006) forecasted declines in participation as the baby-boom generation retired and the 1960s to 1980s surge of women into the paid labor force plateaued. Similarly, Fernald, Thipphavong, and Trehan (2007) discussed the post-2004 slowdown in productivity.

Finally, it is important to recognize that our findings do not imply that the recession was not enormously costly. Indeed, the collapse in demand during the recession and financial crisis contributed to the slow return of output to a trend rate that was already slowing sharply.

Interestingly, two of the authors, Stock & Watson, were the ones who in 2002 coined the “Great Moderation” moniker to describe the behavior of output and inflation from the mid-1980s to the mid-2000s.

In Has the business cycle changed, and why? they conclude:

To the extent that improved policy gets some of the credit, then one can expect at least some of the moderation to continue as long as the policy regime is maintained. But because most of the reduction seems to be due to good luck in the form of smaller economic disturbances, we are left with the unsettling conclusion that the quiescence of the past fifteen years could well be a hiatus before a return to more turbulent economic times.

Soon after, it appears, the Fed “ran out of luck”!

The chart shows a lengthy span for real output (RGDP) and its trend, beginning in 1954.

Note that while during the “Great Inflation” RGDP stays persistently above trend, after the deep 1981-82 recession output rebounds back to trend (“rapid cyclical recovery”), and during the “Great Moderation” hugs closely to trend.

Note also that following the 1990-91 recession, which was shallow and brief, output converges back to trend slowly. The same happens following the 2001 recession. That is one implication of “Great Moderation”. No “busts & booms”.

In 2003, as output was converging to trend, the economy was buffeted by a strong back-to-back oil shock. Did those shocks herald the end of the “good-luck” period? Or did the policy regime fail?

What was the essence of the “Great Moderation” policy regime? It stabilized aggregate spending (NGDP) growth along a stable level path. The NGDP & Trend chart for the 1990s illustrates.

To do so, the policy regime “ignores” or “looks through” supply (oil) shocks. Otherwise, it will impart additional and unwanted instability. Although Bernanke was well aware of that fact (see his 1997 paper Systematic Monetary Policy and the Effects of Oil Price Shocks), he was “tricked”, by his “inflation obsession” to tighten monetary policy (i.e. let NGDP growth fall fast below trend).

The charts illustrate the outcome of not maintaining the policy.

While in his last months at the helm Greenspan “looked through” the impact of the first leg of the oil shock and kept NGDP growth on the stable path, Bernanke did not.

An oil shock has a negative impact on RGDP growth. However, as Bernanke was cognizant:

Substantively, our results suggest that an important part of the effect of oil price shocks on the economy results not from the change in oil prices, per se, but from the resulting tightening of monetary policy.

As he should have expected, the tightening of monetary policy, gauged by the steep fall in NGDP growth, led to a strong drop in real output growth.

It strains credulity, therefore, that according to JF, RH, JS, MW, “the deep recession was superimposed on a sharply slowing trend in underlying growth”, in which case, most, if not all, of the steep drop in labor force participation was the direct consequence of the Federal Reserve´s enormous policy error.

The coincidence in time is simply amazing!

As the first chart above shows, there has been no “cyclical recovery”, with the economy remaining trapped in a “depressed recovery”. The also “depressed” level of the labor force participation is maybe just a reflection.

As a final note, once I wrote a piece called Bernanke, the man in the “irony” mask. I just discovered a new irony.

In February 2004, Bernanke gave a speech that helped popularize the “Great Moderation”. In the conclusion, he states:

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.

Exactly two years later, he took over the Fed…and failed massively. That happened because it was not the lessons of the 1970s that should not be forgotten, but the more recent one of the Fed striving for nominal stability!

Just one of those things

 

 

 

 




Huge US Federal Budget Deficits In Perpetuity: What Should the Fed Do?

The last filmy slips of fabric have been stripped away, and macroeconomists must now view the once-romanced US Congress in flagrante delicto with a real paramour: Mr. Big Bucks Deficits.

The Congressional Budget Office, the Budget Committees, the Tax Committees, the endless pompous pettifogging about national debts—all tossed overboard on the Washington IOU Love Boat.

Worse, Congress is not having a mere wild love affair—they have brought Mr. Big Bucks Deficits to the altar.

So Now What?

From here, a premise of Federal Reserve monetary policy must be that it takes place alongside $1 trillion annual deficits.

For many, the new reality suggests an even tighter monetary policy to offset the fiscal stimulus (of course, for many, monetary policy should everywhere and always be tighter).

Oddly enough, tighter money may be exactly the wrong course. Tighter money could, perhaps probably, trigger a recession that would only dramatically deepen federal deficits, as we have repeatedly seen in the US and many other nations.

When life hands you a lemon, then make lemonade. There may be some workable options.

QE

The Bank of Japan has bought back about 45% on Japan’s national debt, and has held interest rates to 0.10% on 10-year JGBs. Despite record-low unemployment in Japan, the BoJ cannot seem to break a 1% inflation ceiling.

The successful deployment of the QE option raises a hope that the US national debt can be transferred to the Fed’s balance sheet, from which interest payments flow back into the US Treasury, thus mitigating the tax burden of the debt. This is working now, in fact (if not theory), in Japan.  What works, works.

Perma-Bonds at Zero

Curiously, if the Fed does go to tighter money and triggers a recession, likely we will see interest rates for government debt fall to zero (government debt already pays zero interest in Japan and Germany).

From this untoward position, the US Treasury might be able to issue perma-bonds at zero or very low nominal rates, such as 0.10% (as in present-day Japan). So the Treasury might aggressively re-fi debt at 0.10% through perma- or very long-term bonds. Again, this alleviates the debt burden.

Helicopter Drops

Another option is dispense with bonds and Fed balance sheets and the banking system altogether, and use the Fed to simply print money and pay for federal operations, called money-financed fiscal programs, aka helicopter drops.

I prefer that helicopter drops not finance federal operations, but rather finance tax cuts, such as a tax holiday on Social Security taxes paid by employees and employers. This tax loss would be offset by Fed printed (digitized) money injected into the Social Security fund.

Conclusion

The best Fed policy is still to target NGDPLT.

But there is a near-certainty of soaring national debt in the future, which could become unserviceable and suffocate real growth.

Innovative use of monetary policy options, such as long-term QE, or helicopter drops, must now be prominently placed in the Fed tool box.

The use of a central bank to deleverage a nation, without causing inflation, until lately might have been considered unlikely. But we have seen in Japan the BoJ accomplish exactly that. The recent use of QE in the United States also was not associated with inflation.  These policy options may be unpalatable to some.

But the option of not mitigating soaring national debts through monetary policy may prove even less palatable, and less pragmatic.




Janet Yellen says farewell and the stock market sheds tears

Many things happened on February 2, the date the employment report for January came out. Before going into that, it´s worth looking at some history.

In January 2012, the Fed instituted a formal 2% inflation target. Curiously, from the January 2012 FOMC meeting, extending to the June 2013 FOMC meeting, the Fed anticipated that inflation would undershoot the target!

FOMC Meetings from Jan12 to June13

The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective.

In July 2013, they must have realized that was a dumb thing to say, changing the wording to:

FOMC Meeting July13

The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.

In the December 2013 Meeting they were more emphatic:

FOMC Meeting December13

The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.

Seven months later, in the July 2014 FOMC Meeting they were more optimistic:

FOMC Meeting July14

The Committee judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat.

Three months later, in the October 2014 FOMC Meeting the optimism was tempered:

FOMC Meeting October14

Although inflation in the near term will likely be held down by lower energy prices and other factors, the Committee judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year.

Two months later, they were again more sanguine, thinking the Phillips Curve trade-off would turn favorably:

FOMC Meeting December14

The Committee expects inflation to rise gradually toward 2 percent as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate. The Committee continues to monitor inflation developments closely.

In the following meeting, they revised their optimism:

FOMC Meeting January15

Inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate.  The Committee continues to monitor inflation developments closely.

In the next meeting they thought the decline in inflation had run its course:

FOMC Meeting Mar15

Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of energy price declines and other factors dissipate. The Committee continues to monitor inflation developments closely.

For the next five FOMC Meetings (April through October), inflation was “expected to remain near its recent low.”

In the December 2015 FOMC Meeting, which witnessed the first hike in rates for almost a decade, they again became upbeat:

FOMC Meeting December15

Inflation is expected to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further. The Committee continues to monitor inflation developments closely.

In the following month, however, they again back peddled:

FOMC Meeting January16

Inflation is expected to remain low in the near term, in part because of the further declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further. The Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook.

From the March through September FOMC Meetings, inflation was expected to remain low. In November, in preparation for the second hike that would take place in December, they once again changed the tune:

FOMC Meeting November16

 Inflation is expected to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further. Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.

In the January/February FOMC Meeting, they were confident enough to indicate that rate hikes would be more “systematic”:

FOMC Meeting January/February17

The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, labor market conditions will strengthen somewhat further, and inflation will rise to 2 percent over the medium term. Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.

That stance remained in place for the remainder of the year. Anything that would affect inflation, like the first quarter slow growth or the storms later in the year, would be transitory, with “inflation on a 12‑month basis expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term.”

In the January 2018 FOMC Meeting, they set the stage for “systematic” rate hikes continuing into this year:

Jan18

The Committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will remain strong. Inflation on a 12‑month basis is expected to move up this year and to stabilize around the Committee’s 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.

What do all those “statements” tell me about how the Bernanke/Yellen Fed conducted monetary policy?

My answer is that inflation is something that happens beyond their control! Why else would they think, for one and a half years, that inflation would undershoot the target they had just specified? After that, it was mostly “we expect inflation to rise to 2% over the medium term”. To the FOMC, in addition, the concept of medium term is very “flexible”.

How did inflation (PCE-Core) and unemployment behave during 2012 – 2017?

The Bernanke/Yellen Fed monetary policy was guided by (“imaginary”) Phillips Curve trade-offs. This, as Robert Hetzel indicates is an “activist” monetary policy and, to my mind, the source of much trouble for the Fed.

Setting the stage for the February 2 (extending to the next trading day, Feb 5) stock market rout, we look back to the signing of the Tax Cut in December 2017. From many accounts, that would be a “game changer” for growth.

Long-term yields rose as would be expected following an increase in growth expectations. However, if increased growth expectations were the driving force behind the long-term yield rise, we would tend to observe a tendency for the dollar to rise.

As the charts show, this was not what happened. The increase in the bond yield goes together with a down trending dollar. However, that yield-dollar combination is consistent with the rise observed in inflation expectations.

The 2.9% “trigger”

On February 2, the employment report said unemployment had remained at 4.1% for the fourth consecutive month and that payrolls had come in at 200k, higher than expected. The linchpin, however, was the 2.9% growth in average hourly earnings for all employees, touted as the highest since June 2009.

A few remarks:

1 June 2009 was the bottom of the Great Recession!

2 In September 2017, that same wage growth gouge was also 2.9%, later revised down to 2.8%.  The stock market reaction, however, was very different.

The other distinguishing factor on February 2 was that it marked the change of the guard at the Fed, and new Fed chairs are expected to show their anti-inflation credentials…

Who is Jerome Powell?

Jerome “Jay” Powell came to the Federal Reserve Board in May 2012. By September of 2012, the Federal Reserve was once again debating yet more QE; a third round.

Powell was among the more skeptical of the FOMC members. He never dissented, but may, nevertheless, be counted as a “hawk”. He acknowledge that the economy was weak, but what stands out is his interpretation of the weakness.

From the September 2012 FOMC transcripts:

MR. POWELL   My conversations with a group of about 10 diverse industrial companies—this is not autos, so it’s away from one of the real strengths. The other parts of the industrial sector, let me say, are pretty weak, and they strongly confirm that last point about employment. Outside of a couple of bright spots like housing and light vehicles, it’s soft everywhere, especially in Europe.

Big customers are postponing orders; they’re not canceling them. It’s nothing like from 2008 to 2009, but the softness that began about six months ago is now the new normal for these companies. The game is about share gain and taking out costs. It’s a low-growth environment. All new projects are on hold, and there is no hiring.

How, then, could he be skeptical about QE3? To him, QE3 was somewhat an overreaction:

MR. POWELL The question that looms is—and I’m going to, again, leave aside monetary policy—when do we break out of this? And I really do believe that we will. We always have. I can remember many of these cycles where you really wonder if this is it and we’re never going to get out.

I really do feel that if you look at our own projections, essentially, all of us project that we’re going to have those 3 percent, 4 percent catch-up years. They’re now scheduled for 2014 and ’15, but really, there’s a ton of uncertainty around that. So I’m going to share this highly anecdotal evidence in an effort to end on something of a high note.

His “high note” is “appealing” to his professional specialty, Private Equity, as “evidence”.

MR. POWELL I talked to both private equity investors and hedge fund investors, and it’s always very interesting to compare the two of them.

The hedge fund investors are in a really difficult environment. They’re traders who get marked every quarter, and, in a world that has very few ways for them to make money, they’re generally very conservatively positioned, and their investor base seems to be fine with that.

Private equity firms are feeling quite differently about things. They basically think about creating value over a three- to five-year period, and many PE firms right now, large and small, think that this is a great time to buy.

In fact, a string of large industrial properties, which would ordinarily have been expected to trade to corporations, has traded to private equity. There are three reasons why the private equity firms are feeling aggressive.

First, their natural competitors, these big companies, are all frozen on the sidelines, sitting on their cash, ruled by risk-averse public boards, and out of the game. If anything, they’re going to wind up being net sellers as the recession goes on.

Second, leveraged finance markets, as Andreas was discussing this morning, are very attractive, with low rates and issuer-favorable terms that are just about reminiscent of the bubble days, and all of that provides critical flexibility in case deals don’t go well.

Third—and really the one that’s relevant for this policy exercise—private equity firms think about the medium term, and they see the future as better.

These large private equity firms are completely global; they each own hundreds of companies in every major economy and in every vertical; and they systematically mine the data that they get and they’ve got the talent on board to do that. This is not the private equity industry of 20 years ago. So they’re seeing something. They really are.

…So the question is, why take any signal from this, right? I realize it doesn’t tell us anything at all about the next few quarters. But I will say that it’s a bit of a signal to me because this is a group of investors with very successful and, in some cases, long track records that were looking ahead to strong growth in the medium term, and they were willing to put more than just an opinion on the line in that belief.

Interestingly, 2013 – 2014 witnessed a “break-out”. It was, however, short lived. More recently, a “gentle recovery” from the ensuing slowdown is touted a “sign of accelerating growth”!

The idea is that the stock sell-off reflects the view that employers will have to pay higher wages, cutting into profits, and that higher inflation will cause the Fed to raise rates faster, is wrong!

There is no indication that growth will be more robust or that inflation will surprise on the upside, at least not while monetary policy, the stance of which is partly determined by NGDP growth (partly, because the initial level of NGDP also matters), shows no sign of “breaking out”.

Furthermore, the unemployment rate could be (and will be) lower but nothing would change!

Therefore, if the Fed doesn´t go “off the rails” under the new (and untested) management, things should “quiet down”, with inflation expectations coming back down somewhat, with the same being said of long yields. The dollar downtrend should also reverse.




Share Price Drop is not about NGDP Expectations

tldr: Don’t worry

When developing our NGDP forecasting methodology, which uses only data from the NGDP/NGDI time series as well as market prices, we ran a number of validation trials. These trials sought to show that the methodology was invalid. We did simulation studies, we did out of sample tests and weren’t able to find a problem, though the most impressive result came when we ran the system in a simulated daily forecast update against the ’87 stock market crash.

The “Black Monday” crash of October 19, 1987 saw the S&P 500 drop 20% in a single day. However, nothing really happened in the macro economy. Greenspan talked down the dollar (massively), cut rates and life went on, there wasn’t even a sign of a slowdown in macro data. When we ran a version of our system (without TIPS spreads, which didn’t exist at the time) against the Black Monday financial data, NGDP growth showed a small downward blip, but nothing too crazy, nothing like the massive collapse in expected NGDP that occurred when we ran our system against the daily observations from September-2008 through March 2009.

If NGDP expectations are a ‘thing’ that exists in the Collective Unconscious of market participants (and we think this is a useful approximation) then that ‘thing’ is not synonymous or even principally composed of equity price related factors. Or, to put it in reverse order, NGDP expectations do not always drive stock prices, this is how share prices can rise 50% since the election and the economy doesn’t really grow too much faster.

This is exactly what happened yesterday. Somewhat reminiscent of the recent collapse in crypto currency prices, though so far not nearly as dramatic, the S&P 500 fell 4.1%, which is indeed a big drop for a single day. However, our forecast has only fallen 0.06 percentage points, to 4.35%, it’s just another wiggle in the line.

 The bearish move by stocks was mirrored across most asset classes, but the moves just weren’t big enough to matter. Importantly, TIPS spreads actually rose, as did the 5-year yield, and the short end of the curve didn’t drop too much, though the 2 year yield did dump about 15 basis points. The dollar index didn’t move and copper prices even rose. West Texas Intermediate fell but it is still at $63 a barrel. This isn’t a market that’s screaming “recession”, but rather “4.35% nominal growth”.

We don’t know why the stock market fell today. Some say it’s because Trump is planning a coup against the Deep State. Others say it’s because the Deep State is planning a coup against Trump, and others still that it’s because immigration reform is (so this story goes) more likely, which will reduce corporate profits through a higher labor share of GDP and slower population growth. Who knows? What we can say is that, given what we know now, there is no reason to worry about the outlook, things still look about as they have for the last month or so, a little bit faster growth in 2018 than in 2017. Don’t listen to the financial media, who fan the flames to steal your time and attention. There´s nothing here yet.




“Drive slowly, grow longer”

Maybe Janet Yellen set it off with her comment in December “The global economy is doing well. We’re in a synchronized expansion. This is the first time in many years that we’ve seen this.”

It was picked up in Davos:

DAVOS, Switzerland—The world is enjoying its broadest, strongest growth in years, and everyone has an explanation, from the U.S. tax cut to the recovery in oil prices.

Let´s check.

World industrial production may be a good proxy for overall world economic activity. The chart indicates that it is not only the advanced economies such as the US, EZ or UK that are mired in a long depression, the world economy appears to be there also.

An incipient recovery was cut short in 2011. Some of that reflects the ECB tightening under Trichet, which plunged the EZ into a double dip recession.

The chart above shows that the level of world industrial production remains depressed, but there is growth.

The chart below shows that the incipient recovery was cut short when growth fell drastically in 2011. From that point, growth has fluctuated between 1% and 4%. The fact that it has remained near 4% for some months brings forth these “exalted” comments on “synchronized growth.”

Growth, even at 4%, has been low. Instead of “rejoicing” about that lackluster behavior they call “broad and strong”, policymakers should be trying to understand why many economies (including the overall world economy) have never recovered, remaining depressed.

That is certainly not the usual outcome. Using the US as example, there are several instances where the economy experienced deep recessions and even depressions, but recovered. The recovery from the Great Depression, for example, was negatively impacted by monetary policy mistakes in 1937.

One reason might be that the “modern economy” is “constrained” by unknowns. Things like “natural interest rates”, “natural rate of unemployment” and “potential output”. There is also the inflation target barrier.

The mixing of all these ingredients may have led the Fed (and other central banks) to “drive slowly”, afraid to have to use the brake more forcefully down the road. As Kocherlakota put it:

This systematic avoidance of big interest-rate increases might sound like a dovish, growth-friendly regime. In fact, it’s the opposite. To understand why, imagine driving a car in which, for some reason, you’ve decided to never use the brakes. Naturally, you’ll speed up more if you happen to hit a downhill patch. To compensate for that risk, you’ll drive more slowly all the time. It’ll take you longer — maybe much longer — to get where you’re going.

This is exactly the Fed’s situation. It has decided that it will never hit the brakes by raising rates quickly. So it has to apply stimulus very cautiously, to be sure that the economy never gets close to overheating. The result is that inflation has been below target and economic output has been below potential for nearly all of the past 23 years.

In a little over one year, this expansion will beat the record set by the 1990s expansion. Bernanke, Yellen and Powell will be hailed as “heroes”. The new motto will be “drive slowly, grow longer!”




The Lawyer is a Better Fed Chief? Or Fed Plots A Higher Unemployment Rate

 

The US Senate Banking Committee Jan. 17 voted thumb’s up on Jerome Powell, President Trump’s appointment to the Chair of the Federal Reserve. Barring calamity, Powell should take over in February.

With that, a lawyer will supplant Janet Yellen, a dyed-in-the-wool conventional macroeconomist, as leader of national monetary policy.

Lamentably, going to a lawyer is arguably a change for the better.

The Fed Wants Higher Unemployment

In the last two years, Fed staffers have consistently posited the US economy is facing “labor shortages” and is “beyond full employment,” even as wages rise like redwoods in the Sahara.

And on Jan. 16 from the San Francisco branch of the Federal Reserve, we have this gem: “We expect the [unemployment] rate to fall below 4.0% in 2018 as the economy continues to strengthen. With the gradual removal of monetary policy accommodation, we expect the unemployment rate to return gradually to our estimate of the natural rate of unemployment of 4¾%.”

Oh, happy days, the Fed will bring higher unemployment to America.

The Fed, btw, thereby posits that “full employment” is when there are about 1.5 people looking for a job, for every available job opening.

Allow the workforce a tighter market than that 1.5 ratio, and you have….

Phillips Curve and NAIRU

Fed staffers and orthodox macroeconomists still genuflect to the twin totems, the Phillips Curve and NAIRU (non-accelerating rate of unemployment).

Of course, in recent decades, many have noted that price inflation appears impervious to lower unemployment rates. And, gee, currently as well: Unit labor costs have flat-lined in the US, starting two years ago. The PCE is running at 1.5% YOY.

Powell

Future Fed Chief Powell is a Wall Streeter, a GOP political appointee who in previous government stints worked in regulating markets and banks. Powell may not be someone who believes theory trumps fact. True, through osmosis in his years at the Fed, Powell may have adopted the culture and biases of that independent public agency, but we can hope not.

If Powell can bring a practical approach to the central bank, his results may be superior than that which his staffers and some fellow FOMC members want.

Powell may also be inclined to help “the GOP tax cuts work.” If the Fed suffocates the economy now, the voting public may deduce the GOP-corporate tax cuts were bogus, in terms of economic stimulation.

If Powell is smart, he will use such an argument behind closed doors to advocate not using the monetary noose.

Lastly, Powell would do well to adopt NGDP LT, and perhaps he is un-doctrinaire enough to do so.

So, there is the oddity: A lawyer may provide a better monetary policy than many a credentialed macroeconomist.




When the Reagan Boom ended, the Great Moderation began

On July 1 1985, the New Republic published an article by Michael Barker titled “The end of the Reagan boom

Excerpts:

What’s going on here? Only a year ago, the economy was racing along at the fastest clip in more than 30 years. Personal income was up, inflation was down, and to many Americans, if seemed positively churlish to deny that President Reagan had succeeded in “laying the foundations for a decade of supply-side growth.”

… now, seven months after the election, just when we thought it was going to be “morning in America” for at least another four years, the forecasts are turning remarkably gloomy. First-quarter economic growth figures were virtually flat, raising fears of a “growth recession”—a period in which economic growth is so slow that unemployment increases anyway.

it’s hard to believe that the Fed’s action alone will be enough to prevent another recession either late this year or early in 1986.

All that blustery growth through 1983 and 1984 was nothing more than the pendulum swing of the business cycle, spurred along by record deficits and a Federal Reserve terrified of a long string of bank collapses.

The coming recession almost certainly will be the result of our big trade and fiscal deficits. No country has ever managed to run trade and budget deficits simultaneously and still sustain a recovery. We’ll be no exception.

On the other hand, the economy probably won’t just bounce back, as it did in 1983.

The likely result will be sluggish growth through 1986 and 1987, punctuated by at least a few quarters of absolute decline.

I take this as another opportunity to elaborate on NGDP Level targeting, hopefully contibuting to the ongoing “Monetary Framework” debate.

The chart shows that “all that blustery growth through 1983 and 1984…” was the outcome of a successful economic recovery engineered by the Fed. Note the “landing was not “soft” or “hard”, but just perfect!

Inflation came down and stayed down even while the Fed undertook an expansionary monetary policy (rising NGDP growth) to get the economy back on track.

Contrary to what Barker anticipated, there was no recession in 85, 86, 87, 88 or 89. During those years as in the subsequent ones, all the way to the end of Greenspan´s tenure, in fact, the economy evolved close to the longstanding trend path (“potential output”). Meanwhile, NGDP growth was very stable and inflation came down further in the early 1990s.

On the 1990-91 recession and simultaneous fall in inflation, in 1996 Orphanides wrote about the “Opportunistic Approach to Disinflation”.

Proponents of this approach hold that when inflation is moderate but still above the long-run objective, the Fed should not take deliberate anti- inflation action, but rather should wait for external circumstances—such as favorable supply shocks and unforeseen recessions—to deliver the desired reduction in inflation.

I don´t think there was anything “opportunistic” about the fall in inflation. Actually, it may have been a surprise. During 1990, the Fed was concerned with the fiscal situation, rooting for the budgetary changes that were being contemplated. At several meetings, the FOMC tied policy easing to progress in the fiscal front.

Then, Desert Storm happened. In the October 1990 FOMC Greenspan stated:

I would say that the appropriate policy under the oil price supply shock is to do what we were doing before–to try in a sense to maintain the same money supply growth pattern we would have had prior to the oil shock, absorbing a lower level of physical activity and a slightly higher level of inflation largely because we can’t avoid either of those two. I would say that the appropriate action is essentially to be where we were. It’s not to be accommodative; it’s not to try to stop the rise in prices, because we can’t.

He didn´t quite do it because NGDP growth slipped. Thereafter, NGDP growth remained very stable.

Ironically, seven years later, in 1997, Bernanke co-authored an article with Gertler: “Systematic Monetary Policy and the Effects of Oil Price Shocks”, concluding:

Substantively, our results suggest that an important part of the effect of oil price shocks on the economy results not from the change in oil prices, per se, but from the resulting tightening of monetary policy. This finding may help to explain the apparently large effects of oil price changes found by Hamilton and many others.

In 2000, the Greenspan Fed made a rare mistake. It let NGDP growth fall significantly and let it remain low for some time. In August 2003, the introduction of Forward Guidance (FG) was sufficient to lift NGDP growth to its “rightful place”. Real output dutifully climbed back to trend!

In my view, the popular notion that “interest rates were too low for too long” has to be amended to “NGDP growth was too low for too long”.

Unfortunately, 10 years after “Systematic Monetary Policy…” Bernanke completely forgot his own conclusion. Monetary policy was “squeezed”, with NGDP growth tanking. The outcome was the “Great Recession” (that morphed, due to absence of a recovery, into the “Long Depression”).

The charts tell the story.

Appendix

NGDP Targeting has been discussed at the FOMC over the past 35 years.

FOMC Dec 1982

MORRIS. I think we need a proxy–an independent intermediate target– for nominal GNP, or the closest thing we can come to as a proxy for nominal GNP, because that’s what the name of the game is supposed to be.

FOMC Dec 1992

Jordan. I put together a table–a big matrix of every forecast for as many quarters out as the Greenbook does it–for every meeting for the last year. What struck me was that it looked as if we were on a de facto nominal GNP target.

As the chart indicates, he was (and continued to be) “on the mark”.

FOMC Nov 2011

Bernanke (pps 92-93). Thank you very much, and thank you all for your thoughtful comments. Let me make a couple of suggestions and summary remarks. First, on the intermediate targets like nominal GDP and price-level targeting, I didn’t hear much enthusiasm for any near-term adoption, although I think there was at least some interest in continuing to think about these issues perhaps in the context of a significant change in the environment.

Just for interest, I do raise one point, which is that a number of people have mentioned Christy Romer’s piece, and she talked about the 1979 regime change. I actually think that’s the wrong example.

As President Bullard pointed out, when Chairman Volcker changed the policy regime, in fact, it took a long time for people to appreciate it and understand it, and one implication of that is there was a long recession and real interest rates remained very high, and so on.

But there are other examples, like 1933, when Roosevelt took the U.S. off the gold standard, and prices and asset prices changed almost overnight. There are other examples like the end of hyperinflations, and so on.

There’s something sometimes about regime changes that has remarkable effects on an economy. I’m not saying that we know how to predict that, but that’s something that we haven’t really understood or really explored in this conversation. That being said, I think that there was a lot of agreement that there are a lot of practical issues associated with implementing such an intermediate target, including both the very long horizons over which they have to operate and the issues of communication and credibility.

In his book “The courage to act” (pps 517-518) however, Bernanke states:

The full FOMC would discuss NGDP targeting at its November 2011 meeting. After a lengthy discussion, the Committee firmly rejected the idea…

…for NGDP targeting to work it had to be credible. That is, people would have to be convinced that the Fed, after spending most of the 1980s and 1990s trying to quash inflation, had suddenly decided that it was willing to tolerate higher inflation, possibly for many years

The “firmly rejected” was, to put it mildly, an exaggeration!

Furthermore, I didn´t see, in the discussions (neither in those that took place in 1982 and 1992), anyone express the idea that, by adopting NGDP targeting, the “Fed would have to be willing to tolerate higher inflation…”

The Economist made the most scathing comment on that section of the book when it came out in 2015:

And so in January of 2012 the Fed reiterated its inflation-targeting stance and officially designated a 2% rate of inflation, as measured by the price index for personal consumption expenditures, as the target.

We all know what happened next. Since then, the Fed has spectacularly undershot its inflation target. In 2011, most Fed members thought that interest rates would begin to rise in 2014 and would end the year at about 0.75%—and most thought rates would eventually settle at a level between 4-5%. Now, markets suspect rates might not rise to 0.5% until well into 2016, and most Fed members think rates will never get any higher than 3.5%. Treasury prices suggest that inflation will be closer to 1% than 2% over the next five years.

There is good reason to believe that Mr Bernanke’s Fed made a big mistake, in other words. An NGDP target would have worked out better, in two key ways.

First, a switch to an NGDP target would have helped the Fed choose policy more appropriately at a tricky time in the recovery. In 2011 high oil prices drove headline inflation above 2%, despite significant weakness in core inflation, in wage growth, and in the labour market.

In early 2012, at the time the Fed was adopting its inflation target, the central bank sensibly shrugged aside calls to raise rates in response to rising prices. Yet it also took no additional action to boost the economy. The recovery subsequently lost pace, inflation fell, and by the end of 2012 the Fed was forced to restart QE.

Had the Fed instead focused its attention on NGDP, it would have been forced to react to an economy that was well below an appropriate level of output and which was growing too slowly. The Fed could have looked straight through inflation and kept its foot on the accelerator. Instead it took the costly choice to dither.

Just as importantly, a switch to an NGDP target would have sent a strong signal about Fed priorities, precisely because it was a significant departure from past policy-making. Mr Bernanke notes that the Fed spent the 1980s and 1990s trying to quash inflation.

It did not arrive at that policy strategy passively; on the contrary, that strategy was a bold departure from what had come before. Paul Volcker might have argued in the early 1980s that the Fed couldn’t possibly rein in double-digit inflation because it lacked credibility as an inflation-fighter after a decade of neglecting the problem. Instead, he used the tools available to him to demonstrate the Fed’s credibility.

Mr Bernanke’s Fed could have, and should have, taken similarly bold action. It could have set a bold and more effective target and committed itself to unlimited asset purchases until that target was hit. Instead, it made itself a prisoner of its own complacency. As a result, inflation and interest rates will spend most of the 2010s at dangerously low levels, leaving the American economy disconcertingly vulnerable to new economic shocks.

At the same time, Brad DeLong found himself thinking about six things :

# 6: The failure of the Bernanke Fed to admit that the 2%/year inflation target had proved to be a mistake, and shift to a more sensible nominal GDP target.

To wrap up, the charts show the heavy costs imposed by Bernanke´s “dangerous” obsession with inflation targeting.

                   

The first oil shock happened mostly under Greenspan. As expected (headline) inflation goes up and real growth slips. However, Greenspan kept NGDP growth stable, avoiding the worse (as he had said in 1990).

Bernanke, however, contrary to his academic research, tightens monetary policy. NGDP growth turns down and then tanks.

We are reminded of James Meade´s 1977 Nobel Lecture:

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?

Later:

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.




Let´s avoid bad choices

Greg Ip discusses asset bubbles and how they could make Jerome Powell´s life at the Fed difficult:

Any central banker watching the stock market today should get a queasy sense of déjà vu.

A housing boom preceded the last recession. A tech stock bubble ushered in its forerunner.

Today, stock and property prices are once again setting records, in absolute terms and relative to household incomes.

That may leave the Federal Reserve and Jerome Powell, nominated to succeed Janet Yellen as Fed chair next month, confronting some agonizing trade-offs in the next year or two: What if low inflation calls for low interest rates but those low interest rates make an eventual, destructive asset bust more likely?

Should he lean against an incipient bubble by raising rates faster now, or plan to mop up the mess if assets collapse later?

We look at it in another way. What preceded the last recession and its forerunner, as well as previous ones, was a tightening of monetary policy, the stance of which is not gauged by interest rates but by what was happening to nominal spending (NGDP) growth. The charts illustrate.

Note, for example, that with “forward guidance” (FG) in mid-2003, NGDP growth (and the stock market) picked-up. Also, note that from mid-2014 to mid-2016, when NGDP growth recoiled, the stock market balked, but picked up when NGDP growth turned.

The level of nominal spending is less than “ideal”, and its growth rate is on the low side, but that has been enough to keep the stock market chugging along and, by allowing the wage/NGDP ratio to fall, has kept unemployment trending down.

In our view, the choice facing Powell is not “should he lean against an incipient bubble by raising rates faster now, or plan to mop up the mess if assets collapse later?”

What the Fed or Powell cannot allow is another collapse in NGDP like the one we saw in 2008-09. The cost in terms of banking and financial markets distress, worsening public finances, mass unemployment and international discord is simply too big to contemplate.

Recently, the Fed has intensified the discussion on alternative monetary policy frameworks. Bernanke, for example, said in a recent conference:

Speaking at an event at the Brookings Institution, where he is a scholar, Bernanke suggested that Trump Fed chairman nominee Jerome Powell is likely to formally begin re-examining the Fed’s target this year and that there “there will be some pretty serious discussions” on changing it in 2019.

Bernanke’s comments are the latest sign that the Fed is moving toward a historic reassessment of its monetary policy.

We hope that they go about it soon and that they end up choosing an NGDP level target instead of the present “front runner” price level targeting.




“Inflation on demand”

The title was inspired by Olivier Blanchard´s presentation at the Brookings gathering on January 8 on “Should the Fed stick with the 2% inflation target or rethink it”.

Blanchard proposes increasing the target to 4%. He also comments that Bernanke´s recent “temporary price level targeting”, which Blanchard calls “inflation when you need it”, so that real interest rates can be lowered when you are at the ZLB. That´s “Inflation on demand”!

In addition to a higher inflation target, the Brookings gathering also discussed an inflation band (Rosengren), a price level target (John Williams) and nominal GDP targeting (Jeffrey Frankel).

After experiencing more than 30 years of low inflation and a quarter century of low and stable inflation, I find all the talk on inflation “absurd”. It is even stranger that now the talk is about raising inflation!

Greenspan´s objective was to keep inflation “low”, where “low” was that inflation that people didn´t notice. Six years ago, “low” was precisely defined as 2%. With that, the problems began, because the target was never (until now, at least) reached.

However, even before the 2% target was explicitly established in January 2012, when Bernanke took over the Fed in January 2006 everyone new that he was an inflation target freak (@2%). I am reminded of James Meade´s alert 40 years ago in his Nobel Lecture, that the pursuit of price stability (here defined as 2% inflation) is dangerous:

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?

This was exactly what happened in 2008. Bernanke didn´t look through the 2007-08 oil shock, which increased inflation, especially the headline PCE, and tightened policy. Although the Fed Funds rate was coming down, monetary policy, the stance of which is better gauged by NGDP growth relative to trend, was being tightened and after mid-2008, the monetary screw was tightened further, with NGDP growth tanking.

The charts illustrate.

There´s a natural experiment here. Note that there were two back-to-back oil shocks of comparable magnitude. The first in 2004-06 happened mostly under Greenspan. Note that at that time, NGDP growth remained stable. In the second shock, under Bernanke, NGDP growth falls significantly before tumbling into negative territory.

In Bernanke´s case, the NGDP drop was motivated by the surge in headline inflation. A BIG mistake.

More generally, in the charts below you can see that prior to 2006, price level targeting and NGDP level targeting (and also core inflation targeting) were observationally equivalent.

When NGDP fell significantly below the trend level path, the economy deteriorated, indicating that de facto NGDP level targeting was what was providing Nominal Stability, a concept more encompassing than Price Stability.

As James Meade also said in his 1977 Nobel Lecture linked to above:

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.

I hope the Fed under Powell will end up choosing an NGDP Level Target as the new monetary framework.