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Karl posted something that he should have titled “Stream of Consciousness” instead of “Unsubstantiated Claims” where he thought out loud. One of those thoughts landed on the Fisher effect.

My sloppy writing makes it sound as if I am saying Reihan should read up on the Fisher effect. What I mean to say is that Reihan brought up the fact that people fear inflation eroding savings. These fears are common. I have had many a Facebook debate over them. Indeed, Ron Paul has repeatedly pointed to this has his main reason for fearing debasement of the currency.

I believe that the Fisher effect is controversial among Austrians, and Keynes didn’t believe in the relationship at all, except under hyperinflation. Using price inflation in the Fisher equation makes a lot of things confusing, because the composition of output under recession circumstances (less than full employment — or a flat SRAS) is that raising inflation expectations to, say, 3% from 2% will likely cause an increase in real output, leaving inflation at it’s long-run target. Indeed, the Fed isn’t even interested in boosting inflation expectations past its set 2%, and has made that very clear. What the Fed wants is higher NGDP…but unfortunately it operates under a target for nominal interest rates.

Scott Sumner has a post about how inflation is, counterintuitively, good for savers. The thrust of it is that raising NGDP expectations will raise the Wicksellian real interest rate. People will spend more on investment (maybe not consumption, but probably), and we will get far more output, while trend inflation remains intact (and if it doesn’t, then the Fed can act as necessary). This is a boon to savers, as it raises not only the interest rate on savings accounts, CD’s, and the yield on bonds…it raises other asset prices as well, like stocks, real estate, commodities, etc. All are vehicles for saving, and a higher level of NGDP causes every type of investment to increase its yield.

This is the fundamental reason inflation is confusing. People think a lot about cash, but not many people save in cash (as in safes) under a normal positive trend inflation rate — criminals mostly. I think that price inflation is just muddying the debate here, and is completely useless.

A little late, I know, but Happy Thanksgiving everyone!

Remarks from Ben Bernanke indicate that the Fed is shooting itself in the foot:

“I have rejected any notion that we are going to try to raise inflation to a super-normal level in order to have effects on the economy,” [Bernanke] said.

In fact, the Fed should engage in level targeting, as I have been pushing in the last few posts. It should commit to a higher target for nominal expenditure in order to return to the previous trajectory from the Great Moderation. That requires a higher level of NGDP growth than is “normal” in order to catch up. One way to do this under the current monetary regime is to create higher inflation expectations. Do they need to be much higher? I don’t think so, but it’s not entirely unreasonable to disagree.

So we know that most members of the FOMC view 2% as the preferred inflation target. We now also know that the Fed is holding true to that target, come hell or high water. 2% is better than 1%, but a temporarily higher target would produce a much more robust recovery. Arguably, the Fed is in the business of providing stable NGDP growth consistent with high employment and low inflation. It allowed NGDP to plummet and now they should be trying to make up that lost ground as quickly as possible. This statement is clearly against that goal.

We’re in for a rocky road if our monetary authority sees it fit to tie its hands.

Inflation is confusing. The concept makes crazy people crazier. And even worse, it makes otherwise sober people disagree with eachother. Reading through the accounts of QE2 on the internet the past few days have solidified my view that inflation is a thorny enough concept that we should rid it from popular vernacular. Is inflation important? Sure…but what measure of inflation is correct? CPI-U? GDP Deflator? Your crazy uncle’s index? Does inflation help or hurt savers in the current landscape?

If there is anything that gets turned on it’s head when an AD recession hits, it is the concept of inflation. During normal times (full employment and capacity utilization), inflation is harmful as it drives up interest rates, discourages saving, and encourages misallocation of capital. However, none of those things apply to the current situation in which we find ourselves with a large output gap and high unemployment. Thus, we need higher inflation in order to close the output gap (the difference in money expenditures between where we are currently, and the trend rate from the Great Moderation…currently about -13%), but that turns everything that everyone knows about inflation backward. All of a sudden inflation is good for savers, good for the unemployed, and good for economic growth. Well, stable inflation expectations are key…but it’s hard to steer a ship, and it’s hard to get a non-confusing answer out of pundits and other commentators.

In order to square this circle, I propose we forget about inflation. And not just forget about talking about it, but forget about its use in the setting of monetary policy. Instead, we should target nominal expenditure at a steady growth rate (3% a la Woolsey, or 5% a la Sumner, Beckworth, etc.) with level targeting. What advantages does targeting nominal expenditure have? Well…

  • Targeting nominal expenditure (NGDP for short) allows monetary policy to better address recessions which arise from both aggregate supply and aggregate demand shocks. David Beckworth has an excellent discussion of this point.
  • NGDP is a better indicator of monetary shocks than inflation indicators like CPI. Because prices are sticky, and because measures of inflation are so problematic, a fall in NGDP won’t immediately show up in inflation numbers. Also, if there is a large price shock in something like oil, this will raise the money price of all goods and services, causing anyone focusing on inflation to miss the underlying weak economy…and thus potentially set monetary policy to be too contractionary (sound familiar?).
  • NGDP allows us to broaden our focus to aggregates like MZM, asset prices, yields, excess reserves etc. We’ll relinquish our inane focus on interest rates, which are a very problematic indicator of the stance of monetary policy, and have a much better picture of the health of the economy.
  • NGDP sounds better. People have an innate fear of inflation. Inflation destroys savings, after all…and we all know frugal people are virtuous. Well, how about, in the event of a recession, instead of economists clamoring against the crowd that we need inflation, they say that we want aggregate expenditures (and thus nominal income) to be at some level higher than it currently is? Money illusion is a powerful motivator. Who would argue with that?

Targeting nominal expenditure would be a beneficial step from both an economic theory perspective, and a public relations perspective. Lets take the confusing concept of price inflation out of our discourse, so that we can see the world more clearly.

P.S. We are currently 13% below the target path from the Great Moderation, and are where we were at before the crash of Sept/Oct 2008. To make that up by 2011:Q3, the Fed would have to target NGDP at $17.6bn (to continue on a 5% NGDP growth path). However, Bill Woolsey favors a 3% growth path for money expenditures, which means that the Fed would only have to target a 13.8% increase by 2011:Q3 (or $16.4bn), and then continue on with 3% growth, level targeting, from then.

Update: Found the link to Beckworth’s article!

I was going to write up a post on my exasperation at the Fed’s recent meeting statement, but Ezra Klein got to it before me and did a good job, so you should go read what he has to say. One point that I want to highlight, because I have made the point that the dual mandate is mostly just an insiders joke:

Paragraph two: We admit everything is terrible. In fact, it’s so terrible that it means we’re failing our mandate. “Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.”

[Image Courtesy of David Beckworth]

How many of you wish that you had a job where you could consistently fail at the very time when it is clutch that you deliver in a big way? How many of you would like to say, “Well, I have a model of the economy that says we won’t be hitting any of our own targets…but oh well”? The Federal Reserve is in the exact position in the economy where they can act quickly and decisively and actually make a large impact on nominal spending. I would even go as far as to say that they can do so without “long and variable lags”, as markets should price in actions by the Fed nearly immediately, and indeed they have been.

Contrary to the popular narrative, I believe that it is this very passivity by the Fed that brought us to the brink in the fall of 2008, when every indicator of economic activity (industrial output, consumer spending, business confidence, NGDP expectations, etc.) were found to be in sudden free-fall mode. At that time, interest rates were in the 1.5%-2% range, and the Fed’s target was still 2% until October 2008!

And here we are, fully two years later, and we still cannot get the Fed to act…nor can we get the executive branch of government to take the problem seriously! This inaction belies an institution that either is ill-equipped to respond when necessary, or is structured in a way that prevents decisive action. Since I believe that the Fed has all the tools it needs (it being a monetary superpower), I would place the blame on the structure of the network.

There is nothing more important on the Fed’s plate right now than bringing nominal spending back in line with the previous trajectory of NGDP. Not only to assist 50 million people who are currently unemployed, and help numerous others rebuild their balance sheets…but to save our economy from the whims of populist sentiment that will likely take hold if our economic malaise continues for very much longer. That means rounds and rounds of fiscal stimulus. That means the development of an entire class of freeters who never reach full potential. And most importantly, that means the loss of real goods and services that could otherwise be produced in our economy — which translates into a lower real standard of living for everyone.

At this point I would do anything for a little more monetary stimulus.

Update: I probably should have put “during the recession” in the title. Unfortunately it’s gone to press.

Chevelle, at Models and Agents, explains why the previous round of “quantitative easing” performed by the Fed did not have a [sufficient] expansionary effect:

By that metric, the Fed’s past LSAPs have probably fallen short. Clearly, measuring the counterfactual is impossible, but there are reasons to believe that the impact on aggregate demand was small. Why? First, because the reduction in mortgage rates boosted refinancings only by people who could refinance—i.e. people with jobs and some positive equity in their home. Not exactly the most cash-strapped ones who would have spent the extra cash.

Second, the portfolio-balance effect of the LSAPs on the prices of assets like corporate bonds or equities is at best weak, if not counterproductive. The reason (which I explained in detail here) has to do with the fact that US Treasuries and MBS are not “similar in nature” to corporate debt and equities. Unlike the latter, Treasuries/MBS have more of a “safe haven” nature—so that removing them from investors’ portfolios create demand for more “safe” assets, rather than boosting the prices of equities, high yield bonds, etc.

Luckily, one Benjamin S. Bernanke explained how to perform private asset purchases that would, in fact, have an expansionary effect:

If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.

If you see that guy around, tell him to talk to the Federal Reserve. I remember hearing a podcast with Scott Sumner a while back where he floated the idea of the Fed buying bonds off of the public (i.e. You and I), and paying for them with cash. Lets get to it!

Scott Sumner routinely forgets my name when listing people who thought money was tight, and favored unconventional monetary responses to the recession…but that’s okay. I wasn’t blogging that much in late 2008. In any case, I would like to provide a concise answer to a question Scott raises on his blog today:

The very fact that Congress and the President are ignoring this issue (confirming FRB nominations), pretty much tells me that they are clueless on monetary policy. On the other hand, both groups do favor more AD, so their “heart” is in the right place. And of course I’m a big believer in democracy. So who do I favor making the decisions; the clueless or the heartless? I’m tempted to say “Whoever agrees with me; first tell me the target Congress would set.” But of course that’s cheating. The honest answer is that I don’t know. But it is becoming increasingly clear that we won’t get good policy until this dilemma is resolved.

In my mind, the myth of an independent central bank has pretty much been shattered (Karl’s as well). Every time the theory of why we have an independent central bank has been put to the test in a big way, the Fed has failed miserably.

But maybe the answer is more nuanced than that. Perhaps the Federal Reserve itself is simply a proximate cause. If you take the view that the actions of the Fed represent the consensus of the economics profession, then perhaps it is the economics profession who are the underlying cause.

In either case, it is clear that there should be hard rules in place that the Fed must abide by. At the same time, I think that the Fed should have maximum room to act independent of politics when it really needs to. Our current “dual mandate” provides nothing but an excuse for the Fed to shirk its duties. Thus, I believe that the Federal Reserve Charter should be rewritten to state that it is the Fed’s contractual duty to set an explicit nominal target, level targeting, and do everything in their power to hit that target. If you ask me I favor NGDP, but some people favor price level, and some favor inflation…if you really want to pin the Fed down, write which nominal target the Fed needs to hit into the charter. NGDP will still be here 100 years from now.

However, and this is important, that is the end of Congress’ power. Once they have arbitrated as to what the Fed needs to do, Congress gets out of the way and lets the Fed act. The only point at which Congress should have the authority to intervene is if the Fed is off-target, in which case Congress should have the power to remove the current board (or specific members) and appoint a new one. But, and this should be written into the charter as well, the only circumstances in which Congress can do so is if the Fed is missing its target (or criminal behavior, or other things that don’t have to do with monetary policymaking).

Separating politics from policymaking is definitely a good thing (I even came around on TARP), especially in monetary policymaking. However, having a monetary authority that is gallivanting around, allowing NGDP expectations to plummet 8% with zero recourse is unacceptable.

Karl has a post today arguing that Brian Wesbury is wrong for taking the view that fiscal stimulus is not effective (indeed harmful!) for two reasons: 1) that it pushes up interest rates through government borrowing (crowding out), and 2) people will expect future taxes to pay for the stimulus.

Unfortunately these are annoying arguments that get conservatives in a lot of trouble with smart commentators on the other side, and then tend to discredit their entire enterprise. Paul Krugman has made a cottage industry out of sniping these crude arguments from otherwise distinguished economists (see Robert Barro via flexible-price models).

However, while Googling Mr. Wesbury, I came across an article that I want to dredge up from February 2008. I want to do this not to point out that Wesbury has no credibility (like some commentators *ahem*), but to show how thinking in terms of interest rates screws people up, and how uncertainty is very dangerous to reputations. The title of the article is “Brian Wesbury Sees No Recession Ahead“.

Q: You say we are not in a recession and we are not even headed for one, right?

A (Wesbury): That is correct. Every single recession in the United States for the last 80 years has been preceded by a tight Federal Reserve policy — in other words, excessively high interest rates. And we clearly don’t have that today. Recessions are also preceded frequently by tax hikes or protectionism. So I would say that today we have very low interest rates, we have low tax rates, and we are not moving in a protectionist direction. As a result, those conditions that have led to recessions in the past don’t exist. One last point: I know of no point in history where we have ever scared ourselves into a recession. It just has never happened before and I don’t think it will happen this time, either.

This is a bombshell of a quote. My main point is that given the events that had happened up until then, saying that we won’t experience a terrible-horrible recession was not an unreasonable position to take. The problem is equating the setting of interest rates with the stance of monetary policy. I also know of no correlation between taxes and recession, and I’m sure he had in mind Smoot-Hawley when he was talking about protectionism…but that tariff was a drop in the bucket of what the actual problem was (then and today): falling NGDP.

By late 2008, in hindsight, Wesbury looks like a fool…but how would he have possibly known that the Fed would let NGDP fall at the fastest rate since 1938 later in the year? As a counterfactual, had the Fed kept up expectations that it would hit its 5% NGDP growth target, Wesbury’s statement wouldn’t look so bad today.

Arthur Laffer was (YouTube) famously in the same boat while talking with Peter Schiff, and of course made to look like a moron. My first piece of advice would be to not attempt to make public predictions. Since that is impossible, my second piece of advice would be to err on the side of caution when making predictions based on models (that is also true with NK multiplier models)…especially when facing strong headwinds.

P.S: I’m happy about the “Babble” tag.

There has been a lot of chatter around the blogosphere about Narayana Kocherlakota’s speech in Michigan last week, and seeing as I am trying to catch up on news, I think that is a good a place as any to start. First, here is the whole speech, so that you can read it if you would like.

The big focus, especially among left-leaning commentators, has of course been Kocherlakota’s comments on the unemployment situation. The only troubling thing to me about a monetary policymaking body discussing unemployment is the fact that it is happening at all. I don’t believe that there is anything “special” that monetary policy can do to alleviate unemployment — even in a booming economy. The capacity of monetary policy to act is to keep nominal GDP growing at a constant rate, year over year, and to tighten a little when it overshoots and loosen a little when it undershoots — such that the trend path of NGDP is a constant upward slope. I’m not an expert on the welfare-maximizing trend rate of NGDP…but people who are much smarter than me on average advocate 5% NGDP growth.

In any case, in the speech, Kocherlakota breaks down how Fed meetings operate, and then breaks down his “forecast speech” that he gave to the FOMC. Along those lines, he has three points: GDP (real), inflation, and unemployment. On those three points, he has this to say:

Typically, real GDP per person grows between 1.5 and 2 percent per year. If the economy had actually grown at that rate over the past two and a half years, we would have between 7 and 8.2 percent more output per person than we do right now. My forecast is such that we will not make up that 7-8.2 percent lost output anytime soon.


The Fed’s price stability mandate is generally interpreted as maintaining an inflation rate of 2 percent, and 1 percent inflation is often considered to be too low relative to this stricture. I expect it to remain at about this level during the rest of this year. However, our Minneapolis forecasting model predicts that it will rise back into the more desirable 1.5-2 percent range in 2011.[1]


Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers. [...] Given the structural problems in the labor market, I do not expect unemployment to decline rapidly. My own prediction is that unemployment will remain above 8 percent into 2012.

[1]5yr TIPS spread is at 1.43, 10yr @ 1.55.

Now, not making up the lost employment is partially a function of his previous point about per capita GDP remaining under trend for an extended period of time. This is the cyclical component of unemployment. Cyclical unemployment is created due to the relationship of the economy to the cycle of time. As such, the level of cyclical unemployment correlates well with the business cycle, seasonal factors, etc. I believe that most of the unemployment we are currently experiencing is of cyclical nature.

I think the error in Kocherlakota’s thinking stems from this quote:

Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.

This is wildly baffling. Not only does Kocherlakota make the forecast above — i.e. we will not be hitting any of our targets (nominal or otherwise) any time soon — he also states that he believes that money has been easy. That implies that monetary policy has zero effect on the economy, any time. He also identifies that low rates for an extended period of time are a sign of monetary failure, but does so in a future-orientation. While it is true that low rates can (and do) accompany* a deflationary “trap”, the policy prescription that follows is not to raise short-term rates regardless of the composition of employment. The proper policy response in that situation is to set a positive nominal target, level targeting and commit to move heaven and earth to hit that target.

That, rather than his statements about unemployment, is what I view as Kocherlakota’s underlying problem.

*H/T to Andy Harless in the comments. Also, read his post about Kocherlakota’s statements.

In a blog post today, Paul Krugman outlines a hypothetical situation that we could find ourselves in:

And this raises the specter what I think of as the price stability trap: suppose that it’s early 2012, the US unemployment rate is around 10 percent, and core inflation is running at 0.3 percent. The Fed should be moving heaven and earth to do something about the economy — but what you see instead is many people at the Fed, especially at the regional banks, saying “Look, we don’t have actual deflation, or anyway not much, so we’re achieving price stability. What’s the problem?”

I wonder if, on a particularly lazy day when Paul Krugman finds it difficult walk upstairs, he claims that he is in the “main floor trap”? But I digress. There is only one culprit in this situation: the dual mandate.

I’m not an expert on the history of the dual mandate, but I would venture a guess that it was the result of a grand bargain in which “price stability” came from the “hawkish” right, and “unemployment” came from the “dovish” left. The nature of the Fed’s dual mandate is such that it allows the central bank to wiggle out of nearly any situation if finds itself in with little consequence. Since the Fed is aiming at two diametrically opposed targets at once (price stability and full employment), it has large discretion upon which it can draw to justify its policy actions.

Is unemployment 9.5% with core CPI inflation falling below 1% and future expected inflation well below target as well? Well, that’s price stability!

How about persistent inflation rates bordering on double-digits while employment booms? Pat yourselves on the back guys!

In reality, and much to the chagrin of leftists everywhere, the modern Fed (1980′s+) has mostly erred on the side of price stability, which in the recent context has meant 5% NGDP growth with a rough average of 3% real growth and 2% inflation. This has allowed for a NAIRU of around 4-5% for the United States as a whole. Of course, that is a rate…and as long as the unemployed are continually in flux — that is, as long as hires outpaces quits and fires — that rate isn’t much of a problem. What is a problem is that the same dual mandate that was praised by some economists during the Great Moderation is now enabling the Fed to shirk its duties (and perhaps even worse, providing cover for “leveling down” with an implicit policy of opportunistic deflation…which is what Krugman implies above).

The Federal Reserve’s mandate is unique in the world. Most other central banks operate under a “hierarchical mandate” which generally stipulates an inflation target. It is hierarchical, because the central bank can set any target other targets it wants, and pursue them in order as long as they have hit their mandated target. The results of this kind of target vary from country to country.

In my opinion, Congress should scrap the Fed’s dual mandate, and instead mandate that the Federal Reserve set an explicit nominal target, and do everything in their power to hit that target (level targeting). If they’re feeling generous, they can give the Fed discretion as to which target they would like to set. If not, I would specify NGDP. I don’t think that the monetary policymaking body of the Federal Reserve should even look at a single unemployment number. They should focus like a laser on their keeping their nominal target in a very narrow range and leave the question of unemployment (which is a real variable) to other policymakers.

Stabilize monetary policy around a nominal aggregate, and I would wager that unemployment would find a way to work itself out with minimal intervention.

P.S. I kind of smile when I think about the Fed “moving heaven and earth to do something about the economy”. I suppose that is because 1) I think that monetary policy can do so and 2) I’m a huge nerd.

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