Re-visiting R*: Close to the end of the hiking cycle for the Fed

Last week I wrote a blog post in which I updated my outlook for US inflation based on the so-called P-star model.

In that blog post, I argued that my forecast in April 2021 for much higher US inflation essentially had been spot on, but also that inflation now is set to start to inch down relatively fast in the US.

The P-star model basically is a monetarist model that states that inflation is a result of money supply growth being faster than money demand growth.

However, the Federal Reserve normally does not communicate about monetary policy in terms of money supply growth but rather in terms of setting its policy rate.

I am as a (market) monetarist very skeptical about thinking about monetary conditions in terms of interest rates. Instead, I believe that central banks cannot in the longer run control interest rates. Rather, interest rates are determined by structural factors – essentially to clear the market for savings and investment.

What central banks can do is to set a policy rate that is comparable with what the Swedish economist Knut Wicksell called a natural interest rate, R*.

However, to set a policy rate below R* then the central bank will have to increase the amount of money in circulation in the economy. This will, however, cause an acceleration in inflation, which sooner or later will cause the central bank to revise its policy.

When central banks communicate in terms of their policy rate rather than in terms of for example money supply growth (or growth in nominal demand) then it becomes key to understanding the level of R*.

In that sense, we can understand the state of monetary policy by looking at the key policy rate relative to R*.

The problem of course is that we cannot observe R* directly, but we can try to estimate R* from the historical relationship between macroeconomic variables and the policy rate.

Back in February 2021, I presented such a model in a blog post “R* strikes back: The Fed will hike sooner rather than later”.

I have now updated that model and will use the updated model to evaluate US monetary policy over the past two years and to look ahead.

The R* model

This is how I described the variables in my R* model for the US back in February 2021:

“First of all, I look at potential nominal GDP growth (relative to population) growth.

This of course partly reflects the Fed’s inflation target and that we know from the so-called Fisher Equation that high inflation should cause higher nominal interest rates. Furthermore, this also captures the fact that higher productivity growth should be expected to lead to higher interest rates – as we for example recognize it from the so-called Solow growth model.

Second, I use population growth to capture both growth trends as well as for example the impact of changes in savings and risk appetite as a consequence of changes in demographic trends.

Third, even though the Fed’s task is to ensure ‘price stability’ it has not always succeeded in that. The opposite of price stability is price volatility and we, therefore, use a 10-year moving average of yearly changes in inflation to capture the degree of price (in)stability.

Finally, we also want to capture changes in investors’ and consumers’ optimism and pessimism and the general ‘business cycle’, and the general level of economic activity. I could have used unemployment or the output gap, but I also wanted to capture structural-demographic trends so I have used the so-called employment-population ratio as an explanatory variable.”

Furthermore, I took into account in the model that there apparently since 2008 has been a structural shift down in interest rates and yields globally – likely reflecting to a large extent banking regulation.

The graph below shows the effective Fed Funds rate since 1960 and until today and my estimate for R*. The model has been estimated until 2019 so as not to be influenced by lockdowns etc. from 2020.

We see that the model overall fits the development in the Fed funds rate quite well for more than six decades.

Below I will zoom in on the development in the Fed funds rate over the past five years and compare that with R*.

The Fed got it right in 2020, but failed massively in 2021

The US and the global economy and markets were hit by an unprecedented shock in early 2020 when the Covid pandemic spread around the world and governments – also in the US – moved to contain the virus by lockdown the economies and introducing draconian restrictions on civil and economic life.

In the initial phase, the reaction in the financial markets was very close to what we saw in the Autumn of 2008 and all indications were that the US economy would fall into a deep and potentially deflationary recession.

If we look at the model’s prediction of R* then we see that R* dropped sharply in the US in early 2020. In fact, the drop in R* was as sharp and as deep as in 2008 and as in 2008 R* turned negative. In fact R* became even more negative than in 2008.

Contrary to 2008 the Federal Reserve reacted swiftly to the drop in R* and cut the Fed Funds rate to zero and introduced massive quantitative easing. Hence, the Fed surely had learned the lesson from 2008 – when R* drops below zero it is not enough to cut the policy rate to zero – quantitative easing (money printing) is also needed.

The swift policy reaction from the Fed certainly worked – the US economy rebounded strongly as did financial markets.

The recovery was so impressive that I in May 2020 in a blog post argued that US unemployment would drop to 6% by November 2020. When I made that forecast US unemployment was at 15%. My forecast turned out to be nearly right – we got to 6.7% in November 2020.

The swift recovery let me to start thinking that the Fed would soon have to revise it policy stance and start hiking interest rates and undoing quantitative easing and that was very much driven by what I observed in terms of the development in R* relative to Fed’s actual policy.

This was also very visible in the graph above. We see that R* bottomed out around April 2020 close to -4%, but in months following that we saw R* increasing quite fast and by the end of 2020 R* was back to zero.

This would imply that the Fed would have ended its quantitative easing by the end of 2020 and have started interest rate hikes already in early 2021. And this is in fact what I thought the Fed would do – or at least start a process of “normalization”.

As I wrote back in my original R* blog post in February 2021:

“This means that we in 2021 are likely to see the Fed being forced to change its message quite a bit. I am tempted to say that this smells of the stop-go policies of the 1970s and even though the outcome is likely to be less catastrophic than during the 1970s we could very likely see an increase in financial market volatility as a result of this.”

But the Fed did not change its message. Hence, in early 2021 Fed chairman Jerome Powell, again and again, stated the pickup in inflation was temporary and in July 2021 Powell now famously stated the Fed did not even think about thinking about hiking interest rates.

If we compare this to our model for R* we see that by the summer of 2021 R* had increased to 4% – indicating that by the summer of 2021 US monetary policy had become extremely easing.

In fact, if we look at the difference between the actual Fed funds rate and R* – what we could call the R-gap – then this is the easiest US monetary policy has been since 1974. It therefore hardly should have been a surprise to anybody that we would see a sharp spike in inflation in 2021-22.

Hence, the R-gap is telling us the exact the same story as the P-star model – US monetary policy became excessively in 2021 and this is the main reason why we saw a sharp pickup in inflation in 2021-22.

Said in another way we got into 2022 the Fed was way behind the curve and there was a very urgent need to initiate monetary tightening. The Fed started signaling this in October-November 2021 and then initiated the rate-hiking cycle in 2022.

As we see from the graph above R* basically levelled off around 5% in mid-2020 and since then the gap between the actual Fed funds rate and R* has been closing as the Fed has continued to hike rates.

And with the expected rate hike this week from the Fed we are now very close to having closed the gap between the Fed funds rate and R* and it is safe to say that based on the R-gap US monetary policy is now close to being neutral.  

Next: Fed will start cutting rates as inflation comes down

The Fed got way behind the curve in 2021, but during 2022 the Fed has been fast catching up and based on our analysis above is clear that the Fed likely will end its interest rate hiking cycle in the near future.

The next question becomes when the Fed will start cutting interest rates and here we can also get a bit of guidance from our R* model.

What we essentially need to do is to make a forecast for R*, which to an extent gets us into endogenous problems – hence if the Fed keeps Fed funds too high for too long then inflation will drop faster and economic activity slow, which both will push R* down. On the other hand, if the Fed cuts rates too fast then it will cause inflation to come down at a slower pace and economic activity will be higher, which will push up R*.

This, of course, illustrates on of the problems with a policy of interest rate targeting – it is to a large extent a process of trail-and-error and given how much out of whack US monetary policy has been it is easy for the Fed to err in this process.

But on the other hand it is probably reasonable to assume that the Fed eventually will get it right – and bring inflation down towards 2%, while keeping unemployment close to its structural level (NAIRU). If we use this as input in out R* we can simulate a scenario for the Fed funds rate in the coming years.

This is what I have done below. In terms of inflation, I have used our P-star model from my previous blog post to make some assumptions for the development in inflation in the coming years. My base scenario for inflation is a simple average for the two inflation scenarios (“hawkish” and “dovish”) in my previous post.

The graph below shows the simulated Fed Funds rate, which we assume follows R*, based on our assumed scenario for US inflation going forward.

This is no doubt a very benign scenario where inflation comes down back to the Fed’s 2% inflation target gradually over the next couple of years and the Fed funds rate is cut gradually to reflect the drop in inflation.

There is of course a lot of room for mistakes and as such, it is very hard to make anything else than a conditional forecast for the Fed funds rate going forward. That being said given that I expect inflation to start declining rather significantly in the coming six months it is also clear that we are very close to the end of the hiking cycle and eventually the Fed will start cutting rates.

The Fed most definitely will not get it perfectly right, but I am actually somewhat more optimistic that the Fed will manage the next ‘stage’ of this episode better than what it did in 2021 so my ‘best estimate’ is that by 2025-6 we would probably see the Fed funds rate around 1.5% – more or less at the level we hade during the period 2015-2019.

Finally compared to market pricing the scenario above is not significantly different from market pricing. Hence, the market expectation is also for the Fed to initiate rate cuts during 2024, and even though my simulations are actually indicating that we could get rate cuts already in the second half of 2023 given the rather large uncertainties this is not a major difference. Note here that this is not because I assume the US economy will fall into recession – in fact, I have assumed it will not.

The overall conclusion is that while the Fed clearly erred on the overly easing side in 2021 and did right in tightening monetary policy during 2022 we are now entering a period where we have risks on both sides and the Fed can and likely will err in both directions in the coming 1-2 years.

US inflation set to fall sharply in the coming quarters

Back in April 2021, I wrote a blog post with the title “Heading for double-digit US inflation” in which I warned that we were likely to see a sharp increase in US inflation.

We didn’t quite get to 10% but it was close and US inflation certainly turned into the main US policy issue in 2021-22.

My forecast was based on two simple facts.

First, of all the fact that we in 2020-21 saw the largest expansion in the US money supply (I used M2 to illustrate that) ever in peacetime.

This is essentially a monetarist story – if you expand the money supply faster than the growth of money demand then nominal income growth will accelerate and sooner or later you will as Milton Friedman taught us have inflation.

The second point was that in early 2021 the Federal Reserve was eager to tell us that the increase in inflation was ‘transitory’. Or said in another way the Fed essentially refused to take responsibility for controlling over the development in nominal income and hence in inflation.

This is point is market monetarist in the spirit of Robert Hetzel – if the Fed refuses to do its job then it will cause an expectational shift that will accelerate the increase in inflation.

So to me, it was fairly straightforward to forecast higher inflation in the US at that time.

I fully admit that other factors played a role as well such as the much talked about “supply chain” problems as a result of Chinese Covid policies and higher energy prices, but I generally think the importance of these issues have been significantly overestimated.

The core reason US inflation rose sharply in 2021 was excessively easy monetary policy and the Fed’s refusal to take responsibility for price stability.

Furthermore, it should be noted that US inflation, in fact, rose well ahead of Putin’s invasion of Ukraine and inflation actually started to decline in 2022 – after the Fed demonstrated that it would again start to take responsibility for ensuring price stability.

In fact, US inflation was lower by the end of 2022 than at the beginning, which fits badly into a story that this was caused by Putin’s war.

However, the moderation in US inflation during 2022 fits well into the monetarist story I told in 2021. I will return to that below.

The graph below shows the simulation of a so-called P-star model – which is based on the monetarist quantity theory of money – I used to forecast inflation back in April 2021 and the actual development in US inflation since then.

My simulation from 2021 certainly didn’t get it perfectly right, but it is notable that we did indeed see a sharp spike in US inflation as forecasted, but it is equally notable that in the simulation from April 2021, we also saw that inflation wouldn’t just continue to accelerate.

In fact, the simulation indicated inflation would moderate – from a very high level – during 2022. This is in fact also what we have seen.

So our model both got the spike in inflation right in 2021 and the moderation in inflation in 2022 right. The difference, however, was that inflation didn’t quite increase as much (and as fast) as the initial simulation had indicated it would.

To understand that we need to go back to our original model – The P-star model – and what assumptions regarding monetary policy (and the monetary transmission mechanism) I made then.

The P-star model

In my blog post in April 2021, I based my forecast or simulation of future inflation on the so-called P-star model.

The P-star model is based on the equation of exchange:

(1) M•V=P•Y

Where M is the money supply (I used M2 for the US), V is the velocity of money, P is the price level and Y is the real GDP/Production.

If we assume that V over time follows a trend that is determined by structural factors such as financial regulation and demographic and similarly we assume that over time there is a potential level of Y that is determined by structural factors such as technology, taxes, the size of government, demographics, etc. then we can re-write (1):

(2) P* =M•V*/Y*

Where P* (or P-star) is the level of prices in the economy we should expect in the long run given the actual level of the money supply and the structural levels of V (V*) and Y (Y*).

The graph below shows my calculation of P* back in April 2021.

We see at that time due to the sharp increase in the money supply in 2020-21 P-star was significantly above the actual price level and that is basically why I made the call that inflation would increase sharply.

And as discussed above inflation did indeed rise very sharply as forecasted. However, we didn’t quite get to double-digit inflation as the simulation had indicated would have happened.

The Fed turned more hawkish than assumed

When I made the simulations back in April 2021 the Fed was still talking about inflation as something the Fed could not control and as ‘transitory’.

Hence, in March 2021 Fed chairman Jerome Powell said “However, these one-time increases in prices are likely to have only transient effects on inflation”.

Said in another way the Fed had no plans to tighten monetary policy.

So when I made the simulation in 2021 I had to assume that at least for some time the Fed would not tighten monetary policy but also that the Fed would not forever ignore the likely increase in inflation that I was forecasting.

So in my simulation in April 2021 I assumed that starting from May 2021 US money supply would gradually start to slow and from early 2022 it would follow the trend in money supply growth, which ensured around 2% inflation from 2010-19.

However, if we compare this with the actual development in money supply growth we can see that the Fed has turned decisively more hawkish than I had assumed it would.

The graph below shows the level of the US money supply (M2) that I assumed it would follow and how it actually developed.

We see that the development actually followed my assumption fairly closely through most of 2021 but from around November 2021 the growth of the money supply slowed dramatically and during 2022 the US money supply actually declined.

Interestingly enough the rather abrupt slowdown in money supply coincided with the reappoint of Fed chairman Jerome Powell and also with a maked shift in the communication from the Fed. Hence in late November 2021 Powell said “We tend to use [the word transitory] to mean that it won’t leave a permanent mark in the form of higher inflation.”…”I think it’s probably a good time to retire that word and try to explain more clearly what we mean.”

The gap between the ‘forecasted’ and the actual M2 level, however, particularly started opening up from April-May 2022, which marks an ‘acceleration’ of monetary tightening.

Consequently, we should expect inflation to continue to come down faster than forecasted in April 2021.

Re-doing the April 2021 simulation

When I did the simulation in April I used the P-star model to calculate the gap between the actual US price level and P-star – the P-gap.  

To do that I also needed to make assumptions about how fast the P-gap would close – or rather how sticky the inflation rate would be.

Given inflation didn’t increase as much as the simulation had indicated then is an indication that inflation was more sticky than I had assumed.

This is important when we need to forecast inflation going forward. We need to take into account this stickiness in inflation.

In the graph below I have essentially redone the simulation from April 2021, but done it will the actual development in the money supply and adjusted what we could call the ‘stickiness parameter’. We see that this simulation fits the actual inflation development remarkably well.  

I think it is important to note that price stickiness not only reflects that certain prices are fixed by contracts but also to a very large extent is determined by expectations. Hence, if economic agents expect the Fed always to conduct monetary policy in such a way that inflation will alway will be close to 2 percent then even a significant increase in the money supply will not cause a major increase in inflation.

But overall to the extent the original simulation from April 2022 was wrong, it was not primarily due to a wrong assumptions about money supply growth (in it was more or less correct for at least the first 8-12 months). The primary mistake in the simulation hence was the assumption about the degree of price stickiness.

So we certainly should not abandon the P-star model. Rather the model correctly forecasted the sharp rise in inflation and also that inflation would eventually come down again as the slowdown in money supply growth sat in. It is therefore also worthwhile updating the forecast from the model.

This is what I have done below.

Inflation seems set to drop significantly

In many ways, the forecast/simulation from April 2021 was a ‘control experiment’ as the US economy had been in a lockdown and the money so to speak had been printed. We can compare this to a situation where we drink a bottle of whiskey and now forecast that we will get a hangover. It is nearly given by nature that this will happen.

When I forecasted inflation to rise strongly in April 2022 the money had already been printed. There was at that time little to do about it – the hangover would arrive soon in the form of a sharp increase in inflation. The only question was how fast it would take the Fed to ‘stop drinking’ and slow money supply growth.  

The situation now is very different in the sense that it is much less clear what the Fed will do from here. The clear geopolitical risks, the upcoming US presidential elections in 2024 and a potential US recession all could trigger both changes in inflation expectations and also changes in the Fed’s policy reaction function.

So it is certainly not as straightforward to forecast inflation now as it was in April 2021. However, that is no reason for not trying.

But instead of making one forecast, I have instead made two different scenarios for US inflation based on two different assumptions for US money supply growth going forward.

The first scenario is what we could call the ‘hawkish’ scenario. In this scenario, I have essentially assumed that all of the excessive money supply growth during 2020-22 will be undone so the level of the US money supply will return to the ‘old’ 2010-19 trend in the coming year. This basically implies that the slowdown (relative to the pre-2020 trend) in M2 growth continues basically until we are back at the old trend in level terms.

In the second scenario – the ‘dovish’ scenario – I have assumed that from now on – Q1 2023 – US money supply growth will return immediately to the same growth rate as we saw pre-2020 but starting from higher a high level. This is what we normally would term letting bygones-be-bygones.

In both scenarios, the M2 will eventually grow at the same pace but the level of M2 will be different.

In the graph below I have simulated two different scenarios for US inflation based on the two different assumptions for M2 growth going forward and I have used a ‘stickiness parameter’ that ensure the best fit for inflation in the 2021-22 period.

A number of factors should be noted regarding these simulations. First of all, it should be noted that even though US money supply growth has slowed rather dramatically for more than a year there still is a considerable ‘monetary overhang’ – what I above called the P-gap is still positive (around 6-7% versus around 15% at the peak in early 2021). This means that even though money supply growth remains subdued there still are considerable ‘pent-up’ inflationary pressures.

On the hand as Milton Friedman often noted – monetary policy works with long and variable lags. In the simulations above I have assumed (based on the historical relationship) that there is a six-month lag between an increase in the P-gap and higher inflation. This also means that it will take time to bring inflation down, but also once money supply growth has slowed the impact will continue to feed through to inflation over a longer period.

These factors are clearly visible in both scenarios. First of all, we see that in the first half of 2023, inflation drops basically equally fast in both scenarios and the reason for that is that since we have assumed a six-month lag between changes in money supply growth (and therefore in the P-gap) it will take six months before any change in monetary policy is visible in inflation.

Therefore, in the model set-up any slowdown in inflation in the coming six months will be due to the slowdown in money supply growth we saw during 2022.

What is notable is that in the ‘hawkish’ scenario US inflation will continue to decline until the Autumn of 2025 and drop well below Fed’s 2% inflation target.

On the other hand in the ‘dovish’ scenario inflation will come down toward 2% gradually over the next 3-5 years.

The most likely scenario probably is a combination of the two scenarios where the Fed is likely to follow a stop-go or go-stop policy. Hence, with inflation likely to drop significantly in the next 3-4 months the Fed is also likely in that period to end it hiking cycle and therefore also to gradually start to re-accelerating money supply growth.

But the Fed also is likely to struggle with the famous long and variable lags – either by waiting too long to end monetary tightening or by initaiting easing monetary policy too early.

I think that there should be relatively little doubt that inflation will come down toward 4-5% over the next 6 months in the US. However, the tricky part will be for the Fed to get inflation back towards 2% and the policy discussion is likely to intensify in the second half of the year.

Even though the Fed is far from being able to declare victory on inflation we are nonetheless likely to see inflation worries subside considerably (unless a new major supply shock hits) in the coming 6 months.

….

Contact:

Lars Christensen, lacsen@gmail.com

Recession or not? Answering a question the Fed should not care about

A rather bizarre discussion about the lastest US real GDP numbers has been playing out since the 2nd quarter GDP numbers came out on Wednesday.

The official real GDP numbers showed that US GDP dropped 0.2 percent (0.9 percent annualised) in Q2 making it the second quarter in a row with negative real GDP.

This got pundits to scream “Recession!” and yes this is surely a heated political topic (of less real economic relevance).

And yes, one definition (on US data but not data around the world) says that the US economy is in a (technical) recession when we have two consecutive quarters of negative (Q/Q) real GDP growth.

The “official” – rather than the technical – definition of a recession (again only in the US and nowhere else) is made by National Bureau of Economic Research (NBER) who defines a recession in the following way:

“… a recession is that it is a significant decline in economic activity that is spread across the economy and that lasts more than a few months. The committee’s view is that while each of the three criteria—depth, diffusion, and duration—needs to be met individually to some degree, extreme conditions revealed by one criterion may partially offset weaker indications from another. “

This is two very different definitions, but historically there has nonetheless been a very close relationship between the two – and since the World War II all “NBER recessions” have coincided (more or less) with periods where we have had two quarters of negative growth in a row.

However, this is not the case this time around – or we really won’t know for some time as the NBER hasn’t announced anything in this regard and normally only do after the fact, but it is also clear that this doesn’t “feel” like a recession.

The reason it doesn’t feel like a recession is that there certainly is no general glut – there are no signs of demand (in nominal domestic spending continue to growth strongly) declining unexpectedly and unemployment is close to historically low levels and have continued to drop in the Q1 and Q2.

What feels bad is the very high and increasing inflation. And that certainly feels bad, but economic “uneasiness” and uncertainty is not the same thing as a recession.

A way to illustrate this paradox is to look at the relationship between real GDP growth and (quarterly) changes in US unemployment – what is sometimes called Okun’s Law.

We see a quite clear (negative) correlation – slower real GDP is normally associated with higher unemployment.

We have two extreme observations – one negative and one positive. Both are from 2020 and is not really relevant to what we are trying to analyse here.

What is important is what is happening in the ‘red box’ – what happens to unemployment when real GDP growth is negative.

The graph below zooms in on the red box.

What we see is that the ‘normal’ relationship is that in quarters where we have negative GDP growth (all of the dots) we have higher unemployment (32 out of 41 quarters).

We also see that in the quarters where unemployment declined (the 9 red dots) real GDP growth dropped by less than 1 percent (annualised).

But ONE quarter of negative real GDP growth is not a (technical) recession. A technical recession is defined by two consecutive quarters of negative real GDP growth.

So let’s look at that – in the graph below I have looked all of the technical recessions since 1948 (the period where we have both real GDP and unemployment numbers).

In that period there has been 11 technical recessions – including the present one.

Some have been longer than two quarters (e.g. the 2008-9 recession) so I have looked at the average quarterly change in GDP and the same for unemployment during the ‘recession period’.

The graph below shows relationship.

Again the extreme observation is 2020 and again that really isn’t important. The important thing is that for all of the 11 technical recessions with the exception of one we see that not only is there a close correlation between the change in real GDP and the change in unemployment, but it is also so that negative real GDP is associated with an increase in the unemployment rate.

There is only ONE exception – and that is the present technical recession.

What we also see is that this in fact is the mildest ‘recession’ on record (at least so far). So mild that unemployment hasn’t even increased.

Finally if we run a regression on the data we see that there is more or less a one-to-one relationship between real GDP growth and changes in unemployment.

Overall, it seems that the present ‘technical’ recession is somewhat of an outlier as it is clearly very unusual to have a recession where unemployment actually has been declining.

Don’t ever forget NGDP

My friend Scott Sumner famously (at least among market monetarists) in 2009 wrote an influential article with the title The Real problem was Nominal about the causes of the Great Recession making the argument that policy makers (particularly central bankers) should focus on nominal GDP rather than real GDP.

Scott’s argument – as is mine – that central banks control nominal variable and not real variables, but since prices and wages are sticky nominal shocks will in the short-run have an impact on the real variables – such as real GDP growth.

In this regard it is interesting (depressing in fact) that when the Q2 GDP numbers was published there essentially was nobody reporting on what happened to nominal GDP growth.

But not reporting and not discussion the NGDP numbers mean that we are missing a very important point about the US economy – and that the real GDP numbers are be misinterpreted.

If we look at the NGDP we see a complete different picture that what we get from the RGDP numbers – there was no contraction in Q2 at least not a nominal contraction.

As the graph above shows nominal GDP growth in fact accelerated in Q2 to an annualised rate of growth of 7.8 percent – up from 6.6 percent in Q1.

Hence, measured on NGDP growth alone US monetary policy remains excessively easy – in fact very easy.

Assuming that potential real GDP growth in the US is around 2 percent then nominal GDP shouldn’t be growing much faster than 4 percent to ensure the Federal Reserve 2 percent target.

This is contrary to the general interpretation where many commentators have noted that the negative real GDP growth was caused by Fed’s monetary tightening. However, this can’t be correct – if that had been the case then we would have seen a slowdown in both real and nominal GDP growth. Or to be precise – the impact of monetary tightening actually happened from Q4 last year and until Q1, but not from Q1 to Q2. This is by the way fully consistent with the fact that monetary policy often works with long and variable leads as markets react to expectations of changes in monetary policy instruments ahead of it actually happening.

It is also correct that US recessions historically has been monetary in nature – in the sense that historically downturns in real GDP has be preceded by or coincided with a downturn in nominal GDP.

The below shows the de-trend quarterly growth in both real and nominal GDP. I have de-trend the quarterly growth rate with the average quarterly growth rate over the previous 10 years.

What we see is that there close relationship between the two – then NGDP moves up so does RGDP.

However, since early 2021 we have seen an unusual development – NGDP growth have remained high (very high), while RGDP growth have slowed back towards and now below the 10 year trend growth rate.

What the graph essentially shows is that normally (and we could go back much longer and show the same pattern) ups and downs in the US economy is essentially driven by ups and downs in nominal domestic spending or what we in the normal macroeconomic textbook call aggregate demand (AD).

When aggregate demand increases we know that both prices (P) and production (Y) increases. P*Y is exactly nominal GDP – so the graph above shows that we have had very, very strong growth in aggregate demand (obviously caused by the massive monetary policy easing undertaken in 2020-21).

If prices and wages are sticky then an increase in aggregate demand will cause an increase in production (Y). This is of course what we see when real GDP increases in parallel with an increase in nominal GDP.

In this is regard it is not surprising that real GDP also grew strongly in 2021. However, we also know from the textbook AS/AD model that we cannot just expand aggregate demand forever – soon or later we will run into supply side constrains.

The short-term supply curve (SAS) is upward-slopping, but as (input) prices and wages adjust to the increase in aggregate demand the SAS curve shifts leftwards . Hence, in the long run there is a hard constraint in the economy in the form of a vertical Long Run Aggregate Supply curve (LRAS).

I think this is part of the story of the slowdown in real GDP growth – we have simply hit the LRAS. So when commentators are talking about “supply chain distruptions” then it is actually this – it is suppliers (and employees) saying that they will not supply more at present (input) prices and wages.

The graph below illustrates this.

If we think of the 2010-19 trend (the yellow line) in real GDP (Y) as the the long run aggregate supply (LRAS) curve then we see that after the 2020 the gap between actual real GDP and the LRAS was more or less closed in the Autumn of 2021.

The US economy (and the global economy for that matter) hit the roof.

However, we also see there was no roof for NGDP (the blue line) – as NGDP rose well-above the the 2010-19 trend line.

We of course know from the textbook that there is no limits on how much NGDP can increase – there is a limit on how much Y (RGDP) can increase, but prices (P) can increaes without any limits and hence NGDP (P*Y) can increase without any limits.

Normally of course there is a limit in the form of the Fed’s inflation target – and one should expect the Fed to slow NGDP growth once inflation starts to outpace Fed’s 2% target.

However, we all know that the Fed during 2021 was sending a very clear signal that it considered the increase in inflation as “transitory” (it clear was not) and as a consequence NGDP was allowed to run wild. Or rather the Fed caused NGDP and therefore inflation to run wild by first massively increasing the money supply and then later by signalling it had no plans to reverse the massive easing.

The graph below shows what happened to the price level (P).

We see that initially in the crisis prices dropped below the 2010-19 trend (which more or less is a reflection of the 2 percent inflation target).

However, as the real GDP level closed in on LRAS, but NGDP kept on rising strongly towards the end of 2020 prices (the blue) started to accelerate strongly. Exactly as the textbook model would tells us.

There really isn’t anything surprising about this and it was avoidable that inflation would increase sharply with Fed ignoring the strong growth in NGDP. And this is why I in April 2021 forecasted double-digit US inflation – I didn’t need odd explanations such as “supply disruptions” or Putin’s invasion of Ukraine (which had not happened).

All I needed was the textbook AS/AD model and the equation of exchange, which tells us that NGDP is determined by the money supply (M) times the velocity of money (V).

So far so good – the story in 2021 very much was one of an increase in NGDP combined with the RGDP hitting the roof. And this obviously should start to slow real GDP. There shouldn’t be any surprise about that.

But there is more to the story – because what we are seeing now is NGDP continuing to grow robustly (at least compared to the historical trend) while RGDP growth has turned negative. At the same time we see inflation accelerating further.

The textbook AS/AD model tells us that the price level can increase both due to high aggregate demand (essentially higher NGDP growth) or a decline in aggregate supply caused by for example an increase in input prices (such as energy prices).

So just look at the prices level we cannot on its own say that that is caused by easy monetary policy (higher NGDP growth). Therefore, we need to look at real GDP growth (Y) as well.

So what we are seeing now is that in Q1 and Q2 real GDP has not only hit the 2010-19 trend, but it is actually decline relative to this trend and as we cannot observe a similar decline in nominal demand this has to be caused by a negative supply shock (the short run AS curve has shifted left).

This at least is the story if we can trust the data, but let’s start out by assuming that the published GDP numbers actually are correct.

But what have caused a negative supply shock? Well, it is hard to avoid the war in Ukraine and the impact this have had on particularly global energy prices.

The problem of course is that higher energy prices can also be caused by increased demand as well as a negative supply shock. For example energy prices also rose strongly in 2021, but that was clearly not caused by the war in Ukraine (as it hasn’t started) and real GDP grew strongly in 2021.

But let’s nonetheless try to figure out how much increased energy prices might have impacted real GDP growth in Q1 and Q2.

A simple model for RGDP

To answer this question I have estimated a simple model for quarterly real GDP growth with two explanatory variables – nominal GDP growth and the growth rate of US household expenditures on energy as a share of total expenditure.

I should stress this is purely illustrative model, but nonetheless it works very well in explaining the historical development in US real GDP growth (since 1960 and until the end of 2019).

The regression output is below.

We see that the signs on NGDP and “energy prices” (think of it as AD and AS respectively) have the expected signs – higher NGDP growth increases real GDP growth, while higher energy prices reduces real GDP growth.

We can now use this model to “simulated” how we think real GDP should have developed from early 2021 until today given the develpment in NGDP and energy prices.

The graph below shows that.

We see that model works quite well during 2021, but in 2022 a ‘gap’ between the model forecast and the actual real GDP growth opens up.

Hence, even taking the ‘energy shock’ into account we really can’t explain why real GDP have been negative in the US in Q1 and Q2.

However, this does not mean that that shock to energy prices is not large. It is and it certainly have had a significant negative impact on real GDP growth.

Based on the estimation results we can estimate the impact of higher energy prices on real GDP in the US.

The graph below shows that.

We see that already in 2021 higher energy prices lower real GDP growth, but both in Q1 and Q2 the energy price shock lowered US quarterly real GDP growth (annualised) by more than 1 percentage point in each quarter. That is a substantial negative shock.

In fact if we compare this shock to the first (1974-75) and the second (1979-80) energy shocks then this shock is of a similar size as the largest quarterly shocks during those shocks. The difference is, however, that those shock lasted longer than this shock has lasted so far.

We should, however, also note that the US today actually is much less dependent on energy imports than in the 1970s, which might tend to over-estimate the impact of higher energy prices on real GDP, but the impact nonetheless should not be ignored.

Conclusion: Both monetary policy and energy prices are slowing growth

We started out discussing the paradox that US real GDP has dropped two quarters in a row, but unemployment has continued to decline. This is highly unusual and it could indicate that something is ‘wrong’ with the data.

However, our analysis also shows that tighter monetary policy – lower NGDP growth historically will lower RGDP growth and NGDP growth even though it has remained high clearly has slow in 2022 compared to 2021.

Furthermore, high energy prices clearly is very significant negative supply shock to the US economy, but it is much less important than the tightening of monetary conditions (particularly from Q4-2021 to Q1-2022).

Overall, however, we are left with the conclusion that it shouldn’t be a surprise that US real GDP growth have slowed in 2022. However, it nonetheless seems very hard to explain the extent of the slowdown which could be an indication that there simply is something wrong with the data.

This is less controversial than it might sound like – national account numbers are often revised – and if we compare the US real GDP numbers with the similar numbers for the euro zone it is somewhat puzzling that there is no technical recession in euro zone where there certainly has been less easy monetary conditions since 2020 than the US and which arguably should expected to be lot harder hit by the war in Ukraine than the US.

I the graph below I have compared the US and the euro zone numbers.

Interestingly we see that our model for the US actually fits the European data better than the US data in 2022, which is a further indication that there is something wrong with the US data.

So again it is clear that US growth is slowing and this slowdown is caused by a combination of tighter monetary conditions and a negative supply shock, but the US economy is not yet in recession.

That doesn’t mean that the US will not fall into a recession. I believe it likely will has the Fed have to continue to tighten monetary conditions to get inflation back under control and in that process the Fed might have to accept a recession.

However, as the analysis above shows it becoming challenging for the Fed right now. On the one hand NGDP growth remains far too strong and even though NGDP growth is set to slow further in the coming quarters (I discuss that here) there is a risk that the Fed becomes preoccupied with real GDP growth, which as we have shown also is influenced by supply side factors, which it cannot control.

If the Fed where to conclude from the real GDP numbers alone then it would likely abandon monetary tightening right now and ease monetary policy instead and the calls for doing that are likely become louder in the near future.

This would be a repetition of the monetary policy mistakes of the 1970s where the Fed interpreted real shocks as being nominal shocks (or rather it was driven by political pressures and economic thinking that excluded real shocks and ignored monetary policy as a reason for inflation).

Therefore, even though whether or not the US is in fact is in a (technical?) recession or not apparently is hugely important for the political debate in the US the question actually should be of very little importance for the Fed.

What the Fed needs to focus on is the growth rate of nominal domestic spending (eg measured as NGDP growth).

The Fed should be happy to see that NGDP growth has been slowing (in fact significantly), but it should also note that NGDP should be brought down to around 4 percent to ensure that inflation stabilises around 2 percent. We are not there yet, but we are getting there – if the Fed stay focused on domestic spending growth rather than getting distracted by discussions about whether or not the US is in a recession.

Milton Friedman commented on Powell’s Fed in 1978

Watching today’s press conference with Fed chief Jerome Powell reminded me of something Milton Friedman said in 1978:

“Nearly a dozen years ago, I warned of an inflationary recession (Newsweek, Oct. 17, 1966). We have since then had three inflationary recessions and a fourth is almost surely on the way. During the first, the brief mini-recession of 1967, consumer prices rose 2.4 per cent per year; during the longer and more severe recession from December 1969 to November 1970, prices rose 5.3 per cent per year; during the still longer and even more severe recession from November 1973 to March 1975, prices rose 10.8 per cent per year; during the coming recession, prices are likely to rise at least 7 per cent per year.

Each scenario has been the same: rapid growth in the quantity of money followed by economic expansion and then, much later, by rising inflation; a public outcry against inflation, leading the authorities to reduce monetary growth sharply; some months later, an inflationary recession; a public outcry against unemployment, leading authorities to increase monetary growth sharply; some months later, the beginning of expansion, along with a decline in inflation. Back to the starting point.”

Friedman also had the answer:

“What is the right policy now? That is easy to say, hard to do. We need a long-term program dedicated to eliminating inflation. The Fed should announce that it proposes to increase M2 at the annual rate of, say, 8 per cent during 1978, 7 per cent during 1979, 6 per cent during 1980, 5 per cent during 1981; and 4 per cent during 1982 and all subsequent years. To relieve the fiscal pressures on the Fed, such a monetary policy should be accompanied by a budget policy of reducing Federal spending as a fraction of national income—also gradually but steadily.

Such a monetary and fiscal program would eliminate inflation by 1983—for good. Such a gradual program would avoid economic disruption
.”

Today I would formulate it slightly differently as:

“The Fed should announce that it over the coming 2 years gradually will reduce the growth rate on nominal spending to an annual rate of 4% and keep it growing at that rate – year-in-and-year-out thereafter.”

And yes, US fiscal policy makers obviously should support such policy by balancing the US government budget by immediately bringing growth of nominal (non-cyclical) government spending down well-below 4%.

Carl Bildt is puzzled – he should read an economics textbook

Former Swedish Prime Minister Carl Bilde – who normally is a clever man, but not an economist – is puzzled:

I have an answer from the economic textbook for Carl Bildt. We are at point B now.

We are now in the process – at least in the US – of tigthening monetary policy so pushing the aggregate demand curve back leftwards and at the same time labour market inflation expectations are shifting upwards which will shift the short-term aggregate supply curve back towards the long-run aggregate supply curve and we will end up with a price level somewhere between A and C and a production (and unemployment) at the structural long-term level. Hence, higher unemployment than now.

It’s really, really simple.

PS the story is exactly the same for the euro zone and for the Swedish economy.

US domestic spending – a closer look at the 2021-22 data

We have gone from inflation fears to recessions fears in the global financial markets in recent weeks, which mostly reflects the fact that we gone from a situation where the markets were thinking that the Federal Reserve was behind the curve to a situation where market partipants now seems to think the Fed is overdoing it on monetary tightening.

But what is really happening in the US economy? I will try to explain that by having a closer look at US domestic spending – more precisely US nominal domestic spending.

To do that lets have a look at my favourite tool in the monetarist toolbox – the equation of exchange:

M*V = P*Y

Where M is the money supply (for example M2), V is money-velocity, P is the price level and Y is real GDP.

Both sides of the equation (both MV and PY) are measures of nominal domestic spending.

If we ASSUME that V is constant – it is not necessarily – then it follows that M = P*Y and then M and PY are measures of domestic spending.

We normally define the money supply in its most simple form as coins and notes in circulation plus bank deposits.

Consequently if bank deposits is the primary part of the money supply (it is) then the development in bank deposits also becomes a measure of domestic spending. The good thing about deposits is that we have weekly data, which means deposits is a high-frequency measure of domestic spending.

Finally, we can measures P*Y in two ways – either from the production side (we call that Gross Domestic Product) or from the income side (we call that Gross Domestic Income).

Both GDP and GDI are quarterly data. However, we have monthly data for Personal Consumption Expenditure (PCE), which historically has followed the development in GDP and GDI closely. We can therefore use PCE as a monthly proxy for domestic spending.

This give us five measures of US nominal domestic spending:

  1. M2
  2. Bank deposits
  3. GDP
  4. GDI
  5. PCE

Very strong nominal domestic spending growth in 2021

The graph below shows the five measures of nominal domestic spending.

We see that all five indicators through 2021 grew more or less in parallel and that the growth rate was very strong – hence all five indicators were 9-11% higher by the of 2021 than in the beginning of the year.

It is there for not surprising (at least not to any monetarist) that inflation picked up very strongly in 2021.

Said, in another way if real potential production growth is around 2% in the US then we should expect 9-11% nominal domestic spending growth to lead to 7-9% inflation. This is of course exactly what we have seen.

The need for monetary tightening – and hence a slowdown in nominal domestic spending growth therefore should have been obvious to anybody already during 2021.

Domestic spending has slowed markedly in 2022

The Federal Reserve unfortunately took much longer to realise the need for tighter monetary policy.

However, after Fed chairman Jerome Powell was reappointed in late November 2021 the Fed has started to move towards monetary tigtening and already from around October 2021 the financial markets gradually started to price in interest rate hikes from the Fed.

The graph above of our five measures of nominal domestic spending shows a pretty clear “flattening” of all fives measures starting in late 2021.

Another way of looking at this is to look at the growth rates of the more high-frequent measures of domestic spending – PCE, M2 and deposits and compare that to the yield curve as a measures of the financial markets expectations of Fed-tigthening. The graph below shows that.

We see that around Powell’s reappointed – in October-November 2021 the yield curve measured as the spread between 10-year and 2-year US government bond yields started to inch down and soon after that happened our measures of nominal domestic spending started to slow.

In fact all three measures has continued to slow. However, it is also notable that since April this year the yield curve has been more or less flat, which indicates that slowdown in nominal domestic spending likely soon will come to an end.

Hence, we are not seeing a negative ‘shock’ to domestic spending – it is ‘just’ slowing. That being said, the growth in nominal spending seems to nearly completely stopped – at least judging from our most high-frequent measure – bank deposits as the graph below shows.

If this continues for long then US monetary policy goes from inflationary to deflationary – and this obviously is what the markets are now reacting to.

However, year-on-year growth in nominal domestic demand in the US in Q2-Q3 is likely to be 6-8% so it is far to early for the Fed to change course and monetary policy in the US is not recessionary at the moment.

Rather monetary policy has rightly been tightened to undo the far too easy monetary policy during the second half of 2020 and all through 2021.

The challenge for the Fed now clearly is that there has been a massive expansion of the US money supply (for example M2) and it will take time for the Fed to suck up that exess liquidity.

We can illustrate that by zooming out a bit and looking at the development in M2 in recent years.

So yes, we see the same flatting the in line in M2 as we see in depostis in the last 3-6 month, but we clearly also see that the level of M2 is way above the pre-2020 trend line. A trend line that more or less ensured 2% inflation in the US from 2010 to 2020.

So if the Fed just “let go” once the markets start to worry about a recession then we might very soon see domestic spending picking up speed again.

Therefore, the challenge for the Fed is to make sure that nominal domestic growth at a growth rate, which is comparable with inflation around 2% in the medium-term. That would likely mean that nominal domestic spending growth should be around 4%.

We are growing somewhat slower than that now (on a annualised monthly basis), but this is also necessary in a transition period where the Fed need to convince the market that it will not once again go back to the inflationary policies of 2020-21.

If the Fed is able to stick to this – then we should relatively soon begin to see US inflation inch down gradually. How fast inflation will be coming down will ultimately depend on what growth path nominal domestic spending settles at and the Fed is fully in charge of that.

A simple model for inflation that Jerome Powell should understand

Federal Reserve chairman Jerome Powell today acknowledged that he doesn’t understand inflation. See below.

This is somewhat alarming given the fact that the Fed’s is given operational independence to ensure price stability. If Powell doesn’t have a model for understanding why should the Fed been independent?

So we better help Powell.

Here is a simple model for US inflation.

By defition the following is given:

(1) n = y + p

n: nominal gross income growth

y: real income growth

p: inflation

In the medium to long run we know that y is determined by supply side factors such as productivity growth and labour supply growth.

We call that potential real income growth (y*).

We can use this to define demand inflation (pd):

(2) pd = n – y*

The graph below shows pd and actual US inflation (CPI).

We see that over the past two decades actual inflation and pd as followed each other fairly closely with pd generally leading actual inflation.

This was for example the case during the Great Recession where we see demand inflation slowed significantly starting in 2006, while actual inflation intially stayed elevated (due to a negative supply).

If we look at the situation over the past two years we see that initially we saw a sharp drop in pd, but also a fast and sharp recovery followed by a massive spike in demand inflation – peaking above 16% in Q2 2021. Demand inflation has since slowed but continue to grow fairly strongly. Annualized demand inflation in Q1 2022 was around 10%.

If we compare this with actual inflation we see that actual inflation slowed in 2020, but only moderately compared to demand inflation. This negative demand shock was instead reflected in a sharp rise in unemployment.

However, as demand recovered fast in 2020 so did real income growth and as we entered 2021 the level of real gross domestic income rose above potential real gross domestic income. In textbook lingo we hit the vertical long-run supply curve and consequently we should expect any growth in nominal income above this level to cause an increase in inflation.

And this was exactly the time when actual inflation started to accelerate – around April-May 2021 and ever since then US inflation has continued to rise.

There should be nothing surprising in this – if the central bank tries to push real income (Y) above the potential real income (Y*) then we should expect increased inflation.

And we should expect actual inflation to continue to increase as long as demand inflaion is above actual inflation.

We have not yet closed the gap between demand inflation and actual inflation, but we are getting closer and we should expect inflation to start to level off in the coming months.

What the Fed can do

Our simple model for US inflation hence seems to pretty well expain the development in actual inflation and we can conclude that the sharp increase in inflation in the US primarily has been caused by a sharp increase in nominal income growth.

The question is what drive nominal income growth. Again lets go back to the textbook.

The equation of exchange (in growth rates) is defined in the following fashion:

(3) m + v = p + y (= n)

Where m is money supply growth (for example M2) and v is money-velocity growth.

We can therefore also alternatively define demand inflation in the following way:

(4) pd = m + v* – y*

Where v* is the trend-growth rate of v* (for example 10-year moving average).

The graph below shows this alternative defintion of pd.

We are using monthly data where we have used real and nominal personal consumption expenditure (PCE) as proxies for n and y*.

This graph should make Powell optimistic – even though he apperantly do not understand the causes of inflation he has nonetheless managed to slow demand inflation in the last couple of months and in May pd growth had declined to around 6% – hence below the actual rate of inflation.

Consequently, assuming that Powell doesn’t speed up money supply growth going forward or a negative supply shock hits the US economy then we should expect inflation relatively soon to start to level off and gradually start to decline towards 6%.

Back in April last year I warned US inflation could hit double-digit numbers and we might still get there in the next 1-3 months, but it is encouraging that the Fed now has stepped on the brakes and money supply growth has slowed considerably.

As the graph above shows M2 has basically been flat in the past six-seven months and it therefore should not be a surprise that we are also beginning gross domestic income growth slowing, which is causing a drop in demand inflation and we there should expect actual inflation also to slow. To some extent the slowdown likely is also due to a decline not only in the money supply growth but also due to a decline in money demand due to higher interest rates.

The slowdown in M2 growth in 2022 has actually been faster than I assumed in my inflation call from April 2020 and furthermore, even though money-velocity is trending upwards the uptrend is rather muted and more muted than I had expected.

So even though Powell claims not to understand the reasons for inflation it seems like at least in terms of slowing money supply growth and therefore slowing gross nominal income growth he is doing the right thing – at least at the moment.

It is, however, still rather alarming that he apperantly doesn’t know why and how he is doing the right thing.

Hence, the Fed continues to need a proper framework for ensuring nominal stability in the US economy. I hope this blog post can inspire the Fed to re-learn that inflation is a monetary phenomenon and that it is the task of the Fed to control money supply growth in such away that nominal income growth is stable so inflation ultimately is low, stable and predictable.

It really isn’t that hard.

PS 4% nominal gross domestic income growth would more or less ensure 2% over the medium-term. I have earlier suggested that the Fed over the coming 5-10 years gradually bringes the NGDP level path back to a 4% path starting in Q1 2017.

Interview with RIAIntel

I have been interviewed by Eric Uhlfelder for RIAIntel, which is published by Institutional Investor.

The focus is on the outlook for the global economy and markets – and a lot of frank talk about Putin’s war on Ukraine.

Read the interview here.

Hetzel on “Learning from the Pandemic Monetary Policy Experiment”

Robert Hetzel undoubtebly is one of the most important monetary thinkers of our time and for more than five decades he has been involved in US monetary policy making and has furthermore greatly contributed to monetary theory and monetary history.

And he is one of my absolut biggest idols in the world of monetary thinking and I am proud to call Bob my friend.

Luckily Bob and I rarely disagree, but I continue to learn from Bob and anybody interested in monetary matters should read Bob’s papers.

Bob now has a new paper out – published by the Mercatus Center where he now is Senior Affiliated Scholar.

Abstract:

In response to the COVID-19 pandemic, which unfurled starting in March 2020 and raised unemployment dramatically, the Federal Open Market Committee (FOMC) adopted a highly expansionary monetary policy. The policy restored the activist policy of aggregate demand management that had characterized the 1970s. It did so in two respects. First, the FOMC rejected the prior Volcker-Greenspan policy of raising
the funds rate preemptively to preserve price stability. Second, through quantitative easing, it created an enormous amount of money by monetizing government debt. Inthe 1970s, the activist policy was destabilizing. Reflecting the “long and variable lags”phenomenon highlighted by Milton Friedman, a temporary reduction in unemployment from monetary stimulus gave way in time to a sustained increase in inflation. In response, the succeeding Volcker-Greenspan FOMCs rejected an activist monetary
policy in favor of a neutral policy. That neutral policy concentrated on achieving low trend inflation and abandoned any attempt to lower unemployment by exploiting the inflation-unemployment tradeoffs promised by the Phillips curve. The success or failure of the FOMC’s activist monetary policy offers yet another opportunity to understand what types of monetary policies stabilize or destabilize the economy.

Read Bob’s paper here.

The Fed is still way behind the curve – what an “implied NGDP level target” is telling us

I started this blog more than a decade ago in 2011 primarily because I was frustrated with the way monetary policy was conducted around the world.

At that time it was my clear view that both the Federal Reserve and the ECB had far too TIGHT monetary policy and that the reason that the 2008 shock to the global financial system had developed into a deep recession because the Fed has failed to react appropriately to the sharp rise in dollar demand during the Autumn of 2008.

My analysis of the situation at that time was based on a fundamental monetarist analysis combined with what financial market indicators were telling me about the outlook/expectations for nominal demand in the economy.

Other econ bloggers like Scott Sumner, David Beckworth and Marcus Nunes were using – and still are – a similar approach. This approach – or school of thought – later became know as Market Monetarism. A term I coined in a paper back in 2011.

At the core of market monetarist thinking is also advocacy of the use of a NGDP level target. Hence, market monetarists like Scott Sumner and myself have argued that at the core of what central banks should do is to keep nominal GDP (NGDP) on a “straight line”. Or rather, the for example the Fed should ensure that over time NGDP growth at a fixed rate – for example 4% – and that it should be level targeting meaning if the target is undershot one year – NGDP growth is below 4% – then Fed needs to ensure that it will be above the target in the following period and there by ensure that NGDP returns to the targeted level.

There are a number advances with NGDP level targeting over traditional inflation targeting.

First of all, it is the general consensus that central banks should not respond (try to increase nominal demand) to supply shocks. A narrow focus on inflation – even when corrected for energy and food price fluctuation – risk causing central banks to nonetheless to respond such supply shocks. A good example of this if the ECB catastrophic interest rate hikes in 2011, which essentially was a response to an increase in energy prices driven by a supply shock (the 2011 Japanese tsunami).

Contrary to this an NGDP target would allow for inflation to rise temporarily in the case of a negative supply shock while keeping nominal demand growth on track.

Second, by targeting the level rather than the growth of NGDP (or prices) the central bank will signal that it will make up for past mistakes. This ensures that the market will do a lot of the lifting in terms of conduct of monetary policy and thereby ensure a faster return to the target.

The story now is the opposite of in 2008

Neither the Fed nor the ECB implemented a NGDP target following the shock in 2008. However, I think it is fair to say that market monetarist thinking have had a substantial impact on monetary policy discussion and both in Europe and North America over the past decade.

But we didn’t quite make it all the way. The ECB has maintained its inflation target with a few adjustments, while the Fed essentially has been through a process of nearly continuous adjustments to its monetary target.

It should also be noted that the Fed actually did not officially have an inflation target prior to 2008. However, from 2012 the Fed has officially had a 2% inflation which have been adjusted numerous times.

That being said I have earlier argued that de facto the Fed had introduced an 4% NGDP level target in the summer of 2009 – basically with out announcing it.

The graph below illustrates that quite clearly.

The graph shows us that starting at the end of 2015 NGDP started to undershoot the “target” but later returned to the target by the end of 2017.

The undershooting was casused by then Fed chair Janet Yellen’s premature monetary tigthening that was initiated (announced) in October 2015. A decision that I strongly criticised at the time. See for example this blog post from 2016.

However, over all from early 2010 to early 2020 the US NGDP level was kept close to 4% path.

The Covid/Lockdown shock of 2020, however, caused NGDP to drop substaintially below the unannounced NGDP level target and even though the lockdowns likely significantly has distorted the US economic data it seemed pretty clear that aggressive monetary easing was warranted in the US to ensure that we would not have a repeat of the 2008-9 deflationary shock.

And the Fed reacted – fast and aggressively – and consequently we saw a swift recovery in NGDP to the previous 4% path.

So HAD the Fed officially been targeting a 4% path like the one we see in the graph then one would have to argue that the Fed’s policy reaction had been appropriate and that the Fed had done it’s job.

And I have certainly said so – the Fed did the right thing initially and the operation worked.

However, during the second half of 2020 I became increasingly concerned that the Fed was overdoing it in terms of monetary easing and in April 2021 I warned that the US might be heading for double-digit inflation. This of course quite closely coincided with the actually NGDP level starting to move above the 4% path “target” level.

But the Fed do not have a NGDP level target

While we clearly can use NGDP (and NGDP expectations) as a very useful indicator of the monetary policy stance the Fed do not in fact target the level of NGDP.

Rather officially the Fed now has an “Average Inflation Target” (AIT). The AIT was announced by Fed chief Jay Powell in August 2020.

The word “average” is important as it means that the Fed should  “achieve inflation that averages 2 percent over time” as stated by Powell.

This essentially means that the Fed is moving towards “level targeting” in the sense that if inflation has been below 2% for some time then the Fed needs to make up for this by ensure inflation above 2% in the following period.

And as the Fed also is fairly clear that it should not respond to supply shocks we are moving closer to a NGDP level target.

The problem of course is that the Fed has failed to announce what is the starting point of this regime. It is therefore unclear whether we should look at “average” inflation going back one, five or ten years and it is unclear for how long the Fed can take to bring the average back to 2%.

Furthermore, we cannot just look at for example a five-year moving-average of inflation as monetary policy clearly should be forward-looking.

So is the Fed for example targeting the average inflation over the past three-year plus the expected average inflation in the coming two years?

All this is unclear.

Introducing an “Implied NGDP level target”

So the AIT is actually not giving us a very clear indication of whether or not monetary policy is too easy or too tight presently in the US.

We can of course from the communication from the Fed conclude that the Fed presently see a need for monetary tightening, but again it is really unclear what makes the Fed come to this conclusion.

So maybe the Fed needs a bit of help from market monetarist thinking.

I have therefore tried to construct a measure that we (and the Fed) can use to assess for monetary tightening in the US.

I call this measure an “Implied NGDP level target”.

The idea is that the target over time will ensure that “average inflation” is at 2%.

NGDP (N) by definition is real GDP (Y) times the price level (P):

N=P*Y

Based on this we can calculate an implied level of NGDP – or what we could call N-star (inspired by the P-star model)

We define N-star in the following way:

N-star = (P-target level) * (Potential Y).

The “P-target level” is simply a 2% path for the US GDP deflator (hence the inflation target as defined in level), while “Potential Y” is potential real GDP as calculated by the US Congressional Budget Office (CBO).

If the Fed conduct monetary policy in such a way as to keep actual NGDP close to N-star over time then it will at the same time ensure that inflation (measured by the GDP deflator) more or less will average 2% over time. Hence, this is a NGDP target that is consistent with the Fed’s 2% Average Inflation Target.

We, however, have one challenge and that is to determine what should be our “starting date” for this target. Should be go back to 2010? Should we start in 2012 when the Fed first offcially introduced the 2% inflation target or should we start in August 2020 when the AIT was introduced?

The best starting point in my view is a starting where there are no imbalances in the REAL economy.

Hence, basically at a point where monetary policy is neutral. This would mean that we should find a recent date where real GDP is close to potential real GDP and/or unemployment is close to the structural level of unemployment (NAIRU).

The Fed officially has a “dual mandate” meaning that is officially should ensure “price stability” (that is the AIT) and “maximum sustainable employment”.

We already got “price stability” covered with our implied NGDP target and if we base the “starting point” on “maximum sustainable employment” then we have a NGDP target that is consistent with Fed’s dual mandate.

The graph above shows the actual US unemployment rate (the blue line) and the CBO’s estimate for the noncyclical rate of unemployment (NAIRU).

We see that just prior to the shock of 2020 unemployment was in fact below CBO’s estimate of NAIRU. Therefore, we need to go further back to find our starting point for our implied NGDP level target.

Last time prior to 2020 that the unemployment rate was equal to NAIRU was in the first quarter of 2017 with unemployment of just above 4.5%.

So now we have both our starting point and our implied growth rate of our implied NGDP level target.

The graph below show the actual NGDP level and our implied NGDP level target as well as the “NGDP gap” with it the percentage difference between the two. A positive NGDP gap implies that monetary policy is too easy.

The first thing to note is that US monetary policy became excessively easy during the Trump presidency. Whether this reflects president Trump’s very public pressure on the Fed to ease monetary conditions or not is a matter that is open for discussion, but at least based on our implied NGDP level target US monetary policy was indeed too easy during this period.

That being said this “easiness” was within a reasonable “uncertainty band” and in general it is hard to argue that monetary policy became unanchored in this period.

It is also clear that PRIOR to the Covid-lockdown-shock in 2020 NGDP returned to the level target in late 2019 and by the beginning of 2020 the monetary stance was more or less perfectly calibrated.

We, however, also see that the shock of 2020 was very substaintial, but also that the Fed’s appropriate (initial) monetary easing fast brought the NGDP level back towards the target level as also discussed above.

From early 2021 we see that NGDP started to overshoot the target level and hence at that time monetary conditions clearly had become too tight.

In fact as monetary policy works with long and variable leads as Scott Sumner likes to say the Fed obviously should have initiated monetary tightening somewhat earlier.

Hence, in the Autumn of 2020 it was becoming increasingly clear from watching the financial markets that NGDP growth would be very robust and the Fed could easingly have forecasted that actual NGDP would overshoot the target level in early 2021.

However, during that period the Fed rather downplayed this risks and continued to argue that inflationary pressures were temporary and was due to supply side factors.

Looking at the graph above we have to conclude that that was a major policy mistake and the Fed’s reluctance to initiate monetary tightening has caused NGDP to very significantly overshoot the implied NGDP level target.

Based on this it is hardly surprising that US inflation has spiked and market inflation expectations have increased significantly.

Therefore, it is also blatantly wrong when for example President Biden blame the increase in US inflation on geopolitical factors. Vladimir Putin is to blame for a lot of bad things, but not higher US inflation.

As Milton Friedman used to say “Inflation is always and everywhere a monetary phenomenon and that is certainly also the case this time around.

The Federal Reserve has allowed nominal GDP growth to grow far too fast and consequently we have over the past 12-18 seen a substaintial acceleration in inflation.

Positive and negative supply shocks obviously can influence the inflation data from month to month or even quarter to quarter, but supply side factors should not be used to ignore the fact that monetary conditions remain far to easy in the US.

Bring back NGDP to the target over the next five years

The way forward for the US monetary policy right now is for the Fed to clearly announce that to maintain price stability it necessitates that the Fed ensures that NGDP grows at a rate over the medium-term, which is consistent with 2% inflation.

Furthermore, as the Fed is targeting AVERAGE inflation then it needs to “undo” previous mistakes. Hence, NDGP needs to be brought back to the implied target level for example within the next five years.

Below I have simulated such a scenario.

I have assumed that potential real GDP growth in the US will be around 2% in the coming five years. This is also more or less CBO’s forecast and as we target 2% inflation our implied yearly NGDP target growth rate is 4%.

To close the NGDP gap over a five year period actual NGDP growth should hence be slower than 4%.

In fact my simulation shows that NGDP growth need to be slowed to less than 3% (to 2.8%) on average over the next five years.

The graph below shows that simulation.

In a graph this looks like an easy policy to implement, but in reality it would be a lot harder as it would necessitate a very significant slowdown in NGDP growth and a “sudden stop” to NGDP could easily cause the US economy to fall into a recession and potentially also trigger financial distress.

The alternative to slowing NGDP growth, however, is that NGDP growth expectations and therefore inflation expectations permanently shifts up.

This would make it a lot harder (more costly in terms of an increase in unemployment) to re-anchor expectations to ensure 2% in the medium-term.

To me there really isn’t any way around this – the Fed needs to slow NGDP growth and announce a clear target for NGDP for the coming five years. That might hurt in the near-term, but by not doing it the costs will increase sharply going forward.

What will the Fed actually do?

Broadly speaking I believe that Jay Powell and the majority of member of the FOMC understand the logic of my discussion above and understand the risk that if the Fed does not commit to slowing NGDP growth (the Fed will use another language) then it comes with the serious risk of repeating the mistakes of the 1970s.

Therefore, we certainly should expect the Fed to turn more hawkish going forward. However, the problem for the Fed is that it has not defined and announced a clear and transperant target – and the focus of attention for the Fed might change over time.

I therefore think (fear) that the Fed will continue to be behind the curve – tightening monetary conditions too slowly – but at some point the Fed will slam the brakes. That is likely to happen within the next year.

At that time it is too late to avoid a recession or as Rudiger Dornbusch once said economic expansions do not die of natural causes rather “they were all murdered by the Fed over the issue of inflation.” 

A recession – in 2023 or 2024 – then will cause the Fed to do a u-turn even if inflation expectations remain well above 2%.

Hence, I certainly fear that we are entering a period of stop-go or rather go-stop-go monetary policy in the US. And the ECB will likely follow the same path.

With that of course comes more economic and financial uncertainty and it is the badly needed that the Fed (and the ECB) get to work on a proper monetary policy framework.

In this blog post I have outlined such framework. Unfortunately I am not too optimistic that the Fed will listen.

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