All posts in category Federal Reserve

Three simple changes to the Fed’s policy framework

Frankly speaking I don’t feel like commenting much on the FOMC’s decision today to keep the Fed fund target unchanged – it was as expected, but sadly it is very clear that the Fed has not given up the 1970s style focus on the Phillips curve and on the US labour market rather than focusing on monetary and market indicators. That is just plain depressing.

Anyway, I would rather focus on the policy framework rather than on today’s decision because at the core of why the Fed consistently seems to fail on monetary policy is the weaknesses in the monetary policy framework.

I here will suggest three simple changes in the Fed’s policy framework, which I believe would dramatically improve the quality of US monetary policy.

  1. Introduce a 4% Nominal GDP level target. The focus should be on the expected NGDP level in 18-24 month. A 4% NGDP target would over the medium term also ensure price stability and  “maximum employment”. No other targets are needed.
  2. The Fed should give up doing forecasting on its own. Instead three sources for NGDP expectations should be used: 1) The Fed set-up a prediction market for NGDP in 12 and 24 months. 2) Survey of professional forecasters’ NGDP expectations. 3) The Fed should set-up financial market based models for NGDP expectations.
  3. Give up interest rate targeting (the horrible “dot” forceasts from the FOMC members) and instead use the money base as the monetary policy framework. At each FOMC meeting the FOMC should announce the permanent yearly growth rate of the money base. The money base growth rate should be set to hit the Fed’s 4% NGDP level target. Interest rates should be completely market determined. The Fed should commit itself to only referring to the expected level for NGDP in 18-24 months compared to the targeted level when announcing the money base growth rate. Nothing else should be important for monetary policy.

This would have a number of positive consequences.

First, the policy would be completely rule based contrary to today’s discretion policy.

Second, the policy would be completely transparent and in reality the market would be doing most of the lifting in terms of implementing the NGDP target.

Third, there would never be a Zero-Lower-Bound problem. With money base control monetary policy can always be eased also if interest rates are at the ZLB.

Forth, all the silly talk about bubbles, moral hazard and irrational investors in the stock markets would come to an end. Please stop all the macro prudential nonsense right now. The Fed will never ever be able to spot bubbles and should not try to do it.

Fifth,the Fed would stop reacting to supply shocks (positive and negative) and finally six the FOMC could essentially be replaced by a computer as long ago suggested by Milton Friedman.

Will this ever happen? No, there is of course no chance that this will ever happen because that would mean that the FOMC members would have to give up the believe in their own super human abilities and the FOMC would have to give up its discretionary powers. So I guess we might as well prepare ourself for a US recession later this year. It seems incredible, but right now it seems like Janet Yellen’s Fed has repeated the Mistakes of ’37.

PS What I here have suggested is essentially a forward-looking McCallum rule.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

 

8 Comments
by Lars Christensen on January 27, 2016  •  Permalink
Posted in Federal Reserve, FOMC, Janet Yellen, McCallum rule, NGDP Targeting, Prediction markets, Uncategorized
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Posted by Lars Christensen on January 27, 2016

https://marketmonetarist.com/2016/01/27/three-simple-changes-to-the-feds-policy-framework/

Talking to Ambrose about the Fed

I have been talking to The Telegraph’s  about the Fed’s decision to hike interest rates (see here):

“All it will take is one shock,” said Lars Christensen, from Markets and Money Advisory. “It is really weird that they are raising rates at all. Capacity utilization in industry has been falling for five months.”

Mr Christensen said the rate rise in itself is relatively harmless. The real tightening kicked off two years ago when the Fed began to slow its $85bn of bond purchases each month. This squeezed liquidity through the classic quantity of money effect.

Fed tapering slowly turned off the spigot for a global financial system running on a “dollar standard”, with an estimated $9 trillion of foreign debt in US currency. China imported US tightening through its dollar-peg, compounding the slowdown already under way.

It was the delayed effect of this crunch that has caused the “broad” dollar index to rocket by 19pc since July 2014, the steepest dollar rise in modern times. It is a key cause of the bloodbath for commodities and emerging markets.

Mr Christensen said the saving grace this time is that Fed has given clear assurances – like the Bank of England – that it will roll over its $4.5 trillion balance sheet for a long time to come, rather than winding back quantitative easing and risking monetary contraction.

This pledge more than offsets the rate rise itself, which was priced into the market long ago. Chairman Janet Yellen softened the blow further with dovish guidance, repeating the word “gradual” a dozen times.

So no I don’t think the hike is a disaster, but I don’t understand the Fed’s rational for doing this – nominal spending growth is slightly soft, inflation is way below the target, money supply and money base growth is moderate, the dollar is strong and getting stronger and inflation expectations are low and have been coming down.

So if anything across the board monetary indicators are pointing towards the need for easing of monetary conditions – at least if you want to maintain some credibility about the 2% inflation target and or keep nominal GDP growth on the post-2009 4% path.

But I guess this is because Janet Yellen fundamentally has the same model in her head as Arthur Burns had in the 1970s – its is all about a old-style Phillips Curve and I predict that Yellen is making a policy mistake in the same way Burns did in the 1970s – just in the opposite direction and (much) less extreme.

PS some Fed officials are obviously also concerned with the risk of asset market bubbles, but the Fed shouldn’t concern itself with such things (and by the way I don’t think there is any bubbles other than in the market for people concerning themselves with bubbles.)

 

2 Comments
by Lars Christensen on December 18, 2015  •  Permalink
Posted in Ambrose Evans-Pritchard, Arthur Burns, Federal Reserve, FOMC, Janet Yellen, Markets & Money Advisory, Uncategorized
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Posted by Lars Christensen on December 18, 2015

https://marketmonetarist.com/2015/12/18/talking-to-ambrose-about-the-fed/

Yellen is transforming the US economy into her favourite textbook model

When you read the standard macroeconomic textbook you will be introduced to different macroeconomic models and the characteristics of these models are often described as keynesian and classical/monetarist. In the textbook version it is said that keynesians believe that prices and wages are rigid, while monetarist/classical economist believe wages and prices are fully flexible. This really is nonsense – monetarist economists do NOT argue that prices are fully flexible neither did pre-keynesian classical economists. As a result the textbook dictum between different schools is wrong.

I would instead argue that the key element in understanding the different “scenarios” we talk about in the textbook is differences in monetary regimes. Hence, in my view there are certain monetary policy rules that would make the world look “keynesian”, while other monetary policy rules would make the world look “classical”. As I have stated earlier – No ‘General Theory’ should ignore the monetary policy rule.

The standard example is fixed exchange rates versus floating exchange rates regimes. In a fixed exchange rate regime – with rigid prices and wages – the central bank will use monetary policy to ensure a fixed exchange and hence will not offset any shocks to aggregate demand. As a result a tightening of fiscal policy will cause aggregate demand to drop. This would make the world look “keynesian”.

On the other hand under a floating exchange rate regime with for example inflation targeting (or NGDP targeting) a tightening of fiscal policy will initially cause a drop in aggregate demand, which will cause a drop in inflation expectations, but as the central bank is targeting a fixed rate of inflation it will ease monetary policy to offset the fiscal tightening. This mean that the world becomes “classical”.

We here see that it is not really about price rigidities, but rather about the monetary regime. This also means that when we discuss fiscal multipliers – whether or not fiscal policy has an impact on aggregate demand – it is crucial to understand what monetary policy rule we have.

In this regard it is also very important to understand that the monetary policy rule is not necessarily credible and that markets’ expectations about the monetary policy rule can change over time as a result of the actions and communication of the central and that that will cause the ‘functioning’ the economy to change. Hence, we can imagine that one day the economy is “classical” (and stable) and the next day the economy becomes “keynesian” (and unstable).

Yellen is a keynesian – unfortunately

I fear that what is happening right now in the US economy is that we are moving from a “classical” world – where the Federal Reserve was following a fairly well-defined rule (the Bernanke-Evans rule) and was using a fairly well-defined (though not optimal) monetary policy instrument (money base control) – and to a much less rule based monetary policy regime where first of all the target for monetary policy is changing and equally important that the Fed’s monetary policy instrument is changing.

When I listen to Janet Yellen speak it leaves me with the impression of a 1970s style keynesian who strongly believes that inflation is not a monetary phenomena, but rather is a result of a Phillips curve relationship where lower unemployment will cause wage inflation, which in turn will cause price inflation.

It is also clear that Yellen is extraordinarily uncomfortable about thinking about monetary policy in terms of money creation (money base control) and only think of monetary policy in terms of controlling the interest rate. And finally Yellen is essentially telling us that she (and the Fed) are better at forecasting than the markets as she continues to downplay in the importance of the fact that inflation expectations have dropped markedly recently.

This is very different from the views of Ben Bernanke who at least at the end of his term as Fed chairman left the impression that he was conducting monetary policy within a fairly well-defined framework, which included a clear commitment to offset shocks to aggregate demand. As a result the Bernanke ensured that the US economy – like during the Great Moderation – basically became “classical”. That was best illustrated during the “fiscal cliff”-episode in 2013 where major fiscal tightening did not cause the contraction in the US economy forecasted by keynesians like Paul Krugman.

However, as a result of Yellen’s much less rule based approach to monetary policy I am beginning to think that if we where to have a fiscal cliff style event today (it could for example be a Chinese meltdown) then the outcome would be a lot less benign than in 2011.

How a negative shock would play with Yellen in charge of the Fed

Imagine that the situation in China continues to deteriorate and develop into a significant downturn for the Chinese economy. How should we expect the Yellen-fed to react? First of all a “China shock” would be visible in lower market inflation expectations. However, Yellen would likely ignore that.

She has already told us she doesn’t really trust the market to tell us about future inflation. Instead Yellen would focus on the US labour market and since the labour market is a notoriously lagging indicator the labour market would tell her that everything is fine – even after the shock hit. As a result she would likely not move in terms of monetary policy before the shock would show up in the unemployment data.

Furthermore, Yellen would also be a lot less willing than Bernanke was to use money base control as the monetary policy instrument and rather use the interest rate as the monetary policy instrument. Given the fact that we are presently basically stuck at the Zero Lower Bound Yellen would likely conclude that she really couldn’t do much about the shock and instead argue that fiscal policy should be use to offset the “China shock”.

All this means that we now have introduced a new “rigidity” in the US economy. It is a “rigidity” in the Fed monetary policy rule, which means that monetary policy will not offset negative shocks to US aggregate demand.

If the market realizes this – and I believe that is actually what might be happening right now – then the financial markets might not work as the stabilizing factoring in the US economy that it was in 2013 during the fiscal cliff-event and as a result the US economy is becoming more “keynesian” and therefore also a less stable US economy.

Only a 50% keynesian economy

However, Yellen’s economy is only a 50% keynesian economy. Hence, imagine instead of a negative “China shock” we had a major easing of US fiscal policy, which would cause US aggregate demand to pick up sharply. Once that would cause US unemployment to drop Yellen would move to hike interest rates. Obviously the markets would realize this once the fiscal easing would be announced and as a result the pick up in aggregate demand would be offset by the expected monetary tightening, which would be visible in a stronger dollar, a flattening of the yield curve and a drop in equity prices.

In that sense the fiscal multiplier would be zero when fiscal policy is eased, but it would be positive when fiscal policy is tightened.

What Yellen should do 

I am concerned that Yellen’s old-school keynesian approach to monetary policy – adaptive expectations, the Phillips curve and reliance of interest rates as a policy instrument – is introducing a lot more instability in the US economy and might move us away from the nominal stability that Bernanke (finally) was able to ensure towards the end of his terms as Fed chairman.

But it don’t have to be like that. Here is what I would recommend that Yellen should do:

Introduce a clear target for monetary policy

  • Since Mid-2009 US nominal GDP has grown along a nearly straight 4% path (see here). Yellen should make that official policy as this likely also would ensure inflation close to 2% and overall stable demand growth, which would mean that shocks to aggregate demand “automatically” would be offset. It would so to speak make the US economy “classical” and stable.

Make monetary policy forward-looking

  • Instead of focusing on labour conditions and a backward-looking Phillips curve Yellen should focus on forward-looking indicators. The best thing would obviously be to look at market indicators for nominal GDP growth, but as we do not have those at least the Fed should focus on market expectations for inflation combined with surveys of future nominal GDP growth. The Fed should completely give up making its own forecasts and particularly the idea that FOMC members are making forecasts for the US economy seems to be counter-productive (today FOMC members make up their minds about what they want to do and then make a forecast to fit that decision).

Forget about interest rates – monetary policy is about money base control

  • With interest rates essentially stuck at the Zero Lower Bound it becomes impossible to ease monetary policy by using the interest rate “instrument”. In fact interest rates can never really be an “instrument”. It can be a way of communicating, but the actual monetary policy instrument will alway be the money base, which is under the full control of the Federal Reserve. It is about time that the Fed stop talking about money base control in discretionary terms (as QE1, QE2 etc.) and instead start to talk about setting a target for money base growth to hit the ultimate target of monetary policy (4% NGDP level targeting) and let interest rates be fully market determined.

I am not optimistic that the Fed is likely to move in this direction anytime soon and rather I fear that monetary policy is set to become even more discretionary and that the downside risks to the US economy has increased as Yellen’s communication is making it less likely that the markets will trust her to offset negative shocks to the US economy. The Keynesians got what they asked for – a keynesian economy.

PS I have earlier had a similar discussion regarding the euro zone. See here. That post was very much inspired by Brad Delong and Larry Summers’ paper Fiscal Policy in a Depressed Economy.

PPS I would also blame Stanley Fischer – who I regret to say thought would make a good Fed chairman – for a lot of what is happening right now. While Stanley Fischer was the governor of the Bank of Israel he was essentially a NGDP targeting central banker, but now he seems preoccupied with “macroprudential” analysis, which is causing him to advocate monetary tightening at a time where the US economy does not need it.

PPPS I realize that my characterization of Janet Yellen partly is a caricature, but relative to Ben Bernanke and in terms of what this means for market expectations I believe the characterization is fair.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: roz@specialistspeakers.com. For US readers note that I will be “touring” the US in the end of October.

6 Comments
by Lars Christensen on September 20, 2015  •  Permalink
Posted in Ben Bernanke, Brad DeLong, China, Classical, Federal Reserve, Fiscal cliff, Janet Yellen, Keynesian, Larry Summers, Stanly Fischer, Sumner Critique
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Posted by Lars Christensen on September 20, 2015

https://marketmonetarist.com/2015/09/20/yellen-is-transforming-the-us-economy-into-her-favourite-textbook-model/

The ‘dollar bloc’ was never an optimal currency area and now it is falling apart

Global stock markets are in a 2008ish kind of crash today and I really don’t have much time to write this, but I just want to share my take on it.

To me this is fundamentally about the in-optimal currency union between the US and China. From 1995 until 2005 the Chinese renminbi was more or less completely pegged to the US dollar and then from 2005 until recently the People’s Bank of China implemented a gradual managed appreciation of the RMB against the dollar.

This was going well as long as supply side factors – the opening of the Chinese economy and the catching up process – helped Chinese growth.

Hence, China went through one long continues positive supply shock that lasted from the mid-1990s and until 2006 when Chinese trend growth started to slow. With a pegged exchange rate a positive supply causes a real appreciation of the currency. However, as RMB has been (quasi)pegged to the dollar this appreciation had to happen through domestic monetary easing and higher inflation and higher nominal GDP growth. This process was accelerated when China joined WTO in 2001.

As a consequence of the dollar peg and the long, gradual positive supply shock Chinese nominal GDP growth accelerated dramatically from 2000 until 2008.

However, underlying something was happening – Chinese trend growth was slowing due to negative supply side headwinds primarily less catch-up potential and the beginning impact of negative labour force growth and the financial markets have long ago realized that Chinese potential growth is going to slow rather dramatically in the coming decades.

As a consequence the potential for real appreciation of the renminbi is much smaller. In fact there might be good arguments for real depreciation as Chinese growth is fast falling below trend growth, while trend itself is slowing.

With an quasi-pegged exchange rate like the renminbi real depreciation will have to happen through lower inflation – hence through monetary tightening. And this I believe is part of what we have been seeing in the last 2-3 years.

The US and China is not an optimal currency area and therefore the renminbi should of course not be pegged to the dollar. That was a problem when monetary conditions became excessively easy in China ahead of 2008 (and that is a big part of the commodity boom in that period), but it is an even bigger problem now when China is facing structural headwinds.

Yellen was the trigger

Hence, the underlying cause of the sell-off we have seen recently in the Chinese and global stock markets really is a result of the fact that the US and China is not an optimal currency area and as Chinese trend growth is slowing monetary conditions is automatically tightened in China due to the quasi-peg against the dollar.

This of course is being made a lot worse by the fact that the Fed for some time has become increasingly hawkish, which as caused an strong appreciation of the dollar – and due to the quasi-peg also of the renminbi. And worse still – in July Fed chair Janet Yellen signaled that the Fed would likely hike the Fed funds rate in September. This to me was the trigger of the latest round of turmoil, but the origin of the problem is a structural slowdown in China and the fact China is not an optimal currency area.

China should de-peg and Yellen should postpone rate hikes

Obviously the Chinese authorities would love the Fed to postpone rate hikes or even ease monetary policy. This would clearly ease the pressures on the Chinese economy and markets, but it is also clear that the Fed of course should not conduct monetary policy for China.

So in the same way that it is a problem the Germany and Greece are in a monetary union together it is a problem that China and the US are in a quasi-currency union. Therefore, the Chinese should of course give up the dollar peg and let the renminbi float freely and my guess is that will be the outcome in the end. The only question is whether the Chinese authorities will blow up something on the way or not.

Finally, it is now also very clear that this is a global negative demand shock and this is having negative ramifications for US demand growth – this is clearly visible in today’s stock market crash, massively lower inflation expectations and the collapse of commodity prices. The Fed should ease rather than tighten monetary policy and the same goes for the ECB by the way. If the ECB and Fed fail to realize this then the risk of a 2008 style event increases dramatically.

We should remember today as the day where the ‘dollar bloc’ fell apart.

PS I have earlier argued that China might NEVER become biggest economy in the world. Recent events are a pretty good indication that that view is correct and I was equally right that you shouldn’t bet on a real appreciation of the renminbi.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

35 Comments
by Lars Christensen on August 24, 2015  •  Permalink
Posted in China, dollar bloc, Federal Reserve, In-optimal currency area, PBoC
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Posted by Lars Christensen on August 24, 2015

https://marketmonetarist.com/2015/08/24/the-dollar-bloc-was-never-an-optimal-currency-area-and-now-it-is-falling-apart/

Yellen should re-read Friedman’s “The Role of Monetary Policy” and lay the Phillips curve to rest

It is the same thing every month – anybody seriously interested in financial markets and the global economy are sitting and waiting for the US labour market report to come out even though the numbers are notoriously unstable and unreliable.

Why is that? The simple answer is that it is not because the numbers are important on their own, but because the Federal Reserve seems to think the labor market report is very important.

And that particularly goes for Fed-chair Janet Yellen who doesn’t seem to miss any opportunity to talk about labour market conditions.

The problematic re-emergence of the Phillips curve as a policy indicator

To Janet Yellen changes in inflation seems to be determined by the amount of slack in the US labour market and if labour market conditions tighten then inflation will rise. This of course is essentially an old-school Phillips curve relationship and a relationship where causality runs from labour market conditions to wage growth and on to inflation.

This means that for the Yellen-fed labour market indicators essentially are as important as they were for former Fed chairman Arthur Burns in the 1970s and that could turn into a real problem for US monetary policy going forward.

Yellen should re-read Friedman’s “The Role of Monetary Policy”

To understand this we need to go back to Milton Friedman’s now famous presidential address delivered at the Eightieth Annual Meeting of the American Economic Association – “The Role of Monetary Policy” – in 1967 in, which he explained what monetary policy can and cannot do.

Among other things Friedman said:

What if the monetary authority chose the “natural” rate – either of interest or unemployment – as its target? One problem is that it cannot know what the “natural” rate is. Unfortunately, we have as yet devised no method to estimate accurately and readily the natural rate of either interest or unemployment. And the natural rate will itself change from time to time. But the basic problem is that even if the monetary authority knew the natural rate, and attempted to peg the market rate at that level, it would not be led to determinate policy. The “market” rate will vary from the natural rate for all sorts of reasons other than monetary policy. If the monetary authority responds to these variations, it will set in train longer term effects that will make any monetary growth path it follows ultimately consistent with the policy rule. The actual course of monetary growth will be analogous to a random walk, buffeted this way and that by the forces that produce temporary departures of the market rate from the natural rate.

To state this conclusion differently, there is always a temporary trade-off between inflation and unemployment: there is no permanent trade-off. The temporary trade-off comes not from inflation per se, but from unanticipated inflation which generally means, from a rising rate of inflation. The widespread belief that there is a permanent trade-off is a sophisticated version of the confusion between “high” and “rising” that we all recognize in simpler forms. A rising rate of inflation may reduce unemployment, a high rate will not.

…To state the general conclusion still differently, the monetary authority controls nominal quantities – directly, the quantity of its own liabilities. In principle, it can use this control to peg a nominal quantity – an exchange rate, the price level, the nominal level of income, the quantity of money by one or another definition – or to peg the rate of change in a nominal quantity – the rate of inflation or deflation, the rate of growth or decline in nominal national income, the rate of growth of the quantity of money.

It cannot use its controls over nominal quantities to peg a real quantity – the real rate of interest, the rate of unemployment, the level of real national income, the real quantity of money, the rate of growth of real income, or the rate of growth of the real quantity of money.

For many years – at least going back to the early 1990s – this was the clear consensus among mainstream macroeconomists. It is of course a variation of Friedman’s dictum that “inflation is always and everywhere a monetary phenomena.”

Central banks temporary can impact real variables such as unemployment or real GDP, but it cannot permanently impact these variables. Similarly there might be a short-term correlation between real variables and nominal variables such as a correlation between nominal wage growth (or inflation) and unemployment (or the output gap).

However, inflation or the growth of nominal income is not determined by real factors in the longer-term (and maybe not even in the short-term), but rather than by monetary factors – the balance between demand and supply of money.

The Yellen-fed seems to be questioning Friedman’s fundamental insight. Instead the Yellen-Fed seems to think of inflation/deflation as a result of the amount of “slack” in the economy and the Yellen-fed is therefore preoccupied with measuring this “slack” and this is what now seems to be leading Yellen & Co. to conclude it is time to tighten US monetary conditions.

This is of course the Phillips curve interpretation of the US economy – there has been steady job growth and unemployment is low so inflation most be set to rise no matter what nominal variables are indicating and not matter what market expectations are. Therefore, Yellen (likely) has concluded that a rate hike soon is warranted in the US.

This certainly is unfortunately. Instead of focusing on the labour market Janet Yellen should instead pay a lot more attention to the development in nominal variables and to the expectations about these variables.

What are nominal variable telling us?

Friedman mentions a number of variables that the monetary authorities directly or indirectly can control – among others the price level, the level of nominal income and the money supply. We could add to that nominal wages.

So what are these variables then telling us about the US economy and the state of monetary policy? Lets take them one-by-one.

We start with the price level – based on core PCE deflator.

PCE core

The graph shows that it looks as if the Federal Reserve has had a price level target since the (“official”) end of the 2008-9 recession in the summer of 2009. In fact at no time since 2009 has the actual price level (PCE core deflator) diverged more than 0.5% from the trend. Interestingly, however, the trend growth rate of the price level has been nearly exactly 1.5% – pretty much in line with medium-term market expectations for inflation, but below the Fed’s official 2% inflation target.

However, if we define the Fed’s actual target as the trend in the price level over the past 5-6 years then there is no indication that monetary policy should be tightened. In fact the actual price level has this year fallen slightly below the 1.5%-“target path” indicating if anything that monetary conditions is slightly too tight (but nearly perfect). Obviously if we want to hit a new 2% path then someeasing of monetary conditions is warranted.

So how about the favorite Market Monetarist-indicator – Nominal GDP?

NGDP gap

Again the picture is the same – the Fed has actually delivered a remarkable level of nominal stability since the summer of 2009. Hence, nominal GDP has grown nicely along at a trend since Q3 2009 and the actual NGDP level has remains remarkably close to the trend path for NGDP – as if the Fed was actually targeting the NGDP level along a (close to) 4% path.

And as with the price level – the present NGDP level is slightly below the trend over the past 5-6 years indicating a slightly too tight monetary stance. Furthermore, it should be noted that prediction markets such as Hypermind presently are predicting around 3.5% NGDP growth in 2015 – below the 4% de facto target. So again if anything US monetary policy is – judging from NGDP and NGDP expectations – just a tiny bit too tight.

And what about Milton Friedman’s favourite nominal indicator – the broad money supply? Here we look at M2.

M2 gap US

Once again we have seen a remarkable amount of nominal stability judging from the development in US M2 – particularly since 2011 with only tiny deviations in the level of M2 from the post-2009 trend. Milton Friedman undoubtedly would have praised the Fed for this. Hence, it looks as if the Fed actually have had a 7% growth path target for M2.

But again, recently – as is the case with the price level and NGDP – the actual money supply (M2) as dropped moderately below the the post-2009 trend indicating that monetary conditions are slightly too tight rather than too easy.

Then what about nominal wages? We here look at average hourly earnings for all all employees (total private).

wage gap

Surprise, surprise – again incredible nominal stability in the sense that average hourly earnings have grown very close to a near-perfect 2% trend in the past 5-6 years. However, unlike the other nominal measures recently the “wage gap” – the difference between actual nominal wages and the trend – has turned slightly positive indicating that monetary conditions is a bit too easy to achieve 2% trend growth in US nominal wages.

But again we are very, very close to the post-2009 trend. We could of course also notice that a 2% nominal wage growth target is unlikely to be comparable to a 2% inflation target if we have positive productivity growth in the US economy.

Conclusion: Preoccupation with the Phillips curve could course the Fed to hike too early

…Nominal variables tell the Fed to postpone a hike until 2016

The message from Milton Friedman is clear – we should not judge monetary conditions on real variables such as labour market conditions. Instead we should focus on nominal variables.

If we look at nominal variables – the price level, NGDP, the money supply and nominal wages – the conclusion is rather clear. The Fed has actually since 2009 delivered a remarkable level of nominal stability in terms of keeping nominal variables very close to the post-2009 trend.

If we want to think about the Bernanke-Fed the Fed had one of the following targets: 1.5% core PCE level targeting, 4% NGDP level targeting, 7% M2-level targeting or 2% wage level targeting at least after the summer of 2009.

However, the Yellen-Fed seems to be focusing on real variables – and particularly labour market variables – instead. This is apparently leading Janet Yellen to conclude that monetary conditions should be tightened.

However, nominal variables are telling a different story – it seems like monetary conditions have become slightly too tight within the past 6-12 months and therefore the Fed needs to communicate that it will not hike interest rates in September if it wants to keep nominal variables on their post-2009 path.

Obviously the Fed cannot necessarily hit more than one nominal variable at the time so the fact that it has kept at least four nominal variables on track in the past 5-6 years is quite remarkable. However, the Fed needs to chose one nominal target and particularly needs to give up the foolish focus on labour market conditions and instead fully commit to a nominal target. My preferred target would certainly be a 4% (or 5%) Nominal GDP level target.

And Chair Yellen, please lay the Phillips curve to rest if you want to avoid sending the US economy into recession in 2016!

PS My thinking on these issues has strongly be influence by my good friend Mike Darda.

PPS think of the present time as one where Milton Friedman would be more dovish than Arthur Burns.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: roz@specialistspeakers.com. For US readers note that I will be “touring” the US in the end of October.

8 Comments
by Lars Christensen on August 8, 2015  •  Permalink
Posted in Arthur Burns, Federal Reserve, Janet Yellen, Michael Darda, Milton Friedman, Policy failure
Tagged , , , , ,

Posted by Lars Christensen on August 8, 2015

https://marketmonetarist.com/2015/08/08/yellen-should-re-read-friedmans-the-role-of-monetary-policy-and-lay-the-phillips-curve-to-rest/

The hawks should start advocating NGDP targeting to avoid embarrassment

Over the past six years the “hawks” among UK and US central bankers have been proven wrong. They have continued to argue that a spike in inflation was just around the corner because monetary policy was “high accommodative”. Obviously Market Monetarists have continued to argue that monetary policy has not been easy, but rather to tight in the US and the UK – at least until 2012-13.

The continued very low inflation continues to be an embarrassment for the hawks and looking into 2015-16 there are no indication that inflation is about to pick-up either in the US or in the UK.

That said, there might actually be good reasons for turning more hawkish right now – nominal GDP growth continues to pick up in both the UK and the US (I will ignore the euro zone in this blog post…)

The sharp drop in oil prices in recent months is likely to further push down headline inflation in the coming months. Central bankers should obviously completely ignore any drop in inflation caused by a positive supply shock, but with most hawks completely obsessed with inflation targeting a hawkish stance will become harder and harder to justify from an inflation targeting perspective exactly at the time when it actually might become more justified than at any time before in the past six years.

I would personally not be surprised if we get close to deflation in both the UK and the US in 2015 and maybe also in 2016 if we don’t get a rebound in oil prices, but I would also think that there is a pretty good chance that we could get 4-5% or maybe even higher nominal GDP growth in both the UK and US in 2015-16. And that would be a strong argument for a tighter monetary stance.

Hence, if strict inflation targeters would follow their own logic then they would be advocating monetary easing in 2015-16 in both Britain and the US, while those of us who are more focused on NGDP growth will likely see an increasing need for monetary tightening in 2015-16.

As a consequence if you are an old hawk who “feels” that there is a need for monetary tightening then you better stop looking at present inflation and instead start to focusing on expected NGDP growth.

But of course the idea that you are hawkish or dovish is in itself an idiotic idea. You should never be hawkish or dovish as that in itself means that you are likely advocating some sort of discretionary monetary policy. What should concern you should be the rules of the game – the monetary policy regime.

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by Lars Christensen on December 22, 2014  •  Permalink
Posted in Bank of England, Federal Reserve, NGDP Targeting
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Posted by Lars Christensen on December 22, 2014

https://marketmonetarist.com/2014/12/22/the-hawks-should-start-advocating-ngdp-targeting-to-avoid-embarrassment/

Oil prices, inflation and the FT’s good advice for central bankers

This is from the Financial Times’ FT View:

Pity the analyst forecasting today’s global economy. For every signal warning of stagnation there is another glowing green for go. But through this blur of clashing indicators it is possible to discern some consistent themes.

The clearest is weak inflation. The main cause is oversupply in the oil market where prices have fallen by one-third since the summer. With other commodities from cotton and hogs to wheat and soybeans similarly cheap, countries that rely on imported food and fuel have had a welcome boost.

American consumers in particular benefit from cheap fuel, which helps to explain growing momentum in the US economy. Strong jobs numbers on Friday confirmed a growing recovery. These bullish spirits are mirrored on Wall Street where the stock market has rebounded by 10 per cent since the turmoil of October.

But any student of the Great Depression would caution against seeing disinflationary forces in a purely positive light. In Japan and Europe, the persistent downwards trend in inflation is also a reflection of weak incomes. If left unchecked, this threatens to entrench a low-spending, deflationary mindset. Outside of a big slowdown, wage growth in much of the developed world has never been weaker. Even the most ambitious monetary policy can be undermined if pay packets are not growing. Instead of being spent, cash accumulates on the balance sheets of businesses unwilling to invest…

…Monetary policy provides the best key to understanding the variegated global picture. The central banks of the US, UK and Japan all adopted easier policies and were rewarded with an upturn. Given weak wage growth and a lack of fiscal support, such stimulus ought to continue.

Europe is an unhappy exception. Despite German misgivings, low interest rates are no evidence that money is too loose: nominal GDP growth stutters along at less than 3 per cent, a clear sign that the stance is much too tight. In recent years the ECB twice made the mistake of raising rates too soon, and thereby punished Europe with a deeper recession and a worse fiscal crisis. If its president Mario Draghi cannot ease policy further, the consequences will be just as serious.

The welcome boost provided by cheaper oil may help the global economy accelerate over the next year. Even Europe could participate, if only its policy makers would stop confusing the brake with the accelerator.

Do I need to say I agree with 99% of this? Yes, lower oil prices is mostly good news to the extent it reflects a positive supply shock in the oil market and yes if that was the only reason we are seeing deflation spreading then we should not worry.

However, take a look at any indicator of monetary condtions in the euro zone – the collapse in the money base since 2012, meager M3 growth, no NGDP growth, higher real interest rates, a stronger euro (since 2012) and sharply lower inflation expectations – and you should soon realise that the real deflation story in the euro zone is excessively tight monetary policy and the ECB need to do something about that whether oil trades at 40 or 140 dollars/barrel.

PS I don’t think the same story goes for the US. The recent drop in US inflation does not on its own warrant monetary easing. The Fed just needs to keep focused on expected NGDP growth and there is no signs of NGDP growth slowing in the US so I don’t think monetary policy is called for in the US.

PPS For some countries – oil-exporters with pegged exchange rates – lower oil prices is in fact monetary tightening – see here.

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by Lars Christensen on December 6, 2014  •  Permalink
Posted in Deflation, ECB, Federal Reserve, Oil glut
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Posted by Lars Christensen on December 6, 2014

https://marketmonetarist.com/2014/12/06/oil-prices-inflation-and-the-fts-good-advice-for-central-bankers/

The story of a remarkably stable US NGDP trend

Today revised US GDP numbers for Q3 were released. While most commentators focused on the better than expected real GDP numbers I am on the other hand mostly impressed by just how stable the development in nominal GDP is. Just take a look at the graph below.

US NGDP 4 pct trend

I have earlier argued that the development in NGDP looks as if the Federal Reserve has had a 4% NGDP level target since Q3 2009. In fact at no time since 2009 has the actual level of NGDP diverged more than 1% from the 4% trend started in Q3 2009 and right now we are basically exactly on the 4% trend line. This is remarkable especially because the Fed never has made any official commitment to this target.

With market expectations fully aligned to with this trend and US unemployment probably quite close to the structural level of unemployment I see no reason why the Fed should not announce this – a 4% NGDP level target – as its official target.

PS I might join the hawks soon – if the trend in NGDP growth over the last couple of quarters continues in the coming quarter then we will move above the 4% NGDP trend and in that sense there is an argument for tighter monetary conditions.

PPS I am not arguing that monetary policy was appropriate back in 2009 or 2010. In fact I believe that monetary policy was far too tight, but after six years of real adjustments it is time to let bygones-be-bygones and I don’t think there would be anything to gain from a stepping up of monetary easing at the present time.

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by Lars Christensen on November 25, 2014  •  Permalink
Posted in Federal Reserve, NGDP Targeting
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Posted by Lars Christensen on November 25, 2014

https://marketmonetarist.com/2014/11/25/the-story-of-a-remarkably-stable-us-ngdp-trend/

The Fed was targeting the Labor Market Conditions Index 30 years before it was invented

Today the Federal Reserve published its much-hyped new Labor Market Conditions Index (LMCI).

This is how the Fed describes the Index:

The U.S. labor market is large and multifaceted. Often-cited indicators, such as the unemployment rate or payroll employment, measure a particular dimension of labor market activity, and it is not uncommon for different indicators to send conflicting signals about labor market conditions. Accordingly, analysts typically look at many indicators when attempting to gauge labor market improvement. However, it is often difficult to know how to weigh signals from various indicators. Statistical models can be useful to such efforts because they provide a way to summarize information from several indicators…

…A factor model is a statistical tool intended to extract a small number of unobserved factors that summarize the comovement among a larger set of correlated time series.

In our model, these factors are assumed to summarize overall labor market conditions. What we call the LMCI is the primary source of common variation among 19 labor market indicators. One essential feature of our factor model is that its inference about labor market conditions places greater weight on indicators whose movements are highly correlated with each other. And, when indicators provide disparate signals, the model’s assessment of overall labor market conditions reflects primarily those indicators that are in broad agreement.

The included indicators are a large but certainly not exhaustive set of the available data on the labor market, covering the broad categories of unemployment and underemployment, employment, workweeks, wages, vacancies, hiring, layoffs, quits, and surveys of consumers and businesses.

So is there really anything new in all this? Well, not really. To me it is just another indicator for the US business cycle. The graph below illustrates this.

LMCI FF rate

The graph shows the relationship between on the one hand the cumulative Labor Market Conditions Index and on the other hand the year-on-year change in the real Fed Funds rate. I have deflated the Fed Funds rate with the core PCE deflator.

The picture is pretty clear – since the mid-1980s the Fed has tended to increase real rates, when “Labor Market Conditions” have improved and cut rates when labor market conditions have worsened. There is really nothing new in this – it is just another version of the Taylor rule or the Mankiw rule, which capture the Fed’s Lean-Against-the-Wind regime during the Great Moderation. I am hence sure that you could estimate a nice rule for the Fed funds rate for period 1985-2007 based on the LMCI and PCE core inflation. I might return to that in a later post…

That said, there seems to have been a “structural” break in the relationship around 2001/2. Prior to that the relationship was quite close, but since then the relationship has become somewhat weaker.

Anyway that is not really important. My point is just that the LMCI is not really telling us much new. That said, the LCMI might help the Fed to communicate better about it policy rule (I hope), but why bother when a NGDP level target would be so much better than trying to target real variables (fancy or not)?

PS don’t be fooled by the graph into concluding the Fed Funds rate should be hiked. To conclude that you at the least need an estimate relationship between the LMCI and the Fed Funds rate.

2 Comments
by Lars Christensen on October 6, 2014  •  Permalink
Posted in Federal Reserve, Labor Market Conditions Index, Mankiw rule, Taylor rule
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Posted by Lars Christensen on October 6, 2014

https://marketmonetarist.com/2014/10/06/the-fed-was-targeting-the-labor-market-conditions-index-30-years-before-it-was-invented/

The dollar rally is testing the Fed’s credibility

The dollar has continued to strengthen since early July – just take a look at the graph below:

10y BE inflation dollar index

As the graph shows not only has the dollar strengthened since July, but inflation expectations have also dropped somewhat and interesting enough we have now 10-year break-even inflation expectations below 2%.

It is only the second time that that have happened since the Fed officially introduced a 2% inflation target in January 2012 (see here). Obviously we cannot directly compare the Fed’s inflation target and 10-year inflation expectations, but the decline in inflation expectations nonetheless is very indicative of the scale of monetary tightening that is expected from the Fed.

The graph also shows there is a very close negative correlation between the performance of the US dollar and US inflation expectations. This obviously can easily been explained from a monetary perspective. Expectations for Fed tightening (easing) will both cause the dollar to strengthen (weaken) and cause inflation expectations to drop (rise).

The close correlation between inflation expectations and the dollar means that a continued strengthening of the dollar will be a clear test of the Fed’s credibility and if the dollar continues to rally then it would be very obvious to everybody that the Fed’s credibility would be under pressure.

I am not speculating here whether the dollar rally will continue or not, but rather whether Fed’s inflation target is credible or not?

2 Comments
by Lars Christensen on September 25, 2014  •  Permalink
Posted in Federal Reserve, Inflation Targeting
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Posted by Lars Christensen on September 25, 2014

https://marketmonetarist.com/2014/09/25/the-dollar-rally-is-testing-the-feds-credibility/

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