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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.

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.

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Mike Darda tells it as it is – The ECB’s deflationary failure

This is my good friend Michael Darda speaking on Bloomberg TV about the ECB – needless to say I agree with everything he says.

PS this is Mike talking about commodity prices – is it a demand or a supply story?Again I agree with Mike – it is both.

PPS This is myself on FOX Business’ Opening Bell with Maria Bartiromo last week commenting on the Bank of Japan’s latest action.

The Mankiw-Darda rule tells the Fed to wait a bit with hikes

Greg Mankiw has a blog post commenting on my previous post on the so-called Mankiw rule.

I show in my post that according to both the original and a re-estimated version of the Mankiw rule the Federal Reserve should be hiking rates right now. I should stress again that I don’t think the Fed should hike interest rates – I am only using the Mankiw rule to illustrate why we likely are moving closer to a rate hike from the Fed (that is the is a difference between thinking about what the Fed will do rather than what it should do).

Greg makes some good points why the Fed should not hike rates yet:

Taken at face value, the rule suggests that it is time for the Fed to start raising the federal funds rate.  If you believe this rule was reasonably good during the period of the Great Moderation, does this mean the Fed should start tightening now, as the economy gets back to normal?

Maybe, but not necessarily. There are two problems with interpreting such rules today.

The first and most obvious problem is that odd things have been happening in the labor market for the past several years. The unemployment rate (one of the right hand side variables in this rule) may not be a reliable indicator of slack.

The second and more subtle problem is the nagging issue of the zero lower bound.  For several years, the rule suggested a target federal funds rate deeply in the negative territory.  We are out of that range now, but should the past “errors” influence our target today?  An argument can be made that because the Fed kept the target rate “too high” for so long (that is, at zero rather than negative), it should commit itself now to keeping the target “too low” as compensation (that is, at zero for longer than the rule recommends).  By systematically doing so, the Fed encourages long rates to fall by more whenever the economy hits the zero lower bound. Such a policy might lead to greater stability than strict adherence to the rule as soon as we leave negative territory.

I agree with both points. It seems particularly problematic for the original Mankiw rule that there seems to be a major problem on the US labour market with a discouraged worker effect – as a result the actual unemployment data tend to underestimate just how bad the situation has been (and still is?) on the US labour market. Many have simply given up looking for a job and left the labour market.

My good friend Michael Darda (MKM Partners) has suggested to deal with the discourage worker effect and other demographic problems by use the prime age employment ratio rather than the unemployment rate when estimating the Mankiw rule. Michael also uses core CPI rather than the core PCE deflator as a measure of inflation. The graph below shows the Mankiw-Darda rule (Michael’s estimate):

Mankiw Darda rule

 

We see that while the Mankiw-Darda rule has become increasingly “hawkish” since early 2011 it is still not “recommending” a rate hike – the predicted Fed fund rate is still negative (around -1.5%). Hence, it seems like the Mankiw-Darda rule is better at actually describing what the Fed is doing than the original Mankiw rule. This is not totally surprising.

Inflation targeting or price level targeting?

In an update to his post Greg makes some highly relevant comments, which will appeal to any Market Monetarist including myself:

There is another (related) argument for not raising rates now to offset shortfalls in the past. It is not about the interest rate. It is about the price level, the ultimate goal of monetary policy and measure of its performance.

If you plot the PCE deflator, there is a clear shortfall relative to a 2% price-level target. A 2% price level target fits very well during Greenspan’s time.  By the end of 2008, we were exactly on the 1992-target. But when I look at that plot starting in 2009 until the most recent data I see a gap.

A price-level target rule is optimal in normal times (Ball, Mankiw, and Reis) but is also an optimal policy in response to the dangers of the zero lower bound (Woodford). We have to catch up for the shortfall in the price level right now. And if you look at inflation expectations from surveys or markets, there seems to be no catch up expected, indicating that policy is still too tight.

Obviously I would prefer a nominal GDP level target to a price level target, but I think a price level target as here suggested by Greg is much preferable to an inflation target.

As I noted in my own previous post “inflation has drifted lower” since 2008. This is exactly the point Greg makes (based on comments from Ricardo Reis). Since 2008 the Fed has failed to keep the PCE price level on a 2% path trend. The graph below illustrates this:

Price gap US

 

The graph shows that it looks as if the Fed prior to 2008 had a 2% price level target and the actual price level closely followed a 2% trend line. However, since then inflation has consistently been below 2% and as a result the “price gap” has become increasingly negative.

This is paradoxical as the Fed now officially has 2% inflation target, while it prior to 2008 did not have such a target.

This is obviously another argument for why the original Mankiw rule at the moment is too “hawkish”. On the other hand one can certainly also discuss whether the Fed should close the “price gap” or not. Here I have the relatively pragmatic view that the Fed should let bygones-be-bygones as we over the past five years have seen some supply side adjustments. Furthermore, the decline in the price gap does not only reflect demand-side factors but likely also reflects a positive supply shock. In that regard it should be noted that longer-term inflation expectations in the US still remain above 2% (5-year/5-year US breakeven inflation this morning is 2.4%).

Therefore, if I was on the FOMC I would not favour a one-off money injection to close the price gap, but on the other hand the Mankiw-Darda rule and the consideration about the price gap also shows that the FOMC should not be in a hurry to tighten monetary conditions either. The Fed’s gradual and fairly well-communicated policy to continue “tapering” and then sometime next year gradually start increasing the fed funds rate therefore is consistent with a policy of ensuring nominal stability and it is also reducing the risk of a 1937-style premature tightening of monetary conditions, which would send the US economy back in recession. Said in another way I find it hard to be very critical about how the Fed at the moment is balancing risks both to the upside and to the downside.

A NGDP level target rule solve our problems

The discussion about the Mankiw rule illustrates two problems in common monetary policy thinking. First there remains a major focus on the US labour market. The problem of course is that we really don’t know the level of structural unemployment and this is particularly the case right now after we in 2008 got out of whack. Second, while inflation clearly has remained below 2% since 2008 we don’t know whether this is due to supply side factors or demand side factors.

There is of course a way around these problems – nominal GDP level targeting – and as I have argued in a recent post it in fact looks as if the Fed has followed a 4% NGDP level target rule since July 2009.

That would not have been my preferred policy in 2009, 2010 or 2011 as I would have argued that the Fed should have done a lot more to bring the NGDP level back to the pre-crisis trend-level. However, as time has gone by and we have had numerous supply shocks and some supply adjustments have gone on for nearly six years I have come to the conclusion that it is time to let bygones be bygones. We can do little to change the mistakes of six years ago today. But what we – or rather what the Fed can do – is to announce a policy for the future, which significantly reduces the likelihood of repeating the mistakes of 2008-9.

Therefore, the Fed should obviously announce a NGDP level target policy. Whether the Fed would target a 4% or a 5% path for the NGDP level is less important to me. It would be the right policy, but it would also be a pragmatic way around dealing with uncertainties regarding the state of the US labour markets and to avoid having supply side shock distorting monetary policy decisions.

PS My friend Marcus Nunes also comments on the Mankiw rule. Marcus seems to think that I am advocating that the Fed should tighten monetary policy. I am not doing that. All I have been saying it that the original Mankiw rule indicates that the Fed should tighten monetary conditions and that this is an indication of the direction we are moving in.

PPS My “playing around” with the Mankiw rule should be seen in the perspective that I am currently thinking quite a bit – in my day-job – about when the Fed will actually hike relative to what the markets are thinking the Fed will do. If the Fed moves earlier than expected by markets then it obviously is going to have clear implications for the global financial markets.

Michael Darda on Bloomberg radio

Michael Darda is not only a nice guy – he is also clever. But frankly speaking it is a bit boring always being in agreement with him.

This is Mike speaking on Bloomberg radio. I fully share Mike’s positive view of the near-term outlook for the US economy.

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