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.


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):


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.

The ruble has appreciated exactly BECAUSE the sanctions are working

The question I have been asked most over the last week is why the Russian ruble is been appreciating despite the fact Russia has been hit by extensive economic sanctions.

I must honestly admit that since the sanctions were introduced I have not spent much time following the development of the ruble – or rather the ruble exchange rate on our screens does not really tell us much as the ruble today cannot really be said to be a convertible currency in the traditional sense.

If, for example. showed up at an European bank with rubles and wanted to exchange them for euros then in practice you would hardly be able to do so.

This is because the Russian central bank (CBR) has been sanctioned and what happens in practice is that if you have to exchange rubles for euros the money is basically deposited in the Russian central bank, which then gives back euros – directly from the Russian foreign exchange reserve.

This can now not be done as the CBR simply does not have access to trade in e.g. euros or dollars. The foreign currency remains in the foreign exchange reserve, but the CBR just cannot use it. This is equivalent to having money in your bank account, but the online banking and credit cards do not work.

At the same time, Russia is largely shut out of the so-called SWIFT system used to conduct international currency transactions. This means e.g. that in practice you cannot transfer money between e.g. Denmark and Russia. So if e.g. If a Danish company sells a product to Russia, it will now in practice not be able to receive payment for the product.

On the contrary, Russia’s oil and gas exports, which are basically the only thing that Russia exports, are not covered by the sanctions, and Russia can continue to receive payment for e.g. gas exports to EU countries.

Slightly simplified, Russia can now not import very much, but the country can continue to export. In other words Russia’s imports have collapsed while exports are less severely affected by sanctions.

Consequently, Russia’s trade balance surplus has increased sharply in the past month.

And that is basically the reason why the ruble has appreciated in recent weeks.

Does that mean that the sanctions do not work?

If you have a mercantilist view of the world – that is if you think that it is always good to export and that imports are bad then the sanctions are great for Russia.

This view, however, corresponds to saying that it is good to work and bad to consume, but there is basically only one reason to work – namely to consume. We do not work for fun – we work to be able to consume – whether it is food or luxury goods.

Right now, Russia is now basically forced to “work”, that is, to sell oil and gas, but at the same time Russia cannot use the revenue.

At the same time, it is part of the stpry that the Russian government has severely restricted the right and opportunity of Russian citizens and businesses to own foreign currency, and citizens and businesses are forced to convert the bulk of their foreign exchange earnings into rubles. This may also to some extent also have supported the value of the ruble.

In addition, it should be noted that Russian interest rates have skyrocketed and that is basically the market compensation for the fact that the ruble has lost value – and is expected to lose additional value in the future.

Finally, the Russian foreign exchange reserve has fallen quite sharply in the past month. Thus, the weekly foreign exchange reserve data from the Russian central bank show that the foreign exchange reserve on February 25 amounted to USD 629.4 billion. By March 25, that number had dropped to USD 604.4 billion.

This is remarkable given that we know that the trade surplus has risen sharply and that Russia cannot trade Western currencies.

Do the sanctions work?

If one is to judge whether the sanctions “work” then one must relate that to what the purpose of the sanctions is.

The purpose of sanctions is not just to “punish” Russia and revenge is certainly not the main purpose. The main purpose must be to sharply reduce Putin’s ability to continue waging war.

Russia needs imports when it comes to waging war. For example Russia must use technology in military production or tires for military vehicles etc. All indications are that these imports have now been severely hampered.

At the same time Putin is dependent on economic growth both to finance the war itself (and possible future “adventures”) and to bribe those he need to support him both in the wider Russian population and among oligarchs, and more importantly in defence and the security apparatus (the so-called Silovik).

Hence, the sanctions hit the Russian economy and Putin regime very hard, but as Russian oil and gas exports are not covered by sanctions the West will be affected to a much lesser extent.

If on the other hand the EU and the West in general closed off imports of Russian oil and gas it would send oil and gas prices skyrocketing and the European economy would be hit quite hard and the European economy would most certainly end up in recession.  

A recession that could potentially threaten popular support for the hard line against Putin and which could create divisions among the EU countries.

On the contrary, Russia is already in a situation where oil and gas revenues, which are typically in euros or dollars, are not worth much, as Russia basically do not have access to spend euros and dollars.

The only thing these foreign exchange earnings today can be used for is basically to service the Russian debt in these foreign currencies. Again, it is primarily the Western investors who own the Russian government bonds that are benefiting rather than the Russian government.

So yes the ruble has appreciated in recent week, but it actually reflects that the sanctions against Russia are quite well calibrated – it maximizes the negative effects on Putin’s ability to wage war and at the same time it minimizes the negative effects on the global economy.

The “black market value” of the ruble has fallen sharply

Finally, it must be said that the ruble exchange rate that we can observe on various financial news sites is not necessarily the actual exchange rate.

In Soviet times, there was an official ruble exchange rate, but it did not have much to do with the real exchange rate. The actual exchange rate was the one you could read if you asked the black market currency traders on the streets of Moscow when exchanging physical dollars for rubles or the other way around.

In currency terms, we are now to a large extent back to the Soviet era, but today we have an easier way of observing the “black market rate” of the ruble. Hence, you can still trade bitcoin and other cryptocurrencies in Russia.

If I want my money out of Russia, then I can exchange my rubles in Russia for bitcoin, and then fly to for example Turkey and get my bitcoin paid out for dollars or Turkish lira on a Turkish crypto exchange.

Thus, by using the “local” Russian bitcoin price, we can calculate what the real value of the ruble is if one were to exchange it for dollars on the “street” in Moscow.

This “premium” which you have to pay for for example Bitcoin in Russia relative to Bitcoin elsewhere has fluctuated between 10-30 percent over the past month. It is smaller now than in the days immediately after the war started, but it is still significant.

Finally, Russian exporters of goods must also accept a discount when they export. Thus, the price of oil from Russia today is about 30 percent lower than what oil otherwise costs on the world market.

We can thus conclude that, paradoxically, it is the sanctions – because it works – that help keep the ruble exchange rate up, but the goods that Russia exports are sold at a significant discount, and at the same time the “street price” of the ruble is significantly below the “official “Exchange rate.

There is therefore no reason to be blinded by the development of the ruble exchange rate, which we can observe on various finance sites, as it does not really say much about the financial flows in and out and Russia and the state of the Russian economy.

Ukrainian default risk drops BELOW Russian default risk

This is a bit of a humiliation of Putin – the so-called Credit Default Swap (CDS) for Ukraine is now LOWER than Russia’s CDS.

A CDS is the price to insure against losing money on a government bond in the event of a government default.

In other words, investors now see it as MORE likely that Russia will default on its sovereign debt than Ukraine will.

Below, the white line is Ukraine’s CDS, while the orange line is the Russian CDS. The green graph at the bottom shows the difference between the two.

It’s a lot of buts and ifs, but it’s probably a pretty good indication of the situation for the two countries.

On the one hand, Russia can look forward to tough economic sanctions from the West for many years to come – unless there is “regime change” in Russia.

On the other hand, Ukraine can probably very much look forward to help from the West when peace comes at some point.

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