On this day ten years ago I published a Working Paper on Marcus Nunes’ blog “The Faint of Heart” with the title “Market Monetarism – The Second Monetarist Counter-revolution”.

This is the Working Paper in which I coined the term “Market Monetarism”. Little did I know that over the following decade monetary scholars as well as central bankers would refer to market monetarism as a school of thought and little did I know that market monetarism would have such an impact on monetary policy discussions globally as it indeed has had.

I strongly believe that market monetarist thinking had a strong and positive influence on the conduct on monetary policy in particularly the US and the world is a better place for that reason.

I coined the the name of the school and I think I played a important role through my blog in developing the ideas of market monetarism, but others did a lot more – economists such as Scott Sumner, David Beckworth, Nick Rowe and Marcus Nunes.

This is the abstract of the paper I wrote 10 years ago:

Market Monetarism is the first economic school to be born out of the blogosphere. Market Monetarism shares many of the views of traditional monetarism but unlike traditional monetarism Market Monetarism is sceptical about the usefulness of monetary aggregates as policy instruments and as an indicator for the monetary policy stance. Instead, Market Monetarists recommend using market pricing to evaluate the stance of monetary policy and as a policy instrument.

Contrary to traditional monetarists  who recommend a rule for money supply growth Market Monetarists recommend targeting the Nominal GDP (NGDP)level. The view of the leading Market Monetarists is that the Great Recession was not caused by a banking crisis but rather by excessively tight monetary policy. This is the so-called Monetary Disorder view of the Great Recession.

Read (or re-read) the paper here.

Back in April I warned that given the massive expansion of the US broad money supply we could very well be heading from double-digit inflation in the US later in 2021 or 2022.

At that time inflation was at 1.6% (March). Today we got inflation for June – and now inflation is at 5.4% and core inflation is at the highest level in 30 years.

So far my inflation simulation seems to be pretty much on track.

But that is not the topic for this blog post – at least not the main topic. Rather I want to discuss what the latest inflation numbers imply for Fed policy going forward.

Back In August 2020 at the online Jackson Hole conference Fed chairman Jerome Powell announced a revision to the Fed’s long-run monetary policy framework by re-framing this goal as an average inflation target (AIT) of 2% over the long-run.

This means that the Fed will tolerate inflation running above (below) 2% for a period if it in periods years has undershot (overshot) it’s target.

This was by many – including myself – interpreted as the Fed for some time could tolerant inflation above 2% as inflation since the outbreak of the Great Recession in 2008-9 far mostly have been below 2%.

The Fed, however, was not very clearly in telling us anything about the the timeframe – is it an average over 2 years, 5 years or even 10 years? We simply don’t know even though it by some Fed officials have been hinted that it probably was 4-5 years.

Where are we now?

The timeframe of course is relevant if we want to judge whether the Fed should ease or tighten monetary conditions going forward.

But lets say we want to give the Fed a lot of room to ease monetary policy and allow inflation to overshoot on the upside.

We can do that by saying that we will take the entire period after 2008 where inflation has been below a 2% trend path.

If we look at the US price level measured by CPI less food and energy then we can compare the actual development in the price level with a 2% trend path.

The starting point is the time, which gives the Fed the most room to overshoot inflation going forward. We get that by starting the 2% “target” path in the Autumn of 2010.

The graph below shows that.

We see that for a long time – particularly from 2013 to 2019 the Fed was undershooting the 2% inflation target. However, just before the Covid-19 pandemic (and the lockdowns!) hit in 2020 the price level was actually back at the 2% target path.

But when the shock hit in 2020 we saw the price level drop below the 2% path, which obviously justified monetary easing.

HOWEVER, we now see that the price level is well-ABOVE the 2% target path.

Consequently, if the Fed is serious about the AIT then US consumer prices should be growing SLOWER than 2% annualized until the price level (CPI core) gets back to the 2% target path.

Presently (June) the US prices level (CPI core) is around 1.5% above the target path and if the trend in inflation over the past year continues in the coming three months then the price level will be 2% above the target level in the Autumn. If my simulation (from) April continue to be correct then it will be an even larger ‘gap’.

This effectively means that in a few month the AIT will actually imply that the Fed should target DEFLATION going forward.

I very much doubt that the Fed will do that and therefore within a few months the Fed will have to revise it’s AIT framework.

One can only wonder what effect that will have on the Fed’s overall credibility.

One of my great intellectual heroes is no more. Economist and classical liberal scholar Steve Horwitz has died.

Steve lost the fight to cancer. Far too young.

Steve and I was in contact over the years and he was always an extremely kind person and even when we disagreed (which wasn’t often) he always remained a gentleman scholar. A real Mensch.

Steve Horwitz was a great economist and particularly is writing on monetary disequilibrium inspired me a great deal. He was an Austrian and I am a monetarist, but we very much agreed on how to see monetary matters – both of us were inspired by the great economist Leland Yeager.

In recent years I have kept in contact with Steve though social media and again and again I have found myself in agree with Steve’s take on current affairs – both when he has been speaking out populism on the right and the left and in favour of a classical liberal world order.

To me Steve represented the best in classical liberal thinking – freedom, openness, tolerance, peace and optimism.

We have lost Steve far too early but his great scholarly work is still with us and I encourage everybody to read Steve’s books and articles.

My sympathies are with Steve’s wife Sarah and his children.

Rest in Peace Steve. You will be dearly missed.

My former colleagues at Danske Bank has asked me to explain why I believe that the US might be heading for double-digit inflation in 2021-22.

Watch the webinar here.

I have spend a lot of my time since 2008 arguing that US monetary policy was much less expansionary than most people thought and has been arguing for a more aggressive response from the Federal Reserve to combat deflationary pressures.

Furthermore, I have last year welcomed the Fed’s policy respond to the lockdown crisis – see for example here – as I feared a repeat of the deflationary shock of 2008-9.

Furthermore, even though I have been somewhat worried about the sharp pick up in US broad money supply growth I for while was of the view that breakeven inflation rates were quite low and as a consequence we should not worry too much about inflation.

However, over the last couple of months I have become more and more convinced that particularly elevated stock prices, property prices and commodity prices reflected sharply increased inflation pressures.

I have therefore, gradually changed my view on inflation and am now quite convinced that inflation will pick up very strongly in the US. In fact, I now seriously fear that we are heading for double-digit inflation in the US before the end of this year.

I has taken me a lot of time to spell out this view publicly because I full well-know that this certainly is not the consensus view and it is certainly not (fully) priced – at least not by fixed income markets. As somebody who tend to believe markets are close to efficient I don’t lightly second-guess the markets, but I have also convinced myself that this ‘mis-pricing’ in particularly in the fixed income markets at least to some degree reflects a massive liquidity effect that ‘overshadows’ rising inflation expectations.

But today I call it – the US is heading for double-digit inflation in 2021 and it will happen very fast. What I expect is not necessarily permanently higher inflation, but rather a sharp one-off jump in the US price level.

What happens after this starts to unfollowed I believe is a lot harder to forecast and it will strongly dependent on the Fed’s response to this jump in the price level. One possibility is that we will see a serious erosion of Fed’s credibility and longer-term inflation expectations will jump. Alternatively the Fed moves aggressively to curb rising inflationary pressures and is able to convince the markets that this is indeed a post-pandemic one-off jump in the price level, but not permanently higher inflation.

No matter what this is likely to be THE main topic for global financial markets in 2021 and I have a hard time seeing this playing out without causing some volatility in global financial markets.

I am very hesitant even calling this a “forecast” for US inflation. Rather it is a simulation of what we should expect to happen to the US price level if Fed allows the ‘liquidity overhang’ to feed fully through to prices. I doubt that will happen but on the other hand the Fed seems to be ‘deliberately’ behind the curve so at least for the next 3-5 month we are likely to see a very sharp increase in the price level.

Below is my ‘simulation’ for US inflation.

This simulation is based on the so-called P-star model.

In a Twitter thread earlier today I discussed the model and the implications for US inflation and partly the implications for asset prices.

See the discussion below.

Again, I don’t make this forecast lightly. There is a lot of things that can change to change the outcome, but again and again over the last couple of months I have postpone making this forecast because I know it is a rather wild prediction, but I can no longer find excuses not to make this forecast because I fundamentally believe the analysis is correct and I have to follow the logic of the analysis and the numbers and the only conclusion I can reach is that we are in for a very sharp increase in US inflation – very soon.

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I am as always happy to discuss the my analysis with clients and potential clients. Contact: lacsen@gmail.com

I have become substantially more worried about inflation than I was last summer and I now believe we will see a very significant increase in inflation in the US in the coming months.

I will write more on that in the coming week, but until then have a look at this presentation that I did recently at the Danish Chamber of Commerce in Lithuania on April 15.

Watch the presentation here.

The Federal Reserve’s mandate is clear – ensuring the maximum level of employment while at the same time ensuring price stability.

Over time the Fed’s interpretation of this mandate has changed, but we can maybe get a bit closer by saying that the Fed has an ordering of the dual mandate.

First the Fed wants to insure that inflation (inflation expectations) over time is close to 2%.

Second, once this is the case the Fed will try to “push” economic activity in the “right” direction – meaning that the Fed will ease (tighten) monetary conditions if US unemployment is above (below) the structural level of unemployment (NAIRU).

This of course also is what is reflected in for example the traditional Taylor rule, where the Fed ‘sets’ its policy rate – the Fed Funds rate – to reflect both inflation relative to the inflation target and the output gap.

However, what is not often discussed is that the Fed does not actually ‘set’ interest rates. Or rather the Fed cannot just set a level of interest rates, which it likes.

Rather the Fed will have to set the interest rate relative to the structural level of interest rates – or what the Swedish economist Knut Wicksell termed the natural interest rate – or which is often today referred to as r*.

Hence, the task of the Fed is to set monetary conditions so to ensure that actual short-term interest rates are close to r*.

If the Fed tries to push interest rates significantly below r* for a sustained perioded by injecting large of amounts of liquidity into the economy then sooner or later we will get a spike in inflation.

Therefore, the Fed really isn’t in control of interest rates – or at least the fed cannot independent of its inflation target set interest rates.

All the Fed can do is to shadow r* and thereby ensuring than inflation will be close to its inflation target.

The challenge for the Fed is that r* isn’t constant over time.

Hence, we know both theoretically and empirically that the real interest rate has been moving up and down and is different from country to country.

Hence, r* reflects structural factors – such as demographics and productivity.

In this blog post the purpose is to try to help understand the development in r* over time and to assess what implications this has for present day monetary policy in the US.

To shed light on this matter I have estimated a rather simple, but nonetheless robust model for the development in the actual Fed Funds rate since the early 1960s. This is part of a bigger research project I am doing at Copenhagen Business School.

Normally models for the Fed funds rate is seen as ‘policy rules’.

The purpose here is not to estimate a ‘policy rule’ but rather to think about the Fed’s challenge to shadow r* by estimating a model for what the Fed historically has done with interest rates.

Estimating Fed’s r*

Basically the starting point for the analysis is that the Fed is both ‘targeting’ real and nominal economic activity, which is that the dual mandate is about. Real economic activity in terms of the ‘output gap’ and nominal activity in terms of inflation.

However, we also know that this has been changing over time and the Fed’s 2% inflation target is a fairly “new” target.

Furthermore, we also know that r* is not constant over time so even when inflation is at the inflation target and the output is closed (zero) then the Fed might have to change its policy rate to reflect changes in r* that are a result of for example higher saving in the US economy (for example due to consolidation of public finances) or to reflect higher or lower productivity growth.

To reflects these factors I have estimated a model for the Fed funds rate since 1962.

To explain the development in the Fed funds rate I use the following variables:

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

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

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

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

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

Estimation results

I don’t want to bother the readers too much with the specific statistical tests, but what I have done is simply to run a simple linear regression explaining the (nominal) fed funds rate with the four variables discussed above. The estimation period is from 1962 and until today. I use quarterly data.   

The graph below shows the actual Fed Funds rate and the predicted Fed Funds rate and we see the fit over nearly six decades is quite good (R2=0.8).

Furthermore, all four explanatory variables are strongly statistically significant and the sign on all four variables are as expected positive – meaning growth nominal GDP and population growth push up the Fed Funds rate as do higher inflation volatility and a high employment-population ratio.

Furthermore, it is notable that the model well captures the major trends in interest rates over the past six decades – higher interest rates in the 1970s and the decline in rates from the mid-80s and the ‘flat lining’ of rates over the 12-15 years.

I will not go in to too much detail in terms of the decomposition of what drives interest rates during the different periods and I will return to that in later work, but it is sufficient to say that the very low level of interest rates we have seen in the US since 2008 is more or less fully explained by the four explanatory factors – lower potential NGDP/capita growth, low population growth, low inflation volatility and a moderately low level of employment-population ratio.

Hence, the Fed funds rate is not low because the Fed’s has “manipulated” interest rates and is not low because monetary policy is has been overly easy (if anything it has been too tight – at least until recently).

Rather, low interest rates in the past decade reflect economic conditions and mostly structural economic conditions – for example weak population growth and a declining labour force due to the aging of the US population (the baby boomers have been leaving the labour market).

Looking ahead – Fed will need to hike sooner rather than later

In response to the ‘lockdown’ crisis of 2020 the Fed has cut the Fed funds rate (and implemented quantitative easing). This is completely in line with what the prediction of the model have been.

In fact the model predicted that the Fed funds rate should have been cut to -3% (!) in the second quarter of 2020.

This of course didn’t happen due to Zero Lower Bound on interest rates, but the Fed instead has opted to undertake significant quantitative easing of monetary policy. Hence, the money base has been expanded significantly. This in mind my undoubtably has been the right policy – at least in terms of the magnitude of monetary easing.

The predicted decline in the Fed funds rate primarily reflected a sharp drop in the employment-population ratio.

However, both of these variables are now clearly improving, but despite of that the Fed has so far insisted that we are far away from any rate hikes.

However, this week we have nonetheless seen quite a bit of a repricing of the markets’ expectations for rate hikes.

To answer the question about the outlook for rates we can try to make a simulation based on the model we have estimated above.

What we will try to estimate is where the Fed Funds rate should be in ‘steady state’ – hence, once the US economy has moved out of the crisis and returned to the underlining trends that we saw prior to the ‘lockdown shock’ hit in 2020.

Lets have a look at the four explanatory variables.

First we see that potential nominal GDP growth (per capita) as calculated by the Congressional Budget Office (CBO) over the past decade has been stable around 3.0%  – considerably lower than earlier decades. Hence, we use 3.0% as our measure of the long-term growth rate of potential NGDP growth (per capita).

Second, in terms of population growth we use a forecast of 0.7% annual population growth in the US – reflecting more or less most forecasts for US population growth over the coming decade.

Third, we assume that inflation volatility will remain low around the same level as we have seen over the past decade (0.25).

Finally, we assume the decline in the employment-population ratio will continue to reverse – reflecting the closing of the output gap.

Judging from recent economic data this recovery will be quite fast. For simplicity we assume that the employment-population ratio will return 60% by mid-2022. This is not necessarily a forecast of what will happen, but rather an assumption we use when making a simulation for the Fed Funds rate for the medium-term.

Fed Funds rate is heading back to 1.5% sooner than you think

If we assume that these for variables over the coming 4-6 quarters return to their steady-state levels then we can simulate what we should expect to see in terms of the Fed Funds rate.

The graph below illustrates that.

According to the simulation the Fed Funds rate should return to positive territory in the middle of this year. This can be interpreted as the Fed will end QE and change its forward guidance in a more hawkish direction and in the second half of the year we should actually see the Fed start hiking the Fed Funds rate.

During 2022 the Fed Funds rate should approach 1.5%.

This is of course a much more aggressive rate hike path than presently signalled by the Fed and expected by the market (around 100bp above market pricing in by the end of 2022).

However, it does not reflect an extreme assumption regarding the economy.

Rather the only thing we here assume is a return to ‘normal’ over the next 6-8 quarters and given what we are seeing in terms of the macro data at the moment and the planned major fiscal easing this certainly does not seem to be an overly optimistic take on the economic outlook. In fact it might be too pessimistic.

Furthermore, this does not reflect the change in the Fed’s inflation target from a pure 2% inflation target to an average inflation target and it does not reflect any change in the risk premium on US debt despite a very significant expansion of US public debt.

So if anything there might be reason to speculate that the Fed could be forced to hike even faster than this simulation indicates.

What if the Fed fails to hike?

Fed officials continue to argue that there is no reason to hike rates any time soon. In fact Fed chairman Jerome Powell has argued that the Fed is not even thinking about thinking about hiking rates.

But what happens if the simulated path for the Fed Funds rate is right and the Fed despite of that sticks to the promise of not hiking rates?

Then the Fed effectively will be in a situation where it will try to keep r (significantly) below r*.

The Fed has tried such policies before in the later part of 1960s and going into the 1970s and the result was rather catastrophic – inflation rose sharply. As did economic volatility.  

I certainly don’t think that the Fed will repeat the mistakes of the 1970s – at least not to the same extent – but while the Fed mostly have erred on the downside (too tight monetary policy) over the past 12 years the opposite now seems to be the case.

Hence, during the next 2-3 quarters we will likely have a test of the Fed’s commitment to it’s 2% (average) inflation target. Will the Fed for example allow inflation expectation to increase above 3%?

Or – more likely – will the Fed reverse course once it realizes that the output gap will be closed already during 2021 and inflation risks will increase further if it refuse to hike rates.

Unfortunately, the Fed has continued the mistakes of the past and communicated its monetary policy stance in terms of its policy instruments rather than in terms of communicating in terms of its policy goals.

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

PS there are also some elements of what we saw during 2006-7 in what is happening in financial markets, but I do not expect the same outcome as in 2008-9, but I might return to that in a later post.

PPS I have done similar modelling on the US 10 year Treasury bond yield. See here.

I have been tweeting…once again.

As part of my on-going research at Copenhagen Business School on the future of the Nordic banking sector and monetary policy have been researching the idea of Central Bank Digital Currency or rather as I prefer to Central Bank Digital CASH (CBDC).

Tonight I have been tweeting on some ideas and views regarding CBDCs and as with private cryptocurrencies it is not really the technology, which interests me, but rather the monetary aspects of CBDCs and what the importance for the conduct of monetary policy and the monetary transmission mechanism would be. And of course the impact on the wider economy and on the banking sector in particular.

You see my Twitter thread on the topic here (including a lot of typos…).

The Economist magazine quotes me on the important topic of whether we are going to see a spike in inflation or not, but at the same time also illustrates what market montarism really is about:

In the aggregate, though, investors seem unconvinced. The inflation expectations which can be derived from prices in financial markets have recently picked up a little thanks to the good news on vaccines and the prospects for a rebound in the world economy. But they still suggest that investors think next year’s inflation is more likely to be below the 2% central banks target than above it (see chart 3).

Lars Christensen, a Danish economist, points out that this means there is a “clash” between the two best-known economic theories associated with the Chicago school. Milton Friedman said sustained growth in the money supply leads to inflation; Eugene Fama argued that market prices fully reflect all available information. “If you believe that we are going to have inflation now…the efficient-markets hypothesis would have to be wrong,” Mr Christensen argues.

Source: The Economist

I discussed the same topic at a recent presentation at Buckingham University. You can watch that presentation here.