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Talking to Ambrose about the Fed

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

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

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

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

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

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

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

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

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

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

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

 

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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.

Nixon was a crook and Arthur Burns was a failed central banker

Back from my trip to Riga and Stockholm and two books had arrived in the mail from Amazon.

The first one “Inside The Nixon Administration – the Secret Diary of Arthur Burns 1969-1974” (Edited by Robert Ferrell, 2010). The second one is Larry White’s “Free Banking in Britain” (yes, dear readers believe it or not I did not read it before…).

Obviously I have not read the two books yet, but they are in some odd way complementary – the one is about how central banking can become hugely politicized and the second is about how to avoid that the monetary regime is politicized.

I did peak a little into the pages of the Burns diary. Burns who of course was Federal Reserve governor while Nixon was US president wrote a diary with notes from all its meetings with Nixon. I must admit that I am in total shock about how extreme the polarization of the US monetary policy was in the Nixon years. The man surely was a crook. One of the worst. However, from the little I have read Burns diary also clearly shows how misguided his views of monetary policy were. Again and again the diary mentions how he think price and wage controls are necessary to curb inflation, while Nixon at the same time is demanding money printing to be stepped up. Surely a bizarre duo – one a failed economist and one a crook. Very scary indeed.

So what is the lesson? Politics and money is a deadly cocktail and that is why you want to restrict both central bankers and a politicians when it comes to monetary policy.

If any of my readers have read these books I would be very happy to hear your opinion about them.

 

US Monetary History – The QRPI perspective: 1970s

I am continuing my mini-series on US monetary history through the lens of my decomposition of supply inflation and demand inflation based on what I inspired by David Eagle have termed a Quasi-Real Price Index (QRPI). In this post I take a closer look at the 1970s.

The economic history of the 1970s is mostly associated with two major oil price shocks – OPEC’s oil embargo of 1973 and the 1979-oil crisis in the wake of the Iranian revolution. The sharp rise in oil prices in the 1970s is often mentioned as the main culprit for the sharp increase in US inflation in that period. However, below I will demonstrate that rising oil prices actually played a relatively minor role in the increase in US inflation in that period.

The graph below shows the decomposition of US inflation in 1970s. As I describe in my previous post demand inflation had already started to inch up in the second half of 1960s and was at the start of the 1970s already running at around 5%.

After a drop in demand inflation around the relatively mild 1969-70 recession demand inflation once again started to pick up from 1971 and reached nearly 10% at the beginning of 1973. This was well before oil prices had picked up. In fact if anything supply inflation helped curb headline inflation in 1970-71.

The reason for the drop in supply inflation might be partly explained by the Nixon administration’s use of price and wage controls to curb inflationary pressures. These draconian measures can hardly be said to have been successful and to the extent it helped curb inflation in the short-term it provided Federal Reserve chairman Arthur Burns with an excuse to allow the monetary driven demand inflation to continue to accelerate. It is well known that Burns – wrongly – was convinced that inflation primarily was a cost-push phenomenon and that he in the early 1970 clearly was reluctant to tighten monetary policy because he had the somewhat odd idea that if he tightened monetary policy it would signal that inflation was out control and that would undermine the wage controls. Robert Hetzel has a very useful discussion of this in his “The Monetary Policy of the Federal Reserve”.

As a result of Burn’s mistaken reluctance to tighten monetary policy demand inflation kept inching up and when then the oil crisis hit in 1974 headline inflation was pushed above 10%. However, at that point almost half of the inflation still could be attributed to demand inflation and hence to overly loose monetary policies.

Headline inflation initially peaked in 1974 and as oil prices stopped rising headline inflation gradually started to decline. However, from 1976 demand inflation again started inching and that pushed up headline inflation once again.

In 1979 Paul Volcker became Federal Reserve chairman and initiated the famous Volcker disinflation. Scott Sumner has argued that Volcker didn’t really tighten monetary policy before 1981. I agree with Scott that that is the conclusion that if you look at market data such as bond yields and the US stock market. Both peaked in 1981 rather than 1979 indicating that Volcker didn’t really initiate monetary tightening before Ronald Reagan became president in 1981. However, my measure for demand inflation tells a slightly different story.

Hence, demand inflation actually peaked already in the first quarter of 1979 and dropped more than 5%-point over the next 12 month. However, as demand inflation started to decline the second oil crisis of the decade hit and that towards 1980 pushed headline US inflation up towards 13%.

So there is no doubt that rising oil prices indeed did contribute to inflation in the US in the 1970s, however, my decomposition of the inflation data clearly shows that the primary reason for the high and increase through the decade was the Federal Reserve’s overly loose monetary policy.

Finally it should be noted that the 1970s-data show some strength and weaknesses in my decomposition method. It is clearly a strength that the measure shows the impact of the oil price shocks, but it is also notable that these shocks takes 3-4 years to play out. So while oil prices spiked fast in for example 1974 and then settle at a higher level the supply shock to inflation seems to be more long lasting. This indicates some stickiness in prices that my decomposition method does not fully into account. As one of my commentators “Integral” has noted in an earlier comment it is a weakness with this decomposition method that it does not take into account the upward-sloping short-run AS curve, but rather it is assumed that all supply shocks shifts the vertical long-run AS curve left and right. I hope I will be able to address this issue in future posts.

In my next post I will have a closer look at how Paul Volcker beat the “Great Inflation”.

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