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St. Louis Fed: “0% probability that inflation will average more than 2.5% over the next 12 months”

Laura E. Jackson, Kevin L. Kliesen, and Michael T. Owyang of the St. Louis Federal Reserve have constructed a new measure they call the price pressures measure (PPM).

According the authors the “PPM measures the probability that the expected inflation rate (12-month percent changes) over the next 12 months will exceed 2.5 percent”…the PPM is constructed “for both the consumer price index (CPI) and personal consumption expenditures price index (PCEPI).”

This is how the PPM is constructed:

In technical terms, the PPM index is constructed from an ordered probit model that is augmented with nine “factors.” A factor-augmented model is a common method of incorporating a large amount of data in a parsimonious fashion. The nine factors, comprising 104 separate data series, are grouped in the following categories: (1) consumer price indexes, (2) producer price indexes, (3) commodity prices, (4) housing and commercial property prices, (5) labor market indicators, (6) financial variables, (7) inflation expectations, (8) business and consumer survey data, and (9) foreign price variables.

The ordered probit model provides probabilities that inflation will exceed 2.5 percent, on average, over the next 12 months. But the model also allows us to assess the probability that inflation will average something different. In our original article we structured the model to assess the probability that inflation will fall within one of four bins: less than zero (deflation); 0 percent to 1.5 percent; 1.5 percent to 2.5 percent; and more than 2.5 percent. We could also assess probabilities for other outcomes. For example, we could condense the second and third bins into one, leaving three sets of probabilities: Inflation will be less than zero (deflation) over the next 12 months, inflation will average between 0 percent and 2.5 percent, and inflation will be greater than 2.5 percent.

So what is the measure saying now?

Well, the message is very clear – this is what the authors say: “As of October 2015, the PPM predicts a zero percent probability that PCEPI inflation will average more than 2.5 percent over the next 12 months.”

This is obviously wrong – we can never say that there is a zero percent probability of anything, but ok this is the kind of result you sometimes get from probit models. That however, is not the important thing, but rather the key message here is that there is very little likelihood that Fed will overshoot it’s inflation target in the coming next 12 months. In fact it is very clear that the likelihood of deflation is higher than inflation being above 2.5% in 12 months.

Therefore you gotta ask yourself why does St. Louis Fed president James Bullard continue to argue for the Fed to hike rates? After all the research done by his own research department tells him that he rather should worry about deflationary risks.

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PS See the original paper on the Price Pressure Measure here.

PPS Scott Sumner should be delighted that Laura E. Jackson recently became an assistant professor at Bentley University.

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Jim, it is not complicated – NGDP tells you NOT to hike

This is what St. Louis Fed president James Bullard today told CNBC:

“there’s a powerful case to be made that it’s time to raise interest rates. And the case is not complicated. … Policy settings are [in] an emergency. The economy itself, the goals of the committee, have essentially been met.”

Bullard goes on to talk about the labour market and talk about low oil prices is helpful for the US economy. It all very much sounds like Bullard has made up his decision BEFORE he has looked at any data.

In fact it is hard to see what monetary policy rule Bullard is advocating and he seems to be cherry picking data to make an argument for rate hike. It is frankly speaking not very impressive.

But why doesn’t Bullard just look at nominal GDP? After all back in May he co-authored a Working Paper in which he essentially argued that the Federal Reserve should to target nominal GDP!

So lets have a look at how nominal GDP has been developing:

NGDP level 20102015

NGDP has since mid-2009 essentially been on a straight line growing on average slightly less than 4% a year and in Q2 2015 was slightly below this trend.

Why doesn’t Bullard just acknowledge that? He should be happy – the Fed is doing what he said it should be doing. But of course that would mean that there would not be any arguments for hiking interest rates. After all prediction markets (such as Hypermind) presently are forecasting around 3.5% NGDP growth for all of 2015 and in that sense the Fed is slightly undershooting it’s post-2009 de fact NGDP rule.

Jim, I was very happy to see you advocated NGDP targeting back in May – why have you already changed your mind??

PS Bullard talks about interest rates being at “emergency” setting. I guess Bullard has forgot what Milton Friedman told us about why low interest rates. Jim, interest rates are low because monetary policy has been tight.

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.

The market’s message to Yellen: You have become too hawkish

Recently the communication from the Federal Reserve seems to have become more hawkish. It all started on July 15 when Fed chair Janet Yellen testified in front of the House Financial Services Committee. Yellen among other things said:

“If the economy evolves as we expect, economic conditions likely would make it appropriate at some point this year to raise the federal funds rate target”

This has been followed by comments from other Fed officials such as St. Louis Fed president James Bullard who in an interview with Fox TV on July 20 said that there was a “50% probability” a September rate hike. As my loyal readers know I like to watch the markets to assess monetary conditions. So lets see what the markets are saying about the US monetary policy stance right now – and how it has changed on the back of Yellen and Bullard’s comments. Lets start with the much talked about gold price. gold price It is hard to miss that it was Yellen’s hawkish comments that has sent gold prices down in recent weeks. So the drop in gold prices certainly is a indication that US monetary conditions are getting tighter. But it would of course be wrong to reason from the change in one price. We need more – so how about the dollar? DXY This is the so-called Dollar Index (DXY). Here the picture certainly is less clear than from the gold price. In fact the dollar index today is more or less a the same level as on July 15 when Yellen hinted at a rate hike this year.

However, we should remember that the exchange rate is telling us something about the relative monetary policy, so if US monetary conditions is in fact getting tighter and the dollar index is flat then it is an indication that monetary conditions are also getting tighter outside of the US. Given the Greek crisis and Chinese growth worries this is not an unreasonable assumption.

So how about inflation expectations? This is 2-year/2-year inflation expectations (so basically the expectation to the average inflation rate from August 2017 to August 2019) inflation expectations 2y2y Again the picture is clear – after Yellen and Bullard’s comments 2y/2y inflation expectations have dropped and equally important this happened at a time when inflation expectations already where below 2%. It should also be noted that prediction markets are telling the same story. Hence, from some time Hypermind’s market for nominal GDP growth in 2015 has been somewhat below 4% (which I believe has been Fed’s unannounced target for some time – see here.) The Fed is too hawkish and rate hikes should be postponed Concluding, the Fed’s more hawkish rhetoric has de facto led to a tightening of US monetary conditions already, which has pushed inflation expectations below the Fed’s own 2% inflation target. So effectively the markets are tellling the Fed that monetary conditions are becoming too tight and a September rate hike as suggested by advocated by Bullard would be premature. So if I was on the FOMC I would certainly vote against any rate hike in the present situation.

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.

St. Louis Fed’s Bullard comes out in support of NGDP targeting

St. Louis Federal Reserve president James Bullard just came out in support of nominal GDP targeting – or rather he has co-authored a rather interesting new Working Paper, which concludes that NGDP targeting under some circumstances would be the best policy to pursue.

The paper with the ambitious title Optimal Monetary Policy at the Zero Lower Bound Bullard has co-authored with Costas Azariadis, Aarti Singh and Jacek Suda.

As the abstract reveals it is a rather technical paper:

We study optimal monetary policy at the zero lower bound. The macroeconomy we study has considerable income inequality which gives rise to a large private sector credit market. Households participating in this market use non-state contingent nominal contracts (NSCNC). A second, small group of households only uses cash and cannot participate in the credit market. The monetary authority supplies currency to cash-using households in a way that changes the price level to provide for optimal risk-sharing in the private credit market and thus to overcome the NSCNC friction. For succinctly large and persistent negative shocks the zero lower bound on nominal interest rates may threaten to bind. The monetary authority may credibly promise to increase the price level in this situation to maintain a smoothly functioning (complete) credit market. The optimal monetary policy in this model can be broadly viewed as a version of nominal GDP targeting.

I think the interesting thing about the paper is the focus on non-state contingent nominal contracts (NSCNC) as the key rigidity in economy rather wage and price rigidities. Simply stated, essentially NSCNC means that debt is nominal rather than real – and when a major negative shock to nominal incomes (NGDP) occurs then that causes debt/NGDP to rise and that is really at the cure of the financial distress that follows from a major negative NGDP shock (this by the way is why Greece now has a problem).

We can solve this problems in two ways – either by introducing (quasi) real contracts rather than nominal contract or by having the central bank targeting NGDP.

As such the paper is part of a growing, but small literature that focuses on NSCNC and the importance of this for the optimal monetary policy rule.

I was, however, a bit disappoint to see that the authors of the paper did not have a reference to any of the paper on this topic by the extremely overlooked David Eagle. I have written numerous blog posts on David’s work since 2011 and David has even written a number of guest posts for my blog. I list these posts below and I suggest everybody interested in this topic read not only the posts but also David’s papers.

The authors on the other hand do have a reference to the work of Evan Koenig who has done academic work very much in same spirit as David Eagle. I have also written about Evan’s work on this blog over the last couple of years and also list these blog posts below.

Will this change anything?

For those of us deeply interested in monetary policy matters the new paper obviously is interesting. First of all, it is helping deepening the theoretical understanding of monetary policy and second the paper could help further push the Federal Reserve (and other central banks!) toward in fact officially implementing some version of NGDP targeting – or at least I hope so.

That said there is a huge difference between in principle supporting NGDP targeting in a theoretical paper and then actually advocating NGDP targeting the real world and so far as I can see Jim Bullard has not yet done that. But obviously this is a huge step in the direction of Jim Bullard actually becoming an NGDP advocate and that obviously should be welcomed.

I have numerous times argued that the Fed actually from mid-2009 de facto started a policy to NGDP level targeting around a 4% path and this policy effectively has continued to this day (see here and here). However, this has never been articulated by any Fed official, which makes the “policy” much less effective and less credible.

Therefore, it would be great if we not only would get a theoretical endorsement of NGDP targeting from the likes of Jim Bullard, but rather a concrete proposal on how to actually implement NGDP targeting. I hope that will be the next paper Jim Bullard authors.

PS My friend Marcus Nunes also comments on the paper here.

PPS One of the authors of the paper discussed above is Jacek Suda from the Polish central bank (NBP). I would love to see a discussion of introducing NGDP targeting in my beloved Poland!

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Blog posts on and by David Eagle:

Guest post: Central Banks Should Quit “Kicking Them While They Are Down!” (by David Eagle)

Guest post: GDP-Linked Bonds (by David Eagle)

Guest blog: NGDP Targeting is NOT just for Central Banks! (David Eagle)

Guest blog: Why Price-Level Targeting Pareto Dominates Inflation Targeting (By David Eagle)

Guest Blog: The Two Fundamental Welfare Principles of Monetary Economics (By David Eagle)

Guest blog: Growth or level targeting? (by David Eagle)

Guest post: Why I Support NGDP Targeting (by David Eagle)

Dubai, Iceland, Baltics – can David Eagle explain the bubbles?

David Eagle’s framework and the micro-foundation of Market Monetarism

David Eagle on “Nominal Income Targeting for a Speedier Economic Recovery”

Selgin and Eagle should be best friends

Quasi-Real indexing – indexing for Market Monetarists

David Davidson and the productivity norm

Two Equations on the Pareto-Efficient Sharing of Real GDP Risk (a paper David and I co-authored in 2012)

Blog posts on Evan Koeing:

The Integral Reviews: Paper 1 – Koenig (2011)

“Monetary Policy, Financial Stability, and the Distribution of Risk”

 

UPDATE: Scott Sumner also comments on the Bullard el al paper.

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

I can hear Uncle Milty scream from upstairs – at James Bullard

The St. Louis Fed has long been a bastion of monetarist thinking, but something has changed at the Eighth Federal Reserve District. Here is St. Louis Fed president James Bullard in an interview with Bloomberg:

“Treasury yields have gone to extraordinarily low levels. That took some of the pressure off the FOMC since a lot of our policy actions would be trying to get exactly that result.”

I can only imagine how Milton Friedman would have reacted to this kind of statement – most likely he would have said something like this:

“Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy..After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

Friedman said that in 1998. 14 years later central bankers still make the same mistakes. It is incredible. It makes you want to scream and it is especially frustrating when you hear it from the president of a Fed district with a strong monetarist traditions. Just sad…

HT Matt O’Brien

Update 1: Josh Hendrickson was so kind to remind me about this Friedman quote from Milton Friedman’s Monetary Framework (1974):

“On still another level, the approach is consistent with much of the work that Fisher did on interest rates, and also the more recent work by Anna Schwartz and myself, Gibson, Kaufman, Cagan, and others.  In particular, the approach provides an interpretation of the empirical generalization that high interest rates mean that money has been easy, in the sense of increasing rapidly, and low interest rates, that money has been tight, in the sense of increasing slowly, rather than the reverse.”

Update 2: Vaidas Urba has the following comment about Bullard:

“Very strange to hear this from Bullard, as he wrote the Seven Faces of the Peril paper where he discussed the low interest rate deflationary equilibrium….Bullard: “To avoid this outcome for the United States, policymakers can react differently to negative shocks going forward. Under current policy in the United States, the reaction to a negative shock is perceived to be a promise to stay low…”

So yes, Bullard once (in 2010) understood and now apparently he seem to have forgot about how monetary policy works.

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