Reflections on the Fed hike

Have a look at my comments on yesterday’s Fed hike.


And see our “country page” on the Fed, which will also feature in our soon-to-be-published Global Monetary Conditions Monitor. (In PDF here)

Skærmbillede 2017-03-15 kl. 07.20.51


The Trump-Yellen policy mix is the perfect excuse for Trump’s protectionism

It is hard to find any good economic arguments for protectionism. Economists have known this at least since Adam Smith wrote the Wealth of Nations in 1776. That, however, has not stopped president-elect Donald Trump putting forward his protectionist agenda.

At the core of Trump’s protectionist thinking is the idea that trade is essentially a zero sum game. Contrary to conventional economic thinking, which sees trade as mutual beneficial Trump talks about trade in terms of winners and losers. This means that Trump essentially has a Mercantilist ideology, where the wealth of a nation can be measured on how much the country exports relative to its imports.

Therefore, we should expect the Trump administration to pay particularly attention to the US trade deficit and if the trade deficit grows Trump is likely to blame countries like Mexico and China for that.

The Yellen-Trump policy mix will cause the trade deficit to balloon

The paradox is that Trump’s own policies – particularly the announced major tax cuts and large government infrastructure investments – combined with the Federal Reserve’s likely response to the fiscal expansion (higher interest rates) in itself is likely to cause the US trade deficit to balloon.

Hence, a fiscal expansion will cause domestic demand to pick up, which in turn will increase imports. Furthermore, we have already seen the dollar rally on the back of the election Donald Trump as markets are pricing in more aggressive interest rate hikes from the Federal Reserve to curb the “Trumpflationary” pressures.

The strengthening of the dollar will further erode US competitiveness and further add to the worsening the US trade balance.

Add to that, that the strengthen of the dollar and the fears of US protectionist policies already have caused most Emerging Markets currencies – including the Chinese renminbi and the Mexican peso – to weaken against the US dollar.

The perfect excuse

Donald Trump has already said he wants the US Treasury Department to brand China a currency manipulator because he believes that China is keeping the renminbi artificial weak against the dollar to gain an “unfair” trade advantage against the US.

And soon he will have the “evidence” – the US trade deficit is ballooning, Chinese exports to the US are picking up steam and the renminbi continues to weaken. However, any economist would of course know that, that is not a result of China’s currency policies, but rather a direct consequence of Trumponomics more specifically the planed fiscal expansion, but Trump is unlikely to listen to that.

There is a clear echo from the 1980s here. Reagan’s tax cuts and the increase in military spending also caused a ‘double deficit’ – a larger budget deficit and a ballooning trade deficit and even though Reagan was certainly not a protectionist in the same way as Trump is he nonetheless bowed to domestic political pressures and to the pressures American exporters and during his time in offices and numerous import quotas and tariffs were implemented mainly to curb US imports from Japan. Unfortunately, it looks like Trump is very eager to copies these failed policies.

Finally, it should be noted that in 1985 we got the so-called Plaza Accord, which essentially forced the Japanese to allow the yen to strengthen dramatically (and the dollar to weaken). The Plaza Accord undoubtedly was a contributing factor to Japan’s deflationary crisis, which essentially have lasted to this day. One can only fear that a new Plaza Accord, which will strengthen the renminbi and cause the Chinese economy to fall into crisis is Trump’s wet dream.


Donald Trump will replace Janet Yellen with a DOVE in 2018

Some have suggested that when Janet Yellen’s term as Federal Reserve chair expires in 2018 then Donald Trump will try to replace her with a more “hawkish” chairman. Some even has suggested that he could try to re-introduce the gold standard and appoint the king of monetary policy rules John Taylor as new Fed chairman.

I, however, believe that is completely wrong. Donald Trump doesn’t care about the Gold Standard (luckily) and certainly he does not care about a rule-based monetary policy.

The fact is that Trump’s entire policy agenda is inflationary. On the supply side his anti-immigration stance will push up US labour cost and this protectionist agenda will push up import prices.

On the demand side his call for underfunded tax cuts and massive government infrastructure investments also increase inflationary pressures.

So if unchecked (should write un-offset by the Fed?) Trump’s economic policy agenda will push inflation up. However, Trump does not – yet – control monetary policy and if the Federal Reserve is serious about it’s 2% inflation target it sooner or later will have to offset the Trumpflationary policies by hiking interest rates potentially aggressively and allow the dollar to strengthen significantly.

I have argued (see here and here) that initially the Federal Reserve will welcome a “fiscal boost” to support aggregate demand as the Fed for some odd reason is not willing to use monetary policy to hit the 2% inflation target. However, the alliance between the Trump administration and the Federal Reserve could be short-lived if inflation expectations really start to take off.

So in a situation where the Fed moves to hike interest rates more aggressively – for example in the second half of 2017 or in early 2018 it will become clear even to Trump that the Fed is “undermining” his promise of doubling US growth and “create millions of jobs”.

That could very well create a conflict between the Fed and the Trump administration and it is very likely that Trump will accuse Yellen of have too tight a monetary policy. Furthermore, with mid-term elections due in 2018 the Republicans in the Senate and the House are unlikely to be cheering for a “growth killing” tightening of monetary policy.

As I have repeated on the social media over the last couple days – the GOP is (deflationary) “Austrians” when they are in opposition and (inflationary) “Keynesians” when they are in power – they never really favour monetarist and rule-based policies.

After all it was Richard Nixon who famously said “we are all keynesians now” – or rather this is how Milton Friedman interpreted what Nixon said.

Nixon of course had the utterly failed Fed chair Arthur Burns (see more on Burns and Nixon here) to do the dirty work of easing monetary policy when monetary policy already was far too easing.

If Trump reminds me of any US president it is Nixon. So why should we believe Trump would replace Janet Yellen with John Taylor when he can find his own Arthur Burns to help him support his agenda with overly easy monetary policy ahead of the 2020 presidential elections?

If this hypothesis just has a small probability of being right then the market certainly is right is to price in higher inflation during a Trump presidency. I certainly hope I am totally wrong.

PS for a discussion of Nixon and Burns’ relationship seen Burton Abrams very good (and scary) paper How Richard Nixon Pressured Arthur Burns: Evidence From the Nixon Tapes.

PPS Paul Krugman once called for Ben Bernanke to show up for a FOMC press conference in a Hawaii shirt to signal that he would be “irresponsible” and thereby push inflation expectations up and lift interest rates from the ZLB. Maybe Trump is that Hawaiian shirt.

“Make America Keynesian Again”

Today I was asked to do an interview with a Danish radio station about Donald Trump and about whether one could say anything positive about him or rather about his economic agenda. I declined to do the interview. I frankly speaking has nothing positive to say about Trump.

To me Donald Trump is an absolutely vile person and and his views on immigration and trade are completely the opposite of mine. However, I have also in the run up to the election in presentations and comments stressed that the presidential election from an overall financial market perspective would not be a big deal and judging from the market reaction today this indeed seems to be the case.

Reading the markets

But what exactly are the markets telling us today about the economic consequences of a Trump presidency combined with the fact that GOP now has the majority in both the House and the Senate?

First, of all we should concluded that the markets are fairly relaxed about the outcome of the election. This to me is an indication that Trump really will never be able (or seriously want to) implement many of the bizarre “promises” on trade and immigration he made during the election campaign.

Second the markets certainly do not expect the outcome of the election to cause a US recession or a global economic crisis. After all US stock markets are in fact trading in positive territory today. We get the same message from the currency markets where the dollar is little changed over the past 24 hours.

The Republican Keynesians

However, there is one market where we have seen a significant reaction to the outcome of the election and that is in the bond market. Just take a look at the graphs below.



The first graph is the yield on 10-year Treasury bonds and the second graph is 2-year yields.

We see that the 10-yield has increased around 10bp overnight. This certainly is a significant reaction, but it is equally notable that 2-yields in fact is slightly down.

What this is telling me is that more than anything else the markets expect Trump to be an old-school Keynesian. We know that Trump has already promised to increase Federal spending on infrastructure and he has of course also promised major tax cuts. With the Republicans controlling both the House and the Senate he should be able to deliver on some of these promises.

In fact there would be nothing unusual about having a Republican president who is also a “keynesian” (yes, I know he has no clue about what that is). In fact historically public spending has grown faster under Republican administrations than under Democrat administrations. Just take a look at the graphs below.

Since the Second World War public spending has grown by around a quarter of a percent per year faster when the president has been Republican than when there has been a Democrat president.

The picture is even more clear when we look at Federal government investments:

…and on the budget deficit:

So based on history we can certainly say that Republican presidents tend to be less fiscally conservative than Democrat presidents and judging from the action in the bond markets today there is little reason to believe that Trump should be any different from former Republican presidents.

And what will Trump spend money on? There is little doubt what the markets think – infrastructure! This is from Trump’s victory speech:

We are going to fix our inner cities, and rebuild our highways, bridges, tunnels, airports, schools, hospitals,” he said. “We’re going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it.

And see what effect that kind of speech had on copper prices today:


Keynesian president + Keynesian Fed chair = No monetary offset

So it seems like the markets expect Trump to push for an expansionary fiscal policy agenda and this is visible in the bond market. However, it is also notable that it is only long-term bond yields, which have increased while 2-year yields haven’t increased overnight.

That tells me that the markets do not expect the Federal Reserve to (fully) offset the impact on nominal demand from a more expansionary fiscal policy.

This effectively means that an easier fiscal policy stance will cause monetary conditions to be eased. The reason is that if fiscal policy is eased then that will push up the equilibrium interest rate level. If the Fed does not hike interest rates to reflect this then it will automatically ease monetary policy by keeping the fed funds rate below the equilibrium interest rate.

This of course is the standard result in a New Keynesian model when interest rates are at the Zero Lower Bound (see for example here).

Does this mean that the so-called Sumner Critique does not apply? According to the Sumner Critique an easing of fiscal policy will not have (net) impact on aggregate demand if the central bank has an inflation target (or a nominal GDP) as the central bank will act to offset any impact on aggregate demand from a easier fiscal policy.

However, the Sumner Critique does not necessarily apply if the central bank’s inflation target is not credible and/or central bank is not willing to “enforce” it. And this seems relevant to the present situation. Hence, US core inflation continue to be below the Fed’s inflation target so one can certainly argue that there is room for an increase in aggregate demand without the Federal Reserve having to tighten monetary conditions.

Obviously the Fed could have done this on it own by for example not signaling a rate hike in December or signaling that it would re-introduce quantitative easing if inflation once again started to trend downwards.

However, the Fed clearly has “mental” problems with this. It is clear that most key Fed policy makers are worried about the consequences of keeping interest rates “low for longer” and more QE clearly seems to be a no-go.

In other words the Fed has put itself in a situation where further monetary easing is off the table and this is of course the reason why a number of Fed officials in the last couple of months have called for old-school keynesian fiscal stimulus.

It all seems to have started in August. This is Janet Yellen at the Jackson Hole symposium on August 26:

Beyond monetary policy, fiscal policy has traditionally played an important role in dealing with severe economic downturns. A wide range of possible fiscal policy tools and approaches could enhance the cyclical stability of the economy.25 For example, steps could be taken to increase the effectiveness of the automatic stabilizers, and some economists have proposed that greater fiscal support could be usefully provided to state and local governments during recessions. As always, it would be important to ensure that any fiscal policy changes did not compromise long-run fiscal sustainability.

Finally, and most ambitiously, as a society we should explore ways to raise productivity growth. Stronger productivity growth would tend to raise the average level of interest rates and therefore would provide the Federal Reserve with greater scope to ease monetary policy in the event of a recession. But more importantly, stronger productivity growth would enhance Americans’ living standards. Though outside the narrow field of monetary policy, many possibilities in this arena are worth considering, including improving our educational system and investing more in worker training; promoting capital investment and research spending, both private and public; and looking for ways to reduce regulatory burdens while protecting important economic, financial, and social goals.

“Promoting capital investment” of course means government infrastructure spending.

Since August we have heard this again and again from Fed officials. This is Federal Reserve Vice Chairman Stanley Fischer at the New York Economic Club on October 17:

Some combination of more encouragement for private investment, improved public infrastructure, better education, and more effective regulation is likely to promote faster growth of productivity and living standards.

Said in another way – the Fed chair and the Vice chairman are both old-school keynesians and now we will have a keynesian in the White House as well.

The consequence is that if we get massive government infrastructure investments then that will push up the equilibrium interest rate, which will allow the Fed to hike interest rates (which they for some reason so desperately want to) without really tightening monetary conditions if interest rates are increased slower than the increase in the equilibrium rate.

This means that we de facto could have a keynesian alliance between the Trump administration and the Federal Reserve, which would mean that will get both monetary and fiscal easing in 2017 and this might be what the markets now are realizing.

Just take a look at what have happened in 5-year/5-year inflation expectations over the paste 24 hours:


Over the past 24 hours long-term inflation expectations hence have increased by nearly a quarter of a percentage point.

Hence, Donald Trump just eased US monetary conditions significantly by pushing down the difference between the Fed fund target rate and the equilibrium rate. Paul Krugman should love Donald Trump.

The Sumner Critique strikes back – A future conflict between the Fed and Trump?

Obviously this is only possible because the Federal Reserve has not been willing to ensure nominal stability by clearly defining its nominal target and has been overly eager to increase interest rates, but I do think that this keynesian stimulus implemented could increase aggregate demand in 2017 and likely push core inflation above 2%.

But if this happens then the keynesian alliance between the Federal Reserve and Trump Administration might very well get tested. Hence, if fiscal-monetary easing push unemployment below the natural rate of unemployment and inflation (and inflation expectations) start to accelerate above 2% then the Federal Reserve sooner or later will have to act and tighten monetary conditions, which could be setting the US economy up for a boom-bust scenario with the economy initially booming one-two years and then the Fed will kill the boom by hiking interest rates aggressively.

Knowing Trump’s temperament and persona that could cause a conflict between the Fed and the Trump administration.

This is of course pure speculation, but even though the Trump administration and the Fed for now seem to favouring the same policy mix – aggressive fiscal easing and gradual rate hikes (slower than the increase the in equilibrium rate) it is unlike that this kind of old-school keynesian stop-go policies will end well.

2017 – a year of inflation?

Given these factors and others I for the first time since 2008 think that we could see inflation increase more significantly in 2017 in the US. This is of course what we to some extent want, but I am concerned that we are getting higher inflation not because the Federal Reserve has moved towards a more rule-based monetary policy framework, which ensure nominal stability, but because we are moving back towards old-school keynesian stop-go demand “management”.

PS I apologize to serious (New) Keynesians about using the term “keynesian” here. I here use the term as to refer to the kind demand management policy, which so failed during the 1970s. They where inspired by Keynesian economic think and was as such keynesian. However, that is not say that present day keynesians would necessarily agree with these policies.

PPS See also my comment over at Geopolitical Intelligence Service on why the US is “Still the Greatest”– also after Trump has become president.

Update: Read my follow-up post here.

Three simple changes to the Fed’s policy framework

Frankly speaking I don’t feel like commenting much on the FOMC’s decision today to keep the Fed fund target unchanged – it was as expected, but sadly it is very clear that the Fed has not given up the 1970s style focus on the Phillips curve and on the US labour market rather than focusing on monetary and market indicators. That is just plain depressing.

Anyway, I would rather focus on the policy framework rather than on today’s decision because at the core of why the Fed consistently seems to fail on monetary policy is the weaknesses in the monetary policy framework.

I here will suggest three simple changes in the Fed’s policy framework, which I believe would dramatically improve the quality of US monetary policy.

  1. Introduce a 4% Nominal GDP level target. The focus should be on the expected NGDP level in 18-24 month. A 4% NGDP target would over the medium term also ensure price stability and  “maximum employment”. No other targets are needed.
  2. The Fed should give up doing forecasting on its own. Instead three sources for NGDP expectations should be used: 1) The Fed set-up a prediction market for NGDP in 12 and 24 months. 2) Survey of professional forecasters’ NGDP expectations. 3) The Fed should set-up financial market based models for NGDP expectations.
  3. Give up interest rate targeting (the horrible “dot” forceasts from the FOMC members) and instead use the money base as the monetary policy framework. At each FOMC meeting the FOMC should announce the permanent yearly growth rate of the money base. The money base growth rate should be set to hit the Fed’s 4% NGDP level target. Interest rates should be completely market determined. The Fed should commit itself to only referring to the expected level for NGDP in 18-24 months compared to the targeted level when announcing the money base growth rate. Nothing else should be important for monetary policy.

This would have a number of positive consequences.

First, the policy would be completely rule based contrary to today’s discretion policy.

Second, the policy would be completely transparent and in reality the market would be doing most of the lifting in terms of implementing the NGDP target.

Third, there would never be a Zero-Lower-Bound problem. With money base control monetary policy can always be eased also if interest rates are at the ZLB.

Forth, all the silly talk about bubbles, moral hazard and irrational investors in the stock markets would come to an end. Please stop all the macro prudential nonsense right now. The Fed will never ever be able to spot bubbles and should not try to do it.

Fifth,the Fed would stop reacting to supply shocks (positive and negative) and finally six the FOMC could essentially be replaced by a computer as long ago suggested by Milton Friedman.

Will this ever happen? No, there is of course no chance that this will ever happen because that would mean that the FOMC members would have to give up the believe in their own super human abilities and the FOMC would have to give up its discretionary powers. So I guess we might as well prepare ourself for a US recession later this year. It seems incredible, but right now it seems like Janet Yellen’s Fed has repeated the Mistakes of ’37.

PS What I here have suggested is essentially a forward-looking McCallum rule.


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Yellen’s recession and that horrible Phillips Curve

The global stock markets are taking yet another beating today and as I am writing this S&P500 is down nearly 3.5% and the latest round of US macroeconomic data shows relatively sharp slowdown in the US economic activity and more and more commentators and market participants are now openly taking about the risk of a US recession in the coming quarters.

Obviously part of the story is China, but at the core of this is also is the fact that Fed chair Janet Yellen has been overly eager to interest rates despite the fact that monetary and market indicators have not indicated any need to monetary tightening. It is only the defunct Phillips Curve that could led Yellen to draw the conclusion that monetary tightening is needed in the US.

Back in August I wrote:

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.

…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.

…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!

Obviously Yellen did not get the memo and now we are exactly risking that recession that I warned about in August.

And no I am not bragging about my ability to forecast. In fact I am doing the exact opposite. In August the markets were telling us that there was no inflationary pressures (and I was only repeating that), but Yellen has all along insisted that the market expectations about inflation were wrong and that the Phillips Curve was right. That might turn out to be a costly mistake.

Inching closer to a US recession, while Yellen is eager to hike

Today we got the Minutes from the December 15-16 FOMC meeting where the Fed hiked interest rates.  That in itself is not terribly interesting and there is not much news in the Minutes to shock the markets.

Nonetheless it is another day of tightening of US monetary conditions – stronger dollar, lower inflation expectations, lower commodity prices and lower stock markets. But maybe the most alarming set of information comes from the Atlanta Fed that today published a so-called Nowcast for US real GDP growth in Q4 2015 (GNPNow) indicating the US real GDP slowed to just 1% (annualized quarterly growth rate) in Q4.



It is in this environment the Fed continues to signal that more monetary tightening is warranted.

So why is the Fed so hawkish despited very clear signs of continued growth deceleration in the economy and despite the fact that basically all monetary indications that we can think of indicates that monetary policy has become too tight?

To me it we should blame the unholy alliance between those FOMC members that are obsessed with looking at labour market data (to the same extent Arthur Burns was in 1970s) and the macro prudential crowd who worry that the Fed is inflating a bubble (somewhere in some asset market).

Needless to say there are no monetarists on the FOMC and as a consequence the FOMC continues to ignore both the signals from monetary indicators and from the market and as a consequence the risk of a US recession during 2016 (or 2017) continues to rise day-by-day.

PS maybe it is about time to start tracking Google Trends for the trend in Google searches for “recession”.

HT Michael Darda


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: or

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.)


Did Bill Gross get some insight from this blog? Maybe but it might (unfortunately) be outdated

The legendary Bill Gross – formerly of PIMCO and these days Janus Capital – does not believe in a hike from the Federal Reserve this year. This is what he has to say about the issue according to a Tweet from Janus Capital:

Fed really tracks Nominal GDP, which since 2012 and last 12 mos avg 3.6%. Unless it moves higher fugetabout a hike. 4th Qtr? 3.0.

I of course to a very large extent agree. In fact I have long been making exactly the argument that the Fed since the second half of 2009 effectively has been targeting 4% NGDP growth.

The first time I argued that was in the blog post The Fed’s un-announced 4% NGDP target was introduced already in July 2009 back in September last year.

I would course love the Fed to in fact target 4% NGDP growth (level targeting), but I am afraid that the Fed has been moving away from this un-announced target in recent months since Janet Yellen took over as Fed chair.

Hence, back in August in my blog post Yellen should re-read Friedman’s “The Role of Monetary Policy” and lay the Phillips curve to rest I argued that Yellen’s had caused the Fed (or rather the FOMC) to shift focus from monetary/nominal factors and towards the labour market and more specifically towards a focus on a rather old-school style Phillips curve.

Yellen’s argument essentially is that inflation is not a monetary phenomena, but rather a result of lower unemployment, which causes wage growth to accelerate, which in turn push up inflation. This is what presently – due the the “low” level of unemployment – seems to be the driving force behind Yellen’s hawkishness.

As a consequence, I am not sure that Bill Gross is right. I would love him to be right, but I am afraid that Bernanke’s de facto 4% NGDP target might not be as rock solid anymore.

Another factor that is pushing the Fed in a more-than-good hawkish direction seems to be the influence of Fed vice-chair Stanley Fischer who has the responsibility for “macroprudential” analysis at the Fed. With a focus on macropru Fischer seems to increasingly thinking the Fed should worry about bubbles and imbalances in the US economy (I by the way see no signs of bubbles – see here what I wrote back in June on the issue.)

Any monetarist would of course be deeply skeptical about the Fed’s ability to spot bubbles and even more skeptical about its ability to do anything about them. However, Fischer does not share that view and it seems to me that he is causing the Fed to become overly worried about these issues.

I am not in the business of making forecasts on this blog, but I can only say that I am less certain about the Fed’s policy rule today than I was a year ago.

A year ago I would without hesitation have said that the Fed of course was targeting 4% NGDP growth and since NGDP expectations (according to prediction markets such as Hypermind) presently are falling somewhat short of this “target” there would be no reason to believe the Fed would hike. However, with Yellen’s Phillips curve focus and Fischer’s macroprudential focus I am beginning to worry that we might be getting “off track” from the 4% NGDP.

I certainly hope I am wrong and I would very much hope that the Fed would clearly articulate that it was targeting 4% NGDP growth for the medium-term and that it will set monetary parametres to hit this target.



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Yellen is transforming the US economy into her favourite textbook model

When you read the standard macroeconomic textbook you will be introduced to different macroeconomic models and the characteristics of these models are often described as keynesian and classical/monetarist. In the textbook version it is said that keynesians believe that prices and wages are rigid, while monetarist/classical economist believe wages and prices are fully flexible. This really is nonsense – monetarist economists do NOT argue that prices are fully flexible neither did pre-keynesian classical economists. As a result the textbook dictum between different schools is wrong.

I would instead argue that the key element in understanding the different “scenarios” we talk about in the textbook is differences in monetary regimes. Hence, in my view there are certain monetary policy rules that would make the world look “keynesian”, while other monetary policy rules would make the world look “classical”. As I have stated earlier – No ‘General Theory’ should ignore the monetary policy rule.

The standard example is fixed exchange rates versus floating exchange rates regimes. In a fixed exchange rate regime – with rigid prices and wages – the central bank will use monetary policy to ensure a fixed exchange and hence will not offset any shocks to aggregate demand. As a result a tightening of fiscal policy will cause aggregate demand to drop. This would make the world look “keynesian”.

On the other hand under a floating exchange rate regime with for example inflation targeting (or NGDP targeting) a tightening of fiscal policy will initially cause a drop in aggregate demand, which will cause a drop in inflation expectations, but as the central bank is targeting a fixed rate of inflation it will ease monetary policy to offset the fiscal tightening. This mean that the world becomes “classical”.

We here see that it is not really about price rigidities, but rather about the monetary regime. This also means that when we discuss fiscal multipliers – whether or not fiscal policy has an impact on aggregate demand – it is crucial to understand what monetary policy rule we have.

In this regard it is also very important to understand that the monetary policy rule is not necessarily credible and that markets’ expectations about the monetary policy rule can change over time as a result of the actions and communication of the central and that that will cause the ‘functioning’ the economy to change. Hence, we can imagine that one day the economy is “classical” (and stable) and the next day the economy becomes “keynesian” (and unstable).

Yellen is a keynesian – unfortunately

I fear that what is happening right now in the US economy is that we are moving from a “classical” world – where the Federal Reserve was following a fairly well-defined rule (the Bernanke-Evans rule) and was using a fairly well-defined (though not optimal) monetary policy instrument (money base control) – and to a much less rule based monetary policy regime where first of all the target for monetary policy is changing and equally important that the Fed’s monetary policy instrument is changing.

When I listen to Janet Yellen speak it leaves me with the impression of a 1970s style keynesian who strongly believes that inflation is not a monetary phenomena, but rather is a result of a Phillips curve relationship where lower unemployment will cause wage inflation, which in turn will cause price inflation.

It is also clear that Yellen is extraordinarily uncomfortable about thinking about monetary policy in terms of money creation (money base control) and only think of monetary policy in terms of controlling the interest rate. And finally Yellen is essentially telling us that she (and the Fed) are better at forecasting than the markets as she continues to downplay in the importance of the fact that inflation expectations have dropped markedly recently.

This is very different from the views of Ben Bernanke who at least at the end of his term as Fed chairman left the impression that he was conducting monetary policy within a fairly well-defined framework, which included a clear commitment to offset shocks to aggregate demand. As a result the Bernanke ensured that the US economy – like during the Great Moderation – basically became “classical”. That was best illustrated during the “fiscal cliff”-episode in 2013 where major fiscal tightening did not cause the contraction in the US economy forecasted by keynesians like Paul Krugman.

However, as a result of Yellen’s much less rule based approach to monetary policy I am beginning to think that if we where to have a fiscal cliff style event today (it could for example be a Chinese meltdown) then the outcome would be a lot less benign than in 2011.

How a negative shock would play with Yellen in charge of the Fed

Imagine that the situation in China continues to deteriorate and develop into a significant downturn for the Chinese economy. How should we expect the Yellen-fed to react? First of all a “China shock” would be visible in lower market inflation expectations. However, Yellen would likely ignore that.

She has already told us she doesn’t really trust the market to tell us about future inflation. Instead Yellen would focus on the US labour market and since the labour market is a notoriously lagging indicator the labour market would tell her that everything is fine – even after the shock hit. As a result she would likely not move in terms of monetary policy before the shock would show up in the unemployment data.

Furthermore, Yellen would also be a lot less willing than Bernanke was to use money base control as the monetary policy instrument and rather use the interest rate as the monetary policy instrument. Given the fact that we are presently basically stuck at the Zero Lower Bound Yellen would likely conclude that she really couldn’t do much about the shock and instead argue that fiscal policy should be use to offset the “China shock”.

All this means that we now have introduced a new “rigidity” in the US economy. It is a “rigidity” in the Fed monetary policy rule, which means that monetary policy will not offset negative shocks to US aggregate demand.

If the market realizes this – and I believe that is actually what might be happening right now – then the financial markets might not work as the stabilizing factoring in the US economy that it was in 2013 during the fiscal cliff-event and as a result the US economy is becoming more “keynesian” and therefore also a less stable US economy.

Only a 50% keynesian economy

However, Yellen’s economy is only a 50% keynesian economy. Hence, imagine instead of a negative “China shock” we had a major easing of US fiscal policy, which would cause US aggregate demand to pick up sharply. Once that would cause US unemployment to drop Yellen would move to hike interest rates. Obviously the markets would realize this once the fiscal easing would be announced and as a result the pick up in aggregate demand would be offset by the expected monetary tightening, which would be visible in a stronger dollar, a flattening of the yield curve and a drop in equity prices.

In that sense the fiscal multiplier would be zero when fiscal policy is eased, but it would be positive when fiscal policy is tightened.

What Yellen should do 

I am concerned that Yellen’s old-school keynesian approach to monetary policy – adaptive expectations, the Phillips curve and reliance of interest rates as a policy instrument – is introducing a lot more instability in the US economy and might move us away from the nominal stability that Bernanke (finally) was able to ensure towards the end of his terms as Fed chairman.

But it don’t have to be like that. Here is what I would recommend that Yellen should do:

Introduce a clear target for monetary policy

  • Since Mid-2009 US nominal GDP has grown along a nearly straight 4% path (see here). Yellen should make that official policy as this likely also would ensure inflation close to 2% and overall stable demand growth, which would mean that shocks to aggregate demand “automatically” would be offset. It would so to speak make the US economy “classical” and stable.

Make monetary policy forward-looking

  • Instead of focusing on labour conditions and a backward-looking Phillips curve Yellen should focus on forward-looking indicators. The best thing would obviously be to look at market indicators for nominal GDP growth, but as we do not have those at least the Fed should focus on market expectations for inflation combined with surveys of future nominal GDP growth. The Fed should completely give up making its own forecasts and particularly the idea that FOMC members are making forecasts for the US economy seems to be counter-productive (today FOMC members make up their minds about what they want to do and then make a forecast to fit that decision).

Forget about interest rates – monetary policy is about money base control

  • With interest rates essentially stuck at the Zero Lower Bound it becomes impossible to ease monetary policy by using the interest rate “instrument”. In fact interest rates can never really be an “instrument”. It can be a way of communicating, but the actual monetary policy instrument will alway be the money base, which is under the full control of the Federal Reserve. It is about time that the Fed stop talking about money base control in discretionary terms (as QE1, QE2 etc.) and instead start to talk about setting a target for money base growth to hit the ultimate target of monetary policy (4% NGDP level targeting) and let interest rates be fully market determined.

I am not optimistic that the Fed is likely to move in this direction anytime soon and rather I fear that monetary policy is set to become even more discretionary and that the downside risks to the US economy has increased as Yellen’s communication is making it less likely that the markets will trust her to offset negative shocks to the US economy. The Keynesians got what they asked for – a keynesian economy.

PS I have earlier had a similar discussion regarding the euro zone. See here. That post was very much inspired by Brad Delong and Larry Summers’ paper Fiscal Policy in a Depressed Economy.

PPS I would also blame Stanley Fischer – who I regret to say thought would make a good Fed chairman – for a lot of what is happening right now. While Stanley Fischer was the governor of the Bank of Israel he was essentially a NGDP targeting central banker, but now he seems preoccupied with “macroprudential” analysis, which is causing him to advocate monetary tightening at a time where the US economy does not need it.

PPPS I realize that my characterization of Janet Yellen partly is a caricature, but relative to Ben Bernanke and in terms of what this means for market expectations I believe the characterization is fair.

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: For US readers note that I will be “touring” the US in the end of October.

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