What Catch Up Growth Under a Nominal GDP Level Target Looks Like

One more thing about Swedish monetary policy.  I showed in a previous post that the Swedes seem to be effectively targeting the level of nominal GDP.  A nice thing about level targeting is that it has "memory," that is monetary policy does not forget past deviations from its target and works in subsequent periods to make it up.  Thus, it requires higher-than-normal catch-up growth if its targeted nominal variable it undershoots its target and vice versa.  This catch-up growth can be seen for Sweden in the figure below which shows the year-on-year growth rates of nominal GDP:

The Swedes appear to be aiming for just under a 5% nominal GDP growth.  Starting in late 2008 and going into 2009, nominal spending collapses and contracts at about a 5% growth rate.  To make up for this loss in nominal spending, the Riksbank nudges up nominal GDP growth up to almost 10% in subsequent quarters.  Nominal GDP growth still remains elevated but now appears to be slowing down to its trend rate.  Contrast this path with that of the U.S. nominal GDP.  The U.S. also sees a sharp drop in nominal spending, but the Fed only allows it to return to its trend growth rate value of about 5%.  There is no catch-up growth in nominal spending.  Is it any wonder the U.S. economy remains sluggish?

Update:  To be clear, the Riksbank does not explicitly target the level of nominal GDP.  Effectively, though, it policies come out doing something close to what would be done under a nominal GDP level target.  Thus, we can look to Sweden to get an idea of what catch-up growth would look like under a nominal GDP level target. 

The Washington Post Has Me Confused...

Neil Irwin of the Washington Post wrote just last week about how the Swedish economy is doing so much better that the U.S. economy and attributed part of that success to a more aggressive monetary policy there.  Here is Irwin:

The Federal Reserve has won both plaudits and criticism for responding aggressively to the financial crisis, pumping money into the financial system in epic fashion. But by one key measure, the Swedish central bank was even more aggressive.

Like the Fed, the Riksbank lowered its target short-term interest rate nearly to zero. But it also expanded the size of its balance sheet more than the Fed did relative to the size of its economy, flooding the financial system with even more cash during the height of the crisis.

In summer 2009, the Riksbank had assets on its balance sheet equivalent to more than 25 percent of the nation’s gross domestic product. For the Fed, that level never got much over 15 percent.

So here Irwin is implying the Fed has not been aggressive enough.  As I showed in my previous post, this implications is borne out by the different paths of nominal GDP in the two countries.  But now Irwin comes out with an article on the legacy of QE2 and concludes that it shows that U.S. monetary policy really is limited in what it can do to revive the economy:

As it [i.e. QE2] ends, it shows more than anything the limits of the power of monetary policy to correct what ails the U.S. economy.

This is confusing.  Is the Fed truly capable of doing more but just not trying hard enough as suggested by the first article or is monetary policy truly limited as argued in the second piece?  The answer is clear when one considers that (1) QE worked wonders before when it was properly implemented in 1933-1936, (2) the demand for money and money-like assets remains elevated and this is something the Fed could reverse through the proper management of nominal expectations, (3) the Fed has shown no desire  to do level targeting which would require higher-than-normal catch-up growth in  nominal spending and prices.  I wish Irwin and other prominent Fed journalists would change the conversation  from the defeatist mantra that the Fed is limited to one where the true possibilities of monetary policy are explored.

What Successful and Unsuccessful Monetary Policy Look Like

Via Matt Yglesias we learn about the incredible recovery of the Swedish economy and how an aggressive monetary policy played a key role.  Specifically, the Swedish central bank expanded its balance to sheet to 25% of GDP versus the Fed's 15%, it set an explicit and clearly communicated inflation target, and charged a negative interest rate on excess reserves.  Swedish authorities also were not afraid to see their currency depreciate.  All of these steps would horrify the hard-money advocates in the United States, but I would ask to them to consider the benefits the Swedes are now enjoying: lower unemployment, higher real GDP growth, and less overall human suffering.  

Just in case there are any lingering doubts about the benefits of more aggressive monetary policy, take a look a the level of nominal spending in both Sweden and the United States.  Nominal spending in both countries takes a big hit, but only in Sweden does nominal spending undergone a robust recovery.  In fact, nominal spending is about back to its trend level:  (Click on figure to enlarge.)

It almost appears as if the Riksbank, the Swedish central bank, has a nominal GDP level target.  Three cheers for the Riksbank.  Now take a look at the U.S. nominal GDP:

These figures indicate U.S. monetary authorities could learn something from the Swedes.  Therefore, let me make a modest proposal: all incoming Fed officials, whether regional bank presidents or board governors, should spend six months interning at the Riksbank.  And while we are at it, let's also make all incoming ECB governing council members go through the same internship.  The world would be a much better place.

Assorted Monetary Musings

Here are some interesting pieces on monetary policy from past few weeks that caught my attention:

1.  Mike Konczal has been on a tear lately with his calls for more aggressive monetary policy.  Here he interviews Joe Gagnon about QE2's record and what QE3 might look like. Here he shows that FDR was actually quite astute about price level targeting during the early 1930s.

2.  Edward Harrison breaks down the differences between QE1, QE2, and Q3. 

3.  The BIS annual report gets a Jiu-Jitsu takedown from Scott Sumner, Martin Wolf, and Paul Krugman.

4.  Marcus Nunes has come to the conclusion that maybe the academic Ben Bernanke was never really all that different than the central banker Ben Bernanke.

5.  The last FOMC meeting and the follow-up press conference have defeatism written all over them. Ryan Avent is disappointed and  Paul Krugman sees Fed cowardice.

6.  An excellent and thorough article on Milton Friedman's views and how they relate to recent Fed actions by Edward Nelson.  Everything from excess money demand to the portfolio channel of monetary policy is covered.  I plan to do a post on this article later.

7.  Nick Rowe discusses the macroeconomics of doing nothing.  

Monetary Policy Efficacy During a "Balance Sheet" Recession

Over at Credit Writedowns, Edward Harrison discusses Richard Koo's work on balance sheet recessions.  Koo believes that monetary policy is ineffective in such settings. I disagree and have made the case before against Koo's views on balance sheet recession.  Here is the comment (with some slight edits) I left for Harrison:

U.S. households during the 1920s acquired a vast amount of debt and began a deleveraging process during the Great Depression.  Consequently, there was a "balance sheet" recession in the 1930s too.  Monetary policy, however, was not impotent during this time.  At least when it was done the right way.  FDR's price level targeting from 1933-1936 sparked a robust recovery.  In my view, this experience provides a great example of why Richard Koo's balance sheet recession views are wrong.  Yes, deleveraging is a drag on the economy, but for every debtor deleveraging there is a creditor getting more payments. (And if the debtor is not making payments and defaulting then the debtor still has funds to spend.)  In principle the creditor should increase their spending to offset the debtor's drop in spending.  The reason they don't--creditors sit on their newly acquired funds from the debtor instead of spending them--is because they too are uncertain about the economy.  There is a massive coordination failure, all the creditors are sitting on the sideline not wanting to be the first one to put money back to use. If something could simultaneously change the outlook of the creditors and get to them to all start using their money at the same time then a recovery would take hold.  Enter monetary policy and its ability to shape nominal spending expectations.  That is what FDR did from 1933-1936 when he forcefully communicated that he wanted the price level to return to its pre-crisis level. He backed up the message by devaluing the gold content of the dollar and not sterilizing gold inflows.  (See Mike Konczal for more on this experience.) It could happen here too if the Fed would commit to a level (not growth rate) target, preferably a nominal GDP level target.

QE2's limited success was not because monetary policy is impotent in such situations, but because they failed to properly shape and anchor nominal expectations. Ryan Avent summarized this problem well: QE2 changed the direction of monetary policy, but didn't set the destination.  I supported QE2 and hoped the best for it.  I also acknowledged, however, from the start that in the absence of a well defined level target it was bound to be limited and politically polarizing.  I believe Bernanke knows all this--as is suggested by his work on Japan--but he is faced by political constraints and has burned up most of his political capital on QE1 and QE2. 

More Eurozone Burning While the ECB Fiddles

It is bad enough to passively allow monetary policy to tighten in an economic crisis, but to actively do so is unconscionable. Yet, as Michael T. Darda reports, that is exactly what the ECB's seems to be doing at this time (my bold):

Our main concern is that it’s not just Greece. Ireland and Portugal are in very similar predicaments, while Spain’s economy, with twice the debt load of Greece, remains in deep trouble with 20% unemployment and tightening debt markets. Italy, with three times the debt load of Spain, also remains on shaky ground. If the periphery is going to survive, there has to be some path to growth/recovery. As yet, there is none. Austerity programs have dented growth and shrunk the tax base. Data for the last week show that the ECB, inexplicably, is contracting high-powered liquidity at more than a 10% year-to-year rate. Broad money across the zone is weak. Peripheral debt spreads are in the stratosphere. And funding costs are inching ever higher. To us, this is a setup for the weakness of the periphery to spread into the core, rather than for the strength of the core to lift the troubled periphery. Therefore, we would be inclined to “fade” any rally related to “kicking the can” farther down the road in Europe.

Here is his graph:

Maybe my fiddling while the Eurozone burns analogy is off.  The ECB is actively reducing the monetary base which suggests an image of the ECB putting down the violin and throwing some gasoline on the Eurozone burning.  My fear is that the weakness in the Eurozone periphery may spread beyond the core and into the global financial system.

Update:  Michael T. Darda talks about the tightening of ECB monetary policy with the Wall Street Journal.

How Much Cyclical vs. Structural Unemployment?

This is a question that has raged in the blogosphere for some time now.  And here is an answer from Prakash Loungani et al. (2011):

We provide cross-country evidence on the relative importance of cyclical and structural factors in explaining unemployment, including the sharp rise in U.S. long-term unemployment during the Great Recession of 2007-09. About 75% of the forecast error variance of unemployment is accounted for by cyclical factors-real GDP changes (Okun‘s Law), monetary and fiscal policies, and the uncertainty effects emphasized by Bloom (2009). Structural factors, which we measure using the dispersion of industry-level stock returns, account for the remaining 25 percent. For U.S. long-term unemployment the split between cyclical and structural factors is closer to 60-40, including during the Great Recession.

This is a little less than Scott Sumner's 70-30 split, but is still far more weighted toward cyclical factors than Arnold Kling's Recalculation theory suggests.  Tyler Cowen will also appreciate the light this study sheds on his questions regarding the relative importance of aggregate demand and aggregate supply shocks.

Brad DeLong, Jim Grant, and Milton Friedman

Brad DeLong and Jim Grant debate whether the Fed should do QE3.  DeLong makes the case for QE3 and invokes Milton Friedman in support of his view:

We have seen something like this--but worse--twice before: the Great Depression, and Japan's lost decades. A collapse in trust in the solvency of financial institutions induces the hoarding cash as part of the safe-asset tranche of portfolios. The economy's cash disappears from the transactions money stock--and so, for standard monetarist reasons, spending declines and unemployment rises... Expansionary monetary policy even at the zero lower bound via quantitative easing is what Milton Friedman recommended for the Great Depression and for Japan. 

That's what Friedman would be recommending were he with us today--keep doing rounds of quantitative easing until we get the economy's transactions cash balances and the flow of spending back to normal levels.

So did Milton Friedman actually recommend doing successive rounds of quantitative easing until nominal spending returns to normal levels? Let's have Milton Friedman speak for himself.  Here is an excerpt from a Q&A following a 2000 speech he delivered at the Bank of Canada (my bold below). 

David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero,  monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?

Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.

During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?”

It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.

The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.

So yes, Milton Friedman did call for buying longer-term securities until a robust recovery takes hold.  He also notes that policy interest rates can be a poor indicator of  the stance of monetary policy.   I suspect, however, that Friedman would have preferred that such a monetary stimulus program be done in a more systematic manner than that of announcing successive, politically costly rounds of QE.  Imagine how much easier all of this would have been had the Fed announced a level target from the start and said asset purchases will continue until the level target was hit.  There would have been no need to announce the large dollar size of the asset purchases up front that attracts so much criticism.  There would also have been no need to announce successive rounds of QE that make it appear the previous rounds did not work.  More importantly, it would have more firmly shaped nominal expectations in a manner conducive to economic recovery.  The question is what type of level target would Friedman have supported?  This 2003 WSJ article indicates he might have liked a nominal GDP level target.

Update: Here is a piece I wrote for Investor's Business Daily in 2010 on the Bernanke-Friedman relationship.

A Note to FOMC Members

According to this Bloomberg article, you are seriously discussing the adoption of an explicit inflation target.  Let me remind you that a price level target is even better since it has "memory".  Let me also remind you that during the September, 2010 FOMC meeting you folks discussed the possibility of a nominal GDP level target. There is much to like about a nominal GDP level target--it improves upon a price level target in how it handles supply shocks--and I hope you seriously consider it too.  

Raghuram Rajam and the Need for More Systematic Monetary Policy

Raghuram Rajan has come out swinging against U.S. monetary policy.  He argues it is wrong to look to the Fed as some monetary wizard who can "revive the economy through a swish of the monetary wand."  He also believes the Fed's monetary stimulus causes more problems that it solves.  In particular, he views the Fed's low-interest rate polices causing excessive risk taking by investors and harm to savers.  On the surface his arguments are consistent with his belief that the housing and credit boom was similarly driven by monetary policy that was too easy back in the early-to-mid 2000s.  I am sympathetic to his views on the Fed's role in the housing and credit boom, but believe his current take on U.S. monetary policy is off.  Let me explain why.

First, a low policy interest rate target by itself does not mean monetary policy is loose, let alone too loose.  Interest rates have to be low relative to the neutral (or the natural) interest rate to be stimulative.  The neutral interest rate, in turn, is closely tied to the performance of the economy.  Thus, given the anemic economic conditions the neutral interest rate is most likely low now.  Estimates of the real neutral interest rate show this to be the case.  For example, the updated estimates for the highly cited Laubach-Williams paper puts the real neutral interest rate at 0.27% for 2010:Q4.  (Aside: I know John Williams is now busy running the San Francisco Fed, but us bloggers need him to keep updating his natural rate estimates!)  Another way of saying this is that interest rates would probably be low right now even if there were no Federal Reserve.  Savers, therefore, are not being harmed by the Fed's low targeted policy interest rate, but by the weakened economy. 

It is true that the real federal funds rate is probably still slightly lower than the real neutral rate, but that by itself still does not mean monetary policy is too loose if it is being eased to close the output gap.  The Taylor Rule, for example, prescribes a federal funds rate target different than the neutral federal funds rate if there is an output gap or if inflation is running too high. Now, I will concede it is difficult, maybe even impossible for the Fed to finely tune its targeted interest rate so as to flawlessly close the output gap or reign in inflation.  But that is not the issue here.  The point is one has to be careful about claiming low interest rates necessarily mean excessively easy monetary policy.

So what can and should monetary policy do?  First, monetary policy can make a big difference even in a 0% interest rate environment. FDR showed us that with his QE program of 1933-1936.  By most accounts it was a smashing success.  Unlike our current QE programs, it worked because it change nominal expectations in a meaningful manner.  FDR effectively created a price level target that convinced everyone he would return the price level to its pre-crisis value. This caused money demand to fall and nominal spending to take off.  Given the large amount of excess slack, this increase in nominal spending caused a sharp recovery in real economic activity.  The same could be done today if the Fed would announce an explicit level target, preferably a nominal GDP level target.  Such a target would create a period of rapid catch up spending--to return spending to its trend--and thereafter stabilize the growth rate of nominal spending around some target growth rate.  If this happened, the neutral interest rate would rise, investors would be less interested in risky investments, savers would benefit, and there would be long-term certainty about the path of nominal spending.  In short, Rajan's concerns would be eliminated. Rajan just needs more faith in the right kind of monetary policy can do.

Now if, on the other hand, the Fed were simply do another round of QE without an explicit level target I doubt it will help much. Such an approach does not shape expectations well, is a lightning rod for criticism, and ultimately could add more uncertainty to markets.  We need to move toward more systematic monetary policy, one that adds plenty of monetary stimulus but does so in a predictable manner.  What we need is a nominal GDP level target.

Update:  Brad DeLong weighs in and Bill Woolsey responds in his comment section.

The ECB Monetary Policy Mess in One Picture

San Francisco Fed economist Fernanda Nechio shows us in one picture the ECB monetary policy mess:

If there were any doubt that the ECB is in practice narrowly setting monetary policy for the core countries (i.e. Germany and France) this figure should remove it.  The figure should also nix any doubts as to whether what is good for the core is good for the periphery.  ECB monetary policy was too loose in the early-to-mid 2000s and now it is too tight.  If the ECB really wants to preserve the Eurozone in its current form it must confront this reality.  So far it hasn't and this is why I say the ECB is fiddling while the Eurozone is burning.

Options for the Eurozone

Nouriel Roubini has written a number of good pieces on the Eurozone crisis.  His latest one in the Financial Times is no different.  It provides a summary of how the Eurozone got to this point and the options left for it going foward.  Here are the options according to Roubini:

(1) The euro could fall sharply in value towards – say – parity with the US dollar, to restore competitiveness to the periphery; but a sharp fall of the euro is unlikely given the trade strength of Germany and the hawkish policies of the European Central Bank.

(2) The German route — reforms to increase productivity growth and keep a lid on wage growth — will not work either. In the short run such reforms actually tend to reduce growth and it took more than a decade for Germany to restore its competitiveness, a horizon that is way too long for periphery economies that need growth soon.

(3) Deflation is a third option, but this is also associated with persistent recession. Argentina tried this route, but after three years of an ever deepening slump it gave up, and decided to default and exit its currency board peg. Even if deflation was achieved, the balance sheet effect would  increase the real burden of private and public debts. All the talk by the ECB and the European Union of an internal depreciation is thus faulty, while the necessary fiscal austerity still has – in the short run – a negative effect on growth.

(4) So given these three options are unlikely, there is really only one other way to restore competitiveness and growth on the periphery: leave the euro, go back to national currencies and achieve a massive nominal and real depreciation. 

A key point here is that ultimately a real depreciation is needed for the troubled Eurozone countries.  How it gets done is the burning question.   

Fiddling While the Eurozone Burns

So the European Central Bank (ECB) has decided to follow through on its plans to tighten monetary policy this year. The ECB will begin by raising its benchmark interest rate next month.  This is unbelievable. The Eurozone is under severe pressure that could ultimately lead to its breakup and yet the primary concern at the ECB is tightening monetary policy according to schedule.  If followed through, the consequences of this are not only bad for the Eurozone, but for the rest of the global economy too.  The slow-motion bank run now taking place in the Eurozone could easily turn into another severe global financial crisis.  

So why then is the ECB pushing so hard for monetary policy tightening?  From the New York Times we learn the answer:

With Germany, the euro zone’s largest economy, growing so quickly that some economists fear overheating, the E.C.B. has been trying to nudge interest rates back to levels that would be normal in an upturn.

Silly me, I thought the ECB's mandate was for the entire Eurozone not just Germany.  Now Germany is the largest economy in the Eurozone and so its economic conditions have a large influence on the the Eurozone aggregates that the ECB targets.  So maybe I am being too hard on the ECB here. Still, if the ECB really desires to save the Eurozone in its current form then tightening monetary policy is a move in the wrong direction.  

Here is why. If the ECB were to ease monetary policy, it would cause inflation to rise more in those parts of the Eurozone where there is less excess capacity.  Currently, there is far less economic slack in the core countries, especially Germany.  The price level, therefore, would increase more in Germany than in the troubled countries on the Eurozone periphery.  Goods and services from the periphery then would be relatively cheaper.  Thus, even though the fixed exchange rate among them would not change, there would be a relative change in their price levels.  In other words, there would be a much needed real depreciation for the Eurozone periphery.  This  would make Greece, Portugal, Spain, and other periphery countries more externally competitive.

Again, the relative price level change would not be a permanent fix to the structural problems facing the Eurozone--it is not an optimal currency area and there needs to be debt restructuring--but it would provide more flexibility in addressing the problems. Tightening monetary policy, on the other hand, would only make matters worse. It would force all of the needed real depreciation for the periphery on wages and prices in the troubled countries.  That only increases the pain for them and makes it more likely they will leave the Eurozone.  This seems so obvious to me.  Why isn't it obvious to ECB officials?  Why are ECB officials fiddling while the Eurozone burns?

P.S. See Kantoos latest idea for saving the Eurozone: apply countercyclical haircuts on bonds accepted by the ECB for refinacing (HT Matt Yglesias).

Ten Questions I Wish Ben Bernanke Would Answer Today

Mark Thoma cues us in on the hot issues to look for in Ben Bernanke's speech today.  Here are ten questions Bernanke will not answer in that speech, but I wish he would consider: 

1. Does the recent decline in the Treasury break-even inflation expectations raise concerns for the Fed?
2. On a per capita basis, domestic nominal spending is still below its pre-crisis peak level.  Should the Fed be concerned about this?  
3. In past speeches you and other Fed officials have mentioned the Fed could raise the interest payment on excess reserves (IOR) as a way to prevent the large stock of excess reserves from being invested in higher yielding loans or securities.  In other words, you and other Fed officials have claimed the Fed can effectively tighten monetary policy by raising IOR. By that same reasoning, wouldn't that mean the Fed could lower the IOR to loosen monetary policy and thus, by implementing IOR in the first place in late 2008 the Fed effectively tightened monetary policy then?
4. If Congress would sanction it, would you be interested in adopting an explicit level target over a growth rate target?  
5. If so, would you go with a price level target or a nominal GDP level target? Explain your choice.
6. Do you feel political pressure both inside the Fed and from Congress is constraining the Fed from making optimal monetary policy?
7. Though the Treasury break-even inflation expectations series mentioned above is useful, one has to be careful in interpreting it because both aggregate supply shocks and aggregate demand shocks can influence it.   Wouldn't it be better to just cut to the chase and have a futures market for nominal GDP that would directly measure aggregate demand shocks? 
8. How do you reconcile your aggressive recommendations for Japanesse monetary policy   in the 1990s with the Fed's relatively modest approach to U.S. monetary policy today?
9. Why do you think that FDR's original QE program in the early 1930s was so much more effective  than the 2010-2011 QE2?
10. At the September, 2008 FOMC meeting the Fed decided not to cut the federal funds rate because it was concerned about headline inflation.  In the press release it mentions that commodity prices were behind the rise in headline inflation.  By implication, then, the Fed failed to act because it was responding to a rise in commodity prices.  Do you see any parallels to today's environment?

Maybe someday we will know the answer to these questions.

How Effective is Monetary Policy?

Nick Rowe reminds us that if a central bank is doing a good job in terms of hitting its nominal target, then both the indicator variables and the monetary policy instrument it uses should not be correlated with the target. For example, say the central bank were targeting a nominal GDP growth of about 5% a year and adjusted the stance of monetary policy to offset velocity shocks so that the 5% target was hit on average.  Though the stance of monetary policy would be systematically related to the velocity shocks it would not be correlated with nominal GDP growth. An observer, not knowing any better, might study the empirical relationship between the stance of monetary policy and nominal GDP growth and conclude monetary policy is ineffective with regards to nominal spending when in fact it is very effective.  

This insight is important for several reasons. First, it helps shed light on why it monetary policy shocks  in empirical studies appear to have less of an effect on the U.S. economy after 1980 than before. For example, below are two figures showing the typical response of real GDP to a 0.25% federal funds rate shock during these two periods.¹ (Click on figure to enlarge.)

Just looking at these two figures could lead one to conclude monetary policy became less important over time.  Some observers, however, argue that during the latter period monetary policy did a better job responding to economic shocks and thus, helped paved the way for the "Great Moderation" in economic activity.  If so, it would make it difficult to find as strong a relationship between the Fed's operational instrument, the federal funds rate, and economic activity during the "Great Moderation" than before.  This is the point Nick Rowe is making.  It is also one that Jean Boivin and Marc P. Giannoni convincingly make in this influential paper (ungated version). 

Second, this line of reasoning also means that one cannot look at measures of money--monetary base, M1, M3, etc.--and conclude they are unimportant for monetary policy.  Adam P. notes, for example, that with an inflation-targeting central bank a zero correlation between the monetary base and the inflation rate does not mean that the monetary base is inconsequential for inflation, but only that the central bank is doing its job well.  Similarly, Nick Rowe explains elsewhere that if a central bank is successfully targeting a nominal GDP growth rate, then one should not expect to find a relationship between the money supply and nominal GDP growth. Again, this does not mean money is unimportant. What it does mean is that the central bank is managing to offset shocks to velocity and money supply such that nominal GDP growth is being stabilized.

Josh Hendrickson makes a strong case that during the "Great Moderation" the Federal Reserve effectively was targeting nominal GDP growth of around 5%.  If so, then the above reasoning implies that during this time there should be a strong negative relationship between the growth rates of the money supply (M) and velocity (V), but little if any relationship between that of the money supply and nominal GDP.  However, this should be less true prior to this time when the Fed was not stabilizing the nominal GDP growth rate--the period of the "Great Inflation"--and there really was no nominal anchor for U.S. monetary policy.  The graphs below provide evidence on this claim.

Using M1 as a measure of the money supply, the first two figures show the relationships in question for the "Great Moderation" period.  They show that there was a strong relationship between the money supply and the velocity growth rates, but essentially no relationship between the money supply and the nominal GDP growth rates:

Now let us look at the period prior to the "Great Moderation."  Here we find that the growth rates of the money supply and velocity are not related, but there is some relationship between the money supply growth rate and that of nominal GDP:

Similar evidence can be found using other monetary aggregates.  Now these graphs should not be interpreted as meaning the Fed should target a monetary aggregate.  Rather, they should be viewed as evidence that it is difficult to assess the effectiveness of successful monetary policy by looking at indicator variables and policy instruments.  What observers should be looking to is the central's bank's nominal target to see if it is being maintained on average.  Ultimately, that is the best indication of monetary policy's effectiveness.

Of course, the problem currently is we do not really know with certainty the Fed's nominal target.  Is it 2% inflation, 5%  nominal GDP growth, a price level target, or something else? Here the Fed could improve.  It should announce an explicit nominal target and commit to maintaining it no matter what.  Obviously, I would like it to announce a nominal GDP level target, but any announcement would be an improvement over the uncertainty we have now.

¹These responses come from a standard structural vector autoregression that included real GDP, commodity prices, CPI, and the federal funds rate. Six lags were used.

Robert Lucas Believes in Spending Shocks

Robert Lucas has been taking some heat around the blogosphere for a lecture he gave at the University of Washington.  Scott Sumner responds:

In a recent talk, Robert Lucas argued that a decline in “spending” (i.e. NGDP) produced the severe contractions of 1929-33 and 2008-09.  He argued that the slow recoveries were caused by adverse supply-side polices.  This is not “classical” or RBC economics, it’s AS/AD.   I think he’s right about the the Great Depression and the recent contraction, but only about 30% right about the current recovery (I attribute 70% of the slow recovery to lack of NGDP growth.)  Oddly, Paul Krugman and Matt Yglesias seem to think that Lucas denies that demand shocks cause recessions–which is clearly not Lucas’s view.

Let me add to this discussion by noting that recently I met Robert Lucas at a conference.  We started talking and, among other things, he expressed his support for nominal GDP targeting because it would have given the Fed more flexibility in responding to the severe spending shocks.  That is, it would have allowed the Fed to have been more aggressive with monetary policy while still being systematic.  He was also sympathetic to my view that currently there was too much concern about inflation.  At a conference dominated by inflation hawks, I found him to be a refreshing breath of fresh air.  

PS.  We also talked about his former student Scott Sumner and Sumner's proposal for NGDP futures targeting.  He was intrigued by it and compared it to Lars Svensson's work on targeting the forecast.

Watch Out, George Selgin is Now Blogging!

George Selgin is now blogging.  It is about time.  He is the individual who introduced me to nominal GDP targeting, the monetary disequilibrium view of recessions, benign vs. malign deflation, and other interesting ideas. I was fortunate to have him as a professor and now the rest of world can have access to him too.  

To get a taste of the Selgian view of the world, here is a recent article of his evaluating the Fed's performance and here is an older monograph where he promotes his Productivity Norm Rule for monetary policy. 

The Fed Already Repeated the "Mistake of 1937"

Gautti Eggertson has an interesting post where he compares current economic conditions to those that prevailed leading up to the recession of 1937-1938. Here is his description of developments in 1937:

(1) Signs indicate that the recession is finally over. (2) Short-term interest rates have been close to zero for years but are now expected to rise. (3) Some are concerned about excessive inflation. (4) Inflation concerns are partly driven by a large expansion in the monetary base in recent years and by banks’ massive holding of excess reserves. (5) Furthermore, some are worried that the recent rally in commodity prices threatens to ignite an inflation spiral.

The Federal Reserve responded at this time by tightening monetary policy.  Fiscal policy also was tightened. These policy moves turned what had been a robust recovery between 1933 and 1936 into the second recession of the Great Depression. As a result, a full economic recovery was postponed several more years.

Eggertson explains the surge in commodity prices was the galvanizing force then behind the concerns over inflation and, thus, the tightening of policy.  Though these developments sound eerily similar to today's environment, Eggertson is confident that Fed officials will not make the same mistake:

 It is unlikely, however, that a modern economist put in the same position would respond to the commodity price rise in the same way... Fed economists today typically monitor various components of the CPI that are not influenced strongly by temporary supply disruptions. For example, one common measure tracked is “core CPI,” which excludes volatile food and energy prices from the overall CPI basket.

He then goes on to claim the Fed's response in 2008 proves his point:

In early 2008, the economy started a downward spiral that culminated in a crisis... At the same time, however, there was a temporary rally in commodity prices, driven by a rise in oil prices in early 2008, as can be seen in the figure above. This development prompted some commentators to warn against “excessive inflation.” But Fed economists and many others judged that the rise in prices was specific to commodities and did not signal an increase in overall price pressures. Largely ignoring the temporary rally in commodity prices, the Fed focused instead on core inflation and some alternative price measures 

I wish he were right, but  the Fed has already repeated the mistake of 1937. As I and others have shown, monetary policy was passively tightening by mid-2008.   A key reason is that the Fed was concerned about the very surge in commodity prices that Eggertson mentions above. In fact, it was so concerned it decided against lowering its target federal funds rate in its September, 2008 FOMC meeting.  Here is an excerpt from the press release from that meeting (my bold):

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent...

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain. 

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

In short, the Fed's inaction was driven by concerns that the surging commodity prices might push inflation  too high.  The Fed was looking to headline inflation in making this decision, not the core.  Had they been looking at the core they would not have alarmed.  Better yet, had the Fed been focused on the expected inflation rate from TIPS it would have seen that inflation expectations had been falling since July, 2008.  Doing nothing, as it did, in such a setting amounted to passive tightening of monetary policy. So contrary to Eggertson's claim, the Fed has already repeated the mistake of 1937 in 2008.  It is not clear it won't do the same again.