Another Nail in the Coffin

Ramesh Ponnuru and I have a new article in the National Review that places another nail in the coffin of flexible inflation targeting.  Here is the introduction:

Twice in the last century, economic turmoil revealed the failure of a monetary regime and forced the West to abandon it for another. During the Great Depression of the 1930s one country after another abandoned the gold standard — a decision vindicated when they recovered in the same order. The inflation of the late 1960s and 1970s, meanwhile, persuaded most of the developed world’s central bankers to quit trying to “fine-tune” the real growth rate of the economy and instead concentrate on achieving price stability. 

It is once again time for regime change. The crisis in Europe and our stagnation at home both have primarily monetary causes, and a solution will require a new approach to monetary policy that learns from both the successes and the failures of the past.

We make the case that the time has come for a nominal GDP (NGDP) level target to replace flexible inflation targeting in both the United States and Europe.  One advantage is the ability of a NGDP level target to firmly anchor nominal income expectations and thus keep current nominal spending stabilized.  This property would, among other things, prevent the looming debt-ceiling talks from creating the economic uncertainty it did last year.  Betsey Stevenson and Justin Wolfers are concerned the U.S. economy is even more vulnerable this year to politicized debt-talks.  They would not be if the Fed were following a NGDP level target.

It is time for monetary regime change.

Flexible Inflation Targeting Is Just Fine

The Atlanta Fed's David Altig is the latest central banker to defend flexible inflation targeting (FIT).  He says it "feels about right" to him.  This follows the Bank of Canada's Mark Carney who claimed earlier this month that FIT  "proved [its] worth through crisis and will be essential to sustain the recovery." Really? I did not realize that the FOMC deciding not to cut the target federal funds rate in September, 2008 because of inflation concerns makes one "feel right" about FIT. The economy was in free fall, but hey the Fed kept inflation expectations anchored! I also did not know that the ECB increasing interest rates in 2011 because of inflation concerns "proved its worth" during the crisis. Nothing like reigning in inflation expectation during the Eurozone Apocalypse. I also did not know that keeping inflation low over the past few years was "essential to sustain the recovery" in Europe and the United States.  Silly me, I thought that those the large-scale asset purchases (LSAPs) and long-term refinancing operations (LTROs) were an important part of the monetary policy stimulus too.  I guess I was wrong.  All along is was really  just FIT! Yep, there is no need to worry about the level of aggregate nominal spending being below trend and the insufficient aggregate demand problem. It  all can be fixed with FIT. 

P.S. Jeffrey Frankel nails it with this FIT RIP article.  The fact that FIT advocates cannot see that FIT was grossly inadequate for this crisis--if it works so well then why resort to LSAPs and LTROs?--and thus, not a general approach to monetary policy is telling. Why not take a more direct approach that directly targets aggregate demand rather than an imperfect symptom of it? 

A Dereliction of Duty

Market Monetarists have long made the case that a nominal GDP (NGDP) level target would firmly anchor the expected growth path of nominal income.  Doing so, in turn, would stabilize current nominal spending since households and firms are forward looking in their decision making.  For example, holding wealth constant, households generally will put off purchasing a new car or renovating their homes if they expect their nominal incomes to fall and vice versa.  This is why Scott Sumner likes to say monetary policy works with long and variable leads. This understanding implies, therefore, that the reason for nominal spending remaining below is its pre-crisis trend is that the Fed has failed to restore expected nominal income to its pre-crisis path. This failure amounts to a passive tightening of  monetary policy. 

In the past I provided some supporting evidence for this view using data from the Survey of Professional Forecasters.  Thanks to Evan Soltas, we now know of an another measure of expected nominal income growth that provides further evidence for the Market Monetarist view. The data comes from a question on the Thompson Reuters/University of Michigan Surveys of Consumer where households are asked how mcuh their nominal family income is expected to change over the next 12 months.  The figure below shows this measure up through October, 2011.  

Source: Thompson Reuters/University of Michigan

This figure shows that for most of the Great Moderation the Fed kept consumer nominal income expectations anchored around 5%.  That is a remarkable accomplishment.  But the figure also screams massive Fed failure.  It shows a decline in expected nominal income growth that gradually begins in late 2005 and sharply accelerates in 2008. This fall is unprecedented in the series.  What is even more troubling, though, is that expected nominal income growth has remained flat. The Fed has failed to restore expected nominal income growth back to normal levels. It should be no surprise, then, that households are deleveraging and holding an inordinate amount of liquidity in their portfolios.  

Source: Thompson Reuters/University of Michigan, New York Federal Reserve Bank

A recent study that makes use of this data has findings that reinforce the importance of stabilizing nominal income expectations.  Mariacristina De Nardi, Eric French, and David Benson of the Chicago Fed in paper titled "Consumption and the Great Recession" examine the importance of changes in expected nominal income and wealth for aggregate consumption. Among other things, they find that expected nominal income growth deteriorates across all age groups, educational levels, and income levels over the past few years.  This is not some sectoral-specific (i.e. structural) development.  They also find that the collapse in expected nominal income growth was an important determinant of the fall in aggregate consumption during the Great Recession.

This new data, the Chicago Fed study, and my previous post all indicate how important it is for the Fed to properly manage nominal income expectations.  By this criteria there has been a dereliction of duty by the Fed. It is time for the Fed to recognize its failures and adopt an approach that better anchors nominal income expectations.  It is time for the Fed to adopt a NGDP level target.

P.S. Maybe the Chicago Fed study had some influence in converting Chicago Fed President Charles Evans to a fan of NGDP level targeting. 

It Is Never Too Late: Global Economic Collapse Edition

The global economy appears to be headed over cliff this year.  The emerging world is experiencing a significant economic slow down, the Eurozone will probably break apart in the next few months, and the United States faces sharp austerity measures at the end of the year.  There are enough bearish developments here to make the original Mayan calendar look prescient after all.  So should we despair?  Is the global economy fated to collapse in 2012?

No, says Willem Buiter and Ebrahim Rahbari of Citigroup.  Though the outlook is dire, they argue there is much more the Fed, the ECB, the Bank of  Japan, and the Bank of England could do not only to prevent another global economic collapse this year, but also to spur global aggregate demand above its anemic levels as seen below:

Source: OECD Statistics

So what does Buiter and Rahbari recommend?  Via FT Alphaville, here are their recommendations:

(i) reducing rates, first by lowering them all the way to zero (UK and euro area), then by eliminating the effective lower bound on nominal interest rates (all four currency areas)  

(ii) carrying out more imaginative forms of quantitative easing (QE) & credit easing (CE), in all four currency areas, by focusing on outright purchases of and/or loans secured against less liquid and higher credit risk securities, subject to a sovereign guarantee (joint and several in the euro area) for all such risky central bank exposures 

(iii) engaging in helicopter money drops (all four currency areas): a combined fiscal monetary stimulus 

The authors say the best of these options is (ii) and (iii).  These are radical proposals that would require both monetary and fiscal collaboration, but right now radical solutions are exactly what the world needs.  The global economy needs a jarring slap to the face to awaken it from its heightened risk-averse stupor. These proposals would most likely do it, but they lack an endgame.  How much imaginative QE and helicopter drop money should be done? This is an important question, because without an endgame to drive market expectations, these measures will be less effective and have the potential to unmoor long-run inflation expectations. And, as Kelly Evan notes, monetary authorities are loathe to simply try something without some guiding objective.

Enter a nominal GDP (NGDP) level target.  It would provide an explicit endgame for the policymakers as they implemented these imaginative QE and helicopter drops. This would not only keep inflation expectations anchored, but would create the incentives for investors across the globe to do much of the heavy lifting required to restore robust global aggregate demand growth.  For example, imagine that monetary authorities in the United States, Europe, United Kingdom, and Japan simultaneously announced they were going to engage in as much imaginative QE and helicopter drops necessary to restore NGDP to some pre-crisis trend.  How do you think markets would respond to these announcements? It is highly likely that the mother-of-all portfolio adjustments would take place, with investors across the glove moving into riskier, higher-yielding assets in anticipation of higher aggregate nominal spending. This would raise asset prices, lower risk premiums, and create a self-sustaining recovery.  It really is not that hard.

So no, the global economy is noted fated to a Mayan calendar-type collapse.  Policymakers can make a huge difference this year and do so in a systematic, stabilizing manner.  The question is whether policy makers will act in time.  Ambrose Evans-Pritchard is not sure they will:

[S]overeign central banks have the means to defeat any depression thrown at them by launching mass purchases of assets outside the banking system, working through the classic Hawtrey-Cassel quantity of money mechanism until nominal GDP is restored to its trend line.

The problem is not scientific. A world slump is preventable if leaders act with enough panache. The hindrance is that the Euro Tower still haunted by Hayekians, and most G10 citizens – and Telegraph readers from my painful experience – view such notions as Weimar debauchery, or plain Devil worship. Economists cannot command a democratic consent for monetary stimulus any more easily today than in 1932.

 I hope policymakers prove him wrong.

Fed Nominees, the Natural Interest Rate, and Safe Assets

Some parting thoughts for the weekend.

1.   Chris Hayes nails it in this interview on the implications of Senator David Vitter blocking President Obama's Fed nominees.  He correctly notes that Senator Vitter's actions are preventing a robust recovery in aggregate nominal spending.  This, of course, worsens President's Obama's chances of getting relected which is politically smart for Senator Vitter.  But it is also prolonging the human suffering caused by the ongoing economic slump. Here is Chris Hayes:  

 

What Senator Vitter and other hard-money advocates fail to realize is that the Fed has effectively kept monetary policy tight. They also fail to realize there is a rule-based remedy to this problem called NGDP level targeting. It would minimize the Fed's "activism" that bothers the senator so much, but still spur a recovery in aggregate nominal spending.

Senator Vitter should also note that by preventing the Fed from doing more, he is effectively creating a larger cyclical budget deficit and opening the door for more government intervention. Conservatives do not realize it, but they need more (systematic) monetary policy if they want less government involvement in the economy.  For more on this point see my article with Ramesh Ponnuru in The New Republic or my QE2 article in the National Review.   (hat tip Mike Konczal)

2. Scott Sumner recently had the following to say in a recent post:

I don’t think Keynesians should be arguing that lower real interest rates are the key to recovery.  A bold and credible monetary stimulus that was expected to produce much faster NGDP growth might well raise long term risk-free interest rates.

This elicited a response from Tim Duy and Bill Woosley who both agreed that interest rates would ultimately go up if the Fed were doing a better job.  That is, a more aggressive monetary stimulus program by the Fed should raise expected economic growth and, in turn, raise the demand for credit.  These developments would then raise interest rates.  Duy and Woolsey explain this thinking using a modified IS-LM model, something that Paul Krugman and I have has done in the past too.

A key insight from the IS-LM model is that one can only infer the stance of monetary policy by comparing the policy interest rate to the natural interest rate. One cannot simply look at low policy interest rates and conclude that monetary policy is easy.  The policy interest rate has to be low relative to the natural interest rate for there to be monetary stimulus. Right now a strong case can be made that the federal funds rate is not below its natural interest rate counterpart.  Unfortunately, too few people understand the concept of the natural interest rate.  As a result, there is a lot confusion over the stance of monetary policy, financial repression, and Fed activism.  Imagine how different the debate over monetary policy would be if everyone understood this concept.  I now make it a point to drill into my students heads the importance and implications of the natural interest rate. [Update: If the Fed were to raise expected economic growth through a NGDP level target, the natural interest rate would rise.  The Fed then could raise the federal funds rate without harming growth.  Note the order: improved economic growth prospects first, higher interest rates second.]

Here is Scott's argument is a graph.

3.  Izabella Kaminsky and Cardiff Garcia have been doing a great job at FTAlphaville following the safe assets shortage issue.  For example, see here and here.   I have been meaning to do a full post response for them.  For now I want to note the following. It is how I view the safe asset problem in light of NGDP level targeting:

Gorton, Lewellen, and Metrick (2012) show that safe assets have constituted a relative stable share of all assets since the 1950s. They also show, as does Bansal, Coleman, and Lundblad (2011), that public and private safe assets tend to act as substitutes in providing liquidity services.  Given these findings, it stands to reason that when the central bank is doing its job and nominal GDP (NGDP) is growing at its appropriate trend, then there will be enough safe assets being privately provided.  If, however, the central bank slips and NGDP falls below its expected path, then some of the privately produced safe assets disappear, creating a shortage of safe assets. The government steps in and creates safe assets that, if produced sufficiently, would restore NGDP back to its expected path. In other words, if monetary policy does not do its job then fiscal policy could substitute for it, but in a way not normally imagined. It would do so not by increasing aggregate demand via higher government spending, but by making up for the shortage of safe assets that facilitate transactions.  All this requires is running a budget deficit which may or may not imply higher government spending (i.e. it could also come from tax cuts).  Debates about Ricardian equivalence, crowding out, and other fiscal policy concerns become moot.  What matters is if there are enough safe assets, and if not, whether fiscal policy can provide them in the absence of a NGDP-stabilizing monetary policy. 

For more on this excerpt and my views on this matter see here, here, and here.

Monetary Policy Change James Hamilton Can Believe In

What more can the Federal Reserve do at this point in the business cycle?  Can it really help spur a more robust recovery?  James Hamilton is not so sure and is concerned that calls for more monetary stimulus may come at a high cost.  He believes that further large scale asset purchases (LSAPs) would have at best a modest effect on economic activity and worries that they would make the United States more susceptible to a fiscal crisis.  Given how the Fed has done LSAPs so far, his concerns about the effectiveness of additional LSAPs are understandable.  But advocates of more monetary stimulus, like myself, are not asking the Fed to do business as usual.  We are asking for something different, an approach that would better combine the threat (or, if need be, the action) of LSAP with an explicit target.  If this approach to monetary policy were adopted, his concerns about a  fiscal crisis would also become moot. 

So what is this alternative approach?  It is simple: the Fed announces it plans to return the level of NGDP to some pre-crisis growth path and commits to buying up as many treasuries, GSEs, and foreign exchange as needed to accomplish that goal.  Note that this is a conditional LSAP tied to an explicit level target.  It sets a destination for monetary policy and thus firmly manages the expected path of nominal spending.  Previous LSAPs did not set an explicit destination and were very ad-hoc in nature.  They committed explicit dollar amounts of spending up front with vague objectives.  It was the monetary policy version of throwing something against the wall and hoping it would stick.  This, however, was an impossible hope since there never was a commitment by the Fed to allow any of the LSAPs to permanently stick to the wall.  And, as Michael Woodford notes, without this commitment the Fed failed to shape expectations in a way that would spur rapid nominal spending growth. It should not be surprising then that the effect of such LSAPs were modest.  

Now imagine how the public would respond if tomorrow Ben Bernanke called a press conference and announced the Fed was adopting this new monetary regime.  This announcement would send shock waves through  the markets.  Portfolios would automatically adjust toward riskier assets in anticipation of the Fed actually doing these conditional LSAPs.   This would raise asset prices and raised expectations of future nominal income growth.  Current aggregate nominal spending would respond to these developments, helping push NGDP to its targeted path and thus reduce the onus on the Fed to do LSAPs.  In short, a conditional LSAP program tied to an explicit NGDP level target would be a significantly different and far more effective monetary program than any of the LSAPs the Fed has tried so far.

The nice thing about this target is that though it allows rapid catch-up growth in nominal spending it also provides a firm nominal anchor since it is a level target.  Nominal GDP growth that exceeded the  targeted growth path would be corrected too.  Long-run inflation expectations, therefore, would not become unanchored. This would minimize concerns about the Fed's balance sheet. Also, a sharp recovery brought about by a NGDP level target would increase the denominator in the debt/GDP ratio and slow down the growth in the numerator as the cyclical deficit disappeared.  These action would make it less likely a fiscal crisis would emerge in the first place.

I also think that Hamilton's concerns about reducing the average maturity of the public debt are overstated.  It is one thing if the U.S. Treasury moved all of its debt into short-term securities.  That would increase the stock of short-term treasuries and make the U.S. government more susceptible to higher financing costs should a fiscal crisis emerge.  The Fed doing LSAPs, on the other hand, shortens the average maturity but does not increase the stock of short-term treasuries.  If anything, LSAPs makes financing costs easier for the Treasury by removing from the public the longer-term securities the Fed purchases.¹ Moreover, given the huge global shortage of safe assets and the ability of the Fed to finance Treasury if needed, it seems unlikely that a fiscal crisis will emerge anytime soon.

So there you have it.  Monetary policy change that James Hamilton can believe in.

¹Bank reserves which now earn interest and are a close substitutes for short-term treasuries would increase with LSAPs.  But the Fed can adjust what it pays on reserves and the nominal anchoring a NGDP level target provides should prevent  the growth of reserves from becoming a problem.

The Best Fed News of the Week

Matthew O'Brien reports in the Atlantic that one important Fed official has taken the NGDP plunge:  

Chicago Federal Reserve president Charles Evans doesn't look the part of a heretic. But in the cozy, conservative club that is central banking, he certainly qualifies. While most of his colleagues at the Fed have recently taken an even more hawkish turn, Evans remains a champion of additional monetary stimulus. And on Tuesday he took an even bigger step: He became the first sitting Fed member to endorse nominal GDP (NGDP) level targeting. 

This is encouraging news, but not too surprising for Charles Evans. He previously called for the Fed keep the target federal funds rate low until unemployment fell below 7% or inflation tops 3%.  NGDP level targeting is a way of doing that without unmooring long-term inflation expectations.  

The Fed is still a long way off, if ever, from adopting an NGDP level target. But Evans' endorsement of the idea is a big first step in what could be a hugely important paradigm shift. Even if there isn't a large difference between the quasi-NGDP level target that is the Evans Rule and an actual NGDP level target, it's a fairly radical new way of framing policy. Rather than the central bank letting the economy recover faster, it puts the onus for a faster recovery on the central bank. 

I hope O'Brien is right that Charles Evans will serve as a NGDP level targeting-is-cool catalyst at the Fed.  Maybe he can help Fed chairman Ben Bernanke revert back to his old academic self and take the NGDP plunge too.  If that were to happen Janet Yellen would probably follow too.  Throw in some NGDP-friendly recess appoints by President Obama and Scott Sumners and I can stop blogging!  

P.S. In another article Matthew O'Brien reports the worst Fed news of the week:  President Obama's failure to do NGDP-friendly recess appoints to the Fed.

P.S.S. I think David Andolfatto is at least open to NGDP level targeting.  If he takes the plunge then James Bullard might take the idea more seriously too.

David Andolfatto Can Feel More Confident About NGDP Targeting

David Andolfatto recently asked the following question about nominal GDP (NGDP) level targeting:

What is the theoretical underpinning for NGDP targeting? And what is the empirical evidence that leads them to believe that an NGDP target right now is a cure for whatever ails us right now?

He wants to know why proponents of NGDP level targeting are so confident that it would help the sluggish economy. Nick Rowe, Scott Sumner, David Glasner, Bill Woolsey, Mark Thoma, and Jason Raves replied to Andolfatto's first question by providing theoretical justifications for being confident.  Here I want to focus on his second question, but before doing that let me quickly note two important creditor-debtor problems that a NGDP level target would overcome in the current crisis.

The first problem is restoring the expected relationship between creditors and debtors that prevailed prior to the economic crisis.  This is the 'risk sharing' problem recognized by David Andolfatto that a price level or strict inflation target cannot address.   A NGDP level target would solve this problem by restoring nominal incomes to their expected pre-crisis paths when debtors signed their nominal debt contracts.    It is possible for nominal debt contracts to be renegotiated, but as Steve Randy Waldman notes this is very difficult in practice. 

The second problem is that there is a massive coordination failure among creditors now.  Creditors could increase their spending to offset the debtor's drop in spending as the latter deleverages.  The reason creditors have not--non-bank creditors are 'sitting' on money assets while bank creditors are destroying them as they are acquired from the deleveraging debtors--is because they are uncertain about future economic activity. These actions by creditors create an excess demand for money or, equivalently, a shortage of safe assets. Now imagine that something simultaneously catalyzed creditors' expectations such that it got them to start using and creating money assets again. The excess money demand problem would disappear and there would be a recovery.  Enter a NGDP level target and its ability to shape expectations.  If credible, this target would raise expected aggregate nominal spending and, in turn, raise expected aggregate nominal income.  It would also probably lead to a temporary surge in inflation.  All would reduce excess money demand by creditors and spark a nominal spending recovery.    

Okay, so what is the empirical evidence that a higher level of NGDP would make a difference now?   The most obvious answer is that those advanced economies currently doing the best are the ones where aggregate nominal spending has remained on or near its pre-crisis trend.  Case in point is Germany.  Its NGDP has remained very close to its pre-crisis trend and consequently, its economy is doing relatively well.  The German unemployment rate has actually fallen since the crisis and consumer confidence is holding up (though slightly down in recent months).  The rest of the Eurozone has not remained close to its pre-crisis trend and we all know how well things are going there.  From this perspective, the Eurozone crisis is nothing more than a NGDP crisis.  (Yes, the Eurozone is a structurally flawed currency union and some countries like Greece are serially defaulters, but Spain and  France? This figure says it all.)

The table below shows the NGDP gap (% deviation from pre-crisis trend) and the unemployment rate for a number of advanced economies.  The data comes from Fred and where possible harmonized unemployment rates are used.  Look closely and you should see a relationship between the two series.

In case the relationship is not clear, here are the two series placed in a scatterplot.  The figure shows that those countries with NGDP closer to their pre-crisis trend typically have lower unemployment rates.   

The fitted line in this scatterplot indicates that a 1% decline in the NGDP gap will reduce the unemployment rate by 0.325%.  That implies the United States could lower its unemployment rate by almost 2% if it closed the NGDP Gap.

Another bit of evidence that suggests a higher level of NGDP would help the current economy is the figure below.  It shows the relationship between the NGDP gap and the risk premium as measured by the Moody's BAA yield - 20 year treasury yield spread.¹   This figure indicates that a higher level of NGDP would lower the risk premium.  In other words, the shock to commitment that makes it so hard to privately produce safe assets now would be mitigated by a higher level of NGDP.  This too would reduce the excess money demand problem and spur economic recovery.

A final but important piece of evidence is FDR's very own QE program in 1933.  He had publicly called for the price level to return to its pre-crisis trend and then backed up the rhetoric with a devaluation of the dollar (relative to gold).  As Gautti Eggertson shows, this policy dramatically altered expectations and sparked a robust recovery in 1933.  This implicit price level target of FDRs was  no different than a NGDP level target in this case.  It required radically altering expectations and then being willing to act upon it.  A NGDP level target would do the same today.  It would commit the Fed to buying up as many assets as needed to restore aggregate nominal spending to some pre-crisis trend.  Just the expectation of the Fed doing that may itself cause the market to do much of the heavy lifting.  Portfolios would automatically adjust from lower-yielding safe assets to higher-yielding riskier assets. This portfolio adjustment by itself would raise asset prices and reinforce the recovery.

And what is the downside?  What if adopting a NGDP level target does not improve the economy?  The upshot here is that with a level target there is still a strong nominal anchor in place.  The NGDP level target allows rapid catch-up growth (or contraction) in nominal spending without causing long-run inflation expectations to become unmoored.  Thus, there is far less risk in trying NGDP level targeting than many observers assume.  

¹ The 20 year treasury yield is not available for part of the 1980s and 1990s.  This period's yield was estimated using the 10-year treasury yield.