Is the 20-Year Inflation Targeting Detour About to End?

Harvard's Jeffrey Frankel says nominal GDP targeting's time has finally come:

It is time for the world’s major central banks to reconsider how they conduct monetary policy... Monetary policymakers in some countries should contemplate a shift toward targeting nominal GDP – a switch that could be phased in gradually in such a way as to preserve credibility with respect to inflation. Indeed, for many advanced economies, in particular, a nominal-GDP target is clearly superior to the status quo.

Central banks announce rules or targets in terms of some economic variable in order to communicate their intentions to the public, ensure accountability, and anchor expectations. They have fixed the price of gold (under the gold standard); targeted the money supply (during monetarism’s early-1980’s heyday); and targeted the exchange rate (which helped emerging markets to overcome very high inflation in the 1980’s, and was used by European Union members in the 1990’s, during the move toward monetary union). Each of these plans eventually foundered, whether on a shortage of gold, shifts in demand for money, or a decade of speculative attacks that dislodged currencies.

The conventional wisdom for the past decade has been that inflation targeting – that is, announcing a growth target for consumer prices – provides the best framework for monetary policy. But the global financial crisis that began in 2008 revealed some drawbacks to inflation targeting...A nominal-GDP target’s advantage relative to an inflation target is its robustness, particularly with respect to supply shocks and terms-of-trade shocks.

Frankel reminds us that NGDP was first widely discussed in the 1980s, but then fell out of vogue with the advent of inflation targeting in the early 1990s.  Recent developments indicate that this almost 20-year detour into inflation targeting may now be ending as noted  by Matt O'Brien over at the Atlantic:

It's okay if you have that Animal Farm feeling. There's been a revolution, but nothing has changed. The Fed still thinks it's first rate hike will come in 2015-ish, and it's still buying $85 billion of bonds a month. This is a true fact. But it undersells the intellectual shift at the Fed. It's gone from mostly thinking about inflation to creating a framework to guide its thinking about inflation and unemployment. And it's done that in just a year. This framework, the Evans rule, is really just a quasi-NGDP target. It's not exactly the catchiest of phrases, but NGDP, or nominal GDP, targeting would be a real revolution in central banking. In plain English, it's the idea that central banks should target the size of the economy, unadjusted for inflation, and make up for any past over-or-undershooting. In theory, a flexible enough inflation target should mimic an NGDP target, which is why the Evans rule is so historic. It's an incremental step on the way to regime change at the Fed.

That doesn't mean we should expect the Fed to move towards NGDP targeting anytime soon. A risk-averse institution like the Fed will want to see another country try it first -- and it might get that chance soon. Incoming Bank of England chief Mark Carney, who currently heads the Bank of Canada, endorsed the idea in a recent speech, and British Treasury officials indicated they might be open to it too -- which is significant because the British Treasury can unilaterally change its central bank's mandate. It might not be long till NGDP targeting comes to Britain, and from there, the world. If it does, you can be sure that Charles Evans will be figuring out how to make it work here.

Big changes are afoot in the central banking world.  My guess is that by 2020 most large, advanced economies will be doing some kind of NGDP targeting. 

Latest Article in the Atlantic

Ramesh Ponnuru and I have a new article in the Atlantic where we argue concerns about the fiscal cliff are exaggerated if the Fed continues to stabilize nominal spending.  We note two experiences that support this notion:

The Bank of England vividly demonstrated the power of central banks to offset fiscal policy at the dawn of the Thatcher era. In 1981 her government introduced a budget that would sharply reduce the deficit in the midst of a recession. Most economists opposed it on Keynesian grounds, with 364 of them signing a now-famous letter arguing there was "no basis in economic theory or supporting evidence" for it. Yet the Thatcher government implemented its plan and by late 1981 the economy was recovering. The Bank of England at the same time had begun a cycle of monetary policy easing, and the economists had underestimated its effects.

Something similar happened in Canada in the mid-1990s. After running several decades of budget deficits that had led to a debt-to-GDP ratio of 70 percent in 1995, then-Finance Minister Paul Martin introduced a budget plan that began a half decade of reducing the federal budget, largely through cuts in spending. This fiscal tightening led to budget surpluses by the early 2000s. As in the British case, the Bank of Canada eased monetary policy over the same time, offsetting any fiscal drag. The economy performed nicely.

The same outcome is possible for the U.S. fiscal cliff, but would require the Fed to adopt a NGDP level target.  Reihan Salam provides a smart follow-up discussion here.

P.S. This 2010 IMF article lends further support to our claim.  It shows that countries undertaking fiscal consolidation do much better when monetary policy accommodates it.

Historic Times for Monetary Policy

This past summer Ramesh Ponnuru and I wrote that it is time for monetary regime change:

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 argued that NGDP level targeting is the new monetary regime needed. Since we wrote this piece, there have been some major changes in Fed policy that have increased the likelihood of this approach becoming reality.  First, the Fed decided at its September FOMC meeting to start a new large-scale asset purchase program, QE3, conditional on the state of the economy, rather than tie it to a specific dollar amount up front. This conditionality approach was a vast improvement over previous QE programs in that it better tied expectations of future monetary policy to economic outcomes, similar to NGDP level target.  QE3, however, was linked to the vague objectives of "labor market improvements...in the context of price stability."  More clarity was needed to for this program to fully utilize the power of expectations management.

Today the FOMC unexpectedly did just that. It tied QE3--or more accurately QE Flex since it now includes both MBS and treasury purchases--to the specific targets of 6.5% unemployment rate and 2.5% inflation. This is huge. It makes very clear to the public that the Fed will not stop until these targets are hit. Markets, in turn, should respond in anticipation of these goals being hit.  That is, the elevated demand for liquid assets should start declining as households and firms start moving their funds into higher yielding assets. This rebalancing should raise asset prices, help repair balance sheets, and ultimately spur nominal spending.  In other words, by better managing expectations, the Fed should cause the public to do the heavy lifting--and they already have started.  If all goes according to plan, the Fed may not have to actually purchase that many additional assets.  Ironically, this means that had the Fed been doing this all along its balance sheet would be much smaller now.

So this announcement is big news and fundamentally changes how U.S. monetary policy gets conducted.  Matt Yglesias sums it nicely up as only he can:

With today's policy announcement, the Federal Reserve's Open Market Committee has stopped screwing around and started doing real expectations-based monetary easing.

Indeed.  But the transformation is not complete. The Fed needs to take the final step and adopt an explicit NGDP level target.  The new unemployment rate and inflation targets get us closer to this ideal, but as Michael Woodford notes they are not the same. The Fed can only target nominal variables in the long-run and that is where it emphasis should ultimately be. A NGDP level target would do just that.

Interestingly, the Fed's actions today were not the only winds of change bearing down on monetary policy this week. Current Bank of Canada governor and future Bank of England governor Mark Carney came out and endorsed NGDP level targeting in a speech. Wow! It was not so long ago he was against it. These ongoing developments all point to a sea change in how monetary policy gets conducted. These truly are historic changes.

Update: Let me clear that I am not a proponent of targeting real variables, especially the unemployment rate.  But let's keep things in perspective.  First, if high unemployment is structural then the new asset purchases will cause inflation to hits its target and the Fed will be forced to tighten.  Second, given the Fed already embarked on this path with QE3, these explicit thresholds make the Fed more accountable and transparent. Finally, these thresholds are presumably just a halfway step to a full NGDPLT.

Marco Rubio, the GOP, and NGDP Level Targeting

One of the hardest points to make to my fellow conservatives is that Fed policy actually has not been easy over the past four years. Yes, monetary policy has been ad-hoc, unpredictable, and appears to have been hyperactive with its large-scale asset purchases. Despite these actions, the Fed has failed to reduce the elevated demand for liquid assets. This is evident in the seemingly insatiable appetite for treasuries that is keeping yields at historic lows and in the latest Flow of Funds data that shows households are still holding an inordinate share of liquid assets in their portfolios.¹ As Bernanke notes, though, the Fed is actually capable of addressing this problem in a systematic, rule-based fashion but has failed to do so. This failure amounts to a passive tightening of monetary policy.  

One reason for this failure is the political pressure the GOP has placed on the Fed.  Most in the GOP think the Fed has been too easy and want it to do less.  Specifically, many in the GOP want to narrow the Fed's mandate to just inflation targeting.  Senator Marco Rubio is the latest to push this view.  Matt O'brien agrees with Rubio that the Fed's mandate needs to be narrowed, but in a different way:

But Rubio is right that the Fed needs a better, clearer monetary rule nowadays... Imagine the Fed had a single mandate, but not for inflation. Imagine instead the Fed had a single mandate for the total size of the economy, which goes by the unwieldy name of nominal GDP (NGDP). During the Great Moderation, NGDP grew about 5 percent a year, but it's only grown about 2.85 percent a year since 2008. If the Fed had an NGDP target of 5 percent a year, and was supposed to make up for any over-or-undershooting, it would have been aggressively easing the entire time since 2008. It's a dual mandate that doesn't get confused by low inflation and low growth. 

O'brien is correct that a NGDP level target is a superior way to narrow the Fed's mandate.  Unlike an inflation target, it is not susceptible to misinterpreting supply shocks and systematically accounts for past policy mistakes.  NGDP level targeting also increases the transparency of the Fed, makes its actions more predictable, and reduces the need for countercyclical fiscal policy. It is a GOP dream.  Republicans should be out in front of this idea, promoting it vigorously. They could start by reading this paper.

¹Don't even think of blaming the Fed for the low yields on treasury yields.  

The Deeper Secrets of the NFIB

Much ado is being made about the drop in the NFIB small business optimism index.  While interesting, this index is just one part of the larger NFIB Small Business Economic Trends survey that contains a trove of other information.  In fact, a little digging into this survey can shed some light on the nature of the ongoing economic slump. This is because the survey asks firms what specific developments they see as the "single most important problem" they face. This question, in my view, is the more important than the news-making small business optimism index because it tells us why firms feel more or less optimistic. Knowing this information better informs what the appropriate policy response should be to the ongoing slump.  Unfortunately, it rarely makes the headlines.  This post is an attempt to correct this shortcoming.

So what does this survey show for this question? There are a number of answers from which firms can chose.  Below is a graph that shows some of their responses.  

Money Still Matters: Part XIV

Several recent articles have made the case that monetary policy should not ignore information about the stance of monetary policy found in a properly specified measure of the money supply.  Properly specified means (1) appropriately grouping monetary assets into aggregates based on how money-like they are and (2) recognizing that there are both retail and institutional money assets. Standard measures of money like M2 ignore both issues.  The graph above shows monetary aggregates from the Center for Financial Stability that do account for both.  

Peter Ireland made the case for these measures at the most recent Shadow Open Market Committee while Doug Irwin did so on the pages of the Financial Times.  Steve Hanke, meanwhile, invokes them to warn that the Fed may be undermining their growth by imposing stricter bank capital requirements.  My own thoughts on properly measuring money can be found to right under the "Safe Assets, Money, and the Great Recession" header.

Update I: Just to be clear, I am not advocating money supply targeting.  I still prefer a NGDP level target.

Update II:  Michael Belongia reminds me that the targeting the money supply--an intermediate target--should not be confused with the ultimate goal of monetary policy, stable NGDP growth. Point taken. See his paper with Peter Ireland where they show how the Fed could implement NGDP targeting by stabilizing a Divisia measure of the money supply.

Paul Krugman Will Not Like These Figures

[See update below]
See if you can figure out why:

Source 

This first figure shows that aggregate demand growth has not been affected by a tightening of fiscal policy since 2010.  Specifically, it shows that nominal GDP (NGDP) growth has been remarkably stable since about mid-2010 despite a contraction in federal government expenditures. The same story emerges if we look at the budget deficit relative to NGDP growth:

Source

Both figures seriously undermine the argument for coutercyclical fiscal policy and suggest a very a low fiscal multiplier.  They also indicate that the Fed has been doing a remarkable job keeping NGDP growth stable around 4.5%. Monetary policy, in other words, appears to be dominating fiscal policy in terms of stabilizing aggregate demand growth.  This in turn implies that the Fiscal Cliff should not be a big deal if the Fed continues to stabilize NGDP growth around 4.5%. Yes, there would still be distributional and incentive changes if fiscal consolidation occurs, but the fiscal tightening itself should have no bearing on aggregate demand if the Fed continues to do its job. As I noted before, the Fed is the other solution to the Fiscal Cliff.  Lars Christensen agrees.

P.S. Though the Fed has been doing a remarkable job keeping NGDP growth stable since mid-2010, it has yet to allow a period of catch-up nominal spending growth that would return NGDP to its pre-crisis trend. So the Fed's work is not complete.

Update: Noah Smith and Daniel Kuehn provide some pushback to this post. Noah invokes Nick Rowe's thermostat reasoning to conclude the graphs could be consistent with a large fiscal multiplier.  That is a possibility, but given what we know about fiscal policy and the last two years his alternative story does not fit.  The economy has been hit by multiple negative shocks--Eurozone crisis, 2011 debt cliff talks, concerns about China slowdown--over the past few years that have kept demand for safe assets elevated and thus the economy below full employment.  For Noah's interpretation to work fiscal policy must be nimble enough to counter these shocks as they happen. That hasn't happened; fiscal policy is clumsy and has been winding down despite these shocks and despite the consternation of Paul Krugman who has endlessly complained that it hasn't been enough.

Daniel, on the other hand, thinks if we put the variables on the same scale all is well.  No, here are total federal expenditures and NGDP in the same growth rate form and in dollar levels. In both cases, total federal expenditures have been trending down since 2010. 

The Fed, The Budget Deficit, and The Facts

My last post generated some heated push back from the hard-money types.  That post showed the Fed sill has about the same share of treasuries, 15%, as it did before the crisis.  Thus, the large run up in public debt over the past four years has been funded mostly by individuals, their financial intermediaries, and foreigners.  The Fed has not been the great enabler of the government deficits as claimed by the hard-money types.  This fact seems to have been very uncomfortable for them because they largely ignored it.  Instead, they quibbled with my definition of debt monetization and resorted to ad-hominen attacks. 

Given these responses, it is probably too much to hope for further meaningful engagement with them. But in the event some are still listening, here are some additional points I hope they consider.

First, safe asset yields across the globe have been falling for the past four years.  Even more remarkable, is that the yields have been falling in a similar pattern.  This can be seen in the figure below which shows the long-term government yields for Canada, Germany, Japan, the United States, and the United Kingdom.  U.S. monetary policy cannot explain this worldwide phenomenon. 

 

It was already hard to explain the decline in U.S. yields by looking to U.S. monetary policy.  The Fed only holds about 32% of long-term treasuries and the long decline began well before Operation Twist.  The similar decline among all these different long-term government interest rates only further undermines the view that Fed is enabling the low U.S. treasury yields.  A much simpler explanation for the low interest rates is the ongoing economic slump that keeps the demand for safe assets elevated.  

Second, the Fed and U.S. Treasury Department have been pursuing opposite objectives with regard to the maturity of the publicly-held debt.  The Fed has been trying to shorten the maturity with Operation Twist while the Treasury Department has been trying to extend it.  The figure below sums up this tension nicely. It shows the average maturity of marketable debt has been growing and is projected to grow more.  Thus, the Treasury is offsetting the Fed's Operation Twist efforts and will continue to do so.  Surely if the Fed was working to enable the budget deficits it would coordinate with the Treasury department.

Third, even if the Fed were responsible for the low yields it has failed to generate upward inflationary pressures.  For four years hard-money types have been warning about inflation exploding.  This has not happened and indicates that treasury yields are not being held below their natural rate level, the interest rate consistent with the economic fundamentals. This indicates that should the Fed preemptively raise interest rates, as some have suggested, it would not spark a recovery but choke the already weak economy.

Fourth, the hard-money types have overlooked the safe asset shortage problem that has emerged over the past few decades and its implication for U.S. treasuries.  Over this time the global economy has grown much faster than its ability to produce safe assets.  As a consequence, the world has been turning increasingly to the U.S. financial system to create safe assets, particularly U.S. treasuries.  This means the demand for U.S. debt is higher than would otherwise be the case.  It also means for the world financial system to operate smoothly it needs the U.S. government to run budget deficits.  A failure to do so will only drive safe asset yields lower and intensify the all the problems associated with low interest rates. The crisis has only intensified this development.  This means that the rest of the world may continue to enable our budget deficits for some time.

Finally, my view of debt monetization is that it occurs when monetary policy causes the stock of money assets to unexpectedly exceed the real demand for them.  When that happens, the resulting inflation will be higher than anticipated and erode the real burden of the public debt.  This increase in the money supply may also temporarily push interest rates lower and reduce the government's financing costs.  Note, though, for there to be debt monetization it is not enough to say the Fed is purchasing treasury assets.  Such purchases could simply be keeping the money supply in line with real money demand.  Asset purchases by the Fed, therefore, do not necessarily lead to debt monetization.  In fact, the evidence currently points to the opposite problem, an excess demand for money assets. 

For all these reasons, I find it hard to stomach the claims of folks who say the Fed is enabling the large budget deficits.  One such claim by former Fed officials is what motivated the previous post. Equally troubling is this one from the Shadow Open Market Comittee:

The Fed is facilitating the government’s massive deficit spending by lowering the government’s debt service costs and by neutering market discipline on fiscal policy... the Fed is effectively preventing the fixed income markets from sending out warnings about fiscal policy and disciplining policymakers. The “bond vigilantes” of the past that effectively disciplined Washington have been pushed to the sidelines. The old adage “don’t fight the Fed” certainly rings true when the Fed is the biggest holder and purchaser of US Treasury bonds, signals its intentions to keep bond yields low until labor markets improve significantly, and expresses its tolerance—and even advocacy—of a rise in inflation above its stated target.

These type of wild claims that point to debt monetization simply do not stand up to the data.  I agree we need a conversation on what the Fed should be doing, but before we can even do that we need to have our facts right.  Here is hoping this post is a push in that direction.

The Biggest Myth About the Fed

There many myths about Fed policy over the past few years, but the biggest one has to be that the Fed has been monetizing the national debt.  This simply is not true, but it does not stop some folks from making this claim.  For example, at last week's Cato Monetary Conference we find former Fed officials pounding the Fed-is-monetizing-the-debt drums:

Mr Warsh and Mr Poole (who was filling in for Allan Meltzer) made a sharp distinction between the “legitimate” efforts to fight the crisis and the subsequent easing actions that were, allegedly, unjustified by the economic fundamentals. According to them, the interventions of 2007-2009 were required to ensure that “the markets could clear”, as Mr Warsh put it, while the second round of easing was done to satisfy “political masters” by monetising the debt. In fact, Mr Warsh said that the Fed was being actively unhelpful by “crowding in” Congress’s supposedly poor policy choices.

My first response is how can they can say this with historically-low U.S. treasury yields and muted inflation expectations? Surely, if the Fed were truly monetizing the debt we would be seeing a 1970s-repeat in the bond market, but we are not.  And this is happening, in part, because the Fed is not that big of a treasury purchaser.  Consider the figure below.  It shows the Fed's stock of treasuries by remaining maturity compared to the total stock of marketable treasuries as of the end of October, 2012.  Though the Fed's share of treasuries increases by remaining maturity, at most it hits 32% of the total for 10-30 years category. That means that after many months of Operation Twist that roughly 68% of long-term treasuries are still held outside the Fed. Overall, the Fed holds about 15% of marketable treasuries as seen in the "All Years" category.  It is hard to square these numbers with the allegations that the Fed is monetizing the debt.

Some commentators like to focus on the change in treasury holdings in 2011 because it sounds so scary.  Here is Arnold Kling:

In 2011, the Federal Reserve bought 77 percent of new debt issued by our government. We are already resorting to inflationary finance.

While the Fed did purchase a large share of new treasuries in 2011, these purchases only returned the Fed's share of total marketable treasuries to its pre-crisis level as seen below.  Again, not exactly a picture of debt monetization.

So stop accusing the Fed of monetizing the debt and enabling the large budget deficits.  And stop blaming the Fed for the long decline in treasury yields.  If anything, blame the Fed for allowing treasury interest rates to fall, but that is a different story.

Update: JP Koning says we need to carefully define what debt monetization means.

There Is No Fiscal Slope

Households and firms make economic decisions based on how they expect the future to unfold.  If households expect higher future incomes they are more likely to increase consumption spending today. Likewise, if firms expect higher future sales they are more likely to increase investment spending today. Economic expectations are therefore key to understanding current decisions about aggregate nominal spending. They are also why I think it is is a mistake to talk about a "fiscal slope" like this:

But there is not really any kind of “cliff” in the sense that if you stepped over the edge, you would fall fast, land on something hard, and not get up for a long time. In the modern US economy, the scheduled changes constitute more of a fiscal “slope” – meaning that the full effect of the tax increases would not be felt immediately (income withholding takes time to adjust), while the spending cuts would also be phased in (the government has some discretion regarding implementation). 

If households and firms expect the economy to get much worse because of this fiscal tightening--and they have no reason not to given all of media coverage--it does not matter that it is will unfold slowly over next year. They will change their behavior today in anticipation of this fiscal cliff and make it a self-fulfilling outcome.  So unless the Fed offsets the fiscal tightening, there is no fiscal slope.  It is a pipe dream.

This understanding may shed some light on recent developments in expected inflation that have folks like Ryan Avent worried. Expected inflation, as measured by treasury breakeven rates, during this crisis has been a good indicator of the market's economic outlook. Higher expected inflation implies higher future nominal spending. Given the current slack and nominal rigidities, higher expected nominal spending in turn implies higher future real economic growth. That is why the stock market has closely tracked this indicator over the crisis as seen below:

 But lately expected inflation has been falling.  Here is Ryan Avent:

[S]ince mid-October, there has been an unmistakable reversal in the inflation-expectations trend. Based on 5-year breakevens, all of the September spurt has been erased. And 2-year breakevens are back at July levels. Given my optimism over the Fed's September moves and the apparent strength of underlying fundamentals in the economy, I would like to disregard this trend, but one should be very reluctant to abandon guideposts that have served one well just because they've moved in an inconvenient way.

Avent goes on to speculate why expected inflation would be falling now. He cites as possible explanations an expected economic slowdown elsewhere in the world or the breakdown of the relationship between expected inflation and demand growth.  There is a third alternative: markets in mid-October began to price in the increasing likelihood of the fiscal cliff materializing since they realized President Obama was probably going to win reelection.  This fits nicely with the fact that the decline in expected inflation is being matched by a sustained fall in the stock market, indicating the relationship is still strong.  This can be seen in the figure above or in the close up below:

If this interpretations is correct, then it supports the view that it is a mistake to hope for a fiscal slope.  Expectations matter.

There is Another Solution to the Fiscal Cliff

Have the Federal Reserve work to offset every dollar drop in federal spending with a dollar increase in private sector spending.  The Fed would incentivize the private sector to do this by raising expected future nominal income growth via aggressive open market operations or by helicopter drops.  Rapidly raising the public's expectations of future nominal income growth would cause household and firms to increase current spending and offset the decline in federal spending.  Aggressive open market operations could look like this and helicopters drops like this. The point is, the Fed is capable of keeping total current dollar spending stable if really wanted to do so.  In fact, this stabilizing of nominal spending by the Fed has a name: nominal GDP level targeting.  With a credible version of this target, the Fiscal Cliff should not be a big a deal.  The only question is whether the Fed will act.

Along these lines, Michael Darda of MKM Partners had this to say:

NGDP growth has been quite steady at about 4% per annum despite a 200-300bps swing in the fiscal deficit over the last several years and, over the last five quarters, the weakest real government spending growth since the Eisenhower era. The steadiness of NGDP since 2010 suggests that the Sumner critique is still operative, even at the zero lower bound on short rates. The Sumner critique states that fiscal multipliers converge toward zero if a central bank is NGDP or inflation. In other words, the central bank shifts policy in a way that offsets the effect of spending/tax changes on aggregate demand, or MV. Although the Fed does not currently target a path for NGDP, it is aiming for its dual-mandate contingency based on its forecast of how NGDP growth will evolve: While the Fed cannot currently cut rates to offset a shock, it can ramp up QE (or commit to making some portion of the monetary base permanent) to increase the money supply or to check a decline in velocity. Perhaps this also a reason to not worry too much about demand-side implications of the so-called “fiscal cliff” (assuming Bernanke will do enough QE to offset any potential drag on MV from the cliff).

Come on Fed, you can do this.  Save us from the Fiscal Cliff.

P.S. Yes, I know a helicopter drop is really fiscal policy, but it probably needs to be initiated by Fed operation to make it politically viable. 

A Great Vacation or a Great Recession?

[Update: Beveridge Curve analysis added below]

Casey Mulligan is back:

A high ratio of unemployed to job openings means that the unemployed are competing a lot for jobs, many news reports say, when in fact it could indicate the opposite.

It’s true that a reduction in labor demand — from, say, a new tax on employers — would motivate employers to get by with fewer employees. As they do, employers would reduce job openings and lay off workers. One result would be fewer job openings and more unemployed people, and thereby more unemployed people per job opening.

But a reduction in labor supply in the form of additional subsidies for unemployed people would have similar effects. Unemployed people would be choosier about the jobs they accept, especially the low-wage ones. With more help for people after layoffs, employers and employees in struggling industries would do less to avoid layoffs, especially layoffs from low-paying positions. Either way the result would be more unemployed people.

I agree that labor supply incentives matter, but fail to see this as an important explanation for the weak recovery. Most of the evidence I have seen suggests weak labor demand and demographics to be the more important story in labor markets over the past few years.  In regards to Mulligan's specific claims above, unemployment across all groups has been slow to come down, not just with the low-skill laborers looking for low-paying jobs. For example, college-educated individuals have seen similar changes in their unemployment rate as the nation overall.  

Weak labor demand is a powerful explanation for much of these developments and is borne out by the data from the NFIB's Small Business Economic Trend survey.  Among other things, this survey asks firms what is the single most important problem they face.  The answers to this question include government regulation, taxes, inflation, labor quality, labor costs, financing costs, etc. The number one answer over the past few years has been concerns over a lack of sales (though regulatory concerns have been growing).  Labor concerns are near the bottom of this list, not something one would expect if the labor market distortions were as important as Mulligan thinks they are.  What is even more remarkable about this finding is that how close concerns about the lack of sales fits to changes in the unemployment rate:

Note how sales concerns tend to lead the unemployment rate.  No other small business concern has this relationship with the unemployment rate.  The easiest way to interpret this finding is that owing to weak aggregate nominal expenditures growth during the Great Recession firms were reluctant to hire workers and, as a consequence, the unemployment rate rose.  Now, with sales concerns falling, these firms are hiring more and the unemployment rate is falling.

As noted above, weak labor demand is not the whole story.  Demographics are important too as shown by the Kansas City Fed, Chicago Fed, CBO, and the Center on Budget and Policy Priorities.  The point here is that changes in the labor force over the past few years can be explained in part by long-term trends in the baby-boom population.  Specifically, many of them are now retiring which is causing the labor participation rate to shrink.  This is why observers should be careful when looking at measures like the employment-population ratio which currently is flat lining at its new low even as the unemployment rate falls.  Some might conclude this is because of structural changes in the labor market.  But looking at the employment-population ratio for prime-age workers (which controls for retiring baby boomers) in the age bracket of 25-54 years shows that this ratio is recovering in a pattern similar to that of unemployment:

So between weak labor demand and demographics, most labor market developments over the past few years can be explained.  There is no need to resort to implausibly large labor supply effects arising from distortionary government policies.  There is no doubt in my mind that these effects are there--incentives matter--but it is hard to believe they are large. There are far easier ways to explain the Great Recession than claiming it was a Great Vacation.

Update: Below is a modified Beveridge Curve. It shows the relationship between employment and   job vacancies.  Presumably, employment would rise with increasing job vacancies. Following Soberlook, I have drawn the Beveridge Curve with job vacancies plotted against the employment to population ratio for prime age workers (to avoid the demographic changes noted above).  

The figure shows the expected positive relationship up through August 2009, after which it seems to break down for about 20 months.  Some have attributed this to structural shifts in the economy.  However, this figure also shows that the relationship picks back up in early 2011 as seen with the red triangles.  I am not sure how to interpret the black diamond period, but given the return of the relationship I would wary to attribute it to structural shifts.  Especially with studies like these.

Bond Vigilantes and the Risk Premium

Some folks seem to be having a hard time with my previous post, bond vigilantes to the rescue.  They assume that there could be an actual default by the U.S. Treasury Department that would be reflected in a rising risk premium. While this is certainly possible, I find it highly unlikely since the U.S. government could always  print dollars to buy up its debt.  It could gradually "monetize the debt" and allow slightly higher inflation to slowly erode the burden of the national debt as it did after World War II.  This is, in my view, the most likely worst-case scenario, not an outright default.  The real risk for treasury holders then is a higher inflation risk premium, not a higher risk premium. 

But even this outcome seems unlikely in the near term.  The most likely development treasury holders face over the next year or so is a temporary bout of higher-than-expected inflation associated with Fed easing or more rapid economic growth.  This was the premise of my post, not an outright default.  Given my view that a robust recovery has not taken hold because the demand for safe assets remains elevated (i.e. portfolios remain overly weighted to low yielding, liquid assets), a temporary rise in inflation would cause the much needed treasury sell off that would start a recovery.  That is, treasury holders would sell their treasuries and other safe assets and move into riskier, higher yielding assets. We already see this in the relationship between expected inflation (using 10-year treasury breakeven) and stock prices.  The treasury sell off, therefore, would catalyze the rebalancing needed for a strong recovery. 

Note in this story, the risk premium would actually fall with the recovery.  Currently, it is too high as indicated in this post and as suggested by the figure below from Ed Bradford.  The figure shows the S&P500 earnings yield less the 20-year treasury yield.  This equity risk premium spread has been hovering around 5% over the past two years which seems unreasonably high. 

These indicators of inordinately high risk premiums correspond to the ongoing high demand for safe assets. Once the demand for safe assets is normalized--via the portfolio rebalancing--these risk premiums should decline too.

Bond Vigilantes To the Rescue

Paul Krugman claims that should the much-dreaded bond vigilantes show up, they actually would be good for the economy.  He notes that unlike Greece, the United States has its debt denominated in its own floating currency.  Consequently, the appearance of bond vigilantes would lead to an expansionary decline in the value of the dollar, not a contractionary rise in interest rates.  Tyler Cowen is not buying this story, but Nick Rowe sees some merit in it.  I do too, but from a slightly different perspective.  

Currently, investors around the world have their portfolios inordinately weighted toward safe, liquid assets.  This is because of the ongoing economic uncertainty caused by the Eurozone crisis, fiscal cliff, China slowdown, etc.  They also have a seemingly insatiable demand for these safe assets as evidenced by the ongoing decline in their yields across the globe (see below).  These developments, however, mean that investors are avoiding higher yielding, riskier assets more so than normal. Consequently, these unbalanced portfolios are suppressing asset prices, keeping household balance sheets weak, and ultimately are holding back robust aggregate nominal spending.  Another way of saying this is that risk premiums are currently too high relative to fundamentals.  

 Source

The appearance of bond vigilantes would indicate their economic outlook has changed and are in the process are rebalancing their portfolios.  This rebalancing, whether it was driven by higher expected inflation or higher expected growth, would catalyze more aggregate nominal expenditures and given the significant economic slack, more real economic growth.  The problem, as noted by Nick Rowe, is that we want some portfolio rebalancing, but not too much  That is why an nominal GDP level target is important.  It would clearly set expectations on how much nominal income growth and, by implication, how much portfolio rebalancing would be allowed.  In other words, a nominal GDP target would guarantee we get the just the right dose of bond vigilantism needed to shore up the recovery.  And note that the recovery in nominal GDP would push up interest rates too. Using Paul Krugman's terms, this would be an expansionary rise in interest rates. So let's not fear bond vigilantes, but learn to manage their expectations in a way that will spark a real economic recovery.

Update: Just to be clear, the expansionary rise in interest rates does not mean the Fed would raise rates before the recovery.  Rather, recovery would naturally cause yields to rise (i.e. demand for credit increases, desired savings falls) and the Fed would respond by raising its target federal funds rate.  For more on this point see here.

Update II: Further thoughts on bond vigilantes here.

John Taylor Tips His Hat To NGDP Targeting

John Taylor gave a recent talk at the Milton Friedman Centennial Celebration where he made some interesting points.  He makes the case that that monetary policy has been unpredictable and ad-hoc over the past few years, including some periods where monetary policy was too tight.  As a result, he believes a more systematic, rule-based approach to monetary policy would be beneficial to the recovery.  To this end, he tips his hat toward nominal GDP targeting in his discussion of what he thinks Milton Friedman would endorse:

Another question raised during the discussion at the centennial conference is “what about nominal GDP targeting?” In my view, Milton Friedman would have been positive about a proposal to keep nominal GDP growth stable, but would have wanted also to have a specific rule for the instruments of policy to achieve that target.

I agree. Friedman in this 2003 WSJ article indicates he might have liked a nominal GDP level target. As Michael Woodford notes, nominal GDP targeting can be thought as the heir to the Friedman monetary target rule once one acknowledges that velocity is not stable. The predictability, transparency, and certainty this rule would create would also make it appealing to Milton Friedman.  Here is how I explained this point before:

So yes, Milton Friedman did call for buying longer-term securities until a robust recovery takes hold... 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? 

I think the answer is clear.

Casey Mulligan Nails It

At least on this part:

To put it another way: for every worker that construction lost between 2007 and 2010, the rest of the economy lost at least another five workers, rather than gaining workers. I agree with Professor Krugman and other opponents of the “sectoral shifts theory” that something must have happened — in less than a year or two — that profoundly affected practically all industries and practically every region.

Mulligan is right that something suddenly happened that affected economic activity in every region and every industry.  I date this development to about mid-2008 as can be seen in the following figures.  The first one shows that despite the start of the housing recession in April, 2006 employment in the rest of the economy continued to grow through early 2008:  

Similarly, despite the fall in dollar incomes tied to housing, other dollar incomes continued to grow until about mid-2008:

So, as Mulligan notes, something turned a two-year sectoral recession into an economy-wide one.  Many folks attribute it to the worsening of the financial crisis.  I think a better story is that the Fed passively tightened monetary policy around mid-2008.  A passive tightening occurs whenever the Fed allows total current dollar spending to fall, either through a endogenous fall in the money supply or through an unchecked decrease in velocity.  Given a proper measure of the money stock--one that includes both retail and institutional money assets--this can be shown to be the case for the U.S. economy during this time.  This reduction in broad money assets and the drop in velocity amounts to an excess money demand (i.e. safe asset shortage) problem. 

The Fed's failure to stabilize total dollar spending had implications for household balance sheets.  Households had come to expect about 5% annual nominal income growth over the past 25 years or so.  These expectations were assumed by household and firms when they signed long-term nominal fixed debt contracts.  A debt crisis was therefore inevitable when these long-term nominal income forecasts were not realized.

Now Casey Mulligan thinks it was a change labor market incentives brought on by government policies that caused the economy-wide collapse.  I agree with Mulligan's premise that these policies do change incentives, but am not convinced that magnitudes are large enough to explain the severity of the past four years.  A far easier story to tell is there has been an excess demand for money assets (i.e. a shortage of safe assets).  For households this is a particularly compelling story:

Here's hoping that Mulligan, who has done extensive work on money demand, can weave this story into his narrative of the crisis.

What the Obama Win Means for NGDP Targeting

Okay, so Greg Mankiw will not be Fed chairman after all and usher in a golden era of nominal GDP targeting.  All hope is not lost, though, on the nominal GDP targeting front.  Here is the Cynthia Lin of the WSJ:

President Barack Obama‘s re-election has made markets more confident that the Federal Reserve will continue on its current path.

With Obama winning a second term, the odds are higher that any leadership change at the central bank will follow in Chairman Ben Bernanke‘s footsteps. The path of Fed policy now seems clearer to the market, as evidenced in the fed-funds futures market.

November 2014 fed-funds futures now price in no chance of an interest-rate increase by then, compared with a 24% chance priced in at Tuesday settlement. The central bank has said it plans to keep rates near zero at least until mid-2015. But Bernanke’s current term ends in 2014, and some had speculated that a Romney administration would have appointed a Fed chairman who would push for higher rates sooner

So the Fed has less to worry about it as it executes QE3.  To the extent QE3 is a step in the direction of the Fed adopting an explicit nominal GDP level target, this would be a positive development. President Obama also has an opening to fill at the Board of Governors and he could reinforce the Fed's move toward a nominal GDP target by appointing someone who endorses it.  How about his best friend at Goldman Sachs, Chief Economist Jan Hatzius? He would be a nice complement to the Baord of Governors.

If Mitt Romney Becomes the Next President...

I hope he appoints Greg Mankiw as the next Fed chairman.  Here is a post from October, 2011 that explains why Mankiw would be a great choice:

Back in May, 2011 I wrote the following on my blog:

Greg Mankiw recently referred to a paper where he assess which inflation rate should be targeted by the central bank.  Here is his conclusion:

[A]central bank that wants to achieve maximum stability of economic activity should use a price index that gives substantial weight to the level of nominal wages. 

There are several good reasons laid out in the paper for targeting nominal wages.  Here I like to point out that stabilizing nominal wages is similar to stabilizing nominal income per capita.  It is not too much of a stretch to go from this to a nominal income or nominal GDP target.  In fact, Greg Mankiw and Robert Hall have a 1994 paper that sings the praises of a nominal GDP target, especially one that that targets the consensus forecast of the nominal GDP level. 

So where does Greg Mankiw stand today on nominal GDP level targeting?  If he still supports it, does he see the need to return nominal GDP back to its pre-crisis trend or at least higher than its current level?

Though I have never got a direct answer from Greg Mankiw, there is now enough circumstantial evidence to know his answers to my questions. First, he and coauthor Matthew Weinzierl have a recent Brookings Paper on the optimal stabilization policy.  They go through a menu of policy options, but reach this conclusion if monetary policy is not constrained:

The second level of the hierarchy applies when the short-term interest rate hits against the zero lower bound. In this case, unconventional monetary policy becomes the next policy instrument to be used to restore full employment. A reduction in long-term interest rates may be sufficient when a cut in the short-term interest rate is not. And an increase in the long-term nominal anchor is, in this model, always sufficient to put the economy back on track. This policy might be interpreted, for example, as the central bank targeting a higher level of nominal GDP growth.

In other words, monetary policy targeting a nominal GDP level is sufficient to bring the economy back to full employment.  That sounds like a rather favorable view of nominal GDP level targeting to me.   If that were not enough, Greg Mankiw today implicitly endorses nominal GDP level targeting by linking on his blog to the Goldman Sachs paper on nominal GDP level targeting.  I'd say Mankiw has answered my questions clearly.

Now Mankiw is not just a big-time academic economist at Harvard.  He is also an economic adviser to  Mitt Romney, the likely GOP candidate for president.  That means NGDP level targeting might eventually find its way into the White House.  There are good reasons for Republicans to endorse such an approach to monetary policy.  I hope Mitt Romney is hearing them.

We will have to wait another day to see if Greg Mankiw will get a chance to implement nominal GDP level targeting.  

Update: Here is Joe Weisenthal earlier this year talking about Greg Mankiw as Fed chair.

Steve Hanke: a Market Monetarist?

This past weekend while traveling, I was able to listen to Steve Hanke on EconTalk with Russ Roberts.  Hanke has been out in front of the hyperinflation story in Iran and has been doing some really interesting work on it.  While this is an important discussion, another topic that was brought up in the interview was Hanke's views on the stance of U.S. monetary policy.  Hanke argued that monetary policy in the United States has been effectively tight over the past few years.  This is evident, he says, by looking to broad monetary aggregates like the M4 divisia, a view that I share.  Elsewhere, he has argued the Fed should target final nominal sales.  With these views, Hanke could almost be confused for being a Market Monetarist.  He even calls himself a monetarist in the interview.  

There are a few areas, though, in the interview where he appears to differ from Market Monetarists:

(1) He believes that the Fed has been extremely loose with its large expansion of the monetary base that began in late 2008.  Market Monetarist disagree and say that the large run-up in the supply of Fed liabilities has been more than offset by a large run-up in the demand for them.  Monetary policy is not loose if the Fed fails to check an excess demand for the monetary base.  Moreover, monetary policy is not loose if the run-up in the monetary base is not expected to be permanent. If, on the other hand, some part of the increase were expected to be permanent then nominal spending and nominal income should go up today in anticipation of this development. The fact that this has not happened indicates Fed policy has been too tight.

(2) He thinks the Fed has bought up an inordinate share of U.S. treasuries and has therefore kept interest rates too low. Market Monetarist note that the Fed actually holds only about 15% of total marketable treasury securities and therefore is not the main reason for the low treasury yields.  In other words, despite the large run up in U.S. public debt, households, their financial intermediaries, and foreigners are more than willing to hold treasuries.  Blame them and the weak economy causing them to buy more treasuries for the low interest rates, not the Fed (at least not directly).

(3) He thinks the weak recovery in M4 is the result of onerous bank capital requirements that prevents financial firms from producing many safe assets.  There may be some truth here, but this view overlooks the ability of the Fed to catalyze the private creation of more safe assets.  Here is how I explained this process before:

[T]he Fed and ECB should create an environment conducive to monetary asset creation that would support the return of robust aggregate nominal spending.  Since most of the money assets are created by the credit, maturity, and liquidity transformation services of financial firms, policymakers should aim to create an environment conducive to increased financial intermediation.  The easiest way for monetary policy  to do this is to raise the expected growth path of aggregate nominal expenditures. This would raise expected nominal income growth and the demand for money assets.  This, in turn, would catalyze financial intermediation and  lead to the creation of more money assets.  And of course, the way to raise the expected growth path of aggregate nominal expenditures is to adopt a nominal GDP level target.  It is time for monetary regime change!

I suspect the absent of this action by the  Fed is a much bigger factor behind the weak M4 growth than the regulatory burden.  

These differences, though, probably overstate the gap between Steve Hanke and Market Monetarists.  And maybe his views on these issues are not as different as they seem. In any event, it is good to know that someone with his views is still being heard at the CATO institute. 

Target Household Incomes

Scott Sumner recently came up with a new proposal for the Fed:

I’m going to propose a compromise between the current policy of $40 billion bond purchases each month, and a radical policy of immediately targeting the forecast.  Have the Fed start QE3 at $40 billion per month, and then increase their purchases at a rate of 20% each month, until they have achieved their policy goal (of equating predicted nominal growth with desired nominal growth.)

This proposal would most likely pack a punch and raise expected nominal income growth.  It would also once and for all settle the debate on the efficacy of monetary policy at the zero bound.  There is no doubt in my mind what the outcome would be. 

A big problem, though, with implementing so much monetary firepower is the absence of a well defined policy goal.  Currently, the Fed has a vague policy goal of improved labor market conditions in a context of price stability.  No one really knows what that means.  Scott would like to change that by having the Fed target the NGDP forecast using NGDP futures contracts.  This is a great idea as it would put monetary policy on autopilot, increase transparency, and respond to money demand shocks.  But the Fed is along way from adopting such a goal. 

Here is a suggestion for a less ambitious way for the Fed to target the forecast.  First, the Fed would set a target for average nominal household income growth over the next year.  Second, the Fed would contract with multiple polling organizations to do a weekly poll where they ask households how much they expect their dollar incomes to grow over the next year.  Third, the Fed would take some average of these polls and compare it to the Fed's targeted growth rate for nominal household income.  Fourth, the FOMC wold then conduct open market operations to bring household's expected dollar income growth in line with the Fed's target growth rate. 

If more immediate feedback was needed, the Fed could contract to have the polls done twice a weekly.  This still wouldn't give the instant feedback a NGDP futures contract would, but it would be straightforward to implement.  The Thompson Reuters/University of Michigan Survey of Consumer Sentiment currently asks that question every month.  So it should not be that hard for them and other polling firms like Gallup to ask the question weekly.  

Question: would this proposal be susceptible to the circularity critique?  If so, what could be done to fix it?

Financial Shocks, Risk Premium, and Monetary Policy

In the ongoing debate over the causes of the slump, one group of observers sees disruptions to the financial system as an important factor.  Tyler Cowen, for example, has argued that there has been a rise in the risk premium caused by a lingering shock to trust:

In short, there is a prevailing sense that we are simply not as safe, financially speaking, as we used to be. The productive capacity of the economy may appear largely intact, but the perceived risk is significantly higher...The slow cure for this problem is to allow asset prices, along with perceived wealth and trust, to return to or exceed the previous levels over time... But the process would be cumbersome, partly because trust is more easily destroyed than restored.

Others, like David Andolfatto and Stephen Williamson have put forth related arguments, claiming that the crisis has made the "limited commitment" problem more pronounced and reduced the financial systems ability to produced enough safe assets.  In these stories, there have been real shocks to financial intermediation.  The economy has slowed down, then, because of negative shocks to aggregate supply.  And to the extent these shocks are long-lasting or permanent, there is nothing monetary policy can do since the real side of the economy has shrunk.  It is not surprising, then, that Tyler, David, Stephen, and others who hold this view are often skeptical of Fed policies to stimulate the economy.

While I can accept that there has been some real shocks to financial intermediation, I do not see these disruptions as necessarily being permanent or unamenable to monetary policy for two reasons.  First, a case can be made that the risk premium in the short run can be subject to swings not tied to long-run economic fundamentals.  For example, the public might become overly-optimistic during a boom and overly-pessimistic during a bust.  If left unchecked, these mood-swings might create self-fulling outcomes that last some time as shown in Roger Farmer's work.  In other words, what may appear to be a permanent rise in the risk premium might actually be one of many suboptimal equilibria that could be avoided with the appropriate change in economic expectations by the public. 

The figure below suggests we are in such situation now.  It shows the spread between the yield on Moody's BAA bonds and 10-year treasury, one measure of the risk premium. It also shows that unlike in other post-recession periods, this risk premium remains about 100 basis points above its historical average with no sign of declining.  

Surprisingly, this notion that the risk premium maybe too high now was recently noted from a different perspective by Stephen Williamson.  He contends that the destruction of safe assets (mostly privately-produced ones) has now pushed the yields on the remaining safe assets unsustainably low:

The safe market rate of interest is now too low, relative to where it should, or could, be.

Since most safe assets are privately produced, this problem could be fixed by investors demanding more privately-produced safe assets and financial firms providing them.  This is not happening, but should be according to Williamson.  He does not say why, but presumably because the real economy could support more safe asset production if it were running at full potential.  If so, then this could be another manifestation of Roger Farmer's self-fulfilling outcomes arising from over pessimism.  This understanding implies that though the shocks to financial intermediation may be "real" in form they need not have a permanent effect if public expectations could be appropriately jolted by policy.¹ 

The second reason I think these real financial shocks are not permanent and are amenable to monetary policy is that they ultimately matter because they create a shortage of safe assets.  This problem, as I noted before, effectively amounts to an excess money demand problem once one properly accounts for all money assets.  Monetary policy is very capable of addressing this excess money demand problem by better managing expectations of future nominal income growth. In particular, an ambitious NGDP level target that significantly raised expected nominal income growth should both reduce the excess demand for safe assets (because of greater nominal income certainty going forward) while at the same time catalyze financial firms into making more safe assets (because of the improved economic outlook).  It should also provide the jolt needed to move the economy out of the bad equilibria.  For example, imagine how the public would respond if the Fed suddenly announced Scott Sumner's recent proposal of raising their asset purchase amounts by 20% per month until some NGDP level target was hit.  That would be the monetary policy equivalent of shock and awe.

Some evidence supporting this view can be seen in the figures below.  They show two versions of the risk premium plotted against expected inflation from treasuries.  This measure of expected inflation has been highly correlated with stock market movements since the crisis began in 2008.  One way to explains this relationship is that the expected inflation series since 2008 can be seen as indicator of future nominal spending and by implication, future real economic activity given nominal rigidities (See David Glasner).  It makes sense then to use it as a way to asses whether changes in economic expectations are systematically related to changes in the risk premium over this same time.  Are risk premiums being drive by changes in the public's economic outlook?

The first figure shows the same risk premium measure used above, the yield on Moody's BAA minus the 10-year treasury yield. It is plotted against expected inflation created by subtracting the 10-year TIPS interest rate from the 10-year nominal treasury rate. The relationship is strong:

As a robustness check, the following figure plots the spread between the Moody's BAA and AAA yields against the same expected inflation series. Similarly strong results that indicate that an improved economic outlook drives down the spread. 

 

Given these relationships, it stands to reason that the explicit adoption of an aggressive NGDP level target would go a long ways in returning the risk premium back to its long-run value.  In the figure above that would mean returning the BAA - 10 year treasury spread to about its 2% historical average.  This is just another reason why monetary policy can still pack a meaningful punch.

¹This understanding also implies Stephen Williamson might be a lot closer to Mark Thoma's views on the output gap than he realizes.