Tuesday, December 8, 2015

Time Traveling with the Fed

Imagine we travel back in time to the second quarter of 2009. We stop by the Federal Reserve and reveal to Fed officials that the recession has now bottomed out. They are elated until we disclose that the Great Recession will be followed an anemic recovery for the next seven years. We share how ZIRP, forward guidance, and successive rounds of QE will fail to create an robust recovery and this leaves Fed officials aghast.

Reeling from shock, they ask what they should do instead of these policies. We inform them of the argument for a NGDP level target made by Scott SumnerChristina Romer, and Michael Woodford. We also inform them that they should signal the seriousness of their intent to do so by making an arrangement with the Treasury Department to back up their actions with contingent 'helicopter drops' should the Fed fail to hit the NGDP level target.

The Fed agrees with our assessment and decides to spend its political capital on the NGDP level target proposal--instead of using it on ZIRP, forward guidance, and QE programs--and gets the backing of Congress and the Treasury Department. The great macroeconomic experiment begins.

So what would happen next in this counterfactual history? How would the economy respond to these combined efforts of monetary and fiscal policy starting in mid-2009? No one can answer these questions with certainty, but it is likely that at a minimum there would be temporarily higher inflation.

The two figures below lend support to this understanding. They come from a paper I am currently working on where I run a counterfactual forecast of inflation starting in mid-2009. The forecasts are based on three different paths of NGDP returning to its pre-crisis trend: a two-year path, a three-year path, and a four-year path. The first figure shows the three NGDP return paths and the second figure shows the inflation forecasts associated with these paths:



Although temporary, inflation is notably higher than both the actual inflation rate that occurred and the 2% target rate under each of the counterfactual NGDP return paths. The inflation rate would get as high as 3.8% for the two-year path and 3.2% for four-year path. Over all counterfactual paths inflation would average around 2.5% since mid-2009, compared to actual average of 1.5%. 

These numbers are just counterfactual forecasts, but they demonstrate a key reason why the current monetary regime could never have generated the 'catch-up' aggregate demand growth needed to offset the 2008-2009 crash in nominal spending and return it to its pre-crisis path: it would require higher than 2% inflation for a few years. And that is simply intolerable in the current environment. 

The Fed, Congress, and the body politic at large have come to view 2% or less inflation as the norm for advanced economies. Any violation of it--even if temporary and part of a systematic approach like the NGDP level target above--would be viewed as an egregious affront to civilization. Just look at some of the flack former Fed Chair Ben Bernanke got on this issue or the exchange (see last part) between him and former Senator David Vitter on the question of raising the inflation target.

This means that no matter how much QE or forward guidance the Fed engaged in, it would always be done in a way that kept inflation and, as a result, aggregate demand growth in check. This is the Fed's dirty little secret. This understanding also means that no matter how much fiscal policy was done, it too would only be effective up to the 2% inflation threshold. This is the Penske problem with modern macroeconomic policy: it relies on an engine governor rather than cruise control to regulate the speed of the economy. It is time for level targeting. 

Related
The Right Goal for Central Banks
Monetary Regime Change

15 comments:

  1. What sort of Phillips curve equation are you using in your paper?

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    1. Nick, the counterfactual inflation forecast was created using an estimated VAR. The VAR has core PCE inflation, NGDP, and the output gap. So the inflation equation in the VAR is sort of like a Philips curve since it has the output gap in it (but has NGDP and past lags of itself too).

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  2. "It is time for level targeting."

    David, that's a surprising way to end this post. Assuming your counterfactuals accurately depict what would have happened with NGDPLT, then how will you ever sell it now? You show right here the freedom crushing inflation that would result. You're admitting that it would end Western civilization and lead to a new dark age of collectivism, statism and serfdom. ;^D

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    1. Clearly you've wandered far off the reservation. Why not do a more meaningful counterfactual study instead showing the many many benefits of building a giant wall around America, unleashing a deportation force to get rid of 15 million people (Mexicans + Muslims), scrapping all our trade deals and replacing them with isolationism and trade wars (with China, Japan, Europe, Mexico, India, Canada and anyplace else that looks at us funny), and of course auditing the Fed and bringing back the gold standard. You know, the standard freedom loving Milton Friedman type ideas.

      "You know, on Wall Street, the fed is doing great. It's driving up stock prices, Wall Street's doing great. You know today the top 1% earn a higher share of our income than in any year since 1928. But if you look at working men and women... if you look at a single mom buying groceries, she sees hamburger prices have gone up nearly 40%, she sees her costs of electricity going up, she sees her health insurance going up and **LOOSE MONEY** is one of the major problems. We need sound money, and the Fed should get out of the business of trying to juice our economy and simply be focused on sound money and monetary stability, ideally TIED TO GOLD."

      Do you agree with these insightful words David? Loose money is the problem, and gold is the solution? Is that what will bring this crazy runaway inflation back under control for all those working mom's out there paying 40% more for their hamburger? Why won't the Fed stop with all this incessant "juicing" of our economy (that they've clearly been doing these past seven years)??? ;^D

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    2. Capitalism is collectivism and statism. Without it, it would not exist. Private Property is a government enterprise aka statism. You take the typical propertarian line and don't even get the dialect your creating. Pathetic.

      Lets note the "nominal income" came way out of whack in the 00's. His graph is a error. Nominal income has indeed normalized.

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    3. Tom, it is a long struggle but not impossible. One key point we have to stress is that a NGDP level target can be implemented in a rules-based framework. That would go a long ways in making it more acceptable.

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    4. "One key point we have to stress is that a NGDP level target can be implemented in a rules-based framework."

      To be fair, if you rewind the clip I link to above, Cruz does say something to the effect of the Fed should be "rules based" in the first part of his answer. I figured you'd like that, so I skipped over it. (c:

      David, more than a year ago (if I recall correctly) you had a post up with a chart with time on the x-axis (going back several years), and inflation on the y-axis. You had about 10 curves on the plot: I think one showing actual inflation, and the others showing expected inflation... all of which quickly diverged from the actual inflation curve on the upside: in other words a bunch of short upturned curves, all with different starting points in time, showing expectations of inflation overestimated. Do you recall what I'm talking about? I recall being surprised by it because I'd never seen a plot like that before. I'm sure I left you a comment about it. But I can't seem to find it now. Was I hallucinating?

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  3. "it is likely that at a minimum there would be temporarily higher inflation."

    NGDP targeting should produce higher inflation only in the presence of a supply shock, not if the recession is caused by a demand shock. Is that right?

    So with the above you are basically saying that the recession was caused by a supply shock, not by lack of demand. Is this correct? Thanks for your patience :)

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    1. Maurizio, you are right if NGDP is on its targeted growth path. But this was not the case by mid-2009. Nominal spending had collapsed well below its trend (which can be viewed as its implicit targeted growth path). In that case, the catch-up growth shown above was needed to offset the decline and this implies some temporarily higher inflation.

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    2. But with sticky prices, should not real growth react faster than inflation ?

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  4. David, if the Fed had selected one of your counterfactual PCE core inflation curves as a target trajectory (rather than the associated NGDP trajectory), and they were able to hit that target trajectory, would the associated NGDP trajectory result?

    Also, in your view, is there any difference in feasibility between the 2-, 3-, and 4- year NGDP counterfactual trajectories? How short a time is too short, feasibility wise? Or do you think it's just a matter of too short a time (say 1 year) generating unacceptably high (though temporary) inflation? If there is a feasibility issue, how do we know that 10 years or 15 years aren't more realistic periods to get back on track?

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    1. Tom, the inflation forecast is the consequence of counterfactual paths for NGDP, not the other way around. Might get something similar if you targeted path of core PCE, but probably not identical. Also, not sure why Fed would want to target those specific inflation rates.

      I only gave the different paths because it may prove politically easier to do the longer return paths. So they are there as an option of choices for policymakers.

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  5. I submit that the current situation is less tolerable than 4% inflation.

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    1. For the whole economy, sure. But it you're a major creditor, have a big lending portfolio out there...

      Oh wait. Those are the people who run the Fed. Hmm.

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