Friday, September 15, 2017

Monetary Regime Change: Mission Accomplished

Christina Romer, former CEA chair, called for a monetary regime change several times between 2011 and 2013. It is now several years later and it appears we did finally get a monetary regime change. Unfortunately, it is not the kind of regime change Christina advocated and actually goes in the opposite direction. 

Christina called for the Fed to adopt a nominal GDP level target that would restore aggregate demand to its pre-crisis growth path. Instead, we got a regime change that has effectively lowered the growth rate and the growth path of aggregate demand. This regime change, in my view, is behind the apparent drop in trend inflation that Greg Ip recently reported on in the Wall Street Journal. 

It is not easy to change trend inflation--just ask Paul Volker--but the Fed and other forces seemingly accomplished just that over the past decade. Since the end of the crisis, the average inflation rate on the Fed's preferred measure of inflation, the core PCE deflator, has fallen to 1.5 percent The headline PCE deflator average has fallen to 1.4 percent over the same period. Both are well below the Fed's target of 2 percent. 

This persistent shortfall of inflation has received a lot of attention from critics, including me. Lately, some Fed officials are also beginning to see the inflation shortfall as more than a series of one-off events. Governor Lael Brainard's recent speech is a good example of this change in thinking with her acknowledgement that trend inflation may be falling.

Still, there is something bigger going on here that is being missed in these conversations about the inflation rate. A monetary regime change has occurred that has lowered the growth rate and growth path of nominal demand. Since the recovery started in 2009Q3, NGDP growth has averaged 3.4 percent. This is below the 5.4 percent of 1990-2007 period (blue line in the figure below) or a 5.7 percent for the entire Great Moderation period of 1985-2007. Macroeconomic policy has dialed back the trend growth of nominal spending by 2 percentage points. That is a relatively large decline. This first development can be seen in the figure below.

The figure above also speaks to the second part of this regime change: aggregate demand growth was not allowed to bounce back at a higher growth rate during the recovery like it has in past recessions. Historically, Fed policy allowed aggregate demand to run a bit hot after a recession before settling it back down to its trend growth rate.  This kept the growth path of NGDP stable. You can see this if the figure above by noting how the growth rate (black line) typically would temporarily go above the trend (red line) after a recession.  

Had macroeconomic policy allowed aggregate demand growth to follow its typical bounce-back pattern after a recession, we would have seen something like the blue line in the figure. This line is a dynamic forecast from a simple autoregressive model based on the Great Moderation period. This naive forecast shows one would have expected NGDP growth to have reached as much as 8 percent during the recovery before settling back down to its average. Instead we barely got over 3 percent growth. This is why NGDP has never caught back up to its pre-crisis trend path. 

Again, these two developments are, in my view, the real story behind the drop in trend inflation. And to be clear, I think both the Fed's unwillingness to allow temporary overshooting and the safe asset shortage problem have contributed to it. So this is a joint monetary-fiscal problem that has effectively created a monetary regime change.

So yes, we got a monetary regime change, but no it is not the one Christina Romer and most of us wanted. 


  1. David, I think you are missing the elephant in the room. There was indeed an unfortunate, contractionary "regime change" at the Fed. But it isn't the one you emphasize here (though that may also have played a secondary part). It is the Oct. 2008 switch to an IOER-based "floor system." That system more-or-less shut-down the usual connections between Fed reserve creation, bank lending (on both wholesale and retail markets), and aggregate demand. Hence the trillion-dollar excess reserve pileup accompanied by sluggish NGDP growth and below-target inflation.

    To emphasize the distinction between level and growth-rate targeting as a culprit in that sluggish growth is missing the point: the Fed might have targeted NGDP anyway it liked; the fact remains that it would have had trouble, under this "leaky floor" system, achieving whatever target it set, just as it has had trouble reaching its 2% inflation target. The problem isn't the targets themselves, but a deeply flawed operating system that makes ANY sort of nominal targeting (except that of the fed funds rate itself) extremely difficult.

    I know well that you understand the consequences of above-market IOER better than most economists. But in failing to even mention the part it has played you risk giving readers the impression that it has played no part at all in the current low-inflation situation. That point instead needs to be insisted upon if we are ever again to have a (relatively) functional Fed.

    1. George, under a market-based nominal targeting regime, the IOER rate would be one variable that the Fed would be compelled to adjust until the market forecast matched the Fed's target. If you are right that paying excessive IOER would have caused the Fed "trouble ... achieving whatever target it set", then market-guided NGDP level targeting would force the Fed to lower IOER.

      Lack of a proper target is the root of this problem. Unhelpful IOER is just a consequence.

  2. Ken, IOER is certainly not a "consequence" of the Fed's having a wrong policy target (though it has something to do with the Fed's having originally misjudged the state of demand). It is a component of a fundamental regime change that the Fed has sought intentionally, and which has dramatically altered the fed's capacity to achieve any nominal spending or inflation target. The Fed has undershot its own inflation target, yet it has not taken that as a reason to lower IOER. Why not? Because it is wedded to its new "floor" operating system which calls for having IOER above corresponding market rates.

    I very much fear that the Market Monetarists are failing to see adequately the need to insist that the fed give up on this flawed operating system as a prelude to having their ideal policy implemented. Right now, the Fed is like a sailboat that is dragging its anchor; and the Market Monetarists are like skippers who, instead of recognizing the problem, imagine that an improper setting of the tiller is what's slowing things down. Every voice that downplays the need to restore the old operating system, or an alternative proper "corridor" framework with IOER below market rates, is inviting, intentionally or not, the perpetuation of monetary disorder. I share your and David's views about the advantages of NGDP level targets. But, to suggest a second metaphor, it is futile to call for the Fed's marksman to aim for an alternative target so long as they are wielding a defective bow.

    1. "Because it is wedded to its new "floor" operating system which calls for having IOER above corresponding market rates"

      is this formally stated anywhere as a policy?

      or is it just implied somewhere as a new philosphy

    2. Good question. You must either read it between the lines of written Fed statements, or talk to Fed insiders. But believe me, the Fed is enamored of this new system, which can only work if IOER is above-market, so that banks hold substantial excess reserves and the demand schedule for reserves is horizontal at the IOER rate. Think about that, plus the fact that market and "natural" interest rates tend to correspond in long run. That means that a floor system creates an over-tightening bias, for the system can be preserved so long as IOER is above (or at) market equivalents, but not if it is below. That's why the Fed persists in raising IOER as natural rates pick up, despite persistent undershooting of inflation target and slow NGDP growth.