Tag: Federal Reserve

Monetary Policy Outlook: The United States (Fall 2017)

Posted on by Brad DeLong

What Will (Probably) Happen?

  • What the Federal Reserve thinks:
    • that the U.S. economy is near full employment…
    • that U.S. potential-output growth rate is 2%/year…
    • that it should be “normalizing” interest rates…
  • A positive shock to growth (or inflation) will see the Fed raise faster and further:
    • Do not expect real growth much above 2%/year under this Fed…
    • Do expect the Federal Funds rate to rise at about (3/4%/year)/year—or faster—as long as the economy can stand it without recession…
    • A negative shock to inflation will see slowed but not stopped “normalization”…
  • A negative shock to growth will see:
    • The Federal Reserve quickly return the Federal Funds rate to zero…
    • And then dither, with many tools but none of them powerful to affect the economy…

Employment-to-Population, 25-54

  • I think the Fed could be more aggressive at promoting growth…
  • Prime-age employment-to-population numbers in the U.S. still show considerable labor market slack…
  • But the unemployment rate shows over-full employment…
  • Wage growth shows no labor supply-side pricing power for workers…
  • Yet the Federal Reserve trusts the unemployment rate much more than other indicators…
    • This creates a puzzle because…

Inflation Remains Subdued

  • Back in the 1950s Alan Greenspan declared that 2%/year measured inflation was “effective price stability”…
  • The Bernanke-Yellen Federal Reserve decided to use the core PCE chain index…
  • Persistent undershoot:
    • Since January 2009, cumulating to 4%-points in the price level…
    • Recent price news not suggesting any inflationary spiral developing soon…
  • Suggesting that the tightening cycle announced in mid-2013 and begun in 2016 was premature…
    • The market agrees with me…

The Long Nominal Rate, Inflation Breakeven, and Long Real Rate

  • When Larry Summers was Deputy Treasury Secretary, he convinced Bob Rubin to issue TIPS…
    • We now have 15 years of watching the long nominal rate, long real rate, and the difference between them:
      • The expectations based inflation breakeven…
    • These give us a better window…

Secular Stagnation

  • Fall in (notional) TIPS from 4% at end of 1990s to 2% in mid-2000s…
  • Fall in TIPS from 2.0–2.5% pre-crisis to 0.0-0.5% today…
  • Without any signs of a runaway boom of any sort…
    • But increased appetite for debt…
    • Any risks being generated?

Implications for the Fed-Controlled Short Rate and the Long Rate

  • The Federal Reserve controls the interest rate on Treasury bills…
    • Subject to the condition that it cannot drive it below zero (without making substantial institutional changes in the banking system)…
  • The long rate goes where it wants…
    • And it has not wanted to go up for a long time indeed…
    • Expect a lot of time at the zero lower bound over the next decade…

Might We Get a Different Fed?

  • I said “under this Fed”…
  • But might we get a different Fed?
    • Very unlikely…
    • Trump not interested…
    • The non-unitary executive:
      • Will appoint Republican monetary-policy worthies
      • Most of whom think like the Fed already…
      • And the Fed is very good at assimilating new governors and bank presidents…

Summing Up

  • I said that under this Fed:
    • If no recession:
      • A ceiling of 2%/year on growth…
      • A ceiling of 2.5%/year on inflation…
      • Short-term interest rate increases of (3/4%/year)/year or more…
        • Already priced into long rates…
    • If recession:
      • Cut Fed Funds rate back to zero…
      • Dither…

Implications for Trading Partners

  • U.S. not a locomotive for demand…
  • U.S. not a (major) source of likely upward demand or upward interest rate shocks…
  • Trading partners have to decide how to react to the tightening cycle:
    • But it will be slow (probably)…
    • Hence (probably) innocuous…
  • Trading partners do have to worry about a recession in the United States:
    • Given the absence of powerful monetary policy tools to the Fed’s hand…
    • Given the lack of political will for non-monetary stimulus…
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https://www.icloud.com/keynote/07lTGr0dPnEoKQd_LFNsqkAYw

My Sections: As Delivered: Fed Up Rethink 2% Inflation Target Blue-Ribbon Commission Conference Call

Posted on by Brad DeLong

Opening Statement (as Delivered): I digress from my job here to say that I agree with everything that Jason and Josh have said. They do not speak just for themselves. They speak for me as well.

And let me also digress by trumping both Jason and Josh.

They both said “if you thought a 2% inflation target was appropriate a decade ago”. A decade ago I did not think a 2% inflation target was appropriate.

It was twenty-five years ago this summer that Larry Summers and I went to the Federal Reserve’s conference at Jackson Hole to say, among other things, that we thought it would be extremely risky and inappropriate to drop the Fed’s informal inflation target from its then-five percent to two percent. The 1990 savings and loan crisis was a small macroeconomic shock. Yet the Federal Reserve cut short-term interest rates by 600 basis points to respond to it. If there were ever a big shock, we said, the Fed would want all that much room to maneuver and more. It would not have that room to maneuver with a two percent inflation target.

So I’ve been beating this drum for twenty-five years off and on, and feeling very Cassandra-like for the past decade.

Now on to my job here. It is to get all medieval, in the sense of Thomas Aquinas, on you. It is to deal with the objections to our position, and then to provide what we believe are sufficient answers to those objections.

I hear four arguments for not changing the 2%/year inflation target, even though pursuing that target found us in a situation where monetary policy was greatly hobbled in its ability to manage the economy for a solid decade. And, as best as I can evaluate them, all four of these arguments seem to me to be wrong. They are:

The Federal Reserve, even at the zero lower bound, has powerful tools sufficient to carry out its stabilization policy tasks (Cf.: Mankiw and Weinzierl (2011) https://scholar.harvard.edu/files/mankiw/files/exploration_of_optimal.pdf), so moving away from 2%/year as a target is not necessary. This leaves begging the questions of why, then, employment has been so low over the past decade and why production is still so low relative to our circa-2007 expectations.

The problem is not the 2%/year target but rather pressure on the Federal Reserve: pressure from substantial numbers of economists and politicians practicing bad economics and motivated partisan reasoning. (As an example, somebody sent me a video clip this week of the very smart Marvin Goodfriend half a decade ago, arguing that faster recovery required the Fed to hit the economy on the head with a brick to make people more confident in its willingness to fight inflation http://www.bradford-delong.com/2017/06/on-the-negative-information-revealed-by-marvin-goodfriends-i-dont-teach-is-lm.html.) This ignores the Fed’s long institutional history of being willing to ignore outside pressure as it performs its standard monetary policy task of judging what appropriate interest rates are. Pressure only mattered when we got into “non-standard” monetary policies, which we needed to do only because the low inflation target had caused us to hit the zero lower bound.

At 2%/year, inflation is non-salient: nobody worries about it. A higher inflation rate would bring shifting expectations of inflation back into the mix, distract people and firms from their proper task of calculating real costs and benefits to worry about monetary policy, and make monetary policy management more complicated. But right now people and firms are “distracted” by the high likelihood of depressions that last longer than five years. That is a much bigger distraction than worrying about whether inflation will be 4%/year of 5%/year. And right now the zero lower bound makes monetary policy management much more complicated than it was back in the 1990s when the impact of Fed policy on inflation expectations was in the mix.

The Federal Reserve needs to maintain its credibility, and if it were to even once change the target inflation rate, its commitment to any target inflation rate would have no credibility. But the credibility you want to have is credibility that you will follow appropriate policies to successfully stabilize the economy—not credibility that you will mindlessly pursue a destructive policy because you think it somehow wrong to acknowledge that the considerations that led you to adopt it in the first place were wrong or have changed. As my friend Daniel Davies puts it in his One-Minute MBA Course: “Is a credible reputation as an idiot a kind of credibility really worth having?” http://crookedtimber.org/2006/11/29/reputations-are-made-of/

Over to you, Joe…

* * * *

Answers to Questions: There is no unemployment rate target right now.

The Federal Reserve thinks about what the non-accelerating inflation rate of unemployment might be. But they claim not to have any strong view. They claim to be guided by the data, in terms of assessing how much pressure the economy can take. By contrast, the Federal Reserve had an informal inflation target of four to five percent per year in the late 1980s and early 1990s. And it then shifted down first, in the mid-1990s, to an informal target of two percent per year for the core PCE index under Alan Greenspan. It then formalized that under Bernanke in the late 2000. If they did have an unemployment rate target to talk about, we would be talking about that as well. But they don’t.

The question is a very good one. When I come write the economic history of the 2010s, I think that both Ben Bernanke and Janet Yellen are likely to be judged quite harshly. Once the recession of 2008-2009 had reached its end, the Federal Reserve had one overwhelming first priority: to create a strong enough economy that it could sustain short-term safe nominal interest rates of 400 to 500 basis points, and still grow at potential, in order that the Federal Reserve would have room to deal with the next recessionary shock when it came by conventional interest rate policy. The Federal Reserve did not prioritize that objective. Now here we are, late in a recovery, with short-term safe interest rates at 80 basis points or so, and with substantial fear that the economy is not robust enough to support any substantial rise over the time before the next severe recessionary shock hits. Indeed, an attempt to push short-term rates higher in the near future might well be such a recessionary shock.

The Federal Reserve has wedged itself into a position where it has almost no conventional monetary policy ammunition to deploy.

Let me say that the housing bubble did not blow up the economy. Let me say that the deflation of the housing bubble did not blow up the economy. As of the start of 2008, the housing bubble had collapsed, and all of the excess workers who had
been employed in construction had moved out and overwhelmingly found jobs in other sectors without even a small recession or more than a trivial rise in the unemployment rate.

But there was left in the bowels of the financial system the fact that the big money center banks had been playing regulatory arbitrage—claiming that the mortgage-backed securities they were holding were true AAA assets when they were nothing of the sort. It was this concentration of overvalued and mischaracterized assets in the highly leveraged money center banks that got us into big trouble, not the collapse of the housing bubble.

You can see this if you recall that the collapse of the dot-com bubble in 2000-1 took down about five times as much in the way of investors’ wealth as the collapse of the housing bubble took down the wealth of subprime lenders. And yet the 2000-1 bubble collapse did not cause a big recession. Why not? Because the people who took the hit were the rich equity investors in Silicon Valley, rather than the highly overleveraged money center banks that had decided to get a little bit too clever with how they characterized the assets they were holding.

Note that there are people like Larry Summers and Olivier Blanchard who are right now much more on now on Team Expansionary Fiscal Policy than on Team Raise the Inflation Target, in substantial part because of a desire to keep inflation non-salient and because our understanding of how bubbles are generated and what role ultra-low interest rates and quantitative easing play in generating them is very poor.

Let me underscore Jason’s point: Marvin Goodfriend is a potential future nominee to the Federal Reserve Board. Marvin Goodfriend has a remarkable aversion to and suspicion of quantitative easing. But has been very comfortable with the Federal Reserve’s interest rate management role.

When I have pitched this idea of a blue-ribbon examination of the proper inflation target in the past, what I have believed was my cleverest thought was to make Ben Bernanke and Larry Summers co-chairs, and make them in charge of figuring out where the rough consensus of—once again getting Thomas Aquinas on you—the greater and wiser part of the informed community of thinkers about this is.

I have to run to two pointless bureaucratic meetings. If you have any more questions, please email me at delong@econ.berkeley.edu, and if I can hide my phone keyboard and use my thumbs I will answer during the meetings, and if not I will answer as soon as I can afterwards.

And one thing I did not say: We have had four pieces of bad news in the past decade, all of which strongly argue against preserving the two percent per year core PCE inflation target. They are:

  1. bad news about the value of the Wicksellian neutral interest rate.
  2. bad news about the public sphere’s understanding of what the non-interest rate macroeconomic policy tools are and how to deploy them.
  3. bad news about partisanship—the solid opposition of the Republican Party to the policies of South Carolina Republican Ben Bernanke because it was thought they might redound to the benefit of Obama.
  4. bad news about the strength of non-standard stimulative monetary policies.

More References:

Rethink 2%

Posted on by Brad DeLong
3 Month Treasury Bill Secondary Market Rate FRED St Louis Fed

Rethink 2% http://populardemocracy.org/sites/default/files/Rethink%202%25%20letter.pdf:

Federal Reserve Board of Governors
Constitution Ave NW & 20th Street Northwest
Washington, D.C. 20551

Dear Chair Yellen and the Board of Governors:

The end of this year will mark ten years since the beginning of the Great Recession. This recession and the slow recovery that followed was extraordinarily damaging to the livelihoods and financial security of tens of millions of American households. Accordingly, it should provoke a serious reappraisal of the key parameters governing macroeconomic policy.

One of these key parameters is the rate of inflation targeted by the Federal Reserve. In years past, a 2 percent inflation target seemed to give ample leverage with which the Fed could lower real interest rates. But given the evidence that the equilibrium interest rate had fallen substantially even prior to the financial crisis, and that the Fed’s short-term policy rate remained at zero for seven years without sparking any large acceleration of aggregate demand growth, a reassessment of this target seems warranted. Such a reassessment is particularly appropriate when the lack of evidence that moderately higher inflation would harm Americans’ standard of living is juxtaposed with the tremendous evidence that a tighter labor market would improve Americans’ standards of living.

Some Federal Reserve policymakers have acknowledged these shifting realities and indicated their willingness to reconsider the appropriate target level. For example, San Francisco Federal Reserve President John Williams noted the need for central banks to “adapt policy to changing economic circumstances,” in suggesting a higher inflation target, and Boston Federal Reserve President Eric Rosengren cited the different context in which the inflation target was set in emphasizing the need for debate about the right target.[1] [2]

In May, Vice Chair Stanley Fischer highlighted the Canadian system of reconsidering the inflation target every five years, saying, “I can envisage–say, in the case of inflation targeting–a procedure in which you change the target or you change the other variables that are involved on some regular basis and through some regular participation.”[3]

The comments made by Fischer, Rosengren, and Williams all underscore the ample evidence that the long-term neutral rate of interest may have fallen. Even if a 2 percent inflation target set an appropriate balance a decade ago, it is increasingly clear that the underlying changes in the economy would mean that, whatever the correct rate was
then, it would be higher today. To ensure the future effectiveness of monetary policy in stabilizing the economy after negative shocks–specifically, to avoid the zero lower bound on the funds rate–this fall in the neutral rate may well need to be met with an increase in the long-run inflation target set by the Fed.

More immediately, new, post-crisis economic conditions suggest that a reiteration of the meaning of the Fed’s current target is in order. In its 2016 statement of long-run goals and strategy, the Federal Open Market Committee wrote: “The Committee would be concerned if inflation were running persistently above or below this objective.” Some FOMC participants, however, appear to instead consider 2 percent a hard ceiling that should never be breached, and justify their decision-making on that basis. It is important that the Federal Reserve makes clear–and operates policy based on–its stated goal that it aims to avoid inflation being either below or above its target.

Economies change over time. Recent decades have seen growing evidence that developed economies have harder times generating faster growth in aggregate demand than in decades past. Policymakers must be willing to rigorously assess the costs and benefits of previously-accepted policy parameters in response to economic changes.

One of these key parameters that should be rigorously reassessed is the very low inflation targets that have guided monetary policy in recent decades. We believe that the Fed should appoint a diverse and representative blue ribbon commission with expertise, integrity, and transparency to evaluate and expeditiously recommend a path forward on these questions. We believe such a process will strengthen the Fed as an institution and its conduct of monetary policy, and help ensure wise policymaking for the years and decades to come.

Yours,

Dean Baker
Laurence Ball
Jared Bernstein
Heather Boushey
Josh Bivens
David Blanchflower
J. Bradford DeLong
Tim Duy
Jason Furman
Joseph Gagnon
Marc Jarsulic
Narayana Kocherlakota
Mike Konczal
Michael Madowitz
Lawrence Mishel
Manuel Pastor
Gene Sperling
William Spriggs
Mark Thoma
Joseph Stiglitz
Valerie Wilson
Justin Wolfers

[1] John Williams, “Monetary Policy in a Low R-Star World,” August 15, 2016

[2] Sam Fleming, “Inflation Goal May Be Too Low, says Fed’s Rosengren,” Financial Times, April 21, 2015

[3] Greg Robb, “Fed’s Williams Backs Changing Central Bank’s Strategy to Price-Level Targeting,” Market Watch, May 5, 2017

Why the Fed Should Rethink Its 2%/Year No-Lookback Inflation Target

Posted on by Brad DeLong

Conference call today at 9:00 PDT/noon EDT on why the Federal Reserve would be very smart to abandon its 2%/year no-lookback inflation target for a less destructive policy framework. The call is to be moderated Shawn Sebastian. Then Josh Bivens will summarize his short whitepaper: “Is 2% Too Low? Rethinking the Fed’s Arbitrary Inflation Target to Avoid Another Great Recession” http://www.epi.org/publication/is-2-percent-too-low/. Jason Furman will talk about the evidence for the fall in the equilibrium Wicksellian neutral rate of interest and the implications of that for optimal monetary policy. I come next. Joe Stiglitz wraps up. And then questions from reporters.

My task is to set out what the arguments on the other side are—and why we do not find them convincing:

I hear four arguments for not changing the 2%/year inflation target, even though pursuing that target found us in a situation where monetary policy was greatly hobbled in its ability to manage the economy for a solid decade. And, as best as I can evaluate them, all four of these arguments seem to me to be wrong. They are:

  1. The Federal Reserve, even at the zero lower bound, has powerful tools sufficient to carry out its stabilization policy tasks (Cf.: Mankiw and Weinzierl (2011) https://scholar.harvard.edu/files/mankiw/files/exploration_of_optimal.pdf), so moving away from 2%/year as a target is not necessary. The response is: This leaves begging the questions of why, then, employment has been so low over the past decade, and why production is still so low relative to our circa-2007 expectations.

  2. The problem is not the 2%/year target but rather pressure on the Federal Reserve: pressure from substantial numbers of economists and politicians practicing bad economics and motivated partisan reasoning. (As an example, somebody sent me a video clip this week of the very smart Marvin Goodfriend half a decade ago, arguing that faster recovery required the Fed to hit the economy on the head with a brick to make people more confident in its willingness to fight inflation http://www.bradford-delong.com/2017/06/on-the-negative-information-revealed-by-marvin-goodfriends-i-dont-teach-is-lm.html.) The response is: This ignores the Fed’s long institutional history of being willing to ignore outside pressure as it performs its standard monetary policy task of judging what appropriate interest rates are. Pressure only mattered when we got into “non-standard” monetary policies, which we needed to do only because the low inflation target had caused us to hit the zero lower bound.

  3. At 2%/year, inflation is non-salient: nobody worries about it. A higher inflation rate would bring shifting expectations of inflation back into the mix, distract people and firms from their proper task of calculating real costs and benefits to worry about monetary policy, and make monetary policy management more complicated. The response is: But right now people and firms are “distracted” by the high likelihood of depressions that last longer than five years. That is a much bigger distraction than worrying about whether inflation will be 4%/year of 5%/year. And right now the zero lower bound makes monetary policy management much more complicated than it was back in the 1990s when the impact of Fed policy on inflation expectations was in the mix.

  4. The Federal Reserve needs to maintain its credibility, and if it were to even once change the target inflation rate, its commitment to any target inflation rate would have no credibility. The response is: But the credibility you want to have is credibility that you will follow appropriate policies to successfully stabilize the economy—not credibility that you will mindlessly pursue a destructive policy because you think it somehow wrong to acknowledge that the considerations that led you to adopt it in the first place were wrong or have changed. As my friend Daniel Davies puts it in his One-Minute MBA Course: “Is a credible reputation as an idiot a kind of credible reputation one really wants to have?” http://crookedtimber.org/2006/11/29/reputations-are-made-of/

Over to you, Joe…

On the Negative Information Revealed by Marvin Goodfriend’s “I Don’t Teach IS-LM”

Posted on by Brad DeLong

The smart and snarky Sam Bell wants to taunt me into rising to his bait by twittering https://twitter.com/sam_a_bell/status/872116967070732288 a quote from likely Fed nominee Marvin Goodfriend: “I don’t teach IS-LM”. He succeeds. Here is the quote:

TOM KEENE: But, Marvin, with, you know, basic IS-LM and theory and all that stuff you teach in Economics 101, aren’t we going to see a dampening of GDP if we see a restrictive Fed?

MARVIN GOODFRIEND: By the way, I don’t teach IS-LM. But what I would say is this…

And here is the tape:

March 23, 2012: https://www.youtube.com/watch?v=emvSYwUnWyI&ab_channel=Bloomberg

Let me start by analyzing “I don’t teach IS-LM”. And let me preface this by saying that Marvin Goodfried is a very sharp and honest economist. But I believe that whenever anybody says “I don’t teach IS-LM” they are one of:

  1. Making completely implausible and wrong claims about how the economy works.
  2. Being lazy and/or stupid.
  3. Declaring a tribal affiliation to a particular Carnegie-Mellon tradition of macroeconomic analysis that the late Rudi Dornbusch described to me and others as “Jim Tobin with original errors”, and that I think has shed a lot more heat than light on real issues.

Let us start with (1), and let us start with Irving Fisher’s monetarism: the quantity of money demanded in the economy is given by the equation:

Md = PY/V

where M is the quantity of money demanded, P is the price level, Y is the level of production, and V is the velocity of money—the value of transactions that having $1 in the bank or in cash as money can support, in the sense of manufacturing the needed trust so that the transactions will go through.

If you believe that that velocity of money is fixed by the institutions of the banking system and the technology supporting transactions, then you do not have to teach IS-LM. You have reached a full stop, and have the monetarist conclusion that the total nominal spending in the economy—prices times quantities produced—is equal to a constant times the economy’s money stock, with the constant of proportionality chaining slowly over time as the institutions of the banking system and the technology supporting transactions slowly changes.

That is meaning (1) of “I don’t teach IS-LM”: I do not need to teach it because it is not important in determining how much spending there is the economy. That is implausible and wrong. Here is the graph of velocity since 1960—the thing that is supposed to be on a smooth and steady time trend if “I don’t teach IS-LM” is a sensible thing to say:

Velocity of M2 Money Stock FRED St Louis Fed

Even before the 1990s any model assuming an unproblematic relationship between the money stock and total spending was badly awry, although not as badly awry as it has been since.

Now let’s move on to (2)—lazy and/or stupid. The graph above tells you that if you want to forecast—or even retrospectively explain—the relationship between the money stock and the level of spending, you need a model of what the determinants of the fluctuations of velocity we see are. If we draw a graph with the level of spending on the horizontal axis and some sufficient statistics for the determinants of velocity on the vertical axis, the path traced out by our equation:

Md = PY/V

is conventionally called “the LM curve”. But you then need to know where on the LM curve the economy will be—you need another curve. And that other curve is conventionally called “the IS curve”.

To claim that you do not teach IS-LM is to implicitly claim that you do not need to figure out where on the LM curve the economy will be. That is something it is only possible to say if you are being lazy, or stupid.

The third meaning of “I don’t teach IS-LM” is that it is a CMU-school tribal indentification marker, and has no purpose beyond that—no intellectual purpose.

So, yes, the fact that Marvin Goodfriend would go on Tom Keene’s surveillance and say “I don’t teach IS-LM” makes me think a good deal less of him. I do, however, interpret that claim as a declaration of tribal allegiance to CMU-school macro. I do not interpret it as a claim that you don’t need a model of the determinants of fluctuations in velocity. I do not interpret it as a claim that there are no fluctuations in velocity large enough to worry about.

What worries me more, however, is what comes next:

GOODFRIEND: There is no way that this recovery can proceed with any degree of confidence unless the Fed makes sure that inflation does not move up. So I think the risks are exactly reversed from the way the Fed chairman discusses this. He has to make the public understand that any whiff of doubt about the Fed’s ability and willingness to stabilize inflation is going to put a crimp into the public’s willingness to take positions and commitments over the next two or three years that would produce genuine growth. And so I would just take it, and turn it on its head, and not put the question as you did to me, but reverse it.

The risks of allowing any latitude in inflation expectations to build dup, or any doubt about the Fed’s willingness to do what it takes to keep inflation down, is to me the most likely risk in preventing this recovery from getting any traction…

Do notice that Marvin Goodfriend is, here, thinking in terms of an IS-LM model. When he says “any whiff of doubt about the Fed’s ability and willingness to stabilize inflation is going to put a crimp into the public’s willingness to take positions and commitments… is to me the most likely risk in preventing this recovery from getting any traction…”, he is saying: “any whiff of doubt about the Fed’s ability and willingness to keep inflation low will cause a large leftward shift in the IS curve that will prevent this recovery from getting any traction…” He does not do more than gesture at an expectational mechanism for this leftward shift in the IS curve that he wants the Federal Reserve to take action to head off. But it is what he fears.

And, of course, Goodfriend was wrong: a continuation of Bernanke’s extraordinary easing policies was not going raise “any whiff of doubt about the Fed’s ability and willingness to stabilize inflation”.

Here we have a market-based measure of inflation expectations—the ten-year breakeven inflation rate since 2010: that inflation rate over the forthcoming ten years that would, at each date, have made investments in conventional Ten-Year U.S. Treasury bonds and investments in Ten-Year Inflation-Protected Securities (TIPS) equally profitable. The vertical blue line marks March 23, 2012: the date of Marvin Goodfriend’s interview. The point that Marvin was hammering home again and again on March 23, 2012 was that the Federal Reserve needed to rapidly start shrinking its balance sheet and raising interest rates lest inflation expectations break out to the upside.

The Federal Reserve ignored Marvin Goodfriend.

And Marvin Goodfriend was wrong. The shift to a tighter, more restrictive policy he demanded then was not necessary to prevent an upside breakout of inflation expectations.

In fact, the Federal Reserve’s persistent problem since has been that expectations of—and actual outcomes for—inflation have been well below rather than above the Federal Reserve’s targets.

I would very much like to hear Marvin Goodfriend explain why he misjudged the situation in the spring of 2012, and how he has updated his view of the economy and of optimal monetary policy since.

The Truth Behind Today’s US Inflation Numbers

Posted on by Brad DeLong

Live at Project Syndicate: The Truth Behind Today’s US Inflation Numbers https://www.project-syndicate.org/commentary/fed-low-inflation-more-stimulus-by-j–bradford-delong-2017-06: BERKELEY – In December 2015, the US Federal Reserve embarked on a monetary-tightening cycle, by raising the target range for the short-term nominal federal funds rate by 25 basis points (one-quarter of a percentage point). At the time, the Federal Open Market Committee (FOMC)–the Fed body that sets monetary policy–issued a median forecast predicting three things… Read MOAR at Project Syndicate

Will Somebody Please Tell Me Again Why the Federal Reserve Has Embarked on a Tightening Cycle?

Posted on by Brad DeLong
Real Gross Domestic Product Growth Personal Consumption Expenditures Excluding Food and Energy Chain Type Price Index FRED St Louis Fed

With 2017Q1 real GDP growth currently forecast at a 1.2% annual rate—down from 2.7% expected last December—it is worth pausing to remember that if that number comes true:

  • 4Q real GDP growth is: 2.0%/year
  • 8Q real GDP growth is: 1.9%/year

Maybe this is an economy in which slow productivity growth is constraining expansion. But if that is the case, where is the inflation? More likely this is the case in which overly-tight fiscal and monetary policy are constraining an economy that still has some significant amount of macroeconomic slack in it…

Plus: this is what you would expect from a central bank that regards 2.0%/year core PCE inflation as a ceiling not to be crossed, rather than as a central-tendency target…

Note: Our Stabilization Policy Dilemma

Posted on by Brad DeLong

Note to Self: If we want to have a better world, we either need to change the politics to restore the stabilization policy mission to fiscal authorities–and somehow provide them with the technocratic competence to carry out that mission–or give additional powers to central banks, powers that we classify or used to classify as being to a degree “fiscal”.

See: http://www.bradford-delong.com/2016/11/imf-panel-fiscal-policy-in-the-new-normal-partial-transcript.html

Why Does the Federal Reserve Take 2%/Year Inflation to Be a Ceiling Rather than a Target?

Posted on by Brad DeLong
Preview of Central Banks and Economic Structure Since 2009 the Federal Reserve and other global north

A Hypothesis: Some (many?) Federal Reserve policymakers seem to believe that if there is a recession, they lose.

And they also believe that if inflation gets above 2%/year they will be unable to reduce it to 2%/year without a recession.

Thus they do not take an “optimal control” view of the situation at all. Instead, they seek above all else to avoid getting into a situation in which they will have to take active steps to reduce the inflation rate, because they do not believe they can do so without generating something that will be called a recession.

This is a dangerous and a bad habit of thought for them to have…

Misdiagnosis of 2008 and the Fed: Inflation Targeting Was Not the Problem. An Unwillingness to Vaporize Asset Values Was Not the Problem…

Posted on by Brad DeLong

This, from the very sharp Martin Wolf, seems to me to go substantially awry when Martin writes the word “convincingly”. Targeting inflation is not easy: you don’t see what the effects of today’s policies are on inflation until two years or more have passed. Targeting asset prices, by contrast, is very easy indeed: you buy and sell assets until their prices are what you want them to be.

As I have said before, as of that date January 28, 2004, at which Mallaby claims that Greenspan knew that he ought to “vaporise citizens’ savings by forcing down [housing] asset prices” but had “a reluctance to act forcefully”, that was not Greenspan’s thinking at all. Greenspan’s thinking, in increasing order of importance, was:

  1. Least important: that he would take political heat if the Fed tried to get in the way of or even warned about willing borrowers and willing lenders contracting to buy houses and to take out and issue mortgages.

  2. Less important: a Randite belief that it was not the Federal Reserve’s business to protect rich investors from the consequences of their own imprudent folly.

  3. Somewhat important: a lack of confidence that housing prices were, in fact, about fundamentals except in small and isolated markets.

  4. Of overwhelming importance: a belief that the Federal Reserve had the power and the tools to build firewalls to keep whatever disorder finance threw up from having serious consequences for the real economy of demand, production, and employment.

(1) would not have kept Greenspan from acting had the other more important considerations weighed in the other direction: Greenspan was no coward. William McChesney Martin had laid down the marker that: “If the System should lose its independence in the process of fighting for sound money, that would indeed be a great feather in its cap and ultimately its success would be great…” Preserving your independence by preemptively sacrificing it when it needed to be exercised was not Greenspan’s business. (2) was, I think, an error–but not a major one. And on (3), Greenspan was not wrong:

S P Case Shiller 20 City Composite Home Price Index© FRED St Louis Fed

Nationwide, housing prices today are 25% higher than they were at the start of 2004. There is no fundamental yardstick according to which housing values then needed to be “vaporized”. The housing bubble was an issue for 2005-6, not as of the start of 2004.

It was (4) that was the misjudgment. And the misjudgment was not that the economy could not handle the adjustment that would follow from the return of housing values from a stratospheric bubble to fundamentals. The economy handled that return fine: from late 2005 into 2008 housing construction slackened, but exports and business investment picked up the slack, and full employment was maintained:

Macroeconomic Overview Talk for UMKC MBA Students April 1 2013 DeLong Long Form

The problem was not that the economy could not climb down from a situation of irrationally exuberant and elevated asset prices without a major recession. The problem lay in the fact that the major money center banks were using derivatives not to lay subprime mortgage risk off onto the broad risk bearing capacity of the market, but rather to concentrate it in their own highly leveraged balance sheets. The fatal misjudgment on Greenspan’s part was his belief that because the high executives at money center banks had every financial incentive to understand their derivatives books that they in fact understood their derivatives books.

As Axel Weber remarked, afterwards:

I asked the typical macro question: who are the twenty biggest suppliers of securitization products, and who are the twenty biggest buyers. I got a paper, and they were both the same set of institutions…. The industry was not aware at the time that while its treasury department was reporting that it bought all these products its credit department was reporting that it had sold off all the risk because they had securitized them…

That elite money center financial vulnerability and the 2008 collapse of that Wall Street house of cards, not the unwinding of the housing bubble, was what produced the late 2008-2009 catastrophe:

Macroeconomic Overview Talk for UMKC MBA Students April 1 2013 DeLong Long Form

Greenspan’s error was not in targeting inflation (except at what in retrospect appears to be too low a level). Greenspan’s error was not in failing to anticipatorily vaporize asset values (though more talk warning potentially overleveraged homeowners of risks would have been a great mitzvah for them). Greenspan’s error was in failing to regulate and supervise.

Martin Wolf: Man in the Dock:

Of his time as Fed chairman, Mr Mallaby argues convincingly that:

The tragedy of Greenspan’s tenure is that he did not pursue his fear of finance far enough: he decided that targeting inflation was seductively easy, whereas targeting asset prices was hard; he did not like to confront the climate of opinion, which was willing to grant that central banks had a duty to fight inflation, but not that they should vaporise citizens’ savings by forcing down asset prices. It was a tragedy that grew out of the mix of qualities that had defined Greenspan throughout his public life—intellectual honesty on the one hand, a reluctance to act forcefully on the other.

Many will contrast Mr Greenspan’s malleability with the obduracy of his predecessor, Paul Volcker, who crushed inflation in the 1980s. Mr Greenspan lacked Mr Volcker’s moral courage. Yet one of the reasons why Mr Greenspan became Fed chairman was that the Reagan administration wanted to get rid of Mr Volcker, who “continued to believe that the alleged advantages of financial modernisation paled next to the risks of financial hubris.”

Mr Volcker was right. But Mr Greenspan survived so long because he knew which battles he could not win. Without this flexibility, he would not have kept his position. The independence of central bankers is always qualified. Nevertheless, Mr Greenspan had the intellectual and moral authority to do more. He admitted to Congress in 2008 that: “I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.” This “flaw” in his reasoning had long been evident. He knew the government and the Fed had put a safety net under the financial system. He could not assume financiers would be prudent.

Yet Mr Greenspan also held a fear and a hope. His fear was that participants in the financial game would always be too far ahead of the government’s referees and that the regulators would always fail. His hope was that “when risk management did fail, the Fed would clean up afterwards.” Unfortunately, after the big crisis, in 2007-08, this no longer proved true.

If Mr Mallaby faults Mr Greenspan for inertia on regulation, he is no less critical of the inflation-targeting that Mr Greenspan ultimately adopted, albeit without proclaiming this objective at all clearly. The advantage of inflation-targeting was that it provided an anchor for monetary policy, which had been lost with the collapse of the dollar’s link to gold in 1971 followed by that of monetary targeting. Yet experience has since shown that monetary policy is as likely to lead to instability with such an anchor as without one. Stable inflation does not guarantee economic stability and, quite possibly, the opposite.

Perhaps the biggest lesson of Mr Greenspan’s slide from being the “maestro” of the 1990s to the scapegoat of today is that the forces generating monetary and financial instability are immensely powerful. That is partly because we do not really know how to control them. It is also because we do not really want to control them. Readers of this book will surely conclude that it is only a matter of time before similar mistakes occur.

The root problem of 2008 was not that inflation targeting generates instability (even though a higher inflation target then and now would have been very helpful). The root problem of 2008 was not that the Federal Reserve was unwilling to vaporize asset values–the Federal Reserve vaporized asset values in 1982, and stood willing to do so again *if it were to seem appropriate*. The root problem of 2008 was a failure to recognize that the highly leveraged money center banks had used derivatives not to distribute subprime mortgage risk to the broad risk bearing capacity of the market as a whole but, rather, to concentrate it in themselves.

At least as I read Mallaby, he does not criticize Greenspan for “inertia on regulation” nearly as much as he does for Greenspan’s failure to “vaporise citizens’ savings by forcing down asset prices…” even when there is no evidence of rising inflation expectations or excess demand in the goods and labor markets as a whole.

Axel Weber’s full comment:

I think one of the things that really struck me was that, in Davos, I was invited to a group of banks–now Deutsche Bundesbank is frequently mixed up in invitations with Deutsche Bank.

I was the only central banker sitting on the panel. It was all banks. It was about securitizations. I asked my people to prepare. I asked the typical macro question: who are the twenty biggest suppliers of securitization products, and who are the twenty biggest buyers. I got a paper, and they were both the same set of institutions.

When I was at this meeting–and I really should have been at these meetings earlier–I was talking to the banks, and I said: “It looks to me that since the buyers and the sellers are the same institutions, as a system they have not diversified”. That was one of the things that struck me: that the industry was not aware at the time that while its treasury department was reporting that it bought all these products its credit department was reporting that it had sold off all the risk because they had securitized them.

What was missing–and I think that is important for the view of what could be learned in economics–is that finance and banking was too-much viewed as a microeconomic issue that could be analyzed by writing a lot of books about the details of microeconomic banking. And there was too little systemic views of banking and what the system as a whole would develop like.

The whole view of a systemic crisis was just basically locked out of the discussions and textbooks. I think that that is the one big lesson we have learned: that I now when I am on the board of a bank, I bring to that bank a view, don’t let us try to optimize the quarterly results and talk too much about our own idiosyncratic risk, let’s look at the system and try to get a better understanding of where the system is going, where the macroeconomy is going. In a way I take a central banker’s more systemic view to the institution-specific deliberations. I try to bring back the systemic view. And by and large I think that helps me understand where we should go in terms of how we manage risks and how we look at risks of the bank compared to risks of the system.