Kelly Evans on NGDP Targeting and Sustainable Growth

Kelly Evans of The Wall Street Journal has taken a lot of heat from advocates of nominal GDP targeting over her Monday column on the subject. (To her credit, she has engaged with Scott Sumner on the subject in the comments section of his blog post responding to her column.) While I’m also an advocate of NGDP targeting, and I agree with many of their criticisms, I think there are certain points on which her argument is being too quickly dismissed. In particular, both Scott Sumner and Karl Smith point to the following passage:

One worrying aspect of GDP growth prior to 2007 was that it came even as real household incomes stagnated. Assuming that boom-era growth rates were sustainable, and not fueled by a surge in house prices and a credit boom that simply pulled forward demand from the future, is a huge leap in logic.

I think there is some confusion on both sides regarding this point, and to clear it up we need to make a distinction between the demand side and the supply side. Usually when economists talk about “sustainable” growth, they’re referring to the supply side: some growth rates are not sustainable because they deplete the supply of resources too quickly. (In particular, an output growth rate is not sustainable if it exceeds the sum of population growth and labor productivity growth, because we would eventually run out of willing and qualified workers and end up in a wage-price spiral.) But here Kelly Evans seems to be referring to demand sustainability rather than supply sustainability.

Is demand sustainability, in this aggregate sense, a meaningful concept? Many economists would say no, because aggregate demand – demand for everything except money itself – is really just the inverse of the demand for money (or for financial assets in general), and there is no limit on the sustainability of the supply of money: we can always print more. And indeed we can always print more money, but the problem is, will we? Aggregate demand sustainability isn’t meaningful in an absolute sense, but it is meaningful if we condition on the growth of some nominal quantity such as the money supply, the price level, or nominal GDP. A certain level of aggregate demand may not be sustainable at a given rate of inflation, or at a given rate of NGDP growth, and thus there is no guarantee that the trajectory of nominal aggregate demand prior to 2007 was sustainable.

When Kelly Evans refers to a “boom that simply pulled forward demand from the future,” Karl Smith interprets this to mean that people were living above their means. But this is a supply-side interpretation: their means (supply) were not sufficient to sustain the pattern of consumption. I believe that the relevant interpretation is a demand-side one: people were choosing (demanding) a certain pattern of consumption based on false information. To say that their demand was “pulled forward from the future” is to say that they would, had they known the truth, have preferred to consume in the future rather than in the present (or in some cases, that their lenders, had they known the truth, would have preferred that the borrowers consume in the future instead of borrowing from them and consuming in the present)

The underlying problem over the past decade is excessive patience: everyone (by which I mean, mostly, the Chinese) wants to defer their expenditures into the future at the same time. But everyone can’t do that at the same time. In a perfect world, we would solve this problem by allowing prices to drop temporarily, far enough to convince enough people to take advantage of the low prices by spending today instead of in the future. But in the real world, price adjustment doesn’t happen quickly, and it often causes more problems than it solves.

So how do you get people to shift their expenditures into the present? One way is by fooling them. Make them think they’re richer than they really are. Make them think there are ultra-safe assets available to safeguard their future spending capacity. Find the people who want to spend today but don’t have any money, and make someone else think it’s safe to lend them money. But this solution is…unsustainable.

The sustainable solution, in theory at least, is to generate an expected inflation rate high enough that – at some positive interest rate – enough people will choose to spend money today instead of in the future. But that solution may not be on the table. Inflation rates much higher than 2% are heavily frowned upon by…just about everyone, it seems, except a few economists. Is 2% high enough? Who knows?

NGDP targeting is another solution, but is it sustainable? As I discussed at the end of my last blog post, and as Nick Rowe expands upon, NGDP (level) targeting would eventually succeed in raising demand, because every time it failed, it would then promise a yet more aggressive (and therefore more inflationary) policy. But what happens after it succeeds? Unless people have become less patient, we’re back where we started: everyone tries to shift expenditures into the future at the same time. The economy gets depressed again, and the cycle repeats.




DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

Can Knut Wicksell Beat Up Chuck Norris?

Nick Rowe argues that NGDP targeting is a way of dealing with coordination failure. Businesses don’t want to hire if nobody’s buying, and households don’t want to buy if nobody’s hiring. So they’re all hoarding money instead. The way to fix it is that you have Chuck Norris threaten to beat up anyone who hoards money. Then businesses start hiring and households start buying (or else they both buy riskier assets, and the people who sold those assets do the hiring and buying, because they also don’t want to be beat up for hoarding the proceeds).

In the simplest version of the argument, beating people up is a metaphor for inflation. But if you don’t believe the Fed can produce more inflation (as many economists believe that the Bank of Japan has tried and failed to produce a positive inflation rate over the past 20 years), you can take beating people up as a metaphor for reducing asset returns. Even if the Fed can’t produce inflation, it can bid down the returns on a lot of assets until people get fed up and start buying riskier assets that can finance new expenditures. Some people don’t even think the Fed can do that, because maybe people have such a strong need for safety that they will only hoard more cash if other safe asset returns go down. I’m not 100% sure myself, but, for the sake of argument, I’m going to assume that the Fed can, if it is aggressive enough in buying safe assets, convince people to buy enough risky assets to get the economy going again.

Nick’s point, though, is that the Fed can do this without actually reducing the return on safe asests (and presumably without producing a lot of inflation either). Chuck Norris can clear a room without actually beating anyone up. The threat is enough. Similarly, in Nick’s view, the Fed can fix a coordination failure by threatening to reduce the return on safe assets, but it won’t have to carry out that threat if it’s credible. In fact, asset returns will go up, because the improved economy will make businesses more profitable, thus raising the return on risky assets and inducing people to abandon safe assets even if the yields go up. Paradoxically, by credibly threatening to push asset returns down, the Fed succeeds in pushing them up.

OK, fine. I’ll note that Ben Bernanke is no Chuck Norris, but perhaps President Romney will replace him with Chuck Norris, or with the antimatter counterpart of Paul Volcker (who was the Chuck Norris of inflation fighting). I’ll also note that Chairman Norris will enter with a considerable handicap, given that many are uncertain about the Fed’s ability to succeed in convincing people to abandon safe assets. If the threat were credible and everyone knew it to be credible, then everyone would know that stock prices are going up and they really ought to sell their bonds as quickly as they can, and we’d immediately be on the path to the good equilibrium. But even with Chuck Norris as Fed Chairman, a lot of people are going to think, “What if the Fed fails? At least cash is safe.” The threat alone quite possibly won’t be enough: Chuck Norris may well have to beat up a bunch of people – QE, Walker style – before the room clears.

But OK, I’m not opposed to violence, when it’s the only way to get something done. Only here’s my concern: how do we know that coordination failure is the real problem?

Flash back to 2006. There was no coordination failure then. Firms were hiring. Households were buying. Commerce was functioning smoothly. Very smoothly, too, in the sense that the economy was neither overheating (no rising inflation, no labor shortage) nor driving interest rates abnormally high. (The 10-year TIPS yield ranged from 1.95% to 2.68% in 2006, consistently below the perceived long-run real growth rate of the US economy.)

Yet that smoothness was based on being completely out of touch with reality – or at least out of touch with what most people today regard the reality to have been. By most accounts, housing prices were inflated, making people feel wealthier than they really were, and lots of seemingly safe assets were available, which, as it turned out, were not at all safe. Even with interest rates relatively low, this deception was apparently necessary in order to get households to buy and firms to hire in sufficient quantities to achieve full employment. Since the deception is no longer feasible, interest rates will presumably have to be a lot lower – even if we rule out coordination failure – in order to induce enough buying and enough hiring today to achieve full employment.

But how much lower? We can’t say exactly. Today 10-year TIPS are yielding close to zero. Is that low enough, if it weren’t for coordination failure? Maybe. Maybe not. Your guess is as good as mine. I can certainly imagine that could we fix the coordination failure (if there is one) and still end up producing well below our capacity.

That’s where Knut Wicksell comes in. Wicksell was the early 20th century economist who argued that prices would tend to go up or down depending on whether the interest rate was below or above its “natural” level (which varied over time). Modern interpretations allow for sticky prices and wages, so instead of falling prices, you get unemployment when the interest rate is too high. As I suggested in a post last year, and in the paragraph above, the “natural interest rate” could be negative, in which case a higher inflation rate is the only way to achieve full employment.

For practical purposes I advocate the same policy that Nick does – nominal GDP targeting – but I’m a bit less optimistic about how quickly and smoothly we could approach the target. And, given a choice, I’d probably favor a more aggressive target than Nick would. One of the implications of the Wicksellian analysis (which is not so clear if you think coordination failure is the only problem) is that more aggressive targets are easier to hit, because they imply higher inflation rates and therefore a lower floor on the real interest rate.

The important thing is to set a target path and stick to it even if you keep missing the first few targets by larger and larger margins. If the natural interest rate is negative, the early targets may be impossible to hit, but if you continue trying to hit the subsequent targets, those targets will imply higher inflation rates. Suppose your target path rises by 5% per year. A 10% increase in NGDP over two years may not imply enough inflation to get the real interest rate down to its natural level, but if NGDP doesn’t rise at all in those two years, the target path will now imply 20% NGDP growth over the subsequent two year period. That would require a lot of inflation – certainly enough to be consistent with a very negative natural real interest rate. Chuck Norris may take his hits in the first few years, but Knut is eventually going down.




DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

Fixing What’s Wrong with the Taylor Rule

I see four problems with the original Taylor rule:

1. It’s not really a rule at all. The Taylor rule depends on an estimate of potential output. In practice, most of the discretion that goes into central banking is in the estimate of potential output. Even “discretionary” central bank policy is effectively constrained by the consensus of what would be considered reasonable policy actions, and any of those actions can be rationalized by changing your assumption about potential output. Usually, a central bank that has committed to following a “strict” Taylor rule has roughly the same set of options available as one that is ostensibly operating entirely on its own discretion.
   
   
2. It doesn’t self-correct for missed inflation rates. Since the inflation rate in the Taylor rule is over the previous four quarters, the rule “forgets” any inflation that happened more than four quarters ago. This is a problem for four reasons:
   
   
   
   • It leaves the price level indeterminate in the long run, thus interfering with long-term nominal contracting and decisions that involve prices in the distant future.
     
     
   • It leaves the central bank without an effective tool to reverse deflation when the expected deflation rate exceeds the natural interest rate.
     
     
   • It reduces the credibility of central bank attempts to bring down high inflation rates, because the bank always promises to forgive itself when it fails.
     
     
   • It aggravates the “convexity” problem described below, because the central bank effectively ignores small deviations from its inflation target, even when they accumulate.
     
   
   
3. It doesn’t allow for convexity in the short-run Philips curve. If the estimate of potential output is too low, for example, and the coefficient on output is sufficiently low, then, if the short-run Philips curve is convex, the central bank will allow output to persist below potential output for a long time before “realizing” that it has made an error. In the extreme case, where the short-run Phillips curve is L-shaped, the central bank may allow actual output to be permanently lower than potential output. More generally, the convexity problem can be aggravated by hysteresis effects, in which lower actual output leads to lower potential output, so that the central bank’s wrong estimate of potential output becomes a (permanently) self-fulfilling prophecy.
   
   
4. It can prescribe a negative interest rate target, which is impossible to implement. This appears to have been the case for at least part of 2009 and 2010, although there is disagreement about the details.
   

So how do we fix these problems? I suggest the following solutions:

1. Adopt a fixed method for estimating potential output. (One might allow future changes to the method, but they should be implemented only with a long lag: otherwise, they’ll interfere with the central bank’s credibility, since they can be used to rationalize discretionary policy changes.) Since I like simplicity, I suggest the following method: take the level of actual output in the 4th quarter of 2007 (when most estimates have the US near its potential) and increase it at an annual rate of 3% (the approximate historical growth rate of output) in perpetuity.
   
   
2. Replace the target inflation term with a target price level term. In other words, express it as a deviation from a target price level that rises over time by the target inflation rate. To be clear what I mean by the “target inflation term,” take Taylor’s original equation
   r = p + .5y + .5(p - 2) + 2 (where p refers to the inflation rate)
   and note that I am referring to the “p – 2” term but not to the initial “p” term, which is not really a target but part of the definition of the instrument (an approximation of the real interest rate). In my new formulation, “p – 2” becomes “P – P*,” where “P is (100 times the log of) the actual price level and P* is (100 times the log of) the target price level (i.e., what the price level would be if the inflation rate had always been on target since the base period).
   
   
3. Increase the coefficient on output. If you wish, in order to avoid a loss in credibility, you can also increase the coefficient on the price term by the same amount. What we have then is a more aggressive Taylor rule. It doesn’t solve the convexity problem completely, but it does assure that, when output is far from target, the central bank will take aggressive action to bring it back (unless the price level is far from target in the other direction). That way at least you don’t end up with a long, unnecessary period of severe economic weakness. (John Taylor claims that, according to David Papell’s research, there is “no reason to use a higher coefficient, and…the lower coefficient works better.” But that research only looks at changing the coefficient on the output term without either changing the coefficient on the inflation term or replacing it with a price term, as I suggest above. Having a too-small coefficient on the output term, as in the original rule, is only a second-best way of achieving the results that those other changes would achieve.)
   
   
4. “Borrow” basis points from the future when there are no more basis points available today. In other words, if the prescribed interest rate is below zero, the central bank promises to undershoot the prescribed interest rate once it rises above zero again, such that the number of basis-point-years of undershoot exactly cancel the number of basis-point-years of (unavoidable) overshoot. This method will only work, of course, if the market knows what rule the central bank is following, hence (among other reasons) the need for a rule that really is a rule. If the rule is well-defined, the overshoot will be well-defined, the market will expect the central bank to “pay back” the “borrowed” basis points, and the central bank will be obliged to do so in order to maintain its subsequent credibility.
   

OK, let’s look at the big picture. What have I proposed? I have proposed nominal GDP targeting (along with a specific method for how to implement it). When the price level term and the output term have the same coefficient and both are specified as a deviation from target, the Taylor rule can be simplified by combining the price level target with the output target. Combining Taylor’s original 2% inflation target (re-expressed as a price level path target as per my suggestion) with my suggested method for estimating potential output, we arrive at a 5% nominal output growth path as the target.

If you wish, you can go further by making the rule forward-looking (using a forecast of nominal GDP instead of a lagged observation) and increasing the coefficient to a very high number. And you can enforce the credibility of the forecast by requiring the central bank to use the forecast implicit in a publicly traded nominal GDP futures contract, so that the market is putting its money where the central bank’s mouth is. You end up with the proposal that Scott Sumner has already made. People seem to think that Scott Sumner’s ideas about monetary policy are far out of the mainstream. But I’m not proposing anything radical here, just trying to fix some problems with the very orthodox Taylor rule.




DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

Inflation Target Debate at The Economist

I have been featured as a guest expert in an online debate about inflation targeting on The Economist's website. The topic: "This house believes that a 2% inflation target is too low." The debate is between Brad DeLong and Bennett McCallum, with Ryan Avent as the moderator.

Not Inflation

I’m sick of hearing people complain about inflation. Unless your income comes from long-duration fixed-income investments, inflation has nothing to do with how much groceries and gasoline you can afford. Inflation is a pattern of increase in the general price level. What matters for affording stuff is a relative price, not the general price level. Specifically in this case it is the price of groceries and gasoline relative to the price of labor. And whether or not you like to eat iPads, the broader problem (for people with jobs) is not that the nominal price of groceries and gasoline is going up but that the real price of labor is going down.

In fact, when measured in terms of how much that labor can produce, even the nominal price of labor is going down, as illustrated by the last part of this chart from the Bureau of Labor Statistics:


Look at the last two years compared to the rest of the chart. As someone who thinks people are more important than gasoline, I’d say this looks a heck of a lot more like deflation than inflation.

And people are more important than gasoline – not just in the ethical sense implied by my snide suggestion, but in a cold, economic sense: labor is more important than energy as an input to the goods and services that get produced. Therefore if the price of labor is falling while the price of energy is rising, the pressure on the prices of goods and services is likely to be downward rather than upward.

Not that I’m expecting the prices of goods and services to start moving dramatically downward in the immediate future. After all, the price of energy has been rising faster than the price of labor has been falling. And the value of the dollar has been falling, while many of the goods Americans consume are produced abroad. And the price of labor is not necessarily going to continue falling. I will say, though, that I think the price of labor provides a strong anchor for the general price level: just as the gold standard provided assurances against runaway inflation, so the “labor standard” provides such assurances. In fact, the labor standard provides better assurances, because labor is the most important input into the production of many useful things, whereas gold is – well, just gold.

(You might object that we really aren’t on a labor standard, because unit labor costs could start rising at any time, and there is no guarantee that policymakers would resist such increases. All I can say is, if you think the gold standard provides a guarantee against changes in the whims of policymakers, you need to read about what happened in 1933 and 1971.)

I’m going to go further and say that I think the falling real price of labor is a good thing, at least in the short run. I’ll even say that rising food and energy prices, while not good in themselves, are symptomatic of something good that is happening and that I would like to see accelerate rather than decelerate.

The flip side of falling real wages is rising profit margins. In a simplified closed economy this would be trivially true: the profit margin for businesses in aggregate would be the difference between the prices they charge and the wages they pay, i.e., the inverse of the real wage. It’s also true to a lesser extent in the real world, although the situation is more complicated because there are imports and exports, and labor and capital are not the only inputs.

What we experienced in 2008 and 2009 can be seen as a dramatic decline in the willingness of aggregate business to produce more for any given level of the aggregate profit margin. (Obviously, the phrase “aggregate business” hides a lot of critical details: part of the problem was with banks’ willingness to lend; part was with hoarding of cash by large corporations; part was with investors’ preferences over public vs. private sector assets; and so on.) What we need to do to fix this problem (and what we are doing, to some extent) is to make profit margins so high that businesses are willing to expand despite their newfound conservatism.

And it should be noted that there is a continuum of price flexibility. At one end, wages are perhaps the least flexible; at the other end, commodity prices are the most flexible. But there is a whole range in-between. When demand picks up, commodity prices rise first, product prices rise more sluggishly (with varying degrees of sluggishness), and wages rise most sluggishly. If the objective is to raise profit margins, then product prices have to rise more quickly than wages, and an inevitable side effect is that commodity prices will rise even faster than product prices. To the (limited) extent that rising commodity prices represent domestic US demand, they are a sign of a process that needs to be encouraged, not discouraged.

In the intermediate run, the evidence is clear that real wages are procyclial. When a recovery really gets going, real wages eventually rise, presumably because the economy as a whole becomes more efficient and “a rising tide lifts all boats.” In the short run, though, we need to get the recovery going before this can happen, and the way to get the recovery going is to let real wages fall – or at least rise more slowly than productivity. Say what you like, I’m cheering for rising prices.


DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.