James Medoff, Stagflation, the Phillips Curve, and the Greenspan Boom

James Medoff, my thesis advisor in graduate school and later my collaborator and business associate, died on Saturday, September 15 after a long struggle with multiple sclerosis.  In the field, he was probably best known for his work on labor market institutions, and particularly for his work with Richard Freeman on the impact of unionization.  But by the time I started working with him, most of that was in the past.  I was a student of macroeconomics, not labor economics, but I was intrigued by a paper he had written with Katharine Abraham entitled “Unemployment, Unsatisfied Demand for Labor, and Compensation Growth, 1956-1980.” It seemed to provide a critical missing piece in the puzzle of macroeconomics.

Why was there stagflation (stagnation and inflation at the same time) in the 1970’s?  When I was in graduate school, there were two popular (complementary) explanations.  First, the Fed had been too easy because it didn’t adequately account for the way inflation expectations would become ingrained.  (In the cartoon version of this idea, the Fed goes from believing in a static downward-sloping Phillips curve to realizing – much too late in the game – that the long-run Phillips curve is vertical, but in reality there were certainly some steps inbetween.)  Second, there were oil shocks, shocks to aggregate supply which drove prices up and employment down.  A third explanation you might also hear was that the Fed had responded to political pressure from the Johnson and Nixon (and possibly Carter) administrations and loosened at the wrong times.

Doubtless there was something to all of these ideas, but the Medoff-Abraham paper suggested a completely different explanation.  Essentially what it said was that there was not nearly as much “stag” in the stagflation as we thought.  The labor market, it suggested, had been booming during much of the 1970’s despite the appearance of high unemployment.  The implication was that the unemployment of the 1970’s was largely “structural” (at least that’s the term used in debates about today’s unemployment), and once you realized that, the accompanying inflation shouldn’t surprise you.

When I took James’ graduate course in 1989, this idea was particularly important, because the situation was beginning to reverse itself.  The plateau in structural unemployment lasted from maybe 1975 to maybe 1987, and after that it began to decline.  By the time I graduated, in 1994, this decline was well underway, and our data were suggesting that the US economy could support considerably lower unemployment rates without sparking inflation.  James was invited to the Fed’s meeting of academic consultants that year to make the case for lower unemployment, and I went along to help and observe the discussion.  As I recall, there were about 10 people at the table, and James was the only one saying that it was OK to keep interest rates low and let the unemployment rate fall further.

Naturally, rather than listen to a single maverick, the Fed kept raising rates, and maybe that was for the best, since the recovery turned out to be stronger than most people (including us) had expected.  But over the next few years, something unusual happened.  The unemployment rate kept coming down, and the inflation kept not happening, and now it was Alan Greenspan himself, not some out-of-the-mainstream labor economist from Harvard, who was insisting (against some substantial resistance) that it was OK to keep interest rates low and let the unemployment rate continue falling.

Did James Medoff ultimately influence monetary policy, and was he therefore partly responsible for the boom of the late 1990’s?  Who knows?  If I had Alan Greenspan’s ear, I might ask him.  At his funeral, James’ daughter Susanna said that, in fifth grade, she had wanted to dress up as her father for “Dress as Your Hero Day,” but the teacher wouldn’t let her, so she dressed as Alan Greenspan instead.  In those days, a lot of adults may have considered Greenspan a hero, but I doubt many other fifth graders did.  For the record, I still think Greenspan did a remarkable job with the macroeconomic aspects of monetary policy, and his hero status (since rescinded by most commentators) was not without justification.

In any case, I feel that the research I mentioned is relevant today in a couple of ways.  For one thing, the saga of structural-vs-cyclical unemployment goes on today.  Using techniques similar to those used by Abraham and Medoff, my best guess is that, after the long decline that began around 1988, structural unemployment reached a trough in 2005 and has been rising since then.  (However, I see no particular evidence of a discontinuous increase during the Great Recession, or immediately before or after, and the increase since 2005 has not been particularly rapid, so I don’t buy the view that “our problem is structural.”)

Another way the research is relevant is that it reframes the 1970’s.  By the end of the 1970’s, most economists were convinced that, as textbooks put it during my undergraduate years and maybe still do, “the long-run Phillips curve is vertical.”  In other words, there is no long-run tradeoff between unemployment and inflation.  In the minds of most economists this conclusion was necessitated by the experience of the 1970’s, during which it seemed to become obvious that higher inflation was not generally associated with lower unemployment.  But if much of the problem of the 1970’s was structural, then the conclusion is not so obvious.  Perhaps, conditioning on the structure of the labor market, a downward-sloping Phillips curve still exists, even in the long run.  Indeed, more recent evidence suggests that there is such a tradeoff after all, at least at low inflation rates.

This is important because the US seems to be in the middle of that tradeoff right now.  If you believe there is no tradeoff, if you believe the long-run Phillips curve is vertical, then it's hard to explain how there's still any inflation at all after almost 5 years during which we had first an extremely deep recession and then a painfully slow recovery that has left output still well below any reasonable estimate of the economy's potential.  After 5 years, we should surely be making our way toward the long run, that vertical Phillips curve at full employment. If we're not, it must be because demand is astonishingly weak, and that astonishingly weak demand should be associated with an inflation rate that falls lower and lower until it becomes negative. (This is the flip side of an overheated economy that produces ever-accelerating inflation.) But that isn't happening. Instead we're seeing something that looks a little bit like the old-fashioned downward-sloping static Phillips curve, where low, but not necessarily falling, inflation rates are associated with persistent excess unemployment.

I admit this isn't what I expected. I wrote a blog post a couple of years ago predicting deflation. Even after having questioned the conventional wisdom, I had found it too strong to resist. The vertical long-run Phillips curve, I thought, might not be quite right, but it was "a close enough approximation," and if I denied this, I'd face excommunication from the Church of Macroeconomics. Deflation was coming, I thought.  I was wrong.

I never got a chance to discuss this question with James. During his last years he found it increasingly difficult to think and express himself clearly, so it's unlikely we could have had a productive discussion. But I can imagine what he would have said 20 years ago. He would have talked about his contacts in industry and how they weren't about to destroy morale by cutting wages, even if the economy stayed weak for several years. After some discussion I think we would have come to the conclusion that the vertical long-run Phillips curve was actually a pretty crummy approximation. That's certainly what I think now. I'm going to have to pay more attention in the future to what Hypothetical James Medoff has to say. He lives on.

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.

The Fed and Fiscal Responsibility

If the US goes off the fiscal cliff – that is, if tax increases and spending cuts go into effect in 2013 as currently scheduled – can monetary policy actions offset the macroeconomic impact?  Ben Bernanke doesn’t think so – indeed he’s certain they can’t – and he has said as much.

But on some level he must be wrong.  True, it’s hard to think of any feasible monetary policy action that would both be strong enough and have a sufficiently quick impact to offset the fiscal cliff directly.  But what matters more for monetary policy is not the direct effect but the effect on expectations.  Surely the Fed could alter expectations of future monetary policy in such a way that the resulting increase in private spending would be enough to offset the decreased spending due to fiscal tightening.  Just think, for example, if the Fed were to increase its long-run inflation target.  If nothing else, a sufficiently large increase in long-run US inflation expectations would make the dollar sufficiently unattractive to result in an export boom that would offset the fiscal tightening.  More important, perhaps, it would make currency and Treasury securities less attractive to Americans and encourage them to do other things with their wealth, such as buying houses and durable goods and investing in productive capacity.

Of course that isn’t going to happen.  To get the Fed to do something as drastic as increasing its long-run inflation target, we’d need more than a fiscal cliff; we’d probably need something like a repeat of the 1930’s.  But at this point the Fed has substantial amount of flexibility even within the confines of its long-run target, because it hasn’t specified how that target would best be implemented.  It hasn’t said, for example, whether the target should be interpreted as a growth rate target – where policy constantly begins with a clean slate, ignoring previous missed targets – or a level path target – where policy always attempts to compensate for earlier misses and regain the original target path.  If the latter case prevails, the Fed hasn’t said whether the target path would be retroactive and if so how far back it would be retroactive (for example, choosing 2007 as a base year for the target path instead of 2012).  Moreover, while the Fed has affirmed its commitment to its dual mandate, it hasn’t said how its inflation targeting approach would interact with its employment mandate.

One way to implement the long-run inflation target would be as follows.  First, estimate the economy’s potential output path that was, as of 2007, consistent with maximum employment.  Then add to this a 2% inflation path starting from the 2007 price level.  Express the result as a target path for nominal GDP, and project that path into the future at the estimated future growth rate of potential output plus 2%.  Pursue this path as a level path target.

Because nominal GDP has fallen so far below the path that would, in 2007, have been consistent with 2% inflation at estimated potential output, this approach implies a very dramatic period of catch-up.  Essentially, the Fed would be committing to follow a very aggressive pro-growth, pro-inflation policy over the medium run as soon as it is able to get some traction on the economy.  But it would be doing so in a way that is consistent with its 2% long-run inflation target.

The effect on expectations would be quick and dramatic.  By promising either growth or inflation or both, the Fed would make hoarding cash (or other safe assets) look like a clearly losing proposition.  Depending on whether you expect inflation or growth, either your money will lose its purchasing power, or you will miss out on a lot of profits as real assets recover.  My guess is that, with this change in the medium-run outlook, the resulting increase in private spending over the short run would more than offset the fiscal cliff.  Your guess may be different, but in any case we’re talking about an impact considerably larger than what can be accomplished with the kind of changes in its balance sheet that the Fed typically contemplates now when it thinks about trying to stimulate the economy.  If Ben Bernanke were contemplating anything like what I am suggesting, he clearly wouldn’t be justified in being certain of his inability to offset the fiscal cliff.

OK, this isn’t going to happen either.  At least it’s highly unlikely.  Ben Bernanke isn’t going to have his “Volcker moment,” as Christina Romer called it, just in time to offset a huge tightening in fiscal policy.  And, with any luck, the tightening in fiscal policy won’t be as huge as current law prescribes:  after the election, hopefully, either one party will be in power, or Democrats and Republicans will be able to come to enough of an agreement to prevent disaster.

But the sad thing is that preventing disaster almost certainly means putting the US back on an unsustainable fiscal path – because there’s very little chance that Congress will be able to agree on a credible long-run fiscal plan at the same time that it agrees on a way to avoid going over the cliff in the short run.  Assuming that we do go over the cliff and that the Fed doesn’t offset the impact, the long-run fiscal results may not be much better, because the growth impact of the fiscal shock – allowing for hysteresis effects – will undo at least part of the improvement in the budget.  For those whose primary concern is fiscal sustainability, the best-case scenario would be that we do go over the cliff and that the Fed acts aggressively to offset the macroeconomic impact.

Again, it isn’t going to happen.  And that’s kind of sad.  The Fed’s timidity is creating a situation where the only realistic choices – for the moment anyhow – are economic disaster and fiscal irresponsibility.  Doesn’t that mean that the Fed bears some responsibility for the fiscal problems that are eventually likely to emerge?

  

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. 

An Ultraminimalist Model of the Beveridge Curve, or, How I Learned to Start Worrying and Love Structural Unemployment

Where do businesses find people to hire?  A few new employees – graduating students, for example – are recruited from outside the labor force, but I’m going to ignore them (as later I will also ignore retirees, figuring that they roughly offset each other).  Most new employees come either from among the unemployed or from other firms.  Hiring the unemployed is easy inasmuch as they’re usually knocking at your door asking for jobs.  On the other hand, the selection process might be difficult, since they aren’t doing a job now, so you have to make an educated guess as to whether they’ll be good at the job for which you’re hiring.  Hiring people from other firms is difficult in that you have to go out and actively recruit them, as well making an offer that justifies leaving their old job, but the selection process is easier, because all you have to do is find someone who is already doing a job similar to the one for which you’re hiring. 

So there is a tradeoff.   Presumably the terms of this tradeoff depend on how many people are unemployed:  if only a few people are unemployed, then the number of qualified unemployed applicants will be low, and they’ll be in demand from other firms, so you’ll have to pay them well, so you might as well just try to poach someone directly from another firm; if a lot of people are unemployed, the number of qualified unemployed applicants will be high, and they’ll be willing to accept less attractive offers, so poaching might not be worth it.  So here’s the crux of my model:  the fraction of new hires that comes from the unemployed depends on how many unemployed there are.  Using “H” for total hires, “He” for “hires out of employment,” and “Hu” for “hires out of unemployment,” we have Hu/H=f(U), where f() is some increasing function, and for adding-up, we have H=He+Hu.

Now, why do people quit their jobs?  Some retire, but I’ve already said I’m going to ignore them.  Some quit for other personal reasons, and I’m going to ignore them too.  A few people quit, especially when the labor market is strong, because they don’t like their job and figure it will be easy enough to find a new one.  I’m also going to ignore them.  Most people who quit, I believe, quit because they already have another job lined up.  In other words, if we ignore all the categories I’m ignoring, then the number of quits equals the total number of new hires minus the number of new hires that are hired out of unemployment, or Q=H-Hu.  Putting this proposition together with the one at the end of the last paragraph and solving simultaneously, we get Q=H*(1-f(U)).

OK, what about layoffs?  It may sound crazy at first, but I’m essentially going to ignore layoffs.  I’m going to assume that they happen at a constant rate.  We do know that layoffs tend to spike during the early part of a recession (or in the case of the recent recession, in the middle, when the “Great Recession” took over from the “little recession” that was already in progress).  But the typical spike is fairly small compared to the total number of layoffs.  (We notice those layoffs more because they result in significant spells of unemployment, whereas non-recession layoffs often result in just changing jobs, or in brief spells of unemployment that often aren’t long enough to justify filing an unemployment claim.)  So the “constant layoffs” assumption isn’t too far from the truth.  Also, layoff spikes are clearly “disequilibrium” phenomena that induce changes in the unemployment rate rather than explaining how a given unemployment rate is maintained.  In thinking about the Beveridge curve, I’m interested in the equilibrium relationship between unemployment and job openings.

And here’s the equilibrium condition.  I’ll ignore longer run changes in the labor force and the capital stock and define equilibrium as constant total employment (which implies constant total unemployment, since I’m ignoring labor force changes).  Constant employment implies that hires equal separations.  I’ll ignore “other separations” and assume all the separations are either quits or layoffs.  Then we have H=Q+L (where L stands for “layoffs,” not “labor”).

Since I’ve assumed that layoffs are constant, we have three variables here, U, H, and Q.  We’re more interested in hires than quits, so we can solve to eliminate Q, and we get H=L /f(U).  Since f() is an increasing function, this gives as an inverse equilibrium relationship between hires and unemployment.

Ultimately we want to relate unemployment to job openings, since that’s what the Beveridge curve is about.  How do hires relate to job openings?  One traditional approach is to fit a “matching function” in which hires are an increasing function of both job openings and unemployment.  The theory is that it should be easier to fill job openings when there are a lot of unemployed people looking for jobs.  I tried fitting such a function using JOLTS data, and the coefficient on unemployment consistently came out with the wrong sign, no matter how many polynomial time trends or dummy variables I put in, and even when I included an interaction term between unemployment and the availability of extended unemployment benefits.  Actually, that result is what motivated this model.  While obviously a high unemployment rate will reduce the number of people who quit their jobs in order to fill job openings, it does not apparently result in those openings being filled any more quickly.  So my matching function is a one-variable function. H=m(V), where V (“vacancies”) is the number of job openings.

Empirically, I fit H=m(V) as H=a*V^b, where a and b are fitted constants.  (Why do I use that form? Tradition, I suppose:  it just seemed reasonable.  It allows for the intuitive special case where b=1, so that job openings fill at a constant rate, but one casual look at the data will tell you that b<1 in reality: openings fill more quickly when there are fewer of them.)  The fit is pretty good (“log V” explains 78% of the variance in “log H” with a slope coefficient of about 0.5, implying that H is proportional to the square root of V), but there is an obvious pattern in the residuals.  (The Durbin-Watson statistic is a mere 0.7 – in case this post isn’t wonkish enough already.)  The cumulative sum of the residuals peaks in July 2006, suggesting that there may be a structural break in August.  A casual look at the residuals strongly suggests another structural break in July 2010.  Both purported structural breaks go in the same direction:  a decline in the number of hires associated with any given number of job openings.  So, contrary to what I said in 2010, it does look like we are seeing more structural unemployment now than in the past.  (In my defense, the first break occurs long before the recession, so I was right to assert that recession had not produced an increase in structural unemployment; and the second break occurs just when I was making that assertion, so I had no data from after the break.)

After I had done all this pseudo-theorizing, I decided to do a little pseudo-test of my pseudo-model, and it actually holds up surprisingly well (allowing the function f(U) to have the same form as m(V), because don’t all functions have that form, damn it!).   There is a nice, linear-looking, downward-sloping relationship between the log of hires and the log of unemployment.  Log unemployment explains almost 90% of the variance in log hires, with a slope coefficient of -0.37, and the coefficients are robust to the inclusion of an ARMA(1,1) residual process that results in a Durbin-Watson statistic of precisely 2.0.  (Ooooh, talk nerdy to me, Baby!)  There is no obvious pattern in the residuals.  Surprisingly, there are only 3 significant outliers (March 2003, November 2008, and May 2010; call them “Iraq War,” “Post-Lehman,” and “Census”).  At least I find that surprising, because this is an equilibrium model of a system that obviously, in real life, is subject to shocks that move it out of equilibrium – as we know from the fact that the unemployment rate changes a lot.  If you take this test at face value, it suggests that the equilibrating forces (which I haven’t tried to model) are very strong.

So what does all this imply about the natural rate of unemployment?  To answer that question we need a model of aggregate supply, and I happen to have one up my sleeve.  Here’s my model:  there’s a constant natural rate of job openings.  That’s it.  If firms have an unusually large number of positions to fill, they bid up wages, and you get accelerating inflation.  If firms have an unusually small number of positions to fill (like right now, but even more like three years ago), they start to let wages erode, and you get decelerating inflation (although research now suggests that it’s very difficult to erode wages that already aren’t rising, so this won’t work very well unless there is some substantial inflation or productivity growth to begin with – but all that belongs in another post).  Somewhere there’s a happy medium rate of job openings, such that wages tend to continue rising at a rate consistent with the expected rate of inflation.  That’s the natural rate of jobs openings.  Or the Non-Accelerating Inflation Rate of Job Openings (NAIRJO).   Or the Non-Accelerating Inflation Rate of Vacancies (NAIRV).

If the relationship between hiring and unemployment is stable, as it appears to be, then my model implies that shifts in the matching function will determine a shifting relationship between the (assumed constant) NAIRV and the NAIRU (Non-Accelerating Inflation Rate of Unemployment, a.k.a. the natural rate of unemployment).  For what it’s worth, my estimates suggest that the hypothesized August 2006 and July 2010 shifts in the matching function would, collectively, increase the NAIRU by a factor of about one and a third.  So if the NAIRU was 4.5% (my best guess, which happens to be conveniently divisible by 3) in July 2006, it is 6% now.  Of course, by the time the unemployment rate gets down to 6%, there’s a good chance that the matching function will have shifted again, but as for which direction and how far, your guess is as good as mine.

UPDATE: Posted scatter of log hires vs log unemployment on Twitter.

UPDATE2: Posted graph of series hires/sqrt(openings) on Twitter.

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. 

Federal Funds and the Paradox of Conditional Promises

The Fed’s Open Market Committee met on Tuesday and issued a statement. What changed in this statement compared to the Fed’s previous statement? Here’s what I think is the most important change. On January 25, the Fed said:

In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

On March 13, the Fed said:

In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

See the change? What, you don’t? You must have forgotten to put on your X-ray vision goggles!

There is a change, but it isn’t visible to the naked eye. At least it’s not visible if you just look at the words. What we have here is a case of the shifting relationship between signifier and signified.

Suppose your spouse calls from work and says, “I’ll be home in two hours.” Then an hour later, your spouse calls again and says, “I’ll be home in two hours.” The words are the same, but the meaning has changed: changed enough, perhaps, to make the difference between a hot dinner and a cold one. The phrase, “in two hours,” is the same, but the time to which it refers has changed.

In the Fed’s statement, what has changed is the referent for the word “conditions.” I just looked at a chart of the Citigroup Economic Surprise Index, and one thing I note is that, for the past six weeks (and for some months before that), it has remained consistently positive, and indeed consistently above +35, indicating that we have been receiving positive economic surprises. A rational forecaster will not be expecting the same conditions between now and 2014 as they had been expecting on January 25. Logically, if the conditions expected today are likely to warrant the same thing as conditions expected in January were likely to warrant, then the Fed must have changed its idea of what kind of conditions would warrant that.

By repeating the language in its earlier statement, the Fed has in effect announced a change in its reaction function. If the Fed had an explicit economic target for the next three years, it would have to change that target in order to continue being consistent with the language in its statement. By apparently doing nothing, the Fed has eased monetary policy.

Now the effect of an easing of monetary policy is that the economy is likely to be stronger than what was likely before the easing. After all, that’s the whole point of easing monetary policy. And that’s where things get tricky.

What does the Fed’s statement, implying that it expects to keep the federal funds rate low, mean about the likely actual future path of the federal funds rate? It means that the federal funds rate is likely to rise sooner than you previously expected. By promising – quite sincerely – to keep the federal funds rate low, the Fed is increasing the chance that the economy will call its bluff and force it to raise the federal funds rate. This is the paradox of a conditional promise.

It’s similar to the argument I made a couple of years ago with respect to bond yields (and which, in that case, the subsequent experience of QE2 seemed to bear out). Somewhat like the way the leader of a cartel can push prices up by threatening to cut prices if anyone defects, a central bank can raise bond yields by threatening to cut them. A similar logic applies to the federal funds rate, even though, in this case, the rate is under the Fed’s (almost) direct control. By specifying a more stringent criterion for raising the rate, the Fed actually increases the chance that the criterion will be met.

Think about it this way. Suppose the Fed had an explicit economic target such as nominal GDP. The Fed’s repetition of its “likely to warrant” language, in the face of an improved outlook, is like an increase in its nominal GDP target. If the Fed had such a target, and if it increased the target, what would you expect the effect to be on interest rates two-and-a half years hence? Surely a higher target would mean that future interest rates are likely to be higher rather than lower.

If you ask me for my best guess, I still expect that the Fed will most likely end up sticking to the late 2014 timetable. After all, we did have the worst recession in 70 years and have barely started to recover even three years later. And under current law, federal fiscal policy is scheduled to drive directly into a brick wall next year. But the Fed’s repetition of its “likely to warrant” language, because it makes me a little more confident in the economy, makes me a little less confident in my prediction about the federal funds rate.

UPDATE (4/25/2012):  Fed projections (PDF) issued today call my whole argument into question.  Looking at the participants' assessments for the "appropriate timing of policy firming," while the median date is the same as in January, as reflected in the statement, the average has declined, with some of the 2016 "ultra-doves" having moved back to 2014 and 2015.  Meanwhile, the improved outlook for 2012 is largely offset by a weaker outlook for 2013 and 2014.  So it is not clear that there is any change in the Fed's reaction function.



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.

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.