Good Guys Abandoning Ship"

The Fed is not helpless, it´s unwilling

[First posted in January 2012]

In the recent AEA meetings Ryan Avent reported:

But Stanford economist Robert Hall really nailed the crux of the question, so far as I was concerned. At the AEA meetings a year ago in Denver, I listened to Mr Hall speak a few times on this issue and point out that with the market-clearing interest rate below zero the economy was stuck with high unemployment. At the time, I wondered why, if that were true, that the answer wasn’t simply a higher rate of inflation, which could combine with a zero nominal interest rate to move the real interest rate below zero.

This time around, Mr Hall addressed the point head on. He noted that in a liquidity trap, the real rate of interest was simply equal to the negative inflation rate. In other words, if the Fed’s nominal rate is at 0% and the inflation rate is 2%, then the real rate of interest is -2%. If a -3% real interest rate is necessary to clear the economy, then all that’s needed is a higher rate of inflation—3% rather than 2%. Mr Hall noted that this was an important point because potentially the Fed could have an enormously helpful impact on the economy simply by raising inflation just a little. And here’s where things got topsy-turvy. Mr Hall argued that (my bold):

1. A little more inflation would have a hugely beneficial impact on labour markets,

2. And a reasonable central bank would therefore generate more inflation,

3. And the Federal Reserve as currently constituted is, in his estimation, very reasonable; therefore

4. The Federal Reserve must not be able to influence the inflation rate.

Now, perhaps there was a political economy subtext to this argument; if so, I missed it. Rather, he seemed to be saying (as others, like Peter Diamond, have intimated) that at the zero lower bound it is simply beyond the Fed’s capacity to raise inflation expectations. Now admittedly I haven’t done a rigorous analysis, but it seems clear to me that the Fed has been successful at using unconventional policies to reverse falling inflation expectations. Why is Mr Hall—why are so many economists—willing to conclude that the Fed is helpless rather than just excessively cautious? I don’t get it; it seems to me that very smart economists have all but concluded that the Fed’s unwillingness to allow inflation to rise is the primary cause of sustained, high unemployment. And yet…this is not the message resounding through macro sessions. Instead, there are interesting but perhaps irrelevant attempts to model the funny dynamics of a macro challenge that actually boils down to the political economy constraints (or intellectual constraints) facing the central bank. Let’s focus our attention on that, for heaven’s sake.

Not to be undone in the “recanting competition” Mankiw, who in 1994 wrote with Bob Hall a paper proposing NGDP Targeting, revives a paper he wrote for the NBER Conference on American Economic Policy in the 1990s on the subject of Monetary Policy. (Note: in the American Economic Policy in the 1980s NBER Conference the subject of Monetary Policy was assigned to Michael Mussa then at the University of Chicago. In my opinion it was a much richer analysis than the one done by Mankiw).

In his revival of the paper in his Blog today, Mankiw writes:

Not surprisingly, the rule recommended a deeply negative federal funds rate during the recent severe recession. Of course, that is impossible, which is why the Fed took various extraordinary steps to get the economy going. But note that the rule is now moving back toward zero. As Eddy points out, “At the current inflation rate, the unemployment rate needs to drop to 8.3% from the current 8.5% for the model to signal positive rates. We’re getting close.”

Yes, IF the Fed “follows the rule” we´ll take one step closer to “economic ruin”!

Back in 2001 I wrote this comment on his paper:

International Commentary October 19, 2001

Was it mostly luck?

In the early 90’s, the NBER sponsored a conference to debate American Economic Policy during the 80’s. Last July, once again, the NBER hosted a conference on American Economic Policy in the 90’s. The theme of monetary policy was ascribed to Gregory Mankiw from Harvard and of the founders of the New Keynesian School of economic thought.

Monetary policy is one of the major tools for the pursuit of economic stabilization (the other being fiscal policy). Therefore, in order to judge the quality or effectiveness of monetary policy, one way is to see how stable the economy has become. To put things in perspective, Mankiw compares the macroeconomic performance of the 90’s with that of the 50’s, 60’s, 70’s and 80’s. To do this, Mankiw concentrates on three standard time series: inflation, unemployment and real growth that together provide a good view of a country’s economic fundamentals. For example, if a nation enjoys low and stable unemployment, low and stable inflation and high and stable growth, one can be reasonably confident that the fundamentals are in place to permit continuing prosperity (i.e. long run growth).

The figures below provide an impression of the stability of the macro economy as measured by the variability (percent changes) in several aggregates. (the 90’s include 2000/01).

I concentrate on a measure of variability of GDP or productivity because that’s what monetary policy (or stabilization policy) can influence. It should be noted that monetary policy cannot determine long run growth rates or unemployment rates, but only inflation. Although as Mankiw argues, when discussing the long run forces setting unemployment and real growth, monetary policy is far in the background, we believe it is an indispensable prerequisite, since without prior stabilization long run growth will simply not materialize.

The figures clearly show that after the early 80’s, more precisely after the 1980/82 recession, the variability of growth, productivity and the level and variability of inflation have fallen significantly, while the rate of unemployment has been, for the most part, on a downtrend, bringing the level of unemployment close to the low levels observed in the 50’s and 60’s.

It appears, than, that over the last 18 years the US economy has received what economist’s call a “free lunch”, meaning that risk (volatility) has fallen at the same time that returns (growth) have remained high. Since economists are trained not to believe in “free lunches”, there’s a lot of skepticism among the brethren, and Mankiw is not an exception. A quote from Milton Friedman in May 2000 is illustrative: “I’m baffled. I find it hard to believe…What I’m puzzled about is whether, and if so how, they suddenly learned how to regulate the economy. Does Alan Greenspan have an insight into movements in the economy and the shocks that other people don’t have?”

Over the last several years, Mankiw and many prominent economists (including Fed governor Laurence Meyer) have ascribed this phenomenon of low variability of macroeconomic aggregates, falling inflation and unemployment and high average real growth rates, to LUCK.

This is an important issue because if it is true that the US economy’s performance over the last 18 years is due to a “lucky break”, the future could be pretty bleak (images of Japan?), especially following the shock of the September 11 attacks (plus anthrax scares and whatever), that certainly brought an end to any luck that might have existed.

Fortunately the evidence they put forth is not convincing. In part, this is due to the motivation for the “lucky break” proposition. To give just one example, back in 1997, Laurence Meyer appeared frustrated that the falling rate of unemployment was not bringing forth inflation. According to him, “the forecasting model based on the Phillips Curve/NAIRU has shown to be the most stable tool in the economist’s tool-box over the last 20 years…”. Ergo, if it is not working, reality is not real, reflecting an outbreak of luck.

Mankiw’s argument for luck is that the 90’s were notable for the absence of supply shocks. Since supply shocks force upon the Fed a tradeoff between inflation stability and output/unemployment stability (something that does not happen in the case of demand shocks), according to Mankiw “perhaps the enjoyment of both kinds of stability in the 90’s is just dumb luck with the economy not experiencing the supply shocks that caused so much turmoil in earlier decades”.

To arrive at this conclusion Mankiw ignores evidence that shows that for the last 5 decades, only the 70’s show signs of experiencing significant supply shocks. In fact, it was the novelty of this fact that caused so many policy errors.

Mankiw measures supply shocks by the difference between overall CPI inflation and CPI CORE inflation (which excludes food and energy). Figure 3 indicates that only the 70’s shows marked evidence of supply shocks according to this measure (mean of 0.60). In the early 50’s there’s a spike that can be associated with the Korean War, but on average the supply shocks were favorable (mean of – 0.12%). If anything, the 80’s show record favorable supply shocks (mean of -0.52%), and there is clearly nothing especially lucky about the 90’s.

My view is that all the “surprises” of the 90’s; the “surprising” fall in unemployment, the “surprising” acceleration of productivity or the “surprising” fall in inflation, are not surprising at all, resulting from the successful stabilization of the economy that began in earnest in the early 1980’s and was consolidated in the early 90’s. If this is not lost amidst the debris of the WTC Towers, there’s no reason to doubt the resumption of growth sometime soon.

Marcus Nunes

Like the original Taylor rule, “Mankiw´s rule” requires that the Fed respond “strongly” to inflation. Taylor´s coefficient on “excess inflation” is 1.5, Mankiw´s is 1.4. In the wrap up of his 2001 paper Mankiw writes:

One conclusion is that the Greenspan Fed of the 1990s would likely have averted the Great Inflation of the 1970s. From the late 1960s to the early 1970s, the formula interest rate in Figure 1 is consistently several percentage points above the actual interest rate. The same is true, to a less extent, in the late 1970s. This is consistent with the result presented in Table 7: Fed policymakers of the 1990s responded more to rising inflation than did their predecessors.

Funny that a few years before, in early 1996, my conclusions (Are analysts missing the point) were very different:

One plausible explanation for the result that reconciles the (apparently contradictory) muted response of the federal funds rate to inflation after 1982 with a postulated increase in the Fed.’s resolve to fight inflation is evidence that the behavior of inflation changed after the 80/82 recession. Inflation after 1982 exhibits substantially less persistence than in the previous years (see figure 3) so that increases in inflation in one month are viewed as temporary. In other words, inflation is much less autocorrelated so that lagged values of inflation provide little information about future inflation. As a result, unexpected movements (or innovations) in inflation no longer require a monetary policy response (which sits well with our initial argument that the fed funds can be a poor indicator of monetary policy)

A comparison of figure 5.6 with figure 5.1, indicates that the response of the fed funds to weakness in the economy (represented by the unemployment rate) is damped in the second period, consistent with the hypothesis that the Fed has become more concerned with inflation (relative to unemployment) despite the “overhang” of the full-employment act.

The response of unemployment to the fed funds rate (figures 5.7 and 5.3) shows a different pattern of behavior between the two periods. During 1959/79, the long run impact of a positive innovation to the fed funds rate was an increase in unemployment. In the 1983/95 period, this response is negative. This latter pattern is consistent with a more stable real economy i.e., one in which fluctuations in GDP is much less pronounced.

It is extremely unfortunate (and depressing) that even the “good guys are abandoning ship”.

HT David Levey