Topic: Finance, Banking & Monetary Policy

Some “Serious” Theoretical Writings That Favor NGDP Targeting

On Twitter last week Stephen Williamson wrote that he was “puzzled by the infatuation with NGDP targeting. We have good reasons to care about the path for the price level and the path for real GDP. Idea seems to be that if you smooth Py that you get optimal paths for P and y. That’s hardly obvious, and doesn’t fall out of any serious theory I’m aware of.”

I’m not exactly sure what Stephen means by a “serious theory.” But if he means coherent and thoughtful theoretical arguments by well-respected (and presumably “serious”) economists, then there are all sorts of “serious theories” out there to which he might refer, with roots tracing back to the heyday of classical economics. Indeed, until the advent of the Keynesian revolution, a stable nominal GDP ideal, or something close to it, was at least as popular among highly-regarded economists as that of a stable output price level, its chief rival.

If one of today’s outstanding monetary economists isn’t familiar with these writings, it’s a good bet that many other economists don’t know about them either. So I thought it worthwhile to list here some important theoretical works favoring nominal GDP targeting over inflation or price-level targeting, in chronological order, with brief remarks concerning each, and links to those that can be read online. Those interested in a more complete survey of the relevant literature, albeit one written not quite a quarter-century ago, are encouraged to have a look at my 1995 History of Political Economy article, “The ‘Productivity Norm’ versus Zero Inflation in the History of Economic Thought.”

From Fedspeak to “Plain English”

To the surprise of no one, yesterday the Federal Reserve voted to raise interest rates.  Chair Powell, conducting his second FOMC press conference, was true to his reputation in giving direct, plainspoken answers to most questions. He described the economy as doing “very well”; and, when asked about the Fed’s natural rate of unemployment (known as the NAIRU in economics jargon), he replied the Fed “can’t be too attached to these unobservable variables,” rather than offer a long, technical explanation. Many of Powell’s answers affirmed his commitment to seeing to it that having the FOMC’s policy rate settings are data-driven.

One notable development was Powell’s announcement that, starting in January, all eight FOMC meetings will be followed by a press conference. Currently, the Fed Chair takes questions from the press only once per quarter, or after every other meeting.  Powell was quick to add that this change offered “no signal [for] policy rates,” and that it was being made only to improve communications.  However, those comments do not ring true. Since first lifting rates off their zero lower bound in December 2015, the FOMC has only raised rates during meetings that were followed by a press conference, also known as “live” meetings; and it’s now generally assumed that the FOMC will only adjust policy rates at a live meeting.  Internal pressure for adjusting this expectation was building. For example, new Atlanta Fed President and current FOMC voter Rafael Bostic considered the live meeting public expectation to be “a sign that what [the Fed is] doing right now isn’t working.” There were two options available that could convince the public and markets that policy rates could change at any meeting: one, the Fed could adjust rates at a meeting without a press conference or two, every FOMC meeting could be followed by a press conference. Chair Powell chose the second option.

A possible change that got only brief attention is that of having the Fed change its nominal policy target, which is currently a 2% inflation target. Although the FOMC discussed alternative targets late last year, Powell said that an actual change is neither on the calendar nor something he is looking at seriously right now.  Powell did nevertheless refer in his statement to “price level targeting and that sort of thing” as potential alternatives to the Fed’s current inflation target. (It’s not clear whether Powell sounded flippant because he didn’t think much of such alternatives or simply because he wanted to move onto the next question.) In my view a nominal GDP level target would be better than either the current inflation target or a price level target.

Price Level Targeting: A Step in the Right Direction

The Federal Reserve plans to review its inflation growth rate target and potentially select a new monetary policy target. Many Fed officials are in favor of the idea, including Chair Powell. And the latest FOMC minutes show that the Fed’s policy setting committee has discussed new targets.

This is good news, because inflation rate targeting suffers from serious shortcomings. With a growth rate target, a central bank writes off past errors. Instead of deliberately correcting those errors, it “lets bygones be bygones,” allowing its mistakes to permanently alter the value of its policy target. For example, the Fed has persistently undershot its 2% inflation target since adopting it in January 2012. Because it does not plan to atone for this prolonged period of undershooting the price level will forever remain below its original target path, at least so far as deliberate Fed actions are concerned.

Successful price level targeting requires, on the other hand, that the central bank make up for past mistakes. Monetary policy is successful if the price level returns to the trend line it was growing along before the undershooting occurred. This makes the future course of the price level easier to predict. Inflation growth rate targeting cannot match this degree of predictability because its policy errors permanently change the long run price level, making the future path of the price level more like a random walk.

Improved price level predictability is one of the reasons that several Fed officials have discussed the benefits of adopting a price level target. For example, John Williams, who will take over as President of the New York Fed and become Vice Chair of the FOMC next Monday, argues that a price level target would offer an increased level of predictability over inflation rate targeting by better indicating where prices will be 5, 10, even 30 years into the future. Williams also believes, rightly, that this predictability would make future Fed policy more transparent to the public.

The Computer-Glitch Argument for Central Bank eCash

As if central banks’ powers and balance sheets haven’t grown quite enough since the outbreak of the subprime crisis, we’ve been hearing more and more calls for them to expand their role in retail payments, by supplying digital money directly to the general public.

Some proposals would have central banks do this by letting ordinary citizens open central bank accounts, while others would have them design and market their own P2P “digital currency.” Either sort of central bank digital money would, the plans’ supporters claim, be just as convenient as today’s dollar-denominated private monies. But central bank digital money would also have the distinct advantage of being just as safe as paper money.

Earlier this week the FT’s Martin Sandbu jumped onto the central bank “ecash” bandwagon, in an article prompted by the recent disruption of Visa’s European payments network. That disruption, Sandbu wrote, supplied “one of the strongest considerations in favour of introducing official electronic money.”[1]

Sandbu’s argument is just one of many that have been offered for allowing central banks to supply ecash. But it’s representative of the rest in at least one crucial respect: like them, it may seem solid enough at first glance. But upon closer inspection, it turns out to be full of holes.

The Phillips Curve Is Dead (except in Federal Reserve and CBO models)

“Is the Phillips Curve Dead?” asked Princeton economist Alan Blinder in a May 3 Wall Street Journal article. The former Vice-Chairman of the Fed noted that “the correlation between unemployment and changes in inflation is nearly zero… Inflation has barely moved as unemployment rose and fell.”

For a veteran Ivy League Keynesian like Blinder to doubt the Phillips Curve was doctrinal heresy, comparable to a monetarist asking if money matters or a supply-sider wondering aloud if a 91% tax rate is better than a 28% rate.

Wall Street Journal columnist Greg Ip later explained the dilemma and expanded it: “Standard models of the economy are built on a simple relationship: When unemployment goes down, inflation eventually goes up. That relationship, dubbed the Phillips Curve, has looked sickly for years. In Japan, it may be dead.”  Unemployment is 2.5% in Japan, yet inflation is 1.1% and only 0.4% if we leave out energy and food (“core” inflation).  For that matter, the unemployment rate is 2.0% in Singapore yet inflation is 0.2%.

Paul Samuelson and Robert Solow first fabricated a “Phillips Schedule” in 1960 using a wage-push notion of inflation and U.S. data from 1934 to 1958.  Leaving aside the Great Depression and WWII price controls, they concluded “it would take more like 8 per cent unemployment to keep money wages from rising. And they would rise at 2 to 3 per cent per year with 5 or 6 per cent of the labor force unemployed.”  Despite caveats that this relationship might shift, American economists soon began speaking of a trade-off between lower unemployment and higher inflation, notably the alleged necessity to tolerate 4% inflation in order to get unemployment down to 4%.  Those statistical goals were replaced with others (the curve was said to have shifted), but such Phillips Curve trade-off never went away.

“Pushing the Economy Up the Phillips Curve” in Brad DeLong’s 2002 Macroeconomics textbook, for example, says because of “the Federal Reserve’s expansionary monetary policy… unemployment fell from 7 percent in 1986 to 5.4 percent in 1989.  As unemployment fell inflation rose from 2.6 percent in 1986 to 4.4 percent in 1989.”   Although that 3-year span is described as a short-term relationship, any student could be forgiven for thinking that if you want 2.6% inflation you’ll have to settle for 7% unemployment, but if you prefer 5.4% unemployment you’re likely to end up with higher (4.4%) inflation.  [In reality, no Phillips Curve could explain why PCE inflation briefly fell from 3.5% in 1985 to 2.2% in 1986, or why it recovered to 4.3% in 1989].

As Blinder and Ip observe, however, the Phillips Curve is embarrassingly out of touch with international and domestic evidence.  Yet the Federal Reserve’s “standard models of the economy,” like those of the Congressional Budget Office, remain critically dependent on it. They have no other inflation theory.

Rather than basing monetary policy on actual inflation data, diehard Phillips Curve loyalists assume that low unemployment is such a fool-proof indicator of invisible inflation that the Federal Reserve must now raise interest rates repeatedly and preemptively – with the unspoken goal of pushing unemployment up above the CBO’s current 4.73% estimate of the non-accelerating rate (NAIRU).

The late Bill Niskanen and I wrote an obituary for the Phillips Curve sixteen years ago.  Instead of the presumed negative relationship whereby a low unemployment rate supposedly causes to accelerate, we found “a strong positive relationship between the inflation rate and the unemployment rate two years later.”

inflatinon causes unemployment

Don’t take our word for it.  Look at the graph.

The blue line is the monthly adult unemployment rate, excluding teens.  The red line is a smoothed year-to-year trend in “core” PCE inflation, leaving out energy in particular to reveal that the 1970s inflations were definitely not just oil shocks.  

On any given month, the year-to-year trend of inflation would be mostly composed of old 11-months of old news, unlike the current jobless rate.  That makes it even more obvious that core inflation was rising well before the big spikes in unemployment in 1974-75 and 1980-82, and that inflation rose alongside high and rising unemployment (i.e., “stagflation”).  Inflation causes high unemployment, which does not mean low unemployment causes inflation.

As Blinder noted, there has been no significant change in overall inflation since 2000, regardless of the oil price spike in 2008.   On the contrary, with the exception of three recessions (one very bad), the period since 1983 mainly shows a long decline in inflation that was usually matched by long periods of falling unemployment. 

The Phillips Curve has finally been revealed as a stubborn old 1958-60 theory that cannot predict inflation but does predict that high inflation will end in high unemployment.

Could Next Vice Chair Bring A New Rule to the Fed?

Richard Clarida had his nomination hearing to become Vice Chair of the Board of Governors of the Federal Reserve System before the Senate today.  He delivered a nearly mistake-free performance, giving articulate and concise answers to Banking Committee members’ questions.  His responses showed an understanding of both the Fed’s current normalization plans and some political concerns.

Clarida is widely agreed to be an expert on the international monetary system, with his nomination receiving a bipartisan letter of support, a rare occurrence in today’s Washington.  However, most of the questions he fielded were on the regulatory aspects of the Fed.  Here, Clarida mostly underscored Chair Powell’s interest in employing cost-benefit analysis to appropriately tailor regulations throughout the financial system, without sacrificing safety and soundness. 

Clarida’s missed opportunity came when Senator Elizabeth Warren asked whether any Fed “rule” could be made stronger.  Candidly, his answer was mostly boilerplate.  Instead of standard talking points, Clarida could have highlighted the evolution of his own thinking on monetary rules and targets since the crisis that has led him to embrace a price level targeting regime.  While such a target is better than the Fed’s current inflation target, there are reasons to believe Clarida may become an advocate of superior option: nominal GDP level targeting.  Adopting the proper target would improve monetary policy, in terms of both credibility and effectiveness, and address many of the concerns voiced by Senators today—from seeing escalating home foreclosures during downturns to having the Fed employ multiple rounds of QE to combat those slowdowns.

Finally, Welcome Relief from the Unnecessary Burdens of Dodd-Frank

Congress looks set to pass long-awaited changes to the Dodd-Frank Act that would relieve small and medium-sized banks from some of the onerous burdens of the post-crisis financial legislation package, the Hill reports:

The Senate in March passed a bipartisan bill to exempt dozens of banks from the stricter Federal Reserve oversight under Dodd-Frank and scores more from lending restrictions and reporting requirements. The deal, sponsored by Senate Banking Committee Chairman Mike Crapo (R-Idaho), passed by a 67-31 vote with support from more than a dozen Democrats.

A deal between the House and Senate would clear the way for Congress to pass the biggest changes to the Dodd-Frank financial rules since the law was enacted in 2010. The House and Senate have squabbled over the Senate bill, which Ryan vowed to freeze unless the Senate agreed to take up provisions from the House.

House Financial Services Committee Chairman Jeb Hensarling (R-Texas) said he was “excited that our negotiations over the last few weeks have culminated in the Senate agreeing to vote on our House bills.”

The 849-page Dodd-Frank Act introduced 27,000 new regulations on the financial sector. The Senate bill, which the House now appears ready to support, is only a modest step to relieve the burden of such a massive exercise in rule-making.

But the effort is nonetheless welcome. Since Dodd-Frank’s passage in 2010, compliance costs have rocketed up, especially for small banks. The number of new banks has virtually ground to a halt, while there is evidence that reduced small-business lending has adversely affected local communities across America.

To ease the supervisory burden on small and medium-sized institutions, and to exempt them from trading restrictions of which they were never the target, is thus necessary and appropriate. This the Senate bill does, and for that reason it constitutes a positive move to facilitate lending, competition and access to financial services.