A Gentler Slope for the Fiscal Cliff

Evan Soltas explains succinctly the tragic confusion in U.S. fiscal and monetary policy:

Federal Reserve Chairman Ben S. Bernanke, taking questions during a February House hearing on monetary policy, uttered two very special words: fiscal cliff.

“Under current law, on January 1, 2013,” Bernanke said, “there’s going to be a massive fiscal cliff of large spending cuts and tax increases.”


Whatever Bernanke’s intention in February, Congress now works in fear of falling off his fiscal cliff. The irony is that while economic recovery rests largely in Bernanke’s hands, the tyranny of impending austerity is leading Congress toward poor decisions about the long-term structure of public spending and tax policy. These are mistakes monetary policy could never offset.

The cause of our cliff problem rests in the commingling of responsibility between fiscal and monetary policy in managing the economic recovery. A more mature way of doing business would charge the Fed with stabilizing demand in the short run and Congress with a structural environment conducive to the social welfare and economic growth over the long run. The U.S. is doing neither well right now.


Long-term deficit reduction will also require substantial cuts to planned public spending, whether one assumes a return to the historical revenue average or something slightly higher than that to account for demographic change and health costs. This is particularly true beyond the budgetary “out-years,” or 20 to 30 years from now. At that point, federal promises on Medicare and Medicaid become unsustainable without large increases in tax revenue which raise fully a quarter of GDP. There is no reasonable scenario for sustainable public finances without deep rollbacks of spending promises beyond the out-years.

The austerity the fiscal cliff would achieve in one fell swoop would best be done gradually. Such an approach would be more in line with the real danger in our public finances, the combination of structurally low federal revenue and long-term increases in planned spending.


Are the Green Shoots for Real?

Market monetarist David Beckworth posted a cautionary reading on his favorite leading indicators (consumer sentiment and 10-year treasury yields).



This figure shows that during the Great Moderation period (1983-2007) households expected their dollar incomes to grow about 5.3% a year. This relative stability of expected nominal income growth  is a testament to the success of monetary policy during this time. However, since 2008 households have expected 1.6% dollar income growth on average.  Until this changes, there is no way a recovery will take hold.  And yes, this speaks poorly of Fed policy since 2008. (My access to this data is limited by a 6-month lag.  So if you have access to this data, please let me know the latest numbers.)

The second indicator is simply the 10-year treasury yield.  As I noted many times before, this interest rate is currently at historic lows largely because of the weak economy, not the Fed (i.e. the short-run natural interest rate is depressed due to an increase in desired savings and/or a decrease in desired investment).  If the economic outlook were to improve, then the 10-year yield would go up because of higher expected real growth as well as some higher expected inflation.  And yes, the Fed could do more here by raising  expectations of future nominal income growth.  An explicit nominal GDP target should do the trick:
So until these two forward-looking indicators meaningfully turn around, I will remain hopeful but uncertain about our recovery. 

(Via David Beckworth.)

Paul Krugman warns against fiscal stimulus

Thanks to Lars  Christensen, proprietor of Market Monetarist:

This is Paul Krugman on the effectiveness on fiscal policy and why fiscal ‘stimulus’ will in fact not be stimulative:

‘The US is currently engaged in the largest peacetime fiscal stimulus in history, with a budget deficit of around 10 percent of GDP. And this stimulus is working in the narrow sense that it has headed off the imminent risk of a deflationary spiral, and generated some economic growth. On the other hand, deficits this size cannot be continued over the long haul; USA now has Italian (or Belgian) levels of internal debt, together with large implicit liabilities associated with its awkward demographics. So the current strategy can work in the larger sense only if it succeeds in jump-starting the economy, in eventually generating a self-sustaining recovery that persists even after the stimulus is phased out.

Is this likely? The phrase ‘self-sustaining recovery’ trips lightly off the tongue of economic officials; but it is in fact a remarkably exotic idea. The purpose of this note is to expose this hidden exoticism – to show that anyone who believes that temporary fiscal stimulus will produce sustained recovery is implicitly endorsing a rather fancy economic model, the sort of model that finance ministries would under normal circumstances regard as implausible and disreputable…

…What continues to amaze me is this: USA’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.’

Wauw! What is this? What happened to the keynesian Krugman? Isn’t he calling for fiscal easing anymore? Well yes, but I am cheating here. This is Paul Krugman, but it is not today’s Paul Krugman. This is Paul Krugman in 1999 – and he is talking about Japan and not the US. I simply replaced ‘Japan’ with ‘the US’ in the Krugman quote above.

Read the entire article here.

HT Tyler Cowen and Vaidas Urba.

A bottleneck in the economy

The Federal Reserve’s choice to allow only a slow recovery in NGDP has essentially created a bottleneck in the economy, behind which a large crowd of would-be workers is swelling. 

That sentence really captures the US challenge. I recommend this 27 September post by Ryan Avent at Free Exchange, where he attempts to rebut the claim that it is too late for monetary policy to be effective.

(…) Let’s look at some charts. First, here is the year-on-year change in NGDP since 1990:

So, the first thing to note is that NGDP growth is clearly not back to the trend rate for recent expansions. Nominal output routinely grew above 5% per year during the boom of the 1990s (with an average closer to 7% than 5% during the latter, stronger half of that period). Nominal growth decelerated slightly during the 2000s expansion but was clearly and persistently above 5% during the period of meaningful employment growth. Nominal output then shrank at a pace matched only in the postwar period by demobilisation before settling at a rate persistently below 5%. Average year-on-year growth over the whole of this period, including recessions, is 4.7%. Average growth since the end of this recession has been 3.1%. Average growth since the beginning of 2010 has been 3.9%.



Ryan discusses the key points, including the evidence that wages are still sticky three years after the 2008 crash. Read the whole thing.

US Fed members are shifting to consensus on “economic lift-off”

My caption probably overstates the “lift-off” consensus, but there definitely is a movement from the “hawk” to the “dove” perspective on inflation vs. economic growth. Ryan Avent examines the very significant shift of Kocherlakota to a policy square near to the “Evans Rule”.  


NARAYANA KOCHERLAKOTA, the president of the Reserve Bank of Minneapolis, has long been a member of the club of more hawkish voices within the Federal Open Market Committee (to which he’ll return as an alternate next year and a voting member in 2014). But where other hawks like Philadelphia Fed president Charles Plosser and Dallas Fed president Richard Fisher advance criticisms of expansionary Fed action that seem rooted in confusion over just how monetary policy works, Mr Kocherlakota understands monetary policy just fine. His concern has instead been that economic potential has fallen more than is appreciated, and that structural unemployment is correspondingly higher. It’s a perfectly coherent view, albeit one that has seemed to be at odds with labour-market data. 

And so a frisson of excitement ran through the economics commentariat yesterday when Mr Kocherlakota abruptly signed on to a strategy resembling the one pushed by Chicago Fed president Charles Evans, a supporter of much more aggressive action to help the economy. Speaking in Michigan, Mr Kocherlakota described a plan for ‘liftoff’:

The substance of this liftoff plan is that, as long as longer-term inflation expectations remain stable, the Committee will not raise the fed funds rate unless the medium-term outlook for the inflation rate exceeds a threshold value of 2 1/4 percent or the unemployment rate falls below a threshold value of 5.5 percent. Note that neither of these thresholds should be viewed as triggers—that is, once the relevant cutoffs are crossed, the Committee retains the option of either keeping the fed funds rate extraordinarily low or raising the fed funds rate. 

Ryan has much more analysis at Free Exchange.

The Fed’s welcome shift is still not nearly as effective as NGDP-Level-Targetting.

Lars Christensen: NGDP level targeting – the true Free Market alternative

Danish economist Lars Christensen wrote a terrific post that I think will be helpful to anyone trying to get their head around NGDP level targeting for the first time. Lars also attempts to explain why many skeptical free market economists have some fundamental misunderstandings — which he attempts to correct. For those who wish to study this topic in more depth, Lars closes with an excellent reference list of earlier posts.

I’m trying to figure out whether the new Fed policy means new USD weakness. Bernanke didn’t adopt NGDPLT  (the Market Monetarists like Lars are celebrating anyway). But the policy looks to me like a directional move towards expectation-based policy, which may be the most powerful tool the Fed has. Especially near the ZLB. If that’s the case the Fed would be expected to ease until NGDP is closer to the 2007 trend, if not all the way back to trend.

Snippet from Lars original post: July 19, 2012… 

Most of the blogging Market Monetarists have their roots in a strong free market tradition and nearly all of us would probably describe ourselves as libertarians or classical liberal economists who believe that economic allocation is best left to market forces. Therefore most of us would also tend to agree with general free market positions regarding for example trade restrictions or minimum wages and generally consider government intervention in the economy as harmful.

I think that NGDP targeting is totally consistent with these general free market positions – in fact I believe that NGDP targeting is the monetary policy regime which best ensures well-functioning and undistorted free markets. I am here leaving aside the other obvious alternative, which is free banking, which my readers would know that I have considerable sympathy for.

However, while NGDP targeting to me is the true free market alternative this is certainly not the common view among free market oriented economists. In fact I find that most of the economists who I would normally agree with on other issues such as labour market policies or trade policy tend to oppose NGDP targeting. In fact most libertarian and conservative economists seem to think of NGDP targeting as some kind of quasi-keynesian position. Below I will argue why this perception of NGDP targeting is wrong and why libertarians and conservatives should embrace NGDP targeting as the true free market alternative.

Why is NGDP targeting the true free market alternative?

I see six key reasons why NGDP level targeting is the true free market alternative:

1) NGDP targeting is ”neutral” – hence unlike under for example inflation targeting NGDPLT do not distort relative prices – monetary policy “ignores” supply shocks.
2) NGDP targeting will not distort the saving-investment decision – both George Selgin and David Eagle argue this very forcefully.
3) NGDP targeting ”emulates” the Free Banking allocative outcome.
4) Level targeting minimizes the amount of discretion and maximisesthe amount of accountability in the conduct of monetary policy. Central banks cannot get away with “forgetting” about past mistakes. Under NGDP level targeting there is no letting bygones-be-bygones.
5) A futures based NGDP targeting regime will effective remove all discretion in monetary policy.
6) NGDP targeting is likely to make the central bank “smaller” than under the present regime(s). As NGDP targeting is likely to mean that the markets will do a lot of the lifting in terms of implementing monetary policy the money base would likely need to be expanded much less in the event of a negative shock to money velocity than is the case under the present regimes in for example the US or the euro zone. Under NGDP targeting nobody would be calling for QE3 in the US at the moment – because it would not be necessary as the markets would have fixed the problem.

So why are so many libertarians and conservatives sceptical about NGDP targeting?

Common misunderstandings:

1) NGDP targeting is a form of “countercyclical Keynesian policy”. However, Market Monetarists generally see recessions as a monetary phenomenon, hence monetary policy is not supposed to be countercyclical – it is supposed to be “neutral” and avoid “generating” recessions. NGDP level targeting ensures that.
2) Often the GDP in NGDP is perceived to be real GDP. However, NGDP targeting does not target RGDP. NGDP targeting is likely to stabilise RGDP as monetary shocks are minimized, but unlike for example inflation targeting the central bank will NOT react to supply shocks and as such NGDP targeting means significantly less “interference” with the natural order of things than inflation targeting.
3) NGDP targeting is discretionary. On the contrary NGDP targeting is extremely ruled based, however, this perception is probably a result of market monetarists call for easier monetary policy in the present situation in the US and the euro zone.
4) Inflation will be higher under NGDP targeting. This is obviously wrong. Over the long-run the central bank can choose whatever inflation rate it wants. If the central bank wants 2% inflation as long-term target then it will choose an NGDP growth path, which is compatible which this. If the long-term growth rate of real GDP is 2% then the central bank should target 4% NGDP growth path. This will ensure 2% inflation in the long run.

[snip important commentary]


Related posts:

NGDP targeting is not about ”stimulus”
NGDP targeting is not a Keynesian business cycle policy
Be right for the right reasons
Monetary policy can’t fix all problems
Boettke’s important Political Economy questions for Market Monetarists
NGDP level targeting – the true Free Market alternative
Lets concentrate on the policy framework
Boettke and Smith on why we are wasting our time
Scott Sumner and the Case against Currency Monopoly…or how to privatize the Fed

Update (July 23 2012): Scott Sumner once again tries to convince “conservatives” that monetary easing is the “right” position. I agree, but I predict that Scott will fail once again because he argue in terms of “stimulus” rather than in terms of rules.

That last comment is important: NGDPLT is all about a rule-based, not discretionary, policy. It is definitely NOT an argument for more discretionary monetary stimulus.

Please read Lars’ complete commentary, and follow up with a careful read of the prior posts.

Evan Soltas: Bloomberg Endorses NGDPLT

Good news, in the “every little bit helps” department. Thanks for this Evan:

Bloomberg Endorses NGDPLT: “Bloomberg View’s editorial board endorsed using monetary policy to target the path of nominal GDP yesterday — making them, as far as I know, the first major media outlet in the United States to endorse the practice. Naturally, this is excellent news for supporters of NGDP level targeting like myself.

We suggest looking at an old idea that is again attracting attention among monetary economists. Recast the target that the Fed and other central banks are told to follow. Instead of a target for low inflation plus an additional primary or secondary target of high employment, focus on the money value of output — nominal gross domestic product unadjusted for inflation. This combines prices and output in a single number.

Suppose the target was 5 percent. Over the longer term, with the economy growing at 2 percent or a little more, inflation would be 3 percent or a little less, similar to the inflation targets most central banks (including the Fed) have adopted. Here’s the advantage: In the short term, the Fed would be on target if the economy were growing at 5 percent and inflation were zero, or if the growth were zero and inflation were 5 percent.

In other words, the system would call for faster-than- normal growth when inflation is too low, and faster-than-normal inflation when the economy is in a slump. Setting a nominal GDP target wouldn’t be telling the bank to choose between so much inflation and so many jobs, so you could still grant operational independence

We think it’s worth a careful look, and we’re convinced of one important advantage: This approach would make the bank’s actions easier to understand and explain.

As a matter of disclosure, I write for Bloomberg View but was not involved in their endorsement.

Ryan Avent: QE sera sera (why money is too tight and in 1999 Bernanke understood that)

THIS week’s print edition includes a long primer on QE. Asset-purchases have been the principal unconventional monetary policy tool deployed by rich-country central banks in this crisis, and their use is once again ramping up; the Bank of England just scaled up its QE plans by £50 billion, the Fed may use its next meeting to pivot from “Twist” operations back to QE proper, and the ECB’s recent interest rate moves have some suggesting that QE could be on the table there, as well. 

(…)By the late 1990s, Japan was suffering from persistent deflation. As a first response, it deployed the zero-interest-rate-policy (or ZIRP), in which it promised to keep short-term rates at zero “until deflationary concerns subside”. That didn’t have much of an effect, which led Mr Bernanke to complain that:

A problem with the current BOJ policy, however, is its vagueness. What precisely is meant by the phrase “until deflationary concerns subside”? Krugman…and others have suggested that the BOJ quantify its objectives by announcing an inflation target, and further that it be a fairly high target. I agree that this approach would be helpful, in that it would give private decision-makers more information about the objectives of monetary policy. In particular, a target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the “price-level gap” created by eight years of zero or negative inflation.

The above quote is from a “don’t miss this” piece by Ryan Avent of The Economist. Ryan was prescient in that two months later we know that the ECB has adopted a “radical” (for ECB) new policy not too distant from Bernanke’s advice to BOJ. And at the US Fed Bernanke has announced a similar significant new policy.

Ryan concludes his review of Japan’s mistakes, Bernanke’s excellent advice 1999 to BOJ, and where we are today: 

(…) That is the heart of the matter. In the bitterest of ironies, Mr Bernanke is giving America a Japanese recovery. He is doing so, seemingly, because pushing inflation temporarily above an arbitrary target is an unthinkable prospect, even though doing so would almost certainly, by his own convincing argument, have a huge impact on America’s enormously costly unemployment problem. I suspect that the Ben Bernanke of 1999 would characterise this as a moral and intellectual failure of staggering proportions. Maybe the Ben Bernanke of 2012 has a convincing rebuttal; if so, he certainly hasn’t shared it with us. Maybe one day we’ll all be lucky enough to hear it. It had better be one hell of a good excuse.

Bernanke and the Fed’s superpower

Before we get into superpowers, first read Scott Sumner: The Zen Master: Money is too tight.

OK, got that? The Zen Master is telling the Fed to use it’s most powerful monetary tool, the “expectations channel”. Ezra Klein at the Washington Post Wonkblog does a very nice job of explaining how these concepts are applied using the Spiderman metaphor.

(…)The best way to think about the Federal Reserve is that it basically has a superpower. It can create as much money as it wants. Real, American money.

And the Fed doesn’t need anybody’s permission. It’s not like when the president says he wants to do something, like the American Jobs Act, and you have to ask, “What does Congress think?” Or when John Boehner wants to pass something, and you have to ask, “Well, what does Harry Reid think?” Once the Board of Governors decides to move forward, they don’t need 60 votes in the Senate — they just do it. And that makes them incredibly powerful.

But, as Spider Man would say, with great power comes great responsibility. And so the Fed is very cautious in using its powers.

By law, it needs to try to keep unemployment and inflation low. Over the past two years or so, inflation has stayed low, and unemployment has been very, very high. But the Fed has not been doing all that much about it. It’s been hoping the situation would turn around of its own accord, or that Congress and the president would stop bickering and unleash more stimulus — anything so that the Fed didn’t have to further unleash its powers.

But it didn’t happen. And so, on Thursday, Fed Chairman Ben Bernanke said the Fed had finally decided to do something about unemployment. Something big. Something that might actually work.


If the Fed staff is quietly doing NGDPLT to a 4.5 or 5% target level in the back office, while guiding the FMOC to adjust policy to get back on track, then I believe this is likely to finally get the US economy going. Ezra Klein explains how it actually works.

I think Bernanke’s cautious wording is telling the markets that 2% is no longer the inflation ceiling but the medium term target. The markets seem to be getting that message.



Sober Look: Equity prices vs. inflation expectations

Many people are asking what impact the Fed’s more aggressive easing will have on various asset prices. One bit of informed analysis on equity prices based on the last three years data comes from the reliable Sober Look:

In recent years we’ve seen a clear indication that inflation expectations and US equity prices are correlated. Certainly once inflation reaches a certain level (by some estimates 4%), the relationship will break down and even reverse. However in the current environment deflationary risks drive this relationship. In other words we have an aggregate demand problem rather than any supply constraints. Expectations of price increases are a sign of a potentially stronger demand growth and higher margins, which is a positive for shares. The scatter plot below shows the relationship between the US equity prices and TIPS-implied (2×2 breakeven) inflation expectations over the past 3 years. The correlation has been surprisingly stable (around 0.86).