Last week I went on a business road trip with my boss to attend regional board meetings at a couple of our branches up and down the Mississippi River Delta. As we departed Memphis, I asked if instead of the interstate we could take the infamous Highway 61 south through blues country. This is perhaps the most impoverished area of the country and was a very eye-opening experience that provided some economic perspective. In the Delta, they don't care about quantitative easing or the dual mandate of maximum employment in the context of price stability.
This week Chairman Ben Bernanke will deliver his semi-annual Humphrey Hawkins testimony to Congress. The Humphrey Hawkins bill passed in 1978 gave the Federal Reserve its dual mandate, and ever since the Fed has been tinkering with monetary policy to achieve this objective. No doubt when Bernanke speaks he will provide his standard assessment that the economy continues to grow at a moderate pace. What he will not provide is an explanation for why, after three years of extraordinarily easy monetary policy and improving employment metrics, the second quarter growth rate is on pace to print the lowest GDP of the recovery.
Due to their mandate, monetary policy measures success by virtue of the unemployment rate, but policy implementation is focused on stimulating aggregate demand, which in turn stimulates economic activity, which fosters improved employment. During this cycle, though, improved employment has not been a function of increased aggregate demand. The Q2 year-over-year growth rate in PCE is trending at an average of 2.65% near the lowest in 50 years down from 3.1% in Q1 and 3.5% in Q4.
PCE Vs. PCE Deflator
Since 2010 the YoY growth rate in wages has been trending at 1.9% per month and in June grew at its fastest pace of the year at 2.2%. However, what’s unique about this stage of the cycle is that wage growth is not translating into consumption growth. For example, in 2011, the last time wages grew at 2.2%, consumption was growing at over 5.0%. This speaks to the economic uncertainty, quality of jobs, and is why, despite an improved employment picture, the growth rate of the overall economy remains tepid. This distinction exposes the shortfall of quantitative easing and the power of the deleveraging cycle.
When Chairman Bernanke delivered his speech
to the NBER on Wednesday the market seemed to focus on his comments made during the Q&A about the inflation being too far below the Fed’s target. I thought the most interesting comment was made in text of his speech when he credited Princeton economist and noted inflation target advocate Lars Svensson:
The framework for implementing monetary policy has evolved further in recent years, reflecting both advances in economic thinking and a changing policy environment. Notably, following ideas of Lars Svensson and others, the FOMC has moved towards a framework that ties policy setting more directly to the economic outlook, a so-called forecast-based approach.
The footnote to that sentence cites Svensson (2003).
In 2003 Svensson wrote a working paper for the NBER titled Escaping From a Liquidity Trap and Deflation: The Foolproof Way and Others
Given that the central bank cannot reduce the nominal interest rate below zero, what is the best way to escape from the recession and deflation?
The real interest rate is the difference between the nominal interest rate and expected inflation. Thus, even if the nominal interest rate is constant at zero, the central bank can affect the real interest rate, if it can affect private-sector inflation expectations. If the central bank could manipulate private-sector beliefs, it would make the private sector believe in the future inflation, the real interest rate would fall, and the economy would soon emerge from recession and deflation.
Svensson’s solution to managing this “rational-expectation” is for the central bank to announce a positive inflation target or a price-level target path:
Several authors have proposed the announcement of a sufficient positive inflation target as a commitment to a higher future inflation rate (for instance, Bernanke (2000); Krugman (1998); Posen (1998)). In line with the optimal policy of a future overshooting of the normal inflation target, this target should be higher than normal for a few years. Krugman (1998) has stated that the central bank should “credibly promise to be irresponsible,” by which he means setting an inflation target higher than might otherwise be desirable.
Another possibility is to announce an upward-sloping target path for the price level, perhaps rising at 1-2 percent per year, as suggested for Japan in Svensson (2001) and more recently Bernanke (2003). The practical difference between these two approaches is that if inflation falls short of the inflation target in one year, the inflation target for the next year does not change.
However, with a priced level target, lower inflation in one year must be counter balanced by a higher rate of inflation in future years to return to the desired price level path. In the context of escaping from a liquidity trap, a price-level target offers an advantage above an inflation target, since long-term inflation matters more than short term. Long real interest rates are long nominal rates less long term inflation expectations.
A price-level target is a de facto nominal GDP target and Bernanke’s reference to Svensson with regard to policy is notable considering the backdrop of when this policy change was enacted. You will recall that at the 2012 Jackson Hole summit, it wasn’t Bernanke’s speech that drew the most attention; it was Columbia’s Michael Woodford
who advocated the Fed adopt conditional policy based on forward guidance of a nominal GDP target (emphasis mine):
An example of a target criterion that has received considerable attention within the Federal Reserve System is the “7/3 threshold rule” proposed by President Charles Evans of the Chicago Fed (Evans, 2011) and analyzed in Campbell et al. (2012).
Nominal GDP Regression
Adoption of such a commitment by the FOMC would be an important improvement upon current communication policy, in my view. It would emphasize the conditions for exit from the current extremely accommodative policy stance, rather than a date.
An alternative that I believe should be equally easy to explain to the general public, but that would preserve more of the advantages of the adjusted price-level target path, would be a criterion based on a nominal GDP target path, as proposed by Hatsius and Stehn (2011), Romer (2011), and Sumner (2011) among others. Under this proposal, the FOMC would pledge to maintain the funds rate target at its lower bound as long as nominal GDP remains below a deterministic target path, representing the path that the FOMC would have kept it on (or near) if the interest-rate lower bound had not constrained policy since late 2008. Once nominal GDP again reaches the level of this path, it will be appropriate to raise nominal interest rates, to the level necessary to maintain a steady growth rate of nominal GDP thereafter.
Woodford included a nominal GDP chart with a log-linear trend line from 1990 to 2008 that shows a substantial output gap that remains in place today. In fact, at the current pace of nominal GDP growth, the US economy isn’t even in the ballpark of where it needs to be to close that gap.
As I wrote back in December in Bernanke Capitulates, Launches De Facto Nominal GDP Target
The current run rate of nominal GDP growth is 4.0%, and Bernanke’s implied growth rate, with a targeted 2.0-2.5% inflation rate, would equate to an NGDP growth rate of 4.5% to 5.0%. To put those numbers in historical context, the average annual NGDP growth rate since 2002 is 4.0%, and since 1992 it averaged 4.7%.
If you run a regression line to extrapolate output gaps in the future, you will find that in 2015, which was the Fed’s previous target for ending accommodative policy trend NGDP should be at $19.6 trillion. In order to close that gap, NGDP would have to grow at a compound annual growth rate (CAGR) of 7.0%, which is virtually impossible given a 2.5% rate of inflation. To put that number in context, in 2006, during the height of the credit bubble, NGDP was growing at 6.5%. By 2020 trend NGDP is 24.7 trillion, a level that would be reached if the economy were to grow at a 5.6% CAGR, almost 100bps above the 20-year average. If the economy avoids any significant disruptions and continues to grow at 4.0%, the output gap might be closed sometime between 2020 and 2025.
When the Fed launched QE3 in September, right after the Jackson Hole conference, they clearly made a policy change by switching from date-based guidance to open-ended economic conditional guidance. This was perceived as a more dovish policy initiative. It was, as Svensson advised, an attempt to affect the private sector’s inflation expectations in an attempt to lower real interest rates. At the December meeting, with Operation Twist due to expire, the Fed defined the threshold guidance by targeting 6.5% unemployment and raising their inflation bogey from 2.0% to 2.5%.
I find it very curious that Bernanke would cite Svensson when his policy prescription is so similar to Woodford's. When you read between the lines, the policy change is just too coincidental not to be leaning towards a nominal GDP target, but his insistence on an unemployment threshold is muddying the market’s interpretation. Is Bernanke trying to send the market a message that he is indeed targeting nominal GDP without admitting it? If so, why is there so much attention on tapering QE with a significant output gap still in place?
If you want to know why the bond market is blowing up, this is it. The market is very confused. Rightly or wrongly they got long an inflation target commitment and then the Fed got cold feet when they conducted the ex post cost/benefit analysis. Which is it? Is it tapering with inflation/consumption decelerating or a nominal GDP target? Tapering is tightening and a nominal GDP target is easing on steroids. Bernanke didn’t want to explicitly launch a nominal GDP target because he instead wants to stick to their employment mandate, but in his mind he probably thought it was implicitly the same. However it’s not working out that way. Payrolls are not generating an increase in aggregate demand. This poses a conundrum for the Fed because we could conceivably reach their unemployment rate threshold without nominal growth. This could force the Fed to back off stimulus with the economy close to a recession. This would continue to pressure real interest rates at the most inopportune time, risking the very deflationary spiral monetary nightmare every central banker fears.
Bernanke admitted that the Fed launched a new policy initiative when they introduced threshold guidance in lieu of date guidance. However when they opted to perform an ex post cost benefit analysis on the program, they admitted they weren’t fully committed to go all the way, which presents a credibility problem. This has the market very confused and upside down, destroying their ability to produce long term inflation expectations which is key to producing low real rates. Ironically the threshold guidance is meant to be more transparent, however the economic results between employment and aggregate demand are diverging creating a very difficult environment in which to position bond portfolios.
There are a lot of experts who know how to conduct monetary policy when interest rates are at the zero bound, but no one has successfully pulled it off. This threshold-based policy is supposed to raise inflation expectations to lower real rates in order to stimulate aggregate demand. However since open-ended inflation target QE III was initiated, softening aggregate demand has lowered inflation expectations, which are raising real rates. The economic forecast policy evolution that Bernanke cited last week is actually backfiring. Is the Fed really going to taper into decelerating growth? They have a very big decision to make and it’s not clear how the market will react.
Legend has it that Robert Johnson went down to the crossroads and sold his soul to the devil to become the greatest blues musician. It worked. Johnson is regarded as the king of the blues and his music is the foundation of rock 'n' roll. Renditions of his songs went on to be recorded by Cream, the Allman Brothers, the Grateful Dead, Led Zeppelin and the Rolling Stones.
I think monetary policy is now at the crossroads of employment and aggregate demand. In exchange for a more rapid reduction in unemployment, the Fed made their own deal with the devil when they changed policy, opting for threshold guidance. The problem is they adopted the policy but chose the wrong threshold, and the market doesn’t know what to trade. The result is a lack of conviction, a lack of liquidity, and increased volatility. I’m just standing at the crossroad and believe I’m sinking down