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Bernanke Capitulates, Launches De Facto Nominal GDP Target

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The only way the unemployment rate can get back to 6.5% is to close the output gap, which remains extremely wide.

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MINYANVILLE ORIGINAL At the April 2012 FOMC press conference, New York Times reporter Binyamin Appelbaum seemed to be channeling his inner Paul Krugman, asking Chairman Bernanke why the Fed was not doing more to bring down the unemployment rate (emphasis mine).

Appelbaum:

Inflation is under control, and you say that you expect it to remain under control. You say that you have additional tools available for you to use, but you're not using them now. Under these circumstances, it's really hard for a lot of people to understand why you are not using those tools right now. Could you address that?

Bernanke:

I guess the question is, does it make sense to actively seek a higher inflation rate in order to achieve a slightly increased reduction – a slightly increased pace of reduction in the unemployment rate? The view of the committee is that would be very reckless.
While Bernanke didn't come out and say it, he was tiptoeing around an idea that some economists have suggested that the Fed should be targeting a level of nominal GDP in order to close the output gap.

We have – we, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable in that we've been able to take strong accommodative actions in the last four or five years to support the economy without leading to an unanchoring of inflation expectations or a destabilization of inflation. To risk that asset for what I think would be quite tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do.

When he said doubtful gains on the real side he seemed to be suggesting that stimulating nominal growth in an attempt to bring down unemployment was useless if it came at the expense of only higher inflation. In my mind this was big. This was perhaps the most hawkish thing Bernanke had ever said, and his response seemed to take a nominal GDP target off the table.

Back in July as Operation Twist was due to wind down, I raised the possibility that Chairman Bernanke was getting so desperate to bring the unemployment rate down faster that his QE nuclear option might take the form of a nominal GDP target to close the output gap. In Bernanke's Astonishingly Good Idea, I stated:

The idea of targeting NGDP would be to place an extrapolated dollar amount on the output gap based on a specified growth rate and the Fed would commit to tightening or easing based on where nominal growth deviated from that trajectory going forward.

If they launch QE3, whether they employ an explicit NGDP target or not, the objective is the same. In order to bring down unemployment the output gap must be closed, and the options for doing so without accepting higher inflation are dwindling. When Operation Twist ends they are effectively out of bullets, and to continue buying they will have to print. Despite what he said in April, if he continues to follow the path he outlined in 2002, the nuclear option could be a very real possibility.

As I forecasted back in July at Wednesday's FOMC announcement, Bernanke capitulated and opted to attach what are being called "thresholds" to the Fed's uber-easy and accommodative monetary policy by raising their inflation target to 2.5% in order to bring the unemployment rate down to 6.5%.

Make no mistake about it, this is a de facto nominal GDP target. The only way the unemployment rate can get back to 6.5%, which is in fact below what some economists view as full employment, is to close the output gap which remains extremely wide.

In that same piece I noted that while a NGDP target was mostly a "fringe" economist idea, Goldman Sachs' (NYSE:GS) economist Jan Hatzius brought it into mainstream thinking in a report titled The Case for a Nominal GDP Level Target that he published in October 2011. Hatzius does a good job of laying out the framework for how a NGDP target would work.

We believe that the best way for the Federal Open Market Committee (FOMC) to deliver significant additional easing would be to target a nominal GDP path such as the one shown in Exhibit 1, indicating that it will use additional asset purchases-and all other available policy instruments-to ensure that actual nominal GDP reverts to trend over the medium term.



The specific path in Exhibit 1 is calculated as the level of nominal GDP in 2007 extrapolated forward at a rate of 4.5% per year. We can think of this number as the sum of real potential GDP growth of 2.5% and inflation as measured by the GDP deflator of about 2%.

Here's the problem.

During the recession that followed the financial crisis, nominal GDP went negative for four consecutive quarters, which had not happened in the post-WW II era. As you can see by Hatzius' chart, this has put a massive dent in the output gap. The current output gap is just over $17 trillion vs. today's NGDP of 15.8 trillion, yielding a deficit of 7.6%. The regression analysis on Bloomberg shows the current NGDP at nearly two standard deviations below the 20-year trend line.

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.

If Bernanke intends to be easy until the economy reaches full employment and full employment won't be achieved until we close the output gap then it's not out of the realm of possibility to assume this regime of crisis level monetary policy may well last for another decade.

Bernanke has put himself between a rock and a hard place. He can't come out and say that he wants to reach a nominal GDP number of 19.6 trillion by 2015, or worse, that he needs the growth rate to be 7.0% in order to close the output gap. The bond market would crash. But the market is not stupid. The longer he attempts to hold bond yields below the rate of inflation while at the same time trying to stimulate the inflation that erodes these same coupons, the more worthless they become and the more interest rate risk he generates. It seems at some point Bernanke will be facing a Pyrrhic victory. If he is successful eventually the curve will unwind and the bond market will crash.

At Wednesday's press conference that followed the FOMC decision, Chairman Bernanke was asked a good question by Market News International's Steve Beckner about the Fed's credibility in the context of using the world's reserve currency to monetize the US government deficit (emphasis mine).

Beckner:

With the federal government borrowing roughly one trillion dollars a year and now with the Fed on pace to buy roughly a trillion dollars a year in bonds, are you concerned about a public and possibly global perception that the Fed is accommodating not just growth but accommodating federal borrowing needs, and are you concerned about what this might do to the Fed's credibility and the credibility of US finances in general, and the credibility of the dollar as the world's leading currency?

Bernanke:

You know, we've been increasing our balance sheet now for some time, and we've been very clear that this is a temporary measure. It's a way to provide additional accommodation to an economy which needs support. We've been equally clear that we will normalize the balance sheet that will reduce the size of our holdings whether by letting them run off or by selling assets in the future. So this is, again, only a temporary step. It would be quite a different matter if we were buying these assets and holding them indefinitely. That would be a modernization. We're not doing that. We are very clear about our intentions. And I think up till now, it seems our credibility has been quite good. There is not any sign either of current inflation or of any -- there's no strong evidence that there are any increase in inflation expectations for that matter, looking at financial markets, looking at surveys, looking at economic forecasts and so on. So, this is one of the things that we have to look at. Remember, I talked earlier about the potential costs of a large balance sheet. We want to be sure that there's no misunderstanding, that there's no effect on inflation expectations from the size of our balance sheet. That's one of the things we have to look at, but as to this point, that there really is no evidence that the people are taking it that way.

Mr. Chairman, honestly, I think you are being a little disingenuous.

First, to say the Fed is not engaging in monetization because eventually the securities will run off or because there is no plan to hold them indefinitely is kind of a joke. We not only don't know how long they will hold them, but by my analysis, it is looking like this is going to be going on for a long time. Plus, not only are they printing money to finance the deficit, the Fed remits the coupon earned back to the Treasury. This means the Treasury can effectively borrow money from the Fed at no cost.

Second, to say that there is no evidence of inflation or inflation expectations in the markets is also a joke. The reason there is no actual inflation is because QE isn't working, and if you gauge the bond market's most inflation-sensitive metric for inflation expectations -- the yield curve -- it remains historically very steep. Despite the Fed's attempt to flatten the long end of the curve during Operation Twist, the 10-year/30-year spread is near the highs of its historical range above 100bps and in fact steepened further after the Fed's announcement last week.

Credibility?

In just five meetings after the Chairman stated that the view of the committee was that it would be reckless to allow for a higher rate of inflation to bring down unemployment at a faster pace, the committee raised their inflation rate threshold in order to bring down unemployment. Many will brush off the 50bps increase as immaterial but I think it is a slippery slope. If inflation were to exceed the 2.5% rate as in the past, we will likely hear that this is transitory or if unemployment were to fall below 6.5% then this would be viewed as unsustainable.

The fact is, Bernanke has a lot of wiggle room in his thresholds, and if my simple back-of-the-napkin regression analysis is correct, the Fed is going to be active in the market for many years to come. I would like to think Bernanke's intentions are pure, but I am also starting to wonder if his date with deflationary destiny is clouding his judgment. Either way it's pretty clear that he's making this up as he goes along. He admitted as much to in the first response to a question from CNBC's Steve Liesman as to why they have decided to make the guidance qualitative (emphasis mine).

Bernanke:

The asset purchases are a less well understood tool. We have -- we'll be learning over time about how efficacious they are, about what costs they may carry with them in terms of unintended consequences that they might create, and we'll be seeing how -- what else happens in the economy that can affect, you know, the level of unemployment, for example, that we hope to achieve.

As I have been saying since the Fed launched QE3 in September, the biggest risk in the markets today is a loss of confidence that Bernanke can hold this thing together. In my opinion there is a very large false sense of security that they know what they are doing and can indeed wield a wand to control asset prices. However, at the end of the day, this is still a confidence game. They can only do so if the markets believe that they can. If the markets lose faith, then all bets are off and the costs and unintended consequences could be severe.

Twitter: @exantefactor
No positions in stocks mentioned.
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