Saturday, October 17, 2009

What Should the Fed Do Now?

I favor a monetary policy regime of targeting a stable growth path for nominal expenditure. The Fed instead operates on a vague dual mandate to foster price stability and high employment. It has apparently interpreted that to mean targeting a 2% CPI inflation rate from wherever the CPI happens to be, and then leaning towards "ease" or "tightness" based on perceived gaps between aggregate output and productive capacity.

With the trend growth rate of productive capacity being 3%, a 2% inflation rate should imply a 5% growth rate in nominal expenditure. During the period of the "great moderation," nominal expenditure, as measured by total final sales of domestic product, has had a trend growth rate of slightly more than 5%.

Targeting the growth path, however, is not the same thing as targeting the growth rate.
Nominal expenditure has been below its trend growth path since 2006. While the gap remained small and stable until the fourth quarter of 2007, it has grown and has become alarmingly large after the fourth quarter of 2008 and first quarter of 2009. Second quarter 2009 total final sales was $14,327 billion. If it had continued to grow on the 5% trend growth path, it should have been $15,657 billion. The shortfall for the second quarter was nearly 9%.

Scott Sumner has argued for keeping nominal output on a stable growth path. He has proposed targeting expected nominal output one year into the future. The difference between nominal expenditure (total final sales) and nominal output (GDP) is inventory investment. Sumner's target for nominal expenditure, ignoring expected changes in inventory investment, and continuing with the 5% growth path would be for total final sales in the third quarter of 2010 to be $16,757 billion.

Last year, I agreed with Sumner that the Fed should maintain its past 5% growth path of nominal expenditure. While I favored a 3% growth path, the middle of a financial crisis was a poor time to engineer a disinflation. However, now that nominal expenditure is so far below that trend, I favor making an adjustment in the target growth path starting at the third quarter of 2008.

Given that adjusted target growth path of nominal expenditure, and continuing with targeting one year into the future, the proper target for third quarter 2010 total final sales of domestic product is $15,961 billion. That implies a slightly less than 12% growth rate for total final sales over the coming year. And then, for the fourth quarter 2010, it would be $16,081 billion, which would be an increase from the third quarter 2010 at a 3% annual rate.

How should the Fed manage that feat? First, it should publicly commit to nominal expenditure growth path targeting. It should commit to having total final sales in the third quarter of 2010 to be $15,961 billion. It should say nothing about what it expects the federal funds rate to be or how fast the CPI will be rising each month.
Second, it should stop trying to prop up short term, low risk yields by paying interest on bank reserve balances. If banks, foreign investors, domestic investors, or anyone else wants to hold perfectly, or nearly perfectly liquid, and zero or near-zero risk assets, then they should pay a little for that privilege.
And finally, the Fed should get serious about quantitative easing. The Fed should expand base money enough, whatever that might be, so that the expected value of total final sales is on target.


  1. I hope some of the inflation hawks will take a look at this post. Even if you switch to an NGDP growth target consistent with zero inflation in the long run, we need 12% nominal growth to get back to even that more contractionary trend line. And people seem to think I am a crude inflationist calling for about 7% NGDP growth over the next 12 months, and 5% thereafter. (I picked the actual of February 2009 as the new starting point.)

    BTW, Is inputed rent in single family homes included in final sales? How about NGDP?

  2. But why did spending begin falling from October '07? Was it a tightening of policy or an decrease in velocity?

    The Fed began steadily increasing its target rate from about mid '04. Are the charts showing the "long and variable lag" of monetary policy? Or did "animal spirits," fuelled by the housing bust, create a spike in money demand? Why is it that nominal expenditure fell into a tailspin in the first place?

    Furthermore, why do you prefer a 3% growth rate for nominal expenditure? Why not target 0% and let productivity gains lower the price level? Is the preference for 3% merely to satisfy preexisting expectations?

  3. Scott:

    I hope that I don't develop a reputation for being an even greater inflationist that Scott Sumner.:)

    I don't know how implicit rental income is handled in either measure. My guess is that it is included in both. I will look into it.


    I don't think that nominal expenditure dropped in 2007 because interest rates were too low in 2003. I do think that there was a bubble in single family homes and that when the bubble popped, there was an increase in money demand. The Fed failed to increase the quantity of money enough to accomodate that increaced money demand, resulting in a drop in aggregate expenditures. Sumner has convinced me that this failure by the Fed to accomodate the increaced money demand resulted in a second, even larger increase in money demand. And it was that secondary increase in money demand that was responsible for the truly alarming decreases in nominal expenditure in the fouth quarter of 2008 and the first quarter of 2009.

    Why not 0%? I plan a serious of posts on this issue. For now, I think that the first best scenario is for changes in nominal prices, interest rates, and incomes to reflect changes in relative prices, real interest rates, and real incomes. And so, I favor a trend for nominal expenditures consistent with a stable price level. On the other hand, institutions that create monetary disequilibirum to offset fluctuations in productivity, even permanent one time changes, are distruptive and unnecessary. And so, monetary institutions should not try to generate changes in nominal expenditure to maintain price level stability in the face of productivity shocks.

    "Austrian" theories that suggest that trend growth in nominal expenditures cause problems are mistaken in my view.

    I have covered all of this territory before in comments on Sumner's blog and on the Austrian Economics blog.

  4. Bill,

    Thanks for the reply.

    I also hope that you do not develop a reputation as an inflationist. When it comes to describing an increase in the money supply or a rise in the price level, we already have perfectly suitable words -- "increase in the money supply" and "rise in the price level." What we really need a word for is describing an unexpected increase in the money supply relative to money demand (or velocity), and for that words like "inflation" (and "deflation" for its opposite) are ideally suited. What "inflation hawks" really fear are the consequences of inflation in the monetary equilibrium sense, and merely mistake an expanding money supply to be its cause. In other words, neither you nor Scott are "inflationist," in my opinion, but monetary equilibriumists forced to describe your views in a language ill-suited to the task. In any case, you better not be an "inflationist," because that would also make me one and I can't have that!

  5. This comment has been removed by the author.

  6. Bill,

    You said, "'Austrian' theories that suggest that trend growth in nominal expenditures cause problems are mistaken in my view."

    I am beginning to agree, though I would be interested to read your reason. I cannot remember reading it on the "Austrian Economists Blog" and I only recently started visiting "TheMoneyIllusion." It is likely that I may not have understood your comments for what they were when I did read them, since the issue they address was probably invisible to me at the time.

    In any case, I suspect expectations to be vital, and I even amended my definition of monetary disequilibrium in the previous comment to account for it. If the economy is "expecting" nominal expenditure to grow at 5%, then falling short will have many of the same consequences ordinarily associated with deflation. In other words, it is possible, in this view of deflation, to have rising nominal expenditure, rising prices, and an expanding money supply and still have deflation.

    Am I just be "discovering" what everyone else learns when they take higher level macroeconomics classes, and therefore betraying my ignorance and lack of economic education? I don't know, but I have rarely seen these kind of subtleties brought into the debate.

  7. Scott and Bill,

    The answer is yes. Both GDP and final sales include a measure of imputed rent for owner occupied homes as part of PCE. I believe rents are imputed via a combination of BLS and Census data. Obviously, imputed housing is a much smaller % of GDP/final sales than in CPI.

  8. Bill:

    So it seems to be your opinion that both 2007 and 2008 are explainable as nominal problems only. I find that a bit hokey. I definitely believe that much of sept '08 forward reflects a nominal shock due to tight money; I just cannot be so certain as to claim that 2007 and early 2008 where also nominal shocks.

    Nor do I think Scott has made an argument in favor of that that would have convinced me. Both the collapse of the housing market and the run-up in oil prices reflected real-shocks.

    Moreover--and in this I beieve we decidedly differ--the oil shock reflected the squirulous consequences of easing against a real-shock: futile and harmful.

    In this way, I have yet to buy into your claim that holding NGDP to trend would be a cureall.

  9. Jon:

    Thank you for your comment.

    I favor targeting a growth path of nominal expenditures. I have noted what happened to total final sales. I have pointed out what needs to happen to get it back on target.

    I didn't try to explain 2007 and 2008. For what it is worth, I agree that the oil price shock was a real shock, but I think that stable growth of nominal expenditure is the least bad response. The effect would have been a higher price level, inflation, and slower growth of real output---petroleum products and completmentary goods, for the most part.

    As for the housing collapse, I have written a good bit about that, generally in the posts about Kling's views on "Recalculation." It involves a reallocation of resources. The least bad response is stable growth of nominal expenditures. The result would have been higher prices, and so inflation. This would be concentrated in thoses sectors of the economy that need to expand--that had been starved for resources because too many single family homes were produced. Output would have grown more slowly because bottlenecks in expanding sectors slow growth there, whereas housing and related sectors can shrink rapidly. Regardless the higher nominal prices and profits in expanding sectors provides the appropriate signal of what needs to happen--expansion in some sectors of the economy.

    Perhaps describing these two shocks together is instructive. Contracting nominal expenditure to keep the oil price shock from raising the price level would have been disruptive and foolish. I would require a slight deflation of all the other, slightly sticky product prices in the economy, to offset the higher nominal (and relative) price of oil. The growth path of nominal incomes would have too be depressed in order to reflect the somewhat depressed growth path of real incomes. Why should't nominal prices rise to reflect the higher relative price of oil and of other goods generally?

    On the other hand, having aggregate nominal expenditures slowly grow to match expanding capacity in those sectors of the economy that had been starved for resources, while housing an related areas contract is conceptually ideal. Have nominal expenditure exactly track productive capacity would be great. How could that possibly be managed in practice?

    What sort of policy regime do you advocate instead?

  10. dlr, Thanks for the info on NGDP calculations. Even though housing is a smaller share of NGDP than the CPI, I am still concerned because the rent imputation is seriously flawed, it lags far behind actual market rents on new leases. So the decline in NGDP has been understated.

    Jon, I think you misunderstood my argument (and Bill's.) I agree that there were real problems in the last half of 2007 and the first 7 months of 2008. NGDP growth slowed modestly, but the big economic problems were real (oil, housing, and banking.) In my view nominal shocks became paramount beginning in August 2008.

    intplee, Yes, economists do pay a lot of attention to expectations. But I agree with your point about language. We don't have a generally accepted term for the money supply increasing less than money demand. I'd like to call that a contractionary monetary policy, but most of my colleagues don't agree with me.

  11. Scott:
    My phrasing was a bit convoluted, but I was also implying that you hadn't claimed 2007 was a nominal shock. I suppose I did mistake Bill's claim though.

    I agree of course about your chronology. Except that I view early '08 as a mild stagflation.

    If inflation accelerates due to a supply shock and real-production falls such that NGDP dips below trend, why does inflation need to accelerate further? We're already above expectations and already 'stimulating'.

    I have a somewhat different view on the collapse of oil prices in late summer '08. The supply shock had finally begun to ebb, but the combination of Fed easing during this period + the supply shock itself caused inflation expectations to adjust. Once the oil-shock subsided, inflation dipped well below the adjusted expectations and the Fed failed to ease policy.

    Whether you believe my narrative; I think it is a possible one that could happen, but under this regime your policy rule does the wrong thing. It elevates inflation which contributes to disturbing expectations. Once inflation expectations shift, your policy rule will induce a contraction to reset those expectations back to "3%" in your "2%" real-growth + "3%" inflation = "5%" target.

    i.e., you have deal with the conventional claim that once inflation dips below expectations the second-derivative of real-growth is negative.

    My preferred policy is a pure inflation target. My real trouble with your proposals is getting from A to B. "A" being real-variables are influence by the divergence of inflation from expectation and "B" being whether your NGDP growth trend sustains employment (a real-variable). I'm just not convinced that they are the same thing--that they are compatible claims.

  12. Jon:

    I will think about your argument more, but I don't see why a supply shock should cause nominal expenditure to drop below trend. I don't understand how you even see the situation arising where the supply shock has increased the price level (inflation going from zero to some positive amount, and so accelerating) and real GDP growing more slowly, perhaps even negative, and this somehow means that the sum of inflation and real GDP growth must be lower. Inflation is higher and real growth is lower, the sum doesn't obviously fall.

    Also, I consider having the Fed micromanage this as being a nonstarter. A stable growth path of nominal expenditure creates an enviroment or framework where each firm sets prices and makes production decisions. The effect of a supply side shock is going to be higher prices and less growth in production. In the extreme, reduced output and higher inflation. Nowhere in the process is there a decision to accelerate inflation. Inflation comes out of the decisions of each firm. The policy creates the framework.

    At first pass, I don't agree with your theory off aggregate supply at all. I don't think it is the relationship between inflation and expected inflation that cause changes in real output except in an indirect fashion.

    The expectations generated by a stable growth path of nominal expenditure are going to be specific to that regime. Are you worried that people will take the inflation rate from the past and project into the future, and ignore the fact that stable growth in nominal expenditure implies that each firm actually raising prices will be doing so in the face of growing surpluses of their products?

    I am seeing your argument as being that the firms will just expect more inflation, then the actual inflation will be less, so they will slow production. Does this really make any sense? Why wouldn't their inflation expectations take into account the regime of stable growth of nominal expenditure?

    You know, permanent supply shocks causes a higher price level, not a faster growth path of prices. There might be some inflation, but the expectated inflation rate going forward would be zero. And a temporary supply shock might cause inflation, but it should cause an expectation of deflation. Prices will go back down.

    Of course, people would have to judge whether the shock is temporary or permanent. Will oil prices stay high? Or will they come back down. If people really want to choose to quit work or change their hours because of how much gas they can buy, well, then, I guess they will. And that is it! Why complicate matters?

    Like I said, I will think about this more.

  13. @Bill:

    I thought that the 70's taught us that monetary policy can't really lower unemployment very much at all?

    From my understanding, the main effect it could do would be to counter unemployment due to minimum wage laws through inflation.

    Right now, I think we are getting a lot of unemployment due to benefits costs (with only a tiny bit due to the raise in minimum wage), and those benefits rise in costs with inflation, so I don't see how monetary policy will help lower the unemployment rate.

    What is your view on this?

  14. The lesson I would take from the seventies is that raising the trend rate of nominal expenditure will not result in a permanent boom, with real output on a higher growth path and the unemployment rate fluctuating at a lower avererage rate. In other words, the long run phillips curve is vertical and the effort to trade off inflation and unemployment was a horrible mistake.

    On the other hand, the short run effects of nominal expenditure dropping below its trend growth rate is a temporary increase in unemployment. A monetary policy that avoids this event would avoid that unemployment. I also believe that rapidly reversing any such deviation can reverse the increase in the unemployment rate.

    To deny this argument requires (I think) a view that all prices and wages are perfectly flexible, so that real expenditure always tracks productive capacity. If that is true, then it is never the situation that falling, or slower growth in, nominal expenditure would result in falling real expenditure. And so, all that monetary policy can do, in the short run or long run, is impact nominal prices and wages. I disagree with that view.

  15. Honestly, it is very tough to say what we could get next in store from Fed, but at the same time we need to have clear mind, as it is too risky to go with uncertainty. I can’t be sure of things, but at least with having swap free account with OctaFX, I am able to leave my trades open for long without having to worry over them, it obviously won’t lead me to great profits, but saves me from unnecessary pressure of having to pay overnight charges.