Real GDP Up 5.7 Percent: Good News and Bad

First, the good news. The preliminary estimate is that real GDP increased at a 5.7 percent annual rate in the fourth quarter of 2009, rising from $12,973 billion to $13,155 billion. This measures the production of consumer goods and services, capital goods, and government goods and services.

The long run trend growth rate of real GDP is a little more than 3 percent per year, so this is better than average growth. Further, according to the Congressional Budget Office, the productive capacity of the economy only grew at a 1.77 percent annual rate in the fourth quarter of 2009.

Is it a problem that the production of goods and services expanded faster than capacity? On the contrary, real GDP in the fourth quarter of 2009 was nearly 2 percent below the peak reached in the second quarter of 2008. Worse, it is 9.57 percent below its trend growth path and 6.17 percent below the CBO's estimate of the productive capacity of the economy. Real GDP, the real volume of goods and services produced, can only catch up if it grows faster than productive capacity.

Real GDP, its trend, and the CBO estimate of potential output is shown below for the entire period of both the Great Moderation and the Great Recession. The sharp drop in real GDP is apparent.

The current shortfall of real GDP relative to both its trend and the CBO estimate of potential output shows up clearly when looking at the Great Recession.

If real GDP continues to grow at an annual rate of 5.7 percent and productive capacity continues to grow at an annual rate of 1.77 percent, real GDP would return to productive capacity in about 18 months. (CBO projects less than 2 percent growth for productive capacity until 2012.)

Unfortunately, it is doubtful that real GDP will continue to grow at such a rapid rate. The real volume of final sales of consumer goods, capital goods, and government goods only increased at a 2.2 percent annual rate. The other 3.5 percent was an increase in inventories--goods produced but not sold.

The best possibility would be that firms expect rapid increases in sales in the future and expanded production in preparation. If they were correct, then strong production should continue. The worst possibility would be that firms expanded production in the fourth quarter expecting strong sales, but they didn't materialize. The firms have accumulated large stocks of unsold goods and they will reduce production in the future until they sell off these excess inventories.

The third possibility is that firms had sold off inventories in the past, and now are rebuilding those inventories to more normal levels. If that is correct, then next quarter, production should come closer to matching final sales (increasing 2.2 percent) because inventories will have been replenished. Most business economists are talking about this third alternative.

So, the bad news is that last quarter's strong growth of real GDP is unlikely to be repeated, and real GDP remains far below its trend growth path and well below the CBO estimate of the productive capacity of the economy.

Perhaps something new should be tried? Maybe a target for a growth path for nominal expenditures would help return the production of goods and services to capacity?

The Price Level and Inflation

Using the GDP deflator measure of the price level, its value during the 4th quarter of 2009 was 109.93 which means that prices were nearly 10 percent higher than in 2005. This is an all time high for the price level.

Comparing to the trend 2.3 percent growth path of the price level during the Great Moderation, the current value is 1.5% below the 111.6 trend value.

The price level rose at a .62 percent annual rate from its value in the third quarter of 2009. This current low inflation rate, as well as the inflation rates for the other quarters of the Great Recession are substantially below the trend rate of inflation.

Other things being equal, I think the current low inflation rates are much better than the trend of the Great Moderation. If anything, they remain a bit high. The one quarter of "deflation," the drop of the deflator from 109.661 in first quarter 2009 to 109.656 in second quarter 2009, (a drop of .005 which is multiplied by four to get the .02 percent annual rate) is as close to price stability as can reasonably be expected.

However, other things aren't equal. There is good reason to believe that potential output is depressed, and the least bad response to such conditions is stable growth of nominal incomes, allowing higher prices to clear markets and lower real incomes. In other words, the productivity norm advocated by George Selgin is the least best approach, though I favor a zero inflation trend rather than his preferred mild deflationary trend.

Worse, real output is far below its long run 3 percent growth path. And while estimates of potential output are also below trend, there remains a substantial output gap. Since it is likely that there has been some adjustment to lower nominal expenditures, as shown by the price level and inflation rate both falling below trend, (and the growth of nominal wages has slowed a bit,) returning nominal expenditures to their previous growth path is going to cause some disruption. That is one reason for modifying the growth path of nominal expenditures.

I favor shifting to a new, lower growth rate backdated in the past, (3 percent backdated to third quarter 2008,) reducing the needed increase in nominal expenditures to return the the targeted growth path. The notion that this would work perfectly, with a smooth return of prices and output to equilibrium levels would be an example of the fatal conceit. Still, I think something along those lines is the last bad option.

Nominal Expenditures Increase, but it is Still Too Low!

Final Sales of Domestic Product for the fourth quarter of 2009 were $14,503.4 billion. This was a 2.9 percent annual rate of increase from the $14,398.7 billion level in the 3rd quarter of 2009. In my view, this is nearly the ideal growth rate (3 percent,) but the level remains much too low.

Currently, nominal expenditure, as measured by Final Sales of Domestic Product, is approximately 1/2 of a percent less than its peak of $14,583.7 billion reached in the third quarter of 2008.

Looking that the 5.4 percent trend growth path for nominal expenditures during the Great Moderation, the current level is 10.38 percent below the $16,089 billion that is the current value of that growth path. This is an increase in the gap from last quarter, which was 9.74 percent. (This is slightly higher than the figures I was posting earlier this week, I suppose I was still using one of the prior vintages of third quarter 2009 Final Sales of Domestic Product.)

If the Fed targets nominal expenditure to return to its trend growth path one year from now, that is, the first quarter 2011, the target for that quarter remains $17,222 billion. That implies an 18.7 percent increase in nominal expenditure from the fourth quarter of 2009.

A modified growth path, shifting to noninflationary 3 percent growth rate beginning in the third quarter of 2008, leaves a shortfall of 7.3 percent, virtually unchanged from last quarter.

If the Fed targets nominal expenditure to return to this adjusted noninflationary growth path, the target for nominal expenditure in the first quarter 2011 remains $16,202 billion. That would be an 11.7 percent increase from the fourth quarter of 2009.

Nominal Expenditure Targeting and Estimates of Potential Output

Suppose the Fed had been able to keep nominal expenditure growing on a 5 percent growth path? If the productive capacity of the economy had remained on the 3 percent trend growth path of real output, then the inflation rate would have stayed 2 percent.

Suppose that instead the Fed had been able to keep nominal expenditure growing on a 3 percent growth path? If the productive capacity of the economy had remained on the 3 percent trend growth path of real output, then the price level would have remained stable. There would have been no inflation.

Of course, the productive capacity of the economy, potential output, is unlikely to remain on a constant 3 percent growth path. That new technology would improve total factor productivity the same proportion each and every year is implausible. And the world is full of events that surely impact the productive capacity of the economy in both favorable and unfavorable ways--good weather, floods, hurricanes, strikes, the list is long.

The CBO provides an estimate of potential output. Using that estimate, how would the inflation rate have fared if the Fed had kept nominal expenditure on its trend growth path or else a 3% growth path? The price level is simulated by dividing the level of nominal expenditure by the estimate of potential output. The inflation rate is then calculated using log differences.

If the Fed had maintained nominal expenditure on its approximately 5 percent growth path, then the highest inflation rate is approximately 3.5 percent during the first quarter of 2009. With the alternative 3 percent growth path, the highest inflation rate would be approximately 1.1 percent in the first quarter of 2009. The lowest deflation rate would have been -.7 percent, in the first quarter of 2001.

Focusing on the Great Recession, it is interesting that the inflation rate consistent with nominal expenditure remaining on its trend growth rate and the CBO measure of potential output is close to 3 percent, rising to 3.5 percent. Calls for the Fed to raise its target for inflation from 2 percent to 3 percent are roughly consistent with nominal expenditure targeting and the CBO estimate of potential output.

Laubach and Williams estimate much larger fluctuations in potential output than the CBO. Their 2 way measure implies much greater fluctuations in inflation if nominal expenditure remained on a stable growth path.

If nominal expenditure had continued to grow at its trend, and potential output remained at the estimated level, the highest inflation rate would have been 7.7 percent in the first quarter of 2009. If the growth path for nominal expenditures had instead been 3 percent, then the highest

inflation rate would have been 5.2 percent, also in the first quarter of 2009. The lowest deflation rate would have been -3.5 percent in the second quarter of 2000.

This is quarterly inflation at annual rates. The annual rates of inflation are slightly less alarming.

Still, with nominal expenditure growing at trend, the annual inflation rate for 2009 was nearly 6 percent. And even with the 3 percent growth rate of nominal expenditures, the inflation rate was 3.5 percent. These figures are both for the first half of the year, because Laubach and Williams only provide estimates for potential output for the first two quarters. The lowest annual deflation rate was approximately -1 percent in 1998.

The one way estimate from Laubach and Williams has even less attractive consequences for targeting a growth path of nominal expenditure.

If nominal expenditure had been kept on its 5% trend growth path, then Laubach and William's one way estimate results in a double-digit inflation rate--10.7 percent in the first quarter of 2009. The lowest deflation rate would have been -4.1 percent in the second quarter of 2000. If nominal expenditure had been restricted to a 3 percent growth path, then inflation would have still been 8.25 percent in the first quarter of 2009. The lowest deflation rate would have been -6.5 percent.

These are annualized quarterly rates of change. Looking at the annual inflation rate is only slightly less alarming.

The annual inflation rate for 2009 is nearly 9 percent if nominal expenditure grew at trend and 6.6 percent with the noninflationary trend of 3 percent. The deflation rate would have been -1.5 in 1999.

The CBO estimate of potential output suggests that a stable growth path of nominal expenditure would be associated with only modest fluctuations in the price level. On the other hand, the Laubach and Williams' measures show substantial fluctuations in the price level--very sharp quarterly inflation and deflation rates.

To the degree such large fluctuations in prices are foreseen, the result should be inventory investment or disinvestment that would tend to dampen these sharp changes. Are Laubach and Williams' estimates accurate? Would they hold up under a regime of nominal expenditure targeting? Perhaps giving it a try is the best approach.

Trying to manipulate nominal expenditure in order to stabilize the price level or inflation rate requires an estimate of potential output. For example, the Taylor rule includes an estimate of potential output to determine the target for the federal funds rate. Stabilizing the growth path of nominal expenditures and so, nominal incomes, while letting the price level adjust with shifts in the growth of potential output is the more reasonable course when estimates of potential output are uncertain.

Hayek and Keynes Rap

Check out the Hayek and Keynes Rap Anthem!

Fear the Boom and Bust

Great Job!

Hanke on Fed Policy

Steve Hanke argues that Federal Reserve policy was too expansionary three times during the Great Moderation. (Hat tip to Greg Ransom.)

Hanke has the right idea. Rather than looking at the federal funds rate or CPI core inflation, he looks at a measure of nominal expenditure. Unfortunately, he uses final sales to domestic purchasers. Regardless of whether or not the Fed's policy was too expansionary, that is the wrong measure.

If there is an excess supply of money, expenditures will increase. However, the problem is that expenditures can outstrip the productive capacity of the economy.

While final sales to domestic purchasers measures how much U.S. residents spend, the "problem" to be solved is avoiding excess (or inadequate) expenditures on U.S. products, regardless of where the buyers reside. That is why total final sales of domestic product is the proper measure.

The two measures are shown below, with the gap reflecting the trade deficit.

The growth rates of the two aren't really that different. Presumably, if Hanke used the "correct" measure of nominal expenditure, he could make an equally good case for an excessively expansionary Fed policy.

Presumably, Hanke and others using Final Sales to Domestic Purchasers reason that if the Fed creates too much money for U.S. residents, they will expand their expenditures on goods and services. While they may mostly purchase domestically produced goods, some of the excess supply of money may spill over into purchases of foreign goods and services. Measuring how much they spend on all goods provides evidence of the excess supply of money.

This reasoning is correct as far as it goes.

However, consider some other possibilities. U.S. residents own stock in German firms. They sell the stock and purchase cars produced in Germany. Final sales to domestic purchasers rise, but there was no excess supply of money.

Suppose Mexicans holding U.S. currency decide to hold less and use the proceeds to purchase goods imported from the U.S. If the quantity of money is unchanged, the result in an excess supply of money and excess demand for U.S. goods and services. There is no increase in final sales to domestic purchasers in the U.S.

Generally, using final sales to domestic purchasers will confuse equilibrium changes in net exports and net capital flows with monetary disequilibrium. While it might not be wise for Americans to borrow money from foreigners to purchase foreign products, that can occur without there being an excess supply or demand for money.

The real economy is about producing goods and services, earning income from that production, and spending that income on that output. The problem with monetary disequilibrium is that it disrupts the process.

Of course, the prices of final goods and resources can adjust so that the real quantity of money matches the real demand and the real volume of expenditures matches the real volume of output and real income. But if the prices of all goods and services, including resources like wages, are less than perfectly flexible, then these price adjustments will be slow and imperfect. Monetary disequilibrium will disrupt the process of producing goods and services, earning income, and purchasing goods and services. So, monetary disequilibrium is to be avoided when possible. In particular, having the Fed disrupt an economy in equilibrium with a "money supply shock" is undesirable.

If a boundary is set up between parts of the economy, like international borders, then income and purchases of output on each side of the border don't necessarily match, even in equilibrium. There can be trade deficits or surpluses, and balancing net capital inflows or outflows. Of course, monetary disequilibrium can create disequilibrium in those flows, like it can cause so many other problems, but not all changes in those flows reflect monetary disequilibrium.

The production of goods and services in the U.S. generates income in the U.S. regardless of whether the products are sold to domestic purchasers or foreign purchasers. There is no reason why the production of U.S. goods and services solely generates income for U.S. residents, and there is no reason to expect the incomes of U.S. residents to be solely spent on U.S. products.

Further, consider the impact of an excess supply of money on exchange rates. As excess money is spent on foreign products, the prices of foreign currencies rise. The depreciation of the external value of the dollar makes U.S. exports cheaper to foreigners. Expanded exports is a avenue by which the excess supply of money generates an excess demand for U.S. goods and services.

Similarly, the lower value of the dollar makes imported goods more expensive. The shift from imported goods to import competing goods is another avenue by which an excess supply of money leads to increased demand for U.S. products.

On the other hand, suppose the foreigners wanted to increase their holdings of U.S. money. Then the dollar doesn't fall in value, and the demands for U.S. products don't rise through either of those paths. But if the foreigners wanted to hold more money, then there wasn't an excess supply of money, but to that degree, there was an increase in the quantity of money matching an increase in the demand.

Of course, an excess supply of money may not immediately impact the demands for final goods and services. It is even possible that the difference between sales to domestic purchasers and sales of product might communicate something about the lagged effects of monetary policy.

Still, the final sales of domestic product should be the first choice for measuring nominal expenditure. More importantly, the Fed should be targeting a growth path of Final Sales of Domestic Product. I would be a serious mistake to stabilize a growth path for Final Sales to Domestic Purchasers alone. Sales to foreigners count too!

Sumner's Debating Points

Scott Sumner believes that we should not be debating whether Bernanke should be reappointed, but instead:

1. Whether to cut the fed funds target from 0.25% to 0%

We should not target the federal funds rate at all. I suppose the proper range is between positive and negative infinity. While Fed actions will impact interest rates of various sorts, none should be subject to specific targets but should rather float with changes in supply and demand.

However, it is especially important that the Fed specifically reject its past policy of targeting the fed funds rate. The Fed's emphasis on a target for that rate has created the myth that monetary policy is no longer effective because it is so low.

The answer isn't to lower it a bit more, but rather to clearly explain that the fed funds rate is no longer of any interest to the Fed.

2. Whether to put an interest penalty on excess reserves.

The Fed should pay an interest rate on excess reserves equal to 1/4 percent below the 4 week T-bill yield. Currently, that would be negative. So, the Fed should be charging banks for holding excess reserves.

This should not be described as a penalty. The Fed is not punishing banks for hoarding reserves. The Fed is charging banks for the privilege of holding funds in a perfectly safe and liquid form when real investment opportunities involve risk and take time.

While the current rate should be negative, it should rise above zero when the 4 week T-bill yield is greater than .25 percent.

3. Whether to do additional QE.

Yes. The Fed should sell off its holdings of mortgage backed securities, but more than offset those sales with purchases of T-bills, bonds, and notes. The interest rates should be driven to zero on up the yield curve. While the yields on 4 week T-bills are nearly zero, the Fed can buy one year T-bills, notes maturing in 2 years, 3 years, and so on.

4. Whether to set an inflation or NGDP target.

NGDP is better than inflation, though I prefer a target for Total Final Sales of Domestic Product. It does not include inventory investment. While including planned inventory investment would be fine, the reason to use that measure of nominal expenditure rather than nominal GDP is to avoid including unplanned inventory investment. That the national income accounting identity counts goods produced and not sold as having been sold to the producer, and that "profits" on those unsold good count as income, hardly makes it consistent with macroeconomic equilibrium.

5. Whether to target growth rates or levels.

The level, or rather, growth path, of nominal expenditure should be targeted. However, this only makes sense if it is the growth path of nominal expenditure that is being targeted. Creating monetary disequilibrium to force sticky equilibrium prices back to some arbitrary level is counterproductive. Reversing shortfalls or excess expenditures to avoid the need to make changes in sticky disequilibrium prices or wages is desirable.

6. And of course the key overarching question: Would the economy benefit from an increase in AD, or nominal spending?

Yes, the economy would benefit by an increase in nominal expenditure. Nominal expenditure is currently 9 percent below its long run trend.

The notion that current real GDP is equal to potential output and the current unemployment rate is equal to the natural unemployment rate is highly implausible. (I do think it likely that the current level of potential output is below the long run trend of real GDP. I accept that keeping nominal expenditure growing at trend will cause changes in the prices of goods and services.)

P.S. Bernanke should be fired because he listened to Geithner and focused on bailing out broker-dealers on Wall Street rather than maintaining nominal expenditure. He participated in the effort to scare Congress into approving this bailout. Those scare tactics were destructive and plausibly were a key cause of the drop in nominal expenditure. He continues to be committed to going back to the failed policy of targeting the federal funds rate at levels that are expected to be consistent with the core CPI rising at a 2% annual rate from wherever it is.

P.P.S. I will never support a Fed chairman because Obama and Congress are unlikely to provide anyone better.

P.P.P.S Sumner's points are in reverse order. First commit to raising nominal expenditure, commit to a growth path. For nominal expenditure. Do quantitative easing aimed at raising the monetary base. Stop paying interest on reserves. Drop Fed funds targeting.

Taylor Rule and Output Gaps

Taylor wrote:

Taylor Rule is pretty simple. It just says, the interest rate should equal 1 1/2 times the inflation rate, plus 1/2 time the GDP gap, plus 1.

I'm beginning to have doubts.


Using this formula to calculate the proper target for the federal funds rate using different estimates of the output gap naturally results in a variety of targets.

Using the GDP deflator and the Laubach and William's measures of the output gap, the CBO measure of the output gap and the gap between real GDP and its trend results in the following paths for the federal funds rate since 1984:

For the Laubach and Williams' one way measure, (LW1) the highest target was 7.97 percent in the third quarter of 2005. It was nearly as high, 7.73 percent in the first quarter of 2007. The most recent target, for the second quarter of 2009, was -.19 percent, the only negative nominal interest rate.

For Laubach and Williams' two way measure, (LW2), the highest interest rate was 8.22 percent during the first quarter of 2007. It was 7.03 percent during the third quarter of 2008. The lowest is the target for the second quarter 2009, is negative -.19 percent. Again, this is the only negative rate during the period.


The CBO measure generates a high interest rate target of 8.9 percent in the first quarter of 1990. It also suggests a high rate at the beginning of the Great Recession, 8.09 in the first quarter of 2007. The low is second quarter 2oo9, at -1.66 percent. However, the nominal interest rate was also negative in the fourth quarter of 2009, -.1 percent.

The gap between the trend growth path of real output and real GDP suggests a federal funds rate that reached a high of 9.21 percent in the first quarter of 2000. It also suggests an interest rate of 6.7% for the first quarter of 2007 and 4.97 for the third quarter of 2008. It turns negative as nominal income began to fall, -1.83 in the fourth quarter of 2008, -.32 in the first quarter of 2009, and -3.59 for the second quarter of 2009.


These applications of the Taylor rule do call for negative nominal interest rates, but for some of them, the negative rates are not much different from zero, and only apply to a single quarter.

Of course, these calculations are using the GDP deflator, which includes all goods and services. The standard approach is to ignore capital goods and government goods and instead just look at the prices of some consumer goods--well, everything other than food and energy. Further, these calculations used the current inflation rate and output gap to find the proper information. The Taylor rule needs to use available information. Look for another post later.

Output Gaps and Potential Incomes

David Beckworth commented on my post about the Taylor rule, and suggested that I look at Laubach and Williams estimates of potential output. Here is the link to their data.

Laubach and Williams have two measures of the output gap, a one-way and a two-way. The following rather busy graph shows real GDP, the trend of real GDP, and the CBO, LW1, and LW2 measures of potential output.

In the second quarter of 2009, real GDP was 9.1 percent below its 3 percent trend growth path The output gap according to the CBO is -5.3 percent. And both of Laubach and Williams' measures show a -2.3 percent gap.

According to the CBO, the productive capacity of the economy is currently about 3.8% below trend. Laubach and Williams estimate that the productive capacity of the economy is about 6.8 percent below trend.

Perhaps more interestingly, the CBO's estimates shows potential output growing less than the trend growth rate of real GDP. Potential output never falls, it just grows more rapidly or more slowly. Laubach and Williams' estimates, on the other hand, show absolute drops in the productive capacity of the economy.

According to LW 1, productive capacity peaked in the second quarter of 2008 and had fallen 2.3 percent by the second quarter 2009. According to LW 2, productive capacity peaked in the third quarter of 2008 and hit a low in the first quarter of 2009, having fallen about .8 percent, and in the second quarter of 2009 had risen a bit, but remains just shy of 1/2 of one percent below its peak.

What are the implications of these different measures of the output gap for the Taylor rule? More importantly, what are the implications for inflation if the Fed had been able to keep nominal expenditure growing at a 5 percent or 3 percent rate?

More later...

Is Inflation "Too Low?"

I favor targeting a growth path for nominal expenditure. The growth rate should be 3 percent. Because of the 3 percent trend growth rate of real output, that should result in zero inflation on average.

Suppose the Fed had been able to keep nominal Total Final Sales of Domestic Product on a 3% growth path for the entire period for the Great Moderation--from 1984 until today. Further assume that the CBO estimate of potential output is correct and that nominal expenditure targeting always left real GDP equal to potential output.

What would have inflation looked like during the Great Moderation?

What would inflation look like today, during the Great Recession?

First, a look at the simulated value of the GDP deflator.

Rather than nearly doubling, the price level, as measured by the GDP deflator, would have stayed very close to 60, that is, prices would have stayed at about 60% of their 2005 level for the entire period. The highest price level would be the most recent one, 62.35 and the lowest in the third quarter of 1989, 59.93. The difference is 4%.

Next look at inflation for the entire period.

There is a slight trend inflation over the period, a bit under .1 percent. The most severe deflation rate would have been in the first quarter of 2001, at a -.7 percent annual rate.

The highest inflation rate would have been in the first quarter of 2009, at a 1.1 percent annual rate. The third quarter of 2009 is nearly as high, with a 1.08 percent annual rate.

According to the CBO, potential output is currently more than 4 percent below the long run trend growth path of real GDP. If the Fed could keep nominal expenditure on a 3 percent growth path, a substantial deviation of productive capacity from trend would have led to only mild inflation.

This "ideal" inflation rate is well below the actual rate of inflation for most of the Great Moderation, until the Great Recession begins. Inflation has been "too low" by this standard in the fourth quarter of 2008, and the second and third quarters of 2009.

I guess I just have to admit it -- there is a sense in which I think that inflation today is too low.

My Lesson in Monetary Policy

In a comment on my last post, Jon gave me another lesson on monetary policy and John Taylor's arguments about the crisis.

I have read other articles by Taylor on the crisis and continue to see money and credit confused, and an obstinate desire to claim that the federal funds rate was just fine, it was the rest of the economy that was wrong.

Jon claims that Taylor believes that his audience understands "loose" money in terms of the federal funds rate. If Taylor panders to his audience in that fashion, then, that makes him part of the problem.

Making monetary policy work when no one believes it will work is more difficult. Continuing to encourage the identification of monetary policy with a target for the federal funds rate, and so perpetuating the myth that with the federal funds rate set at a range of zero to .25 percent, monetary policy is "out of ammunition," is destructive.

Jon describes what the Fed did in the federal funds market as "liquifying" the market. I find the concept of liquifying a particular market a bit odd. My blender has a setting of liquify. Liquidation is sometimes a euphemism for assassinate.

Jon explains that Taylor believes that by selling its T-bill portfolio, the Fed reduced liquidity in the OTM market. I suppose that means the "over the counter" market. I am not sure who supposedly had little money in their checking accounts and how they were associated with what sort of over the counter trading.

I think I do understand what Jon reports is Taylor's view about federal funds and LIBOR. The Fed injected funds into the federal funds market, but those funds were not being relent by banks onto the LIBOR market. The federal funds rate fell, but the LIBOR rate remained high.

From Jon's last lesson on monetary policy, I took it that the Fed added funds to the economy by making secured overnight loans to primary security dealers (broker dealers.) But they were not lending those unsecured funds on the LIBOR market.

Here is some information from the British Bankers Association on LIBOR:

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The LIBOR rate is the interest rate a handful of large money center banks pay to borrow money. The British Bankers association selects them and then polls them on their borrowing costs. It isn't like there is some kind of exchange where funds are traded and the interest rates are reported. If we assume that these large money center banks have the best credit, then other banks and nonbank borrowers can be expected to pay more.

Note that it is an average rate and the BBA carefully discards the higher and lower rates. But what happens when most of the banks that the BBA's selection committee chose have similar problems at the same time? Instead of LIBOR communicating something about market interest rates, it is now communicating information about the financial problems of a handful of banks.

The Fed funds rate is the relevant overnight borrowing rate for most U.S. banks. During the crisis, there was a large volume of overnight lending at low rates. But, heaven forbid, many of the large money center banks had to pay higher interest rates than most banks (rather than lower rates, as is their birthright, of course,) because they had financed large portfolios of mortgage backed securities with short term funds. I suppose we can call their inability to sell the mortgage backed securities "the queen of spades" problem, that is, who knows which mortgage backed securities include mortgages that will default. And those banks ability to borrow no doubt changed with changing perceptions of whether and how they would be bailed out.

Taylor (and Jon) insist that these money center banks didn't have a liquidity problem. Well, if that means that their problem wasn't that the people that would otherwise lend to them wanted to hold money, and that there wasn't enough money for those potential lenders to hold, and so they were refusing to lend to those banks, then maybe. Creating more money may have resulted in more lending, but maybe none of it would have flowed through the money center banks.

On the other hand, I am sure there was a problem with liquidity in the U.S. economy. While the quantity of money rose, it rose by less than the demand to hold money, so nominal expenditure began to grow more slowly in the third quarter of 2008, and then dropped in the fourth quarter of 2008 and the first quarter of 2009. To this day it remains 9% below its long term trend because the quantity of money is less than what the demand to hold money would be if nominal expenditure were on its trend growth path.

And that is what the Federal Reserve needs to worry about, not the borrowing rates of a handful of money center banks. And claiming that the interbank lending rate is just fine--well, maybe. I think it is time to understand that interbank lending rates are beside the point.

Taylor's Macroeconomics

Sumner asked Taylor about monetary stimulus:

Question: Should the Fed have been more aggressive with monetary stimulus in September-November 2008? (Scott Sumner, The Money Illusion)

John Taylor: I think the Fed cut interest rates during that period just about right. I think it was basically coming down, it could have been a little faster at that point, and of course, GDP did fall tremendously. But I think if they had kept the interest rates along the same path it would have been fine. The problems I see at that period was the tremendous amount of uncertainty added by these new effects, if you like, the quantitative ease, and sometimes I've called somewhat **** mundustrial policy to where the actions went well beyond the usual interest rates. And I don't think they were appropriate. We're still studying them. Some of them were inappropriate. I just finished a study on mortgage interest rates.

Like Sumner mentioned, what is most striking about Taylor's response is that "monetary stimulus" is simply identified as lowering the Fed's target for the federal funds rate.

More troubling, however, is the notion that the targeted level of the federal funds rate was fine, but it was rather uncertainty generated by the financial policy -- the bailouts -- that caused the problem.

Could this mean anything other than that the Fed's target for overnight interbank lending was just fine. The problem is that the natural interest rate was "wrong" because of uncertainty about government action?

This view is wrongheaded. "The" natural interest rate is the interest rate that coordinates saving and investment--given the expectations that households and firms actually have. It is the level of the interest rate that makes total real expenditures equal the productive capacity of the economy--again, given the expectations that households and firms actually have.

If uncertainty about government action raises saving or reduces investment, the natural interest rate is lower. The role of any market price, including the market interest rate, is to coordinate given actual market conditions, not hypothetical ideal conditions.

Suppose there is a shortage in the gasoline market at the current, official, government-fixed price. Taylor might say, the official price of gasoline is just fine. It is all the uncertainty about new environmental regulation that has increased demand and reduced supply, and so we have the shortage on the market. Once all that uncertainty settles down, the rule relating the official price of gasoline to inflation and traffic conditions will work just fine.

While it may be true that uncertainty would raise the demand and reduce the supply of gasoline, the equilibrium price of gasoline isn't the price that makes quantity demanded equal to quantity supplied if there is no uncertainty about future government action. The equilibrium price is the price where quantity supplied equals quantity demanded. The reason for a shortage of gasoline would be that the market price is not allowed to rise because of a price ceiling.

Of course, there is not a federal price floor under interest rates. It is rather than with a regime of interest rate targeting, the Fed creates monetary disequilibrium (or allows it to develop) in order to prevent interest rates from falling below target. The expected effect of that disequilibrium is disruption of the flow of nominal expenditure on currently produced output. For example, the drop in nominal expenditure during the fourth quarter of 2008 and the first quarter of 2009.

Taylor correctly notes that the effective Federal Funds rate had fallen below target for much of the fall of 2008. And then the Fed began paying interest on reserves, specifically to prevent this from happening. Because Fannie and Freddie can't earn interest on reserve balances, it didn't work fully, but both the intention and effect is clear. It was like putting a price floor on gasoline to keep the price from falling. Taylor has no problem with this sort of thing, because it is the equilibrium price (the natural interest rate) that was "wrong.".

While the confused bailout policy of the fall of 2008 was destructive, a sensible free market policy would have also led to uncertainty. Which of the investment banks were insolvent and would go through bankruptcy? When (and if) will expedited bankruptcy legislation pass? How long will traditional bankruptcy take? How many commercial banks are insolvent and how quickly can FDIC reorganize them? How fast will commercial banks learn to fund loans with growing deposits rather than sell them to investment banks? The implications for the interbank lending rate for commercial banks with substantial insured deposits (and likely growing insured deposits) is unclear.

Thoma asked Taylor:

Question: What is the most important unresolved question in monetary economics? (Mark Thoma, Economist’s View)

John Taylor: I think the most important unresolved question of monetary economics is the interaction between the financial sector and monetary policy. There's been lots of thinking about it over the years, some of it actually done here at Stanford; Girly and Shaw. A lot of it done by Tobin at Yale, Ben Bernacke has done some of it. But I think the most promising part is the combination of the newest work on pricing of bonds and securities. A lot of it's done by Monica Busasy[ph] and some of her colleagues, that combine that with monetary policy so that you have a sense of what's going to happen to longer term rates when the short rate is reduced. What's going to happen to credit flows and how much are credit flows going to impact the economy?

This crisis has been very clear in demonstrating that more work on the connection between the financial economics and monetary policy is needed. In fact, there's still a lot of questions out there in policy about whether the financial markets performed well, or not. It seems to me, if you look at them, they absorbed a tremendous shock from policies. It's effectively a panic induced by some ad hoc policy changes and they responded quickly and they responded in a way which has been smooth, as the markets themselves. The institutions, the financial institutions of course, have been in great difficulty, but the markets themselves have worked well.

So, to me, where we should focus our attention really is this connection between the financial markets, including the financial institutions and the monetary policy itself.

This all relates to the failure of Taylor and other macroeconomists to get beyond thinking about "the" interest rate. The Fed changes the federal funds rates, and that is a change in "the" interest rate. But everyone, even macroeconomists, knows that there are many interest rates in the economy. So while one can say that "the" natural interest rate is the interest rate that coordinates saving and investment and keeps total real expenditure equal to the productive capacity of the economy, which of the many interest rates in the economy would that be?

Since real households and firms (as opposed to representative agents) adjust their saving and investment plans depending on the interest rates they can actually receive and pay--interest rates that include a variety of risk premiums and terms to maturity, (and not the current and expected interest rate on overnight loans between commercial banks,) "the" interest rate, market or natural, is an abstraction.

And so, what happens if there is a shift in risk premiums? What happens if the yield structure changes? What happens if the interest rates firms pay (say on Baa corporate notes) rises relative to the overnight interest rate on interbank loans?

It is wrongheaded to think that the overnight interbank loan rate is somehow "right" and that whatever it is that has caused the change in risk premiums or the yield curve is "wrong." It is the interest rates that people actually pay and receive that must be at the correct levels to coordinate savings and investment.

If there is a long period of time where risk premiums and the yield curve remain stable, and so the relationship between the interest rates people actually pay and receive have a very stable relationship to the interest rates banks pay and receive on overnight loans among one another, that is just fine. Perhaps some simple rule of thumb can be found that relates the level of the federal funds rate to inflation and an estimated output gap. Perhaps, combined with anchored expectations about the rate of change in the core CPI, such a simple rule of thumb can allow changes in the interest rates people pay and receive to change in ways that keep nominal expenditure on a stable growth path.

Maybe...

But that comes close to being good luck. It is similar to the long period where M2 velocity hardly changed. Why would the ratio between the quantity of currency, checkable deposits, savings deposits, and CD's under $100,000 to nominal expenditure remain constant? Well, it did. So maybe a monetary policy based upon keeping that aggregate of monetary assets growing at a slow stable rate could keep nominal expenditure growing at a slow stable rate. Maybe....

But when these chance relationships no longer hold, it is time to return to fundamentals. What is the goal? My view is that a stable growth path for nominal expenditure is the proper goal for monetary policy. What is it that the Fed really controls? Short term lending? No. There are many sources of short term lending. What the Fed controls is the quantity of base money. No doubt manipulating that quantity, particularly varying the amount of overnight and two week loans made to primary security dealers, impacts short term interest rates. There may be no simple rule of thumb relationship between what the Fed controls, base money, and nominal expenditure. Perhaps during some periods, a rule of thumb between the federal funds rate and nominal expenditure will work. Perhaps at other times, a relationship between M2 and nominal expenditure will work.

But if they stop working, the problem is with the rule of thumb. The problem isn't the rest of the economy.

The Taylor Rule

John Taylor wrote:

First of all, I don't think the Taylor Rule does show a large negative interest rates right now. That's kind of a myth. The Taylor Rule is pretty simple. It just says, the interest rate should equal 1 1/2 times the inflation rate, plus 1/2 time the GDP gap, plus 1. Well, if you plug in reasonable estimates for what inflation is and what the GDP gap is, I get a number that’s pretty close to zero. Not minus four, minus five, not numbers like that. So, in fact I would say the amount of quantitative easing could be reduced right now. I hope it is reduced in a gradual way. Some of the mortgage purchases I think could be slowed down and then actually reversed.

That is pretty simple--

R = 1 percent + 1.5 x inflation + .5 x (Real GDP - Potential GDP) /Potential GDP

If the target for the inflation rate is 2 percent and the inflation rate is 2 percent and the economy is producing at capacity, then the proper level for "the" interest rate is 4 percent. If this is expected to persist in the future, then the real interest rate is 2 percent.

If the target for the inflation rate was zero percent (as I prefer) and the economy was producing at capacity, then the target for the interest rate would be 1 percent. If this is expected to persist, the real interest would be 1 percent.

That is a bit of a puzzle, but perhaps the Taylor rule only applies if the target for the inflation rate is two percent.

There are many different measures of inflation. How does the Taylor rule apply using the GDP deflator?

The trend inflation rate during the Great Moderation as measured by the GDP deflator was 2.3 percent. The inflation rate has been well below trend during the Great Recession.

Not only is there a question of which inflation rate should be used, the Taylor rule depends on an estimate for potential output. The Federal Reserve bank of St. Louis includes a series for Potential Output sourced from the C.B.O. It uses year 2000 dollars, but that can be easily corrected.

The growth rate of this measure of potential output closely tracks the growth rate of Real GDP. The recessions show up as slow or negative growth.

The relationship between the levels of real GDP and this measure of potential output are a bit odd.

While Real GDP and this measure of Potential Output track closely during the first decade of the Great Moderation (though with a clear recession in 1991,) real GDP takes off and stays above potential output for most of the remaining period until the Great Recession. The recession of 2001 shows up as an unusual period where Real GDP was close to Potential Output.

Focusing on the period of the Great Recession, real GDP was greater than potential output and has now fallen well below potential output. The output gap is the percent difference between the two.

This measure of potential income shows very large positive output gaps--unsustainable booms. Focusing in on the Great Recession, the output gap rapidly shifted from positive to negative.

Putting together the inflation rate implied by the GDP deflator and the output gap generated by real GDP and the CBO estimate of potential output, the interest rate implied by Taylor's "simple" rule can be calculated.

These figures show a "Taylor Rule" interest rate that is less than zero for the last two quarters--1.5 percent and -1 percent. While not -4 percent, they are not zero either. Using these figures to find the interest rates for the entire period shows tremendous volatility.

Perhaps the CBO estimate of potential output is off. Or, maybe the GDP deflator is the wrong measure of the price level. However, a third possibility is that trying to find some simple rule that relates the proper interest rate on overnight interbank loans to inflation and the gap between real GDP and some estimate of potential real output is a mistake.