FOMC Minutes on Nominal GDP targeting

FOMC on Nominal GDP and Price Level Targeting:

The Committee also considered policy strategies that would involve the use of an intermediate target such as nominal gross domestic product (GDP) or the price level. The staff presented model simulations that suggested that nominal GDP targeting could, in principle, be helpful in promoting a stronger economic recovery in a context of longer-run price stability. Other simulations suggested that the single-minded pursuit of a price-level target would not be very effective in fostering maximum sustainable employment; it was noted, however, that price-level targeting where the central bank maintained flexibility to stabilize economic activity over the short term could generate economic outcomes that would be more consistent with the dual mandate. More broadly, a number of participants expressed concern that switching to a new policy framework could heighten uncertainty about future monetary policy, risk unmooring longer-term inflation expectations, or fail to address risks to financial stability. Several participants observed that the efficacy of nominal GDP targeting depended crucially on some strong assumptions, including the premise that the Committee could make a credible commitment to maintaining such a strategy over a long time horizon and that policymakers would continue adhering to that strategy even in the face of a significant increase in inflation. In addition, some participants noted that such an approach would involve substantial operational hurdles, including the difficulty of specifying an appropriate target level. In light of the significant challenges associated with the adoption of such frameworks, participants agreed that it would not be advisable to make such a change under present circumstances.

Yes, a price level target is a bad idea--big problems with supply shocks.

Yes, picking a growth path of nominal GDP is difficult.

But nominal GDP targeting results in stable inflation in the long run, so there should be no problem with inflation expectations becoming unanchored. That is the danger of inflation targeting. When the rule is to do nothing about inflation surprises, then there must be a constant worry about inflation expectations.

Not yet? Perhaps one day.

Does Nominal GDP Exist?

Taylor claims:

But it introduces another problem: if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targetting and most likely result in abandoning the NGDP target.

Market Monetarists treat nominal GDP as something that really exists--the flow of money expenditures on current output. Critics treat nominal GDP as the product of real output and the price level. "If an inflation shock takes the price level and thus GDP above the NGDP path, then the Fed will have to take sharp tightening action."

Given the growth path of the flow of money expenditures on output, an inflationary shock pushing the price level above its trend growth path will reduce what firms and households will buy and so what firms can sell and produce. While the price level rises to a higher growth path, real output falls to a lower growth path. Nominal GDP remains on target.

If this "inflationary shock" pushed real output below capacity, the resulting surpluses would put downward pressure on prices--automatically reversing the "inflationary shock." Prices would grow more slowly and fall back to their previous growth path and real output would rise again to the growth path of capacity. On the other hand, if the reason for the inflationary shock was a reduction in capacity, then the price level remains on the higher growth path and real output remains on the lower growth path with capacity. Still, nominal expenditures and nominal GDP remain on the target growth path.

On the other hand, suppose nominal GDP is nothing that really exists. It is just the product of the price level and real output. For example, suppose the policy interest rate determines real output in the next period, and then the output gap causes inflation the period after. Of course, we assume some stochastic process that causes inflation shocks during the current period too. Given real output, which was determined by last period's policy rate and its own idiosyncratic shocks, and multiply by the price level, which is already determined by last periods output gap, then multiply and an inflationary shock pushes the product--nominal GDP--above target. How to get the nominal GDP back down? A higher policy rate reduces real output next period, which lowers nominal GDP. And then the period after, the resulting output gap will get the price level back down too. (And will all of this manipulation of the policy rate lead to cycling? Will it be explosive?)

Now, how does this all work? Why does a lower policy rate cause output to change next period? Could it be that it directly causes money expenditures on output to change and firms respond to changes in sales? What happens to the amount that firms can sell next period if the great random number generator in the sky mandates that they charge higher prices? Can they really sell the same amount of output at higher prices? Does the quantity of money rise? Does the demand to hold real money balances fall? Is it that people borrow more? At what interest rate? The last period's interest rate that is supposedly determining output? Or is it the current period's interest rate--the one that will be determining output next period?

If the purpose of a model is to trace out how a given policy rate will impact nominal expenditure, real output, and the inflation rate over time, then perhaps skipping the nominal expenditure step, and going from real output (gaps) in the next period and the inflation rate in the subsequent period will do. But the flow of nominal expenditure on output is the true causal factor in the process. Right? Or are there people who really believe that the policy rate determines output next "period" and output (gaps) determine inflation the following period?

In my view, there is no such thing as an "inflation shock." There are supply shocks where the supply of some particular good or service changes. If the supply of a good decreases, the price rises and the quantity falls. As a matter of arithmetic, the price level rises and real output falls. A price level target requires a monetary contraction to push the price level back down.

An inflation target does nothing to reverse this periods random shock to the price level. But, in the real world, where supply shocks are not produced by stochastic processes but rather reductions in the supply of some particular good, then an inflation target implies a monetary contraction to prevent a developing supply shock from generating inflation. (To pull an example out of thin air, rising oil prices cause worries about inflation expectations becoming unanchored, deterring a decrease in policy rates.)

With a nominal GDP target, the results are more complicated. If the demand for the particular good whose supply decreased is unit elastic, then the increase in the price of the good is inversely proportional to the decrease in the quantity. The arithmetic increase in the price level is inversely proportional to the arithmetic decrease in real output. There is no tendency for nominal GDP to move away from target. Given flow of expenditures in the economy, there is no change in spending in the rest of the economy. There is no need for prices or output to change in other markets.

But if the demand for the good whose supply decreased is inelastic, then the increase in the price of that good is more than proportional to the decrease in quantity. Arithmetically, the price level rises more than in proportion to the decrease in real output. This tends to raise nominal GDP, perhaps pushing it above target. However, if the flow of nominal expenditure on output is already determined, then nominal GDP doesn't rise above target. What happens is that spending rises in the market where supply decreased and falls in the rest of the economy. This decrease in demand tends to depress prices and output in other markets. That is how nominal GDP remains on target despite the sharp increase in the price of the good whose supply decreased.

If demand for the good with the decrease in supply is elastic, then the analysis is reversed. The increase in price is less than in proportion to the decrease in quantity. The arithmetic increase in the price level is less than in proportion to the arithmetic decrease in real output. Nominal GDP tends to fall below target. To the degree that aggregate spending is already determined, then spending on the good whose supply decreased goes down, and spending in the rest of the economy expands. The increase in demand in the rest of the economy tends to raise prices and output for those goods. That is how nominal GDP remains on target despite the sharp decrease in the quantity of the good whose supply has decreased.

In my view, nominal GDP targeting is imperfect. However, the other alternatives are worse. But thinking about random "inflation shocks" in a simple new Keynesian model where the policy rate determines next period's output and this period's output gap determines inflation is highly misleading. It is just as misleading as thinking about random shocks to this periods real output and imagining that inflation must be generated in subsequent periods to return nominal GDP to target.

Negative Interest Rates

Why is there a zero nominal bound on interest rates?

According to Todd Keister, from the New York Fed:

Given the markets’ limited experience with very low interest rates, it is difficult to predict with any degree of certainty how they will react to them. If the types of disruptions described above turn out to be significant, taking steps to lower short-term interest rates could actually make financial conditions tighter rather than looser and thus hinder the economic recovery. To avoid this outcome, policymakers tend to choose policies that keep market interest rates positive.

In other words, the potential for negative interest rates to disrupt financial markets limits the extent to which policymakers can stimulate economic activity by lowering interest rates. This limit is known as the zero lower bound.

In other words, the reason there is a zero nominal bound is that the Federal Reserve chooses to keep interest rates above zero.

Keister had already pointed out how interest rates have been below zero for limited periods of time. He also explains why. It is costly to store currency, especially large quantities. As I have explained in the past, this makes the lower bound on nominal interest rates equal to the cost of storing currency.

Of course, the Federal Reserve is very committed to framing its actions in terms of setting interest rates. From that perspective, the Fed chooses to keep interest rates above zero.

If, for example, the Fed was targeting the quantity of base money, and there were a shortage of T-bills at a nominal interest rate of zero--perhaps because of a flight to safety--then the interest rate would fall until storing currency is cheaper. In other words, paying for safes, guards, and the like.

However, to avoid "money market disruptions," the Fed would seek to prevent this. The most obvious course would be to change its target for base money, reducing the quantity of base money. The resulting excess demand for base money should create a liquidity effect that would at least temporarily raise short term money market yields.

What would be the disruptions that would justify engineering an imbalance between the quantity of money and the demand to hold it? As is usual, there is an air of "only the central bankers know."

Still, Keister provides three possible problems.

Money market funds operate under rules that make it difficult for them to pay negative interest rates to their investors, either directly or by assessing fees. Many of these funds would likely close down if the interest rates they earn on their assets were to fall to zero or below, possibly disrupting the flow of credit to some borrowers.

Since ordinary mutual funds have no difficulty in charging for their services when the underlying portfolio suffers looses, this is a bit of a puzzle. The marketing material for money market funds claims they work very hard to prevent capital loss, and in the Fall of 2008, the "breaking the buck" by Primary Reserve fund, suggests it is possible. Do mutual funds charge for their services as a percent of yield rather than total assets managed like stock mutual funds. Regardless, perhaps it is time for mutual funds to change their rules.

Keister continues:

The auction process for new U.S. Treasury securities does not currently permit participants to submit bids associated with negative interest rates. If market interest rates become negative, new Treasury securities would be issued with a zero interest rate—effectively a below-market price—and bids would be rationed if demand exceeds supply. Such rationing, which has occurred in recent auctions, would generate an incentive for auction participants to bid for more than their true demand, leading to even more rationing. This situation could generate market volatility, as unexpected changes in the amount of rationing in each auction could leave some investors holding either many more or many fewer securities than they desire.

The New York Fed (along with the Office of the Public Debt,) operates the T-bill auctions. The Fed generates monetary disequilibrium to avoid the inconvenience of modifying their procedures in operating the auctions to clear markets? How hard could it be to allow bids of negative yields?

And finally:

A decrease in the IOR rate would also likely affect the federal funds market, where banks and certain other institutions lend funds to each other overnight. A lower IOR rate would give banks less incentive to borrow in this market, which would likely decrease the amount of activity. When less activity takes place, the market interest rate will be influenced more by idiosyncratic factors, making it a less reliable indicator of current conditions. This decoupling of the federal funds rate from financial conditions could complicate communications for the FOMC, which operates monetary policy in part by setting a target for this rate.

So, if market interest rates become negative, then banks would not be motivated to borrow overnight. It is difficult to see why that is true. Certainly, the problem would be the opposite. If the interest rate on reserves is zero, and the federal funds rate is negative, then holding reserves is better than lending them. If the interest rates paid on reserves were negative, along with other short term interest rates, then lending reserves at less negative rate would be desirable. Of course, if the interest rate on overnight loans (or the interest rate on reserves) approaches the cost of holding vault cash, then there would be no motivation to lend.

Frankly, these reasons for keeping interest rates above market clearing levels look to be excuses....bad excuses. Unfortunately, as long as the Fed frames its activity as setting interest rates rather than avoiding imbalances between the quantity of money and the demand to hold it, creating monetary imbalances to manipulate interest rates will seem natural.

HT Mark Thoma

Post Apocalyptic Nominalism

Karl Smith takes issue with my argument that the monetary authority should solely focus on keeping nominal expenditure on target, and should not serve as "lender of last resort" to the government or the banks. Smith believes that the consequence of this approach will be "Post-Apocalyptic Nominalism." Apparently, a few will become vastly wealthy because they will be able to borrow at negative nominal interest rates.

I don't consider this likely. (I hope it is a joke.)

Smith accepts a scenario where a policy aimed at 4 percent nominal GDP growth creates expectations such that all European governments can "self-finance," and the euro-zone economy rapidly recovers.

It seems that the key element of this favorable scenario is that none of the PIGS default. The apocalyptic scenarios both include actual defaults. In one scenario, nominal expenditure is expected to grow on target, but default occurs anyway. The other occurs when nominal expenditure is not expected to grow on target, and default occurs.

Why does government default lead to such a disaster? In my view, the effect is that those governments that lose confidence of creditors default, reduce government spending to current tax revenues, make minimal payments on interest and principal, and presumably reduce the provision of government services. Not exactly pleasant, but hardly apocalyptic.

So why the disaster? Smith assumes the banking system "collapses." Why? Presumably, it is because all the banks in Europe hold the debt of the PIGS. If any of the governments default, then the banks become insolvent. The ECB, then, is supposed to commit to lending to the PIGS so that they will be able to repay banks. And that means that the banks remain solvent. Otherwise, the banks collapse and then it is the apocalypse.

I suppose in Smith's world, when the banks are insolvent they are closed and liquidated, and the depositors receive some partial payment. And then there is a world without banks. Presumably, everyone uses hand-to-hand currency to make all payments. And the ECB creates money solely by purchasing bonds from people they consider solvent. There being so few such people, in order to get them to issue and sell enough bonds, the nominal interest rate is negative.

My view is that permanently closing and liquidating all banks is a very bad idea. If there are many small banks and a few of them are insolvent, closing and liquidating those banks is a reasonable approach. However, when a substantial portion of the banking system is insolvent, reorganizing and reopening those banks is important. If all banks are insolvent, rapid reorganization and reopening is essential.

The simplest approach is that the banks close on Friday, and Monday morning they open again and all of the depositors have substantially lower deposits and shares of stock in the reorganized bank. The banks open and then carry on operations as usual.

If the governments of France or Germany instead want to bail out their banks, then they can purchase the bonds of the governments that default. If, on the other hand, they want to only bail out the depositors in their banks, they can do the same, but reorganize the banks--sell stock to new owners. If they want to solely avoid runs, and bail out all the short term depositors, then they can again do the same, reorganize the banks, and impose haircuts on long term creditors too.

But who exactly is bailed out and how should be the determination of the fiscally sound governments. The ECB should focus on expanding the quantity of money, currency if necessary, enough to meet the demand to hold currency with nominal GDP growing on target. It should not be the responsibility of the monetary authority to lend money to governments so that they can pay off their debts to banks. Nor should it be the responsibility of the monetary authority to lend money to insolvent banks so that they can pay off their depositors.

Taylor on Nominal GDP Targeting

John Taylor still opposes nominal GDP targeting. The Market Monetarist response was rapid. Scott Sumner still hopes that Taylor will get to work developing a "rule" for Nominal GDP rather than inflation. Nick Rowe's post contrasted instrument rules with target rules.

Taylor complains that advocates of nominal GDP targeting have failed to provide a simple formula for a central bank to follow--like the Taylor rule. One version of the Taylor rule is that the target interest rate should be set at 1 + 1.5*(inflation - 2) + .5(output gap.) Taylor favors dropping the output gap term, so that the nominal interest rate should be set at 1 + 1.5*(inflation - 2).

The Taylor rule implicitly makes the target 2 percent inflation. Market Monetarists favor a target for the growth path of nominal GDP. The target is a series of levels of nominal GDP that head off into the future. The goal is to keep (NGDP - NGDP*) equal to zero for each and every future date, where NGDP* is the target level at each future date. NGDP* is growing at a constant rate. The proposed growth rates vary from 5.4% to 2%. However, the key to the proposal is to choose a growth path and stick to it.

How can a central bank actually accomplish this? In my view, if a central bank finds some simple relationship between the short term interest rate in the near future, and nominal GDP in the more distant future, then that would be great. However, it must always be recognized that finding such a regularity is a matter of luck and circumstance. As soon as the regularity breaks down, then adjustments must be made. This is especially true when a short term nominal interest rate is being manipulated.

Taylor claimed that Milton Friedman would have opposed nominal GDP targeting.

For this reason, as Amity Shlaes argues in her recent Bloomberg piece, NGDP targeting is not the kind of policy that Milton Friedman would advocate. In Capitalism and Freedom, he argued that this type of targeting procedure is stated in terms of “objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions.” That is why he preferred instrument rules like keeping constant the growth rate of the money supply. It is also why I have preferred instrument rules, either for the money supply, or for the short term interest rate.

I am not sure what Milton Friedman would do, but Taylor's appeal to rules is confused. Milton Friedman is best known for proposing that the M2 measure of the quantity of money be kept growing at a 3 percent annual rate. But M2 is not directly controlled by the Federal Reserve. From Taylor's perspective, this money supply rule was no rule at all. Where was the actual rule? For example, the policy interest rate is equal to 1 + 1.5*(growth M2 - 3%)?

Of course, during the period when he advocated an M2 money supply rule, Friedman was very critical of the use of short term interest rates as an instrument. He favored looking at the monetary base, which is even more directly controlled by the Fed than interest rates. Did he develop or advocate a rule for the base? Bt = Bt-1 + 1.5*(M2t - M2t*)?

I don't think so. My understanding of "old monetarism," was that the Fed should be given discretion to adjust the monetary base however much is needed to offset any change in the M2 money multiplier so that M2 remains on target. In particular, if bank runs resulted in a decrease in the money multiplier, like in the Great Depression, Friedman insisted that it was the Fed's duty to undertake whatever quantity of open market purchases needed to raise base money enough so that the reduction in the money multiplier is fully offset and the M2 measure of the quantity of money continues on its target path. It has always been my understanding that any errors should be promptly reversed, so that if M2 falls below its trend growth path because of a decrease in the money multiplier, base money should be increased enough to return M2 to the target growth path.

Market monetarists have a view roughly similar to what is outlined above, but taking into account that the observed regularity that M2 velocity was very stable no longer holds. And so, the market monetarist approach is that the least bad replacement target is nominal GDP, and the Fed must adjust the monetary base enough to offset both changes in the money multiplier and velocity.

In my view, the task is inherently more challenging. Statistics of the money supply are reported weekly. While the relationship between depositors, banks, and their borrowers is complicated, the relationship between the demand to hold money and the quantity of money is vastly more complicated. If there is a more or less constant relationship between nominal GDP and some measure of the quantity of money, then adjusting the quantity of base money so that this broader measure of money stays on a constant growth path would be a useful approach to exercising discretion. Similarly, if there is some simple relationship between a short term interest rate and the growth path of nominal GDP, then following a "rule" based on that interest rate would be sensible.

But it must always be understood that there is no reason to expect that any constants will hold in the market system. And when these "instrumental rules" break down, it is the rules that need to change.

While watching some short term interest rate or conglomeration of bank liabilities should not be made into an end in itself, it is essential that the monetary order be based on something other than whatever the central bank likes. "Flexible inflation targeting," means letting the central bank do what it wants.

For many years, I advocated a stable price level. I now believe that this approach is flawed. When the price level is shifted due to changes on the goods side, creating monetary disequilibrium to force it back to a target is disruptive. In my view, keeping total spending on output on a slow, stable growth path is the least bad option. That is the proper rule for the monetary authority. Exactly how best to accomplish that rule where discretion is necessary.

Investment in Equipment and Software

Karl Smith claims that what most people think of as "Investment" is investment in equipment and software, and that it has performed well during the current modest recovery. Real investment in equipment and software has reached its previous peak. The broader measures of investment remain below their previous peaks, but this is due to residential investment and investment in structures. In Smith's view, the problem is construction.

To some degree, Smith is seeking to respond to those "free market" economists, centrally Robert Higgs, who point out that real consumption expenditures has reached its previous peak, so that consumption isn't a problem. Smith has also shown that real retail sales remain below its previous peak, and that the recovery in real consumption expenditures has largely been in implicit rental payments by homeowners, health care paid by Medicare and Medicaid, and the difference between the interest rates banks earn and the very low interest paid on deposits.

My view is that comparing any element of real expenditure to a peak four years ago is really beside the point. As a rule of thumb, each element of real expenditure should by now be about 12 percent higher than its previous peak. (Yes, my rule of thumb doesn't take into account compounding.) More importantly, given that nominal GDP is 14 percent below its growth path of the Great Moderation, my first question is always to compare the nominal value of some type of expenditure to its growth path of the Great Moderation. For example, nominal consumption is nearly 15 percent below its growth path of the Great Moderation. (Real consumption is nearly 12 percent below its growth path of the Great Moderation.)

What about investment in equipment and software? It's current value is $1,137 billion, which has just surpassed its peak of the third quarter of 2007. The trend growth rate of investment in equipment and software during the Great Moderation was 5.92 percent. (From quarter 1 1985 to quarter 4 2007.) This is slightly higher than the trend growth rate of nominal GDP, which was 5.4 percent.

And so what would investment in equipment and software be if it had continued to grow at trend? It's current value would be $1,517 billion. It is currently 24 percent below its trend growth path from the Great Moderation.

Looking at the diagram, perhaps the trend is pushed up by the huge increase right before the 2001 recession. (On the other hand, it is possible that the "problem" was that investment in equipment and software was crowded out by investment in housing.) Interestingly, only a slightly reduced growth rate, to 5.7 percent, puts actual investment very close to this modified trend before the Great Recession.

Even with this slightly slower growth path for investment in equipment and software, it currently remains 17.8 percent below trend. (And if it had been growing with the rest of nominal GDP at 5.4 percent, its current value would be 10% below trend.)

And what about real investment in equipment and software?

Real investment in equipment and software is 28 percent below the trend of the Great Moderation! Like the nominal series, it just passed its previous peak. And while there have been some very high quarterly growth rates during the recovery, (21 percent in the second quarter of 2010,) the collapse was steep during the recession (37 percent in the first quarter of 2009.)

What about the price index for equipment and software? The trend for the Great Moderation was 1.2 percent deflation. And while the price index is currently 5 percent above trend, it has been remarkably stable since 2002 (at 100!) Remarkably, something like the modified nominal series, showing investment 18 percent below trend is likely much more "real" than deflated (that is inflated,) series.

In my view, monetary disequilibrium has depressed nominal expenditure on output across the board. Both consumption and investment in equipment and software have been depressed. That the real value of some element has finally passed its previous peak provides approximately no reason to believe that its current nominal value is appropriate.

Are Nominal Wages Sticky?

Arnold Kling and Bryan Caplan are back to debating aggregate demand and supply. Kling is a skeptic. Caplan supports the "sticky wage" version monetary disequilibrium. Excess demand for money results in reductions in nominal expenditure that should result in lower prices and wages and unchanged output and employment. Prices are flexible and would fall enough to clear markets, but wages only adjust sluggishly. Falling prices and sticky wages imply rising

real wages. Employment and output fall. Easing the monetary disequilibrium would result in higher nominal expenditure, higher prices of final goods, lower real wages, and greater output and employment.

Kling's views are harder to categorize. In my view, they are inconsistent with scarcity. But whether or not his PSST (Patterns of Sustainable Specialization and Trade) makes sense as an explanation for the Great Recession, his most recent argument involved criticism of Caplan's sticky wages approach. ( Sumner also emphasizes sticky wages.) Kling generated the following table:

What Kling sees is that the rate of increase in employment cost slowed more than than the rate of increase in consumer prices. Kling thinks that if employment costs are sticky, then they would have perhaps slowed some (due to growing unemployment) but less than the supposedly flexible consumer prices.

While reasonable enough, what I "see" is that the demand for labor grew faster than the supply of labor resulting in modest growth in real labor compensation (cost to the employers,) during the first period. And then, it would seem, the demand for labor continued to rise, but only slightly more rapidly than the supply of labor during the second period, resulting in even more modest growth in real labor compensation.

But there is some missing information. What happened to employment? My explanation of the above would suggest more rapid growth in employment during the first period and then slower growth in employment in the second period. (The assumption would be that labor supply is growing at a constant rate so that it is the rate of growth of labor demand driving the faster and then slower increases in real compensation.)

Of course, starting in 2007, employment dropped. It is certainly possible that labor supply fell more than demand, and the result was a slight increase in equilibrium real labor compensation. However, a much more plausible explanation is that supply continued to grow and demand fell, and the equilibrium level of real labor compensation fell significantly. But rather than fall with equilibrium real labor compensation, the actual level of real labor compensation grew slightly.

The problem with Kling's reasoning is that during the first period, real labor compensation should have been rising, and in the second period, it should have been falling. It didn't. On the other hand, if product prices are perfectly flexible, then why didn't consumer prices fall? If they are being forced up by growing labor costs, then why didn't they rise by less than labor costs?

Here is a graph of the employment cost index:

It looks like it continued to rise until well after the recession started, and then slowed before rising again at perhaps a slower rate. It looks like it moved to a lower growth path.

What was the growth path of this index during the Great Moderation? What is its current level relative to that growth path? Unfortunately, the series only begins in 2001.

There is a series for wages that exists during all of the Great Moderation--wages of production and nonsupervisory workers. Obviously, this series doesn't include the expense of benefits and it only includes some workers. Still, what has happened to those nominal wages during the Great Moderation?

This measure of nominal wages is 1.39 percent below the trend growth path of the Great Moderation. The price level, as measured by the GDP chain-type price index, is 1.79 percent below its trend growth path. While both prices and wages have risen continuously, this approach and measure suggests that prices are slightly more flexible relative to trend than wages--but not much.

What about compensation? The wage cost index Kling reports only goes back to 2001, but aggregate labor compensation and trend for the Great Moderation are shown below:

Like other nominal measures, the amount firms spend on wages and benefits fell below the trend of the Great Moderation and remains well below trend. However, at 16.47 percent, it has fallen further than nominal GDP, which is "only" 13.87 percent below trend. The other noticeable deviation was in 1999 and 2000, when a positive the gap grew to nearly 5 percent before rapidly disappearing in the 2001 recession.

Employment has fallen during the Great Recession as shown below:

Employment is 9.53 percent below the trend of the Great Moderation. (This is level of employment from the household survey.) There is a very noticeable "boom" in employment right before the 2001 recession. Employment was nearly 3 percent above trend in the second quarter of 2000.

What has happened to compensation per employed person?

Compensation per employed person is currently 7 percent below the trend of the Great Moderation. It did drop significantly during the first quarter of 2009, at a 5% annual rate, but that was fully reversed after two quarters. A better characterization of the period is that compensation per worker quit growing during the recession, but when the economy began to recover in the third quarter of 2009, it began growing again, but remains on a lower growth path. Also note that the "boom" in employment is reflected in a boom in compensation per worker as well right before the 2001 recession.

During this period, there have been substantial changes in the hours worked. Unfortunately, the series going back to 1984 is for production and nonsupervisory workers. Still, the loss in average weekly hours for all private employees was about the same during the Great Recession (About one hour.) Government workers aren't included. (Some government workers were given furlough days. I was.) The following is the average hourly compensation calculated using the average weekly hours of production and nonsupervisory personnel.

When adjusted for the drop in hours worked, the compensation per hour did not drop in the first quarter of 2009. However, its growth certainly slowed with the onset of the Great Recession. It is currently 7.3 percent below the trend of the Great Moderation. It is not that different from the compensation per employed person. (The boom in total compensation, employment, and compensation per worker, also shows up in compensation per hour, though is lagged a bit, hitting 3 percent in the first quarter of 2000.)

These results show no evidence that firms are able (or willing) to significantly cut labor compensation per worker. However, like Kling's simpler analysis, it does suggest that the failure of final goods prices to drop significantly below the trend of the Great Moderation, in the face of a nearly 14 percent decrease in nominal GDP from trend, should not be blamed on labor costs. Nominal labor costs per employee have fallen much further from trend than the GDP chain-type price index.