Some monetary hawks want Jay Powell to emulate Paul Volcker. I wonder if they realize what that means. After Paul Volcker was appointed to chair the Fed in August 1979, monetary policy remained highly expansionary for another 2 years. NGDP growth averaged over 10% between 1979:Q3 and 1981:Q3. And this was not due to “policy lags”; indeed nominal growth actually sped up to an annual rate of over 14% in Volcker’s second year (the period from 1980:Q3 to 1981:Q3.) Only in the summer of 1981 did Volcker get serious about inflation. Unfortunately, the myth of Volcker has crowded out the reality.
There’s currently a vigorous debate about whether the Fed’s “tight money” policy is too restrictive. But what if both sides of the debate are wrong? What if the Fed hasn’t even adopted a tight money policy?
Long time readers know that I don’t view rising interest rates or quantitative tightening as being useful indicators of the stance of monetary policy. My views are closer to those of Ben Bernanke:
The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth. . . .
Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman’s advice to heart.
I prefer NGDP growth, as inflation is distorted by supply shocks. (Total labor income might be even better.) At the beginning of the year, I argued that the Fed should sharply slow NGDP growth in order to move toward their 2% inflation target. In the long run, NGDP growth needs to be about 3.5% to deliver 2% inflation. I didn’t expect the Fed to get there immediately, but I also didn’t expect NGDP growth to be so rapid during the first two quarters of 2022 (a 7.5% annual rate.) The third quarter figures are not out yet, but forecasters seem to expect another big number.
Some might argue that the sort of monetary tightening that I proposed would have resulted in unacceptable pain in the labor market. That’s possible, although I doubt that with NGDP growth slowing to about 4% by yearend, unemployment would have risen above 5%. But this is all a moot point, as the Fed actually imposed absolutely no pain on the labor market. Indeed, the unemployment rate has recently fallen to a 50-year low of 3.5%. So if you are one of those people that believe tight money is bad because it imposes pain on labor markets, can I assume that you agree with me? Can I assume that you also believe that the Fed has not tightened at all?
To be clear, I do not view the unemployment rate as an indicator of whether money is easy or tight. I prefer to look at NGDP growth. But lots of people do seem to view unemployment as an important policy indicator. And unless I’m mistaken, they often are the same people that complain the Fed has done too much tightening. I see hand wringing about what Fed “tightening” is doing to developing countries. Just imagine the shape those countries would be in if the Fed actually were tightening—if it actually were sharply slowing NGDP growth to a level consistent with 2% inflation!
I’d like to avoid debates over semantics. If someone wishes to argue that Fed policy in 2022 represents tightening because it’s gone from extremely expansionary in 2021 to merely very expansionary in 2022, I won’t quibble with that characterization. Rather, I’m encouraging people to look beyond words and try to focus on what the Fed is actually doing. And while NGDP is not perfect, it’s far superior to lazy assumptions about the stance of Fed policy in much of the media. Also keep in mind that the fast NGDP growth of 2021 partly (not entirely) reflected a healthy return to trend, whereas the slightly less extreme NGDP growth of 2022 is occurring in an economy that has already overshot trend and is overheating.
Some argue that Fed policy affects the economy with a lag. That’s true of sticky wages and prices, but it’s not really true of NGDP. If NGDP growth is not slowing, then monetary policy is not tightening to any significant extent. So why are interest rates much higher than in 2021? Partly because the economy is much hotter than the markets expected in 2021. (Fiscal stimulus may also play a role.)
To summarize, let’s hope that Powell does not “do a Volcker”. Let’s hope he doesn’t wait two entire years after it’s clear we have a demand side inflation problem before tightening. Let’s hope he gets serious about inflation much more quickly than Volcker did.
Update: I did this post before knowing that Ben Bernanke was awarded the Nobel Prize in Economics. Bernanke has had an important influence on my own work, and I am very pleased to see him earn this recognition. Also, congratulations to Douglas W. Diamond and Philip H. Dybvig for work on bank runs. I am currently traveling, but will have more to say on Bernanke in future posts.
Update #2: I endorse this Julius Probst tweet.
READER COMMENTS
Andrew_FL
Oct 10 2022 at 3:06pm
There’s some level/trend confusion going on with people
Arguably the Fed has tightened relatively (trend), but its policy is not tight in an absolute (level) sense (taking the normal trend rate as an implicit policy norm)
Garrett
Oct 10 2022 at 3:18pm
It seems people have a hard time considering that the equilibrium interest rate can be rising as the Fed is hiking.
Thomas Lee Hutcheson
Oct 11 2022 at 10:25pm
Part of the confusion is in looking at interest rates as a metric. We should be looking at inflation, especially expected inflation. By that standard the Fed has ben tightening enough to get expectations down from well above target to about target.
Michael Sandifer
Oct 10 2022 at 6:54pm
The S&P 500 is down nearly 25% from it’s pre-tightening high, 5 year inflation expectations are down more than 60 basis points over the same period and are now very near 2% in PCE terms, as interest rates have risen considerably, in the context of Fed rate hikes. Also, there are some indications that employment growth has slowed, and commodity prices are way down since March. Then, there is the appreciating dollar over this period.
If one defines monetary tightening as actions taken by a central bank that reduce proxies for NGDP growth expectations and money supply growth, it’s hard to argue the Fed hasn’t tightened policy.
MarkLouis
Oct 11 2022 at 8:57am
Unclear. For example, SPX forward earnings are not down much at all. Nearly the entire decline has been via the discount rate. That same discount rate adjustment will affect commodities and the USD. Don’t think we have any excellent proxies for NGDP.
Michael Sandifer
Oct 11 2022 at 9:39am
MarkLouis,
The S&P 500 price decline is much more important than anything happening with much more immediate future earnings estimates, as it obviously represents discounted future expected earnings.
If you know how to interpret it correctly, the S&P 500 is a very good proxy for the mean expected NGDP growth path.
Thomas Lee Hutcheson
Oct 11 2022 at 10:28pm
Discounted at what expected nominal intereest rate?If Treasury wanted us to have NGDP futured instrument it would issue a NGDP indexed instrument.
Michael Sandifer
Oct 13 2022 at 12:17am
One doesn’t discount stock prices using nominal interest rates. There is an implicit forward-looking discount rate, the mean of which equals the mean NGDP growth rate over time.
Thomas Lee Hutcheson
Oct 10 2022 at 7:50pm
I go by the fairly sharp fall in TIPS as indicating Fed policy. WHAT they buy and sell to manage inflation is of little interest to me as an outsider.
Mark D. Friedman
Oct 10 2022 at 9:18pm
On the subject of Ben Bernanke, he did not realize that the Great Recession was coming until it smashed him and us in the face. Even in late 2007, he thought everything was peachy. Does this not indicate that whatever economic model he is using is seriously flawed?
Scott Sumner
Oct 11 2022 at 1:53am
I don’t think so. In my view, the factors that caused the Great Recession had not yet occurred by late 2007. It is extremely difficult to predict the business cycle.
Lot’s of pundits thought the unemployment rate would rise this year due to Fed tightening and a severe supply shock. It did not. A few months ago Robert Barro (who also deserves a Nobel) said we were almost certainly in recession in early 2022 due to two negative quarters of GDP. That was incorrect.
Thomas Lee Hutcheson
Oct 11 2022 at 10:32pm
The bottom had fallen out of the TIPS market, well below target at the end of August and minus 2.3% by late November. Markets could not have been screaming for monetary untightening louder.
Spencer
Oct 11 2022 at 11:34am
Bankrupt-u-Bernanke in his book “The Courage to Act”: “taught a highly mathematical economic course to MIT undergraduates”
“Monetary policy is a blunt tool” and “Unfortunately, beyond a quarter or two, the course of the economy is extremely hard to forecast”.
Bernanke contends: “a flawed and over-simplified monetarist doctrine that posits a direct relationship between the money supply and prices” in his book: 21st Century Monetary Policy.
Monetarism has never been tried. The American Banker’s Association has usurped monetary policy. The ABA is responsible for the removal of Reg. Q Ceilings and required reserves.
Economic prognostications are infallible. There’s a good reason why economists haven’t figured it out. As e-mailed me,
To Spencer From: Richard.G.Anderson@stls.frb.orgSent: Thu 11/16/06 9:55 AMTo: Spencer Spencer, this is an interesting idea. Since no one in the Fed tracks reserves, such a coincidence in the data perhaps confirms that the Fed funds rate settings have been correct. Sounds like an essay topic. I think I will examine it. Thanks for the idea, and for writing. rga Richard G AndersonFederal Reserve Bank of St Louisanderson@stls.frb.org
Spencer
Oct 11 2022 at 11:50am
This how I denigrated Nassim Nicholas Taleb’s “Black Swan” theory (unforeseeaable event), 6 months in advance and within one day:
To: anderson@stls.frb.orgSubject: As the economy will shortly change, I wanted to show this to you again – forecast:Date: Wed, 24 Mar 2010 17:22:50 -0500Dr. Anderson:It’s my discovery. Contrary to economic theory and Nobel Laureate Milton Friedman, monetary lags are not “long & variable”. The lags for monetary flows (MVt), i.e., the proxies for (1) real-growth, and for (2) inflation indices, are historically, always, fixed in length.Assuming no quick countervailing stimulus:2010jan….. 0.54…. 0.25 topfeb….. 0.50…. 0.10mar…. 0.54…. 0.08apr….. 0.46…. 0.09 topmay…. 0.41…. 0.01 stocks fallShould see shortly. Stock market makes a double top in Jan & Apr. Then real-output falls from (9) to (1) from Apr to May. Recent history indicates that this will be a marked, short, one month drop, in rate-of-change for real-output (-8). So stocks follow the economy down.And:flow5 Message #10 – 05/03/10 07:30 PMThe markets usually turn (pivot) on May 5th (+ or – 1 day).
I.e., the May 6th “flash crash”, viz., the second-largest intraday point swing (difference between intraday high and intraday low) up to that point, at 1,010.14 points.
Spencer
Oct 11 2022 at 12:07pm
Volcker was a trip. He wasn’t any different than Burns. Dr. C.Y. Thomas flew Dr. Leland Pritchard, Ph.D. Economics, Chicago 1933, M.S. Statistics, Syracuse, to D.C. to meet with Volcker in 1980.
Pritchard predicted the “time bomb” that occurred in the 1st qtr. of 1981 (the un-gating of NOW accounts). See: “The ‘mystery of the missing money’ (Goldfeld et al., 1976).
Volcker stopped inflation by imposing reserve requirements against NOW accounts in April 1981.
Ohad Osterreicher
Oct 13 2022 at 12:38pm
I tend to agree with the points in the article, but if make me wonder: what should the FED be doing to tighten monetary policy? The FED can’t change NGDP directly, only raise rates and sell off assets. So you’re saying they should strongly increase the rate in which they’re following this strategy? Or is there something else they should be doing right away? Thanks
Scott Sumner
Oct 13 2022 at 6:29pm
I’d prefer they sell off assets.
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