Now that the Fed is gradually raising interest rates, there’s a lot of discussion of whether policy is too easy or too tight. I don’t have strong views either way on this question, as current policy seems reasonably appropriate to me. But I also thought it might be useful to sketch out a few reasons why I’m fairly content, relative to some other observers.
1. Some people take a “Phillips Curve” perspective, and argue that tight labor markets will lead to higher inflation. The current low rate of wage growth is viewed as a sort of mystery, given the very low rate of unemployment. In my view there is no mystery at all, as wage growth is determined largely by NGDP growth, not the tightness of labor markets. TIPS spreads still don’t show much risk of higher inflation.
2. At the other extreme, some people worry that a falling yield spread, i.e. a flattening yield curve, indicates that the risk of recession is rising. Here it’s important to note that the current yield spread does not forecast a recession, and even if the yield curve were to become completely flat there would still be less than a 50% chance of recession over the next 12 months. Instead, the flattening yield curve should be seen as an indication that NGDP growth is likely to gradually slow over time, as is appropriate if the Fed is serious about its 2% inflation target.
BTW, the reason I expect growth to slow is that the unemployment rate will probably stop declining within the next 12 months. That will slow RGDP growth. If the Fed wants to keep inflation at 2%, they’ll need to also slow NGDP growth.
3. While the yield curve forecasts better than most other indicators, I believe the Hypermind NGDP market is the best single predictor of the future path of NGDP growth. That market shows NGDP growth running at about 4.5% from 2018:Q1 to 2019:Q1. If you don’t like that market, the consensus view of private sector forecasters is closer to 4.8%. We don’t yet have a NGDP futures market for 2019-20; my hunch is that it would show about 4.0% growth, if such a market were created.
PS. Speaking of NGDP futures markets, I hope to soon be able to report some information on that score, which may augur improved prospects of NGDP futures targeting at some point in the future.
READER COMMENTS
Thaomas
Jul 17 2018 at 9:53am
Is the Price level below the trend it was on before 2009? If it is, then Fed policy right now is too tight. Should they reduce ST interest rates? Buy long tern Treasury obligations ? Stop paying interest on reserves? All of the above? Buy foreign exchange or some other assets? Those are technical issues for Fed economists to work out which is the best instrument to use. The important thing is for markets to understand the Fed’s target.
Andrew_FL
Jul 17 2018 at 12:25pm
This is ridiculous. What’s the difference between saying this and “Is the Price level below the trend it was on before 1981? If it is, then Fed policy right now is too tight.”? There’s no difference at all.
Brian
Jul 17 2018 at 10:03am
Scott,
Could you explain point #1? I guess the usual argument would be that low unemployment means that labor demand exceeds supply, thereby driving up the cost of labor. Why do you say that wages are determined by NGDP growth?
Thaomas
Jul 18 2018 at 11:57am
Fair question about which trend line for PL on NGDP the Fed should take as its target. I chose pre 2009 because 2009 was the point at which NGDP growth went disastrously wrong and getting back on target would not require “too much” inflation. Both are judgment calls and I could see other judgement. The important thing is to avoid having an interest rate target or an inflation rate ceiling, or even a “natural” unemployment rate target.
EB
Jul 17 2018 at 10:16am
What does the Fed do? I think it does three things: first to ensure that the system of payments works well enough to meet users’ expectations about settlements; second to watch that intermediation of fund through banks and other financial companies works well enough to meet investors’ expectations about the uses of their funds (and sometimes to meet government’s objectives about the use of some of these funds); and third to divert enough funds from banks and other companies to finance government.
Despite all the noise about the macroeconomic consequences of what the Fed has been doing, only in relation to the financing of government one may say that the Fed has been active for a long time. The first two functions require interventions during emergencies, as in 2001 and 2008, but the financing of the Federal government has been a regular activity and amounts to determining the relative importance of money (M1) and bonds in the financing of deficits. Although the Treasury issues money or bonds to finance its deficits, the stocks of money and bonds at any time depend on the purchases and sales of bonds by the Fed. Since 2008, low-interest rates have resulted in larger stocks of bonds in relation to money. The rates are low because of the huge savings accumulated worldwide in relation to “good” investment opportunities, not because of any Fed’s intervention. Indeed, if tomorrow the Fed decides to sell half of the bonds accumulated in the past 10 years, or the Treasury to sell half of the lands owned in the Western U.S. (see https://en.wikipedia.org/wiki/Federal_lands) and people borrow to buy them, short-term interest rates will increase but the shock would hardly have effects beyond the financial markets. As long as short and long interest rates remain low, the Fed will continue financing most of the federal deficit (a flow) by purchasing bonds (although first, it may sell other assets that were purchased exceptionally some years ago).
Michael Sandifer
Jul 17 2018 at 12:16pm
Scott,
I model the change in unemployment during recoveries as a function of the difference between GDP growth and unit labor costs. It seems a pretty good model, at least for the present era. If unemployment decreases another .5% over the next year or so, would it be safe to look back and say that monetary policy was a bit too tight in 2018?
Scott Sumner
Jul 17 2018 at 12:37pm
Thoamas, You said:
“Is the Price level below the trend it was on before 2009?”
There were an infinite number of trends before 2009, so I can’t answer that question. Even if I could, it’s not relevant to today.
Brian, That confuses microeconomics with macroeconomics. Micro is about relative prices, macro is about absolute prices. NGDP is the funds available to pay nominal wages. In micro, firms in hot industries will raise wages to lure workers away from other industries.
Michael, No, but it would suggest that money was too tight in earlier years.
HL
Jul 17 2018 at 2:07pm
I was once amused by the fact that between early 1990s and 2008, among Japan, Australia, Germany, and US:
Japan – steepest yield curve on average, lowest absolute yield level, strongest NEER, not a single day of inversion, more than 1/3 of time spent in “recession” (or negative growth quarter, as they don’t have 7 NBER economists)
Austalia – flattest yield curve on average, highest absolute yield level, weakest NEER (I think), occasional inversion, basically no “recession
US – kinda close to Australia but a bit worse
Germany – kinda close to Japan but a bit better
We basically have a sample size less than appropriate for these rate cycle / business cycle argument based on yield curve, but the moment you expand the analysis to Japan the country throws a wrench at you. I came to think maybe it is the idiotic policy setup that keeps creating accidents and lower rates that generates misperception that “steep yield curves are good” and “flat yield curves are bad”… wouldn’t an ideal yield curve be a relatively flat one, i.e. perception of long term stability with some recognition of tech progress prospect in the future?
Daniel R. Grayson
Jul 17 2018 at 5:23pm
… may augur improved prospects …
Michael Sandifer
Jul 17 2018 at 6:35pm
Scott,
Thanks for the reply. Does this mean you don’t think somewhat higher inflation might increase employment more quickly?
Scott Sumner
Jul 17 2018 at 10:40pm
HL, I don’t think we should target the yield curve, so I have no opinion on an ideal yield curve. Focus on stable NGDP growth, and whatever yield curve results will be ideal.
Thanks Daniel, I fixed it.
Michael. No, I do think it would boost employment. But I don’t think monetary policy should aim to “boost employment”. I’d like it to provide a stable monetary environment for long term stable growth. Focus on stable NGDP growth, not employment.
HL
Jul 18 2018 at 12:19am
Thank you for the reply!
Michael Sandifer
Jul 18 2018 at 1:08am
Scott,
I find your view respectable, but would prefer a higher NGDP target. I don’t think those waiting to be employed should have to wait any longer than necessary. I also think there’s some merit to the idea of possibly boosting the natural interest rate, though it is uncomfortable in a way to try to change an unobservable, hypothetical variable.
Scott Sumner
Jul 18 2018 at 7:03am
Michael, Don’t fall into the trap people fell into in the 1960s, trying to use monetary policy to reduce unemployment. The best the Fed can do is reduce instability in unemployment.
Michael Sandifer
Jul 19 2018 at 8:36am
Scott,
Thanks for taking the time to explain your position. So, you think having a 4.5% or 5% NGDP target, rather than a 4% target would present such a danger?
Don Geddis
Jul 20 2018 at 3:21pm
Switching to a monetary policy framework of NGDPLT, at most any reasonable growth rate, would significantly reduce unemployment volatility.
Choosing between possible rates of 4%, 4.5%, or 5% annual growth would have almost no long-term effect on long-term unemployment. For a long-term monetary policy commitment to NGDPLT, the path of unemployment under any of those proposed growth rates would likely be essentially identical.
Sumner’s mention of “the danger” is not in choosing a higher NGDPLT growth rate target. It is, instead, in attempting to chase down unemployment, by continuing to raise NGDP growth in a vain effort to permanently lower unemployment. And unemployment target is doomed to fail, and the only result would be skyrocketing NGDP growth (and thus skyrocketing inflation). But merely choosing a slightly higher NGDPLT annual growth target, would have (essentially) no effect on unemployment.
Scott Sumner
Jul 22 2018 at 5:54pm
Don, Well put.
Michael Sandifer
Jul 23 2018 at 8:56am
Don and Scott,
Yes, I only favor a one-time increase in inflation. No 70’s Phillips curve stuff here.
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