Inflation Above (Official) Target

Among its other benefits, a policy regime of inflation targeting, where a central bank has a clear primary focus of keeping inflation as close as possible to a certain level, has a pleasing clarity.  For example, the Bank of England Act of 1998 states:

In relation to monetary policy, the objectives of the Bank of England shall be –
(a) to maintain price stability, and
(b) subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment.  

Compared to the mushy "dual mandate" of the Federal Reserve Act,

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.  

Matthew Yglesias finds the unambiguity of the Bank of England's regime refreshing:

The genius of this is that you now don’t need to have monetary policy matters be the subject of debates on op-ed pages and blogs with various board members giving interviews and speeches. If 2 percent inflation is too much inflation, well that’s on the heads of the politicians who set the target. If inflation is over 2 percent, then the Bank of England needs to tighten. And if inflation is below 2 percent, then the Bank of England needs to expand. Consequently, when faced with a giant downturn the Bank of England has had none of the self-induced paralysis of the Fed, the ECB, or the Bank of Japan. 

Yes, but... the Bank of England has been missing its target lately:

I think the BofE deserves great credit for being aggressive in its response to the economic crisis, but the inflation targeting regime forces it into making awkward excuses, like this from its inflation report:

CPI inflation remained well above the 2% target, elevated by temporary effects stemming from higher oil prices, the restoration of the standard rate of VAT to 17.5% and the past depreciation of sterling.  And the forthcoming increase in the standard rate of VAT to 20% will add to inflation throughout 2011.  As these effects wane, downward pressure on wages and prices from the persistent margin of spare capacity is likely to pull inflation below the target.  But the pace and extent of that moderation in inflation are impossible to predict precisely.  

The FT's Money Supply blog notes that the IMF approves of Britain's current loose monetary/tight fiscal policy mix (see also Free Exchange's comments).  But it is not clear that the inflation target has been helpful... indeed, the risk is that, by allowing inflation exceed the target, the Bank of England is damaging the "credibility" that inflation targeting was designed to buy.  Considering the circumstances, I'm inclined to believe that's a risk worth taking, it does raise questions about the whole inflation targeting concept. 

Inflation targeting is still relatively new. New Zealand was the first country to implement it, in 1988. The current global slump is inflation targeting's first real test, and, after the dust settles it will be interesting to evaluate how it performed.

Inflation Below (Unofficial) Target

In its Tuesday statement, the Federal Open Market Committee said that inflation is too low for its taste:

Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.  

Of course, we're used to central banks worrying about inflation becoming too high, so this is an unusual thing to see.  As Gavyn Davies writes:

The Federal Reserve broke a taboo yesterday when it said quite baldly that inflation in the US is now below the level “consistent with its mandate”. In other words, it is too low. This is a very big statement for any central banker to make, since the greatest feather in their collective cap is that they successfully combated inflation after the 1970s debacle. Led by the Fed’s Paul Volcker, they re-asserted the importance of monetary policy, after two decades of failed wage and price controls. Since that period, most central bankers have been careful to avoid any language which even hints that a rise in inflation is acceptable to them. I can certainly find no previous record of the FOMC saying that inflation is too low, so it was a jolt to see this stated so starkly in the Fed statement yesterday.  

Those who are still worrying about inflation, in spite of the data, are fighting the last war.  Fortunately, the Fed isn't interpreting the "price stability" part of its mandate to mean "zero inflation." The projection of board members' for inflation in the "longer run" can be taken as its unofficial target; as of the last release in June, they were aiming for expecting 1.7%-2.0% (as measured by the deflator for personal consumption expenditures). 

Both the consumer price index (red line) and core PCE deflator are consistent with the notion that the Fed is missing its target.

Moreover, the markets are skeptical that the Fed will hit it in the future, according to the Cleveland Fed:

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.54 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

Moreover, the Cleveland Fed's estimates are for CPI inflation, which is generally higher than PCE inflation.

The Fed didn't actually do anything about this, but the acknowledgment of the problem is a step in the right direction.

The NBER Calls It

Today's announcement from the NBER Business Cycle Dating Committee:

[A] trough in business activity occurred in the U.S. economy in June 2009. The trough marks the end of the recession that began in December 2007 and the beginning of an expansion. The recession lasted 18 months, which makes it the longest of any recession since World War II. Previously the longest postwar recessions were those of 1973-75 and 1981-82, both of which lasted 16 months.

In determining that a trough occurred in June 2009, the committee did not conclude that economic conditions since that month have been favorable or that the economy has returned to operating at normal capacity. Rather, the committee determined only that the recession ended and a recovery began in that month. A recession is a period of falling economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. The trough marks the end of the declining phase and the start of the rising phase of the business cycle. Economic activity is typically below normal in the early stages of an expansion, and it sometimes remains so well into the expansion.

While this was the correct call in terms of consistency with their definition and past practice (and I thought they should have made it sooner), it highlights the limitations of the "recession"/"expansion" dichotomy in describing the state of the economy. As they were careful to note, the economy continues to operate substantially below capacity. The "expansion" state is about the rate of change, not the (still lousy) level; as the NBER's FAQ puts it:

Q: Isn't a recession a period of diminished economic activity?

A: It's more accurate to say that a recession—the way we use the word—is a period of diminishing activity rather than diminished activity.

So, since June, we've been in a period of non-diminishing activity. That's certainly better than continuing contraction, but growth has not been fast enough to make a substantial dent in unemployment.

In the chart below, the red line shows retail and food service sales, and the blue line is the industrial production index, both normalized to 100 at the Dec. 2007 peak. Both turn up around the end of 2009, but 14 months into the recovery, their levels remain below the previous peak. Employment (green line) continued to fall for several months after the end of the recession and has only improved slightly since.

The phrase "growth recession" describes this state of slow growth and non-declining unemployment, but its somewhat cumbersome. I've found myself using the word "slump" alot.

See also: Mark Thoma and Catherine Rampell (who talked to Robert Gordon).

Raising the Speed Limit

At Project Syndicate, Barry Eichengreen writes that one of the Great Depression's lessons is that slumps can be good for productivity growth:

Output expanded robustly after 1933. Between 1933 and 1937, the US economy grew by 8% a year. Between 1938 and 1941, growth averaged more than 10%.

Rapid output growth without equally rapid capital-stock or employment growth must have reflected rapid productivity growth. This is the paradox of the 1930’s. Despite being a period of chronic high unemployment, corporate bankruptcies, and continuing financial difficulties, the 1930’s recorded the fastest productivity growth of any decade in US history.

How could this be? As the economic historian Alexander Field has shown, many firms took the “down time” created by weak demand for their products to reorganize their operations. Factories that had previously used a single centralized power source installed more flexible small electric motors on the shop floor. Railways reorganized their operations to make more efficient use of both rolling stock and workers. More firms established modern personnel-management departments and in-house research labs.

There are hints of firms responding similarly now. General Motors, faced with an existential crisis, has sought to transform its business model. US airlines have used the lull in demand for their services to reorganize both their equipment and personnel, much like the railways in the 1930’s. Firms in both manufacturing and services are adopting new information technologies – today’s analog to small electric motors – to optimize supply chains and quality-management systems.

A similar argument has been made that extensive business restructuring around the time of the 2001 recession contributed to productivity growth in the following years.

Indeed, productivity growth recently has been quite strong:

(Business sector output per hour - Bureau of Labor Statistics)

Eichengreen goes on to argue that policy support is necessary:

But this positive productivity response is not guaranteed. Policymakers must encourage it. Small, innovative firms need enhanced access to credit. Firms need stronger tax incentives for R&D. Productivity growth can be boosted by public investment in infrastructure, as illustrated by the 1930’s examples of the Hoover Dam and the Tennessee Valley Authority.

Which sounds alot like the Obama administration's recent initiatives to increase small-business credit, build more infrastructure and make the R&D tax deduction permanent. While a case can be made for the first two as short-run stimulus, the benefits of the research and development tax credit are almost entirely of the long run variety.

In the long run, higher productivity is good news: it means more output per worker and, therefore, higher average wages. However, it also means less employment is needed for any given level of output, which means the increase in unemployment during the recession was than the decline in output would normally imply (see this previous post).

By increasing potential output, ceteris paribus, productivity growth increases the distance between actual economic activity and the economy's capacity sometimes known as the "output gap." This suggests that even stronger demand growth is necessary to close the gap.

The resurgence of productivity growth in the mid-1990's is one of the factors that allowed the Fed to keep interest rates low and allow unemployment to fall to 4% without igniting inflation (whatever else we say about Alan Greenspan now, he deserves credit for recognizing this early on). If Eichengreen is correct, the "productivity boom-in-waiting" will raise the economy's speed limit, and this is one more reason for the Fed to step on it.

Sideways

The August employment situation report from the BLS suggests an economy stuck in neutral - nonfarm payroll employment, calculated from a survey of businesses, fell by 54,000. If one removes the loss of 114,000 temporary census jobs, its a gain of 60,000, which is far short of the pace needed to make a dent in mass unemployment of nearly 15 million.

The unemployment rate, which is calculated from a survey of households, ticked up from 9.5% to 9.6%. While the number of people employed increased by 290,000, so did the number of unemployed, by 261,000, as 550,000 people entered the labor force, which is a modestly encouraging sign (the labor force participation rate rose slightly to 64.7%).
Note that those are all seasonally adjusted figures which correct for the drop in labor force participation which normally occurs in August - on an unadjusted basis, the numbers of people employed and unemployed both declined, with the unemployment rate falling from 9.7% to 9.5%. That is, the gain in (seasonally adjusted) labor force participation can be thought of as a gain relative to what normally happens this time of year.

For more, see David Leonhardt, Calculated Risk, Free Exchange, and Real Time Economics' round-up.

Free Silver Going Mainstream?

At Project Syndicate, Ken Rogoff says a little inflation might not be such a bad thing:

While America is facing the limits of fiscal policy, monetary policy can do more, as Federal Reserve Chairman Ben Bernanke detailed in a recent speech in Jackson Hole, Wyoming. With credit markets impaired, the Fed could buy more government bonds or private-sector debt. Bernanke also noted the possibility of temporarily raising the Fed’s medium-term inflation target (a policy that I suggested in this column in December 2008).

Given the massive deleveraging of public- and private-sector debt that lies ahead, and my continuing cynicism about the US political and legal system’s capacity to facilitate workouts, two or three years of slightly elevated inflation strikes me as the best of many very bad options, and far preferable to deflation.

Two things:

1. I don't agree that we're "facing the limits of fiscal policy" and, more importantly, the bond markets don't either - the yield on 10-year Treasury bonds is 2.58, indicating that if the US wants to borrow more, it will have no problem finding willing lenders. However, it does seem that our political system has reached the limit of what it is able to do.
   
2. In last week's speech, Bernanke did "note the possibility" of raising the Fed's implicit inflation target, and then he went on to clearly rule it out (see previous post).

That said, having a heavyweight like Rogoff calling for more inflation lends the idea some respectability - a former chief economist of International Monetary Fund doesn't turn William Jennings Bryan-ish lightly. Moreover, Olivier Blanchard, who currently holds Rogoff's old post also has raised the idea, though for somewhat different reasons (as I discussed here).

Warming Up the Helicopter

In his speech at the Jackson Hole conference, Ben Bernanke acknowledged that the economy isn't growing fast enough:

Although output growth should be stronger next year, resource slack and unemployment seem likely to decline only slowly. The prospect of high unemployment for a long period of time remains a central concern of policy. Not only does high unemployment, particularly long-term unemployment, impose heavy costs on the unemployed and their families and on society, but it also poses risks to the sustainability of the recovery itself through its effects on households' incomes and confidence.

Bernanke methodically weighed several ideas that have been circulating about how the Fed could give the recovery a push (see e.g., Joseph Gagnon and Alan Blinder).

• Reducing the interest rate on excess reserves (IOER, currently 0.25%) would provide incentive for banks to lend some of the money they are parking at the Fed. Although Bernanke said the availability of bank loans remains a problem for small business, he is not a fan of this option:

  [U]nder current circumstances, the effect of reducing the IOER rate on financial conditions in isolation would likely be relatively small... Moreover, such an action could disrupt some key financial markets and institutions. Importantly for the Fed's purposes, a further reduction in very short-term interest rates could lead short-term money markets such as the federal funds market to become much less liquid, as near-zero returns might induce many participants and market-makers to exit. In normal times the Fed relies heavily on a well-functioning federal funds market to implement monetary policy, so we would want to be careful not to do permanent damage to that market.

  Meanwhile, Senate Republicans have blocked a bill that would funnel more credit to small business through the Treasury.

• Another option would be for the Fed to influence expectations by committing to keeping interest rates low for a given period of time, but this is tricky in practice:

  [C]ommitting to keep the policy rate fixed for a specific period carries the risk that market participants may not fully appreciate that any such commitment must ultimately be conditional on how the economy evolves.
  

  Indeed, by putting it that way, methinks the chairman makes it harder to make any such future promises credible.

• Some have suggested raising the (implicit) inflation target (which I have discussed here and here). Bernanke really smacked that one down:

  I see no support for this option on the FOMC.... [R]aising the inflation objective would likely entail much greater costs than benefits. Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed's hard-won inflation credibility. Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets--including inflation risk premiums--would rise. The combination of increased uncertainty for households and businesses, higher risk premiums in financial markets, and the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy.

• That leaves more "quantitative easing" - creating money and using it to buy assets, which is, according to Bernanke, the "first option":

  A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve's holdings of longer-term securities. As I noted earlier, the evidence suggests that the Fed's earlier program of purchases was effective in bringing down term premiums and lowering the costs of borrowing in a number of private credit markets. I regard the program (which was significantly expanded in March 2009) as having made an important contribution to the economic stabilization and recovery that began in the spring of 2009. Likewise, the FOMC's recent decision to stabilize the Federal Reserve's securities holdings should promote financial conditions supportive of recovery.

  I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed's balance sheet would have to be weighed against potential risks and costs....

Overall, the Fed is ready to do more if necessary and they are not going to let a Japanese-style deflation (a.k.a. "it") happen here:

[T]he FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.

Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.

Although many of us think there is no need to wait and see if "further action should prove necessary" (e.g. Mark Thoma) the speech should be somewhat reassuring to those, like Paul Krugman, who argue the Fed is in denial (but he is not reassured).

More reaction from Free Exchange and Calculated Risk.

Lento assai

That is, even more slowly than lento (slowly)...

The BEA's second estimate revised the growth rate of real GDP in the second (April-June) quarter to 1.6%, down from the previous 2.4% "advance" estimate, and slower than the 3.7% growth rate in the first quarter.While still positive - i.e., consistent with a "recovery" - that growth rate isn't fast enough to keep unemployment from rising over time, i.e., its not recovery that feels like a recovery.

The less-bad news is that much of the downward revision came from two sources:

• Inventory "investment" was revised down, which means that businesses haven't accumulated as much stock as previously thought, so they would need to produce more to meet a given level of demand going forward.
• A revision upwards in imports. People are buying stuff: consumption spending was actually revised upwards slightly, but more of it was on foreign-made goods than previously thought.

Calculated risk has a nice table comparing the advance to the second estimate. The third estimate is due September 30.

Keynes on the Science and Art of Economics

J.M. Keynes to Roy Harrod, July 1938:

Economics is the science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world.

That comes to my attention via David Colander, "The Death of Neoclassical Economics" (HT: Frances Woolley).

Going for the Permanent Semi-Slump

Some vital statistics of the US economy as of Aug. 13, 2010:

• Inflation (12-mo. CPI): 1.2%
• Unemployment rate: 9.5%
• 10-year Treasury yield: 2.74%

So, therefore,
Really?!?

KC Fed President Thomas Hoenig (via NY Times):

“In judging how we approach this recovery, it seems to me that we need to be careful not to repeat those policy patterns that followed the recessions of 1990-91 and 2001,” he said. “If we again leave rates too low, too long, out of our uneasiness over the strength of the recovery and our intense desire to avoid recession at all costs, we are risking a repeat of past errors and the consequences they bring.”

John Maynard Keynes:

Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.