Sigh.

NYTimes.com headline:

The Fed's forecasts are here.  Their projection for 2012 real GDP growth is 2.5-2.9%, down from the June estimate of 3.3-3.7%.

Romer: Bernanke's Volcker Moment?

In the Times last weekend, Christina Romer suggested a precedent for a switch in our monetary policy regime.  The Volcker Fed tightened money growth (thereby letting interest rates rise severely - the Fed funds rate was briefly above 19% at a couple of points in 1981) - the point was to bring the hammer down on inflation. As Romer notes, this very unpleasant policy was justified by a shift to a "monetarist" regime of targeting money growth.  As I've discussed before, I have mixed feelings about the lionization of Paul Volcker, but I think Romer has a good point that it may be time for another regime shift, this time to nominal GDP level targeting:

Mr. Bernanke needs to steal a page from the Volcker playbook. To forcefully tackle the unemployment problem, he needs to set a new policy framework — in this case, to begin targeting the path of nominal gross domestic product.
Nominal G.D.P. is just a technical term for the dollar value of everything we produce. It is total output (real G.D.P.) times the current prices we pay. Adopting this target would mean that the Fed is making a commitment to keep nominal G.D.P. on a sensible path. 

Just as Volcker's regime shift provided cover for a controversial action the Fed felt it needed to undertake (extreme tightening) and facilitated a shift in inflation expectations, a shift to a nominal GDP target would make possible (indeed, require) more aggressive expansion and thereby raise inflation expectations (which means lower real interest rates, ceteris paribus).

See also Paul Krugman, who agrees and Binyamin Appelbaum, who reports that the Fed is unmoved. Free Exchange's Greg Ip makes a contrary case and his colleague Ryan Avent responds.

GDP: The Video

Its not exactly "Thriller," but this video from Slate and NPR, starring Simon Johnson, is a relatively zippy exposition of what "Gross Domestic Product" means:

Its the first in a series.

3Q GDP: Is the Recovery Recovering?

The BEA's advance estimate of real GDP growth for the third quarter was 2.5% (annual rate).  That's in the same ballpark as the long-run trend rate of growth - i.e., its a pretty normal growth rate, consistent with maintaining a stable unemployment rate as the labor force and productivity rise over time, but not fast enough to dig the economy out of the hole (14 million unemployed) that its in.  It is, however, a significant improvement over the first two quarters of 2011, which saw growth rates of 0.4% and 1.3%.

Also, this puts real GDP back above its pre-recession (4Q 2007) peak; a milestone we previously thought had been attained at the end of 2010 until the estimates were revised downwards last summer.

More reaction: The Economist's "Free Exchange" blog,  NYT's Catherine Rampell, Calculated Risk, James Hamilton, Mark Thoma, RTE's round up of Wall Street "economists."

The Structure of Macroeconomic Revolutions?

Macroeconomics sometimes appears to be a somewhat confusing swirl of models and "schools of thought." This can be a somewhat off-putting feature to students (though for some of us it is also part of what makes macroeconomics more interesting than microeconomics).  When I introduce it to my students, I make a nod to Thomas Kuhn's "Structure of Scientific Revolutions" framework, which provides a way of putting some structure on the development of macroeconomics that is more sophisticated than framing it as a series of "debates" between "sides" (i.e., "classical" vs. "Keynesian", "saltwater" vs. "freshwater", etc.).

So I liked this post by Matthew Yglesias, where he invokes Kuhn and draws an analogy between macroeconomics and the Copernican revolution in astronomy.  He recounts how Copernican (Earth revolves around the sun) astronomy eventually supplanted Ptolemaic (Earth is center of universe), but initially the Ptolemaic system made much better predictions, and concludes:

My view, with both all due respect and all due derision, is that the Robert Lucas types are like the early Copernicans here. There’s something admirable in their insistence that it ought to all work out to an easily modeled system grounded in compelling theoretically considerations. The New Keynesian model is a mess, like late-Ptolemaic astronomy, thrown together to account for observed reality. But you don’t fly to a moon with an elegant model that delivers mistaken predictions about where the moon’s going to be. And what we actually need is a Kepler to give us an elegant model that actually predicts the phenomena, and then a Newton who can explain what that model means. 

Hmmm... I'm more inclined to place the users of old Keynesian models, including the IS-LM-based macroeconometric models used by policymakers, in the "late-Ptolemaic" role, but, in any case, the Kuhninan approach helps explain why I simultaneously agree with Brad DeLong, Paul Krugman and Greg Mankiw that the IS-LM model remains a very useful tool, while being a little more optimistic than Krugman about the state of macroeconomics.

Also, I'm not sure that Lucas and others (including new Nobel laureate Tom Sargent) who have pushed macroeconomics towards "structural" or "micro-founded" models are leading us to an "easily modeled system." What counts for "elegance" in modern macro is consistency between the macroeconomic model and micro-economically optimal behavior on the part of consumers and firms (I suppose the obvious retort to that is to invoke Emerson: "A foolish consistency is the hobgoblin of little minds").

Eurosnark

A nice column from Floyd Norris on the parallels between Argentina's exit from its dollar peg, and Greece's potential exit from the euro.  It would be messy, in part because there is no legal mechanism in place to do that; or as Norris puts it:

The euro was designed to be the Roach Motel of currencies. Once you enter, you can never leave. There is no provision for departure. 

Hmm... Norris' column might be a good reading for Econ 270, but will Greece still be in the euro by spring semester??

Norris is referencing this vintage TV ad.

September Employment: Partly Cloudy

The BLS reported today that employers added 103,000 people to their payrolls in September, of which 45,000 were workers returning from the Verizon strike.  That's not a great number - due to natural growth in the labor force and productivity improvements, the economy needs to add roughly 130,000 jobs per month just to keep the unemployment rate from rising.  But in light of fears that the economy could be sliding into recession due to the hits on confidence from the debt ceiling fiasco and Europe's woes, a continuation of the pattern of sluggish employment growth may be somewhat of a relief.  Also, July employment growth was revised up from 85,000 to 127,000 and August was revised from 0 to 57,000.

The numbers from the household survey (which has a smaller sample, so is considered less reliable) were more encouraging.  The unemployment rate held steady at 9.1%.  The number of people employed rose by 398,000, but the reason that didn't bring the unemployment rate down is that the labor force grew by 423,000 and the labor force participation rate ticked up to from 64.0% to 64.2%.  The unemployment rate is measured as a percentage of the labor force, and to be counted as in the labor force, someone must report that they are working or looking for work, so this is a sign that people are re-entering the labor force, which may mean that they are more encouraged about prospects of finding a job.

Overall, the economy remains in a deep hole, with nearly 14 million people unemployed, 6.2 million of whom have been out of work for 27 weeks or longer.  Government continues to be a drag on employment (i.e., the exact opposite of what it should be doing); government payrolls fell by 34,000 in September.  The BLS noted that local government employment has fallen by 535,000 since September 2008 (more on this from Floyd Norris).

On a non-seasonally adjusted basis, the unemployment rate fell to 8.8% in September and payroll employment rose by 519,000.  That is, September is a month that normally sees an improvement in the employment picture, which is removed by the seasonal adjustment factor.

More reaction: Calculated Risk, Mark Thoma, RTE's round up of Wall St. "economists".

Keynes and His Rivals

The New Republic has a very nice review essay by Robert Solow (the founding father of modern growth theory) on Sylvia Nasar's new book "Grand Pursuit: The Story of Economic Genius." I particularly liked these three sentences:

SCHUMPETER thought of Keynes as his natural rival for the title of “greatest economist.” They were born in the same year, 1883. Keynes probably did not believe that he had a natural rival.

Zing!

Keynes on YouTube!

Changing the Rules?

In a recent speech, Chicago Fed President Charles Evans argued that the Fed has been neglecting the "maximum employment" part of its mandate "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Evans explains:

Suppose we faced a very different economic environment: Imagine that inflation was running at 5% against our inflation objective of 2%. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market.

In the United States, the Federal Reserve Act charges us with maintaining monetary and financial conditions that support maximum employment and price stability. This is referred to as the Fed’s dual mandate and it has the force of law behind it.

The most reasonable interpretation of our maximum employment objective is an unemployment rate near its natural rate, and a fairly conservative estimate of that natural rate is 6%. So, when unemployment stands at 9%, we’re missing on our employment mandate by 3 full percentage points. That’s just as bad as 5% inflation versus a 2% target. So, if 5% inflation would have our hair on fire, so should 9% unemployment.

At his blog, Stephen Williamson offers a critique of the speech.  Among his arguments:

Evans is forgetting the lessons of the 1970s. What Evans is proposing is a change in the policy rule - a change in how the state of the economy maps into actions by the Fed. What economists understand today that they did not in 1975, is that commitment by the Fed to a policy rule is critical for its success in fulfilling its mandate. Once the public understands that the Fed intends to exploit a short-run Phillips curve relationship (and the problem is worse if the short-run inflation/unemployment tradeoff in fact does not exist), then all bets are off. High inflation can become well-entrenched and we have to go through an episode like the policy-induced "Volcker recession," followed by a long period where the Fed re-establishes its credibility. 

Although the wording of the Federal Reserve Act requires the Fed to care about both inflation and unemployment, as Williamson notes, its practice has evolved towards a de facto inflation targeting rule with an objective similar to the European Central Bank's "below, but close to 2%".  This is evinced by all the mentions of the Fed's "comfort zone" as well as the "longer run" projections of 1.5-2% inflation from Fed board members and regional bank presidents.  In terms of economic theory, it can be justified by the result, in some models, of "divine coincidence" - that policies which stabilize inflation also stabilize output.

If the Fed heeded Evans' argument, it would be more willing to risk breaking its inflation target rule to reduce unemployment.  In economic theory, one of the main points benefits of having a rule is that it lends "credibility" to monetary policy and "anchors" expectations (this speech by Charles Plosser is a nice intuitive exposition of the "time consistency" logic underlying this argument).  But that only works if the central bank actually follows its rule.  Hence Williamson's concern.

Inflation targeting is relatively new - New Zealand was the first to adopt the practice in 1989, and it has since been implemented by the UK, Canada, and the European Central Bank, among others.  Most of the countries that have adopted inflation targets have set them in the vicinity of 2%.

While there are good reasons in economic theory for having monetary policy rules, the past few years have raised questions over whether a 2% inflation target is the right rule.  There are several alternative rules that might have performed better in the wake of the financial crisis:

1. Inflation targeting with a higher target would reduce the risk of hitting the "zero lower bound" on short-term interest rates.
2. Price level targeting would require higher inflation to make up for periods of too-low inflation.  
3. Nominal GDP targeting is a re-incarnation of Milton Friedman's stable money growth rule, focusing on the right hand side of the identity MV = PY, which avoids the problem of unstable velocity (V), which doomed the early 1980's experiments with money growth rules.

All three alternatives have been discussed over the past several years in commentary about policy and are good subjects for academic research, which may ultimately show that many of the world's central banks have adopted the wrong rule.  

However, that raises a conundrum: if the Fed breaks its (implicit) rule, even for the sake of adopting a better rule, it risks denting its credibility....

Of course, the real problem with Evans' speech is that Ben Bernanke has no hair, so there is no reason for him to act like his hair is on fire.  That may be why bald guys are so cool.