Monetary Policy And Secular Stagnation

March 28, 2014
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The Federal Reserve directly controls the short-term interest rate. But what it really tries to target is inflation and its expectations. The Fed’s goal is to achieve the target of 2% inflation in the long-term, and its preferred price index is the core personal consumption expenditure price index that excludes the volatile food and energy sectors (or core PCE for short). So how has the Fed performed in achieving its target of 2% inflation in the past 15 years?

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The chart above plots the implied core PCE index if inflation had met its 2% target (red line), and the actual core PCE index (blue line) starting from 1999.  The blue line is consistently below the red line, the gap has only diverged further since the Great Recession. The cumulative effect is that today the price level is 4.7% below what it should have been had the Fed achieved its long-run target.

The divergence between target and actual inflation is all the more striking given the elevated rate of unemployment during the sample period. We have discussed in a previous post how the post-2001 and post-2009 recoveries were “jobless” – a recovery in output but not much in employment. The Fed has a dual mandate – inflation targeting and maximizing employment. It is traditionally believed that there is a trade-off between the two and a higher level of unemployment permits the Fed to go beyond its 2% inflation target (this is the famous Taylor rule). Yet the Fed has failed to achieve its target inflation despite high unemployment rates.

It is hard to fault the Fed for not trying – it brought short term rates to zero for an extended period of time, and bought trillions of dollars in bonds. Yet the gap between the red and blue lines continued to diverge.

The Fed’s difficulty in maintaining a 2% target is not just about the Great Recession. The divergence started in the 2000′s despite the Fed keeping nominal rates quite low by historical standards. In fact the only period when the blue line runs parallel to the red (implying a 2% rate of inflation for a while) is the 2004-2006 period when the economy witnessed an unprecedented growth in credit.

In ordinary times we should have seen run-away inflation given the rate of credit extension and spending against it (more on this soon). But we do not live in ordinary times anymore.

What we are witnessing is the limit of what monetary policy alone can do. Sometimes there is a tendency to assume that the Fed can “target” any inflation rate it wishes, or that it can target the overall price level – the so-called nominal GDP targeting. The evidence suggests that the Fed may not be so omnipotent.

The problems relating to below-target inflation are deeper and more structural. We discuss these issues in more detail in one of the chapters of our forthcoming book.

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8 Responses to Monetary Policy And Secular Stagnation

  1. theyenguy on March 28, 2014 at 9:29 ami

    Misconceptions about the role of the US Fed are rampant. The US Fed and other central banks were God’s agents of inflationism that beginning with the repeal of the Glass Steagall act birthed the investor, and brought liberalism, which is defined as the age and paradigm of freedom from the state, to its zenith through the dynamos of creditism, corporatism, and globalism to the peak of moral hazard based prosperity.

    The greatest ever credit creation initiative came in 2008 with the US Federal Reserve beginning with QE 1, where money good US Treasuries were traded out for the most toxic of debt held by banks, such as those traded by Fidelity Investments, mutual fund FAGIX, and has underwritten stock investments worldwide with ongoing reiterations of world central bank easings through global ZIRP.

    Jesus Christ, acting in dispensation, a concept presented by the Apostle Paul in Ephesians 1:10, completed the age of credit beginning Monday March 23, 2014, as the Bear Market Of 2014 picked up steam on the exhaustion of the world central banks’ monetary authority.

    The new normal economic dynamic is destructionism, which will be seen in economic deflation, and ever increasing austerity, coming largely from disinvestment out of currency carry trade investments, and derisking out of debt trade investing, on the exhaustion of the world central banks’ monetary authority, as these have crossed the rubicon of sound monetary policy and have made money good investments bad.

    The failure of credit has commenced. The bond vigilantes calling the Interest Rate on the US Ten Year Note higher to 2.79%, in early March 2014, on the failure of trust in the world central banks to stimulate global growth, has caused Distressed investments, FAGIX, (as well as other High Yielding Debt such as JNK, BDCS, VCLT, HYXU, HYMB), which the US Fed to take in under QE 1, and trade out money good US Treasury Notes to trade lower from their early March 2014 high.

    Stocks are no longer leveraging higher over debt as is seen in World Stocks, VT, relative to Aggregate Credit, AGG, VT:AGG, to trade lower.

    Deleveraging out of currency carry trade investments and derisking out of debt trade investments that is producing the Bear Stock Market of 2014, which is introducing Kondratieff Winter, the final phase of the Business cycle, and all four components of Total Spending will plummet introducing great economic recession, characterized by economic deflation.

    Despite the WSJ prediction that U.S. Unemployment Seen Below 6% by Year’s End. Global economic crisis is coming soon from the failure of money and credit on investment derisking and deleveraging stemming the failure of the world central banks’ monetary policies to stimulate global growth and trade as well out of geopolitical risks throughout the world.

    This crisis will be resolved by the establishment of regional economic fascism, where the Creature from Jekyll Island, that is the Banker Regime, with its policies of investment choice in democratic nation states and schemes of credit, will be replaced by the Beast Regime of Revelation 13:1-4, with its policies of diktat in regional governance in all of the world’s ten regions, and schemes of totalitarian collectivism in each of mankind’s seven institutions.

  2. AV on March 29, 2014 at 3:50 ami

    I think we need a more mayeutic (socratic) view.I see a tendency here too repeat over and over the same arguments (and charts!). Well, I insist the trade-off between inflation and unemployment is not a stable one, especially in unusual, extraordinary times, is it? By the way, for those who think I utterly disagree with what I read here, what I have just written would be a strong argument in favor of a NGDPT. Now, what is really there for the Fed to target ? Unemployment? Jobs? Output? These are real variables! Can a nominal variable really determine the real side of the economy? Maybe in the short run. For me 5 years is not the short-run! If you add unstable relations, then you do not really know what you are targeting.You can’t separate both real and nominal magnitudes. If one wants to target a nominal magnitud such as NGDP, one is implicitly (i) assuming stable relationship between real GDP and inflation and (ii) stating that one cares about pice inflation! Then why so much anger against price stability? Moreover, since this is a jobless recovery, shall we define a nominal Jobs target? A kind of payroll target? Or may be a nominal consumption target? No one appears to have a persuasive and convincing explanation of what is really going on. Again, sailing in unchartered waters. Please do not get me wrong. This blog is getting kind of boring. We shall improve over our previous arguments and really get to the bottom of the underlying issues. Otherwise we keep going back and forward with the same arguments. An endless and unproductive debate. This shall not turn into a debate on ideas or dogmatic discussion. Repetion does not add any value, especially if there are so many germaine questions that remain unanswered. I hope I have posed some of them. If you have an answer to some of them, you replies are welcome.
    Have a good one!

  3. AV on March 29, 2014 at 3:57 ami

    I like Theyenguy reply. He is right. Financial stability is a major consideration in this debate. The 2008 crisis was a financial crises, not a macroeconomic type of crisis of unsustainable fiscal policies, inadequate monetary policy, an external imbalance or an Exchange-rate crisis. This was a run on Banks and other financial intermediaries and market products. There was a bubble sustained by bullish expectations. Many saw it coming, but the idea that the bubble did not exist because the US economy was becoming more productive and internationally competitive was accepted without much thought. Financial crises are rare animals, with many non-linearities and unstable relationships. I deeply welcome someone who moves out of the traditional way of thinking and tries to get to the real bottom of thinks.

  4. Brent Buckner on March 29, 2014 at 4:42 pmi

    You write:
    “The Fed’s goal is to achieve the target of 2% inflation in the long-term, and its preferred price index is the core personal consumption expenditure price index that excludes the volatile food and energy sectors (or core PCE for short).”

    Over the period from 2000, if the Fed’s own goal were asymmetric (2% as a target, but being above taken as being much worse than being below) then the 1.7% realized inflation rate would not be evidence against a very powerful ability of the Fed to achieve its own target.

    I also note that the last explicit Fed target measure was headline PCE, not core PCE (explicitly stated by Bernanke in his January 2012 press conference).

  5. Benjamin Cole on March 29, 2014 at 11:16 pmi

    I agree with Brent. The Fed regards the 2 percent “target” as a “ceiling” to never be breeched. So, the real target is in the 1.5 percent range. BTW, Janet Yellen has rhapsodized about a 1 percent inflation target and FOMC member Plosser says even deflation might be a good thing.FOMC Fisher says any amount of inflation is “rot,” even in Japan.

    The Fed appears fixated, even monomaniacally obsessed with inflation.

    It is not surprising that monetary policy asphyxiated the USA in 2008, not that the economy is still blue in the face now.

    The Fed may say it has a dual mandate, but in fact it operates with a single mandate to keep inflation below 2 percent.

  6. eric on March 30, 2014 at 5:03 pmi

    It’s a ceiling, not a target, as Brent points out, and the Fed has been very good at meeting it.

  7. ReturnFreeRisk on March 31, 2014 at 3:55 pmi

    You know there is NO GAP using CPI. CPI has averaged 2.4% over the past 20 years since the Fed started to implicitly target 2% inflation. Core CPI has averaged 2.2%. Bernanke has himself said that over the long term the Fed has met its inflation goal. These charts are using cherry picked data and cherry picked time periods. I am sorry.

  8. ReturnFreeRisk on March 31, 2014 at 3:57 pmi

    And to those who think Fed treats 2% as a ceiling should look at the last cycle when from 2003-2007, CPI averaged 3.1%. Even core PCE deflator was over 2.2%. they let it run over target for years the last cycle. These criticisms of the Fed are not rooted in facts. This cycle, they are just not able to produce inflation.