AMERICAN ENTERPRISE INSTITUTE

MEND IT, DON'T END IT: REVAMPING THE FED FOR THE 21ST CENTURY

MODERATOR:

JAMES PETHOKOUKIS, AEI

PANELISTS:

RYAN AVENT, THE

DAVID BECKWORTH, WESTERN KENTUCKY UNIVERSITY

SCOTT SUMNER, BENTLEY UNIVERSITY

10:30 AM – 12:00 PM FRIDAY, MARCH 22, 2013

EVENT PAGE: http://www.aei.org/events/2013/03/22/mend-it-dont-end-it- revamping-the-fed-for-the-21st-century/

TRANSCRIPT PROVIDED BY: DC Transcription – www.dctmr.com

JAMES PETHOKOUKIS: Welcome to our AEI panel today “Mend It, Don’t End It: Revamping the Fed for the 21st Century.” This is AEI’s third panel this week on the Fed and if anyone made all three panels, there’s no prize for you other than way to go.

In its 100-year history, the Federal Reserved has become more defined by its failures than its successes. The Fed played essential role in the of the 1930s, the Great of the 1970s, and arguably the Great of the 2000s. And now, some Fed watchers worry that the U.S. is making another historic error, this time by keeping interest rates at very low levels and by maintaining its massive bond buying program, known as , despite a recovering economy.

This opinion is particularly relevant among center-right policymakers. Almost universally, they see the Bernanke Fed as undertaking a reckless monetary experiment that will only end in tears.

As Texas Governor Rick Perry quotably said, back in 2012, when he was beginning his presidential run, if this guy Bernanke prints more between now and the election, I don’t know what you all will do with him in Iowa, but we treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in American history is almost treasonous in my opinion.

Many on the right, and to be fair, some on Wall Street, and even at the Fed itself fear the Fed’s, in their view, extremely loose will eventually create much higher inflation or dangerous asset bubbles. They also view the Fed as enabling Washington’s out of control deficit spending.

While many libertarians and followers of Ron Paul would like to end the Fed perhaps, many congressional Republicans would be happy merely changing the Fed’s legal mandate to one that focuses solely on keeping prices stable. As they see it, the Fed’s job is to keep inflation at 2 percent or so and nothing more. And right now, the Fed, as I say on Twitter, is not doing it right.

At this point, let me quote Oliver Cromwell, who in 1650 wrote The Church of Scotland, making the following plea: “I beseech you in the bowels of Christ, think it possible that you may be mistaken.”

One purpose of this panel today is to explore the idea that the current consensus center-right view of the Bernanke Fed and how to conduct monetary policy in general may indeed be mistaken. And we all tend to do this through the lens of market , perhaps the first economic theories birth by bloggers, albeit ones with Ph.D.s in . Market monetarism is actually an update of the monetary policy theories of and to broadly generalize, market monetarists might argue the following. One, an overly tight Fed, in 2008, turned a period of economic weakness or even a mild downturn into the Great Recession, a minor replay of the Great Depression. Low interest rates today are likely assigned monetary policies too tight rather than too easy. The Bernanke Fed’s bond buying program, targeting, and new communications strategy have actually moved the Central Bank in the right monetary direction toward a strategy of targeting the level of nominal . And it is NGDP targeting that is essential to market monetarism. Instead of directly trying to keep inflation stable and unemployment low, the Fed should instead announce its intension of taking whatever action is necessary to maintain a long run nominal GDP growth rate target.

This rules-based approach will create, we hope, a long run economic certainty for business, investors, and consumers, and make it less likely the U.S. would again suffer another severe recession or .

Incoming Governor , Chief Economist Jan Hatzius, and former White House Economist are among the bankers and who broadly embraced the market monetarism critique. To explore the idea of rethinking how the Fed and foreign central banks should operate, we have – and I don’t use this phrase lately, an all-star panel here.

Starting at the very end – I’ll quickly go through their bios – starting at the very end, we have David Beckworth, an assistant professor of economics at Western Kentucky University, and a former international economist at the U.S. Department of the Treasury. He’s done research on the measurement of monetary policy, the transmission mechanism through which it works, and its impact on the global, national, and regional economies.

He’s published in various academic journals and is the editor of the recent book Boom and Bust Banking: The Causes and Cures of the Great Recession. He’s blogging at Macro and Other Market Musings, has been cited by the Washington Post, New York Times, Financial Times, and many fine other publication.

In the middle, we have , who’s taught economics at Bentley University for the past 29 years. He researches , particularly the role of the standard in the Great Depression. He’s also researched liquidity traps and how monetary policy can be effective at the zero bound. His policy work has focused on the importance of expectations, particularly policies aimed at targeting expectations in the futures market. He’s been writing blog posts at the MoneyIllusion.com and he has a book coming out later this year, I think late summer, on the Great Depression.

And sitting next to me, we have Ryan Avent, economics correspondent at and the primary contributor to the economics blog Free Exchange. His work has appeared also in the New York Times, New Republic, Bloomberg, Reuters, the Atlantic, and the Guardian. Before joined the Economist, he’s worked as an economic consultant in Washington, D.C., and he’s author of the 2011 book The Gated City, which I just downloaded this morning on my Kindle, no joke.

I think we’ll start off at the very end. Professor Beckworth.

DAVID BECKWORTH: Thank you. This morning, I want to invoke Milton Friedman and make the case that money still matters, and I want to use this perspective to show that one of the key reasons for the prolonged economic slump is a monetary slump. I want to use this observation then to kind of make sense of what the Fed should be doing going forward and along the way maybe address some of the criticisms that have been raised about the Fed and some of its policies to date.

So I want to begin by noting what I think is one of the more important lessons learned about money from this crisis, and that is our standard notions of what is money, the standard view – what my textbooks I use with my undergrads show – it presents too narrow measure of money.

Typically people, when they think of money, they think of M2 or retail money assets, assets that households would use, small firms would use, cash, checking accounts, saving and time accounts, many market funds, the transaction assets that we use to facilitate exchange. Well, one thing that this crisis revealed is that there’s a whole other class of investors, institutional investors. They’ve always been there, but we weren’t as aware as we were now – are now – that they also have assets they use as money.

These institutional investors use Treasury bills, mortgage-backed securities, commercial paper, repos, and for them, they have a much larger transaction volume. They have larger dollar amounts that they have to use, to facilitate, to trade. And the traditional commercial banking system just isn’t sufficient. So they – you know, they’ve turned to the shadow banking system. And I’m sure you’re all aware that there is a run on this shadow banking system and in effect, it was a run for the money, the assets that make up to shadow banking system funds.

So when we want to think about a proper measure of money, we want to include both retail money assets and institutional money assets. So I want to do that and look at a couple of measures this morning that tried to reflect the fact that there are, both retail money assets and institution money assets being used, and see what it tells us.

This first measure comes from Gorton and his co-authors in a 2012 paper – it’s the blue line you see on the screen – and they call this a asset measure, but it’s effectively a measure of assets. It facilitates transactions or it’s money effectively. And as you can see the blue line growing and it collapses in about mid-2008 and falls. Now, if you look on the screen, you can see that it’s now surpassed the pre-crisis level, but by several measures, it’s still not adequate. Let me point out several to you.

I’ve put on the screen there a gray dashed line and a black dashed line. The gray dashed line shows the amount of safe assets or money that would be needed to hit the Congressional Budget Office potential nominal GDP. Now, their measure of potential nominal GDP is, you know, the level of spending that would be required to return to full employment, plus roughly 2 percent inflation. And that – using that in equation of exchange, where you plug it in and you take trend velocity, you can kick out this estimate.

So it shows approximately about this shy of about $5 trillion short of the amount of money, broad measured money that would be needed to hit that point.

Now, some observers would say, but hey, there was this housing boom, you know, it’s kind of artificially – (inaudible) – to that. So if you take that view, I’ve included the black dashed line, and that line shows the trend path for nominal GDP before the boom. If we take that instead of the Congressional Budget Office potential nominal GDP as a substitute and plugged that into the equation of exchange, it implies a similar level of safe assets shortfall.

And so by that measure, we see that there is a shortfall of effectively money, even though Gorton calls it safe asset, but what he’s saying is there’s a shortfall of money using his measure.

If we break this blue line down into two main components, the safe assets created by the federal government, Treasuries, and safe assets provided by financial firms through liabilities on their balance sheet, we see that the big fall comes from the private sector. And we know the story, many shadow banking assets disappeared, but they’ve fallen to a point where they haven’t recovered yet to a pre-crisis level, even to a pre-crisis trend. And so there’s still a shortfall from the private sector.

Now, the government, as you know, has run a budget deficit for several years and that black line, as you see, has increased, which has made up for some of the shortfall, but, again, you know, based on an estimate of potential nominal GDP there is not enough. And you know, from my perspective, we don’t want to rely just on government safe assets. We want the private sector to be providing the inside money.

So there’s an inadequate amount of money there. Another measure comes from the Center for Financial Stability. They have a measure called M4 Divisia. Now, Divisia is just a sophisticated way of grouping assets together so we account for how – how liquid they are, how will they substitute among each other as money assets. An M4 is a broad measure, not as broad as the Gorton measure, but it includes institutional money assets. And again, if we look at this, we see it too has fallen short the amount of money that would be needed to hit kind of a full employment level of spending or a pre-housing boom nominal GDP trend. SO by both measures, there’s a shortage of money.

Now, if you look just at M2 or M1, you wouldn’t see this, so it’s important to look at the right measure of money, right? So that’s the supply of money. There’s a shortage of it. What about the ?

If you go to the demand side – put this slide here – first off, I have a graph that shows the household demand for liquidity. And what this graph shows is the share or percent of household assets that are liquid. So if I go to the average household and I ask, you know, what share of your household assets are cash, checking accounts, how many market funds, Treasuries, and I take that and divided it by the total amount of assets, and I did it for everyone in the country, I’d get this ratio here.

The gray bars represent recession and you can see, during the 2001 recession, it elevates, as one would expect. When there’s economic uncertainty, people want more liquidity, want more funds. They save more. They hoard – money comes down after 2001 slowly. And there’s a huge spike during the Great Recession and what’s interesting about this is that it has yet to return. Households are still holding an inordinate amount of liquid assets relative to their total share. So you see that households still are hanging on to an elevated amount of liquid or money funds relative to before the crisis.

Now, from a broader perspective, I want to present this slide here. This shows the total amount of marketable Treasuries and there’s two categories here. The black area on the top shows the total marketable Treasury securities up to the end of 2012. The blue area shows total marketable Treasuries lest those held by the Fed. So the blue area would show all marketable Treasuries held by the public, other than the Fed, all right? So that would be individual investors, financial firms, foreigners, anyone but the Fed. And if you look at that, you can see several things. Number one, you can see the huge run up in the stock of public debt, marketable public debt, but you also see that most of it was bought by entities other than the Fed.

The Fed has not been the source of funding for the huge budget deficits. Many observers like to claim that, but the Fed’s holdings is only about 15 percent. If I go to flip these scales around and look at the percent of marketable Treasuries held by the Fed, it’s around 15 percent. And it’s been that average really since 1970s. It hasn’t changed much.

Now, it did go down, in 2007, when the Fed sold off some of its Treasuries. It went up in 2011 – and some people have to point it out. But right now, the Fed’s holdings of Treasuries is about 15 percent.

So another way of saying this is 85 percent of the largest dollar run up in U.S. debt history was funded by you, me, our financial intermediaries, and foreigners. If you want to blame someone for the budget deficit, blame those groups of individuals. It’s not the Fed. The Fed has been buying Treasuries, but not at the rate that many people observed. Now, this demand represents, you know, this need for liquidity. There’s this unmet – well – unmet and an elevated demand for liquidity. And it’s not just in the U.S.; it’s in many other countries. And just to illustrate this, I’ve put up on the screen here a graph that shows the history, recent history of long-term government interest rates among countries that are considered relatively safe, so safe sovereign debt. It would be safe assets, the assets that would be used, you know, as money by institutional investors. And you can see for the first few years, 2006 to about early, mid-2008, interest rates were relatively stable. They’re going up, going down, but no – no definite trend down, but about mid-2008, all of them began to head down, all of them. And they headed down in a very similar fashion; the turns they take are very similar. What it indicates is an increased demand for all safe assets, public safe assets. Because of the shortage of private safe assets, the huge destruction of them, investors have turned to public safe assets.

And if you go around the world to these countries, you see low yields across the globe, so it can’t be just the Fed. It’s an appetite from outside the Fed for safe assets. We have to be careful. I mean, some of this may also reflect the shortage of safe assets. That, too, with lower yield, as well as well the increased demand, but it certainly supports the notion that there’s huge appetite for safe assets and government safe assets in those particular countries that are deemed still worthy.

OK, to recap what I’ve just gone over, one, we’ve observed that the supply of safe assets has decreased, primarily the private supply of safe assets. There’s been an increase in the public portion, but not enough to offset it.

There’s also been an increase in the demand for safe assets, all right? So both of those things present a safe assets shortage or a shortage of transaction assets or money effectively. And when you have a shortage of money, money still matter. This is going to affect the level of spending.

So there’s been a shortfall of total dollar spending, given the shortfall of money, properly measured. And to illustrate this, here is the graph that all of us up here like to look at and stare at and present many times. This shows total current dollar spending. This is, you know, if you go along and you observe total spending, this is what you’d find. It’s nominal GDP.

The blue line, again, shows the actual dollar amount. And the black dash and gray dash show, you know, where it should be, given the pre-crisis trend or given the CBO’s potential nominal GDP. So by any measure, the level of dollar spending is low and an easy story to tell is there’s a shortfall of money. There’s shortfall of , an increased money demand, and a relative shortage overall.

OK, so what role does the Fed have to play in solving this problem? Well, one possibility is to return total dollar spending to its pre-crisis growth path. And we can, you know, argue over what’s the appropriate path, but to return it, announce it once to return total spending and to a predictable, stable path we committed to. And if did that, it would raise expectations of future , at least nominal growth, maybe real growth too – real growth as well. And if it did that, it would increase demand for financial remediation. Whenever there’s an improvement in economic growth that tends to increase the outlook and tends to improve optimism and increase the amount of financial remediation. In other words the demand for credit, demand for bonds, demand for loans would increase. And the private sector should respond by producing more safe assets. In other words the demand for money would be met by an increase in supply.

One thing I want to be clear is I’m not suggesting we target the money supply, even though there’s this issue that money still matters. If we were able to stabilize total spending, monetary conditions would take care of themselves. But the point I want to make today is that there is this lack of stability in monetary conditions and it’s evidenced by properly measuring money, as well as in total spending. Just a quick look at some evidence and how the Fed could play a role. Here’s a measure of these two measures of money, broadly defined. And this is just a private portion, a private sector portion. And I have QE1, QE2, QE3 highlighted. You can see QE1, the growth rates of these series both declined. And of course, QE1 was purposely, you know, intended to be a way to prevent the financial system from collapsing. That was its goal. Bernanke even said, don’t call this quantitative easing, call it credit easing. His objective was to save the financial system. So that’s what it did. It prevented – created a floor there. So QE1 prevents the growth rates from falling any further and starts a recovery.

QE2 is the first, you know, large scale asset program that was intended to purposely increase employment, to stimulate the economy beyond financial system. And you can see that there is a spike in the growth of these safe assets, this broad measure of money. But QE2 is very limited in scope. It was very – it was explicit. There was an end game. And so after it was shutdown in June of 2011, the growth rate begins to decline and QE3 it’s introduced, and again, the safe assets pick up. What it suggests is that the fed is capable of influencing the growth of the supply of money broadly defined if it does it in a manner that’s consistent with shaping expectations. QE3 is a conditional program. It shapes expectations much better than QE2 did.

One last slide to illustrate this and I’ll hand this off to the next discussant. Josh Hendrickson of the University of Mississippi and myself have been doing some research, using this Gary Gorton measure of safe assets. And we’ve asked this question. What effect on safe asset supply does a shock to nominal GDP expectations create? So we looked at data from 1968 to 2012 and we were considering, you know, what would – what happens typically? Controlling for interest rates, credit risk, unemployment a host of other things, what happens if you raise nominal GDP expectations if the market believes that suddenly there’s going to be higher nominal GDP in the next year?

And we’ve got data – the data from this comes from the Survey of Professional Forecasters, the Philadelphia Fed, and other sources. So we looked at what would be a typical shock. So if you look at the data and you estimate a model, you’re going to ask, what’s the typical shock look like? So just to illustrate this may look a little involved, but it’s really straightforward, this just shows what typically happens when there’s a shock to the expected growth rate of nominal GDP or forecasted nominal GDP. The black line is kind of the average. The blue line shows two center deviations. But the objective here is just to see that – what typically happens.

Now, that’s the shock, what happens in the bottom axis shows quarters after this positive shock. What’s interesting to see is what happens to the other, you know, variables that are in our estimated system here. So actual level of nominal GDP after the shock would increase, which is not surprising. If you think that there’s going to be more spending in the future, more nominal income in the future, it tends to increase spending presently. So we see that. We also see, if you look at the private creation safe assets, it also increases. So if you increase the expected future growth rate of nominal GDP, there’s an increase in the private safe asset level. Government safe assets go down, which shouldn’t be surprising either. If the economy improves the cyclical portion of budget deficit would decline, so there’s less government safe assets.

Ten-year Treasury yield increases. Again, going back to the point I made earlier, you know, the reason yields are so low is because the economy is weak and there’s a shortage of safe assets. Here, we go to a different scenario, where we can create – creating more private safe assets, less demand for government assets, and so that would increase the yield. Rates would go back to more normal levels. Premiums would fall and finally, unemployment would also go down based on the results that we’ve found in this model.

So my recommendation is for the Fed to explicitly adopt something like a nominal GDP level target, something that we’d be committed to making it more accountable, transparent, and add more certainty to the outlook.

SCOTT SUMNER: Should I go next? OK. Nominal GDP is not really a new idea in monetary economics. Back in the ’90s, Milton Friedman talked about what had gone wrong in Japan. And he pointed out that nominal GDP growth in Japan was around 5 percent during what he viewed as the golden age of the mid-’80s, and it dropped below 2 percent at that time, in the ’90s. And he blamed monetary policy for being overly contractionary and contributing to the Japanese slump.

Well, the Federal Reserve, basically, did the same thing. In the three years after 2008, nominal GDP growth dropped below 2 percent from its 5 percent norm during the Great Moderation, and so that probably would be – if Milton Friedman were alive today, I presume he would have the same view of what went wrong this time around as what happened in Japan. He also said that low interest rates, very low interest rates usually mean that money has been tight, not easy. And in this statement, he sort of lamented the fact that the public and many economists, even, had forgotten that fact and talked as if low interest rates somehow were indication of easy money. All the evidence points, of course, the other way. You have very high interest rates during hyperinflation and near zero interest rates during the Great Depression.

Ben Bernanke, in 2003, I believe, said neither interest rates, nor the money supply are a reliable indicator of the stance of monetary policy. And then, later in the talk, he said ultimately, you have to look at nominal GDP growth and inflation to ascertain the stance of monetary policy.

And I think that’s very interesting. If you do that, if you take at his word and look at nominal GDP growth and inflation since mid-2008, average the two, we’ve had the most contractionary monetary policy since Herbert Hoover was president, using Ben Bernanke’s own criteria from 2003. Obviously, that goes against the conventional wisdom, but I think this is something that has to be reemphasized again and again because economists tend to forget that these indicators we look at are often very, very misleading.

OK, the British case, I think, is a good example of why – if we go back to Bernanke’s comments, nominal GDP or inflation, why do we think nominal GDP is better, if you look at what central banks are actually interested in, it seems like nominal GDP is a better indicator. In Britain, in the last five years, clearly inflation’s run way above the Bank of England’s 2 percent target. And yet, the Bank of England and the British government more broadly have been looking for additional ways to simulate the economy, including monetary techniques of various sorts.

So you can see by their actions that they don’t think there’s enough nominal growth in the economy. And I you look at nominal GDP in Britain, it’s been running well below norm in recent years. So that’s the indicator that seems to really show what policymakers care about, not inflation. Yes, they pay lip service to inflation and, you know, it’s certainly true that was an improvement over what went before, in the 1970s, when everything was completely unanchored and inflation rates drifted up in the double digit levels. So inflation targeting was definitely a step forward, but it’s not the final step. It still doesn’t get to what central bankers are actually interested in.

I think nominal GDP comes much closer to that. It’s not perfect, but it’s a better indicator of what we’d really like to see in terms of macroeconomic stability.

Sometimes, people ask me, you know, why do you think the Fed needs to do more and whenever I hear the phrase “do more,” I think the person is really asking the wrong question. It’s not about doing more. It’s about doing different. I like to use the analogy of someone steering a large ship. When you’re trying to steer the ship effectively, it’s not a question of doing more or less. It’s a question of setting the steering mechanism such that you expect the ship to go where you want it to go. So it’s not more or less. And the Fed needs to basically have a policy where they expect the economy to go where they wanted to. And they did that for 25 years under the Great Moderation. They stopped doing that in late 2008, when the economy clearly was underperforming what the Fed would have wanted, even in nominal terms.

So the nominal GDP growth rates, starting in late 2008, was way below what the Fed would have liked to see happen, and yet they sort of passively allowed it. They set policy in a position where they expected that policy to fail. They were forecasting failure, forecasting suboptimal growth in nominal GDP.

So it’s really more about setting in place a policy regime, rather than quibbling over day-to-day decisions of the Fed. If they actually had a more expansionary – or a more effective policy regime, say, nominal GDP targeting from 2008, it’s very possible the Fed would have done much less than they’ve done over the last five years.

If you look at the central bank that’s been the most successful in maintaining adequate nominal GDP growth of the developed countries, it’s clearly been Australia. And they’ve actually done far less than the other central banks. They still have a very small monetary base, about 4 percent of GDP. In America, it’s ballooned to over 18 percent of GDP, in Japan to more than 23 percent GDP. So when your policy fails, your interest rates will fall to zero and you’ll almost be forced to inject all kinds of reserves into the banking system, because at zero interest rates, that’s what banks want to hold. So you do that to prevent an even deeper collapse of the Great Depression. But if you have an effective policy, where people expect nominal growth, then you can get by with a much smaller money supply because people will be more optimistic. They’ll want to put money to work. Or to use the terminology of economists, there’ll be more velocity to the existing money stock.

It’s quite possible that with a more effective monetary policy, the Fed could actually do less. The money they’ve already injected might be more than enough. We would get more velocity, more nominal growth on that basis.

Another part that I think is often overlooked the level of targeting part of nominal GDP targeting. One of the attractions of coming back to the trend line is to make the initial deviation from the trend line smaller. So if investors had known in late 2008, that the Fed was determined to bring the economy back to the old trend line within a few years, asset markets would have reflected the facts that will be back on that trend line in a few years, and the asset price crash would have been much milder. And the asset price crash, in the last half of 2008, was the biggest factor in intensifying the banking crisis.

Yes, we had a preexisting subprime banking crisis from ’07, but it got much worse because the collapse in nominal GDP expectations drove asset prices much lower, that devastated the balance sheet of firms like Lehman. So that’s a key, that confidence that we’re going to have a regime in place with a steady growth of nominal GDP. If we deviate from the trend line, we come back to it. That gives markets confidence. And it makes those deviations smaller in the first place. Much the same way, if you targeted prices or foreign exchange rate, and you have committed PEG, you don’t get much fluctuation because markets expect you to come back to that PEG in the near future.

Just a few comments – let me know if I’m running over, by the way, on time. Things I hear, questions, bubbles. This is an issue that comes up a lot. Wouldn’t this just create more bubbles? Actually, bubbles tend to be created by unstable nominal GDP growth. So providing more stability would actually reduce bubbles. However, bubbles are still going to exist even with nominal GDP targeting. But we have to keep our eye on the ball. What really matters is macroeconomic stability. If you keep nominal GDP stable or the growth rate relatively stable, then a boom and bust in some asset market, like the 1987 stock market crash, will have almost no ripple effects in the economy. So what really matters is macroeconomic stability, not trying to stabilize some particular asset price. The Fed did try that once. In 1929, they’ve decided to try to pop the stock market bubble with a tight money policy, and they succeeded, but they also killed the economy. And after that, the Fed sort of gave up on that. So there’s a reason why the Fed wasn’t trying to pop the stock bubble, the tech period, or the housing bubble, 2006. They were looking back to the last time they tried to pop an asset price bubble.

The central that was opposed to that policy, in the ’20s, Governor Strong, once said if one of my children misbehaves, do I have to spank them all? In other words, if Wall Street misbehaves, do I have to spank Main Street as well? And he died in 1928, so the new leadership of the Fed decided finally they’d have their chance to pop the stock market bubble.

Another question that comes up is isn’t this highly inflationary? No, you can match any inflation target with a equivalent nominal GDP target. We’ve actually run, since the middle of 2008, below 2 percent inflation. So anyone that thinks Bernanke’s policy over the last four or five years has been inflationary has to confront the fact that even if the Fed didn’t care at all about unemployment, they were coldhearted, they couldn’t care less if people were unemployed, monetary policy has been too contractionary just under the 2 percent inflation criteria, even if they’d had a single mandate.

So that’s something to think about and I think that gets lost – people lose sight of that in this discussion of how Bernanke’s doing this highly inflationary policy.

Also, don’t forget that nominal GDP targeting was first propounded in a big way in the 1980s, mostly by relatively conservative economists, people like McCallum, Mankiw, and others talked about this idea.

And finally, I would emphasize that inevitably, we’re going to have some sort of dual mandate in monetary policy, something to do with inflation, something to do with a real side of the economy growth or unemployment. And under the current system, it’s very unclear what the Fed is doing, where it’s going because there’s so much uncertainty in the current dual mandate setup. So if you want certainty, predictability, consistency in monetary policy, you need a single target that incorporates this dual mandate. That single target is nominal GDP growth, which contains real GDP growth plus inflation, so it hits both sides of the mandate in a very neutral way, in a way that would be acceptable to both many liberal economists and many conservative economists, which I think in the long run, you need that buy in to make it be a consistent policy going forward and not have the Fed lurch back and forth between one extreme and the other, depending on the makeup of the Federal Open Market Committee. So I’ll stop there.

RYAN AVENT: These guys have done a very nice job putting some sort of technical meet on the bones of the discussion today. I’m going to try to step back a little bit a take kind of a broader look at the evolution of policy in recent years and how that kind of fits in to what’s going on over the past 100 years in the Fed’s history.

The Fed was initially created to try and reduce financial volatility. In the years before the Fed’s creation, there was – there were some serious boom and bust cycles related to financial crises and it was thought that creating a central bank could help address these issues.

Since its creation, the Fed has done quite a lot of learning about how best to do that, what it’s capable of and what it’s not capable of. Sometimes it’s learned lesson, forgotten them, and had to go back and re-learn them again. But I’m going to try to sort of draw out a couple of the lessons that seemed to have really emerged over this period.

One that Scott has just been talking about is that there is a sort of a circular relationship between financial sector volatility and macroeconomic stability, that you can have crises that caused weakness in the economy. That weakness in the economy will also feedback into the financial sector and cause crises. And so you sort of have to worry about both of them. And I – this really sort of came to the floor in late 2007, as we saw in recent Fed minutes. And Tim Geithner said, you know, look, if we – I know we’re worried about housing. If we let the economy begin to grow at a slower pace, that’s going to have a direct impact on people’s ability to service their mortgages and that, in turn, will affect Wall Street. So you have to think about both the macro side and the financial side.

The Fed has also learned over this period that there is an – that money still matters. That there’s an incredibly important role for monetary policy. In sort of old classical models, you didn’t need that. Prices would always adjust immediately, and so there was never any gap between demand in the economy and supply. In practice, there is quite a large gap. People are – don’t have perfect information. They’re not able to perfectly insure. Prices and wages are rigid and don’t adjust very quickly. And so nominal changes, nominal shocks can have very big, real impacts. They can lead to high levels of unemployment and slow growth in the real economy. And so that leaves open a very important role for the Fed to play in trying to make sure we don’t wonder into macroeconomic disasters. And so then the question becomes how do we do that? What should the Fed target in trying to solve this issue? And I think that, you know, in the – one of the things that has emerged over the sort of different paradigms that we’ve had in the history of the Fed is that the Fed only has so many degrees of freedom. It would probably love to stabilize all sorts of things, but it sort of has to choose one target and then let other things sort themselves out. And in some sense, you might read the history of the Fed as the Fed opting for a target, seeing how that fails, and then learning.

In the sort of early years, in the period of the 1920s and 1930s, there was a strong ideological commitment to the gold standard. And so one of the Fed’s chief roles was to make sure that the gold stayed put, so that there was continued convertibility at a certain dollar price of gold. But making that the target tied the Fed’s hands on other variables, such as the money supply, such as the . And as a result, it was unable to respond to shocks in the economies in the early 1930s the way we might have wanted it to and that led directly to a collapse in demand and the seriousness of the Great Depression.

Beliefs sort of evolved after that. You know, as Scott mentioned, policy was very unanchored in the ’60s and ’70s. That was a time in which I think a lot of people thought that the Fed or policymakers in general could control both inflation and unemployment, and that in fact it was a direct tradeoff between the two. And so they could just sort of pick a point on what we call the and decide what they liked.

In fact, there’s not stability in the Phillips Curve and what the Fed ended up doing and what monetary policymakers ended up doing was sort of continuing to push for more and more demand in the economy that led to rising inflation levels. And that ended up validating some of the thoughts of economists like Robert Lucas, like Milton Friedman, who had said that, you know, this is – that we’re making a big mistake and that we need to focus on on something else.

And from that, I think, we sort of got to the modern era, in which the – we realized that expectations play an important role in policy, that – and that probably one of the best things we can do is target the largest sort of nominal variable that we can get our hands on and that’s the best way to sort of stabilize the economy.

Now, to me it seems a little bit odd that the choice at that point was inflation rather than NGDP. As Scott mentioned, in the ’80s and ’90s, there was discussion about using a nominal GDP as one of the key variables, rather than inflation. And to me, nominal GDP is a bit more logical. If you think that the central bank’s role is to stabilize demand, nominal GDP really is nothing more than demand. It’s P times wise the total amount of money spent in the economy. And so why – why not just sort of go straight for that?

Instead, they sort of took a bank shot approach, stabilizing inflation. I think that was probably a bit of a reaction to the 1970s and the idea that, you know, whatever we do, we can’t repeat that experience and let inflation get out of hand.

But I think that we have seen the weakness in that and that when you choose to target inflation, that still allows for volatility and other variables, including nominal GDP. And in this most recent recession, there was a big decline in nominal GDP relative to trend and that directly relates to the pain we’ve suffered in the Great Recession.

So to me that’s how we’ve gone to this point. And that’s where the Fed is slowly moving in its latest policy evolutions toward just targeting the thing that it’s best able to target and that will generate the best results. But that still might leave some questions out there for skeptics of nominal GDP targeting or indeed of monetary policy in general. And I think the argument might be looking back at this sort of checkered past, do we really want the Fed involved in monetary policymaking? Does that not just increase the odds that they’ll do something wrong and create more pain for everyone?

And I think there are three responses to that, at least as I think about the problem. The first, I think, is that we have seen that good monetary policymaking can have beneficial effects on the real economy and can alleviate suffering. An alleviation of suffering is a good goal to have. There’s nothing – there’s no moral content to . There really just – the impact of a change in expectations that leads to an imbalance between what people want to save and what people want to spend and invest. You know, no one is being punished for behaving badly. And so if the Fed can step in there and address that imbalance and alleviate suffering, then by all means they should do so.

I think a follow up point to that is that recessions are bad in the way that they break the connection between individual actions and economic outcomes. When a recession hits, the good and bad are punished alike. People who made sound loans go bust. People who worked hard lose their jobs. And if you’re interested in personal responsibility and in trying to get incentives right, it’s important to try to get the demand side right to make sure that those incentives remain as we’d like them to be.

And then a final point I would make is that, letting sort of monetary policy go off on its own or tying it to a commodity standard is not going to get rid of the pressure for intervention in the economy. It’s just going to shift it elsewhere. What it’s going to do is shift it to the fiscal authorities, to Congress, and I think that in general is something that we’ve learned to be very weary of. The failures of monetary policy in the Depression led to protectionism. They led to the New Deal and to quite a lot of new interventions in the economy, to the expansion of the welfare state, and so on. And I think that we can also say that the failures of monetary policy, in 2008, led directly to things like TARP, to the stimulus, which I suspect some people in this room were not too fond of, and to other interventions in the economy.

And so from a perspective, we need to realize there’s going to be a demand for actions to stabilize the macro-economy. And we can leave that in the hands of monetary authorities for the most part, or we can leave it to the people who will tend to do things in a much more heavy-handed and permanent way, and – you know – my choice is obviously in favor of the monetary approach. So with that, I’ll –

MR. PETHOKOUKIS: Great, thank you. I’m going to take a little bit of prerogative and ask a question, though I would – then we will get to you all at some point to ask questions. So please be thinking of some, and I want to encourage the panelists to jump in, ask questions, you know, dispute, where they can find them.

I’ve written about this and I tweet about and there’re certain questions I get all the time and anyone can, you know, answer them. It seems that people often have two minds, either they think – (audio break) – is sort of all powerful and can ruin the economy of hyper inflation, yet they also seem to think that the Fed is sort of helpless. There’s nothing the Fed can do at certain times. So I’m wondering if sort of the consensus here is that perhaps the Fed should try to hit a target – a target rate, you know, 4 or 5 percent nominal GDP growth, one, can the Fed hit that target? Two, how do we know that’s what like the, you know, the rate should be? How do we know it shouldn’t be 3 percent? How do we know it should be 6 percent? And if we go through a period, where the Fed should – where we should undershoot that rate, that means then – (inaudible) – we should sort of overshoot that rate to get it back on that path? And is it OK to overshoot that rate, even if it means inflation being 3 percent or 4 percent? So three questions, everyone, so take a shot.

MR. AVENT: I’ll answer one part of that and leave the others to the other guys. I answer the easy one, I think, which is that – is the Fed capable of doing – taking action to stabilize NGDP at a particular level. I think that we’ve seen with inflation targeting that if the central bank sets a target and that its expectations around that are clear, that it will tend to hit it and stay on it and that there’s sort of mean reversion to the target over time. So I don’t think that’s an issue. Now, there’s another question, which is what if interest rates fall to zero and we sort of lose the ability to reduce nominal interest rates to get the economy going away? And I think that the best answer to that conundrum came from Ben Bernanke, in 1999, as he was talking to – talking about the situation in Japan. And he essentially said the central bank has the ability to buy unlimited, you know – the central bank can buy all the outstanding sovereign debt if it wants to, can buy outstanding debt sovereign debt from foreign countries. It can participate in foreign exchange markets. And to think that the Fed, for instance, could go and buy all outstanding Treasury debt, all outstanding Fannie and Freddie debt, all outstanding mortgage-backed securities guaranteed by Fannie and Freddie, you know, all outstanding Cypriot debt and Greek debt and whatever else it’s allowed to do and not have any effect on expectations is sort of – seems unreasonable and that’s what my sense the best answer of that question is.

MR. SUMNER: In the worse case, we own the world.

MR. PETHOKOUKIS: Or best case, from our stance at AEI.

MR. SUMNER: Yeah, you know, this split view you talk about has been around a long time in depression. A lot of conservative critics of monetary stimulus said two things. It won’t do anything. It’s pushing on the stream and it’s going to lead to hyper- inflation. The Bank of Japan said it won’t do anything, it’s pushing on a string, and it will lead to too much inflation. And I don’t know how you can believe both, but somehow, people compartmentalize their thinking on that.

You know, in terms of the success of inflation targeting, Americans often have a very America-centric view of the world so Greenspan was viewed as this maestro who had miraculously produced low and stable inflation. Well, every country just about in the world, developed countries anyway that tried inflation targeting succeeded so it can’t be that difficult.

And so I wanted to touch on one other issue that was raised. How do we know, you know, what the right number is and what if inflation changes? I think we have to stop thinking of inflation and stability as being the nominal problem and actually think of nominal GDP as a better indicator of the costs of inflation.

So a lot of the problems that we sort of associate with inflation, first of all, some of them have nothing to do with inflation. The man on the street thinks in terms of lower living standards, but that’s actually supply shocks. That’s not inflation. But what economists understand is the cost of inflation, like punishing savings and investment through, you know, higher taxes, real taxes because of higher inflation, that’s actually better measured by nominal GDP growth anyway.

So in my view, it’s no problem if we target nominal GDP growth at 4 or 5 percent, some number like that, and you get some fluctuation and inflation of real GDP because nominal GDP growth is a number we should really care about anyway. Inflation is going to move up and down, sort of reflecting variations in our living standards related to variations in our productivity. So if productivity is very strong, Americans will get higher living standards via lower inflation. And if productivity is weak, there’s nothing we can do about the fact that our living standards will take a hit and that will show up in a little bit more inflation. But it will do so in a way that minimizes the unemployment consequences of those shocks. And just allocates the hit to our living standards through variations in inflation.

MR. BECKWORTH: Jim, let me respond to your question that Ryan touched on regarding, would there be these sudden reversals if we go away from trend, back to trend, all this volatility? And I think Ryan’s right. If the market knows – if the public understands clearly that the Fed’s goal is to maintain no matter what a certain level of nominal GDP growth, it tends to minimize any deviation in the first place.

So if you go back to 2008, there was panic, panic in the financial system. Well, if everyone understood that the Fed was going to do the type of large scale asset purchases that’s doing now back then with the objective of returning, it would have minimized their fear in the first place. People, institutions, firms; they hoard money; they hoard liquidity when there’s uncertainty about the future. This would minimize uncertainty about the future and tend to minimize any deviation off the path. So I think that concern is not, you know, one that we needed to worry.

MR. SUMNER: Let me – one quick point there. There’s a lot of the skepticism about whether the Fed can do anything at zero rates. Japan is even deeper into a, quote, “” than the United States. And starting in mid-November, just rumors of possible monetary easing in Japan drove up their stock market about 45 percent in three months. And it’s not even clear that the Bank of Japan is going to carry through with this policy because there’s, you know, disputes within the bank. But that gives you a sense of how powerful monetary signals can be, even relatively weak signals and even when interest rates are stuck at zero.

MR. PETHOKOUKIS: But, again, how do we know what the sort of – you know, potential nominal GDP growth rate should be? I mean, maybe –

MR. SUMNER: Oh, I see what you’re saying.

MR. PETHOKOUKIS: We’ve been saying 4 to 5 percent. How do we know it’s not 6 percent? How do we know we haven’t had some tremendous boost in productivity now that rates should be, you know, 7 percent? Who knows?

MR. SUMNER: I would argue we don’t need to adjust that because we should – we should be focusing on nominal GDP growth as the variable we care about, not inflation.

So if our growth is stronger than we thought when we set the target – like let’s suppose we set the target at 5 percent and it turns out growth was stronger than we thought, it was 4 percent real growth going forward, some supply side miracle, well, that just means we’d get lower inflation than we anticipated. We get 1 percent inflation and vice versa.

But it’s – nominal GDP is probably better able to measure the cost of inflation. So there’s really no natural rate of growth in nominal GDP. You can pick any rate. There’s a natural rate of growth in real GDP, but since we can choose any nominal rate, what you want to do is minimize costs at either extreme.

If you have too high rate of growth of nominal GDP, you’re imposing a heavy tax on savers and investors because you create inflation and that puts a higher tax rate on. If you have too low a growth rate of nominal GDP, it makes the labor market inefficient because you have to cut workers’ nominal wages in declining industries. That’s very painful to do, difficult to do. You get higher unemployment. So you want to pick some happy medium. And we can disagree about where that should be, 3, 4, 5, 6 percent, people disagree. But once you decide on that, changes in the trend rate of growth in real GDP should not cause you to revise that target for nominal GDP. You just let the inflation rate adjust.

MR. BECKWORTH: But, Jim, let me respond to that this way. Typically, changes to the potential of the real economy are more gradual. I mean – you know, the disruptions that cause recessions in advanced economies tend to sharp, sudden demand shocks. So to the extent you do have these changes in potential GDP that, you know, some are concerned about, they would, you know, slowly manifest themselves. There wouldn’t be sudden changes.

So, for example, if you look at the post-bellum period in the United States, they had, on average, about 4 percent real GDP growth and about 2 percent over a 30-year period. I mean, that was the norm. And somehow, they adapted. But the key was it was a very gradual, had rapid productivity gains, the capacity grew fast. It was a very gradual process as compared to something like the Great Depression, that sudden collapse.

So, you know, concerns about potential GDP, you know, overlook the fact that they tend to be more gradual in nature. And the objective is a stable – to stabilize monetary conditions. And the best we can do is to stabilize those created by, you know, demand shocks.

MR. AVENT: I’ll just add my two cents. I’d say, in the short to medium run, monetary policy can influence the real component of growth. But over the long run, it can’t. And so I think if we’re thinking about setting a target for the long run, what we’re effectively saying is we’re – there’s not much difference in setting a target for nominal GDP and setting a target for the inflation, the long-run inflation rate you’d like. And so then you have to think about, well, are we worried about hitting the zero lower bound, you know, how costly are relative price shifts, and things like that. So it’s more – I don’t think there’s that big a difference in the things you think about in setting a target under nominal GDP than under inflation.

MR. PETHOKOUKIS: And, just to be clear, what the sort of transmission mechanism is here because oftentimes, again, I’ll write about it, and people say, well, this is just a fancy plan to weaken the dollar. That’s all you’re trying to do is weaken the dollar. Exactly how are we influencing the economy by doing this?

MR. SUMNER: Well, expectations will probably be the main transmission mechanism. It works I think in a couple of ways. Just an expectation of faster nominal GDP growth will affect people’s decisions.

Now, a lot of people say to me, well, nobody even knows what nominal GDP is, but they certainly understand the concept. It’s the total amount of dollars spent in the economy. So when the auto companies are thinking about how many factories to build, it’s very relevant in terms of how many dollars are going to be spent two, three, four, five years out in the future.

So it affects expectations about nominal GDP growth. That has an effect on current in all the modern macro models. Then it affects asset prices of all sorts. I think people tend to love one asset price or another. If they’re interested in the foreign exchange market, they talk about the dollar. If they’re interested in the stock market, they talk about stocks, or bond yields, or whatever. Commercial real estate –

MR. PETHOKOUKIS: I’m interested in the asset of underwater homes. That’s my personal interest.

MR. SUMNER: Yeah. But I mean, it affects everything, commercial real estate prices, all sorts of commodity prices. They’re all affected. But I think the key one is actually the effects on expectations of future nominal GDP growth.

MR. BECKWORTH: Let me add another advantage of nominal GDP targeting related to this is that when people make contracts for long-term debt, mortgages, 30-year mortgages, 15-year mortgages, they’re implicitly making a forecast of their nominal income 30 years into the future. And, you know, people made mortgages – you know, these mortgages before the crisis in 2007, 2008. And they were severely disappointed. Nominal incomes are now on a lower path than they were prior to the crisis. And what nominal GDP does is it corrects for that. It’s not – you know, it’s not a handout. It’s managing expectations. It’s providing certainty.

Another point I wanted to raise is – and this has come up to me many times as well, like the average man on the street isn’t a nominal GDP, but he does know when there’s greater demand for jobs. He does know when his neighbors are doing better. He does know when there’s a general sense of optimism in the economy. And nominal GDP provides that as best that that can. It manages demand, demand shocks, and tends to provide the most stable path.

The market watchers, all of us up here might observe nominal GDP directly, be aware of it. But the average person on the street doesn’t have to. What they have to be aware of is that the economy is doing well, it makes them more optimistic. They go out and make a purchase they weren’t going to purchase.

And if the economy were to improve – there’s a lot of – I showed the graph. I showed the households are sitting on a lot of cash. I mean, all these people are folks who have money and they’re holding off to buy that new car. They’re holding up to do the extension on their home. If they – if their outlook improved, it would change how to make their spending decisions currently, and nominal GDP targeting would do that. They don’t have to know the target. They just know that things are looking better.

MR. SUMNER: I’d like to make one follow-up on that. A lot of central bankers and policymakers say, well, you know, the public understands inflation but they don’t understand nominal GDP. It’s exactly the opposite. And one of the reasons we’re in this dilemma is the public doesn’t understand inflation.

So go back to 2011, when Bernanke announced QE2. Core inflation had fallen below 1 percent so the Fed announces, we’re trying to raise the inflation rate back up to our target. Well, it turns out the public had never bought into inflation targeting. They thought the Fed was just trying to hold inflation down, the less, the better.

And when the – you know, the news media announced the Fed is trying to raise your cost of living and they’re printing money to do so, the public was scratching their heads wondering why would the Fed want to try to raise our costs of living? But, actually, the Fed wasn’t trying to raise their cost of living. The Fed was trying to raise nominal GDP growth and they actually hoped that most of it would be real and as little as possible would be inflation. So if the Fed had been more truthful, it also would have been more popular.

What the Fed should have said we’re in a deep slump, because, recently, the incomes of Americans have grown way below normal. So we think we need to have at least 4 or 5 percent income growth in America to get back to prosperity. That would have been far more popular than announcing we’re trying to raise the cost of living.

So I think the policymakers have it exactly backwards. The public doesn’t understand at all what inflation targeting is, doesn’t understand why it’s symmetrical. And there was such as a firestorm of criticism from the Fed that they immediately backed off and then later had to do a QE3 because the economy faltered after they backed off. So I think they’ve got that backwards in terms of comprehension with the public.

MR. AVENT: Just a couple additions. I think that Scott is right that nominal GDP is a more intuitive concept, maybe not if you call it nominal GDP, because no one knows what that is, but in the short run, again, nominal is real effectively. And so, what we’re talking about is more growth. And the people – people understand that, you know. The headline says the Fed wants the economy to grow faster and the market is up because the Fed took an action to achieve that end, people get that. They know what that means.

I’d also say that, you know, we sort of put a lot of technical trappings on it. What we’re talking about is the need for more spending in the economy, for money flowing through the economy. There’s just not enough of that going on. And the sort of the way you get inflation in the economy is by people spending more, but spending turns out to be the same thing as incomes.

And so I think we’re not really talking about prices going up sort of magically, sort of immaculately, as Krugman might say. That there’s a mechanism here, and that is people expect better growth, more spending in the future, and that will have some impact on prices, some impact on incomes. You know, we can’t be entirely confident beforehand how that’s going to play out in terms of what the long-run real benefits are. But it’s – it’s I think more intuitive to think about it just in terms of trying to raise the growth rate.

MR. PETHOKOUKIS: David put up the chart showing the – sort of gap between what nominal GDP has been doing and what the – what the potential was. And there’s that growth gap. So given that we have that gap, what should we do right now to close that gap? Does it – would it mean – again, for – maybe for a couple of years having – trying to get nominal GDP at above that rat, I don’t know, 6 percent, 7 percent, even if it meant that some of that increase was higher inflation, inflation above that 2 percent target sort of ? Would it be OK to do that, and how should the Fed go about doing that?

MR. SUMNER: Well, one problem here – and this is where even nominal GDP proponents will disagree – is once you have a regime in place, it’s clear, but when setting up the regime, it’s not clear where your starting point should be, where your trend line should be set.

So, initially, I wanted to go back to the old trend line. Now, I think we’re so far down the road that we should try to only go part way back to the trend line. It would be too inflationary in my mind to go all the way back.

Now, some of my, you know, colleagues disagree with me on that, but you have a range of opinion of people that want to start from right where we are now, then people like me, who want to go maybe a third of the way back to the old trend line, to people like Christina Romer that want to go all the way back to the old trend line.

But once you get that policy regime established, there’s no more debate. There’s no discretion. Then it’s clear what you need to do. But when you first establish it, I think there’s inherently a judgment call as to where that first trend line should be set. There’s no scientific way to perfectly resolve that issue because it’s judgments about how much slack there is in the economy and so on.

MR. AVENT: I guess I would say that I don’t think I agree with Scott that we don’t need to go all the way back. I think there’s no real world scenario where we do go all the way back, no matter – even if Ben Bernanke were to come in right now and say, you guys are right, and I agree, we’re going to do everything you said.

I think that there’s room for overshooting. And sort of the right context to think about this discussion is that, at the moment, the inflation target is an obstacle for faster recovery. That’s essentially what we’re talking about.

And you can, you know, sort of think about that in different ways. You can think about it in terms of just overall expectations, that there’s a limit to how fast demand can grow given that inflation target and that that’s the binding constraint.

You can think about it in terms of zero lower bound that effectively borrowing costs are too high. The only way to reduce them when you can’t reduce nominal interest rates anymore is to raise inflation, but no matter how you slice it, right now, the obstacle to a faster recovery is the 2 percent inflation target.

And so one way of looking at this discussion is about how do we create a policy framework that gets us out of this trap and that prevents us from falling into it again in the future? And I happen to think that the policy that does that is also the policy that’s going to be better in the long run, and that’s targeting a level of nominal GDP. But that’s the context for this – this discussion I think.

MR. BECKWORTH: Just to be clear, so even if there were some catch-up inflation that was faster than normal, over the long run, it would be anchored. I mean, with a nominal GDP target, we wouldn’t have to worry about long-run inflation expectations to become unanchored. The whole point is no longer are there certainty. So, over the long run, there’s going to be some average little growth rate that kicks in along with some kind of trend inflation rate, which you mentioned, ultimately, it’s long run inflation rate we’re going to ultimately be targeting in some indirect sense.

MR. SUMNER: I agree with Ryan, but just to give you a sense of how deep we are in this hole – even if you use inflation as a criteria, not nominal GDP, and said, well, let’s go back to Lehman Brothers crisis, when it really got bad, in September of 2008, and just draw an inflation trend line of 2 percent from that month forward using the Fed’s preferred inflation indicator, we’re around 3 percent below that trend line. So we could run 3 percent inflation for three years, which would probably mean really fast real GDP growth. And we would only get back to a 2 percent inflation trend line from September 2008. That’s how deep we are.

So I do agree with Ryan’s point about the inflation targeting is a little bit of a handicap in terms of what the Fed’s doing now, but that’s only because it’s not doing level targeting. It forgot about the deflation we had in 2009. But that gives you a sense of how people have overstated the inflation issue in the U.S. economy recently.

MR. PETHOKOUKIS: And how close do you think current Fed policy with bond buying, creating – it’s not an unemployment target, a threshold, how close is it to being sort of the optimal policy that you see? Fifty percent there?

MR. SUMNER: No. It’s a policy that if it takes us 1,000 years to get there, the Fed can say they succeeded, because all they’re doing is promising not to prematurely remove stimulus before those thresholds are hit. There’s no timeframe on when they’re going to hit them. That’s all – there’s no level targeting really there.

I mean, I will give them credit for taking small steps. They’re clearly moving in this direction. And I think it’s had some effect. I don’t mean to downplay what they’ve done, but it’s still a long way for – the last step is so hard for any central bank to do because as soon as you move to something like level targeting, you take ownership of the economy. You have a commitment. The economy has to be there or policy’s failed. You can no longer do gestures, and we’ll do this, and see what happens. If it doesn’t, we’ll try something else. We have a benchmark to judge.

But, again, the policy announced last year, if it takes 1,000 years to get down to 6.5 percent unemployment, nobody can say the Fed failed in its policy, because they gave no timeframe for how long it would take. And that timeframe is the last step that any central bank is reluctant to take because it really makes them have ownership for failure at least in the nominal side of the economy.

MR. AVENT: You know, I think Scott’s right, but I’d put slightly differently. And I’m a little happier I think with the Fed’s evolution here. There’s sort of two steps that the Fed needed to take to get from where they were to where we sort of think they should be.

One is changing the framework so that something other than a strict inflation rate target is allowed. And the second step is sort of telling the public that you actively want this new target. And I think that we’ve taken the first step in that they’ve adopted a framework in which they’re clearly using nominal GDP growth as more of an input into deciding how they react. We’re not in the second one yet.

It’s sort of – and Scott’s right in that that isn’t (making ?) a big difference. It’s like if you set out for New York in a ship headed for South Hampton and your ship get blown under a course for North Africa, you know, the Fed has effectively said, well, if a storm blows us back towards South Hampton, we’re fine with that, but we’re not going to try to steer the ship there.

And so I think, you know, obviously, there’s a big gap there from where we’d want to be, but I think that – you know, the Fed is a conservative institution and it is very deliberate. And I think – and particularly Ben Bernanke is worried about making sure there’s a consensus among everyone about the direction they’re going so that when he’s gone, the policy doesn’t suddenly and sharply change direction in a damaging way. So I’m not – I’m not convinced that what they’ve done is not a real positive step in the right direction.

MR. SUMNER: I shouldn’t have sounded that negative. I mean, all we have to do is look across the Atlantic and see what even far slower nominal GDP growth looks like. So relatively to the European Central Bank, the Fed has dome a phenomenal job.

MR. PETHOKOUKIS: One phrase that we haven’t talked about too much maybe initially, again, a question that often gets raised. How can we be talking about continuing this bond buy, maybe increasing the bond buy when the Fed already has this massive balance sheet, which is probably going to cause higher inflation? Shouldn’t the Fed right now be stopping the program? You know, talking more aggressively about when they’re going to wind it down? I mean, how worried are you about it? And the situation that often gets mentioned to me is that, well, it’s going to be a situation like in 1994, we’re going to see a spike in interest rates, carryable (ph) bond market. I’m not sure if that’s a worst case scenario. So how about the big Fed balance sheet?

MR. BECKWORTH: Well, just to repeat a point made earlier, had the Fed been doing something like nominal GDP targeting, you probably wouldn’t have a big balance sheet.

But given that we’re here, one way to look at it is the huge increase in the monetary base that everyone talks about reflects a huge increase in the demand for it. It’s often common to hear you critics point to this huge run up in the monetary base, but they’re looking just at the supply, the supply of money, narrow measure of money. We often overlook that there’s a demand for it. It’s been an almost insatiable demand for that, that monetary base. So in some sense, the Fed is just responding to that. I mean, had the Fed not increased – given the way they operate, given its imperfections, we’d be far – you know, worse off today than we are. So I think we’ve got to take, you know, a bigger picture here. There’s the demand for the base and there’s a supply of it.

MR. AVENT: The Fed’s answer, which I think is probably the right one, is that the actual size of the balance sheet may matter less than people think, that, you know, if a larger balance sheet was inflationary, we’d have a lot of inflation right now. So on its own, it’s obviously not.

Effectively – you know, the question we’re interested in is: how much lending is that balance sheet or particular level of reserve supporting? And the determinant of that is – as the rate of return that banks get on various activities, and what the Fed thinks will happen is if the economy is picking up and banks are starting to go out and create these private money, and they’re doing it in a way that’s too rapid, what they’ll do is raise the interest on excess reserves, which will make banks less anxious to sort of get that money out there earning high returns.

And so, what they’ve done is effectively put a collar around lending rates by introducing that lower limit interest on excess reserves in addition to the federal funds rate target, which all sounds kind of technical. But the point is they have a mechanism to prevent banks from being really, really anxious to go out and pass those reserves off to other lenders in order to earn high returns. And I think that it’s true, that if they yank that interest rate up to 10 percent, banks would be more than happy to just sit on what they’ve got and take that, and that would nip inflation in the bud.

MR. BECKWORTH: If you look at long-run inflation forecast, whether from the bond market or from a survey of forecasters, it’s been remarkably stable around 2.5 percent, in like 10-year horizons – (audio break) – the huge run up in the size of the Fed’s balance sheet. So the way we interpret that is, well, the market thinks that in the future, the Fed is going to somehow wind that down in a way that won’t generate inflation.

So, I mean, the people are trading bonds, people who have skin in the game, when they see the future, they see that balance sheet having no effect. In fact, that’s maybe one critique is that the Feds, you know, increase some portion that’s not going to be – some portion that is not going to – you know, raising spending in the future. But all markets’ signals indicate that long-run inflation forecasts are stable, signaling that they believe the Fed has control over the balance sheet.

MR. SUMNER: There’s also a history here that I think is interesting. The first of these situations I can recall was in the Great Depression when the interest rates were near zero. The Fed exited its low-interest policy too soon in 1937 and went back into a double- dip depression and interest rates stayed near zero all the way until 1951, when they started raising them.

And, as far as I know, I know five cases like this – 1951 is the only case where they were too late in exiting the zero bound situation, and we only had one year of high inflation and then we went right back down the low inflation for more than a decade. So the costs of being a little bit too late in 1951 were very, very small, but they were huge for exiting too early in ’37.

And, again, other cases I’m aware of, Japan, in 2000, tried exit by raising rates. They went right back into deflation, had to cut them to zero again. They raised rates in 2006, then they went back into deflation, had to cut them to zero again. The European Central Bank tried to exit in 2011, prematurely, Europe went right back into recession and the European Central Bank had to cut them down to near zero again. So four of the five cases of exiting from the near zero situation was clearly premature. The one that was too late had very small negative consequences that only lasted for about a year.

MR. AVENT: I’d make it even simpler in that the Fed doesn’t have to reduce the size of its balance sheet to tight monetary policy, because it has the interest on excess reserves tool. Now, there still might be costs to having a large balance sheet. If interest rates start to go up, the Fed will take some losses and a lot of people worry about that. And I think that’s mainly a political economy issue and the Fed’s been transferring pretty sizeable profits to the Treasury. And I think if you sort of net those all up over the period, you know, the Treasury will have come out ahead but still there’s going to be room for a lot of grandstanding when the Fed has to say, well, you know, we’re going to run a balance sheet loss this year.

MR. PETHOKOUKIS: Speaking of grand stands, I want to follow up – and this is – you said something which is going to I think – in and of itself will terrify, I think, maybe my libertarian friends. We talk about the Fed taking ownership of the economy. It might be a good time just to – we haven’t mentioned it. The potential role of the –

MR. SUMNER: The nominal economy.

MR. PETHOKOUKIS: Yeah. The nominal economy. What is the potential of creating a futures market, of an NGDP futures market, as a way of making this more market centered and less human judgment centers?

MR. SUMNER: Right. So when I respond to libertarian critics – and I’m kind of libertarian myself – I talk about the fact that I’d actually prefer a regime where the market determined both interest rates and the money supply, not the Fed.

The way it would work is they’d set up a nominal GDP futures market and peg the price at wherever they wanted nominal GDP growth to go, say 5 percent higher a year from today. And then, the money supply and interest rates would automatically be adjusted by the market until it was at a level where we were expected to hit that nominal GDP. It would be sort of like replacing the gold standard, where you peg the price of gold at a certain level and let the market determine the money supply and interest rates at that gold price peg with a price peg on a nominal GDP futures market. So that would be one way of making it sort of more market friendly.

And I shouldn’t have said take ownership of the economy, which sounds very socialist. What I really meant was sort of the nominal economy. And really what – nominal GDP is really the flipside of the value of the dollar and as long as we have a system where the Fed has a monopoly on producing dollars, even if you’re a libertarian, you want them to operate that monopoly in a way that does the least amount of damage possible. And so that would be nominal stability, but maybe it was a poor choice of terms.

MR. PETHOKOUKIS: I think we have about 10 minutes left. So I wonder if our interns could be – there’s at least one or two questions. They can bring the – bring the mike around. The first person to catch my eye is right there – so we’re going to be very democratic about it – the gentleman over there. And if you could say who you are, where you’re from, and, remember, questions, not political manifestos.

Q: I’m Jim Allen with CFA Institute. I was – wanted to ask, David, you just said something about how interest rates are very low and they’re indicating that the market is not anticipating inflation anytime soon. How much of that may be related to other factors like the – essentially, there’s no good alternatives out there in the global marketplace to invest. I mean, you look at like interests rates were very low in Ireland, very low in Greece before the collapse here as well and there was a bit of an artificial interest rate. I’m wondering how much of that do you see as being sort of caused by, you know, other investors from the globe sort of seeing U.S. as a good alternative?

MR. BECKWORTH: Well, I showed the graph that indicated long term rates for across the world for the (safe ?) asset sovereigns so the United Kingdom, the U.S. And those rates do reflect the fact that there’s a weak economy. There’s an increased demand for safety. And that’s a sign of weakness. But those countries there can always – there’s never a chance they’re going to default. They can always print money if they had to. There’s no explicit threat. And I would actually like to see those rates go up. I mean, if those rates went up, to me, it would be a sign the economy is recovering.

Now, you’re referring I think to the question, the point I made about inflation being low. And –

Q: (Off mic.).

MR. BECKWORTH: Expected inflation, right? So not interest, but expected inflation. So I’m talking about the spread between the Treasury, nominal and TIPS interest rate, break even rate, as well as the – you know, the expected inflation rate you find from surveys of forecasters. And I don’t think that reflects those developments as much as just the overall expectation the economy is weak going forward.

MR. SUMNER: Could I make a quick comment on it too? If you look at a graph of real interest rates on 10-year Treasury bonds from the last 30 years, they start around 7, 7.5 percent. These are real interest rates and they cycle downward, almost on a linear trend line for 30 years into negative territory. That’s a phenomenal drop in real interest rates that’s been going on for 30 years. That means it involves more than this cycle. This cycle played a role. It involves more than easy money because it’s been a 30-year period of falling inflation. If it was easy money, we would have seen rising inflation.

So something odd is going on with the credit markets globally in terms of real rates. It’s been going on for 30 years. There’s all these theories, you know, savings, and age, and everything. But I think we have to recognize that interest rates just aren’t a good indicator and we don’t fully understand why they’re so low, but certainly it’s partly the weak economy now, but it’s also probably other mysterious things that at some point in the future, we’ll better understand.

MR. PETHOKOUKIS: This gentleman right here. Can we get him the mike? Right in front.

Q: Warren Coats, International Monetary Fund. About 99 percent of this very interesting presentation has been on the virtues of targets and the merits of nominal GDP target. Could you say a bit more about the instruments needed to achieve it, whether they need to be used differently in light of enormous policy uncertainty coming from the Hill, the debt problem, which – you know, has been completely absent from the discussion. Do the instruments you want to see used work in the same way in the face of that policy uncertainties, you know, when you might be pushing on the string., bubbles, and so on?

MR. SUMNER: Well, the one thing I think we’ve learned is the nominal interest rates, which is what every central bank wants to use as a policy instrument, don’t work well at the zero bound.

And I use the analogy of a car, where the steering works fine all the time except when you’re on twisty mountain roads and then the steering wheel locks. So we have this instrument, interest rates, that work fine during the great moderation, but when we most need them, in a deep recession, we can’t adjust them.

So I would suggest they pick a different instrument from nominal interest rates. You know, I don’t think they’re going to adopt my nominal GDP futures idea, but perhaps adjusting the monetary base or something that doesn’t face a zero boundary condition would be preferable.

MR. AVENT: I don’t foresee a big change in the tools that the central bank would use. I think the hope is that if you had a credible nominal GDP target, first of all, the expectations channel would be stronger and so you would have more traction for a given statement or policy at the zero lower bound.

I think there’s also the assumption or at least I operate under the assumption that inflation would be a little more volatile and that that might make us less likely to hit the zero lower bound in the first place. And, of course, you could also just set the nominal GDP target a little bit higher and that would be equivalent to setting the inflation target a little bit higher so that you hit the nominal – hit the zero lower bound less in the first place.

I’m probably a little more in favor of automatic stabilizers as sort of a – you know, a means to amplify the effects of monetary policy during deep recessions. And I think, you know, if you talk about Milton Friedman’s helicopter drop or money financed sort of handout of – you know, of checks or whatever to everyone in the economy, that’s not something the Fed can do on its own necessarily. And so if you have strong automatic stabilizers and then effectively monetary policy does more work during a downturn, then you’re amplifying that effect in dealing with less of an issue. But I think that – I mean, the general idea is that expectations will do a lot of the work of solving this issue.

MR. PETHOKOUKIS: The man in the stripe shirt.

Q: Hello. My name is Heiman Argon (ph) and I’m an economist with the Bureau of Labor Statistics. My question is for Mr. Sumner. Knowing how destructive boom and bust cycles have been, especially since the creation of the Federal Reserve, and knowing how deeply rooted in microeconomic phenomena recessions and depressions have been, how would an implicit or explicit target of nominal GDP would smooth out microeconomic environment while still have asset bubbles and boom and bust cycles? And I know you touched this a little bit, but could you please elaborate?

MR. SUMNER: Did you say microeconomic phenomena were underlying recessions? I couldn’t quite hear. I’m sorry.

Q: I said that most recessions, even though they involve problems like unemployment and low growth, they’re rooted in microeconomic problems. So I was wondering how would an explicit or implicit nominal GDP targeting policy would allow microeconomic environment to be stable while still having asset bubbles or boom and bust cycles?

MR. SUMNER: OK. I’m going to disagree with the premise of your question. I think that certainly that’s the conventional wisdom that this recession in particular was rooted in microeconomic failures. In my view, that’s sort of an illusion, almost like an optical illusion.

The severity of the financial crisis was to some extent a reflection of the depth of the recession itself. And so I think what people did is they saw this subprime crisis happen, then later they saw a deep recession, and they naturally connected the two events.

But, in all probability, if we had had stable nominal GDP growth, stable monetary policy, the subprime crisis would not have created anything more than a mild slowdown in growth.

In fact, even as late as mid-2008, when conventional macroeconomists that disagree with me, those who think the subprime crisis did cause the deep recession, in mid-2008, they weren’t predicting a deep recession. The consensus macroeconomists were predicting growth in 2009, 5.5, 6 percent unemployment in 2009.

So, clearly, something happened that was outside of this microeconomic fundamental that created a deep recession. And I think that something was the monetary policy failure that led to that collapse. Now, if that’s wrong, we’ll find out. You know, I point to the ’87 stock crash that didn’t cause a recession. And if we had stable nominal GDP growth and a financial crisis and get a deep recession, obviously, we’ll have to take other steps.

MR. BECKWORTH: Can I respond to that quickly? If you look at employment between April, 2006, when the housing, which is at its peak, begins to collapse, and employment – about early to mid-2008 is actually growing, if you look at construction and income from real estate sector, it’s falling. So construction begins to fall in April 2006 and continues to fall all the way forward.

But employment in the rest of the economy, outside of construction, actually grows. So there you have a microeconomic story going on, where the U.S. economy is absorbing and handling that sectoral contraction just fine. And I believe the reason it did so is because the Fed did an adequate job between 2006 and early to mid-2008.

You know, if you keep the macroeconomic environment stable so monetary conditions are relatively stable, you know, then micro conditions, given good – you know, regulatory environment and laws will kind of take care of themselves. So I mean, the evidence from 2006 to 2008 I think supports this notion that a stable macro- environment makes it easier at least for the micro-environment to work itself out.

MR. PETHOKOUKIS: I think we only have time for like two more questions. I have no done this side of the room yet. So right here.

Q: Hi. Chad from the Mercatus Center. This might be a little begging the question no more political economy than pure economics. But one issue that Kevin Drum and Matt Yglesias and others have raised is the very issue of expectations and the public actually responding to the expectations that the Fed presents if it were to adopt nominal GDP growth.

So I guess the first question would be, particularly given the lack of understanding about inflation among the general public and the political pressure that comes from that, that was mentioned earlier, do you feel that the Federal Reserve, as a political institution would have the will to maintain nominal GDP targeting in light of unexpected inflation growth? And two, are they politically independent enough to do so if there is pressure from Congress to alter that midway?

MR. SUMNER: OK. One question I often get is wouldn’t – you know, even if we adopted this, wouldn’t even some of the supporters for it back off when conditions were different and it called for tightening rather than easing?

I would point to the so-called great moderation, this period of a couple of decades when, for some reason, monetary policy stopped being controversial, when liberal and conservative economists both sort of agreed, well, the Federal Reserve is doing pretty much what we want them to do, maybe not exactly, but it stopped being a controversial issue.

And what’s interesting about that period, while we had pretty stable nominal GDP growth, at about 5 percent, and when we deviated from it, like in the 2000 recession, we came back to the trend line pretty reasonably, and so when we actually produced the sort of policy that’s close to what we’re advocating, it seems like monetary policy becomes relatively uncontroversial. The hawks and the doves don’t disagree very strongly. But when we deviate sharply, either now or in the great depression, then the schism becomes very large between the left and the right about what monetary policy should be all about. So I would just point to that example in support.

MR. PETHOKOUKIS: One last question? This gentlemen right here. If we get him a mike.

Q: Joe (Gagnon ?), the Peterson Institute. I’m actually very sympathetic to nominal GDP growth targeting, but I guess I have a question about growth versus level. I wondered – and this sort of follows up from that point.

I mean, there’s always going to be mistakes. And there will be a time in the future, if we were on a nominal GDP level target, where due to data revisions, policy errors, shocks to the economy, we find ourselves several percent above the path. Even if inflation goes back to where we want it to be and outputs at potential, the Fed is going to have to engineer a recession to get us back to that trend line. I’m just wondering how political feasible that would be. It seems pretty tough to me.

And I wonder if – a couple of things that make me question it further is just I was talking to a macro modeler recently who has a modern macro model of – (inaudible). And he said, look, when I put a leveled GDP target, it induces more cyclicality into real output than if have a growth rate GDP target, which sort of fits with the impression you get that you’re having to counteract shocks with opposite shocks that will hit the real economy.

The other thing is you yourself, just now, when you talked about what path should we adopt, implicitly took on board some idea, well, maybe we should allow some of this shock to nominal GDP to be permanent and adopt a lower trend line than we had before, which seems to me inconsistent with sort of what you would want if you really believed in a level target.

MR. AVENT: I’ll just interject and then you can answer the question. I would just say that in my – based on my observations, the Fed often seems pretty enthusiastic about engineering recession. And so I’m not sure that that should be a big concern, that it gives them a chance to sort of show their toughness.

MR. SUMNER: OK. Well, first, I’m going to plead innocent to the arbitrary charge at the end because there is no objective trend line. You can start your trend line from 1800, from 1850, from 2006, from 2001, and every different starting point will get you a different point right now. So any decision about where to make the trend line from this point going forward is going to be arbitrary.

And the criteria I would use for defending, going only one third of the way back perhaps is, look, basically, you have a problem here that both debt contracts and wage contracts are negotiated based on certain expectations. In the short run, if you deviate, all these contracts were negotiated under previous expectations of where nominal GDP growth would be. So you want to quickly go back.

But if it’s been five years, you’ve got a lot of new debt contracts and new wage contracts that are negotiated with a new reality. So to take reductio ad absurdum, suppose it was 500 years out. Would you still want to go back to the old trend line? Obviously, not. And so there is always going to be an arbitrary element in picking the new trend line.

In terms of the instability, now I’ve kind of forgotten your first point. Oh, yes. The pressure to go back – I don’t think that if we were above the trend, that you would necessarily have to engineer a recession or at least a deep recession to get back to the trend line.

What tends to happen in the later stages of business cycles often is you get subpar growth, sub-trend growth in real GDP for a period of time and not much increase in unemployment. Sometimes, you do dip into a mild recession. And look at what they did in 2001. I mean, I don’t think that that would be particularly politically unpopular. It didn’t seem to be so at the time, and yet that cycle sort of got them back onto the trend, if you believe, let’s say, that in the year 2000 we were overheated in some sense.

So I think the economy would naturally stay closer to the trend line just because of expectations of coming back. If we deviated 1 or 2 percent, and said, OK, over the next couple of years, we’re going to try to get back, I don’t think it would create a sizeable enough to be particularly controversial.

MR. PETHOKOUKIS: All right. Thank you everybody for the great questions and for coming today and to our panelists.

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