The Data Is Fed-Dependent

The Fed should act now

James Alexander via Historinhas | The Federal Reserve and other central banks like to see themselves as “data-dependent”. They sit in objective judgement of the facts of the economy as revealed by “data” and then portentously decide whether to attempt to alter the future facts with monetary tightening or loosening.

And then when the new “facts” begin to roll in, the data somehow becomes independent of the prior central bank actions. Or rather the data is seen as independent if it doesn’t go the way the central bank wants.

If the data goes the way the central bank wants then the self-same central bank usually is all too quick to claim the credit. Well, they can’t have it both ways: avoiding the blame for missing targets and only taking credit for meeting them.

It sometimes seems as if in their own eyes the Fed can do no wrong, or at least not admit it until decades later. Central banks are duty bound to maintain an absolute confidence in the efficacy of their actions, regardless of the facts.

For Market Monetarists the current run of weak nominal data in the US is not somehow independent of prior Fed actions but a consequence. The Fed is the creator of the nominal data given its power over money, one side of all transactions. For a given level of productivity, if the Fed wants a higher price level then it creates more money to achieve that, if it wants a lower price level it destroys money to achieve that goal. If it wants a steady growth in the price level then it should achieve a steady growth in money.

The nominal data is thus Fed-dependent rather than the Fed being data-dependent.

Because productivity can never really be known with much degree of accuracy, more so these days than ever due to the size of the service sector, targeting the price level is a hopeless course of action. It is far better to just target a nominal growth path and let economic historians puzzle out what part of that growth is due to productivity and what part to changes in the price level. Or politicians.

We were very pleased to see that the notion that data is dependent on the Fed recognised by Lael Brainard, one of the new’ish permanent governors of the Federal Reserve Board, in a recent speech:

Thus, while the easing in financial conditions since mid-February is very welcome, it is important to recognize that some of the conditions underlying recent bouts of turmoil largely remain in place, and an important reason for the fading of this turbulence was the expectation of more gradual U.S. monetary policy tightening. Should an event trigger renewed fears about global growth or a reassessment of the policy reaction function in the United States, turbulence could well return.

Unfortunately, this heresy about the Fed’s role in causing the data was not followed up in the rest of the speech. Although recognising, dovishly, that the economy was weak and growth seemed very low, she did the usual thing of blaming everything but the Fed in allowing growth to weaken. Weak productivity growth took a big share of the blame:

From 1953 to 2003, potential output growth varied between 3 and 4-1/2 percent, with one brief exception, according to the Congressional Budget Office. Over the recovery, it has averaged only 1-1/4 percent. One contributor to this decline has been a reduction in the labor force participation rate due to population aging. Another has been a marked slowing in productivity growth. Over the six years from the end of 2009 to the end of 2015, productivity grew only a little over 1/2 percent per year, compared with average growth of 2-1/4 percent over the 50 years prior to the Great Recession.

The reasons for such a dramatic slowing in productivity growth are not clear. Possible explanations include the fading of a one-time boost to productivity from information technology in the late 1990s and early 2000s; the reduced movement of resources from the least productive to the most productive firms, including new businesses, perhaps due to greater financial constraints for new and small businesses; and a delay between the introduction of new technologies, such as robotics, genetic sequencing, and artificial intelligence, and their effect on new production processes and products.

But if productivity growth really is as weak as Brainard claimed then the Fed has a duty to stimulate  more to keep nominal growth on track. I suspect that if productivity really is as weak as reported this may be more due to weak nominal growth, rather than vice versa. Correlation is not causation. In particular, faster nominal wage growth, back up to 5% or so, gives many more incentives for labor-saving improvements in technology and techniques than if labor remains cheap.

Oh well, Rome wasn’t built in one day, and Brainard has to try and build a new consensus inside the Fed rather than becoming isolated and eventually calling it a day as seen with other sensible members in the recent past like Mishkin and Kocherlakota.