Components of a Fed rate… Real rate & Inflation response
Below the previous post on Refining a NGDP target for a policy rate rule, there were comments by Reason regarding real growth of output and the effects of inflation. These are the two components of the Fed rate, which seeks to stabilize inflation and promote full-employment output growth.
I thought it would be helpful to post a graph that separates out those two components side by side. The data for the graph comes from my own equations for determining the short-term real rate and the inflation response in the Fed rate. (link) My equations determine the short-term real rate and the inflation response, and then add them together to prescribe a Fed rate.
First here is my equation plotted against the actual Fed rate. The blue line represents my equation to determine the Fed rate.
Now I will separate out the two components of my equation for the Fed rate.
The blue line here shows the short-term real rate which reflects real output growth. You can see that it normally plateaued between 2% and 4% since the 1960’s. Normally real output growth was in the 3% range. But since the crisis, we see that real output growth is still below 2%. The economy is sick, unproductive and demand constrained.
The orange line represents the response to inflation so that nominal GDP would return to its price level target. The general pattern shows that the need to control inflation has been going lower. Now we have the reverse where there is a need to liberate inflation.
The complication now is that real output growth is suffering at the same time that inflation pressures are weak.
You might want to call your Fed rate curve something other than the “effective” rate. The Wu-Xia shadow rate probably defines a more meaningful effective rate post-ZLB :
https://www.frbatlanta.org/cqer/researchcq/shadow_rate.aspx
It’s interesting that your model implies that the FF rate would have been little different had the Fed been targeting NGDP , rather than inflation , since the ’80’s. That’s probably because that’s what they were doing , in fact :
So , NGDP targeting gave us two periods of unsustainable leverage-increasing growth enhancements – in the ’80s and 2000’s – bringing us to the debt-overhang stagnation we have today.
And we’re supposed to believe that NGDP targeting is the answer to our problems ?
http://research.stlouisfed.org/fred2/graph/?g=9gr
Now , you might argue that macroprudential regulation can prevent leverage from growing further , but ask yourself , if debt/gdp had remained at the stable pre-1980 level of ~1.3 , what would have happened to gdp growth ?
For a clue , consider the recent past.
We’ve had stable debt/gdp levels over the last several years , and the result has been lackluster growth. That’s why Obama is pushing for looser FHA lending standards – to generate another housing boom , which , if successful , will come with another step up in the debt/gdp ratio. More leverage. Yippee !
Wash. Rinse. Repeat.
We never learn.
Marko,
I can make my equation fit the past data of the Fed rate by adjusting the parameters. That is what I did. But then if you look at the parameters I needed to do that, you will see an inflation target of 3%. The Fed was actually saying that they were targeting 2% inflation. What that tells me is that Fed policy was too loose for many years.
In other words,if I put the correct parameter of a 2% inflation target for NGDP price level targeting, the Fed rate’s past data looks too loose.
The problem.I see with a too loose Fed rate is that markets and firms lose discipline slowly over time and become less socially efficient. There is a slow decay of vitality within the economy.
So my equation for a policy rule for NGDP price level targeting gives insight into past Fed policy.
And I use the word effective for the Fed rate because the data in FRED uses that label. It makes it easier to search thr data.
And your comment points to the lack of discipline too when you mention Obama’ plan to lower lending standards. Standards were lowered for so long that now standards have had to be tightened tonprotect banks risk. Obama is trying to return to the mistakes of the past. Zlb is another mistake. In the end, the markets have to be disciplined gradually over many years in order to regain a strong economy.
Edward,
Yes, I agree with that description. The problem with NGDP targeting is that during periods of slow real gdp growth , the Fed’s tendency was to try to get blood from a stone using loose money , thus ratcheting up leverage.
The change in leverage , i.e. economy-wide debt/gdp , should fluctuate over time around zero in an economy with a mature financial sector. Our financial sector matured decades ago , but we seem to think it’s still in it’s infancy.
Marko,
You used the key word… maturity. Can capitalism behave with maturity? Can capitalism mature? If not, the world is heading for more trouble.