Yellen is transforming the US economy into her favourite textbook model
When you read the standard macroeconomic textbook you will be introduced to different macroeconomic models and the characteristics of these models are often described as keynesian and classical/monetarist. In the textbook version it is said that keynesians believe that prices and wages are rigid, while monetarist/classical economist believe wages and prices are fully flexible. This really is nonsense - monetarist economists do NOT argue that prices are fully flexible neither did pre-keynesian classical economists. As a result the textbook dictum between different schools is wrong. I would instead argue that the key element in understanding the different "scenarios" we talk about in the textbook is differences in monetary regimes. Hence, in my view there are certain monetary policy rules that would make the world look "keynesian", while other monetary policy rules would make the world look "classical". As I have stated earlier - No 'General Theory' should ignore the monetary policy rule. The standard example is fixed exchange rates versus floating exchange rates regimes. In a fixed exchange rate regime - with rigid prices and wages - the central bank will use monetary policy to ensure a fixed exchange and hence will not offset any shocks to aggregate demand. As a result a tightening of fiscal policy will cause aggregate demand to drop. This would make the world look "keynesian". On the other hand under a floating exchange rate regime with for example inflation targeting (or NGDP targeting) a tightening of fiscal policy will initially cause a drop in aggregate demand, which will cause a drop in inflation expectations, but as the central bank is targeting a fixed rate of inflation it will ease monetary policy to offset the fiscal tightening. This mean that the world becomes "classical". We here see that it is not really about price rigidities, but rather about the monetary regime. This also means that when we discuss fiscal multipliers - whether or not fiscal policy has an impact on aggregate demand - it is crucial to understand what monetary policy rule we have. In this regard it is also very important to understand that the monetary policy rule is not necessarily credible and that markets' expectations about the monetary policy rule can change over time as a result of the actions and communication of the central and that that will cause the 'functioning' the economy to change. Hence, we can imagine that one day the economy is "classical" (and stable) and the next day the economy becomes "keynesian" (and unstable). Yellen is a keynesian - unfortunately I fear that what is happening right now in the US economy is that we are moving from a "classical" world - where the Federal Reserve was following a fairly well-defined rule (the Bernanke-Evans rule) and was using a fairly well-defined (though not optimal) monetary policy instrument (money base control) - and to a much less rule based monetary policy regime where first of all the target for monetary policy is changing and equally important that the Fed's monetary policy instrument is changing. When I listen to Janet Yellen speak it leaves me with the impression of a 1970s style keynesian who strongly believes that inflation is not a monetary phenomena, but rather is a result of a Phillips curve relationship where lower unemployment will cause wage inflation, which in turn will cause price inflation. It is also clear that Yellen is extraordinarily uncomfortable about thinking about monetary policy in terms of money creation (money base control) and only think of monetary policy in terms of controlling the interest rate. And finally Yellen is essentially telling us that she (and the Fed) are better at forecasting than the markets as she continues to downplay in the importance of the fact that inflation expectations have dropped markedly recently. This is very different from the views of Ben Bernanke who at least at the end of his term as Fed chairman left the impression that he was conducting monetary policy within a fairly well-defined framework, which included a clear commitment to offset shocks to aggregate demand. As a result the Bernanke ensured that the US economy - like during the Great Moderation - basically became "classical". That was best illustrated during the "fiscal cliff"-episode in 2013 where major fiscal tightening did not cause the contraction in the US economy forecasted by keynesians like Paul Krugman. However, as a result of Yellen's much less rule based approach to monetary policy I am beginning to think that if we where to have a fiscal cliff style event today (it could for example be a Chinese meltdown) then the outcome would be a lot less benign than in 2011. How a negative shock would play with Yellen in charge of the Fed Imagine that the situation in China continues to deteriorate and develop into a significant downturn for the Chinese economy. How should we expect the Yellen-fed to react? First of all a "China shock" would be visible in lower market inflation expectations. However, Yellen would likely ignore that. She has already told us she doesn't really trust the market to tell us about future inflation. Instead Yellen would focus on the US labour market and since the labour market is a notoriously lagging indicator the labour market would tell her that everything is fine - even after the shock hit. As a result she would likely not move in terms of monetary policy before the shock would show up in the unemployment data. Furthermore, Yellen would also be a lot less willing than Bernanke was to use money base control as the monetary policy instrument and rather use the interest rate as the monetary policy instrument. Given the fact that we are presently basically stuck at the Zero Lower Bound Yellen would likely conclude that she really couldn't do much about the shock and instead argue that fiscal policy should be use to offset the "China shock". All this means that we now have introduced a new "rigidity" in the US economy. It is a "rigidity" in the Fed monetary policy rule, which means that monetary policy will not offset negative shocks to US aggregate demand. If the market realizes this - and I believe that is actually what might be happening right now - then the financial markets might not work as the stabilizing factoring in the US economy that it was in 2013 during the fiscal cliff-event and as a result the US economy is becoming more "keynesian" and therefore also a less stable US economy. Only a 50% keynesian economy However, Yellen's economy is only a 50% keynesian economy. Hence, imagine instead of a negative "China shock" we had a major easing of US fiscal policy, which would cause US aggregate demand to pick up sharply. Once that would cause US unemployment to drop Yellen would move to hike interest rates. Obviously the markets would realize this once the fiscal easing would be announced and as a result the pick up in aggregate demand would be offset by the expected monetary tightening, which would be visible in a stronger dollar, a flattening of the yield curve and a drop in equity prices. In that sense the fiscal multiplier would be zero when fiscal policy is eased, but it would be positive when fiscal policy is tightened. What Yellen should do I am concerned that Yellen's old-school keynesian approach to monetary policy - adaptive expectations, the Phillips curve and reliance of interest rates as a policy instrument - is introducing a lot more instability in the US economy and might move us away from the nominal stability that Bernanke (finally) was able to ensure towards the end of his terms as Fed chairman. But it don't have to be like that. Here is what I would recommend that Yellen should do: Introduce a clear target for monetary policy
- Since Mid-2009 US nominal GDP has grown along a nearly straight 4% path (see here). Yellen should make that official policy as this likely also would ensure inflation close to 2% and overall stable demand growth, which would mean that shocks to aggregate demand "automatically" would be offset. It would so to speak make the US economy "classical" and stable.
- Instead of focusing on labour conditions and a backward-looking Phillips curve Yellen should focus on forward-looking indicators. The best thing would obviously be to look at market indicators for nominal GDP growth, but as we do not have those at least the Fed should focus on market expectations for inflation combined with surveys of future nominal GDP growth. The Fed should completely give up making its own forecasts and particularly the idea that FOMC members are making forecasts for the US economy seems to be counter-productive (today FOMC members make up their minds about what they want to do and then make a forecast to fit that decision).
- With interest rates essentially stuck at the Zero Lower Bound it becomes impossible to ease monetary policy by using the interest rate "instrument". In fact interest rates can never really be an "instrument". It can be a way of communicating, but the actual monetary policy instrument will alway be the money base, which is under the full control of the Federal Reserve. It is about time that the Fed stop talking about money base control in discretionary terms (as QE1, QE2 etc.) and instead start to talk about setting a target for money base growth to hit the ultimate target of monetary policy (4% NGDP level targeting) and let interest rates be fully market determined.