The Ongoing Dereliction of Duty

[Note: see update below]

Last year I made the case that the Fed’s failure to keep nominal income growth expectations stable was a dereliction of duty:

[We] have long made the case that a nominal GDP (NGDP) level target would firmly anchor the expected growth path of nominal income.  Doing so, in turn, would stabilize current nominal spending since households and firms are forward looking in their decision making.  For example, holding wealth constant, households generally will put off purchasing a new car or renovating their homes if they expect their nominal incomes to fall and vice versa.  This is why Scott Sumner likes to say monetary policy works with long and variable leads. This understanding implies, therefore, that the reason for nominal spending remaining below is its pre-crisis trend is that the Fed has failed to restore expected nominal income to its pre-crisis path. This failure amounts to a passive tightening of  monetary policy.

Since then, the Fed has improved its management of expectations by introducing the conditional asset purchasing program of QE3. While this program is progress, it is still far from adequate. This can be easily seen by looking at data from a question on the University of Michigan/Thompson Reuters Survey of Consumers where households are asked how much their dollar (i.e. nominal) family incomes are expected to change over the next 12 months. The figure below shows the average response for this question up through March, 2013:

The fall of household dollar income expectations and its failure to fully recover is stunning. It suggests that the now lower expected future income growth is depressing current household spending, a point forcefully made by Mariacristina De Nardi, Eric French, and David Benson of the Chicago Fed. Digging into the data, they find that expected nominal income growth deteriorates across all age groups, educational levels, and income levels over the past few years. This is not some sectoral-specific development, it is a systemic nominal problem. They also find that the collapse in expected dollar income growth explains much of the decline in aggregate consumption since the crisis erupted.

But there is more. The figure also indicates that real debt burdens are higher than many households expected prior to the crisis. Look at the dashed line. It shows the average expected dollar income growth rate over the ‘Great Moderation’ period was 5.3%. Now imagine it is early-to-mid 2000s and you are taking out a 30-year mortgage and determining how much debt you handle. An important factor in this calculation is your expected income growth over the next 30 years. If you were average, then according to this data you would be forecasting about 5% growth rate. But that did not happened. Household dollar incomes declined and are expected to remain low. Nominal debt, however, has not adjustedas quickly leaving higher than expected real debt burdens for households.

This is something that the Fed could correct. QE3 is a step in the right direction, but more needs to be done with this program to raise expected nominal income growth. One way to do this is to make the size of the asset purchases conditional. That is, instead of conducting fixed $85 billion purchases every month until the economic targets are hit, vary the size of the purchases depending on the progress of the recovery. For example, if inflation and unemployment are not moving fast enough to their target, then increase the dollar size of the of asset purchase and vice versa. For if $85 billion is not enough for the nominal economy to gain traction, then it must be the case that money demand is rising enough to offset the benefits of the $85 billion injection. If this conditionality were added and widely understood, QE3 would better manage expectations and pack a larger punch. No more dereliction of duty.

Update: Per Nick Rowe’s request I have added the following two figures.  The first one shows expected household dollar income growth plotted along side NGDP growth over the past year. The former does seem lead the latter.

The second figure shows the mean and the median expected household dollar income growth. Interestingly, the gap between the two series is relatively stable until the crisis, after which it narrows.

This piece is cross-posted from Macro and Other Market Musings with permission.

2 Responses to "The Ongoing Dereliction of Duty"

  1. Burk   April 24, 2013 at 12:08 pm

    Well, is QE having any effect anyhow? Not much, as far as anyone can tell. It helps at the margins, and more helps very little indeed. The Fed is pushing on a noodle.

    I think that Bernanke could have much more effect by vocally telling Congress to spend more. He has sent gentle signals of this sort, mixed with the usual warnings about long-term debt. He would do better to categorically say that congress should stop cutting, and spend a trillion more on recovery.

  2. wastewater1   April 30, 2013 at 3:25 am

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