Evan Koenig on the Fed’s Review Period, Monetary Regimes, and Yield Curves

David Beckworth: Our guest today is Evan Koenig. Evan is the senior vice president and principal policy advisor for the Federal Reserve Bank of Dallas where he has been since 1988. Evan joins us today to discuss his time at the Fed and some of his research. Evan, welcome to the show.

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Evan Koenig: Thanks very much, David.

Beckworth: We're glad to have you on. I've been eager to chat with you for some time, since you've been both a long-term employee of the Federal Reserve System and a long-time scholar of nominal GDP targeting with some great research on it. But before we get into that, I want to first ask, how did you get into economics, and ultimately into working for the Fed?

Koenig: Well, that goes way, way back, back to my high school days in Madison, Wisconsin. I took a course, I think it was called economics. It was as much personal finance as anything else. But I found it extremely interesting. Did a long paper for that course that was well received and that got me going, made me decide I wanted to take some economics courses in college. My intention was to major in applied math and engineering physics. But when I took an economics course and took a physics course in the same semester, the economics course was just so much more interesting. Before long my nickname in the dormitory was Econ, so I took to it right away.

Beckworth: Oh really? Very nice. Econ Evan, huh?

Koenig: That's it.

Beckworth: Yes. Then you went on to Harvard and from there you taught briefly and ended up at the Dallas Fed. What is your current role and responsibility at the Dallas Fed?

Koenig: Well, as principal policy advisor, I'm really part of a team that is responsible for keeping our board of directors, and our bank president up to date on what's going on in the economy, discussing monetary policy issues with them, making sure that the briefing process that we have to help prepare the bank president, before he goes off to Washington DC, is operating smoothly. Those would be my chief responsibilities.

Koenig: Also, write for bank publications, and insofar as there is time, I'll try to get some academic-style research done as well. And, of course, there are the typical department management responsibilities, participating in those discussions.

Beckworth: So, you advise the president directly, you're there to help him shape his views, provide information. Do you ever get the chance to go to the FOMC meetings?

Koenig: Yeah. I've been to a number of FOMC meetings, starting five or six years ago, I think six years ago under Richard Fisher. And even before then, I had attended a few FOMC meetings under previous bank presidents. What we've been trying to do in recent years is give other people in the department some experience with the FOMC meetings, so we've been sending a variety of economists to Washington DC, which is a great experience for them. They see what it's actually like in person. But yeah, attending FOMC meetings is part of the job.

Beckworth: Okay. What is your role at the FOMC meetings if you are there?

Koenig: Well, people in my position at FOMC meetings, most of our role is to sit and take notes so that we can advise the research department staff when we get back to our home banks, what the issues are that were raised at the meeting and that will need to be addressed at the upcoming meeting. That's a big part of the job. We're also there to discuss with the policymakers when the meetings aren't in formal session, if they have any questions, last minute questions about policy or about the state of the economy, where there is resources, to help sort those things out.

Koenig: Then we have discussions amongst ourselves about what's going on at the different Federal Reserve banks, our own views on policy and the economy. So it's a good chance to catch up with colleagues.

Beckworth: Sounds like a really rich experience when you get up there. Now, it's a two-day event. What happens after the first day? You guys go out and have dinner together? Do you just go to your hotel room? I mean, is there collegiality outside of the formal FOMC meeting itself?

Koenig: Now, there's typically a reception and dinner that is hosted by the board of governors after the first day of the meeting, and a lot of participants attend that reception and that dinner. Some go off on their own for dinner with some of their colleagues. So it's a mixed bag.

Beckworth: Okay. Let's go back to the Dallas Fed now where you spend most of your time. What is a typical day like for you?

Koenig: Well, I'm not sure there is a typical day. It's quite varied. If Rob Kaplan has an essay or a press interview or a speech coming up, some of my time might be taken up with reviewing the essay or the speech, offering suggestions. Some of my day may be spent in preparation for an upcoming board of directors meeting. I will sometimes give economic updates to our board of directors, so that involves some preparation time.

Koenig: Part of my time might be spent with discussions with colleagues. Some of my time spent doing academic-style research, finishing off an article for the Federal Reserve Bank of Dallas website. Those are examples of some of the things that occupy my time.

Beckworth: Okay. What would you recommend to a budding young macroeconomist now that you've spent so much time in the field, you've seen it from the perspective of the Fed. You've done research yourself. You've published. Any thoughts you'd give to a budding macro student, grad student, or early-career-track economist?

Koenig: Well, I would certainly encourage a young economist to consider spending some of their time within the Federal Reserve System. It's a rich source of ideas for research, ideas that may have practical application. You’re surrounded by a large group of macroeconomic specialists, probably a larger group of macro people than you'd find at most academic departments. So I think being exposed to that environment... and also involves more teamwork than would be typically the case at an academic department.

Koenig: If you like working with others on interesting topics, having interesting topics rise in the natural course of your day-to-day business, it's a great place to be. You do have to be somewhat more interruptible than you would be at an academic institution. Not everybody finds that comfortable. But it's definitely something worth considering and worth trying out I think.

Beckworth: Okay. Did any of your children become macroeconomists? Did you talk them into it?

Koenig: No, I'm afraid not. We have a son who became an architect, and we have a daughter who became a psychology counselor at an academic institution, so helping people get over emotional problems.

Beckworth: Yeah. Well, I've got three kids myself, and I don't think they're on track to be macroeconomists either. We'll have to leave the legacy to our own work and stop there.

Beckworth: Well, let's move on to something big that's been happening this year at the Fed, and this has been the Fed's year of review. They're reviewing their strategy, their tools, their communication. The first six months was this period of listening. There was this big Chicago Fed conference. I know you went to it. I think I heard you give some feedback to some... one paper in particular, Lars Svensson's paper. But I also saw you at the Hoover Fed conference which wasn't a part of the official listening stage, but I think it was part of the broader conversation going on during the stage. In the next six months, it's going to be some kind of, I guess, internal discussion. What is your sense of this year, this review going on? What do you see it doing and where is it going?

Koenig: First off, this is probably a good time for the Fed disclaimer.

Beckworth: Oh yeah.

Koenig: That what I say this morning, these are my own opinions, and not necessarily the official views of the Federal Reserve Bank of Dallas or Robert Kaplan's views, or the views of anyone else in the Federal Reserve System.

Beckworth: Okay.

Koenig: First off, with regard to the Fed listening and this general strategic review, I think it's something that's very welcome. We're in a very different monetary policy and economic environment than we were in before the financial crisis. It's important that the Fed periodically take a look at its policy strategy and think about whether there are ways that it can be improved. So this is a very welcome development. I'm glad the Federal Reserve is undertaking it.

Beckworth: Okay. The first six months was a listening stage. Explain to our listeners, what was this listening stage about?

Koenig: Well, this varied a little bit from Federal Reserve bank to Federal Reserve bank. There have been a number of events around the system. Some of them were oriented more for its academic-style papers and economists, and some were oriented more towards reaching out to the broader community. So gaining some appreciation for how the broader community views the Federal Reserve, how what we do impacts their lives, day-to-day lives.

Koenig: In considering strategy, it's important to keep those sorts of questions, those sorts of considerations in mind. Then, as I say, some of these events, more academically oriented trying to take advantage of the most up-to-date thinking on monetary policy strategy.

Koenig: The Chicago event was a mixture of both. You saw some panels of people in the broader community, and you saw some papers that were presented by very respected academic economists.

Beckworth: Yeah. Let me ask this question. When some of the regional banks went to talk to regular people, non-academics, about the Fed, and I believe Vice Chair, Richard Clarida, came down to your district, right, with the President Kaplan and they went out and visited some folks. Is that right?

Koenig: That is correct.

Beckworth: Okay. Events like that, I'm wondering, does the average person even know what the Federal Reserve is, I guess? I mean, are you on the radar screen of a typical American?

Koenig: I think that varies a great deal, and I think that came out at the Chicago conference when a number of panelists said that in fact they had never looked at an FOMC statement. Some were completely unfamiliar with what those look like. I suspect that's pretty typical. So not everyone is glued to their television set when the chairman is going to give his press conference.

Koenig: But on the other hand, if you're watching any of the major business news stations, CNBC or any of the other cable stations, the Fed is the focus of a lot of attention, and I think that has been true over the course of my career. The Fed has been increasingly in the news, and I think more and more people are aware of what the Federal Reserve does and the Federal Reserve's role.

Beckworth: You know, when times are going really well, my sense is people don't pay much attention, aren't very aware, like during the Great Moderation, maybe even prior to President Trump's election and maybe few years leading up to that. But during the Great Recession, everyone... not everyone. A lot of people knew about the Fed. There is the End the Fed campaign by some folks, or are we creating inequality from the other side, critique of the Fed. Now I think President Trump, to some extent, is putting the Fed back on the map, for better or for worse. So it is interesting to see this and have conversation with people who may not be as familiar.

Beckworth: Let me ask you a different question related to this review. If I were to be truly cynical, I could say this. There's been a lot of discussion already, even before this review took place. We've had 10 years to think about the crisis. Lots of papers have been written outside of the Chicago Fed conference in this year, what can we do differently next time, different regimes, different approaches, different tools. What new value is this review actually providing beyond what we've already talked about at other conferences and other places?

Koenig: Well, I think it's a chance to pull together some of the research that has been done over the last 10 years. I mean, a lot of new research was stimulated by the financial crisis. I think there has been increasing appreciation as long-term interest rates have come down. Maybe we should have anticipated this with the demographic transition that the world is undergoing. But the fact is that people did not appreciate all of the implications of that demographic transition.

Koenig: The realization that if an adverse shock were to hit the world economy, that there might be less maneuvering room than we've been used to in the past. That starts to get people's attention, and I'm just glad that we're looking into this the way that we are.

Beckworth: Yeah, and to be fair... I was being cynical there playing devil's advocate, but the fact that the Fed has recognized this... if you look at the web page for the discussion of this review, one of the paragraphs there talks about the fact that this neutral interest rate or what you guys call r star, has fallen, and that really does change the nature of the game. You guys don't have as much room to cut. Kind of an average number people throw out there is historically the Fed has cut interest rates about five percentage points, or 500 basis points, typically going into recession. Right now we're just below two and a half, and looks like rates might be cut in future, so that doesn't leave a lot of wiggle room.

Beckworth: I think it's in some ways novel and new that the Fed is recognizing this weakness ahead of time and saying, "Hey, what do we do about it?"

Koenig: Yeah. There are differences of opinion about how much of a difference that makes. There are other tools that we relied on at the height of the financial crisis and in the early stages of the recovery, that appear to have been effective. There are some backup tools that we can use, but still, the more tools you have, the better.

Beckworth: Right, and that's part of this conversation, right, part of the review is like, should the Fed use negative interest rates, yield curve control, kind of expanding the tool chest just in case you do hit the effective lower bound or the zero lower bound at some point in the near future. What will this next stage be like? We talked about the next six months of internal discussion. What do you think's going to happen? A lot of meetings? Is this something happening at the FOMC? Is it regional presidents calling each other up and just chatting over the phone? What will it entail?

Koenig: One thing that's going to go on is that internally, we're going to have papers written, analyses done, memos written on the different strategy options, the different tools available. Those will be vetted internally. They will be shared with policymakers most likely at FOMC meetings discussed. Policymakers will have discussions. Then at the end of that, we'll try to draw some conclusions.

Beckworth: Okay. Let's move to one of the topics that's going to be discussed, and that is the framework, the monetary policy framework. They're looking at frameworks, tools of communication. I want to zero in on the framework because both of us share an appreciation share an appreciation for a particular framework called nominal GDP targeting. What is your definition of nominal GDP targeting? What is your preferred version of it?

Koenig: Okay. I've actually got a pretty loose definition. I think there are a lot of details that would need to be thought about carefully insofar as we can rely on models to simulate performance. Different versions that would need to be simulated. But I think the basic idea is that there is an argument for worrying about not just the variability of inflation and the variability of output, but also their correlation, so that one might want prices and quantities to move in opposite directions, that that might be important in macro performance. That's the basic idea behind nominal GDP targeting.

Koenig: If you take it literally as targeting nominal GDP, if you have a negative output surprise, so GDP is less than you had thought it was going to be, you would want a positive price level surprise, a movement in the opposite direction in the price level, and vice versa. If you had a positive output surprise, you'd want a negative movement in inflation, or a negative movement in the price level. I think that's the main feature that distinguishes it from past policy strategies.

Beckworth: So the defining characteristic is it creates a tendency towards countercyclical inflation?

Koenig: Right.

Beckworth: Okay. Now, you have written in some of your papers, at least one of the papers, that you like a PCE version of it. What does PCE stand for?

Koenig: Personal Consumption Expenditures.

Beckworth: Yeah. Is that right, you would maybe have them target that portion of nominal GDP?

Koenig: This is one of those details that I think bears further investigations. In some models, if the problem is wage stickiness, that money wages aren't flexible, then you can show. And if there's some wedge between consumption and output, it may be government purchases that is the wedge. It might be investment spending, that you want to pay attention not just to nominal GDP, but also in particular to nominal consumption spending.

Koenig: If the friction is nominal debt contracts under some circumstances, you'd want to pay particular attention to nominal consumption spending rather than nominal GDP. As in practical terms, we've got monthly information on personal consumption expenditures. GDP statistics come out quarterly. So there is some informational advantage perhaps of looking at nominal consumption spending. But I think what might be true in theory and practice, you have to take into account those practical considerations like the availability of information about how much the data get revised. Those things become important.

Beckworth: Yeah. I want to come back to those concerns in a minute, about nominal GDP targeting. I want to just flush out the general idea for a few minutes. What about people calling it nominal income targeting, and some would even go further than that and say, "Let's target labor income," so maybe they’re targeting some kind of waging index, or some aggregate measure of labor income, any thoughts on that perspective?

Koenig: Again, this is something I'm open-minded about. Something that targets nominal labor income I think would have the feature that I was talking about where you tend to have countercyclical movements in the general level of wages and prices, and that's in general what you want to achieve by going this route. But I took a look at the wage income component of personal income and how that moves. It's actually a fairly volatile series, which could be a disadvantage for targeting that.

Koenig: We also know that there have been structural shifts in the economy where labor’s share has been constant or had been varied around a constant for many, many years, decades, has shown some drift since the mid-1990s. I think that would be something I'd worry about a little bit.

Beckworth: Okay. What has been your sense of nominal GDP targeting's reception among Fed officials? Just to maybe motivate this, at the Chicago Fed conference, Lars Svensson gave a paper and he kind of dismissed nominal GDP targeting. He said, "I'm not even going to talk about it," in his paper. He got some blowback after it in the Q and A. You were one of them. I think James Bullard was another one, Eric Sims, and someone else got up and said it. Bloomberg wrote up a piece that says, "Wow, Fed people really like nominal GDP targeting.” But that was just few of you that I know already are sympathetic towards nominal GDP targeting. What is your broader sense of what the reception has been or is to nominal GDP targeting?

Koenig: I think, as you mentioned, a number of Fed officials have expressed some interest. I think that's the fair way to put it, some interest, in nominal GDP targeting, including Jim Bullard of the St. Louis Fed. Also, John Williams, back when he was in San Francisco, had expressed some interest in nominal GDP targeting. And then of course Rob Kaplan on a couple of occasions has expressed some interest in the concept as well.

Koenig: I think from a number of Fed officials, some curiosity, have heard enough positive things about it that they'd like to know more. I think that characterizes the reception.

Beckworth: Okay. Cautiously optimistic. So, I gave you a nominal GDP targeting mug, coffee mug, and maybe I should send one to all the members of the FOMC, so every morning when they drink their hot beverage, they're looking at nominal GDP targeting.

Koenig: I use that mug almost every day and I've had some questions about it, and I'm happy to explain whatever it represents.

Beckworth: Very nice. That mug actually is a highly sought after item because we give it out to guests on the show, and I gave one to you ahead of time because you've been such a champion in nominal GDP targeting. It's a small token of our appreciation for guests who come on the show, and I've had numerous emails, “How can I get that mug? What can I do to buy it?” There's probably a secondary market for it, but hang on to yours because apparently it's serving a purpose within the Federal Reserve System.

Beckworth: Let's move on on this question of nominal GDP targeting and let me ask this question here. What have you found to be the best selling point for nominal GDP targeting?

Koenig: Well, I think that depends on who your audience is. If you are talking with someone who is used to thinking in terms of something like the Taylor rule as a guide for policy, the fact that you can put nominal GDP targeting into the Taylor rule framework, that it's sort of a generalization of the Taylor rule, is something that those people find appealing. So there's no divine revelation that we ought to be looking at inflation over a one-year period. Certainly, maybe we ought to be looking at inflation over a six-quarter period or over a three-year period instead. People who are comfortable with the Taylor rule are open to that possibility.

Koenig: Similarly, when it comes to measuring the output gap or the reference level of output, do you necessarily want to use the very most up-to-date estimate of potential GDP or perhaps is there an argument... and this is realistic. We have to base our estimates, potential GDP, on lagged information. How important is it that that information be totally up to date? Is it okay for it to be lagged information?

Koenig: For those people, taking that approach works well. I think if we're talking with the person on the streets, they find it very intuitive and very appealing. If you've got nominal debt obligations, if you've got student loan debt, if you've got a mortgage, having a reliable, predictable stream of nominal income is something that resonates. In fact, that's how I first got into nominal GDP targeting. A colleague back... boy, this must've been the late 1980s or the very early 1990s. Inflation targeting was still relatively new. We're talking about different policy strategies that might have been pursued during the Great Depression and wouldn't it have been great to do price-level targeting during the Great Depression.

Koenig: I thought about this and I had just purchased a home at a mortgage payment. I really think having a predictable income stream would be more important to me.

Beckworth: Very interesting.

Koenig: I think any individual who has those sorts of nominal obligations finds it appealing.

Beckworth: Yeah. Well, that's fascinating. You kind of reason from your own experience to a more general point, that having a predictable nominal income stream in your own life is important, very important.

Beckworth: Yeah. That's something I think too that resonates well, is you're going to tell people, "Look, we're trying to stabilize the expected or average growth path of dollar incomes, and I think that definitely resonates. Well, I think politically, it's a good sell too. We've mentioned this on the show many times. But it's a much harder sell to talk about raising inflation to many people, particularly when you're in a severe recession. The example that I've used before is Bernanke in 2010 I believe was talking about QE2 and how it was going to help get inflation back up close to where they wanted and Congress couldn't believe him. Why would you want to raise inflation? The economy's already been hit with these other shocks. Why raise inflation? If instead he had said, "We want to raise dollar incomes to households. That would have made a much better pitch. What have you found to be the biggest concerns about nominal GDP targeting?

Koenig: Well, again, that varies a little bit depending upon who you talk with. I think there is a generation of economists who have grown up working with what's now called the canonical New Keynesian macro model where the only nominal friction in the economy is price stickiness, where prices don't adjust immediately. If you've grown up with that model and are familiar with its policy implications, it leads you in the direction of inflation targeting or maybe average inflation targeting, something along those lines.

Koenig: And to think about switching gears, and thinking about different sorts of nominal frictions that are out there, it's just not something that has been on their radar screens, so getting comfortable with that idea that, hey, we just can't take it for granted that this particular model is going to steer us in the right direction, is probably the biggest challenge.

Beckworth: Yeah. I've had several people push back in terms of the dual mandate. Well, how is nominal GDP targeting going to satisfy the dual mandate? And it strikes me that the dual mandate implies that sometimes you've got to have some flexibility on the price side. If you're going to manage two different mandates, you've got to have some flexibility sometimes, in fact it requires that. And nominal GDP targeting is exactly the best way to do it, creates this countercyclical inflationary tendency.

Beckworth: But some people, you're right, I think come up thinking price stability is a very rigid, strict, maybe price-level vision of the world, and it is kind of foreign to them to think of a nominal GDP target where you would have short-to-medium-term increased flexibility in inflation while you still anchor over the long term. Maybe that's just a tough pill to swallow.

Koenig: Yeah. It is a disciplined way of allowing some short-term price flexibility. Disciplined both in the short run in terms of its countercyclical movements, and in the long term in that you're choosing your targets so that over the long term you are meeting your two percent inflation objective.

Koenig: Yeah, this notion that some price flexibility, some price movement might actually be desirable is a big hurdle because in the New Keynesian framework, that just isn't the case.

Beckworth: Yeah. I know I've sent you a paper of mine where I've used this illustration, but I want to bring it up again here, and that's the case of Israel since 2008. Now, they don't intentionally target nominal GDP, but the end result of whatever they're doing, which is they have an inflation target, but the end result is something that looks like a nominal GDP target. They had relatively stable nominal GDP growth. You can draw almost a straight line from 2008 to the present, a whole decade of relatively stable nominal demand growth.

Beckworth: Then if you look at the components, if you look at the GDP deflator and real GDP in growth rate terms, you see almost like a mirror opposite, this two-series move in countervailing fashion. Real GDP slowed down in 2009. The GDP deflator shot up, and vice versa. Then it kind of, in my mind, is like a text book demonstration of what nominal GDP targeting would be like. What's interesting is, in the case of Israel, they allow this to temporarily overshoot and then it undershoots. But on average, it hits about two percent.

Beckworth: If I understand correctly, they have an inflation target range of one to three percent. On average, over this past decade, they've hit about two percent even though sometimes they've gone above that or below it. That, to me, is like the picture you want to paint. Does that seem right?

Koenig: I think that's basically right, yes.

Beckworth: Okay. Now, you mentioned earlier you were motivated in a nominal GDP targeting… this reasoning from your own experience thinking of the Great Depression since the late 80s. There was some discussion back then about nominal GDP targeting. It kind of was a popular idea back then, and it fell out of favor or just lost adherence with the advent of inflation targeting in the 90s. Were you following this discussion much back then? The [discussion between] Bennett McCallum, Greg Mankiw, I think Robert Hall. Some others were Jeff Frankel, I think we had talked about it back then. What were your thoughts at the time when they were discussing it?

Koenig: I discovered that literature a little bit later. After I got interested in nominal GDP targeting, I went back and saw that there was this prior literature that discussed it. There was a paper by Charlie Bean as well.

Beckworth: That's right. Yeah.

Koenig: He was talking about nominal GDP targeting. In that context, it wasn't nominal debt contracts but nominal wage contracts that motivated the approach. I think back in the 1970s in particular, there was a literature associated with money growth targeting, Milton Friedman, the big champion of that.

Koenig: I was looking at the Federal Reserve Act as amended in 1977, and that's the Act that laid out the dual mandates. If you read the actual language, it says that the Federal Reserve Open Market Committee is charged with maintaining long-run growth of the monetary and credit aggregates commensurate with the economy's long-run potential to increase production so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. Clearly, that Act had in mind targeting a growth rate, maintaining a growth rate of money and credit aggregates so as to achieve these objectives.

Koenig: Well, when the relationship between the monetary aggregates and the nominal GDP, nominal spending broke down in the early 1980s, I think that's when people started shifting their focus, okay, maybe we could target some measure of nominal spending or nominal income instead. I think that's what set off this literature that you were talking about. I think there is a history here that goes back in spirit at least back to Milton Friedman days.

Beckworth: Yeah. Michael Woodford in his 2011 paper at Jackson Hole, he comes out in favor of nominal GDP targeting as a practical solution to zero lower bound problems. He says somewhere in that paper that you can think of this as an updated version of Milton Friedman's rule, kind of the velocity-adjusted money supply target in the spirit of-

Koenig: Exactly.

Beckworth: ...what Milton Friedman had way back when. But it is interesting how sometimes, ideas are subject to the whims of fads or popularity... or first-mover advantages. 1990s, New Zealand starts off inflation targeting. It catches on. Goes around the world in advanced economies, and nominal GDP targeting is left in the dustbin.

Koenig: It was in the 1990s that people started to construct these rigorous models of price stickiness using this Calvo approach, the price adjustment. So you had the New Keynesian model, which was relatively easy to analyze, which seemed to capture an important aspect of reality. In that context of that model, inflation targeting makes a whole lot of sense. I think once that approach to thinking about the economy took hold, it was natural for the literature also to embrace the policy implications of that approach and to embrace inflation targeting instead of something like nominal GDP targeting.

Koenig: You really have to open your mind to other sorts of nominal frictions. As Eric Sims mentioned at the Chicago conference, wage stickiness moves you in the direction of something like nominal GDP targeting, or nominal debt contracts, which where the subject of my paper, lead you in that direction.

Beckworth: Hey. Let's talk about that paper, your most recent one on this topic, I believe, and it's titled “Like A Good Neighbor: Monetary Policy, Financial Stability, and the Distribution of Risk.” Speak to us and explain to us why nominal GDP targeting is really good for risk sharing and in situations with a lot of nominal debt contracts.

Koenig: Well, we sort of covered the intuition a little bit earlier on. If people in the economy have nominal obligations, nominal debt obligations, then they want to have a predictable stream of income. It's still the case that if more of that... if their real incomes fall, so your nominal income could be steady, and your real income could fall, your standard of living is going to decline, but a whole lot less than if you held a price level steady so that your nominal income fell. If your nominal income falls along with output, then you're really squeezed in meeting those nominal debt obligations.

Koenig: On the other hand, if you're a creditor, if you don't have any debt, in fact you've made loans to other people, well, then, price level targeting is wonderful because it guarantees you a real income that is insulated from shocks to real output. So you love something like a price-level target.

Koenig: Under a nominal GDP target where the price level would rise, your real standard of living would fall proportionately, just like a debtor's real standard of living. So nominal GDP targeting spreads the impact of real shocks to the economy across debtors and creditors in a way that price-level targeting or inflation targeting does not.

Koenig: If it was easy to negotiate contingent debt contracts, people would elect to protect themselves from these situations on their own, voluntarily. But in fact, the monetary policy can step in and accomplish the same task.

Beckworth: Yeah. Now, how has this argument been received, this idea of better risk sharing through nominal GDP targeting? Because it's kind of a newer argument for it. Do people understand it and latch onto it?

Koenig: Let me go on a little bit-

Beckworth: Sure.

Koenig: ... and extend that argument a little bit. I said that creditors are completely protected. But of course, if debtors are squeezed so much that they go bankrupt or start defaulting on loans, then you're endangering your whole financial system. I think there is a financial stability argument. If you have poor risk sharing in an economy, it increases the chances that you'll experience difficulties in your financial system.

Koenig: What are the reactions to that? Well, again, I think the person on the street finds this very intuitive and very appealing. You do get some pushback from people saying, "Well, financial stability, that's the responsibility of the financial regulators. That's not something that monetary policy makers should be worrying about. Let the financial regulators take care of that." I think that's a pretty common reaction to the argument.

Beckworth: Let me flesh out that argument just one more way, and that is to look at booms. You've described the situation when there's a recession, but the same argument has a symmetry, right, on the expansion side. Basically, you're telling a story of countercyclical inflation, that leads to kind of a procyclical, real debt burden. So during a recession, inflation goes up, the real debt burden goes down. The risk is more equally shared between your creditors and debtors.

Beckworth: But during a boom, if a creditor has lent funds at some interest rate and now the real return of the economy's gone up, some unexpected gain to productivity, that creditor feels like, "If I had held onto the money and put it onto the market, I could have earned more." They don't benefit from a windfall gain and the debtor effectively does. This also helps out on that situation too. Is that right?

Koenig: Yeah, that is correct. That is not a situation where you would expect the implications, potential implications, for the financial system aren't the same. But it is certainly correct that it allows creditors to benefit from booms in a way that they wouldn't otherwise.

Beckworth: Yeah. Effectively, just to summarize, this turns a world of debt into a world of equity, or at least it behaves like equity.

Koenig: Yeah. There's an element of that to it. Yes.

Beckworth: Okay. To me, that's a very compelling argument. I find it very, very fascinating. Okay. Well, let's move on from nominal GDP targeting, in the time we have left, and talk about some of your other work. One of the things that's going on right now is there's yield curve inversion going on, depending on which measure you look at. If you look at the 10-year minus three months, it's been inverted over a month. 10-year minus two-year hasn't been inverted. Some Fed economists at the Board of Governors have looked at another measure. They call it the near-term forward spread, six quarter minus one quarter forward spread. That one's also inverted.

Beckworth: You have a paper where you look at this spread as well as some other indicators in a forecasting exercise, and maybe the name of the paper from the Journal of Money, Credit, and Banking is “Credit Indicators As Predictors of Economic Activity, A Real-time VAR Analysis.” So how important is the yield curve relative to other credit indicators?

Koenig: Well, it's good for some purposes and not so good for others. What we found most useful in a number of contexts is spread between a long-term rate and something like that one-year rate, rather than a two-year rate or something shorter like a three-month rate. The long rate, we've looked at a couple of things, that the 10-year rate and also it's something we call the long forward rate or it's more technically the five-year-five-year forward rate. The idea is you're looking at what people are expecting the five-year rate to be, five years from now. The advantage of that is it insulates... that thing is relatively insulated from near-term cyclical forces and near-term expectations about monetary policy.

Koenig: Looking ahead that far out, the five-year-five-year forward rate should be a reasonably good approximation, and I emphasize approximation, to a phenomenal r-star. It's where people are expecting policy to end up after cyclical forces run their course. By looking at the difference between a short-term rate and something like that long-forward rate, you're approximating the gap between the policy rate and r-star. That's the way we think about it. It's an approximate measure of the stance of monetary policy.

Koenig: When short-term rates are high, relative to that long-forward rate, it's a signal that policy is tight. In practical terms, it discourages intermediation. It makes borrowing short and lending long, which is what banks do, relatively unprofitable, so discourages credit formation. Short rates, high relatively long-forward rate signal that R is greater than r-star, monetary policy's tight. Conversely, when short rates below the long-forward rate signal that monetary policy is accommodative, is easy.

Koenig: We've got a Dallas Fed blog piece, Dallas Fed Economics piece that talks about the relationship between... the stance of policy as measured that way, and subsequent movements in the unemployment rate. It's interesting. You find that there's a strong non-linear relationship so that when the yield curve is positively sloped, just how positively sloped it is doesn't seem to make a whole lot of difference for the outlook of the unemployment rate.

Koenig: But there's a point, as the yield curve flattens, then all of a sudden monetary policy becomes much more important for the future course of the unemployment rate. Now, the problem is, and if you look historically, and people talk about this all the time, the record of yield curve inversions preceding recessions is just phenomenal. The problem is that you don't know when the recession is going to come. You can have a yield curve inversion and it might be less than a year when the economy slips into a recession.

Koenig: You can have a yield curve inversion, it might be two years later that the economy slips into a recession. So it's great for setting up a caution flag that you need to be careful. But it's sort of like the thing on Game of Thrones where “Winter is Coming.” Okay…?

Beckworth: … “When?”

Koenig: Yes. You'd like to know more.

Beckworth: Yeah. So what is it telling us now? Is winter coming now or is it not too bad, just a slowdown? What is your take?

Koenig: I think about the same right now, is that we're in a period of heightened recession risk. But it by no means is sending an unambiguous signal. If you look at the difference between the one-year rate and the five-year-five year forward rate, or even the difference between the three-month rates and the five-year-five-year forward rate, it's not inverted. We're in this range where monetary policy has a stronger impact on the economy where it begins to bite more strongly, but not in the period where you can unambiguously say, "Oh, this is a clear recession signal." So that caution flag is up, but not the warning flag.

Beckworth: Okay. Well, we'll be paying attention to the “Evan caution flag” as time goes forward, we'll look at this unique yield curve measure. We thank you for coming on the show. Our time is up. Our guest today has been Evan Koenig. Evan, thank you so much for coming on the show.

Koenig: Thanks, David.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app. While you're there, please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening.

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