Murder on the Orient Express
By Scott Sumner
President Donald Trump hailed his appointment of Jerome Powell to be the next Federal Reserve chair, citing Powell’s “considerable talent and experience.” Given the realistic alternatives, Powell was one of Trump’s better appointments.
If the economy goes south in the next three years, however, Trump’s tune will change. He’d surely lash out at Powell and the Fed with vitriol.
Let’s put aside the question of whether it makes sense for a person to blame one of their own appointees for a policy failure. I’m interested in another question; would an economic downturn be the Fed’s fault? And if the answer is “maybe”, then how would we determine fault?
1. If the downturn in real GDP were not accompanied by a sharp decline in NGDP growth, then it would not be the Fed’s fault.
2. If NGDP also fell sharply, then it would be the Fed’s fault.
Surely it can’t be that simple? Don’t we need to consider why there was a decline in NGDP? Actually no. If NGDP growth falls sharply, it’s always the Fed’s fault.
Here’s why people get confused on this issue. Fed policy errors don’t happen in a vacuum, they occur when the Fed takes it’s eye off the ball, say due to an oil shock, or a financial crisis. These distractions may cause the Fed to lose focus on maintaining adequate NGDP growth (as both shocks did in 2008), triggering a recession. But even in that case the recession would probably be caused by the fall in NGDP growth, not the oil shock or the financial crisis. Real shocks by themselves can cause a mild recession in a large diversified economy like the US, but it happens very rarely.
Consider this analogy. Someone has given you slow acting poison, which may or may not be a fatal dose. Then someone comes up and shoots you in the heart. That gunshot wound is the cause of death, regardless of the poison in your system. In this analogy, the poison is like a real shock and the gunshot wound is like a monetary shock. With sticky wages, a sharp fall in NGDP growth means higher unemployment.
Some people have a very odd belief that a tight money policy instituted during a period when the economy is healthy can cause a recession, but a tight money policy instituted during a period of financial turmoil cannot cause a recession. In the latter case, they see the financial turmoil as the “real cause” of the recession. That’s like claiming that a gunshot to the heart will kill a healthy person, but will not kill someone with poison in their system.
A sharp fall in NGDP growth is always contractionary, regardless of what else is going on in the economy. If NGDP falls sharply then the Fed has fired a gun into the body of the economy. That body might or might not also have poison in its system, but if NGDP growth plunges then the Fed fired a gun into the body of the economy. It’s that simple.
PS. Stephen Williamson had a good post on the choice of Powell for Fed chair. My first choice was Goushi Kataoka; I’ll explain why in a future post.