Please, don't experiment with monetary policy
By Scott Sumner
I am seeing an increasing number of pundits calling for policymakers to experiment with the economy. The basic idea seems to be to have (demand-side) policy run hot; to see just how much growth potential is out there. This was a bad idea in the 1960s, and seems like an equally bad idea today. Here’s Karl Smith:
Whether by design or default, the nation has found itself in the midst of a momentous economic experiment. A combination of tax cuts and spending increases are creating an economic stimulus as large as the one that was enacted by a Democratic Congress in 2009. That one was a response to the financial crisis, though, and many economists fear that stimulating today’s recovering economy would be useless or worse.
Not so fast. There are strong reasons to doubt this claim. I believe that the U.S. economy has significant room to grow. Yet even if I am correct, the burgeoning boom could be cut short by overly aggressive monetary policy.
The Fed is supposed to balance the aims of maximum employment and stable prices. Today, that dual mandate implies that the central bank should be hesitant about raising interest rates, as tax cuts and potential increases in spending on infrastructure and the military work their way through the economy and increase overall demand.
In my view it would be a mistake to experiment with monetary policy by not raising rates. At its best, monetary policy can provide a stable nominal backdrop for the real economy to thrive. What it cannot do is create sustainable growth when the monetary backdrop is already stable.
Let’s start with some data:
1. RGDP growth has averaged 1.43% over the past 10 years. During that period, the unemployment rate has fallen from 5.0% to 4.1%. From this we might infer that the recent trend rate of growth is probably below 1.43%. On the other hand, the financial crisis might have depressed growth, even after unemployment recovered.
2. CPI inflation has averaged 1.6% over the past 10 years. PCE inflation has averaged 1.45% over the past 10 years. From this we can infer that PCE inflation is now running about 0.15% below CPI inflation.
3. TIPS spreads are at about 2.1% for 5 and 10-year maturities. These reflect market expectations of CPI inflation, and imply something close to 1.95% inflation for the PCE (which is the index that the Fed targets at 2.0%.)
4. The consensus private sector forecast of inflation over the next few years in 1.9% for 2018, and 2.0% for subsequent years.
5. The unemployment rate of 4.1% is slightly below the Fed’s estimate of the natural rate, and forecast to decline further next year.
To summarize, the economy is close to achieving the Fed’s dual mandate of 2.0% PCE inflation and high employment, and is expected to continue to roughly achieve this mandate over the next few years. So what kind of expected future monetary policy has brought about these rosy forecasts? Right now, the financial markets are forecasting a number of rate hikes over the next few years. That means that contrary to the claim of Smith, the current condition of the economy does not imply that the Fed should be hesitant about raising interest rates, indeed just the opposite. Not doing so could be destabilizing.
Now it’s quite possible that I’m too pessimistic about the long run growth potential of the US economy (which I now estimate at 1.5%). But that doesn’t matter. The Fed does not and should not target RGDP. As long as the Fed hits its dual mandate, the growth rate of the economy will depend on the supply-side potential of the US economy. Monetary policy is not going to restrain real growth unless the Fed fails to hit its dual mandate (as in 2008-09, when inflation plunged and unemployment soared.) As long as inflation is near 2% and unemployment is below 5%, then the growth rate of the economy will not be held back by monetary policy. I can’t emphasize enough that monetary policy is not some sort of magic wand that can “solve problems”. The very best we can expect from monetary policy is to refrain from causing problems. I frequently disagree with the Austrian school on monetary policy, but this is one area where I agree. Monetary policy cannot solve problems; it can merely refrain from causing them. It is not something we should be experimenting with.
I was pleased to see the cover of the new Economist:
But my heart sank when I read the article:
In some ways today’s experiment looks more like the boom of the late 1990s (see Free Exchange). Alan Greenspan, then chairman of the Federal Reserve, kept monetary policy loose enough to push unemployment down to 3.8% by April 2000. Mr Greenspan had correctly anticipated that computerisation would increase the economy’s productive capacity and let some of the pressure out of the expansion. Inflation stayed comfortably below 2% even as wages soared. The boom eventually came to an end because a bubble in technology stocks popped–and, perhaps, because Mr Greenspan was less alert to recessionary signals than he had been to evidence of technological change.
Isn’t a more likely explanation that the Fed let the economy run too hot in 2000, and that this contributed to the subsequent recession? Business cycles are not just caused by contractionary mistakes (as some Keynesian accounts seem to imply) and they aren’t just caused by expansionary mistakes, (as some Austrian accounts seem to imply.) They are caused by unstable monetary policy—more expansionary that average in some years, and less expansionary that average in other years.
Let’s keep monetary policy exactly average, every single year. That’s the policy that will best allow us to see the potential growth rate of the economy.
PS. I’m not trying to tar all Keynesians and Austrians, just giving a sense of the tendencies I see on each side—the more extreme views of the hard core in each group. In contrast, Milton Friedman didn’t always get it right, but he did have a balanced set of criticisms of monetary policy—too easy at times, and too tight at other times.
HT: Caroline Baum