Does the recognition lag give the Fed an alibi for 2008?
By Scott Sumner
George Selgin has an excellent post, which looks back 10 years at key mistakes made by the Fed in 2008. He rightly emphasizes the excessive focus on inflation, as well as the unwise decision to begin paying interest on reserves in October 2008. He also alludes to the problem of the recognition lag:
Yet April 30th 2008 was no less critical a turning point in the recession’s history than these other dates, for it was then that the FOMC, having cut the Fed’s target interest rate to 2 percent, resolved to cut it no further — drawing a line in the sand by which it unwittingly helped seal the fate of the US, and world, economy.
At the time neither Fed officials nor anyone else knew that a recession had started, let alone that it was to be the worst recession since the 1930s. Not until December would the NBER’s Business Cycle Dating Committee officially decide that the economy had been shrinking for a year. Instead, having apparently calmed markets by helping to rescue Bear, Fed officials imagined that the worst was over. “When I look at where I was in the last [March] FOMC meeting,” Frederic Mishkin told his fellow FOMC members during that fateful late April gathering, “I sounded so depressed…as though I might take out a gun and blow my head off… . But my sunny, optimistic disposition is coming back…. . I think there is a very strong possibility that the worst is over.”
Despite the financial system’s shaky state, what several Fed officials most feared that April was, not a looming recession, but inflation. Between the fall of 2007 and the Fed’s April 30th meeting the CPI inflation rate had jumped from about 2 percent to twice that level. Thanks mainly to rising oil prices, it kept going up well into the summer, when it peaked at 5.5 percent.
George is right to focus on the Fed’s unwise decision to obsess about inflation, but I’d like to address an additional problem. Before doing so, consider a couple of commonly cited excuses for Fed behavior in 2008:
1. No one knew the economy was in recession at the time.
2. We were so deep into a severe downturn that even additional monetary stimulus would not have helped very much.
I see defenders of the Fed make both points, even though it’s hard to see how both can be true. But it is possible that the first defense applies to the early part of 2008, while the second applies to the last part of the year. Then a Fed defender might argue that the economy transitioned fairly quickly between the two situations, and that the Fed was somehow powerless to prevent the decline.
The mistake here is to treat the sharp decline in NGDP as an exogenous shock, whereas it was actually caused by tight money. So why don’t most economists understand this?
The main problem is that most economists focus on concrete steps, such as changes in the policy rate, or QE. But that’s not what caused the contractionary monetary shock of 2008. Rather the key problem was a lack of level targeting. The economy collapsed in late 2008 because the markets came to (correctly) realize that the Fed had no plan B, no policy of level targeting to promote recovery if spending did plunge much lower. Thus the most severe stage of the Great Recession was not primarily caused by mistaken concrete steps (although mistakes like IOR did play a role), but rather the failure to have an effective monetary regime in place.
If level targeting was needed in 2008, should we then try to overshoot the inflation target today in 2018, to make up for the past shortfall? This is a debatable point, but on balance I’d say no. The whole point of level targeting is to prevent output from falling by making policy more expansionary during a recession, via the expectations channel. If you do not have an explicit level targeting regime in place and then arbitrarily try to push up inflation 10 years later, when the economy is booming, you risk making monetary policy even more procyclical. It’s like closing the barn door after the horses have fled. The time to institute level targeting was 2008, not today. If we want to switch to a level targeting regime today, I’d suggest letting bygones be bygones and start the new trend line from here. We don’t need more demand stimulus right now.
Indeed there is a bit of evidence that the economy may already be beginning to overheat.