Questions that have no answer
By Scott Sumner
There are some questions that have no answers. One example is the question: “Was monetary policy too expansionary during the housing boom?” The only sensible answer is “it depends.” It’s not clear what the Fed was trying to do during this period. If we knew, we could evaluate whether the policy was too loose or too tight to achieve their policy goal.
Now that unemployment has fallen to 6.6%, it’s possible to begin to make sense of the past decade. Prior to 2008, the highest unemployment rate of the 21st century occurred in June 2003, when it reached 6.3%. Let’s examine what the US economy has done over the past 10 1/2 years:
1. NGDP has grown at almost exactly 4% per year since 2003:2.
2. The PCE price index (which the Fed targets at 2%) has grown at almost exactly 2% over the past 10 1/2 years.
Because we are currently at about the same position in the business cycle as in June 2003, I think it’s fair to say that the trend rate of RGDP growth has been about 1.9% over the past 10 years. I suspect the rate is slowing, from a bit over 1.9% prior to the crash to below 1.9% since 2008, mostly due to retiring boomers, but also the immigration crackdown.
What are we to make of the 2% inflation rate? One could argue the Fed has been successful. After all, 2% is their target. But I believe that’s wrong for 3 subtle reasons.
1. I don’t believe the Fed was targeting inflation at 2% between 2003 and 2008, or if they were they were extraordinarily incompetent. They certainly did not act like a central bank targeting inflation at 2%. Indeed the rate of inflation ran well above 2% between 2003 and 2007 and the Fed responded by cutting interest rates repeatedly in 2007.
[Update: Kevin Erdmann caught me reasoning from a price change. The rate cuts of late 2007 don’t mean the Fed was easing–monetary base growth slowed, for instance. A better argument is that money was too easy in 2005-07 if the Fed was serious about 2% inflation.]
2. One could argue that the rate cuts were justified by the Fed’s dual mandate. But the dual mandate makes the Fed’s performance look far worse than a simple 2% inflation target, single mandate. That’s because under the dual mandate the Fed should aim for above 2% inflation when the economy is depressed and below 2% inflation during booms. But the Fed did exactly the opposite. Inflation ran far over 2% during the housing boom and only 1.2% since July 2008, when the recession first got severe. Men have drowned in lakes that average 3 feet in depth, and economies have drowned in the midst of long periods where inflation averaged 2%.
3. The third problem with the Fed policy is that inflation is the wrong target, they should target NGDP growth, level targeting. It turns out that the NGDP growth rate that kept inflation right at 2% over the past 10 1/2 year was only 4%, well below the 5.4% rate of 1990-2007. And yet, at the very moment when they needed to downshift NGDP growth to 4% to keep inflation on target, the Fed upshifted to more than 6.5% NGDP growth during the housing boom of 2003-06.
The third mistake allows us to better understand the mild dispute between some market monetarists over whether Fed policy was too
tight loose in 2003-06. David Beckworth says yes, growth was above 5%. Marcus Nunes says no, there was some catch-up from the 2001 recession, and it’s level targeting that matters.
In my view there is no answer to this question. If the Fed had continued along the level target path that Marcus suggests, then he would have been right, the policy would have been fine. Given the Fed wanted 2% inflation, Beckworth’s advice would have been better in retrospect. If the Fed went even further and switched to 4% NGDP growth in 2003, then the recovery would have been agonizingly slow, John Kerry would have won Ohio and the Presidency in 2004, and there would have been no Great Recession of 2008. It would have looked like a bad Fed policy in retrospect because of the very slow recovery. The policy would have been condemned by many people, but it would have been far superior to the actual policy.
[Elsewhere I’ve argued that almost any alternative monetary policy in the interwar years would have been superior to what actually happened, but almost any alternative would have been condemned by economic historians for being “bad” (they never would have imagined just how bad “bad” can get.)]
Most people have trouble wrapping their heads around the notion that there is no answer to the question of whether monetary policy during 2003-06 was appropriate. It really does depend on what you assume their policy goals actually were. Policy was too easy for a 2% inflation target. However inflation targeting is bad, because sometimes it leads to NGDP shocks, and NGDP is what matters. So it made no sense to suddenly downshift from 5.4% to 4% NGDP growth. To be sure, 4% is a perfectly fine trend line, but if you want to go there then you get there slowly—6.0% in 2003, 5.5% in 2004, 5.0% in 2005, 4.5% in 2006, etc.
But that’s a minor issue. What is absolutely insane is to both downshift to 4%, and simultaneously make the inflation rate highly procyclical. That was the big mistake. Yes, there are a few madmen in America who occasionally talk of “opportunistic disinflation.” And yes, there are a few madmen in the eurozone who talk of “good deflation” restoring “competitiveness” to economies ravaged by plunging NGDP. But surely no serious economist like Mishkin, Bernanke, Yellen, Evans, Dudley, etc, would ever fall for that nonsense. No, this absurd policy played out accidentally, an almost prefect storm of bad luck and bad policy goals and bad models and inability to read the stance of monetary policy and driving the economy by looking in the review mirror. Here are just a few of the mistakes:
1. Targeting inflation rather than NGDP, combined with the bad luck that trend growth slowed to 2% after 2003.
2. Letting inflation run above target because it reflected rising commodity prices, and also because they misjudged the output gap (recall the Great Stagnation was underway, but not even Tyler Cowen knew it yet.)
3. Switching from targeting inflation up to 2008 (and missing on the upside) to effectively (unintentionally) targeting the price level after 2008–with a 2003 starting point. If Bernanke had announced in July 2008 that he was aiming for 1.2% inflation over the next 5 1/2 years Wall Street would have demanded his resignation. That was not the plan! But that’s what happened, and Bernanke even once mentioned that inflation had averaged about 2% under his watch (in reply to an inflation hawk—BTW it was actually 1.8%.) So after making the mistake of letting inflation run above 2% during the boom, they did a policy (by accident) that effectively moved prices back to the trend line from 2003 during a deep slump–the worst time to do disinflation.
4. In September 2008 they finally realized that inflation was a problem, just as the markets were suggesting the opposite–disinflation was the new problem. They refused to cut rates in the meeting after Lehman failed, and cited a fear of high inflation. On the same day the TIPS markets predicted 1.23% inflation over the next 5 years. Guess who was right.
5. In 2009 they realized they had a big AD shortfall problem, but refused to do the sort of level targeting that Bernanke had recommended for Japan. They could have started the clock when fed fund rates hit the zero bound (late 2008), and made up for the 2009 deflation. But they didn’t. Insiders say Bernanke was overruled by “FedBorg.” They relied too much on the zero rate policy, and QE. Not enough on setting a clear and bullish target path.
6. Only in late 2012 did things start to get back on track with the forward guidance policy. It successfully offset savage fiscal austerity in 2013, and 2014 should also see rapidly falling unemployment.
PS. Kevin Erdmann has a post showing that quits are almost back to June 2003 levels, and Timothy Taylor has a post showing the number of unemployed persons per job opening and also quits per layoff are both running a bit better than 2003 levels. So we are very likely at about the same place in the cycle as June 2003. That means 1.9% RGDP growth (and slowing) is the “new normal.”
BTW, Kevin’s post have some very interesting stuff on the Beveridge Curve, indeed all his recent posts are must reading for those interested in unemployment.
PPS. Mark Sadowski did a nice graph of the “Musical Chairs model” during the Great Depression. The malfunction during 1933 is partly due to FDR cutting hours worked by 20%, a policy that affected output much more than the unemployment rate. Just thinking out loud, could the joint hypothesis “sticky wages plus musical chairs model” be addressed by deflating predicted wages by NGDP, not actual wages by NGDP? Predicted wages for year t would be derived by assuming expected wage growth between year t-1 and year t was equal to actual wage growth between year t-2 and year t-1. (That is the sticky wage assumption.) That makes the model look a bit less like an identity, and makes it work better if wages are in fact sticky, than if they are not. I am fairly confident that this version would look almost equally good for the 2005-2013 period.