How the interest rate increase of 2015 caused the Great Recession
By Scott Sumner
Evan Soltas has an excellent new post explaining why the Fed is likely to raise interest rates in late 2015. He thinks this policy is appropriate, but I’d like to focus on a different issue—whether this rate increase caused the Great Recession of 2008-09.
At first glance my hypothesis seems absurd for many reasons, primarily because effect is not suppose to precede cause. So let me change the wording slightly, and suggest that expectations of this 2015 rate increase caused the Great Recession. Still seems like a long shot, but it’s actually far more plausible than you imagine (and indeed is consistent with mainstream macro theory.) I’ll build up my argument in several steps:
1. When I first got into blogging I suggested the Fed was to blame for the biggest fall in NGDP since the 1930s. Some countered this argument with the claim that the Fed was powerless when interest rates were stuck at zero. Later we found out that that was not true. At the time I argued that my interpretation would be proven correct when the Fed finally exited the zero rate trap. I said that at that point everyone would agree that the Fed had the nominal economy where it wanted it. Even Keynesians would have to agree that if the Fed was raising rates we did not suffer from low NGDP because of a liquidity trap, but rather because that’s where the Fed wanted the economy to be. Let’s look at NGDP since 2000:
NGDP had been rising at just over 5% for several decades, when it suddenly declined 4% between mid-2008 and mid-2009, which is 9% below trend. That was the cause of the Great Recession, not the financial crisis.
[People reject this argument for two reasons. First, they correctly note that a financial crisis is a supply shock. And second, they argue the financial crisis caused the fall in NGDP, and there is nothing the Fed could do about it. Over time these arguments have lost force, especially with the eurozone’s double dip recession caused by plunging NGDP growth. And unemployment remaining high when the banking crisis was over. But for anyone who had studied macro policy in 1933 these arguments never had much force. A banking crisis doesn’t prevent the Fed from sharply boosting either nominal or real GDP.]
In 2009 the economy was deep in recession. The Fed could have and should have tried to return to the original trend line (or at least part way back.) Of course if they had that sort of policy regime in mind, then we probably would not have had a severe recession in the first place. Asset prices crashed in late 2008 precisely because they did not expected NGDP to return to the original trend line. If they had expected a bounce back, then the fall in NGDP growth would have been much milder—more like Australia.
2. Now let’s suppose we accept modern new Keynesian economics, or market monetarism. The current path of aggregate demand (NGDP) is strongly influenced by the expected future path of AD. And let’s assume that the market correctly anticipated that the Fed would eventually exit the zero bound under circumstances similar to those described by Evan Soltas. It seems likely that NGDP growth between now and late 2015 won’t diverge much from the 4% to 4.5% growth experienced ever since mid-2009. Under that scenario, what would the “equilibrium” path of the economy have been back in 2009? Unless I’m mistaken, it’s hard to conceive of any macro model where the expected path from the trough in mid-2009 to the level of NGDP in late 2015 is anything very far from a straight line. In other words, “connect the dots.” The low of 2009 is one dot. The expected position of NGDP when they exit in 2015 is another dot. I’ll wager that when we get there the actual path of NGDP will be quite close to a straight line (not exact of course.)
The Fed’s decision to tighten in 2015 is essentially equivalent to the Fed saying to the public “all things considered we think a 4% to 4.5% NGDP growth rate is about right for the period of 2009-2016, and probably beyond.” Which is fine if that’s the way they want it. But in that case there was never any chance of the US having a fast recovery, like the 11% annual NGDP growth rate we observed in the first 6 quarters of the Reagan recovery (1983-84). The Fed literally made it impossible. The slow recovery was baked in the cake once the Fed indicated there would be no “make-up” for the undershooting of NGDP in 2008-09.
This confuses people, because they correctly believe that the Fed in general, and Ben Bernanke in particular, really would have liked to see faster NGDP growth after 2009. I agree with this perception; I believe that Bernanke and many others at the Fed (not all) sincerely wished for faster nominal growth. But they weren’t willing to do the forward guidance necessary to make that happen. That would have been a guidance that suggested some “make-up” of the NGDP shortfall, not starting a new trend line on a lower level. That make-up might have led to some above target inflation (albeit less than most people assume.) But the Fed wasn’t willing to take that step. And that made the very slow recovery inevitable.
Now back up one step, by late 2008 the markets had a growing realization that the Fed wasn’t willing (or able?) to do much about the path of NGDP. This caused asset prices to crash, and turned a mild recession into a steep recession. If the Fed had announced level targeting of NGDP along even a 4% trend line in mid-2008, the recession would have been far milder. Indeed we would have already exited the zero rate boundary by now, probably by 2012.
For those unable to understand my argument, the following exchange rate analogy might be helpful. Suppose there is an exchange rate crisis, such as the UK pound crisis of 1931 or 1967 or 1992. There is a debate over whether the markets forced a devaluation, or correctly anticipated a devaluation that the government wanted in any case. How do we know who is right? Suppose that several years later when the crisis is over the government does not try to push the exchange rate back up to the original level. They put macroeconomic factors like employment ahead of exchange rates, even when the crisis is over and the speculators are no longer pressuring the currency. In that case it’s pretty clear that the government wants a devalued currency, or at least they aren’t willing to accept the deflation necessary to prevent it. The speculators who “forced” Britain to devalue, actually merely predicted what the government was going to do in any case. We can retrospectively understand these exchange rate crises much better than we do in real time, when the sturm and drang of crisis causes emotional reactions. “It’s all George Soros’s fault!!”
Perhaps the Fed didn’t want the slow growth of NGDP, but they weren’t willing to accept the inflation that level targeting of NGDP might have required. (This is of course Paul Krugman’s argument–where I differ is that I see no expectations trap, just a conservative central bank.) The 2008 asset price crash was not a “exogenous shock” that the Fed had to valiantly fight against, but rather a correct prediction of the excessively contractionary monetary policy that was on the way. We didn’t see that with all the turmoil of the 2008 crisis, but by 2015 it will be abundantly clear that this is the NGDP that the Fed wants, or more precisely is willing to accept. And if they (will) want that NGDP in 2015, then they must also accept the very low NGDP of 2009 as an inevitable consequence. Michael Woodford has a wonderful phrase–seeing macroeconomics from a “timeless perspective.”
PS. This post might seem critical of Evan Soltas’s suggestion that the Fed should raise rates in late 2015 (if things progress as expected.) However that’s not quite what I’m saying. By now the horses have left the barn. Because this post has run on too long already, I’ll deal with his argument over at TheMoneyIllusion.
PPS. Notice my claim that with a better (more expansionary) policy, interest rates would have risen by 2012. That’s why rates are not a good way of describing the stance of monetary policy. Rather you need to look at the path of NGDP. At best an unexpected move in rates can provide insight into where the central bank wishes to see NGDP move. So the title of this post should actually read something like “The Fed being “OK” with NGDP in late 2015 caused the deep slump in 2009.” But I must live in a world where everyone thinks in terms of interest rates.