"In retrospect, that decision was certainly a mistake"
By Scott Sumner
Prior to late 2008, I had gone 25 years without having a strong opinion on monetary policy. It seemed about right, even if on occasion I might have preferred something a bit easier or a bit tighter. Then it seemed to suddenly go completely off the rails. And this seemingly bizarre policy occurred well before the Fed hit the zero bound. From the outside, it almost seemed like the Fed had completely forgotten about monetary policy, forgotten that monetary policy was what steered the ship (of nominal GDP.)
I knew that Fed officials (such as Ben Bernanke) understood that monetary policy determined the path of prices and NGDP. Bernanke had admitted that an excessively tight money policy by the Fed caused the Great Depression, and that excessively easy money caused the Great Inflation. Now the Fed was causing a “Great Recession” with excessively tight money. This was obvious to me, and (I think) obvious to the markets. But apparently not to the Fed. Why?
At the time, I assumed that the Fed was distracted by the financial crisis. My PowerPoint presentations over the past 6 years were generally entitled “The Real Problem Was Nominal”, pushback against the widespread perception that the Great Recession was caused by real factors, such as financial turmoil. And even if I was wrong about financial turmoil, surely it was not in our interest to let NGDP fall at the sharpest rate since 1938. Any recession caused by financial turmoil would become far worse if NGDP also fell sharply. So why didn’t the Fed do more to boost NGDP, especially while interest rates were still positive? Why not do enough so that the Fed’s own internal forecast was for on-target growth in aggregate demand?
I’m a slow reader, so I’m only about 60% of the way through Bernanke’s memoir. But based on what I’ve read so far I believe that my initial assumption was correct. The Fed simply lost track of the need to focus like a laser on monetary policy. In fact, it wasn’t that hard for me to figure out the problem, because the Fed employs a representative sample of macroeconomists who are experts on monetary policy. And it also seemed obvious to me that macroeconomists outside the Fed had dropped the ball, so why should those inside the Fed have been any different?
Let’s back up a little bit. Although Bernanke is admirably polite, fair and even-handed, here and there his inner thoughts slip through:
Richard Fisher warned that too large a rate cut would be giving in to a “siren call” to “indulge rather than discipline risky financial behavior.” But, given the rising threat to the broader economy, most members, including myself, Don Kohn, Tim Geithner, Janet Yellen, and Mishkin, had lost patience with this argument. “As the central bank, we have a responsibility to help markets function normally and to promote economic stability broadly speaking,” I said. (p. 162)
Although Bernanke must’ve been exasperated by Fisher, “lost patience” is about as negative as he got (at least up to page 365). On page 170, Bernanke said:
However, in a concession to the hawks that I would later regret, I agreed to a shift in language that signaled we weren’t eager to cut rates again absent a change in the data.
In his press conferences, Bernanke came across as a moderate, the face of the institution. In the memoir, however, it’s clear that Bernanke was on the dovish side of debates within the Fed.
But not always. Bernanke also thought it important that the Fed present a fairly united front. in December 2007, Bernanke encouraged Mishkin to support a quarter point cut in the Fed funds rate, rather than the half-point cut Mishkin initially favored. In retrospect, that was mistake. But to his credit, Bernanke quickly realized that more stimulus was needed, and Fed (interest rate) policy was quite aggressive in early 2008. Bernanke saw the danger to the economy and pushed the Fed to cut rates quickly enough to stave off at sharp recession in early 2008. Instead the economy was flat in the first half of 2008, and by the spring and early summer it looked like the US might even be able to avoid a recession.
The big puzzle is the second half of 2008. As the economy and the financial system both deteriorated sharply in September and October, the Fed was actually less aggressive in easing monetary policy than they had been in late 2007 and early 2008, when both the economy and the financial system were much stronger. This is what puzzled me so much at the time, and still does.
Two days after Lehman Brothers failed, the FOMC decided to do absolutely nothing to ease monetary policy. This was probably the single most shocking Fed decision in recent decades. Naturally I was interested in learning what Bernanke thought about the meeting. Here’s what he said:
In retrospect, that decision was certainly a mistake.
Bernanke then points to the fact that the Fed had been so focused on dealing with the financial turmoil that they hadn’t really had much time to focus a lot on monetary policy. One has the odd impression that if they had faced the exact same macro data but without a financial crisis, they would have cut rates. This might be unfair; it’s probably more a question of the Fed assuming that the financial crisis was “the problem”, and that any slowing of the economy was merely a symptom of that crisis. In my view, the Fed had to a very large extent reversed causation. Tight money was reducing NGDP, which was worsening the banking crisis.
One Fed mistake does not make a Great Recession. In fact, monetary policy was far off course throughout all of late 2008. Bernanke later discusses the Fed’s efforts to get permission to pay interest on bank reserves. He indicates that without this power the Fed’s large base injections to save the banking system might have caused the Fed to “lose control of monetary policy.” I don’t think very many readers would understand that Bernanke was actually saying that without IOR, Fed policy would become more expansionary. “More expansionary” (in October 2008) doesn’t sound as scary as “lose control”. Then there was the decision by the Fed to cut rates by 1/2% on October 8, 2008, to 1.5%. But why not more? In January 2008 they had cut rates by 3/4% under far less dire circumstances. Indeed why not cut them to zero?
Bernanke was certainly aware that rate cuts could help, and that a stronger economy could also boost the asset markets:
I continued urging other major central banks to join us in a coordinated interest rate cut. I believed that the rate cuts themselves would support global economic growth and that the demonstration of unity would cheer the markets. (p. 346)
Yes, so why not do more, much more?
To summarize, at this point in the memoir I’m every bit as perplexed as before. In 2008, the profession as a whole seemed to suddenly stop believing that monetary policy drove NGDP growth. That shift in belief seemed to occur both within the Fed and among academic economists. That’s why I got into blogging. Unfortunately, Bernanke’s memoir doesn’t really shed any light on why macroeconomists suddenly stopped believing that monetary policy determines the growth in NGDP. Or why policy was so passive. I do, however, find consolation in Bernanke’s admission that the September decision was a mistake. If the Fed had been following market monetarist principles it certainly would have cut rates in September 2008. So at least in one very important meeting, market monetarism outperformed the standard monetary policy framework employed by the world’s major central banks.