Monetary policy: Better to expect too much than too little
We simultaneously expect too much and too little of monetary policy. It’s better to expect too much.
A few months back I argued that it was mistake to use a falling unemployment rate as evidence that monetary policy has been too tight in recent years. Unemployment was also declining in the late 1960s and again in the late 1970s, and yet monetary policy was certainly not too tight. I do think policy has been a bit too tight in the past few years, but mostly because inflation has undershot the 2% target and more reliable indicators such as NGDP growth have also remained subdued.
Recent posts by Tyler Cowen and Alex Tabarrok make a similar argument. Here’s Tyler:
Slow labor market recovery does not have to mean the core fix is or was nominal in nature, even if the original negative shock was nominal:
A negative nominal shock was associated with a big rise in European unemployment in the 1970s and 1980s, but it turns out that part of the rise was structural, not fixable with monetary stimulus.
Alex adds the following:
The natural rate can change over time, even in a sustained direction, as the structural characteristics of the economy change, as demand, supply, demographics, information and so forth change. Change does not mean disequilibrium. When the production of apples is bigger this year than last year we don’t jump to the conclusion that last year the apple market was out of equilibrium. Similarly, the fact that unemployment was lower this year than last year does not mean that we weren’t at full employment last year.
All this is true. At the same time, I’m actually rather heartened to see so much scrutiny of recent Fed actions. Even if we now expect a bit too much from the Fed, that’s much better than back in 2008 when we expected almost nothing from the Fed, even as its policies were pushing NGDP sharply lower and needlessly pushing millions into unemployment. At the time, only a few of us were pointing to the disastrous Fed actions, such as paying interest on bank reserves, and also refusing to cut interest rates in May, June, July, August and September, errors that are now widely recognized by almost all well-informed observers.
As time goes by it becomes increasingly obvious that the US business cycle is largely monetary in nature, and that a monetary policy that stabilized 12 or 24-month forward NGDP expectations would dramatically moderate the business cycle. Interestingly, I see signs that the Fed itself is becoming increasingly aware of this fact, which bodes well for the future. Still, it’s too soon to declare victory, and the bloggers who obsess over every slight Fed mistake, er, I mean “misunderstanding“, are actually performing a valuable public service. They are helping to keep the Fed on its toes.
In 2008, the Fed ignored market warnings and we had a severe recession when the equilibrium interest rate plunged. In 2019, the Fed paid attention to market warnings and we had no recession when equilibrium interest rates plunged—even though many pundits predicted a recession, and even though we would have had a recession if the Fed had relied on its traditional “Phillips Curve” models.
In 2008, the Fed said nothing about making up any near-term shortfalls in aggregate demand. Today, Fed official frequently talk about the need to make up shortfalls in inflation with future above target inflation.
In 2008, Fed officials obsessed about above target inflation even as plunging NGDP growth was completely ignored. Today, many Fed officials talk about the value of NGDP as a policy indicator, and warn that inflation can be a misleading indicator.
I don’t know about you, but I call that progress. But then I’m someone who has always favored paying attention to market forecasts of aggregate demand, engaging in level targeting, and prioritizing NGDP over inflation.
PS. I expect a lot of the Fed. That’s why I’m on record predicting only one recession in the next 37 years.