“Appropriate Monetary Policy”

My only point of disagreement with David Beckworth is his insistent claim (here and the links within) that MP during 2002-04 was greatly responsible for the onset of the crisis. I also think, as I argued in another post that for thinking that way he is strongly influenced by his reliance on a measure of dollar spending that appears to be unreliable. Early today I encountered this Vox column concluding:

[These] results are in line with Bernanke’s (2010) testimony. They suggest that the deviations from the Taylor rule between 2002 and 2006 reduced the risk of deflation and high unemployment materially, and were thereby consistent with the pursuit of the dual mandate.

In his counterfactual he finds that:

In 2003:Q4 and 2004:Q1 the probability of inflation exceeding 1% would have been close to zero. In addition, the probability of unemployment greater than 8% in 2004:Q2 would have been over 90%.

I find this quite consistent with the view on “instability” provided by the figure below that contemplates FSDP as the measure of dollar spending (although the exact same result would be obtained using NGDP as the relevant measure of aggregate spending). During 2003-04, aggregate spending rose toward the trend level from which it had dipped in 2001-02, so MP was “appropriate” during that time.

John Taylor doesn´t agree at all. Here is his recent op-ed in the WSJ, subtly exhorting his “Rule”, and here is a piece from his post, where he links to a piece by Amity Shlaes that concludes:

Soon after Hu heads back to China, Congress will be writing new Fed law. Some legislators want to follow the advice of Dallas Fed President Richard Fisher and change the statute governing the Fed to narrow its discretion and restrict its job to controlling inflation. Such a law might speed up the Taylor cycle in a fashion welcome to anyone investing in the U.S.

My view is that “Taylor Rules” should be “outlawed” even more so if the Fed´s mandate is restricted to controlling inflation. I much prefer Greenspan´s coinage of the term “appropriate monetary policy” which he used in all FOMC meetings between March and November 2005. Maybe an operational content could be given to that “lovely” expression, such as “keep aggregate spending growth stable along a level path”. This, in fact, is essentially what he (mostly) did (quite unconsciously) during his 19 year tenure.

So how come Bernanke lost this “fantastic inheritance” in two short years? In his last two FOMC meetings, December 2005 and January 2006, Greenspan dropped the expression “appropriate monetary policy” from the Statement. In its place he included the expression “The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance”. It didn´t make much sense to me at the time because in all those previous meetings where he used “The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal”, interest rates had been increased by 25 basis points, and they kept being increased at the same rate in the December 2005 and January 2006, continuing to increase under Bernanke´s leadership in March, April and June 2006. The only reasonable explanation I come up with for this wording change is that Greenspan didn´t want to “tie Bernanke´s hand” over a “concept” that was his own!

What did Bernanke do in 2006-07 and into August 2008? He kept pouncing on the inflation risks, even while acknowledging the negative impact on growth from the fall in house prices and the worsening of credit conditions. Here´s a sample from FOMC Statements in 2007-08:

Bernanke (Oct 07): Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation.  In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully

Bernanke (Dec 07): Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks.  Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time.

Readings on core inflation have improved modestly this year, but elevated energy and commodity prices, among other factors, may put upward pressure on inflation.  In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully

Bernanke(Mar 08): Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened.  Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.

Inflation has been elevated, and some indicators of inflation expectations have risen.  The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization.  Still, uncertainty about the inflation outlook has increased.  It will be necessary to continue to monitor inflation developments carefully.

Bernanke (June 08) The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time.  Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased.  The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Bernanke (Aug 08): Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

So let’s take a look at the inflation and spending growth landscape from 2005 onwards. This is what was on the screen:

In words: His inflation phobia has to come from the fact that he was paying close attention to the headline numbers and there is no evidence that “some indicators of inflation expectations have risen” (March 08). Oil prices doubled over early 2007 and mid 2008 and that is reflected in the headline inflation numbers. But from late 2003 to mid 2005, oil prices also doubled! So what? The last two figures show why everything went “haywire”. Beginning in late 2007 (the official start of the 2007-09 recession) spending dropped a little below trend. But Bernanke was content with that because it “eased pressures on resource utilization”! His hammering on the “inflation dangers” over the next months certainly affected people´s expectations on the future growth of nominal spending, and was likely the main factor behind the continued drop in AD in the second half of 2008 and into 2009.

Bernanke was acting according to the precepts of “Taylor Rules”, looking at inflation and pressure on resources (his June 2008 Statement underlined above is consistent with this view). The consequences, as we know, were tragic! Much better if he had followed on Greenspan´s footpath and (consciously) tried to keep AD stable. For that he would need to compensate the drop in velocity with an increase in money supply. He didn´t because for him MP was “easy” since interest rates had been lowered to 2%!

After all that loss, the economy faces an uphill battle to regain what could be termed a “new adequate trend level path” Scott Sumner writes that there are some optimists out there (me included). Hope that comes to pass.

Update: Macroblog (David Altig) came out today with a critique of Taylor´s WSJ opéd mentioned above. His conclusion:

The theme that runs through many a critique of current and past Fed decisions arises from the assertion repeated in this most recent Taylor piece that “decisions to hold interest rates very low in 2003–2005… may have caused a bubble and led to the high unemployment today.” The evidence presented to date on this count is, in my opinion, tenuous at best.

Update: John Taylor is stomping his Rule promoting tour:

Following the financial crisis, it is understandable that central bankers want better advice from economists and their economic theories, as Mojmir Hampl of the Czech central bank writes this week in the European Opinion section of the Wall Street Journal. But Princeton economist and recent president of the American Economic Association put it best when he said “economic theory came out of this better than policy practice did.”

The lesson for central bankers from the financial crisis is straightforward: do not deviate from policies like the ones that worked well during much of the 1980s and 1990s. It was such a deviation–in the form of low interest rates compared with what good existing policy practice suggested–that was behind the excessive risk taking and housing booms in many countries as OECD research has shown.

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3 thoughts on ““Appropriate Monetary Policy”

  1. Outro ótimo post!

    Eu teria uma dúvida e uma pergunta:

    A dúvida: você conhece bibliografia mais teórica sobre a “transmissão” do NGDP para o RGDP de que fala Summer no poste citado: “The transmission mechanism is asset prices.”

    A pergunta: o que você acha de propostas segundo as quais os BCs, além de inflação e produto/desemprego, devem olhar para os mercados financeiros?

    Por exemplo, no período problemático 2002-4, os ativos financeiros seguiam sua escalada, apesar do período de baixa da economia “real”. Isso impediu que o Fed jogasse água no chope financeiro. Acha que esse é um problema mais de regulação do que de PM?

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