(Insisting on) Targeting the Fed Funds rate can be bad for the economy´s health

(Note: This piece was written in April 2010. I decided to post it after reading this article linked to by Tyler Cowen:

The recent financial crisis and global recession have called into question conventional wisdom related to macroeconomic thought and stabilization policy. The Federal Reserve (Fed), tasked with a dual mandate to maintain price stability and full employment, seemed to be successful in its endeavors during the two decades preceding the crisis—a period referred to as the “Great Moderation” in which consumer price volatility and inflation were low and recessions mild and short-lived. However, beneath this calm surface economic imbalances were building up, both in the financial sector as well as the wider economy.

In 2007–2009 these imbalances surfaced, dragging the U.S. and global economy into the worst economic crisis since the Great Depression of the 1930s. With high unemployment and virtually every sector of the economy struggling, the Fed is facing some major challenges: What is the proper role of a central bank in the economy? What is the relationship between asset bubbles— such as bubbles in housing and housing-related securities—and monetary policy? What should the monetary authorities do to prevent such bubbles from getting out of hand?)

Why was there a “Great Moderation” – a situation of stable RGDP growth and falling (low) and stable inflation? Was it luck (smaller macroeconomic shocks)? Inventory (just in time) technology? Economic (monetary) policy?

Since inflation is a monetary phenomenon and one characteristic of the Great Moderation was an initially falling and later stable inflation (see figure 1), I´ll concentrate attention on monetary policy as the backbone of the Great Moderation. For completeness, figure 2 illustrates the dramatic fall (50%) in output growth volatility.

In “the change in monetary policy is responsible for the great moderation” hypothesis many, among them Taylor and Bernanke, have attributed this “feature” to the fact that monetary policy following the appointment of Paul Volker to the Fed is characterized by an increased responsiveness of monetary policy (interest rate targeting) to inflation. This means that from the perspective of a Taylor Rule, which relates the Fed Funds (FF) rate to the difference between inflation and its “target” and the “output gap”, the coefficient on inflation has increased and was set above 1 following Volker.

As always, in economics conclusions are not definitive. So it is that more recent research by Orphanides calls into question the shift in how monetary policy responds to inflation showing that, when using data available to policymakers in real time, monetary policy during the 1970´s was characterized by a rule that is consistent with the estimated rules for the period after Volker, i.e. the coefficient on inflation was also greater than one in the period of the “Great Inflation”.

An alternative view of the change in monetary policy from the Great Inflation to the Great Moderation is that there was a change in the “doctrine” of the Federal Reserve. According to Hetzel, during the period of the Great Inflation, the prevailing view, and the one embraced by Arthur Burns, Fed chairman from 1970 to 1977, was that inflation was a real (cost-push), and therefore non-monetary, phenomenon.

From that (Keynesian orthodoxy) perspective, the optimal combination of fiscal and monetary policy could deliver sustained real growth while “incomes policy” would be effective in containing inflation pressures that might arise! This view is clearly illustrated by Burns who argued as early as 1970 that “monetary and fiscal tools are inadequate for dealing sources of inflation such as are plaguing us now – that is, pressure on costs arising from excessive wage increases”.

Later, in different situations, he would alternatively blame, in addition to union power, oligopolists for keeping prices high and Arabs for jacking up the price of oil. Since each of these shocks could be viewed as real (cost-push) shocks, Burns denied any role for the Federal Reserve in generating inflation and repeatedly argued against a tighter monetary policy!

When placed in the dynamic Aggregate Supply (AS)/Aggregate Demand (AD) framework, this “cost-push view” as advocated by policymakers in the 1970´s suggests that the short-run AS (SAS) curve was perceived as horizontal when output is below potential.

The implication of this perceived characteristic of the SAS curve is that negative supply shocks would drive inflation higher and output lower. Given the horizontal shape of the SAS, monetary policy could successfully increase AD without generating additional inflationary pressures. On the contrary, as Arthur Burns argued following the 1973 oil shock, “a markedly more restrictive policy would have led to a still sharper rise in interest rates and risked a premature ending of the business expansion, without limiting to any significant degree this year’s upsurge in the price level”.

This “cost-push” view of inflation, together with an SAS perceived as horizontal when output is below potential, can explain the observed differences in the estimates of the parameter on inflation in the Taylor Rule during the Great Inflation and the Great Moderation.

Under the cost-push “doctrine” prevalent during the 1970´s, a forecast of inflation based on the short-run Phillips Curve (which negatively relates changes in inflation to the level of unemployment (the NAIRU – Non Accelerating Inflation Rate of Unemployment) or, positively relates changes in inflation to the output gap) would result in systematically under forecasts of inflation since after the negative supply shock output is below potential and unemployment above the NAIRU. The fact that inflation was systematically under forecast implies that estimates of the Federal Reserve reaction function as measured by the Taylor Rule using real time data that the Fed had a much stronger response to inflation than the response obtained using “final” data.

So, if during the Great Inflation the Fed did not under react to inflation, given real time data – the error coming from a flawed forecasting mechanism: The Phillips Curve – how come the Great Moderation emerged? In other words, how did Fed “doctrine” change and why was this new “doctrine” consistent with reduced volatility in both inflation and real output growth?

On becoming chairman of the Fed, Volker challenged the Keynesian orthodoxy which held that the high unemployment high inflation combination of the 1970´s demonstrated that inflation arose from cost-push and supply shocks – a situation dubbed “stagflation”.

Volker´s challenge placed inflation as the FOMC´s top priority. He also brought to the fore of policy discussions the ideas developed during the previous 12 years – since Friedman´s address to the 1967 AEA meetings – on the importance of inflation expectations and the question of credibility raised by Kydland and Prescott on the part of the monetary authority.

To Volker, the policy adopted by the FOMC “rests on a simple premise, documented by centuries of experience, that the inflation process is ultimately related to excessive growth in money and credit”.

This view, an overhaul of Fed doctrine, implicitly accepts that rising inflation is caused by “demand-pull” or excess aggregate demand.

Now, why is this new “doctrine” consistent with the observed increase in economic stability?

Given the cost-push “doctrine” on the inflation of the 1970´s, the Fed would compensate the fall in AS with an increase in AD, an expansionary monetary policy. This followed from the perceived flatness of the SAS curve below potential output. Since this was a flawed doctrine, over time we should observe trend growth in AD (or nominal expenditures).

Volker, on the other hand, believed that inflation was the result of excessive AD. So nothing more natural than to assume that the Fed should increase its responsiveness to the growth in nominal spending. How would this change in “doctrine” (from regarding inflation as a “cost-push” to “demand-pull” phenomenon) show up in the data?

Recall that under the cost-push “doctrine” the Fed would react vigorously to negative output gaps making policy expansionary, so nominal spending would grow. Under the new “doctrine” the Fed doesn´t react much to supply shocks since a negative supply shock, for example, would decrease real output an increase prices with little effect on nominal spending, but would react vigorously to AD or nominal spending shocks.

Therefore, under the new “doctrine”, policy would make AD growth stationary, in which case AD growth will not show a rising trend as under the cost-push “doctrine”. Figure 3 illustrates.

The main difference between the two “doctrines” is not the change in the Fed´s responsiveness to inflation as argued by Taylor and Bernanke, but the changed responsiveness to aggregate demand or nominal income growth. A collateral effect of the change in “doctrine” shows up in the reduction and stabilization of inflation and decreased volatility in real output, as shown in figures 1 and 2 above.

The Fed never explicitly targeted anything – inflation or nominal income (AD) growth – but implicitly you could say it targeted nominal AD along a 5.5% growth path growth after Volker.

Figure 4 shows that the Great Moderation (dated from the second quarter of 1984 – mid way through the “Volker Adjustment” – and early 2008) can best be characterized by nominal expenditure remaining very close to its trend growth path of about 5.5%.

Note that nominal demand growth is the sum of growth in prices ( P) – inflation – and growth in real output y. Given that the average growth rate of real output has hovered around 3.2% since 1960, from the start of the Great Moderation inflation has been on average a little above 2%.

Since long run real output growth is determined by real factors – productivity and labor force growth and the “institutional” backdrop –“targeting” nominal demand growth along a 5.5% growth path say, is equivalent to targeting inflation at close to 2%.

The “fit” in figure 4 is not perfect. Leaving aside for the moment the large decrease in nominal expenditure after mid 2008, noticeably between 1998 and 2006 there were substantial deviations of nominal expenditures around that growth path.

Figure 5 zooms on this period.

Figure 5 shows something interesting and counterintuitive. Many economists blame the Great Recession that began after mid 2008 on a credit boom instigated by the Fed in 2001 -2004. During that period the Fed is accused of keeping the FF rate too low for too long and that this misguided policy was responsible for the house price bubble and the associated excessive credit creation in the securitized (especially mortgage) markets.

On the other hand, a closer inspection of figure 5 indicates that during that period nominal spending was not only below the “target” path but also, for some time, growing at a rate that was slower than the “target” growth rate, in effect distancing itself from the “growth path”.

This shows that there is an important difference between “targeting a path” and “targeting a growth rate”. In the first case, if AD falls below the “target path”, the subsequent growth rate of AD has to be higher than that on the “target path” if AD is to return to it. In the case of a “growth target”, if AD growth falls below the “target growth” one only worries about bringing it back to the “growth target”. The fact that the new AD path will be below the original one (a permanent loss of income) is immaterial.

Figure 6 illustrates the conceptual differences and explains why those that believe that the Fed should target a “growth rate” for AD say that monetary policy was “easy” beginning in mid 2003. From that moment on the growth rate of AD was above “target” (5.5%). To those that believe that long run stability is predicated on keeping AD growing as close as possible to a “target growth path”, from the beginning of 2002, if anything, monetary policy was “tight” since AD was below the “target path”.

For 2002, for example, both groups would agree that monetary policy was “tight” while for 2001 their positions would be different, with the “target path” group saying that monetary policy was “being tightened” (since AD was about on “target” but AD growth was falling below the rate needed to keep it there) and the “growth target” group saying that monetary policy was too “tight” since AD growth was below the “target growth rate”.

Before we go on, let me bring interest rates (FF) into the picture. Over the years, the Taylor Rule has become the indicator through which market participants judge the “appropriateness” of monetary policy. From that perspective an FF rate persistently below the rate indicated by the “rule” is an indication that monetary policy is “easy” (loose, lax, expansionary), and vice-versa.

Figure 6A depicts the effective FF rate and the rate that would have transpired if the Fed targeted the FF rate according to the Taylor Rule (TR) for the 1998 – 2006 period.

From the Taylor Rule perspective, between 2001 and 2004 monetary policy (MP) was clearly too “easy”. This conclusion assumes that the difference between the effective FF rate and the “TR” rate is a good measure of the stance of MP.

Even if the goal of the Fed were to keep AD on a stable growth path and a decrease in interest rate is the method by which the Fed expands nominal expenditure, figure 6 shows that the decrease in the FF rate was “excessive”. But as figure 5 indicates it wasn´t. All the way to the end of 2004 AD was significantly below its “target path”. According to this view, even the “too low” target FF was “too high”!

But the Fed´s goal was never stated as “stabilize AD”. It has been to “keep inflation low” (with an implicit target of around 2% in the past 10 years). So what was happening to inflation during the “crucial” 2001 – 2004 period? Figure 7 shows.

Given it´s “inflation goal”, it is not surprising that the Fed went into “anti-deflation mode” in late 2002. By that time, the FF rate had been reduced from 6.5% in late 2000 to 1.5% and inflation was still trending down. The Fed was fearful of hitting the Zero Lower Bound (ZLB) for the interest rate.

On November 13 2002 Greenspan made the first move:

There is an implication that the notion (of fighting deflation risks) that we are restricted solely to overnight funds. But our history as an institution indicates that there have been innumerable occasions when we have moved out from short-term assets and invested in long term Treasuries. We do have the capability, if required to do so, to go well beyond activities related to short-term rates”.

This was followed by Bernanke´s famous “Deflation: making sure “it” doesn´t happen here” one week later. He asks:

“So what then might the Fed do if its target interest rate, the federal funds rate, fell to zero”? One answer: “One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period…” Another: “A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer maturity Treasury debt…”

Figure 8 shows the FF rate together with the 10 year Treasury for the period.

In the second half of 2002, the 10 year rate dropped significantly. Until then it had remained close to 5% despite the dramatic fall in the FF rate. But that is not surprising given the statements following the FOMC meetings: As an example:

 Aug 13 2002: “Nonetheless, the Committee recognizes that, for the foreseeable future, against the background of its long run goals of price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness”.

In the first half of 2003, they dropped further (daily data show the 10 year bond almost touching 3% in early June). In the May meeting of the FOMC, it became clear after decades, that the Fed had “won the war on inflation”. From the May statement it transpired that the Fed was afraid it had even “over-won” it.

May 6 2003: “Although the timing and extent of that improvement remain uncertain, the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal. In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future”.

So everyone remembered Greenspan´s and Bernanke´s musings of some months earlier and “rushed” into the long end of the curve.

But nothing happened. At the June meeting the Fed reduced the FF rate by only 25 basis points and didn´t mention the possibility of purchasing longer dated bonds. Long rates quickly shot back up. In the next FOMC meeting (August) the Fed decided to implement a version of one of Bernanke´s countermeasures brought up 10 months earlier in his “Deflation” speech.

August 12 2003: “The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period”.

Later, when the Fed began to increase the FF rate in mid 2004, it announced that the policy accommodation would be reduced at a pace that “was likely to be measured”. Before May 2004, to prepare for the gradual removal of policy accommodation that would soon begin the statements read: “the Committee believes that it can be patient in removing its policy accommodation”.

The lack of response of the 10 year bond to the “measured” removal of policy accommodation as seen in figure 8 became known as the “conundrum”, a popular explanation of which, first put forward by Bernanke in 2005, was a world-wide “savings glut” (related to the reserve accumulation of emerging market, especially Asian, countries).

In addition to the backdrop of a weak economy (remember the term “jobless recovery”?), there was more to the story behind the steep fall in long term rates in 2002. There were special circumstances related to the proliferation of accounting scandals (21 major scandals in 2002) that gripped the news following the Enron case in late 2001.

Coming on the heels of the terrorist attacks of 9/11/2001, these scandals likely augmented investors’ perceptions of the risk of holding stocks, and heightened financial market uncertainty. Stock prices and bond yields typically move in the same direction in periods of uncertainty and, as figure 9 shows, this was strongly evident in 2002.

The scandals and weak economic conditions also affected the corporate bond market, where spreads to government bonds widened (figure 10).

The low level of interest rates also contributed to prolonging the large-scale refinancing wave on the US mortgage-bond market that began in 2001. Towards the end of 2002, average interest rates for 30 and 15 year housing loans had reached their lowest level in several decades (figure 11). The increased conversion risk for mortgage bonds augmented demand for long-term government bonds, whereby long-term yields declined further.

More or less coincident with all this interest rate “action”, figure 12 shows that the ratio of mortgage debt to nominal GDP (the lion´s share of consumer debt) began a rising trend after which house prices rose a bit faster.

Figure 12 illustrates why many economists blame the Great Recession that began after mid 2008 on a credit boom instigated by the Fed in 2001 – 2004, when it kept the FF target rate “too low for too long”.

Maybe the problem resides with the fact that targeting the FF rate (usually interpreted as the “instrument” of MP) is not the best alternative, especially when inflation has been “conquered” (converged to “target”).

This conjecture is consistent with the recent proposal made by Olivier Blanchard, chief-economist of the IMF, that the inflation target should be higher (4%) so as to avoid the ZLB “problem” of using the interest rate as the MP “instrument”.

In her April 17 2010 speech at the Woodrow Wilson School at Princeton University, Christina Romer, head of the Council of Economic Advisors (CEA), paraphrasing former president Bill Clinton, defines the present unemployment and growth situation as “It´s aggregate demand, stupid!” One passage is particularly revealing:

The recent recession was obviously not caused by tight monetary policy. Interest rates were not especially high when it began, and so the Federal Reserve had only limited room to cut them. It has brought short-term rates down to virtually zero, but it cannot push them below that. The result is that we have not had the strong monetary stimulus that we would normally have in these economic circumstances. One study found that given the Federal Reserve’s usual responses to inflation and unemployment, economic conditions would lead it to cut its target for the federal funds rate by an additional 5 percentage points if it were able to do so. That is, despite the very low level of interest rates and all the attention to the growth of the Federal Reserve’s balance sheet, current monetary policy is in fact unusually tight given the condition of the economy

The combined result of the policies that we have taken, the inherent resiliency of the American economy, and the headwinds that we face, is that we are growing again, but not booming. GDP is rising at a solid pace, but not as quickly as after other severe recessions and not as quickly as it needs to. As a result, the unemployment rate remains painfully high and is not predicted to reach normal levels for an extended period.”

Christina Romer makes the common mistake of associating the stance of MP with the level of the FF rate and to say that MP is constrained by the ZLB. Given all the advice Bernanke has given Japan, both while an academic and as a Fed governor, he knows very well that the ZLB is no constraint to an expansive MP! And also, on several occasions he has tried to dispel the popular tendency to associate the stance of MP to the level of the FF rate.

Furthermore Christina Romer makes a logical error. In the first sentence of the first paragraph she says low interest rates indicate that MP was not tight in early 2008. In the last sentence of the same paragraph she says that despite the low interest rate, in effect almost zero, current MP is unusually tight! Just goes to show that the level of the FF rate is a misleading indicator of the stance of MP.

Christina Romer´s “error”, however, hints at a better indicator of the stance of monetary policy. In early 2003, nominal expenditure was close to 3% below the “target path” (see figure 4) and MP was said to be “easy” because interest rates were too “low”. In late 2009, nominal expenditure was 10% below the “target path” and although the FF rate was close to zero, MP is considered “tight”.

Since in both situations AD (nominal expenditure) is below the “target path”, it would seem that MP should be defined as “tight” on both occasions, irrespective of the degree of “tightness”. In that vein, the stance of MP would be better measured by the deviation of nominal expenditure from its “target level”. But for that to be operational, the Fed´s target needs to change from an (implicit) inflation target to an explicit target for the level (or path) of nominal expenditure.

If the deviation of nominal spending from its target level is positive, it suggests that MP has been overly expansionary. If this value is negative, it suggests that MP has been overly contractionary, regardless of the level of the nominal interest rate or the behavior of monetary aggregates (just like a “low” FF rate does not indicate that MP is easy, a “low” growth of M2, say, does not imply that MP is “tight”. In this latter example, velocity could be rising).

The problem in the US seems to center around the fact that the Fed has no explicit goal for MP. Rather it has the dual mandate to promote “full employment” and “low inflation”. Because of this, both the Fed and analysts tend to rely on the behavior of intermediate targets like the FF rate and monetary aggregates to gauge the stance of MP when, as many have pointed, these variables can be potentially misleading.

Nevertheless, why did the “consensus model” for MP (which sees the Fed setting an interest target for the FF) work relatively well between the mid 1980´s and 2007, a period during which  AD evolved close to the “target path” and inflation first fell and then remained low and stable?

Without going into the technical details, the “consensus model” (which in effect assumes a non-banking, non-monetary system) works well under “normal” circumstances, defined as periods in which risk premia are relatively low and steady and defaults are low. In those circumstances, which characterize the 1984 – 2007 period, the main driving force affecting financial conditions is the expected change in the target for the FF rate, determined by the application of Taylor-like Rules and expectations of future developments in inflation and the output gap.

But even under those “normal” circumstances it doesn´t work well when inflation has been “conquered” (is low and stable) because the target interest rate cannot fall below zero if circumstances become “abnormal” like in 2008. This makes things harder (and more distortive) by giving the impression that MP has become powerless and so fiscal policy (FP) has to work “double shift”.

In any case, targeting the FF rate is of doubtful utility when the goal is to keep nominal expenditure on a stable growth path. Why? Because if nominal expenditures has been growing too slowly for some time (or even falling like it did recently), and AD is substantially below its “target path” (like it was in 2003 and even more so at present), having the Fed commit to  falling, low or even “zero” short term rates is almost certainly not an appropriate approach.

The depressed level of AD reduces credit demand at any given nominal rate so that the equilibrium level of short term interest rates can easily be quite low due to the destructive effects of the drop in nominal expenditures.

However, if instead of committing to keeping the FF rate at “zero” for a long period of time, the Fed committed to change the quantity of money as much as necessary to get nominal expenditure back on target, rising credit demand could result in increases in nominal interest rates.

As the quote from Bernanke´s 2002 speech on “Deflation, making sure “it” doesn´t happen here” indicates, the result above is the exact opposite. For Bernanke, committing to “low” policy rates for a “long time” or “targeting” long rates, is all about keeping long rates low.

This means that if the Fed targets AD, so that there is an expectation that nominal expenditure will tend to return to its target path over a short horizon, the direct effect of Fed purchases of longer dated bonds, which will tend to reduce their yields, could very well be more than offset by sales from the private sector, leading to lower prices and higher yields.

This is likely to be true if nominal expenditure is expected to quickly return to normal, in which case, the destructive effects of falling or low nominal expenditures following a shock will not take hold.

Looking back at the 2002 – 2004 episode of “too low” rates, I surmise that the Fed was certainly not committed to a target for the path of nominal expenditure because if it were, it is not at all clear that rates would have remained so low. Conversely, if the Fed had not been so deeply committed to interest rate targeting, it is not obvious that an expansionary MP would imply lower nominal interest rates.

In a nutshell, as a direct application of the Lucas critique, which in this case refers to the fact that the statistical relation between interest rates and inflation will not be invariant to the policy regime, if the monetary regime had been different, monetary policy could have been looser and the FF rate could have been higher.

Still considering the 2002 – 2004 period, I have showed that nominal expenditure was too low. But this does not necessarily imply that interest rates were not “too low”. As observed, they were the result of the MP regime in place and it is certainly possible that those “too low” rates were one of the many factors contributing to the house price “bubble”, the bursting of which, and the attendant consequences for the losses of financial firms that had lent into that bubble, were the key trigger for the meltdown in nominal expenditure in the second half of 2008.

The jump in risk premia and in defaults, as observed above, are two important factors that make the continued use of the “consensus model” inappropriate. So, maintaining the policy approach and promising to keep the short term interest rate low for an extended period of time, not only is not getting nominal expenditure back to its trend path, it might also be responsible for future speculative bubbles. More immediately, since “it´s aggregate demand, stupid!”, all sorts of second or third best policies are proposed to help out the with the dire employment situation.

Again, instead of treating the symptom of the problem through distortive third or fourth best policies, why not go straight for the “jugular” and commit to getting nominal expenditure back on its growth path?

Figure 13 indicates that employment will not come back until AD growth is high enough to indicate that the economy is on its way back to the growth path. From this perspective the moniker “jobless recovery” or even “job loss recovery” is the direct result of AD remaining below the “growth path” due to inadequate AD growth.

One question that cries to be answered is: why did Bernanke, who has shown through his academic and policy maker experience (notably through the history of his advice to Japan) that he is well aware of the problems associated with a slump in AD, presided over this debacle?

My attempt at an answer builds on the fact that Bernanke is an “inflation targeter”. In January 2000, long before being appointed Fed Governor, in an op-ed piece on the WSJ titled:  “What happens when Greenspan is gone”, Bernanke had this to say:

As our research on the use of this approach around the world documents, successful inflation targeting requires that the central bank and elected officials make a public commitment to an explicit numerical target level for inflation (usually around 2%), to be achieved over a specified horizon (usually two years)”.

Unfortunately, especially in situations where inflation has been “conquered”, inflation targeting – in particular that of the “informal” variety, since “doubts about intentions” are pervasive – has a serious shortcoming; that being the policymakers concentration on inflation/disinflation/deflation, with nothing being said about the corresponding movement in nominal expenditure (AD or Nominal GDP). According to Scott Sumner: “this language failure is mirrored by an analytical failure; when economists discuss Fed policy and nominal shocks they speak in terms of inflation and deflation, not rising and falling nominal GDP”.

The “analytical failure” came about in late 2007 and the first half of 2008. As figures 14 and 15 show, at the end of 2007 headline inflation was rising towards 5% but AD which had been navigating close, but below the growth path, was growing close to the trend rate (5.5%). Core inflation was pretty much stable and contained.

Apparently Bernanke and the FOMC were focused on the headline CPI and surmised, at the beginning of 2008, that its rise reflected a positive nominal shock. However, based on AD growth it was a negative nominal shock as AD began to grow below the “normal” rate and was, therefore, distancing itself from the “growth path”.

The sequence of FOMC statements in 2008 (with the relevant portions transcribed below) was arguably one of the most misguided (and confusing) in the modern history of the Fed. Given that these statements are closely parsed, it was a disaster waiting to happen; since from the language and hierarchy of “Fed worries” it was quite likely that the Fed would soon “tighten”.

Although at almost every meeting the economy is viewed as either weakening or weak – being pushed down from all sides: consumer spending, labor market, financial market stress, tightening credit conditions, oil prices and housing contraction – the FOMC´s attention is obtusely focused on the risk of rising inflation. The exception is the June statement which considers that “overall economic activity continues to expand(!)” indicating that maybe an “alcohol heavy cocktail party preceded the meeting”.  At the end of that meeting, Richard Fischer of the Dallas Fed was quick to react and voted for a rate increase! Rising inflation and expanding activity? Good Lord, AD must be “overflowing”.

In most of the statements there were dissents, all in the “tightening” direction and this continues to happen as late as the August meeting.

 March 18 2008 (FF rate reduced to 2.25%): 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. (Voting against were Richard W. Fisher and Charles I. Plosser, who preferred less aggressive action at this meeting).

April 30 2008 (FF rate reduced to 2%): Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. 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 remains high. It will be necessary to continue to monitor inflation developments carefully. (Voting against were Richard W. Fisher and Charles I. Plosser, who preferred no change at this meeting).

June 25 2008 (FF rate kept at 2%): Recent information indicates that overall economic activity continues to expand, partly reflecting some firming in household spending.  However, labor markets have softened further and financial markets remain under considerable stress.  Tight credit conditions, the ongoing housing contraction, and the rise in energy prices are likely to weigh on economic growth over the next few quarters.

The Committee expects inflation to moderate later this year and next year.  However, in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high. (Richard W. Fisher voted for a rise).

August 5 2008 (FF kept at 2%): Economic activity expanded in the second quarter, partly reflecting growth in consumer spending and exports. However, labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and elevated energy prices are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

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. (Richard W. Fisher voted for a rise).

September 16 2008 (FF kept at 2%): Strains in financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending. Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

But note that figure 16 indicates that at the time of that meeting medium term (5 years) expected inflation was about to fall below “target”.

Further note that the September meeting was just 48 hours after the Lehman collapse and a few hours after the release of the industrial production figure for August, which showed a 1% drop MoM.

By not “looking”, let alone targeting AD, FOMC members confused a negative supply shock from rising oil and commodity prices, which would not require “tightening” measures if the goal were to maintain AD on its target growth path, with an increase in AD! And the FOMC decisions and statements were taken in the context of an extremely hostile environment for nominal spending, an inexcusable mistake that proved very costly.

Interestingly, in 2004 – 2005 the US had experienced a supply shock from oil prices which was of an intensity comparable to the one that buffeted the economy in 2007 – 2008.  Figure 17 illustrates. But at that time, nominal expenditure remained close to the “target path”. Since the behavior of the different classifications of inflation was also comparable, the FOMC must have reasoned differently.

The statement from the August 25 2005 meeting chaired by Greenspan, at the peak of the oil shock, is illustrative:

“The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Aggregate spending, despite high energy prices, appears to have strengthened since late winter, and labor market conditions continue to improve gradually. Core inflation has been relatively low in recent months and longer-term inflation expectations remain well contained, but pressures on inflation have stayed elevated.

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. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured”.

Yes, Greenspan mentions aggregate spending. Yes, Greenspan mentions productivity. Yes, Greenspan  is focused not on headline but on core, or underlying, inflation, all things that are not touched upon by Bernanke. Finally, Greenspan speaks about “appropriate” MP action – whatever that may be!

The “message”. Look, guys, don´t fret, we are on top of things!

Would Greenspan have recognized the negative impact on AD from the financial crisis? How would the open-ended “appropriate MP action” have been interpreted? Although the negative impact on AD of financial crisis is Bernanke´s specialty, he certainly didn´t!

João Marcus Marinho Nunes – April 21, 2010

Update This article argues that MP (low rates) was the culprit.

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