Was monetary policy easy in 2003-2004? Not according to Robert Hetzel

I read a draft of Robert Hetzel´s new book – The Great Recession: Failure of Markets or Policy about 8 or 9 months ago. The deal was that I could not quote from it until it became public. That´s now happened. And it´s interesting that John Taylor was the first to announce it and quote from it. David Beckworth did a post and so did Scott Sumner.

Chapter 11 of the book asks: Easy Money in 2003-2004: What Is the Evidence? And it´s from that chapter that Taylor quotes. In my view, Taylor “twists” Hetzel´s arguments in his favor:

In his book, Hetzel suggests that using a LAW rule with a given price stability goal does not indicate that policy was too easy in 2003-2004. However, as he argues on page 197 of the book, the Fed seemed to have relaxed its price stability goal at this time, so in this sense policy may have actually been too easy, and in fact inflation did rise. Hetzel was working at the Fed and thus speaks with considerable personal knowledge. Here is how he puts it:

“In 2003-2004, the Greenspan FOMC did make a decision that would later have enormous implications. At this time, the FOMC backed off its long-run objective of returning to price stability and instead adopted an ill-defined objective of positive inflation, perhaps best characterized as 2 percent plus…. Starting in spring 2004, both core and headline PCE inflation moved persistently above 2 percent…. By summer 2008, that overshoot caused the FOMC to allow a growing negative output gap to persist by holding the funds rate unchanged at 2 percent. If the FOMC had maintained its target for price stability….the sustained inflation shock that began in summer 2004 with increases in energy prices would have yielded lower headline inflation. The FOMC in summer 2008 might have then felt comfortable allowing the inflation shock to pass through the price level while aggressively using monetary policy to deal with the worsening inflation.”

So with this interpretation, there is a clear connection between the too easy period and the too tight period, much like the connection between the “go” and the “stop” in “go-stop” monetary policy, which those who warn about too much discretion are concerned with. I have emphasized the “too low for too long” period in my writing because of its “enormous implications” (to use Hetzel’s description) for the crisis and the recession which followed. Now this does not mean that people are incorrect to say that the Fed should have cut interest rates sooner in 2008. It simply says that the Fed’s actions in 2003-2005 should be considered as a possible part of the problem along with the failure to move more quickly in 2008.

I think I have a better interpretation of what Hetzel meant. Remember that was the time that Ben (IT) Bernanke was a Fed Governor and had recently written the famous “Deflation, making sure “it” doesn´t happen here”. When saying “an ill-defined objective of 2% plus inflation”, Hetzel could be saying that the “inflation target” was not precise, and/or that IT is not a good proposition.

Taylor´s interpretation, I believe, is “made up” by him to make his “Taylor Rule “look good”.

But in the section of the chapter “The Taylor Rule as a Guide to Policy in the post-2202 period”, Hetzel writes: “Taylor rules provide no uniform message about the appropriateness of monetary policy in the post-2002 period.”

Let´s read more from Hetzel (my bolds) Note: LAW=”Lean Against the Wind”:

II. Easy Money in 2003-2004: What Is the Evidence?

“After June 25, 2003, when the FOMC lowered the funds rate to 1%, was monetary policy unduly easy? Proponents of the credit-cycle view, who reply affirmatively, point to an increase in house prices. However, as shown in Figure 10.2, the sustained increase in house prices began much earlier, namely, after 1997. The more plausible source of this sustained increase was government policy to increase the home ownership rate (Figure 10.1).

Leaving aside the housing sector, a review of macroeconomic variables reveals no evidence that monetary policy was expansionary during recovery from the 2000-2001 recession. Economic recovery was not strong by post-war standards. For the two-year period following the cyclical trough in 2001Q4, the cumulative growth rate of real GDP was 7.1% (almost equal to the cumulative growth rate of 7% after the 1991Q1 cyclical trough). This figure is half of the 14.5% number that characterized economic recoveries in the 1949-1982 period (omitting the 1980 expansion, which was shorter than two years). For this two-year period, payroll employment fell by .9%. The 1% level of the funds rate reached in June 2003, therefore, does not appear inappropriately low.

In coming out of the 2000-2001 recession, the Greenspan FOMC followed LAW procedures by initiating increases in the funds rate starting in June 2004 following evidence of sustained economic recovery in the form of sustained reductions in the unemployment rate (Hetzel 2008b, Ch. 20). The real, short-term interest rate increased steadily beginning in mid-2004 (Figure 11.1). Most important, inflation of about 2% measured by the core PCE deflator remained close to the FOMC’s implicit inflation target (Hetzel 2008b, Ch. 20). The inflation numbers are impossible to reconcile with the assumption of an expansionary and ultimately inflationary monetary policy.

A focus on the short-term real interest rate also ignores the behavior of the term structure of interest rates that emerged given the credibility of the Greenspan Fed. In 2003-2004, financial markets realized that the funds rate was unsustainably low and long-term rates presaged the normalization of the term structure. Over the entire period, long-term rates (real and nominal) exhibited considerable stability and that stability was consistent with the actual moderate  economic recovery, not an unsustainably rapid recovery consistent with overly stimulative monetary policy.

From 2004 to 2006, the 10-year Treasury bond rate averaged about 4¼%. From 2006-2007, it averaged about 4¾ percent. This increase of ½ a percentage point is hardly an indication of the inflation scare that would have accompanied an inflationary monetary policy. Consider the recoveries from the two recessions prior to the 2008-2009 recession. Both exhibited a sustained interval of near zero short-term real interest rates (Figure 11.2). Both of these recoveries were times of significant pessimism about the future. In the first half of the 1990s, the feeling developed that low productivity growth would for the first time in history leave the younger generation worse off than the older one. As with the recovery from the 2001 recession, the recovery became known as the jobless recovery because of the slow growth in employment. Extreme pessimism also characterized the period after 2002 (Hetzel 2008b, Ch. 20). A huge loss in wealth accompanied the decline in the stock market in 2000 and 2001; geopolitical uncertainty centered on the Middle East rattled investors; and the governance scandals of companies like WorldCom and Enron made investors wary of investing in the stock market.

In addition, productivity growth soared in this latter period. If individuals extrapolate high productivity growth to the future and as a result anticipate being relatively better off in the future, they will attempt to smooth consumption by consuming more at present. The real interest rate must be higher to keep aggregate demand in line with potential output. In contrast, if individuals associate high productivity growth with the transitory substitution by firms of higher productivity for increased employment, uncertainty about future employment may exacerbate pessimism and require a lower real interest rate.

According to the LAW-with-credibility rule, the FOMC should begin to raise short-term interest rates when rates of resource utilization begin to increase in a sustained way. In the last two recessions, the FOMC used unemployment as the gauge of resource utilization rather than GDP (Figure 11.2). These two measures gave different signals because of the “jobless recovery” character of the two recessions. The use of the unemployment rate as the measure of resource utilization worked because optimism about the future did not revive (along with the need for an increase in real rates) until the public became optimistic again about job prospects.

IV. What Greenspan said and what he did

Greenspan then defended the FOMC’s performance by pointing out how difficult it is to move in advance of shifts of market psychology. What was important in Greenspan’s commentary, however, was not his understanding of the dynamics of business cycles but rather his actual practice of monetary policy. In practice under Greenspan, apart from the departure in the last half of 1998 and first half of 1999 at the time of the Asia and Brazil crisis, policy remained focused on sustainable growth in real output not on asset prices. Policy responded only indirectly to the behavior of asset prices as they affected growth in output. In the language used here, policy retained its LAW character.

In 2003-2004, the Greenspan FOMC did make a decision that would later have enormous implications. At this time, the FOMC backed off its long-run objective of returning to price stability and instead adopted an ill-defined objective of positive inflation, perhaps best characterized as 2% plus. As shown in Figure 11.6, starting in spring 2004, both core and headline PCE inflation moved persistently above 2% (dashed line). By summer 2008, that overshoot caused the FOMC to allow a growing negative output gap to persist by holding the funds rate unchanged at 2%. If the FOMC had maintained its target for price stability, which it had largely achieved in 2002, the sustained inflation shock that began in summer 2004 with the increase in energy prices would have yielded lower headline inflation numbers. The FOMC in summer 2008 might have then have felt comfortable allowing the inflation shock to pass through to the price level while aggressively using monetary policy to deal with the worsening recession.”

Below some pictures that help illustrate Hetzel´s story.

What the 2 charts above indicate – they show the same thing in different ways – is that the policy “error” took place in 1998/99. Spending “overshot and then “undershot” the level target. 2003-05 show the Fed trying to bring  spending back to trend, something the Fed should be trying today, but isn´t (even if you assume the trend level has lowered somewhat).

Hetzel says that “starting in spring 2004, both core and headline PCE inflation moved persistently above 2%”. Likely my data “vintage”, being the most recent, has the past revised. The fact is that core never persistently goes above 2%. Interestingly it´s more “bumpy” after Bernanke took over as Fed Chairman. There was an oil shock of comparable magnitude during the last years of Greenspan´s chaimanship. Headline goes way up but core stays “attached” to 2%! Not so much under Bernanke.

Maybe Greenspan´s “Appropriate Monetary Policy” helps explain. And Bernanke, given his IT “obsession”, just couldn´t resist the oil shock.

And the Unemployment chart indicates, as indicated by Hetzel, that rates start rising only after unemployment is on a clear downtrend.

Update: Bill Woolsey has a post on the Hetzel Book

Update 1: So does David Glasner