No wonder the economy tanked in 2008

Daniel Thornton is an old member of the Fed research staff, having been active at the St Louis Fed for more than 30 years. So if he says:

“… the Federal Reserve has never used a policy rule, and there is no evidence that any other central bank has either.”

I have no reason to doubt him (although I do).

His opening paragraph is disheartening:

Old debates about the use of rules versus discretion for conducting monetary policy and the efficacy of nominal gross domestic product (GDP) targeting have recently returned to the forefront of monetary policy discussions. The economics profession has largely sided with rules over discretion, while the debate about nominal GDP targeting continues. However, despite the support among economists for policy rules, transcripts of the Federal Open Market Committee (FOMC) meetings suggest that the Federal Reserve has never used a policy rule, and there is no evidence that any other central bank has either. On the surface, a nominal GDP-targeting rule would seem easier to agree on and, hence, more likely to be adopted. However, this essay discusses reasons policymakers have not used policy rules and are unlikely to target nominal GDP.

Targets can be implicit. The fact that the Fed had no stated target (for example a 2% inflation target) does not mean it acted with unbounded discretion.

It is more or less accepted that in the early 1990s the Fed brought inflation down to an ‘acceptable’ (close to 2%) level (remember the talk about opportunistic disinflation at the time?). So we can think (and analysts did) that 2% was the inflation that the Fed (implicitly) targeted. But as the charts show, we could also think that the Fed was targeting the price level (PLT) along the 2% trend or even that the Fed was targeting NGDP along a 5.4% trend (in fact this was amply discussed in the December 1992 FOMC meeting). In any case, from 1992 to 2005 all these were observationally equivalent (see Nick Rowe with regards to Canada)

From that point, mostly due to Chinese growth, commodity and oil prices took off. To the US and many other countries that configured a negative supply shock. In that case, according to the dynamic AS/AD model, prices rise above trend and real output falls below trend (those points are signaled in the charts by fat arrows).

Note that for a while (until early 2008) NGDP was kept close to trend and the economy was doing a great job absorbing the fall in house prices and the negative impact this had on the financial sector. Unemployment, for example, remained low.

Being a die-hard inflation targeter, Bernanke saw the rise in prices and decided ‘to do something about it’. He was not acting with discretion, just following his own implicit rule of acting so as to keep headline inflation around 2%. Interestingly, when oil prices went up in 2004/05, Greenspan let people know he would pursue an “appropriate monetary policy”. Maybe that´s discretion, or maybe he figured that keeping NGDP on an even keel was the right “rule” to follow.

So bad things happened not because the Fed acted with “discretion” but because it became “fanatic” about the wrong “target” at the wrong time!