Ignore monetary policy at your peril

Almost two years ago, Mark Thoma and Krugman did a piece on excess capacity and unemployment. This is their picture (updated).

From Thoma:

the sooner unemployment returns to normal the better, but we need to be better prepared than we are for the very real possibility that unemployment will continue to trend upward. I’d like to see more done on both the monetary and fiscal policy fronts as a preemptive measure, we can always ease off if things turn our better than expected, but at the very least we need to resist calls from the deficit and inflation hawks to begin pulling back and continue the programs that are already in place.

From Krugman:

So what about our current situation? It’s just like the two previous “postmodern” recessions, only more so, since the bubble before the slump was in housing itself. This suggests a long period of jobless growth; so does the international evidence on the aftermath of financial crises.

Note that since they wrote, excess capacity came down from 29.8 to 22.5 while unemployment only fell from 9.9% to 9.1%, and is far above “normal” for comparable excess capacity levels.

Tyler Cowen picked up on that yesterday and after some discussion, leaves us with the following consideration:

Excess capacity is one reason why monetary policy isn’t always so effective, even when labor resources are unemployed.

Which is short hand for Krugman´s conclusion.

Time´s “The curious capitalist” in a post yesterday titled “It´s the demand, stupid” is closer to the “mark” with the title, but then “wastes” the discussion by focusing only on the “impossibility” of fiscal stimulus:

In Yglesias’s mind, we need more fiscal stimulus, and he’s not sure Krueger is going to drive that home. Macroeconomic Advisers echoes that point, not about Krueger specifically, but about the idea that, if fiscal stimulus is going to work, it has to be large-scale. And in this political environment (and with credit-raters breathing down the government’s back), large-scale simply won’t fly. The bigger the fiscal stimulus proposed, the less politically possible.

And again, like Krugman in late 2009, concludes:

It’s time to face up to a long, hard recovery regardless of who’s in charge.

The “real excess capacity” in the economy is brought to light by this picture that uses monthly NGDP data from Macro Advisers.

Unemployment remains stubbornly high because the spending level is “stuck” deep inside the “ravine”. Monetary policy mistakes are responsible for the “plunge” in spending and inadequate monetary policy is responsible for keeping spending “submerged”.

But many at the Fed seem “happy” that deflation has been avoided and inflation is within the “target bound”.

From Bernanke´s speech at Jackson Hole I “nurture” one iota of optimism. This passage did not get much media attention, although it’s “our only hope” (my bold)

Normally, monetary or fiscal policies aimed primarily at promoting a faster pace of economic recovery in the near term would not be expected to significantly affect the longer-term performance of the economy. However, current circumstances may be an exception to that standard view–the exception to which I alluded earlier. Our economy is suffering today from an extraordinarily high level of long-term unemployment, with nearly half of the unemployed having been out of work for more than six months. Under these unusual circumstances, policies that promote a stronger recovery in the near term may serve longer-term objectives as well.

Couple that with the decision to make the September FOMC meeting a two day affair, so that there could more discussion (time for him to try and convince the die-hard “recalcitrant’s”?), and a tiny light has “shined”.

Yes, it´s the spending, stupid! And that´s the province of monetary policy.

Update: Excerpt from the minutes of the FOMC August 9 meeting:

Federal Reserve officials debated the remaining options they have to lift a stubbornly weak U.S. economy, minutes of their last policy-setting meeting showed Tuesday.

The most potent tool, a third round of asset purchases which markets have dubbed QE3, was raised as a possibility by some officials, according to the minutes of the Aug. 9 Federal Open Market Committee.

“Some participants noted that additional asset purchases could be used to provide more accommodation by lowering longer-term interest rates,” the minutes showed.

That´s not a “remaining option”, it´s the “only” option they think they have! How much more “uncreative” can the Fed become?

3 thoughts on “Ignore monetary policy at your peril

  1. But already money is so easy now! You see the lesson of Japan, where interest rates went to zero an they had …..deflation? Deflation for 20 years? And the yen is so strong?

    You mean money is not easy?

  2. Great post, had a question. Could a looser, easier monetary policy be all that is needed to do the heavy climbing out of the current ravine or would fiscal stimulus (if it were politically feasible) be necessary as well?

Leave a Reply to João Marcus Marinho Nunes Cancel reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.