“My broader take on this is that the quasi-monetarists are trying too hard to find a deep essence when what’s really needed is just a model. Let’s tell a story about what economic players do, and see what it says about policy options. That’s all it takes”.
So here goes a story.
The Great Moderation, extending from the mid 1980´s to 2007, is regarded as a period of impressive economic stability, with stability meaning a period of low volatility growth and falling/low inflation.
Over this time frame it was assumed that the Fed had an implicit target for inflation (I assume that beginning sometime in the 1990´s, the “target” was something close to 2% for PCE-Core inflation) and that by making its actions credible, the Fed was mostly responsible for the good economic outcome.
It is interesting to note, however, that as soon as inflation converged to the “target”, and therefore was “low”, we started hearing about “how monetary policy should be conducted in a low inflation environment”. Presumably the reason for that concern was the fact that, with the interest rate controlled by the Fed (the fed Funds (FF) rate) at low levels, any shock could send the rate to the ZLB, with monetary policy losing power.
One of the first to brooch the subject was an essay in the 1998 Cleveland Fed Annual Report titled: “Beyond Price Stability: A Reconsideration of Monetary Policy in a Period of Low Inflation”.
At the very end it states (my bold):
There is another, equally important point. If the economy does suffer a downturn exacerbated by financial market corrections, it would be wrong to conclude that a monetary policy geared toward price stability was a mistaken choice. Price stability represents a significant improvement over managed economic growth. But price stability is, after all, a means to an end. And, as has been demonstrated, it has limitations as an overall indicator of economic health. During a period of rapid technological change and exuberant financial markets, monetary authorities must still account for —and reckon with — excessive monetary growth.
Sounds like a “prelude” to 2008? So, let´s start there. First let me define “excessive monetary growth”. I shall call it “net money” (as suggested by Lars Christensen) since it refers to money supply growth in excess of money demand growth by more than 5.5%, which is the growth rate of nominal spending (NGDP) along the level path that characterized the “Great Moderation”. Stated in the Cambridge form of the equation of exchange: M=kPy, where k is the inverse of velocity, M is money stock, P the price level and y real output (RGDP), we can write it in growth terms as: gMS-gMD=gP+gy=5.5%.
The figures show for 1992.I – 00.I falling inflation and unemployment. We also notice that from 1998 spending rises above the trend as a result of “net money” being persistently above 5.5%.
How did this come about? As the Cleveland Fed essay argues, “monetary policy geared to price stability was a mistaken choice”. A positive supply (productivity) shock is consistent with falling unemployment and inflation. And if the Fed acts so as to keep inflation from falling below “target” by increasing “net money”, instability will ensue. The rising productivity trend is shown below.
Then came the “Phillips Curve outcry”, of which Krugman was an apologist, arguing the economy was growing too fast (unemployment too low) so that inflation was “just around the corner”. The Fed “didn´t resist” and tightened policy. “Net money” dropped and so did spending. Additional shocks intervened – terrorist attack, Eron et al. – that had the effect of raising money demand, increasing the spending gap. Unemployment rose and inflation remained below “target”.
In 2003 monetary policy began to “loosen” (in August the Fomc introduced ‘forward guidance’). The spending gap stopped increasing and soon began to fall. By late 2005 early 2006, spending was back on trend. Note that from late 2003 to early 2006, “net money” was positive (above 5.5%). But that´s the only way spending can rise to go back to trend. RGDP growth increased from an average of 1.4% in 2001 to early 2003 to an average of 3.2% from then to mid 2006, while inflation went up from 1.7% to 2.1%!
That´s the time Bernanke became Fed Chairman. Soon after he was “graced” with three shocks, one negative demand shock from the bursting of the house price bubble and two negative supply shocks, from the financial sector and oil and commodity prices. Both had the effect of increasing money demand but Bernanke was focused on the “dangers” presented by the increase in headline inflation and on providing “support” to the financial sector so as to avoid a repeat of 1930. The end effect was a substantial tightening of monetary policy, with “net money” at first falling gradually and in “free fall” after mid 2008, marking the real start of the crisis. Unemployment jumped and inflation tanked!
Since mid 2009 “net money” has bounced back – that´s why the recession was declared to be “over” at that time – but monetary policy still remains “tight”, as can be gleaned from the wide gap (still increasing) of nominal spending.
Note that the infinitely smaller gap in the first half of the last decade only “closed” when “net money” rose above the “equilibrium” value. At present “net money” is still below. And from all we hear it will remain so! Since it´s unlikely any effort will be made to close the gap, even partially, there´s not much hope for the unemployed and also no risk of even temporarily rising inflation. In fact, as released today by the Cleveland Fed, the “inflation expectations curve” is down!
The evidence above provides ample confirmation that, as Scott Sumner has long argued, both the “greatness” of the housing slump and the “epic character” of the financial crisis were the consequence, not the cause, of the “Great Recession” that arrived on the throes of the “Grand Monetary Tightening”.
And as Lorenzo almost in desperation puts it:
Lowering inflation from 13% to 4% in the “Volcker Transition” is one thing. Lowering it from3% to 0% while pushing transactions seriously below trend and creating a much worse economic downturn is quite another. What do the people who preside over such an outcome think money is for? What do they think they are for?
Update (HT W Peden): This is a great piece by Tim Congdon, written more than 2 years ago. At the very end:
Another enigma here is that the alternative view — that in the long run, national income is a function of the quantity of money — has clear and overwhelming substantiating evidence from all economies at all times. Both evidence and standard theory argue that the expansionary open market operations that are the hallmark of quantitative easing, not bank recapitalisation, should have been policy-makers’ first priority last autumn. In the next crisis they must accept that money, not bank credit by itself, is the variable, which matters most to macroeconomic outcomes.