A tale of two obsessions

The 1960s was characterized by the unemployment obsession. The 1962 Economic Report of the President (ERP) is clear on that point:

Unemployment of 4 percent is a modest goal, but it must be emphasized that it is a goal which should be achievable by stabilization policy alone. Other policy measures, referred to in the next section and discussed in detail in Part II of this chapter, will help to reduce the goal attainable in the future below the 4 percent figure. Meanwhile, the policies of business and labor, no less than those of Government, will in large measure determine whether the 4 percent figure can be achieved and perhaps bettered in the current recovery, without unacceptable inflationary pressures.

And this is how things evolved over the decade:

By the end of the decade we read in the 1969 ERP:

THE REMARKABLE ACHIEVEMENT of prosperity as the normal state of the American economy has been recorded in Chapter 2. Recent price performance has been far less satisfactory. Since 1965, prices have been rising too rapidly. The history of both the United States and other industrial nations shows that high employment is generally accompanied by inflationary tendencies, and that when prices are reasonably stable, this is at the cost of too many idle men and idle machines. The record of the past poses the critical challenge of the years ahead. Reconciling prosperity at high employment with price stability is the Nation’s most important unsolved problem of over-all economic performance. Though the United States has done better than most industrial countries, its record is far from adequate. That record can and should be improved by measures discussed in this chapter.

We know that the inflationary tendencies got the better of things, so that the decade of the 1970s, known as “The “Great Inflation” looked very different from the 1950s and 60s.

The “Great Inflation”, which followed the “unemployment obsession”, morphed into the “Great Moderation”. The lesson learned was that sustained inflation arose from expansionary monetary policy so monetary policy should prevent the emergence of sustained inflation rather than having to respond to its emergence. In the words of Robert Hetzel, monetary policy should provide an environment of nominal expectational stability.

And that´s exactly what the “Great Moderation” reflected, with nominal spending (NGDP) evolving close to a stable level path. And there was a time Bernanke believed that was true!

And suddenly all was lost. Why? Forget the house price bubble, the financial crisis and even the oil/commodity shock of 2007-08. All those things taken together could be responsible for at most a run of the mill recession, but the “lesser depression” that ensued has bad monetary policy written all over it. And the bad MP was the direct result of Bernanke´s (and the FOMC´s) obsession with inflation.

As late as the June 24 2008 FOMC meeting we read in the minutes that (note the consequences of the mistaken view of judging the stance of MP by the level of the policy rate):

Some participants noted that certain measures of the real federal funds rate, especially those using actual or forecasted headline inflation, were now negative, and very low by historical standards.  In the view of these participants, the current stance of monetary policy was providing considerable support to aggregate demand and, if the negative real federal funds rate was maintained, it could well lead to higher trend inflation.

In this view, a significant portion of the easing in monetary policy since last fall was aimed at providing insurance against the risk of an especially severe weakening in economic activity and, with downside risks having diminished somewhat, some firming in policy would be appropriate very soon, if not at this meeting.  However, other participants observed that the high level of risk spreads and the restricted availability of credit suggested that overall financial  conditions were not especially accommodative; indeed, borrowing costs for many households and businesses were higher than they had been last summer.

In the Committee’s discussion of monetary policy for the intermeeting period, members generally agreed that the risks to growth had diminished somewhat since the time of the last FOMC meeting while the upside risks to inflation had increased…Conditions in some financial markets had improved, but many financial institutions continued to experience significant credit losses and balance sheet pressures, and in these circumstances credit availability was likely to remain constrained for some time.

At the same time, however, the near-term outlook for inflation had deteriorated, and the risks that underlying inflation pressures could prove to be greater than anticipated appeared to have risen.  Members commented that the continued strong increases in energy and other commodity prices would prompt a difficult adjustment process involving both lower growth and higher rates of inflation in the near term.  Members were also concerned about the heightened potential in current circumstances for an upward drift in long-run inflation expectations.  With increased upside risks to inflation and inflation expectations, members believed that the next change in the stance of policy could well be an increase in the funds rate; indeed, one member thought that policy should be firmed at this meeting. 

And the obsession with inflation was a hallmark of all major central banks, so that MP was contractionary all around, increasing the severity of the recession. The Central Banks banded together and cried out: “One, two , three, GO”!

But in Japan what goes down stays down!

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10 thoughts on “A tale of two obsessions

  1. Nice post. If it’s a “global recession” – it’s obviously not the fault of anyone in particular. Like a natural phenomenom. This excuse seems to work very very well for policy makers. So when they move, they move together.

  2. “Forget the house price bubble, the financial crisis and even the oil/commodity shock of 2007-08. All those things taken together could be responsible for at most a run of the mill recession, but the “lesser depression” that ensued has bad monetary policy written all over it.”

    It’s so bizarre that MMs keep making this assertion. Yes, the Fed caused the lesser depression, but not because of tight money in 2008; rather, because of the Fed’s ignorance of the trade deficit in the early 2000s. By the time 2008 came, there was really no way the economy wasn’t going to crash.

    For monetary policy to have real effects, there needs to be offsetting mechanisms. Where were they in 2008? RI was going down; we had an $8 trillion housing bubble. Investment in structures was also going down; there was a smaller bubble in the CRE market, ya know. PCE was going down; if one’s home drops in value by 50%, why would that person not cut spending?

    The offsetting mechanism, then, would have had to have been some combination of I, G, and Nx. The correlation between I & C is very high, so w/o C we don’t get I. Nx is tough to get when the dollar is the principle reserve currency and has flight-to-safety qualities. If G is the offsetting mechanism, then we’re in a Keynesian world that has nothing to do w/ NGDPLT.

      • Thx. I have read a lot of Scott’s stuff, but hadn’t seen this post.

        A couple things:

        – We need to talk about real GDP because that’s what matters to the general public. We could have gotten more inflation along with the +3.0 percent drop in RGDP in 2009, but it hardly would have made a difference to the lives of Americans; the unemployment rate would have still soared, for example.

        – In Scott’s piece, he’s not even attempting to break out the real sectoral effects that NGDPLT would have had in late-2008; he’s just saying how useless it is to think that way, and then he points to the 1930s as proof. The 1930s are relevant. But back then the Fed actually had the ability to prevent the money supply from dropping — for example, by guaranteeing bank deposits, or something to that extent. How would the expectational effect of a credible NGDP target have counteracted the +$1 trillion fallout from consumer spending and RI that occurred after the bubble burst? Through more business investment? Why would businesses invest more precisely as the demand for their products and services is plummeting. Scott is not answering this question.

        – I’m not sure what Scott’s infatuation with declining real wages is. The correlation between real wage growth and real GDP is positive and high. This makes intuitive sense: When people earn more money, they buy more things, which increases aggregate demand. Why is Scott continuously pushing the argument that real wage growth is bad for recoveries? It’s really strange.

    • Pretty good write up. You put a lot of work into it, so kudos for that. But there are a couple things left unmentioned.

      First, you didn’t say anything about the trade deficit or the value of the dollar. We can’t just ignore those variables — the US is not a closed economy. I’m actually in the camp that monetary policy was too tight in the early 2000s; as evidenced by the fact that the trade deficit continued to widen after the Fed cut the FF rate from 6 percent to 1 percent (http://www.jseydl.com/money-has-been-too-tight-since-the-early-2000s/).

      Second, you write: “what became known as a bubble was to a significant degree a reflection of AD instability,” presumably implying that bubbles would occur less frequently if the Fed stabilized NGDP. But the Fed did pretty much stabilize NGDP in the years leading up to the crash in 2008! Here’s a chart that compares NGDP to land prices: http://img189.imageshack.us/img189/2548/ngdpandlandprices.png In other words, just because NGDP is growing at a stable pace doesn’t mean that asset bubbles won’t inflate. We need to look deeper than NGDP to understand asset bubbles, which is why I favor using MP to reduce the trade deficit.

      I thought the whole discussion on supply shocks was excellent. I’ve said before that I like NGDPLT because it would prevent the Fed from unnecessarily tightening/loosening MP after negative/positive supply shocks.

      But I’m simply saying that it’s not enough, unless you can show: (1) That asset bubbles wouldn’t emerge under NGDPLT or (2) that NGDPLT could prevent the real economy from taking a huge hit in the aftermath of an asset bubble bust. I’m willing to bet you (and Scott) don’t believe (1) is true, but believe (2) is true. But if that’s the argument, then I need to hear a more convincing case than simply, “a drop in spending in one area will be offset by more spending in another,” as Scott continues to assert (http://www.jseydl.com/scott-sumner-wants-the-fed-to-maintain-bubble-inflated-home-prices/).

  3. We’re getting closer, but there is an important factor left out of the analysis.

    You’re looking at the correlation between the FF rate and the 10-yr UST yield, and concluding that the correlation supports the monetary credibility argument rather than the GSG argument. I have a problem with this. Recall that in the mid-2000s it was the private sector that was mostly financing the CA deficit, not the public sector — the public sector was actually running fairly modest deficits. This fact can be seen in the following chart, which breaks net saving flows out into four sectors (the public sector, private business, households, and the rest of the world): http://img24.imageshack.us/img24/1102/netsavingupdate.png

    As the chart shows, the private sector was entirely financing the CA deficit in the late-1990s during the dot.com bubble, and played a big role in financing the CA deficit in the mid-2000s. So you need to look at how the global saving flows impacted prices on securities other than USTs. For example, check out the correlation between saving flows and MBS spread. I bet that you’ll find that the correlation is tight.

    In general, I think the MMs talk up the idea of central bank credibility too much. Scott was ranting an raving when the SNB imposed a currency ceiling, suggesting that the SNB wouldn’t have to intervene all that much in the FX markets so long was the ceiling was credible. And the SNB did everything right: It issued a forceful statement about the ceiling and intervened in large size at the get-go. Yet the SNB is finding that it has to regularly intervene to maintain the ceiling: http://www.businessweek.com/news/2012-08-07/swiss-franc-defense-pushes-reserves-to-record-71-percent-of-economy

    But I did like this statement in your piece: “I like to think 1997/98 was the moment when it all started.” I agree: http://www.jseydl.com/how-it-all-started-in-1997/

  4. Pingback: Political Pressure on the Federal Reserve « dajeeps

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