Malthus wrote in Essay on the Principle of Population published in 1798, on the eve of the Industrial Revolution, that the future of mankind was bleak in the sense that mankind wouldn´t be able to rise much above subsistence. Believing that human nature could not be changed, Malthus wrote:
Must it not then be acknowledged by an attentive examiner of the histories of mankind, that in every age and in every State in which man has existed or does now exist,
That the increase of population is necessarily limited by the means of subsistence,
That population does invariably increase when the means of subsistence increase, and,
That the superior power of population is repressed, and the actual population kept equal to the means of subsistence, by misery and vice.
On October 2007, on the eve of the “Great Recession”, in a Conference at the Federal Reserve Bank of Dallas – The Taylor Rule and the Transformation of Monetary Policy – Bernanke spoke on the underpinnings of the “Great Moderation”, implying that policymakers had got the “hang of it”.
According to Bernanke, during the 1960s and 1970s, monetary policymakers systematically overestimated the amount of slack in the economy and tended to attribute upward movements in inflation to “cost-push” shocks rather than to policymakers own attempts to achieve and maintain artificially low rates of unemployment.
The consequences of those actions were:
- Inflation expectations became unmoored
- Commodities & exchange rate shocks that should have had only a small and transitory inflation impact instead had effects that were both large and persistent
Bernanke notes that in studies that ignore the effects of expected future policy on inflation behavior, it has appeared that the shocks hitting the economy during the pre-Volcker period were unusually large; with these studies in fact mistakenly attributing the effects of bad policy to the shock process itself.
We now know that Bernanke and the Fed did not fare well. Interestingly, a large part of the reason is that Bernanke did not heed his own ‘advice’.
I put up three panels. The first (the ‘control’), illustrates the situation during the oil shock of 2003-05, under Greenspan. The second shows what transpired during the 2007-08 oil shock, under Bernanke. The third illustrates the ‘aftermath’.
The variables in the illustrations are:
a) The index of oil prices (100 indicates the moment prices begin to rise)
b) The growth of both nominal spending (NGDP) and real output
c) The rate of inflation (%YoY) for both the Headline and Core PCE
d) The unemployment rate
- Oil shocks are of comparable magnitudes
- Headline inflation goes up – more so in 2007-08 – but core remains contained
- NGDP growth robust in 2003-05 and real output growth falls somewhat. In 2007-08 both trend down (more on this below)
- While unemployment is falling in 2003-05 it rises strongly (from a low level) in 2007-08.
The aftermath is ‘shocking’. Aggregate world demand dries up so oil prices plunge. In the US the Fed allows nominal spending to take the biggest dive since 1938 bringing real output down with it. That is the quintessential example of an AD shock. Headline inflation ‘dances in step with oil prices’ while core inflation remains subdued. Unemployment shoots up.
All in all a huge disaster. What were Bernanke and the Fed doing? Likely paying undue attention to headline inflation, forgetting what Bernanke said about “the transitory and small impact on inflation” of real shocks. While in the old days the obsession was with unemployment, in the age of inflation targeting the obsession is with inflation. While in the old days inflation was a consequence of ‘misreading’ the amount of slack in the economy, in the age of inflation targeting the high unemployment is a consequence of ‘misreading the amount of inflation’.
Remembering the shocks of the 70s and wanting to avoid a repeat, it got its ‘mirror image’!
The fourth panel helps to understand the robust growth in nominal spending in 2003-05. It also illustrates very clearly the unemployment consequences of deviating and more recently ‘unmooring’ the economy from the “Great Moderation” NGDP trend, estimated for the period 1987-97 and extended to the present.
Looking back at the first panel, the high growth of NGDP in 2003-05 reflects the ‘catch-up’ to the trend level. With spending being below the trend, the only way it can get back to it is if it grows above the trend growth for a period of time. It essentially did so by the end of Greenspan´s tenure. Note that the simultaneous occurrence of strong nominal spending growth and rising oil prices did not let the ‘core inflation genie’ out of the bottle!
It appears that Bernanke never paid much attention to where spending was relative to its trend, because soon nominal spending began deviating below trend. And when the FOMCs concern for inflation heated up in early 2008 spending growth began to decrease further plunging in the second half of the year.
Again, Bernanke forgets his own ‘counsel’: if we ignore the effects of expected future policy on inflation behavior… remains valid if we substitute ‘spending behavior’ for inflation behavior. And no one doubted, given Fed ‘credibility’, that policy would be tailored to bring spending down.
In January 2000, long before even becoming a Fed Governor, Bernanke wrote “What happens when Greenspan is gone”. His answer is far removed from his accomplishment. Another reminder of Thomas Malthus!