The events of the past few weeks which ended up requiring a litany by FOMC members over the past week is the best indication that the Fed, once again, is not listening to the markets.
One might think that it´s the markets that should listen to the Fed, in particular to its ‘outlook for the economy’. But no matter the amount of information the Fed has, or the ‘technical prowess’ at its disposal, the markets process information, including the information the Fed puts out by the words of its members, much more efficiently.
The Fed should have learned the lesson of 2007-08, when it did not listen to the markets, ending up crushing the economy. I´ll parse Frederick Mishkin, Fed governor from September 2006 to the ‘tipping point’ in August 2008. The stories he tells in his Macroeconomics text, published in 2011 is likely to be representative of the views prevailing in FOMC decision-making.
By early 2007, one year after house prices peaked, strains begin to be felt in the financial system. In February The Federal Home Loan Mortgage Corporation (Freddie Mac) announces that it will no longer buy the most risky subprime mortgages and mortgage-related securities. On April 2, New Century Financial Corporation, a leading subprime mortgage lender, files for Chapter 11 bankruptcy protection.
At that moment, nominal spending dropped below the trend level, indicating monetary policy was tightening, but according to Mishkin:
When the financial crisis started in August 2007, inflation was rising and economic growth was quite strong. A movement along the Monetary Policy curve would have suggested the Fed would continue to keep hiking interest rates, but instead it did the opposite: it began an aggressive lowering of the federal funds rate, despite the continuing high inflation, The Fed thus shifted the monetary policy curve down. The Fed pursued this autonomous monetary policy easing because the negative shock to the economy from the disruption to financial markets indicated that, despite current high inflation rates, the economy was likely to weaken in the near future and the inflation rate would fall. Indeed, this is exactly what came to pass, with the economy going into recession in December 2007, and the inflation rate falling sharply after July 2008.
But what if, instead of looking at ‘Headline’ inflation the FOMC had focused on ‘Core’ inflation? Probably they could have been much more “aggressive” in their interest rate moves!
And when Mishkin says that in December 2008 the FOMC “announced a surprisingly bold policy decision” the chart below indicates that it was in fact very late in trying ‘to close the gates after the horse had bolted away’!
The chart shows that the stock market continued to fall and inflation expectations didn´t move much after the “bold policy decision”. That only happened when in March 2009 the Fed announced QE1.
In reality, neither the late 2007 “aggressive easing” was aggressive nor was the late 2008 “bold policy decision” bold. Why do I say that? From looking at the NGDP gap (distance from the “Great Moderation” trend) chart below we observe that in late 2007 NGDP was already below trend and the “aggressive easing” did nothing to lift spending towards the trend. On the contrary, spending fell further below trend. This fact is consistent with markets being negatively surprised with the meager 25 bp “easing” that took place in the December 2007 FOMC meeting.
Regarding the fiscal stimulus announced in early 2009, Mishkin has this to say:
In the fall of 2008, the US economy was in crisis. By the time the new Obama administration had taken office, the unemployment rate had risen from 4.7% just before the recession began in December 2007 to 7.6% in January 2009. To stimulate the economy, the Obama administration proposed a fiscal stimulus package that, when passed by Congress, included $288 billion in tax cuts for households and businesses and $499 biliion in increased federal spending, including transfer payments. As this analysis indicates, these tax cuts and spending increases were intended to increase planned expenditure, thereby raising the equilibrium output at any given interest rate [“zero” at the time] and so shifting the IS curve [or the aggregate demand curve] to the right.
Unfortunately, things didn´t work out as the Obama administration planned. Most of the government purchases did not kick in until after 2010, while the decline in autonomous consumption and investment were much larger than anticipated. The fiscal stimulus was more than offset by weak consumption and investment with the result that the planned expenditure ended up contracting rather than rising, and the IS curve did not shift to the right, as hoped. Despite the good intentions of the fiscal stimulus package, the unemployment rate ended up rising to over 10% in 2009. Without the fiscal stimulus, however, the IS curve would likely have shifted further to the left, resulting in even more unemployment.
It is from this sort of analysis that someone like Krugman confidently says that it wasn´t the case that fiscal stimulus didn´t work, it´s just that it wasn´t “big enough”. To everyone else, Mishkin´s story leaves the impression that the contraction in consumption and investment spending was “just one of those things”.
It´s interesting to note that at about the same time the fiscal stimulus was announced, the Fed implemented QE1 (March 2009). Although QE1 was enough to verse the downtrend in NGDP growth, it was a far cry from what was needed to get spending back on trend.
Also, with the ‘other hand’ the Fed was offsetting the fiscal stimulus. This is shown clearly in the next chart, which illustrates that from the start of the fiscal stimulus monetary growth dropped together with velocity (increase in money demand) .
The analogy is with the professional driver that steps simultaneously on the accelerator and brake pedals to control the car on a curve at high speed!
It wasn´t the case, according to Mishkin, that “in 2007 and 2008, the US economy encountered a perfect storm.” Much more likely it was the Fed concentrating on headline inflation and disregarding what market indicators – such things as the stock market, inflation expectations and the foreign exchange rate – were signaling.