I believe two ‘obsessions’ are at the root of the loss in nominal stability that took place in the Bernanke Fed: the ‘obsession’ with inflation and its counterpart, the ‘obsession’ with interest rates. As it became obsessed with an eventual inflationary impact of the supply shock (oil and commodities) of 2007-08, the Fed didn´t take into account the impact of its obsessions on expectations of future nominal spending, allowing the steep drop in aggregate demand.
Radical ‘obsessions’ could also be felt outside the FOMC. One example is Kenneth Rogoff who on July 29, 2008, just as the economy began ‘tilting’ wrote:
Of course, today’s mess was many years in the making and there is no easy, painless exit strategy. But the need to introduce more banking discipline is yet another reason why the policymakers must refrain from excessively expansionary macroeconomic policy at this juncture and accept the slowdown that must inevitably come at the end of such an incredible boom. For most central banks, this means significantly raising interest rates to combat inflation. For Treasuries, this means maintaining fiscal discipline rather than giving in to the temptation of tax rebates and fuel subsidies. In policymaker’s zealous attempts to avoid a plain vanilla supply shock recession, they are taking excessive risks with inflation and budget discipline that may ultimately lead to a much greater and more protracted downturn.
The ‘extent of disorientation’ can be ascertained by Rogoff himself, who a little over six months later, in February 2009, desperately suggested that the Fed should adopt a 6% inflation target!
Excess inflation right now would help ameliorate the problem. For that reason, it would be far better to have 5pc to 6pc inflation for a couple of years than to have 2pc to 3pc deflation,” he told the Central Banking Journal.
And these obsessions refuse to go, quietly or not. After having reduced interest rates to “zero” the Fed, as well as a large number of economists, acknowledged having lost its major (only?) policy instrument. Krugman quickly revived his 1998 ‘liquidity trap’ paper (where Rogoff was a commenter!) indicating that everything hinged on fiscal stimulus. When it became patently clear that the passively contractionary monetary policy (despite “zero” rates”) blocked any benefit to aggregate demand from fiscal stimulus, the search began for other instruments to try and promote the economy´s recovery. The search is still ongoing…
Curiously Friedman, who during most of his life was highly critical of Fed action, in 2003 had praise:
The obvious question: whence the new thermostat? Why just then? Given the near coincidence of the improved behavior and Alan Greenspan’s tenure as chairman of the Fed, it is tempting to conclude that Mr. Greenspan was the new thermostat. I am a great admirer of Alan Greenspan and he deserves much credit for the improvement in performance, yet this simple explanation is not tenable. It is contradicted by the simultaneous improvement in the control of inflation by many central banks at about the same time, including the central banks of New Zealand, the United Kingdom, Canada, Sweden, Australia, and still others. Many of these central banks adopted a policy known as inflation targeting, under which they specified a narrow target range for inflation — 1% to 3%, for example. But inflation targeting and non-inflation targeting central banks did about equally well in controlling inflation, so explicit inflation targeting is not the answer.
Admittedly, this is an oversimplification. The accumulation of empirical evidence on monetary phenomena, improved understanding of monetary theory, and many other phenomena doubtless played a role. But I believe they were nowhere near as important as the shift in the theoretical paradigm. The MV=Py key to a good thermostat was there all along.
To Friedman the “thermostat” indicates whether the Fed is doing “whatever is necessary to stabilize nominal income”.
It certainly is not!