Ignore history (and what you knew) to everyone´s detriment

This post was inspired by the Milton Friedman quote (from The Monetarist Counterrevolution) Lars put up:

As it happens, this interpretation of the depression was completely wrong. It turns out, as I shall point out more fully below, that on re-examination, the depression is a tragic testament to the effectiveness of monetary policy, not a demonstration of its impotence. But what mattered for the world of ideas was not what was true but what was believed to be true. And it was believed at the time that monetary policy had been tried and had been found wanting.

In part that view reflected the natural tendency for the monetary authorities to blame other forces for the terrible economic events that were occurring. The people who run monetary policy are human beings, even as you and I, and a common human characteristic is that if anything bad happens it is somebody else’s fault. In the course of collaborating on a book on the monetary history of the United States, I had the dismal task of reading through 50 years of annual reports of the Federal Reserve Board. The only element that lightened that dreary task was the cyclical oscillation in the power attributed to monetary policy by the system. In good years the report would read ‘Thanks to the excellent monetary policy of the Federal Reserve…’ In bad years the report would read ‘Despite the excellent policy of the Federal Reserve…’, and it would go on to point out that monetary policy really was, after all, very weak and other forces so much stronger.

The monetary authorities proclaimed that they were pursuing easy money policies when in fact they were not, and their protestations were largely accepted.

Six years since the so called Financial Crisis began, the Fed feels very comfortable to talk about a “normalization (of monetary policy) strategy”. By that they mean that at some point in time interest rates will increase. On the other hand, observers are pondering about the degree of permanent damage that has been inflicted on the economy.

Recent articles in that vein are Robert Hall´s “Quantifying the lasting harm to the US economy from the financial crisis”, to which John Cochrane recommends adding the subtitle “and policy responses to that crisis” and Laurence Ball´s “Long-term damage from the great recession in OECD countries”. On elaborating on Ball´s article Matt O´Brien opens with the perfect punch-line: “Don’t blame the Great Recession for making us permanently poorer. Blame our policymakers for letting it.”

It turns out Matt is right on target!

According to San Francisco Fed president John Williams the Fed has done “great”. In the conclusion of a recent speech he states:

It’s been a long road back from recession.  The recovery has been slower than I would have liked, and there are a thousand different views on the Fed’s decision making.  But the path was eased by strong monetary policy, and it helped us to get where we are today—on the road back to full employment and price stability [where by “strong” he means monetary policy was “easy”].

Ain´t that swell? In a short sentence he both absolves the Fed from any responsibility for the “Great” in the recession and indicates the Fed is the “savior”.

The Federal Reserve “script” Friedman unearthed in his research long ago is still alive and well: “the Fed is only responsible for the ‘good’ outcomes”.

The rest of this post is a display of visual evidence for the Fed´s responsibility for the recession becoming “Great”, for the extremely subdued “recovery” (that risks keeping the economy forever at a lower level (permanent damage)), and also indicates the reason behind it all; an obsession with inflation that came on board with Bernanke and reached a “paranoid level” during 2008.

The first group of charts shows how monetary policy began to tighten as soon as Bernanke took over from Greenspan in early 2006, to only tighten more strongly as time went by and never being sufficiently expansionary to produce a recovery worthy of the name. If John Williams is to be believed, the whole FOMC is very happy with the present state of affairs and even thinks that “we´re on the road back to full employment and price stability”! (and not just “rolling in the deep”). [Note: monetary policy is being tightened if money supply growth is insufficient to offset money demand growth (fall in velocity)]

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The second set of charts indicates that up to about 2006, the PCE price level (both headline and core measures) were evolving along a trend that represented about 2% inflation, while NGDP was riding on a 5.4% trend growth path. Without having an explicit target, be it for prices or nominal spending, the Fed was behaving as if it did. And the targets were observationally equivalent.

The oil shock began in 2004 and intensified in 2007. The FOMC became hysterical about inflation (as can be ascertained from reading the 2008 FOMC Transcripts) and monetary policy that was slowly tightening got additional turnings of the screw.

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Interestingly, in a famous speech in 2004 entitled “The Great Moderation”, Bernanke said:

Let us begin by asking what economic theory has to say about the relationship of output volatility and inflation volatility. To keep matters simple, I will make the strong (but only temporary!) assumption that monetary policymakers have an accurate understanding of the economy and that they choose policies to promote the best economic performance possible, given their economic objectives. I also assume for the moment that the structure of the economy and the distribution of economic shocks are stable and unchanging. Under these baseline assumptions, macroeconomists have obtained an interesting and important result. Specifically, standard economic models imply that, in the long run, monetary policymakers can reduce the volatility of inflation only by allowing greater volatility in output growth, and vice versa. In other words, if monetary policies are chosen optimally and the economic structure is held constant, there exists a long-run tradeoff between volatility in output and volatility in inflation.

The ultimate source of this long-run tradeoff is the existence of shocks to aggregate supply. Consider the canonical example of an aggregate supply shock, a sharp rise in oil prices caused by disruptions to foreign sources of supply. According to conventional analysis, an increase in the price of oil raises the overall price level (a temporary burst in inflation) while depressing output and employment. Monetary policymakers are therefore faced with a difficult choice. If they choose to tighten policy (raise the short-term interest rate) in order to offset the effects of the oil price shock on the general price level, they may well succeed–but only at the cost of making the decline in output more severe. Likewise, if monetary policymakers choose to ease in order to mitigate the effects of the oil price shock on output, their action will exacerbate the inflationary impact. Hence, in the standard framework, the periodic occurrence of shocks to aggregate supply (such as oil price shocks) forces policymakers to choose between stabilizing output and stabilizing inflation.6Note that shocks to aggregate demand do not create the same tradeoff, as offsetting an aggregate demand shock stabilizes both output and inflation.

We know what he chose in 2008. And given the weakened state of the economy from the fall in house prices, the increase in output variability was magnified.

This is unforgivable because we know Bernanke knew better. Even earlier (1997) he had written (with Gertler and Watson) a paper “Systematic Monetary Policy and the Effects of Oil Price Shocks”, which concluded:

Substantively, our results suggest that an important part of the effects of oil price shocks on the economy results not from the changes in oil prices per se, but from the resulting tightening of monetary policy.

But you may argue, as does the Fed, that monetary policy was “eased” significantly after August 2007, with the FF rate falling to the extremely low level of 2% by April 2008, and remained at that very low level for the next 6 months. Sorry, but Bernanke himself, following Friedman, long ago said that the level of interest rates is not an appropriate measure of the stance of monetary policy! Better look, as he said, at what´s happening to aggregate nominal spending. Unfortunately, he didn´t! He only looked at inflation and worse, only to the headline measure, contaminated by the oil price rise.

Update (HT Doug Irwin):

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4 thoughts on “Ignore history (and what you knew) to everyone´s detriment

  1. Just in case you hadn’t seen this quote from Friedman in 1968……….

    “As an empirical matter, low interest rates are a sign that monetary policy has been tight-in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy-in the sense that the quantity of money has grown rapidly … Paradoxically, the monetary authority could assure low nominal rates of interest-but to do so it would have to start out in what seems like the opposite direction, by engaging in a deflationary monetary policy … These considerations not only explain why monetary policy cannot peg interest rates; they also explain why interest rates are such a mis- leading indicator of whether monetary policy is “tight” or “easy.””


  2. Very interesting indeed. But the Federal Reserve does not provide Divisia M4. What is the source of those data?

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