Supply Shocks, Demand Shocks, Good, Bad & Very Bad Monetary Policy

Commenter James in London sent me this e-mail:

Apologies for not posting this as a comment, but I don’t know how to add a chart, if one can anyway.

I was looking at the US U-3 number out today in the US and was struck by how much “on the move” this number is, it never settles, why is that?

To which he attached a version of this chart.

James Comment_1

My take is that since the macro economy is a “dynamic beast”, the numbers that define it should certainly be “on the move”. What´s interesting is to try to associate patterns of the moves to economic policy, in particular, monetary policy.

That´s what the two charts below try to do. In the first, I graph inflation and unemployment. In the second, NGDP growth (a measure of monetary policy) and inflation.

James Comment_2

The background to the story I´ll tell is the Dynamic Aggregate Demand-Aggregate Supply (DAD-DAS) model, and I concentrate on the post 1970 period.

The first (dark) bar depicts a period where supply shocks, in the form of strong oil price increases, dominate. The model tells us that in that case, both unemployment and inflation will rise. However, the rise in inflation will depend on how monetary policy behaves. At the time, Fed Chairman Arthur Burns tried to compensate the negative effect of the shock on unemployment by stepping down on the monetary pedal.

The second chart clearly shows that NGDP growth accelerated! Given that economic agents are not dumb, they form expectations of inflation that are brought to the bargaining table, in which case the unemployment rate continues to increase.

In the early 1980s, with Volcker at the Fed, there was a demand shock. NGDP growth is reduced and inflation falls. Initially, with the Fed lacking credibility after more than one decade of monetary profligacy, expectations do not adjust, in which case unemployment rises. A period of falling inflation and unemployment follows.

While the Volcker demand shock was geared to curb runaway inflation, the Greenspan demand shock of the early 1990s (second green bar) has been dubbed “opportunistic disinflation”:

Monetary policy actions are widely considered to be better implemented and more effective when they are credible–that is, when the goals and strategies of the central bank have been clearly and believably communicated to the public. Thus, credibility is highly valued by central banks. Indeed, among some central banks, credibility is almost a mantra of policy.

In apparent contrast, an “opportunistic” strategy for monetary policy has recently gathered attention. With an opportunistic strategy, monetary policymakers officially maintain an ultimate goal of low inflation but may do little to achieve it, waiting instead for good fortune to supply it. For example, as noted in the Wall Street Journal (Wilke 1996), “…when inflation is relatively low, as it is today, [opportunistic] policymakers should wait for unforeseen recessions to make further progress against inflation….”

I don´t think there was anything “opportunistic” about the disinflation. It was a monetary induced recession once you look at what happened to NGDP growth. It appears the fed was quite intent on further reducing the level of inflation.

In the years that followed, NGDP growth was never more stable. Inflation and unemployment continued to fall. This was the result of a positive supply (productivity) shock during the second half of the decade. Since there was not explicit inflation target, the Fed did not have to react to “too low” inflation. “Too low” unemployment, however, was something else altogether.

Phillips Curve thinking at the time (as today) was in fashion. Therefore, when unemployment fell below 4% in early 2000, the Fed (as all manner of analysts and pundits) got the jitters! This was the first time that unemployment fell below 4% since the late 1960s, and all remembered what happened in the subsequent decade!

Worried about the eventual inflationary effect of “too low unemployment”, monetary policy turned “bad” (pink bar), with NGDP growth falling substantially below the stable level obtained in the previous years. The policy mistake was eventually corrected, with NGDP growth going back to the previous level and unemployment coming back down after having risen with the AD shock.

Soon after Bernanke took over as Fed Chairman, inflation targeting, even if not yet explicit, became much more a concern of the Fed. After all, Bernanke was a “hard-core” inflation targeter!

The timing for the increased concern with inflation could not have been worse because a negative supply (oil shock) followed in Bernanke´s heels. The DAD-DAS model is very clear on the consequences of such a shock. Inflation will rise and so will unemployment (lower real GDP growth). The best the Fed can do is to hold nominal spending (NGDP) growth steady. The red bar shows that monetary policy became very bad, with NGDP taking a deep plunge, with unemployment shooting up and inflation tumbling down.

The aftermath has been characterized by low NGDP (and RGDP) growth, well below target inflation and an unemployment rate, that although falling, is still some way above the average of the several years before the huge monetary mistake was made.

Unfortunately, policymakers have once again “chosen” the unemployment rate as the “guiding light” for monetary policy, which they still view as the juggling of the target FF rate!

This cannot end well!


One thought on “Supply Shocks, Demand Shocks, Good, Bad & Very Bad Monetary Policy

  1. Hey, thanks! A very full reply. And an excellent history lesson.

    Still, would it be inconceivable for the rate to ever just “bump along” at 3-4% for a few, or even several, years?

    If not, and it looks not, the odds are rapidly growing of yet another lurch upwards.

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