When the Fed ran out of luck!

I think that coincided with Bernanke taking over from Greenspan.

Let´s back track to a speech by Governor Laurence Meyer from June 2001, six months before he left the Board of Governors after serving for almost five years.

In “What happened to the New Economy?” he writes:

In 1995, the growth rate of the gross domestic product was close to the prevailing estimate of trend, the unemployment rate was close to the prevailing estimate of the non-accelerating inflation rate of unemployment (NAIRU), and inflation was modest. I am reviewing this bit of recent history just to set the stage for my arrival on the Board of Governors in mid-1996. What did the challenges facing monetary policy look like, and what did they turn out to be? The contrast is remarkable.

When I joined the Board, the statement I made at my very first Federal Open Market Committee (FOMC) meeting was that, although economic performance had been very good–perhaps the first-ever soft landing–it would be a challenge to sustain that performance, and we certainly shouldn’t expect it to get any better. Without a doubt, that was my worst forecast.

In fact, as you all know well, the economy’s performance did improve, dramatically, over the next four years. I have often described the ensuing reaction of the FOMC. First, we celebrated. Second, we gracefully accepted a share of the credit. Third–and in terms of time expended, this swamped all the others–we struggled to understand why performance had turned out to be so exceptional and what this explanation implied for the appropriate conduct of monetary policy. In the private sector, I learned that if you made a bad forecast, clients were more forgiving if, as a result, they ended up richer than they expected rather than poorer. So we struggled to understand the unexpected performance at the same time that we were accepting accolades for our contribution to the outcome, if not for our forecasting acumen.

And, importantly:

One reason that I am beginning with this nostalgia is to focus on the exceptional performance of 1996 through mid-2000 and take your minds off the more recent travails of the economy. But I certainly understood that the time would come when monetary policymakers would find it challenging to keep the economy on a favorable course–as we had been briefly challenged in 1998. Indeed, last October, I said a transition to slower growth was likely already under way.

The charts illustrate the economy´s performance (in terms of real growth, unemployment and inflation) during the four years plus the “more recent travails” alluded by Meyer.

Fed out of luck_1

The next chart depicts the market monetarist stance of monetary policy (NGDP growth). The 1998 “challenge”, for example, was the brief “tightening” of monetary policy reflecting the “Phillips Curve” view that above trend growth and below NAIRU unemployment called for “action”. Greenspan quickly reversed the “wrong” decision, claiming (correctly) that productivity had increased, something that pulls down inflation and increases real growth.

Fed out of luck_2

Meyer (and the FOMC) thought they “got it”, but clearly didn´t, because a couple of years later, maybe reacting to the “tech crash”, they cranked up monetary policy. The increase in headline inflation was a reflection of the rise in oil prices (which had fallen considerably on the heels of the Asia crisis), while the rise in core reflected the monetary policy expansion. The consequent monetary “tightening” (despite the FF rate being forcefully lowered since early January 2001) was responsible for the “travails”!

They never “guessed” that the nominal stability that prevailed was responsible for the good outcome (stable real growth, low unemployment and low & stable inflation).

How did things progress to the end of Greenspan´s term?

Things remained “bad” for another couple of years. Real growth low (below trend), unemployment on the rise and inflation “too low”.

Fed out of luck_3

Despite the FF rate being lowered to 1% the economy didn´t react. That changed when the Fed announced “forward guidance” in August 2003. NGDP growth picks up, and so does RGDP. Unemployment begins to drop and inflation climbs back to “target”.

Fed out of luck_4

Enters Bernanke

His obsession with inflation targeting leads him to forget about overall nominal stability. The Fed´s reaction to real (oil) shocks, in an environment weakened by financial sector difficulties, leads to an almost unprecedented drop in nominal spending (NGDP).

Fed out of luck_5

Fed out of luck_6

But the Fed feels it´s on “top of things”, never giving up its Phillips Curve/NAIRU “analytic framework”, and with unemployment falling persistently, there´s just no way inflation won´t soon begin the climb to the 2% “ceiling”!

But that´s what they´ve been saying for more than one year, revising down their estimate of NAIRU as unemployment falls, first below 6.5%, then 6%, then 5.5% and now at 5.1%, even while inflation remains falling (at least “dormant”).

Now we´ve had a rate hike “on the table” and “off the table” for several months. Our old friend from the Board Laurence Meyer, back as a private forecaster, calls the Fed to “pull the trigger”, which leads me to think he still “doesn´t get it”!

Board Members show themselves to be completely at a loss. This recent interview by San Francisco Fed president John Williams is standard fare.

From Jeremy Stein we get a paper where in the abstract we read (HT Evan Soltas):

“Here’s how the problem works, as per Stein and Sunderam. Say the central bank decides internally that its long-term target for the policy rate is too low. Because the central does not want to shock the bond market with a big change, it moves gradually. But markets aren’t stupid. Understanding policy inertia, they infer from small moves in the short run what will happen in the longer run. As a result, the effort to avoid shocking the bond market doesn’t work, essentially because a small hike today has more informational content about future hikes. The central bank becomes trapped by its own inertia rather than doing what it thinks would be best for the economy.”

The problem is that the Fed has for a long time shown that it has no idea about what would be best for the economy!

5 thoughts on “When the Fed ran out of luck!

  1. Inflation—given the obsession central bankers have with inflation—they disxussed nothing else at Jackson Hole—I would say things look bad for US economy.

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