If only monetary policy in 2008 had been what it was in 2020.

Many like to compare the Covid19 contraction with the Great Depression. In addition to the nature of the two contractions being completely unrelated, while in the first two months of the Covid19 crisis (from the February peak to the April trough) RGDP dropped 15%, it took one year from the start of the Great Depression for RGDP to drop by that amount.

Although the Covid19 shock has also no common element with the Great Recession, a comparison between the two is instructive from the monetary policy point of view. This is so because the Great Recession was the “desired outcome” of the Fed´s monetary policy. Bear with me and I´ll try to convince you that is not a preposterous statement.

Motivated by the belief that the 2008-09 recession originated with the losses imposed on banks by their exposure to real estate loans and propagated through a consequent breakdown in the ability of banks to get loans to credit-worthy borrowers, government, the Fed and regulators intervened massively in credit markets to spur lending.

Bernanke´s January 13, 2009 speech “The crisis and the policy response” summarizes that view:

“To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally.”

Bernanke´s “credit view” of the monetary transmission process is well established. Two articles support that view.

His flagship 1983 article is titled “Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression.”

“…we focus on non-monetary (primarily credit-related) aspects of the financial sector–output link and consider the problems of debtors as well as those of the banking system. We argue that the financial disruptions of 1930-33 reduced the efficiency of the credit allocation process; and that the resulting higher cost and reduced availability of credit acted to depress aggregate demand.”

His 1988 primer “Monetary Policy Transmission: Through Money or Credit?”

“…The alternative approach emphasizes that in the process of creating money, banks extend credit (make loans) as well, and their willingness to do so has its own effects on aggregate spending.”

For details on the Fed´s credit market interventions (with the purpose of reducing spreads, which to the Fed is a sign of credit market dysfunction), see chapter 15 of Robert Hetzel´s “The Great Recession”

“The answer given here is that policy makers misdiagnosed the cause of the recession. The fact that lending declined despite massive government intervention into credit markets indicated that the decline in bank lending arose not as a cause but as a response to the recession, which produced both a decline in the demand for loans and an increase in the riskiness of lending.

In their effort to stimulate the economy, policy makers would have been better served by maintaining significant growth in money as an instrument for maintaining growth in the dollar expenditures [NGDP growth] of the public rather than on reviving financial intermediation”

The charts below attest to that fact insofar as spreads began to fall, the dollar exchange rate began to depreciate and the stock market began to rise, only after the Fed implemented quantitative easing (QE1) in March 2009.

The purchase of treasuries by the Fed was what “saved the day”, not the array of credit policies that had been implemented for several months prior. Note, however, that the monetary policy sail was only at half-mast. On October 2008, the Fed had introduced IOER (interest on reserves), so that the rise in the monetary base from all the Fed´s credit policy would not “spillover” into an increase in the money supply. (The rise in the reserve/deposit (R/D) ratio in fact more than offset the rise in the base, so money supply growth was negative).

What QE did was to increase the velocity of circulation. With that, spending (NGDP) growth stopped falling and then began to rise slowly. As the next chart shows, the Fed (due to inflation worries) never allowed NGDP growth to make-up for the previous drop, “calibrating” monetary policy to keep NGDP growth on a lower trend path and lower growth rate.

Skipping to 2020, when the Covid19 shock hit, NGDP tanked. With spreads rising, the Fed again, now under Jay Powell (who must have learned “creditism” from his time with Bernanke), quickly announced a large batch of programs to intervene in credit markets to sustain financial intermediation.

While in the U.S., it was all about “closing spreads”, in Europe the sentiment was the opposite:

Christine Lagarde (March 12): “We are not here to close spreads”

Laurence Meyer (March 17): “The Fed is here to close spreads”

In “Covid19 and the Fed´s Credit Policy”, Robert Hetzel writes:

“…When financial markets actually did continue to function, Chairman Powell claimed that it was because of the announcement effect that the programs would become operational in the future…”.

Looking at the charts for the period, we again observe that spreads fell (markets functioned) when monetary policy – through open market operations, with the Fed buying treasury securities – becomes expansionary. The difference, this time, is that the monetary policy sail was at “full mast”, so that money supply growth rose fast.

Compared to the post 2008-09 period, NGDP reversed direction in a V-shape fashion (data on monthly NGDP to June from Macroeconomic Advisers). This time around, it seems the Fed is set in making-up for the lost spending, returning NGDP to the trend level that prevailed from 2009 to 2019.

Going forward, once the economy fully reopens the Fed will have to make clear that monetary policy will the conducted to maintain nominal stability (i.e. NGDP cruising along the trend level path it was on previously). Given the degree of fiscal “overkill” that has been practiced, the Fed will have to resist pressures to maintain an overly expansionary monetary policy to relieve fiscal stress through inflationary finance.

Demand & Productivity

In “The Great Productivity Puzzle”, John Cassidy writes:

More worrying is the fact that slow productivity growth has now persisted for almost a decade, and that this development hasn’t been restricted to the United States. Something similar has happened in countries like Japan, Germany, France, and the United Kingdom. Whatever is driving the slowdown in productivity growth appears to be affecting the advanced world as a whole. What is it?

One possibility is:

The bigger issue is that many corporations aren’t seeing enough demand for their products to justify large new investments. And even when they do see an uptick in demand they hire new workers who have to make do with existing equipment. So employment growth looks healthy, but the economy remains stuck in a low-growth, low-investment, low-productivity trap.

If this is what’s happening, there isn’t anything wrong with new technology, or the economy’s capacity to grow: the issue is how exploit its potential. If higher demand could be sustained, perhaps through a fiscal or monetary stimulus, firms would step up investment, and the economy would return to a more virtuous circle, in which higher rates of productivity growth and G.D.P. growth reinforced each other. This is basically what happened between 1945 and 1973.

In the same vein, Bernanke writes:

On the other hand, as mentioned earlier, the recent decline in productivity growth (and thus in potential output) has been both large and mostly unexpected. Some have hypothesized that this decline is not purely exogenous but has been influenced, to some extent, by short-term economic conditions. For example, the slow recovery from the Great Recession likely impeded capital investment, business formation, and the acquisition of skills and experience by workers, which in turn may have contributed to the disappointing pace of productivity gains. The converse possibility, that stronger economic growth today might have positive and lasting effects on the economy’s ability to grow, is for some an argument for erring on the side of more stimulative policies.

The charts provide an illustration of the importance of the stability and growth level of demand (NGDP) for the productivity growth outcome.

Update (Aug 11) Kocherlakota pitches demand:

What to do? When faced with a decline in productivity, economists typically offer so-called supply-side solutions, such as lowering taxes or eliminating regulations. It’s important to recognize, though, that policies aimed at stimulating demand might be able to help a lot.

Suppose, for example, that macroeconomic policy choices convinced businesses to expect faster growth in the demand for their goods and services than they currently do. Companies would react by investing in more physical capital, and in the innovation needed to make that capital (and the people who work with it) more productive.

The Fed wastes time “star trekking”!

While the Fed goes “star trekking”, nominal stability is forsaken. As Bernanke argues, the FOMC´s forecast of the “star variables” – y*, u*, and r* – which, respectively, denote potential real output, natural rate of unemployment and the neutral interest rate, variables over which the Fed has no control, have been systematically downgraded. His table illustrates:

And Bernanke concludes:

FOMC communications also have been affected by the recent revisions in the Fed’s thinking. It has not been lost on Fed policymakers that the world looks significantly different in some ways than they thought just a few years ago, and that the degree of uncertainty about how the economy and policy will evolve may now be unusually high. Fed communications have therefore taken on a more agnostic tone recently. For example, President Bullard of the St. Louis Fed has recently proposed a framework which implies that, in most circumstances, economic forecasters can do no better than to assume that tomorrow’s economy will look like today’s. Other participants, noting earlier failures of forecasting, have argued that (for example) policy should not react until inflation has actually risen in a sustainable way, as opposed to being only forecast to rise. In general, with policymakers sounding more agnostic and increasingly disinclined to provide clear guidance, Fed-watchers will see less benefit in parsing statements and speeches and more from paying close attention to the incoming data.

To argue that you should all but ignore the Fed is certainly very confusing!

Meanwhile, the people at Gavekal are on the right track when they write:

We were fortunate enough to have Nancy Lazar, from Cornerstone Macro, in our office today and she emphasized a very important point: nominal GDP is ultimately what really matters.

Nominal growth is what drives corporate revenue, and in turn, drives business spending. Because businesses are the backbone of any economy, trends in nominal GDP greatly impact inflation, wage growth, consumer spending, capex and interest rates to name just a few macro economic variables.

When the first release of 2Q GDP came out in late July, we noted how the 10-year annualized change in GDP had fallen to just 2.94%, which is the lowest growth rate on record going back to 1957. In the subsequent charts below we see how this structural decline in nominal GDP is reverberating through other parts of the economy.

There´s a better way to see the importance of nominal stability – the appropriate level and growth rate of nominal GDP (NGDP). In the panel below, which charts NGDP growth at time t against growth at time t+1, we see that what came to be called “Great Moderation”, characterized by stable real growth and stable and low inflation, was a period in which NGDP growth was stable and evolving along a stable trend level path.

During the “Great Inflation” we see that NGDP growth was excessive and upward trending. At present (“Great Stagnation”), after trending down, NGDP growth has once again come back into the “stability circle”. However, NGDP growth is “too low” and is evolving along a trend path that is also too low. In fact, as the chart below indicates, it appears that since 2014 NGDP growth is even veering off from this lower path.

No surprise, then, that “Fed communications have taken on a more agnostic tone”. As Bernanke argues: “It has not been lost on Fed policymakers that the world looks significantly different in some ways than they thought just a few years ago.” And what´s different is of Bernanke´s own making when, as Fed Chairman, he let NGDP (something which the Fed can closely control, in contrast to the “star variables”) drop significantly. But since they don´t know “what´s different”, stay tuned for more Fed mistakes going forward!

Fed´s usefulness is waning

According to Bernanke:

In general, with policymakers sounding more agnostic and increasingly disinclined to provide clear guidance, Fed-watchers will see less benefit in parsing statements and speeches and more from paying close attention to the incoming data. Ultimately, the data will inform us not only about the economy’s near-term performance, but also about the key parameters—like y*, u*, and r*—that the FOMC sees as determining that performance over the longer term.

 

When the Fed killed growth

Neil Irwin writes “We’re in a Low-Growth World. How Did We Get Here?”:

One central fact about the global economy lurks just beneath the year’s remarkable headlines: Economic growth in advanced nations has been weaker for longer than it has been in the lifetime of most people on earth.

This slow growth is not some new phenomenon, but rather the way it has been for 15 years and counting. In the United States, per-person gross domestic product rose by an average of 2.2 percent a year from 1947 through 2000 — but starting in 2001 has averaged only 0.9 percent. The economies of Western Europe and Japan have done worse than that.

His “Tell-Tale” evidence comes from this chart

He certainly could have done a better reading of the evidence. First of all, the very high (but falling) average growth, especially in Europe and Japan before 1980, is a reflection of the catch-up growth following the end of WWII. This can be clearly seen by comparing real per capita output in Japan and the US from 1950 onwards shown in the chart.

By the early 1970s, Japan´s catch-up growth petered out. After 1990, per capita growth almost completely disappeared. In Irwin´s chart we see 10-year average annual growth in Japan falling off steeply.

Meanwhile, observe that per capita growth in the US and Europe during the period between the two vertical bars (“Great Moderation”) is very stable and only falls off fast with the onset of the “Great Recession”. In that sense, the low per capita growth phenomenon is “new”.

What happens when we look at real per capita growth for a long span of time. For the US the table gives the summary statistics for growth over 1850 to 2015.

1850 – 2006	1985 – 2006	2009 – 2015
Mean=2.1%	Mean=2.1%	Mean=0.6%
St Dev=4.9	St Dev=1.2	St Dev=1.9

During the Great Moderation (1985 – 2006) real per capita growth was the same as the previous 156 years, but growth volatility (Standard Deviation) was lower by a factor of 4, a much more “pleasant” life experience. During the recovery that began 7 years ago, it is growth itself that was reduced by a factor of almost 4.

At times during the long period of 2.1% growth, we observe periods of deep penury. For example, in 1934, in the midst of the Great Depression, the average annual 10-year per capita growth reached a minimum of -0.9%!

Then, that was the result of a massive monetary error. You wouldn´t be off to conclude that the steep drop in per capita growth at present is also the result of a less massive, but more persistent monetary error. From looking at Irwin´s chart, it almost looks like “everyone wants to be Japan”, a risk Bernanke himself warned about as far back as 1999.

So many culprits!

That´s what you get when you do GDP component analysis. Sounds smart but is utterly useless:

Macroeconomics should be about aggregates, not components of spending.  Yes, changes occurring in the various components of GDP can impact interest rates, and thus velocity.  And if monetary policy is inept (i.e. doesn’t offset changes in velocity) that can impact nominal spending, but it certainly isn’t the most illuminating way of looking at the issue.  It’s like trying to explain changes in the overall price level by modelling changes in the nominal price of each good—theoretically possible, but a waste of time.

Dean Baker says:

The biggest risk is that a set of bad events elsewhere in the world could cause the trade deficit to deteriorate further.

According to Brookings:

Hutchins’ Fiscal Impact Measure shows sluggish government spending contributed to weak fourth quarter GDP growth.

Bernanke himself once said:

As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth…

The absence of a clear and straightforward measure of monetary ease or tightness is a major problem in practice. How can we know, for example, whether policy is “neutral” or excessively “activist”?

Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation…”

If you follow Bernanke´s lead, this is what you see

Clearly not what you could call a “stable monetary background”.

An AD shock spits in their faces but they don´t feel it!

This is how insensitive FOMC participants are. Typical comment:

From Vice Chair Stanley Fischer:

“I’m not very worried,” Fischer told an audience at the Council on Foreign Relations. “The lower inflation that we’ll get from the lower price of oil is going to be temporary.”

He also said lower oil prices were “a phenomenon that’s making everybody better off.”

He gets it wrong on both counts!

The chart shows daily 10-year breakeven inflation and oil price.

Between mid-2003 and mid-2008, there were two back to back significant oil shocks, with prices more than quadrupling over the period.

Note that despite the strong increase in oil prices, inflation expectations remain stable, even falling and becoming more stable during the second leg of the shock.

The reason the oil shock did not affect inflation expectations will be seen below.

Notice, however, that when a gargantuan negative demand shock hits, oil prices and inflation expectations tumble.

Later, when the environment turned “peaceful” again, oil prices stabilized at a high level and inflation expectations fluctuated quite a bit, but showed no trend, responding to the on/off nature of monetary policy (the QE´s). And when the taper begins, inflation expectations “settle down”.

In mid-2014, oil prices and inflation expectations drop significantly. This is consistent with a negative demand shock. In this case the oil price drop is not “making everybody better off”, but is a reflection of reduced nominal growth expectations, “making everyone worse off”!

When I put up the chart showing NGDP growth, things become clear.

The reason rising oil prices did not increase inflation expectations in 2003-08, is due to the fact that, contrary to what happened in the 1970s, NGDP growth remained stable (in the 70s it showed a rising trend). Interestingly, in 1997 Bernanke had said that the impact of an oil price shock depended on the behavior of monetary policy!

As soon as Bernanke takes over at the Fed, NGDP growth drops, which is consistent with the fall in inflation expectations observed in the first chart. When NGDP growth sinks, so does inflation expectations and oil prices. This is the prototype negative AD shock.

More recently, the Fed has talked a lot about policy “normalization”. But the simultaneous fall in inflation and inflation expectations make them sound “funny”. To counter that impression, they allege that the low inflation observed is a temporary thing, associated with the fall in oil prices, and that this effect will soon “dissipate”. And in order for the Fed not to fall behind the (inflation) curve, they have to “act” now!

They miss the fact that the joint behavior of oil prices and inflation expectations is reflecting the fall in nominal growth expectations. In fact, since the middle of last year, monetary policy, as gauged by NGDP growth has been tightening. But our genius monetary policy makers think monetary policy has been extremely accommodative!

On the 16^th they are likely to throw salt in the wound. Any pain will likely be temporary because the economy has been “duly prepared”!

Give the Fed a new compass. We´re going in the wrong direction

According to the news:

Friday’s employment report clears the way for the Federal Reserve to raise short-term interest rates by a quarter-percentage point at its Dec. 15-16 policy meeting, ending seven years of near-zero interest rates.

The Fed can reasonably well control nominal spending (NGDP) growth. Stable NGDP growth at the appropriate level well defines what good monetary policy is supposed to look like.

If that´s true, when NGDP growth falters, things like employment growth will register the “punch”, just as it will “blossom” when monetary policy pulls NGDP growth up. Stable NGDP growth goes hand-in-hand with stable employment growth (only thing is if NGDP level falls short, so will the level of employment)

Examples from the mid-1990s and early 2000s show the Greenspan years. For the last ten years, we have been under Bernanke and Yellen. The pictures are illustrative. (The montlhy NGDP numbers come from Macroeconomic Advisers)

Throughout the period, inflation was not a problem. By the mid-1990s, it had reached the “low and stable” target of the time. Ironically, after the numerical 2% target was set in January 2012, inflation has languished, but is still “low and stable”!

But if you zoom in on the past 15 months, things seem “fishy”. For all the Fed´s “communication”, the truth is that they have been tightening policy. NGDP growth is coming down which was shortly followed by decreasing employment growth. Won´t even mention inflation.

To wrap up, where´s the much touted wage growth-inflation nexus so cherished by some at the FOMC?

Great harm might be on the way!

PS If you don´t believe me about the “beauty” of stable nominal spending, believe George Selgin:

a central bank that allows the overall volume of spending to collapse has blown it, no matter how much emergency lending it undertakes.  Indeed, to the extent that a central bank engages in emergency lending while failing to preserve aggregate spending, it may be guilty of compounding the damage attributable to the collapse of spending itself with that attributable to a misallocation of scarce resources in favor of irresponsibly-managed firms.

Greenspan´s last 10 years and Bernanke/Yellen´s first Decade

No visible difference in the behavior of inflation, which remained closer to “target” during Greenspan´s last decade.

There´s a big difference in the behavior of unemployment, much lower during Greenspan´s tenure.

The defining difference is in the behavior of nominal spending (AD or NGDP) growth, which translates into a significant difference in the growth of real output.

Note than in 2001, when Greenspan allowed NGDP growth to drop below trend, unemployment goes up and stays up until NGDP growth returns to trend. In 2008, unemployment soars when NGDP growth tanks and becomes negative. The yellow bar shows that when NGDP growth stops falling, unemployment “levels off”, beginning to fall when NGDP growth becomes positive once again.

Unfortunately, the Fed this time around chose an inadequate level of spending growth. The result is that the economy got stuck in a “Great Stagnation”, defined by a level of real output and employment well below the previous trend level!

To get out of this trap, the monetary policymakers have to start thinking outside the “interest rate box”! From all the nonsense we hear from them, that is not likely.

Crimes against the economy and, by extension, against its citizens

In 1997, Bernanke (with Gertler and Watson) wrote “Systematic Monetary Policy and the Effiects of Oil Price Shocks“:

THE PRINCIPAL OBJECTIVE of this paper is to increase our understanding of the role of monetary policy in postwar U. S. business cycles. We take as our starting point two common findings in the recent monetary policy literature based on vector autoregressions (VARs).’

…Put more positively, if one takes the VAR evidence on monetary policy seriously (as we do), then any case for an important role of monetary policy in the business cycle rests on the argument that the choice of the monetary policy rule (the “reaction function”) has significant macroeconomic effects.

…The results are reasonable, with all variables exhibiting their expected qualitative behaviors. In particular, the absence of an endogenously restrictive monetary policy results in higher output and prices, as one would anticipate. Quantitatively, the effects are large, in that a nonresponsive monetary policy suffices to eliminate most of the output effect of an oil price shock, particularly after the first eight to ten months.

…The conclusion that a substantial part of the real effects of oil price shocks is due to the monetary policy response helps to explain why the effects of these shocks seems larger than can easily be explained in neoclassical (flexible price) models.

…Substantively, our results suggest that an important part of the effect of oil price shocks on the economy results not from the change in oil prices, per se, but from the resulting tightening of monetary policy. This finding may help to explain the apparently large effects of oil price changes found by Hamilton and many others.

In other words the explicit warning is: “Don´t impose a negative demand shock over a negative supply shock”.

Then I read this from Blanchard, Cerutti & Summers: Inflation and Activity – Two Explorations and their Monetary Policy Implications:

“We find that, indeed, recessions associated with either oil price increases or with financial crisis are more likely to be followed by lower output later. But we find that recessions plausibly triggered by demand shocks are also often followed by lower output or even lower output growth.”

Therefore, it appears that Bernanke (and the Fed) imposed a massive negative demand shock on a significantly negative supply shock, comprising both an oil shock and a financial crisis!

That´s the main cause of the Great Recession (which has morphed into the “New Normal” or “Secular Stagnation”). The house price boom and bust and the ensuing financial crisis, in addition to “second fidllers” in the drama, serve as the “strawmen” that exculpate the Fed and even helped turn its Chairman into Person of the Year, 2009, Hero and bestselling author!

The story is illustrated below.

We start in late 2003, when the oil shock (could call it the “China shock”) began. From then to mid-2008, the price of oil quadrupled. According to Bernanke, you shouldn´t “drink” from that fountain.

From 2003 to January 2006, it was Greenspan´s show. It appears that Greenspan followed Bernanke´s advice, and didn´t allow monetary policy (gauged by NGDP growth) to tighten. But Bernanke forgot his own counsel, and chose a monetary policy rule (strong reaction to the rise in headline inflation) with significantly negative macroeconomic effects.

As we know, that was only the beginning. Things became much worse during the next 12 months.

Let´s backtrack and ask the question: Was Greenspan lucky?

The answer to this question leads us to examine in greater depth the role of monetary policy in generating the “Great Recession”.

The Dynamic AS/AD model tells us that a negative (positive) AS (oil) shock will decrease (increase) real growth and increase (decrease) inflation.

Bernanke et al very sensible conclusion from 1997 was that monetary policy should not react to those shocks.

But how can we gauge the stance of monetary policy? As Bernanke, channeling Milton Friedman, once said:

“As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth…

The absence of a clear and straightforward measure of monetary ease or tightness is a major problem in practice. How can we know, for example, whether policy is “neutral” or excessively “activist”?

Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation…”

[Note: Unfortunately, he preferred to concentrate on inflation, and worse, the headline variety, which was being buffeted by the oil and commodity price shocks! As indicated by the Dynamic AS/AD (DASAD) model, inflation is not always a good indicator of the stance of monetary policy.]

The chart below provides a view of the stance of monetary policy by looking at the NGDP gap. The NGDP gap is the deviation of NGDP from its stable trend path. Therefore, if, for example, NGDP is rising above trend, monetary policy is deemed “loose” and “loosening”. Other cases are illustrated in the chart. The unemployment rate stands as counterpart for the real effects of monetary policy.

In the second half of the 1990s, the economy experienced a positive (productivity) supply shock. According to the DASAD model, inflation falls and real growth increases (unemployment falls).

The chart above tells us that Greenspan allowed monetary policy to loosen, magnifying the growth and employment effects of the shock. When unemployment dropped below 4%, the “Phillips Curve/Slack crowd” took over and monetary policy tightened.

The Fed “overtightened” monetary policy [note: despite interest rates falling fast], as NGDP continued to fall below trend.

In mid-2003, the Fed adopted “Forward Guidance”, in effect “loosening” monetary policy, so that NGDP began to climb back to trend. If you refer to the NGDP growth chart at the beginning, you will notice that NGDP was growing at the high rate of 6.5% from late 2003 to early 2006. That´s the only way NGDP can climb back to trend, i.e. by growing for a time at a rate above the trend growth rate of around 5.4%.

Greenspan was “lucky” because, when the oil shock hit, monetary policy was on a “correction” trend, and thus minimized the negative real growth effect of the shock, with the unemployment rate even turning down.

When Bernanke took the helm, NGDP was “on trend”, i.e. NGDP growth was “just right” to provide a “stable monetary background”. But he forgot what he had known for 10 years and adopted a monetary reaction function focused on headline inflation. With the ongoing and even strengthening oil shock, monetary policy was tightened with NGDP falling below trend at a fast pace.

Now, given the fragile financial economic environment, the tightening of monetary policy only made that environment more fragile…

At that point, another Great Depression was in the making, so Bernanke, faithful to his credit channel view of the propagation of the Great Depression, came quickly to the rescue of banks.

Monetary policy, however, remained tight and was only weakly loosened with the introduction of QE1 in March 2009.

NGDP and RGDP growth recovered, but for the past five years have remained at a level well below the previous trend growth rates; no wander the monikers “New Normal” and “Secular Stagnation” have become household words!

The Blanchard et all paper rationalize this state of affairs by indicating that “even recessions triggered by demand shocks are often followed by lower output or even lower output growth”.

That sort of reasoning forgets that one thing monetary policy can avoid, or at least minimize the effects of, are demand shocks! Moreover, as Bernanke told us in 1997, monetary policy can also minimize the output effects of supply shocks, particularly by not reacting to those types of shocks.

Monetary policy, however, does not participate in the discussions. In a recent paper, “Long-term damage from the Great Recession in OECD countries”, for example, Lawrence Ball writes:

“The global financial crisis of 2008-2009 triggered national recessions of varying severity. The hardest-hit economies include those in the periphery of the euro area, which experienced severe banking and debt crises. At the other extreme, Australia was almost unscathed because of factors including fiscal stimulus and strong exports to Asia.”

One did badly because of banking and debt crisis. The other did well because of fiscal stimulus!

Interestingly, the economies that didn´t experience a recession (or a financial crisis) in 2008-09, like Australia, Israel and Poland, are the ones in which monetary policy managed to keep NGDP growth close to trend! That seems to be just luck because Stanley Fischer, now Vice-Chairman of the Federal Reserve Board, at the time was head of the Bank of Israel, and from his recent utterances still has no idea why he was successful!

And when you hear someone like New York Fed president Dudley, who has a permanent vote at the FOMC, express himself so disjointedly:

“We hope that relatively soon we will become reasonably confident that inflation will return to our 2 percent objective,” he said at Hofstra University. Dudley said it was “very logical” to expect that the Fed’s inflation and employment conditions would be met “soon,” allowing policymakers to “start thinking about raising the short-term interest rates.”

You easily conclude that the economy will likely get worse!

Appendix

One point emphasized by both the Blanchard et al and Larry Ball´s article, is the concept of hysteresis (and super-hysteresis), which concerns the level (and growth rate) of real output following real or nominal shocks.

The chart below casts some doubt on the idea, at least for the US.

Even the oil shocks of the 1970s or the demand shock from Volcker’s disinflation did not permanently reduce the level or growth rate of real output, which always returned to trend (the trend in the chart was formed from 1970 to 1997).

The more recent Bernanke/Yellen supply/demand shock has worked out differently, with both the level and growth rate of output forcefully reduced, i.e. denoting hysteresis/super-hysteresis!

As argued above, that comes mostly from the misconceived monetary policy adopted since Bernanke took over. That policy has drastically reduced both the target level of NGDP and its growth rate. The charts illustrate for the most recent period.

The real damage is that now the much lower level and growth rate of real output have become the “New Normal”!

The chart below well describes the inadequacy of using interest rates to gauge the stance of monetary policy. Interest rates, in fact, say that monetary policy is loosening when it is tightening, and vice-versa! That is consistent with Friedman´s saying from 1968: “low interest rates indicate that monetary policy has been tight and high interest rates that it has been easy”.

Another point often made, especially by the people at the FOMC, is that the unemployment rate is down to levels that indicate the economy is running out of slack (so policy must be “tightened”).

I find it wrong to reason from an unemployment change when unemployment at present means something possibly very different from what it meant in previous decades. The chart illustrates that at present, both unemployment and labor force participation rates are falling. In previous periods, a fall in unemployment went together with increasing or high labor force participation.

The tight coincidence between the fall in participation rates and the deep drop of NGDP below trend also make me skeptical to attribute any significant share of the drop in participation to structural/demographic factors.

Here also, most of the damage to the labor market lies in the hands of the misguided monetary policy adopted by the Bernanke/Yellen Fed! They feel that “the time has come to “tighten” monetary policy”. By misunderstanding monetary policy, they ignore that for the past year monetary policy has been tightening, with implications for the dollar and oil prices!

The charts illustrate:

And, being clueless, they think the low inflation is something temporary that is due to the oil and exchange rate effect. In other words, monetary policy is even absent from direct discussions of inflation!