The Fed Shows Class Bias?

A Benjamin Cole post

In general, the “class glass” is a poor lens for analyzing U.S. politics and macroeconomic policies.  To be sure, the nation has interest-group politics in spades, and groups are often well-financed.

And certainly, whenever past Dallas Fed President Richard Fisher sallied forth there was the potential for embarrassing spectacle, as when he held a press conference to condemn wages rising faster than prices. Or to warn that rising prices of antiquarian collectible books harbingered an inflation that merited a tighter monetary noose immediately.

But, in general, does Fed monetary policy exhibit class bias?

Perhaps So

Think about two aspects of Fed policy: The Fed appears committed to keeping (at a minimum) about one out of 20 Americans who want work to being unemployed, and now has committed to paying 0.50% interest on excess reserves (IOER), regardless of how much capital is surplus.

On jobs, the picture may be worse than at first blush. According to JOLTS data there are 5.3 million job openings in the U.S., but the number of unemployed is 7.9 million at latest read, and that excepts the millions who have given up looking for work. There are still, in aggregate, more people who want work than available jobs, and this appears at least partially the result of official Fed policy. People who want to work get to play musical chairs. No class bias? Would the AFL-CIO endorse such a policy? Would any job-hunter?

On IOER, the question can be asked, “Have those with money to save demanded a return on ultra-safe short-term savings—market forces be damned—and has the Fed complied?”  To be sure, there has been a constant chorus from some quarters that the Fed is engaged in “financial repression”—that is, holding down interest rates. There is a vocal, influential tribe in the U.S. that at any moment calls for tighter money, with the servile organ of The Wall Street Journal op-ed page ever available.

An earnest question cuts the other way as well. Without the Fed’s “reverse repo” program, what would be short-term interest rates today? Rates are negative through much of the developed world.

Of course, the proposition that the Fed’s 0.50% IOER is merely interest group politics, and capture of regulatory agency (the Fed) by the regulated (the banks) is a viable one as well.


The policy-making Federal Open Market Committee does not have a “labor” seat, or seats from the manufacturing, real estate, agriculture, or tourism industries.  To say the financial industries are influential at the Fed would not be provocative.

Do influential financial industries create proxy for class bias at the Fed?

It is a reasonable question.


From the St. Louis Fed, here are the PCE Deflator figures, chain-type index, for the last two years. It shows a 1.54% increase in prices in the last eight quarters. That is not per quarter; that is total. That is about 0.75% annual inflation, or not even 1% annual inflation.  The Fed has proposed four rate increases in 2016. Really?

2013-10-01  108.108

2014-01-01  108.540

2014-04-01  109.117

2014-07-01  109.441

2014-10-01  109.322

2015-01-01  108.795

2015-04-01  109.391

2015-07-01  109.740

2015-10-01  109.775



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 wellThe 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”.

Time For Central Banker Global Summit And Policy Shift

A Benjamin Cole post

And so the Bank of Japan becomes the latest monetary policy-making body to introduce negative interest rates, in what has been a years-long yet curiously feeble battle by global central bankers to avoid sluggish growth, recession and deflation.

From CNBC:

“The Bank of Japan adopted negative interest rates for the first time at the end of its two-day policy review on Friday, buckling under pressure to ease concerns about the health of the world’s third-largest economy.

[T]he BOJ said it will apply a rate of negative 0.1% to excess reserves that financial institutional place at the bank and introduce a three-tier system on rates.

The news saw the benchmark Nikkei shoot up 3 percent, the yen slide 2 percent against the greenback and U.S. stock futures rally 1%.”

The Inflation Bogeyman

So, we see negative interest rates in parts of Europe and in Japan, and the People’s Bank of China is employing stimulus of lower rates and possibly quantitative easing. The Reserve Bank of India has been cutting rates and conducting periodic “liquidity injections.”

Weak global aggregate demand has left worldwide manufacturing with superfluous capacity, commodities markets flooded, while the ongoing pervasive capital glut shrinks investor returns. Major economies are in deflation, or exhibiting microscopic and sinking inflation, as measured.

Yet to read literature from the U.S. Federal Reserve or the Bank of International Settlements is like entering an alternative universe in which there are only three topics: inflation, inflation past, and inflation future.

On Jan. 27 the Fed issued its 520-word FOMC policy statement, with the word “inflation” in it 11 times, and “prices” five times. That’s actually less monomaniacal than usual; last August at the annual Kansas City Fed inflation-fest in Jackson Hole, Fed Vice Chair Stanley Fisher used the word “inflation” 75 times, and the word “price(s)” 31 times in a speech of barely 2,000 words. The word “growth” appeared three times, and “unemployment” eight times.

Inexplicably, the Fed is promising a tighter monetary policy.

The BIS issued a study in June of last year entitled, Another Year of Monetary Policy Accommodation, with this sentence “extraordinary degree of monetary accommodation in the major advanced economies.”

This is an anorexic saying, “I have been eating to an extraordinary degree, and I have lost only two pounds in the last year.”


The world’s major central banks need to meet quickly, summit-style, and in unison agree to promote national and global nominal GDP growth going forward for five years, whether by interest-rate cuts, quantitative easing or any means necessary. I would suggest national targets of 7% NGDP growth, possibly higher in India and China.

For the next five years, the primary goal of global monetary policy should be economic expansion, while “fighting inflation” is put on the back burner. Frankly, with so much global excess capacity and competition, I doubt inflation will amount to much anyway.

Yes, there are structural impediments galore in the global and national economies. There always will be, that is the nature of government and man.

But for independent central bankers to put a monetary noose on the global economy and then to issue sanctimonious sermonettes about inflation and better government is intolerable, especially in light of polemical political movements in most of the developed world. Central banks cannot suffocate the world into political stability and free markets.

Print more money, and a lot of it.

PS I hope the Western experiment with the “independent central banker” is coming to a close. I want to vote for better monetary policy—is that not the nature of democracy?

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”!

Employ Report 11-15_1

Employ Report 11-15_2

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.

Employ Report 11-15_3

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

Employ Report 11-15_4

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.

Haruhiko Kuroda Again The Globe’s Best Central Banker. FOMC Look Like Fops

A Benjamin Cole post

In Japan, the inflation rate is about 1.2% by the Bank of Japan’s alternative index, and the unemployment rate is a scant 3.1%. The stock market is up 15.1% in the last year. Capital spending by Japanese companies in Q3 was up 11.2% year-over-year.

Haruhiko Kuroda is the Governor of the Bank of Japan, and the world’s best central banker. Kuroda could wring his hands about “long and variable lags,” and curtail the Bank of Japan’s quantitative easing program, now running about $50 billion a month in an economy half the size of the United States economy. BTW, the Bank of Japan pays 0.10% interest on excess reserves.

Instead Kuroda shows steel and resolve. Read this from Nov. 30, Reuters: “Bank of Japan’s governor has dismissed calls from critics to go slow on hitting the central bank’s 2% inflation target and stressed the need to take ‘whatever steps necessary’ to achieve its ambitious consumer price goal.”

Kuroda told an audience of Toyota auto execs and others, “In order to overcome deflation—in other words, break the deadlock—somebody has to show an unwavering resolve and change the situation. When price developments are at stake, the BOJ must be the first to move.”

Contrast the stalwart Kuroda with the feeble, dithering, inflation-cowering of Chairman Janet Yellen and Vice Chairman Stanley Fischer of the U.S. Federal Reserve Board.

But first consider: The U.S. unemployment rate is 5.0%, much higher than Japan’s 3.1% rate. The core U.S. PCE inflation rate is 1.3%, about the same as Japan’s, and below target. The S&P 500 is about back to where it was a year ago, not up 15.1% like the Japan’s stock market. U.S. capital spending is weak, while Japan capital spending is strong.

While the mediocre U.S. economy compares unfavorably to Japan’s on many levels, the Fed is actually and presently tightening monetary policy. Think about it: Where Japan does $50 billion monthly in QE, the Fed is shrinking its balance sheet, or reverse QE. Where the Bank of Japan pays 0.10% IOER, the Fed pays 0.25%. And the Fed, after endless fretting, appears ready to raise rates at their Dec. 16 meeting.

So we have the U.S. central bank conducting reverse QE, raising interest rates, and paying banks not to lend through IOER. All this while the PCE price index is below target and falling, and real growth is sluggish.

Please Mr. Kuroda, come to America. We need you at our central bank.

Cautionary advice from a former Fed Staffer

In Why It’s Still Too Early for the Fed to Start Raising Interest Rates, Andrew Levin writes:

The Federal Reserve has signaled that it will begin raising short-term interest rates at its Dec. 15 meeting. The Federal Open Market Committee has maintained its federal funds rate target close to zero for seven years, and it has frequently described the removal of monetary policy accommodation as “normalization.” So many will infer from this decision that the Fed judges the economy to be sufficiently close to “normal” to warrant the onset of tightening. Yet current economic conditions are not consistent with this action, and starting the tightening process now would pose substantial risks to the Federal Reserve’s statutory goals of maximum employment and price stability.


All of these considerations indicate that, instead of starting to remove monetary accommodation, the Federal Reserve should maintain its current policy stance until the employment shortfall has declined further and core inflation is moving definitively back toward its target.

He´s right. It´s nothing like Blinder´s “Be calm and carry-on”. Everyone should really be concerned that the Fed is likely to badly blunder once again, something that has been going on for almost a decade!

Levin makes comparisons to the 1990 and 2001 recessions, and the “tightening” that followed on the steps of the recoveries, where by tightening he means the rate “lift-offs” that took place.

The panel below shoes how dismal the Fed´s performance has been since Bernanke took the helm, which he passed on to Yellen early last year.

Compared to the 1990/91 recession, the 2001 recession was mild, more like a growth recession. Nevertheless, the recovery was protracted because the Fed “held spending growth back”.

Note that despite a comparative strong spending rebound following the 1990/91 downturn, inflation kept going down and twenty years ago reached the “gotcha (2%) level”. Since then, it has much of the time stayed below that threshold.

After managing to depress spending to an extent not seen since 1937/38, the Fed has been quite casual in bringing it back, actually stopping the process “short”.



Given the economy´s depressed state that resulted from the momentous monetary blunder, many feel that the “reserve cavalry” has to come to the rescue!

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

Greenspan´s first 10 years

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.

The early days of the Volcker Adjustment – A reply to Bob Murphy

Bob Murphy has a post, which starts with a parody:

Suppose someone asks you, “What was the stance of US monetary policy in mid-1980? Pretend you are a Market Monetarist answering.”


First thing, we would not look at interest rates; that is a totally misleading indicator. As Sumner tells us in this post, “Interest rates tell us nothing about the stance of monetary policy.” In context, he is saying that the Fed interest rate cuts in the early 1930s were still consistent with very tight policy.

Instead, let’s look at NGDP and unemployment: (and puts up a version of this chart)


And says:

Oh man, there’s a smoking gun, right? The unemployment rate skyrockets in the middle of 1980, while NGDP growth (blue line) collapses. (The blue line is the level of NGDP, so you can see that it falls way below the previous trend starting in 1980.) Think of all the employers who had signed wage contracts during the late 1970s, and all the consumers who took out home mortgages, expecting NGDP to grow at a brisk pace. The rug was pulled out from them by the tight-fisted Volcker, right around mid-1980.

I said parody, because to a market monetarist it would be: “Let´s look at NGDP growth and inflation”.

Changing the chart above to accommodate (beginning the chart in mid-1979 to coincide with Volcker becoming Fed Chairman and extending to mid-1985 that more or less defines for Volcker “mission accomplished):


We gather that monetary policy (NGDP growth) was being tightened as the US went into the 1980 recession (Jan-Jul 1980). However inflation was still rising so, in a sense, monetary policy was not “tight enough”.

Coinciding with the end of the 1980 recession monetary policy becomes “expansionary”. NGDP growth rises and inflation still increases for a while. In mid-1981, monetary policy tightens significantly, with both NGDP growth and inflation coming down. At the end of the 1981-82 recession, NGDP growth increases and inflation continues to decline, indicating monetary policy is neither “tight” nor “loose”, but “just right” to stabilize the economy.

Most people knew, when Volcker came along, that it wouldn´t be easy to conquer inflation. Over the previous 15 years of high, rising and volatile inflation, inflation expectations had become entrenched. Moreover, since the early 1960s, it was the rate of unemployment that “governed” monetary policy. Also, as clearly stated by Arthur Burns during his tenure as Fed Chairman from 1970 to 1978, inflation was not a monetary phenomenon, being the result of, depending on the circumstances, union power, oligopolies, powerful oil producing countries.

To Burns, monetary policy could only try to mitigate the effect on unemployment of those real (or supply) shocks.

So, when Volcker´s early tightening resulted in a 2-percentage point rise in unemployment, from 5.7% to 7.7% while inflation (due to lack of credibility given the go-stop style of monetary policy over the previous 15 years) continued to rise, the Fed “backtracked”. The attack on inflation one year later proved successful, although costly in terms of unemployment. Lesson: It´s not easy to break inflation expectations!

As the next chart shows, the cost was high, but temporary, because the economy regained its previous real output trend level path.


From then, until the end of Greenspan´s tenure, the economy experienced a “Great Moderation”. With the mistakes made by Bernanke, and continued with Yellen the economy has been downgraded to “Secular Stagnating”!

The Fed´s gone AWOL and says “Mission Accomplished”?

Tim Duy´s bottom Line:

Bottom Line:  The Fed is set to declare “Mission Accomplished” at the next FOMC meeting.

Indeed, many policymakers have already said as much. Absent a very significant change in the outlook, failure to hike rates in December would renew the barrage of criticism regarding their communications strategy that prompted them to highlight the December meeting in their last statement.

Once they have communicated their intentions for subsequent rate hikes, they will turn their attention to the issue of normalizing the balance sheet. Even though officials have not committed to a specific path, I am working with a baseline of 100bp of tightening between now and next December, or roughly 25bp every other meeting. I expect that by the second quarter of next year they will begin communicating the fate of the balance sheet.

Whether they should hike or not remains a separate issue. Over the next twelve months we will learn the extent of which the Federal Reserve can resist the global downward pull of interest rates. Other central banks have been less-than-successful in their efforts to pull off the zero bound – not exactly a hopeful precedent.

How come “Mission Accomplished” if over the past five years nothing of relevance has changed? Don´t tell me about the “low” (maybe too low for them) rate of unemployment. That´s at least two stages removed from “relevant”. They´re only grasping at the first straw that floated down.

NGDP growth is running below average (3.8%), RGDP growth is right on average (2.1%) and core inflation is below average (1.5%)


In fact, the “Mission” was accomplished five years ago when the FOMC, after pulling the economy up by it´s hairs, decided that´s the pace they wanted it to keep!

They should be careful because the beast is showing signs of fatigue again. It needs more “fuel”, not less. But find a “better grade” one!

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 wellThe 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!


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!