Grasping the Root

The Joint Economic Committee recently published a new annual report, written by Alan Cole. In my opinion, the report is ten times better than all of the qualified economic journals written in 2020.
It’s not possible to review the entire report here, but I will share some parts that I like.


Let’s start with the Great Recession:

Unfortunately, Federal Reserve policy from 2007-2018 erred too far towards curbing the growth of nominal spending—a stance known colloquially as “too tight” monetary policy. The result was a long, persistent “output gap,” or shortfall in GDP relative to what the economy could have produced with more ample nominal spending. While not the only policy problem of the time period, the output gap was a clear consequence of the Federal Reserve’s choice of policy anchor and its level of commitment to the anchor.

This era is useful to study because it can inform policy in future recessions, including, to some extent, the current one. A well-chosen and consistent monetary policy anchor will not solve every problem—and certainly not ones directly related to public health—but it can facilitate the execution of financial and business contracts and shore up the social contract by lowering uncertainty about the future.

How many economists know these days that the Great Recession was caused by tight money? I’m sure it’s no more than 5 percent.

Some economists believe that the Fed had nothing more to do in 2008-9. Quite the contrary, the problem was that the Fed did not take any proper action. Only the wrong decisions were made during the whole recession:

Taken separately, the bailout and interest rate decisions are coherent. But together, it is difficult to square them. As the Federal Reserve told it, spending enabled by emergency below-market-rate liquidity injections to Bear Stearns was good spending that helps Main Street, while spending enabled by a federal funds rate of (for example) 1.75 percent would have been bad spending that would spur inflation.

This pattern of easier credit for troubled financial institutions but tighter credit than necessary for the rest of us continued throughout 2008: as George Selgin documents, the Federal Reserve actually took care to offset its emergency operations’ effect on overall demand. Increases in credit to troubled banks were matched with corresponding decreases in credit elsewhere in the system.34 In Bernanke’s words, this was done to “keep a lid on inflation.”35

One tool in this offsetting process was interest on excess reserves (IOER). In October of 2008, the Federal Reserve began paying IOER.36 This policy induced banks to hold reserves and earn interest from the government rather than lending to private-sector individuals or institutions. This constrained credit for the private sector, outside of the banks that were rescued with below-market-rate lending.37

Another paragraph is to address the mistakes made during the 2010s:

One problem worsening the 2008-2019 output gap was that the Federal Reserve increased its estimates of the “natural rate of unemployment” (the lowest sustainable rate) as more people lost jobs, lowering potential GDP inaccurately and underestimating the output gap. This strategy has the obvious problem of mistaking cyclical movements for structural ones. The Federal Reserve has since revised its estimates of the natural rate back downward, as jobs were added once again. While updating one’s beliefs in response to new data is good, one should be wary of updating beliefs about long-run capacity based on data collected under unusual short-run conditions.

But there was a problem with forward guidance in the 2010s: Federal Reserve communications often described a hawkish reaction function—an inclination to run monetary policy relatively tightly.

Consider the Federal Reserve Board’s projections from January 201240, when interest rate predictions (often known as “dot plots,” for the way they were frequently charted) had just been issued for the first time. The projections told us that the median participant in the exercise believed that 2014 was the appropriate year for interest rates to rise. They also told us some other things about 2014: that participants believed Core PCE inflation would be below-target in the range of 1.6 to 2.0 percent, and that participants believed the unemployment rate would be in the range of 6.7 to 7.6 percent.

Put together, these predictions paint a clear picture of extraordinarily tight monetary policy. They told us that a Federal Reserve faced with an economy with elevated unemployment and below-target inflation would act to curb spending by tightening credit.

Most economists use interest rates to look at the stance of monetary policy. However, interest rates are not a good indicator in this regard. Unfortunately, as long as the economists use these assumptions, they will neither be able to understand the causes of the Great Recession, nor will be able to develop the proper policies for the next recessions. The JEC report understands that:

One particularly technical point about measurement concerns the stance of monetary policy. FOMC statements have frequently identified low interest rates as a sign of accommodative policy.

This is not always and everywhere correct. Neither is the converse: that high interest rates are a sign of tight policy. As Milton Friedman observed in his famous American Economic Association presidential address:

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.45

This observation—made in 1968—has largely held up, and in fact predicted to some degree both the late 1970s (when, despite high interest rates, inflation soared to record levels) and the early 2010s (when, despite low interest rates, inflation remained persistently below target and unemployment remained elevated.)

The key to the observation is that easy money gives ample credit, allowing spending to increase at an accelerating pace, raising nominal GDP growth expectations and inflation expectations, pushing the equilibrium interest rate (at least in nominal terms) upward. Tight money does the opposite: it causes spending to slow and lowers nominal growth expectations and inflation expectations, which pushes the equilibrium rate of interest down.

The report suggest that NGDP Targeting is a better policy indicator:

Scott Sumner phrases it in an improved and more modern formulation.46

Interest rates are not a reliable indicator of the stance of monetary policy. On any given day, an unexpected reduction in the fed funds target is usually an easing of policy. However, an extended period of time when interest rates are declining usually represents a tightening of monetary policy. That’s because during periods when interest rates are falling, the natural rate of interest is usually falling even faster (due to slowing NGDP growth), and vice versa.

The natural rate of interest is another economic abstraction that is hard to pin down precisely, but Sumner can be loosely translated as follows: during periods where the central bank is cutting interest rates, the risk-adjusted attractiveness of private-sector investments is falling even faster, so savers are still crowding into government bonds even at the lower rates.

Sumner considers the growth rate of NGDP a better guide to the stance of monetary policy. A policy that enables an acceleration in spending—however it is implemented—is loose, and one that forces a deceleration or contraction—however it is implemented—is tight. This formulation—based on effects—seems more appropriate than a measure based on interest rates alone.

The emphasis on market forecasts is also notable:

A number of market indicators can help the Federal Reserve make good predictions about the future. Mechanically tying Federal Reserve actions to market data is largely not a reasonable policy option, but markets can help the Federal Reserve predict the consequences of policy.

Treasury inflation-protected security (TIPS) spreads, or the difference in yield between inflation-protected bonds and ordinary bonds, have been underused in the Fed’s decision-making process in the past. These can tell the Federal Reserve what market expectations of inflation are. While the Fed’s inflation projections are typically good, TIPS spreads are extraordinarily quick to update in critical moments—as they were in 2008. By the September 2008 meeting, where the FOMC statement considered downside growth risks and upside inflation risks to be about equal, TIPS markets were pricing in far-below-target inflation of just one percent.

And the recommendation for the level targeting is especially important:

Level targeting is perhaps the single most effective zero lower bound policy, and likely has benefits even outside of the zero lower bound. The idea of “level targeting” is to have a consistent long-run growth path in mind for the target variable, not just growth rate to target anew each period.

There are two strong reasons to believe a level target would be effective. The first is that level targets would do a better job of anchoring expectations for long-term contracts, such as mortgages. For example, it is considerably easier for a mortgage lender to operate if she has at least a general sense of what nominal incomes in America will look like in the 30th year of the loan. Will they double? Will they triple? A nominal income level targeting regime can actually provide an answer to that question, making long-term contracts considerably easier to write. Similarly, if a pension plan were interested in implementing a cost-of-living adjustment to benefits based on inflation, it would be easy to make long-run projections under an inflation level targeting regime.

The second reason for believing in the effectiveness of a level target is that a level target constitutes a kind of forward guidance, which—through its impact on expectations, can actually work backwards in time. In promising a steady long-run path, it encourages people to invest more steadily in the present, knowing that over the long run, rough patches will be smoothed out.

Nominal GDP level targeting, or NGDPLT, is one of the most popular uses of the level targeting idea. Level targeting dovetails particularly well with NGDP targeting because it turns the target into a long-run goal. In a level-targeting regime, short-run blips like revisions to GDP data are understood to be less consequential; instead the central bank maintains focus on keeping the long-run path steady.

To be honest, I was full of hope while reading the whole thing. More economists need to acquire the insights found in this report. And Alan Cole shows that he understands the roots of the macroeconomics.

HT: Scott Sumner

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