The Joint Economic Committee in Congress put out its annual report on the economy, written by Alan Cole. My overall impression is that the JEC has a better grasp of real world macroeconomics than many people at top 10 econ departments.
Let’s start with their diagnosis of 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.
The mass unemployment that followed the 2008 financial crisis was an economic disaster whose effects will be felt for years to come. Americans lost trillions of dollars of income and tens of millions of years of work. The job losses were also concentrated among disadvantaged groups, increasing inequality along the dimensions of both education and race.
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 macroeconomists understand that the Great Recession was caused by a tight money policy by the Fed? You could almost count them on one hand.
The report cites Kevin Erdmann’s excellent book on the housing crisis:
[I]n his book Shut Out, Kevin Erdmann notes that the Federal Reserve as a whole would issue statements describing the weakness in the housing market as a “correction,” suggesting a kind of normative view that housing prices should fall.31 The Federal Reserve kept this language even well into the decline of employment measures. The focus on moral hazard and housing prices largely detracted from attention to an ailing labor market.
Most economists believe the Fed was “doing all it could” in 2008. The JEC reports understands that actual policy was quite schizophrenic, both expansionary and contractionary at the same time:
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
It’s as if the Fed simultaneously believed the economy faced a danger of too little spending and too much inflation—-which is literally impossible!!
The report also correctly describes how the Fed completely screwed up its forward guidance:
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.
There’s also a recognition that the unemployment rate is often a useful warning sign of recessions—the Sahm Rule:
Recent work by the Federal Reserve has affirmed this view of employment measures. Economist Claudia Sahm devised an algorithm colloquially known as the “Sahm Rule,” which treats sudden rises in the unemployment rate as reliable early warning signs of a contraction.44 While the Sahm Rule is based on the official unemployment rate for simplicity’s sake and to facilitate comparability across time, it is likely that other employment measures, such as payroll surveys or unemployment claims, could be used as additional data points to scan for early signs of recession.
Most economists put too much weight on interest rates as an indicator of the stance of monetary policy, which led them to (wrongly) assume that policy was accommodative during 2008. The JEC report understands that rates are not a good policy indicator:
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.)
They suggest that NGDP growth is a superior 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 report then explains why measuring the policy stance correctly is so important:
Why are the semantics here important? First, because effects matter. Monetary policy stances are named after their intended effects; loose or accommodative or expansionary monetary policy should presumably be loosening, accommodating, or expanding something. Tight or contractionary policy should presumably be tightening or contracting something.
Second, semantics are important because names have an effect on the policy’s politics. The Federal Reserve in 2015 had essentially achieved some relatively-normal results for years: steady improvement in the employment rate, steady (though below-target) core inflation, and steady four percent growth in NGDP, which is also a normal result. However, it labeled these policies “accommodative.” This lent credibility to the plausible-sounding-but-wrong critique that the low interest rates at the time were “artificial” in a way that higher interest rates would not have been. It put the FOMC under pressure to “normalize” policy by tightening, which it did by the end of the year.
Third, a results-based measure of the stance of monetary policy, such as NGDP growth, appropriately captures the effects of policies that do not involve the setting of short-term interest rates: for example, quantitative easing or forward guidance.
The report also contains excellent policy suggestions:
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.
The dual mandate leaves much room for ambiguity in terms of how to weight unemployment and inflation concerns; however, it is possible to integrate inflation and unemployment data into a single mandate that implicitly contains both components. The most promising methods for this begin with the observation that inflation is a price, and employment is a quantity. Therefore, they look to measures of price multiplied by quantity.
Fortunately, many such metrics exist. One of the most obvious of these is nominal GDP. The idea of targeting nominal GDP originated with monetary economist Bennett McCallum,48 but also has been advocated by other economists such as Scott Sumner, Christina Romer,49 Jan Hatzius,50 and Joshua Hendrickson.51 While there are some technical issues implementing a nominal GDP target in real time, economist David Beckworth, another advocate, proposes methods to predict nominal GDP more quickly, including the use of new data sources or futures markets.52 At a minimum, stable nominal GDP growth is an excellent medium- and longer-run measure of central bank performance.
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.
Honestly, this report is far better than 90% of the articles one reads in top level economics journals. Its fine to be able to write down highly mathematical models of the economy, but one also needs to have an intuitive grasp of which economic concepts are relevant to the sort of macroeconomic problems faced by real world economics. Alan Cole definitely understands the role of monetary policy in business cycles.