Scott Sumner  

Questions that have no answer

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There are some questions that have no answers. One example is the question: "Was monetary policy too expansionary during the housing boom?" The only sensible answer is "it depends." It's not clear what the Fed was trying to do during this period. If we knew, we could evaluate whether the policy was too loose or too tight to achieve their policy goal.

Now that unemployment has fallen to 6.6%, it's possible to begin to make sense of the past decade. Prior to 2008, the highest unemployment rate of the 21st century occurred in June 2003, when it reached 6.3%. Let's examine what the US economy has done over the past 10 1/2 years:

1. NGDP has grown at almost exactly 4% per year since 2003:2.

2. The PCE price index (which the Fed targets at 2%) has grown at almost exactly 2% over the past 10 1/2 years.

Because we are currently at about the same position in the business cycle as in June 2003, I think it's fair to say that the trend rate of RGDP growth has been about 1.9% over the past 10 years. I suspect the rate is slowing, from a bit over 1.9% prior to the crash to below 1.9% since 2008, mostly due to retiring boomers, but also the immigration crackdown.

What are we to make of the 2% inflation rate? One could argue the Fed has been successful. After all, 2% is their target. But I believe that's wrong for 3 subtle reasons.

1. I don't believe the Fed was targeting inflation at 2% between 2003 and 2008, or if they were they were extraordinarily incompetent. They certainly did not act like a central bank targeting inflation at 2%. Indeed the rate of inflation ran well above 2% between 2003 and 2007 and the Fed responded by cutting interest rates repeatedly in 2007.

[Update: Kevin Erdmann caught me reasoning from a price change. The rate cuts of late 2007 don't mean the Fed was easing--monetary base growth slowed, for instance. A better argument is that money was too easy in 2005-07 if the Fed was serious about 2% inflation.]

2. One could argue that the rate cuts were justified by the Fed's dual mandate. But the dual mandate makes the Fed's performance look far worse than a simple 2% inflation target, single mandate. That's because under the dual mandate the Fed should aim for above 2% inflation when the economy is depressed and below 2% inflation during booms. But the Fed did exactly the opposite. Inflation ran far over 2% during the housing boom and only 1.2% since July 2008, when the recession first got severe. Men have drowned in lakes that average 3 feet in depth, and economies have drowned in the midst of long periods where inflation averaged 2%.

3. The third problem with the Fed policy is that inflation is the wrong target, they should target NGDP growth, level targeting. It turns out that the NGDP growth rate that kept inflation right at 2% over the past 10 1/2 year was only 4%, well below the 5.4% rate of 1990-2007. And yet, at the very moment when they needed to downshift NGDP growth to 4% to keep inflation on target, the Fed upshifted to more than 6.5% NGDP growth during the housing boom of 2003-06.

The third mistake allows us to better understand the mild dispute between some market monetarists over whether Fed policy was too tight loose in 2003-06. David Beckworth says yes, growth was above 5%. Marcus Nunes says no, there was some catch-up from the 2001 recession, and it's level targeting that matters.

In my view there is no answer to this question. If the Fed had continued along the level target path that Marcus suggests, then he would have been right, the policy would have been fine. Given the Fed wanted 2% inflation, Beckworth's advice would have been better in retrospect. If the Fed went even further and switched to 4% NGDP growth in 2003, then the recovery would have been agonizingly slow, John Kerry would have won Ohio and the Presidency in 2004, and there would have been no Great Recession of 2008. It would have looked like a bad Fed policy in retrospect because of the very slow recovery. The policy would have been condemned by many people, but it would have been far superior to the actual policy.

[Elsewhere I've argued that almost any alternative monetary policy in the interwar years would have been superior to what actually happened, but almost any alternative would have been condemned by economic historians for being "bad" (they never would have imagined just how bad "bad" can get.)]

Most people have trouble wrapping their heads around the notion that there is no answer to the question of whether monetary policy during 2003-06 was appropriate. It really does depend on what you assume their policy goals actually were. Policy was too easy for a 2% inflation target. However inflation targeting is bad, because sometimes it leads to NGDP shocks, and NGDP is what matters. So it made no sense to suddenly downshift from 5.4% to 4% NGDP growth. To be sure, 4% is a perfectly fine trend line, but if you want to go there then you get there slowly---6.0% in 2003, 5.5% in 2004, 5.0% in 2005, 4.5% in 2006, etc.

But that's a minor issue. What is absolutely insane is to both downshift to 4%, and simultaneously make the inflation rate highly procyclical. That was the big mistake. Yes, there are a few madmen in America who occasionally talk of "opportunistic disinflation." And yes, there are a few madmen in the eurozone who talk of "good deflation" restoring "competitiveness" to economies ravaged by plunging NGDP. But surely no serious economist like Mishkin, Bernanke, Yellen, Evans, Dudley, etc, would ever fall for that nonsense. No, this absurd policy played out accidentally, an almost prefect storm of bad luck and bad policy goals and bad models and inability to read the stance of monetary policy and driving the economy by looking in the review mirror. Here are just a few of the mistakes:

1. Targeting inflation rather than NGDP, combined with the bad luck that trend growth slowed to 2% after 2003.

2. Letting inflation run above target because it reflected rising commodity prices, and also because they misjudged the output gap (recall the Great Stagnation was underway, but not even Tyler Cowen knew it yet.)

3. Switching from targeting inflation up to 2008 (and missing on the upside) to effectively (unintentionally) targeting the price level after 2008--with a 2003 starting point. If Bernanke had announced in July 2008 that he was aiming for 1.2% inflation over the next 5 1/2 years Wall Street would have demanded his resignation. That was not the plan! But that's what happened, and Bernanke even once mentioned that inflation had averaged about 2% under his watch (in reply to an inflation hawk---BTW it was actually 1.8%.) So after making the mistake of letting inflation run above 2% during the boom, they did a policy (by accident) that effectively moved prices back to the trend line from 2003 during a deep slump--the worst time to do disinflation.

4. In September 2008 they finally realized that inflation was a problem, just as the markets were suggesting the opposite--disinflation was the new problem. They refused to cut rates in the meeting after Lehman failed, and cited a fear of high inflation. On the same day the TIPS markets predicted 1.23% inflation over the next 5 years. Guess who was right.

5. In 2009 they realized they had a big AD shortfall problem, but refused to do the sort of level targeting that Bernanke had recommended for Japan. They could have started the clock when fed fund rates hit the zero bound (late 2008), and made up for the 2009 deflation. But they didn't. Insiders say Bernanke was overruled by "FedBorg." They relied too much on the zero rate policy, and QE. Not enough on setting a clear and bullish target path.

6. Only in late 2012 did things start to get back on track with the forward guidance policy. It successfully offset savage fiscal austerity in 2013, and 2014 should also see rapidly falling unemployment.

PS. Kevin Erdmann has a post showing that quits are almost back to June 2003 levels, and Timothy Taylor has a post showing the number of unemployed persons per job opening and also quits per layoff are both running a bit better than 2003 levels. So we are very likely at about the same place in the cycle as June 2003. That means 1.9% RGDP growth (and slowing) is the "new normal."

BTW, Kevin's post have some very interesting stuff on the Beveridge Curve, indeed all his recent posts are must reading for those interested in unemployment.

PPS. Mark Sadowski did a nice graph of the "Musical Chairs model" during the Great Depression. The malfunction during 1933 is partly due to FDR cutting hours worked by 20%, a policy that affected output much more than the unemployment rate. Just thinking out loud, could the joint hypothesis "sticky wages plus musical chairs model" be addressed by deflating predicted wages by NGDP, not actual wages by NGDP? Predicted wages for year t would be derived by assuming expected wage growth between year t-1 and year t was equal to actual wage growth between year t-2 and year t-1. (That is the sticky wage assumption.) That makes the model look a bit less like an identity, and makes it work better if wages are in fact sticky, than if they are not. I am fairly confident that this version would look almost equally good for the 2005-2013 period.


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COMMENTS (11 to date)
Thomas Sewell writes:

Scott,

Could you detail more of what you mean by the "immigration crackdown" since 2008?

Genuinely puzzled here, as my (loose) impression was that we had reduced numbers of illegal immigrant workers, but that it was a result more of weak economic growth, not of increased enforcement actions.

Philo writes:

One question is: was monetary policy appropriate to achieve the Fed's goal? Another question is: was monetary policy appropriate to achieve the goal that ought to have been the Fed's? Both of these questions, like all real questions, have answers. The "questions" that don't have answers are incomplete formulations, which leave the reader/hearer unable to tell what the question really is.

Kevin Erdmann writes:

Thanks for the shout out, Scott.

I like this post, but I have one nit pick.

"Indeed the rate of inflation ran well above 2% between 2003 and 2007 and the Fed responded by cutting interest rates repeatedly in 2007."

I don't think you agree with the sentiment of that statement, do you? Their Treasury security holdings were sinking like a stone at the time.

Michael Byrnes writes:

So we now have a decade of 4% NGDP growth, but we have gotten there with procyclical monetary policy. As a result of this, we have no real idea what the Fed's intentions were with regard to NGDP growth during the past decade. More importantly, we have no real idea what the Fed's intentions are with regard to NGDP growth from 2014-2024.

I think we can be confident that the economy will experience nominal shocks during the next decade.

I think we can be confident that, faced with another 2008, the Fed won't be as asleep at the switch as they were then.

Maybe we can even be confident that the Fed considers 4% NGDP growth to be acceptable.

But can we be confident that the Fed will follow countercyclical monetary policy? Can we be confident that the Fed will respond aggressively and proactively to future nominal shocks?

I don't think so, though the reasons why are less clear. Maybe it is all politics. Clearly there are some economic actors who would be hurt, at least in the short term, from countercyclical policy during a boom. Even more clearly, there has been a lot of criticism of the Fed's countercyclical policies since 2008, and not all of it from whackos like Peter Schiff - the critics include various FOMC members, highly-regarded macroeconomists like John Taylor, Meltzer, etc.).

Some of those who do believe in wage/price stickiness as a driver of the business cycle have argued that 5 years is more than enough time for the needed adjustments to take place. Thus, we cannot still be experiencing the adverse effects of insufficient AD shock.

But the Fed is not following a level target of 4% NGDP growth. And there is no real reason to believe that they will respond appropriately to nominal shocks going forward, is there? Heck, in 2018, John Taylor could succeed Janet Yellen as Fed chair. (They are the same age, and one could certainly imagine a Yellen reappointment if the Deomcrats win in 2016.)

Isn't the uncertainty around the Fed's reaction to future nominal shocks a sort of negative shock in and of itself.


Philip George writes:

The question whether monetary growth was expansionary during the housing boom can only be answered by a look at a monetary aggregate.

The last graph on http://www.philipji.com/M1-and-Mc/ which shows the monetary aggregate Mc for five decades from 1961 to 2010 answers the question for the period of the housing boom.

And yes, Mc growth is very high right now. Of course we won't realise the effect until the Fed throttles money growth. When that happens one or more asset markets will collapse and we will have another recession.

Note how successfully the graph of Mc tracks every recession and asset boom over the five decades. Friedman's famous comment on the quantity theory needs to be modified as follows: "There is no instance in which a substantial change in the stock of money has occurred without a substantial change in either the level of nominal GDP or financial asset prices or both. And conversely there has been no instance of a substantial change in the level of nominal GDP or asset prices without a substantial change in the stock of money in the same direction."

John Becker writes:

Here's my favorite graph of this recession. I think it explains why the recession has endured for so long and recovery has been so slow.

https://research.stlouisfed.org/fred2/graph/?graph_id=160908&category_id=0

After other recessions, bank lending rebounded strongly with a normal during "good times" around 10%. In 2008-2009, bank lending dropped sharply and never bounced back. It upticked to about 3% and fell below 0% during the years that were supposed to bring recovery (2010-2012). It appears to be falling again to 0% again.

Scott Sumner writes:

Thomas, Beginning around 2006 the Federal government began a crackdown on illegal immigration. Yes, the economy was one factor, but the tighter restrictions also played a role.

Philo, Yes, good point. But notice that we don't know what the Fed's goal was in 2003-06, so any attempt to judge their performance is going to be pretty arbitrary.

Here's another way of addressing the issue. The answer to whether money was too easy in 2003-06 depends on what you think the appropriate policy was after 2006. Or perhaps it depends on the actual counterfactual policy after 2006. But that's unknowable.

Kevin, Good catch. Perhaps a better argument is that if they were serious about inflation they should have tightened monetary policy well before late 2007. But you are right, the base leveled off in late 2007 and early 2008 and NGDP growth slowed. So money was getting tighter in those respects. If 2% inflation was actually the goal, then policy was too easy in the 2005-07 period.

Michael, Lots of good points. I do expect roughly 4% NGDP growth going forward, and agree that the Fed hasn't yet learned the lessons it needs to learn, but probably would not repeat the worst mistakes of the last cycle. My hunch is that the next cycle will be milder for that reason, but perhaps that's just wishful thinking on my part.

Philip, I don't believe that money, however defined, is the best indicator of monetary policy. Certainly better than interest rates, but inferior to NGDP growth.

John, That may be a factor, but the Fed could have and should have offset the drag from banking.

Justin Dailey writes:

--"Because we are currently at about the same position in the business cycle as in June 2003, I think it's fair to say that the trend rate of RGDP growth has been about 1.9% over the past 10 years. I suspect the rate is slowing, from a bit over 1.9% prior to the crash to below 1.9% since 2008, mostly due to retiring boomers, but also the immigration crackdown."--

Are we really in the same position in the business cycle as June 2003? On an employment to population ratio basis, it doesn't appear that way (67.5% now vs 71.2% then).

http://research.stlouisfed.org/fred2/series/LREM64TTUSM156S

--"I don't believe the Fed was targeting inflation at 2% between 2003 and 2008, or if they were they were extraordinarily incompetent. They certainly did not act like a central bank targeting inflation at 2%. Indeed the rate of inflation ran well above 2% between 2003 and 2007 and the Fed responded by cutting interest rates repeatedly in 2007."--

When I look at the data, I see the Core PCE deflator growing at a 2.05% annual pace from Dec-2002 to Dec-2007 and 2.32% from Dec-2006 to Dec-2007. A little high, I agree, but still pretty close to 2%.

http://research.stlouisfed.org/fred2/data/PCEPILFE.txt

Philo writes:

Is it really true that *no one* knows what was the objective of the 2003-06 Fed? I suspect that the Fed itself, as a collective entity, knew what its objective was (of course, the objective was not necessarily constant over this whole period). There may also be individuals who knew, and who still know, though evidently you are not among them, and I certainly am not. But the fact that you and I do not know the answer does not imply that no one knows it.

And by "questions that have no answer" I thought you meant more than *questions about which you and I do not know the answer*; more, even, than *questions for which no present individual knows the answer*. I thought you meant something like *questions for which no one COULD POSSIBLY know the answer*.

MingoV writes:
Now that unemployment has fallen to 6.6%
It's hard for me to understand how any economist can use the unemployment numbers cooked up by the federal government. Numbers that don't include high school or college grads who never found a job. That don't include people who have not worked for more than five years and cannot get a job. That don't include people who exhausted their unemployment benefits and didn't get a job afterwards. That don't include people who had high paying jobs and now work part-time for low wages. That don't include people who retired early due to poor job prospects. We have record high percentages of non-retired adults who aren't working, yet somehow unemployment is declining. We also know from the recent past that the executive branch has falsified data to generate better numbers, and then issues a correction weeks or months later that gets little media attention. The 6.6% figure means absolutely nothing.
Lorenzo from Oz writes:

MingoV: Yes, but the unemployment figures/labour force statistics generally always have those problems, so still work as an indicator of changes in conditions over time.

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