He said his model is consistent with the Fed maintaining its 2% inflation target, but would simply mean the central bank would work more aggressively to counter any undershooting or overshooting of that objective. For instance, a nominal GDP target would have likely prescribed even more aggressive Fed monetary easing during the crisis-ridden 2007-2009 period, Mr. Bullard said.
"If you took this paper seriously we should have done even more in 2007-2009," he said. "Something like nominal GDP targeting, if it's appropriately formulated, does look like optimal policy."
In their model, the central bank would aim to raise the price level when there is a negative economic shock, such as we saw in 2007-09. Here I'd like to consider why the Fed did not do this optimal policy. I'll argue they failed because they were focusing on stabilizing inflation, not NGDP growth.
Paul Krugman has suggested that pre-1985 recessions were usually caused by the Fed raising interest rates to fight inflation, but more recent downturns were "balance sheet recessions", and were not preceded by a sharp upward spike in interest rates. There's some truth to the claim that recent recessions differ from those occurring before 1985, but I'll try to show that fighting inflation played a larger role in policy mistakes during 2008 than you might assume.
I could focus on NGDP and inflation, which behaved very differently in 2008. NGDP slowed throughout 2008, whereas inflation rose sharply until midyear, and then fall sharply. But the NGDP data is reported with long lags, and has been revised downward substantially since 2008. So policymakers in real time may not have perceived a big NGDP problem. Instead I'll focus on the unemployment rate, which is reported in a timely fashion, and generally isn't revised very significantly. Here's Michael Darda on the unemployment rate and recessions:
. . .anytime the U.S. unemployment rate has risen 0.5 percentage points or more from year-earlier levels (after a period of annual declines), the U.S. has either been in recession or on the cusp of one with no exceptions to this rule in post-war history.
I've made a similar point in previous posts, but I like Darda's formulation better. Keep in mind that a 0.5% increase is really small, and that it's hard to find non-trivial indicators that correlate 100% with post-war recessions. (Note that this is different from predicting recessions before they occur. For that goal economists tend to rely on yield spreads, which are less accurate but more timely. Here I'm more interested in identifying recessions that have already begun, or are about to do so.)
Below I've provided the 12-month change in the unemployment rate, and also the 12-month change in the price level (i.e. PCE inflation) for key dates in 2007 and 2008:
Here I have included all of the data available to FOMC members as of the September 16, 2008 meeting. It's striking that the unemployment rate for December 2007 was the first to provide a recession signal. That's the date the recession actually began, but even as late as mid-2008 the Fed did not expect a recession.
Of course just because a signal has always been correct in the past, doesn't mean it will work in the future. And the 12-month change in unemployment did moderate to 0.4% in January and February of 2008. Then another even stronger signal in March (plus 0.7%), followed by a fallback in April (to plus 0.5%). We seemed to be skirting on the edge of recession. After May, however, the economy went into a deep tailspin, with the unemployment rate showing a plus 1.0% in May, rising to a huge plus 1.5% in August.
How did the Fed react to these very scary unemployment numbers? By doing nothing, or by tightening, depending on your perspective.
The Fed held its fed funds target stable (at 2.0%) from late April to October 2008. This despite extremely serious deterioration in the labor market. But why? In the statement issued after the September 16, 2008 meeting, which occurred two days after Lehman failed, the Fed gave us their reasoning. They indicated that they saw equal risk of recession and high inflation. Given that they perceived these risks as balanced, they decided not to change policy.
In my view, policy was being continually tightened throughout this period. If we had had a NGDP futures market, it would have indicated falling NGDP expectations. TIPS spreads were declining, and reached 1.23% for the 5-year spread by the time of their September meeting.
Today we know that the real problem was deflation, which had set in by early 2009. But the Fed was worried about high inflation, and this led them to unintentionally tighten monetary policy. Even though the policy rate was stable at 2.0%, the Wicksellian natural rate was falling fast between April and October. Hence the effective stance of monetary policy was getting progressively tighter.
The new paper by James Bullard (who is president of the St Louis Fed) and three other researchers, tells us what went wrong in 2008. The Fed needed to allow a higher price level, to offset the negative shock from the housing/banking crisis. That would have required them to ease monetary policy. But the inflation numbers were very scary. Not only were they higher than the Fed's 2% target, they were increasing up until July 2008, the last data point available by the September meeting. Little did they know that inflation had already fallen to 4.0% in August, and would reach less than 0.4% in December. By March of 2009 the 12-month inflation rate was negative---we were in deflation.
The markets figured out this problem before the Fed. If the Fed had adopted NGDP targeting, they would have ignored the inflation numbers and focused on NGDP growth. Even so, because of data lags they might have been a bit behind the curve. But the markets would have expected a catch-up from any near-term NGDP undershoot, and thus NGDP growth expectations would have stayed strong enough to prevent the economy from hitting the zero bound.
The problem was not so much that the Fed didn't cut rates quickly enough in 2008 (although that was a problem) but rather that they didn't have a monetary regime in place that would have prevented the Wicksellian natural interest rate from falling to zero in the first place.
The Bullard, et al, paper represents a huge step in the right direction, toward a better understanding of how monetary policy failed in 2008.