Scott Sumner  

"In retrospect, that decision was certainly a mistake"

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Prior to late 2008, I had gone 25 years without having a strong opinion on monetary policy. It seemed about right, even if on occasion I might have preferred something a bit easier or a bit tighter. Then it seemed to suddenly go completely off the rails. And this seemingly bizarre policy occurred well before the Fed hit the zero bound. From the outside, it almost seemed like the Fed had completely forgotten about monetary policy, forgotten that monetary policy was what steered the ship (of nominal GDP.)
I knew that Fed officials (such as Ben Bernanke) understood that monetary policy determined the path of prices and NGDP. Bernanke had admitted that an excessively tight money policy by the Fed caused the Great Depression, and that excessively easy money caused the Great Inflation. Now the Fed was causing a "Great Recession" with excessively tight money. This was obvious to me, and (I think) obvious to the markets. But apparently not to the Fed. Why?

At the time, I assumed that the Fed was distracted by the financial crisis. My PowerPoint presentations over the past 6 years were generally entitled "The Real Problem Was Nominal", pushback against the widespread perception that the Great Recession was caused by real factors, such as financial turmoil. And even if I was wrong about financial turmoil, surely it was not in our interest to let NGDP fall at the sharpest rate since 1938. Any recession caused by financial turmoil would become far worse if NGDP also fell sharply. So why didn't the Fed do more to boost NGDP, especially while interest rates were still positive? Why not do enough so that the Fed's own internal forecast was for on-target growth in aggregate demand?

I'm a slow reader, so I'm only about 60% of the way through Bernanke's memoir. But based on what I've read so far I believe that my initial assumption was correct. The Fed simply lost track of the need to focus like a laser on monetary policy. In fact, it wasn't that hard for me to figure out the problem, because the Fed employs a representative sample of macroeconomists who are experts on monetary policy. And it also seemed obvious to me that macroeconomists outside the Fed had dropped the ball, so why should those inside the Fed have been any different?

Let's back up a little bit. Although Bernanke is admirably polite, fair and even-handed, here and there his inner thoughts slip through:

Richard Fisher warned that too large a rate cut would be giving in to a "siren call" to "indulge rather than discipline risky financial behavior." But, given the rising threat to the broader economy, most members, including myself, Don Kohn, Tim Geithner, Janet Yellen, and Mishkin, had lost patience with this argument. "As the central bank, we have a responsibility to help markets function normally and to promote economic stability broadly speaking," I said. (p. 162)
Although Bernanke must've been exasperated by Fisher, "lost patience" is about as negative as he got (at least up to page 365). On page 170, Bernanke said:
However, in a concession to the hawks that I would later regret, I agreed to a shift in language that signaled we weren't eager to cut rates again absent a change in the data.
In his press conferences, Bernanke came across as a moderate, the face of the institution. In the memoir, however, it's clear that Bernanke was on the dovish side of debates within the Fed.

But not always. Bernanke also thought it important that the Fed present a fairly united front. in December 2007, Bernanke encouraged Mishkin to support a quarter point cut in the Fed funds rate, rather than the half-point cut Mishkin initially favored. In retrospect, that was mistake. But to his credit, Bernanke quickly realized that more stimulus was needed, and Fed (interest rate) policy was quite aggressive in early 2008. Bernanke saw the danger to the economy and pushed the Fed to cut rates quickly enough to stave off at sharp recession in early 2008. Instead the economy was flat in the first half of 2008, and by the spring and early summer it looked like the US might even be able to avoid a recession.

The big puzzle is the second half of 2008. As the economy and the financial system both deteriorated sharply in September and October, the Fed was actually less aggressive in easing monetary policy than they had been in late 2007 and early 2008, when both the economy and the financial system were much stronger. This is what puzzled me so much at the time, and still does.

Two days after Lehman Brothers failed, the FOMC decided to do absolutely nothing to ease monetary policy. This was probably the single most shocking Fed decision in recent decades. Naturally I was interested in learning what Bernanke thought about the meeting. Here's what he said:

In retrospect, that decision was certainly a mistake.
Bernanke then points to the fact that the Fed had been so focused on dealing with the financial turmoil that they hadn't really had much time to focus a lot on monetary policy. One has the odd impression that if they had faced the exact same macro data but without a financial crisis, they would have cut rates. This might be unfair; it's probably more a question of the Fed assuming that the financial crisis was "the problem", and that any slowing of the economy was merely a symptom of that crisis. In my view, the Fed had to a very large extent reversed causation. Tight money was reducing NGDP, which was worsening the banking crisis.

One Fed mistake does not make a Great Recession. In fact, monetary policy was far off course throughout all of late 2008. Bernanke later discusses the Fed's efforts to get permission to pay interest on bank reserves. He indicates that without this power the Fed's large base injections to save the banking system might have caused the Fed to "lose control of monetary policy." I don't think very many readers would understand that Bernanke was actually saying that without IOR, Fed policy would become more expansionary. "More expansionary" (in October 2008) doesn't sound as scary as "lose control". Then there was the decision by the Fed to cut rates by 1/2% on October 8, 2008, to 1.5%. But why not more? In January 2008 they had cut rates by 3/4% under far less dire circumstances. Indeed why not cut them to zero?

Bernanke was certainly aware that rate cuts could help, and that a stronger economy could also boost the asset markets:

I continued urging other major central banks to join us in a coordinated interest rate cut. I believed that the rate cuts themselves would support global economic growth and that the demonstration of unity would cheer the markets. (p. 346)
Yes, so why not do more, much more?

To summarize, at this point in the memoir I'm every bit as perplexed as before. In 2008, the profession as a whole seemed to suddenly stop believing that monetary policy drove NGDP growth. That shift in belief seemed to occur both within the Fed and among academic economists. That's why I got into blogging. Unfortunately, Bernanke's memoir doesn't really shed any light on why macroeconomists suddenly stopped believing that monetary policy determines the growth in NGDP. Or why policy was so passive. I do, however, find consolation in Bernanke's admission that the September decision was a mistake. If the Fed had been following market monetarist principles it certainly would have cut rates in September 2008. So at least in one very important meeting, market monetarism outperformed the standard monetary policy framework employed by the world's major central banks.

Comments and Sharing

COMMENTS (17 to date)
Steve Waldman writes:

I think you've found a challenge to your admirably whiggish disposition.

The economics profession stopped believing that monetary policy drove NGDP precisely when it was going to institutionally difficult for the Federal Reserve to stabilize NGDP even if, as you have so assiduously argued, it was entirely in the Fed's power to do so.

The Federal Reserve is an institution at the center of the economics profession, a core sponsor of economic research in financial terms and the clearest embodiment of the prestige and influence of economists in policy. Given that, for indeterminate reasons, the Fed signaled clearly enough reluctance to embrace the kind of policy innovations you have advocated, innovations that might have stabilized the NGDP path, the profession faced a choice. It could hew to the prior consensus, as you did, and accuse an institution at the center of the profession of allowing political frictions to skew policy in ways that deeply harmed millions of people. Or the profession could change its consensus, and rally to the support of an institution from which much of the profession's prestige and funding derives.

The economics profession did one of those things.

Jose Romeu Robazzi writes:

Great post. Lot's of take aways:
1. Separate bank supervision from monetary policy under a fiat money system.
2. Use prediction markets: Prof. Sumner said "...Then there was the decision by the Fed to cut rates by 1/2% on October 8, 2008, to 1.5%. But why not more?...". Perhaps because with the quantitative tools they had available, they underestimated the severity of the crisis.
3. Causation: sharp NGDP shortfall may cause sharp reduction on nominal flows, that in turn may cause some market participants insolvent which leads to a financial crisis.

marcus nunes writes:

"Bernanke then points to the fact that the Fed had been so focused on dealing with the financial turmoil that they hadn't really had much time to focus a lot on monetary policy."
Not surprising since his "made my name" article was "Non monetary effects of the financial crisis in the propagation of the Great Depression"!

R Richard Schweitzer writes:

Quoting Bernanke:

As the central bank, we have a responsibility to help markets function normally and to promote economic stability broadly speaking,"

Now, where, in the statutory authorizations, is that "responsibility" established?

Where does the "knowledge" come from, where is it possessed, that determines what is "help," and what "promotes?"

The conceit necessary for such judgments has become one of our major academic products.

marcus nunes writes:

This post provides details:

Kevin Erdmann writes:

Sadly Fishers belief that the Fed's job is to exact discipline on financial markets is widely held. At this point that's all we need to know about monetary policy. Normally "beatings will continue until morale improves" is a sort of satirical way to point out the unintended consequences of damaging actions. But here, it is the explicit point of the policy. And, I'll be G&# da*&,# if it's not the one policy that salvaged the Fed's popularity.

Is it too early for gin?

marcus nunes writes:

Scott, I´ll only read Bernanke´s memoirs in December, but I already know the veredict: Guilty, Guilty, Guilty!
He was not only arguably the most prepared Fed Chairman ever, both because of his academic credentials, but most important, for such a hands on job, he was highly trained, first as a board member for two years and then as head of the CEA for almost two years, in what was probably the longest job interview ever!
He just wasn´t supposed to fail so miserably.

J Hanley writes:

Scott, am I correct in thinking that payment on reserves discourages getting money moving through the economy, and so works directly against monetary expansion?

(Macro makes my head hurt. I don't know how you guys do it.)

Scott Sumner writes:

Steve, There is some truth to what you say, but I have a different perspective on 2008 (the period I'm considering here, where the Fed was not at the zero bound.) I wanted the Fed to continue its conventional policies, such as they had employed in the early part of 2008. Instead they went off into innovative new areas, such as interest on reserves, which were highly destructive.

I'll continue to hold my "Whiggish views" as long as the Fed does a bit better after each crisis, as has been the pattern so far. The fact that Bernanke has admitted the Fed erred in late 2008 is a good sign.

And of course the view of economists outside the Fed was roughly the same, so the problem (if I'm right) had nothing to do with the Fed as an institution, and everything to do with the profession as an institution.

You said:

"It could hew to the prior consensus, as you did, and accuse an institution at the center of the profession of allowing political frictions to skew policy in ways that deeply harmed millions of people. Or the profession could change its consensus, and rally to the support of an institution from which much of the profession's prestige and funding derives."

This is too cynical---the economists that I talk to sincerely disagree with me, even if outside the Fed. And it has nothing to do with the Fed's influence. Economists are not shy about criticizing the Fed (look at Krugman, DeLong and Summers) it's just that even those willing to criticize did not seem to understand what was going wrong in late 2008.

It's cognitive illusions, all the way down.

(And don't forget that the simplest answer is that I'm wrong.)

Jose, Good points, but Bernanke clearly understood the severity of the crisis after Lehman failed, or at least that AD would come in way too low.

Richard, Yes, the Fed is trying to do too much. They should focus like a laser on NGDP, and let others try to address banking regulation.

Marcus, Good point, but other economists in and out of the Fed made similar errors.

Kevin, I'll have one too.

J Hanley, Yes, it increases the demand for bank reserves, encouraging banks to hold on to the money, rather than move it out into the economy.

James Alexander writes:

If the Fed was being guided by NGDP expectations isn't there a bit of a problem.

Expectations would not be signalling a crash as they would have included an expectation that the Fed would act after a Lehman failure.
So, how would those expectations have signalled the NEED to act after the failure, but before the Fed meeting?
It would have required the Fed to KNOW how badly a failure to act would be taken by expectations (after the Lehman failure).

This logic would argue the need for a smarter Fed rather than one just driven by NGDP expectations.

Am I being too reductionist?

Philo writes:

Yes, the Fed should have done more in the crisis, and Bernanke kept saying, in reply to queries, that it could do more. But at the time the press never followed by asking, "then why aren't you doing more?" This was a major failure by the financial press

Dustin writes:

I second James Alexander's question and have myself long wondered his an NGDP futures market would remain active if the Fed performed admirably and kept NGDP on track - why would anyone take a position otherwise?

Jose Romeu Robazzi writes:

@James Alexander, Dustin
Why does a interest rate futures market exist? Why does an equity markets exist? Why don't every stock immediately price the latest analyst report on the target price of that stock? Why don't the markets immediately price the Fed dots ? Markets are driven by expectations, sure, but those have to be fulfilled at some point. Also, expectations can be off the mark, by a lot. But markets are still the best way to correct those expectations quickly ...

Dustin writes:

Targeting expectations is a whole different ball of wax: where you end up is a function of where you expect to end up. More generally, gambling (i.e., futures market) typically takes place between counter-parties who cannot control the outcome of an event and where said event is not influenced by the gamblers' wagers. NGDPLT and an NGDP futures market violates 1 or both of these conditions, and is, I believe, the thrust of Scott's proposed Fed subsidization. I think he addressed this well in his Mercatus paper, I'm just not entirely convinced (no firm reason, just vague intuition):

"Even an absence of trading of NGDP futures contracts might not cause problems for monetary policy. If no NGDP contracts were traded, it would mean that the market consensus expected the current setting of the money supply and/or interest rates to produce on-target NGDP growth. At worst, it would mean that any expected deviations from the NGDP target would be so small that investors did not think it was worth the time and effort to trade NGDP futures."

In other words, if you place a bet at 4% NGDP under a 5% NGDPLT framework (given a competent Fed), you are driving market expectations downward and away from the target and so compelling the Fed to take action that directly counters your position. As additional investors agree with you and take a 4% NGDP position, your probability of loss increases.

Rajat writes:

Scott, you often mention mistakes made by the Fed in September and October 2008. But equity markets still fell quite quickly between mid-May and early July 2008, down below March lows. Do you think the Fed should have realised it hadn't done enough by then and done more in July and August as well?

B Cole writes:

Excellent blogging. Perhaps the answer to Bernanke's timidity lies in the very loud inflationistas that sat on the FOMC, and Bernanke's desire to bring about a consensus rather than the correct answer

James Alexander writes:

I do understand that it is all about the reaction function. I was just trying to think of it from an innocent central banker's point of view, who might be able to claim that they were just "following orders".

The market used to talk all the time under Greenspan about the "Greenspan put", a version of a quick reaction function. No one talks of the "Bernanke put", more about the "plunge protection team" showing how bad monetary policy has been under Bernanke and Yellen.

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