Scott Sumner  

Please, don't experiment with monetary policy

The Tragedy of Modern Academia... Question for Scott...

I am seeing an increasing number of pundits calling for policymakers to experiment with the economy. The basic idea seems to be to have (demand-side) policy run hot; to see just how much growth potential is out there. This was a bad idea in the 1960s, and seems like an equally bad idea today. Here's Karl Smith:

Whether by design or default, the nation has found itself in the midst of a momentous economic experiment. A combination of tax cuts and spending increases are creating an economic stimulus as large as the one that was enacted by a Democratic Congress in 2009. That one was a response to the financial crisis, though, and many economists fear that stimulating today's recovering economy would be useless or worse.

Not so fast. There are strong reasons to doubt this claim. I believe that the U.S. economy has significant room to grow. Yet even if I am correct, the burgeoning boom could be cut short by overly aggressive monetary policy.

The Fed is supposed to balance the aims of maximum employment and stable prices. Today, that dual mandate implies that the central bank should be hesitant about raising interest rates, as tax cuts and potential increases in spending on infrastructure and the military work their way through the economy and increase overall demand.

In my view it would be a mistake to experiment with monetary policy by not raising rates. At its best, monetary policy can provide a stable nominal backdrop for the real economy to thrive. What it cannot do is create sustainable growth when the monetary backdrop is already stable.

Let's start with some data:

1. RGDP growth has averaged 1.43% over the past 10 years. During that period, the unemployment rate has fallen from 5.0% to 4.1%. From this we might infer that the recent trend rate of growth is probably below 1.43%. On the other hand, the financial crisis might have depressed growth, even after unemployment recovered.

2. CPI inflation has averaged 1.6% over the past 10 years. PCE inflation has averaged 1.45% over the past 10 years. From this we can infer that PCE inflation is now running about 0.15% below CPI inflation.

3. TIPS spreads are at about 2.1% for 5 and 10-year maturities. These reflect market expectations of CPI inflation, and imply something close to 1.95% inflation for the PCE (which is the index that the Fed targets at 2.0%.)

4. The consensus private sector forecast of inflation over the next few years in 1.9% for 2018, and 2.0% for subsequent years.

5. The unemployment rate of 4.1% is slightly below the Fed's estimate of the natural rate, and forecast to decline further next year.

To summarize, the economy is close to achieving the Fed's dual mandate of 2.0% PCE inflation and high employment, and is expected to continue to roughly achieve this mandate over the next few years. So what kind of expected future monetary policy has brought about these rosy forecasts? Right now, the financial markets are forecasting a number of rate hikes over the next few years. That means that contrary to the claim of Smith, the current condition of the economy does not imply that the Fed should be hesitant about raising interest rates, indeed just the opposite. Not doing so could be destabilizing.

Now it's quite possible that I'm too pessimistic about the long run growth potential of the US economy (which I now estimate at 1.5%). But that doesn't matter. The Fed does not and should not target RGDP. As long as the Fed hits its dual mandate, the growth rate of the economy will depend on the supply-side potential of the US economy. Monetary policy is not going to restrain real growth unless the Fed fails to hit its dual mandate (as in 2008-09, when inflation plunged and unemployment soared.) As long as inflation is near 2% and unemployment is below 5%, then the growth rate of the economy will not be held back by monetary policy. I can't emphasize enough that monetary policy is not some sort of magic wand that can "solve problems". The very best we can expect from monetary policy is to refrain from causing problems. I frequently disagree with the Austrian school on monetary policy, but this is one area where I agree. Monetary policy cannot solve problems; it can merely refrain from causing them. It is not something we should be experimenting with.

I was pleased to see the cover of the new Economist:

Screen Shot 2018-02-15 at 3.25.12 PM.png
But my heart sank when I read the article:

In some ways today's experiment looks more like the boom of the late 1990s (see Free Exchange). Alan Greenspan, then chairman of the Federal Reserve, kept monetary policy loose enough to push unemployment down to 3.8% by April 2000. Mr Greenspan had correctly anticipated that computerisation would increase the economy's productive capacity and let some of the pressure out of the expansion. Inflation stayed comfortably below 2% even as wages soared. The boom eventually came to an end because a bubble in technology stocks popped--and, perhaps, because Mr Greenspan was less alert to recessionary signals than he had been to evidence of technological change.
Isn't a more likely explanation that the Fed let the economy run too hot in 2000, and that this contributed to the subsequent recession? Business cycles are not just caused by contractionary mistakes (as some Keynesian accounts seem to imply) and they aren't just caused by expansionary mistakes, (as some Austrian accounts seem to imply.) They are caused by unstable monetary policy---more expansionary that average in some years, and less expansionary that average in other years.

Let's keep monetary policy exactly average, every single year. That's the policy that will best allow us to see the potential growth rate of the economy.

PS. I'm not trying to tar all Keynesians and Austrians, just giving a sense of the tendencies I see on each side---the more extreme views of the hard core in each group. In contrast, Milton Friedman didn't always get it right, but he did have a balanced set of criticisms of monetary policy---too easy at times, and too tight at other times.

HT: Caroline Baum

Comments and Sharing

COMMENTS (13 to date)
David R Henderson writes:

When you say that you estimate the long-run growth potential at 1.5% annually, what do you mean by the long run? The next 5 years? The next 10 years? Both?

Nathan Smith writes:

A reasonable argument. But:

1. Given that inflation has been below target for many years now, there has been an effective transfer from debtors to creditors. A few years of above-average inflation would help to stabilize the long-run rate of cumulative inflation.

2. Banks are still holding large excess reserves at the Fed. It would be nice to return to a normal situation where banks lend to the max, and the M1 money supply is a nice 1/R multiplier of the base.

3. Interest rates have risen a bit, but there's still a major risk of hitting the zero lower bound when another recession comes along. Why not push trend inflation a little higher to mitigate that risk? I tend to think that money illusion, shoeleather costs, and other downsides of inflation are less serious problems than the zero lower bound.

Effem writes:

I blame economists. Economics does not exist within a void: it cannot be separated from politics. Economists should celebrate that we have a central bank which is both highly credible on inflation and able to undertake massive action in a crisis.

Instead, there has been a steady chorus of complaints that inflation is mildly below target. This has convinced many (including those in DC) that there are large gains to be had from "doing more" when in reality the gains to more stimulus are probably quite mild.

Now that we've convinced DC to "do more" we run the risk of putting the Fed in a difficult position. If stimulus is met with rate increases I suspect there will be political pressure on the Fed to let things run hot. And all those articles by economists will provide the justification.

Sometimes I really wonder if most economists are looking at their 401k and home value when they consider a group, they seem to be "long inflation."

Scott Sumner writes:

David, Not the next 5 years, I'd expect faster growth over the next few years. The longer the time horizon, the closer we'll get to 1.5%, in my view. Ten years is better, 15 is even better.

I know that I'm an outlier, and other forecasts are higher. We'll see.

BTW, nothing regarding my views on monetary policy, or my criticism of Smith, in any way hinges on this forecast.

Mark writes:

Is their argument that something like ‘computerization’ has driven up potential production such that we can sustain below 4% unemployment today? That seems very doubtful. We couldn’t even sustain it in the late 90s and it shot back up.

Perhaps we should get Robert Shiller should study the phenomenon of irrational exuberance among economists and commentators on the economy.

Rajat writes:

Scott, why do you say in response to David that medium-term growth is likely to be faster than 1.5% given that: (i) the US grew slower than that over a period when unemployment fell and (ii) in your view, we are now basically at equilibrium?

Is it because you expect some overheating over the next few years or because you think short run growth may be higher due to the reversal of some hysteresis effects (given that you concede, "the financial crisis might have depressed growth, even after unemployment recovered")? If the latter, are you suggesting that such reversal is likely to come about even if the economy doesn't overheat, and hence over-heating offers no incremental benefit? But if over-heating offers no incremental benefit, then it is puzzling to me why average growth since the financial crisis has not seen faster than 1.5% growth - I would expect hysteresis reversal to happen more quickly immediately after it has occurred than 10 years later.

Scott Sumner writes:

Mark, Yes, and even if there were some sort of supply-side miracle, that would certainly not be an argument for demand side stimulus.

Bob Murphy writes:

Scott, I generally agree with this post--especially your (qualified) praise for Austrians!--but this part messed me up:

"As long as the Fed hits its dual mandate, the growth rate of the economy will depend on the supply-side potential of the US economy. Monetary policy is not going to restrain real growth unless the Fed fails to hit its dual mandate (as in 2008-09, when inflation plunged and unemployment soared.) As long as inflation is near 2% and unemployment is below 5%, then the growth rate of the economy will not be held back by monetary policy."

I realize you often switch between "Scott Sumner, textbook Market Monetarist in an Ideal Universe" and "Scott Sumner, speaking the language of other macroeconomists who live in this world."

So, in the interest of clarifying, can you tell me if this is right?


If the Fed were truly to adopt a policy where monetary tightness would never be a cause of restraining economic growth, then a much better indicator would be to see if NGDP growth stayed relatively constant.

Although it's a bit contrived, we can actually imagine a scenario where the Fed maintains its dual mandate while engaging in contractionary monetary policy.

For example, suppose there is a supply shock where (for some reason) worker productivity goes down 3%. So the "real" shock itself would imply RGDP falling 3%, even with constant employment. If the Fed were run by Market Monetarists, it would let price inflation rise to 4% or more, in order to keep NGDP growth constant.

Alas, the Fed in this scenario foolishly adheres to a dual mandate, and tightens monetary policy once inflation breaks the 2% target.

We end up with unemployment at 5% and inflation at 2%, even though the natural rate of unemployment is (say) 4% and price inflation should have been at least 4%. NGDP growth stalls out, clearly indicating that monetary policy is too tight.

I realize the above is a bit contrived, but haven't I shown that actually, we could observe the Fed hitting its dual mandate, even though NGDP growth would have indicated monetary policy was too tight?

Louis Woodhill writes:

If you look at the BEA "Fixed Asset" numbers, you will see that, for the past 66 years, RGDP has always been (approximately) equal to 0.440 X real nonresidential assets + 0.085 X real residential assets. Nonresidential assets account for 91% of RGDP and 100% of all jobs. So, RGDP is just driven by capital investment--labor has nothing to do with it.

Until recently, America had a very unfriendly environment for capital investment (highest corporate tax rate, regulatory jihad, etc.).

Unstable money creates a risk to capital investment that raises the cost of capital and thereby suppresses investment. The Fed should just announce that it is going to stabilize the real value of the dollar (against the CRB Index) and then do it.

With the right policies, the U.S. can sustain 3.5% to 4.0% RGDP growth.

Thaomas writes:

I think the Fed should not raise rates until necessary to prevent the price level from exceeding the 2% trend starting from before the financial crisis. If that is "running hot," so be it. That's the implication of having an inflation target instead of an inflation ceiling.

Thaomas writes:

Is it not probable that real investment is being depressed by the probability that in the next crisis the Fed will again allow inflation to fall below an average of 2% absent a demonstration that it has abandoned the 2% ceiling?

Scott Sumner writes:

Bob, Yes you can construct scenarios where my claim is not 100% true. I should have said "growth will not be significantly held back by monetary policy."

I'm trying to get people to focus on the right variables, and not be distracted by the view that monetary policy can somehow produce growth miracles. But yes, the current dual mandate is not precisely the optimal policy, and hence under certain conditions an alternative policy (perhaps NGDPLT) could produce slightly higher growth, for a brief period of time.

Louis, That's possible, but I'm very skeptical of that claim. Certainly we do not currently have the policies in place needed to produce those sorts of growth rates on a sustained basis. Alternative policies such as open borders might be needed to achieve that sort of growth.

I oppose targeting commodity price indices, as monetary policy then gets pushed off course by Chinese demand for commodities.

Thaomas, No, what you describe is not inflation targeting, it's price level targeting. That's actually a superior policy, but only if announced ahead of time by the Fed. Because it has not been announced, it would be destabilizing to adopt it right now.

Adam writes:

Yes, raising rates makes sense if there were only AD stimulus. But we just got a huge AS shift by corporate tax reduction.

Looking forward, isn't monetary tightening a 1929 policy in light the likely shift in AS?

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