Monetary Policy and the Great Recession

A Market Monetarist perspective

As soon as you mention “market monetarist”, NGDP comes to mind. While for most the all-encompassing variable is inflation, to MMs, the “target” variable is NGDP being kept at a steadily rising trend level path.

While “inflation targeters” look at inflation, real growth and unemployment to gauge the “need” for monetary policy “action”, MMs look only at NGDP relative to its trend level path.

While “inflation targeters” look at the change/level of the FF rate to gauge if monetary policy is easing/tight (expansionary/loose), MMs say monetary policy is easing/easy (tightening/tight) if NGDP is rising/remaining above trend (falling/remaining below trend).

While “inflation targeters” decide on the “correct” stance of monetary policy (the “correct” level of the FF rate) by comparing the level of actual/expected inflation relative to the target level and the gap of output/unemployment relative to the “potential”/”natural” level, MMs strive to offset changes in velocity (money demand) with money supply, thus obtaining overall nominal stability (NGDP evolving as close as possible to trend).

The performance of monetary policy over the 1992-09 period is discussed below through a series of illustrations. The NGDP trend depicted in the charts began in the mid-1980s after Volcker´s successful adjustment and evolved at a 5.4% rate of growth.

The first panel covers 1992-96.

That can be seen as a period of “superb” monetary policy. NGDP remained very close to trend, unemployment was on a downward trend as was inflation. The FF rate was first lowered and stayed leveled at 1% for two years before climbing significantly. Does that indicate that monetary policy was “eased”, remained “easy” and then was “tightened”? It would be hard to justify that taxonomy!

The 1997-00 period is interesting.

In 1998, monetary policy is “eased”. NGDP rises above trend AND the FF rate is lowered. Maybe because inflation (both headline and Core) was way below “target”, the Fed was “tricked” into adopting a more expansionary monetary policy. This provides a good illustration of the danger associated with inflation targeting.

At the time the economy was undergoing a productivity shock, something that shifts the AS curve down and to the right, increasing real output growth and reducing inflation. By keeping NGDP “on trend”, the Fed would have avoided the nominal instability that ensued.

It also shows how misleading it is to look at inflation, especially the headline variety, which is strongly affected by things such as oil and commodity price shocks. As the chart shows, oil prices decreased significantly following the 1997 Asia crisis, only to come back up strongly afterwards. The Fed reacted by jacking up the FF rate.

The “flip-side” of the instability is seen in the following period (2001-03).

NGDP falls below trend, indicating monetary policy was tightening, despite the strong decrease in the FF rate. Although the FF rate remained “low”, it didn´t mean monetary policy was easy! By NGDP remaining below trend we know policy was “tight”.

Once again, headline inflation danced to the beat of oil prices!

Monetary policy was made “right” in the following period, which coincides with Greenspan´s last years as Fed Chairman.

Forward guidance signaled that monetary policy would be expansionary. And it was successful in taking NGDP back to trend. This shows how misconceived the notion, most closely associated with John Taylor, that during 2002-04 interest rates were “too low for too long”.

“Good” monetary policy was successful in bringing unemployment down and in keeping core inflation close to “target”. Needless to show, headline inflation “adapted” to oil prices!

When he replaced Greenspan, Bernanke was at first successful in maintaining nominal stability, but when financial troubles hit in mid-2007 he “bungled”.

Monetary policy was tightened as indicated by NGDP dropping below trend despite the reduction in the FF rate. Unemployment began to rise and headline inflation was impacted by oil prices. Inflation targeting led the Fed to indicate NGDP would be constrained.

This “challenging” environment would be a test for any central bank. Unfortunately the Fed (and many other central banks) failed miserably as seen below.

Nowhere else the notion that reducing rates means policy “easing” and low rates means “easy” policy is so clearly shown to be false. Every conceivable indicator was flashing “policy is too tight” signal.

Why did that happen?

Following his seminal paper from 1982 – “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression” – Bernanke´s “credit view” was that what was required was emergency lending to banks to keep credit flowing. And so he did, “saving” the banks but “screwing” the overall economy!

The market monetarist view is that the Fed should have offset the big drop in velocity (rise in money demand) by raising the growth of money supply. The chart shows how, in fact, instead of offsetting the fall in velocity, the Fed “magnified” its impact on nominal spending (NGDP), allowing broad (Divisia M3) money growth to fall steeply and even contract!

The rest, as they say, is history!