The case of the "missing shock"

A brief comment on the Romer´s Narrative Approach

Christina and David Romer (R&R) just released a Working Paper at the NBER: “Does Monetary Policy Matter? The Narrative Approach after 35 years”. This is a sequel and update to their 1989 paper on the narrative approach.

The basic question: Does monetary policy matter?

It is a question that lies at the heart of any model of short-run macroeconomic fluctuations. If monetary policy matters, then it is vital to include a channel through which changes in aggregate demand have real effects.

It is also a question that is inherently hard to answer. Like so many empirical questions in economics, omitted variable bias is a central issue.

Both monetary policy actions and real economic activity are likely to be influenced by other variables. Anything that affects output—expectations, fiscal policy, financial stress—is also likely to drive decisions by the Federal Reserve.

As Kareken and Solow (1963) pointed out long ago, in the extreme case where monetary policymakers use policy to successfully counteract other forces affecting output, one would find monetary policy variables moving all around and output not changing. A simple regression of output on an indicator of monetary policy would naively and incorrectly conclude that monetary policy didn’t matter.

That is, if countercyclical monetary policy actions are common, the estimated impact of monetary policy will be biased toward zero.

What Kareken and Solow point to is nothing more than an enunciation of the “Thermostat Analogy”. Only this time applied, not to the aggregate nominal economy (NGDP), but to the real economy (RGDP). As I argued in my previous post, however,

The first thing to have in mind is that monetary policy should be concerned, exclusively, with the nominal economy. It should not be concerned, directly, with real variables such as employment/unemployment or real output. By taking good care of the nominal economy, it would be doing the best it can to keep the real economy in the best possible light!

Because of that, to my mind, the narrative is flawed! Why, for example, would it not recognize the outcome of 2008 as, not only a monetary shock, but a massive one?

Back to R&R.

What are we looking for in the narrative record for this revisiting of the effects of monetary policy?

At a very broad level, we are looking for times when monetary policymakers changed money growth and interest rates for reasons unrelated to current or prospective real economic activity.

These are policy “shocks” in the sense that monetary policy is not being driven by output or other factors affecting output. Thus, the behavior of output and other indicators of real activity following such episodes should give relatively unbiased estimates of the causal impact of monetary policy.

As in our original paper, we look for times when monetary policymakers felt the economy was roughly at potential (or normal) output, but decided that the prevailing rate of inflation was too high.

Policymakers then chose to cut money growth and raise interest rates, realizing that there would be (or at least could be) substantial negative consequences for aggregate output and unemployment. These criteria are designed to pick out times when policymakers essentially changed their tastes about the acceptable level of inflation. They weren’t just responding to anticipated movements in the real economy and inflation.

Does that sound, at least somewhat, as “fine tuning”? The proper question would be “why was the prevailing rate of inflation too high?”

In this sequel to the 1989 paper, R&R say:

An important extension that we do in the new work is to broaden the criteria to include expansionary monetary policy shocks.

In particular, we now also look for times when policymakers believed that they were at a stable level of economic activity, but took actions to lower the unemployment rate—and were willing to accept adverse consequences for inflation.

That is, we look for times when policymakers were deliberately shifting the aggregate demand curve out because of a change in their view of the acceptable or desirable level of unemployment. If monetary policy has real effects, output should rise following such actions.

That sounds even more like they will try to “fine tune” the economy! It appears, however, that “taking expansionary actions to lower unemployment” has not been very “popular” since they only find one instance, over the 1947 - 2016 sample, that monetary policy was expansionary, and that´s more than 50 years ago, in January 1971.

In summary:

Our contractionary shocks are decisions to tighten policy because the current level of inflation was felt to be unacceptable. Our expansionary shock is a decision to loosen because the current stable rate of unemployment was felt to be unacceptable, realizing that such a policy risked raising inflation.

One conclusion from a recent “narrative account” of my own was:

To this point, ignoring for the moment the C-19 episode, my strongly held conviction is that, for almost 3 decades, the Fed never eased monetary policy.

Which is consistent with the R&R conclusion that there was only one expansionar episode in their 70-yr analysis, and that was long before the start of my sample in 1992!

Here, however, I want to deal with a monetary policy shock that, I believe, accords to their criteria, and is glaringly missing, being the most brutal monetary policy shock of the post war era. That´s the 2008 contractionary shock.

Maybe the monetary shock was “camouflaged” by everything that was going on at the same time, things like a house crisis leading to a financial crisis and everything “wraped” inside a significant oil shock.

The 2008 transcripts show the confusion and uncertainties that pervaded inside the FOMC. I obviouly have not read the 2008 transcripts with the degree of attention and detail that the Romers have, but as soon as the 2008 Transcripts were made available in early 2013 I wrote a post entitled:

THE 2008 TRANSCRIPTS CONFIRM: THE FED´S OBSESSION WITH INFLATION “CRASHED” THE ECONOMY

If I can show there was an “obsession with inflation by the Fed”, I will satisfy the Romers criteria that:

Our contractionary shocks are decisions to tighten policy because the current level of inflation was felt to be unacceptable.

This is the chart showing why they “freaked out”

I put the start of the monetary policy contraction at June 2008, one month before the peak in inflation (4.1%).

In the June transcript we read:

Despite this recent news, we expect inflation to rise sharply over the next few months. In part, this reflects our judgment that core prices were held down in the first half by some factors that will not persist into the second half. In addition, as shown to the right, we expect increases in food and energy prices to push up the twelve-month change in the total PCE price index more than 1 percentage point over the next several months, to about 4½ percent.

Regarding inflation, every single participant with the possible exception of Mishkin, showed grave concern. This is reflected in Bernanke´s summary:

My bottom line is that I think the tail risks on the growth and financial side have moderated. I do think, however, that they remain significant. We cannot ignore them.

I’m also becoming concerned about the inflation side, and I think our rhetoric, our statement, and our body language at this point need to reflect that concern. We need to begin to prepare ourselves to respond through policy to the inflation risk; but we need to pick our moment, and we cannot be halfhearted.

When the time comes, we need to make that decision and move that way because a halfhearted approach is going to give us the worst of both worlds. It’s going to give us financial stress without any benefits on inflation. So we have a very difficult problem here, and we are going to have to work together cooperatively to achieve what we want to achieve.

The last thing I’d like to say is on communications. Just talking about communications following this meeting, I’d like to advise everyone, including myself, to lean, not to lurch. That is, we are moving toward more concern about inflation, but we still have concerns about economic growth and financial markets.

We should show that shift in emphasis as we talk to the public, but we should not give the impression that inflation is the entire story or that we have somehow decided that growth and financial problems are behind us, because they are not.

So if we can convey that in a sufficiently subtle way, I think we will prepare the markets for the ultimate movements that we’re going to have to make.

Unfortunately, and that was to be expected, the “public” gathered that inflation, if not the entire story, was the major part. In the Minutes of that meeting we read that “likely the next move in interest rates will be up”!

It is useful to compare the June 2008 Transcript with the September 2005 Transcript, when the Fed was manned by Greenspan. In both instances, the economy was being buffeted by an oil shock of comparable magnitude. Greenspan did not face a financial crisis, only the shock of Katrina.

The widespread devastation in the Gulf region, the associated dislocation of economic activity, and the boost to energy prices imply that spending, production, and employment will be set back in the near term. In addition to elevating premiums for some energy products, the disruption to the production and refining infrastructure may add to energy price volatility.

While these unfortunate developments have increased uncertainty about near-term economic performance, it is the Committee’s view that they do not pose a more persistent threat. Rather, monetary policy accommodation, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity.

Higher energy and other costs have the potential to add to inflation pressures. However, core inflation has been relatively low in recent months and longer-term inflation expectations remain contained.

The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.

The 2005 statement explicitly and emphatically mentions the stability of core inflation. In 2008 the statement eschews any mention of core inflation (worse, the Fed thinks it is being held down by “temporary factors”) and is very concerned with rising headline inflation pulled up by oil prices.

The comparative chart on inflation follows.

A big difference in the two statements, to my mind, is Greenspan´s emphasis on “appropriate monetary policy action”. That´s certainly an elusive concept, but maybe a much better form of “communication” than the “lean not lurch” style proposed by Bernanke.

Let´s take a look at what happened following the June 08 meeting.

Aggregate nominal spending, NGDP began to slide, before tanking. The same is recorded by RGDP growth

Unemployment, which had increased somewhat due to the oil shock, takes a hike while inflation, which couldn´t “breathe” any longer, becomes prostate.

I really don´t know why those evnts did not qualify as the result of a monetary shock by R&R. Maybe their definition of “monetary shock” is too stringent.

I much prefer to interpret a “monetary shock” as an error by the Fed in controlling the “thermostat” (maybe because its “taste” for inflation changed). As the picture below indicates, after the June 08 FOMC Meeting, hightened uncertainty led velocity to slide down, initially very gradually. Money supply growth, instead of sliding up, slided down, and when velocity fell more forcefully, money supply growth barely rose.

These moves generated an excess demand for money that can only be satisfied by a fall in aggregate spending and, therefore, in real output, bringing forth an increase in unemployment and a fall in inflation. (To “Phillips Curvers”: It was not the fall in unemployment that pushed inflation down, but the fall in aggregate spending resulting from the excess demand for money.)

The “wide screen” picture below provides, I think, a “primer” on the workings of the thermostat (where M is the thermostat closely controlled by the Fed, V is the “outside temperature” and NGDP growth the “inside temperature”).

Note that shortly after taking office in February 06, Bernanke showed some “ineptitude” to control the thermostat. This only got worse, maybe because he worried more and more about (headline) inflation. Then he “shut-off the thermostat” and allowed the “house to freeze”. Afterwards, he made “ammends” and allowed the house to “warm up” again, but not to the temperature that prevailed previously!