Why was there no recovery & no inflation after the Great Recession and why did we get a quick recovery followed by inflation after C-19?
Monetary Policy, NOT interest rate policy explains both, with no place for "greedflation" and other "excuses".
The question posed by the title of this post has not been sufficiently addressed. That´s interesting because a comparison of the two periods brings out very clearly the monetary nature of the problems. As I´ll argue, it also confirms the “principle” that, because it is extremely reluctant to accept blame, the Fed incurs in grave monetary policy errors. An added benefit is that you don´t need to tell convoluted stories.
The panel below, depicting the nominal economy in the two periods provides a clear understanding.
The top of the panel shows the level of aggregate nominal spending (NGDP) and the path along wich it was evolving prior to the shocks, while the bottom part of the panel indicates the growth rate of NGDP (the dashed horizontal line in the NGDP growth charts indicate the average NGDP growth between 1992 and 2019, ~4.5%).
In the top part of the panel, note that the nominal shock (portrayed by the fall in NGDP) in early 2020 was much stronger and abrupt than in mid-2008. Nevertheless, NGDP in 2020 quickly rebounded back to the trend path. In the RHS of the top panel, NGDP never goes back to the trend path, “forging” a new lower path along which it will travel for the next decade.
In the lower part of the panel, we note that this happened because monetary policy (the stance of which is portrayed by NGDP growth) was much more expansionary after the 2020 shock. For NGDP to climb back to the trend path after the 2008 shock, monetary policy (NGDP growth) would have had to follow the path indicated by the arrows. Since it did not do so is evidence that, despite having brought interest rates to “zero” and “practiced” QE, monetary policy remained extremely tight!
One reason for the difference in outcomes might be that the Fed “learned” from the previous experience (although those that subscribe to that reason appeal to the much stronger fiscal policy adopted in 2020, and say little or nothing about monetary policy).
I believe the difference in outcomes is related to the “trigger” for the shock. In 2020 it was clearly C-19, an exogenous shock, completely unrelated to what the Fed was doing or was thinking about doing. In just two months real output (RGDP) dropped 12% YoY. (During the Great Depression it took all of twelve months for RGDP to drop by an equivalent amount (13% YoY)). The Fed must have been realy “scared”!
In 2008, the “ trigger” was the Fed´s “paranoia” with inflation (evidence from the Transcripts here). Impossible, for example, not to be “thrilled” by this take from FOMC Member and Dallas Fed president Richard(Inspector Clouseau)Fisher:
“I think it would be wise, just to shift my analogy here and think in canine terms, to take a newspaper across the snout and call for a 25 basis point increase. We’re always talking about tightening at some point.
I think it just becomes increasingly difficult to take that first step. I grant
you that the economy is weak. The financial situation is brittle. That hasn’t changed in my view, but the inflationary behavioral patterns that I’m beginning to hear about reinforce my concern about an updrift in the core and the headline data.”
So, when the economy tanks, with RGDP growth going from +2.3% YoY in mid-2008 to -5% YoY one year later), the Fed has to “extricate” itself from responsibility. For example in the January 2009 FOMC Meeting we read this exchange between Bernanke and Lacker:
After Lacker made his exposition, Bernanke intervenes:
CHAIRMAN BERNANKE. I am going to regret this, but I am going to ask you a question. [Laughter] Do you think the United States economy is at a Pareto efficient point at this moment?
LACKER. Probably.
CHAIRMAN BERNANKE. With the best position we can be at right now?
LACKER. Roughly speaking. All constraints taken on board.
And not too long after, Bernanke is hailed as “Hero”, having saved the economy from a second Great Depression!
Denying responsibility, however, is nothing new for the Fed. Orphanides has an enlightening article on the Fed during the Great Depression. Following the downturn in 1937 we read:
Though the extent of the sharp decline in activity was not immediately evident, by Fall it became fully clear to the Committee that the economy was thrown back to a severe recession, once again.
The following evaluation of the situation by (John) Williams at the November 1937 meeting is informative, both for offering a frank admission that the FOMC apparently wished for a slowdown to occur and also for outlining the case that the recession, nonetheless, had nothing to do with the monetary tightening that preceded it.
Particularly enlightening is the reasoning offered by Williams as to why a reversal of the earlier tightening action would be ill advised. We all know how it developed. There was a feeling last spring that things were going pretty fast ... we had about six months of incipient boom conditions with rapid rise of prices, price and wage spirals and forward buying and you will recall that last spring there were dangers of a run-away situation which would bring the recovery prematurely to a close. We all felt, as a result of that, that some recession was desirable ... We have had continued ease of money all through the depression. We have never had a recovery like that. It follows from that that we can’t count upon a policy of monetary ease as a major corrective. ...[Doesn´t that sound familiar?]
In response to an inquiry by Mr. Davis as to how the increase in reserve requirements has been in the picture, Mr. Williams stated that it was not the cause but rather the occasion for the change. ... It is a coincidence in time. ...
If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn. It makes a bad record and confused thinking. I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground. There is no good reason now for a major depression and that being the case there is a good chance of a non-monetary program working out and I would rather not muddy the record with action that might be misinterpreted. (FOMC Meeting, November 29, 1937. Transcript of notes taken on the statement by Mr. Williams.)
Move forward 71 years to 2008 and we have NY Fed president Tim Geithner arguing during FOMC Meeting:
The argument that makes me most uncomfortable here around the table today is the suggestion several of you have made—I’m not sure you meant it this way—which is that the actions by this Committee contributed to the erosion of confidence—a deeply unfair suggestion.
… But please be very careful, certainly outside this room, about adding to the perception that the actions by this body were a substantial contributor to the erosion in confidence.
Take away: If after the 2008 debacle the economy had climbed back to the original trend path the Fed would have been seen as guilty of bungling the house and financial crises! Much better to “sell” yourself as “Savior”! After all “recoveries from financial crises are slower”.
The irony is that a few years later the 2009-19 expansion would be hailed the “longest expansion on record”! An expansion? Yes, but most certainly a “depressed” one, since there was never a “recovery” from the recession.
Next the charts for inflation during the two periods. I use the CPI for convenience, allowing breakdown on components not avalable in the PCE.
The fact that there was no increase in inflation after 2008 is no mystery. As we saw in the panel above, NGDP growth remained contained and the level of NGDP never climbed back to the original trend path. Headline CPI fluctuated to the tune of oil prices.
In the present case, even with all the make-up NGDP growth (i.e. expansionary monetary policy) undertaken to bring the NGDP level back to trend, there was no inflation “problem”. Inflation only appears when NGDP climbs above the trend path in early 2021 and NGDP growth rises above 4.5% (the long term average growth of NGDP).
During the next 12 months, inflation reflects excess demand (excess supply of money), maybe enhanced by supply restrictions resulting from the pandemic. After the second vertical dashed bar, inflation stops rising (the spike in headline CPI reflects the effects of the start of the war on oil and some commodity prices).
At that point the Fed begins to increase interest rates, but note that NGDP growth had already begun to cool down. It has continued to slowly cool down and so has inflation.
Since the start of this year, core CPI has stopped falling. Zooming in on the inflation chart brings that fact out.
We can infer that what´s “breaking” the fall in the core cpi inflation is shelter and used car prices. Shelter inflation is distorted by how it is calculated and used car prices reflect the lingering effects of pandemic induced supply constraints.
Not much the Fed can do about those by increasing rates! That also illustrates why inflation can be a “shizophrenic target”. If the Fed manages to keep NGDP growing at 4.5% inflation will naturally come down, with the speed of the fall depending on how fast supply impediments from the pandemic fade and shelter distortions lose traction.
End note: Just as the Fed allowed the level of NGDP to permanently fall after 2008, if now it tries to bring the level of NGDP to that lower level, it will most certainly bring about a recession.