Jun 20, 2016

Robert Hetzel on Milton Friedman, the Monetarist-Keynesian Debate, and the 2008 Crisis

How Monetarism can help us understand the Great Inflation, Great Recession, and other episodes in economic history.
David Beckworth Senior Research Fellow , Robert Hetzel

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Robert Hetzel, formerly of the Richmond Federal Reserve Bank and senior affiliated scholar with the Mercatus Center, has published several books including “The Monetary Policy of the Federal Reserve: A History” and “The Great Recession: Market Failure or Policy Failure?” His research has appeared in journals such as the Journal of Money, Credit and Banking, and the Journal of Monetary Economics. Robert joins David on the podcast to discuss the Monetarist framework, the Great Recession, historical episodes of high and low inflation, and specific proposals for monetary policy reform.

Read the full episode transcript

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: The first thing I'd like to find out is how did you get into macroeconomics?

Robert Hetzel: Well, I'm going to change the question just a little bit.

Beckworth: Sure.

Hetzel: I went to the University of Chicago, and I started there in 1967. I had to leave for a couple of years because of the Vietnam War, and then I came back. And Chicago, every class started with microeconomics, and so macroeconomics has always been just an extension of microeconomics in economics. So, I think the question is how I got into economics, and I'd like to change it just a little bit more. Where did my passion for economics come from, if that's okay?

Beckworth: Absolutely.

Hetzel: So, obviously Chicago was informative. Every course was organized around microeconomics, and at the time, there was a practice which I attribute to Milton Friedman. He attributed it to T.W. Schultz. Students always carried around these questions, true, false, and uncertain, which professors got out of newspapers, all different sources, and you were always working in groups on these problems. You didn't think about it at the time, but by the time you graduated, you really had the feeling that the general competitive equilibrium market model was powerful. It really helps you understand how the world worked, because you'd been using it for four, five, six years, however long you were there.

Hetzel: So, over time, I developed this belief that economics is the universal language spoken by everyone who believes that reasoned discourse can make the world a better place. Doesn't make any difference what your nationality is, your religion, gender, race, whatever. It's a universal language that we have that's common, and that's... I don't have to tell you this. That's very important at this time. And I want to say one more thing about Milton Friedman, because he was my thesis advisor, and I was in the money and banking workshop, and obviously ran the workshop. Friedman believed that if groups within society used the political system to force their values on other groups, the inevitable result would be violence.

Hetzel: So, he believed in a society that created the maximum amount of freedom for the individual. But within that framework, he believed that groups should sit down, start with a common objective of whatever problem it was they wanted to solve, and then use the discipline of economics, or reasoned discourse, rational discourse, to come to some common understanding. So, for example, today everyone talks about income inequality. Personally, I care about poverty more than inequality, and so you have all these proposals on minimum wage is one. Obviously Chicago would be negative about that disparate impact. You're going to throw kids in the inner city out of work. On the other hand, Milton Friedman proposed a negative income tax that would be phased out as your income increased.

Hetzel: So, my passion for economics came from Chicago, and obviously Milton Friedman was an important influence.

Beckworth: So, you did your undergrad work there and your graduate work. Is that correct?

Hetzel: Yes.

Beckworth: And Milton Friedman was your advisor, so you call yourself a monetarist. In 2012, you had an article, an interesting one that I found when I was looking over your work, entitled “Does Monetarism Maintain Relevance?” So, what's the answer to that question?

How Relevant is Monetarism Today?

Hetzel: Yes. There's two sorts of answers to that question. One has to do with methodology, how you go about testing hypotheses, and the other has to do about optimal monetary policy. If you go back to Friedman's “A Program for Monetary Stability,” published in 1960, that's where he proposed his k-percent rule, a rule for steady money growth. Now, at the time, that would have worked very well with a interest insensitive stable money demand function for the monetary aggregates like M1. Stable money growth would have produced stable nominal output growth, and also at the time, with steady labor force growth and productivity growth, the result would have been stable inflation.

Hetzel: Now, money has become a much less reliable indicator of nominal income growth for a variety of reasons. For one thing, the Fed doesn't put any effort into measuring it, but there are also other reasons, like is interest up sensitivity. So, keep the spirit of that rule alive, which is that the monetary authority, the central bank, needs to provide a stable… the expectation of price stability, and within that framework allow the prices the maximum latitude to determine real variables. And to me, that's the heart of the monetarist program, and I've never deviated from it. I expect we'll talk about the methodological issues later.

Beckworth: Yeah. So, there aren't many people today who do call themselves monetarists. I mean, you're one of them. There's some other groups out there. Stephen Williamson has been labeled a new monetarist, and he takes, he approaches things from a kind of a monetary search model. There's market monetarism. I'm wondering what your thoughts are in terms of the future of monetarism, and will there be monetarists, or just some of the ideas, the underpinnings of modern macroeconomics, will that be what we see in terms of monetarism going forward?

Hetzel: Well, again, in terms of what we just said, I don't think there's any debate any longer that it's the responsibility of the central bank to create a stable nominal anchor. That's been a huge change. And there's also been a huge change in terms of the belief within the economics profession of how well the price system works. If you go back to the Monetarist-Keynesian debate, the Keynesian consensus in the fifties, sixties, and seventies, was based on the assumption that markets don't work well. They don't work well on a micro level. On a micro level, they're ridden with monopolies, the exercise of monopoly power in financial markets. They're dominated by the animal spirits of investors. And that failure on a microeconomic level appears in the macroeconomic level and requires government to be active in stabilizing aggregate demand.

Hetzel: Well, monetarists won those …

Beckworth: Okay.

Hetzel: And now, if you're going to do research, you have a base. You start with a model where the price system works and then you introduce specific friction. So, in a sense, monetarists have won. But I think we'll get back into the challenge, the new challenge to that, when we get back into discussion of what's going on currently.

Beckworth: Okay, so let's step back a minute, then, and ask how would you conduct monetary policy in an ideal world? I know in lots of your writings you've talked about this leaning with the wind. I'm sorry, leaning against the wind, be precise there, approach to monetary policy. What is the way you think monetary policy should be conducted?

How Should Monetary Policy be Conducted?

Hetzel: I start from the assumption that recessions are infrequent events, and so the basic underlying conduct of monetary policy has to be stabilizing, so the objective then is to try to figure out, kind of what's basic about monetary policy that allows it to work, and then how does it go wrong? And of course this relates to our earlier conversation about the monetarist preference that the optimal rule provides a stable nominal anchor, and within that framework, allows the price system to work. In particular, it works when central banks have these discovery procedures for discovering the natural rate of interest, so what they're really doing is tracking the natural rate of interest, keeping the real rate equal to the natural rate, and in that way the price system determines real variables.

Hetzel: Where the system, where that procedure breaks down is as recovery progresses, if the Fed has let inflation rise above target, it deviates from those procedures by trying to develop a negative output gap. When the economy weakens, call it opportunistic disinflation, it has to put inertia into these procedures with the attempt to engineer a soft landing, and inevitably for the kinds of reasons that Friedman talked about, long and variable lags, it doesn't work. And we'll get to this in a minute, I think, but I see the Great Recession as a special case of that.

Beckworth: Okay. You mentioned that it's important for the central bank to line up its target interest rate with the natural interest rate. That would be a case where it's keeping monetary policy neutral. Am I correct in my understanding of what you said?

Hetzel: Yeah. We probably need to define that term. In terms of the models that economists use, it's the real rate of interest that emerges when there are no price, no nominal, there's no nominal stickiness in the economy. The price level is free to move. And the key concept to understand is that the real rate of interest is part of the price system in the sense that it reconciles the desire of households to smooth their consumption over time with the inability to do that because of the way that production can't be smoothed over time. So, people are optimistic about the future, they think things will get better, they want to bring consumption into the present, but they can't do that because of resource limitations, so it takes a high rate of interest to cause them to save rather than to consume.

Hetzel: Similarly, in recession, when households are pessimistic about the future, they think they might be out in the street in the future, they want to distribute consumption into the future to guard against that. They want to save a lot. Well, then at those times you need a low rate of interest, and the sort of key divide in macroeconomics has always been how well that mechanism works. Of course, the Keynesian view of animal spirits is that the herd behavior of investors just runs over that stabilizing property of the real rate of interest, and then you need aggregate demand policies, fiscal policies and so on.

Hetzel: The monetarist view has always been that the price system works well as long as the central bank doesn't interfere with it. If the central bank begins to interfere with it and try to exploit Phillips curve trade-offs by, as we mentioned, creating negative or positive output gaps, then you get the kind of money creation which destabilizes the system, so this gets us back to the idea of a rule that lets the price system run in an unfettered way. But of course that divide still exists, and it's come back, obviously, with the Great Recession.

Beckworth: Well, I want to stick with this natural interest rate idea for a few minutes. It seems to me if we have a central bank that is targeting interest rates in a kind of, as a way to guide monetary policy, and if they're going to do that, and if the right way to do that is to align it with this market-clearing natural interest rate, it seems to me they ought to publish estimates of the natural interest rate, just like when they were targeting the money supply. They published M1, M2. So, why doesn't the Federal Reserve publish estimates of the short run natural interest rate? Now, I know the projections from the FOMC have what would be close to a natural rate over the medium term, several years out, but kind of an immediate near term natural rate estimate, why are there none of those available?

Hetzel: Of course, that's the heart of these DSGE, dynamic stochastic general equilibrium models that economists try to create. But the problem is the problem that Friedman pointed out in his presidential address in 1968, that the equilibrium values of real variables, like the natural rate of interest, the rate of interest that would exist if there were complete price flexibility, and the natural rate of interest, we don't know enough about the structure of the economy to have numerical estimates of those in a sense of having a simple arithmetical policy rule that would allow us to track the natural rate of interest.

Hetzel: If you think about it in terms of what we just said, the natural rate of interest, the real rate of interest, is a very sensitive measure of households' optimism and pessimism about the future. And there are lots of factors that go into affecting that degree of optimism, and we don't have a central planner who can, with knowledge of what that real rate of interest is, so we need procedures for discovering it. And the basis of those procedures is that when the economy's going faster than potential, in a sustained way, that households will become optimistic about the future, they'll want to transfer resources from the future to the present.

Beckworth: Sure.

Hetzel: The real rate of interest will move up. Vice versa. So, when central banks are successful, they have these procedures for moving the interest rate around in a way that tracks the real rate of interest, and again, I come back to my monetarist hypothesis that these procedures go off track when central banks depart from them in a way designed to create output gaps, negative or positive. Again, an output gap is where output differs from potential output, so if a central bank is concerned about inflation, typically what happens, I think this is a pretty general hypothesis. If central banks move the interest rate up so the real rate is above the natural rate, the economy begins to weaken, and then they depart from their procedures in the sense that they put inertia into them and movements in their policy rate in attempt to create a negative output gap, a level of output that's below potential as a way of controlling inflation. And that's where things get out of hand.

Beckworth: Well, Janet Yellen, in a speech late last year, she actually reported kind of a consensus estimate, not a consensus, a range of estimates for the natural rate. She said in one of her speeches, so there's like the median value, and then there was several bands, like maybe one standard deviation, two standard deviations out, that reflected kind of a range of estimates for this natural rate. And if you look at the figure, it shows that this natural rate, it turned negative right after the crisis or during the crisis, and slowly has been crawling its way back up close to zero now, and it seems to me that if the Fed had released these estimates all along with the caveat, "Hey, this is uncertain." And that's why they have these confidence bands around their point estimates. But if they released these, it would really improve its communication.

Beckworth: Just imagine if they went to Congress, right? Congress screams, "Why are you artificially depressing interest rates?" If Janet Yellen could have every time she came up, revealed this chart to them, it may have made things a little bit easier in terms of communication. She could say, "No, look. We're not depressing rates. It's the economy. It's households," as you said. Their pricing of the future versus the present is such that the natural rate has gone down. So, don't you think revealing even estimates of a range for the natural rate would be helpful?

Hetzel: Well, again, let me come back to these models of the economy called DSGE models. They turn out estimates of the natural rate of interest. But the levels are very high, and that's a way of saying that there's a lot of uncertainty about these estimates, so if you think about it, the real rate of interest has been low for, zero or negative, for six years now, yet the economy is growing pretty steadily. The unemployment rate's fallen from 10% to 5% now. Households should be optimistic about the future again, and we shouldn't need high or low rates of interest to restrain their desire to smooth consumption. And yet, things aren't blowing up. We aren't seeing the dollar depreciate. We're not seeing the price of gold fall. We're not seeing the commodities increase.

Hetzel: So, the real rate has to be fairly close to the natural rate where it's going. Of course, that's a current issue of debate. But no one would have predicted that. It seems like households were so burned by the experience of the Great Depression, and the feeling that they really could suddenly lose a lot of wealth, and they really could be hit, excuse the jargon, fat tail risk situation, where they lose their job or they're out in the street. There's still really, there's a lot of precautionary savings. So, we don't know what the real rate of interest is, although it's an extremely useful concept, and certainly one thing that could be emphasized that would be embarrassing is that in all these models, the models show a very dramatic decline in the natural rate of interest from 07 into 08 and 09, which is not matched by the decline in the funds rate. That would be a problem.

Hetzel: But, so I have a different sort of proposal.

Beckworth: Okay.

Hetzel: My proposal is that the FOMC take these quarterly projections by the participants, they're called SEPs, summary of economic projections, and they involve forecasts of real economic activity, real GDP, employment rate, the funds rate, and come up with a committee forecast. Because it's hard. So, it's not so much a problem in terms of communicating with Fed watchers, because they look at all these forecasts, and they figure out what's the chairman's forecast, and how does that align with the board or the FOMC, but that's pretty... That takes a lot of sort of Fed criminology. So, I think that even though it would be hard work, it would be better if the Fed came up with a majority FOMC forecast for these variables, along with a forecast for the funds rate.

Hetzel: At the same time, the FOMC would publish its best estimate of the path for potential real GDP. Again, that's a hard thing to get a handle on. It's going to move around even quarter to quarter, but still, it's a necessary. It's implicit in everything the Fed does. The FOMC is operated on the basis of whether the economy is growing faster or slower, than this baseline path and whether it's moving above, or whether it's moving below, so you would have this baseline path for potential real GDP, which would be the FOMC's best guess, and then you would add on to that the inflation target, 2%. So, you would also have a path for nominal GDP, and then when the chairmen testified, he or she would explain where the economy is relative to these two benchmark paths, and what's the strategy for either returning to or staying on these paths.

Hetzel: And in particular, whether staying on the nominal path, the path that incorporates inflation, whether that would be … creating a negative output gap, whether there's some kind of conflict between where you are on this relative to the potential real GDP path, and where you want to be on the nominal path. So, I think that would structure debate in a useful way.

Beckworth: No, that would be an improvement over what we have, because right now it seems when the two sides come together, whenever Janet Yellen has to testify, that they're coming from different perspectives altogether often. And just having a benchmark path of any variable would be I think useful as a starting point for conversation.

What caused the ‘Great Inflation’ in the US?

Beckworth: Well, let's switch to your work on the history of Fed policy. I mentioned your first book in 2008, “The Monetary Policy of the Federal Reserve: A History.” It's a really good read, and I went through it a while back, and one of the things I want to bring out, we don't have time to discuss all of it, is this period called the Great Inflation. So, it's about mid-sixties to the early eighties, when inflation became unmoored, it took off, and kind of standard story is Paul Volcker steps in, he's the hero, he's the knight in shining armor, comes in and rescues us from the evils of inflation.

Beckworth: I would like you to go and share with us, what caused this to happen? Why did inflation become unanchored and take off? What developments led to this unstable period?

Hetzel: I think you have to go back and put yourself into the timeframe. As you go into, especially into the last part of the 1960s, there's an enormous amount of social division. Because of the Vietnam War, and also because of the Civil Rights Movement, which is becoming more militant, and you've got the riots in the cities, so society is fractured, and the political system looks to a low rate of unemployment as a social balm, as a way of dealing with these tensions. It's not going to eliminate them, but the political system sees that a prerequisite for social stability. At the same time, you've got a Keynesian consensus which says that through fiscal policy and later monetary policy, the government can control aggregate demand to keep the unemployment rate low and stable, and the Phillips curve, which shows empirically the relationship between unemployment and inflation, that would provide for you an estimate of what the cost of achieving low, stable unemployment would be in terms of inflation. And it was viewed as socially acceptable.

Hetzel: So, two things came together. The demand by the political system for low, stable inflation at an acceptable cost, and the supply on the part of the economics profession of a model of aggregate demand management that would achieve that objective. And so, we have an extraordinary experiment. The experiment was tried. Now, in terms of the view at the time, it was complicated because pretty quickly it became clear that you were getting a level of unemployment which at the time was considered unacceptable, 6%, and you were still getting inflation. You weren't getting this nice movement along a downward-sloping Phillips curve. So, there was an enormous amount of intellectual turmoil within the economic and the political profession, and the initial consensus was, "Well, the reasons you weren't getting an acceptable level of inflation given your unemployment target was cost-push inflation."

Hetzel: Corporations and unions were pushing up inflation in an exogenous way, and the central bank had to accommodate that. If it didn't, it would create unacceptably high rates of unemployment. So, the second part of the experiment was wage and price controls, so you have the combination of aggregate demand management policies combined with wage and price controls to create, to eliminate, restrain cost-push inflation, and the idea was then you would get this nice combination of low, stable unemployment and moderate inflation. And of course, you know what happened. The thing blew up.

Hetzel: And that's what the monetarists forecast, and then that created the intellectual environment and the political environment which Volcker could bring the inflation rate down, and the Keynesian presumption was that if you were going to have low, stable inflation, you could only achieve that through periodic large increases in the unemployment rate, which would offset these cost-push effects. Well, that didn't happen, so you had two parts of this experiment. You had this experiment with aggregate demand management, and then you had the movement away from that, and the Keynesian forecast didn't come to fruition, and so the economics profession became much more susceptible to models, as we said earlier, based on the presumption that the price system works well, and disorder is not an inherent event built into the economy.

Beckworth: And that's why we now have new Keynesians, not many old Keynesians. They accepted that paradigm shift.

Hetzel: New Keynesian, but recently as you know it's come under attack, and we have a lot of old Keynesians, like Robert Shiller and Paul Krugman coming out of the woodwork, so now we see the same kind of turmoil within the economic profession. In terms of macroeconomics, not in terms of microeconomics. This is a similar kind of turmoil that we saw in the early 1970s, so the pot is boiling and now we need to go and do the really hard research to figure out what happened in the Great Recession, and it's going to be like the Great Depression. It's going to take a long time, but I confidently predict that over time, just as happened with the Great Depression, views on the Great Recession will also change.

Beckworth: Well, that's a nice segue into the next part of our program, and that is your work on the Great Recession. As a regional Fed economist, you surprisingly put forth a hypothesis for what caused the Great Recession, and I imagine it must have caused you some pushback inside the Fed. But you argued in a 2009 article, titled Monetary Policy in the 2008-2009 Recession, that the Federal Reserve itself helped turn what might have been an ordinary, mild recession into the Great Recession. So, can you share with us the outlines of your arguments and why you believe this?

The Fed’s role in the Great Recession

Hetzel: Sure. So, first of all, I need to defend the Richmond Fed. There's a real tolerance for unconventional views. I've never gotten any pushback.

Beckworth: Okay.

Hetzel: From Richmond. And I'm in enough of a minority that I can be ignored, so that helps. So, this goes back to what we talked about earlier. During economic recoveries, the economy is growing faster than potential, and the Fed is moving rates up, and implicitly that's happening because the real rate is below the natural rate. The real rate's got to move up. See, we're using all these concepts we've introduced. But there's no arithmetical formula about where the real rate is relative to the natural rate. I mean, just how to get it right.

Hetzel: So, at some point the economy begins to weaken. Now, if you think about the periods of time where the Fed has moved rates up and then brought them back down successfully, so '94, '95 is an example, and if you want to consider 2000, 2001, which was a very moderate recession as an example. What you see is that the Fed's successful on making the transition from moving rates up to moving rates down if it doesn't become concerned inflationary expectations are becoming unanchored. If it's kept expected inflation anchored. And then when bond rates start coming down, which sends a signal that the economy's weakening, the Fed follows that information and reduces the funds rate.

Hetzel: The problem comes during periods where the economy begins to weaken, and the central bank, and this is not just the Fed, becomes concerned that inflation is getting to the point where expected inflation is rising above target. And then it introduces this inertia into our movements in the funds rate, or what I call leaning against the wind with credibility. And that attempt to create a negative output gap is what sets off the recession.

Hetzel: Now, what's so fascinating about the current period is that it occurs within the context of this credit disorder. That is starting in the late-1980s, going into the 1990s, there was a movement of financial intermediation out of the commercial banking system, into bank holding companies, as a way of reducing the capital requirements that the commercial banks and the bank holding companies would have to hold. And there was also a movement out of, in terms of a broader shot of a banking system, in terms of the packaging of securities, like mortgage-backed securities, by the large investment banks, and selling those into the open market. Now, a variety of things happened starting in the summer of 2007, and in August it became clear to markets that a lot of these securities that were packaged, the collateralized debt obligations, the mortgage-backed securities, that they were really riskier than their credit ratings had suggested.

Hetzel: So, the entities called structured investment vehicles that had been set up to hold these assets, and they were financed short-term by commercial paper, well, there was a run. The cash investors, the individuals investing short-term, they stopped financing these structured investment vehicles. So, the assets held in these off balance sheet entities moved back onto the balance sheets of banks, and that process continued to the summer of 2008, and I argue that it worked very well, that the banking system handled it very well.

Hetzel: Now, there was a second phase of this re-intermediation from the shadow banking system into the commercial banking system, that began after the failure of Lehman. Up to that point, the presumption had been that the financial safety net would extend to any financial organization that was highly leveraged, that had a large amount of debt. Well, the willingness of the regulators, or the inability of the regulators to save Lehman changed that perception, so that there was a... It turned out that we didn't realize how fragile the system was. The cash investors who had been financing investments in the shadow banking system, they jumped en masse either to Treasury securities or to the too-big-to-fail banks, and that jump, if left alone, would have caused a redistribution of intermediation through the safe banks, the conservatively banks, the too-big-to-fail banks, and away from the shadow banking system and banks that had taken on too much risk.

Hetzel: Now, at that point, the issue of stress on financial intermediation as being an independent source of the business cycle, there it becomes much harder and probably financial frictions, the frictions involved in making this re-intermediation from the shadow banking system to the commercial banking system, it was a bumpy ride. But in defense of my position, I would say a couple things. First of all, by the summer of 2008, the world economy was going into a serious recession. It wasn't realized at the time. That wasn't realized until the fall of 2008, and if you accept my story that the real disturbances to financial intermediation had to occur starting in the fourth quarter of 2008, that doesn't explain why the world economy was going into serious recession by summer of 2008. And also, there are these indirect effects.

Hetzel: As of Lehman in the fall of 2008, the Fed and other central banks, like the ECB, they see the problem not as contractionary monetary policy, but as a credit channel issue as a dysfunction in financial markets. So, the Fed, and you've talked about this, the Fed introduces interest on reserves in October of 2008, as a way of keeping interest rates up rather than letting them fall. So, I would argue that there's this indirect effect where monetary policy is more contractionary than it would have been otherwise if central banks hadn't been so focused on what was going on in the financial markets. And to extend that, and I'll let you come back in a second, I think that there was a period of time in early 2009 where the focus was on financial intermediation, and the attempt to restore to a significant extent the markets, the securitization markets for things like consumer loans, auto loans, and also for securities, the mortgage-backed security market, through the large scale purchases of these mortgages, and so the focus was on credit policy, not monetary policy.

Hetzel: Over time, we got monetary policy right in terms of forward guidance. That is in the sense that once you got down to the zero lower bond, where you couldn't lower the fund rate anymore, the Fed developed procedures where it communicated to markets that it was going to keep the funds rate at zero for a longer period of time. That was the substitute for actually lowering the contemporaneous value of the funds rate. And when the Fed moved away from credit policies toward monetary policies, then I would argue that monetary policy became quite stabilizing, and the Fed was able to engineer a recovery where output grew moderately above potential, to lower unemployment without recreating inflationary expectations. The ECB, by the way, did not do that. But that gets us a little beyond the immediate story.

Beckworth: Yeah, so I want to briefly touch on this period again, because as you mentioned, I have written on this, too, and I share a similar view of what made this crisis worse. Some people have argued that it goes back to 2007. I haven't made this argument. Some have argued that the Fed's procedures in late 2007, when it maintained its balance sheet at a constant size, so it was lending to troubled financial institutions, but it was sterilizing that lending, some have argued that that should have been unsterilized lending. The Fed should have been more eager to allow some inflation, some maybe more rapid aggregate demand growth. I've argued the problem emerges, like you, in 2008, when between early 2008, I think the April FOMC and September FOMC, the Fed kind of sat on its hands. A lot of expectations deteriorated really fast.

Beckworth: If you look at the futures rate on federal funds market, you see that the Fed actually had talked up interest rates, because they were concerned about inflation. I guess my question though, cut to the chase here, you see the problems, when the Fed made the mistake, occurring in 2008, not 2007. Is that correct?

Hetzel: Well, couple things. In September of 2007, the Fed did lower the funds rate, and lowered the funds rate again in early-2008. But then it began to back off, and the reason it backed off, I believe is because of this extraordinary inflation shock, which had begun in the summer of 2004, and persisted through the summer of 2008. The particularly demand by China, but also Brazil and India, created an enormous amount of commodity price inflation. Worldwide. It was an inflation shock on the commodity price side, which was passing into headline inflation in countries like the United States, and in the Eurozone, and central banks were afraid of their credibility.

Hetzel: At this time, the Fed didn't have an inflation target. That didn't happen till January 2012, and the Fed had backed away from price stability earlier on as an objective. It was unclear where the Fed wanted inflation to come down, so the markets weren't sure. The markets were thinking 2%-plus, but I think Greenspan and the FOMC were thinking more like 2%, so this persistent high headline inflation of around 4% relative to core inflation of somewhat more than 2% constrained the Fed and other central banks, and so they began to back off aggressive interest rate decreases of the sort that Greenspan engineered in the early recession of 2001. That's the first thing.

Hetzel: And the second thing is that, as something you've dwelled on which is very important, the funds rate's an overnight interest rate. It doesn't mean anything to anybody, what happens between interest rates between now and tomorrow. So, monetary policy is all about communicating the path of interest rates to the markets, so that the FOMC feels like the term structure of interest rates will keep inflation at target and at the same time cause output to grow at potential. And so, as you mentioned, central banks, the ECB, the Fed, began to communicate that the next increase in the funds rate was going to be up. So, effectively while the economy was weakening, central banks were pursuing a policy that was turning more aggressively toward bringing inflation down now.

Beckworth: Okay. Let me switch gears here in the time we have left to the present, and actually ask something that's puzzled many observers, and that is the low inflation rate we've had since the crisis. So, since the bottoming out in mid-2009, core PCE inflation, which is the preferred measure of the Federal Reserve, it's average around one and a half percent, and this has been seven years or so, so why do you think that's occurring? I mean, some people have said, Janet Yellen has said recently it's because of commodity prices going the other direction, going down, but after so many years, this seems more like a preference, or something systematic, so what is your take on the persistently low core inflation?

Why has inflation remained low since ’09?

Hetzel: That's a very important question, and I'm going to say one more thing on the question before I attempt to answer. We're in a difficult period, because financial markets see central banks as having pushed interest rates down to zero or negative values, very low values. In the case of the United States, they also see inflation below target, so they have this perception that central banks are out of ammunition, and if there were a shock to the world economy, central banks wouldn't be able to stabilize the economy. And I think that explains a lot of the behavior of long-term interest rates and why investors are running to hold government securities like German bonds, or Swiss debt, Japanese debt at negative interest rates.

Hetzel: So, the issue is really important, so I think to get a handle on it you have to think of inflation as coming from two sources. Economists talk about a sticky price sector. These are firms that set prices for multiple periods. That's where the term sticky price sector comes from. There's also a flexible price sector. These are prices set in markets where you have regular market clearing, like wheat, and in a way that's very consistent with the monetarist spirit of providing a stable nominal anchor and allowing relative prices maximum flexibility to move, our models, or these DSGE models, say that central banks should stabilize expected inflation in the sticky price sector, so that firms setting prices for multiple periods will set their dollar prices consistent with the inflation target, but allow inflation in the flexible price sector just to move around, so the headline moves relative to core inflation.

Hetzel: So, what we're seeing now, I believe, is a combination of two things. With the Great Recession, expected inflation in the sticky price sector moved down across countries as indicated by secular reduction in the inflation rate in the service sector, which has to be mostly sticky price firms. At the same time, weakness in the world economy is keeping commodity inflation low, so the combination is keeping inflation low. So, inflation in the United States is moving back to 2% in a slow, moderate way, which is encouraging, but this combination of moderately low sticky price inflation, and low commodity price inflation, has a lot to do with the hangover from the great recession, and the contractionary monetary policies followed by the European Central Bank from 2011 through 2014, and also by the movement in China away from highly expansionary monetary policies from 2009 through 2013-14, to more contractionary monetary policies.

Hetzel: And so, what we're seeing is the sorts of things that market monetarists like yourself emphasize. We're seeing a combination of low growth, low inflation, and low interest rates, that's this kind of witch's brew of past policies, but it's not baked into the world economic system like some kind of grand secular stagnation. It's the consequence of these earlier policies. So, it's important to understand that, because the United States is on a path to recovery, and my concern is that we could overdo the belief that somehow or other secular stagnation, low interest rates and low inflation is just somehow built into the economy, and monetary policy could become expansionary, and we could set off another stop cycle.

Hetzel: I want to be clear, I don't think we're close to that yet, but it's something that... It's a concern that a long-run perspective gives us, because you can move from having these long-run cycles of contractionary and expansionary monetary policy, so we need stability now as much as ever.

Beckworth: On that note, we have to end today. Our guest today has been Robert Hetzel of the Richmond Fed. Bob, thanks for being on the show.

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