Earlier this month, the Joint Economic Committee (JEC) published its annual economic report. In its chapter on “Macroeconomic Outlook,” the JEC examines why both inflation and the rate of nominal spending have been so persistently low since the Great Recession. We are encouraged that the JEC report seems to be embracing certain market monetarist tenets. Do read the whole thing, but here are some excerpts:
“The Report and Federal Reserve officials find low inflation rates “puzzling,” especially given the low unemployment rates. The “Phillips Curve” theory of price inflation posits that low unemployment rates drive up wages, which leads firms to raise prices to offset rising costs. The Committee Majority explores alternative explanations for below-target inflation. Notably, monetary policy may not have been as “accommodative” as commonly perceived.” (pp. 55)
The report makes the point that low interest rates do not necessary imply easy monetary policy:
“Furthermore, despite the low level of the Fed’s fed funds rate target, monetary policy arguably remained relatively tight, as monetary economist Scott Sumner notes in the context of a 2003 Ben Bernanke speech:
Bernanke (2003) was also skeptical of the claim that low interest rates represent easy money:
'[Bernanke:] As emphasized by [Milton] Friedman… nominal interest rates are not good indicators of the stance of monetary policy…The real short-term interest rate… is also imperfect…Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation.'
Ironically, by this criterion, monetary policy during the 2008-13 was the tightest since Herbert Hoover was President." (pp. 55-56)
Readers should look at this 2017 Mercatus paper by Thomas Raffinot that goes into greater detail on the unreliability of interest rates in determining the stance of monetary policy.
The report then examines the Fed’s large-scale asset purchase (LSAP) programs, also known as “quantitative easing” or QE, which were meant to promote strong recovery, but were largely ineffective. According to the report, despite the fact that QE created a large temporary increase in the monetary base, the Fed never intended to allow QE to permanently increase the money supply. As such, it never committed to a true expansionary policy to offset the contractionary monetary shock in 2008:
“The Fed was clear from the outset that it would undo its LSAPs eventually (i.e., remove from circulation the money it created in the future). The temporary nature of the policy discouraged banks from issuing more long-term loans. Alternatively, as economist Tim Duy pointed out during the inception of the Fed’s first LSAP program: Pay close attention to Bernanke’s insistence that the Fed’s liquidity programs are intended to be unwound. If policymakers truly intend a policy of quantitative easing to boost inflation expectations, these are exactly the wrong words to say. Any successful policy of quantitative easing would depend upon a credible commitment to a permanent increase in the money supply. Bernanke is making the opposite commitment—a commitment to contract the money supply in the future. Sumner (2010), Beckworth (2017), and Krugman (2018) observe similar issues.” (pp. 59-60)
Another important point made by the report is the impact of the Fed’s introduction of interest on excess reserves (IOER). The Fed, then worried about inflation, began to pay interest on excess reserves in 2008 to encourage banks to deposit their reserves at the Fed, instead of allowing them to circulate in the broader money supply. However, the problem in 2008 was not rising inflation; it was falling nominal spending. In order to combat the real problem, the Fed needed expansionary policy, but it pursued the opposite path:
“Furthermore as Sumner (2010), Feldstein (2013), Beckworth (2017), Selgin (2017), and Ireland (2018) note, payment of IOER competitive with market rates led banks to hoard the reserve, which contributed at least partially to the collapse of the money multiplier.”
For more on the problems posed by IOER, check out this Macro Musings episode with the Cato Institute’s George Selgin.