Alan Cole on Monetary Policy for a Post-COVID Economy

Lessons learned from the 2008 Financial Crisis could make for a swifter recovery in 2020 and beyond.

Alan Cole is a senior economist at the Joint Economic Committee of Congress. Alan joins David on Macro Musings to discuss his work with the JEC and his thoughts on the economy. Specifically, Alan and David discuss the high savings rate during the COVID-19 crisis, the track record of US monetary policy from the 2008 financial crisis to the 2020 COVID-19 crisis, why the Fed’s commitment to average inflation targeting is an incremental step toward level targeting, and suggestions for the Fed moving forward.

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 [email protected].

David Beckworth: Alan, welcome to the show.

Alan Cole: Thank you. Good to be here.

Beckworth: It's great to have you on. Now, we've met once in person. I believe it was at the Federal Reserve. We were both invited to an event there, Fed Listens. It was great to chat with you there, but we've had a lot of conversation online, and you've done a lot of interesting work. In fact, we're going to talk about two of your papers today that you have recently put out. You've been very busy at the Joint Economic Committee of Congress, and you're also just a very public figure in economics. So, it's good to have you on and have this conversation, and before we get into your work and your papers, I know you want to have a disclaimer that you want to make. So, why don't you do that at this time?

Cole: Yeah, of course. While I work at the Joint Economic Committee of the U.S. Congress, I don't necessarily speak for any member of that committee. The views expressed here are my own.

Beckworth: Okay, with that out of the way, why don't you explain to us what is the Joint Economic Committee? What do they do and what is your relationship to it?

Cole: The Joint Economic Committee is joint in the sense that it contains members from both the House and the Senate. I'm part of the chairman's office. This Congress, the chairman's office is in the Senate and under Senator Mike Lee, but it rotates between the House and the Senate. So, next Congress, the chairman's office will be in the House. There's also a vice chairman's office that's in whichever House of Congress, doesn't have the chairman's office, and for now though, I work for the chairman's office.

Beckworth: Now, Senator Mike Lee, does he also have his own staff that is separate from the JEC staff?

Cole: Yeah, that's right. For each committee that a senator chairs, they might have staffers that are devoted explicitly to that committee, but committee staffers are friendly with the personal office staff of the person that put them there.

Beckworth: Yeah, I recall visiting a congressperson's office, and they had their own economist from their staff, and then they had the staff economists from the JEC there as well. So, they were both there and were talking about the Federal Reserve and going over issues, but it was interesting to see there's two different sets of economists, one from the committee, one from the office itself. Now, the JEC is this committee that you're a part of, and they've been doing a lot of work. So, tell us about some of the issues they cover and how do they do that? Do they call experts in? I know you write reports for them, but how are they actually influencing policy? What's the steps they take?

Cole: The Joint Economic Committee is often focused on more long-run vision for the economic future of the country, not necessarily any individual bill. It holds hearings, the most prominent of which feature Federal Reserve officials. For example, Jay Powell, and sometimes the hearings are on whatever either the Chairman or the Vice Chairman wants to discuss. So, each member that chairs or vice chairs the committee can choose some areas of focus that they want to focus on extra.

Beckworth: The JEC is a think tank for Congress. It sets the grand vision on economic issues, where they want the economy to go in the long run, and that's why they have people like you doing these big projects, writing these papers, and it's your work, but the senator signs off on it, but it's your work, and I know he may not agree with everything in your work, but he signs off on it. The committee signs off on it, and you mentioned you have hearings, so Fed Chair Jay Powell will come over. How often does that occur?

Cole: Hearings are as often as the schedule permits and as often as we're basically capable of coming up with a thing and inviting witnesses and preparing people.

Beckworth: Okay. Now, one of the big projects I'm aware of, and there's probably others that you're working on, but I know one of the big projects that the JEC has been a part of and promoting is the Social Capital Project. In fact, the papers we're going to talk about today are a part of that conversation, but tell us about the Social Capital Project. What are the goals of it and what are you trying to uncover?

Cole: There are five main issue areas for the Social Capital Project. The first of those is connecting more Americans to work. The second is making it affordable to start a family. The third is family stability. The fourth is investment in youth, and the fifth is rebuilding civil society, and all of those issue areas are important. Lately, I've been most focused on the first one, connecting more Americans to work because of the employment situation we find ourselves in 2020, and also a bit because that's just the area where I have the strongest background and the most to say.

Beckworth: Well, Alan that is a very ambitious agenda for the Social Capital Project, and it's a great one covering a lot of areas, and we'll get to your area in a minute, but it reminds me of Robert Putnam's work where he talked about bowling alone, the breakdown of civil society, the importance of getting people connected again, and you mentioned his work. I know someone else I read that really appreciated that touched on this was Charles Murray's book “Coming Apart.” The similar themes where the breakdown in society, families, and issues like that, and those definitely determine long-run growth. We've had people on the show in the past who've talked about fertility rates, population growth, talked about technology. All these things I think are tied into your Social Capital Project. So, I think it's a very worthwhile endeavor. I'm glad to see you guys working on it.

Beckworth: Now, is this work being done primarily by the Republican side of the committee or are the Democrats a part of this conversation as well?

Cole: This is the Republican side of the committee. The Democrats are also free to do whatever projects interests their vice chair representative Don Beyer. We're doing the projects that are of interest to the chairman, Senator Mike Lee.

Beckworth: Okay. Well, again, very ambitious, very interesting project, the Social Capital Project, and you have documents on your web page. We'll provide links to it for our listeners, but let's move into the area where you've been working and you've had two recent papers out, and I like them because, one, it speaks so near and dear to my heart monetary policy and how it affects labor outcomes, full employment, but also you had a paper recently on what's happened this year with the COVID-19 crisis, and it's a great way to unpack what we've seen unfold, and the title of your paper is “Saving and COVID-19,” and you talk about this remarkable development that the saving rates just exploded during the crisis.

Beckworth: Now, today news came out. It's come down a little bit, but it was remarkably high, and this has been a very unusual recession. I mean, it's been an unusual crisis, a large supply shock at the economy, but it's been a lot of interesting things that have happened. So, we had the sharp contraction in the second quarter. Now, there's signs that the economy is recovering. There's also signs that the economy's still weak. If you look at labor markets for example, it's a very dire picture. We've lost around 20 million jobs, got about 10 million back, got a big hole to fill still. The unemployment insurance claims are still really high, but if you look at other indicators, it looks like things are just roaring back to full employment. We'll be there soon.

Beckworth: So, it's a very mixed message, and you helped us sort some of that out in this essay that you've written, “Saving and COVID-19.” So, walk us through that and help us understand why did the savings rate explode during this crisis.

Explaining the Savings rate during COVID-19

Cole: I think the savings rate exploding during the crisis is mostly about households that have their jobs and were able to stick to them and then found that they didn't have as much to spend on as before, but anticipate that eventually, they'll be able to spend on more things later. So, right now, they're just improving their balance sheets. That might be through saving in a bank account. That might be through just paying down their mortgage, but there's a lot of saving. It's about tripled from the first quarter of 2020 before the pandemic started to the second quarter after it started. It's at about a $4.7 trillion annualized rate, which means if the second quarter saving rate kept up the whole time, you'd end up with $4.7 trillion of additional household savings by the end of the year, and I believe that's mostly about people not having enough to spend on.

Beckworth: So, their income shot up. Now, why did their incomes go up during this crisis? You would think all else equal, they would fall down, but if you look at personal incomes... I was just looking at the numbers before the show. They started off near 19 trillion. This is total, of course, and jumps up into 21 trillion. It's come back down some, but it's still about on trend where it would have been had there been no recession. So, what's your story for the sustained increase in personal incomes?

Cole: So, personal income rose by about one and a half trillion in that same second quarter, so it doesn't explain all of the rise in the saving. It's not just people got more income and then saved it all, but they got additional income on net overall and saved even more than that $1.5 trillion rise. What that's mostly about is transfer receipts. That's things that come from the CARES Act and whether you support any individual provision in it or not. There's plenty of debate to be had on that. It's very clear. The budget math has been done that overall, it raised personal incomes. Transfer receipts rose almost $2.4 trillion, and then market incomes went down about 0.9 trillion. So, it more than made up for the loss of market income, and one way of thinking about this is it's like we got to count certain dollars twice.

It's not just people got more income and then saved it all, but they got additional income on net overall and saved even more than that $1.5 trillion rise.

Cole: You imagine someone is working from home, still has their job, and they don't spend money on, say, concert tickets, but the people who work for the concert venue got increased unemployment assistance from that same CARES Act. So, they were able to keep the money as if they were still working whereas the people who would have consumed would have gone to the concert still got to save the money as if they didn't spend it. So, it's like the money got duplicated for households, and that's because of the CARES Act picking up the tab there and putting it on the government's tab.

Beckworth: Yeah, a very interesting experience. Nothing like we've seen before as far as I know in terms of the huge amount of transfers that went to the public, stabilized incomes. I mean, it really expanded incomes, and there was a lot of conversation in August when the extended federal unemployment insurance came to an end, and there was a lot of worries that we'd be falling off a cliff. We haven't seen that. Now, we still have again a big hole to film labor markets, another 10 million or so to get back to where we were at the beginning of the crisis, and maybe a little bit more if you count the trend path that we were on. There's still a lot of people claiming unemployment insurance overall.

Beckworth: How do you feel going forward? Do you feel like we're going to have a swift recovery? Do you think the termination of the extended unemployment insurance has been a drag? I mean, where do you think this all settles out? Are we on the road to a rapid recovery or not?

Prospects for Near-Term Recovery

Cole: I don't think it would be prudent to predict that everything's going to be great say a year from now that everything's going to be perfect, but I would say we're going to recover a lot faster from this. Where there's actually a real shock that you can identify, there's a real problem to be solved, and I think we might recover substantially faster from the problems of 2020 than we did the problems of 2008, which is odd if you think about it because you can point to the phenomenon that made 2020 a bad year whereas when you point to 2008, it's not as obvious. It's almost like you got to hand wave it a little bit, and I think that almost shows that sometimes a new challenge forces you to fight a little bit more creatively and also maybe shows that we've learned a few lessons from 2008, and we're doing better this time.

I think we might recover substantially faster from the problems of 2020 than we did the problems of 2008.

Beckworth: Yeah, so there's been a lot of talk about a V-shape recovery versus a K-shape recovery. So, a K-shape recovery if I understand correctly is there there's two groups in this economy. One is having this nice upshot, the upper part of the K. It's going up, and then there's some who are stuck and falling behind. They're the lower part of the K that's going down, and again, there's a lot of evidence that things are really robust and on some fronts. So, I'm looking at a post, an article by our friend Tim Duy. He has a great newsletter called Tim Duy's Fed Watch. I recommend subscribing to it if you don't already, but he had a recent piece out where he said, "Bullard may be more right than wrong." This is Jim Bullard, the President of St. Louis Fed who interestingly came out recently and thinks that the economy is going to recover really rapidly, and we don't even need any more fiscal stimulus.

Beckworth: So, right now, there's a discussion in between Secretary Mnuchin and Speaker Pelosi about a second round of stimulus, and Jim Bullard came out and said, "We don't even need that. We're on path to a full recovery relatively soon." His view is very different than the rest of the Federal Reserve officials. They think it's going to be a much slower recovery, but Tim Duy made the case that he may be more right than we think, and he points to things such as a number of homes being sold have just taken off. He looks at manufacturing orders, the PMI that has taken off. Lots of indicators that show robust recovery and job openings. Job openings fell early part of this year. It's jumped up. It looks like a V as well. A lot of industries and specific areas where you see a V-shape recovery where you don't see it, and again, as I mentioned earlier, is in the labor market.

Beckworth: We see there's a lot of ground to make up still, but there's this talk about a K-shape recovery. Does the K-shape recovery make sense to you? I mean, is it just another letter we're throwing out there or should we still keep the V shape in mind?

Cole: There are some places where I think you can talk about the K shape. For example, if you're focused mostly on asset prices and on jobs, and those are the two measures you see. You'll see asset prices have done pretty all right. The after early turbulence, they essentially recovered while jobs haven't and especially lower wage jobs. So, you can get a K shape there. I'd argue that's a little bit incomplete, for example, because the higher asset prices are also associated with lower yields going forward. So, to the extent that all these people holding assets, generally richer people, want to live off of future income from those assets. I don't think they're actually necessarily doing better than they were in February. They're probably doing much worse.

Cole: But if they could redeem it all for money now and spend it, then they would actually be ahead if that's what they cared about, but I don't think that is what they care about that they're saving for a reason, and that's because there's nothing really to spend on.

Beckworth: Well, let me go back to the point you just raised about the stock market. That is one of the indicators that's doing relatively well this year. It's had its up and downs, but overall, it's been doing relatively well. It's been growing, and there's been a number of commentators who've taken two different views on this. One, it doesn't reflect the real economy. It reflects the Fed’s backstopping. It reflects what you said, maybe the low yields, low interest rates. So, you're discounting a different rate than you were before, but then there's others who say, "No, no, no. It actually is tied to the real economy. It's tied to those higher manufacturing orders I mentioned earlier, the higher home prices."

Beckworth: So, there's this debate going on right now that some say the stock market is actually more closely tied to the real economy than we normally think, and others will say, "No, it's just these inflated asset prices." Alan, where do you come down in that debate?

Cole: I think both sides have some merit. It's definitely true that nominal interest rates have fallen and nominal cost of capital for all sorts of different financial products have gone down. Basically, take your pick. They're all at lower yield than they used to be. That said, there has been a real... You can point to physically the home construction starting back up. You can point to physically the capital orders from manufacturers. I actually discussed those in the “Saving and COVID-19” paper, and one of the reasons for that is that the lower interest rates and the lower cost of capital are almost a signal to home builders into manufacturers. Go ahead with your projects. It's okay. We're expecting the returns to be somewhat lower, but you should go ahead and do them anyway because it's the best we can do right now.

Cole: So, it's a little bit about the economy finding a reasonable compromise in tough times, and one of the elements of that reasonable compromise is that asset holders are going to have to accept a lower rate of return.

Beckworth: Yeah, I think a key part of the story if we want a robust recovery is we need to get that vaccine delivered and out. We need to see the vaccine here, and I think many of the other pieces of the puzzle will fall into place. There's a lot of other things to consider, but I'm looking forward to whenever that does arrive. Well, let's move on from that first article of yours. Again, it's titled “Saving and COVID-19,” and let's move on to the one that I was really excited to see when you published it. It came out recently, and the title of this second paper is “Stable Monetary Policy to Connect More Americans to Work.” So, this takes us back to the Social Capital Project, getting people to work.

Beckworth: Our friend Karl Smith likes to say that when you're not at full employment, capitalism isn't really being tried, that capitalism is at its best when we pull everyone into the labor market and they're working, and that's when you see a lot of these problems that we're worried about. They go away. They disappear. They're reduced. For example, the number of people on disability over the past decade dropped dramatically as the economy continued to move along and jobs continued to grow. People were pulled in.

Beckworth: So, I'd like that framing, and I think it's the framing you use as well. If monetary policy is doing its job, the economy recovers. You pull more people in. It's a great way to heal many of our social ills, but tell me why did you write this paper? What was your motivation going into... I know it's tied to social capital that we've just talked about, but why do this paper now and why you?

Cole: So, a little bit. This was the chance to get it done. I've actually been thinking about the topic of this paper for probably nine or 10 years at this point, first introduced to it and really got interested in it through Scott Sumner, a colleague of yours.

Beckworth: Yep.

Cole: I think it's particularly relevant now in part because by 2019 or 2020, I think we were mostly done with the experience of that cycle. We had gone from the beginning of the crash pretty much to the end when we were back to what a lot of people would say was a normal economy. So, the experience was complete, and we saw the whole thing through, and we were able to derive lessons from it. Then, also, as I was writing it, we got a new recession, a very different one from COVID-19, and eventually, I had to add some more to the paper to discuss how many of these lessons from the general normal case apply to this strange particular case with some unusual features, and I think some of the lessons from the general case supply and some of them don't, but in the future, I think the 2008 problems are much more likely to repeat than the 2020 problems.

Cole: So, I'm a little bit more interested in getting the 2008 stuff exactly right. That said, I'm not a public health expert. I don't know how much these coronaviruses will be the new normal or anything like that.

Beckworth: Well, we hope they are irregular and don't happen very often and that you're right that the shocks we faced were more like the ones in 2008. Now, you end up where I hoped you would end up in the paper, and that's with nominal GDP targeting, and before we get into that in your paper though, I'm curious to hear your thoughts on the Fed’s new framework. So, you proposed one approach. The Fed did something different, and I would argue it's a step in the direction of nominal GDP targeting, but average inflation targeting, as you know, it allows for makeup in the inflation target if they're below the average. Now, it's not been well-defined. Maybe that's a feature, not a bug, depends on who you ask, but I'd love to hear your thoughts on that. What do you think of average inflation targeting?

Level Targeting

Cole: It's definitely a step in the direction of level targeting. The only difference is that I think level targeting has a very, very well-defined place you want to be at any given point, whereas in average inflation targeting, you might not know exactly what period you want to make the average smooth over. So, say you've got 0.5 points to make up, do you make them up 0.1, 0.1, 0.1, 0.1, 0.1 or do you make them up 0.25 at a time? How fast is your turnaround path?

I think level targeting has a very, very well-defined place you want to be at any given point, whereas in average inflation targeting, you might not know exactly what period you want to make the average smooth over.

Beckworth: Yeah, so the makeup period is not well-defined. Also, the window, the average over which this target's going to cover is not well-defined, and I think of it as a way to allow the Fed to possibly be very aggressive and do something close to level targeting without calling it that. Now, our friend George Selgin takes a much more skeptical view. He thinks it's going to create more problems than it's going to solve, and maybe he's right, but I'm hopeful that they'll use it as an opening to go in the direction that you outlined in your paper. So, overall then, you're happy to see average inflation targeting and given the political constraints and realities of changing monetary policy, you think it's a good step?

Cole: Yeah, definitely. Given the system that we have, and there are things that can be debated about the system we have, it's an incremental improvement and better than the status quo ante.

Beckworth: Let me ask you another question about average inflation targeting and also about a nominal GDP level targeting, any kind of level targeting or makeup monetary policy. What is your sense about people in Congress endorsing or embracing this idea? Do you get a sense that people won't understand it like your typical senator or congressman or congresswoman? Do they, one, grasp the importance of a makeup policy, and two, do they support it if they do understand it?

Cole: One way I think about this a lot is that every Congress person relies heavily on learning from specialists. They've got specialists in each individual issue area. They're often called legislative assistants or legislative directors, and one thing I've noticed about nominal GDP targeting is that it's very popular among people my age, and people my age are the sort of people to hold those jobs.

Beckworth: Oh, good.

Cole: So, I think of it almost as something where staffers are interested in this idea and might be putting it in front of their bosses, but of course, most of their bosses grew up before this idea really took hold. So, that's the situation we're in right now, I think.

Beckworth: So, just to be clear, staffers like yourself, both from the Republican and Democrat side are open to nominal GDP targeting?

Cole: Yeah, absolutely, and you saw it in a few campaign plans, on the Democratic side too, but especially among the more centrist economics-focused Democrats on the presidential race, and obviously, eventually things consolidate into one candidate and a whole bunch of coalitions get pushed together, and I don't know what, say, the Biden campaign would have in store, but there are definitely Democrats interested in the idea too and Democrat staffers in Congress who are interested.

Beckworth: Well, good. So, you're saying there's a chance that we may one day see a warm embrace of nominal GDP targeting by Congress and the Senate. Let me ask this, have you got any feedback on your report on monetary policy, any reception yet from people in Congress?

Cole: Usually, it's the geeks who are interested in monetary policy. So, it's the people you would think that have given me feedback, and generally, the people who are interested in reading a report on nominal GDP targeting are already pretty favorably disposed to it. So, I'd say we've gotten mostly positive feedback on this report.

Beckworth: Fantastic. Well, thank you for writing the report. As listeners know, I'm a big fan of it myself, a big champion of it, but it's great to see someone in Congress writing up this paper on it. So, let's move into your paper now. Let's talk about it, and you begin the paper talking about output gaps and why they're important. Now, I think most of our listeners will know what an output gap is, but in case they don't, walk us through it. What is an output gap and why does it matter?

Output Gaps

Cole: If we imagine a platonic ideal of the economy functioning well and sustainably over the long run without any financial crises, there's a level of employment there that we think of as potential employment, what the economy could be producing, but then sometimes there are crises and especially if it's a financial one where you have people who seem mostly capable but through turmoil and financial markets, and monetary markets you might say, they get thrown out of their jobs even though they have good skills, the skills they have are demanded, and so on. When that happens, we would say that there's an output gap because it feels from the real economy, from the person's real skills that they should be employed, and yet for some reason they are not, and some of those can get pretty large. They can be a pretty darn big problem, and that's why they're worth focusing on, and especially given the Joint Economic Committee Republicans' strong commitment to connecting people to work, it just seemed like a very obvious issue to focus on, but I think we didn't do as good of a job connecting people to work between 2008 and 2019 as we could have.

Beckworth: So, would you say output gaps are created by large aggregate demand shocks? Is that a way to summarize it or are they more complicated than that?

Cole: I think that's usually the best way of summarizing. It's usually just there isn't enough money bouncing around in the economy. It's good to use some sort of expression of this that involves both the size of the monetary base and how many times each unit of money has been used. You'll note that that's MV. In a monetarist equation, that's monetary base times velocity, but essentially the key property of currency is that it can be used more than once or not at all in any given period. So, almost a dollar used five times counts as much as five dollars used one time in my formulation.

Beckworth: Okay, so you're talking about a situation of recession, which as you mentioned, you might be someone who is employed, have latest skills. You're productive, but something happens. It's not unique to your industry or your job or your firm. It's a systemic crisis where all industries are getting hit hard and everyone is getting hammered and therefore layoffs occur across the board. It's not due to some personal reason, you're not a good worker. It's just no matter what you do, you can still be affected by this. This is what we think of as a recession, and output gaps emerge from it. Now, you mentioned in your paper that we look at these aggregate measures of output gaps that they're really hard to measure, one, and two, the distributional effect of them is also not evenly spread.

Beckworth: It's not like each firm, each type of person is equally bearing the weight of that output gap. It's spread differently upon different groups.

Cole: Right. Output gaps. If you imagine that say there's a lower demand for labor, and we all spread it evenly among ourselves. We each took 5% more days off, like 5% of our work days we took off, and we all did that together, and we all had our income reduced by 5%, that might be okay, but that's not really how it works. It's a much more lumpy distribution in which some people get unemployed for half a year or more at a time, and some people don't lose their jobs at all and continue working normal. At the peak of the 2010's problem with this, there were about seven million people who were unemployed for more than half a year. So, it really fell hard on those people. Those people tended to be lower education than the people who remained in their jobs, and they also tended to be less white than the people who remained in their jobs, but there were problems for all groups.

Cole: Also, when I say that they had lower educations, this doesn't necessarily mean that they should not have been employed. It's easy to say, "This person had fewer skills. That's why they were laid off," but it's really the conjunction of they are less-advantaged and also times get tougher. Just because the most precarious people get kicked off by bad circumstances doesn't mean that that's inevitable. You can try to save them.

Beckworth: Right, so for some of them, it's a compounding problem. It's just a systemic crisis, and then they're in a very weak position to start off with. So, they fall quick and fast compared to others. Now, tying this back into your Social Capital Project now, why care about this? What are the long-term consequences of getting these big output gaps, these big deep recessions?

Social Cost of Unemployment

Cole: Yeah, so the bloodless economist's way of saying this is just we lost several trillion dollars’ worth of money from this 2010's output gap, maybe five trillion, maybe seven trillion, somewhere around there depending on how you measure. You could also say we lost 45 million or more person years of work, but I think one of the great things about the Social Capital Project is that we've been invited to go a little bit beyond the very bloodless economist descriptions of things and think about the details, and we've looked into what happens when people don't have jobs, and you think maybe in the ideal case, they would have a lot more time to do volunteering. They would have a lot more time to engage in all sorts of fun, productive activities that working people don't have the time to do but wish they could, and that would be nice if it were true, but it's really not.

Cole: People who don't have jobs tend to get sad. They tend to have worse mental health outcomes. They tend to have fewer connections to others despite the free time to make them, and generally, their self-reported happiness goes down, and this is especially easy to spot in men. We had a report specifically on non-employed men because there's very few presumptions in society that a man is definitely not going to work. Most men do want jobs. So, the ones that don't presumably are not entirely out of work by choice, and they tend to really struggle with it. They have worse outcomes on a huge variety of measures, and I think understanding that and understanding that we threw nine or 10 million people into this situation, it was a real scarring social event in addition to $7 trillion of lost income, and even if it were the lost income alone, that's still, like the annual size of the economy of Germany, that's a big deal.

Most men do want jobs. So, the ones that don't presumably are not entirely out of work by choice, and they tend to really struggle with it. They have worse outcomes on a huge variety of measures, and I think understanding that and understanding that we threw nine or 10 million people into this situation, it was a real scarring social event.

Beckworth: Absolutely.

Cole: I think it goes beyond that too.

Beckworth: Most macro economists understand this, but we don't think through clearly all the implications, and you mentioned mental health suffers immensely. Relationships are harmed, and I think this is a big deal when we think about why do they persist so long. So, you stress in your paper sticky prices or prices and wages don't adjust quickly is a key reason that we don't see these things clear, but there's other stories that complement that that one can tell. They could tell relationships, and macro would call this a search theory, right?

Beckworth: It's easy to terminate a relationship. It takes a long time to build one back up, and our jobs are our relationships. We're based on relationships with our employers, people who work for us if we happen to be the boss, and it's easy to destroy that relationship. It takes a long time to build it up again. So, it's nice to avoid it in the first place having this distortion, and the other thing I think that's also an important part of this story is the fact that we have so much debt that it's in dollar terms. It's nominal debt with a fixed price. So, mortgages for example. When you touched on mortgages in your first paper, but people, they commit to 30-year mortgages on their homes with this fixed price on it that they can't adjust. It'd be great if all of our debt contracts were indexed, but most of them are not. There's a few of them that are indexed to inflation, and some have proposed tying them to economic condition.

Beckworth: There's been proposals for mortgages to be tied to the condition of your local economy, the principal payment, but it's not, and as a result, these fixed debt contracts have a huge bearing, and as you know, we live in a world with more and more leverage, and therefore, it's highly consequential. So, there's a lot of imperfections, or rigidity's maybe a better term in the economy that prevents markets from clearing instantly and making everything better. So, we want to avoid this crisis in the first place, these outcomes in the first place. We've talked about output gaps, what happens, what goes on. So, let's go ahead and apply this understanding to some of the periods we've just talked about.

Beckworth: You in your paper break it down into certain years, right? You tie this into monetary policy as well. What could the Fed have done differently or what can it do differently going forward? But you talk about the year 2007 through 2008, and there's several things going on there including what is the Fed looking at in terms of an indicator. It's looking at inflation. Inflation is really going up, but I think you mentioned that part of it is due to supply shocks to higher oil prices. So, talk us through 2007-2008. What is your story of what went wrong during that period?

Evaluating Fed Policy: 2007-08

Cole: I think the big picture there is that the Federal Reserve was looking at the wrong indicators, and then once it began to notice the poor indicators in other places, it was slow to switch and under-reactive. The indicators it was looking at were a lot to do with oil prices and a lot to do with housing and a perceived bubble in housing prices, and they were hoping to cut those prices down, but at the same time, they did not notice a rapidly deteriorating employment situation. So, it's like they were ignoring the warning lights because they were looking at another part of the dashboard.

Beckworth: Okay, so they were slow to react, and this is a point I've stressed as well. If you look at indicators for the market by the middle of 2008, the market was expecting rate hikes going into the next year. In 2009, they were expecting quite a few rate hikes, and fed officials were talking up rate hikes up through the middle of 2008, which seems poorly timed, but understandable given what you just said. They were looking at headline inflation, which was reflecting the high oil prices. So, they were talking up rate hikes because they were worried about inflation in the middle of 2008. In the meantime, the economy is falling off a cliff. All right, let's go to 2009 to 2014, another period you look at closely in your paper. What defines that period?

Evaluating Fed Policy: 2009-14

Cole: A metaphor often used by people in the Fed’s media circle is the idea of the punch bowl and taking away the punch bowl or giving it back, and the idea is if you give people a punch bowl, the party is a lot more vibrant than if you take it away. The party simmers down, and the way I think about this, it's almost like you could say maybe by having immediate lower zero rates, the Fed was holding the punch bowl out, but it's like they were also warning, "Hey, my mom's coming home, and we're going to have to clean this party up." There was a lot of forward guidance that suggested that the Fed was going to hike rates too early, take away the punch bowl relatively soon, and then it actually ended up doing that in 2015. It hiked rates before employment was really very close to normal times. It was still several million jobs short, and I don't think that people have really totally grappled with how much that warning that you're going to take things away soon can affect behavior in the short run.

There was a lot of forward guidance that suggested that the Fed was going to hike rates too early, take away the punch bowl relatively soon, and then it actually ended up doing that in 2015. It hiked rates before employment was really very close to normal times.

Cole: People see ahead. People see ahead to what you're planning on doing, and they correctly perceived from the Fed’s forward guidance that it was going to hike rates relatively early, and I think they held back on a lot of things like construction and housing, things that are interest rate sensitive because they saw that coming.

Beckworth: So, the economy was slow to recover in part because the Fed was talking up rate hikes and wanting to wind down its balance sheet. All right, let's go to 2015 and 2019. What's the story there?

Evaluating Fed Policy: 2015-19

Cole: This is where they followed through on the mistakes that they were signaling that they were planning on making. A 2018 analysis, one that called it in real time, comes from Moody's economists Adam Ozimek and Michael Ferlez, and they argued that while the unemployment rate was just about 5%, that's already worse than the best pre-crisis months. You're not totally back to where you were in early 2007, but also that there are other measures you could look at and on those other measures of the labor market, it was even worse than that unemployment rate showed, in short, because the unemployment rate doesn't show some discouraged workers or people who dropped out because of the economy, and we found that we could draw a lot of those people back in, and we still had much, much more room to go than the Fed thought.

On those other measures of the labor market, it was even worse than that unemployment rate showed, in short, because the unemployment rate doesn't show some discouraged workers or people who dropped out because of the economy, and we found that we could draw a lot of those people back in.

Cole: It's like you see a red light coming, and you're trying to glide into the red light and stop, but then you apply your breaks a mile too early, and you don't make it to the intersection.

Beckworth: That's a great analogy. So, they stall long time before they actually get to the actual intersection. Part of the Fed’s new framework we talked about earlier, the average inflation targeting framework, it includes this idea of makeup policy, as we talked about, but it also includes a change in this very area you just covered, the unemployment rate, reaching full employment, and they used to say during this very period you're talking about that they wanted to avoid deviations from this natural rate of unemployment. This level where they really can't go any lower without creating inflation, and they got it persistently wrong. In fact, they continued to push down their estimate of the natural rate of unemployment over time. They kept dropping and dropping and dropping, but they still had in their language and their statements that they wanted to avoid deviations from that whether above or below.

Beckworth: But now in this new framework and the statement they put out, they say they want to avoid shortfalls from full employment. So, before it was deviations from full employment. Now, it's shortfall. It's an asymmetric view of how to respond to labor market conditions, and it would have been very different had this been applied during the 2015-2019 period. How do you feel about that? What do you think about the Fed taking an asymmetric view towards the labor market? They're going to worry more about shortfalls is the term they use, not deviations.

Cole: I'm not sure that an asymmetric view is totally necessary. I think what we're trying to correct for was a failure to handle a symmetric view. We spend way, way, way more time below the Fed’s employment targets than above and then sometimes we even adjust the employment targets to be worse so that you don't see them as far away from the target as they actually are. So, I see a failure to meet a symmetrical target. That said, there's a lot of evidence that when things deteriorate, they deteriorate quickly, and when things recover, they recover much more slowly. So, that suggests maybe some asymmetry is a valid idea for hitting things right on average. Maybe you need to be asymmetrical to be symmetrical if that makes sense.

There's a lot of evidence that when things deteriorate, they deteriorate quickly, and when things recover, they recover much more slowly. So, that suggests maybe some asymmetry is a valid idea for hitting things right on average.

Beckworth: Yeah, well, I'm wondering how they're going to actually implement that. I understand the average inflation target idea in terms of the inflation target although as I mentioned earlier that the parameters aren't well-specified. How far back does the average go? How quickly will they make up the misses? But I really would like to know what they are looking at when they say shortfalls in full employment and how do they systematically respond to that. So, one suggestion is they do something like a plucking model, Milton Friedman's plucking model. So, you would only respond to periods where unemployment really shoots up and then you wait for it to come down, and then after that, you do nothing.

Beckworth: But it would be interesting to see, for example, a Taylor rule. What does the Taylor rule look like when the Fed only responds to shortfalls in full employment? So, it's easy to make a Taylor rule when you talk about deviations from full employment because you just settle a parameter there. It could be a positive sign. It could be a negative sign, but this makes it look like it's only going to be one sign. So, I'm sure there'll be many papers coming out soon that touch on this, but it'll be interesting to see what it means. Again, this has to actually be credible, has to be actually done, carried out in practice, and we'll have to wait and see if it is, and that's one worry I do have about this is that when inflation does start rising above 2%, will the Fed follow through and stick to its new framework?

Beckworth: But assuming that it does, I would love to know how they're going to handle shortfalls in terms of their reaction function. So, it's something to think about. Let's go now to the present, the current crisis. So, how do you feel about the Fed’s performance this year, given this is a unique situation?

Evaluating Fed Policy in 2020

Cole: Yeah, so the most interesting thing is certainly that us NGDP targeters have been put in a very awkward position because it seems increasingly implausible that any NGDP target could have worked under lockdowns. If you think about what that would entail, say all the restaurant workers are laid off or temporarily on furlough, you need to find all of that spending and move it to other industries. Even though there are fewer people at work, you would need a rapid increase in prices everywhere else to make up for the hospitality and dining and live entertainment types of events that have been canceled, and I don't think that was particularly plausible, but I think we've accidentally found our way into a new thing that does work, which is maybe nominal income hasn't been kept on target as measured by NGDP, but it has been kept on target as measured by household income.

I think we've accidentally found our way into a new thing that does work, which is maybe nominal income hasn't been kept on target as measured by NGDP, but it has been kept on target as measured by household income.

Cole: Household income was actually way up in Q2 of 2020. It looks like, following the expiration of some provision, it's only a little bit up from the start of the pandemic now, but it's still up, and it's actually up slightly, and that's almost what you want because it suggests that households still have the incomes to return and GDP back to trend when restaurants are fully reopened and all of that. So, I think while in this unusual special case an NGDP hard and fast rule would not have been the right thing to do, we've seen that something in the spirit of NGDP targeting is still going on, and as you mentioned, we're actually pretty optimistic about this recession, all things considered, and I think that's because the spirit of NGDP targeters' ideas have been followed even if the actual literal prescription clearly can't be.

Beckworth: Well, and that is a very upbeat and optimistic way to look at what has happened. I appreciate it that you view this year through the lens of the spirit of nominal GDP targeting. I think that's reasonable. One of the ways to look at nominal GDP targeting is also nominal income target, and the reason we care about stabilizing that is because of all the financial commitments we make, right? Our mortgages, leases, all kinds of arrangements, and it's important to maintain those. So, I think even though we may not be able to spend on all the goods and services we would have before, we still have financial obligations that can undermine us even more.

Beckworth: We don't want to have these secondary bankruptcies liquidations. We're going to take a real hit no matter what because of COVID. We don't need to exacerbate it, and I think that's where the nominal income argument comes in. We got to at least minimize that level of income that was pre-committed already to these financial contracts, but with that said, let's talk about going forward here. So, what do you want to see the Federal Reserve doing? We now know the Fed’s going to have a review every five years. At least Chair Powell has said they will do this, and they'll commit to this. So, what are your thoughts? Next five years, what should the Fed be discussing?

Suggestions for Fed Policy in the Future

Cole: I suppose, first, we should say that one thing that was done very well was interest rates were moved to zero very quickly. In fact, while I said that in 2007, 2008, they under-reacted to employment measures, and there were several months of bad data before they did anything. By contrast here, they had interest rates at zero before it showed up in any unemployment figures at all because they were actually faster than the data releases. They saw what was happening out in the real world. They read the news. They looked out the window, and they realized that large unemployment claims were coming, and they were already at zero in march. So, they did that part well. They didn't make the mistakes of the 2007-2008 period.

Cole: The most important thing they can do now is just signal that they aren't going to make mistakes of the 2015 to 2019 period either. They aren't going to threaten to take away the punch bowl. They aren't going to threaten to raise interest rates when there's still actually a lot of real capacity in the economy left. When it comes to more extraordinary measures, those are layering more constitutional sketchiness on top of the already constitutional sketchiness of the Federal Reserve at large, and it would probably be better if Congress or private markets were able to step in, and for example, private markets can loan to companies, and because of that large stock of saving from households that we talked about, I think that private markets are actually doing a lot of the Fed’s extraordinary measures work that we would have, back in the Bernanke days, we would have had all of these emergency packages.

The most important thing they can do now is just signal that they aren't going to make mistakes of the 2015 to 2019 period either. They aren't going to threaten to take away the punch bowl.

Cole: But here, I think we're going to have normal private sector people investing their money, expecting corporations to take some losses in quarter two and quarter three of 2020, and saying, "I'm okay with that. I will share-hold for the long run and wait for them to become profitable again," and that's a lot better. It's a lot better because it's much fairer in terms of political economy. You see the savers are taking the loss and dealing with it, but then moving on and returning to profitability in the future, and there's no political economy issues. I really like the way we've done that, and I think it's a lot better than having these very politically controversial packages.

Beckworth: Okay. With that, our time is up. Our guest today has been Alan Cole. Alan, thank you so much for coming on the show.

Cole: You're welcome. Thank you for having me.

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About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.