Raising interest rates might not be the medicine we need.
Last Wednesday, Janet Yellen, chairwoman of the Federal Reserve, announced that the Fed will reduce its holdings of Treasury bonds and mortgage-backed securities, starting in October. She also announced that the Fed remains on target to raise the short-term interest rate this December. These changes will be incremental, to the point that the Wall Street Journal said, “No one should call any of this a tight monetary policy.” But it’s worth asking whether Yellen is right to make them.
In the wake of the financial crisis, the Fed bought billions of dollars in financial assets, adding them to its balance sheet in a process known as “quantitative easing” (QE), and it also engineered lower interest rates. Since then, it’s kept interest rates low and embarked on two more rounds of QE. The consensus is that the Fed has presided over nine years of easy monetary policy — increasing the money supply by making the conditions to borrow money more favorable — that have coincided with nine years of economic expansion.
We’ve heard similar stories from around the world. The European Central Bank kept interest rates low on an absolute basis, raising them briefly in 2011, and engaged in QE; the monetary union managed to survive its sovereign debt crisis. Japan is perhaps an exception — it pursued the most aggressive QE of all the developed countries, and has kept interests rates low, to less successful results. But growth has generally continued in the developed world and in emerging markets.
Now, the Fed appears to be ushering in a new era, however gradually. Should it be?
Conservatives tend to favor “tight” monetary policy, in which the money supply is kept under control. When the central bank raises interest rates or reduces the amount of assets it holds, that is generally construed to be a tightening. Many on the right argued in the wake of the financial crisis that the Fed’s “easy” policy in the mid 2000s had encouraged excess borrowing and caused the housing bubble that precipitated the financial crisis. In their view, the economy had become “addicted” to Fed stimulus, and they thought that fiscal policies such as tax cuts and regulatory reform would be a better path toward sustainable growth. But, per the consensus story, the Fed continued on an easy path.
It would follow that the Fed’s apparent decision to tighten is overdue. Yet putting aside the question of whether the consensus is accurate, there are several reasons that tightening could be a mistake. Households and businesses are saddled with debt, and these borrowers will be especially sensitive to any increases in interest rates. If an economic downturn happens, the Fed will have its hands tied because the federal-funds interest rate is already low (just above 1 percent). On the fiscal-policy front, our lawmakers may struggle to successfully navigate a recession.
Households and businesses are saddled with debt, and these borrowers will be especially sensitive to any increases in interest rates.
None of this settles the question as to what our monetary policy should be, but it does counsel caution. Unfortunately, some on the right, such as Ron Paul, are beset by unsound thinking on the subject, subscribing to a dogmatic belief in hard money. Monetary policy is not a panacea — one of the great conservative insights is that there are no panaceas to problems in a complex and undirected world — but the monetary-policy debate is an opportunity for fresh thinking.
In that spirit, J. W. Mason, an economist at John Jay College and a fellow at the left-wing Roosevelt Institute, has a provocative analysis that is worth considering. In a paper called “What Recovery?” he marshals a large body of evidence in service of the argument that there is “substantial additional space for expansionary policy.” Mason examines the pre-2008 trend in GDP growth and finds that our recent growth has fallen short. He identifies “a mix of lower labor force participation and slower productivity growth” as the culprit. What looks like a tight labor market — today, unemployment clocks in 4.4 percent — has not yielded substantial wage gains, and that, Mason says, is because the labor market is weaker than it seems. The drop in labor-force participation is not solely due to a surfeit of retiring Baby Boomers, Mason contends, as even people in their twenties are working less. He also finds that education does not yield the same economic benefits it once did. Mason argues that the United States is growing at too slow a rate because of low demand, and advises easy policy to encourage spending.
His is a comprehensive analysis, but it’s also a politically fraught one. Mason sees the current 2 percent inflation target set by the Fed as overly cautious, not only because inflation has lagged recently but also because, in his view, labor concerns are more important than inflationary ones. Matt Yglesias recently made a similar, albeit more general, point at Vox, saying that the federal government should be “obsessed with avoiding recessions” and comfortable with short-term inflationary shocks because “wage earning is the backbone of the mainstream economy.” In another Vox piece, Yglesias noted that easier monetary policy could be a route to “widespread job creation.”
But it’s not just left-wing thinkers who are advocating for easy policy. Some Republicans have signaled a willingness to buck the tight-money orthodoxy. Last year, Ted Cruz, who once flirted with Ron Paul–style thinking on the issue, argued that the post-crisis monetary policy labeled as loose by most economists had actually been too tight. For what it’s worth, President Trump — who will appoint Yellen’s replacement in February — told the Wall Street Journal in July that he would “like to see rates stay low.”
And Cruz’s comments loosely track with an ongoing effort by some conservative thinkers to reorient the Right on the issue. Ramesh Ponnuru and David Beckworth have argued in National Review that the Fed should take a different approach. In their view, which echoes a position called market monetarism, monetary policy should target the stable growth of nominal spending (the total amount of dollars spent throughout the economy) rather than aim to control the level of inflation. Its advocates think it’s a mistake to judge the stance of the monetary regime on the basis of interest rates, and they therefore reject the consensus story that policy was too easy from 2008 to 2011, when nominal-spending growth lagged. Their approach is rooted in different principles from those of the left-wing arguments for expansionary policy, but it might reach a similar conclusion: Beckworth has written that, after the financial crisis, “there needed to be some exogenous permanent increase in the monetary base to spur robust aggregate demand growth.” That never happened, and if Mason’s analysis is to be believed, such an increase could still be necessary — which means easier policy.
Conservatives should keep an open mind when it comes to monetary policy. It could lead them to surprising conclusions.
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