Making Up Is Not So Hard to Do

The Federal Reserve has been spectacularly ambitious in its response to the COVID-19 crisis. The Fed has lowered its interest-rate target to zero, expanded its balance sheet to $7 trillion, plugged liquidity holes in the global financial system, veered into private credit markets, and more. The flurry of activity has been so pronounced that it has pushed the central bank into areas, such as lending to businesses and households, normally reserved for Congress.

Despite this determined response, there is a major shortcoming that threatens to undermine all the central bank’s efforts to stabilize the economy. This deficiency, which also impairs relief efforts from Congress, is the framework that guides how the Fed conducts monetary policy. This framework does not, in its current form, allow for “make-up” policy, the ability to correct for unexpected shortfalls in the dollar size of the U.S. economy. This means that total dollar income in the United States is unlikely to be returned to its pre-crisis trajectory in the years to come, which will weigh heavily on households and businesses that made long-term financial commitments based on pre-crisis expectations of income growth. As a result, many of them will be pushed toward bankruptcy.

This is likely to happen because the Fed’s current monetary-policy framework is defined by a firm commitment to low inflation. Like a speed limit that keeps traffic from traveling too fast, this commitment keeps the economy from growing too rapidly, which is normally a good thing. But after a recession, it can stifle a recovery. Just as vehicles need to temporarily go faster than the speed limit to make up for lost time after a traffic jam, so an economy needs to temporarily grow faster than normal to get back to its pre-crisis trajectory after a recession.

Doing so, however, requires temporarily running the economy hot, which may cause inflation to briefly surge above the Fed’s 2 percent speed limit. The current Fed framework strictly enforces this speed limit and therefore does not allow for such catch-up growth in the dollar size of the economy. This means that even if there is still a big hole in the economy, and dollar incomes are still below pre-crisis trend values, the Fed will begin tightening monetary policy if inflation starts rising and approaches 2 percent.

This is not a theoretical concern. It is already being baked into economic forecasts. Take households. The University of Michigan’s Survey of Consumers includes a question about how much respondents expect their dollar incomes to grow over the next year. From 2018-9, households were expecting their dollar incomes to grow about 5 percent over the following years, and they made financial decisions — say, taking out a mortgage or a car loan — accordingly. But as you can see in the figure above, the coronavirus crisis has forced a dramatic downward revision in that expectation.

Of course, the economy is more than households: Businesses also make decisions, such as signing leases and investing in plants, based on forecasts of their income growth. So to get a complete measure of dollar income for the country and any unexpected shortfalls in it, one must compare the actual combined incomes of households and businesses to their forecasts. The figure below does just that, juxtaposing the true dollar size of the U.S. economy with the dollar size expected by households and businesses. The blue line represents the former, as measured by nominal GDP. The red line represents the latter, and shows a special estimate of nominal GDP derived from the Blue Chip forecast series. The red line is titled “neutral dollar size” in the figure because it is the dollar size needed to meet the expectation of total dollar income the public used to make long-term financial decisions in the past. This red line, in other words, indicates the level of dollar income needed to avoid widespread financial distress for households and businesses.

The figure shows that the gap between the actual and expected dollar sizes of the economy is expected to be $2.87 trillion during the second quarter of 2020. It is expected to narrow to $1.63 trillion by the end of 2021, but still remain persistently below the neutral dollar level. Households and businesses, in other words, are not expecting the Fed to disregard its 2 percent inflation speed limit in the service of a robust economic recovery. And the public is not alone in expecting that there will be no make-up policy. The Congressional Budget Office and the official body that sets the Fed’s monetary policy, the Federal Open Market Committee (FOMC), see no catch-up growth in the dollar size of the economy, either, and forecasts from the New York Federal Reserve Bank suggest a permanent loss in total dollar income over the next few years.

None of this should be surprising, given the Fed’s current monetary-policy framework; Fed officials are, after all, the enforcers of the low-inflation speed limit. But such enforcement in this case is likely to offset the relief efforts of Congress if it spurs the very catch-up growth needed to fill the economic hole created by the COVID-19 crisis, This suggests that the framework is badly flawed. Make-up policy, then, is not just about designing a better Fed response to the crisis, but about making sure the Fed does not get in the way of a robust recovery.

To be clear, the Fed’s ambitious response to the COVID-19 pandemic probably prevented a severe financial crisis and, in conjunction with Congress’s relief packages, halted another Great Depression. But the Fed’s inability to adopt a make-up policy means that, just as after the 2008 financial crisis, we are likely to experience a weak recovery in the years to come. This will further polarize our already fractured society.

In short, then, the Fed’s monetary-policy framework must be reformed to allow for make-up policy. Fortunately, the Fed has been considering this change and is indicating that it might make an announcement to this effect by the end of the year.

If the Fed does decide to adopt some form of make-up policy, there are several principles it should follow.

First, make-up policy should be used immediately after a recession to return the dollar size of the economy as quickly as possible to its pre-crisis growth path. The longer the Fed waits, the more damage is done. Timing is everything.

Second, make-up policy should be communicated as more than just allowing inflation to temporarily exceed its speed limit. The Fed must make clear what is really happening: The economy is being allowed to briefly run hot so that total dollar income can be rapidly restored to its pre-recession growth path. Explaining make-up policy in these terms is much easier to justify to the public than a statement saying that what is wanted is higher inflation.

Finally, how and when make-up policy will be used should be made clear to the public. There should be a well-specified and conditional rule that governs the Fed’s power to let the economy temporarily run hot.

Based on the above three principles, a natural way to implement make-up policy would be to explicitly target the level of total dollar income when there is a shortfall. This approach is more popularly known as nominal-GDP-level targeting and, as Boston College professor Peter Ireland recently noted, it would satisfy the Fed’s dual mandate from Congress. There are other good reasons for supporting it, too, including the fact that it provides an easy rules-based approach to monetary policy.

Make-up policy is sorely needed and may be coming soon to America. Here’s hoping that it does and that it comes in the right form.