Magazine | March 5, 2018, Issue

A Monetary Correction

Gold seal at the Federal Reserve Bank in Kansas City, Mo. (Photo: Fotoeye75/Dreamstime)
It now displays the kind of open-mindedness that conservatives have been begging for.

Our economy is finishing its ninth year of expansion following the economic crisis of 2008 and 2009. While this expansion has been long-lasting, it has also been weak by post–World War II standards. Theories abound for this weakness. One common explanation, particularly on the right, is that the Federal Reserve’s attempts to stimulate the economy have had the perverse effect of keeping economic growth low.

In 2007 and 2008, the Federal Reserve reduced the federal-funds rate — the interest rate it targets — from 5.25 to 0.25 percent. It held that rate down for seven years. Since 2015, it has increased it in increments to 1.5 percent. The Fed has also made large-scale asset purchases to ease credit. Most of the Fed’s conservative and libertarian critics allow that some of these moves were justified as a response to a sharp recession, but maintain that the Fed has kept monetary policy too loose for too long. Its actions distorted markets so much as to amount to “financial repression.” With interest rates held low, investors moved to risky assets, including stocks, to reach for yield. Inequality worsened but the real economy did not prosper.

Many of these same critics spent the first years of the recovery warning that easy money would lead to a surge in inflation. With no such surge having occurred, the argument has shifted. The current critique is that the expansion has been artificial, and will be revealed as such as the Fed retreats from its extraordinarily accommodative policies. As interest rates rise to normal levels and the Fed’s asset holdings shrink, that is, we will see how dangerously dependent the economy has become on support from the Fed to achieve even modest growth.

There is an alternative perspective that better fits the facts. The truth is that poor Fed policy has contributed to the weakness of the expansion. But the Fed has erred by keeping money too tight, not too loose.

The best indicator of the stance of monetary policy is the rate of growth of spending throughout the economy. Accelerating growth in spending signals an expansionary policy and decelerating growth a contractionary one. In the 1970s, spending growth was high and rising, leading to high rates of inflation. During the Great Moderation that followed that period, spending grew at a relatively steady pace, averaging 5.3 percent a year. This steady pace promoted macroeconomic stability. Economic actors were able to make and coordinate their plans against a backdrop expectation that the volume of spending would keep growing at the accustomed rate.


SOURCE: FRED Database, Authors’ Calculations;
NOTE: Money spending is measured by NGDP.

The crash of 2008 and 2009, however, saw the steepest decline in spending since the Great Depression. In its aftermath the Fed did not pursue a policy of letting spending bounce back to maintain its average growth rate. The red line in Figure 1 shows what a historically normal spending path would have looked like. A loose-money policy would have led to growth significantly above that line. Instead, as the figure shows, spending grew at a level significantly below the pre-crisis rate. It has risen at 3.7 percent per year during the recovery.

Inflation is another indicator of the stance of monetary policy, and it too has signaled tight rather than loose money. Since the end of the crisis, inflation as measured by the Fed’s preferred indicator — the core PCE price index — has averaged 1.5 percent per year. That rate is below the average level of the previous decades, and, as Figure 2 shows, also below the Fed’s target of 2 percent inflation. Both Fed officials and many outside observers call the low inflation rate a “puzzle” given loose monetary policies. But there is no mystery once you drop the assumption that monetary policy has been loose.


FRED Database, Authors’ Calculations

A key reason this mistaken assumption is so widespread is that people wrongly associate low interest rates with easy money. They fall into this error because central banks commonly seek to stimulate economies by cutting interest rates and to cool down economies by raising interest rates. But what is stimulative is an interest rate below the natural, or market-clearing, interest rate, and what is contractionary is an interest rate above the natural rate. If the Fed has set interest rates low but a weak economy has a natural rate of interest that is even lower, then monetary policy is tight. And an excessively tight policy can cause the economic weakness that brings down the natural rate. As Milton Friedman explained, the low interest rates of the Great Depression were a result of extremely tight money.

Multiple studies suggest that the natural rate of interest has been very low in recent years, and was negative during the worst of the crisis. It is thus misleading to say, as Fed officials and their critics commonly do, that the Fed has pursued a low-interest-rate “policy.” The recession, the slow recovery, and the high global appetite for Treasury securities — all of which tight-money policies exacerbated — were the main reasons for low interest rates.

During the economic crisis, the Fed cut the interest rate it targets — but did not cut it as fast as the natural rate fell. While it engaged in “quantitative easing” (QE) to aid the recovery, it also made decisions that limited the effect of this move. First, it paid banks above-market returns for parking the money created by QE at the Fed. That money was therefore not invested in Treasury securities and new loans. Second, it signaled that QE would be temporary. Standard monetary theory holds that permanent expansions of the money supply are much more effective than temporary ones in boosting spending and inflation.

Among the reasons the Fed has refrained from a more expansionary policy is that it has feared a return of the high inflation of the 1970s. Many of its officials have also adopted the assumption that low interest rates and an expanded balance sheet are dangerously loose-money policies. And so in recent years they have moved to raise interest rates and shrink the balance sheet — two unambiguously contractionary policies — even while inflation has been below target. The alternative of letting spending bounce back would have involved a period of higher inflation, but also higher real output and a faster recovery of the labor market. It would also almost certainly have led to a faster rise in interest rates.

The economy seems largely to have adjusted to the new, lower pace of spending growth. The problem now is not that monetary policy is erring on the side of tightness and thus holding back the economy’s potential. It’s that the Fed’s apparent bias against letting spending and inflation drift higher, even temporarily, makes it more likely that the next economic downturn will again be severe and the next recovery will again be sluggish.

To avoid this danger, what matters most is not whether the Fed raises or lowers the federal-funds rate in the near term. What is most important, rather, is that the Fed commit itself, in public, to stabilizing the long-run growth rate of spending. The Fed could, for example, set a 4 percent growth rate with the understanding that if it misses the target one year it will seek to make up for it the next. If spending comes in at 3 percent one year, that is, the Fed’s target the next year should be 5 percent — and vice versa. The expectation that spending will not be allowed to collapse will help to put a floor under interest rates and thus, to a certain degree, be self-fulfilling. In the event a downturn happened, though, the Fed would not be constrained from pursuing a more expansionary policy. We would follow something like the red line in Figure 1 in that case.

At the same time, inflation would not drift ever upward as it did in the period before the Great Moderation. Since spending growth is mathematically equivalent to real economic growth plus inflation, a commitment to stabilizing spending growth implies a commitment to stabilizing inflation as well. The inflation rate would rise above its average level when real growth is slow and below it when real growth is fast, but would stay within a narrow band.

In practice, the Fed’s current inflation target is asymmetric: The Fed is less concerned about undershooting it than overshooting it. A commitment to stabilize spending growth should in contrast be symmetric. Achieving symmetry would require an abandonment of the Fed’s current policy of paying banks more for holding excess reserves than they could earn from lending and buying Treasuries. That policy, as Cato Institute monetary-policy scholar George Selgin has explained, constrains the Fed’s ability to encourage spending while leaving it free to discourage it.

The Fed is unlikely to take any of these steps, however, unless it first jettisons the conventional wisdom about our allegedly hyperstimulative policies over the last decade. It should get our recent history right, lest it condemn us to repeat it.

— Mr. Beckworth is a senior research fellow with the Program on Monetary Policy at the Mercatus Center at George Mason University and a former international economist at the U.S. Department of the Treasury. Mr. Ponnuru is a senior editor of  National Review.

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