In a series of posts on the assessment of the bias of the US Fed prior to the Global Financial Crisis published on Alt-M, the blog of the recently established Center for Money and Financial Alternatives at the Cato Institute, David Beckworth just published a post with a very clear analysis of the inflationary bias of the Fed before 2008, based on an excellent paper written along with George Selgin and Berrak Bahadir in the Journal of Policy Modelling (those interested in monetary policy rules cannot miss it!).
The publication of both these posts and the academic article couldn’t be more timely. Surprisingly enough, monetary economists still disagree on the stance of monetary policy (not just in the US but elsewhere) before the outbreak of the Global Financial Crisis; this proves that we, economists, are not even that good at what we were supposed to do well, that is, the ‘prediction’ of the past. Leaving the academic interest of the subject aside, this is a policy question of major concern for all, should we want to contribute to the running of more sound, and more monetary-stability-oriented, monetary policy rules in the years to come. Now there are very good academics suggesting the way to exit QE and to move forward towards a more ‘normal’ monetary environment, and it is thus the perfect time to make the case for a different type of policy rules, those compatible with the fall of prices in a growing economy.
As I wrote as a comment on a recent George Selgin’s entry to this blog, the productivity rule ‘certainly provides solid theoretical basis to support the running of a different type of monetary policy rules; indeed different to the (CPI) inflation stabilising rules applied by all and sundry before 2008, which contributed to the recent crisis as well as to the instability generated in markets in the last years. It is time to apply less active and less inflationary monetary rules, those that allow the price level to reflect changes in productivity during expansions. Rather than focusing on price stability (actually it is most often ‘inflation stability’) we should be focusing on rules that better preserve monetary and financial stability on longer term basis; and the productivity norm is a good example of the latter. They are not going to be the cure for all problems but at least they will not be adding monetary disturbances on top of other (real-side) disturbances and shocks affecting the economy. And this will help agents form their expectations and make their plans.‘
For those unfamiliar with this literature, David Beckworth’s post provides the explanation for why (market or Fed’s) interest rates should be increased whenever productivity raises, so that the market interest rate runs in parallel with the natural interest rate, as Wicksell put it a century ago. Since then, this has been taken as the condition to keep monetary equilibrium in the economy (or at least, to put it more modestly and accurately, to avoid at least major disequilibria in the markets) and thus to prevent from the excess of money creation that so often has contributed to monetary and financial crises in the past as well as to the succession of the so-called boom and bust business cycles. Quoting Beckworth’s words from his recent post, ‘Was monetary policy loose during the last housing boom?’:
‘Note that the rise in the labor force and productivity growth rates both raised the expected return to capital. The faster productivity growth also implied higher expected household incomes. These developments, in turn, should have lead to less saving and more borrowing by firms and households and put upward pressure on the natural interest rate. Interest rates, in short, should have been rising given these large positive supply shocks during this time.‘
And guess what the Fed did during those years of increase in productivity? Focused much more on (a falling) CPI rate of inflation in a growing economy (which shouldn’t be surprising at all), its policy rule didn’t recommend a change in the Fed’s nominal interest rates (at the very best) and later on it kept on cutting them down for years to avoid deflation by all means. It is well time to put the debate on policy rules on the agenda so we dot repeat the same mistakes in the future.
Juan Castaneda
PS. To be fair and fully transparent, let me declare myself any possible conflict of interest (if at all): I am a lecturer at the University of Buckingham and yes, I am a visiting research scholar at Cato (during the spring 2015).
the old lady of threadneedle street 