The Fed's Monetary Policy Has Veered Off Course

Although the risk of deflation has receded in recent months, Fed policy is still too contractionary for the needs of the economy, as the money supply has not kept up with increases in money demand.

Two percent inflation is the goal
Both Lee Ohanian and I have published papers arguing that, during the Great Depression, policies aimed at raising wages delayed recovery by six or seven years. So we are in agreement that wage cuts can help the economy adjust to deflation. Deflation that occurred during times when wages were flexible, such as 1920-21, did not cause long depressions. But wages today are less flexible than in 1920, and they may not fall quickly enough to keep unemployment from worsening. For instance, the minimum wage is set to increase by more than 10 percent next month. Unemployment may stay high for years to come unless the Fed acts to quickly raise inflation up to two percent.

Last fall, deflationary policies by the Fed caused the sub-prime mortgage crisis to spread to other types of debt. Unfortunately, almost all economists misdiagnosed the problem, assuming that it was the worsening financial crisis that was reducing demand, when in fact the reverse was increasingly true -- falling demand reduced asset values and weakened bank balance sheets. And the 1.3 percent deflation experienced by the U.S. over the last 12 months actually understates the size of the deflationary shock. Because wages and prices are "sticky," a sharp fall in nominal GDP will initially result in much lower output, with inflation falling only gradually.

Why this recession is so bad
Of course, the Fed does not focus solely on inflation; they also have a mandate to take account of how their policies impact output and employment. A healthy U.S. economy requires about five percent nominal GDP growth (NGDP), which translates to roughly three percent real growth and two percent inflation. But NGDP has been falling at a rate of nearly five percent since last September, which is why we are in much worse shape than in other recent recessions.

What does falling NGDP mean for the economy? It means we are likely to suffer from very high unemployment for several years until wages and prices eventually adjust downward to reflect lower nominal spending. Because NGDP represents the gross income that individuals and businesses have available to repay debts, it's also the best indicator of the effect of monetary policy on the financial crisis. Debt defaults soared when NGDP starting falling rapidly.

The Fed's grave mistake
Where I disagree strongly with Ohanian is his view that the Fed has done a fine job during the current crisis. On September 16, 2008 -- two days after Lehman Brothers failed -- the Fed indicated that the risk of inflation and recession were roughly balanced, and decided not to cut interest rates. How could they have made a decision that looks so foolish in retrospect? They focused on a backward-looking indicator -- the high inflation that accompanied record oil prices over the summer -- and not forward-looking indicators such as stock, bond, and commodity prices, which showed the economy (and inflation) slowing dangerously.

If the Fed had moved aggressively enough to keep five-year Treasury bonds showing roughly two percent expected inflation last fall, we would have avoided both the deflation and the worst of the recession. Think of the economy as a big ship that the Fed is steering through treacherous waters. Now imagine the Fed trying to steer this ship by looking backward and only changing direction once they had seen that they had already veered off course. The Fed must pay more attention to forward-looking indicators if they want to avoid repeating the costly mistakes of last year.

Last October I went on something of a crusade to convince other economists that Fed policy was far off course. Eventually, the Fed itself realized it had made a mistake. How do we know this? Because under the "inflation targeting" approach used by modern central bankers, policy should be set at a level expected to produce on-target inflation, or roughly 2 percent. By October, even the Fed's internal forecasts showed both nominal GDP and inflation falling well below their policy goals.

Massive deficits would not have been needed
With a forward-looking monetary policy there should be no need to use fiscal policy (deficit spending) to help stabilize demand. The Fed should set policy to produce the desired level of demand (and inflation) in the economy. Among macroeconomists, it was widely understood that Ben Bernanke's call for fiscal stimulus last year was a tacit admission that monetary policy had failed. And despite the fact that markets have improved since March, monetary policy is still much too contractionary. Indeed, inflation expectations (and stocks) fell even further after the Fed failed to offer any new stimulus at its meeting last Wednesday, and are now far too low for a robust recovery.

Follow Blog War on the inflation-versus-deflation debate:

• Scott Sumner, 6/26: Deflation is Our Biggest Problem -- Not Inflation
• Lee Ohanian, 6/29: The Fed Fears Deflation More Than Inflation
• Scott Sumner, 6/30: The Fed's Monetary Policy Has Veered Off Course
• Lee Ohanian, 7/1: Fed Policy on Inflation: As Good As It Gets
• Scott Sumner, 7/2: We Need Inflation to Spur a Recovery
• Lee Ohanian, 7/3: No, Inflation is Not the Key to This Recovery