US housing starts peaked in January 2006. Home prices did the same in the middle of the year or early 2007, depending on the metric. Yet the jobless rate barely rose over the 2006-2007 period, from 4.9% at the end of 2005 to 5.0% at the end of 2007. But it was 7.3% by the end of 2008 and rising. Yet from April through October of that year, the Federal Reserve left unchanged its fed funds rate. St. Louis Fed President James Bullard now says “we should have done even more in 2007-2009. Something like nominal GDP targeting, if it’s appropriately formulated, does look like optimal policy.” That opinion is based on a new paper Bullard co-authored, “Optimal Monetary Policy at the Zero Lower Bound.”
Economist Scott Sumner is favorably inclined toward this development:
The Fed held its fed funds target stable (at 2.0%) from late April to October 2008. This despite extremely serious deterioration in the labor market. But why? In the statement issued after the September 16, 2008 meeting, which occurred two days after Lehman failed, the Fed gave us their reasoning. They indicated that they saw equal risk of recession and high inflation. Given that they perceived these risks as balanced, they decided not to change policy.
In my view, policy was being continually tightened throughout this period. If we had had a NGDP futures market, it would have indicated falling NGDP expectations. TIPS spreads were declining, and reached 1.23% for the 5-year spread by the time of their September meeting.
Today we know that the real problem was deflation, which had set in by early 2009. But the Fed was worried about high inflation, and this led them to unintentionally tighten monetary policy. Even though the policy rate was stable at 2.0%, the Wicksellian natural rate was falling fast between April and October. Hence the effective stance of monetary policy was getting progressively tighter.
The new paper by James Bullard (who is president of the St Louis Fed) and three other researchers, tells us what went wrong in 2008. The Fed needed to allow a higher price level, to offset the negative shock from the housing/banking crisis. That would have required them to ease monetary policy. But the inflation numbers were very scary. Not only were they higher than the Fed’s 2% target, they were increasing up until July 2008, the last data point available by the September meeting. Little did they know that inflation had already fallen to 4.0% in August, and would reach less than 0.4% in December. By March of 2009 the 12-month inflation rate was negative—we were in deflation.
The markets figured out this problem before the Fed. If the Fed had adopted NGDP targeting, they would have ignored the inflation numbers and focused on NGDP growth. Even so, because of data lags they might have been a bit behind the curve. But the markets would have expected a catch-up from any near-term NGDP undershoot, and thus NGDP growth expectations would have stayed strong enough to prevent the economy from hitting the zero bound.
In a recent The Week column, I basically asked if Republicans had learned any economic lessons from the Great Recession. One possible takeaway might be that the Fed was too tight in 2008 and afterward, playing a huge role in the downturn and sluggish recovery. A second lesson would be that reform of the Fed should perhaps focus on what both Sumner and Bullard are talking about rather than what Republicans are mostly talking about these days.
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