A lot of people are discussing Bernanke’s defense of “monetary ease” in 2002, but everyone seems to be missing the much bigger story. Bernanke’s explanation for the Fed’s actions in 2002 show exactly how monetary policy failed in 2008. In particular, Bernanke made the following three observations regarding 2002:
1. Monetary policy needs to focus on the macroeconomy, not specific sectors.
2. Monetary policy must be forward-looking, must target the forecast.
3. Monetary policy must be especially aggressive when there is risk of liquidity trap (which would render conventional policy ineffective.)
In 2008 the Fed did exactly the opposite. Between September and December 2008 the Fed focused on banking, not the macroeconomy, they adopted a backward-looking Taylor Rule, and they were extremely passive when the threat of a liquidity trap was already obvious.
In the 1920s Governor Strong argued that if the Fed were to try to stop the stock market boom, it would be like spanking all one’s children just because one had misbehaved. Bernanke seems to feel the same way:
Monetary policy is also a blunt tool, and interest rate increases in 2003 or 2004 sufficient to constrain the bubble could have seriously weakened the economy at just the time when the recovery from the previous recession was becoming established.
So the Fed should focus on the macroeconomy, not a specific sector. I agree. Unfortunately, they did exactly the opposite in the last 4 months of 2008.
The second quotation shows that Bernanke does not accept the policy implications of backward-looking Taylor Rules, he strongly believes that monetary policy must be forward-looking; policy must respond to looming inflation or deflation threats, not the previous year’s inflation rate:
Slide 4 shows that the version of the Taylor rule based on forecast inflation (in green dots) explains both the course of monetary policy earlier in the past decade as well as the decision not to respond aggressively to what did in fact turn out to be a temporary surge in inflation in 2008. This comparison suggests that the Taylor rule using forecast inflation is a more useful benchmark, both as a description of recent FOMC behavior and as a guide to appropriate policy.
There might be no better example of the distinction between forward and backward-looking Taylor Rules than economic situation on September 16, 2008, when the FOMC made its most momentous error. To set the scene, recall that we had been in recession for nine months. But the early stages of the recession were extremely mild, and the last unemployment reading had been about 6.2%. The last CPI data that was available was for July, and due to the extremely high oil prices the headline inflation numbers were over 5%, far above the Fed’s implicit target. Core inflation, however, was still well-behaved. And most importantly, the precipitous fall in commodity prices between mid-July and mid-September had greatly reduced inflation expectations. Two days before the FOMC meeting Lehman failed, and this further reduced inflation expectations in the TIPS markets. By the time of the September 16th meeting, 5 year TIPS spreads had fallen to only 1.23%. Now let’s compare the policy implications in September 2008 of a backward looking Taylor Rule, to the forward-looking policy that Bernanke says that he favors:
Backward-looking rule: There is both a risk of recession and high inflation. No policy action called for.
Forward-looking rule: There is risk of recession, and risk that inflation will sharply undershoot the implicit 2% target. Cut rates.
The FOMC statement said the risks of recession and inflation were roughly balanced. The Fed took no action. John Taylor won and I lost.
At this point you might wonder why I put so much emphasis on one meeting, after all the Fed did eventually get around to cutting rates almost to zero, so what’s the rush? How much harm can be done from one botched meeting? Normally a single error can be easily corrected, but let’s see what Bernanke says about policy where the economy is teetering on the edge of a liquidity trap:
The aggressive monetary policy response in 2002 and 2003 was motivated by two principal factors. First, although the recession technically ended in late 2001, the recovery remained quite weak and “jobless” into the latter part of 2003. Real gross domestic product (GDP), which normally grows above trend in the early stages of an economic expansion, rose at an average pace just above 2 percent in 2002 and the first half of 2003, a rate insufficient to halt continued increases in the unemployment rate, which peaked above 6 percent in the first half of 2003. Second, the FOMC’s policy response also reflected concerns about a possible unwelcome decline in inflation. Taking note of the painful experience of Japan, policymakers worried that the United States might sink into deflation and that, as one consequence, the FOMC’s target interest rate might hit its zero lower bound, limiting the scope for further monetary accommodation. FOMC decisions during this period were informed by a strong consensus among researchers that, when faced with the risk of hitting the zero lower bound, policymakers should lower rates preemptively, thereby reducing the probability of ultimately being constrained by the lower bound on the policy interest rate. (emphasis added.)
Of course this is precisely the mistake the Fed made in late 2008. In mid-September they saw no need for a rate cut, even though rates were only 2%, and even though T-bill rates had briefly dipped close to zero in the financial crisis of early 2008, and even though Lehman had just failed, and even though TIPS showed a dangerous plunge in 5 year inflation expectations, and even though we had been in recession for 9 months. In other words, things were already far more scary than in 2002. By mid-October many observers argued that we were already in a liquidity trap and there was nothing more that the Fed could do. Time for fiscal stimulus. That sure didn’t take long! I have to give credit to Bernanke, he is a superb at diagnosing problems. To use a medical analogy, Bernanke is the guy you want diagnosing the patient and Krugman is the guy you’d send into the operating room. In a crisis, you need someone with a sense of urgency and decisiveness, and as well as an understanding of what could happen if you don’t act in time.
I was lulled by all those academic articles (some by Bernanke) into thinking that the Fed had a backup plan if we went into a liquidity trap. Krugman kept saying “it’s harder than it looks.” I still don’t think it is that hard, but as a practical matter Krugman was right. There was no backup plan. The Fed acted as if there was little they could do once rates hit zero. That makes Bernanke’s pre-emption doctrine all the more essential.
When I was young, I recall some teenagers who played a dare-devil game on top of those white mushroom shaped water towers that dot the Midwest. They would start at the top, and see who dared slide the furthest down. Of course if you make a mistake it is all over. Once you start sliding, the slope keeps getting steeper. (Kids, don’t play this game without a parachute. And if you must play, wear sneakers!) It turns out that the Fed was playing a similar game, seeing how far down they could let T-bill yields fall without enacting an aggressive policy of monetary ease. In the first 10 days of October the stock market crashed by 23%. I’m guessing that by October 10th Bernanke had the sickening feeling in his stomach that one of those kids would have had if they went “over the horizon” on a water tower. There must have been some point when the Fed realized it was too late for monetary policy. Why not go immediately from 2% to zero once the mistake was realized? I’m guessing that they thought that would look too desperate, and admission that they had blown it in the September meeting.
The Fed had already suffered a similar embarrassment in December 2007, when they cut rates 1/4 at a meeting where many were looking for a 1/2 point cut. The stock and bond markets panicked after the 2:15 pm announcement. Stocks are easy to explain, but you might be surprised to hear that 3 month T-bill prices actually rose, i.e. yields fell. How could yields have fallen on a tighter than expected Fed announcement that sharply depressed the stock market? Easy, the markets knew the Fed blew it, and that this would push us into recession. They also knew that the recession would force the Fed to make an embarrassing make-up call in the near future. And they were right, we went into recession and the Fed panicked and cut rates an additional 75 basis points just a month later, and another 50 at the next scheduled meeting—a total cut of 125 basis points in 10 days. In the fall of 2008 they needed an even more aggressive move. They needed to cut rates so sharply that 3 month T-bill yields rose. And they blinked.
Arnold Kling likes to make my belief that tight money was to blame seem very mysterious:
Like Scott Sumner, Krugman views the main problem as deflationary expectations. I am not sure where these expectations come from. In Sumner’s story, people just decide that the monetary authority is willing to see the price level drop.
If you think that low interest rates are easy money and high interest rates are tight money, then it does seem very mysterious. But it is not mysterious to the stock market. Unlike Kling, the stock market does believe monetary policy has a near-term impact on the economy. It isn’t just coincidence that the Dow soared hundreds of points right after 2:15pm on September 18, 2007, or that it crashed hundreds of points right after 2:15pm on December 11th, 2007. And it’s not just coincidence that 3 month T-bill yields fell on a tighter than expected Fed announcement that plunged us into recession. Those market responses are sending us powerful signals about how Fed policy shocks (or even Fed errors of omission in the face of an increase in money demand during financial crises), can have a powerful effect on AD. And the markets also understand how deflationary policies can dramatically worsen a financial crisis.
Most economists ignore these signals because they don’t fit in to their “low interest rates = easy money” worldview. The markets were warning us all along, it’s just that we weren’t paying any attention.
Here’s how I read the recent AEA meeting speech. Bernanke is in a box. He feels he must defend the Fed from the neo-Austrian charge that monetary ease in 2002-04 blew up the housing bubble and led to the sub-prime fiasco. But if he does so it leaves him open to criticism from people like me who point out that his explanation implies money was much too tight in late 2008. Bernanke knows that for every Sumner, Woolsey or Hetzel, there are 1000 neo-Austrians. In purely political terms he probably made the right move at the AEA. History may not judge him so kindly.
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