Beckworth, Ponnuru, and Niskanen on Monetary Policy

Economist David Beckworth and conservative commentator Ramesh Ponnuru have an interesting piece in the New Republic blaming the Federal Reserve's unduly tight monetary policy for the recent recession and current slow recovery:

For the 25 years leading up to our current mess—the period economists have come to call “the great moderation”—the Fed did a pretty good job of stabilizing the economy. The result of its monetary policies was that the economy, measured in current-dollar or “nominal” terms, grew at about 5 percent a year, with inflation accounting for 2 percent of the increase and real economic growth 3 percent. Keeping nominal spending and nominal income on a predictable path is important for two reasons. First, most debts, such as mortgages, are contracted in nominal terms, so an unexpected slowdown in nominal income growth increases their burden. Also, the difficulty of adjusting nominal prices makes the business cycle more severe. If workers resist nominal wage cuts during a deflation, for example, mass unemployment results.

During the great moderation, people began to expect spending and incomes to grow at a stable rate and made borrowing decisions based on it. But maintaining this stability requires the Fed to increase the money supply whenever the demand for money balances—people’s preference for cash over other assets—increases. This happened in 2008 when, as a result of the recession and the financial crisis, fearful Americans began to hold their cash. The Federal Reserve, first worried about increased commodity prices as a harbinger of inflation and then focused on saving the financial system, failed to increase the money supply enough to offset this shift in demand and allowed nominal spending to fall through mid-2009.

That drop in nominal spending was the most severe decline since 1938. Since then, none of the Fed’s much-debated moves toward monetary ease have brought nominal spending back to where it would have been had the expected 5 percent growth been maintained all along. Consequently, incomes are lower, debt burdens are higher, and banks are weaker than they should be.

Beckworth and Ponnuru's focus on maintaining a steady growth in nominal GDP is very similar to the position espoused by the late Bill Niskanen. Writing in the most recent edition of the Cato Handbook for Policymakers, Niskanen called for the Fed to maintain the growth of nominal domestic spending:

The intent of Congress would be better served and monetary policy would be more effective if Congress instructed the Federal Reserve to establish a monetary policy that reflects both their concerns in a single target. The best such target, I suggest, would be the nominal final sales to domestic purchasers—the sum of nominal gross domestic product plus imports minus exports minus the change in private inventories. First, this is a feasible target: nominal final sales to U.S.-based purchasers are almost completely determined by U.S. monetary policy, whereas the rate of economic growth and the inflation rate are separately affected by a variety of domestic and foreign conditions. Second, this target provides the correct incentives: for any rate of increase in final sales, a reduction of the inflation rate increases the rate of economic growth. Congress is best advised (1) to specify a target rate of increase of final sales and (2) to instruct the Federal Reserve to minimize the variance around this target rate. The target rate of increase of final sales may best be about 5 percent a year, sufficient to finance a realistic rate of economic growth of 3 percent and an acceptable rate of inflation of about 2 percent.

For the past 20 years, actual final sales increased at a 5.4 percent annual rate with an average inflation rate of 2.4 percent, illustrating that a 5 percent annual increase of final sales would be both feasible and a slightly superior target. The primary problem of U.S. monetary policy during this period, as illustrated by Figure 36.1, is that the Federal Reserve overreacted to three financial crises, creating three ‘‘bubbles’’ of aggregate demand—the correction of which caused two subsequent shallow recessions and, most likely, a third.

Niskanen was writing in mid-2008, before the full extent of the financial crisis had become apparent. He worried that the Fed was over-reacting with easy money:

Most of the variation in demand during the past 20 years has been triggered by the Fed’s response to financial crises. A second lesson is that the Fed seems to overreact. A reasonable standard by which to judge the Fed’s response to a financial crisis would be to avoid a decline in the growth of demand relative to the target path. Instead, the Fed’s response to financial crises has led demand to increase relative to the target path. A third lesson is that the necessary measures to deflate the demand bubbles caused by overreacting to financial crises should be expected to lead to a recession.

"This story is not yet over," Niskanen wrote. The fall in nominal spending in 2008-09 cited by Beckworth and Ponnuru suggests that the Fed may have underreacted to an unusually severe financial crisis.