Are you sure that the Fed has been tightening?

Some financial hawks want Jay Powell to emulate Paul Volcker. I wonder if they understand what that means. After Paul Volcker was appointed chairman of the Fed in August 1979, monetary policy remained highly expansionary for another 2 years. NGDP growth averaged over 10% between 1979:Q3 and 1981:Q3. And it wasn’t because of “policy lag”; In fact it was only in the summer of 1981, during Volcker’s second year (the period from 1980:Q3 to 1981:Q3.) that Volcker became serious about inflation. Unfortunately, Volcker’s myth has crowded out reality.

There is currently a vigorous debate over whether the Fed’s “tight money” policy is too restrictive. But what if both sides of the debate are wrong? What if the Fed doesn’t even adopt a tight monetary policy?

Longtime readers know that I do not view rising interest rates or quantitative tightening as useful indicators of the stance of monetary policy. My opinion is close to them Ben Bernanke:

The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we have nothing really satisfactory to replace it with. As emphasized by Friedman (in his Eleventh Proposition) and Alan Meltzer, the nominal interest rate is not a good indicator of the policy stance, as a high nominal interest rate can indicate monetary tightening or easing, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary easing was the source of major problems in the 1930s, and has probably been a problem in Japan in recent years. Real short-term interest rates, another candidate measure of policy stance, are also imperfect, as they mix monetary and real effects, such as the rate of productivity growth. . . .

Ultimately, it appears, only looking at macroeconomic indicators such as nominal GDP growth and inflation can test whether an economy has a stable financial background. This measure shows that modern central bankers have taken Milton Friedman’s advice to heart.

I prefer NGDP growth, because inflation is distorted by supply shocks. (Total labor income may be better.) Earlier in the year, I argued that the Fed should slow NGDP growth to get to their 2% inflation target. In the long run, NGDP growth would need to be around 3.5% to deliver 2% inflation. I didn’t expect the Fed to get there immediately, but I didn’t expect NGDP growth to be so fast in the first two quarters of 2022 (7.5% annual rate.) The third quarter figures haven’t been released yet, as forecasters seem to be expecting another big number.

Some might argue that the kind of fiscal tightening I proposed would have caused unacceptable pain in the labor market. It is possible, though I suspect that if NGDP growth slows to around 4% by the end of the year, unemployment would rise above 5%. But that’s all a moot point, because the Fed hasn’t really inflicted any pain on the labor market at all., The unemployment rate recently fell to a 50-year low of 3.5%. So if you’re one of those people who believes that tight money is bad because it hurts the labor market, I can assume you agree with me? Can I assume that you also believe that the Fed has not tightened at all?

clarify, I don’t see the unemployment rate as an indicator of whether money is easy or tight. I like to see NGDP growth. But many people seem to see unemployment as an important policy indicator. And if I’m not mistaken, those are often the same people who complain that the Fed has tightened too much. I see hand in hand what the Fed is doing “tightening” for developing countries. Imagine what those countries would look like if the Fed actually tightened—if it actually slowed NGDP growth to a level consistent with 2% inflation!

I want to avoid arguing about semantics. If someone wants to argue that Fed policy represents a tightening in 2022 because it went from being very expansionary in 2021 to merely very expansionary in 2022, I won’t quibble with that characterization. Rather, I encourage people to look beyond the words and try to focus on what the Fed is actually doing. And while NGDP isn’t perfect, it’s much higher than lazy estimates of the Fed’s policy stance in most of the media. Also note that the faster NGDP growth in 2021 partly (but not entirely) reflects a healthy return to trend, while the slightly less extreme NGDP growth in 2022 is occurring in an economy that has already overshot trend and is overheating.

Some argue that Fed policy affects the economy in a backward manner. This is true of sticky wages and prices, but not of NGDP. If NGDP growth is not slowing, then monetary policy is not tightening to any significant extent. So why are interest rates so high in 2021? Partly because the economy is much hotter than the market expected in 2021. (Financial incentives may also play a role.)

In short, let’s hope that Powell “doesn’t Volcker”. Let’s hope he doesn’t wait Two whole years After it’s clear we have a problem of inflation on the demand side before tightening. Let’s hope he gets serious about inflation much faster than Volcker.

Leave a Reply

Your email address will not be published.