Title of my latest book The Money Illusion, I sharply criticized Fed policy during the Great Recession of 2007-09. Donald Cohn was vice chairman of the Federal Reserve Board during this period and wrote a Very thoughtful review of my book I encourage people to read the whole piece.

The most controversial aspect of my book is the claim that the Fed’s error made the recession in 2008 much more severe than it otherwise would have been. I base this claim on the premise that, in my view, a reasonable alternative monetary policy would have prevented the sharp decline in NGDP growth during 2008-09. Cohn argues that the Fed lacked accurate data during a critical period in 2008 that showed weakening NGDP, due to both data lags and errors in initial estimates of NGDP growth:

Furthermore, the growing economic weakness in the current data vintage of Q3 2008 – which would have set off alarm bells at the Fed – was not evident in the immediate lead-up to Lehman’s bankruptcy.footnote 5 NGDP is now estimated to have grown at a seasonally adjusted annual rate (SAAR) of just 0.9% in Q3 and fell to a 7.6% SAAR in Q4, which Sumner argued should prompt the Fed to begin more aggressive easing in Q3. was But at the end of July, the board staff was projecting 4.3% SAAR growth in NGDP for Q3 and 3.9% for Q4-2008 to Q3-2009. Individual predictors were in close agreement; A survey of professional forecasters in August showed NGDP growing at an annualized rate of 4.3% in Q3 and 4.1% for the next four quarters, rising interest rates. Clearly, none of this suggests an imminent collapse that would require immediate monetary policy attention in July and August.

In fact, Q3 NGDP growth was first released — a month after the end of the quarter — at 3.8% SAAR, and was revised slightly by two subsequent revisions in subsequent months. The current estimate of just 0.9% SAAR growth, which Sumner cites as evidence of very tight monetary policy, comes much later. The difference between first-published and current-estimated growth remained the same with a 3.5 percentage point downward revision in Q4 (from −4.1 to −7.6). This experience underscores several serious weaknesses for NGDP targeting—difficulties in estimating and forecasting accurately, availability of only lagged quarterly data, and the size of revisions; The latter can have a material impact on the policy assumptions required to achieve the NGDP level target.

This is roughly the argument I would make if I were asked to defend the Fed’s position. I have three responses to this general argument:

1. Other data clearly show that the economy is headed for recession in mid-2008. For example, unemployment rose 170 basis points from the previous low in August, and a large increase in the unemployment rate is a 100% accurate indicator of a recession. Indeed even a rise Half that big A 100% accurate inflation index would be. This data suggests that the government needs to do a better job of coming up with NGDP estimates in real time.

I understand that complaints about our GDP data do not invalidate the core of Kohn’s argument. My next two points are more important:

2. Lehman fails in mid-September, and soon after various market indicators (such as the TIPS spread) clearly suggest that money is very tight, as both inflation and employment forecasts are falling below the Fed’s underlying policy mandate. Thus even before we got the revised NGDP data, various resource market forecasts clearly suggested that we had a large deficit in demand. The Fed needs to respond to forecasts, not the backlog of NGDP data.

Even so, some might argue that mid-September is too late to do anything to avoid a severe recession. I don’t believe it’s too late, but it’s my third point that’s the most important:

3. Level targeting. I cannot stress enough the need for some level of targeted policy governance. The Fed needs to tell the market that no matter what happens in the short term during the banking crisis, NGDP will be about 8% above current levels in the next two years. They need to insist that they will Whatever it takes So that markets expect an average NGDP growth of around 4% over the next two years

When I mention level targeting, many people assume I’m obsessed with righting wrongs, undoing policy mistakes. This is not the purpose of level targeting. The key is to prevent an initial under or overshoot of NGDP growth (or at least otherwise make it milder.)

[Here I might use the analogy of the Mutual Assured Destruction doctrine in nuclear war game theory.  The point of massively retaliating against a nuclear attack on your country is not to seek revenge, not to “even the score”, the point is to deter the initial attack from occurring in the first place.  If you have not credibly committed to that doctrine ahead of time, then it’s pointless (which the theme of the film Dr. Strangelove.]

Let’s now consider how these three parts relate to the end of 2008. Despite the flawed NGDP data, markets clearly saw that money was too tight to achieve the Fed’s underlying policy target of around 4% NGDP growth. Markets have seen high frequency data on everything from ocean shipping rates to U.S. equity prices (and many other data points) to payroll employment, and putting all of this data together suggests that a recession is underway. Under a level targeting regime, markets expected a very expansionary Fed policy to bring NGDP back to the trend line over the next few years.

And that brings us to the main point, which is missed in so much discussion of level targeting. Market expectations of NGDP growth over the next few years are essentially what Keynes meant by “animal spirits”. Long-run NGDP expectations are the primary factor driving aggregate demand in the short-run. (Michael Woodford formally modeled that future expected demand growth drives current demand in the economy.) This is why the current economy is so sensitive to the expected future path of monetary policy.

In a policy regime where the Fed promises to bring NGDP back to the trend line as quickly as possible, initial deviations from that trend line become much smaller. As an analogy, if a swing oil producer pledges to do whatever it takes to bring oil prices back to target within three months, the impact of a near-term oil production disruption caused by a missile attack on Saudi Arabia is much smaller. Wholesalers sell oil out of inventory, expecting that they will be able to refill within 3 months at a reasonable price.

Of course this is an analogy, but it is also true of macroeconomics. Business investment decisions during a temporary period of banking crisis will be very different if the actual investment decision makers expect a deep and prolonged recession, whereas they expect the Fed to bring NGDP back to trend within two years. In the latter case, even the initial drop will be much smaller. NGDP rose in 1933, despite the closure of many banking systems for several months, as the devaluation of the dollar created expectations of higher NGDP in future years.

Many events that look like “exogenous shocks” to most people are actually changes in investment driven by a loss of confidence in the future path of monetary policy. There may be external factors that cause a lack of confidence (say financial turmoil or fiscal spending) but it is the Fed’s job to cushion those shocks.

I don’t know if there will be a deep demand slowdown in 2023. But I do know that if there is a deep demand-side slowdown in 2023, it will be because the market thinks the Fed won’t generate enough NGDP growth in 2024. and 2025.

Rest assured. I say “deep” recession, since one could at least argue that a very mild recession is an acceptable cost of reducing inflation. A deep demand-side recession would be inexcusable.

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