In late 2021 and early 2022, many pundits warned that the Fed was moving too quickly to tighten monetary policy. It is now clear that this scholar was wrong. The Fed just didn’t tighten too much. There is almost no evidence that the Fed has tightened monetary policy at allAt least to any measurable extent.
Roughly a year ago, it became clear (even to the Fed) that the economy was heading for overheating. So why might the sudden tightening at the end of 2021 be a mistake? After all, inflation is a big problem, and tight money is the only reliable way to reduce inflation. Tighter money could reduce NGDP growth to a level consistent with 2% inflation.
The standard answer is that the Fed needs to be cautious, because tight money puts pain in the labor market. And I believe that’s true – we all saw what happened in 2008 when the Fed over tightened. The unemployment rate has risen to 10%.
If that’s your criteria for more tightening, the Fed certainly hasn’t. In fact, not only has the Fed imposed too much pain on the labor market, they have projected NGDP growth so fast into 2022 that the labor market is almost absurdly hot. Job openings are currently well above previous boom period levels as of late 2019.
A desirable policy of gradual deflation would strike a balance between inflation and unemployment costs. This will impose a modest amount of pain on the labor market, but not too much. But the Fed inflicted no pain at all. In fact it has not returned to the labor market like the boom conditions of late 2019. There is no cost balance. And inflation has not come down significantly at all. Despite what you may have read in the press, there was no tight monetary policy in 2022.
Later this year, I plan to publish a book discussing the problems with the way we measure the stance of monetary policy. Here are some of the mistakes made in 2021-22:
1. Assuming that interest rates measure the stance of monetary policy. They don’t. Rising rates do not indicate strict money. Money supply is also not a good indicator.
2. Consistency in adjusting policy instruments. It is true that you want to reduce NGDP growth gradually, so as not to create massive unemployment. But that doesn’t mean you have to gradually increase the target interest rate.
3. Confuse the bond market with a falling stock and tight money. (This is referred to as a tight “fiscal condition”.) During my lifetime (1966-81) the most expansionary monetary policy was accompanied by a very poor performance of the stock and bond markets. Markets hate high inflation—but high inflation is not a product of tight money. Don’t equate tight finances and tight money.
4. Assuming that monetary policy affects NGDP over long and variable lags. Indeed, monetary policy affects NGDP almost immediately, as we see in a few clearly identified fiscal shocks (eg 1933). It seems like a long gap if you assume that rising rates are tight money, but they are not.
5. Too much focus on inflation and not enough focus on NGDP growth. There was a long and completely useless debate about whether inflation was caused by supply or demand side factors. It doesn’t matter! NGDP growth, which is 100% demand driven, is important. And NGDP growth is obviously much higher.
6. President Biden waited too long to reappoint Powell. It’s possible that Powell was uncomfortable making the decision to tighten monetary policy just a month or two before Biden was slated to be the new Fed chair.
7. Most importantly (by far), the Fed’s FAIT failure. The Fed has signaled an intention to target an average rate of inflation of 2%, just as it has adopted a highly expansionary monetary policy. FAIT would actually be a great idea if implemented properly. But as soon as a tighter monetary policy was needed to stabilize the average inflation rate, the Fed announced that policy was in place asymmetricAnd they won’t offset inflationary overshoots with future undershoots.
At the end of 2019, monetary policy in the US was in a very good place, the best policy I have seen in my entire life. Sadly, all these gains were thrown away in the next few years, in a desperate attempt to artificially create wealth by printing huge amounts of money. FAIT would be a great policy. Asymmetric FAIT has been a disaster.
Rest assured. I received this email from Bloomberg:
It’s that time of the month– Working day. The US nonfarm payrolls report will be closely watched for any clues that the Fed may next step down to a 50 bp hike or reaffirm a higher terminal rate. Evidence may be mixed: The economy likely added 195,000 jobs in October, down from September but still okay.
No, 195,000 won’t do; It will be much more. I’m not advocating high unemployment, but is it too much to ask that the Fed can at least return the labor market to a historically strong boom in late 2019, rather than the almost irrational overheating we see today? In any case, Bloomberg was wrong. The economy added 261,000 jobs in October, and was also revised upward from previous months. Nominal wage growth was also above expectations. We’re still booming.
PPS. A few months ago, a bunch of commentators told me that the US entered a recession as early as 2022. These people need to rethink their economic model. Just for the people who warned that the Fed was tightening too aggressively in early 2022. Time for some soul searching. (I did some soul searching in January, when I realized that the Fed’s FAIT is a fake.)