Market monetarist ideas often sound quite paradoxical to the uninitiated. Back in 2008 and 2009 it was a struggle to get anyone to even pay attention. How are we doing today? One indication is provided in the cover story of a recent Economist magazine:
The danger is that, having used up their arsenal, governments and central banks will not have the ammunition to fight the next recession. Paradoxically, reducing that risk requires a willingness to keep policy looser for longer today.
. . .
When central banks face their next recession, in other words, they risk having almost no room to boost their economies by cutting interest rates. That would make the next downturn even harder to escape.
The logical answer is to get back to normal as fast as possible. The sooner interest rates rise, the sooner central banks will regain the room to cut rates again when trouble comes along. The faster debts are cut, the easier it will be for governments to borrow to ward off disaster. Logical, but wrong.
Raising rates while wages are flat and inflation is well below the central bankers’ target risks pushing economies back to the brink of deflation and precipitating the very recession they seek to avoid. When central banks have raised rates too early—as the European Central Bank did in 2011—they have done such harm that they have felt compelled to reverse course. Better to wait until wage growth is entrenched and inflation is at least back to its target level. Inflation that is a little too high is a lot less dangerous for an economy than premature rate rises are.
Here’s the technical explanation. When the Fed tightens monetary policy, the Wicksellian interest rate falls as the market interest rate rises. Why is that important? Because the Fed adopts expansionary monetary policies by reducing its target rate to a level below the Wicksellian equilibrium rate. The lower that rate, the less room central banks have to conduct “conventional” monetary policy (i.e. raising and lowering short term rates.) So if you want the ability to cut rates below the Wicksellian equilibrium rate in the future, the best way of insuring that you can do so is by not raising them today.
Notice the Economist suggests that the ECB’s tight money policy of 2011 triggered the double-dip recession. This is also progress. A few years ago I recall economists claiming that modern recessions were different. The idea was that earlier recessions were caused by the Fed raising rates to combat inflation, whereas modern recessions were caused by balance sheet issues. This is wrong, as you can see from this graph of ECB target rates:
The ECB raised rates in July 2008, and then twice in the spring of 2011. In 2008 they raised rates because they were worried about high inflation. In 2011 they raised rates because they were worried about high inflation. Of course in both cases they made a mistake, as NGDP growth was weak. But inflation is the ECB’s special obsession. Now for the results. In 2008 the tight money policy caused a mild recession to suddenly become much more severe. This economic downturn sharply reduced the Wicksellian equilibrium rate, so that even later reductions in interest rates were not enough to make the policy expansionary in an absolute sense. And in 2011 the tight money policy also caused a recession, and again later rate cuts were not enough to turn things around. Only when the ECB adopted QE did monetary conditions improve (slightly.)
Before Americans feel too smug about this sorry record, recall that the Fed refused to cuts rates in the meeting after Lehman failed. Their excuse? Worry about high inflation.
I’ll end with a quote from Gandhi:
First they ignore you, then they ridicule you, then they fight you, and then you win.
PS. The rate increases of 2008 and 2011 do not, by themselves, tell us anything about the stance of monetary policy. For that you look to NGDP growth. I simply include them for the “people of the concrete steppes”, who complain that central banks didn’t “do anything” to cause the recent recessions. Yes they did.
PPS. The Great Recession was triggered by a Fed decision in December 2007 to cut rates by 1/4% rather than 1/2%. Frederic Mishkin and Janet Yellen understood what a horrible mistake the Fed was making.
PPPS. Over at Econlog I have a new post comparing fiscal policy during 1937 and 2013.