Expansionary monetary policy causes recessions
Imagine a large flat piece of land out West. If a series of rivers run through this land for millions of years, it will create a series of canyons. In order to cross this land, hikers have to trudge up and down, up and down. Not good.
Instead assume that a set of giant piles of rock are dumped on this flat land, creating a series of mountains. Hikers must climb up and down these mountains to cross the land. Not good.
Suppose you start with a stable monetary policy, and no business cycles. They you start doing tight money every few years, creating a boom and bust cycle in the economy. Not good.
Or, suppose you start with a stable monetary policy, and then do a highly expansionary policy every few years. Once again, you create a series of business cycles, booms and recessions. Not good.
Many people understand that contractionary monetary policies can create business cycles, but far fewer understand that expansionary monetary policies are equally likely to create business cycles. (Austrians get it.)
The optimal is roughly 4% growth in NGDP, year after year.
I’m currently not all that worried about the economy overheating, but not because I don’t think it would be all that bad if it did. It would be very bad if the economy overheated, likely creating a recession soon after.
So don’t listen to people making arguments that were already discredited in 1968, that is, people claiming that overheating wouldn’t be that bad because it would help workers to find jobs. The actual risk of an overly expansionary monetary policy is that it would cause a subsequent recession.
Back to geology. You don’t want northern Arizona. You don’t want central Colorado. You want Kansas.
The Fed’s gradually building credibility behind it’s 2% AIT. Keep up the good work!!
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12. February 2021 at 14:09
I can see how a Fed mistake might goose the economy too much could lead to above target inflation, but why would that necessarily lead to a recession? As soon as the mistake is realized (they figure out where the model linking policy instruments and policy outcomes was wrong) they revert to moving their instruments so as to again produce 2% increase in the PCE and full employment.
Or do you assume that one misstep instantly re-anchors inflationary expectations to the higher level and 2% PCE increase not gives us less than full employment (=recession?) until markets re-re anchor back at 2%.?
12. February 2021 at 14:13
“So don’t listen to people making arguments that were already discredited in 1968, that is, people claiming that overheating wouldn’t be that bad because it would help workers to find jobs.”
That appears to be what Powell is trying to do!
https://marcusnunes.substack.com/p/powell-had-his-eureka-moment-monetary
12. February 2021 at 14:54
10y inflation swaps are currently at 2.375%:
https://pasteboard.co/JO4JEGK.png
10y breakeven meanwhile is at 2.226%:
https://pasteboard.co/JO4KjCj.png
https://pasteboard.co/JO4KAtE.png
And finally the 5y5y forward breakeven is at 2.128%:
https://pasteboard.co/JO4M2jw.png
So the market is pricing in the Fed allowing some catch-up inflation in the next 5 years before bringing it back to target.
12. February 2021 at 15:32
Thomas, your scenario seems theoretically possible, but historically the Fed has seemed more likely to generate recessions rather than soft landings (admittedly 2020 may have been a soft landing without the pandemic).
12. February 2021 at 16:21
Thomas, Recessions are caused by unstable NGDP growth. You can create instability in multiple ways, via expansionary or contractionary policy. No policy is expansionary or contractionary in an absolute sense, only relative to the average.
Thus if you have periods of 4% and 8% NGDP growth then the 4% periods will be the recessions. If you have periods of 4% and 0% NGDP growth, then the 4% percent periods will be the booms.
Marcus, I pay more attention to his commitment to 2% AIT than to his vague PC statements about wanting a strong labor market.
Thanks Garrett, It seems they are close to being on target.
12. February 2021 at 16:34
All of this is implied in the SRAS/SRAD and LRAS models, but how seriously do economists actually take these models? For example, in Q3 of 2018, when YOY NGDP growth approached 6%, many economists said the economy was overheating and favored rate hikes. Not a single one I spoke to, including a few who didn’t think the economy was overheating, was moved by me pointing out that RGDP was rising faster than inflation. That implies that the economy is on the flatter portion of the SRAS curve, with room to go better before hitting sustainable RGDP potential, if one takes the standard graph seriously.
12. February 2021 at 17:19
Scott, you said: “Marcus, I pay more attention to his commitment to 2% AIT than to his vague PC statements about wanting a strong labor market.”
But that strategy (AIT) is inextricably linked to a NK PC view! That´s why I think the strategy was DOA! https://thefaintofheart.wordpress.com/2020/10/09/is-the new-monetary-policy-framework-ait-an-improvement/
12. February 2021 at 17:28
Marcus nunes is having a woody!! But seriously, for many people who believe money is neutral, these silly Sumner posts are about as relevant as sunspots predicting the stock market. It’s a rehash of the largely discredited Friedman doctrine that the Fed should have a steady x%/yr money creation rate for permanent prosperity. Given money is short and long term neutral, everywhere and always, it’s a chimera. And speaking of chimeric (sic), what is making us sick? China’s SARS-CoV-2
12. February 2021 at 18:18
I suspect that it would be really difficult to run the US economy too hot. Between automation, improved tools for offshoring, and immigration of all sorts, the ability of companies to expand output is likely vastly underestimated.
13. February 2021 at 00:12
Austrians think that overly expansionary monetary policy creates booms which distort the structure of production and leads to a bust when the economy has to shrink while the distortions are fixed. But why do market monetarists think that overly expansionary monetary policy leads to busts? It will create higher than optimal NGDP growth which will which be reflected in higher inflation. I suppose the fact that NGDP is above the optimal level will slow growth a bit but I’m struggling to see why this would necessarily lead to an Austrian-type recession.
13. February 2021 at 02:20
Scott, is there anything that makes 4% special?
It seems like a reasonable number, but so does eg constant NGDP
(If I remember George Selgin right, constant NGDP was roughly what the classic freebanking examples of Scotland and Canada had?)
As long as people can rely on stable expectations, many growth rates should be mostly fine?
13. February 2021 at 02:21
Lizard Man, what’s keeping companies from using those automation etc opportunities at eg 4% stable and expected NGDP growth that they could pursue at 9% stable and expected NGDP growth?
13. February 2021 at 03:45
But will President Paul Ryan follow this logic in 2025? Central bankers, most investors, and anyone seeking a 30 year fixed rate mortgage can appreciate the stability of a Kansas-like monetary policy.
Absent a significant shock like war with China are there fiscal shenanigans that could wreck the Fed’s AIT management structure?
And I’m not referring to shocks like the one-off of another Covid relief package. That’s pocket change in the context of low interest rates.
13. February 2021 at 05:34
“Thomas, Recessions are caused by unstable NGDP growth. You can create instability in multiple ways, via expansionary or contractionary policy. No policy is expansionary or contractionary in an absolute sense, only relative to the average.”
Scott, this seems to me to be a restatement of the post’s thesis rather than an explanation of the model from which it was derived.
13. February 2021 at 06:25
@Matthias
The lack of demand and revenue are what keeps them from taking advantage of those opportunities. Why hire an extra person if it doesn’t bring you extra revenue? Why automate if it you can already fulfill all of your sales and extra capacity would lie idle?
Running the economy hot, in my mind, isn’t about NGDP growth. Rather, it is about central bankers not trying to put brakes on the rate of growth of the economy out of fear of inflation. The economy could be running hot at 4% or 9% NGDP growth.
13. February 2021 at 07:43
“I’m currently not all that worried about the economy overheating”
Could you elaborate? Why do you think this stimulus won’t cause the economy to overheat? What percent chance would you give it? What’s the cost of being wrong? How much confidence do you have in your opinions?
13. February 2021 at 09:00
Michael, Output grew faster than prices in 1966, but the economy was overheating.
Marcus, I’m not sure Powell has much confidence in Phillips Curve models. I hope not.
Lizard, you said:
“I suspect that it would be really difficult to run the US economy too hot. Between automation, improved tools for offshoring, and immigration of all sorts, the ability of companies to expand output is likely vastly underestimated.”
In fact, both productivity and labor force growth have slowed in recent decades, so exactly the opposite is true.
Market, Not just monetarists, the mainstream textbook model says recessions are caused by unstable NGDP growth. Expansionary policies create unstable NGDP growth. You want neutral policies.
Matthias, I don’t favor stable NGDP because of downward wage inflexibility. I don’t think Canada or Scotland had zero NGDP growth.
David, You asked:
“Absent a significant shock like war with China are there fiscal shenanigans that could wreck the Fed’s AIT management structure?”
No.
Thomas, The underlying model is Friedman’s Natural Rate Hypothesis.
MikeDC, Fiscal stimulus doesn’t cause overheating, monetary stimulus does. As long as the Fed sticks to the AIT program we won’t have overheating. But yes, there’s a significant chance that the Fed will fail. Maybe 25%?
13. February 2021 at 10:36
Scott,
Thanks for the optimism–and I won’t rush out to make bets against TIPS spreads (if such a thing is even possible).
13. February 2021 at 17:23
Scott, I’ve tried to work out how out how symmetric FED mistakes both led to recessions even with only a ZLB on rate of price changes but no upper bound.
Is this how it works?
1. Fed is successfully running an NGDP policy
2a Fed mistakenly allows CPE price level to actuallyl.
3a Some prices cannot adjust fast enough because of ZLB on rate of price change to maintain full employment structure of relative prices
4a Real output of ZLB goods and services falls, enough perhaps to cause aggregate output to fall (=recession)
5a Fed discovers source of mistake, allows inflation to exceed target enough for long enough to get PCE PL back to pre-mistake level
6a Prices adjust to full employment structure of relative prices
7a Output returns to full employment.
1. Fed is again successfully running an NGDP policy.
2b Fed mistakenly allows actual inflation to rise
3b Fed discovers source of mistake, allows inflation to undershoot target enough for long enough to get PCE PL back to pre-mistake level
4b Some prices cannot adjust fast enough because of ZLB on rate of price change to maintain full employment structure of relative prices?
5b Real output of ZLB goods and services falls, enough perhaps to cause aggregate output to fall (=recession)
6b PCE price level growth returns to target
7b ZLB goods and services are no longer constrained by ZLB, full employment structure of relative prices returns
8b Output returns to full employment.
1. Fed is again successfully running an NGDP policy.
14. February 2021 at 05:38
– But this assumes the FED is able to control how much money is flowing into the economy. This assumes that there is no trade (surplus/deficit) and no international money flows.
14. February 2021 at 05:42
And in this article I don’t see the words “Commercial banks”. Commercial banks (CB) also create “money out of thin air”. Does the FED also control the CB on how much money they create ? The asnwer is – of course – a resounding “no”. CB lend when they can find a willing borrower and as long as banks WANT to lend.
14. February 2021 at 05:54
Isn’t fiscal stimulus financed by a drawdown in the Treasury General Account essentially monetary stimulus ?
15. February 2021 at 10:46
Scott – Is it the expansionary monetary policy itself that causes recessions or the subsequent overreaction to it?
Using Friedman’s thermostat analogy, assume I feel most comfortable at 72 F. One day, through carelessness, I set my thermostat to 75. I start to feel overheated, so I react by setting it to 69. Then when I feel cold, I could blame my initial mistake of setting t to 75 for the fact I feel cold. But it seems to make more sense to blame myself for overreacting by subsequently setting it to 69 instead of 72.
Or does the thermostat analogy not hold in this case?
15. February 2021 at 15:57
Thomas, You are making it too complicated. Recessions are caused by unstable NGDP. Full stop.
Effem, No, the Fed offsets that effect.
Negation, If the temperature fluctuates, then you’ll have booms when the temps are above average and recessions when they are below average.
16. February 2021 at 01:20
What is the reason to prefer NGDP targeting over final consumption expenditures targeting?
Gross fixed capital formation and inventories inflate during the expansive phase of the cycle and contract during recessions, so I don’t see the reason to include them in the target.
I would greatly appreciate any feedback, even if that is just a link where I can read about the rationale.
16. February 2021 at 15:38
Fernando, You want something closely linked to labor income, and NGDP is probably more closely linked than nominal consumption.
18. February 2021 at 05:34
re: Scott Sumner “Recessions are caused by unstable NGDP growth”
How retarded. Recessions are caused by an increase in interest rates which diverts demand deposits into savings deposits, thereby destroying money velocity.
Economic growth is based on the real rate of interest, i.e., higher real rates of interest. You obtain higher real rates of interest by driving the banks out of the savings’ business, i.e., the supply of loan funds increases, but the supply of money remains unaltered. Ergo, the demand for money falls.
—Michel de Nostradame
18. February 2021 at 05:38
This is exactly what Dr. Philip George’s “The Riddle of Money Finally Solved” says with his “corrected money supply” CMS vs. recessions.
http://www.philipji.com/
18. February 2021 at 05:40
The second biggest error in economics is the distributed lag effect of money flows, volume times transactions’ velocity.
19. February 2021 at 00:11
Even Milton Friedman got it almost right:
Dr. Milton Friedman “The government-imposed interest rate of zero on demand deposits encouraged the emergence of money market funds and the growth of substitutes for and alternatives to banks.”
https://miltonfriedman.hoover.org/…/Cato_03_1999.pdf
23. February 2021 at 06:46
What is your view on 100% land value tax?
23. February 2021 at 08:55
Land taxes are fine, but not 100%.