What would a “tight money” recovery look like?
After most recessions the Fed allows above trend NGDP growth, to spur the recovery. In the first quarter of the 1983-84 recovery NGDP rose at an 11% annual rate (7.7% real, 3.3% inflation.) But suppose they kept money so tight that NGDP actually grew slower than trend? What kind of recovery would we expect?
1. Contrary to what you might expect, we would expect a recovery. Wage growth would gradually slow and unemployment would fall. But the recovery would be far slower than normal.
2. Interest rates would stay very low, held down by both the slow NGDP growth and the low level of RGDP relative to trend.
3. During a recession highly cyclical industries such as housing and autos decline more sharply than overall GDP. If the recovery was very slow, then over time the housing and auto industries would pickup due to growing population, and also the depreciation of cars. You’d see RGDP growth move from services to autos and cars, but importantly the overall rate of RGDP growth would not be affected by this “rotation.” Autos and housing growth would pick up, causing growth to slow in other sectors. Recall that the Fed controls the overall increase in NGDP, not individual sectors of the economy.
And of course this is exactly what’s happened:
Federal Reserve Chairman Ben S. Bernanke has something to tout before Congress in hearings this week: job growth in the auto and housing industries.
Consumers rely on loans to buy cars and homes, so these segments of the economy are among the most responsive to Bernanke’s strategy of holding interest rates low and pressing on with bond purchases of $85 billion a month.
“The rate-sensitive sectors, most notably housing and autos, are kicking into a higher gear,” said Mark Zandi, chief economist for Moody’s Analytics Inc. in West Chester, Pennsylvania. “This reflects the Fed’s aggressive monetary policy and resulting rock-bottom interest rates,” along with “working off the excesses of the boom and bubble.”
Bernanke and his colleagues on the Federal Open Market Committee have pledged to continue buying bonds until the labor market improves “substantially.” Climbing employment in construction and vehicle manufacturing bolsters the case that asset purchases can help spur the improvement.
Zandi predicts total job growth this year of “close to 2 million,” about the same as last year.
“About the same as last year.” Hmmm, doesn’t that undercut the argument that easy money is spurring a faster recovery?
For those who think housing is important, consider these data points:
January 2006: Housing starts = 2.303,000 U = 4.7%
April 2008: Housing starts = 1,008,000 U = 4.9%
December 2012: Housing starts = 973,000 U = 7.8%
January 2013: Housing starts = 890,000 U = 7.9%
Yes, unemployment is high, but not because of housing. It’s the NGDP, stupid.
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25. February 2013 at 08:48
Assuming you are not one of a very select few smart people in the world, what do you think has and continues to be the barrier to an understanding of the importance of NGDP? An obsession with M has existed for several decades now. Why is it taking so long for that to shift to an obsession with MV?
25. February 2013 at 09:00
Good post. I would just say that sometimes autos/housing can give us a early proxy for whether the Fed has pushed the administered rate above/below the natural rate — that’s why these sectors tend to lead overall GDP instead of lagging it. But I agree that if the Fed has a specific path of NGDP in mind, we’re just moving the deckchairs around on the Titanic.
25. February 2013 at 09:02
“You’d see RGDP growth move from services to autos and cars, but importantly the overall rate of RGDP growth would not be affected by this “rotation.””
Scott, are you basically saying that in the long run the only thing the “recovery” would entail is that potential output doesn’t fall below the lower trendline RGDP is currently on, despite falling to that line entirely?
25. February 2013 at 09:04
And in light of the above, isn’t the current talk about a “great rotation” in fact a highly worrisome development that signifies that damage to potential output has been going on a very steep rate in the last few years?
25. February 2013 at 09:06
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25. February 2013 at 09:10
Let me frame my concern in a different way: once unemployment has falling to very low levels as a result of the process you describe, can looser monetary policy still raise RGDP by boosting NGDP, or is the door firmly closed on that by that time?
25. February 2013 at 09:15
THe recovery looks like ‘mañana’ is not coming. Interestingly, inflation is just where the Fed wants it!
http://thefaintofheart.wordpress.com/2013/02/23/when-manana-never-comes/
25. February 2013 at 09:37
J, New ideas take time to be accepted.
Tommy, Good point. After I posted this I realized it might be misinterpreted. It is true that if the Fed does a genuinely stimulative policy, autos and housing would likely rise faster than other industries. But you need faster NGDP growth.
Rademaker, If I understand your question correctly, one needs to look at employment data (or even better the unemployment rate) to see what’s going on with potential GDP. In my view “recovery” means a lower unemployment rate. Whether than means above 3% RGDP growth is less clear. It’s possible the trend rate of RGDP has fallen, as you suggest (and as Tyler Cowen argues.)
Once unemployment falls to a low level, the recovery is probably over–although I suppose you could drag a few people back into the labor force. But in my view the unemployment rate is the best single indicator–even though even the U-rate is distorted by shifts in the natural rate rof unemployment.
Marcus, Yes, I keep meaning to do a post on O’Brien’s graph.
25. February 2013 at 13:47
“After most recessions the Fed allows above trend NGDP growth, to spur the recovery. In the first quarter of the 1983-84 recovery NGDP rose at an 11% annual rate (7.7% real, 3.3% inflation.)”
How do you distinguish between a post recession boom in private credit issuance, which adds to the money supply and NGDP, and a post recession boom in bank reserves from the Fed, which encourages but does not necessarily cause more credit issuance?
Seems like it could be the case that a “tight” Fed may end up being more active, OMO-wise, than a “loose” Fed, depending on the rate of private bank credit expansion.
25. February 2013 at 13:57
“Yes, unemployment is high, but not because of housing. It’s the NGDP, stupid.”
It’s more like welfare and people leaving the workforce.
People don’t refuse to work and hold out for higher wages for 4 years running because of insufficient “aggregate spending”.
25. February 2013 at 16:02
Geoff: “People don’t refuse to work and hold out for higher wages for 4 years running because of insufficient “aggregate spending”.”
You’re only thinking of the long-term unemployed themselves. But sticky wages is more complex than that. The real situation is that the most productive employees, who were not laid off, continue working for above-market prices. They have the bargaining power to not take pay cuts. Perhaps they get no raises for four years, but there’s a strong psychological zero lower bound on wage changes.
So the employer, for a fixed wage budget, could hire more employees at market rates. But hardly any company or organization, fires their entire workforce, and then rehires at current labor rates. Instead what you have is long-term employees being overpaid, resulting in obvious high unemployment for the less senior or less skilled.
(As a concrete example, my local school district has strong California teacher’s unions, and a couple of years ago they deliberately chose, as a group, to have the district lay off the junior staff, rather than have all teachers take an across-the-board pay cut.)
25. February 2013 at 18:34
“You’d see RGDP growth move from services to autos and cars, but importantly the overall rate of RGDP growth would not be affected by this “rotation.””
This would be a more appropriate thread for the NYT link I posted yesterday highlighting the sharp decline in expenditures on household pets.
Jeremy Stein and Esther George should get to working preventing the next Golden Retriever Bubble!
25. February 2013 at 20:54
Yes, money is so “loose” that the CPI has been flat or down in seven of the last nine monthly readings.
Is anyone paying attention? I mean, even at the Fed?
26. February 2013 at 08:03
Geoff, Unemployment doesn’t rise when people leave the labor force.
26. February 2013 at 10:46
[…] Scott Sumner explains why the Federal Reserve’s policies are still too tight, causing nominal gross domestic product (NGDP) to grow “slower than trend” and producing a sluggish and uneven recovery. […]