Why is the Fed so embarrassed about wanting more AD?

For decades the Fed has steered the economy along a path of two to three percent inflation.  The policy has not been controversial.  Sometimes they ease, and sometimes they tighten.

Recently inflation has run closer to 1%, and Bernanke has suggested pushing the rate back up to 2%.  Others at the Fed are more radical, calling for level targeting.  This would allow a bit above 2% inflation to offset periods of below 2% inflation.  Even those radical proposals are more conservative than the actual 2% to 3% average rate of recent years.  So how is the public reacting to monetary policy proposals that are more conservative that what actual occurred in recent decades?  According to Time magazine, they’re so angry it might lead to a civil war:

What is the most likely cause today of civil unrest? Immigration. Gay Marriage. Abortion. The Results of Election Day. The Mosque at Ground Zero. Nope.

Try the Federal Reserve. November 3rdis when the Federal Reserve’s next policy committee meeting ends, and if you thought this was just another boring money meeting you would be wrong. It could be the most important meeting in Fed history, maybe. The US central bank is expected to announce its next move to boost the faltering economic recovery. To say there has been considerable debate and anxiety among Fed watchers about what the central bank should do would be an understatement. Chairman Ben Bernanke has indicated in recent speeches that the central bank plans to try to drive down already low-interest rates by buying up long-term bonds. A number of people both inside the Fed and out believe this is the wrong move. But one website seems to believe that Ben’s plan might actually lead to armed conflict. Last week, the blog, Zerohedge wrote, paraphrasing a top economic forecaster David Rosenberg, that it believed the Fed’s plan is not only moronic, but “positions US society one step closer to civil war if not worse.” (See photos inside the world of Ben Bernanke)I’m not sure what “if not worse,” is supposed to mean. But, with the Tea Party gaining followers, the idea of civil war over economic issues doesn’t seem that far-fetched these days. And Ron Paul definitely thinks the Fed should be ended. In TIME’s recently cover story on the militia movement many said these groups are powder kegs looking for a catalyst. So why not a Fed policy committee meeting. Still, I’m not convinced we are headed for Fedamageddon. That being said, the Fed’s early November meeting is an important one. Here’s why:

Usually, there is generally a consensus about what the Federal Reserve should do. When the economy is weak, the Fed cuts short-term interest rates to spur borrowing and economic activity. When the economy is strong and inflation is rising, it does the opposite. But nearly two years after the Fed cut short-term interest rates to basically zero, more and more economists are questioning whether the US central bank is making the right moves. The economy is still very weak and unemployment seems stubbornly stuck near 10%.

In the past I’ve argued their mistake was to argue for more inflation, which sounds undesirable.  Contrast Fed policy with fiscal stimulus.  In early 2009 there was lots of criticism about the fiscal stimulus plan, but I don’t recall a single critic arguing that fiscal stimulus was a mistake, because it “might work.”  Instead, they argued it was a waste of money and would probably “fail,” which meant it wouldn’t boost AD.  It was taken as a given that more AD was desirable.  Now monetary policy has become so controversial that people are talking about civil war.  Why?  Because some of the more radical members of the Fed are proposing average inflation rates almost as high as what we have experienced over the last two decades.

What are some possible explanations:

1.  Higher inflation sounds bad–the Fed should have said it was trying to boost AD, or NGDP, or the average income of Americans.

2.  The monetary base has already exploded in size, so people are already worried that only “long and variable lags” separate us from Zimbabwe-style inflation—despite 2% bond yields and despite the fact that similar policies had no effect on long run inflation in Japan.

Today I’d like to suggest a different explanation.  Perhaps this crisis is a sort Waterloo for Keynesian interest rate targeting, analogous to the effects of 1982 on monetarism.  You may recall that in the early 1980s monetarist ideas were popular.  Slower money supply growth helped slow inflation.  But velocity seemed to decline sharply in 1982, so the Fed let the money supply rise above target, and went back to interest rate targeting.  (Indeed some claim they never really abandoned interest rate targets, but let’s put that aside.)

This crisis has put the economy into a position where the Fed’s normal interest rate mechanism doesn’t work.  It can’t steer the economy in the only way it feels comfortable steering the economy.  Maybe we need a new steering wheel.  And the search for a new steering wheel is what is so controversial.

If we had been doing NGDP futures target all along, nothing interesting would have happened in late 2008.   Expected NGDP growth would have stayed at 5%, nominal rates would have stayed above zero, and the monetary base might not have exploded (that is less clear.)  The severe financial crisis would have been far milder, if it occurred at all.  The Fed would have continued steering the economy in the same way it always had.  (BTW, the decline in house prices in bubble areas was already largely complete by late 2008—the second leg down was caused by falling NGDP.)

Instead, when rates hit zero the Fed stopped trying to steer the economy at all; it followed Stiglitz’s advice and stopped using monetary policy.  Of course they were still doing policy (and highly contractionary policy at that) but didn’t realize it, as their normal policy tool had jammed just as the wheels of the car were pointed toward a ditch called “recession.”  In the next post I’ll explain why it’s almost impossible to pry the Fed’s hands off the old steering wheel, even though it is now broken and not connected to the wheels.



24 Responses to “Why is the Fed so embarrassed about wanting more AD?”

  1. Gravatar of marcus nunes marcus nunes
    21. October 2010 at 12:27

    It´s ironic, to me, that the “old steering wheel” is a “figment of NK imagination”. Greenspan was mostly successful exactly because (quite unconciously) he stabilized NGDP. That´s why Friedman had good words to say about him, because he (Friedman) recognized that Greenspan had put in practice his suggestions from a Monetary Theory of Nominal Income (1971)

  2. Gravatar of Liberal Roman Liberal Roman
    21. October 2010 at 13:13

    “Higher inflation sounds bad-the Fed should have said it was trying to boost AD, or NGDP, or the average income of Americans.”

    Oh Scott, I hate it to say it but you are really naive….listening to you rationalize the “Tea-Party” type viewpoint is sad.

    You obviously have not been following the political discourse of late. I think I have mentioned this before but here is the extent of the Tea Party movement’s thinking.

    Government does something. Bad. The End.

    To put it another way, here how Scott Sumner sounds to a Tea Party type:

    Them: The Fed is just printing all this money to spend it on Obama’s and Pelosi’s socialist agenda!

    Scott: What? No. It’s just trying to create positive nominal growth expectablablablablabla. Ugh. Can’t believe I am stuck talking to another liberal. REVOLUTION TIME! YEAAA!

  3. Gravatar of JimP JimP
    21. October 2010 at 13:40


  4. Gravatar of Gregor Bush Gregor Bush
    21. October 2010 at 14:09

    The majority of economists think of demand in real rather than nominal terms. They are unaware, or at least have forgotten, that AD is a nominal concept. Because of this they, don’t blame the Fed for the depth of the recession or the sluggishness of the recovery. Instead they look at real factors – blaming the banking crisis for the downturn and “consumer deleveraging” for the weak recovery (completely ignoring of course that ‘deleveraging” implies only a decline in nominal consumption relative to nominal income and says nothing about the growth of nominal income itself).

    If the Fed now announced that it was targeting NGDP, it wouldn’t fit in easily with how the majority of economists and people in financial markets view the economy. And after the Fed finally demonstrated that it had the power to target NGDP, many people would (rightly) ask “well if you guys can boost NGDP any time you want, then why you did let it fall in the first place?”

    I’m not sure the Fed wants to answer that question.

  5. Gravatar of scott sumner scott sumner
    21. October 2010 at 18:21

    Marcus, Yes, Friedman did see that the essence of what they were doing was stabilizing NGDP, and that interest rates were a side issue–hence my next post.

    Liberal Roman, I plead guilty to not following the Tea Party. But my hunch is that you are wrong, and that many are well-intentioned people who honestly fear all this money will produce hyperinflation. But yes, I’m sure some just hate Obama.

    I think most people on both the left and the right are well-intentioned.

    JimP, Thanks for that article. If you are going to suddenly start doing price level targeting, you don’t want to start from a point far back in history, as that will cause a large shock.

    In my view you start from when the liquidity trap started, as that’s the point where you lost control of monetary policy.

    Gregor, Those are good points. But how can someone even look at an AD curve without thinking in terms of NGDP? It looks roughly like a constant NGDP hyperbola.

  6. Gravatar of The Capital Spectator: REVISITING FRIEDMAN’S ADVICE The Capital Spectator: REVISITING FRIEDMAN'S ADVICE
    22. October 2010 at 03:33

    […] Scott Sumner makes a good point: "For decades the Fed has steered the economy along a path of two to three percent inflation. The […]

  7. Gravatar of Parker Sheppard Parker Sheppard
    22. October 2010 at 05:27

    I think a advocates of a free market see loose money and government housing subsidies as causes of the current crisis. They see fiscal stimulus as slowing down the economy, not speeding it up. When they hear the Fed wants to boost aggregate demand through quantitative easing, they associate it with past attempts to artificially jump start the economy.

    The Fed would be better off addressing the reason why aggregate demand has fallen in the first place instead of using quantitative easing to paper over problems in the mortgage market. Once people are more certain about the value of their homes, about the steadiness of their incomes, and about the level of their taxes, aggregate demand will rise on its own without the need for monetary stimulus.

  8. Gravatar of marcus nunes marcus nunes
    22. October 2010 at 07:17

    And it seems Bernanke was well aware of the Monetary Theory of Nominal Income all along!

  9. Gravatar of Bill Woolsey Bill Woolsey
    22. October 2010 at 07:31

    Great post.


  10. Gravatar of Morgan Warstler Morgan Warstler
    22. October 2010 at 07:48

    Scott, there is a FAR MORE logical Tea Party position than fear of hyper inflation.

    I say it to you everyday. I am their spokesperson!

    Printing money ALLEVIATES the fiscal pressures our government MUST SUFFER. We want to see government suffer large scale austerity… not Social Security. Not Medicare. We want $400B cut from Public Employee hides. We LONG for the day when the cost of borrowing for the Public Sector goes up, and they must make cuts. Listening to Krugman cheer the low cost of government borrowing makes our ass itch.

    So, Scott Sumner’s ideas are GREAT, after we get what we want. If you interfere, we will threaten to Audit the Fed and you will get nada.

    As I said, get ready to show your musket. The logical Scott Sumner position is the Milton Friedman position:

    1. Take ANY OPPORTUNITY to cut government.
    2. Withing the boundaries of #1, use monetary policy to keep economy growing.

  11. Gravatar of Richard W Richard W
    22. October 2010 at 10:34

    Morgan, I always thought you were a funny but crazy dude. Spokesperson for the Tea Party? Oh my god.

  12. Gravatar of W le B W le B
    23. October 2010 at 03:18

    Shouldn’t that read, “I always thought you were a crazy but funny dude”?

  13. Gravatar of marcus nunes marcus nunes
    23. October 2010 at 03:53

    “Proposes” more AD without ONCE mentioning MP alternatives!!!And these two are otherwise bright and well known.
    “Yet while these calculations are admittedly oversimplified in many dimensions, we believe they are illustrative of the orders of magnitude involved. Our numbers suggest that a large Chinese revaluation, whether forced or voluntary, is far from a free lunch for the United States, and that further fiscal stimulus should not be dismissed as an alternative if the goal is to create jobs at lowest cost in terms of national income”.


  14. Gravatar of scott sumner scott sumner
    23. October 2010 at 05:32

    Parker, You’re comment about advocates of free markets obviously doesn’t include people like me and Milton Friedman.

    Any conservative who thinks the biggest fall in NGDP since 1938 was caused by housing subsidies and easy money should have his head examined. You fix low NGDP with monetary stimulus, not regulatory changes.

    Marcus, Thanks, that’s great stuff (except I think he gets the lags issue wrong.)

    Bill, Thanks.

    Morgan, I’d rather cut Medicare than those public employees.

    Marcus, I agree. In any case fiscal stimulus won’t happen, and won’t be very effective if it does.

  15. Gravatar of marcus nunes marcus nunes
    23. October 2010 at 07:10

    I think in those days of “adaptive expectations” everything was backward looking, so Friedman talked about the 6 – 9 months lag (and these numbers are still used everywhere, Brazil included)!
    This is from Krugman (he knows he´s takink a big “risk”):
    Consistent with his view that the GD only ended because of G spending for WWII!

  16. Gravatar of Scott Sumner Scott Sumner
    24. October 2010 at 07:08

    Marcus, Yes, I was thinking of doing a post on that.

  17. Gravatar of Steve Steve
    24. October 2010 at 12:02

    Marcus and Scott,

    The “Real-Time Economics” article linked to by Krugman from Marcus’ link above includes the following two quotes:

    “Since August 27, when Federal Reserve Chairman Ben Bernanke signaled the central bank was likely to pump more dollars into the economy, the greenback’s value has fallen about 4.8% against the currencies of U.S. trading partners”

    “In one ominous sign, the price of oil is up 8.7% since August 27.”

    So a 4.8% decline in the dollar causes an 8.7% increase in the price of oil?

    This kind of commodities are a 2x, 3x, or even 5x leveraged play on dollar weakness is absolutely pervasive in the hard-money crowd (everyone from the stock market pundits, to “Conservative” blogs, to the WSJ, to the Fed hawks. Does this make any sense? NO!!! Correlation is not causation! But no one calls them out on it!!!

  18. Gravatar of Steve Steve
    24. October 2010 at 12:16

    I made a couple of typos in the above blog, but the lunacy of the WSJ needs to be pointed out. They seem to be asserting

    4.8% decline in dollar causes 8.7% increase in oil.

    To rephrase that statement, a 4.8% increase in non-dollar currencies causes a 3.9% increase the price of oil denominated in non-dollar currencies. That is the assertion of cause and effect that passes as “Economic insight and analysis from The Wall Street Journal.” Anyone care to explain that one?

  19. Gravatar of Doc Merlin Doc Merlin
    25. October 2010 at 04:45


    1. Um, thats sort of how it works.
    2. The 4.8% decrease is against other currencies, which are also on an expansionary path.
    3. Any increase in expected future money supply is going to increase the price of other stores of value via the substitution effect.
    4. The fed can tighten again (NOT RECOMMENDED) at any time and cause commodity prices to crash again as they did in mid 2008 (this is why gold, oil, etc crashed).

    “Marcus, I agree. In any case fiscal stimulus won’t happen, and won’t be very effective if it does.”

    It already happened and wasn’t very effective.

  20. Gravatar of scott sumner scott sumner
    25. October 2010 at 06:45

    Steve, I agree about the leverage problem. My take is this; nominal oil prices can reflect dollar weakness, but the bigger movements are real prices (relative to other traded goods) and that mostly reflects expectations of real growth in the world economy.

  21. Gravatar of ohplease ohplease
    25. October 2010 at 15:33

    the Fed is shy because the masses, in all their dubious wisdom, are still infinitely wiser than the ranks of “professional” economists who have been indoctrinated to know so many things that aren’t so. (Are there any other professions out there that that, without exception, destroy value from society? Certainly not to the extent of the damage economists have caused.)

    Your blog title is inaccurate, all I see here is Keynesian orthodoxy, aka the definition of insanity.

  22. Gravatar of ssumner ssumner
    25. October 2010 at 17:17

    ohplease, Yeah, I want the market to control the money supply, not the Fed. I guess that’s “Keynesian orthodoxy.”

  23. Gravatar of Doc Merlin Doc Merlin
    25. October 2010 at 18:32


    Ssumner isn’t a keynesian. He has called for a market system that would remove the Fed’s control over the money supply. He isn’t an Fed disestablishmentarian, as he still sees a role for the fed (unfortunately), but he doesn’t see its role as a central planner as it is now.

  24. Gravatar of Ist jetzt Geld drucken gut oder nicht? « Aus dem Hollerbusch Ist jetzt Geld drucken gut oder nicht? « Aus dem Hollerbusch
    30. October 2010 at 13:56

    […] der dokumentierten Erfolglosigkeit des US-Konjunkturpakets sehr mutig ist. Andere Kommentatoren, unter ihnen besonders US-Ökonom Scott Sumner, meinen allerdings, dass die Fed bis jetzt zu wenig expansiv war. Warum in einer Welt des […]

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