12
nominal rigidities require that real income decline in order to offset the incipient increased
demand
for the risk-free asset. There is, however, no clear way to disentangle the effect on output of a
disruption to financial intermediation from a decline in the natural rate of interest not tracked by a
reduction in the funds rate.
16
With a single episode, economists will never agree on the relative importance of monetary
contraction and financial frictions in making the Great Recession so severe. However, an implication
of the NK model is that a decline in both the output gap and in inflation is inconsistent with optimal
monetary policy. Also, the persistent decline in inflation below the FOMC’s 2 percent target must
reflect monetary policy (Figure 15). In the monetarist spirit of identification, does the NK model flag
central bank interference with the operation of the price system in the Great Recession?
One characteristic of the Great Recession is the close correspondence of cycle peaks in
developed countries (Hetzel 2016b). An explanation for this commonality is the similar response of
central banks to a prolonged inflation shock. Analogously to the stop phases of past recessions, the
central banks of the developed countries kept interest rates at cycle highs while their economies
weakened in order to create a negative output gap that would restrain high headline inflation. The
unacceptably high inflation in 2008 emerged not from prior monetary expansion but rather from a
worldwide increase in commodity prices. Illustrative of the increase in commodity prices, Figure 16
shows the sustained rise in the real price of oil that began in summer 2004 and peaked in summer
2008. Figure 15 shows how the inflation shock pushed headline inflation above core inflation.
Earlier, using the NK model, Kosuki Aoki had applied monetarist arguments relevant to the
Great Recession. In order to allow the price system to determine relative prices, central banks should
have allowed high headline inflation, which originated in the flexible-price sector, to pass through to
the price level. Aoki (2001, 57 and 75) pointed out that a policy designed to achieve divine
coincidence stabilizes the aggregate output gap by pursuing price stability in the sticky-price sector.
[T]here is a trade-off between stabilizing the aggregate output gap and aggregate inflation,
but … there is no trade-off between stabilizing [the] aggregate output gap and stabilizing core
inflation…. [S]uppose there is an increase in the price of food and energy … putting an
upward pressure on aggregate inflation…. The central bank could respond with a sharp
contractionary policy and reduce aggregate demand by a large amount so as to decrease
prices in the sticky-price sector…. However, our model shows that such a policy is not
optimal. The optimal policy is to stabilize core inflation.
The remainder of the section provides the narrative that fills out this monetarist identification.
The increase in energy and commodity prices produced the decline in consumption below trend
shown in Figure 17 by depressing real personal disposable income (PDI). Average annualized
monthly changes in real personal consumption expenditures (PCE) went from 3.2 percent from
16
The panic of fall 2008 when Ben Bernanke, Tim Geithner (New York Fed president), and Henry
Paulson (Treasury secretary) warned that the economy was teetering on the brink of another Great
Depression likely lowered the natural rate of interest while the FOMC was trying to keep the funds
rate up using IOER (interest on excess reserves) out of a concern for inflation (Hetzel 2012, Ch. 12).
13
January 2005 through December 2006 to 1.3% from January 2007 through November 2007.
17
Residential investment, which began to fall in 2005Q3, provided an additional shock.
As the economy weakened, following its LAW procedures, the FOMC lowered the funds rate
from its cyclical peak of 5.25 percent at its September 18, 2007, meeting to 2 percent at its April 29-
30, 2008 meeting. The peak of the business cycle occurred in December 2007. In the March 13,
2008 Greenbook, the Board (2008a, March 13, I-1 and I-7) staff projected that for 2008 real final
sales to private domestic purchasers would decline 1.6 percent and wrote that “[P]rivate payrolls are
estimated to have contracted about 100,000 per month since the turn of the year…. We are
anticipating a further retrenchment in consumer spending in the next few months; Consumer
confidence has plummeted; soaring energy prices are biting into household purchasing power; the
labor market is weakening; and real estate values are dropping.”
The April Greenbook remained pessimistic about the economy. “With mounting job losses
and outsized increases in energy prices holding down real income, falling home values cutting into
household net worth, and consumer sentiment deteriorating further, we would, all else equal, expect a
noticeable decline in PCE in the second quarter” (Board 2008a, April 23, I-6). Nevertheless, the
Minutes (Board 2008b, April 29-30, 9) for the April 29-30 FOMC meetings put financial markets on
notice that that the easing cycle had likely ended:
[A]lthough downside risks to growth remained, members were also concerned about the
upside risks to the inflation outlook, given the continued increases in oil and commodity
prices and the fact that some indicators suggested that inflation expectations had risen in
recent months.… [R]isks to growth were now thought to be more closely balanced by the
risks to inflation. Accordingly, the Committee felt that it was no longer appropriate for the
statement to emphasize the downside risks to growth…. In that regard, several members
noted that it was unlikely to be appropriate to ease policy in response to information
suggesting that the economy was slowing further or even contracting slightly in the near
term, unless economic and financial developments indicated a significant weakening of the
economic outlook.
17
The three spikes in real PDI in the years 2008 and 2009 shown in Figure 17 derived
from the Bush
tax rebate, augmented social security payments, and the Obama stimulus program. The following
figures are for annualized growth rates of monthly real PCE:
12/2007 – 2/2008: -1.9 percent
3/2008 – 5/2008: 1.7 percent
6/2008 – 9/2008: -3.8 percent
10/2008 – 12/2008: -4.5 percent
The interruption of negative growth in March, April, and May 2008 came from the boost to income
from the Bush tax cut signed into law February 12, 2008. Although the rebates arrived in the month
of May, households anticipated them. Real PDI rose at an average monthly rate of $12.1 billion from
January 2007 through September 2007; at the average rate of $6.6 billion from October 2007 through
April 2008; and then soared to $562.1 billion in May 2008.