14
Monetary policy actions comprise the information the FOMC
conveys to markets about the
future path of the funds rate that it anticipates. With the April 2008 meeting, the focus changed from
a deteriorating economy to inflation (Hetzel 2012, 217-219). For observations the day following an
FOMC meeting, Figure 18 plots the difference between the 3-month (6-month) Treasury bill rate and
the funds rate target. The difference is positive when markets expect the FOMC to raise the funds
rate. The series declined after the May 9, 2007, FOMC meeting and declined significantly after the
September 18, 2007, FOMC meeting. At the April 29-30, 2008, meeting, the FOMC lowered the
funds rate from 2.25 percent to 2 percent. However, in line with the message sent by the FOMC
about the likely direction of the next move in the funds rate, as shown in Figure 18, the yield curve
jumped. (The decline after September 2008 reflected the flight to safety offered by Treasury’s.)
In June 2008, Chairman Bernanke (2008) expressed the dual concerns that continued high
headline inflation would erode the FOMC’s credibility and that the dollar would depreciate:
Another significant upside risk to inflation is that high headline inflation, if sustained, might
lead the public to expect higher long-term inflation rates, an expectation that could ultimately
become self-confirming…. We are attentive to the implications of changes in the value of the
dollar for inflation and inflation expectations and will continue to formulate policy to guard
against risks to both parts of our dual mandate, including the risk of an erosion in longer-term
inflation expectations.
For the September 2008 FOMC meeting, the Board (2008a, September 10, 2008, I-1) staff
based its forecast for the economy on the assumption that the funds rate would remain at 2% and then
rise toward the end of 2009. As indicated by the sharp rise in the inventory/sales ratio and sharp
decline in the ISM manufacturing index in July 2008, however, the economy had already entered into
a deep recession earlier in the summer (Hetzel 2012, 207). The Board (2008a, October 22, I-1) staff
later made this point. “[I]ncoming data on consumer and business spending, industrial production,
and employment suggest that aggregate output had already decelerated sharply during the summer—
before the recent intensification of financial turmoil….” The reference to financial turmoil was to
the flight of the cash investors from financial institutions with illiquid, opaque portfolios following
the Lehman bankruptcy on September 15, 2008. The FOMC did not lower the funds rate until
October 6, 2008, however, and did not reduce its range to 0-25 basis points until December 15, 2008.
Once the cyclical peak had occurred, the December 2007 to June 2009 contraction displayed
relatively low real interest rates.
At the time, FOMC Chairman Bernanke (2009) interpreted the low
level of short-term interest as evidence of expansionary monetary policy.
18
Based on this
assessment, he discounted the efficacy of monetary policy and advocated credit policy based on
programs intended to revive the flow of credit to specific sectors of the economy. The underlying
assumption was that dysfunction in credit markets was preventing funds from flowing from savers to
investors with viable investment projects. The FOMC then was slow in aggressively adopting
forward guidance in order to bend down the yield curve.
18
That assumption conflicts with the fact that the real rate of interest stayed somewhat below zero for
years during the recovery without the reemergence of inflation (Figure 11).
15
The prescient comments of Aoki (2001) highlight the continuing relevance of the
Keynesian/monetarist debate over the role of the Phillips curve in monetary policy. Following the
basic NK model exposited by Goodfriend and King (1997), the Fed should implement a rule that
provides for the separation of the determination of the price level from relative prices and real
quantities—the classical dichotomy. In the design of such a rule, it is important to decompose
inflation into the parts that arise in the sticky-price sector and in the flexible-price sector. The
unfettered movement of relative prices requires controlling inflation in the sticky-price sector while
allowing inflation in the flexible price sector to pass through completely into headline inflation. The
FOMC then follows a rule that moves the funds rate in a way that tracks movements in the natural
rate of interest. A monetarist critique of policy in the Great Recession is that the Fed reverted to
manipulating an output gap in order to control inflation.
7.
A summary of the issues
The issues raised in the monetarist/Keynesian debate remain relevant. If the price system
does not work well to attenuate cyclical fluctuations, then the Fed is forced into trading off between
price and output stability. In a Keynesian world in which cost-push pressures cause increases in
relative prices to pass through to the price level, a goal of price stability would exacerbate real
instability. Similarly, in a Minsky world in which investor euphoria lowers the external finance
premium (the wedge between intertemporal rates of substitution for households and firms), the Fed
should create a negative output gap and below-target inflation in order to prevent the emergence of
asset bubbles. An exclusive goal of price stability would again exacerbate real instability.
If the price system does work well in the absence of central bank interference that imparts
unpredictability to the evolution of prices, then the basic NK model is an apt representation of
monetarist principles. Monetarists were wrong in their normative prescriptions about the central role
that money should play in the formulation of policy and about the nature of a stable nominal anchor.
Nevertheless, money remains central. Although in the Volcker-Greenspan era, the Fed did not move
to a stable nominal anchor using a money target: money remained central as the “stick in the closet.”
The power to discipline inflationary expectations originates in the ability of the central bank to create
a difference between the real rate of interest and the natural rate through money creation and
destruction. That power allows it to enforce a rule that creates a stable nominal anchor in the form of
nominal expectational stability. As exposited in the NK model, that rule not only causes firms to set
dollar prices in a way that aggregates to a price level conformable with the central bank’s inflation
target but also separates the determination of relative prices from the determination of the price level.
In order to maintain price stability, the central bank must have procedures that cause nominal
money to grow in line with real money demand. Those conditions hold regardless of whether the
central bank exercises explicit control over money. If the NK model is relevant, then the central
bank should follow the monetarist golden rule of providing a stable nominal anchor and allowing the
price system to determine the real interest rate and, by extension, other real variables. With an
interest-rate target, nominal money will then follow the real money demand consistent with growth in
potential output and with price stability.
Finally, there is no self-evident experimental design to the forces that cause recessions. As a
result, economists will never form a consensus over the cause of a particular recession. Various
approaches toward the identification of the shocks that cause recessions exist. All offer some insight
but there is no econometric technique that does not incorporate significant judgment. The Friedman-