What We’ve Learned About Unconventional Monetary Policy
In a recent BloombergView piece, Noah Smith writes that: “It’s becoming clearer that the Fed’s experiments during the Great Recession, dramatic as they were, taught us little about how monetary policy works.” In this post, I argue an alternative perspective. I describe three lessons that we’ve learned since late 2008:
- unconventional monetary policy tools don’t have extreme downside risks
- central banks can control inflation using unconventional tools
- hitting inflation objectives may not translate into hitting growth objectives
(Admittedly, the last one is not exactly a new lesson.)
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I’ll also mention one important residual question about long-term use of expansionary monetary policy.
Lesson 1: Even over relatively long periods of time, unconventional monetary policy tools don’t have extreme downside risks.
In November 2010, the FOMC launched its second large scale asset purchase program (QE2). Observers expressed concerns about possible big upward spikes in inflation and inflation objectives. They were worried about the development of large bubbles in key asset prices. They were worried about a potential collapse in the dollar.
It’s been five years. I don’t believe that we’ve seen any of these consequences yet. Maybe they’ll show up later – but should monetary policymakers have given up on price stability in 2010 because of consequences that might materialize ten or twenty years down the road?
Lesson 2: Central banks are able to guide inflation close to its desired level using unconventional tools.
This lesson will seem controversial – but it’s actually also the claim that is easiest to back up using available data.
To try and clarify what I mean: I’m not talking about the 2% target that was announced by the FOMC in 2012. I’m talking about the actual medium-term inflation objectives of Fed policymakers in the 2008-10 time frame. These are available with a six-year lag from the individual-level data in the Summary of Economic Projections (SEP) made by FOMC policymakers. (As I’ve noted here, these “projections” are made under the assumption of appropriate monetary policy. Hence, they should be seen as goals, not true forecasts.)
I’ll use the last SEP of every year, because it provides a relatively lengthy three-year forecast. (Three years is typically thought to be long enough to allow current monetary policy decisions to have most of their impact on the macro-economy.)
From these data, we can see that in October 2008, the median FOMC participant was aiming for the core PCE inflation rate to be 1.5% in three years’ time. The core PCE inflation rate in 2011 turned out to be 1.9%.
In November 2009, the median FOMC participant was aiming for the core PCE inflation rate to be 1.5% in three years’ time. The core PCE inflation rate in 2012 turned out to be 1.8%.
In October 2010, the median FOMC participant was aiming for the core PCE inflation rate to be 1.4% in three years’ time. The core PCE inflation rate in 2013 turned out to be 1.5%.
One could certainly ask: why was the FOMC consistently aiming for such a low inflation rate in this time frame, given that they expected such a high unemployment rate? (I have posed that question here.) But let’s leave that question aside. Throughout much of the 2008-10 period, many observers outside of the Fed expressed strong concerns about the risk of unduly high or unduly low inflation. Given that level of background uncertainty, I would say that the FOMC did a very good job at using unconventional tools to achieve what policymakers wanted in terms of inflation outcomes.
Lesson 3: Hitting inflation objectives does not translate into hitting growth objectives.
This is not a new lesson for monetary policy makers! But it has been very true in the recent recovery: growth has been much slower than pretty much anyone on the FOMC thought was desirable. Remember, though, these disappointing growth outcomes are conditional on the Committee’s largely achieving what it wanted in terms of inflation. My own interpretation is that the drag on aggregate supply associated with the financial crisis (and perhaps the policy response to the crisis) turned out to be considerably stronger than the Committee anticipated.
Remaining question: Is the long-term use of expansionary monetary policy (like low interest rates or QE) actually causing inflation expectations and potential growth to decline?
I would answer this question with no. (I believe that almost all macroeconomists would also answer it by saying no.) In my view, if monetary policy is responsible for these declines, it’s through the erosion of Fed credibility (so the Fed should be doing more, not less). And, for inflation expectations, the timing seems wrong to me: the decline in (market-based) inflation expectations is largely associated with the Fed’s tightening, not easing.
But I admit that this is a subtle counter. The available macroeconomic data doesn’t provide as sharp an answer as I would like to this question.
To wrap up: I view Noah’s piece as highlighting the last remaining question. It’s a big one. But we shouldn’t allow that important remaining question to obscure the three important lessons from the FOMC’s monetary policy experiments.