One of the big questions about the economy right now is whether monetary policy is a significant factor in the sluggish growth of the last five years. Lots of economists think that easy money was important for speeding the recovery between 2008 and 2010. But even some economists who believe monetary policy mattered in the early post-2008 years think that monetary policy can’t explain the sluggish growth we’ve seen more recently.
To quote the always-insightful Eli Dourado: “Monetary policy is important for 18 months or so after a nominal shock w/ an otherwise functioning financial system. That’s it.” Alex Tabarrok, co-author of the popular Marginal Revolution blog, recently told me it’s “crazy” to think monetary policy could explain the slow growth we’ve seen in the last few years.
I’m not so sure.
There are two major arguments that monetary policy can’t explain the recent slowdown. First, monetary policy is about as loose as it can be, so there isn’t room for the Fed to do more. And second, even if the Fed could do more, it wouldn’t do any good because with unemployment at 4.9 percent there isn’t any slack left in the economy.
As we’ll see, neither of these claims is very persuasive.
The Fed’s itchy trigger finger is holding back the recovery
After a big demand shock like the 2008 financial crisis, output temporarily falls below the economy’s long-term potential. Workers are laid off, factories get idled, construction projects are slowed down, causing the economy to produce goods and services at less than its full capacity.
But the conventional view holds that this shortfall shouldn’t persist for all that long. Businesses want to increase output. Workers want to work. And so unless there are further shocks, the argument goes, output should return to potential within 18 months or so.
Now imagine it’s 2009 and we have a diabolical Fed chair who wants to prove this conventional view of monetary policy wrong. Her strategy: every time the economy shows signs of catch-up growth — growing faster than the long-term trend to close the output gap — she tightens just enough to prevent that extra growth from occurring. Contrariwise, if the economy looks like it’s tipping into a recession, she eases enough to keep the economy growing, albeit at a sluggish pace.
If you think a sufficiently tight monetary policy can produce a big downturn in real output — and most economists do — then it stands to reason that less-tight monetary policy should be able to produce slow but positive growth. So theoretically, a central bank should be able to maintain a non-trivial output gap indefinitely.
And while I definitely don’t think Janet Yellen has been trying to prevent an economic boom, I think that’s been the practical effect of her decisions since she took office in early 2014.
This might seem implausible since interest rates have been close to zero ever since 2008. But as Milton Friedman emphasized, low interest rates can be a misleading barometer of whether monetary policy is tight or loose.
It’s useful to go back to earlier in the crisis, when the Fed had cut interest rates to 0 percent and still believed more stimulus was needed. One thing the Fed did was a bond-buying program known as “quantitative easing.” But another thing the Fed did was called “forward guidance.”
Forward guidance meant that the Fed promised to keep interest rates low for a long time — even after the economy started to recover. In 2011, the Fed promised to keep rates low for an “extended period” without specifying how long that period would be. In Septemner 2012, the Fed said that it would maintain low rates “for a considerable time after the economic recovery strengthens.” Then in December, it adopted the “Evans Rule,” which said that interest rates would stay low until the unemployment rate fell below 6.5 percent.
In a narrow sense, the Fed wasn’t “doing anything” when it issued this kind of forward guidance. It was just talking. But economists know that this kind of talk can be powerful. Market actors care about future Fed actions almost as much as they care about current ones. A commitment to maintain low rates in the future means a higher probability that there will be a big and long-lived economic boom, which means that investments made today are more likely to pay off in a few years. So when the Fed commits to easy money in the future, it can stimulate more investment in the present.
Since 2014, the Fed has taken the opposite tack, repeatedly talking about “normalizing” monetary policy — that is, raising interest rates. The Fed has been doing this even though inflation remained well below the Fed’s 2 percent inflation target and GDP growth remained sluggish.
The reason the Fed hasn’t followed through on these threats is that the economy keeps under-performing expectations. An expected June 2015 rate hike was delayed until December after disappointing economic performance in the summer and fall of 2015. The December rate hike happened despite the fact that inflation expectations were falling at the time. That was supposed to be followed by a series of rate hikes in 2016, but at each meeting the Fed has flinched in the face of disappointing economic performance and global economic turmoil.
We can view this policy as the opposite of the stimulative forward guidance the Fed was offering between 2011 and 2013. Back then, the Fed said “don’t worry, we’ll keep rates low even after the economy has recovered. Now, the Fed is saying “watch out! We’re going to hike rates as soon as we’re sure it won’t cause a recession — and maybe sooner.” If promising to keep rates low for an extended period makes monetary policy looser, promising to hike rates ASAP makes it tighter.
And because the Fed’s statements about future policies can effect the economy in the present, promising to raise rates soon can actually cause rates to stay low for longer. The Fed’s signals about impending rate hikes makes markets more pessimistic about the economy’s trajectory. That depresses spending and investment, weakening the economy enough that the Fed is forced to delay its rate increase.
In short, the Fed’s policy over the last couple of years has effectively been to tap on the brakes any time the economy shows signs of producing faster-than-trend growth. And because markets know that’s the Fed’s policy,
they’ve come to expect slow growth, making them less likely to invest in boosting output.
“Full employment” isn’t necessary full employment
OK, so money isn’t as loose as it could be. But the conventional view holds that this doesn’t matter because the unemployment rate is 4.9 percent. That’s very close to the level that economists consider to be “full employment.” With very few idled workers, the argument goes, there’s no room for higher demand to produce higher real output. If the Fed made monetary policy looser, it would just produce more inflation.
But I think this takes too simplistic a view of the concept of full employment. There are a number of ways an economy can be at 4.9 percent unemployment and still be well below its potential output.
One way is known in economics jargon as “scarring.” A bunch of people lost their jobs in 2009. As the recession dragged on, a lot of them couldn’t find work for several years. And once a worker had a multi-year gap in his resume, it became harder and harder to find a job, since employers worried that the worker’s skills were stale or that there was something wrong with the worker that led to the prolonged spell of unemployment. Eventually, many of these workers gave up looking for work altogether. If they were in their 50s or 60s, they may have been forced into a premature retirement. If they were younger, they might have gone on disability, become stay-at-home parents, or moved in with family.
The conventional view treats scarring as an irreversible event: once a worker has left the workforce, he or she’s no longer counted in the unemployment rate and is effectively excluded from the concept of full employment.
But these workers do exist, and they could starting working again with some extra encouragement and training. What they need is a 1990s-style boom, in which employers are so desprate to find workers that they’re willing to hire people they wouldn’t have considered in leaner times. In tight labor markets, employers start asking friends and family if they know of anyone looking for work. They set up training programs to teach skills that are scarce on the ground. And so the labor force can become partially “unscarred,” with thousands of people who had given up on finding work returning to the workforce.
A boom could can also help workers shift into jobs where they’ll be more productive. During a recession or a slow recovery, many workers feel that their job situation is precarious — that if they lose their current job, they’re unlikely to get another one like it. That makes them reluctant to make risky career moves — like switching to a new field, going back to school, or starting a business — that could boost their long-run productivity. As a result, many workers wind up in career ruts, spending years in jobs where they’re performing at well below their level of potential.
In a 1990s-style boom, employers become desperate for workers and workers become confident that they’ll be able to find a decent job if they need one. At the same time, employers become more open to hiring people with unconventional backgrounds, making it easier for people to hop from one industry to another. In short, the labor market becomes more fluid, and this dynamism allows more workers to find jobs where they can maximize their long-term productivity and pay.
A similar point applies to capital investment. Say you’re in charge of a factory and you have a idea for an overhaul that could double output with the same number of workers. However, the refit would be expensive and there’s a risk that the gains won’t pan out.
In a weak recovery, you (or your bosses) might be reluctant to give it a try. If the investment works, you might find the sales force can’t sell all the extra units you’re producing. If the investment doesn’t work, you worry that you (and whoever approved the investment) could lose your jobs. So you might decide that it’s safer to stick with current technology, satisfying small demand increases by hiring more workers and buying more of existing equipment.
In a boom, the calculation looks different. The entire industry is struggling to keep up with soaring demand so there’s little doubt you’ll be able to sell the extra units. You’re not too worried about losing your job because there’s an industry-wide shortage of experienced managers. Indeed, if the project fails but demand is still strong, the CEO might be eager for you to take what you’ve learned and try again.
In short, the fact that the unemployment rate is 4.9 doesn’t prove that the economy is operating at — or even close to — its maximum output. I suspect that if the Fed were to step on the gas, we’d see a sudden surge in labor force participation, investment spending, and total factor productivity. The economy might be at “full employment,” but that doesn’t necessarily mean it’s actually at full employment.