By Scott B. Sumner, Director of the Program on Monetary Policy at the Mercatus Center at George Mason University, a Research Fellow at the Independent Institute, and an economist who teaches at Bentley University in Waltham, Massachusetts
The financial crisis of 2008 and the Great Recession led to a dramatic reappraisal of monetary policy. Since the end of 2008, the consensus among pundits has been that near-zero interest rates and “quantitative easing” (QE) represent a highly expansionary monetary policy. In addition, this policy is widely viewed as having been relatively ineffective at boosting aggregate demand.
Here I will make two arguments. First, that this view of monetary policy is radically different from the pre-2008 views of many top macroeconomists. Second, that the pre-2008 consensus view is much more accurate than the prevailing view that has emerged in the wake of the Great Recession.
For several decades, I taught monetary economics using the number-one monetary textbook in America. Its author is Frederic Mishkin, a highly respected economist who has served on the Federal Reserve Board. Toward the end of the book, Mishkin summarized three key points that he thought it was essential for students to know:
- It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates.
- Other asset prices besides those on short-term debt instruments contain important information about the stance of monetary policy because they are important elements in various monetary-policy transmission mechanisms.
- Monetary policy can be highly effective in reviving a weak economy, even if short-term rates are already near zero.
The first and third points are in direct contrast to the prevailing view of 2009—the view that low interest rates represented an easy money policy and that the Fed was pretty much “out of ammunition” once interest rates fell to zero. The second point is particularly interesting, as virtually all “other asset prices” (that is, other than short-term, risk-free government debt) indicated that monetary policy was highly contractionary during the second half of 2008.
For instance, the real interest rate on ten-year TIPS (Treasury Inflation-Protected Securities) rose from less than 1 percent in July 2008 to more than 4 percent by the end of November 2008. The value of the dollar in the foreign-exchange market soared by about 15 percent between July and December 2008. The prices of stocks and commodities fell very sharply, as of course did the price of residential properties. Even the price of commercial property, which held up well during the initial phases of the subprime debacle, started falling in late 2008. All were signs of tight money.
An especially important asset price is the spread between the yield on conventional Treasury bonds and the yield on TIPS. This spread is a rough proxy for inflation expectations. The TIPS spread declined steeply in late 2008, indicating sharply falling inflation expectations for the next few years.
Two days after Lehman Brothers failed, the FOMC (Federal Open Market Committee) met to decide monetary policy. They declined to cut interest rates, which were 2 percent at the time, because of a fear of high inflation. And yet on that very same day, the five-year TIPS spreads showed just 1.23 percent inflation was expected over the next five years, far below the Fed’s 2-percent target.
Mishkin was certainly not the only economist who looked at policy this way. Milton Friedman and Anna Schwartz had famously argued that monetary policy was highly contractionary during the early 1930s, despite very low interest rates and (in 1932) quantitative easing.
In 1997, Friedman became exasperated with the way the media and even many economists were interpreting the Japanese economy: “Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy. . . . After the US experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.” (WSJ, Dec. 1997)
Notice the past tense in Friedman’s remarks. He wasn’t saying that low interest rates meant money was tight, rather that it had been tight. A policy of tight money leads to slower growth in output and prices, and this puts downward pressure on interest rates in the medium to long run.
Perhaps the most striking example of pre-2008 monetary economics comes from Ben Bernanke. Here is Bernanke in 2003, explaining why neither interest rates nor money-supply growth are good indicators of the stance of monetary policy: “The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman . . . nominal interest rates are not good indicators of the stance of policy . . .. The real short-term interest rate . . . is also imperfect . . ..
Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation.”
What’s especially striking about this claim is that it implies that monetary policy between 2008 and 2013 was the most contractionary since Herbert Hoover was president in the early 1930s. Ironically much of Bernanke’s academic career was focused on research on the Great Depression. He had also written extensively on the situation in Japan, and he recommended that the Bank of Japan take much more aggressive steps to boost aggregate demand and inflation. And yet, once Bernanke became the Fed’s chair, he was only able to implement a fraction of the recommendations that he had given the Japanese. And while he never stated that the Fed was not able to do more, he did characterize Fed policy as being extraordinarily accommodative, despite the fact that his 2003 criteria for determining the stance of monetary policy implied just the opposite.
One might argue that the profession had good reason to move on from the pre-2008 views of Mishkin, Friedman and Bernanke. After all, haven’t events since 2008 showed those views to be incorrect? One problem with this claim is that we had already seen similar scenarios play out in the United States during the 1930s and in Japan in the late 1990s and early 2000s. So it is not apparent that the Great Recession provides any new information that wasn’t already available to well-informed monetary economists in 2007. In that case, why did so many economists change their views after 2008?
In my view, monetary policy is more subject to “cognitive illusions” than almost any other area of economics. In a sense, monetary economics is a sort of Alice in Wonderland world in which nothing is quite what it seems. To illustrate this, consider a thought experiment in which a central bank engages in a highly contractionary monetary policy. Suppose that this policy leads to a highly depressed economy and very low inflation, if not outright deflation. What then? What would you expect credit markets to look like?
Throughout history, the combination of economic depression and very low inflation almost always leads to near-zero interest rates. That is even true in an economy in which there is no Fed, such as the US prior to 1913. Falling output leads to a sharp drop in business-credit demand for new investment, and low inflation or deflation reduces interest rates due to the (Irving) Fisher effect (real interest rate equals to the nominal interest rate minus the expected inflation rate). Just the opposite occurs with highly expansionary monetary policies, which lead to high rates of inflation. Whenever and wherever countries experience persistently high rates of inflation, nominal interest rates tend to rise sharply due to the Fisher effect.
Once interest rates fall close to zero, the demand for base money rises sharply. This is because the opportunity cost of holding bank reserves is basically zero, and thus the demand for excess reserves rises sharply. This means you have two stylized facts that look like “easy money” to most people—low rates and QE. In fact, neither ultra-low interest rates nor a bloated monetary base are foolproof signs of easy money. Both may well be a reflection of the fact that monetary policy has been expansionary in the past, driving nominal GDP (gross domestic product) growth to extremely low levels.
In recent decades, Australia has had one of the most expansionary monetary policies in the developed world. Because of this expansionary monetary policy, Australia has more rapid nominal GDP growth than other developed countries. And that means Australia tends to have higher nominal interest rates than other developed countries. Because interest rates in Australia never fell to zero during the Great Recession, the central bank of Australia did not have to engage in any QE, and their monetary base remains quite low as a share of GDP. The irony here is that a country with one of the most expansionary monetary policies in the entire developed world appeared to many pundits to have the most contractionary monetary policy. In 2014 it was one of the few developed countries with interest rates still above zero.
Because many pundits have misinterpreted what it means to have an expansionary or contractionary monetary policy, they also ended up misdiagnosing the causes and possible cures for the Great Recession. Hardly anyone blamed tight money for the sharp drop in aggregate demand during 2008–09, even though if we take Mishkin’s textbook definition of tight money seriously (or Ben Bernanke’s, for that matter), then the Fed was in fact guilty of using a tight-money policy in 2008 to drive the US into a deep recession.
Similarly, because most pundits wrongly thought that the Fed was “out of ammunition”, very little pressure was put on the Fed to stimulate the economy. Indeed, President Barack Obama didn’t even bother to try to fill several empty seats on the Federal Reserve Board when he took office in 2009. He accepted the prevailing view that the Fed was out of ammunition, despite arguments to the contrary by his CEA chair, Christina Romer.
The Eurozone recently provided one of the best examples of Milton Friedman’s maxim that low interest rates usually indicate that money has been tight. Back in 2011, the leadership of the European Central Bank (ECB) was relatively hawkish. Indeed, ECB officials were critical of Bernanke’s policies, which they viewed as dangerously expansionary. To head off an increase in inflation, the ECB raised interest rates twice during the spring of 2011. This drove the Eurozone into a double-dip recession, while the US continued to recover from the Great Recession.
Under new leadership, the ECB eventually recognized its mistake and began cutting interest rates aggressively. Today, short-term interest rates in the Eurozone are slightly negative. Meanwhile, the US has finally begun to raise interest rates, as our economy is much stronger than the Eurozone economy. Ironically, the Eurozone has ultra-low interest rates precisely because back in 2011 their monetary policy was more contractionary than in the United States.
A common mistake in economics is to “reason from a price change”. Thus reporters often try to analyze the impact of higher oil prices without first establishing whether the price increase was due to less supply of oil or more demand for oil. The same is true of interest rates. It makes no sense to try to evaluate the impact of interest rates without first establishing why they changed. Higher interest rates that reflect a stronger economy are very different from higher interest rates that reflect the short-run impact of a contractionary monetary policy.
Most of the changes in interest rates that we observe in the real world are not changes in monetary policy; rather they represent central banks accommodating changes in the underlying economy. Only when central banks move their target interest rate above or below the natural or equilibrium interest rate is there a true change in monetary policy. Misinterpreting the implications of changes in interest rates is perhaps the single-most common error in monetary economics.