I was in Washington DC last week to attend a conference at the Peterson Institute for International Economics, organised by its president and ex-Monetary Policy Committee member, my pal, the insightful Adam Posen. It brought together representatives from all branches of the US government to talk about labour market slack. There were oodles of distinguished academics, as well as representatives from the Federal Reserve Board, the US Treasury, the Congressional Budget Office, the Bureau of Labor Statistics and the President’s Council of Economic Advisors (CEA).
The CEA is an institution who has only one client: the President. It has had a number of famous economists as its chair, including Ben Bernanke, Alan Greenspan and Janet Yellen. It would be a really good idea if there was an equivalent office in the UK to advise the Prime Minister on economic matters. Boy could the current incumbent do with one!
The highlight was a speech by the excellent and dovish (that’s ok!) Charles Evans, president of the Federal Reserve Bank of Chicago, who is a member of the Federal Open Markets Committee, although he currently does not have a vote, as this rotates between the 12 bank presidents (but will have one in 2015). It should be noted though that the president of the New York Fed, the watcher of Wall Street, always votes. The speech was entitled “Patience Is a Virtue When Normalizing Monetary Policy” and it set out beautifully the case for the doves.
The bottom line is it is better to make a mistake of keeping stimulus going too long than the much worse and potentially fatal error of removing the stimulus too soon. Hopefully Martin Weale and Ian McCafferty and other hawks will read, learn and inwardly digest. The speech warrants our close attention.
In the speech my friend Charlie made clear his concerns about what it means to be at the Zero Lower Bound (that Americans delightfully call the “Zee L B”!) where interest rates are as low as they can go. The ZLB, Evans suggests, prevents using our very best policy tools to address negative shocks. He argues that “the constraint also means that interest rates cannot fall low enough to equate the supply of saving with the demand for investment. This, of course, significantly impedes capital formation, future economic growth, and further employment expansion. Furthermore, the ZLB often comes hand-in-hand with undesirably low inflation or even a falling price level, carrying with it the associated costs of debt deflation on the real economy.” Bottom line: never go there again.
Past experience with the zero lower bound, Charlie argued, also counsels patience as history has not looked kindly on attempts to prematurely remove monetary accommodation from economies: “The costs of being mired in the zero lower bound are simply very large.” He illustrates this with three examples. First, the US experience during the Great Depression – in particular, in 1937, which he suggests is a classic example for monetary historians. “In response to the positive growth and re-inflation that occurred after devaluation and suspension of gold convertibility, the Fed raised reserve requirements, the Treasury sterilised gold inflows, and there was a fiscal contraction. Subsequently, the economy dropped back into recession and deflation. During this time, interest rates remained very low and it took the big fiscal expansion associated with World War II to exit the Great Depression.”
Second, the Japanese experience over the past 20 years. After attempting to expand production and avoid deflationary prospects in the late 1990s, monetary policy reversed course prematurely in the early 2000s as the inflation rate inched above zero. Deflationary pressures soon re-emerged and policy rates returned to zero by 2001. This experience was repeated again later in the decade. Indeed, it has only been over the past year following nearly 20 years of stagnation that we see what Evans calls the recent “goal-oriented monetary expansion” making significant headway in extracting Japan from below-target inflation.
Third, the recent European experience of premature tightening in 2011 Evans suggests also tells us what not to do. The European Central Bank in 2011 judged that the eurozone economy was emerging from recession and headline inflation was at risk to rise persistently above target so they responded by raising interest rates in 2011. The ECB soon had to backtrack as output in the eurozone fell again and inflation began to head down below target. Today, the eurozone faces continued economic weakness and an inflation rate of 0.3 per cent. As a result, the ECB recently lowered policy rates to the ZLB, has started undertaking additional unconventional monetary policies, and is now encouraging fiscal expansion among eurozone countries that are able to do so. But the eurozone PMI surveys of industrial activity this week were weak again and there is little sign of the eurozone getting out of their self-inflicted mess.
These lessons from monetary history suggest that there are great risks to premature lift-off from the zero lower bound or near-ZLB conditions. Unless economic conditions are fundamentally strong and the previous impediments to growth have receded sufficiently, the odds remain high that monetary authorities will need to disastrously retreat right back into the ZLB if they raise rates too soon.
Evans noted in the Q&A after his speech that the Fed has a symmetric inflation target meaning they should be averaging 2 per cent inflation over time. Since 2008, year-over-year total inflation as measured by the Personal Consumption Expenditures Price Index (PCE) the Fed’s preferred inflation measure, has averaged just 1.4 per cent, well below its 2 per cent target. Today, PCE inflation stands at 1 to 1.5 per cent and is expected to move up only slowly toward the FOMC’s target. Hence it’s probably OK to have moderately above target inflation for a limited period of time as simply the flipside of the recent inflation experience. So central banks should not “shy away from policy prescriptions that generate forecasts of inflation that moderately overshoot our 2 per cent target for a limited time”.
Charlie concludes by arguing: “I am very uncomfortable with calls to raise our policy rate sooner than later. I favour delaying lift-off until I am more certain that we have sufficient momentum in place toward our policy goals. And I think we should plan for our path of policy rate increases to be shallow in order to be sure that the economy’s momentum is sustainable in the presence of less accommodative financial conditions.”
This is one speech I really wish I had given. Good stuff. MPC take note. ZLB beware.Reuse content