This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics.
Market analysts and the mainstream press believe in an all-powerful Fed. For example, in the March 21 issue of the Wall Street Journal, Greg Ip suggested “the Fed can be satisfied with what it has achieved. The economy is expected to grow solidly this year, unemployment at 3.8% is below officials’ median estimate of its “natural” level of 4.3%, and inflation this year, excluding food and energy, should hit its target of 2%.” Just as Dorothy’s dog, Toto, pulled back the curtain on the all-powerful Wizard of Oz to reveal the ersatz wizard, it’s time to pull back the curtain on the Fed’s mystique: The Fed is much less powerful that most people believe.
But before I pull back that curtain, I want to point out that the Fed wants you to believe it is all powerful. At the March 18, 2009, Federal Open Market Committee (FOMC) meeting, Philadelphia Fed President Charles Plosser noted that he and St. Louis Fed President Jim Bullard recommended that the FOMC’s purposed statement, which read “the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus will contribute to a gradual resumption of sustainable economic growth,” be changed to “the Committee anticipates that market forces and policy actions will contribute to a gradual resumption of sustainable economic growth” (italics added). He noted that the statement under consideration “says that policy actions alone will stabilize the world. And, frankly, I think creating an impression that the only game in town is policy actions and that market economies have no contribution to make in this stabilization is setting us up for failure and a credibility problem. So we [he and Bullard] added the reference to market forces.”
Just before the policy vote was to be taken, Plosser reminded Chairman Bernanke that the alternative wording that he and Bullard proposed had not been discussed and asked if the Chairman had forgotten it. Bernanke responded, “No. I was trying to keep life as simple as I can.” Bernanke is a good enough economist to understand the inherent truth of Plosser and Bullard’s recommendation. All he would have had to do is support the proposed rewording and everyone would have said OK. But instead he asked: “Are people okay with substituting the sentence.” Governor Tarullo responded immediately, “To what market forces are you referring?” Before Plosser could respond, Governor Kohn interjected, “I think what I heard around the table, Mr. Chairman, was not much confidence that market forces are moving in that direction and might even be moving in the other direction.” Plosser responded, “There’s not much confidence that government forces are going to fix it either.” Richmond Fed President, Jeffery Lacker, interjected, “Surely, if the economy recovers, it’s going to be a combination of policy actions and market forces. Surely that’s the case.” Bernanke then said, “Well, all we’re saying here is that these things will contribute. We’re not saying that they’re the only reason. Let me go on.”
President Bullard interrupted saying, “I just want to press on that a bit. It [the purposed statement] gives the impression that we’re hanging on a thread as to what the Congress does or what we do or something like that. I don’t think you want to leave that impression. Despite what the government does, you might recover faster or you might recover slower, and I think you should leave that thought in the minds of private citizens.” Bernanke then terminated the discussion saying, “Again, I think what we’re saying here is that we anticipate that these things will contribute to an overall dynamic.” The suggestion that market forces would contribute to the improvement in the economy did not appear in the March 18, 2009, FOMC statement or any statement since.
Given that Bernanke and other members of the FOMC were unwilling to even acknowledge that factors other than monetary and fiscal policy impact the economy, Ip and others can be forgiven somewhat for believing in the all-powerful Fed. However, professional economic commentators such as Ip should have a better understanding of economics and be more circumspect.
Now let’s consider each of Ip’s claims beginning with the claim that the Fed brought the unemployment rate down to 3.8 percent. Your first clue that the Fed should not get all of the credit is the fact that employment growth has been weak by historical standards—just 1.1% since the beginning of the economic expansion in the third quarter of 2009. Such employment growth could not have reduced the unemployment rate to 3.8%.
Indeed, the Fed got a lot of help. The unemployment rate can decline for two reasons: an increase in employment or a decline in the labor force participation rate (LFPR). Figure 1 shows the unemployment rate and the LFPR from January 1948 to March 2019. The LFPR increased fairly steadily from early 1965 to a peak of 67.3 percent in January 2000. Hence, during this period the behavior of the LFPR alone was causing the unemployment rate to be higher. Consequently, it took a larger increase in employment to reduce the unemployment rate. Since January of 2000, the LFPR has been constant or falling. Consequently, it takes a smaller increase in employment to produce a decline in the unemployment rate. From December 2007, when the recession officially started, until September 2015, when it bottomed out at 62.4 percent, LFPR declined by 2.6 percentage points. Had the LFPR not declined from its December 2007 level, the March 2019 unemployment rate would be 8.1%.
There are several hypotheses for why the LFPR has declined so much since 2000, but no one knows for sure. Nevertheless, the same employment gains when the LFPR was rising would have produced a much smaller reduction in the unemployment rate.
Now let’s consider Ip’s claim that the Fed should get credit for getting the inflation rate up to its 2% target. At its December 2012 meeting the FOMC officially announced an inflation target of 2% for the Personal Consumption Price Index, less food and energy (PCEX). However, it was widely believed that the FOMC had an implicit 2% inflation target for the PCEX years earlier. The PCEX inflation rate fluctuated around an average of about 2.2% from early 2004 to Lehman Bros.’ bankruptcy announcement on September 15, 2008, when it declined to 1%. With the exception of a few months, the inflation rate remained significantly below 2% until March 2018 when it appears to have stabilized at or near the FOMC’s 2.0% target level.
The question is: Did the Fed make this happen? The answer is: Not bloody likely! The FOMC kept its target for the overnight federal funds rate at zero for seven years, from December 2008 to December 2015, when it began increasing its target. The FOMC also began its massive bond purchasing program in November 2008 that ended in October 2014. The period from November 2008 to December 2015 is hands down the most aggressively easy monetary policy period in the Fed’s history. It stretches credulity to believe that the policies that began in late 2007, wrapped up by December 2015, and had no appreciable effect on inflation over this entire period finally succeeded in getting inflation up to 2% two and half years after these policies ended. Indeed, since December 2015 the FOMC has increased its interest rate target to about 2.5 percent and reduced the size of its balance sheet. These restrictive policies should have quelled inflation, not accelerated it.
Of course, the same argument applies to Ip’s claim that the Fed should be congratulated for the expected solid economic growth this year. You should find it hard to believe that the excessively easy monetary policies from December 2007 to December 2015, which produced an average growth rate of real GDP of just 2.2% from the recession’s end to December 2015, somehow got output growth above 3%.
To further understand why it’s folly to believe in the all-powerful Fed, it is useful to know that economists also determine “full employment” by the gap between actual and “potential” output. The so-called “output gap” measure of full employment declined to nearly -6.0 percent of actual GDP by the recession’s end and has risen continuously since. Indeed, by the third quarter of 2018 the output gap became positive—actual output was above potential—for the first time since the fourth quarter of 2007.
This might seem to exonerate Ip, but it doesn’t. The reason is the continuous increase in actual output relative to potential output occurred because (as I pointed out in The Myth of Potential Output) estimates of potential output have been revised down every year since 2007. The output gap did not get progressively smaller because the FOMC’s massively easy monetary policy produced a corresponding massive increase in output. Rather, it happened because economists continuously reduced their estimate of potential output. There is absolutely no reason to believe that man-made downward revisions in the output gap could possibly account for inflation getting up to 2%, or for getting the economy back to full employment.
It’s human nature to want to ascribe a cause to every observable effect. The FOMC had a 2% in inflation target and the inflation rate appears to be 2%, pesto, the Fed made this happen. The economy is growing more robustly and the Fed has been trying to get this to happen—thank God for the Fed. That people think this way is, of course, facilitated by the fact that the Fed wants you to believe that everything good that happens to output and employment is due to its policy actions, while all bad changes in output and employment are due to economic forces beyond their control and whose effect policymakers have to offset.
But no economist should believe such nonsense. Neither should professional economic commentators or so-called monetary policy analysts. They should know that much of the success of any economic recovery is due to the inherent healing power of a market-based economy. Good economic policies can help the process, while bad economic policies can impede it, but the self-healing power of a market economy should get much of the credit. Many factors affect output and prices all the time. Some have small individual effects, but collectively they may have a large effect. Some cause temporary fluctuations in output growth and inflation; others cause persistent, but not necessarily permanent, changes in output growth and inflation. These factors are often difficult to identify when they are happening. Most remain elusive, which is why many recessions and recoveries, the Great Depression, the Great Inflation, the Great Moderation and many other economic events are so difficult to explain and why economists cannot all agree on what caused them or brought them to an end. As I noted in The Limits of Monetary Policy: Why Interest Rates Don’t Matter, economists believe the Volcker Fed ended the Great Inflation of the 1970s and early 1980s, but can’t agree on exactly how the Volcker Fed ended it. Of course, they never considered the possibility that the Fed had little to do with inflation ending. This is truly odd for a science with two theories of inflation—“the too much money theory” and the Phillips curve/output gap theory—neither has been successful in explaining inflation historically nor successful in predicting inflation.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.