Scott Sumner  

The Fed at 100: A century of procyclical policy

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Up until 2008 I had a sort of "Whig view" of Fed history. They made many mistakes, but learned enough from those mistakes to gradually improve. Now I'm not so sure.
Here are 6 policy regimes, all excessively procyclical:

1. Real bills doctrine (early years): Lend money as needed for productive investments. Unfortunately, more money is "needed" during booms, and hence monetary policy becomes more expansionary during booms and more contractionary during recessions. The drop in the monetary base from October 1929 to October 1930 is a perfect example.

2. Interest rate pegging (1942-51): If you hold rates absolutely fixed, then the money supply will move in tandem with money demand. Because money demand tends to rise during inflationary booms, the money supply will also rise and policy will be procyclical.

3. Interest rate targeting (1951-79): This is better, in principle. Adjust the interest rate as needed to stabilize the economy. In practice they relied too much on nominal interest rates, and hence misjudged the stance of policy. They also misjudged the natural rate of unemployment. Thus policy became too expansionary, as inflation reduced real interest rates and the Fed overestimated the economy's potential.

4. Money supply targeting (1979-82): This did bring inflation down, but velocity tends to fall during deep recessions like 1982, which makes the policy overly contractionary.

5. New Keynesian (1982 - 2008): The "Taylor principle" fixed the inflationary bias of the 1960s and 1970s. Until 2008 this was as good as it gets--even Milton Friedman praised the policy before he died. But interest rate targeting does not work at the zero bound, so the policy was abandoned in late 2008. And there were weaknesses exposed even before it was abandoned--particularly the lack of level targeting.

6. Unconventional policies (2008-??): These included interest on reserves, QE, and forward guidance. Here the weakness was passivity. The Fed was less willing to use unconventional than conventional policy tools. Because unconventional tools are needed at the zero bound, and because the zero bound tends to occur during deep recessions, policy ends up being too contractionary during deep recessions.

7. NGDP futures targeting, level targeting (?? - infinity and beyond): This represents the state of the art in terms of monetary stability. First we need to get an NGDP futures market up and running. Investors, policymakers and pundits will then begin using NGDP futures prices as proxies for expected growth in AD. This market forecast will gradually assume a larger and larger role in policy formation. Eventually its role will be formalized.

PS. Of course I was kidding about infinity. NGDPLT will run for a few decades, and then get replaced by something even better, which is as it should be.

PPS. Policy was also procyclical under the classical gold standard (1879-1913.) During recessions interest rates tended to fall. This increased the real demand for gold (due to a lower opportunity cost of holding gold), which was deflationary.

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CATEGORIES: Monetary Policy

COMMENTS (10 to date)
Yancey Ward writes:

And twenty years from now, should NGDP targeting be adopted, some whippersnapper will write an essay where there are eight failed policy regimes of the past discussed, and he will be proposing his for "infinity and beyond".

Yancey Ward writes:

There is no "better" system, Scott- just different. All these systems fail because people and markets adapt in ways that policy makers are simply too slow and stupid to adjust to.

A writes:

I suppose that you could say there are better systems in the way that you distinguish "Great Recession" from "Great Depression". They are different, but one seems better than the other.

Scott, was the Gold Standard more or less procyclical than the others on average?

Yan writes:

Unconventional policies like QE(Quantitative easing) are not only taken in the United State, but also in European Union, (EU), Japan, and China. Is there any possibility for these county to work together to minimise the adverse effects of their QE policies?

dannyb2b writes:

"7. NGDP futures targeting, level targeting (?? - infinity and beyond)"

Why will the fed by any more capable than now in budging expectations? Wont excess reserves just pile up like now under ngdp futures?

Even if the fed is more aggressive or expansive why do you assume it can reach its targets? Maybe beyond a certain point expansions of MB don't affect expectations. Do you think that the limitation of MB in terms of who can hold it and transact in it electronically limits the effect expansions of MB have on the economy? Maybe this issue could be included in v3 of your ngdp futures targeting paper.

How much MB does the fed need to create now to reach its stated targets if we assume it can?

paul writes:

I think this is the problem with "monetarists." they have the cause and effect is backwards. "Monetary policy" is not expansionary, peoples expectation of future growth is higher. the aggregate of individual decisions might be correct or not. but money is PASSIVE.

real bills doctrine RULES! ; )

Scott Sumner writes:

Yancey, Of course some systems are worse than others, don't be ridiculous.

Jayson, I don't know, but it was probably more procyclical than the current regime.

Danny, The Fed is already more than capable of "budging" expectations.

If the Fed fails, then they end up owning all non-American wealth. Does that prospect concern you?

dannyb2b writes:


I dont understand what you mean.

Ognian Davchev writes:

dannyb2b writes:

"I dont understand what you mean."

The Fed ends up buying all the assets in the world with freshly printed USD.

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