Forgotten Lessons From the Past
Capital Thinking: January 14 · Issue #1016 · View online
These are crazy times.
The unemployment rate is 3.9%, inflation is at 6%, and real interest rates are well below zero, all while the Fed is still doing QE.
Yes, they’re phasing it out, and there are plans about increasing rates to something slightly less below zero over the next two years.
But even after all the rate hikes, this is still a very accommodative monetary policy.
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Monetary Policy
Accommodative monetary policy refers to when the real policy rate is below the natural rate (or the market risk-free rate).
I agree that there are reasons to believe that the natural rate is lower than it was in the 1990s. There’s more demand for low-risk assets, more savings, etc. But I have yet to hear a compelling argument that the natural risk-free rate is negative.
What model can explain that?
Instead, it seems that we have monetary policy that’s juicing the economy indefinitely. They just plan on juicing it a little bit less in the future.
I feel like we’re reliving the 1970s, and not because we are facing similar economic conditions. Prices are much lower, and inflation dynamics are totally different.
Better access to information and more international suppliers may be what’s keeping inflation from reaching the levels of the 1970s. The underlying economy is also much healthier.
What reminds me of the 1970s is the rationalization from policymakers that inflation will go away, is not so harmful, or exists due to greedy corporations jacking up prices. These are all excuses that relieve policymakers from making hard decisions.
I came of age as an economist during the Great Moderation, and now I look back on those times and marvel at how naïve we all were.
I was taught that we had learned what bad policy looked like, specifically that we shouldn’t mess with supply and demand, that information imperfections cause market failures, and that inflation is a monetary phenomenon. I was taught that the Great Moderation (low inflation, low interest rates, and low unemployment that persisted for decades) occurred in large part due to the fact economists knew what they were doing.
However, that line of thinking sounds pretty deluded now—not just that we thought we could control the economy and prevent bad recessions, but what’s even crazier is that we believed we wouldn’t repeat mistakes from the past.
Cut to 2021—are we seriously talking about price controls?!
So far, the government has not been talking about them explicitly, but blaming big company greed for inflation is either teeing it up or is already some sort of implicit price control.
I guess it’s easier than admitting that the Keynesian stimulus went too far. And it’s definitely easier than doing the hard work to increase supply or pulling back on demand.
Some things are different from the 1970s, though. I’ve heard another economist mention that Forward Guidance (the idea that talking about doing something instead of actually doing it is an effective monetary policy because expectations are what matter) has made central bankers believe that they don’t have to actually do anything that will harm the economy in order to tackle inflation.
They believe that if they just talk about doing something, it will have just as powerful an effect.This is starting to remind me of the arrogance we had back in my grad school days. After all, aren’t we really saying that economists (or lately, lawyers) at the Fed can outsmart the market?
Now maybe I’m more of a finance than macro economist these days, because this all seems sort of absurd to me.No one outsmarts the market—at least not forever.
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