Fed Repeats Error of 2008 With Tight Money

(Bloomberg Opinion) -- Following today’s economic debates is giving me deja vu, and not the good kind. We seem to be repeating the biggest policy mistake the U.S. made after the financial crisis a dozen years ago — and doing it, as before, with our eyes closed.

Back then, the Federal Reserve kept monetary policy too tight in the face of economic weakness, prolonging the recession and weakening the recovery. But it faced essentially no pressure to loosen policy, because most observers mistakenly believed it was already extremely loose. Conservatives generally argued that monetary policy was too accommodative and posed too great a risk of high inflation. Liberals maintained that the Fed had it right but had done all it could, and that Congress needed to provide additional fiscal stimulus as well.

The false premise both sides accepted was that low interest rates were proof of loose money. But that was a fallacy. Low interest rates can, as the great economist Milton Friedman said, be evidence that money has been too tight: It can be, that is, a byproduct of a depressed economy. That’s what we had in the years after the great recession. Unemployment remained elevated while inflation was below the Fed’s target. These are classic symptoms of tight money, but low interest rates (and Fed asset purchases) got in the way of an accurate diagnosis.

And now? We are once again hearing arguments that inflation is about to come roaring back. And those who aren’t worried that the Fed has done too much are saying that it has done nearly all it can and what we need is more fiscal stimulus.

Meanwhile, actual inflation has been falling. Breakevens suggest that markets expect inflation to keep running well below the Fed’s 2% target over the next five and even 10 years. Futures markets project a near-zero federal-funds rate next summer — which is more consistent with a depressed economy than a V-shaped recovery. Household expectations of income growth over the next year have plummeted. The prices of commodities, while rising, remain lower than a few months ago.

The market seems to be assuming that there will be a persistently elevated demand for money balances that the Fed will not fully accommodate. And not just the market: The Fed itself is making the same assumption. Its board members and presidents predict that, even under their preferred monetary policies, unemployment will remain above its pre-crisis level and inflation below target through 2022.

It ought to be a scandal: To borrow an analogy from Scott Sumner of the Mercatus Center, the captains of the Fed are saying they are setting a course they don’t believe will reach their supposed destination.

“We’re not out of ammunition by a long shot,” Federal Reserve Chairman Jay Powell recently said. “There are a number of dimensions where we can move to make policy even more accommodative.”

He’s right. The Fed could make additional asset purchases. It could stop paying banks interest on excess reserves, a contractionary policy the Fed instituted, perversely, a few weeks after the Lehman Brothers collapse. As Boston College economics professor Peter Ireland has recently written, ending this policy would have the effect of “easing monetary conditions enormously to offset any and all deflationary pressures.”

The Fed could attempt to alter market expectations by announcing that its policies on interest rates and asset purchases will be tied to the goal of getting the total amount of spending in the economy back to its pre-Covid path by the end of 2021. (Which is to say, about 8% above its level at the end of 2019.)

Steps like these might not do much to boost the economy right now, when the pace of reopening and the public’s assessment of health risks are the main determinants of growth. But they could make the difference between a robust recovery and stagnation once the health crisis is over.

Why isn’t the Fed taking these actions or signaling that it will take them? Probably for some of the same reasons it didn’t act more aggressively from 2008 onward, including an excessive fear of inflation. (That wasn’t the first time, either. R.G. Hawtrey was discussing Britain in the early 1930s when he wrote: “Fantastic fears of inflation were expressed. That was to cry, Fire, Fire, in Noah's Flood.”)

Politics may be playing a role too. Even an independent central bank is influenced by the debate surrounding it. There wasn’t much pressure for the Fed to do more in 2010. Criticism came mostly from those who wanted a tighter policy. Both conditions are still true.

The state of the economy today is obviously different in important respects from what we faced back then. But there are too many similarities for comfort.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ramesh Ponnuru is a Bloomberg Opinion columnist. He is a senior editor at National Review, visiting fellow at the American Enterprise Institute and contributor to CBS News.

©2020 Bloomberg L.P.