Will the FOMC Repeat the Mistake of September, 2008?

I hope not. As you may recall, the FOMC met a day after Lehman collapsed on September 16, 2008 and decided against lowering the federal funds rates. Yes, the Fed decided to keep its targeted interest rate unchanged at 2% just as the financial crisis was reaching its peak. Amazingly, the reason the FOMC acted this way was its concerns about inflation, which at the time were driven by commodity prices and reflected a backward-looking view of inflation. Had the Fed given more weight to forward-looking indicators like the expected inflation rate coming from TIPS and a host of other market indicators, the Fed would have realized the market was pricing in a sharp recession. Even though the Fed intervened more aggressively after this point, it never rose to the point that would restore current dollar spending to a healthy, sustainable level. The Fed, therefore, effectively tightened monetary policy at that time.

Though the circumstances are somewhat different today, the same Fed inertia that kept it from responding appropriately in late 2008 could similarly prevent the Fed from getting ahead of the current crisis. Now is not the time to be conservative and cautious. It is time for Chairman Bernanke and the FOMC to take the initiative and provide some real “shock and awe” monetary policy stimulus. Adopt the Joseph E. Gagnon program or the quasi-monetarist goal of nominal GDP level targeting. Yes, both approaches would be very controversial and have many observers freaking out, but that is the point. It would provide a much needed slap to the face of public’s economic expectations.

Now some observers claim there is nothing more the Fed can do since short-term interest rates are already close to 0%. Moreover, they argue the Fed already is pushing easy monetary policy without any success. So why bother trying to do more monetary stimulus? Two things these folks need to remember. First, low interest rates are not stimulative if the natural (or neutral) interest rate is low too. The natural interest rate is driven by the fundamentals of the economy. When the economy improves the natural rate increases and when the economy falters it decreases. It is the interest rate that would prevail in the absence of the Fed intervening. Over the past few years the economy has been weak and appears to be weakening even more. Thus, the natural rate is low and falling, implying the Fed’s low interest rate target isn’t very expansionary, if at all.

Second, even though the Fed cannot push the short-run nominal interest below 0% and below the short-run natural interest rate value, it can push the real short-term interest rate below 0% and the real short-run natural interest rate value. Moreover, if needed, the Fed can start working its way up the term structure of interest rates by purchasing longer-term assets and pushing their yields below their natural interest rate values. Another way of saying this, is that the Fed needs to keep buying assets until money demand is satiated and nominal spending resumes. The 0% bound on short-term interest rates is simply a red-herring. It did not prevent FDR from creating a robust monetary-driven recovery in the Great Depression, it did not prevent the Swedish central bank from spurring a remarkable recovery in this crisis, and it should not prevent Fed officials currently.

So please FOMC, do not make the September, 2008 mistake again. Get ahead of this unfolding crisis.