There’s another view of the Fed’s role in the crisis, though, that has been voiced by economists such as Scott Sumner of Bentley University, David Beckworth of Western Kentucky University and Robert Hetzel of the Richmond Fed. They dissent from the prevailing view that the Fed has been extremely loose since the crisis hit. Instead, they argue that the Fed has actually been extremely tight, and that when its performance during the crisis is measured against the proper yardstick, the central bank emerges as the chief villain of the story.
In the second half of 2008, housing prices, many commodity prices, inflation expectations and stocks all suggested deflation was coming. Fed officials, though, kept talking about backward-looking measures of inflation that made it look high. Their hawkish pronouncements effectively tightened monetary policy by shaping market expectations about its future direction. In August 2008, the Fed minutes explicitly said to expect tighter money. Even after Lehman Brothers Holdings Inc. collapsed the following month, the Fed refused to cut rates and fretted about inflation (which didn’t arrive). A few weeks later, the Fed decided to pay banks interest on excess reserves, a contractionary move. Only then did it cut interest rates.
[t]he Fed passively tightened monetary policy starting around mid-2008. This can be seen in the figure below:The figure shows that despite the fall in the growth rate of personal income from construction and real estate services that began in early 2006, personal income in the rest of the economy continued to grow at about 5% a year up through mid-2008. The Fed was able to stabilize nominal incomes overall for almost two years while structural changes were taken place in those sectors closely tied to the housing boom. This is a remarkable accomplishment and is especially clear when comparing construction employment with all other employment:
But around mid-2008 the Fed began failing to sufficiently respond to the decline in expected aggregate demand growth. Thus, it began passively tightening around that time as can be seen in the two figures below. The first figure shows the spread between the nominal and real yield on 5-year treasuries. It fell about 170 basis points during the period leading up to the collapse of Lehman in September. This decline in inflation expectations implies a decline in expected aggregate spending and thus a passive tightening of monetary policy. (Even if the spread was reflecting a heightened liquidity premium during this time the implication is the same. A heightened liquidity premium indicates increased demand for liquidity that, in turn, also implies less spending.)The decline in expected aggregated demand began affecting current spending decisions as seen below. Nominal GDP began falling in June 2008.The Fed’s failure to stabilize and restore aggregate spending meant it was passively tightening. This failure to act was epitomized by the Fed’s decision in September, 2008 to not lower the federal funds rate despite the collapsing economy. This passive tightening is what turned a mild recession into the Great Recession.
This piece is cross-posted from Macro and Other Market Musings with permission.