A version of this article appeared in Central Banking.
President Obama’s administration, the Federal Reserve and independent economists have to answer the central question about this recovery: why did the enormous sustained monetary stimulus have so little effect on real output, employment and prices?
My answer comes in two parts. First, the Fed’s policy is based on major economic errors. It has tried to resolve real economic problems by printing money, but its staff should know this is not possible. Second, the real problems were created by the Obama administration. Its insistence on imposing costly regulation on firms and industries, its support for stronger labor unions, its opposition to tax reduction and its other policies based on what the Economist magazine calls “the criminalization of American business” hampered economic recovery.
The principal result was slow investment and increasing pessimism regarding the state of the economy. Evidence of the latter include the decisions by many major companies, such as Apple, Halliburton, Merck, Time Warner and Walmart, to repurchase their shares at high prevailing stock prices instead of investing in new capital.
Six years into the recovery, median income remains much below the prerecession peak. The unemployment rate has fallen, but that is mainly because of decisions by prime age workers to leave the labor force. Much of the increased employment is part-time work. Why has the economic recovery remained so sluggish?
Three Federal Reserve Errors
The Fed made three major errors. After responding appropriately to the 2008 financial crisis, it continued the policy of massively expanding bank reserves long after this was required. Surely, by 2009, the Fed could have seen that most of the reserves it supplied ended up as idle reserves held by banks.
Long before idle reserves reached $2.7 trillion, the Fed should have asked: ‘What can we achieve by adding more reserves that the financial firms do not use, which commercial banks cannot achieve by using some of the idle reserves they hold? Apparently that question was not asked.
The accumulation of idle reserves was not the only sign that monetary policy had little effect on the real economy. The transmission of monetary policy to the real economy occurs, first, by raising the price of existing assets – stock prices and the cost of existing homes are examples – and this happened; asset prices increased substantially.
The next step followed weakly or not at all. In the recovery from a monetary recession, the rise in stock market prices and the price of existing houses makes the cost of new capital and new homes relatively cheap. Relatively cheap new capital induces new investment by business and the production of new housing. This time, home ownership is at 64 percent, well below the earlier peak of 70 percent before the recession. The failure of business investment to expand and the weak increase in new housing should have sent this message to the Fed: the main problems of this economy are real, not monetary.
Meanwhile, the Affordable Care Act encourages employers to give preference to part-time workers to escape expensive healthcare costs, yet Fed principals point to the rise in part-time employment as a reason for continuing to keep interest rates near zero. Are they so confused as to think financial policy can counteract real government rules?
A second major Fed error is the excessive attention paid by the US central bank to very ‘noisy’ monthly and quarterly data, such as the monthly jobs report. It soon became clear that a big increase encouraged the belief that the recovery was gaining momentum. The next month the number would be revised, often reduced considerably. Discouraging monthly reports were often followed by positive revisions. By relying on a very noisy indicator, the Fed increased uncertainty. More importantly, it showed it overreacted to current events and lacked a coherent strategy.
It still lacks one. Reducing $2.7 trillion of excess reserves requires a long-range plan, conditional on events. Eliminating the excess reserves without causing inflation, recession or both is a major problem for the future.
The Fed’s third major error is its baffling inattention to the growth of monetary and credit aggregates. Central banks supply the raw material on which financial markets build the credit and money magnitudes. The reason given for neglecting these aggregates is usually a claim they are unstable. That is true only, if at all, of quarterly values. It is not true of medium- and longer-term values, as many researchers have shown.
A New Error?
Currently, some Fed principals express concern about deflation. Their error is to mistake a large decline in the oil price – a relative price change – with a decline in the general price level. The Fed made the same mistake in the 1970s when oil price increases became the reason for anti-inflation action. By the early 2000s, the Fed recognized its error and allowed the oil price to pass through the economy.
This is the correct policy response to a sharp decline in oil prices – do nothing, even if the reported index becomes negative for a few months. The Fed has many competent spokesmen who can explain to the public that deflation occurs when enough different prices decline for broad-based price measures to fall. The Fed has the authority to explain the reasons for inaction and why it is appropriate to permit the fall in oil prices to work its way through the economy.
Inappropriate administration and Fed policies are the reason why a weak recovery followed the enormous monetary stimulus. After preventing a major financial crisis in 2008, the Fed has pushed discretionary policy in an extraordinary effort to restore full employment. The effort failed to achieve its goals. It continued long after the Fed should have recognized monetary policy could do little because the problems were not monetary – they were real.
Allan H. Meltzer is the Allan Meltzer University Professor of Political Economy at Carnegie Mellon University, Distinguished Visiting Fellow of the Hoover Institution, and author of A History of the Federal Reserve (University of Chicago Press, 2003 and 2009).
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