Earlier, circa 2007, the Fed decided the three mandates in the Federal Reserve Act were just too much to handle, and that it should only be concerned about price stability and inflation. The other two mandates, if it was dedicated to the first two priorities it had set, would be naturally fulfilled. Together with that, it decided that the appropriate inflation rate to shoot for was 2%.
So, along comes a recession in 2008 and an opportunity to let the inflation rate for the given price level, which I’ll call price level A, fall from 4% to 2% to become consistent with the new inflation target. But, while it was allowing inflation to fall, a few things happened that complicated matters – a MBS market collapse (cash substitutes, therefore loss of base money) and a financial crisis, during which, market participants where looking to the Fed to shore up the economy, not let inflation fall too far, as it had in response to other recessions and received no assurance and no action. In the process, inflation expectations fell by 8%, which caused the price level to fall to level B.
Now, arriving at price level B is obviously already a disaster for the price stability mandate. In allowing the price level to fall, rather than just squeezing 2% inflation out, we get into all kinds of problems like sticky prices (which includes wages), unemployment becomes elevated and employment levels are reduced and remain that way until wages fall to equilibrium. In addition, prices, when they fall tend to fall too much and need to stabilize at a new equilibrium, price level C, which would be somewhere between A and B. Price level B is merely a transitory level, or so we would think.
What should have happened almost as soon as it was apparent that inflation was falling too far too fast, and would therefore quite undershoot the 2% target, was to attempt to shore up expectations to prevent the price level from being impacted too much, thus price level B would not have been quite as dramatic a change. But that did not happen. The next step would have been to bring the price level back up as far as possible with very strong statements followed up with action to keep sticky prices from doing too much damage to the broader economy. But that did not happen either. Instead of mitigation efforts, what we got was satisfaction with price level B with the 2% inflation target applied to it, turning a manageable disaster into a complete unmitigated disaster for financial solvency, employment markets and the Federal budget. And here is where the problem, this appalling state of economic affairs, comes from.
The Federal Reserve Act set three mandates that spell out expected economic conditions that are to be achieved and maintained. One of them is price stability, which had already failed, but it cannot be interpreted correctly without taking the other two, promoting full employment and moderate interest rates into account. What they all mean together is maintenance of full utilization of resources, not an undue obsession with squeezing every last bit of inflation from the system. The price stability piece comes in because when we have full utilization of resources, monetary stimulus does create unnecessary inflation and causes prices to rise with no or very fleeting benefit; but if we let the price level fall too much we get underutilization, high unemployment and other noxious effects that we want to avoid. The full employment mandate means that the Fed is expected to not accept an output gap, falling prices and interest rates as a result, and monetary stimulus should be applied. Moderate interest rates imply a positive level of inflation is expected to be maintained and we should not get into the situation of being like Japan after we’ve failed at accomplishing everything else, stuck at the zero bound with nowhere else to go.
When the Fed takes a price level that is at a rather deranged level from a demand shock and arranges the monetary targets around it, it is forcing the price level even lower than it would otherwise be if allowed to reach equilibrium. In other words, the Fed is not only applying a price stability mandate, it is dictating price level B, instead of allowing price level C, which of course is a very different thing, and produces much different results than the totality of the Fed mandates mean.
The economy will adjust to the imposition of price level B at some point in time, but we will have an extended period of economic gyration in the process that could take years to complete; it would be much shorter if price level C were allowed to be achieved, and even shorter if fostered. It’s like the difference between having surgery with anesthesia and going it hardcore without with no difference in outcome. You might think lower prices are better for you, but it also means you get paid less, and the only advantage there might be, if you are not among the unfortunate people who lose a job and everything else you’ve worked for, is while wages are adjusting. I am left with a certain amount of wonder at why we would endure the pain of doing this with elevated unemployment and employment market dysfunction, bankruptcies, and the high cost of safety net programs with record numbers of people in them for no real benefit, or what the Fed thinks it is doing deviating from the law and making these kinds of choices for the country as a whole. I really do not see anywhere in the law that provides that kind of authority.
So much time has gone by that the benefit of doing anything about the problem now is greatly diminished. We can’t unspill the milk. I think more monetary stimulus that is conditions-based is still necessary, however, because we still have a large output gap and the Taylor Rule is indicating that a Federal Funds rate of between negative 6 and negative 4 percent is required to stabilize the economy – zero is still too high. We need to close the output gap and bring interest rates positive again, and the only way to do that and be in compliance with the Federal Reserve Act in an expedited way is to do QE. When I talk about expeditiously complying with the law, I am talking somewhere in the area of a year or so. If we leave the current condition as is, we are likely to lose an entire decade or more of productivity that I am not sure, with the condition of government finances, we can afford to lose; and I don’t think our kids will be better off if we did.
And speaking of being better off, I feel it necessary to address the inflation question as it relates to QE. It is true that in normal times, when there is no output gap, if the Fed attempted to boost employment with monetary stimulus, the effect would be to create inflation and almost nothing else by creating more demand for products than the economy can produce. But that is not true when economic resources are underutilized. It is at that point in which full utilization is achieved that inflationary pressures pick up. The change in prices that we might see in some things and not others is due to depressed demand levels for those products coming back into normalcy, prices reaching equilibrium with the other factors in the economy. QE would stabilize equilibrium at price level C instead of forcing price level B, which in the end, you are not better off at one level or the other in real terms after price equilibrium is reached. The only real difference in the two levels is one of them hurts a lot getting to, leaving many financially devastated, and the other, not so much.