by Jerry O’Driscoll*
The U.S. economy has been growing slowly but steadily since the trough of the Great Recession in June 2009. Deep recessions are typically followed sharp recoveries. Not so this time.
More recently, there is the mystery of low inflation. The Fed’s preferred inflation measure, the core PCE index, has consistently fallen short of its target rate of 2 percent. In July 2017, it came in at a 1.41-percent annual rate. For the Fed, improved growth in employment and the falling unemployment rate should foreshadow a higher inflation rate. The rationale for this is the old Phillips Curve. The reality is that the model is flawed.[1]
There is still the expansion of the Fed’s balance sheet and its creation of a huge stockpile of excess reserves. For years, monetary economists expected those reserves to translate into money creation through bank lending and deposit creation. That would eventually result in a higher inflation rate. That has not happened, a conundrum that has generated a considerable literature.
George Selgin has written several pieces on the topic, most recently his Congressional testimony.[2] In his testimony, Selgin recounts how the Fed began paying interest on bank reserves (both required and excess). Other things equal, that would incentivize banks to hold additional reserves over and above what they would otherwise do. In Selgin’s words, paying IOR was intended to get banks “to hoard reserves.” The move was “an anti-stimulus measure.” Presumably, the Fed did this to keep its expansion of the balance sheet from generating inflation.
The two policies (balance-sheet expansion and IOR) jointly diverted savings from commercial banks to central banks, and thus from more productive to less productive uses. The two policies were a form of financial repression. In Selgin’s words:
The Fed’s current operating system, with its above-market interest rate on reserves and bloated balance-sheet, is very financially repressive. That is one reason for the continuing post-crisis ‘productivity slowdown.’ Yet the same system, far from at least improving basic monetary control, has prevented the Fed for 5 years running from meeting the 2% inflation target it set in 2012.
To summarize Selgin’s argument, first, the expansion of the Fed’s balance sheet and the payment of interest on reserves redirected credit toward favored groups (the Treasury and the housing industry) and away from other sectors. It substituted government allocation of credit for market allocation. Second, it contributed to the post-crisis productivity slowdown. And, third, it is the cause of low inflation.
I will examine the arguments in seriatim.
Selgin is surely correct about the first issue. Along with others, I have made the same argument myself.[3]
Selgin would be hard-pressed to defend his second contention. First and foremost, the slowdown in productivity growth predates the economic crisis and recovery. One study dates the slowdown beginning at the end of 2004. Second, the slowdown has occurred in dozens of advanced economies and is a general phenomenon.[4]
Additionally, macroeconomic factors affecting productivity are such things as the size of government and inflation. A recent study finds that both macro factors are negatively related to productivity growth. So, to the extent the Fed kept the lid on inflation, it contributed positively to productivity growth.[5] Thus, there is no apparent linkage between post-2008 monetary policy and an earlier slowdown in productivity growth.
On the issue of low inflation, I don’t know how to read Selgin’s testimony. The Fed has continually missed its inflation target on the low side. Is that a good or bad thing? One can only answer that in terms of an economic model. Lee Hoskins, former president of the Cleveland Fed, has long argued that zero inflation should mean just that: zero inflation with deviations above and below that rate occurring equally often. Selgin has defended productivity-driven deflation in the past.[6] So, maybe zero is too high. Again, the question can be answered only with an economic model.
I now look at the stance of monetary policy in more detail. Has monetary policy been too loose, too tight or about right? Measured by interest rates, monetary policy looks pretty loose. Nominal interest rates have been very low, near zero for a long time, while inflation rates have been low but positive. So, real interest rates have been very low or even negative.
Judged by the growth rate of money, the answer is more complicated. Money growth, as measured by the growth rate of the M2 money supply, has been normal in this economic recovery. There is no obvious break from the trend rate of growth of money in the past. (Similar stories can be told for narrower and broader measures of money.) Whether because of, or despite unorthodox monetary policy, the supply of money has been expanding much as it has in the past. So, measured by the growth rate of M2, monetary policy has not been obviously tight.[7] It is not the source of low inflation.
What has not behaved normally, however, is velocity. M2 has fallen to a record low level. And it has fallen very sharply from its peak in the 1990s.
If there is a monetary story in the current recovery, it is on the demand side. Movements in velocity, rather than in the supply of money, seemed to have financed the hi-tech boom. Velocity began its decline before the dotcom bust. After a recovery in the 2000s, it began a decline before the economic crisis. I associate the movements in velocity with the rise and fall of shadow banking. But establishing that would require a separate study.[8] For now, call it velocity’s dance.[9]
I would suggest the rise in money demand, and concomitant fall in velocity, reflect a flight to liquidity by the public. The accumulation of reserves by banks reflects a similar scramble for liquidity. IOR influenced how banks satisfied their demand for liquidity but did not create the demand.[10] Banks and the nonbank public both scrambled for liquidity in the wake of the financial crisis. And the demand has not abated in the recovery and expansion.
Credit for business has not been crimped. Measures of credit growth seem normal when compared to past recoveries, For instance, after a slow start (and initial decline), commercial and industrial loans have grown as in past recoveries.
If the Fed can be faulted, it is for not factoring in the large swings in velocity over the last three decades. For a class of models, comprising monetarist, Austrian, and Keynesian approaches, stabilizing MV (level or growth rate) is a central bank’s responsibility. It would have been no easy task to offset the rise of shadow banking in the 1990s. It would likely have required not just an activist monetary policy, but also regulatory intervention. The tenor of the times went in the opposite direction, however. The Greenspan Fed was for light regulation, and legislation (Gramm-Bliley-Leach) was designed to regularize shadow banking. These actions may have been justified from a regulatory perspective, but they had unintended monetary consequences.
As to the current recovery and expansion, different approaches provide different answers to whether monetary policy was expansionary, contractionary or just right. That reflects an unsettled state of monetary theory.
Monetary economists should also take note of arguments advanced by Jerry Jordan and others that, under the new operating procedures, the Fed cannot influence aggregate economic activity. That is a more fundamental and long-run issue.[11]
Finally, what can we say of the weak economic expansion in the post-crisis era? I suspect that monetary theory cannot explain it, certainly not entirely. That suggests a role for a different explanation, possibly a microeconomic one.
I thank Kevin Dowd and Jeff Hummel for their helpful comments on an earlier draft.
[1] James Bullard, “Does Low Unemployment Signal a Meaningful Rise in Inflation?” Economy Blog, Federal Reserve Bank of St. Louis, August 29, 2017.
[2] Reproduced in “Our Unhinged Fed,” Alt-M, July 25, 2017.
[3] I did so most recently in “Rethinking Central Banking,” Cato Journal 37 (Spring/Summer 2017): 294-95.
[4] For data, I rely on Tyler Cowen, “Silicon Valley Has Not Saved Us From a Productivity Slowdown.” The New York Times, March 4, 2016. https://nyti.ms/1QRTW3A. Accessed 9/7/2017. Cowen, in turn, relied on Chad Syverson, “Challenges to Mismeasurement Explanations for the U.S. Productivity Slowdown.” NBER Working Paper No. 21974 (February 2016). There was an earlier slowdown in the 1970s and then a pickup in the 1990s with the hi-tech boom. https://www.wsj.com/articles/the-great-productivity-slowdown-1493939350
[5] Boileau Loko and Mame Astou Diouf, “Revisiting the Determinants of Productivity Growth: What is New?” IMF Working Paper WP/09/225.
[6] George Selgin, “Less than Zero.” (London: Institute of Economic Affairs, April 1, 1997.
[7] This implies the M2 money multiplier has fallen. Indeed, I would describe it as a collapse.
[8] A beginning is Gary Gorton, Slapped by the Invisible Hand: The Panic of 2007. (Oxford: Oxford University Press, 2010).
[9] Jeff Hummel reminded me that M1 velocity has fallen even more sharply than M2 velocity.
[10] It is an issue of demand for versus the quantity demanded of reserves.
[11] J. L. Jordan, “A Century of Central Banking: What Have We Learned?” Cato Journal 34(Spring/Summer 2014): 213-27; and Jordan, “The New Monetary Framework.” Cato Journal 36 (Spring/Summer 2016): 367-83.
*Jerry O’Driscoll is a Senior Fellow at the Cato Institute.
ThinkMarkets 
Several points in reply, Jerry.
First, as you note, I said that the Fed’s enlarged intermediation footprint “contributed” to the productivity slowdown. I never claimed that other factors were unimportant, or even that they were not substantial more important, than the one I happened to discuss, not in an attempt to explain the productivity slowdown but as part of a critique of the Fed’s current policy. (The context after all was a hearing on monetary and fiscal policy.) The suggestion that I may be unaware of other factors in the productivity slowdown is unwarranted. In fact I’m well aware of them.
Nor do I feel the least bit “hard pressed” to defend the argument that the Fed’s new regimes has “contributed” to slower productivity. That argument is supported by a substantial literature on financial development and financial “repression.” Although i don’t refer to that literature in my 5-minute spoken Congressional testimony, I do refer to it in my _22,000 word_ written testimony. Sometimes in compressing things to fit a 5 minute spoken limit, one leaves out certain arguments. I wish for that reason that you had referred to the full testimony, rather than to the quick spoken summary. Both are available on the same Congressional site and linked to my Alt-M post. Here is the link again to the full testimony: https://financialservices.house.gov/…/hhrg-115-ba19-wstate-gselgin-20170720.pdf
Second, regarding my position on inflation: as you are familiar with my views on optimal inflation, it should not require that much effort to understand me, not as banging the drum for 2 percent inflation, as opposed to something lower (or to some form of NGDP target, which I have consistently favored), but as wishing to draw attention to evidence that the Fed’s monetary control mechanism has gone awry. That, too, is part of my complaint against the Fed’s IOER-based control regime. I think this is also clear enough from my 5 minute testimony. It should be perfectly so from the full-length version
That brings me to the last point, which concerns your observation that “Monetary economists should also take note of arguments advanced by Jerry Jordan and others that, under the new operating procedures, the Fed cannot influence aggregate economic activity. That is a more fundamental and long-run issue.” With all due respect, Jerry, that is the very point of my testimony, both written and spoken; it is, moreover, the reason for my drawing attention too the fed’s now notorious, persistent undershooting of its own inflation target.I take that failure to be important evidence that the Fed can no longer “influence aggregate economic activity” as it used to. It is good evidence because it refers to the Fed’s self-proclaimed target. What better evidence have you, or Jerry Jordan, to offer? And if none, what sense is there in faulting me for pointing to evidence that less proof of the very problem you consider most “fundamental,” and why go out of your way to overlook the possibility that I am concerned about nothing other than that very problem?
In short, a modicum of charitable reading of my brief testimony, not to mention a little time spent reading the full-length version, should have sufficed to convince you that your disagreements with my arguments are phantoms of your own invention. If I am really saying anything different than what Jerry Jordan has said, it is only by virtue of supplying more specific details about the underlying causes of the fed’s loss of monetary control.
George, I extended two professional courtesies to you in my post. First, I cited your work when I could easily have cited work by others on the same point. Second, I quoted you verbatim on the key points on which I intended to comment.
When you give Congressional testimony, it must be clear and to the point. That is the written record to which people will refer. On the Fed’s control of inflation, you were not clear. Each time you’ve been challenged on the point, you have provided a different account of what you meant. The idea that criticism is unfair if people do not refer to your 22,000-word attachment is absurd. The world doesn’t work that way. You wrote what you wrote and it didn’t suffice.
Causes typically proceed effects. If the productivity slowdown began before the financial crisis, I don’t see how the Fed’s post-crisis policy can be held accountable. It’s not that there are “other factors,” but it is questionable whether post-crisis Fed policy is a factor. if Fed policy had an impact, it was positive (via low inflation). I now doubt, however, that the Fed is responsible for low inflation.
Why did I cite Jerry Jordan and not you? First, he has intellectual priority on the Fed’s loss of control. He was ahead of all of us. Second, he is clear exactly where you are not.
Elsewhere you ask why you have had so much pushback on your work on IOR (interest on reserves). I am reminded of a story an American bishop told me about Pope John Paul II. A group of American bishops were meeting with John Paul. His English was limited and one bishop used the word “fanatic.” He did not understand its meaning at first. After several minutes of explanation, the Pope responded that he understood. “A fanatic is someone who sees a piece of pie and thinks it is the whole pie.”
Jerry
[…] More recently, there is the mystery of low inflation. The Fed’s preferred inflation measure, the core PCE index, has consistently fallen short of its target rate of 2 percent. In July 2017, it came in at a 1.41-percent annual rate. For the Fed, improved growth in employment and the falling unemployment rate should foreshadow a higher inflation rate. The rationale for this is the old Phillips Curve. The reality is that the model is flawed.[1] […]
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