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Fed policy: The Golden Age begins

Summary:
Michael Rulle directed me to a WSJ article by Greg Ip on the decline in central bank effectiveness: The Era of Fed Power Is Over. Prepare for a More Perilous Road Ahead. The Federal Reserve and other central banks have long been the unchallenged drivers of financial markets and the business cycle. “Don’t fight the Fed,” goes one Wall Street adage. That era is drawing to a close. In many countries, interest rates are so low, even negative, that central banks can’t lower them further. Tepid economic growth and low inflation mean they can’t raise rates, either. Since World War II, every recovery was ushered in with lower rates as the Fed moved to stimulate growth. Every recession was preceded by higher interest rates as the Fed sought to contain inflation. But with interest

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Michael Rulle directed me to a WSJ article by Greg Ip on the decline in central bank effectiveness:

The Era of Fed Power Is Over. Prepare for a More Perilous Road Ahead.

The Federal Reserve and other central banks have long been the unchallenged drivers of financial markets and the business cycle. “Don’t fight the Fed,” goes one Wall Street adage.

That era is drawing to a close. In many countries, interest rates are so low, even negative, that central banks can’t lower them further. Tepid economic growth and low inflation mean they can’t raise rates, either.

Since World War II, every recovery was ushered in with lower rates as the Fed moved to stimulate growth. Every recession was preceded by higher interest rates as the Fed sought to contain inflation.

But with interest rates now stuck around zero, central banks are left without their principal lever over the business cycle.. .

It’s not just the WSJ, you see this sort of thing all over the place.  Bloomberg reports that Larry Summers is making the same sort of claim:

Summers Calls Bernanke Speech ‘Last Hurrah’ for Central Bankers

Fortunately, this pessimism is 100% wrong. We are entering a golden age of central banking, where the Fed will become more effective and come closer to hitting its targets than at any other time in history. Over the next few decades, inflation will stay close to 2% and the unemployment rate will generally be relatively low and stable. And this certainly won’t be due to fiscal policy, which is currently the most recklessly pro-cyclical in American history.

The conventional wisdom on monetary policy has been pretty consistently wrong, mostly because of the widespread tendency to conflate “monetary policy” with “interest rate path”. At the time, most people incorrectly thought money was not too tight in the 1930s, and not too easy in the 1970s, and not too tight in 2008-09. Today they look at low interest rates and wrongly conclude that the Fed is nearly out of ammo. Ignore the conventional wisdom.

In fact, Fed policy is becoming more effective because it is edging gradually in a market monetarist direction, with more focus on:

1. NGDP growth

2. Level targeting

3. Market forecasts of aggregate demand growth

If they continue moving in this direction, then NGDP growth will continue to become more stable, the business cycle will continue to moderate, inflation will stay in the low single digits, and unemployment will stay relatively low and stable.

It won’t be perfect; the business cycle is not quite dead. There will be an occasional recession. But the business cycle is definitely on life support.

We had 4 recessions during 1920-30, 4 recessions during 1949-60, and 4 recessions during 1970-82. My younger readers will never experience that sort of actual “business cycle”, with one recession right after another.

As an analogy, when I was young I would frequently read about airliners crashing in the US. One crashed a few miles from my apartment during the late 1970s. My daughter is a junior in college and doesn’t recall a single major airline crash in the US, excluding a couple of small commuter planes in the 2000s (she was only 2 during 2001). After each crash, problems were fixed and planes got a bit safer.

Recessions and airline crashes: They are getting less frequent, and for the exact same reason.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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