The Federal Reserve is Tapering Again. Did They Get it Right This Time?
The Fed is on its Way to Ending its Quantitative Easing Program Again. But are They Repeating the Mistakes of the 2010s?
The views expressed in this blog are entirely my own and do not necessarily represent the views of the Bureau of Labor Statistics or the United States Government.
In 2013 Federal Reserve Chair Ben Bernanke caused a sharp tightening of financial conditions when he suggested that the Federal Reserve would begin “tapering” it’s Quantitative Easing (QE) program. In 2015 the prospect of higher future interest rates contributed to a mini-recession concentrated in manufacturing and business investment. In 2019 the Federal Reserve was forced to undo a series of misguided rate hikes after economic conditions began worsening.
In the wake of the 2008 recession, the Federal Reserve has often moved too hastily in tightening monetary policy. This is the essence of the asymmetric response function—the Federal Reserve’s tendency to respond more forcefully to increases in inflation than to decreases in output and employment. This proclivity for tight monetary policy has had disastrous consequences for American workers and the US economy.
Today, talk of tightening monetary policy has again returned to the Federal Reserve. “It is time to taper, we think, because the economy has achieved substantial further progress toward our goals,” said Federal Reserve Chair Jerome Powell on Wednesday. Is this time different, or is the Federal Reserve again making a mistake by retracting monetary stimulus too early?
Income, Interest, and Output
First of all, it is worth understanding what “tapering” QE means and how it affects monetary policy. Essentially, through QE the Federal Reserve buys long term government debt from financial institutions with newly created bank reserves, which themselves are functionally a type of short term government debt. This can create bank deposits, but the primary effect is a lowering of long term interest rates through lower expected future short term interest rates. Through QE the Federal Reserve is putting up a credible commitment that rates will be “lower for longer.”
What is going on now? The Federal Reserve is “tapering” by slowing the pace of its QE program and planning to cease bond-buying completely by the summer. They are signaling that future short term interest rates rates will be higher, and therefore driving up long term interest rates. Of course, market participants already expected this move, so there was no major visible shift in bond yields alongside the announcement (markets actually reacted slightly positively because the risk of an extreme hawkish tilt was ruled out). Nevertheless, tapering represents a clear tightening of monetary policy under the Federal Reserve’s current policy regime. So the question remains, is it premature?
To answer that we must first look at growth in Nominal Gross Domestic Product (NGDP), which measures the total monetary value of all the finished goods and services produced in the economy. It has recently climbed back to its pre-pandemic trend after the pandemic caused it to drop significantly in early 2020. This is in stark contrast to the 2008 recession, after which NGDP never returned to its pre-recession trend.
Restoring NGDP to trend is critical to effective monetary policy as contracts are signed, salaries are set, debt is borrowed, and investments are made on the basis of expectations of nominal income. When nominal incomes unexpectedly decline businesses struggle to make debt payments, workers struggle to pay rent, and employers are forced to lay people off. Through the short term non-neutrality of monetary policy, the real economy suffers due solely to changeable monetary policy decisions. Keeping NGDP on target, however, ensures that monetary policy will guide the economy back to full employment.
More important than NGDP, however, is nominal Gross Labor Income (GLI). Where NGDP measures all sources of expenditure and income, GLI focuses in on the nominal value of all workers’ compensation. GLI is a generally superior measure of economic output as it focuses on worker income, a simpler and clearer empirical measurement, and ignores variations in capital income, which are subject to more statistical noise and significant long term structural changes.
The official measurement of GLI, which comes from the Bureau of Economic Analysis, shows that it has recently returned to trend. An additional crude index constructed by multiplying data from the Bureau of Labor Statistics on nonfarm employment (NFP), average private sector wages, and average weekly hours similarly shows GLI returning to trend. However, these data series can be subject to significant revisions and compositional issues, especially given the pandemic’s disruption of the labor market. Using the employment cost index (ECI) for private sector workers alongside the prime age employment-population ratio allows us to track GLI in real time without revisions, and this measure shows that there is still work to go before GLI returns to the pre-pandemic trend.
What explains this gap between NGDP and GLI? In short, government transfer payments (primarily stimulus checks and unemployment insurance) increased personal income above-trend, which has pulled personal outlays back to trend. An increase in federal deficit spending allowed Americans to spend more, in aggregate, than they were earning in non-transfer income and even enabled them to sock away significant “excess savings.” Since personal outlays feed directly into NGDP through Personal Consumption Expenditures, this deficit spending allowed NGDP to return to trend.
In normal times, Federal Reserve policy should bring NGDP above trend in order to compensate for periods spent below trend. It would not enough to tell a worker who would have normally have earned $50,000 but lost $15,000 due to a drop in NGDP that they will earn an on-trend $52,000 next year. Ensuring that nominal income expectations are validated is critical to the success of monetary policy.
However, the pandemic is a unique case. COVID-19 completely disrupted the normal link between consumer spending and income. The aggregate personal savings rate climbed to a record 33.8% in April 2020 as consumers cancelled plans and hoarded cash to try and protect themselves financially. In aggregate, personal income has already overshot expectations, it is only pandemic-driven spending constraints that have held expenditures, and therefore NGDP, back until recently.
In short, while there is still progress to be made in the the labor market, aggregate nominal output and income remains generally on trend. This would appear to justify the slight tightening of monetary policy that tapering represents. However, monetary policymakers have to be forward-looking, not backward-looking. It’s great that we remain close to the pre-pandemic nominal trend now, but but the Federal Reserve should be making decisions based primarily on current and future risks to the economy.
The Real Economic Risks
To that point, the main risk to the economy remains that nominal income and output will be too low, not too high. The federal deficit has been decreasing as pandemic emergency provisions from the CARES Act and American Rescue Plan expire, and the labor market remains well below full-employment. Though the Federal Reserve has unlimited authority to set long run NGDP, it has chosen not to allow interest rates below 0% for financial stability reasons—even marginally raising interest rates at certain facilities in order to keep short term rates from going negative. Since the Federal Reserve self imposes limits on the size of its monetary policy stimulus, it falls to the federal government and fiscal policy to pick up the slack.
As the graph above shows, the federal deficit has decreased significantly from its pandemic highs, although it still remains significantly elevated. The infrastructure bill and other federal legislation currently under negotiation will be less deficit-financed than previous pandemic stimulus bills, so it will likely have a more limited effect on nominal output whatever its effects on real output are. Alongside below-trend GLI, this reduction in federal deficit spending leaves the US at significant risk of being stuck with 0% interest rates for a long period of time.
The primary risks of too much monetary stimulus is, unsurprisingly, inflation. However, the risks of significant sustained inflation are low without significant above-trend aggregate nominal income. Some economists who are worried about excessive inflation have warned about a wage-price spiral where rising wages force companies to increase prices in a vicious cycle. However, the current evidence contradicts this: the abnormal price increases are concentrated in the goods sector while wage increases are concentrated in the service sector.
This should be unsurprising given the disproportionate spending on goods by American consumers and unprecedented supply chain disruptions, both of which are caused by the pandemic. As the pandemic abates we should expect consumer spending to rebalance, supply chains to renormalize, and inflation to subside.
More than that, inflation simply shouldn’t be centered in monetary policy decision-making to the degree that it currently is. Since long run inflation cannot occur without long run increases in nominal income, stabilizing income should be the primary concern of policymakers. In addition, accurately aggregating price data in order to construct an inflation index is extremely difficult and has not been made any easier by the pandemic. Elevated short run inflation expectations reflect high commodity prices more than almost any other variable. That is not to say that monetary policy shouldn’t be concerned with inflation, as there are significant economic and political costs of high inflation, just that a nominal income target will regulate inflation while better encouraging full employment and output.
So, circling all the way back, is it time to taper? In short, tightening is still slightly premature. The risks to nominal output are significant, especially considering the progress needed in the labor market, declining fiscal stimulus, and risk of monetary policy getting stuck at 0% interest rates. That last point is crucial—escaping the so-called “liquidity trap” caused when a central bank is unwilling to lower interest rates below 0% requires monetary policymakers to “credibly promise to be irresponsible”. Essentially, in order to escape the liquidity trap the Federal Reserve must work to keep expected future short term interest rates as low as possible until nominal output is high enough to ensure a safe escape from 0% interest rates.
Still, today’s tightening is nothing near the policy mistakes of years past. When Ben Bernanke caused the taper tantrum of 2013 the unemployment rate sat at nearly 7%. The first interest rate hike occurred in 2016, when the prime age employment-population ratio was 77.5%. Today the Federal Reserve is just starting to taper and the unemployment rate sits at 4.6% while the prime age employment-population ratio was 78.3%. Jerome Powell and the other members of the FOMC are committed to full employment in a way they have not been in decades, and while more should be demanded from them it is worth appreciating the tremendous policy improvements that have already been achieved.
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