An intriguing research note from Goldman's Global Economics team tonight brought up the subject of 'unconventional' unconventional policies and how they ended the 'first' Great Depression. This gentle push towards softening the inflation leg of the Fed's mandate 'stool', while interesting in its own right given Goldman's policy-leading record, reminded us, by contrast, of a paper discussing how deflation is perhaps the more likely outcome when one shifts perspective from Keynesianism to a more Austrian view of the Fed's options. We are not choosing sides but for a quiet evening following a hope-shattering sell-off in risk assets, we thought it worth reflection.
Goldman Sachs: "Unconventional" Unconventional Policies and the End of the Great Depression
- We argued in last Friday's US Economics Analyst that the Fed retains a number of "unconventional" unconventional options that would entail pushing inflation above the Fed’s "mandate consistent" rate for a number of years through a temporary change in the Fed’s inflation goal.
- In an interesting paper, Gauti Eggertsson of the New York Fed argues that Franklin D. Roosevelt’s successful implementation of such policy actions in the 1930s – adopting a price level target and combining it with fiscal stimulus – shifted expectations and thereby played a key role in lifting the economy out of deflation and depression.
Eggertsson's analysis holds two potential lessons for US policymakers in the current context: (1) credible commitment to raising inflation expectations could deliver a powerful boost to the economy, and an effective way to enhance the credibility would be to pair such a policy change with additional fiscal stimulus; (2) commitment to raise inflation to boost the economy is most desirable – and thus most likely – during times when the economy is weak and inflation is below the Fed's target.
- In Friday’s US Economics Analyst, we explored the Fed’s options for delivering additional monetary stimulus. (See "The Fed’s "Unconventional" Unconventional Options," US Economics Analyst, September 23, 2011.) We believe the Fed is most likely to make further use of the "conventional" unconventional monetary policies already pursued through renewed asset purchases. But the Fed also retains a set of "unconventional" unconventional options that would entail pushing inflation above the Fed’s "mandate consistent" rate for a number of years through a temporary change in the Fed’s inflation goal. Doing so could boost the economy by pushing down real interest rates and by inflating away some private sector debt. Proposals to do so include a higher inflation target, the "Evans proposal," and a price/nominal GDP level target.
Our simulations of a "toy economy" suggest that the boost to the economy from such policies could be sizable if the Fed managed to commit credibly to their implementation. But this would require a delicate balancing act. In the short term, the Fed would need to “commit to being irresponsible.” That is, the real interest rate would only fall if the Fed managed to commit credibly to generating higher inflation in the future. But promising to do so is difficult because the Fed cannot cut the funds rate any further to boost the economy and, once inflation has risen—and real rates fallen to stimulate the economy—the Fed has an incentive to renege on its promise and raise interest rates prematurely. Markets understand this and no short-term benefits might be achieved. In the long run, the Fed would need to return to its usual "responsible" behavior and keep inflation in the "mandate-consistent" range. Although the Fed would again have the funds rate at its disposal to do so, the concern is that a temporary change in the Fed’s inflation goals could lead to a persistent increase in inflation expectations and that a return to price stability would require a prolonged period of tight monetary policy and subdued growth in the future.
In an interesting paper, Gauti Eggertsson of the New York Fed argues that Franklin D. Roosevelt’s successful implementation of such “unconventional” unconventional policies was a key factor in ending the Great Depression. (See “Great Expectations and the End of the Great Depression,” American Economic Review, 98:4, 2008.)
President Roosevelt took office in March 1933 at the height of the Great Depression: real GDP had declined by 13.4% in 1932—pushing the unemployment rate up to 25%—and deflation was running at double-digit levels (see exhibit below). Conventional monetary policy, however, was powerless as short-term nominal interest rates were stuck near zero (see exhibit). With negative inflation rates, real short-term interest rates—both ex-post and ex-ante—were therefore sharply positive, acting as a further drag on activity. (The ex-ante measure of the real interest rate is taken from a paper by Stephen Cecchetti, who estimates inflation expectations from available data on prices, interest rates and money growth. For details see “Prices During the Great Depression: Was the Deflation of 1930-32 Really Unanticipated?” American Economic Review, 82:1, 1992).
The Economy Climbed Out of Depression after 1933, As Real Interest Rates Declined Sharply
In this environment, President Roosevelt implemented two radical new policies. First, he abolished the gold standard in 1933—giving the administration unlimited power to print money—and announced the objective of inflating the price level to pre-Depression levels. That is, he adopted a price-level target that was designed to raise inflation for a number of years. Second, Eggertsson argues that President Roosevelt abandoned prior balanced budget principles and sharply expanded federal spending by running record-high budget deficits. Between 1932 and 1934, federal consumption and investment spending almost doubled.
Eggertsson shows that this policy regime change was key in breaking out of the Great Depression by affecting expectations about future policy: the adoption of price level targeting was a commitment to raise inflation and fiscal stimulus made this commitment credible. That is, the cooperation of monetary and fiscal policies shifted expectations from “contractionary” (the private sector expected future economic contraction and deflation) to "expansionary" (the private sector expected future expansion and inflation). Although short-term nominal interest rates continued to be stuck at zero, inflation expectations rose and real interest rates declined sharply after 1933 (see exhibit above). At the same time, the economy received a boost and the economy climbed out of deflation (see exhibit).
We can draw two potential lessons from Eggertsson's analysis for US policymakers in the current context. First, credible commitment to raising inflation expectations could deliver a powerful boost to the economy and the best way to enhance the credibility of any such commitment would be to pair a temporary change in the Fed's inflation goal with additional stimulus. Fiscal stimulus would probably be the most effective option but, if unavailable, the Fed could combine any promise to boost inflation with additional balance sheet expansion. Second, a commitment to raise inflation to boost the economy is most desirable during times when the economy is weak and inflation is below the Fed's target (as was the case when President Roosevelt took office). Otherwise, the Fed would need to trade off the costs of above-target inflation with more growth. The likelihood that the Fed would adopt an "unconventional" unconventional policy would thus rise sharply should deflationary concerns re-emerge going forward.
Which contracts interestingly with the insights of the following article, particularly the author's perspective on the Fed's raison d'etre (for the benefit of the banking class) versus its capability to print, advocating a slow-and-steady 'controlled deflation':