BEN BERNANKE JUNE 25, 2013
The Federal Reserve appears eager to begin “tapering,” that is, reducing the monthly bond purchases it is making to support the economic expansion. Based on FOMC projections and Chairman Ben Bernanke’s comments, the Federal Reserve expects to start tapering later this year and to end asset purchases by the middle of 2014. Though the economy is improving, this discussion is premature. The Fed should signal that it is not about to tighten money—and won’t until total dollar spending has moved closer to its pre-crisis trend.
The impulse to taper is based partly on the surprising resiliency of the U.S. economy. It has fared much better than many observers expected in 2013 given the rise in taxes and the fall in federal spending. Consequently, Fed officials believe they will soon be able to scale back the bond purchases. The temptation to taper, however, is also based on the widespread but incorrect perception that the Fed has been running an extremely loose monetary policy. That perception is based on the facts that since the economic crisis hit in 2008, interest rates have been low and the Fed balance sheet has been expanding rapidly.
Yet neither fact indicates loose money. As Milton Friedman explained, low interest rates can be a sign that money is tight—that it is throttling the economy—rather than loose. And it is a mistake to judge policy by looking at the money supply without also looking at the demand for money balances. Since the crisis began people have put a premium on the safety of cash and near-equivalents. Although the Fed has expanded its balance sheet, it has not fully accommodated this demand for money. Hence total dollar spending remains depressed.
A better indicator, then, of whether monetary policy is loose or tight is what’s happening to nominal spending: the total amount of dollar spending in the economy. When the growth of that figure accelerates, monetary policy is getting looser; when growth decelerates, it’s getting tighter. When growth holds steady, which is what the Fed should aim for, monetary policy is in neutral.
For several decades leading up to the crash, nominal spending and the total dollar income earned from it grew at roughly 5 percent a year. This steady growth got baked into households and firms’ economic plans. Many households, for example, took out long-term mortgages with the expectation that dollar incomes would, on average, keep expanding at the accustomed rate. The financial crisis, coupled with ill-advised tightening moves by the Fed in 2008, instead caused nominal income and nominal spending to plummet at the fastest rate since the Great Depression. The result was turmoil in credit and labor markets. Debt burdens, for example, suddenly became much heavier than people had expected.
The Fed’s rounds of quantitative expansion arrested the decline in nominal spending and is the reason the U.S. economy has been so resilient in 2013. But the economy is still growing at a slower rate than it was before the crisis. Nominal spending has averaged just under 4 percent growth since the end of the recession in 2009 and none of the lost ground from the crisis period has been made up. Based on pre-crisis trends, the level of nominal spending and total dollar income is about 10 percent below where it should be. Relative to the dollar size of the economy people expected, then, the Fed has been giving us tight money, not loose. Tapering now would make tight money tighter. That is why markets have reacted so negatively to news that the Fed is moving in that direction.
A better policy would be for the Fed to announce that it is explicitly seeking to stabilize the long-run path of nominal spending. It should aim for growth of 5 percent a year, explain that if it undershoots that pace one year it will overshoot it the next to stay on track. For the next few years, that means it ought to overshoot.
How much the Fed buys (or sells) each month should be based on those targets. The more credible the targets are, the less the Fed will have to do. Higher expected nominal income growth in the next few years should translate into a lower demand to hold cash today, and as money circulates at a faster pace the Fed will need to make fewer purchases to keep on its chosen track. The best way to taper, in other words, is not to set a date for tapering or even to hint at one. It’s to subordinate the Fed’s purchasing decisions to a target path for nominal spending.
But if the Fed does not accept the case for targeting nominal spending, there is also a simpler argument against tighter money. The Fed is bound by law to keep both inflation and unemployment low. Since the end of the recession, inflation has on average been below its target inflation rate of 2 percent a year. The best estimate of inflation expectations we have, that calculated by the Cleveland Fed, has it running at a mere 1.4 percent per year over the next decade. Unemployment, meanwhile, has been above the Fed’s target rate of 6.5 percent. With both indicators suggesting that the Fed should be looser, it would be madness to tighten.