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Federal Reserve concerned that economic growth could come back

The back-story: When the banks freaked out last year, the Federal Reserve pumped a lot of money their way. But the banks haven't been lending that money. Instead, they've been sitting on it, using it to cushion themselves against any unexpected problems. That's part of why economic growth has been so sluggish: The banks aren't lending, which means businesses are having trouble expanding. But then you read this:

“The Fed’s great worry is that instead of holding onto these reserves, the banks would decide they’d rather take the money they’re tying up and lend it out,” said Anil K. Kashyap, a professor of economics and finance at the University of Chicago’s business school. If they did that, “you’d see broad measures of money growing quickly, and presumably that would be the start to having some inflation.”

In the short term, that prospect seems remote, as banks have been wary and tightfisted in lending since the financial crisis erupted. But in the long run, a huge balance sheet carries risks.

It's weird to read that the Fed's great worry is that the banks might stop sitting on the money and instead use it to kick-start economic growth, which could in turn lead to a couple of bare flickers in our measures of inflation. So rather than encouraging the banks to lend that money, it looks like the Federal Reserve is going to try to time it so that they get that money back at the exact moment that the banks would otherwise begin pumping it into the rest of the economy.

I'm not much of a Fed-basher, as I think these things are complicated and I don't feel confident opining on them. But it's hardly a minority opinion to say that the main problems we're facing are insufficient growth and high unemployment, and we shouldn't be primarily focused on heading off a problem that doesn't currently exist -- particularly if that means cutting back on policies that could accelerate growth and increase employment.

By Ezra Klein  |  February 10, 2010; 4:02 PM ET
Categories:  Federal Reserve  
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Bartlett talks about the same phenomenon in his book The New American Economy. The Fed in the Depression was worried about inflation, as well, and kept stifling growth for fear of increasing inflation. Bartlett's theory is that they should be recognized it as "reflation" and worried about inflation once the economy was back on track.

Posted by: StokeyWan | February 10, 2010 4:14 PM | Report abuse

Hyperinflation is a bi*** if it comes. It is the biggest fear that I have of the future. There is nothing worse for a society than when a good paying $50,000 a year job almost instantly coverts to a job with the buying power of a $25,000 a year job. I am glad that the fed is watching out for that possibility, given the deficits that the US Treasury is compiling.

Posted by: lancediverson | February 10, 2010 4:20 PM | Report abuse

The banks didn't freak out last year, they almost collapsed under a mountain of bad loans and collapsing values of toxic assets. They've been sitting on money for several reasons, the most important of which is the fact that the problems underlying their near collapse last year have been papered over but not repaired. They have to sit on money because the edifice is likely to collapse again. What's more, who are they going to lend to? Unemployed people with no prospects of repaying the loan?

But far be it from me to sound like a defender of the big banks. That article about Citi's plans to get into the financial collapse credit derivative market is mind boggling. The FDIC ought to cancel all Citi deposit insurance immediately and let those fools die a well deserved financial death.

Posted by: bgmma50 | February 10, 2010 4:26 PM | Report abuse

Ezra, come one, just point out the elephant in the room. Fed officials are obsessive about fighting non-existent inflation because:

a) they hate that the Democratic party is in power, and know if growth excelerates and unemployment goes down, they will have to deal with future Democratic political power that will hurt their pro-wealth policy bias

b) inflation hurts the value of assets held by super rich people, the same people who the Fed sets their policies to benefit

The lurking suspicion is that Fed, embodied by Ben Bernanke, will engage in partisan behavior to aide conservatives and the Republican party. This partisan behavior will not be able to be called out by credible sources because it would imply that the Fed isn't independent, and such a suggestion is socially unacceptable in conventional Washington. Thus all credible sources will just dishonestly pretend that the Fed are making sound decisions that benefit the country as a whole, and partisanship simply doesn't exist within the Fed. Harry Reid called Greenspan a political hack, and the same characterization applies to Bernanke. The take away point that everyone should internalize is that the Fed does not want to see democrats in power, and will make decisions that intentionally hurt democratic politicians

Posted by: keever66 | February 10, 2010 4:29 PM | Report abuse

2010: it's the new 1937!

Posted by: BigTunaTim | February 10, 2010 5:07 PM | Report abuse

Plese Big Ben, give us some damn inflation. The value of my house sure could use it!

Posted by: truth5 | February 10, 2010 5:49 PM | Report abuse

There is nothing worse for a society than when a good paying $50,000 a year job almost instantly coverts to a job with the buying power of a $25,000 a year job.
How about when a good paying $50,000 a year job is cut and there's no job to replace it?

Posted by: rpy1 | February 10, 2010 5:56 PM | Report abuse

Sadly, I am becoming convinced that no one has a clue in Washington! Money needs to circulate in the form of loans, wages, jobs, etc., for the economy to flourish! When the money dries up (like now) nothing good can happen. We need to bring clarity to the tax structure for businesses so they can plan on recovery. Today, they have on idea what then next government "wet dream" will be!!


Posted by: my4653 | February 10, 2010 5:56 PM | Report abuse


I have a few thoughts on this comment: "I'm not much of a Fed-basher, as I think these things are complicated and I don't feel confident opining on them."

I would cite Scott Sumner on this one - I think he is someone who knows his monetary economics. Paying interest on reserves and keeping all that money locked up instead of reflating nominal GDP is a Fed policy that he trashes often on his blog The Money Illusion. He makes a convincing case that targeting nominal GDP would allow us to reflate and to keep long-run inflation expectations anchored.

After letting prices and nominal GDP crash for several quarters, the Fed now seems back to targeting some rate of low inflation (some evidence for this is that Ben Bernanke smacked down Brad DeLong's suggestion of naming an explicit inflation target of 3%). This is bad because in theory, an inflation targeting central will offset fiscal stimulus 100%, making any multipliers precisely zero. If the Fed is targeting 2% inflation, and it seems to be getting it, then a move by the Obama administration to stimulate the economy will increase aggregate demand, raising output and prices. However, the price rise will then be offset by open market sales (or perhaps selling MBS or something else in the portfolio), which reduces aggregate demand, and prices and output as well.

Posted by: justin84 | February 10, 2010 7:27 PM | Report abuse

Don't underestimate the Fed's other role in managing our country's ballooning debt, which is being rolled in the form of short-term notes. There have been recent increases in the cost of managing this debt with decreased market appetite for more. Inflation could conceivably wipe out every dollar that the Fed printed for the last two years, yet it would still be paying for it. That's why they're worried about inflation; it has nothing to do with job creation/destruction or rich preservation/destruction. Runaway inflation, at this point in our history, with massive amounts of rolling short term debt, could drive not sovreign default but something close to it. It would be like having to pay for all of medicare and SS's future deficits over the next two years.

Inflation is great if you're paying down long term debt at a now low-rate. Inflation is a killer if you're rolling over debt, however, because you will be paying higher interest on the same old debt. If the Fed's really get crazy and let inflation go, payments will go up, and there will inevitably be market fear that the Fed is intentionally inflating away its debts a la third world countries. Good luck selling treasuries in that environment. That's what the Fed fears.

Posted by: Philly213 | February 11, 2010 6:17 AM | Report abuse

Philly213 knows exactly what the situation is, in much greater detail than I do.

I as you Bernanke naysayers out there, why did he get renominated and reconfirmed by a liberal president and Congress if he is so wrong and the liberl position on this is so right.

While I am conservative, I firmly believe that President Obama is smarter than most of us and he knows what needs to be done on this issue. Bernanke is committed to watch against inflation because that is the big threat out there as Philly 213 described. Obama reappointed him to do just that.

I should add one point agains rpy1's attack on my post. Losing a job is a fraction of our population. The inflation I describe would affect every single member of our society. That would be catastrophic while the loss of jobs to many of our people is just tragic.

Posted by: lancediverson | February 11, 2010 9:11 AM | Report abuse

I don't think debt rollover should deter the Fed from reflation. If the government had to roll over all of the ~$8 trillion in publicly held debt, at interest rates 5% higher than we are currently facing, then our annual interest bill goes up $400 billion. That scenario is highly unlikely but is managable, particularly given that a central bank that decides to target a growth path of inflation or nominal output shouldn't have to worry about an adverse shock to long-term inflation expectations. In any case, there really isn't a plausible reflation scenario that would 'feel' like paying for our tens of trillions worth of social security/medicare liabilities in a year or two. A Zimbabwean monetary policy might do it, but I don't think anyone is calling on the Fed to imitate what Zimbabwe's central bank did last decade.

The goal isn't hyperinflation, or even double digit inflation. The goal is to get nominal GDP back onto its recent growth path of 5.5%/yr, with 2007 (or 2008 even) as the base year.

Posted by: justin84 | February 11, 2010 2:10 PM | Report abuse


You seem very smart, but what you don't seem to get is that using 2007 as a base year with 5.5%/year growth was not and is not sustainable. That type of imaginary growth was what caused our bubble.

Remember that is is excessive growth that brings about the busts that we so lament. You can't have growth based on bubbles, they have to be based on real productivity and technology gains in the economy. That is more modest but sustainable growth.

Posted by: lancediverson | February 11, 2010 2:52 PM | Report abuse


I'm speaking in terms of nominal growth. I agree that real GDP will grow based on real inputs (labor, capital and technological progress etc). From time to time, real imbalances occur that require adjustment (real estate/construction/finance became bloated last decade), and the adjustment can cause output growth to slow or fall if other sectors can't pick up the slack. The U.S. economy did a remarkable job picking up the slack from the housing adjustment - despite the housing market peaking in 2005, and sinking rapidly thereafter, the economy managed to grow above potential in 2006 and at potential in 2007 (by that, I mean if the unemployment rate is unchanged in a given year, then growth that year was at potential). As late as the summer of 2008, several economists felt they could say that the recession - which at the time was very mild - was mental and not real.

Then, all of a sudden, the economy began to rapidly contract, and what had been multi-decade record rates of inflation turned to multi-decade record rates of deflation. Knowing nothing else about 2008, that screams demand shock. As a result of the financial crisis (Lehman, AIG), the demand for money soared (or put another way money velocity plunged). The Fed stepped in to supply more money, but it plainly wasn't sufficient. Most of the new money supply seems to be sitting inside banks, and falling nominal GDP demonstrates that money demand growth outpaced money supply growth.

Lots of our problems were caused purely NGDP contraction. If NGDP falls it means businesses on average see sales fall. All sorts of economic decisions are based on expectations of future sales - loans to businesses, how many employees a firm wants to have on hand, etc. Wages are sticky, and so since businesses can't easily adjust money wages downward to adjust to lower revenues, employees are let go. Also, since lower demand manifests itself in both lower prices and lower output, firms shed workers not only because of lower revenues, but because production levels were lower.

I believe that the severity of the recession can be pinned largely on the failure of the Fed to keep nominal GDP close to its expected growth path.

I view nominal GDP, and nominal GDP growth as variables entirely determined by monetary policy. I pick 5.5% because that it is the growth path that individuals and businesses were used to. I'm more of an inflation hawk, and so I'd like that path to come down over time - since money is neutral to GDP growth over the long haul, lower NGDP growth means lower inflation - but for the purpose of getting back to some semblance of normal, I think we should try nominal reflation. On the real side, I also think we should scale back policies which encourage leverage in order to reduce the occurence of real economic imbalances (tax deductibility of interest, for example).

Posted by: justin84 | February 11, 2010 4:35 PM | Report abuse


I appreciate the education (I am not joking) on your view on nominal GDP growth being necessary to stabilize the economy.

My problem with your thesis in my view is that it diverts us from the real issue that caused 2008 and that was an excess of debt across the universe (individual, corporate, and governmental). I don't see how what I believe to be a necessary deleveraging occurs under your NGDP growth scenario.

What was and is needed is to get the above universe on a responsible savings course. This 2008 revaluation was necessary so that the values on all types of goods and services could be correctly priced and people then could understand the new normal and make new saving decisions based on this new normal.

This is a painful experience, but that is the course that is required to get our economy on a firm foundation. People don't complain about all of the goodies during a great economic expansion, but it is in that expansion and overvaluation of prices that sows the seeds to corrections such as what we are experiencing now.

Posted by: lancediverson | February 11, 2010 5:33 PM | Report abuse


Thanks for your comments. I share your concern about leverage, as it appears that it did create some real imbalances. I do want to note that letting nominal GDP shrink makes any given amount of debt more difficult to bear, and makes our debt situation worse. We are currently 10% below the long-run NGDP trend. If you believe our debt levels are more than 10% below what they would have been otherwise, then perhaps this method of deleveraging is faster.

My personal opinion - and it is only that - is that the correction in the housing market would have kept demand for mortgage debt in decline, and consistent NGDP would have led to a shallower recession and a much better government fiscal situation - it's much easier selling an $800 billion stimulus when unemployment is above 7% and rising 0.4% per month, than when it is 5.5% and rising 0.1% every other month. Corporate debt on the other hand probably would have increased, but again they would have healthier revenue sources and so it's an open question as to whether leverage ratios would have deteriorated, or whether banks would have decided charging LIBOR+225 for single B loans was unsustainably low and wider spreads would have kept a lid on leverage ratios.

That all being said, I don't want to come off as saying that we should just inflate our debt away. My primary concern is that so much real economic activity is based on assumptions regarding the current price level and an expectation that recent price and sales trends will continue, and that the sudden negative shock caused a lot more damage than was necessary - that higher NGDP might make debt easier to service is only an ancillary and temporary benefit. I see you have a fairly Austrian view on the business cycle. Note that under the current policy regime, the Fed is stuck keeping the Fed Funds Rate at 0.25%, and it will have been there for years (which should remind you of 2001-2004). Under an NGDP targeting framework, the Fed no longer targets interest rates, and NGDP stability reduces the likelihood of very low rates fueling any sort of credit binge.

Posted by: justin84 | February 12, 2010 11:38 AM | Report abuse

I would prefer that the Fed begins to target NGDP futures around its historical trend rate of growth (economist Scott Sumner advocates this at his blog The Money Illusion - lots of what I say is stuff he writes about that I find convincing), and over the next 5-10 years, slowly to lower the targeted trend rate of growth to reduce inflation. I agree that inflation creates costs and distorts pricing signals - I also think that inflation targeting as practiced by central banks currently isn't going to be successful in bringing down inflation. Central banks will be afraid of letting inflation get too low. By targeting NGDP, it is probably easier to create a stable macroenvironment which has very low average inflation.

I am not quite certain which precise level of NGDP growth is best - in theory we could even target NGDP growth below expected real GDP growth and generate deflation during expansions much like we saw during the classical gold standard, although I worry that real wage adjustments will be difficult if money wages rise too high in a deflationary environment. Given that, I think 3% NGDP growth is a good target, with the expectation that RGDP growth will trend somewhere between 1.5% and 2.5% and we'll see average inflation of 0.5%-1.5% over time. We might also choose to target our RGDP expectations, keeping stable prices, (if you look at Japan's CPI, this is basically what they have achieved over the past 15 years - outside of the 2008 crash, Japan wasn't doing all that bad, I think much of their economic malaise had to do with demographic factors and a weak banking sector).

There is a risk that a very stable economy with low inflation (and hence low interest rates) encourages debt accumulation. To manage this, and to reduce current leverage, I'd prefer we use policies explicitly designed for that purpose. Create a minimum legal downpayment for a house, starting at 5%, raising it to 7.5% in 2011 and 10% in 2012, then 2% each year until we hit 20% (making this plan explicit probably creates demand to buy a house now in similar form to the homebuyer tax credit, but doesn't cost the government money). Phase out the deductibility of interest (mortgage and corporate), and use the funds partially to reduce marginal tax rates, and partially to reduce the deficit. Stuff like that.

Posted by: justin84 | February 12, 2010 11:41 AM | Report abuse

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