The moment of maximum danger

28th September 2018 Off By binary
The moment of maximum danger
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Some people are confused when I argue that excessive monetary ease right now could make a recession more likely.  Aren’t recessions caused by tight money?  Yes, but they are also caused by mistakes that lead the Fed to want to sharply slow NGDP growth.  And that sort of mistake is more likely to occur when policy has previously been too expansionary.

There is an especially large risk of recession when an excessively expansionary monetary policy coincides with a peak in the real side of the economy.  If inflation has been running above target at a time when real growth is robust, then there’s a danger than a slowdown in inflation will coincide with a slowdown in RGDP growth.

Here are a couple recent examples.  In 2000-01, RGDP growth slowed due to the end of the tech boom.  So why didn’t the Fed compensate with easier money, to keep NGDP growing fast enough to avoid recession?  Partly because in the second half of 2000, inflation (GDP deflator) was running at 2.4%.  By mid 2002 the inflation rate was down to about 1.5% (again using the GDP deflator.)  Thus NGDP growth slowed even more than RGDP growth.  The Fed took a real shock and turned it into an even bigger nominal shock.  It would have been easier for the Fed to adopt an aggressively expansionary monetary policy in 2001 if they had not already been experiencing above target inflation in late 2000.

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The same set of events played out during the housing boom.  Once again, inflation rose above target.  When housing slumped, it was inevitable that RGDP growth would also slow.  But the Fed made things worse by causing inflation to slow even more sharply, especially in 2008-09.  And the cause of their mistake is pretty clear.  Because inflation had been running above target during the housing boom, they felt they had less leeway to adopt a highly expansionary monetary policy in 2008.

You can say these were mistakes by the Fed, and I’d agree.  My point is that this sort of mistake is more likely to occur when NGDP growth and inflation have been excessive during the previous boom.  Right now, the Fed forecasts 3.1% growth in 2018.  They think this is temporary, due to factors such as the recent tax cut.  They forecast growth slowing to 2% in 2020 and 1.8% in 2021.  At the same time, inflation (GDP deflator) is currently running at 2.5%.  It seems likely that inflation will also slow somewhat over the next couple years.  Put these two claims together and it’s not hard to imagine NGDP growth slowing rather sharply by 2020.  Especially if there is a “mistake”.  And interest rate pegging is a regime tailor made to produce procyclical mistakes.

Under the Fed’s dual mandate, the Fed should run inflation below target during booms and above target during recessions.  They have historically done the opposite, and this procyclical policy continues to this very day.  Now that we are booming, inflation is finally edging above 2%.  That makes a recession more likely.

I’m still not forecasting a recession, partly because I believe that recessions are unforecastable, and partly because current policy does not seem far off course.  For any given one or two year period, the most likely outcome is continued growth.  My point is that an excessively fast NGDP growth rate right now would make a recession in 2020 more likely, not less likely.  Jay Powell has his work cut out for him.

PS.  I cited the GDP deflator even though the Fed targets PCE inflation, because the GDP deflator inflation rate and the RGDP growth add up to NGDP growth.

PPS.  If there is a recession in 2020, who will deserve the most blame?  Perhaps those who now say, “Gee, let’s use monetary policy to see how tight a labor market we can produce.”  No, let’s use monetary policy to keep NGDP growing at 4% from now until the end of time.

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