The Fed driving too fast down an unknown road
Is the current aggressive monetary policy effective? Do the risks outweigh the benefits?
Mark Thoma wrote on August 31st…
“It’s just that some members of the Fed do not believe the Fed has much influence over the economy beyond stabilizing the financial system. Once that is done, the Fed’s powers are very limited (when at the zero bound) and — in the eyes of some members of the Fed — the risks of further aggressive action, e.g. QE, outweigh the potential benefits. So I think both camps (banking and macroeconomic) have the same goal, stabilizing the macroeconomy, the difference is in the view of how much the Fed can do without risking bubbles, inflation, etc.”
I think the same way and many others do too. Aggressive and loose monetary policy definitely helps the economy bounce back from a recession, but the economy still must function within its own constraints. Monetary policy can try to push the economy beyond a natural GDP level, but the result would most likely be inflation or bubbles as noted in Mark Thoma’s quote.
How one judges the risks and benefits of monetary policy is based on one’s assessment of what the economy is capable of. Many economists like Thoma and Krugman look at the high unemployment rate and spare capacity and say the economy will eventually return to full-employment below 6% unemployment. To me that is a view with rose-colored glasses that disregards Keynes’ concept of an effective demand limit that can cut an economy short of full-employment. The principles of the effective demand limit are really an unknown.
But what I understand in Thoma’s words is there is a view that once monetary policy stabilizes the financial system, the economy then runs its course. Monetary policy can affect the course of the economy within limitations, but is more limited when at the zero lower bound like now.
My view, which is based on seeing an effective demand limit that will stop unemployment around 6.8% to 7%, is that the Fed must be very careful being too aggressive. It’s like driving too fast on an unknown road and not knowing there is a stoplight ahead that is turning red. That stoplight is the effective demand limit based on low labor share of income. In this scenario, the risks outweigh the benefits from aggressive monetary policy. Bubbles are more likely than inflation due to labor income unable to push inflation. Bubbles come from owners of capital, whose income has rebounded extremely well since the crisis.