Charles Evans, Normalization of the Policy Rates & the 2011 Eurozone Recession

In a speech this week, the President of the Federal Reserve Bank of Chicago, Charles Evans, made a case for keeping the effective Fed rate low well into the foreseeable future. He concluded…

“To summarize, I am very uncomfortable with calls to raise our policy rate sooner than later. I favor delaying liftoff until I am more certain that we have sufficient momentum in place toward our policy goals. And I think we should plan for our path of policy rate increases to be shallow in order to be sure that the economy’s momentum is sustainable in the presence of less accommodative financial conditions.”

He bases his view of normalizing the Fed rate upon first having sufficient and sustainable momentum. He uses the 2011 recession in the Eurozone as an example implying that the recession was caused by prematurely raising nominal rates when Europe did not have sufficient momentum.

“The recent European experience in 2011 is yet another example of premature tightening. Despite the headwinds from continuing debt-overhang and recent financial distress, European authorities in 2011 judged that the Eurozone economy was emerging from recession and headline inflation was at risk to rise persistently above target. The European Central Bank (ECB) responded by raising policy rates in 2011. They soon had to backtrack as output in the Eurozone fell again and inflation began to march down below target.”

“These lessons from monetary history strongly suggest that there are great risks to premature liftoff from the zero lower bound or near-ZLB conditions. Unless economic conditions are fundamentally strong and the previous impediments to growth have receded sufficiently, the odds remain high that monetary authorities will need to retreat right back into the ZLB.”

He implies that the rise in the ECB’s policy rates triggered the recession. The ECB policy rate was raised from 1.0% to 1.5% for 6 months. Was that enough to cause a recession? Well, there were adjustments taking place in the periphery countries, like Spain and Greece, where the recession was most intense. Those countries were lowering wages and enacting policies of austerity. Before the ECB raised the policy rate, unemployment was still rising in Spain while it was falling in Germany. So the rise in the ECB policy rate looks to be a cautionary step for Germany at the great expense of some periphery countries. In fact, during the 2011 Eurozone recession, unemployment kept rising in Spain, while it continued to fall in Germany… Hmmmm….

Simon Wren-Lewis wrote yesterday that a large cause of the 2011 Eurozone recession was the widespread fiscal contraction.

“The idea that a large fiscal contraction shortly after a huge financial crisis would lead to a second recession is not the wild imagining of a group of ‘anglo-saxon’ economists, or a particular macroeconomic ‘school of thought’. It is just mainstream macroeconomics. And we must never forget that this is not the unfortunate cost of having to get debt down in a few periphery countries: as the chart above shows, this fiscal contraction occurred everywhere in the Eurozone. As the simulations described in this link (pdf) show, using the Belgian NIME model, these costs could have been largely avoided if the fiscal consolidation had been delayed until monetary policy was in a position to offset them. It is not just a predictable recession; it is a recession made by policymakers without good cause and therefore an entirely avoidable recession”

Is Simon Wren-Lewis implying that the Euro recession would have happened without a rise in policy rates? Not really. He states that monetary policy should have been in a position to offset the fiscal contraction, which implies that the policy rates needed to be higher in order to decline to offset fiscal contractions. He is implying that fiscal contraction should only take place once the policy rates are normalized to higher rates. So, raising the policy rate, instead of dropping the rate, aggravated the economic consequence of the fiscal contraction.

But was the fiscal contraction by itself strong enough to cause a recession? Yes. So the rise in the ECB policy rate just made the recession worse for some countries more than for Germany. The recession was not symmetric throughout the Eurozone. It is obvious that Germany had preferential status in ECB monetary policy in 2011.

The key element in this story and in Charles Evans’ speech is the normalization of policy rates. It is very important to normalize policy rates. As Charles Evans says…

“And the costs of being mired in the zero lower bound are simply very large. I have already talked about how the ZLB prevents using our very best policy tools to address negative shocks. The constraint also means that interest rates cannot fall low enough to equate the supply of saving with the demand for investment. This, of course, significantly impedes capital formation, future economic growth, and further employment expansion. Furthermore, the ZLB often comes hand in hand with undesirably low inflation or even a falling price level, carrying with it the associated costs of debt deflation on the real economy.”

Normalizing policy rates will not be easy, probably almost impossible at this point. How high can the stock market go, while real wages must rise cutting into profits? How quickly can firms hire new workers to maintain profit rates as real wages rise with productivity stalled? Capital investment will have to subside to maintain profit rates.

We will see the economy grind forward looking vulnerable at every moment. This grinding will not motivate the Fed to normalize the policy rate quickly. Consequently, the Fed rate itself will grind upward very slowly. The economy will be increasingly vulnerable to rate hikes.

Psychologically, the Fed does not want the blame of causing the next recession. So they will always put the Fed rate on the low side. A recession can happen in spite of a very low Fed rate. It’s a profit rate thing based on demand and the utilization of labor and capital.

The Fed’s biggest concern is the increasing probability of the Fed rate falling back onto the ZLB prematurely before normalizing.  As Charles Evans says…

“We should keep our focus on our policy goals and should be highly attuned to both the likelihood and the costs of missing those goals. To me, the risks imposed on an economy forced to operate at the zero lower bound on policy rates are paramount.”

The Fed fell into a trap of keeping the Fed rate at the ZLB due to unrealistic expectations of high potential. They fell behind the curve as potential was revised down unexpectedly. Now the Fed rate would have to rise too fast in response to the unexpected drop in potential . The economy is simply too vulnerable to fast policy rate hikes. The Fed does not want to tighten and cause a recession like in the past. So the Fed is in a trap of slow and cautious rate hikes behind the curve.  The probability is increasing fast that the Fed rate will fall back to the ZLB prematurely.

The future of monetary policy will have lots of drama and soul-searching.