Mickey Levy and Michael Bordo have a longtime partnership when it comes to monitoring, assessing and critiquing the Federal Reserve’s policy over the years.
They are both visiting fellows at the Hoover Institution at Stanford University, doing research, writing papers and appearing at events, many of which I have eagerly attended including the latest meeting of the Shadow Open Market Committee where they are both longstanding members.
This is a 50-year old organization, a committe of academic and business economists formed in the 1970s that advocates for rules-based monetary policy acting as a watchdog of the the policy setting conducted by the Federal Open Market Committee.
Michal, Mickey and I meet up in New York as the SOMC, now in partnership with the Center for Financial Stability, is on the eve of its latest conference, “The Fed in the Crosshairs: Independence, Systematic Monetary Policy, GSE Reform, and Financial Stability.” They are getting ready to present a paper on “Monetary Policy and Shocks,” a short title for a comprehensive paper that looks at supply shocks the Fed has mistakenly tried to treat like demand shocks and ended up failing miserably as a result.
”Monetary policy studies are about countercyclical responses to business cycles, and that’s not what this paper’s about.It’s about how they respond to shocks,” Mickey explains. “What this paper is about is the Fed should respond differently to shocks than it does to normal cyclical fluctuations in the economy that are driven by fluctuations in aggregate demand.”
”So conventional monetary policy, conducts a countercyclical stabilization policy, and that’s designed to smooth out the business: when the economy’s heating up, the Fed will raise interest rates and tighten when the economy is, is declining,” Michael adds.
”And in the face of shocks, the central bank has to have a different strategy tan a normal aggregate demand management…And so what this paper about is about is to look at the rhetoric in U.S. on how the Fed has responded to shocks in the past 60 or 70 years.”
So dive in and hear what the SOMC’s Dynamic Duo has to say about how the Fed’s failure to recognize a supply shock when it hits them has led to overheated inflation, recessions, and even financial instability if not crisis. And the two of them argue that the in order to learn from past mistakes they must first admit mistakes were made and vow not repeat them.
And after you hear them talk about supply shocks big and small, you want to learn more, here’s the link to their recently-written Hoover Institution paper:
https://www.hoover.org/sites/default/files/research/docs/25116-Bordo-Levy.pdf
Paper is about shocks and policy 00:01:05:15
Levy: here is something in the title here because, you know, monetary policy studies are about countercyclical responses to business cycles, and that’s not what this paper’s about. It’s about how they respond to shocks…. What this paper is about is the Fed should respond differently to shocks than it does to normal cyclical fluctuations in the economy that are driven by fluctuations in aggregate demand.
The framework for the paper 00:01:27:22 -
Mike: Right. So conventional monetary policy, conducts a countercyclical stabilization policy, and that’s designed to smooth out the business cycle. So, when the economy’s heating up, the Fed will raise interest rates and tighten when the economy is, is declining. That will offset that with reduced rates. Okay. But what often happens Is there are other events that are not really anticipated which economists call shocks unlimited. Nobody knew they were coming. Okay. And, in the face of shocks, the central bank has to have a different strategy than a normal aggregate demand management. Okay. And so what this paper about is about is to look at the rhetoric in U.S. on how the Fed has responded to shocks in the past 60 or 70 years.
Examples 00:02:37:14 -
Mike: Now, normally when you think of shocks, you say, oh yeah, Covid. Of course, that was a huge shock for us. And then someone says, well, you know, the oil price shocks. Remember those from the 70s? Okay. And so these are when we think of shocks we think of those type of events. And there’s a lot of work that’s been done on these shocks ever since they happened.
Shock response policy evaluation; its track record 00:03:51:19
Mickey: And so what we do in this paper is we look at the various shocks, not just Covid, but the oil shocks. And there are different types of shocks, those that are inside, you know, some are determined by some are generated by, misguided economic policies, fiscal policy, regulatory policies. Some are endogenously determined by previous monetary policies. So there are different types of shocks. And what we do is, is investigate how the Fed responds to different types of shocks. And keep in mind that, as Mike alluded to, monetary policy is an aggregate demand tool. To a supply shock. It’s a different type of animal. And so we investigate how the how monetary policy should respond. Okay. And then how it actually has a track record.
What the Fed learned from history: do not react… 00:05:13:04
Mike: What the Fed learned from history from starting going back to the 1970s oil price shocks, is that if you have a shock, it’s a temporary phenomenon. Okay, okay. And so you don’t react to it. You see through it. In other words, if the price of oil goes up, you know that people are going to substitute away from using gasoline in their cars to something else. And so that eventually the price of oil will go down. And that’s what a shock does, a shock, it’s a temporary phenomenon. And so what the Fed should do is not treat it like it’s an aggregate demand shock, which they have to counteract, but something which they should let the economy adjust to. Okay, that’s what we’ve learned from the ‘70s.
Trump tariff shock 00:07:13:16
Mike: But one thing we should mention is that because it’s just a matter of time. And so right now and right now we are dealing with the effects of a shock. What’s the shock? The Trump tariffs… okay? And the and the question is, has the Fed treated those shocks okay? The way they should have treated them, and the way they might have treated some that didn’t treat others. So it’s not just a story of history. It’s a story right now, okay?
A misguided policy response: tariffs & innovations - 00:07:56:12
Mickey: Trump’s tariffs are a good example of a misguided policy shock. And that creates distortions and monetary policy to try to offset it. But it can’t offset the distortions because it’s an aggregate demand tool. Now Mike, before we look back at history, another shock that may be unfolding right now that Mike and I’ve talked about is the positive productivity shock that may be coming from, ‘AI’ innovations, maybe… should the Fed respond to a positive productivity shock?
Greenspan recognized a positive productivity shock 00:08:41:11
Mickey: Sure. Well, there’s a history that, Fed Chair Greenspan in 1996-97, recognized the productivity, boom. And there were actually some, some members of the Federal Reserve that said, oh, the unemployment rate is coming down so the Fed should be raising rates….<but, the Fed stayed its hand>
When shocks mix with other effects 00:09:34:03 - 00:10:02:21
Mike: When shocks mix with other effects we get signal-to-noise problems. Right. So, for example, with the you know with Covid okay. It was a supply shock and a demand-shortage a supply shock. The shortage was created by all those ships lined up outside of Long Beach. But the demand shock was the fact that people stopped spending. And then what happened was there was in the recovery, a very expansionary fiscal policy and the Fed accommodated that. Okay. But yet the Fed didn’t really attach that much importance to that. It focused on the supply side and said, wait a minute. You know, this is a fixed supply problem. It’s transitory. It’s going to work itself out. It went up. It’s going to come down. Okay. But what’s really going on is this big expansion in fiscal policy and aggregate demand. So what happened was they ended up not recognizing that inflation was going to go up a lot more than they thought, like, in fact, the Fed hung its hat on the notion of a transitory supply shock.
Inflation had started BEFORE the oil shocks- in the mid-1960s 00:11:22:02
Mickey: Monetary policy was <in trouble> before we get to the oil shocks. Okay. I think there’s something very important to say. So the common notion is. Oh, you had horrible inflation in the 1970s, and it was caused by two big oil shocks. Well, that’s only a small portion of the story. The real story is the great inflation started in 1965. And from 1965 to 82, yes. There were two oil shocks, one in November 1973 and one in spring of 1979. But during that 15 or 17 year period, there were so many misguided economic and monetary policies that it tells a much richer story. <For example> The, the Vietnam War spending ramped up dramatically in 1965. At the same time you had a dramatic increase in spending on the Great Society programs. And so you have this big surge in fiscal stimulus that’s driving aggregate demand in the economy. And you had, president LBJ, threatening a Fed chair, William Chesney. Martin, don’t raise interest rates. And he really threatened him. And Martin gave in to that pressure. And guess what? From 1965 to 1970, inflation rose from less than 1.5% to 6%. And that was before the 1970s. Right?
The oil shock mistake 00:14:11:07
Mike: All right. So one of the key parts of the story with the oil price shocks was that the Fed accommodated them. In other words, they didn’t see through them. It’s all the fact that when oil prices went up, we had a gasoline economy look like it was through the bad shape. So what the Fed treated this as a downward shock to demand, it pumped up money growth. And you know, lowered interest rates, which in a sense, made things worse. And what happened is inflation expectations took off. In other words, people didn’t believe that the Fed was really going to stop this. And people started to expect inflation to go up. Future? Not okay. And things got out of control.
Oil was intermixed with series of other shocks too 00:15:52:22
Mickey- There happens to be a US postal strike. Burns comes in in 1970, starts easing policy. Economy bounces back. Then there’s the GM strike in the fourth quarter, which is the biggest in history. And everybody said, to Mike’s point, these are temporary shocks. In one year, Burns lowers the funds rate from 9% to below four. And inflation stabilized. The next thing that happened in 1972. It’s Nixon. He’s running for reelection, and it’s pretty well known that Burns pumped things up. Yeah, but even before then, in 1971, with inflation rising, there’s the Nixon shock, where, you know, the abandonment of the gold standard. They imposed wage and price controls under this framework of wage and price controls in 1972.
Enter Volcker looking to replace gold as an anchor 00:18:18:24
Mike: And so these policies incentives mistaken policies, whole series of them and started by market and followed by booms followed by G. William Miller okay. In a sense on unanchored inflation. And Volcker realized the only way to get back to something like price stability is to follow a policy that was called cold turkey. In other words, we would just follow such a tight policy. The economy is going to have a recession, but people are going to realize they mean business and expectations are going to readjust. And that’s what he did. And that created a really serious recession.
The Fed funded Covid as though the nation were on a war footing 00:19:51:09
Mike: It made a mistake in 2020-21 because they thought this is <the largest supply disruption>. And they did. They neglected the demand side of things quite a bit. And then when <government> did follow expansionary policy, the Fed neglected the fact that the expansionary policy was really big. Okay. That was it was such a big fiscal expansion. And the Fed accommodated it by following very loose monetary policy that was equivalent to what the U.S. did in World War two. Okay. World War two and other wars, World War one, civil war. You don’t worry about anything. You just want to win the war. So what the central bank does, in a sense, funds the deficits that Treasury is going to run to pay for the war. And so what happens in wartime is you get a situation called fiscal dominance for the Treasury. The Fed just goes along with it that many people argue that Congress has been the loudest, you know Congress noise. It was really a fiscal shock with passive money, passive monetary policy. And that’s why we have the big inflation that we had. And the Fed did not recognize this. They started to recognize it like 4 or 5 months, even 2 or 3 quarters into 2021. And then they thought maybe it isn’t just a supply shock, okay. But that was a big mistake. And we’re still suffering from that mistake.
What we learn about the Fed’s mistakes 00:21:28:22
Mickey: So, when the Fed does make mistakes in response to shocks, it elongates and deepens the cost of the original shock. Let me make another point. What Mike and I have found looking at the three big shocks. Okay, plus a lot of minor shocks that we go into in this paper, is that the Fed has a pretty mediocre track record on how to respond to shocks, and also its judgment about its own, about the impact of its own policies is largely inaccurate.
Financial crises emergency policies overstay their welcome 00:24:11:23
Mickey: We only bought mortgage backed securities, he says, don’t worry, we’ll unwind in a timely basis. Don’t worry. Well, fast forward a couple of years and they they with zero inflation it was zero interest rates and quantitative easing and President Obama’s fiscal stimulus. The Fed forecasted a strong economic rebound that didn’t happen. It ended up being a very slow recovery with high unemployment. Fast forward to 2012 and the Fed promotes and then enacts QE three. But it was very interesting, Kathleen, that all of a sudden they were doing so. The Fed is using emergency style policies and conventional actions and it’s using them to achieve growth, lower unemployment, and it’s dual mandate. So all of a sudden that unconventional emergency policy becomes too conventional.
Final Lessons from past policy mistakes; a singular focus? 00:26:06:18
Mike: Other than a couple lessons. And one is that they should <look at> how they responded to supply shocks to deal with a problem or with the second issue that <develops>. So you know, the subtext is that when the Fed reacted to the oil price shock <as they did> what were they worried about was the real economy. They worried about what happens. You know <it begins with> what’s happening right now. We have inflation still left over from the Covid. But they’re switching gears and they’re starting to loosen policy. Why? Because they’re more worried about the real economy unemployment side of the dual mandate. And this is a big, big problem. This is a bias that we’ve seen them making over many years that comes out during some of these events
A case of selective perception 00:27:34:10 –
Mickey: Yeah. And let me, let me just let me just add something, you know, when we put in the last slide that monetary policy the Fed would really benefit from, you know, a thorough, a careful understanding of history, but also of, itself. And, and I say that because here we are three years after the high inflation and, you see the Fed still coming out with studies saying, well, ‘three quarters of the inflation was due to transitory supply shocks.’ Well, if they were due to transitory supply shocks, then the general price level would have come back down to where it was. <Instead> the general price level is over 25% higher than what it was. And so that suggests to me that the Fed is a little closed minded… It wants to talk, it wants to learn, it wants to understand from history, but although it wants to understand, it is pretty closed-minded about it.
Can you learn from mistakes if you do not admit them? 00:29:07:18
Mike: Okay. I mean, the classic story is the Great Depression before 1930s and the Fed never… you know, it happened in the 30s… the Fed never, never said it was their fault until Ben Bernanke in 2002 and Bill Friedman’s 90th birthday said, Milton and Anna, you were right. We did it and we won’t do it again. Okay, so that was a very unusual thing that the Fed actually… well, it wasn’t shared <blame>… but he was a member of the board actually <who> admitted that they got it wrong and try to fix it. Okay. That’s very rare. They don’t usually do that. They always come up with a full story. Well, the dog ate my breakfast. That’s a giant forward-step.
Michael D. Bordo is the Ilene and Morton Harris Distinguished Visiting Fellow at the Hoover Institution. Bordo is a Board of Governors Professor of Economics and director of the Center for Monetary and Financial History at Rutgers University, New Brunswick, New Jersey. He has held academic positions at the University of South Carolina and Carleton University in Ottawa, Canada. Bordo has been a visiting professor at the University of California at Los Angeles, Carnegie Mellon University, Princeton University, Harvard University, and Cambridge University, where he was the Pitt Professor of American History and Institutions. He is currently a distinguished visiting fellow at the Hoover Institution, Stanford University. He has been a visiting scholar at the International Monetary Fund; the Federal Reserve Banks of St. Louis, Cleveland, and Dallas; the Federal Reserve Board of Governors; the Bank of Canada; the Bank of England; and the Bank for International Settlement. He is a research associate of the National Bureau of Economic Research, Cambridge, Massachusetts, and a member of the Shadow Open Market Committee. He is also a member of the Federal Reserve Centennial Advisory Committee. He has a BA degree from McGill University, an MSc in economics from the London School of Economics, and PhD from the University of Chicago in 1972.
Mickey Levy is a macroeconomist who uniquely analyzes economic and financial market performance and how they are affected by monetary and fiscal policies. Dr. Levy started his career conducting research at the Congressional Budget Office and American Enterprise Institute, and for many years was Chief Economist at Bank of America, followed by Berenberg Capital Markets. He is a long-standing member of the Shadow Open Market Committee and is also a Visiting Scholar at the Hoover Institution at Stanford University.
Dr. Levy is a leading expert on the Federal Reserve’s monetary policy, with a deep understanding of fiscal policy and how they interact. He has researched and spoken extensively on financial market behavior, and has a strong track record in forecasting. Dr. Levy’s early research was on the Fed’s debt monetization and different aspects of the government’s public finances. He has written hundreds of articles and papers for leading economic journals on U.S. and global economic conditions, and has been an active voice on how financial markets are influenced by monetary policy. He has testified frequently before the U.S. Congress on monetary and fiscal policies, banking and credit conditions, regulations, and global trade, and is a frequent contributor to the Wall Street Journal, Bloomberg, and other media.
