hen crisis struck US financial markets in September 2008, the Federal Reserve’s response was swift. Cutting the federal funds rate to a range of 0 to 0.25%, the central bank almost immediately hit the zero lower bound – the point at which interest rates cannot be further cut, and the effective limit of its conventional stimulatory capacity. The Federal Reserve reacted by drastically expanding its balance sheet, issuing emergency loans to at-risk financial institutions and purchasing large quantities of long-term securities in a bid to drive down their yields and reduce the cost of borrowing for corporations.
A retrospective assessment of the impact of the latter policy by the New York Federal Reserve found that it was broadly effective at stimulating economic activity. Large-scale asset purchases (LSAP) reduced the term premium on ten-year securities by 38 to 82 basis points, permitting corporations to borrow at more favourable rates: Moody’s AAA corporate bond yield dropped by 102 basis points in the month immediately following the Federal Reserve’s initial LSAP announcement in November 2008.
However, a full recovery from the Great Recession has taken longer to materialize than expected, leading some economists to question whether the Federal Reserve could have taken a more aggressive approach to monetary stimulus. Among them is Michael Woodford of Columbia University. In a paper first presented at the 2012 Jackson Hole Economic Symposium, Woodford argued that the Federal Reserve’s statements during the recession failed to send sufficiently strong signals to investors regarding its intentions to continue its monetary stimulus policies. The crux of his argument is the contention that market movements are significantly influenced by investors’ expectations of future monetary policy. Woodford found that the Federal Reserve has refused to issue binding policy commitments, instead focusing its announcements on predictions of future economic conditions.
Such statements have occasionally backfired: the New York Times reported one such announcement in 2012, suggesting that economic conditions would justify low interest rates through 2014, as “Fed Signals That a Full Recovery is Years Away.” Incidents such as these reveal the risk that doom-and-gloom predictions by central banks in fact lead to slowdown of a country’s economy if they are not coupled with firm commitments to pursue monetary stimulus. A standalone prediction of weak growth is hardly a recipe for increased investor confidence. Conversely, an associated promise to maintain an attractive borrowing climate is far more likely to spur investment, as returns are expected to be high over a longer period.
Woodford acknowledges that central banks are typically unwilling to commit to inflation-rate targets over short time horizons. If interest rates are already near zero, central banks have little room to increase inflation, leaving them exposed to a loss of credibility if they miss their targets. Since expectations typically drive the markets’ response to actions by central banks, maintaining credibility is of paramount importance to central bankers. Woodford’s proposed solution is for central banks to begin targeting nominal GDP levels instead of inflation rates. He suggests that during recessions, central banks commit to keeping interest rates at their lower bound until nominal GDP rises to match potential GDP – that is, until GDP rises to match the level that it would be at were it not for the intervening recession. In effect, advocates of nominal GDP level targeting call for central banks to “keep their foot on the accelerator” for longer than they otherwise would to ensure that GDP levels match long-term trends. Since there is no fixed time horizon for this policy, central banks need not fear a loss in credibility if they miss their target. They may simply extend monetary stimulus indefinitely until their nominal GDP target is reached. Additionally, investor confidence is likely to respond well to such targeting. If assured that economic output will eventually return to match long-term trends, investors will be more likely to inject money into the markets, which would in itself speed up a prospective recovery.
The Great Recession produced a significant gap between potential and actual nominal GDP that is visualized in the above figure. Under a regime of NGDP level targeting, the Federal Reserve would continue monetary stimulus until the red curve, representing actual NGDP, joins the blue curve, representing potential NGDP. At the peak of the divergence, in Q2 of 2009, the discrepancy between potential and actual GDP was just over $1.1 trillion. This represents a needless loss in output that the Federal Reserve is able to mitigate through the application of aggressive NGDP targeting.
By implementing an NGDP level target, central banks would be able to boost investor confidence during recessions and spur a quicker recovery. Such a policy already claims broad support from economists, including Federal Reserve chair Janet Yellen. There has indeed been speculation that the Federal Reserve has been quietly pursuing an NGDP target since 2009. If Woodford’s conclusions hold, that target would have been even more effective had the Federal Reserve openly announced its policy shift and boosted investor confidence at the nadir of the recession.