We've looked at fiscal policy and we could come to the conclusion that
fiscal policy has been not really appropriate to the US business cycle.
Because we don't see,
the surpluses in years of inflationary gap,
we see only deficits.
If there were surpluses,
it would show the government was using a restrictive policy to slow down the economy.
Then with the deficits,
it would be an expensive policy to speed up the economy that would be appropriate.
So let's turn to monetary policy and see whether
it has been appropriate in the United States,
whether it's doing what we learned that policy,
the monetary policy should do in understanding economic policy making.
This first chart shows you
the short-term interest rate in the United States over a long period, 17 years.
Then it also portrays the output gap.
Now remember the output gap if it's negative,
it means we have a recessionary gap,
and if it's positive,
it means we have an inflationary gap, okay?
So what we would expect with monetary policy is that,
when there's an inflationary gap,
Interest rates would rise.
Because they want to slow it down and bring it back down to potential.
When there is a recessionary gap,
interest rates would fall so that they can stimulate
investment and other kinds of spending and bring GDP back up to potential.
And on this chart we see broadly not looking at the details closely,
we see broadly that's what's happening.
We can see an inflationary gap before
the crisis that we've talked about from 2002 to 2008,
and we see that interest rates were high.
In a moment we'll talk about how high, okay?
Then we see that when the crisis hits in 2008 and then becomes a recession in 2009,
rates come down very quickly in order to address
that recessionary gap and try to bring the US economy back up to potential.
It was actually pretty successful monetary policy.
At the end of the period, you see interest rates going up again which is appropriate,
the economy moving back into an inflationary gap and interest rates are rising.
So broadly, without looking at any specific numbers we would say,
"Okay pretty much the right thing."
We can dig in a little deeper though,
and see if the interest rate is about where it should be.
And here, you may recall from understanding economic policy making,
we talked about the Taylor Rule which is a way of
calculating the right interest rate based on what's happening with inflation,
what's happening with GDP growth.
Then there's another comparison we can make between
the real interest rate and the real GDP growth rate.
So let's take a quick look at those and see
whether US interest rates have actually been appropriate,
whether US monetary policy has been
appropriate to the different moments of the business cycle.
Now this first picture,
shows the Taylor Rule, okay?.
Then it shows the FED's target interest rate which is the Federal Funds Rate.
So according to the Taylor Rule,
you watch these two curves.
You can see that there is a period in
the early 2000s when US interest rates were too low, okay?
You see the interest rate falling below the Taylor Rule in this chart.
Meaning that, authorities did not raise the interest rate
enough to slow down the economy in that inflationary gap.
That's a thought you're going to want to keep in the back of your minds.
Then, we go into crisis and you see that now the Taylor Rule
would prescribe a really low interest rate which we couldn't go negative.
So it went as low as it could go.
Now you see the Taylor Rule as the recovery proceeds.
The Taylor Rule would show interest rates should have risen quite a bit,
and they haven't very much.
They're still just at the tail end of this chart.
You can see them creeping up in 2017.
So we could say that,
there have been moments particularly in the crisis,
when US interest rates have been appropriate according to what the Taylor Rule would say.
But in the inflationary gap and in this new inflationary gap,
they have been too low,
and there are implications of that as we will see.
Finally, on this chart I'm putting together
two indicators that we talked about in understanding economic policymaking.
Where we would say, when you are in an inflationary gap,
your monetary policy should have a restrictive effect and in
order to have a restrictive effect one way of thinking about is,
the real interest rate should be below the real GDP growth rate.
It should drop below the real GDP growth rate.
In an inflationary gap,
the real interest rate should rise above the real GDP growth rate.
So here I'm showing for a different period of time,
1990 to 2012 because that encompasses the crisis,
I'm showing that relationship.
You can see once again in the recessionary gap,
the very beginning of this chart,
the US got interest rates down low as they should.
So that was appropriate.
But we move into that large inflationary gap that we've been talking about,
and you can see that US interest rates were extremely low,
way too low for an inflationary gap.
Look at those years 2003,
2004, 2002, where they're actually negative in real terms.
I take the interest rate,
subtract inflation from it, it's gone negative.
So those interest rates were way too low.
They finally come up just shortly before the crisis to
a level that would be appropriate for an inflationary gap.
Then they come down to a level that is appropriate for a recessionary gap.
So we're seeing something sort of odd in
the United States which you may observe many times.
In a recessionary gap,
The United States usually does the right thing.
With monetary policy and with fiscal policy,
deficits low interest rates.
In an inflationary gap in a recovery,
The United States normally does the wrong thing.
Deficits when they should have surpluses,
and interest rates that are too low,
and this entails some risks for the country's future.
Gayle AllardProfessor
