132 – Scott Sumner on the Lessons Learned for Monetary Policy, Ten Years Later after the Crisis

Episode Summary

Executive Summary: Scott Sumner argues the Great Recession was worsened, not just caused, by Fed policy errors in 2008: the Fed misread supply-driven inflation and low nominal rates, then let nominal GDP collapse. He compares the U.S., ECB, and more successful central banks, and advocates nominal GDP level targeting plus market-based accountability reforms.

Main Topics: Fed policy error in 2008 (Priority: 5/5): Sumner says the Fed misread oil-driven inflation and a 2% policy rate as signals of tightness/ease, keeping policy too contractionary as the natural rate fell and nominal spending collapsed. Nominal GDP as the key stabilization metric (Priority: 5/5): He argues nominal GDP, not just inflation or interest rates, best captures monetary stance because it reflects total dollar spending and the income stream behind contracts, debt service, and labor payments. Europe as a counterfactual (Priority: 4/5): The ECB’s harsher 2008-2013 policy path—rate hikes in 2008 and 2011—produced a deeper double-dip recession, which Sumner cites as evidence that monetary policy mattered greatly. Why the recovery remained weak (Priority: 4/5): Even after ZIRP and QE, nominal GDP growth stayed below trend, so policy remained too tight by Sumner’s definition; he rejects using interest rates or base expansion as sufficient proof of ease. Policy regime reform: level targeting and NGDP targeting (Priority: 5/5): He favors nominal GDP level targeting over a higher inflation target because it can stabilize spending with less inflation cost and better expectations management across the cycle. Market monetarism and futures-based policy (Priority: 4/5): Sumner proposes using nominal GDP futures markets, or a pragmatic 'guardrails' version, so the Fed sets policy based on market expectations rather than its own forecasts. Accountability and communication at the Fed (Priority: 3/5): He recommends annual retrospective reviews to force the Fed to specify success metrics and admit policy errors, strengthening clarity and commitment over time.

Key Arguments: The Great Recession became severe when nominal GDP fell sharply in 2008; housing and banking stress alone did not require a deep recession. The Fed’s 2008 refusal to ease further after Lehman was driven by backward-looking inflation fears even though market-based inflation expectations were low. A 2% policy rate was not easy money once the natural rate plunged below zero; stance must be judged relative to the natural rate and nominal spending outcomes. Low rates and QE are unreliable indicators of ease or tightness; the best evidence of stance is the behavior of nominal GDP. The ECB’s even tighter policy and subsequent double-dip recession strengthen the case that monetary policy errors, not just financial fragility, drove outcomes. Australia is presented as a counterexample: similar boom conditions but no recession for 27 years, suggesting better monetary stabilization can prevent a great recession. Nominal GDP level targeting would make inflation temporarily above target after downturns and below target in booms, but keep the long-run price path predictable. Higher inflation targets would solve the zero-lower-bound problem, but at a greater cost than nominal GDP targeting, which aims to stabilize demand without permanently raising inflation. Market-based forecasts are superior to central-bank intuition in crises, so futures contracts could help the Fed keep policy aligned with its target. Annual Fed accountability reports could improve clarity about the dual mandate and reduce repeated policy mistakes.

Data Points: Fed funds target rate: 2% - The Fed held rates at 2% through much of mid-2008 and even after Lehman failed, citing inflation fears. TIPS inflation spread: 1.2% - Bond market inflation expectations for the next five years were this low on the day of the Fed’s post-Lehman meeting. Core PCE inflation average since crisis: about 1.5% - Used to illustrate persistent undershooting of the Fed’s 2% inflation target. Nominal GDP growth trend before crisis: about 5% per year - Sumner describes this as roughly 3% real growth plus 2% inflation before the Great Recession. Nominal GDP growth in 2009: about -3% - He says nominal GDP fell roughly 8 percentage points below trend, creating a large demand shock. Australia recession record: 27 years without a recession - Cited as evidence that a similar economy can avoid recession with better monetary policy. ECB rate hike timing: July 2008 - The ECB raised rates during the crisis, which Sumner sees as a major policy mistake. ECB additional rate hikes: twice in 2011 - These hikes were followed by a double-dip recession in late 2011 lasting to 2013. Japan/Switzerland central bank balance sheets: roughly 100% of GDP - Used to show how very low inflation and zero rates can force massive QE balance sheets. Long-run U.S. trend real GDP growth: roughly 3% in the 20th century - Mentioned in the discussion of how the Fed could set NGDP targets using trend real growth plus inflation.

Pivotal Quotes: "the cold morphed into pneumonia" — Scott Sumner: His analogy for how an early financial crisis became a much more serious macroeconomic collapse once nominal spending fell. "they're looking at the wrong indicators" — Scott Sumner: His critique of using interest rates and QE as the main measures of monetary ease during and after the crisis. "whatever it takes" — Scott Sumner: His description of the kind of aggressive, forecast-targeting monetary policy he believes the Fed should have used in 2008-2009.

Implications: Listeners should view 2008-09 as a monetary policy failure as well as a financial crisis. For future crises, Sumner argues the Fed should target nominal spending, use market signals, and adopt clearer accountability to avoid repeat mistakes.