Exiting the New Recession: Monetary Policy Limitations

Perhaps it is time to reconsider the economic theory underlying monetary policy. Keynes General theory suggests lowering interest rates will incentivize businesses to invest and the additional Aggregate Demand will lower unemployment. 

A study of interest rate history questions that assumption:

‘C o n c l u s i o n s

Interest  rates  have  generally  been  high  and  rising during  periods  of rapid  economic  expansion  and have been  low  and  declining  during  periods  of  economic contraction.  Exceptions have occurred, such as the un­usually  high  rates  during  the  first  year  of the  1920-21economic  contraction,  the  sharp  upward movement of rates  during  the  depression  in  1931,  and  the  comparatively  low  rates  during  the  period  of  heavy  demand for  goods  and  services  during  and  immediately  fol­lowing World War II.

According to  a popular belief,  proper economic sta­bilization  action  calls  for  relatively  high  and  rising interest  rates  during  periods  of  rapid  expansion,  es­pecially  when  output  is  pressing the limits  of produc­tive  capacity  and  prices  are  rising.   Conversely,  it  is generally  thought  that  lower  rates  are  desirable  in periods  of insufficient and declining demand for goods and  services.   According  to  this  view,  interest  rates have  behaved  in  a  stabilizing  fashion during the  past half century,  except for a few atypical periods.

Proper  interest  rate  policy,  however,  may  be  much more  complicated  than  merely  determining  that  rates are  rising  during periods  of  strong  economic  advance and  inflation  or  declining  during  periods  of  substantial  and  rising  unemployment.   Questions  arise  as  to how much interest rates need to change under various conditions,  what  should  be  the  relation  among  rates on  loans  of various maturities,  the  influence of factors other  than  monetary  actions,  and  lags  in  the effect  of changes in interest rates on economic activity.’  

(Interest Rates, 1914-1965, Norman N. Bowsher,[ https://fraser.stlouisfed.org/files/docs/publications/frbslreview/pages/1965-1969/62472_1965-1969.pdf])

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I think lowering interest rates and printing more money most likely will not change economic activity without an increase in consumer demand.

Total bank deposits rose to about 80% of GDP in 2008 and have stayed there. That may reflect a two-tier economy rather than any other economic fundamental. Recovery requires more spending and less savings.

Units:  Percent, Not Seasonally Adjusted

Frequency:  Annual

The total value of demand, time and saving deposits at domestic deposit money banks as a share of GDP. Deposit money banks comprise commercial banks and other financial institutions that accept transferable deposits, such as demand deposits.

Suggested Citation:

World Bank, Bank Deposits to GDP for United States [DDOI02USA156NWDB], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DDOI02USA156NWDB, May 12, 2020

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 Consumption spending as a share of GDP remained rose above 67.5% during the recent expansion. It rose from less than 60% to the 67.5% range over several years between 1965 and 2010.

Units:  Percent, Not Seasonally Adjusted

Frequency:  Quarterly

BEA Account Code: DPCERE

For more information about this series, please see http://www.bea.gov/national/.

Suggested Citation:

U.S. Bureau of Economic Analysis, Shares of gross domestic product: Personal consumption expenditures [DPCERE1Q156NBEA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DPCERE1Q156NBEA, May 12, 2020.

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We can expect a reduction in consumer spending as unemployment rises and millions of families lose incomes. Thus, increasing money supply while interest rates are at or below the historic Liquidity Preference threshold of 3% will not do much to stimulate an expansion.

It’s likely that both GDP and consumption will fall together in a new recession.

It is also likely that a GDP expansion requires an increase in consumer real incomes. The path to recovery lies in raising consumer incomes through more worker friendly labor laws, higher marginal tax rates to fund budget expenditures and other measures to raise consumers’ real incomes above their current level.