Archive for the Category Monetary Policy


Reply to DeLong smackdown

In a recent post I claimed that monetary policy failure associated with the zero bound, not financial turmoil was the cause of the Great Recession.  Brad DeLong had correctly noted that the S&L fiasco of the late 1980s involved losses similar to the subprime crisis as a share of GDP.  Where I disagreed with DeLong is that he focused on differences between the resolution of the 1980s and 2008 crises, whereas I focused on differences in monetary policy.  In particular, I argued that rapid NGDP growth in the late 1980s put us so far above the zero bound that it was never an issue in the 1990 recession, and hence there was no failure of monetary policy.  I argued that falling NGDP caused by overly tight monetary policy explains the severity of the 2008-09 recession.

I also argued that we could have had a severe recession in late 2008 even if the financial turmoil had been handled optimally.  For instance, suppose Lehman had been successfully resolved and there was no post-Lehman banking crisis.  Even in that case the tightening of lending standards would have depressed the Wicksellian equilibrium rate, perhaps below zero, and we could very well have had the same monetary policy failure. Here’s how DeLong responds:

As I have said repeatedly: I simply do not buy this. From the fourth quarter of 2005 through the fourth quarter of 2007 lending standards tightened enormously, and investment is residential construction collapsed. By the end of 2007 residential investment had fallen 2.5%-points from its peak-of-the-boom level. But the heightening of lending standards and the unwillingness of people to make further NINJA (no income, no job or assets) loans had not sent the economy into any sort of a recession. It was the spiking of risk premia in 2008 that sent us to Wicksellian natural-rate-of-interest-below-the-ZLB territory. And there is no reason to think that we would have been in such a situation but for the financial crisis–and every reason to think that the whole mishegas would have been avoided had congress simply put the too-big-to-fail banks into conservatorship in January 2008…

Let me first concede that DeLong might be correct, my claim is certainly not a necessary part of the general market monetarist worldview.  But I don’t think he is correct.  Consider the following:

1.  I agree that the long downslide in residential real estate between late 2005 and the end of 2007 was not associated with a recession.  Indeed I’ve made that argument myself on a number of occasions, as a way of pointing to the importance of monetary policy (aka NGDP growth.)

2.  Here’s how I read the events of 2008.  During calendar 2008 the Wicksellian equilibrium rate fell gradually, under the impact of both the housing slump, and feedback from sharply slowing NGDP growth, which was itself an indication of tighter monetary policy.

3.  Let me point to two important facts for people who don’t like the Bernanke-Sumner “NGDP” indicator of monetary policy, and who insist on “concrete steppes.”  The monetary base, which had been trending upward for many years at more than 5% per year, stopped growing between August 2007 and May 2008.  If you prefer interest rates as your concrete step, note that stock market responses to (timid) Fed rate cuts indicated that in late 2007 that the Fed was “behind the curve,” as even Bernanke later admitted.

4.  This accidental tightening of monetary policy tipped us into a very mild recession in early 2008. But still nothing severe, so at this point I still agree with DeLong.

5.  The inflation surge in the first half of 2008 scared the Fed, and prevented them from doing what they otherwise would have done, as it became increasing clear we were in a recession.  By May 2008 the rise in unemployment was already more than you ever observe in non-recessionary periods. And as (I seem to recall) Bernanke once observed, it’s almost impossible to be too expansionary when the economy is tipping into recession.

6.  But the Fed was not expansionary, even using the conventional interest rate indicator.  Fear of inflation led to them to keep their interest rate target on hold at 2% after April 2008; indeed they did not even cut interest rates at the first meeting after Lehman failed in September. Unemployment had reached an expansion low of 4.4% in 2006.  Here are the unemployment rates from April to August 2008, all fully known to the Fed at its September meeting:  5.0%, 5.4%, 5.6%, 5.8%, 6.1%. And there were no rates cuts at all!  Look at that data and ask yourself if a steady fed funds target represents normal Fed behavior on the edge of a recession.  Then think about the fear of inflation that is so evident in the minutes of the 2008 meetings.

7.  Because the Wicksellian equilibrium rate was falling during this period, the stable fed funds target tipped the economy from a mild recession into a severe recession.

8.  Ignore quarterly GDP numbers, which can be very misleading at turning points. The monthly GDP estimates from Macroeconomics Advisors show GDP (both real and nominal) suddenly plunging sharply between June and December 2008.  By December the plunge was almost over, even though quarterly data for 2009:1 were much lower, as the level had been falling sharply throughout the 4th quarter of 2008.

9.  My claim is that accidentally tight monetary policy caused the NGDP plunge in the second half of 2008.  Because of data lags (and later revisions in data) we didn’t know about that NGDP plunge until after the post-Lehman financial crisis broke.  So at the time it seemed like the financial crisis caused the severe recession.  And almost all economists still believe that to be the case.  But markets were already sensing problems before Lehman, and falling asset prices caused by falling NGDP almost certainly helped trigger the September to December financial crisis, which occurred in the last half of the tight money-induced June to December fall in NGDP.

Let me finish by admitting that financial crises can have real effects, and thus it’s possible that DeLong is correct.  It’s possible that I’ve underestimated the independent impact of financial distress on RGDP.  Maybe RGDP would have fallen sharply even with a monetary policy aggressive enough to boost NGDP in late 2008.  But I’d point to one observation in my favor.  FDR enacted a highly expansionary monetary policy during the spring of 1933, when much of the US banking system was closed down.  Both NGDP and RGDP rose very strongly.  The technique FDR used (dollar depreciation) has some similarities to NGDPLT, as it raises expectations of future NGDP.

PS.  I have one quibble with DeLong’s post.  His use of ellipses in a quotation of material from my earlier post somewhat mischaracterizes what I wrote:

One area where I slightly disagree with Krugman is his focus on inflation. A 5% NGDPLT target path would have been enough, we didn’t need 4% trend inflation. Nor do we need fiscal stimulus…. All stabilization policies eventually fail…. The trick is to have a modest failure like Clinton or Obama, not a serious failure like FDR or Nixon. NGDPLT would have given us just that in 2008-09.

The ellipsis right before “The trick is” makes it seem like the final sentence refers to failed stabilization policies of each President.  Not so, I was discussing their overall performance.  Here is the complete passage:

All stabilization policies eventually fail, just as all presidents are judged failures in their 6th year in office. The trick is to have a modest failure like Clinton or Obama, not a serious failure like FDR or Nixon. NGDPLT would have given us just that in 2008-09.

It’s no big deal, and my comment was probably ambiguous.  But Nixon’s big failure was Watergate, and Clinton didn’t even have a modest failure of stabilization policy, just a silly scandal.

Swedish central bankers and Korean ferryboat captains

For years I’ve been fighting against the (new) conventional wisdom in economics—that the 2008 crisis shows that monetary policy must move beyond macro stability, and focus on asset price bubbles. Unfortunately, Ambrose Evans-Pritchard reports that we seem to have achieved our first important success.  I say unfortunately, because it came at the expense of Sweden:

The Riksbank has been trying to “lean against the wind” to curb house price rises and consumer credit, pioneering a new policy that gives weight to the dangers of asset bubbles. But this is proving easier said than done without hurting the productive economy, suggesting that it may be better to use mortgage curbs or other means to rein in property mania.

But Jeremy Stein says that regulation doesn’t “get in all the cracks,” you need to smash asset price bubbles with a monetary sledgehammer.  Or like a tidal wave that gets in all the cracks of a leaky old boat. Here are the results:

Sweden has become the first country in northern Europe to slide into serious deflation, prompting a blistering attack on the Riksbank’s monetary policies by the world’s leading deflation expert.

Swedish consumer prices fell 0.4pc in March from a year earlier, catching the authorities by surprise and leading to calls for immediate action to avert a Japanese-style trap.

Lars Svensson, the Riksbank’s former deputy governor, said the slide into deflation had been caused by a “very dramatic tightening of monetary policy” over the past four years. He called for rates to be slashed from 0.75pc to -0.25pc to drive down the krona, and advised the bank to prepare for quantitative easing on a “large scale”.

Prof Svensson said Sweden was at risk of a “liquidity trap” akin to the 1930s, with deflation causing debt burdens to ratchet up in real terms. Swedish household debt is 170pc of disposable income, among Europe’s highest.

The former Princeton University professor wrote the world’s most widely cited works on deflation, his advice being sought by the US Federal Reserve’s Ben Bernanke during the financial crisis.

You can’t “get in all the cracks” without hitting AD hard.

And then after being warned by Svensson, and a wide range of bloggers from market monetarists to Paul Krugman, the Riksbank has the gall to claim no one could have foreseen it:

Sweden’s Riksbank admitted in its latest monetary report that something unexpected had gone wrong, perhaps due to a worldwide deflationary impulse. “Low inflation has not been fully explained by normal correlations between developments in companies’ prices and costs for some time now. Companies have found it difficult to pass on their cost increases to consumers. This could, in turn, be because demand has been weaker than normal,” it said.

Yes, and when that Korean captain ordered those 300 children to stay inside the ship as it was sinking, while he waltzed away, no one could possible have foreseen a bad outcome.  Right?

An exaggeration?  Of course.  But consider the following:

1.  The Riksbank was given a legal mandate to target inflation and unemployment, not asset price bubbles.

2.  For several years they have been explicitly ignoring this mandate.  They have set interest rates at a level so high that their own internal research unit has consistently predicted that they would fall short on both the inflation and employment front.  There’s no dispute about these facts.  The board included one of the world’s leading monetary experts, Lars Svensson, and a bunch of amateurs who are in completely over their heads.  They repeatedly ignored Svnesson’s warnings, even accusing him of being rude.  Eventually he got so frustrated with their incompetence that he resigned.

And now they claim no one could have foreseen this policy failure?

This is exactly what would have happened in the US in the mid-2000s if the Fed had tried to pop the housing “bubble.”  It’s exactly what did happen in 1929 when the Fed popped the stock price “bubble.”

Will this stop the bubblemongers?  Don’t count on it.  They are so convinced they are right that no amount of information will sway them.

If Sweden wants to regain its reputation for monetary policy excellence then they will fire the entire Riksbank board, put Svensson in charge, and give him a veto over any proposed additions to the board.

PS.  Of course it’s NGDP that really matters, not inflation.  Which is why market monetarists were ahead of the curve on these issues.  It really doesn’t make much difference if the ECB inflation rate is 0.5%, or 2.5%.  As long as NGDP growth in Europe is ultra-slow, the debt and jobs crises will continue.

PPS.  Lars Christensen linked to an excellent new paper by Clark Johnson, discussing Ben Bernanke’s take on the events of 2008.  Clark’s analysis is influenced by Keynes’s Treatise on Money.  (A better book than the General Theory.)

Bernanke reveals frustration that the Fed’s effort to lower long term rates did not bring recovery: “We have gotten mortgage rates down very low. You would think that would stimulate housing, but the housing market has not recovered.”

Bernanke scarcely regards the underlying monetary problem, which was the rise in systemic demand for money. His discussion in the following pages returns to the importance of targeting a low inflation rate – apparently through all phases of the business cycle – and the importance of letting financial markets know the central bank’s interest rate targets. These are the targets identified above as ill-chosen, and use of which Bernanke has himself criticized in the past.

.  .  .

In in pre-Fed writings, Bernanke acknowledged the ability of central banking to satisfy demand for liquidity, and thereby to boost demand for goods and services – even under extreme conditions. There is no evident reason why such methods would not work several years after a banking crisis, or for that matter, immediately after.

HT:  Paul Krugman

Joe Gagnon on what the Fed got wrong

Marcus Nunes sent me a post by the always excellent Joe Gagnon.  I’m not sure I fully agree with Gagnon’s view of the situation, but his post does a beautiful job of explaining the issues faced by the Fed in December 2008, and how they evaluated their various policy options:

The FOMC did not discuss the possibility of a negative interest rate on bank reserves, but it is widely agreed that a significantly negative interest is not feasible because banks would convert their reserve balances to paper currency. A lingering puzzle is why the Fed never lowered interest on reserves to zero in subsequent years, when financial strains had diminished and depositors and market participants had gotten used to the low rate environment, but standard macroeconomic models imply that the benefits of such a small decline would have been correspondingly small.

This paragraph shows that the Fed had two serious misconceptions.  Vault cash is a part of bank reserves, and hence there is no reason that the negative IOR could not also be applied to vault cash. (There may be legal barriers, but laws can be changed.) In earlier posts I’ve recommended that banks be exempt from negative IOR on a “normal” level of bank reserves, perhaps required reserves plus X%. The key is to make excess reserve holding costly at the margin, so that new injections of base money go out into circulation as cash. Because cash is very costly to store, this would depress market interest below zero, if the policy failed.  More likely it would succeed and dramatically boost AD, and therefore the mere threat of negative IOR would make the actual implementation of negative IOR unnecessary.

Update: Mark Sadowski clarifies the legal status of vault cash

The second misconception is the assumption that the benefits from a further small reduction in interest rates are minor.  That comes from flawed Keynesian models of monetary economics, which ignore the role of money as a medium of account.  If you set IOR at a rate slightly above the T-bill yield, then the demand for base money rises dramatically, which is highly deflationary.  To be sure, a lower rate might decrease T-bill yields by a roughly similar amount, in which case the spread is preserved, but that assumption raises all sorts of further questions, such as what impact does lower interest rates have on the expected future path of monetary policy.  There are numerous cases where over a trillion dollars in global stock market wealth has been created or destroyed within minutes by a decision over a 25 basis point change in the fed funds target. In other cases that sort of change has little impact. There is no basis for simply assuming that a small change in the fed funds target would be unimportant when the economy is poised on the knife edge of a depression.

There was some discussion, both within the meeting and in the background memos, about the possible benefits of committing to hold the policy rate low for so long that the economy would be likely to overshoot the long-run desired levels of employment and inflation temporarily. Some participants questioned the credibility of such a commitment, given the likelihood that the Fed would come to regret it later. More generally, FOMC participants seemed to have little appetite for tying their hands in such a dramatic fashion. Although they were all for getting back to their economic goals quickly, they had no desire to speed up the recovery at the expense of overshooting their goals.

Not willing “to speed up the recovery at the expense of overshooting?”  Sorry Fed officials, but that is against the law.  You have a dual mandate.  A decision that you are unwilling to overshoot 2% inflation by even a tiny bit, even when unemployment is 10%, is tantamount to admitting that only inflation matters.  A policy of never trying to overshoot 2% inflation is basically a single mandate policy, inflation targeting pure and simple.  That which has no practical implications, has no policy mandate implications.  If your policy is indistinguishable for a single mandate IT regime, then it is a single mandate IT regime.

There was widespread approval of the Fed’s generous provision of liquidity during the crisis, with some participants noting that measures of financial stress were beginning to ease a bit. Both the discussion and one of the background memos agreed that the liquidity facilities had a macroeconomically important effect to the extent that they were preventing cutbacks in consumption and investment that would otherwise have occurred. Some noted that these facilities were less effective at providing additional stimulus than they were at offsetting negative shocks because market participants could not be coerced into using these facilities.

God help us all if 80 years after the Great Depression Fed officials were still worried about pushing on strings and leading horses to water.

The FOMC discussion shows that there was little appetite for a dramatic push to increase inflation expectations, with some participants expressing doubt that the Fed could raise expectations substantially through statements about its intentions without any additional actions. But there was also an acknowledgment that the Fed had not been as clear as it could have been about what inflation rate it aimed to achieve. Speeches and other published materials seemed to show a comfort zone for inflation with a lower end around 1 to 1.5 percent and an upper end at 2 percent. One of the background memos assumed an inflation goal of 1.75 percent. Participants did not agree on a common inflation goal at this meeting.

The first sentence might be translated as: “There was little appetite for pushing inflation expectations up to a level where the policy was expected to succeed, and in any case in order to actually raise inflation expectations we might have to actually do something.”  Not quite sure what “little appetite” has to do with optimal monetary policy.  Perhaps it just means the FOMC members were not as hungry as the 15 million unemployed.

On the plus side, the actual adoption of a 2% inflation target in January 2012 might be viewed as a limited victory for Ben Bernanke, given that the implicit target was a bit lower.  Keep in mind that a 2% PCE inflation rate implies a 2.4% CPI inflation rate.  Very few people understand that the current 5 years TIPS spread of 2.16% means that markets expect the Fed to fall short of their PCE inflation target. And since unemployment is also elevated, there is an overwhelming case for easier money (if you accept the Fed’s announced policy goals–perhaps not if you favor a lower target.)

PS.  Just to be clear, I’m not recommending negative IOR in the current situation, the Fed has far better options.

PPS.  Note that the excerpts I quoted here aren’t necessarily Gagnon’s views.  He occasionally recommended a more aggressive Fed stance. They are his view of what the Fed was thinking.

PPPS.  My second link was to a recent Charles Evans speech which contained this gem:

Although all central banks face these strategy and communications issues, and they implement them somewhat differently, my view is that 90 percent of the communications challenge is met by expressing policy intentions clearly so that the public can understand the Federal Reserve’s goals and how the Fed is committed to achieving these goals in a timely fashion.A clear expression of policy intentions requires stating the Fed’s policy goals clearly and explicitly. These messages need to be repeated – over and over again. It is also necessary to clearly demonstrate our commitment to achieving these goals in a timely fashion with policy actions.

That’s what the Fed did not do in 2008-09.

Update:  Mark Sadowski also has some comments on Gagnon’s post.

Fed hawk who helped implement Obama’s tight money policy announces resignation

TravisV sent me the following:

A top Federal Reserve official who has expressed concerns about the possibility that the central bank’s policies could spark financial instability said Thursday he is resigning from his post on May 28.

Jeremy Stein, an economics professor at Harvard University, will be returning to Cambridge, Mass. to teach again, Mr. Stein said in his resignation letter to President Barack Obama.

Just last month, the 53-year old highlighted his argument that the Fed must be mindful of the possibility that its policies could contribute to asset bubbles. “Monetary policy should be less accommodative — by which I mean that it should be willing to tolerate a larger forecast shortfall of the path of the unemployment rate from its full-employment level—when estimates of risk premiums in the bond market are abnormally low,” he said.

While his views weren’t shared by many of his colleagues, Mr. Stein’s role as an academic economist made him an influential figure within the central bank’s powerful Washington-based board.

.   .   .

In combating a deep recession and supporting a weak economic recovery, the Fed has kept official interest rates effectively at zero for over five years now. It has also purchased some $3 trillion in mortgage and Treasury bonds in an effort to keep long-term rates down and spur economic activity. But the program has not been without its skeptics. Mr. Stein, while supporting bond buys when they were launch, has been most vocally skeptically of them among board governors.

Given that Stein played a key role in the Fed’s premature taper, this is good news. Let’s hope the seat remains unfilled.

PS.  In 2009 I was encouraging Obama to fill Board seats as quickly as possible, until I figured out that he thinks monetary policy is credit policy, not AD management.

PPS.  Obama appointed Stein and Powell 2 years ago. Stein was the Democrat.  The slow recovery?  It’s all the Republican Party’s fault.

Let’s play 1960s-era Fed

Marcus Nunes has a nice post comparing the views of Janet Yellen and Martin Feldstein.  I noticed that Feldstein is worried that we are going to repeat the mistakes of the 1960s.

Experience shows that inflation can rise very rapidly. The current consumer-price-index inflation rate of 1.1% is similar to the 1.2% average inflation rate in the first half of the 1960s. Inflation then rose quickly to 5.5% at the end of that decade and to 9% five years later.

Before we consider whether we are likely to repeat the mistakes of the 1960s era Fed, let’s review precisely what those mistakes actually were. Here’s the data as of November 1966:

Unemployment rate = 3.6%, and falling.

Inflation = 3.6% over previous 12 months.  That’s a big increase from the 1.7% of the 12 months before that, and the 1.3% inflation rate two years previous.  The “Great Inflation” began here.

The fed funds rate was 5.76%.

Hmm, what should the Fed do in a situation like this?  Inflation is beginning to accelerate.  Unemployment is near all time lows for peacetime.  Decisions, decisions.  You’ve taken EC101, what do we do next?

The answer is easy.  The Fed decided the economy needed a massive emergency jolt of easy money.  By December 1966 the fed funds rate was cut to 5.40%.  By January 1967 the rate was cut to 4.94%.  By April it was cut to 4.05%.  By October 1967 it’s at 3.88%.  Keep in mind NGDP was rising at 6% to 8% throughout the late 1960s.  If you prefer the monetary base as your “concrete steppe”, that indicator started growing much faster as the 1960s progressed.

Now read the minutes of September 2008, when the Fed refused to cut rates in the midst of the mother of all financial panics because of inflation worries, despite TIPS spreads showing 1.23% inflation over the next 5 years, and commodity prices plunging.  Does this seem like a Fed that would slash interest rates much lower when inflation is soaring above target and unemployment is 3.6%?

PS.  Keep this data in mind when some fool tells you that the Great Inflation was caused by oil shocks or the Vietnam War or budget deficits or unions, or some other nonsense.

PPS.  The economics profession (with a few exceptions) was complicit in the crime of 1966.  The Fed generally does what the consensus thinks it should do.  The “best and the brightest,” the VSPs.  Still think it’s impossible that the entire profession could have been as crazy in 2008-09 as I claim they were?  How will the Fed’s behavior in 2008 look 50 years later?  I’d say about like the 1966-67 Fed looks today. Out of their ******* minds.  And then there’s the ECB . . .

PPPS.  One economist that did understand what was going on was Friedman.  I find this (from an Edward Nelson paper) to be amusing:

From April 1966 to the end of the year, the evidence of monetary policy tightening started appearing uniformly across monetary aggregates; the “credit crunch” of 1966 is also evident in other financial indicators and is widely recognized as a period of monetary tightness (Romer and Romer, 1993, pp. 76−78). The Federal Reserve would shift to ease in 1967, and that easing marked a dividing point for Friedman. He would classify 1967 as the beginning of an extended departure from price stability, one in which monetary policy fitted the pattern he had laid out in 1954: an inflation roller-coaster around a rising trend, with the occasional deviations below that trend reflecting shifts to monetary restraint that were abandoned once recessions developed (M. Friedman, 1980, p. 82; Friedman, 1984, p. 26).

The FOMC did not, however, appreciate the scale of its easing during 1967. By explicitly associating high nominal interest rates with tight policy, Committee members and other Federal Reserve officials neglected the distinction between real and nominal interest rates. Friedman, in contrast, was pressing this distinction on policymakers. Chairman Martin could not ignore the criticism, not least because Friedman had attracted the interest of Martin’s Congressional interlocutors. Friedman’s revival of the Fisher effect was referred to when Martin appeared at a February 14, 1968, hearing of the Joint Economic Committee (1968, p. 1980):

Senator SYMINGTON. A famous economist has developed the theory that easy money creates higher interest rates. If you have not examined that concept, would you have someone on your staff do so? It is an interesting theory. I discussed it with the economist in question only last week. Would you have somebody look into it?

Mr. MARTIN. I will be very glad to. 

The “famous economist” was, of course, Friedman.

In 2008 no senator asked Bernanke to look into the theory of an obscure Bentley economist that low interest rates are often a sign that money has been tight.