Archive for the Category Monetary Policy


Did the monetary policy environment change in 2011?

Lots of people have pointed me to an article on the zero bound by Eric Swanson:

According to traditional macroeconomic thinking, once monetary policy hits the zero lower bound, there is nothing more the Committee can do to stimulate the economy – monetary policy is essentially ‘stuck at zero’. A corollary of this observation is that fiscal policy becomes more powerful than in normal times because any stimulus from fiscal policy on output or inflation will not be partially offset by monetary policymakers raising interest rates to keep inflation in check. In other words, monetary policy will not act to ‘crowd out’ fiscal policy because interest rates will remain stuck at zero as long as the economy is weak (see, e.g., Mankiw 2013, Chap. 12).

The role of monetary expectations

More recent research, however, has emphasised how monetary policy expectations can alter this reasoning. Reifschneider and Williams (2000) and Eggertsson and Woodford (2003) show that, if the Federal Committee can credibly commit to future values of the federal funds rate, then it has the power to largely work around the zero lower bound constraint. As these authors point out, the economy depends not just on the current level of the federal funds rate (a one-day interest rate), but rather on the entire path of the expected future federal funds rate over the next several years. Put differently, businesses and households typically look at interest rates with maturities out to several years when making investment and financing decisions. Even if the current federal funds rate is stuck at zero, the Committee could continue to push longer-term interest rates lower by promising to keep the federal funds rate low for an extended period of time. In this way, the Committee could continue to stimulate the economy even when the current federal funds rate is constrained by the zero lower bound.

This line of reasoning suggests that monetary policy has probably not been as constrained by the zero lower bound as the traditional way of thinking would imply.  Figure 1 plots the federal funds rate along with the one-, two-, five-, and ten-year Treasury yields. Although the funds rate (solid black line) is essentially zero from December 2008 onward, even the one-year Treasury yield averages close to 0.5% throughout 2009 and 2010, and fluctuates noticeably as the outlook for the economy and monetary policy rose and fell over this period. The two-year Treasury yield is even higher and more volatile. Thus, Figure 1 suggests that monetary policy might not have been very constrained by the zero lower bound until at least mid-2011.

I certainly agree with the primary claim of this article–monetary policy was not very constrained by the zero bound in 2009-10.  But it’s disappointing to see someone call the wacky liquidity trap view “traditional macroeconomic thinking.” Perhaps it could be called traditional old Keynesian thinking, but it was certainly a discredited model by the 1980s, if not earlier.

I’m also a bit uncomfortable with focusing on mid-2011, when 1 and 2-year T-bond yields fell close to zero.  There is nothing special about that date, because there is nothing special about 1 and 2 year T-bonds.  Three-month yields were close to zero throughout 2009 and 2010, and 5-year yields have been well above zero since 2011.  Nothing of importance changed in 2011.  The Fed always has the ability to adopt monetary stimulus if it chooses to do so, as interest rates are not an important part of the monetary policy transmission mechanism.  Of course the Fed ended QE1 and QE2 and QE3 because each time they (wrongly) thought the economy didn’t need any more stimulus.

The paper uses a rather indirect method of trying to ascertain whether monetary policy is constrained.  Swanson looks at whether longer-term bond yields are impacted by economic news. But why not look at whether longer-term bond yields are impacted by monetary news?  And why pick a highly ambiguous indicator like interest rates? Why not look at whether forex prices and stock prices and TIPS spreads are impacted by monetary news?

Nonetheless, I’m pleased that a distinguished economist like Eric Swanson has concluded that monetary policy was much less constrained than many pundits assumed.  At the end of the article, Swanson notes that this implies that crowding out continued to apply after 2008, thus weakening the impact of the ARRA stimulus program.  But crowding out assumes a constant money supply, which is obviously unrealistic.  In fact, “crowding out” depends almost entirely on the degree of monetary offset. I’d like to see the profession stop talking about the crowding out of aggregate demand and move on to the real issue; how do central banks respond to fiscal initiatives?


The new jobs numbers provide one more bit of evidence in support of the claims I’ve been making in this blog:

1.  Job growth in the first 10 months of 2014 was almost 2.3 million, roughly the amount for the entire 12 months of 2012 or 2013. Thus the total for 2014 will end up being about 400,000 more than the average of the previous two years.  That may reflect the expiration of extended unemployment benefits.  Ditto for the still sluggish nominal hourly wage growth (stuck at 2.0%.) The household survey (less reliable) shows nearly 2.6 million jobs so far this year.

2.  I’ve often referred to the fact that since the beginning of 2013 the unemployment rate has been falling at 0.1% per month, and will continue to do so. It did so again in October, down from 5.9% to 5.8%. That means we are only 4 months from the Fed’s definition of “full employment.”

3.  Some have pointed to the low employment/population ratio as evidence that we are not recovering.  After being stuck in the trading range of 58.2% to 58.8% from October 2009 (when unemployment was 10.0% (exactly 5 years ago)) to February 2014, we finally have a decisive breakout on the upside:

Screen Shot 2014-11-07 at 9.31.11 AM

We also have a breakout for average weekly hours, which were stuck in the 34.3 to 34.5 range for years:

Screen Shot 2014-11-07 at 9.30.11 AM

New claims for unemployment as a share of the workforce keep hitting all-time lows.  Never in all of history did workers have less need to fear layoffs.

No Fed chairman ever had an easier job that Janet Yellen has right now.  Normally you want to tighten before nominal wage growth accelerates.  But in this case the Fed can wait for nominal hourly wage growth to accelerate from 2.0% to 2.5% before tightening, as the 2.0% figure is too low to hit their inflation target.  So the Fed merely needs to wait until wage growth accelerates.  No need to read the tea leaves.

(BTW, when I say “tighten,” I mean raise the fed funds target–policy is already tight.)

The last two years disproves several theories:

1.  In January 2013 unemployment was still 7.9%, and many conservatives were pessimistic about the prospect for monetary stimulus to lower unemployment. They claimed we had “structural problems.”  Now unemployment is 5.8% and still falling fast.  We had a demand shortfall—in early 2013 wages hadn’t fully adjusted to the huge plunge in NGDP growth in 2008-09, and slow recovery.

2.  Liberals claimed “austerity” in 2013 would slow the recovery.  Exactly the opposite happened.

3.  Liberals also claimed that ending extended unemployment benefits would not reduce unemployment (which was itself odd, because prior to 2008 liberals did believe that ending extended unemployment benefits would create jobs.)  In fact the 2008 liberals were right, job growth accelerated in 2014 without any acceleration in wages.  The acceleration was a “supply of labor-side” story.  So while the overall recovery since late 2012 is a demand-side story, the acceleration in job growth after the first of the year was a modest supply-side addition to the recovery.

Despite all this good news, we could have done much better with a more expansionary Fed over the past 6 years.  There are some “structural problems” in America, but they never had much to do with the near 10% unemployment rate of 2009-10.

PS.  Tim Duy has an excellent post demolishing the conservative argument that the Fed is creating growth with “inflation.”

PPS.  Here’s the steady fall in unemployment since January 2013.  In contrast, from January 2012 to January 2013 unemployment had only fallen from 8.2% to 7.9%, which is why so many people were pessimistic “structuralists” at the time.

Screen Shot 2014-11-07 at 9.51.20 AM

PPPS.  The employment-population ratio for the all important 25-54 age group also rose, and has regained 2 points of the slightly over 5 points lost during the Great Recession. There’s still some slack out there.

HT: Garrett McDonald






Responding to John Becker

John Becker asked me this question:


If the government massively cut spending and the economy boomed, do you think Paul Krugman would wave a white flag? If the Fed announced they were adopting NGDP level targeting and the markets tanked, would you admit defeat or start scrambling for other reasons why markets might react that way? I don’t think either of you would be wrong in either case, I’m just trying to make the point that economics theories are non-falsifiable by external events.

If the Fed announced a 5% NGDPLT and the markets tanked, then yes, I’d admit defeat.  I can’t speak for Krugman . . .

In fairness to Krugman, the proposed test of my theory is much more decisive.

If it were a 2% NGDPLT target I’d be much less confident, indeed I think markets might fall.

PS.  For some strange reason I like my new Econlog post, blaming Keynes and Hayek for the Great Recession.

Three widely held theories discredited in 5 minutes

I woke up this morning to find that my very useful commenters had provided me with information showing that 3 widely held economic theories were discredited last night between 12:45 and 12:50 am.  These theories are Keynesian economics, RBC theory, and the theory of beggar-thy-neighbor policies.  Yes, these theories have been totally discredited dozens of times before over the past few years (or decades if you wish), but piling on is fun!

Here’s the first comment, by Cameron:

BOJ announces it will expand its QE program, Nikkei rises 4.5%!

The liquidity trap theory is dead. Please please please follow in their footsteps ECB.

Of course Keynesian economics predicts the QE announcement would have no effect on stock prices, as the new money would just sit there as excess reserves.  You are just swapping one low interest government asset for another low interest government asset.  (In fairness, I don’t know what the BOJ is buying in this case, but we also see big market effects when central banks just buy government bonds.)

And yet the economic blogosphere is full of people telling us “we just don’t know” if QE has any effect.  Yesterday I saw an article indicating that the “markets” were uncertain whether QE had had any effect.

Of course the real business cycle people will say; “yes, monetary stimulus will raise nominal stock prices, but that effect merely represents inflation.”  On to comment number 2, from Steve:

BOJ expands monetary base to 80T yen per year

The central bank says it will expand annual bond purchases to 80 trillion yen a year, up from the current 50 trillion yen. It will also extend the duration of bonds it holds to about 7-10 years.

The impact on markets was swift: dollar-yen jumped 1 percent to 110.26, while the Nikkei surged over 4 percent to its highest levels since September 25.

So the Japanese stock market also soared in dollar terms, and if you look at the intraday data the huge spike was right after the announcement.  RBC theory says it’s just inflation, and that real values should not be affected.  And yet Noah Smith tells us that RBC theory is alive and well. And I’m sure it is, in the elite journals.

[As an aside, there are people who claim that some RBC models allow for nominal shocks.  Sorry, but the sine qua non of RBC theory is that nominal shocks don’t matter.  If both types of shocks matter it’s not an RBC model, it’s an NK model with both supply and demand shocks being important. When people say they don’t believe that RBC theory is correct, they mean that they think nominal shocks matter.  Everyone believes that real shocks also matter.  After all, the devastating earthquake/tsunami/shutdown of all nuclear power in Japan caused a  . . . oh wait; it didn’t cause a recession, or an increase in unemployment.  OK, everyone agrees that a real shock 10 times bigger than the Japanese tsunami could cause a recession. Say Godzilla destroying Tokyo.]

The last resort of the anti-QE crowd is to admit that it “works,” but only in a beggar-thy-neighbor way.  Stealing growth from other countries via currency depreciation and trade surpluses.  But macro is not a zero sum game.  Commenter Steve also provides this information:

I was wondering why the S&P500 futures abruptly spiked 15 points (0.75%) at 12:45am EDT. TheMoneyIllusion has the answer!

Steve, I’m sure that was a coincidence.  There must have been was lots of other news at 12:45 am that would have caused broad indices to spike sharply higher in the US.  And if it was Japan, it was surely only stocks in US companies with operations in Japan.

Seriously, the extent to which people go to try to deny the obvious is almost comical.  I think it has something to do with Bernanke’s comment that QE works in practice but not in theory.  That’s not true of course, it works in theory by raising the expected future money supply and expected future NGDP, but it gets at reasons why economic bloggers deny the obvious.  They live in a world of theories, of models, not reality.

PS.  Cameron also provides this nugget:

Also debunked is the belief that consensus is more important than policy stance. The vote was 5-4 in favor of expansion.

Make that 4 theories debunked.  Not a bad day’s work for my comment section!  I don’t have links, but all comments are quoted in full, and are listed among the first 8 comments of the previous post. They are easy to find.

PPS.  This is another reason why we need a NGDP futures market.  Hypermind has started one, but it’s still small, and appears inefficient in my view.  The market forecast 3.9% NGDP right before yesterday’s announcement, which seemed too low to me.  The actual figure was 4.9%.  So there are still $100 bills on the sidewalk.  The prizes at Hypermind will grow sharply in a few days, so when I make the announcement get in there and start picking them up.

Maybe the economics profession doesn’t want NGDP and RGDP futures markets because deep down they know that Keynesian and RBC models would be totally discredited almost immediately. I can’t think of any other rational explanation.

Will it matter when the Fed has “traction?”

People have made all sorts of arguments against “monetary offset,” but there’s only one that actually makes much sense.  The argument is that the Fed does not like doing “unconventional policies” like QE, because they feel “uncomfortable” with a large balance sheet.  (Put aside the fact that QE is perfectly conventional monetary policy–open market operations—and that there is no reason at all to feel uncomfortable with a large balance sheet.  The Fed is effectively part of the Federal government.)

Nonetheless, there is a sort of plausibility to the theory; Fed officials will occasionally say they would cut interest rates further if they could.  But what is the implication of this theory?  It seems to me that this theory implies that Fed policy should become much more aggressive when the Fed is no longer hamstrung by the zero bound.  When they can stimulate without adding to the balance sheet.  But this raises an interesting paradox—the Fed is conventionally viewed as being “stimulative” when they cut rates.  Thus the Fed should want to cut rates as soon as they can do so, which means right after they raise them!

Of course I’m half-kidding.  More realistically the implication is that once the Fed stops doing the “uncomfortable” QE, there will be a long period of zero rates before they raise them.  And perhaps there will be, but right now the Fed suggests it will be raising interest rates in less than a year.

Here’s a graph from a Marcus Nunes post:

Screen Shot 2014-10-30 at 6.15.21 PMNGDP had been rising at about 5% per year in the 17 years before the recession, and it’s been rising about 4% per year in the “recovery.”  Because wages and prices are flexible in the long run, the real economy has been recovering despite the lack of any demand stimulus.  We have fallen from 10% to 5.9% unemployment.  But most people think the economy is still in the doldrums, and needs more stimulus.  President Obama just instructed the Department of Labor to increase unemployment compensation benefits (without any authorization from Congress of course–why do you think would Congress be involved in spending decisions?) This was done because unemployment is at emergency levels, requiring extra-legal remedies.

Fortunately the Fed is no longer doing the “uncomfortable” QE policy, which adds to the balance sheet.  So if you believe the fiscal policy advocates, the Fed should be raring to go with stimulus. How do they do that?  By promising to hold rates near zero for a really long time, or until the labor market is really strong.  But instead, they are suggesting that they will probably raise interest rates soon.  There will be no attempt to get back to the old trend line; the new one seems just fine.

Let’s consider an analogy.  A bicycle rider has a “policy” of maintaining a steady speed of 15 miles per hour.  Then he hits a long patch of ice, and slows to 10 miles per hour, perhaps due to a lack of traction, perhaps because he decided to go slower.  How can we tell the reason?  How about this, let’s put a strong headwind in his face, and see if the speed slows even more.  But now he petals harder and keeps maintaining the 10 miles per hour speed.  That suggests it’s not a lack of traction. But the pessimists insist it must be a lack of traction, why else would he have slowed right when he hit the ice?  Then the bicycle final comes to the end of the ice.  The lack of traction proponents expect him to suddenly speed up, exhilarated by the sudden traction of rubber on asphalt.  Oddly, however, the bike keeps plodding along at 10 miles an hour.  Nothing seems to have changed even though the ice patch is long past.

[In case it's not clear, the headwinds were the 2013 austerity, and the end of the asphalt was the end of the liquidity trap.]

Here’s my claim.  The Fed promise to raise rates soon is not the sort of statement you’d expect from a central bank that for the past 5 years had been frustrated by an inability to cut rates.  (Nor is their other behavior consistent—such as the on and off QE.)  Rather it’s the behavior of a central bank that has resigned itself to pedaling along at a slower speed.  Ten miles per hour is the new normal.

I don’t want to sound dogmatic here.  Obviously monetary offset is not “true” in the sense that Newton’s laws of mechanics are true; the concept only applies in certain times and places.  Oh wait, that’s true of Newton’s laws too .  .  .

Opponents of monetary offset face two big problems.  In theory, the central bank should target some sort of nominal aggregate, and offset changes in demand shocks caused by fiscal stimulus. And in practice it seems like they do, as we saw in 2013, even at the zero bound.  So if monetary offset is not precisely true, surely it should be the default baseline assumption.  Instead, as far as I can tell 90% of economists have never even considered the idea.

PS. Totally off topic, I love this sentence from an article on why a million dollars no longer makes you rich:

Although it sounds like a lot of cash, $1 million of today’s money is only worth $42,011.33 of 1914 dollars, which is less than today’s median household income.

Someone should collect all these amusing claims in the media.  They could have added that today’s median income of $42,011 is only equal to $1764 in 1914 dollars, roughly equal to the per capita GDP (PPP) of Haiti.  I guess I was wrong, the American middle class really is struggling.