Lots of economists pay lip service to rational expectations, but don’t really believe it in their bones. By that I mean they use it in their theoretical models and then casually analyze real world problems using the old, pre-Ratex, Keynesian model. Here’s an example of why rational expectations are so important.
On December 11, 2007, the Fed cut rates by a quarter point. Here’s how the T-bond market reacted:
Table 1. Treasury Bond Yields, December 10-11, 2007.
Maturity December 10 Closing Yield December 11 Closing Yield
3 month 2.89% 2.80%
6 month 3.14% 3.04%
2 year 3.17% 2.91%
3 year 3.15% 2.87%
10 year 4.15% 3.96%
So it looks like the Fed is reducing interest rates. Mission accomplished! Actually, not at all, but to see what’s really going on it will be helpful to first examine the Fed half point cuts of January 2001 and September 2007. Both of those were when the economy was nearing recession, and both were the first cuts in a long down cycle. Both of those cuts were larger than expected. Both led to big stock market rallies. Both caused short term rates to fall (liquidity effect) and long term rates to rise (income and expected inflation effects.) Long rates often rise on expansionary monetary surprises.
By December 2007, we were teetering on the edge of recession. The Fed’s decision was hugely consequential. The fed funds futures showed a 58% chance of a 1/4 point cut and a 42% chance of a 1/2 point cut. The more than two percent fall in US equity indices after the 1/4 cut was announced implied a 5% swing in US equity prices hinged on the Fed decision. And foreign markets seemed to respond almost equally strongly–implying that the Fed’s decision destroyed well over a trillion dollars in shareholder equity worldwide.
Now take another look at the reaction in the T-bond market. The contractionary surprise caused expectations to became so bearish that T-bond prices rose sharply and yields fell. But even the three month T-bill yield fell, so where was the liquidity effect? Is it possible that the income and inflation expectations effects could overwhelm the liquidity effect at three month maturities? Not only is it possible, it happened. December 2007 is the official date for the onset of the recession, but one might as well date it December 11, 2007. Things got bad so fast after the Fed’s decision (and partly because of the Fed’s decision) that the Fed cut rates by 75 basis points even before their next scheduled meeting, and then another 50 basis points at the meeting in late January. The markets saw this coming before the Fed. (As they did once again in early October 2008.)
During this period when I spoke to economists they couldn’t figure what I was talking about. Isn’t the Fed “doing its job,” easing money to lower interest rates? Actually, it was monetary tightness, relative to what was required to meet their dual mandate, that was depressing interest rates. I’m not breaking any new theoretical ground here, Robert King made this point 16 years ago in the JEP (pp. 77-78):
“If changes in the money stock are persistent, then they lead to persistent changes in aggregate demand. With a rational expectations investment function of the neoclassical form, persistent changes in demand for final output lead to quantitatively major shifts in the investment demand schedule at given real interest rates. These effects are generally sufficiently important that real interest rates actually rise with a monetary expansion rather than fall: the IS curve effect outweighs the direct LM curve effect. Further, if persistent changes in the money stock are only gradually translated into price or wage increases, then there are very large additional expected inflation effects on nominal interest rates.”
Maybe it’s time we started taking rational expectations theory seriously.