Do you “believe” in rational expectations? (important)

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.


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28 Responses to “Do you “believe” in rational expectations? (important)”

  1. Gravatar of Aaron Jackson Aaron Jackson
    9. February 2009 at 06:40

    Scott,
    I don’t know if I would go so far as to say “Lots of economists pay lip service to rational expectations, but don’t really believe it in their bones.” I think the vast majority of economists today believe in rational expectations. The extent to which market frictions move us away from the (pure) R.E. outcome is clearly debatable, and hinges on things like menu costs, agent learning, and agents ability to gather and process information about the economy (see Evans and Honkapohja; Sims; Mankiw and Reis).

    I see the point you raise as a somewhat related but different one, which is nonetheless valid: Markets are more efficient at finding the RE than individuals or small groups. The T-bond market, which aggregate disparate information from a variety of sources and participants is much better placed to produce the “right” outcome than is a small group of individuals (i.e. a monetary policymaking committee). The only difference between the market and the group is the information available, and how it is used. It can be argued that monetary policymakers, as a group, have superior information about the state of the economy (however this is debatable – see our paper on “Velocity Futures Targeting” for a discussion of this issue) than do bond traders. Thus, the question comes down to how you use that information. Your example demonstrates that markets have done a much better job of aggregating the information than an insular group.

    In other words, the policymaking group is still using R.E. but perhaps with an inefficient or flawed model of the economy compared to markets.

  2. Gravatar of Scott Sumner Scott Sumner
    10. February 2009 at 10:21

    Thanks Aaron, I should have been more specific about what I meant by “believe it in their bones”. I agree that most good economists employ Ratex in their formal research, but I think a lot of the problem we currently face is that in a crisis policymakers tend to revert to gut instincts that may have come from the simple Keynesian model they may have studied decades ago. I certainly get a lot of strange looks when I tell my fellow economists that Fed policy has recently been very tight. Of course I may be wrong about the December 2007 example, but if one believes in the Ratex approach to macro, my assertion is certainly not farfetched. Nevertheless, your point is well-taken, I need to be careful about broad-brush generalizations about other economists.

  3. Gravatar of Bill Woolsey Bill Woolsey
    12. February 2009 at 10:25

    Do rational expectations require Ricardian equivalence? Does being a scientific economist require that we assume that everyone is rationally maximizing fical policy.

  4. Gravatar of ssumner ssumner
    12. February 2009 at 13:22

    Bill, I see Ratex and Ricardian equivalence as separate issues, although I suppose that is debatable point. RE requires several assumptions, one of which is Ratex, but there are also some assumptions about bequest motives, distributional effects, etc., that go beyond Ratex. My own view is that Ratex is a good assumption, whereas RE is a bit of a stretch.

    On the other hand, there is probably a bit more to RE than many people believe. I often ask my students to raise their hands if they think they will get all the Social Security that they have been promised. None do. Then I ask how that would affect their saving decision–many say that they would save more knowing that they cannot count on Social Security. That is RE-like behavior, so although I don’t believe in complete RE, I think constant news stories about how our debts will reduce future entitlements or require higher taxes may have some impact on saving.

  5. Gravatar of Bill Woolsey Bill Woolsey
    12. February 2009 at 14:46

    Do businessmen sit down and calculate marginal cost and revenue? Or does a competitive market cause the surviving frims to develop rules of thumb that have that consequence?

    Does everyone sit down and calculate lifetime consumption and plan their savings, taking acount of future government tax policy? Or does repeated experience of defitics, national debt, and repayment cause them to learn to save for future taxes in order to survive? I don’t see how.

    Figuring out how monetary policy should impact pricing decisions looks to be somewhere in between.

    Is economics the study of markets? Or is the study of constrained optimization?

  6. Gravatar of Aaron Jackson Aaron Jackson
    21. February 2009 at 12:43

    Scott,
    Its interesting you suggest “in a crisis policymakers tend to revert to gut instincts…” I agree with that, especially considering that it is exactly during crises when policymakers may become most unsure of themselves; particularly considering that it is presumably the models themselves (to some extent) that may have facilitated getting into a crisis in the first place.

    That leads me to wonder how or whether Greenspan would have pursued policy any differently than Bernanke. This is of course impossible to know, but Greenspan was famous for eschewing formal models (such as the Taylor Rule, or other optimizing frameworks) in favor of his, for lack of a better term “gut instincts”. This is of course where he got the nickname the “Maestro”, by way of conducting policy more as an art than a science. I don’t know (much less anybody else) whether Greenspan would be more effective in constructing policies to deal with the crisis. But, given Greenspan’s reputation (up until recently, anyway) with Wall Street, I can’t help but wonder about the following: If Greenspan pursued the same policies as Bernanke, would they have been much better received than by Bernanke, who seems to be viewed by markets and the public with a fair amount of skepticism (i.e. lack of inherent credibility)?

    This is somewhat off topic, but seemed like an interesting point to make.

  7. Gravatar of Aaron Jackson Aaron Jackson
    21. February 2009 at 13:25

    I should clarify more my original point that I think I didn’t quite make in my previous post above: If a Counterfactual Greenspan (CG) did pursue policy with more of a “gut instinct” leading up to and through the crisis, would the policies early on that a CG devised have produced a better outcome? That is,

    Would CG have been more aggressive at cutting rates early to pre-empt negative (and seemingly irreversible) effects on private-sector expectations?

    Would CG have recognized sooner that policy should not be focused on inflation going forward, but rather be squarely concerned with an (at the time) low probability, high consequence problem in credit markets?

    His reputation in handling the Oct. 1987 crash and the East Asian financial crisis in the 1990s would seem to favor the view that CG may have acted earlier and more agressively to stem these problems.

    Oddly enough, I almost can see the traditional ideologies of Greenspan and Bernanke flipped in a Bernanke vs. CG comparison of this crisis. Greenspan is known to be an inflation hawk, yet I can’t help but think that a CG would have responded sooner and more aggressively, without worrying so much about inflation. Meanwhile, you would think that Bernanke, as a much hyped “Depression scholar” would have recognized the problem much sooner and taken more overt actions, yet the Fed seemed overly preoccupied with controlling inflation. Even in Sep. 2008, when credit markets were on life support, the Fed statement still alluded to some concern about inflation.

    A CG may or may not have been better. One thing is certain: he most certainly would have run into the same criticisms that he is only pouring more fuel on the fire.

    Just thought I’d throw that out there… again a little off topic.

  8. Gravatar of ssumner ssumner
    23. February 2009 at 05:25

    Aaron, That’s an interesting question. Although I don’t know the answer, I’ll throw out a few observations.

    1. After the subprime crisis broke, Greenspan was heavily criticized (fairly or unfairly) for holding rates too low for too long. That criticism might have made him reluctant to adopt ultra-low interest rates again.

    2. I haven’t heard Greenspan suggest that money has been too tight (although I suppose this could be explained by the reluctance of one central banker to make things harder for his successor.)

    3. The profession has not blamed the Fed for excessively tight money, and big institutions like the Fed tend to go with the conventional wisdom.

    4. The one area where I agree most strongly with your comment is the reputation effect. I need to read the Taylor piece you sent me, but just from skimming it I gather he was critical of the way Bernanke and Paulson botched their original bank bailout proposal in Sept-Oct 2008. Markets may have perceived Bernanke as being in over his head. I think that would be somewhat unfair (as the current administration is also finding this problem exceedingly difficult), but perceptions matter, and the perception that the crisis was not under control may have increased the bearish sentiment on Wall Street. Greenspan might have been more reassuring.

  9. Gravatar of Un nouveau blog de macro monétaire bigrement intéressant « Rationalité Limitée Un nouveau blog de macro monétaire bigrement intéressant « Rationalité Limitée
    25. February 2009 at 08:59

    [...] Ce billet qui réhabilite les anticipations rationnelles est également à lire. Bref, voilà le point de point de vue d’un macroéconomiste manifestement non-keynésien… mais qui rejette aussi l’explication autrichienne : [...]

  10. Gravatar of ssumner ssumner
    26. February 2009 at 18:07

    Rationalite Limitee, One of my students translated this for me. Thanks for your interest.

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  12. Gravatar of Clayton Clayton
    24. March 2009 at 13:34

    “Inflation expectations are not at 2%. If they had been over the past year, we would never had had the recession.”

    I think I’m missing an assumption in your argument as I could easily see a rational expectations perspective where the exact opposite was true:

    – If expectations are *lower* than inflation, prices are too low and the actual monetary impulse (larger than anticipated to cause higher inflation) should have a temporary, positive real effect (mitigating recession).

    – Vice versa, if expectations *exceed* inflation, then excessive pricing is met with inadequate money supply, contributing to contraction in real terms.

    In this view, 0% inflation with 2% expectations will create or intensify a recession (closer to what I meant)… while 0% inflation with 0% expectations would be RE neutral (closer to how I interpret your statement).

    What am I missing? You could easily inflate by 2% an economy that has contracted (in real terms and due to non-monetary factors like risk) by 10%… which would translate to a reduction of ~8% or so in money supply (all other things being equal).

    Hoping I don’t wake an even more ruthless dragon… under NGDP pathing, I think you could at least theoretically generate a 2% NGDP growth by inflating at 12% an economy that shrinks by 10% if again (1) the real contractions are not monetary in nature and (2) expectations do not exceed 12%.

    Given the high level of transparency, the latter seems extremely likely. Perhaps you should point me to a paper of yours to clarify if I’m wrong about the former?

  13. Gravatar of Clayton Clayton
    24. March 2009 at 13:34

    wrong post sorry… was reading up on your RE before I responded to your Fed post

  14. Gravatar of ssumner ssumner
    24. March 2009 at 16:19

    Clayton, You make a good point. When I referred to expected inflation, I meant something closer to actual inflation. I realize that’s totally confusing, so here’s my explanation:

    As of last September, people expected 2% inflation over the next few years. Wage and loan contracts were signed on the basis of those expectations. By October and November, inflation expectations had fallen sharply, as well as actual inflation. To a level well below that required for people to repay loans, and for companies to be able to pay workers their negotiated contracts. Loan defaults and unemployment rose sharply. Why didn’t I just say actual inflation fell below target in late 2008? Because I am used to talking about the Fed targeting inflation expectations. So the fall in near term inflation expectations meant policy was too contractionary. Eventually wage and loan contracts will adjust to the lower actual inflation, but it will take time. So I was actually saying near term inflation expectations fell below long term inflation expectations.
    Your intuition was right, I don’t blame you for being confused.

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  19. Gravatar of Steve Steve
    13. April 2010 at 08:56

    Scott,

    weird comment after such a long time, but I have trouble understanding the whole interest rates issue.

    During the Great Depression, interest rates are a bad indicator for the stance of monetary policy, because nominal rates were low, and real rates were high, indicating tight money. Is that correct? (Mishkin says something like that, I think)

    Now, you argue that nominal interest rates were falling, but so were real rates, again indicating tight money. Not sure I understand the difference.

    Thanks,

    Steve

  20. Gravatar of scott sumner scott sumner
    14. April 2010 at 05:34

    Steve, I am saying that interest rates are not a reliable indicator. Most economists agree that nominal rates can be unreliable (although they forget this occasionally.) But real interest rates are also unrelaible, despite what Mishkin says. They are better than nominal rates, but they can also fall during a period of tight money if the income effect is strong enough. Tight money can cause recessions, which lowers business demand for loans, which lowers real rates.

  21. Gravatar of Steve Steve
    14. April 2010 at 07:34

    Scott, thanks again.

    So you are saying that real interest rates can…

    …fall in times of tight money (like in Dec 2007?) for the reason that demand for loan decreases

    …rise in times of tight money like they did during the Great Depression (what was the reason at that time?)

    And therefore they are a bad indicator for the stance of monetary policy.

    S

    PS: I saw in Mishkins text that interest rates (real and nominal) show spiking patterns in the 80s. Is that due to the high inflation from before, and the Volcker policies after?

  22. Gravatar of scott sumner scott sumner
    15. April 2010 at 04:49

    Steve, I don’t agree that real interest rates rose during the Depression, they use ex post real rates, whereas I think ex ante rates are more appropriate. The same problem occurs in the 1980s. But I do think real rates may have risen somewhat in the mid-1980s, due to the strong economy.

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