Recognizing easy money

People who pay attention to monetary policy know that easy money often raises long term interest rates.  We have lots of high frequency data showing this (expansionary monetary surprises often raise long term bond yields) and low frequency data (long periods of accelerating M2 growth usually result in higher inflation and higher bond yields.)

But most people don’t understand this, probably because they equate the terms ‘easy money’ and ‘low interest rates.’  So the claim that easy money raises rates leads to one of the “that does not compute” moments of puzzlement.

Commenter Brendan recently directed me to a blog post that had some fun with some predictions by a Wall Street commentator named John Hussman.  Here’s Brendan commenting on a quotation from a Hussman post:

It’s June 28th, 2010. The S&P 500 has declined from a high of 1220 in April to 1,011 in late June, a plunge of 18% in just two months. The economic expansion and bull market is barely more than a year old and people are skittish. Here is what John Hussman had to say at the time (emphasis mine):

“Based on evidence that has always and only been observed during or immediately prior to U.S. recessions, the U.S. economy appears headed into a second leg of an unusually challenging downturn.”

Then Brendan goes on to report some follow-up information:

Two months later Ben Bernanke, speaking at Jackson Hole, hinted that further Fed stimulus could be coming. And a bit more than a two months later QE2 was officially announced.

Since monetary policy works primarily through shaping expectations, it makes sense to consider the QE2 hints at Jackson Hole as the functional start date for QE2. . . .

The S&P, which was at 1100 when QE2 was hinted at, rose to 1330 in the next six months, a gain of 21%. And over that same time frame 10-year inflation expectations rose from an anemic 1.7% to a healthier 2.6%.

By late 2010 or early 2011, economic data was firming and statistical recession forecasting models were no longer predicting recession. Human nature being what it is, bears who had been predicting recession and predicting the futility of QE2 refused to admit that the policy may have successfully averted recession.

Here’s Hussman in late December 2010:

“As for the notion that the Fed’s targeted Treasury purchases have directly aided the economy, the argument requires bizarre logical gymnastics. It demands one to believe that although the purchases were intended to stimulate the economy by lowering rates, they have been successful without lowering them, and in fact by raising them, because the expectation of lower rates was so stimulative that it caused rates to rise, so that the higher rates can be taken as evidence that lowering rates without lowering them was a success. Oh, brother.”

Yes, the Fed says it’s trying to lower bond yields.  Don’t believe them.  They are trying to raise the yields; they just don’t know it.

PS.  I added the Hussman links to the Brendan quotes, to make it easier for readers to follow the threads.


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40 Responses to “Recognizing easy money”

  1. Gravatar of Liberal Roman Liberal Roman
    26. December 2012 at 10:31

    Reading hedge fund newsletters makes my sympathetic to those who claim that a large chunk of the finance industry provides no value, are rent-seekers and basically commit glorified fraud.

  2. Gravatar of Scott N Scott N
    26. December 2012 at 11:14

    Bernanke’s Jackson Hole speech has only been read in HINDSIGHT as the beginning of QE2 because it coincided with the stock market lows of 2010. Very few people; thought at the time that Bernanke was hinting at QE2 (Bill McBride at Calculated Risk was one). The stock market certainly didn’t think he was hinting at QE2. What started the rally shortly after Bernanke’s speech was better than expected global PMI data.

    Bernanke did hint at QE2 but it was’t until he gave a speech on 4 October 2010, which just happened to be the same day that bond yields were at their lows for the year. After Bernanke’s speech, bond yields and inflation expectations shot dramatically upward. This is when the market knew QE2 was coming and adjusted its expectations accordingly (

  3. Gravatar of Max Max
    26. December 2012 at 11:17

    Isn’t the most natural definition of “easy money” a condition where short term rates are expected to sharply increase (i.e. steep yield curve)?

    And likewise “tight money” a condition where short term rates are expected to sharply fall (i.e. inverted yield curve)? Incidentally, this has been a good predictor of recessions, including the last one.

    Finally, “neutral money” would be a state where the forecast of the short rate is the current short rate.

  4. Gravatar of Nick Rowe Nick Rowe
    26. December 2012 at 11:53

    Good post Scott (and Brendan). I actually really like that second Hussman quote, because it’s so honest. Perfectly illustrates your point.

  5. Gravatar of Doug M Doug M
    26. December 2012 at 12:23

    “Yes, the Fed says it’s trying to lower bond yields. Don’t believe them. They are trying to raise the yields; they just don’t know it.”

    You are suggesting that the monitary authority doesn’t understand monitary policy….I fear that you are correct.

    Yes, the fed should want higher bond yields.

  6. Gravatar of jknarr jknarr
    26. December 2012 at 13:24

    Scott, I take it then that an increase in debt – to from 1.5x to 3.5x GDP for example – is then a symptom of tight policy. Low interest rates – a high price of debt – pulls in more borrowing. Greater debt availability has been seen as a sign of loose policy.

    The Fed appears to target and stablize the availability of debt and the price of debt as the vector for its putative AD goals. Yet this suggests that they are not necessarily making a “policy mistake” – their focus on debt creation necessitates tight policy toward NGDP.

    They can target and stabilize debt, or NGDP, but not both.

  7. Gravatar of 123 123
    26. December 2012 at 13:35

    Brendan, I hope Hussman will read your posts.

  8. Gravatar of anon anon
    26. December 2012 at 13:39

    jknarr, low interest rates (so, higher prices for riskless assets) would indeed pull in more borrowing and investment, all other things being equal. However, business investment is quite dependent on expectations of future NGDP (which are not especially high at present), as are stock prices. So all else is not in fact equal: in practice, it seems that NGDP expectations drive “natural” interest rates and asset prices.

  9. Gravatar of Scott Sumner Scott Sumner
    26. December 2012 at 14:22

    Max. I think expected NGDP growth is the best indicator of easy and tight money.

    And the inverted yield curve is a reasonably good forecasting tool, but it actually did not predict the most recent recession. It inverted in mid-2006 and there was no recession in mid-2007. Forecasts need to be both accurate and timely. It was accurate but not timely, hence it failed. But it did predict many previous recessions.

    Thanks Nick, you won’t like the next post in my queue, on $100 bills.

    jknarr, No, I favor targeting NGDP, and see that as the best indicator of easy and tight money.

  10. Gravatar of Doug M Doug M
    26. December 2012 at 14:36

    “And the inverted yield curve is a reasonably good forecasting tool, but it actually did not predict the most recent recession. It inverted in mid-2006 and there was no recession in mid-2007. Forecasts need to be both accurate and timely. It was accurate but not timely, hence it failed. But it did predict many previous recessions.”

    The inverted curve indicator is ususally credited as predicting 12 of the last 8 recessions. However, this last time, it called it corectly. The recession began 1/08! 18 months of lead time is not excessive. If tight money did indeed cause the recession, as you like to point out, then if the Fed had started lowering rates in late 2006 rather than late 2007, who knows where we would be.

  11. Gravatar of Scott Sumner Scott Sumner
    26. December 2012 at 14:57

    Doug, Sorry, but that’s called “moving the goal posts.” You can’t look at a financial indicator and macro outcome, ex post, and try to match them up, ansd then claim you’ve tested the theory. That’s data mining, which is (should be) used to create models, not test them. Ex ante the standard model claimed the yield curve signalled a recession within 12 months. It failed. If you want to develop a new theory with an 18 month window, that’s fine, but it’s a much weaker claim given that the average US business cycle only lasts about 5 years. Just wait until an expansion has been going on for a long time, and predict a recession with a few years. That’s why it’s important to demand a very high standard of excllence for forecasts, or else assume they have failed. It’s also why most published scientific studies misuse statistical significance, and hence cannot be replicated.

  12. Gravatar of jknarr jknarr
    26. December 2012 at 15:08

    anon – yes, NGDP expectations drive asset yields/prices. My point is that tight policy lowers NGDP, which then lowers yields, (and raises p-e multiples for equities), and thereby creates a boatload of debt and leverage.

    Businesses are fairly well-behaved with leverage, mostly rooting it in investment (but now mostly stock buy backs). Leverage in the financial sector and households is *not* well behaved, and show little connection to investment.

    Scott, absolutely NGDP reveals the policy stance. The problem is that debt is the current target of Fed policy efforts. The Fed targets and stabilizes debt markets, and lets NGDP vary and fall where it may.

    You propose that the Fed target the real economy. I agree that they should, but I also would suggest that NGDPLT would mean that the Fed cannot stabilize and target debt markets as they had.

    The Fed has been stabilizing banks and debt, and thereby destabilizing households and NGDP – by definition. Retargeting *monetary policy* to focus on NGDP means that we would no longer require a *central bank* to stabilize debt markets.

  13. Gravatar of Doug M Doug M
    26. December 2012 at 15:18

    “It’s also why most published scientific studies misuse statistical significance, and hence cannot be replicated.”

    That is a big statement you just made….Probably true.

    Regarding the inverted curve…it suggests that the marginal expectation of bond investors is for lower rates in the intermediate future. A recession is a cause, but not necessarily the only cause of lower rates.

  14. Gravatar of flow5 flow5
    26. December 2012 at 16:13

    “we would no longer require a *central bank* to stabilize debt markets”

    It’s an excessively easy money policy that destablizes the debt markets, creates excessive risk taking, & fosters lawlessness.

  15. Gravatar of flow5 flow5
    26. December 2012 at 16:27

    “cannot be replicated”

    That’s also because of “true-ups”. And the “desk” is always making “adjustments”. Not to mention that one should ignore the seasonally mal-adjusted data.

  16. Gravatar of Doug M Doug M
    26. December 2012 at 17:00

    Flow,

    “Cannot be replicated”

    It is a bigger problem than economics. Read John Ioannidis — “Why most published research findings are false.”

    The ‘hard’ sciences are rife with poor methodology.

  17. Gravatar of marcus nunes marcus nunes
    26. December 2012 at 17:29

    If the Fed was more forthright, they wouldn´t confuse the hordes of Husmans out there!
    http://thefaintofheart.wordpress.com/2012/12/11/they-should-say-we-want-long-term-rates-to-rise/

  18. Gravatar of Max Max
    26. December 2012 at 17:29

    “I think expected NGDP growth is the best indicator of easy and tight money.”

    What you mean is, expected NGDP is the best indicator of too easy and too tight money.

    It impoverishes the language if you can’t talk of easy/tight money independently of whether it’s appropriate. Easy money could be too easy, too tight, or just right.

  19. Gravatar of flow5 flow5
    26. December 2012 at 17:36

    “poor methodology” & even poorer theory

    The Fed’s never been cooperative in providing comparative data. And, for example, William Bretz (Juncture Recognition) would often call & complain that the data released contained errors & should be reexamined & revised (he’s was right of course).

    But for targeting ngDp the lags are long enough, & the data conforms closely enough, that after the 1st qtr, we know 2013 is going to be rough. Its projected path needs to be adjusted upward – which will take something over & above just QE3.

  20. Gravatar of Tommy Dorsett Tommy Dorsett
    26. December 2012 at 19:39

    Hussman has been hanging on to the september 2011 ECRI recession call since before they made it. The guy is a shamrful, painful, arrogant bully who had been predicting a market crash and recession every year since 1995. Clownshow in clownshoes.

  21. Gravatar of Benjamin Cole Benjamin Cole
    26. December 2012 at 19:41

    Yes, the Fed should be transparent, and provide clear guidance. I am an MM’er.

    But—-does it matter?

    1. Greenspan was notoriously opaque. Had great success.

    2. In Western democracies, the population does not trust public agencies or leaders. Gee, the dense clouds of perfidy and PR…..so why trust some guys who call themselves central bankers?

    Ask this: Today, there are screamers everywhere about inflation, and the Fed. The Fed has just conducted a successful 30-year rout of inflation, along with other major central bankers. The world is teetering on zero bound, Japan-style.

    But the Fed has no credibility as an inflation-fighter. If the Fed has no credibility as an inflation fighter now—after 30 years of inflation-fighting—when would it have credulity.

    The answer is never. Central banks in Western democracies will never have credibility. It is not the nature of the beast.

    Monetary policy must rely on other mechanisms besides credibility to get the job done. Greenspan did it, so it can be done

  22. Gravatar of Major_Freedom Major_Freedom
    26. December 2012 at 21:44

    Since only the market process can provide the information pertaining to partial relative overproduction and partial relative underproduction of commodities, it follows that the optimal standard for judging partial relative overproduction and partial relative underproduction of a non-market money (our current system) is to compare the rate of aggregate non-market money supply production with the rate of aggregate market money supply production.

    Since we unfortunately can’t directly observe market production of money, we have to make an educated guess of what money would probably have prevailed in a free market of money if one existed. One estimate is the production of gold.

    This is the world production of gold:

    http://i.imgur.com/h6d5J.jpg

    Compare this chart to the production of non-market money, and you can get a better sense of when money was loose and when it was tight.

    NGDP isn’t as good a measure, because world market changes would otherwise influence national level money supplies and spending. Thus, if we are in an environment where there are large trade deficits, then even stagnant or gradually rising NGDP rates would suggest very loose money, whereas MMs might believe money is tight because they compare it to an arbitrary 5% annual growth rate.

  23. Gravatar of Thursday Morning Links | Iacono Research Thursday Morning Links | Iacono Research
    27. December 2012 at 06:24

    [...] up 16% – OC Register Foreclosures come slowly in Florida, prices rise – Housing Wire Recognizing easy money – The Money Illusion No comments [...]

  24. Gravatar of Andrew Andrew
    27. December 2012 at 08:04

    This statement…

    “Yes, the Fed says it’s trying to lower bond yields. Don’t believe them. They are trying to raise the yields; they just don’t know it.”

    … does not make me feel any better that anyone knows what they are doing/talking about.

  25. Gravatar of Bill Ellis Bill Ellis
    27. December 2012 at 08:44

    Prof Sumner et al,
    Does anyone have a nomination for Chart of the Year ?

    Here is a fun post from Wonk Blog… Fun for folks that love charts that is.

    http://www.washingtonpost.com/blogs/wonkblog/wp/2012/12/27/2012-the-year-in-graphs/

  26. Gravatar of W. Peden W. Peden
    27. December 2012 at 09:06

    Bill Ellis,

    That’s a real curate’s egg of graphs. Some are great, some are good, some are bad, some are so bad that they are utterly misleading.

    Of course, the last of those are the most fun, since it’s much more fun to pick apart a graph than be informed by it!

  27. Gravatar of W. Peden W. Peden
    27. December 2012 at 09:08

    In particular, can we just ban all inferences about prosperity based on median household income? I doubt that the few inferences that aren’t bone-headed are worth all of them that are bone-headed.

  28. Gravatar of Doug M Doug M
    27. December 2012 at 09:10

    Benjamin Cole,

    “Greenspan was notoriously opaque. Had great success”

    And yet he was far more trasparent than is predicessors. It was in the Greenspan era that the Fed began to publicise its Fed funds target rate, and provide statments after each meeting with guidance.

  29. Gravatar of TallDave TallDave
    27. December 2012 at 09:37

    It’s an interesting and counterintuitive point. Though much of it may just boil down to the difference between nominal and real rates of return (which is of course its own thicket) near ZLB that difference may be more difficult to discern.

  30. Gravatar of TallDave TallDave
    27. December 2012 at 09:42

    W. Peden — Yeah, that bothers me more and more too. It’s almost as bad as the standard usage of “poverty” as relative poverty, which seems mainly designed to ensure one never has a standard of poverty under which poverty has been eliminated.

  31. Gravatar of Philo Philo
    27. December 2012 at 09:55

    @Max
    “It impoverishes the language if you can’t talk of easy/tight money independently of whether it’s appropriate.” Why should we want to do that? *Easier than appropriate* and *tighter than appropriate* are important concepts, but of what use are *easy* (= easier than X) and *tight* (= tighter than X) measured relative to some standard (X) that is independent of appropriateness? For example, we could easily define *easy* as *M3 is growing at more than 3% per annum* and *tight* as *M3 is growing at less than 3% per annum*; but these are useless concepts.

  32. Gravatar of W. Peden W. Peden
    27. December 2012 at 10:47

    TallDave,

    I agree, but I think it’s even more insidious: by using one word (‘poverty’) for both absolute poverty and relative poverty, one can carry over moral beliefs that people have about the former into argument for doing something about the latter.

    If the relative poverty line was $1,000,000, and no-one had a net income of less than $250,000, then one might still have a statistic like “30% of all children are born in poverty”. Similarly, while there is some absolute poverty today in advanced societies, the poverty line is far, far above what most people would define as absolute poverty.

    It’s tempting to use a word like ‘destitution’ again to mean ‘absolute poverty’, but if the use became widespread, how long would it be before that term was expropriated by income-egalitarians?

  33. Gravatar of flow5 flow5
    27. December 2012 at 11:29

    During periods of low inflationary expectations (the NBER lists March 2001–Nov 2001 as a recession), an easier money policy will temporarily depress rates (take 9/11/2001 as an example when the Fed injected +34b in total reserves).

    If the manager of the Open Market Account (FRBNY-William Dudley) puts in buy orders for Treasury bills for the accounts of the 12 Federal Reserve banks, the prices of these bills will tend to rise, & their yields (interest rates) fall. This particular procedure, taken alone, would be evidence of an easier or less restrictive monetary policy. And the opposite action would be evidence of a tighter monetary policy.

    But this is a “24-hour phenomenon” (not 24 months). Over a period of time, open market operations of the buying type increase the quantity of loanable federal funds & thus excess reserves (+ clearing balances) into the commercial banking system (increasing its legal lending capacity). Given profitable bankable opportunities, the CBs will take advantage of this new lending capacity & expand bank credit (+ the money supply).

    It is the excessive increase in bank deposits combined with the transactions velocity of these funds that increases monetary flows (money multiplied by velocity). When aggregate monetary purchasing power increases at a faster rate than real gross national product (the volume of goods & services offered in the markets) we get increasing rates of inflation accompanied by higher interest rates.

  34. Gravatar of flow5 flow5
    27. December 2012 at 11:46

    “Money banking textbooks written before 2008 are “now obsolete”, as the Fed now has the ability to pay interest on excess reserves, he said in response to an audience question” — WILLIAM DUDLEY

    Coming out of the Great Depression the CBs didn’t become fully “lent up” until 1942 at which time the volume of excess reserves became more releated to its need for interbank clearing balances (like vault cash is needed for currency withdrawls). Bank managers strived to minimize non-earning assets to maximize profits.

    Since Oct 9, 2008 interbank demand deposits have become bank earning assets. The Fed has with this “tool” [sic] effectively emasculated its power to control the money stock — but increased the length of time it can peg short-term interest rates (increased its ability to screw things up).

  35. Gravatar of Brian Donohue Brian Donohue
    27. December 2012 at 15:01

    Scott,

    I think you talk with too much confidence about interest rate movements. I have watched rates pretty closely over the past couple decades as part of my job.

    For example, Treasury rates today (nominal and TIPs) closed about exactly where they were on December 13, before the big QE4 hullaballoo.

    Also, I think young Brendan picks his end points just a bit conveniently to fit his narrative.

    The general pattern of QE followed by a blip in rates, yes there is some truth here, but against the backdrop of a 30-year secular trend of declining rates, a blip here and there is just that.

  36. Gravatar of Brian Donohue Brian Donohue
    27. December 2012 at 15:01

    Scott,

    I think you talk with too much confidence about interest rate movements. I have watched rates pretty closely over the past couple decades as part of my job.

    For example, Treasury rates today (nominal and TIPs) closed about exactly where they were on December 13, before the big QE4 hullaballoo.

    Also, I think young Brendan picks his end points just a bit conveniently to fit his narrative.

    The general pattern of QE followed by a blip in rates, yes there is some truth here, but against the backdrop of a 30-year secular trend of declining rates, a blip here and there is just that.

  37. Gravatar of Bill Ellis Bill Ellis
    27. December 2012 at 18:10

    BOOM goes the austerity bomb…

    So If unemployment has been kept high because of extended unemployment benefits… How long until the benefits being cut off shows up in in higher employment ?

    snark.

  38. Gravatar of ssumner ssumner
    28. December 2012 at 09:36

    Max, I strongly disagree. Every “absolute” measure of the stance of monetary policy (price of gold, exchange rates, commodity prices, nominal interest rates, real interest rates, slope of yield curve, the monetary base, M1, M2, etc) has been utterly discredited. In the end the only meaningful description is relative to the policy goal. Which of the discredtied metrics do you prefer?

    Brian, I believe in the EMH, so I have no confidence in my ability to predict rates. I would not expect any anticipated policy action by the Fed to have much impact on rates. I observe that throughout history major unexpected monetary easing usually (not always) raises rates. Two good examples where the strongly unexpected easings of January 2001 and September 2007. If you work in the Treasury market I’m sure you recall those events.

  39. Gravatar of Major_Freedom Major_Freedom
    28. December 2012 at 10:10

    ssumner:

    Max, I strongly disagree. Every “absolute” measure of the stance of monetary policy (price of gold, exchange rates, commodity prices, nominal interest rates, real interest rates, slope of yield curve, the monetary base, M1, M2, etc) has been utterly discredited. In the end the only meaningful description is relative to the policy goal.

    All of those metrics ARE “policy goals”, when they are made as goals.

    You claim they have all been “discredited.” But by what standard? What, the fact that by making any of them a “policy goal” it would not guarantee a fixed NGDP growth? That is only a “failure” if you a priori assert that NGDP growth IS the very standard by which to judge monetary policy. But then you would only be begging the question, because you would be saying NGDP is optimal because of the premise that NGDP is optimal.

    NGDP growth is no less “absolute” than any of the “discredited” metrics you listed.

    Brian, I believe in the EMH, so I have no confidence in my ability to predict rates.

    You predict that tight monetary policy leads to lower interest rates.

    You predict that collapsing NGDP leads to unemployment and recession.

    You predict all sorts of things.

  40. Gravatar of Sumner Responds Sumner Responds
    4. April 2013 at 19:27

    [...] On Dec. 26, 2012, in a post entitled “Recognizing easy money” (apropos, yes?) Scott [...]

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