If you haven’t read my previous post, read that first. Here’s Frederic Mishkin in December 2007 on the state of the economy; later we’ll look at his policy analysis:
But I want to talk about why my sunny disposition is much less sunny right now and why I’m actually very, very worried—not to say depressed, but at least a little more that way than usual. It is because I think that the kind of negative scenarios that are pointed out in the Greenbook are very real possibilities. In particular, there are two scenarios that they go into separately—the housing correction scenario and the credit crunch scenario. I think that there’s a very strong possibility those would come together because, if housing prices go down more, that creates a much more serious problem in terms of valuation risk, and a serious problem in valuation risk will mean a further credit market disruption, which then can lead to more macroeconomic risk because it leads to this downward spiral. The real economy gets worse. That means that there is more uncertainty. Credit spreads get worse, and you get a very bad scenario happening. That could lead to the credit crunch scenario. Similarly, a credit crunch scenario, I think, would have a very negative effect on the real economy, which would mean that housing prices would go down, which would then make it much more likely that we have the greater housing correction scenario. So that’s the first part of my depression.
The second issue is that the Greenbook does not go into the issue of what effect that might have overseas. There has been a lot of discussion in the media about decoupling the U.S. economy from foreign economies, and when it’s just trade that’s going on, I think that is usually completely reasonable. But when it’s financial, then there is very good reason to think of recoupling because a financial disruption in the United States is very likely to spread to financial disruption abroad. We, of course, have already seen that. It’s remarkable that what happened in the subprime sector has in some sectors affected European banks maybe even more than American banks. So the possibility that problems develop in the United States and lead to problems in Europe and other advanced countries and then those problems actually spill over back into the United States again means that there’s a third scenario that could be all tied together.
When you look at all of this, I get very nervous. The bottom line is that my modal forecast is certainly down, very much along the lines of what the staff has suggested. But I think there is a significant probability that things will go south. You don’t like to use the R word, but the probability of recession is, I think, nearing 50 percent, and that really worries me very much. I also think that there’s even a possibility that a recession could be reasonably severe, though not a disaster. Luckily all of this has happened with an economy that was pretty strong and with banks having good balance sheets; otherwise it could really be a potential disaster. I don’t see that, but I do see that there is substantial risk that the economy could have a severely negative hit to it that would be very, very problematic.
So Mishkin understood the dangers facing the economy. But so did lots of other people. It’s his policy recommendations that presents an absolute a masterpiece of analysis:
So let me just lay out this argument. Would a 50 basis point cut matter? This is a question that President Fisher has asked. I think the answer is very much “yes.” It is not the actual cut itself that matters; it is the managing of expectations that really matters. In fact, whenever we make a 25 basis point cut and you ask, “How big an impact does that have on the economy?” the answer is, “Not a whole lot.” That comes out of our simulations. It is really the path of interest rates implied by our actions that is important. In particular, the idea here of a 50 basis point cut is that, by getting ahead of the curve, we provide a signal to the markets that we would be willing to take steps to react to events in the financial markets that might indicate that we are getting into a vicious-circle type of situation. That is exactly what I felt we did in the September meeting. That move was very successful, and the markets really improved very dramatically afterward. The signal we were sending at that point was that, if things got much worse, we might have to do it again. (emphasis added.)
Mishkin is warning that the standard view coming out of the simulations is wrong—a 25 basis point difference can be a very big deal if it tells us something about the Fed’s willingness to aggressively prop up NGDP growth. And of course Mishkin was right, 700 points on the Dow were separated by a mere 25 basis points in the fed funds rate. It’s all about expected future policy, as Sumner (1993)/Krugman (1998)/Eggertsson/Woodford, etc., keep insisting.
Mishkin continues his policy recommendations:
Now, as I said, we thought in October that things were looking pretty good. I thought we had this great game plan; we were on board for the game plan; and, of course, the game plan is unfortunately out the window. So I think that taking an action like a 50 basis point cut would have an important impact and would provide the signals and the managing of expectations that can have critical implications for how the economy evolves, particularly how the credit markets evolve. It also raises the issue that one thing we do need to do, no matter what, is to indicate to the markets that we understand that our job is to prevent bad shocks from propagating in a very bad way. We can’t prevent the shocks—because things happen—but our job is to make sure that they don’t propagate in a very bad way. (emphasis added.)
A “very bad way” is of course falling NGDP, as in the early 1930s. Mishkin understood that “no matter what” that cannot be allowed to happen. And it’s “our job” to prevent it from happening. And the Fed needs to “indicate to the markets” that they understand it is their job. Reading that almost brings tears to my eyes, especially when I think of all the totally unqualified people who serve on the FOMC. People who are not experts in monetary policy and yet who make decisions costing millions of people their jobs. Years ago I did a post arguing that only people like Mishkin, Bernanke, Woodford, Krugman, Mankiw, McCallum, Svensson, etc, should even be allowed to serve on the FOMC. Pay them whatever it takes. (If you don’t believe me then read a few Richard Fisher speeches.)
Here Mishkin responds to the hawks who were worried about inflation:
I think we are operating in a very proactive, forward-looking way. In that regard, we would have to act similarly in terms of thinking about inflation. There are two cases in which there would be signals that we would have to act very differently. One is that credit conditions could improve very quickly. We are hoping that this would happen, and actually sometimes you do see these things just turn around on a dime. All of a sudden a virtuous circle occurs. If that actually started to happen, it would be imperative if we did a 50 basis point cut that we reverse very quickly on that action. Second, we have information about inflation expectations, and if we saw those numbers starting to go in a bad direction, we should also operate very quickly in a reversing direction. It is extremely important not to be in the Taylor-rule type of framework, where you wait to see actual inflation and output outcomes to drive your policy. It really has to be much more proactive than that. There have been mistakes in the past, at least in my viewpoint, when we could have reacted more quickly. For example, in ’98, it was very appropriate for us to cut rates the way we did. But we were a bit slow to raise them, and I think part of the reason was that we were reacting more to what was going on. I’m not sure—you can correct me in private afterward, Don—but I think that inertia was there, and if we think about doing things differently, it could work out very well. (emphasis added.)
Mishkin understands that what matters is not past inflation, but inflation expectations. That makes me think of the September 2008 meeting, where the Fed refused to cut rates below 2%, even though Lehman had just failed and the economy was reeling. Why didn’t they act? Because they were worried about high inflation. It’s true that headline inflation was elevated due the the oil price shock in early 2008, but by the time of the Fed meeting 5 year TIPS spreads showed only 1.23% inflation (a prediction that will eventually prove fairly accurate.)
Many of those who favored the 1/4% point cut cited a fear that a 50 basis point cut would frighten the markets, as investors worried that the Fed might know something that they didn’t know. In retrospect that concern seems almost laughably naive; the markets were actually worried that the Fed didn’t know something that the markets knew—we were in deep trouble.
I can forgive people who made erroneous forecasts—-I didn’t expect a big recession back in December 2007. What I cannot forgive is policymakers who don’t even know the basics of the EMH. Who don’t know that their job is not to try to avoid scaring the markets with bad news, as if market were an impressionable child, but rather to give markets confidence by doing the right thing.
So Mishkin got almost everything right. He understood the danger that NGDP could plunge causing the housing recession to spill over into the broader economy. He saw that the Fed was not ahead of the curve on policy, but was trailing behind the rapidly deteriorating financial conditions. He understood that it was essential that the Fed not allow NGDP to plunge, and that they needed to convince markets that they would not allow NGDP to plunge. He understood that they needed to target the forecast, not rely on 20th century techniques like the Taylor Rule. His comments basically explain why the stock market crashed right after the vote was announced, and why the Great Recession happened. The Fed did not do their job—it’s as simple as that.
Mishkin’s only mistake was that when he saw he’d lost the battle he decided to support his pal Bernanke, to avoid an embarrassing split at the Fed. But that’s certainly forgivable, as a dissent would have been merely symbolic. I’m not sure I would have done any different.
This raises the question of why Bernanke supported a 1/4% cut. Didn’t I just argue that only monetary policy experts like Bernanke/Mishkin/Yellen should serve on the FOMC? Yes I did, and I’ll consider Bernanke’s views in the next post.