September 16, 2008

Five years ago today I became a market monetarist.  For the preceding 26 years I’d never really had strong views on monetary policy. Then I became enraged when the Fed refused to ease policy in its September 16, 2008 meeting, two days after Lehman failed.  At the time output was in free fall and inflation was plunging sharply.  Yet the Fed decided to stand pat, citing fears of both recession and inflation.  In fact, five year TIPS spreads showed 1.23% inflation.  I’m told that the Fed didn’t believe these numbers.  Too bad, as they proved to be pretty accurate.

Ironically, at the time this happened I was working on a sort of “monetary offset” paper explaining why economists could not predict recessions.  The basic idea was that:

1.  The Fed does what the consensus of economists wants them to do.

2.  The Fed wants to prevent recessions.

3.  Ergo policy will be set in such a way as to prevent a situation where the Fed expects a recession.

4.  Ergo the consensus of economists will also not expect a recession.

James Hamilton put it more succinctly:

“You could argue that if the Fed is doing its job properly, any recession should have been impossible to predict ahead of time.”

My second blog post was on this topic (the first was on IOR).

The September 16 meeting blew my hypothesis right out of the water.  Which made me angry for three reasons; loss of a clever idea, loss of 401k wealth, and unnecessary suffering caused by mass unemployment.

Yes, the 2007-09 recession was not predicted by economists, so technically my theory was still intact.  But I knew that the September 2008 meeting undercut the spirit of the idea.  Things were going to get a lot worse in 2009, and yet the Fed was going to passively let it happen.  That made me a radical.

PS.  I’d appreciate any information you have on how TIPS spreads of various maturities responded to the Summers news.  BTW, if my calculations are correct the expected yield on a 20 year bond issued 10 years from today seems flat or slightly higher.

PPS.  Saturos sent me a link to a good post by Eliezer Yudkowsky on what this tells us about the prospects for global rationality.

PPPS.  Off topic, people keep asking me about this Tyler Cowen post.  I agree with the summary sentence:

The “nominalist” approach was absolutely correct for 2008-2009, it is simply becoming less correct as time passes, which is exactly what standard economic theory suggests.

I would simply add that “less important” is still very important.  I believe that about 20% our unemployment is caused by tight money, down from 40% in October 2009.

PPPPS.  Even though I didn’t notice that monetary policy was off course until September 2008, a market-oriented approach (NGDP futures targeting) would have noticed sooner, and corrected the problem sooner.

HT:  Kevin Tryon

Update:  In the comment section John Hall has data suggesting not much impact on TIPS spreads, albeit the 10-year may be up a couple basis points.  So real rates fell.  Possible explanations:

1.  Not much impact on NGDP expectations.

2.  Significant impact on NGDP, but fairly flat SRAS.

3.  Some market segmentation—TIPS spreads don’t precisely measure expected inflation changes.

Or perhaps a bit of each.  If I had to guess I’d say NGDP expectations rose, but by a very small amount.


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27 Responses to “September 16, 2008”

  1. Gravatar of J.V. Dubois J.V. Dubois
    16. September 2013 at 06:05

    Scott: just a reaction on Tyler Cowen part – I am curious how important for “recovery” is a notion that Fed may get it wrong the next time some shock comes.

    I mean you yourself suggested that we may have another demand shock this decade – we had had some kind of shock and recession during last two, it seems more likely that we will have one given that ZLB seems to be more of a problem now compared to 20 years ago.

    Could increased expectation of demand side recession in a near future suppress employment today? We could see that if we has NGDP futures market. All we can see now is that even though we are not at NGDP trend level we are at least at NGDP trend growth rate. But is this growth expected to continue? Expectations of future may be more important for macroeconomy than what we will see in the future.

    PS: It is wonderful to see that Eliezer Yudkowsky reads your blog. It was some time ago that I went to his site after you linked some post that he wrote and it was wonderful discovery for me. I really enjoyed his “Advanced Epistemology” and “Quantym Physics” series and spend considerable time over there on other topics. Thanks for the pointer.

  2. Gravatar of John Hall John Hall
    16. September 2013 at 06:05

    The latest 5 year I have on Bloomberg is 1.557% for Treasuries and -0.347% for TIPS, or 1.9% implied inflation. The values on 9/13 end of day were 1.694%, -0.205%, and 1.9%.

    Latest 10 year Treasury is 2.786% and TIPS is 0.659%, or 2.13% implied inflation. The values on 9/13 end of day were The values on 9/13 end of day were 2.886%, 0.775%, and 2.11%.

    So it looks like implied inflation didn’t change, only a shift in the curves.

  3. Gravatar of Brian Donohue Brian Donohue
    16. September 2013 at 06:42

    I’m seeing what John Hall is seeing. 10-year Treasuries down 0.1%, similar movement from TIPs, little change in expected inflation.

    It’s almost like the markets are saying that more accommodating monetary policy won’t stoke inflation. Not sure I agree, in which case I reckon I should take a position.

  4. Gravatar of Saturos Saturos
    16. September 2013 at 07:36

    Glenn Hubbard on institutional change to stop the next crisis: http://www.theatlantic.com/business/archive/2013/09/how-to-stop-the-next-financial-crisis-the-fed-might-be-our-last-great-hope/279594/

  5. Gravatar of jknarr jknarr
    16. September 2013 at 07:45

    Of course, there is the administration-is-stupid-and-screwing-up-big-stuff-everywhere risk premium. And Yellen is no in by any means.

    9/16/2013 2Y 5Y 10Y 30Y
    NOMINAL 0.383 1.5691 2.8069 3.8159
    TIPS -1.0199 -0.3421 0.6846 1.5322
    BREAKEVEN 1.4029 1.9112 2.1223 2.2837

    9/13/2013 2Y 5Y 10Y 30Y
    NOMINAL 0.4312 1.693 2.8846 3.8349
    TIPS -0.9836 -0.2144 0.7677 1.5503
    BREAKEVEN 1.4148 1.9074 2.1169 2.2846

    CHANGE 2Y 5Y 10Y 30Y
    NOMINAL -0.0482 -0.1239 -0.0777 -0.019
    TIPS -0.0363 -0.1277 -0.0831 -0.0181
    BREAKEVEN -0.0119 0.0038 0.0054 -0.0009

  6. Gravatar of Ricardo Ricardo
    16. September 2013 at 07:58

    PIMCO’s El Erian mentions NGDPT. Also interesting is the possible introduction of an inflation floor.

    http://finance.fortune.cnn.com/2013/09/16/el-erian-fed-taper/

    Fed officials will likely be looking at the following options to further pre-commit in the eyes of the private sector their future policy stance: return to calendar guidance (highly unlikely now that they have shifted to thresholds), lower the unemployment threshold from the current 6.5% (unlikely but more possible), shift to nominal GDP targeting (possible though not at this time) or insert an inflation floor (say 1.5% — highly possible though controversial).

  7. Gravatar of Ashok Rao Ashok Rao
    16. September 2013 at 08:17

    Scott, I think the problems with predicting recessions is far more fundamental than expectations of central bank action. Whereas prevention of a predicted event is one possibility, so too is self-fullfillment of predictions.

    I wrote this in reply to that New York Times editorial arguing that economics isn’t a science because it cannot predict recessions, and I think it is impossible at every level – even without a central bank – to credibly predict a recession: http://ashokarao.com/2013/08/28/philosophical-problems-with-prediction/

    Simply put, if I have a brilliant model that predicts a recession precisely one year from now, firms and investors will contract investment due to falling expectations of future profit, and hence as investment falls now the recession becomes self-fullfilling.

    The only way you can predict a recession is if no one believes your model. But if it’s a good model, and it’s consistently right, people will believe your model. Basically EMH.

    So I’d go one step further than Hamilton and say that “You could argue that if your model is doing its job properly, any recession should have been impossible to predict ahead of time.”

  8. Gravatar of Tommy Dorsett Tommy Dorsett
    16. September 2013 at 08:19

    Scott — The 30yr/2yr Treasury yield curve spread widened today even though the level of rates fell. This along with rising stock prices suggests NGDP expectations moved up a bit on the Summers news.

    I continue to be bothered by the financial press attributing the move up in long rates over the last year to “tighter” monetary conditions — that makes no sense in light of the steepening curve and generally rising equity markets.

  9. Gravatar of kt kt
    16. September 2013 at 08:42

    As I type Obama is talking about five years ago and the subsequent events and how bad it was when he took office.

    He has said nothing about the Fed and monetary policy.

  10. Gravatar of Morgan Warstler Morgan Warstler
    16. September 2013 at 08:51

    “Even though I didn’t notice that monetary policy was off course until September 2008, a market-oriented approach (NGDP futures targeting) would have noticed sooner, and corrected the problem sooner.”

    True. It would have noticed FAR SOONER.

    It would have noticed by mid 2005 that money was too loose, and would have started beating Mortgage lenders with a stick until they were in a supine position.

    Why we can’t mention this in polite company I do not understand….

  11. Gravatar of Morgan Warstler Morgan Warstler
    16. September 2013 at 08:58

    Ashok,

    WELL DONE YOUNG MAN!

    “So I’d go one step further than Hamilton and say that “You could argue that if your model is doing its job properly, any recession should have been impossible to predict ahead of time.””

    Now perhaps maybe after many years Scott will consider that MM ought to make the bold clam that it could have stopped the Housing Crisis.

    And since the Housing Crisis begat the Financial Crisis, while it is interesting that MM could solve the Financial Crisis after the fact, it is MORE INTERESTING that it could have first avoided the Housing Crisis.

    The difference here is WHO IS REWARDED by the MM narrative.

    By focusing on avoiding the Housing Crisis, MM promises that the lender NEVER got the too fat transition fees in the first place.

    This wins conservatives.

    So, Scott, has Ashok convinced you to mention what NGDPLT would have done in 2004-2006?

  12. Gravatar of TravisV TravisV
    16. September 2013 at 09:13

    Prof. Sumner,

    Given that 20% our unemployment is caused by tight money, where is the other 80% coming from?

  13. Gravatar of TravisV TravisV
    16. September 2013 at 09:18

    Michael Darda:

    Why the US economy might finally accelerate to 3% growth (in less than 150 words)

    http://www.aei-ideas.org/2013/09/why-the-us-economy-might-finally-accelerate-to-3-growth-in-less-than-150-words

  14. Gravatar of Bob Murphy Bob Murphy
    16. September 2013 at 10:25

    Scott Sumner wrote: “Yes, the 2007-09 recession was not predicted by economists, so technically my theory was still intact.”

    Who’s got two thumbs and predicted a really bad recession in October 2007? This guy!

    (And actually it was based on bank analysis I made in July 2007.)

  15. Gravatar of ssumner ssumner
    16. September 2013 at 10:39

    JV, Yes, that’s possible.

    Thanks John, I added an update.

    Thanks Brian and jknarr.

    Ricardo, Interesting, but unlikely.

    Ashok, Good comment. I hate those people who blather on about whether economics is a “science.” They don’t even understand that it’s a meaningless question. In any case, I suppose geology isn’t a science as they can’t predict earthquakes.

    I agree that the EMH provides another reason why crises are hard to predict. Lucas made the same point.

    Tommy, Good point.

    Travis, Frictional and structural (the natural rate is around 5.8%)

    Bob, Broken clocks, twice a day. :)

  16. Gravatar of Brian Donohue Brian Donohue
    16. September 2013 at 12:19

    Changes on the day today:

    5-year Treasuries -0.06%
    5-year TIPS -0.07%
    5-year Exp CPI +0.01%

    30-year Treasuries +0.03%
    30-year TIPS 0.00%
    30-year Exp CPI -0.03%

    Steeper Treasury curve, flatter expected CPI curve.

  17. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    16. September 2013 at 13:13

    Ed Lazear and Keith Hennessey, (who were present in the room with Bernanke, Paulson and Bush after Lehman folded)have their version of events;

    http://keithhennessey.files.wordpress.com/2013/09/observations-on-the-financial-crisis.pdf

    ‘Had the Bush Administration not loaned TARP funds to these firms [GM and Chrysler], both firms would have faced a supplier run in January and soon thereafter had to enter a Chapter 7 liquidation process. As much as we wished it had been, Chapter 11 restructuring was not an option. In more stable financial markets private debtor-in-possession financing might have been available, but in December 2008 it was not.

    ‘It remains unclear whether this resulted from a savvy strategic move on the part of both firm’s leaders, or instead from massive incompetence and mismanagement. It is possible that the leadership of both firms (correctly) calculated that policy makers would be unwilling to allow two of the three largest U.S.-based auto manufacturers to fail, and that they gambled their firms’ existence on this political prediction. In GM’s case this is reinforced by the little-known gambit they pulled in October of 2008, when they told Bush Administration officials they faced a likely supplier run the Monday before election day if they did not receive an immediate infusion of cash.’

  18. Gravatar of Bob Murphy Bob Murphy
    16. September 2013 at 16:53

    Scott,

    Putting aside the issue of whether my prediction was due to skill or dumb luck, I just want to point out something to make sure you realize what (I think) you are doing on this stuff. You wrote:

    “Yes, the 2007-09 recession was not predicted by economists, so technically my theory was still intact.”

    But I’m pretty sure that because of your view of the EMH, even *in principle* you wouldn’t accept anyone’s putative “prediction” of the 2007-09 recession.

    Now that’s fine, I have no problem if you want to say on methodological grounds that investors can’t know we’re in a bubble since then it would pop immediately etc. That’s a perfectly defensible move.

    But, it seems like what you’re doing in the above quote is looking with an open mind at the empirical record, then saying, “Nope, I don’t see any predictions of the 2007-09 recession, so now I have more confidence in my theory of how financial markets work.”

    So my only point here is to make sure you see what you’re doing. You CAN’T see any successful predictions of the 2007-09 recession; look at what you did with my prediction, for example. (Note, it’s not like I’m a permabear. In fact I flipped; I made the opposite mistake of being too bullish up until January 2007.)

  19. Gravatar of ssumner ssumner
    16. September 2013 at 16:59

    Bob, No no no no. You are completely misreading what I wrote. I have no interest in individual predictions. My paper claimed that the consensus of economists will never be able to predict a recession. BTW, that’s also a separate issue from the EMH, as the EMH is silent on the question of whether one can predict recessions. If you can predict recessions that’s great, it has no bearing on my paper, however.

  20. Gravatar of Nick Rowe Nick Rowe
    17. September 2013 at 03:09

    Scott: “Ironically, at the time this happened I was working on a sort of “monetary offset” paper explaining why economists could not predict recessions. The basic idea was that:”

    What a coincidence. I had been working on the same thing:

    http://econpapers.repec.org/paper/carcarecp/01-07.htm

  21. Gravatar of ssumner ssumner
    17. September 2013 at 05:08

    Nick, Double coincidence, I was thinking of doing a paper on why Hong Kong had the best Phillips curve in the world 1985-2012. Exogenous monetary shocks from US, but stable expected inflation from dollar peg. But I never got around to it.

  22. Gravatar of Full Employment Hawk Full Employment Hawk
    17. September 2013 at 05:08

    “the Fed refused to ease policy in its September 16, 2008 meeting, two days after Lehman failed”

    This alone is a solid reason why Bernanke should not have been reappointed to the Fed chairmanship.

  23. Gravatar of Blue Aurora Blue Aurora
    17. September 2013 at 07:00

    Although I don’t agree with you on all matters, Professor Scott B. Sumner, I will commend you on doing a public service with your blogging and increasing the level of discourse. I hope you had a happy fifth anniversary!

  24. Gravatar of SG SG
    17. September 2013 at 10:06

    Scott,

    Neil Irwin at Wonkblog further answers your question about TIPS spreads:

    http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/16/markets-are-thrilled-larry-summers-wont-be-fed-chair/

  25. Gravatar of 5 year anniversary of a fateful decision | Historinhas 5 year anniversary of a fateful decision | Historinhas
    18. September 2013 at 11:00

    [...] of the Fed´s fateful decision to ‘stand pat’, despite the Lehmann affair of the previous day. Scott Sumner has a post in which he says that´s the day he became a market [...]

  26. Gravatar of ssumner ssumner
    18. September 2013 at 17:55

    Thanks Blue and SG.

  27. Gravatar of Geoff Geoff
    24. September 2013 at 18:01

    “I became enraged when the Fed refused to ease policy in its September 16, 2008 meeting, two days after Lehman failed. At the time output was in free fall and inflation was plunging sharply. Yet the Fed decided to stand pat, citing fears of both recession and inflation.”

    I always knew your position was based on emotion, not rationalism.

    BTW, output falling and unemployment rising that you believe are caused by deflation are CURES for the disease that inflationist people like you wreak upon the world.

    Central banking is a cancer. You want the cancer to stay. You don’t want to accept the consequences.

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