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.