Lessons learned

1.  Dow was up almost 300.  This is a reasonably expansionary move.  Not a game changer, but significant.

2.  Lots of wild swings, but ten year yields ended almost unchanged.  That tells us that the liquidity effect and the longer term effects (from faster expected NGDP growth) were both powerful, but fought to a draw. A classic example of how interest rates tell us very little about the stance of monetary policy.  The simplistic liquidity view is clearly wrong.  The simple contrarian view is also clearly wrong.  It’s complicated.  I’ve always believed it’s complicated, but some of my past posts emphasized the contrarian view, and today made those posts seem off base.  As did the modest run up in rates when taper talk first surfaced. I need to be more clear. But we also learned in September that most of the run-up was due to stronger growth expectations, perhaps only about 20 basis points was taper talk.

3.  Back in 2009 and 2010 I frequently argued that the fiscal multiplier might be negative.  Many people had trouble understanding this idea, which was based on monetary offset overreaction.  Suppose Congress does nothing in 2009.  Bernanke thinks; “Oh my God we have a Great Depression on our hands.”  He doesn’t want to go down in history as the Fed chair who presides over another Great Depression.  Not after being a scholar who devoted his life to showing how the Fed could have prevented the Depression.  My claim was that in the absence of fiscal stimulus the Fed would have offset Congress’s failure with some really powerful monetary stimulus, probably the level targeting that he recommended to the Japanese, but which the Fed itself never did (perhaps because Bernanke could never convince “Fedborg.”)

OK, but that’s just monetary offset, a zero multiplier.  How could I claim the multiplier might be negative? The second part of my argument was that the Fed overestimated the power of QE and underestimated the power of forward guidance, such as level targeting.  Had there been no fiscal stimulus, they would have done something else dramatic in order to prevent a depression.  And that “something else” would have been far more powerful than the Fed anticipated, indeed more powerful than QE plus the ARRA fiscal stimulus.  Some of what Bernanke calls “Rooseveltian resolve.”

So how does today support my negative multiplier theory?  The Fed felt uncomfortable doing so much QE. They wanted to taper.  But they didn’t really want to tighten.  So they tried to offset the taper with a modest increase in forward guidance.  But they didn’t realize how powerful forward guidance is, and actually ended up more than offsetting.  Much more.  It’s like the first time I went to England and had a few pints of beer.  The pint glass was much bigger than in America and it was 6% alcohol, not 3.5% like American “beer.”  I was almost drunk.  Or to paraphrase Bob Dylan:

The Fed started out on burgundy but soon hit the harder stuff.

 


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43 Responses to “Lessons learned”

  1. Gravatar of Morgan Warstler Morgan Warstler
    18. December 2013 at 18:10

    The fiscal multiplier is negative because government employees are negative ZMP workers.

    Handing a government employee $60K a year for the work a $25K a year employee does in private sector literally HURTS the economy.

    We spend more than we get out. We cannot make it up in volume. Period. The end.

    Next question?

  2. Gravatar of Saturos Saturos
    18. December 2013 at 18:26

    Scott, have you seen this?
    http://www.marketwatch.com/story/yen-to-decline-by-whatever-it-takes-to-awaken-japan-2013-12-16

  3. Gravatar of Saturos Saturos
    18. December 2013 at 18:27

    “They wanted to taper. But they didn’t really want to tighten. So they tried to offset the taper with a modest increase in forward guidance.”

    How is that a negative *fiscal* multiplier? I still don’t see evidence on that.

  4. Gravatar of Edward Edward
    18. December 2013 at 18:31

    I’m stunned that forward guidance is THAT powerful. There’s no requirement in law for future fed chairs or even janet yellen to pre commit to what the current committee is saying. So what the heck is the market partying over?

    (I’m on your side scott, but Ive always been skeptical of the Peter Pan like nature of forward guidance and expectations, to me words are worthless if not backed up by action )

  5. Gravatar of foosion foosion
    18. December 2013 at 18:51

    @saturos – the argument seems to be that the Fed is able to, and would, offset fiscal policy, so if the govt tries fiscal stimulus the Fed will over-correct.

    @Edward – they’re partying over what the Fed said and did compared to what they expected.

  6. Gravatar of Dan W. Dan W.
    18. December 2013 at 18:54

    Scott,

    Last I checked the Fed was under no obligation to follow its forward guidance and the market was under no obligation either.

  7. Gravatar of foosion foosion
    18. December 2013 at 18:58

    @Dan – the Fed appears to care about its credibility

  8. Gravatar of Some Sumner Shuffles Some Sumner Shuffles
    18. December 2013 at 18:59

    [...] what he has to say about the Fed’s “taper” announcement–it was expansionary since the stock market went up, of course–but in so doing I ran across something that doesn’t add [...]

  9. Gravatar of Geoff Geoff
    18. December 2013 at 19:08

    “So how does today support my negative multiplier theory? The Fed felt uncomfortable doing so much QE. They wanted to taper. But they didn’t really want to tighten. So they tried to offset the taper with a modest increase in forward guidance. But they didn’t realize how powerful forward guidance is, and actually ended up more than offsetting.”

    I love this empirical theory. One can never be wrong no matter what happens.

  10. Gravatar of Dan W. Dan W.
    18. December 2013 at 19:09

    @foosion,

    The market has a way of making fools out of kings.

  11. Gravatar of maynardGkeynes maynardGkeynes
    18. December 2013 at 20:14

    Prof Sumner: You often suggest, as you did today in mentioning the 300 point pop in the DOW, that the reaction of the stock says something meaningful about the wisdom (or lack therof) of FED policy moves. Isn’t that an example of “reasoning from a price change,” which I gather is something that you deplore?

  12. Gravatar of Matt Matt
    18. December 2013 at 20:54

    This is an awful lot of conclusion drawing from a one-day fluctuation in two prices (one price staying constant even leads to two conclusions!).

    It seems to me that, even if your grand NGDP theories are true, attempting to draw support for them after every daily blip in the graphs may not be the best approach.

  13. Gravatar of Tommy Dorsett Tommy Dorsett
    18. December 2013 at 21:12

    Scott – the 10yr yield rose 4 bps today. Looks like the fisher effect dominated the liquidity effect. Don’t be so hard on the contrarian view it’s been largely vindicated!

  14. Gravatar of kebko kebko
    18. December 2013 at 21:41

    Eurodollar futures started the day with an estimated first rate increase in Nov. 2015 with a slope of 35bp per quarter after that. At the end of the day, the date of the increase had moved back 1 month, and the slope had increased to 37bp per quarter. I think this basically reflects the Fed’s guidance today. They are going to try to keep the rate at zero for longer, which should increase inflationary pressure and lead to faster increases once they do. Rates in the 2-3 year range ended the day down, but rates beyond that ended the day up.

    This evening, it appears that the market is moving their rate hike expectation back toward November, however, while keeping some of the steeper curve, so that rates across the time range are now slightly higher than they were yesterday.

  15. Gravatar of kebko kebko
    18. December 2013 at 22:19

    The median FOMC member appears to expect the first rate increase in June 2015, with a slope of 25bp per quarter after that.

    The mean FOMC member appears to expect the first rate increase in April 2015, with a slope of 28bp per quarter after that.

    Not that anyone cares, but I expect the first increase in the first half of 2015 with maybe 40bp per quarter for the following year or two. Unless fiscal policy screws up the economy.

  16. Gravatar of kebko kebko
    18. December 2013 at 22:23

    Morgan,

    There were economists arguing that paying the furloughed government workers, after the fact, for their downtime during the shutdown would be stimulative.

  17. Gravatar of James in London James in London
    18. December 2013 at 22:36

    Oh no, Scott, please don’t start saying the Fed made a mistake in underestimating the power of guidance yesterday. Offsetting too much the taper. Pleas say they meant to loosen, it was a master plan, Bernanke’s mea culpa, the impact of Janet Yellen, Stanley Fisher, anything, just not a mistake.

    If you are right, then they are likely to realise their mistake, start worrying about it, and take it back next FOMC by somehow tightening.

  18. Gravatar of Benjamin Cole Benjamin Cole
    19. December 2013 at 00:24

    Well…looks like one could construct any argument wanted based on this one-day event.

    My guess is that the market said, “Okay, $75 billion a month in QE is still good.”

    I have always been more reserved about the impact of forward guidance. My experience with institutional real estate investors is that they pay no attention to forward guidance. I would guess that is even more true of homebuyers.

    That said, forward guidance, explicit and detailed and straightforward, is part and parcel of transparency and good government.

    Investors seem to look at what happened in the last six months and draw the trend line forward.

  19. Gravatar of Michael Byrnes Michael Byrnes
    19. December 2013 at 03:55

    Dan W wrote:

    “Last I checked the Fed was under no obligation to follow its forward guidance and the market was under no obligation either.”

    Sure, but think in probabilities. Prior to the announcement, there was some probability that the Fed would raise rates in 2014, call it p. Today, there is a new probability that the Fed will raise rates in 2014, call it p’. p’ is lower than p (reflecting the new forward guidance), but still higher than 0 (reflecting the Fed isn’t actually precommitted to anything).

    That means policy is more expansionary today than it was before the Fed’s announcement, but less expansionary than it would have been if the Fed had somewhow committed itself absolutely to not rasing rates in 2014.

  20. Gravatar of Michael Byrnes Michael Byrnes
    19. December 2013 at 04:03

    Scott,

    You’ve argued, on the topic of fiscal stimulus, that a positive fiscal multiplier is an indication of central bank incompetence. That applies to this negative fiscal multiplier scenario as well.

  21. Gravatar of JTapp JTapp
    19. December 2013 at 05:15

    FWIW–John Taylor was on NewsHour last night debating Adam Posen on the effect of QE. Taylor declared it a failure due to long-term rates having gone up, argues we’d have been better off without it. Posen boldly (and rightly) scolds him.

  22. Gravatar of nubdaug nubdaug
    19. December 2013 at 05:56

    Just Like Scott Sum’s Blues

  23. Gravatar of Brian Donohue Brian Donohue
    19. December 2013 at 06:09

    I don’t think I buy all this. What is clear to me is that inflation expectations have fallen this year, about 0.45% over five years and 0.24% over thirty years, likely due to continued low realized inflation.

    Those (like me) who have come to MM cautiously from a starting point of “worried about inflation” have adjusted our expectations.

  24. Gravatar of Robert Simmons Robert Simmons
    19. December 2013 at 06:25

    Fiscal policy can definitely be contractionary. If the additional government spending is inefficient, at a given level of NGDP it increases inflation and decreases RGDP, but doesn’t affect NGDP (by assumption). If the Fed is successfully targeting inflation, and the spending hurts RGDP, it must hurt NGDP.

  25. Gravatar of Steve Steve
    19. December 2013 at 06:25

    Maybe the market was celebrating Bernanke’s exit.

    In order for forward guidance to be effective, you need to have more credibility than, say, Hassan Rouhani.

    Janet Yellen’s forward guidance is more potent than Bernanke’s.

  26. Gravatar of Saturos Saturos
    19. December 2013 at 06:28

    Just been reading some 2007/08 FOMC transcripts. I think I have a new appreciation now for why Scott wants to abolish inflation.

  27. Gravatar of Saturos Saturos
    19. December 2013 at 06:41

    From JTapp’s link:

    Adam Posen: “The cart is before the horse in what David just said. It wasn’t an extraordinary period in monetary policy. It was an extraordinary period in the economy. And the monetary policy tried to react to that.”

    John Taylor: “And rates are higher now than they were then. So how you can say it helped? Low interest rates have not been the result. I would say, again, to distinguish between these actions taken in September-October 2008 and everything else since then. Those actions are were classic central banking. They were good. Ben Bernanke did a good job at that point.”

  28. Gravatar of TravisV TravisV
    19. December 2013 at 06:42

    Prof. Sumner,

    JTapp just pointed to an INCREDIBLE VIDEO of John Taylor repeatedly declaring QE a failure because interest rates are higher:

    http://www.pbs.org/newshour/bb/business/july-dec13/economy_12-18.html

    Everyone should watch it!

  29. Gravatar of TallDave TallDave
    19. December 2013 at 06:46

    I have an instinctive dislike of any model that considers decisions made by Fed governors or elected officials to be “effects” rather than choices, because the model can’t work if Fed governors and elected officials have an accurate understanding of how the economy responds to fiscal/monetary stimulus (according to the model).

    Granted, to a large extent they probably don’t, but to the extent they figure it out the model fails even if it’s otherwise correct. But then I suppose if we already had optimal policy (targeting fiscal spending at 25% of GDP and a 4-5% NGDI growth path) we wouldn’t need models :)

    underestimated the power of forward guidance, such as level targeting.

    I think this will eventually be adopted as the consensus explanation of The Great Recession, at least in terms of how the Fed responded to the shock.

  30. Gravatar of Edward Edward
    19. December 2013 at 07:17

    I’ve completely lost any respect whatsoever for john Taylor

  31. Gravatar of ssumner ssumner
    19. December 2013 at 08:33

    Saturos, Yes, I’ve been saying all along that the BOJ needs to do much more. And they do.

    I did not say yesterday was negative multiplier. I tired to use it as an analogy so that people could get a better idea as to how a negative multiplier could exist.

    Edward, You said;

    “to me words are worthless if not backed up by action”

    I fully agree. But the market quite rationally expects dovish Yellen to back up these words with future actions.

    DanW, You said;

    “Last I checked the Fed was under no obligation to follow its forward guidance and the market was under no obligation either.”

    That’s right, and the fact that the market did react, without any obligation, means they expect the Fed to follow their guidance.

    Maynard, No, reasoning from a price change would be noticing the rise in stocks and assuming the Fed must have done something. In this case we noticed the Fed did something, and looked for how the market interpreted it.

    Whenever you have two separate data points that occur at the same time, you are able to avoid reasoning from a price change. The danger is using a single data point. Observing oil prices change and drawing conclusions on just that fact is reasoning from a price change. Observing oil prices change the moment a war breaks out in Libya is not reasoning from a price change.

    Matt, You said;

    “It seems to me that, even if your grand NGDP theories are true, attempting to draw support for them after every daily blip in the graphs may not be the best approach.”

    Normally that would be true. But unexpected Fed policy changes are fairly rare. When they occur the reaction of markets gives us some very valuable information. Especially if the reaction is strong (stocks in this case, not bonds)

    Tommy, Next day results don’t count in my view, but obviously one can never be sure. When monetary announcements are complex and must be digested and interpreted, the market reaction takes longer than simple fed funds target change. So you might be right, but I’d prefer to remain agnostic.

    kebko, Very useful, and just what I would have expected from the draw in the liquidity effect//long term effect battle.

    James, Good point, and I need to further explain myself in another post. I was trying to make a different point, using this as an example of how overreaction MIGHT occur.

    Ben, You said;

    “My guess is that the market said, “Okay, $75 billion a month in QE is still good.”

    It can’t be that simple, back in September the market was strongly opposed to 75/month. Guidance really is important.

    Michael, Yes, incompetence either way.

    Brian, I agree that inflation expectations have fallen this year, but they probably rose slightly today. That was my point.

    Robert, That’s right.

  32. Gravatar of JohnB JohnB
    19. December 2013 at 08:47

    Scott,

    I thought you were of the opinion that forward guidance was fairly ineffectual. After all, if the Fed is keeping rates low that is a sign of a depressed economy. A vigorous recovery would put them into a position to raise rates much quicker. When I hear of forward guidance, I think of your ideas and see it as them promising to keep the economy in the toilet for another few years.

  33. Gravatar of JohnB JohnB
    19. December 2013 at 08:58

    Morgan,

    I think you are being too kind to government workers. We don’t simply overpay them for services the private sector could perform more cheaply, many if not most government jobs actually make people worse off. The fiscal multiplier is negative because much of what the government does people (on net) would be willing to pay them not to do.

    I personally would pay as much money as I could possibly afford for the government to stop throwing people in jail for violent crimes or killing innocent people all over the world with drones (only a small % of people we kill actually did anything to harm Americans).

    Taking someone’s money and using it to do something that they would have been willing to pay you to not do is the clearest example of value destruction (negative economic growth) imaginable.

  34. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    19. December 2013 at 09:06

    ‘I tired to use it as an analogy….’

    There’s no rest for the wicked.

  35. Gravatar of TallDave TallDave
    19. December 2013 at 09:26

    Just been reading some 2007/08 FOMC transcripts.

    It’s almost like reading early WW II dispatches, isn’t it?

  36. Gravatar of RAstudent RAstudent
    19. December 2013 at 09:27

    Morgan,

    On what planet is a government employee getting paid nearly 3 times as much as a private sector employee? A senior executive federal employee makes less than 200k per year. His equivalent position in the private sector makes easily 2-5 times that much, if not more. There may be a premium for low skilled federal employees compared to their private sector equivalents but that pretty much disappears at about the 4 year degree level of education.

    JohnB,

    I don’t believe for a second that you would pay as much money as you could possibly afford to keep violent criminals from going to prison. I wonder how you would feel if the victim of that violent crime was your spouse or child. I can agree with your statement that we are wasting to many resources on unnecessary war but this idea that all government employees are lazy ass, incompetent. ZMP workers is a crock.

  37. Gravatar of Doug M Doug M
    19. December 2013 at 09:49

    There is a phrase on Wall St. “Buy the rumor, sell the news.”

    The market reaction of new information is frequently the opposite of what one would expect it would be, especially if the news is highly anticipated.

  38. Gravatar of Brian Donohue Brian Donohue
    19. December 2013 at 10:07

    Scott, re: inflation expectations. Yesterday’s move was down about 0.02%. More interestingly, compared to the previous spike in rates on September 5th, 5-year inflation expectations are lower (1.67% vs. 1.71%) while 30-year expectations are higher (2.30% vs. 2.24%), which I think is consistent with your view.

    The dawning realization that the Fed action isn’t driving inflation higher, IMO, increases the Fed’s room for maneuver. I find talk about ‘contractionary’ vs ‘expansionary’ confusing and prefer to think of it as markets getting a better understanding of Fed policy, which has been pretty well telegraphed.

  39. Gravatar of Lorenzo from Oz Lorenzo from Oz
    19. December 2013 at 14:12

    I suppose we could ask anyone who was sceptical about the power of expectations if they reject Milton Friedman’s critique of the Philips Curve–which is all about expectations. In fact, the problem with Milton’s famous AEA Presidential address is he did not take the point about expectations far enough (hence thinking a set rule for monetary quantity would be enough).

    There is no information from the future. That is just a point of fundamental physics. So a Central Bank that sets clear signals about future policy which are believed, sets up powerful expectations.

    The problem is not that Central Banks have failed to set up expectations; they all do that. They all have policy frameworks which they operate under and about which expectations are built up. The problem is generating the wrong (or at least too narrow) expectations. The conventional inflation targeting central banks have all set up strong expectations about the (domestic) value of their currencies; they have failed to set up positive expectations about the path of (nominal) income. Letting nominal income drop dramatically certainly confirms the lack of commitment to maintaining nominal income.

    There are issues about inferred versus clear expectations (hence the importance of clear communication strategies). The RBA learnt that the hard way during the Recession We Had To Have and its lead up. (Which, btw, was Australia’s worst recession since the Great Depression.) But there is no such thing as a Central Bank without associated expectations. The argument is about what they should be generating expectations about.

  40. Gravatar of ssumner ssumner
    19. December 2013 at 19:59

    JohnB, Yes, unconditional forward guidance is often ineffectual. But the Fed is making the forward guidance increasingly conditional. Perfect forward guidance would be something like NGDPLT or PLT.

    Doug, The market reaction to the unexpected part of new information is almost always as predicted, conditional on the new information.

    Brian, Thanks, that’s very interesting, and a bit different from what I would have expected. I would have expected a slight increase in short term inflation expectations and a bigger increase in long term inflation expectations.

    Lorenzo, Very good point.

  41. Gravatar of Brian Donohue Brian Donohue
    20. December 2013 at 06:57

    Scott, not sure what it means but yesterday saw some curious interest rate moves.

    Mid-range (3-10 year) Treasury yields spiked, but long-term yields hardly budged.

    For TIPs, mid-range yields were flat, but 10-30 year yields were up.

    So, ‘expected CPI’ jumped about 0.1% yesterday over 5-7 years, but was down a couple BPs at 10-30 years.

    Also, credit spreads have narrowed over the past couple days, which I think is a bullish sign.

    What does it mean, Basil?

  42. Gravatar of TallDave TallDave
    20. December 2013 at 07:00

    Carney is right that I am often very hard to understand, but that’s mostly because monetary economics is almost as confusing as quantum mechanics

    Have to disagree, QM is highly testable (indeed QM is by far the best-proven of all the sciences). Ecomomics is much more confusing. :)

  43. Gravatar of ssumner ssumner
    21. December 2013 at 07:16

    Brian, Interesting, Perhaps the faster NGDP growth?

    Tall Dave, You left that comment in another post, and I answered.

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