Somewhere between rocket science and quantum mechanics

Monetary economics is definitely harder to grasp than rocket science, but easier than quantum mechanics. One of the hard parts is breaking free from the notion that interest rate changes are reliable guides to the stance of policy.  And one thing that makes that difficult is that sometimes rate changes they are reliable. When rates rose on rumors of tapering last summer, it was in fact a reliable indicator that policy was expected to tighten, which meant that policy had already tightened by the time you read about it (another concept that is hard to grasp.)

But yesterday monetary policy clearly loosened  (based on the rather obvious stock market rally after the 2:15 announcement), but long rates were almost unchanged.  Yesterday I speculated that the zig zag of 10 year rates reflected the back and forth effects of tapering, forward guidance, and the Fisher/income effects.  The first two shouldn’t even be controversial.  Everyone knows:

1.  A taper announcement by itself pushes up rates.

2.  A taper announcement is the easiest part of the report to quickly ascertain. Traders with their finger on the “sell button” saw “$75 billion” flash on their retina at 2:15 and hit the button. Rates spiked. Stocks fell. That shouldn’t even be controversial.

3.  Then they processed the more complex forward guidance info and rates quickly fell, as you’d expect with forward guidance.

I agree that reading market zig zags is usually a fools game, but I really don’t see how any reasonable person could disagree with this interpretation.  Remember that MMs don’t even have a dog in this fight; we have never claimed that tapering necessarily raises rates, indeed I was initially skeptical until I saw the effect last summer.

But here’s the clincher.  I did all this without having any idea what was going on in the fed funds futures markets.  I wouldn’t even know how to find that data on the internet.  My interpretation implies the rates should have been expected to stay lower for longer, but since 10 year yields finished the day unchanged the subsequent path of rates should have showed a steeper increase (income/Fisher effects).  Today kebko sent me the following comment:

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.

Exactly right.  Several commenters sent me a recent debate where John Taylor argued QE had failed because rates didn’t fall:

JOHN TAYLOR: No, I think — if you think about the purpose of the quantitative easing as stated was to lower long-term interest rates, and if — again, look at QE3. It began just in December of last year, September of last year.

And rates are higher now than they were then. So how you can say it helped? Low interest rates have not been the result.

It would appear Taylor forgot to account for the longer term effects (income and Fisher effects.) Taylor is certainly aware of those effects, but it seems to me that many people tend to overlook their importance in ordinary conversation.

So stocks soared yesterday as ten year yields were unchanged, perhaps because the “unchanged” hid large crosscurrents, which were both expansionary.  Lower yields on the expected future liquidity effect (forward guidance) and then a bounce back on the income and Fisher effects.  Both changes are expansionary.

BTW, Here’s one similarity to quantum mechanics.  A new monetary policy does not take effect until it is observed.  Yes, guidance must be backed up with future actions, but given that Yellen is a dove I see no reason why the markets would have been unusually skeptical about the guidance.  And remember that guidance has important effects even if markets only consider it 40% likely that it will be carried out.  In this case it’s far more than 40%.

Some readers misread my “negative multiplier” comment.  Yesterday was not a negative multiplier example.  It was an example of a market reaction that helps one to better understand how a negative multiplier could occur.  It proves nothing, just an analogy.  Let me explain in a different way.  Suppose I went to the Fed meeting and at the end told the FOMC; “your decision today will drive the Dow up almost 300 points.” I think it’s fair to say they would have been dubious.  They had decided to taper, which normally depresses stocks.  Yes they also slightly adjusted the guidance wording, but I don’t think any reasonable person would disagree with my claim that the rise in stocks was more than the FOMC might have expected for a combined contractionary/expansionary move.

My other claim was that if I am right that they underestimated the effect, it’s because the Fed (like most people) puts more weight on “concrete steppes” than forward guidance.  But they (and most other people) are wrong.  Instead Woodford/Krugman and MMs are right—forward guidance matters more than QE. Where I disagree with Paul Krugman (and perhaps Woodford) is that I believe the likely policy counterfactual in March 2009 if Congress had voted against stimulus was some really serious forward guidance, which would have had an impact that surprised even the Fed.   Maybe even producing a negative multiplier. Yesterday’s market reaction upped my subjective probability of being right about the negative multiplier from about 15% to 25%.  Which means I still think it unlikely, but slightly more plausible than before.

HT:  JTapp, TravisV


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49 Responses to “Somewhere between rocket science and quantum mechanics”

  1. Gravatar of David Glasner David Glasner
    19. December 2013 at 12:08

    Scott, Aren’t you implicitly assuming that the market was expecting no taper before the Fed’s announcement yesterday? That seems implausible to me. What if “the market” was expecting an even larger taper, say to $50 billion a month of asset purchases. I realize that you are relying on the fact that stock prices fell yesterday before rising, but we’ve seen those sorts of temporary fluctuations before. “The market” is not composed of a group of representative agents with identical expectations; there could have been a kind of tug of war between conflicting expectations and expectations could have changed once people saw which way the wind was blowing. This is way more complicated than rocket science.

  2. Gravatar of Mark A. Sadowski Mark A. Sadowski
    19. December 2013 at 12:16

    Scott,
    Off Topic.

    Some “inspirational” reading on QE’s role by Evans-Pritchard:

    http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/10526947/Farewell-QE-you-have-been-a-magnificent-success.html

  3. Gravatar of TravisV TravisV
    19. December 2013 at 12:23

    Does Taylor actually believe what he’s saying?

    Couldn’t he be intentionally spouting nonsense in order to appeal to elite Republicans such as Paul Ryan and Scott Walker?

    Put yourself in Taylor’s shoes. He sees Mankiw praise Yellen and Taylor thinks “THIS IS MY OPPORTUNITY to outflank Mankiw (influence among elite Republicans)!”

  4. Gravatar of Brian Donohue Brian Donohue
    19. December 2013 at 12:33

    Good link Mark. Couple heresies from AEP, but a very good read.

    This bugs me: “This may surprise those who think it necessary to generate a surplus in order to cut debt ratios. That is the Schwabian housewife syndrome, which confuses an economy with a family budget.”

    I think “governments aren’t households” is an odious doctrine. In this case, AEP seems to be suggesting that a family cannot reduce leverage by growing the asset side of its balance sheet, which is dumb.

  5. Gravatar of Ironman Ironman
    19. December 2013 at 12:36

    Picking up David Glasner’s comment about how big a taper the market was expecting, we ran some numbers for yesterday’s announcement and the reaction to it (tacked onto the end of this post, but here it is in its entirety):

    Some quick back of the envelope numbers for the Fed’s taper decision.

    There are two positive economic factors enabling the change in Federal Reserve policy at this time:

    1. Falling oil prices – they have fallen about 10% since summer and unlike last year, are likely to hold for a longer period of time thanks to the recent decay in France’s economic situation. Here, a 10% decline in the price of oil would boost GDP by a factor of 1.4%.

    For U.S. nominal GDP in 2013-Q3 of $16,891 billion, that would be a gain of $236.5 billion over a one-year period, which works out to be $59.1 billion for just one quarter or $19.71 billion per month. The reduction in oil prices in 2013-Q3 is a contributing factor to the re-emergence of organic economic growth in the U.S., although its contribution in that quarter was small compared to the impact of record bumper crops in U.S. agriculture. It will have a bigger impact going forward, particularly for transportation-related industries and automobile manufacturing.

    2. The recently concluded budget deal in the Congress will increase federal spending throughout 2014 by roughly $64 billion, which if spread out equally per month would be about $5.3 billion. Per Owyang, Ramey, etc., when the official U.S. unemployment rate is below 7.5%, the GDP multiplier for government spending is 0.5.

    That puts the economic boost to GDP for the budget deal at $2.7 billion per month.

    Combining the numbers, that’s a $22.4 billion per month boost to GDP for these driving factors. The Fed’s announced taper is conservative at approximately half that value (at $10 billion per month.) Given the Fed’s past practice, that reduction in its asset purchases will take place in the month following the announcement of the change in policy.

    Stock prices will rise thanks to the end of uncertainty related to the Fed’s near-term intentions for its QE program, and should return to the approximate level they were before 10 December 2013, which is when the latest outbreak of Fed-taper related noise broke out in the stock market.

    Combined with the GDP-boosting factors noted above, the Fed’s taper is net positive.

    And that is why the S&P 500 rose by nearly 30 points to 1810 yesterday. Two points above the level it closed at on 9 December 2013. Merry Christmas from the Fed, who could have played the Grinch instead by announcing a much larger QE taper than they did!

    As a clarification, it’s France’s deteriorating economic situation, the drag for which will be felt across the Eurozone, which will help hold down world oil prices (tis also assumes the new detente with Iran holds.)

    And yes, if you follow the link to our original post, we had previously only accounted for just the impact of the budget deal, without factoring in the relatively new expectation for sustained lower oil prices in 2014.

    That said, that the market only put stock prices back to the level they were before the latest Fed-taper related noise event began on 10 December 2013 suggests that they were expecting just the $10 billion taper – stock prices would have continued rising today if that figure was less than the market’s expectation.

  6. Gravatar of TravisV TravisV
    19. December 2013 at 12:43

    “Bullard Leads The Fed” Good point!

    http://econospeak.blogspot.com/2013/12/bullard-leads-fed.html

    “the decisionmaker there who seems to be calling what will be happening in the future is St. Louis Fed President, Jim Bullard. After the initial foray to talk about tapering in May, he dissented at the June meeting on the dovish side, despite being prez of one of the traditionallhy most monetarist Feds. He argued that they needed more data supporting an end to the taper to go for it, particularly on the inflation side. In September the FOMC surprised the markets by essentially following Bullard’s advice, pulling back from a taper and declaring that more data was needed to support a taper.

    Now he has done it again. At the meeting concluded yesterday, the Fed announced a “tiny taper,” cutting securities purchases from $85 billion per month to $75 billion per month. Who was the first to publicly call for such a move? Yep, Jim Bullard, on December 9 in a public statement, indeed, using the term “tiny taper” for what he thought they should do, and now they have done it.

    So, things may change with the leadership transition, but anybody wanting to watch what the Fed is likely to do in the near future is advised to keep an eye on the public statements by Bullard.”

  7. Gravatar of Mark A. Sadowski Mark A. Sadowski
    19. December 2013 at 13:58

    Scott,
    Off Topic.

    I found the following post by merijinknibbe interesting:

    http://rwer.wordpress.com/2013/12/17/the-difference-a-price-level-makes/

    December 17, 2013

    The difference a price level makes
    By merijinknibbe

    “The European Central Bank targets the consumer price level, among other reasons because neoclassical macro-economic models often picture a world where this is the only level which matters. Indeed, as there is only one product in quite some models, the only level which even can exist. In reality, money is not only used to purchase vegetables and cars (household consumption) but also to pay for street lights (government consumption)and new houses and machinery (fixed investment). Theoretically, a broader inflation metric like ‘domestic demand inflation’ (household consumption + government consumption + investments) is therefore superior to a consumption price metric as far as targets go…”

    I found that at Mike Norman Economics so it’s evidently something MMT finds agreeable.

    And of course a dyed-in-the-wool New Keynesian like Simon Wren-Lewis has argued that the GDP implicit price deflator would make a better target than CPI (e.g. “But which inflation?”).

    This is an argument that a number of Market Monetarists have been making for a long time, in particular Lars Christensen (e.g. “The dangers of targeting CPI rather than the GDP deflator – the case of the Czech Republic”, “The scary difference between the GDP deflator and CPI – the case of Japan” etc.).

    P.S. Of course no price index is as good as NGDP.

  8. Gravatar of ssumner ssumner
    19. December 2013 at 14:21

    David, I can’t be sure but all the reports I read suggested that a delay of taper was viewed as fairly likely by the markets, and if taper did occur it would probably be $10 billion. Perhaps others who follow market forecasts can provide additional information. I certainly believe the taper would be $10 billion if it occurred, as that’s the number I kept seeing in all the press reports.

    Mark, Thanks for the link.

    Ironman, Several things surprise me about your post. A 10% change in oil prices seems small. We often see those sorts of swings without much impact on GDP. Small changes in the French growth rate can’t possibly have much effect on the oil market. And I can see why lower oil prices would raise RGDP, but doubt the effect on NGDP is all that significant (although of course there may be some effect.)

    You said:

    “That said, that the market only put stock prices back to the level they were before the latest Fed-taper related noise event began on 10 December 2013 suggests that they were expecting just the $10 billion taper – stock prices would have continued rising today if that figure was less than the market’s expectation.”

    No, stocks only respond to new information.

    Travis, Bullard is always interesting.

    Mark, Yes, I’ve also argued the deflator is better than the CPI.

  9. Gravatar of Tom Brown Tom Brown
    19. December 2013 at 14:29

    Between rocket science and quantum mechanics??

    1. I’m not sure about “monetary economics” in particular, but in terms of the whole field of economics, from my outsider vantage point, it looks FAR more complicated. Predicting the behavior of groups of humans, even if limited in scope to “economic” behavior, seems astoundingly complicated! Well well beyond trying to predict the weather (the weather doesn’t read your research and incorporate the results into new behavior). Why don’t economists try to tackle predicting how groups of chimps will behave before moving on to humans? Do chimps have a behavior that can be classified as “economic?” What’s “monetary” to a chimp? Like the weather, at least your research doesn’t close another giant set of non-linear feedback loops once it’s completed. If chimps are too complicated try rats… or frogs.

    2. Rocket science and quantum mechanics are also comparatively simple in terms of designing experiments to test their hypothesis: both fields have standard accepted models which are successful at predicting results to something like 15 digits of precision. Essentially we can find no disagreement between predicted theoretical results and actual laboratory measurements down to the limits of our current measuring ability. Economics and meteorology are nowhere near that!! … and again, I’d expect economics to be orders of magnitude more complex than meteorology.

  10. Gravatar of Felipe Felipe
    19. December 2013 at 14:30

    The strange thing is that inflation expectations fell (as measured by TIPS)[1]. I wouldn’t have expected inflation expectations to fall on monetary easing news.

    [1] https://www.google.com/finance?q=NYSEARCA%3ATIP&ei=A3OzUoD8KqXz0gGT1gE

  11. Gravatar of Geoff Geoff
    19. December 2013 at 15:20

    “One of the hard parts is breaking free from the notion that interest rate changes are reliable guides to the stance of policy.”

    For some other people, it’s even harder to break free from the notion that NGDP changes are “reliable guides to the stance of policy.”

    “But yesterday monetary policy clearly loosened (based on the rather obvious stock market rally after the 2:15 announcement),”

    Reasoning from a price change example #7565

  12. Gravatar of Geoff Geoff
    19. December 2013 at 15:30

    “Some readers misread my “negative multiplier” comment. Yesterday was not a negative multiplier example. It was an example of a market reaction that helps one to better understand how a negative multiplier could occur.”

    Nah, it was clearly just an attempt to indirectly protect MM theory from being falsified, by introducing a new factor that can explain why the stock market rallied after the Fed reduced its inflation.

  13. Gravatar of Sean Sean
    19. December 2013 at 16:28

    Don’t forget about treasury supply this week. 5 and 7 year auctions so a lot of supply that correlates highly with those interest rates. EMH has a degree of truth to it, but its volatile around a mean…when the market in a fairly illiquid environment gets hit with a bunch of supply it can lean on some of those other rate markets.

  14. Gravatar of Michael Byrnes Michael Byrnes
    19. December 2013 at 17:38

    To me (a biologist, not an economist), the hard parts are:

    1. A lot of human reasoning is based an “all things equal” assumption – but “all things equal” never ever happens in real-world macroeconomics. All things equal, QE will lower long term interest rates (prices rise, yields fall). All things equal, a higher Fed funds rate means tighter policy. In some disciplines, “all things equal” type reasoning is useful. From what I can tell about macro, “all things equal” is always useless and misleading.

    2. “Causation” is complex. All things equal, a financial crisis would cause nominal income to fall. It’s an easy and obvious conclusion to make – but wrong. If a financial crisis happens, and nominal income falls, the real chain of causation is more like: crisis –> tight money –> failure to offset –> lower nominal income.

    The crisis itself is neither necessary nor sufficient to slow the NGDP growth – effective monetary offset would prevent the crisis from affecting NGDP (or greatly reduce its impact), and arbitrary tightening could cause NGDP to fall in the absence of a crisis. The more interesting, but less obvious causation is: collapse in nominal income —> massive financial crisis.

    3. The role that expectations play. Future policy is what really matters – current policy is important only to the extent that it informs about the future stance of policy.

    4. A person can easily choose to hold more cash or less cash, but an economy as a whole cannot do the same.

  15. Gravatar of dtoh dtoh
    19. December 2013 at 18:41

    The easiest way to think about this is a graph which slopes downward from left to to right with real rates on the vertical y axis and NGDP on the horizontal x axis. (Lower rates generally equate to higher NGDP). However,

    The graph will shift right if expected NGDP increases, and you will you get higher NGDP with the same rate…. or you can have higher NGDP even if rates rise. (It’s essentially a shift in the Wicksellian rate).

    This is neither quantum mechanics nor rocket science. It’s just intuitive grade school mathematics.

  16. Gravatar of ssumner ssumner
    19. December 2013 at 19:44

    Tom, I was talking about how hard it is to understand the basic concepts, not how hard it is to set up experiments.

    Filipe, That’s odd, I read an article that said they rose.

    Michael, Other things equal is absolutely essential in macro. And it’s not true that QE lowers interest rates other things equal, unless you are holding inflation expectations equal. But QE affects inflation expectations.

    dtoh, I can’t tell what you are holding constant on a single line on that graph.

  17. Gravatar of ssumner ssumner
    19. December 2013 at 19:46

    Filipe, What exactly is that graph showing?

  18. Gravatar of Dan W. Dan W.
    19. December 2013 at 19:54

    Scott,

    I believe your rocket science analogy it very appropriate. As the linked video shows it has required a lot of failed rocket launches for rocket scientists to figure out how to do them successfully. Even today not every rocket launch goes as planned.

    Just me but I believe predicting, oops, I mean targeting, the national income of a 300+ million population is infinitely more complex and subject to many more unexpected outcomes than launching a rocket.

    I don’t think it is fair to challenge you to claim your model can never be wrong. I do think you have an obligation to research and disclose what can happen if the model is wrong.

    (70 years of rocket launch failures)
    http://www.youtube.com/watch?v=McbCwSW2moo

  19. Gravatar of Ralph Musgrave Ralph Musgrave
    20. December 2013 at 02:26

    Science attaches importance to simple laws which explain a lot, e.g. E=MC2. I.e. science is rightly suspicious of ideas which are almost as complex as quantum mechanics, but which don’t produce a widely accepted solution.

    Now here’s a phenomenally simple solution: abandon the distinction between monetary and fiscal policy. I.e. in a recession, just create new money and spend it public sector stuff plus cut taxes which will increase household incomes, which in turn raises household weekly spending.

    There’s only one drawback in that solution: the possible difficulty in reversing the process. However a finite amount of reversibility is easy. The only question is whether the amount of reversibility that’s feasible is enough to adopt the above “combined monetary and fiscal” lock stock and barrel.

    Of course huge numbers of academic economists would be out of work if that simple idea were adopted, which is why academic economists just love complexity for the sake of it (as pointed out time and again by Lars Syll).

  20. Gravatar of Daniel Daniel
    20. December 2013 at 03:16

    Ralph Musgrave

    And as to any excessive inflationary effects, that can be dealt with by increased taxes

    So the nations that have enjoyed low and stable inflation over the past 2+ decades have done so because their taxes happened to be just right ?

  21. Gravatar of Michael Byrnes Michael Byrnes
    20. December 2013 at 03:43

    Scott wrote:

    “Other things equal is absolutely essential in macro. And it’s not true that QE lowers interest rates other things equal, unless you are holding inflation expectations equal. But QE affects inflation expectations.”

    I guess I think useful in trying to think about what is going on, but not as an underlying assumption. You have to assume a lot, most of it wrong, to conclude that monetary policy was much tigher in 1978 than today.

    I agree QE affects inflation expectations, but even at the ZLB it doesn’t seem necessary or sufficient to change inflation expect ions. Isn’t part of the story of the last 5 years that the Fed has kept inflation expectations so-well anchored that the dollar for dollar impact of QE has been minimized. To me, the market consensus appears to be that most of QE is temporary or will be sterilized. Otherwise inflation expectations would have to be much higher. The Fed could have generated a better recovery with less QE or perhaps with none.

  22. Gravatar of Michael Byrnes Michael Byrnes
    20. December 2013 at 04:01

    Dan W wrote:

    “I believe your rocket science analogy it very appropriate. As the linked video shows it has required a lot of failed rocket launches for rocket scientists to figure out how to do them successfully. Even today not every rocket launch goes as planned.”

    We’ve had “failed rocket launches”. 1929 to 1941. The 1970s. The past five years.

    “Just me but I believe predicting, oops, I mean targeting, the national income of a 300+ million population is infinitely more complex and subject to many more unexpected outcomes than launching a rocket.”

    You seem to be conflating the nominal with the real. The Fed can’t produce or control the production of real goods and services, which is ultimately the source of wealth. But this is not a bug, it’s a feature. Even if the Fed could control the production of real goods and services, it’s not something we would want the Fed to do.

    What the Fed can control is the supply of base money. It can supply enough money to match the demand to hold money, or it can supply more of or less than the amount demanded. But if it supplies more or less, it will have real effects.

  23. Gravatar of Dustin Dustin
    20. December 2013 at 04:42

    ^ Michael,
    The Fed attempts to control the supply and demand of money. This happens via a few scenarios:

    1) Reserve requirements control supply via more/less risk tolerance and corresponding credit expansion
    2) FFR control demand as price of money is increased (decreased)
    3) OMOs control supply as the Fed creates excess reserves straight on a bank’s account a la QE

    So to me the question is one of efficacy. (1) And (3) create directly excess reserves, which are useless if there is no banking activity and loans created from these excess reserves … Which is what is occurring currently with QE, if some lending were occurring against these reserves they would be called required reserves.

    So really the Fed is only directly controlling the *opportunity* for supply of money.

  24. Gravatar of Daniel Daniel
    20. December 2013 at 04:43

    For neo-Calvinists like Dan W, if the Fed prevents a monetary contraction – it is bailing out all the sinners who made bad decisions.

    And that just cannot be – better to have 1000 innocent suffer than one sinner get away.

  25. Gravatar of dlr dlr
    20. December 2013 at 05:07

    Two quick empirical notes.

    On David Glasner’s point, it is pretty clear that he market expected “less” taper than it got. While of course there is no futures market, BBG compiles updated surveys of professional forecasters. Of the 68 estimates on Wednesday, the median was $85b the low was $65b and the average was $81b+ (i.e. a weighted expected taper of $3.5b versus the actual $10b taper). Two thirds of the economists predicted no taper.

    Second, TIPS-generated Breakeven Inflation rates did decline slightly post-announcement. They declined about 2bps over pretty much every tenor while TIPS yields rose.

  26. Gravatar of Ironman Ironman
    20. December 2013 at 05:07

    ssumner quotes and write:

    “That said, that the market only put stock prices back to the level they were before the latest Fed-taper related noise event began on 10 December 2013 suggests that they were expecting just the $10 billion taper – stock prices would have continued rising today if that figure was less than the market’s expectation.”

    No, stocks only respond to new information.

    Yes and no. You need to take the actual mechanics and inefficient nature of the transactions involved into account. After money goes out of the stock market, it takes time for it to reenter from where it has been parked. Often, money is able to leave the market more easily than it can enter because of those mechanics, which is the major reason why stocks are quick to fall, in the case of a crash, and slower to recover back to pre-crash levels.

    You also need to account for the effect of noise, where stock prices deviate away from the level from which an information signal would set them. The effect of noise is such that stock prices are almost never exactly at the level that their fundamentals would set them based on just that information. Sometimes higher and sometimes lower, given the random nature of noise.

    You can actually see both of these at work in how stock prices changed following the Fed’s announcement. Specifically, if you look at the difference between where the S&P 500 closed on 18 December 2013 and opened on 19 December 2013.

    There was no new news overnight to account for that change. And if you look closely, you’ll see that the value of the S&P 500 just 10 minutes before the close on 18 December 2013 was right about where it opened. For all practical purposes, it might as well have closed at that level – the only reason there is a gap at all is due to the presence of noise on 18 December 2013 to boost it to the level that it did close at.

    On 19 December 2013, there was no major news to drive stock prices. After the early morning where stock prices initially dipped by a very small amount, stock prices went on to steadily rise throughout the day with very little volatility – until closing at almost exactly the same level it did on 18 December 2013.

    In the absence of any other significant news to move stock prices (which we can say because of the market cap weighting of indices like the S&P 500, where the largest stocks have the greatest influence over the index’ value, which means that we only need to focus on news related to its top components), what we saw on 19 December 2013 was the rest of the money that left the stock market in the previous week return, because the market hadn’t yet finished absorbing the news of the Fed’s action on 18 December 2013, largely thanks to those mechanics mentioned earlier.

    Put more simply, the new information wasn’t old yet, so the rally related to it wasn’t done yet either.

    That explains why the market ultimately reached the level it did on 19 December 2013, but leaves a more interesting question – how come the market was able to get to that almost identical level on 18 December 2013 in the first place?

    The answer surprises a lot of people. The presence of noise helps to make the market more efficient. If you want to draw upon an example from the physics of rocket science and quantum mechanics, it’s very much like how the presence of noise can improve the performance of solar cells.

    Here, the presence of noise allowed stock prices to rise to the level they ultimately would much more quickly than they could with just the fundamental signal alone.

    Keep in mind that what I’ve just described is very different from what you would expect from the Efficient Market Hypothesis, whose practical value is contained in the observation that changes in prices rapidly reflect changes in information. The market in practice isn’t anywhere near as perfectly efficient as Fama’s hypothesis would make it seem.

  27. Gravatar of Dan W. Dan W.
    20. December 2013 at 05:09

    Daniel,

    I would rather the government not provide alcoholics an endless supply of cheap wine.

    By the way, if wages are sticky then are they not sticky going up as well as going down? As such is not currency debasement a tax on wages? Of course it is.

    Since 1981 real incomes have increased less than 20%. Real GDP per capita is up 90%. How? The answer is debt. And the leverage of borrowed money is the true money illusion.

    http://monetaryrealism.com/wp-content/uploads/2013/03/Median-Wages-vs.-GDP.jpg

    “What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?” – Adam Smith

  28. Gravatar of Ralph Musgrave Ralph Musgrave
    20. December 2013 at 05:35

    Daniel,

    I’m simply saying that raising taxes and unprinting the money collected has a deflationary / inflation reducing effect, all else equal. I.e. what taxes and public spending are as a proportion of GDP is irrelevant.

  29. Gravatar of Felipe Felipe
    20. December 2013 at 05:36

    The graph shows a TIPS ETF. I couldn’t find an online graph for any TIPS maturity yield. Essentially, since nominal rates held constant, but TIPS prices fell (that is, real yields rose), the difference has been reduced.

    But I see I may have misinterpreted the graphs. I will try to get a screenshot of the intraday difference on the 18th, I remember the spread widened after the Fed announcement.

  30. Gravatar of Michael Byrnes Michael Byrnes
    20. December 2013 at 06:33

    Dustin wrote:

    “So to me the question is one of efficacy. (1) And (3) create directly excess reserves, which are useless if there is no banking activity and loans created from these excess reserves … Which is what is occurring currently with QE, if some lending were occurring against these reserves they would be called required reserves.”

    This is true only if you make the assumption that if banks had much lower reserves their lending activities would be the same as they are today with huge reserves.

    Another possibility to consider is this: had QE not been done, or been done to a lesser extent, with no alternative policy accommodation, money creation by banks (and thus nominal income) would be even *lower* than it is today.

    Rather than talking about a poor recovery and banks sitting on massive amounts of excess reserves, we could be looking at continued contraction, a double dip, etc.

  31. Gravatar of NV NV
    20. December 2013 at 06:34

    It looks like the negative multiplier argument assumes that policy makers got into a time machine that took them to 2013 and learned all the lessons of the past 5 years and then went back to 2009 to implement the right policies. The negative multiplier may very well be true for a future recession but I think it is highly unlikely in 2009 – for most policymakers and economists (not Scott) Japan is still an abstraction.

  32. Gravatar of Michael Byrnes Michael Byrnes
    20. December 2013 at 06:44

    Dan W wrote:

    “I would rather the government not provide alcoholics an endless supply of cheap wine.”

    Bad analogy. Did Prohibition stop alcoholism? I would say Prohibition restricted the freedom of many responsible adults, did not prevent the drunks from getting their booze, and really pumped up organized crime as a business model.

    It’s an odd kind of Puritanism that says the many must suffer for the sins of the few.

  33. Gravatar of ssumner ssumner
    20. December 2013 at 06:46

    Ralph, Doing fiscal stimulus merely wastes vast amounts of fiscal resources for no good reason.

    Michael, I agree with that.

    Thanks dlr.

    Ironman, You said;

    “After money goes out of the stock market, it takes time for it to reenter from where it has been parked. Often, money is able to leave the market more easily than it can enter because of those mechanics, which is the major reason why stocks are quick to fall, in the case of a crash, and slower to recover back to pre-crash levels.”

    No, money does not go into and out of markets. That’s a complete myth. Markets don’t contain money, only individuals hold money. A record number of shares were purchased on October 19, 1987. Did money go into the stock market that day?

    If you were right about the delayed impact of information then investors could take advantage of that fact.

  34. Gravatar of Dan W. Dan W.
    20. December 2013 at 06:48

    Ralph,

    The advantage of monetarism is that the value of money is manipulated by an unelected body of people. The ability of the central bank to act unilaterally, outside the political process, allows for much quicker, less compromised, and less transparent, decision making.

    That said anything done monetarily could be done fiscally. For example, it would be perfectly legal for Congress to pass legislation authorizing the Treasury to sell bonds that pay no interest for 20 years. Voila, money is injected into the economy, NGDP and real GDP rise and everyone is happy. Just ignore the liability on the out years.

    Keynesian fails because politicians have no interest in balancing stimulus in the bad years with austerity in the good years. Monetarism falls short for the same reason, although admittedly central bankers are much better at being grumps than are politicians.

  35. Gravatar of Dan W. Dan W.
    20. December 2013 at 07:14

    By less transparent I meant the general public just hears about a Fed announcement but is pretty much clueless about what it actually means. Of course the experts will tell us what it means! On the other hand, the political process involves lots of press coverage on what a policy means when in reality it means none of that (aka Obamacare). So the political process is in fact not very transparent either but it allows the general public to believe it is.

  36. Gravatar of Ralph Musgrave Ralph Musgrave
    20. December 2013 at 07:43

    Dan W,

    I quite agree that under existing institutional arrangements, monetary adjustments can be made far more quickly than fiscal ones. I.e. to make fiscal adjustments under current arrangements, we have to wait for a collection of economic illiterates known as “politicians” to squabble for months on end.

    However, it would perfectly possible to have an arrangement under which strictly political decisions like what proportion of GDP is allocated to public spending and how that is split between education, law enforcement, etc left to politicians and the electorate, while CHANGES to AGGREGATE fiscal spending is in the hands of a committee of independent economists. Details of that system are set out on pp.10-11 here:

    http://www.positivemoney.org.uk/wp-content/uploads/2010/11/NEF-Southampton-Positive-Money-ICB-Submission.pdf

    I.e. the “advantage of monetarism” to which you refer arises purely out of current administrative arrangements, not for strictly economic reasons.

    Re your second paragraph, you seem to suggest that monetary and fiscal policy are interchangeable. Strikes me there are fundamental differences. E.g. monetary adjustments (interest rate changes or QE) do not change the sum of public debt and monetary base in the hands of the private sector. I.e. monetary adjustments just swap debt for base. In contrast, fiscal stimulus increases the above sum (which MMTers call “private sector net financial assets”).

    Second, fiscal can be selective: e.g. it can channel stimulus into household pockets or into bankster’s pockets. In contrast, monetary adjustments are not selective in that way.

    Re your third paragraph, if politicians were not interested in reining in public debt in the good years, then national debts would continue rising for ever. The reality is that US and UK debt, while they are higher than normal because of the crises, are not far from the average over the last century or two (relative to GDP).

  37. Gravatar of Dustin Dustin
    20. December 2013 at 07:49

    Michael,
    Right. I shouldn’t have made such an extreme statement regarding QE because some is being leveraged.

    My point was more broadly that the Fed targets supply and demand, and that in targeting supply when the Fed creates excess reserves, they are more likely to be leveraged for money supply expansion when the Fed also 1) has no IOER 2) considers them permanent – because a bank doesn’t want to have loans on the books when reserves are withdrawn through future offsetting OMOs, and 3) provides forward guidance to allow for inflation – which would occur through all the mechanisms you described in an earlier illustrative post if the reserves are leveraged.

    Otherwise the Fed’s ability to control supply of money via expanded money base is impaired.

  38. Gravatar of Ironman Ironman
    20. December 2013 at 09:01

    ssumner quotes and write:

    “After money goes out of the stock market, it takes time for it to reenter from where it has been parked. Often, money is able to leave the market more easily than it can enter because of those mechanics, which is the major reason why stocks are quick to fall, in the case of a crash, and slower to recover back to pre-crash levels.”

    No, money does not go into and out of markets. That’s a complete myth. Markets don’t contain money, only individuals hold money. A record number of shares were purchased on October 19, 1987. Did money go into the stock market that day?

    If you were right about the delayed impact of information then investors could take advantage of that fact.

    Attentive investors do. Frequently. The only reason you don’t see it more often is because the duration of noise events tends to be short, where the opportunities to pick up that money lying in the street tend not to last very long, and more often, because of the transaction costs involved.

    But sometimes, the volume of the noise is loud enough and lasts long enough where those obstacles can be surmounted. When that happens, those who can see the difference between the what prices are with the noise and where they would be in the relative absence of noise do quite well.

    Going back to the matter of money going into and out of markets, it would perhaps be better to say that the composition of holdings by investors changes, where money say flows from stocks to money markets to real estate to bonds, and vice-versa, etc. As you correctly note, individuals hold money – it’s only a question of how they hold it. The perception that money goes in and out of a market is however certainly accurate from the point of view of a given market.

    And since you mentioned Black Monday, that was simply the very abrupt end of a positive noise event that began on 2 January 1987….

  39. Gravatar of Felipe Felipe
    20. December 2013 at 09:30

    Scott:

    I have now a better image here. The second graph is the difference between 5 year TIPS and treasuries (so the number being plotted is the negative of the inflation expectations). As you can see, the on 18th at the time of the announcement the inflation expectations fell around 2 basis points. On the 19th they continued to fall.

  40. Gravatar of Ralph Musgrave Ralph Musgrave
    20. December 2013 at 09:32

    Scott,

    I’m baffled as to what you mean by “Doing fiscal stimulus merely wastes vast amounts of fiscal resources for no good reason.” So spending money on the large range of stuff consumed by households and government is a “vast waste of resources”?

  41. Gravatar of Dan W. Dan W.
    20. December 2013 at 11:47

    Ralph,

    The effects of monetary easing could be realized fiscally by taxing savings and redistributing the revenue into the economy. Granted, monetary methods do this much more efficiently than would a tax but the political solution would give government more control over would receive the benefits of the tax revenue.

    I agree the politicians display some fiscal control at times but they never really follow the Keynes formula of alternating between fiscal surplus and deficits. Rather deficits are standard fare and then in recessions they move to a higher plateau. What will be real interesting to watch is what the new normal of federal funds rate will be. Will it ever return to 5%? How could it with the federal debt so high?

  42. Gravatar of Dustin Dustin
    20. December 2013 at 13:22

    Dan W,
    “Since 1981 real incomes have increased less than 20%. Real GDP per capita is up 90%. How? The answer is debt. And the leverage of borrowed money is the true money illusion.”

    Comparing mean to median isn’t so helpful to convey the point you are trying to make.

  43. Gravatar of josh josh
    20. December 2013 at 15:05

    The quantum mechanics analogy is really interesting – it’s like there’s an uncertain superposition of potential NGDP paths, but coordinating expectations causes a wave function collapse, so the system behaves classically. Kind of a Quantum Sumner Critique.

  44. Gravatar of ssumner ssumner
    20. December 2013 at 15:25

    Ironman, I don’t think you understood my comment. Did money flow into the stock market on October 19, 1987, where a record number of shares were purchased?

    And there is no evidence that people can predict short term movements in the market.

    Ralph, Fiscal stimulus is government spending that does not pass cost/benefit analysis, and is simply being done in the false belief it will pump up GDP. Obviously if it passes cost/benefit analysis it should be done recession or not, but that’s not fiscal stimulus, it’s ordinary government spending.

    Josh, Nice analogy.

  45. Gravatar of Ironman Ironman
    21. December 2013 at 11:24

    ssumner writes:

    Ironman, I don’t think you understood my comment. Did money flow into the stock market on October 19, 1987, where a record number of shares were purchased?

    No, I understood the question, but assumed you were asking it rhetorically. Since the number of shares transacted on any given day has nothing to do with either their value or the real number of buyers and sellers, no conclusion may be drawn on whether a flow of funds exists from a simple change in price level. (Isn’t that what you mean every time you say “never reason from a price change”?)

    What you can do however to identify if such a flow occurred is see how the actual money supply changed in response to that event – I assume you’re already aware of the large spike in M1 following 19 October 1987, which is where a good amount of the money that left the stock market at that time was parked until things settled down. And since the Fed wasn’t behind that spike, because the change in MB was steady all through that time, that money had to come from somewhere, say from a place where asset prices were rapidly falling, where a large number of people might be suddenly highly motivated to sell even at falling price levels for the sake of trying to preserve whatever gains they had made….

    And there is no evidence that people can predict short term movements in the market.

    I agree, when such movements are truly random. Not all such movements are random.

  46. Gravatar of ssumner ssumner
    22. December 2013 at 06:47

    Ironman, You said;

    I assume you’re already aware of the large spike in M1 following 19 October 1987, which is where a good amount of the money that left the stock market at that time was parked until things settled down.”

    No, money cannot leave the stock market. When someone sells a share they do have money to put into DDs. But someone had to buy the shares, and pull and equal amount of money out of DDs. So money does not leave the stock market. If DDs went up it’s because the money multiplier rose.

  47. Gravatar of Mark A. Sadowski Mark A. Sadowski
    22. December 2013 at 08:28

    Scott,
    “If DDs went up it’s because the money multiplier rose.”

    Not surprisingly, commercial bank loans and leases spiked during the same time period. M1 increased by $16.3 billion from October 12 to October 26, 1987. Commercial bank loans and leases increased by $15.7 billion from October 7 to October 28, 1987:

    https://research.stlouisfed.org/fred2/graph/?graph_id=152523&category_id=0

  48. Gravatar of Ironman Ironman
    23. December 2013 at 10:38

    ssumner writes:

    No, money cannot leave the stock market. When someone sells a share they do have money to put into DDs. But someone had to buy the shares, and pull and equal amount of money out of DDs

    Within the very limited time frame in which you’re considering the event, that is correct.

    Mark A. Sadowski follows up:

    Not surprisingly, commercial bank loans and leases spiked during the same time period. M1 increased by $16.3 billion from October 12 to October 26, 1987. Commercial bank loans and leases increased by $15.7 billion from October 7 to October 28, 1987.

    So they did – a good portion of that spike in loans and leases were securities loans made by the commercial banks at that time, which were aimed at supporting margin calls for the sake of supporting the market’s liquidity.

  49. Gravatar of ssumner ssumner
    24. December 2013 at 11:20

    Ironman, I don’t see what Mark’s data has to do with what you were claiming. Bank deposits were created. That’s very different from saying that money already in circulation was moved “into” the stock market.

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