Here is Frances Coppola:
Scott Sumner argues thatwhen the monetary base is fixed, low interest rates are deflationary. I’ve emphasised the fixed monetary base because it is an important condition. If the monetary base is NOT fixed then the relationship between low interest rates and deflation is much less clear.
Logically, this makes sense. If the supply of base money is fixed, then falling interest rates indicate* rising demand for base money, increasing its value and therefore causing prices to fall. Aficionados of a classical gold standard will recognise this as “benign” deflation. Falling interest rates when the monetary base is fixed are an indicator of healthy growth.
I would argue the opposite. Low interest rates are usually indicative of weak growth, as both real and nominal interest rates are procyclical. Barsky and Summers showed that under the gold standard, when the economy slowed interest rates tended to fall. This increased the demand for gold (the medium of account) and was deflationary.
The “good deflation” was a secular phenomenon. It was associated with a rise in the demand for money from positive trend real GDP growth, not lower interest rates.
It’s misleading to say falling interest rates are only deflationary under a constant monetary base. They have a deflationary impact regardless of the base, it’s just that when the base is changing the deflationary impact from falling interest rates is often offset by the inflationary impact of a rising monetary base.
The Fed was not holding the monetary base fixed and allowing the interest rate to fall, which is what Sumner implies. It was actively supporting the Fed Funds rate.
The Fed Funds rate is not simply a market interest rate. At the time, it was the primary monetary policy tool, though these days – because of the presence of excess reserves in the system – it has been superseded by the interest on reserves (IOR) rate.
Interest rates fell becasue of a weakening economy, not because the Fed cut interest rates. When the Fed announcement in December 2007 was less expansionary then expected, 3 month T-bill yields (which are market interest rates) fell on the news. Markets understand market monetarism. A few weeks later the Fed had a panicky emergency meeting and cut it’s fed funds target in an attempt to keep up with changing economic conditions. The reduced demand for loanable funds was pushing rates lower, and because the Fed did not respond by increasing the base this led to a further slowdown in NGDP.
Sumner seems to think that the Fed should not have supported the rate by draining reserves. On he contrary, he explicitly blames the Fed’s failure to expand the monetary base at this time for the subsequent collapse of NGDP:
Between August 2007 and May 2008 there was no change in the monetary base, and yet interest rates fell sharply. Not surprisingly NGDP growth slowed and we tipped into recession.
But the problem was inflation:
Expansionary monetary policy when inflation was already so far above target would have seemed like madness. Even since the crisis, it takes a brave central bank to hold its nerve and its expansionary policy when inflation is a long way above target, as the Bank of England has discovered.
Yes, at the time the market monetarist message would have seemed like madness—focus on NGDP growth and ignore inflation. But we now know it is inflation targeting that is madness. Even Bernanke now admits that actual policy was too tight during the crisis.
Nor would NGDP targeting necessarily have made much difference to Fed policy. We now know, with the benefit of hindsight, that NGDP was going to fall off a cliff in 2008. But at the time, NGDP didn’t show much sign of such a dramatic collapse:
It would have made a huge difference, because with NGDPLT monetary policy works with “long and variable leads.” The expectation that the Fed would return to the 5% trend line in the long run would have stabilized asset markets in the short run, and Lehman might not have even failed.
Those in favour of a strict rule-based approach to monetary policy based on something like an NGDP target will no doubt be disappointed: but as I said above, an NGDP target would not necessarily have resulted in a markedly different policy stance in the crucial early part of the financial crisis.
Maybe not all that different, but then the initial part of the recession was exceedingly mild. Most importantly NGDPLT would have created expectations of a very different policy in the latter half of 2008, which would have made the recession far milder.
PS. The Coppola post refers to a money supply graph that I wasn’t able to find. Was it included? Another graph has a garbled horizontal axis, and another refers to potential NGDP which is a nonexistent concept. “Potential” only has meaning for real variables.
Update: I mistakenly linked to the wrong version of the post. The correct version does have a money supply graph.
HT: Travis V.