A recent David Beckworth post linked to Macroeconomic Adviser’s monthly nominal GDP series. Please click on the Macro Adviser’s GDP link and take a look at the graph showing estimated monthly NGDP data. You will see that almost the entire drop in NGDP during this recession occurred during a brief 6 month period between June and December 2008. This fact is obscured by quarterly data, which show a very large drop in the average level of NGDP between 2008:4 and 2009:1. But again, by December 2008 it was almost all over, even though the official recession trough wouldn’t occur until June 2009, at a tad below December NGDP levels.
[Update, 10/25/10: I erred in telling you to look at the graph, which shows RGDP. The tab at the bottom opens another page which shows the nominal monthly data. This is even better—all of the decline in NGDP now occurs between June and December 2008, and almost all between July and December. This almost precisely aligns with the period of ultra-tight money.]
I wish the Federal government would publish monthly NGDP data. It can’t be that hard to get estimates; after all, GDP is mostly constructed out of other monthly time series. And even the quarterly GDP reports are estimates, often sharply revised years after the fact.
The period of June to December 2008 also saw one of the tightest monetary policies in American history. Between July and late November the real interest rate on 5 year TIPS soared from about 0.5% to 4.2%. The dollar soared against the euro. Stock, commodity, and commercial real estate prices plunged.
And all of this occurred before the Fed ran out of conventional monetary policy ammo. That’s right, it wasn’t until mid-December 2008 when the Fed reduced rates close to the zero bound (0.25%.) During the crash rates were always at least 1%, and mostly 2%. And that’s ignoring the contractionary impact of interest on reserves.
Frequent commenter “123” has studied this period more intensively than I have, and he recently sent me a post that sheds new light on the debate over whether the key problem was solvency or liquidity:
Brad DeLong ponders the issue of the root cause of the crisis. Is it that the full-employment planned demand for safe assets is greater than the supply, or is it that the full-employment planned demand for medium of exchange is greater than the supply? In other words, is it the flight to safety, or is it the flight to liquidity? Brad DeLong argues that we have the flight to safety:
“Thus we would expect a downturn caused by a shortage of liquid cash money to be accompanied by very high interest rates on, say, government bonds–which share the safety characteristics of money and serve also as savings vehicles to carry purchasing power forward into the future, but which are not liquid cash media of exchange.”
The problem is that government bonds serve both as savings vehicles and as medium of exchange. As Gary Gorton said, “it seems that U.S. Treasuries are extensively rehypothecated and should be viewed as money”. You purchase groceries with cash, and you purchase other financial assets with U.S. Treasuries, but in both cases we are dealing with media of exchange.
It is very hard to disentangle these two facets of U.S Treasuries, but we have a great natural experiment. After the collapse of Lehman, TIPS were a perfectly safe savings vehicle, but they were much less liquid than cash or other Treasuries. Lehman has mainly used TIPS as repo collateral, and after liquidation the pattern has shifted, the marginal holder of TIPS was more likely to use it as savings vehicle rather than for transactional purposes. The result was what FT Alphaville has called “The largest arbitrage ever documented”, as the price of TIPS fell by as much as 20 cents on the dollar as compared to much more liquid Treasuries. This gives us a clear indication that post-Lehman panic was a flight to liquidity, and not a flight to safety. This means the best policy response was the expansion of the quantity of liquid, rather than safe assets. After March 2009 QE announcement, the Fed has greatly enhanced liquidity properties of TIPS.
This does somewhat undercut my argument that the TIPS spreads showed inflation expectations falling sharply. They did fall, but not as sharply as the spreads suggest. But I’ve always acknowledged that the TIPS spreads might have been distorted by a rush for liquidity, and I’ve also argued that the rush for liquidity shows the Fed was behind the curve just as surely as would lower inflation expectations. Either way, money was much too tight.
It also seems to undercut my cherished belief in the EMH. Perhaps someone in the mutual fund industry can tell me why bond funds didn’t just construct a portfolio of TIPS plus inflation futures that was guaranteed to outperform Treasury note funds of equal maturity. 123 linked to an arbitrage paper that seemed to suggest there were lots of $100 bills lying on the ground.
PS. I’ve been so busy that I haven’t linked to this David Beckworth and William Ruger article on Milton Friedman in Investor’s Business Daily. Good stuff.
PPS. I also wanted to link to this good James Hamilton post on QE:
A related complication is the fact that the market has already anticipated substantial additional LSAP [i.e. QE]. My guess is that an additional trillion dollars in purchases is already priced into current bond yields and exchange rates.
For all these reasons, the key message of the November FOMC statement may not be the size of purchases that the Fed announces, but instead the framework it offers as guidance for exactly what such purchases are intended to accomplish.
Exactly. It’s all about the framework. In retrospect, the biggest problem in the second half of 2008 was the lack of a policy framework. The was no indication that the Fed would do anything to stop, or later reverse, the sickening plunge in NGDP.
Tags: TIPS spread