January 3, 2001

In recent years I have mostly taught Monetary Economics.  I spend precisely zero minutes covering IS/LM, and lots of time covering market responses to Fed announcements.  Based on some of the comments I received from my last post, I thought it might be interesting to examine one of my favorite Fed announcements, the surprise 1/2 rate cut of January 3, 2001.  This was the first rate cut of the 2001 recession, and reduced the fed funds target from 6.5% to 6.0%.  Here were some market reactions:

1.  The S&P 500 soared by 5.0%

2.  T-bill prices rose by 1/32  (yields fell)

3.  28 year TIPS prices fell by 16/32  (yields rose)

4.  28 year T-bond prices plunged by 76/32 (yields rose sharply) 

I generally attribute the slight fall in T-bill yields to the liquidity effect, the rise in stock prices and TIPS yields to the income effect, and the sharp rise in T-bond yields to the income and expected inflation effects.  IS/LM says easy money lowers rates.  I say it is much more complicated than that.

I know I am in the minority, because here’s how the Wall Street Journal (1/4/01) described the market reaction:

Treasury Prices Plummet as Stock Prices Soar on Earlier than Expected Fed Interest Rate Cut

.   .   .  ”Market participants were remembering history: that when the Fed’s on your side, stocks are the place to be,” said Mark McQueen, executive vice president of Sage Advisory Services.

Traders said the selling in bonds also reflected the fact that the market had been anticipating an easing of Fed policy soon and already had rallied strongly on the expectation.  When the Fed actually cut rates, people were, in bond market terms, “selling the fact.”

Have you noticed that when reporters don’t have a clue as to what is going on, they attribute it all to market irrationality?  No wonder there’s so much hostility to the efficient markets hypothesis.  Reporters are taught that easy money leads to lower interest rates.  When the markets behave in seemingly irrational ways, the natural reaction is to blame the EMH.  Readers of this blog know that easy money often leads to higher long term interest rates, so we don’t have to resort to market irrationality to explain these reactions to Fed announcements.

Some commenters noted that yesterday’s complex bond market reaction reflected changes in the proportions of maturities that the Fed was likely to purchase.  Maybe so, but in qualitative terms the reaction really wasn’t much different from January 2001, a policy move associated with virtually no bond purchases.  (During normal times the level of excess reserves is tiny and the Fed buys only an infinitesimal amount of bonds when it eases policy.)

Of course most Fed moves are widely expected, and elicit no market reaction.  For instance, the Fed did a long series of quarter point increases between 2004 and 2006, which the market took in stride.  The biggest reactions occur at key points in the business cycle, when a significant change in policy is contemplated. 

The next key policy move occurred in September 2007, when the Fed did its first rate cut of this cycle.  Again, the cut was larger than expected (1/2 point), and once again short term rates fell and long term rates rose.  Stocks rose a couple percent after the announcement.  Asian stocks soared on the news. (Sound familiar?) 

In December 2007, the fed funds futures market showed the cut would be either a quarter or a half point.  The actual 1/4 point cut caused a severe stock price decline.  This time the income effect stretched all the way down to three months, as yields fell from 3 months to 30 years.  And remember, these rate cuts were responding to a contractionary surprise, so the IS/LM model says yields should have risen.  The stock and bond markets turned out to be prescient.  A recession began at exactly that moment, and by January the Fed realized it had blown it.  It did two rates cuts totaling 125 basis points within 2 weeks, which validated the earlier T-bill market reaction in December. 

This was enough to prop up NGDP for another 6 months.  But between July and December 2008 NGDP went into free fall, as the Fed became mesmerized by commodity inflation and failed to respond to abundant signs that NGDP growth was plummeting.  Then they became obsessed with the banking crisis.  Indeed the great collapse of July-Dec. 2008 was more than half over before the Fed started doing monetary policy, and the first move was not a rate cut but rather the interest on reserves program of October 2008—a highly contractionary move!

Lessons for the Fed?  Pay attention to markets that provide information about future NGDP growth, and don’t ever let NGDP expectations going 1, 2, and 3 years out collapse to a level far below trend.  And don’t assume that low rates mean easy money.


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30 Responses to “January 3, 2001”

  1. Gravatar of marcus nunes marcus nunes
    4. November 2010 at 13:08

    Scott
    A couple of hours ago I dis a post called “QE=Cocaine”? The markets are becoming dependent on it. What is bad is that the limit to the “High” is not specified (through a nominal target). So, if the economy doesn´t react people will expect another “dose”, and so we go…

  2. Gravatar of StatsGuy StatsGuy
    4. November 2010 at 13:27

    If the economy doesn’t react, then the markets should expect another dose – and they should get it. EVENTUALLY, prices will react. The question is whether unemployment reacts – or more accurately, how big will the reaction be.

    Imagine that housing prices (among other things) reflect structural maintenance costs. There are two costs – labor, and goods. Let’s assume many construction goods (or their primary components) are imported, since they are. If QE causes domestic prices to rise, and import prices to rise even higher, along with a fall in real wages, there are several effects here. The loss of dollar buying power increases part of the cost of house maintenance (component imports), but decreases other costs (labor). The net effect on the value of the house (rationally) is indeterminate. There SHOULD be a substitution of labor for product (e.g. people do more repairs, fewer replacements). How much more? Who knows… Not me.

    What I found interesting about the market’s reaction was the LACK of reaction in the US, which I do attribute to the widespread belief that QEII has been “priced in”. What the US seemed to fail to realize was that the rest of the world had apparently NOT “priced in” QEII. Or at least they were about 2% off. Or, in gold terms, 5% off?

    Gold moved impressively today. I just have a hard time owning it.

  3. Gravatar of JPIrving JPIrving
    4. November 2010 at 13:45

    @statsguy

    In my opinion the gold market is forecasting demand for electronics and the fact that most of the untaped deposits are in places like the Congo. These middlebrow reporters who claim gold is useless except as a Zimbabwe hedge dont understand that that gold has become an important industrial commodity.

  4. Gravatar of Liberal Roman Liberal Roman
    4. November 2010 at 14:03

    “Have you noticed that when reporters don’t have a clue as to what is going on, they attribute it all to market irrationality?”

    Honest question. What percentage of financial reporters have any clue as to what is going on on a macro economic level? (I am sure they do a fine job covering individual business wheeling and dealing) I am going to be generous and say 20%. Me and my friend always find the front page of Yahoo! Finance to be absolutely hilarious. Especially, when they offer their take on why the market did what it did during the day.

    However, my emotions swing from laughter to annoyance/anger when I read how the Fed actions could have unintended consequences like…**gasp**…inflation!

  5. Gravatar of Stephen Stephen
    4. November 2010 at 14:14

    Why compare QE to heroin? If investors make bad decisions and cause price distortions, they lose their own money. Not the Fed’s money- the Fed is only buying govt bonds, signaling a desire for higher inflation, and taking action by increasing the money supply.

  6. Gravatar of Simon K Simon K
    4. November 2010 at 14:21

    @JPIrving – The amount of gold needed for electronics is tiny. Add to that the fact that demand for gold jewelry is shrinking, and mine production is rising, and you’re left with current investment demand from ETFs far out-stripping future need.

  7. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    4. November 2010 at 14:56

    “Indeed the great collapse of July-Dec. 2008 was more than half over before the Fed started doing monetary policy, and the first move was not a rate cut but rather the interest on reserves program of October 2008—a highly contractionary move!”

    What about changes in monetary base? Isn’t it a monetary policy?

  8. Gravatar of Doc Merlin Doc Merlin
    4. November 2010 at 15:16

    @ Simon K

    Yes, its a result of expected supply of gold is growing much smaller than expected supply of dollars is so dollar denominated assets are switching to gold denominated ones or increasing their rates. When the money supply contracts again, gold is going to crash hard, but until then its going to keep increasing.

  9. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    4. November 2010 at 15:17

    In 2001 stock market indicated that there was an AD surprise. This time stock market said there is no AD surprise, so it is likely that the news was about proportions of maturities.

  10. Gravatar of Doc Merlin Doc Merlin
    4. November 2010 at 15:21

    @ Liberal Roman:
    “However, my emotions swing from laughter to annoyance/anger when I read how the Fed actions could have unintended consequences like…**gasp**…inflation!”

    Honestly, I am more worried about asset bubbles forming right now than I am about CPI inflation. The gold bubble is going to get very bad and cause a lot of pain.

  11. Gravatar of Liberal Roman Liberal Roman
    4. November 2010 at 16:00

    Doc,

    I don’t remember where, but I read somewhere that the gold market is relatively small. Oh, I am sure it has grown over the last few years, but it’s a drop in the ocean compared to the real estate market. So, even if gold gets cut by 25%, the amount of wealth lost is a pittance. Hence, I am not too worried.

    It is kind of interesting to look at some of the commodity ratios. In early 2008, one ounce of gold could only buy you about 6.5 barrels of oil. Now an ounce of gold will get you about 17 barrels of oil. Crazy.

  12. Gravatar of Morgan Warstler Morgan Warstler
    4. November 2010 at 16:09

    Here comes the Drudge…

    http://www.ft.com/cms/s/0/981ca8f4-e83e-11df-8995-00144feab49a.html#axzz14MSwalEP

    I think Ben in order to get to print his money is going to have to start demanding Obama make deep hard cuts to the budget.

    To even get this much out the door, he’s going to have to align with the budget scolds and preach Austerity… to convince the Tea Partiers and Central Bankers that he’s not Obama’s enabler.

  13. Gravatar of Simon K Simon K
    4. November 2010 at 16:29

    Doc – I think you’re right gold is overvalued. People see it as an inflation hedge, but the fundamentals don’t support the current price, even if we assume very high levels of CPI inflation, so its not a very good hedge. A basket of industrial and agricultural commodities would be a much smarter move if you’re really worried about hyperinflation (which I’m not). But I don’t think you need to wait for the money supply to contract for gold to fall – once there’s real growth stocks will rise and bonds will fall and people will start to sell off those gold ETF shares.

  14. Gravatar of Simon K Simon K
    4. November 2010 at 16:36

    Liberal Roman – Yes the total value of the worlds production of gold is somewhere around 70 billion at today’s closing price. That prices is very high by historical standards, but 70 billion is less than 17% of the US budget deficit.

  15. Gravatar of Pragmi Pragmi
    4. November 2010 at 16:51

    To completely deviate from the point of the post, who wants to take bets on how Scott voted on Tuesday? :)

  16. Gravatar of JTapp JTapp
    4. November 2010 at 17:16

    Tomorrow in Int’l Macro I’ll be teaching about the Volcker Fed using IS-LM-FX (using Feenstra & Taylor) also including Reagan’s outward shift of IS. Tight money, higher nominal rates, pronounced nominal & real appreciation of the dollar and a sharp downturn in investment.

    But I’m glad I spent the earliest weeks of the semester harping on the monetary approach to the BOP. Because now the students ask “wouldn’t a change in the money supply cause the expected future exchange rate to change?”; textbook answer is always “not if it’s a temporary change.” Allows me to bring in the idea of explicit monetary policy targets and so forth. It’s useful to teach ISLM to give a Keynesian worldview and to then deconstruct it, IMO.

  17. Gravatar of marcus nunes marcus nunes
    4. November 2010 at 17:37

    Scott
    This must be “the most srewed up article” of today!
    http://economix.blogs.nytimes.com/2010/11/04/was-that-a-plea-from-bernanke/

  18. Gravatar of scott sumner scott sumner
    4. November 2010 at 18:04

    Marcus, Yes, a larger dose may be necessary.

    Statsguy, I’d rather focus on NGDP, not inflation. If NGDP rises, I think jobs will follow. My hunch is that today stocks (and gold) reacted to the Bernanke WaPo article. But I can’t be sure.

    JPIrving, Yes, I think non-hoarding demand is important, but not the whole story. Central bank demand is also an issue.

    Liberal Roman, I agree.

    Stephen, I agree.

    123, That was viewed as “banking policy”. It was viewed as temporary–the Fed gave no signal that it was trying to stimulate (which would have been a lower ff target when rates were still 2%.)

    123, Stocks may have rising slightly, but it’s hard to tell–it depends what time frame you use. In any case, my hunch is that it was some of each. The fall in the dollar against the euro strongly suggests that it was viewed as stimulative. Unfortunately, the changes were too modest to give a clear signal this time. But we know from previous episodes that easier money should raise long term rates.

    Doc Merlin, How could the gold bubble cause pain? Who cares if gold speculators lose money? Anyone who can afford $1400 an ounce obviously isn’t short of money. It’s just like going to the casino for them.

    Morgan, Bernanke should be saying “let us handle it” but I don’t think he will. He did say something like that in 2006–he indicated that fiscal policy was offset by monetary policy.

    Pragmi, I’ll take that bet. Seriously, why would anyone care how I voted? I support Swiss-style democracy because I don’t trust my own opinions.

    JTapp, Yes, I suppose it could be fun to deconstruct IS/LM, but I think it would confuse undergraduates.

    Marcus, Yes, he doesn’t really pay much attention to what Bernanke says. Bernanke said in the Jackson Hole speech that the Fed could create more AD, but he didn’t think it was needed at that time. If he thought we needed more stimulus, why not just do an $800 billio QE instead?

  19. Gravatar of Joe C Joe C
    4. November 2010 at 18:48

    Scott:

    I thought, with a fed rate cut, the lm curve shifts to the right, thus decreasing interest rates (short term)….why would the expected reaction using is/lm be an increase in yields? Is it because the fed rate cut was not really an expansionary cut relative to the “contractionary surprise”?

  20. Gravatar of Morgan Warstler Morgan Warstler
    4. November 2010 at 20:20

    See I think you have it backwards Scott, I think he just put his jewels down on black, and just crossed over from what he “should” do as Fed policy guy… into something MORE than we even saw with Greenspan/Clinton.

    Greenspan said to Bill, “yes, I know you promised to ‘invest’ in things, but only X new dollars are entering the supply, so either you deficit spend or I lower short term interest rates – choose.”

    I think Ben just acted which means Obama already bent OR Ben is about to become Chief Austerity Cheerleader. It’s not more Fiscal Stimulus or Monetary, it’s “I did Monetary, you HAVE to cut spending.”

    —–

    More here comes the Drudge:

    UP. UP, UP: Stocks at Highest Since LEHMAN’s Fall…
    Jobless claims higher…
    Oil six-month high…
    Gold new high…

    And the kicker… (click) Jobless Claims higher you see: Productivity Up, Costs Down

    Message loud an clear: Unemployment 9.6% – Wall Street Rallies!

    Not what the Tea Party has in mind….

  21. Gravatar of Richard W Richard W
    4. November 2010 at 21:33

    The reaction to the 75 basis cut at the end of January 2008 would be interesting because that was an out-of-sequence, out-of-hours announcement.

  22. Gravatar of 123 123
    5. November 2010 at 04:59

    Scott, you said:
    “That was viewed as “banking policy”. It was viewed as temporary–the Fed gave no signal that it was trying to stimulate (which would have been a lower ff target when rates were still 2%.)”

    But then IOR is also “banking policy”, as ff target did not change after IOR was introduced.

  23. Gravatar of Full Employment Hawk Full Employment Hawk
    5. November 2010 at 17:27

    “IS/LM says easy money lowers rates.”

    Only simple versions of the IS/LM model say that. Somewhat more sophisticated version do not imply that easy money NECESSARILY lowers interest rates. For example the IS/LM model in Mankiw MACROECONOMICS, 7th.ed. page 331. This version has the IS curve shift in response to changes in expected inflation. If the downward shift in the LM curve resulting from the easy money is less than the upward shift in the IS curve caused as a result of the increased inflationary expectations resulting from the easy money, the nominal interest rate will increase.

    This slightly more sophisticated model permits one to show the liquidity, income, and inflationary expectations effects of an expansionary or contractionary monetary policy.

    If one keeps the limitations of the IS/LM model in mind and moves beyond the most simplistic versions of the model, it continues to be a useful EXPOSITORY device.

  24. Gravatar of Andrew Andrew
    6. November 2010 at 06:28

    Really interesting interpretation of 2008, and the policy focus.

    A question: what are “the markets that provide information about future NGDP growth”? Which are the best to look at? why? Thanks.

  25. Gravatar of scott sumner scott sumner
    6. November 2010 at 11:02

    Joe, I don’t like IS/LM. When the money supply increases, the effect on interest rates depends on the effect on the economy. Rates follow the economy. If the economy is expected to grow faster, rates may rise.

    Morgan, If they do enough monetary stimulus, the jobs will come.

    Richard, I don’t recall whether it was expected.

    123, That’s possible, but my hunch is that QE was viewed as temporary, while IOR was viewed as permanent.

    I’m not saying the QE was not better than nothing, BTW. I’m saying that it was reactive, an attempt to prevent the liquidity crunch from making the crisis worse, not an attempt to raise NGDP growth. I think IOR was an attempt to slow NGDP growth, given the massive increase in the base that was contemplated.

    Full Employment Hawk, You are right, but didn’t 99% of economists assume money was easy in 2008 because rates were cut to very low levels? IS/LM is often misused. I think other models are much more useful.

    Andrew, Unfortunately, we lack a NGDP futures markets. I look at CPI futures and TIPS spreads, and for the real part of NGDP I look at stocks and commodities and real estate prices. Stocks are probably best, but can give false signals–as in 1987. New unemployment claims are also very timely. The slope of the yield curve can help, but must be interpreted with caution.

  26. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    6. November 2010 at 11:47

    Scott, you said:
    “That’s possible, but my hunch is that QE was viewed as temporary, while IOR was viewed as permanent.”
    I view IOR as a signal that QE will be less temporary than was expected before the announcement. IOR basically means that if excessive inflation expectations reemerge, QE will not be discontinued, and IOR will be raised instead.

    “I’m not saying the QE was not better than nothing, BTW. I’m saying that it was reactive, an attempt to prevent the liquidity crunch from making the crisis worse, not an attempt to raise NGDP growth. I think IOR was an attempt to slow NGDP growth, given the massive increase in the base that was contemplated.”
    I’m sure Bernanke understood that money is too tight, he even communicated that to Bush. His goal was to raise NGDP growth. 25bps IOR was just a placeholder. IOR was meant to be used as a tool of exit strategy when expectations return to trend.

  27. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    6. November 2010 at 12:07

    In other words, IOR has automatically created expectations that the permanent part of monetary base has increased, so in the worst case IOR had no effect. IOR had a positive effect if it reduced risk of QE as perceived by FOMC.

  28. Gravatar of ssumner ssumner
    7. November 2010 at 12:10

    123, That’s exactly the problem, when inflation expectations are too low the last thing you should be doing is putting in place a policy that prevents excessive inflation expectations. You should be trying to prevent excessively LOW inflation expectations. The Fed didn’t understand that. They said there was an equal risk of recession and inflation, meaning excessively HIGH inflation. IOR was put in place for a problem that did not exist, and the markets saw the Fed was making a mistake and quite correctly concluded that the Fed was going to let AD collapse. And they were right. The Fed should have been trying to push inflation expectations DOWN to 2%, instead they implemented a policy that prevented them from rising UP to 2%.

    You said;

    “I’m sure Bernanke understood that money is too tight, he even communicated that to Bush.”

    Go back and read the minutes from the September 16 meeting, Bernanke did not understand NGDP was too low. And rates weren’t 0.25% they were 2.00% (200 basis points above zero) when IOR was announced.

  29. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    7. November 2010 at 16:42

    The initial IOR was 125 bps (on excess reserves), and was lowered afterwards.

    September 16 meeting was a mistake, but you can’t create a Great Depression 2.0 by making a mistake in a single FOMC meeting.

    On September 18, Bernanke understood that money is too tight, that the hoarding of reserves has started, so on this very day he announced additional $180 billion stimulus, and this action has generated a huge 2 day stock market rally. From September 18, the only worry Bernanke had was deflation.

    You said:
    “123, That’s exactly the problem, when inflation expectations are too low the last thing you should be doing is putting in place a policy that prevents excessive inflation expectations.”
    Bernanke wanted 2% inflation expectations. He certainly did not want 5% inflation expectations. He wanted to use the unconventional stimulus that is on average expected to generate 3% inflation expectations, and IOR is just a contingent tool that is likely to cap those expectations at 2%.

  30. Gravatar of ssumner ssumner
    8. November 2010 at 18:16

    123, You said;

    “September 16 meeting was a mistake, but you can’t create a Great Depression 2.0 by making a mistake in a single FOMC meeting.”

    Keep in mind that the entire 4% plunge in NGDP (at the monthly frequency estimated by Macroeconomics advisers) took place between June and December 2008. It wasn’t just the September meeting, but it was a relatively small number of errors of omission that did most of the damage.

    If Bernanke thought he was using IOR to hold inflation expectations down to 2% from above, then he was completely clueless. Inflation expectations were plunging sharply below 2% well before IOR was announced, and not just in the TIPS markets, but other places as well (such as the CPI futures markets.) He should have been trying to raise inflation expectations on October 6th, not lower them.

    I talked to Mankiw in October and asked him “doesn’t Bernanke know the Fed will undershoot their target? He replied something to the effect “oh they know, they just don’t know what to do about it.” I’m still convinced Mankiw was right.

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