In the spirit of giving, I’ll give my commenters a voice today. Later I’ll comment on recent posts by Arnold Kling and Jim Hamilton.
Here is commenter Cameron:
I was actually able to find fed fund futures reaction to the December 2007 25 (rather than 50) basis point cut. The only problem : for some reason they only provide data on the January meeting outcome and not March (still, I’ll argue this data supports your point).
Here is a link to the data. You can download an excel file at the bottom for more detail.
Here are the probabilities for before and after the December meeting…
FF Rate – Probability on December 10 – Probability on December 11
3.50 – 18.7% – 6.5%
3.75 – 7.0% – 24.3%
4.00 – 40.8% – 40.1%
4.25 – 30.1% – 28.6%
4.50 – 3.4% – 0.5%
At first glance, it seems like after a disappointing 25 basis point cut markets simply swapped the chance of the FF rate being 3.5% in January to 3.75%. But the average expected FF rate actually stood still (fell very slightly actually). That should be surprising given that the Fed cut by less than expected. I think the markets thought that even though the Fed screwed up, they wouldn’t be willing to cut 100 basis points in one meeting. Beyond that though, they actually saw less of a chance of rates being 4.00-4.5% in January even though the rate cut was less than expected.
(In the end the rate ended up being 3% after the January meeting FYI!)
In another comment he pointed out that the Fed funds futures markets responded to the recent tax cut by signaling that policy tightening was more likely in 2011 (a fact that Paul Krugman war rightly annoyed by.) This is one more piece of evidence that one cannot estimate the fiscal multiplier without forecasting the central bank reaction. Of course that doesn’t stop Keynesians from doing exactly that.
Here’s another Cameron comment, in response to a recent post where I discussed Tyler Cowen’s suggestion that the markets might not have taken seriously a Fed promise to target NGDP in the middle of a financial panic:
Reading this reminded me of this calculated risk post in December 2008 titled “What if the Fed had a meeting and no one cared?”
To this day I don’t think I ever remember people caring less about a Fed meeting. Of course it may have been because people were too focused on financial matters, but when the Fed surprised markets and cut to 0.00-0.25% rates (and also hinted at QE) the S&P rallied nearly 5%!
It’s hard for Avent and Cowen to imagine the Fed mattering because the Fed made it look like it didn’t matter. When the Fed actually started getting “aggressive”, markets pretty clearly did react, even to relatively standard policies. Imagine what would have happened if the Fed promised to target an NGDP growth path.
In my study of the 1930s I noticed that economists often overlooked important policy developments, but markets almost invariably did notice. I guess things were the same in 2008. Economists didn’t think Fed policy was important because their instincts told them it wasn’t important. Markets understood that monetary policy can be important even during a financial crisis.
And here is a comment by Gregor Bush, also after my reply to Tyler Cowen and Ryan Avent:
I think you left out an important aspect of Sumnerism from this post, which is that the Fed rarely or never deviates from the Consensus of the profession. And the consensus of the profession was, and, amazingly, STILL is, that the Fed was a relatively unimportant factor in the downturn and that there is little that it can do now. An article on Bloomberg the other day showed that most Wall St. economists STILL thought that QEII had minimal effect (and others though it was a net negative) – despite the fact that these forecasters all were frantically marking up their forecasts due to a mysterious and completely unexplainable uptick in the economic data in the fall.
Again, just like the 1930s.
And here is fellow blogger Marcus Nunes quoting from a recent paper by Zingales:
This must surely qualify as one of the great ironies in recent economic history. The quote is from Zingales essay on EMH:
“In a 1999 article with fellow economist Mark Gertler, Bernanke analyzed the impact of monetary policy when prices move away from fundamentals. That this contingency was the object of their analysis illustrates how the EMH was losing ground. Their conclusion, however, was that the Fed should not intervene, not only because it is difficult to identify the bubbles but also because “our reading of history is that asset price crashes have done sustained damage to the economy only in cases when monetary policy remained unresponsive or actively reinforced deflationary pressures.”
He´s surely “The man who knew too much” but when the time came to apply his knowledge…he failed!
Yes, Bernanke and Gertler were exactly right; financial crises are only harmful to the macroeconomy when monetary policy fails, i.e. when it allows NGDP to fall at the fastest rate since 1938.
Arnold Kling recently criticized monetarists who focus on the equation of exchange:
1. Why did money and velocity move in opposite directions for the most part from 1980 – 2007? Beckworth’s answer is that the Fed did a great job of offsetting shocks to velocity. The answer that I would give (and I suppose James Hamilton is with me, although I do not want to put words in his mouth) is that nominal GDP was doing its own thing, so that when the money supply changed, velocity moved in the opposite direction. I would say that velocity was able to offset monetary shocks.
My first reaction was that I can’t imagine any plausible money demand function where NGDP “does its own thing” at positive interest rates, and I’d be utterly shocked if Jim Hamilton agreed with Kling (for the 1980-2007 period. He might well agree for the period after the Fed started paying interest on reserves.) And when I went over to Hamilton’s blog, I found my hunch was exactly right:
Now, I think it is true that, in normal times, nominal GDP is one of the most important determinants of the demand for M1 or the monetary base. In the absence of other factors changing these demands, there certainly is a connection between money growth and inflation, and you do find a correlation if you look at much longer horizons than the quarterly changes plotted above.
But conditions at the moment are far from normal. In particular, something quite remarkable has happened to the demand for the monetary base. (Italics added.)
Kling linked to this post, so he must have read the passage I just quoted. This raises the question of why Kling thought Hamilton would agree with him. Perhaps I am mistaken, but whatever the truth it’s clear to me that Kling and I see this issue very differently, as I would have thought Hamilton made it quite clear he did not think NGDP did its own thing during normal times (i.e. when rates are above zero.) Did I misread Hamilton?
Merry Christmas to my readers, and Happy New Year to those who don’t celebrate Christmas. By the way, here’s an interesting fact: In China, Christmas is a fun holiday where you go out and party. New Year’s is a family holiday where you get together and exchange gifts.