From the comment section

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:

Scott,
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.

http://www.clevelandfed.org/Research/data/Fedfunds/archives.cfm?dyear=2007&dmonth=12&dday=13

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?”

http://www.calculatedriskblog.com/2008/12/what-if-they-had-fed-meeting.html

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:

Scott,
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.


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22 Responses to “From the comment section”

  1. Gravatar of Mark A. Sadowski Mark A. Sadowski
    25. December 2010 at 13:46

    Hamilton earlier expressed in a simple clear manner (unusual for him IMO) that he thinks NGDP is hard to target:

    http://www.cato-unbound.org/2009/09/16/james-d-hamilton/its-harder-than-it-looks/

    But, I’m sorry, the Kling statement is hilariously way over the top (surely he doesn’t really mean it). Kling has now been more or less quoted as saying NGDP “does its own thing”:

    “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.”

    Replace economic terms with nautical and what you get is:

    “The answer that I would give is that boat’s heading was doing its own thing, so that when the rudder was moved, the wind and current acted in the opposite direction. I would say that the wind and current were able to offset the position of the rudder.”

    Um, really?

    While I’m in a analogical mood I should point out (if it hasn’t been already) that Nick Rowe covered the recent Hamilton/Beckworth/Kling velocity debate by bringing up Friedman’s thermostat analogy:

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/12/milton-friedmans-thermostat.html#more

    “If a house has a good thermostat, we should observe a strong negative correlation between the amount of oil burned in the furnace (M), and the outside temperature (V). But we should observe no correlation between the amount of oil burned in the furnace (M) and the inside temperature (P). And we should observe no correlation between the outside temperature (V) and the inside temperature (P).

    An econometrician, observing the data, concludes that the amount of oil burned had no effect on the inside temperature. Neither did the outside temperature. The only effect of burning oil seemed to be that it reduced the outside temperature. An increase in M will cause a decline in V, and have no effect on P.”

    So, given Kling’s thinking, if I turn off my furnace summer will come back? Hmmm.

  2. Gravatar of ssumner ssumner
    25. December 2010 at 16:43

    Mark, I did see the Nick Rowe piece, and I certainly agree. The negative correlation between M and V during the modern era is a signal that policy is getting more stable, not that money has no effect.

    Wasn’t the Hamilton piece a comment on my article?

  3. Gravatar of Mark A. Sadowski Mark A. Sadowski
    25. December 2010 at 19:55

    Scott wrote:
    “Wasn’t the Hamilton piece a comment on my article?”

    Of Course! Keep it up!

    If we keep twisting the Tiger’s tail eventually he will notice.

    Merry Christmas!

  4. Gravatar of Andy Harless Andy Harless
    25. December 2010 at 20:49

    I can’t imagine any plausible money demand function where NGDP “does its own thing” at positive interest rates

    I guess there are differences in what money demand functions different people find plausible. It doesn’t sound outlandish to me that NGDP could do its own thing (if money demand is quite sensitive to interest rates, which I don’t have trouble imagining). But I do have trouble imagining that money demand is so sensitive to interest rates that we could get such an outcome and experience only relatively mild interest rate volatility. When I look at actual interest rates between 1985 and 2007, they don’t look consistent with the high volatility scenario I would expect if Kling were right.

    In 1984, there were still a lot of people who thought that NGDP did its own thing and that the prior correlation with money was a statistical artifact. Most of those people changed their minds after observing what happened to money, NGDP, and interest rates over the next decade or two. Ironically, it was the breakdown of the money-NGDP correlation that ended up convincing most of the skeptics of the efficacy of monetary policy. But apparently it didn’t convince Arnold Kling.

  5. Gravatar of TGGP TGGP
    26. December 2010 at 12:12

    Scott, since you’re interested in early 20th century “money cranks”, I thought you might like this:
    http://unqualified-reservations.blogspot.com/2010/12/monetary-reconstruction-presented.html

  6. Gravatar of Mark A. Sadowski Mark A. Sadowski
    26. December 2010 at 14:38

    Scott,
    OK. This is the second Jim Hamilton (Econbrowser) post where I’ve said something so disagreeable JDH actually acknowledges my existence.

    What am I suddenly doing so right (or wrong)? All I did today was point out that if the purpose of QE II was to flatten the yield curve then why:

    1) did the FOMC make no official statement to that effect?
    2) did the FOMC authorize under QE II purchases of 71-94% less than 10 year terms in T-Bonds?
    3) why, indeed, are the results what they are, a steepening of the yield curve, not a flattening?

    Is it me? Or is JDH just suddenly utterly clueless.

  7. Gravatar of ssumner ssumner
    26. December 2010 at 21:07

    TGGP, Yes, there were many such reform proposals in the 1920s. Indeed there was a Stable Money Association, and I seem to recall that several hundred economists signed a petition advocating a stable price level policy. THEY understood that level targeting was better than growth rate targeting.

    Mark, Good questions. Hamilton’s new post is reasonable, but I don’t like the way he says we’re heading in the right direction–it suggest asset markets have momentum.

  8. Gravatar of ssumner ssumner
    26. December 2010 at 21:13

    Andy, Yes, I suppose you could construct a scenario where interest rates offset the effect of NGDP, but then monetary policy has no long run effect on interest rates. So that’s one problem.

    And here’s another. If you assume monetary policy has an effect on interest rates (remember I was ruling out the zero bound case) then it’s hard to deny it has an effect on NGDP, unless you think that a Fed policy that lowers both real and nominal interest rates would somehow fail to boost AD. In any case, would you agree with me that Hamilton’s statement pretty clearly indicates that he does not agree with Kling in “normal times.”

  9. Gravatar of Doc Merlin Doc Merlin
    26. December 2010 at 21:38

    @Mark
    ‘But, I’m sorry, the Kling statement is hilariously way over the top (surely he doesn’t really mean it). Kling has now been more or less quoted as saying NGDP “does its own thing”:’

    Just sounds like he is saying that NGDP is endogenous.

    Also, about the yield curve, I don’t think they are actually trying to flatten it. I think they are /trying/ to re-create long term inflation in investment goods (but not CPI) which would steepen the yield curve without affecting TIPS too much.

  10. Gravatar of Bill Woolsey Bill Woolsey
    27. December 2010 at 05:44

    Kling is not making a quasi-liquidity trap argument.

    Kling is claiming that the price level is sticky, so when real GDP changes, then nominal GDP changes too. Real GDP depends on real factors, including changes in the real demands for goods and services. In particular, when people have all the goods and services they want, they quit buying until some new good is developed that they do want.

    If you point out that NGDP = MV then he says, V = NGDP/M and just adjusts with M. But the entire thrust of the argument is P is given and y adjusts for a variety of reasons, so NGDP changes.

    Half of the economists in the world say that V = py/M by definition. If that is true, what is the problem with the claim that V adjusts?

    My view is that Md = Ms as is an equilibrium condition, where Md is the amount of money people want to hold. If Md = Yk, and k = 1/V, then Md = Y/V.

    In equilibrium, Ms = Md implies that MsV = Y.

    And then, as Sumner says, you have to explain how Md (desired money balances) adjusts so that Y adjusts with y.

    Like all such arguments, Kling is implicitly assuming the Md is a residual. People decide how much to spend, and their money balances change by the difference between their flow income and expenditures. (This works better when money is accumulating. What happens when it runs out?)

    The experience of people who are cash constrained–they want to spend all their money, but they don’t want to run out–is the reverse of this approach.

    Instead, think of people so wealthy that they don’t perceive a budget constraint. They consume what they want and their saving is what is left over. Then, they may use the money that is accumulating to buy assets to make money (invest in laymen’s terms(for fun? because money is how you keep score in the game of life?)

    In other words, it is economics without scarcity. And this is exactly the implications of Kling’s recalculation. People don’t want to invest in real estate. And so, we wait until something else comes along for people to produce. Those who used to produce houses just go into household production.

  11. Gravatar of OGT OGT
    27. December 2010 at 13:34

    Woolsey- Great explanation of Kling’s views. First time I’ve ever been able to make any sense of them.

    One question on the implications of the budget constraint issue, how does that interact with the permanent income hypothesis? I assume peoples’ estimate of how much money they demand at any given point should be affected by not only their current money on hand but their expectations of future money needs and income. IE, if a given short fall is perceived as short term fluctuation money demand might act like a residual, but if it is perceived as long term it would be the driving force.

    Also, OT, I wonder if Scott has any comments on PK’s latest in the NYT. It would seem to agree with his views as I’ve read them.

    http://www.nytimes.com/2010/12/27/opinion/27krugman.html?hp

  12. Gravatar of Mark A. Sadowski Mark A. Sadowski
    27. December 2010 at 13:49

    Doc Merlin wrote:
    “Just sounds like he is saying that NGDP is endogenous.”

    Didn’t I just say that? Maybe I’m just not speaking clear enough. More importantly, do you really believe that?

    Bill Woolsey wrote:
    “In other words, it is economics without scarcity.”

    Good luck with that.

  13. Gravatar of Mark A. Sadowski Mark A. Sadowski
    27. December 2010 at 13:54

    Doc Merlin,
    Excuse me, I thought you had used “exo” instead of “endo”. Thus I’m confused by your statement.

  14. Gravatar of Doc Merlin Doc Merlin
    27. December 2010 at 22:51

    @Mark:

    Any arguments that wholly look at just the demand side eventually come out the same way. And I meant it seemed as if he was just treating NGDP as completely endogenous to AD and AD as exogenous, yes it was awkward.

    And no, I don’t think anything is truly exogenous.

  15. Gravatar of Scott Sumner Scott Sumner
    28. December 2010 at 09:04

    Bill, You said:

    “Kling is claiming that the price level is sticky, so when real GDP changes, then nominal GDP changes too.”

    How could he claim the price level was sticky between 1980 and 2007? The price level more than doubled. And even the rate of inflation was highly erratic–13% in 1980 and 3% in 1983. What’s his model of inflation?

    You said;

    “Like all such arguments, Kling is implicitly assuming the Md is a residual.”

    During normal times the base is more than 90% currency, and most people go to ATM machines about once a week to adjust their cash balances to the desired levels. How can Md be a residual?

    OGT, I mostly agree with Krugman on commodity prices.

  16. Gravatar of Cameron Cameron
    28. December 2010 at 17:21

    It’s an honor to be mentioned Scott. :)

    I decided to look further into the late 2008 crisis period and found what I feel like is more evidence of the importance of monetary policy during those times. I found that some of the best and worst days seem to be correlated with the perceived tightness or easiness or monetary policy (increases in expected future FF rates when all other markets were tanking, for example). It was rather long and littered with links so I just put up a post.

    http://monetarycrank.blogspot.com/

  17. Gravatar of Mark A. Sadowski Mark A. Sadowski
    28. December 2010 at 20:05

    The solution is simple
    1) Have the FED print money and buy stuff (whatever).
    2) Eliminate interest on excess reserves (Born 10/6/2008).
    3) Adopt a nominal GDP level target.
    All else is either hand wringing or hand waving.

    What do we want? Increased nominal income! When do we want it? NOW!

  18. Gravatar of marcus nunes marcus nunes
    29. December 2010 at 03:58

    Taylor thinks interest rates indicate the stance of MP:
    “What about the argument that an inflation rate below the Fed’s target is alone enough to rationalize the unorthodox QE2 policy? I do not agree with this because the current low interest rate policy without QE2 is what is appropriate to deal with inflation being below the target. For example, the Taylor rule says that the federal funds rate is where it is because inflation is below its target. In other words that low interest rate policy means that monetary policy is doing what it should be doing to combat “too low” inflation, without QE2. Moreover, I think it would have been much harder to drum up support for QE2 based solely on deflationary concerns. As the Bloomberg graph below on breakeven inflation (USGGBE10) shows, the dip in expected inflation was quite small in 2010 and an argument based on that alone would not have carried the day in my view”.
    http://johnbtaylorsblog.blogspot.com/2010/12/impacts-of-proposed-changes-in-feds.html

  19. Gravatar of Mark A. Sadowski Mark A. Sadowski
    29. December 2010 at 12:32

    I saw the Taylor article earlier today. When Taylor says that the dip in expected inflation was “quite small” he’s implicitly comparing it to the collapse in inflation expectations that occurred in late 2008 through early 2009.

    Looking at USGGBE10 it appears that the range that corresponds to the Fed’s inflation expectations comfort zone is between 2.2% and 2.6%. In fact it was amazingly stable (the graph is virtually flat) prior to late 2008.

    So with that in mind the drop in inflation expectations that occurred in May through August of this year was actually huge (and swift). The USGGBE10 fell from 2.40% on April 30 to 1.57% on August 25th on the eve of Bernanke’s Jackson Hole speech.

    In short, despite the fact the FOMC used the dual mandate as a justification for action they could just as have easily made a case for QE2 based entirely on inflation expectations alone. Furthermore, one has to wonder how far inflation expectations would have had to have fallen before John Taylor would have supported QE2.

    P.S. The USGGBE10 has closed above 2.2% since December 13 (2.30% on December 28) so perhaps by that measure QE2 can already be considered “mission accomplished”.

  20. Gravatar of Fed Up Fed Up
    29. December 2010 at 23:25

    Bill Woolsey said: “In particular, when people have all the goods and services they want, they quit buying until some new good is developed that they do want.”

    So aggregate demand is not unlimited?

    In MV=PY, are P and V related?

    “Instead, think of people so wealthy that they don’t perceive a budget constraint. They consume what they want and their saving is what is left over. Then, they may use the money that is accumulating to buy assets to make money (invest in laymen’s terms(for fun? because money is how you keep score in the game of life?)”

    I tried pointing this out in another post but did not get very far. Should it be the wealthy who don’t retire and spend down what they have?

    “In other words, it is economics without scarcity.” … for the rich while they “control” everyone else’s spending with interest rates to affect debt levels and low wages

  21. Gravatar of ssumner ssumner
    30. December 2010 at 08:36

    Cameron, That’s a great post. I’d like to quote as much of it as possible, but I know it’s considered bad form to quote 100% of another post. What percentage would you allow me to quote? I will also link to you.

    Mark, I agree.

    Marcus and Mark, Thanks for the information on Taylor, and I agree with Mark’s critique.

    I prefer shorter term inflation expectations, because they better show the current cyclical problem. Longer term inflation expectations can rise if investors think the budget deficit will need to be partly monetized eventually, but the deficits are to a significant extent the product of the tight money/recession.

    I agree the 10 year TIPS spreads show QE2 “worked” from the Fed’s perspective. Because I favor level targeting, and a shorter horizon (say one or two years) I think there is more to be done.

    Fed Up, I think even the rich have budget constraints. A billionaire can buy original painting by Money and Picasso, someone with 10 million cannot. Ditto for a mansion in a nice area like the Upper East Side, or Beverly Hills.

  22. Gravatar of Cameron Cameron
    30. December 2010 at 14:50

    I have to say 100% considering that without TheMoneyIllusion blog the post wouldn’t have ever existed in the first place.

    I’m planning a few more posts. One about some more days where expectations of easier monetary policy coincided with sharp rallies and another on how a 1:45 pm December 1st 2008 Bernanke speech likely sent the Dow tumbling 3% in the last hour of trading.

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