Archive for the Category Monetary Policy


Do low interest rates stimulate housing?

If you answer this question with a “yes”, then you are reasoning from a price change. I thought of this when reading the abstract to a paper by David W. Berger, Konstantin Milbradt, Fabrice Tourre, Joseph Vavra on monetary policy and mortgage interest:

How much ability does the Fed have to stimulate the economy by cutting interest rates? We argue that the presence of substantial household debt in fixed-rate prepayable mortgages means that this question cannot be answered by looking only at how far current rates are from zero. Using a household model of mortgage prepayment with endogenous mortgage pricing, wealth distributions and consumption matched to detailed loan-level evidence on the relationship between prepayment and rate incentives, we argue that the ability to stimulate the economy by cutting rates depends not just on the level of current interest rates but also on their previous path: 1) Holding current rates constant, monetary policy is less effective if previous rates were low. 2) Monetary policy “reloads” stimulative power slowly after raising rates. 3) The strength of monetary policy via the mortgage prepayment channel has been amplified by the 30-year secular decline in mortgage rates. All three conclusions imply that even if the Fed raises rates substantially before the next recession arrives, it will likely have less ammunition available for stimulus than in recent recessions.

People tend to refinance mortgages when long-term interest rates fall.  So what type of monetary policy generally causes long-term interest rates to decline?  I’d say the answer is contractionary, whereas the authors of this study seem to assume the answer is expansionary.  (I base this assumption on the first sentence of the abstract.  I have not read the entire paper, so it’s very possible I misinterpreted their claim.)

This is actually a complex question, and my reading of the evidence is that long-term rates will usually increase when monetary policy is made more expansionary (as in the 1960s and 1970s), but not always.  Of course it partly depends on how you define “expansionary”.

Consider the Fed announcements of January 2001 and September 2007.  In both cases, the Fed cut rates for the first time in years.  In both cases, the policy rate was cut by 0.5%, not the usual 0.25%.  In both cases, stocks soared on the unexpectedly expansionary policy news.  In both cases, long-term bond yields increased on the news (dramatically in January 2001), even as short term rates declined. If a highly liquid NGDP futures market had existed, then NGDP futures prices would have probably also increased.  On the other hand, you can also find lots of examples where short and long-term interest rates move in the same direction.  But the two cases I cited are important because they were so easily identifiable–the dramatic market responses at 2:15 pm seemed clearly linked to the Fed announcements.  “Identification” of policy shocks is easier in that case.

If I’m right that falling long-term bond yields generally reflect a contractionary monetary policy, then I think it’s a mistake to rely too much on the mortgage refinance channel when the Fed is trying to stimulate the economy.

I believe that monetary policy is always highly effective, even at zero interest rates.  We have lots of historical evidence to support that claim.  But if it is effective, it’s not because lower interest rates stimulate demand, rather it is because monetary stimulus increases the monetary base and/or reduces base demand, which boosts NGDP.  And higher NGDP leads to higher employment in a world with sticky wages.  In most cases, long term interest rates will also increase.

HT:  Tyler Cowen

If there’s a recession, would it be Trump’s fault?

The short answer is “probably not”. But this requires making some careful distinctions:

1. It’s possible that Trump’s policies might become so reckless as to create a “real shock” that is large enough to cause a recession. Say a massive all-out global trade war. That seems very unlikely.

2. More likely, Trump’s policies might create a real shock large enough to complicate the implementation of effective monetary policy. Think of the way that the housing bust complicated things for the Fed in 2006-08. In this scenario, it would still be the Fed’s fault, but it would be bad trade polices combined with a flawed monetary regime that led to recession.

In this second case, I still think it would be very important not to blame Trump for the recession. We are never going to fix the problem of bad monetary policy until we stop misdiagnosing the problem. Today, 99% of economists continue to misdiagnose what went wrong in 2008, absolving the Fed of blame for an excessively tight monetary policy. To fix that, we need to start talking honestly about what causes most recessions—falling NGDP, not real shocks. And we also need to implement a regime that prevents real shocks from spilling over and causing bad monetary policy—which means NGDPLT.

3. It might be argued that Trump is to blame because he appointed the top officials at the Fed, and they made serious policy errors. To be honest, I would not blame the Dems for blaming Trump for any recession. After all, he’ll take undeserved credit for anything good that happens, so it’s only fair. Nonetheless, impartial observers who want to get at the truth should be careful before blaming Trump for any Fed screw-ups. If a demand-side recession did occur, would it be because Powell, Clarida, Quarles and the others were poor choices, or because the Fed’s entire operating system is flawed, and has been for decades? Obviously, the latter is much more likely.

Some people blame Bernanke for the Great Recession, but Greenspan’s public comments during this period suggest that the Fed would have done even worse if he had still been chair. As long as we focus on personalities we won’t solve the underlying problem, which is a flawed monetary regime.

Hopefully, the Fed has learned from the mistakes of 2008.  But we won’t know for sure until the next real shock comes along—the next crisis that requires the Fed to take aggressive steps to stabilize expected NGDP growth.

Those suffering from TDS may find this post to be dispiriting.  It would feel good to blame Trump for any recession.  Don’t worry, the voters will always blame the government for recessions, no matter what I say.

Some people who like Trump may be surprised that I take this view.  If so, it’s probably because your thinking is corrupted by politics and you assume that everyone is similarly corrupt.  Just as habitual thieves assume that everyone else would steal if they could get away with it.

I’ve been very clear all along that presidents have very little impact on the business cycle. Trump has done some useful tax changes, and lots of bad policies in areas such as trade, immigration, deficit spending, global warming, promoting an unstable financial system, etc.  But none of that has much impact on the business cycle—those are things that impact long run trend growth.  That’s how the President’s impact on the economy should be judged.

PS.  I’m not currently predicting a recession, as I don’t believe recessions can be forecasted.

Fed bashing

I’ve tried to avoid commenting on Trump’s Fed bashing, as I don’t wish to insult my reader’s intelligence.  But the media reports that Trump is now bashing the Fed on an almost daily basis, in order to have a fall guy in case the economy turns south.  So I suppose I must say something:

1.  In the real world, presidents don’t get to excuse policy failures by pointing to the mistakes of government officials that they themselves appointed.  But of course we no longer live in the real world; we live in TrumpWorld, where it is rhetoric, not reality, that matters.  (If you want a good laugh, read a serious media report (say the NYT) where they go out and interview Trump voters who explain why they are thrilled with Trump’s performance.  Great accomplishments like the peace deal with North Korea.)

2.  OK, enough Trump bashing.  What about the substance of his complaint?  Here I’d say he’s very likely wrong, but not obviously crazy.  The indicators I look at (NGDP, inflation, unemployment, etc.) do not indicate that money is too tight, but there’s at least a small possibility that we still don’t have a credible 2% PCE inflation rate going forward.  It’s at least debatable.

3.  If you talk to the average economist, point #2 is what they’d complain about.  Most economists don’t see money as being too tight.  But the real problem is elsewhere; Trump assumes that interest rates represent the stance of monetary policy.  Even worse, he thinks that low rates mean easy money.  Other economists are less likely to ridicule Trump for this error, as many economists are similarly confused.

The Fed influences the economy in many ways.  One method is by adjusting the policy interest rate (fed funds or IOR).  A far more important way is by affecting the natural rate of interest.  Thus the Fed sharply reduced the natural rate in 2008, while only gradually reducing the policy rate.  To the average economist (and to Trump) the Fed was “easing” monetary policy.  In fact, because the natural rate was falling even faster than the policy rate, they were tightening policy.

How does the Fed affect the natural rate of interest?  By shifting the expected NGDP growth rate (and also the level of NGDP relative to trend.)  A tight money  policy (such as late 2007 through 2008) will reduce NGDP growth expectations, and this reduces the natural rate of interest. That’s what Trump doesn’t understand, but it’s also what lots of economists don’t understand. Even the smarter economists, the one’s that understand it’s the gap between the policy rate and the natural rate that matters, often think that the natural rate is falling due to external “shocks”, not bad Fed policy.

So by all means ridicule Trump for the insanity of excusing potential policy failures by pointing to the mistakes of his own appointees, but don’t bash him for making the same mistake that many economists make.  Instead, it’s the economists that deserve ridicule.

Nothing like the 1960s?

Commenter Michael Sandifer left this comment:

One key difference between the current period and ’66 is that inflation is tame.

He’s referring to our relatively low inflation:

Screen Shot 2018-10-11 at 10.00.17 AMOver the previous 6 years, unemployment has fallen from 8% to 3.7%.  Inflation has mostly stayed in the 1% to 2% range, occasionally dipping below 1%, and recently rising above 2%.

In contrast, here’s the picture as of mid-1966:

Screen Shot 2018-10-11 at 10.02.27 AMIn this case, unemployment rose to a peak of 7% in 1961, then gradually trended down to 3.8% in mid-1966.  Inflation mostly stayed in the 1% to 2% range, occasionally dipping below 1%, and recently rising above 2%.

Hmmm, that sounds familiar.

I don’t expect the next 3 years to look anything like the late 1960s.  But if we are to avoid a repeat of the 1960s, it will not be because the current situation is radically different from 1966, it will be because we take steps right now to make sure than the future situation is radically different.  And that requires a dramatically less expansionary monetary policy that what the Fed adopted in 1966-69.

In the 1960s, the Fed tried to use monetary policy to drive unemployment to very low levels.  Let’s not make that mistake again.  Better to produce stable NGDP growth, and let unemployment find its own natural rate.

Today’s stock market decline

Stocks dropped sharply this morning.

In don’t view today’s decline in stock prices as being important.  In recent years, stocks have often plunged for a few days, and then recovered.  I put more weight on the level of stock prices, which is still quite high.  Thus I believe the macroeconomy is still in very good shape.

But there’s also something more interesting going on—bond prices have also been falling (i.e. higher yields):

“It’s always hard to judge at what point you hit an inflection point where the correlation between yields and stocks goes into reverse,” says Liz Ann Sonders, chief investment strategist at Charles Schwab & Co. “One of the markers to when that happens is typically when you move from a deflationary era or at least a deflationary mindset to more of an inflationary mindset.”

It’s potentially a big deal.

An enduring rupture in positive correlations — yields moving up along with stocks — would signal a break in the weak-growth, low-interest regime seen over much of the past decade. Markets driven by negative tandem moves — yields up, shares down — have tended to be in the grip of inflationary pressure or potential economic over-heating.

David Glasner did a very important study that found stock prices became positively correlated with TIPS spreads (inflation expectations) during the Great Recession, but not before.  This may have reflected the fact that market participants thought the US economy would benefit from a more expansionary monetary policy during the period of high unemployment and near-zero interest rates.  That assumption was correct in my view. If long-term bond yields and TIPS spreads start becoming negatively correlated with stocks, then presumably excessively tight money is no longer much of a problem.

That doesn’t mean money is now too easy.  In my view we are so close to optimal that it’s hard to be sure whether policy is appropriate or a tad too expansionary.  We’ll know better in a few years.  But certainly most of the data looks pretty good from a dual mandate perspective.

I’d encourage people not to think in terms of binaries, rather shades of grey.  Monetary policy has been gradually moving from much too tight, to slightly too tight, to about right.  We don’t know precisely where we are on the spectrum, but the trend it clear.  It’s also clear that current monetary policy is far more appropriate than policy in 2009, or 1979, or 1930.