Here’s Tyler discussing John Cochrane’s views on liquidity traps:

But on the liquidity trap, John Cochrane is essentially correct.  He has worked through some of the key details, and it’s time to lay that one to rest.

This statement is technically correct, but seems highly misleading to me.  I think 99% of readers would assume that Cochrane doesn’t believe in liquidity traps.  But in fact he does, and indeed much more so than people like Paul Krugman. Krugman thinks QE might have a modestly expansionary effect, although he doesn’t think it’s very powerful.  Cochrane claims it will have no effect at all.  You are just swapping one zero interest rate asset for another.

So what was Tyler Cowen so impressed by?  Probably this passage in the Cochrane post he links to:

New-Keynesian models produce some stunning predictions of what happens in a “liquidity trap” when interest rates are stuck at zero. They predict a deep recession. They predict that promises work: “forward guidance,” and commitments to keep interest rates low for long periods, with no current action, stimulate the current level of consumption.  Fully-expected future inflation is a good thing. Growth is bad. Deliberate destruction of output, capital, and productivity raise GDP. Throw away the bulldozers, let them use shovels. Or, better, spoons. Hurricanes are good. Government spending, even if financed by current taxation, and even if completely wasted, of the digging ditches and filling them up type, can have huge output multipliers.

Even more puzzling, new-Keynesian models predict that all of this gets worse as prices become more flexible.  Thus, although price stickiness is the central friction keeping the economy from achieving its optimal output, policies that reduce price stickiness would make matters worse.

In short, every law of economics seems to change sign at the zero bound. If gravity itself changed sign and we all started floating away, it would be no less surprising.

And of course, if you read the New York Times, people like me who have any doubts about all this are morons, evil, corrupt, and paid off by some vast right-wing conspiracy to transfer wealth from the poor to the secret conspiracy of hedge fund billionaires.

Cochrane’s contempt for “liquidity trap economics” is all 100% justified, but not for the reasons he supposes.  The real problem is that these models assume the Fed is powerless to impact NGDP and that NGDP shocks matter a lot.  Hence you need backdoor solutions. That’s wrong, but you don’t fix the problem by assuming demand shortfalls don’t exist, and thus it doesn’t matter that the Fed can’t control NGDP.  You fix the problem by noticing that nominal shortfalls are a huge problem in the real world, but also that the Fed drives NGDP, even when rates are zero. This means that any attempt at fiscal stimulus will simply be offset by less monetary stimulus.  That’s the real reason fiscal multipliers are zero.

PS.  I agree with almost all of the complaints in the Cochrane quotation. However, if instead of “keep interest rates low for long periods,” Cochrane had said “keep interest rates low until NGDP returns to the pre-2008 trend line,” then I would have strongly disagreed.  The Japanese have showed that long periods of low rates don’t necessary work, but forward guidance in the form of something like a higher inflation or NGDP target certainly does work.

. . . and pretty soon you are talking real money.  The Summers pullout boosted global equities by more than half a trillion dollars, which means a trillion or so compared to the level if he had been picked with 100% certainty.  Yesterday Bernanke gave global equity investors another 3/4 of a trillion.

Recently I’ve been very happy:

1.  Policy is slowly moving my way (Japan, no US tapering, etc.)

2.  The Fed justifies its policy with monetary offset language.

3.  My 401k is rising.

But I’m a silver lining guy anyway.  In contrast, Tyler Cowen takes a “cloud” perspective.  He cites data showing emerging markets were “on fire” yesterday, and then adds the following cautionary note:

I’ve read many pro-delay-the-taper posts, and agreed with the (domestic) analysis in most of them, but I haven’t seen anyone address the um…shall we call it a trade-off?…here.

The optimistic reading is that those are sustainable gains based on higher U.S. growth, and thus higher demand for developing country exports, but it’s very hard to get the numbers to add up, or anything close, for that kind of explanation.  More likely the pricking of those bubbles has been delayed.  Is that good or bad?  (What happened to caring most about the poor?)  To even raise such a question means we probably should be agnostic about what is going on, and that is hardly the most popular attitude in the economics blogosphere when it comes to monetary policy.

My view is that there is no such thing as bubbles.  That means if emerging market equity prices rose (and they did) it makes a future financial crisis less likely not more likely.  I see belief in bubbles as a sort of cognitive illusion, as it certainly looks to the average person (and to me) as if there are bubbles.  But applying rigorous logic to the problem suggest that bubbles do not exist, and that people are “fooled by volatility.”  It you generate a line on graph paper with a random walk process, it will look like it contains bubbles, even though (by construction) it does not.

So yesterday really was good new for emerging markets.

PS.  There is a certain irony in me accusing Tyler of falling for a cognitive illusion, as he better than almost anyone else at avoiding that sort of mistake.  I recently emailed him a new set of “George Bush paintings” that I thought he would find interesting.  He very gently and very politely asked me if I had considered that it might have been a hoax.  Too gently, as it took me another round of emails before I realized what a fool I was.  Of course it had to be a hoax, why didn’t I see that right away?  Because I’m not Tyler Cowen.

PPS.  A few days ago Andy Harless left a comment pointing out that when interest rates are falling, higher stock prices don’t necessarily imply higher NGDP expectations.  BC left a comment with data suggesting that NGDP growth expectations have probably risen as a result of recent events:

I do have some inflation swaps data.  Inflation swaps are usually a little higher than TIPS breakevens due to some differences in financing rates between TIPS and nominal treasuries in the repo market.

The most pronounced change in inflation swap rates was in 1-2 yr forward inflation (expected inflation between Sep 2014 and Sep 2015).  It rose from 1.80% to 1.95% between Friday 9/13 and Monday 9/16, coincident with the Summers withdrawal.  As of Wednesday, it had risen to 2.18% in response to the Fed surprise non-tapering.  So, overall in increase of 0.38% between Friday and Wednesday.  Over that period, 0-1 yr inflation has not changed much (increased from 1.59% to 1.63%), nor has 2-5 yr inflation (decreased from 2.54% to 2.49%).  5-10 yr inflation has increased from 2.70% to 2.93%.

And RGDP expectations?  That’s why we need a .  .  . that’s right, an NGDP FUTURES MARKET!!!

The relationship between interest rates and money is pretty confusing.  So I’m not surprised most people are confused.  I’m somewhat confused.  But I’m nowhere near as confused as some of my somewhat confused commenters (Bob Murphy) assume I am.  In some respects it’s pretty simple.  We’ve always known the following:

1.  Moves toward easier money usually lower short term rates.  The effect on long term rates is unpredictable.

2.  Moves toward tighter money usually raise short term rates.  The effect on long term rates is unpredictable.

3.  Extremely easy money policies (hyperinflation) almost always raise interest rates.

4.  Vice versa.

And those are still true.

When I talk about money and interest rates I am sometimes talking about cases 1 and 2 “Interest rates are an unreliable indicator of the stance of monetary policy.”  And sometimes I’m talking about cases 3 and 4 “Ultra low interest rates are a sign that money has been tight.” I should make that distinction clearer.

Nothing that has happened recently has changed my basic views on these 4 points.  We have a long data set to look at, and recent events simply add a few points, consistent with what we already knew.  So why does it look like it conflicts with market monetarism?  Several reasons:

1.  We emphasize the contrarian cases, where tight money lowers rates, in order to differentiate our brand.  People begin to think we believe that always occurs. If we are going to do that, we better be ready to take a hit when things go the other way.  I plead guilty.

2.  We don’t have a good theoretical model explaining why the liquidity effect sometimes dominates at the longer maturities.  We observe that fact, but can’t really explain it.

But remember that I’m 58 years old and have been observing monetary policy my whole adult life.  I certainly knew that tighter money can raise long term bond yields.

Now here’s where commenters seem to get confused.  Even when the liquidity effect is important, other effects are important two.  Yesterday monetary policy returned to the status quo ante.  Last September the Fed told us that QE would be data-driven.  Bond yields were very low, around 1.7%.  (But 10 year bond yields actually ROSE on the news!) In the middle of this year there were hints that the Fed was switching policy, and that they’d taper despite the fact that the data did not call for tapering.  Bond yields rose to a peak of roughly 2.9%.  Then they returned to the earlier policy of a data-driven QE.  Bond yields are now about 2.7%.

Many people assume that tapering rumors caused bond yields to rise from about 1.7% to 2.9%, and then the return to the earlier policy caused rates to fall back to 2.7%.  But that is almost certainly false.  Yes, the decision not to taper did cause rates to fall, but not very much.  That means the hints that they would taper caused rates to rise, but not very much.  Most likely we had a 100 basis point rise in yields over the past year due to macroeconomic forces, and another 20 basis points due to fear of tapering.  Now that 20 points has been unwound.

Note that my hypothesis is not just pulled out of thin air, it’s confirmed by other markets. Consider equities.  We know for a fact that equities were hurt by taper talk and helped by yesterday’s decision not to taper.  Suppose it really were true that taper talk had explained the huge run-up in bond yields over the past year. What should have happened to equity prices? What did happen?  Obviously the same economic forces that were pushing bond yields 100 basis point higher were also pushing the S&P sharply higher.

And we know what some of those forces were.  I recall one strong jobs report (early July?) where bond yields rose sharply, and so did stock prices.

Why did so many people miss this?  Because:

1.  The liquidity effect is real.

2.  Once you start thinking in terms of the liquidity effect, it’s hard to think of anything else (the face/vase problem–cognitive illusion.)

For instance, people will cite the fact that the path of short term rates fell yesterday, i.e. the Fed is now expected to raise short term rates later than before, and assume that means money is getting easier.  As far as yesterday is concerned that’s true.  But only because we know what caused the change yesterday—monetary policy.  Over the long term however, the expected path of shorter term rates is mostly endogenous.  You might think the Fed has “complete control” over short term rates.  But that would only be true if they didn’t care about the macroeconomy. But they do care.  If there are forces expected to raise NGDP growth to excessive levels, the Fed would respond by raising rates.  In that case the “cause” of the future expected higher rates is not an “expected liquidity effect” it’s an “expected income and inflation effect.”

So don’t fall into the trap of thinking that all rate changes reflect Fed policy, just because you clearly observe that some of them do, and also because the Fed has near total control of short term rates in a technical sense.

PS.  Here’s what I said minutes after QE3 was announced last year:

Here’s what the Fed says it’s trying to do:

These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

Nope.  Long term yields increased on the news, just as market monetarist’s would have expected.  And thank God they did!  The higher yields are an indication that markets have (slightly) raised their NGDP forecasts going forward.  The jump in equity markets suggests that RGDP growth will also rise (albeit modestly.)  The bad news is that 100 points on the Dow is indicative of a really small change in the RGDP growth rate, basically within the margin or error.  So we’ll never know any more than we know right now about whether the policy will “work.”  Of course that won’t prevent hundreds of economists from making silly pronouncements a few months from now, based on actual changes in RGDP.  I beg you to ignore them all.

I should not have said “just as expected”, when what I meant was “just as MMs suggest often occurs with easy money policies.”  So the confusion is partly my fault.  I gloat when things go my way.

Note that the instant reaction of stocks is a more reliable indicator of monetary policy that long term bond yields.  Long term rates rose on the announcement of QE3, and rose again on taper talk.  Why is the long term bond market so schizophrenic?  I have no idea.

From the Fed statement, emphasis added:

Taking into account the extent of federal fiscal retrenchment, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy. However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.

Translation:  “We are determined to hit our growth and inflation targets.  Because of fiscal retrenchment there is a danger we will fall short.  Thus we will not do the taper that everyone expected, because doing so would allow fiscal policy to actually move RGDP growth and inflation away from where we want them.  And that’s not acceptable.  With all due respect to Congress and the President, it’s our job to control inflation and growth.  We won’t taper until we can do so and still hit our targets.”

Shorter version:  The fiscal multiplier is zero.

1.  Fed does what it said it would do—make its decisions based on the data.  Good for them, and good for policy credibility.

2.  Stocks up sharply .  .  .  but wait, all the experts say QE doesn’t matter at zero rates.  Pushing on a string. Perfect substitutes, etc, etc.

3.  Bond yields down.  Yes, that goes against the view that the income and inflation effects usually trump the liquidity effects for long term bonds.  But consider:

a.  The level of the 10 year is still around 2.8%.  (Update: 2.76%, down 10 basis points.)  That’s the yield with no tapering at all.  What does that tell us? It tells us that very little of the run-up in yields since last year is due to expectations of tapering.  In other words, the Keynesians are right that QE means slightly lower yields right now, but people like Michael Darda are even more right; expectations about the future path of the economy are the major factor pushing up rates.  That doesn’t necessarily mean higher real growth expectations (the composition of growth also matters) but it probably does at least to some extent. This was a big natural experiment, and we just found out that very little of the more than 100 basis point run-up in yields was due to fear of tapering.

b.  It’s possible that due to market segmentation the QE purchases have more of a liquidity effect on the 10 year that ordinary OMOs during normal times.  But if so, doesn’t that mean QE is less likely to lead to a stock bubble than otherwise?  I.e. if markets are segmented then the “distortions” are more likely to be in the asset classes directly purchased by the Fed.  Or am I missing something?  (The risk of instant reaction.)

Update:  Lars Christensen was also proved right about the reason for rising bond yields–he said taper fears were not the driving force.  Here’s Lars:

Many have highlighted that the rise in US yields have been caused by the Federal Reserve’s plans to scale back quantitative easing. The fear of “tapering” is certainly a market theme and I would certainly not rule out that the tapering talk has contributed to the rise in bond yields. However, we don’t know that and a lot of other factors certainly also have contributed to the rise in yields and I certainly do not think that the recent rise in yields in itself is likely to derail the US economy.

Update:  I notice that yields took another sharp drop after 2:45, was there any news?