I was recently discussing my new book with someone, and he asked why a small difference in the Fed’s target interest rates could have vast effects on the economy, such as the Great Recession. Most people don’t even pay any attention to the fed funds rate, so how could a small misalignment have much impact on aggregate demand?

I’d break this down into two parts. First, what is the actual transmission mechanism between Fed interest rate policy and the economy? And second, how does a change in Fed policy become known to the broader public? I’ll start with the first question.

There are three ways to think about the transmission mechanism between the fed funds target and aggregate demand:

1. Interest rates as an epiphenomenon
2. Interest rates as a signaling mechanism
3. The cumulative process

I will use the example of December 2007 (the beginning of the Great Recession) as an example to illustrate these three concepts. You need to keep in mind that these aren’t really three different transmission mechanisms; they are three ways of visualizing what’s going on.

In December 2007, the Fed cuts rates 1/4%, at a time when markets were hoping for a 1/2% cut. The stock market crashed on the news, ending up almost 5% lower than where it would have ended up with a half point cut (over 2% lower in absolute terms.)

I often argue that interest rates are an epiphenomenon, something that happens as a side effect when monetary policy changes, but not the core of the policy. The core policy is changes in the supply and demand for base money. One way to institute a tight money policy is slowing the growth rate of the monetary base, which is exactly what the Fed did in late 2007. Interest rates may rise or fall in response; it depends on the relative importance of the liquidity, income and Fisher effects. In late 2007, tight money reduced interest rates. The reason the smaller than expected rate cut of December 2007 hurt markets is that the economy needed a bigger monetary base, and if the Fed had given it a bigger monetary base then rates would have fallen a bit faster. The base was the actual problem; interest rates a side effect.

Monetary policy affects all sorts of asset prices. In many cases, such as December 2007, the effect on other assets is much greater than the effect on short-term interest rates. Interest rates aren’t a good indicator of changes in the stance of monetary policy.

That’s a sort of monetarist explanation of how a measly quarter point can matter so much. Now for a Keynesian explanation:

The December 2007 Fed decision was viewed as a policy signal. Even a quarter point rate cut can have a big effect if the markets see the rate cut as signaling important changes in the future path of monetary policy. By itself, overnight interest rates have almost no impact on the economy—what matters is longer-term interest rates and other asset prices. But the way the Fed adjusts a short-term rate can send a powerful signal about the likely future path of monetary policy.

Now for a Wicksellian explanation:

Suppose the policy rate equals the natural rate of interest. Now assume the policy rate is suddenly raised 1/4%. Or if you prefer, assume the natural interest rate falls 1/2% and the Fed only cuts the policy rate by 1/4%. In either case, the policy rate is 1/4% above the natural rate. So what’s the big problem?

The big problem is that this small disequilibrium sets in motion a cumulative process. It slows the economy slightly, which reduces the natural interest rate slightly. Now the policy rate is 1/2% above the natural rate. The economy slows further, and now the policy rate is 3/4% above the natural rate. Eventually the Fed will begin cutting the policy rate, but by this time the natural rate is falling rapidly.

That’s the story of late 2007 and 2008. For instance, the Fed set the policy rate at 2% from late April to early October 2008. But during that period, the natural interest rate was falling sharply. How do we know this? Because NGDP growth was plunging dramatically lower. The Fed was behind the curve.

To most economists, the 2% policy rate did not seem like a big deal. But the financial markets became increasingly alarmed as it became apparent that this rate was too high to maintain adequate NGDP growth.

Again, all three of explanations are describing the same underlying transmission mechanism in different languages: monetarist, Keynesian and Wicksellian.

Now for the second part of the question. How does the broader public become aware of the policy change?

The public doesn’t direct observe monetary policy, but does observe the effect it has on informed observers in the financial markets. Upper middle class people spend less because their stocks go down. Working class people spend less because they lose a job building a commercial development when the high yield bond market tanks. Etc., etc. There are a million transmission mechanisms to the broader public.

So in one sense interest rates matter hardly at all, they are an epiphenomenon. In another sense interest rates can have an impact far beyond what even a Keynesian economist would expect, if the Fed sets its target at the wrong level and sets in motion a cumulative process of depression or high inflation.

In July of 2008, 12-month CPI inflation hit 5.5%. That was really bad.

But in what way was it bad? It was bad because the inflation rate was too low. It would have been much better if inflation had hit 6% or 6.5% in mid-2008. Because inflation was only 5.5%, we fell into the Great Recession and the economy remained severely depressed for many, many years.

If only we could have 6% inflation in mid-2008. So sad.

Today, inflation is 6.8%. That’s also really bad. Inflation is too high. Today, it would be better if inflation were 5.5%.

1. Once dueling was banned, masculinity was gone forever. It’s not coming back. Nonetheless, the always out of date National Review has a piece discussing Senator Hawley’s futile attempt to revive masculinity:

Trump, it must be said, is the most prominent bearer of the reputation of manliness at this time. He is surely the model today for male aggressiveness, the one who dares to risk the dislike of women. He does have the support of those women who do not care for sensitive males with too much education but prefer rougher, more manly types willing to take on the responsibility of insulting their enemies. But he is happy to abandon and destroy the conventions of normality, which, unbeknownst to feminists, are so protective of women. Why should women with their newfound independence remain in need, indeed have greater need, of barriers against harassment by pushy males? But it seems that they do, and that they feel they have reason and at long last power to defend themselves, or in practice to be defended by law and government. “Women for Trump” are thus, it appears, a fading minority the senator cannot count on.

And does Trump merit the badge of manliness? Should he carry the flag? Returning to the description of manly man we began with, one cannot say that Trump does not notice microaggressions. He notices nothing more than slights of any size, especially small ones, and makes a policy of constantly complaining of those done to himself, above all the crowning injustice of not being reelected. His idea of standing tall makes him willing to stoop to say anything to defend his fragile dignity. In sum, he gives manliness a bad name. But is it necessary for a Republican politician in a difficult situation, like Senator Hawley, always and in every regard to speak frankly like a man? Manliness is not the whole truth of a human being. Sometimes womanly silence is prudent, if only to preserve the deference manly men always show to women, though not always for their prudence.

I’ll hold back my manly urge to mock, and instead maintain a womanly silence.

2. A website entitled “Law and Liberty” has a piece defending Putin’s war on Ukraine:

Of course, it is conventional wisdom in western capitals that Vladimir Putin is an imperial monster, and he is always ready to brutalize his neighbors with military force.

Um, isn’t that because it’s true?

But what if conventional wisdom is wrong? What if Eastern Ukraine and Crimea are legitimate spheres of influence for the Russian nation, with deep cultural, language, and religious ties going back to the 10th century when Ukraine converted to the Eastern Orthodox religion?

And what if the Czech Sudetenland has deep historical ties to Germany? What if northern Romania has deep historical ties to Hungary? What if Taiwan has deep historical ties to China? What if the Rio Grande Valley has deep historical ties to Mexico? So many questions that can be asked!

What if NATO and the West are the imperialists, attempting to bully Russia from involving itself in a nation whose historical ties to Russia are far deeper than the United States’ ties to Canada?  

Would it be OK for the US to invade Canada?

3. In a new Atlantic piece, David Brooks looks at modern conservatism and is appalled.

Trumpian Republicanism plunders, degrades, and erodes institutions for the sake of personal aggrandizement. The Trumpian cause is held together by hatred of the Other. Because Trumpians live in a state of perpetual war, they need to continually invent existential foes—critical race theory, nongendered bathrooms, out-of-control immigration. They need to treat half the country, metropolitan America, as a moral cancer, and view the cultural and demographic changes of the past 50 years as an alien invasion. Yet pluralism is one of America’s oldest traditions; to conserve America, you have to love pluralism. As long as the warrior ethos dominates the GOP, brutality will be admired over benevolence, propaganda over discourse, confrontation over conservatism, dehumanization over dignity. A movement that has more affection for Viktor Orbán’s Hungary than for New York’s Central Park is neither conservative nor American. This is barren ground for anyone trying to plant Burkean seedlings.

He’s ready to jump ship:

I’m content, as my hero Isaiah Berlin put it, to plant myself instead on the rightward edge of the leftward tendency—in the more promising soil of the moderate wing of the Democratic Party.

But for every David Brooks, there will be 100 working class Hispanic voters going in the opposite direction.

We are a banana republic, a place where elections are fought over the issue of the fairness of elections. In countries such as Canada, Germany and Denmark, elections are fought over policy issues. In countries such as Venezuela, Russia, and the US, the issue is the election itself–each side accuses the other of stealing the election. In Canada, Germany and Denmark, politics revolves around political parties. In Venezuela, Russia, and the US, politics revolves around personality cults. All that matters is loyalty to the “man on horseback”. (And it must be a man. Kamala Harris? I’ve got more chance of being president.)

So which group of countries is best described by the term “banana republic”?

BTW. When I first compared Trump to Orban, conservatives were outraged. “How dare you suggest that Trump is a authoritarian populist!” Now Orban is the poster child of modern American conservatism.

4. I’ve been tough on Trump, but today I wish to praise his wisdom. On the night of the 2012 election it looked like Romney might have received more votes. Trump responded appropriately:

In additional tweets since deleted, Trump asks why Romney should lose if he received a greater number of votes. Upon the final tally, President Barack Obama defeated Romney in both the popular vote and electoral college.

“He lost the popular vote by a lot and won the election. We should have a revolution in this country!” said Trump in one deleted tweet, and “More votes equals a loss … revolution!” in another.

Yes, a revolution. In 2016 we all should have stormed the Capitol for Hillary.

5. A few weeks later, Trump had a thoughtful postmortem on the election:

Donald Trump: Mean-Spirited GOP Won’t Win Elections

The Republican Party will continue to lose presidential elections if it comes across as mean-spirited and unwelcoming toward people of color, Donald Trump tells Newsmax. . . .

Romney’s solution of “self deportation” for illegal aliens made no sense and suggested that Republicans do not care about Hispanics in general, Trump says.

“He had a crazy policy of self deportation which was maniacal,” Trump says. “It sounded as bad as it was, and he lost all of the Latino vote,” Trump notes. “He lost the Asian vote. He lost everybody who is inspired to come into this country.”

So true!!

6. Ever wonder why China’s Communist Party likes Donald Trump? Read this tweet. No American has done more to advance China’s technological development.

7. Why was Trump better in the old days? Kevin Drum cites evidence that cognitive ability declines after age 62. BTW, I’m 66, so that explains a lot of what went wrong with this blog about 4 years ago.

8. Former NJ Governor Christie was put into intensive care by Trump’s selfishness:

“I would have worn a mask if I knew that,” Christie said. “We knew everybody in that room, except for the president, was getting tested every day. We didn’t know what the president’s testing regimen was.”

“So if Mark Meadows knew that somebody that I was sitting across from for four days had popped the positive test, [he] should have told us,” he added.

“He didn’t tell us,” Christie said. “I went into the hospital in the intensive care unit. He didn’t call and tell me. So I think that’s inexcusable.”

I wouldn’t wish Covid on anyone. But did Christie not know what kind of person Trump was? If you play with snakes, don’t complain if you get bitten.

To say the labor market is “strong” would be an understatement. The unemployment rate is now 4.2%. Only 3 of the previous 50 years saw lower unemployment rates (2000, 2018, 2019). Firms are desperately short of workers, despite fast rising wages. Service sucks almost everywhere I go.

Inflation is also above target, whether you look at a 1, 2, 3 4, or 5-year time frame.

So why is the Fed currently doing QE? What is the goal of this program?

PS. David Beckworth directed me to a Skanda Amarnath tweet showing the amazingly quick recovery in the job market, compared to the Great Recession (for prime age workers):

PPS. Total employment in the US remains nearly 4 million below pre-Covid levels, while in Canada the previous peak has already been surpassed:

The unemployment rate fell to 6% — very near pre-pandemic levels — from 6.7% in October. Employment is now 186,000 jobs beyond where it was in February 2020. Hours worked rose 0.7%, fully recouping Covid losses for the first time.

Whatever factors are depressing US employment do not seem to be operative in Canada.