The Wall Street Journal sees Australia skirting on the edge of a recession:

SYDNEY””From the vast mining pits that dot Australia’s arid northwest to the multimillion-dollar luxury homes with views across Sydney Harbour, economists are seeing red flags that point to a looming economic slump.

Thousands of kilometers away, China is providing another cause for concern. The country buys roughly a quarter of resource-rich Australia’s exports. But its slowing economy translates into less construction of skyscrapers, bridges and railways””hurting demand for raw materials like iron ore.

The darkening outlook, underpinned by deeply disappointing data in recent days, has prompted several economists to warn that Australia””which has gone 24 years without any severe downturn””may finally be ripe for a recession, commonly defined as two straight quarters of contraction.

Some economists, including from UBS, Goldman Sachs and Morgan Stanley, believe the first contraction may already have happened””in the second quarter, for which data is due Wednesday.

Meanwhile, The Economist magazine’s panel of forecasters predicts good times ahead, with 2.4% RGDP growth for 2015, and 2.8% RGDP growth for 2016.

Who’s right?  I don’t know, and neither do you.  But this shows the need for market forecasts of 12 or 24 month forward NGDP.

PS.  Australia has never faced the zero bound problem and thus can easily avoid a NGDP collapse using conventional monetary policy, if it wishes to do so.

PPS.  After the WSJ piece was published, Q2 came in at 0.2%, and 2.0% over 4 quarters.

PPPS.  Suppose Australia had more recessions than the US; what would people say?  They’d say America has a well diversified economy, while Australia is reliant on the highly unstable global commodity cycle.  Instead Australia has far fewer recessions than the US, and my commenters tell me that’s because Australia relies on commodity exports.

HT:  Marcus Nunes

The first quarter NGDP growth numbers are in, and they show about 0.1% annualized growth.  The Hypermind full year forecast fell from 3.8% to 3.6% on the news.  I doubt if we’ll even hit 3.6%, which would require nearly 4.8% annual growth for the final three quarters of the year.

The Fed seems anxious to raise interest rates this year, but I’m having trouble understanding what “problem” this is supposed to solve.

Overheating?  Expected future overheating?

Or is this urge a sort of atavistic gesture, like an arm or leg that suddenly jerks after being still for too long?  Are they planning to raise rates because . . . well because it’s the job of central banks to move interest rates to and fro?

The new and improved modern Fed says they will be “data driven.”  OK, what do they learn from the fact that the economy is once again underperforming their expectations?

A few weeks ago there was some discussion about the prospects of a double dip.  I try to stay out of the fortune-telling business, as I don’t believe I or anyone else can predict the cycle better than markets.  But one line of reasoning that I found less than convincing was the argument that monthly car sales and monthly housing sales are already quite low.  And other parts of GDP aren’t that cyclical.  We know from the 1930s that things can get a lot worse.  If NGDP falls sharply, RGDP will also fall sharply.

But it’s only fair to point out that a month or two later those making the optimistic case (for avoiding the double dip) seem vindicated (knock on wood.)  If so, I’d point to another factor—monetary policy.

In the 1930s the Fed was incredibly passive; hence there was no floor on NGDP, or at least a very low floor.  Since 1982 the Fed has been following something close to a Taylor Rule.  As long as nominal rates are positive, markets have confidence that shocks won’t drive NGDP much lower.  Remember how bleak things seemed right after 9/11?  RGDP actually rose in the 4th quarter of 2001.

In my view there is still a floor on NGDP, even at zero rates, because the Fed still has some credibility.  But the floor is much lower than when rates are positive.  The upshot is that while there might be a mild downturn, I’d be shocked if we had a severe recession.  That’s not to say it can’t happen, but it would certainly be inconsistent with Fed behavior over the past couple of years, when they have used various unconventional stimulus tools when things looked especially bad.  I suppose my biggest fear would be a fast moving crisis, perhaps centered in Europe—with the Fed again letting bygones-be-bygones, and settling for growth rate targeting.

There’s no reason anyone should take any of my hunches seriously.  I didn’t predict the Great Recession until the markets did.  And if there’s another dip, I won’t predict it until the markets do.  All I’m saying is that visualizing the likely Fed response function is the most useful way to explore the possibility of a double dip, not whether various categories of RGDP “can’t go any lower.”

It was announced today that Christopher Sims and Thomas Sargent will be awarded the Nobel Prize in economics.  A number of bloggers have discussed their contributions, with MarginalRevolution leading the pack.  I don’t keep up with the field enough to provide a comprehensive overview, but I thought I’d provide a few remarks:

1.  I was shocked to hear that Sargent won, because I’d assumed he must have already won the award years ago.  Sargent and Wallace did a lot of important work integrating rational expectations into monetary economics back in the 1970s and early 1980s.  This work may have contributed to Krugman’s paper on expectations traps.  I often argue that if we do eventually get high inflation, the cause will most likely be tight money over the past few years.  That argument comes directly from this paper by Sargent and Wallace.

2.  The Swedish academy provided a short paper explaining some of the contributions of each winner, and I thought I’d make a few comments on impulse response functions and VARs, since those innovations (due mostly to Sims) are being singled out as particularly important:

The difference between forecast and outcome – the forecasting error – for a specific variable may be regarded as a type of shock, but Sims showed that such forecasting errors do not have an unambiguous economic interpretation. For instance, either an unexpected change in the interest rate could be a reaction to other simultaneous shocks to, say, unemployment or inflation, or the interest-rate change might have taken place independently of other shocks. This kind of independent change is called a fundamental shock.

The second step involves extracting the fundamental shocks to which the economy has been exposed. This is a prerequisite for studying the effects of, for example, an independent interest-rate change on the economy. Indeed, one of Sims’s major contributions was to clarify how identification of fundamental shocks can be carried out on the basis of a comprehensive understanding of how the economy works. Sims and subsequent researchers have developed different methods of identifying fundamental shocks in VAR models.

This certainly sounds like a promising approach, and yet I’ve always been skeptical about its practical applicability.  To be honest, I don’t know if my objections hold water, perhaps some commenters can let me know.

When impulse response functions are estimated for monetary shocks, they typically show tight money leading to a near term reduction in output, lasting for several years.  They also show no near term impact on prices, with a slight decline after about 18 months (although it’s not clear if the results are statistically significant.)

I have several problems with this approach.  Researchers often use changes in the monetary base or (more often) interest rates as indicators of monetary shocks.  I don’t find these to be reliable indicators.  They also use macro data such as the Consumer Price Index, which I view as not only highly inaccurate, but systematically biased over the business cycle.  If monetary shocks are misidentified, then you have big problems.  For instance, are higher interest rates tight money, or a reaction to higher NGDP growth expectations?

I’ve noticed that when we do have massive and easily identifiable monetary shocks, as in 1920-21, 1929-30, and 1933, output seems to respond almost immediately to the shock, as does prices.  This makes me wonder about those impulse response functions.  Why would severe monetary shocks immediately impact prices, whereas mild monetary shocks only impact prices after 18 months or more.  That doesn’t seem intuitively plausible, but perhaps I’m missing something here.

Perhaps VAR models are misidentifying monetary shocks.  I’d argue we saw a severe negative monetary shock in the second half of 2008, and that this caused both prices and output to decline significantly between mid-2008 and mid-2009.  What do VAR models show?  Do they correctly identify this contractionary monetary shock?  If not, is there any way of telling why not?  What variables might have given off a misleading reading?

3.  Paul Krugman recently made this argument:

Most spectacularly, IS-LM turns out to be very useful for thinking about extreme conditions like the present, in which private demand has fallen so far that the economy remains depressed even at a zero interest rate. In that case the picture looks like this:

Why is the LM curve flat at zero? Because if the interest rate fell below zero, people would just hold cash instead of bonds. At the margin, then, money is just being held as a store of value, and changes in the money supply have no effect. This is, of course, the liquidity trap.

And IS-LM makes some predictions about what happens in the liquidity trap. Budget deficits shift IS to the right; in the liquidity trap that has no effect on the interest rate. Increases in the money supply do nothing at all.

That’s why in early 2009, when the WSJ, the Austrians, and the other usual suspects were screaming about soaring rates and runaway inflation, those who understood IS-LM were predicting that interest rates would stay low and that even a tripling of the monetary base would not be inflationary. Events since then have, as I see it, been a huge vindication for the IS-LM types

I certainly agree about the lack of inflation resulting from the tripling of the base, which I also predicted, but I don’t see it as having much to do with the shape of the LM curve.  Indeed Sargent and Wallace (1973) provide a much clearer explanation; the Fed publicly announced that the monetary injections would be temporary (although you could also view the IOR program as an explanation.)

Here’s why I don’t like IS-LM.  Suppose the Fed had instead announced that the tripling of the base would be permanent.  What does the IS-LM model predict?  Notice the LM curve is flat, which means the variable on the vertical axis is the nominal interest rate.  But saving and investment depend on real interest rates.  A tripling of the base that was expected to be permanent, would lead to a large increase in inflation expectations—probably to double digit levels.  This would shift the IS curve far to the right, to where it intersected the LM curve at a positive interest rate.  Easy money would make interest rates rise.

So there is no liquidity “trap,” just a promise by the Fed not to allow significant inflation, which they have kept.  From the Fed’s perspective, and even more so from the ECB’s perspective, it’s mission accomplished—inflation has stayed low.  So IS-LM doesn’t show that monetary policy “doesn’t work,” because it has worked out exactly as the Fed hoped; no breakout in inflation expectations.  Some people are under the illusion that the Fed tried to create higher inflation and failed.  But Bernanke explicitly indicated that he was very opposed to a 3% inflation target.  People need to pay more attention to the Fed’s announced objectives, as those objectives are a major cause of the Great Recession.  And Sargent and Wallace help us to understand why.

PS.  I do not favor having the Fed announce that monetary injections will be permanent.  Rather I favor an announced target trajectory for NGDP (or prices), with level targeting.  This would implicitly mean that the Fed was promising enough of the injections would be permanent to hit the nominal target in the future.

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.