I suppose that most of us have experienced that sense of helplessness when our employers are determined to do something, even though it’s becoming clear that it’s the wrong move. In my field (academia) it might be a new and “innovative” MBA program, which is not well thought out.  Once a lot of effort has been put into developing the program, it’s hard to stop.

This problem occurred in the space program, back in 1986:

More than 30 years ago, NASA launched seven crew members to space on the space shuttle Challenger, but they never got there.

Seventy-three seconds after lift-off, one of the shuttle’s fuel tanks failed, generating a rapid cascade of events that culminated with a fireball in the sky, eventually killing all the passengers on board.

While we all probably know this story, there’s another equally tragic account from engineer Bob Ebeling that strikes a chord with us for a different reason.

The night before the disaster, Ebeling, along with four other engineers, had tried to halt the launch, according to an exclusive interview from NPR with Ebeling.

The five engineers worked for NASA contractor Morton Thiokol, who manufactured the shuttle’s rocket boosters — the two rockets on either side of a shuttle that fired upon lift off.

They knew that this mission would involve the coldest launch in history, and that the shuttle’s rocket boosters weren’t designed to function properly under such extreme temperatures.

The night before the explosion, Ebeling said in the NPR interview, he’d told his wife: “It’s going to blow up.”

I recall reading that while NASA pretended to be bewildered by the accident, the stock market figured out the cause almost immediately, and Morton Thiokol stock plunged.  Now we find out that the NASA bigwigs knew all along who was to blame, they were.

In December, Narayana Kocherlakota warned that the Fed was in danger of losing credibility, as market indicators of inflation expectations fell increasingly far below target.  But the Fed had put a lot of effort into developing a “liftoff” of interest rates, and wasn’t going to be pushed off that goal by warnings that it was a mistake.  Let’s hope NGDP in 2016 does better than the Challenger. If not, the Fed will pretend to be bewildered by “shocks” that mysteriously hit the economy in 2016.

The beauty of markets is that they admit mistakes within milliseconds, and reverse course when new data comes in. They have no ego.  Recall Keynes’s famous comment:

When the facts change, I change my mind.  What do you do, Sir?

This applies to very few people and almost no organization.  But it perfectly describes markets.  That’s why intellectuals with minds closed to new ideas are so contemptuous of the flighty nature of market prices.  “Make up your mind!”  No, don’t make up your mind—keep changing it as new information comes in.  Every millisecond.

BTW, Ramesh Ponnuru sent me an interesting article by Jed Graham, showing that the Fed raising rates during a quarter of 1.5% NGDP growth was unprecedented in modern history:

If you take a four quarter perspective, the rate increase looks even more unusual. The 4 quarter NGDP growth rate came in at 2.9%, which is well below the levels of previous rate increases:

The data discussed above and displayed in the accompanying chart reflect the annualized pace of growth in each quarter the Fed hiked rates. But if one looks at the pace of GDP growth from the year-earlier quarter, the Yellen Fed stands alone as the only Fed to hike rates when nominal growth was below 3%.

Commerce Department data show the economy grew 2.9% from the fourth quarter of 2014, unadjusted for inflation. There have only been three other times that the Fed hiked when nominal year-over-year growth was less than 5%. Once was in 1986, when growth was 4.9%. The other two times came during the Volcker recession in 1982, when nominal growth fell as low as 3.2%.

While the Yellen Fed didn’t go so far as to admit a mistake, its policy statement after Wednesday’s meeting did implicitly acknowledge that policymakers were no longer confident about the path of inflation.

A footnote on the Japanese decision to adopt negative IOR.  I’m told it only applies to new reserves, not existing reserves. This is similar to an idea I proposed back in April 2009, in a (ridiculously long) reply to Greg Mankiw.

Suppose the government pays 4% positive interest on required reserves and negative 4% interest on excess reserves.  The penalty rate on excess reserves affects behavior at the margin, and should reduce ER holdings to the very low levels that existed before reserve and T-bill rates were nearly equalized.

Not exactly what the BOJ did, but close in spirit.  Just one more crazy MM idea that people told me could never be done in the “real world”, because I’m just an academic in an ivory tower that knows nothing about finance and banking.

Check out Nick Rowe’s post on this same general issue.

PPS.  I won 10 euros in the Hypermind market last year, as I shorted NGDP early in 2015, when the price was around 4.2%

Sometimes it seems like macroeconomics never makes any progress.  Fads go in an out of style in an endless cycle: classical, Keynesian, classical, Keynesian, classical, Keynesian, etc.  Beneath the surface, however, progress is steadily occurring.  Today provided one more example.

A few years ago there was a lively debate as to whether negative interest on reserves would be expansionary or contractionary.  Pundits who took a “finance approach” suggested the effects would likely be contractionary, due to their impact on the financial markets.  Market monetarists argued that policies that pay less interest on base money are expansionary, because they reduce the demand for base money.  Today provides another powerful example that the monetary approach to macro is superior to the finance approach, as the yen plunged on news that the BOJ had unexpectedly adopted negative IOR (after dismissing the idea just weeks ago.)  There had been previous experiments in Europe with the same outcome, but some of them were combined with QE.  This was a particularly clean test, in a major economy:

Bank of Japan Governor Haruhiko Kuroda sprung another surprise on investors Friday, adopting a negative interest-rate strategy to spur banks to lend in the face of a weakening economy.

The move to penalize a portion of banks’ reserves complements the BOJ’s record asset-purchase program, including 80 trillion yen ($666 billion) a year in government-bond purchases, which was kept unchanged at the board meeting. By a 5-4 vote, Kuroda led his colleagues to introduce a rate of minus 0.1 percent on certain excess holdings of cash.

Long a pioneer in adopting unorthodox policies to tackle deflation and revive economic growth, the BOJ is now taking a page out of European policy makers’ playbooks in the goal of stoking inflation. The yen tumbled after the announcement, which came after Kuroda just last week rejected the idea of negative rates.

It will be interesting to see if those claiming negative IOR would be contractionary will now admit their error.

PS.  Here’s a FTAlphaville post by Izabella Kaminska from 2012:

If imposed, negative rates would be enforced via the base money market. This could see banks charged for holding excess reserves at the central bank. Which ever way you look at it, the move would ultimately be contractionary rather than expansionary because it would lead to base money destruction, or wider credit destruction as banks hand over credit to cover charges.

HT:  Cameron,  Julius Probst

No, this is not a NeoFisherian post.  I’m not claiming that a Fed policy that depresses interest rates is contractionary, I’m claiming lower interest rates are contractionary, ceteris paribus.  And ceteris paribus in this case means for any given money stock.  For simplicity, we’ll start with a simple model–no IOR— and then bring in IOR later.  And in doing so I’ll answer a question a commenter asked me: Is talking about the effect of IOR an example of reasoning from a price change?

Let’s start with this identity:

M*V = P*Y

Where M is the base and V is base velocity.  Now let’s build a model:

M*V(i) = P*Y

Since V is positively related to i, lower interest rates are contractionary, they reduce V and hence NGDP, AKA aggregate demand.  Larry Summers once wrote an article (with Robert Barsky) pointing this out, but only for the gold standard period.

So why do people not named Summers and Sumner not know this?  There are several reasons:

Sometimes, not always, reductions in interest rates are caused by an increase in the monetary base.  (This was not the case in late 2007 and early 2008, but it is the case on some occasions.)  When there is an expansionary monetary policy, specifically an exogenous increase in M, then when interest rates fall, V tends to fall by less than M rises.  So the policy as a whole causes NGDP to rise, even as the specific impact of lower interest rates is to cause NGDP to fall.

2.  Another problem is the Keynesian model, which hopelessly confuses the transmission mechanism.  Any Keynesian model with currency that says low interest rates are expansionary is flat out wrong.  That’s probably why economists were so confused by 2008.  Many people confuse aggregate demand with consumption.  Thus they think low rates encourage people to “spend” and that this somehow boosts AD and NGDP.  But it doesn’t, at least not in the way they assume.  If by “spend” you mean higher velocity, then yes, spending more boosts NGDP.  But we’ve already seen that lower interest rates don’t boost velocity, rather they lower velocity.

Even worse, some assume that “spending” is the same as consumption, hence if low rates encourage people to save less and consume more, then AD will rise.  This is reasoning from a price change on steroids!  When you don’t spend you save, and saving goes into investment, which is also part of GDP.  Now here’s were amateur Keynesians get hopelessly confused.  They recall reading something about the paradox of thrift, about planned vs. actual saving, about the fact that an attempt to save more might depress NGDP, and that in the end people may fail to save more, and instead NGDP will fall.  This is possible, but even if true it has no bearing on my claim that low rates are contractionary.

To see the problem with this analysis, consider the Keynesian explanations for increases in AD.  One theory is that animal spirits propel businesses to invest more.  Another is that consumer optimism propels consumers to spend more.  Another is that fiscal policy becomes more expansionary, boosting the budget deficit.  What do all three of these shocks have in common?  In all three cases the shock leads to higher interest rates.  (Use the S&I diagram to show this.)  Yes, in all three cases the higher interest rates boost velocity, and hence ceteris paribus (i.e. fixed monetary base) the higher V leads to more NGDP.  But that’s not an example of low rates boosting AD, it’s an example of some factor boosting AD, and also raising interest rates.

Again, I defy you to explain how low rates can boost NGDP, ceteris paribus.  If you think you have an explanation, it’s probably something that confuses consumption with total spending on NGDP.  An explanation that wrongly assumes the public’s desire to spend more on consumption, as a result of lower interest rates, is expansionary for NGDP.  Yes, an exogenous change in M will often cause short term rates to move in the opposite direction, but how often do you see exogenous changes in M?  If we were operating in a normal economy, with say 3% or 4% interest rates, and I told you rates would fall to zero in the next 12 months, would you predict a recession or boom?  Obviously a recession.  Yes, if the Fed perversely cut rates to zero in an otherwise stable economy, via fast growth in the base, that would be expansionary.  But more than 100% of the expansionary impact would come from the rise in the base (hot potato effect), and less than zero from the lower rates.

There is simply no mechanism in macroeconomics where low rates actually CAUSE more NGDP.  None.  Nada.  Lower rates reduce velocity, and that’s contractionary.  It’s not about “spending”, unless by “spending” you mean velocity.  If you mean “spending” vs. saving then you are hopelessly off track.  You aren’t even in the right train station.

Now for the hard part.  The Fed recently raised the fed funds rate, and did so without lowering the base.  So am I claiming that the Fed’s decision was expansionary?  No, but I wouldn’t blame you for seeing a contradiction here, especially if your last name is “Murphy.”

Suppose the Fed had raised the fed funds target, without raising IOR.  What then?  Then they would have had to reduce the monetary base enough to make the rate increase stick.  How much?  Fasten your seatbelts—by almost $3 trillion.  That’s right, without IOR, to even get a measly quarter point increase, they would have had to withdraw almost the entire previous QE (except the part that went into currency held by the public.)

Instead the Fed did something else, they raised IOR.  Even though IOR includes the term ‘interest,’ as part of its acronym, it actually has absolutely nothing to do with market interest rates as I’ve been discussing them so far.  It’s better to think of IOR as a tax/subsidy scheme.

Previously I claimed that higher interest rates are expansionary.  They are.  But higher IOR really is contractionary.  That’s why the New Keynesians love IOR so much.  It helps make their false “non-monetary” models of the economy less false, indeed sort of truish.  It really is true that higher IOR is contractionary.  So why the difference?  Let’s return to the simple model above.  I said that model applied to a world of no IOR.  If IOR exists, then the more general model is:

M*V(i – IOR) = P*Y

That is, velocity is positively related to the difference between the market interest rate and the interest rate on money.  This gap is the opportunity cost of holding reserves.  I wish there were no IOR, if only because it would make monetary analysis so much simpler.

In order to make monetary policy more contractionary, the Fed merely needs to shrink the gap between i and IOR.  That reduces the opportunity cost of holding base money, which causes more demand for base money (as a share of NGDP), which is contractionary.  Consider the weird situation we are in:

1.  Almost everyone assumed higher rates were contractionary, but almost everyone was wrong.

2.  Now IOR comes along, and higher IOR really is contractionary.

Now I fear that it will be even harder to slay the Keynesian dragon; the model now seems superficially even more plausible. If I was a conspiracy nut I’d think it was all a plot to make Woodford’s moneyless models appear more accurate.

To summarize, IOR is not really a market price, it’s a subsidy on base money, and negative IOR is a tax on base money. Just as it’s OK to reason from an increase in excise taxes on gasoline, it’s OK to reason from a change in IOR.  (Of course you also need to consider other changes that are occurring in monetary policy, as is always the case.)

So if lower interest rates are not the reason that monetary stimulus is expansionary, then what is the reason?  Why do more people want to go out and assume car loans when the Fed cuts interest rates via an easy money policy?  Here’s why:

1.  If the Fed lowers rates via an increase in the base, then more base money raises NGDP via the hot potato effect (AKA, laws of supply and demand).  Interest rates play no role, indeed NGDP would rise by even more if rates (and velocity) didn’t fall.

2.  The higher NGDP causes more hours to be worked, due to sticky nominal hourly wages.

3.  More hours worked means more output and more real income.

4.  Say’s Law says supply creates its own demand.  So as workers and capitalists produce more output and earn more income, they go to car dealers to splurge with their sudden newfound wealth.  Interest rates got nuthin to do with it.  Saving (and investment) as a share of GDP actually rises during booms created by monetary stimulus.  It’s not about “spending” (as in consumption), it’s about actual spending on C+I+G+NX, i.e. NGDP.

5.  Of course all this happens simultaneously, as we live in a Ratex world.

PS.  I’m begging you, don’t try to explain what you think is wrong with Say’s Law, unless you want me to be as insulting as possible in response.

Over at Econlog I pointed out that Ted Cruz asked some rather market monetarist sounding questions to Janet Yellen, during her recent testimony in the Senate.  I think it’s fair to say Cruz easily came out ahead on the exchange.  But that doesn’t fit the press corps’ pre-conceived ideas of their relative expertise, and David Beckworth points out that the WSJ reporter who was live blogging the event initially thought Cruz had his facts wrong, especially the claim that the Fed tightened in the second half of 2008.

The Washington Examiner claims that Ted Cruz’s questions reflected some diverse intellectual influences:

Mundell, known as one of the intellectual architects of supply-side economics, said at a Reagan Foundation event in 2011 that tight money caused the financial crisis. “The Fed did some tightening, and the dollar started to soar,” Mundell told Wall Street Journal editorial page editor Paul Gigot.

The dollar rose by 10 percent between the Fed’s rate cut in April 2008 and the December meeting, against a broad range of currencies.

Furthermore, Cruz was right to note that the major declines in inflation and stock prices, both alternative indicators of monetary policy, occurred during the same period.

“Sen. Cruz basically gave a Market Monetarist critique of the Fed policy in 2008,” Western Kentucky University economist and former Treasury official David Beckworth, one of the economists cited by Cruz’s office, told the Washington Examiner. “The essence of this argument is that the failure of the Fed to respond properly in late 2008 turned an ordinary recession into the Great Recession. Ditto for the Fed’s response in 1929-33.”

That case was laid out in greater length in a 2009 study by Federal Reserve Bank of Richmond economist Robert Hetzel. In his paper, Hetzel wrote that “restrictive monetary policy rather than the deleveraging in financial markets that had begun in August 2007 offers a more direct explanation of the intensification of the recession that began in the summer of 2008.”

Hetzel argued that financial markets were “reasonably calm” as late as summer 2008. “The intensification of the recession,” he wrote, “began before the financial turmoil that followed the Sept. 15, 2008, Lehman bankruptcy.”

Widely overlooked was an exchange on interest on reserves (near the end), where Cruz again bested the Fed chair.  Cruz first asked how much interest had been paid since 2008.  Janet Yellen was not sure, but added:

.  .  . It is a critically important tool of monetary policy . . .

Cruz then asked:

So what has the impact been paying billions of dollars to those banks in the last seven years?

Yellen responded:

It’s helped us to set interest rates at levels that we thought were appropriate for economic growth and price stability.

To say this is misleading would be an understatement.   Everyone, including the Fed, agrees that raising the interest rate on reserves is a contractionary policy. The Fed sharply raised interest on reserves in October 2008. Just think about that. Now it’s true that the Fed was also doing some expansionary “concrete steps” during the same period. But Cruz was not asking about those other steps, he specifically asked about interest on reserves.

During 2009, Janet Yellen said, “we should want to do more.” She clearly meant that it would be better if interest rates were lower. That means that the (positive) interest on reserve program was actually moving the US economy farther away from the Fed’s economic growth and price stability objectives.

At the time, there was some concern about the stability of money market funds. Given the widespread adoption of negative interest on reserves in other countries, the Fed is no longer afraid of reducing IOR to zero, or even below. But concern over the stability of money market funds is very different from meeting the Fed’s economic growth and price stability objectives. There is no question that this policy has pushed the economy further away from those objectives, and Sen. Cruz was quite right to raise the issue with the Fed chair. It’s a pity she didn’t have a persuasive response.

A correct answer from Janet Yellen would have been.

1.  When we instituted IOR (at a time of 1.5% interest rates) we made a serious mistake.  As Ben Bernanke pointed out in his memoir, monetary policy was too tight during this period.

2.  We also erred in continuing the program in 2009, and after.  We thought that zero short-term rates were a threat to financial stability, and later discovered that this was not true.  In retrospect we neither should have initiated the program in late 2008, nor continued it after 2008.

Central banks are really good at admitting mistakes made by their predecessors (i.e. the Great Depression, the Great Inflation, etc.)  But they are not good at admitting mistakes that they themselves made.  That needs to change, which is why we need much more Fed accountability.  Senator’s Cruz’s questions were almost a model of what that accountability should look like.  The Fed needs to be much more upfront about admitting its mistakes.

Update:  George Selgin has an excellent new post that provides incisive analysis of how the Fed ended up sterilizing its monetary injections during 2008.

Update#2:  Chad Reese and I have a piece on policy rules in American Banker.

PS.  I doubt that either Paul Krugman or Ted Cruz would support a 4% NGDP target rule, level targeting.  Krugman might think it’s too low to deal with the zero bound problem.  But the level targeting factor would make a huge difference at the zero bound.  Senator Cruz might prefer something with a role for gold; I seem to recall he mentioned Bretton Woods at one point.  But I think he underestimates how much better NGDP targeting would be at making capitalism look good—making bailouts of auto companies and banks and fiscal stimulus seem unneeded.  If two people that far apart were to ever support NGDPLT, its momentum would be unstoppable.

PPS.  James Alexander has a very good post on the growing interest in NGDP targeting within the eurozone.

HT: Caroline Baum

The view that QE is ineffective is pretty widely held—except in the asset markets. Earlier today, Mario Draghi hinted than another round of QE might be coming later in the year, if the global economy continues to be weak.  The euro fell 2% against the dollar, and European stock indices rose sharply.  Even Wall Street rallied on the news (so much for “beggar-thy-neighbor” theories.)  For an ineffective policy QE sure has a big effect on asset prices.  (And note that the big move down in the euro means that imported oil, and other commodities, are immediately more expensive, and hence the eurozone cost of living rose a few basis points today.)

At the same time these steps are much too weak to solve “the problem”, they merely make the eurozone economy a bit less weak.  The ECB should do much more.  One possible step is a further cut in interest rates:

“The ECB will almost certainly be delivering an early Christmas present this year,” said Nick Kounis, head of macro and financial markets research at ABN Amro.

“This could include an adjustment of the QE programme but also further policy rate cuts, something which had been ruled out before.”

Analysts at Barclays said: “We do not rule out the possibility of a deposit rate cut in December, although this is not our baseline. The likely trigger for a deposit rate cut, in our view, would be a further material appreciation of the euro, possibly in a scenario where the Fed remains on hold for longer.”

Wait, I thought the zero bound was the lowest that rates can fall.  I guess not. Lower interest rates will help, but what they really need is a better policy target, as explained by James Alexander:

Nominal GDP growth and thus Real GDP growth cannot get that much better in the Eurozone as a whole while the overarching target remains the self-defeating one of the <2% inflation ceiling. Draghi can prevent tail risks with the QE programme, lower rates for longer and even more negative rates. But it will never be enough to see healthy growth. The inflation ceiling offsets almost of the good work from the other policies.

Overall, monetary policy is just not that accommodative. Draghi says he and his fellow governors and their staff are working hard:

“the strength and persistence of the factors that are currently slowing the return of inflation to levels below, but close to, 2% in the medium term require thorough analysis.”

Please, Mr Draghi, it is the mandate itself that is the obstacle. In the UK we may be looking soon at the mandate  and there were hints that the European Parliament is also looking into the mandate. At least talk about NGDP Targeting and you can then “Feel The Power” in time for the pre-Christmas release of Star Wars 7.

Amen.