During late December, there was a lot of chatter in the press and the blogosphere about monetary policy.  Many pundits expressed concern that policy was off course.

Back in September 2010, there was relatively little chatter about monetary policy.  Why is there a great deal of discussion at some points in time, but not others?  One answer is that people talk about monetary policy when it is not hitting its targets.

Let’s look at the most recent unemployment and (PCE) inflation data that was available as of late September 2010 and late December 2018:

August 2010:  12-month PCE inflation = 1.38%, unemployment = 9.5%

November 2018:  12-month PCE inflation 1.84%, unemployment = 3.7%

Hmmm, which set of data points is closer to hitting the Fed’s dual mandate?

Which set of data points suggest that policy is clearly off course?

It might be argued that the Fed was out of ammunition in September 2010.  Actually, that is not the case:

1.  Bernanke insisted the Fed had more ammunition.

2.  The Fed was paying interest on reserves.

3.  The Fed was not doing quantitative easing.

4.  The Fed was not doing significant forward guidance.

So why was there a lot of discussion of the Fed being off course in late December of last year, but very little discussion in September 2010?

1.  A lack of understanding that if AD is too high or too low it’s always 100% the Fed’s fault.

2.  An inability to understand what it means for money to be easy or tight.

Thus most pundits wrongly assumed the Fed was tightening policy in 2018, even as NGDP growth picked up.  This so-called tightening was seen as a “concrete step” that threatened the recovery.  In 2010, policy was wrongly seen as being “expansionary”, and the Fed was wrongly seen as being not responsible for the fact that AD was currently far too low to achieve the Fed’s dual mandate.

Bottom line:  When discussion of monetary policy is at its highest pitch, there is often less cause for concern than when almost no one it talking about it.  Consider late 2008, when monetary policy was disastrously off course, and yet there was almost no discussion of that fact in the media.

That’s not to say that policy is not currently off course—it may well be.  Rather my point is that any errors in the current policy setting are trivial compared to 2008 or 2010, when people were mostly ignoring the Fed.

David Beckworth has a new Mercatus paper that examines the Fed’s decision to adopt a “floor” system for interest rates.  Beginning in October 2008, the Fed began paying interest on bank reserves.  This effectively created a floor on market interest rates, as banks would have no incentive to lend money at rates lower than they could receive on reserves held on deposit at the Fed. Prior to 2008, the Fed controlled short-term interest rates by adjusting the supply of base money, a “corridor system”.  Now they have two independent policy tools, changes in the money supply (open market operations), and changes in money demand (done via interest on reserves.)

David sees several flaws in this new system:

The Fed’s floor system, then, may be a drag on economic growth for two reasons. First, it may weaken aggregate demand growth by setting the target interest rate above the natural interest rate. Second, it may inhibit credit and money creation by removing banks’ incentives to rebalance their portfolios away from excess reserves. If so, the critics are right to be worried about the Fed’s floor system, because it would constitute a Great Divorce for monetary policy.

I worry that deposit insurance biases banks toward too much lending, so at the moment I’m most worried about the first issue.  In monetary history, one recurring theme is central banks misjudging the stance of monetary policy because they focused too much on interest rates and not enough on the money supply.  Thus during late 2007 and early 2008, the Fed wrongly assumed that it was “easing” monetary policy, even as the growth in the monetary base came to a halt.

Admittedly, this excessive focus on interest rates can occur even without IOR.  But the system of interest on bank reserves makes the mistake even more likely to occur, as the quantity of money becomes even less informative.  Monetary policy is seen as being all about changes in interest rates, not changes in the supply and demand for base money.  The Fed’s monetary policy stance during the fall of 2008 would have almost certainly been less contractionary if Congress had not authorized the Fed to pay interest on reserves.

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

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.

Stephen Williamson recently made this observation:

As a side note, I thought the part of the FOMC discussion where the staff gives a presentation relating to an alternative indicator – the difference between the current fed funds rate and what the market thinks the future fed funds rate will be – was good for a chuckle. If the FOMC thinks the market knows more about what it’s going to do than what it knows about what it’s going to do, we’re all in trouble.

I have the opposite perspective; we are in big trouble if the FOMC thinks it knows more than the market about what it will do to rates in the future.

Back in late 2015, the Fed began raising their target interest rate.  At the time, they anticipated another 4 rate increases in 2016.  Markets were skeptical, expecting only about one rate increase in 2016.  In fact, rates were not raised again until the very end of 2016.  That’s because economic growth and inflation during 2016 were below Fed expectations.  The markets were correct on this occasion (not always).

If you want an efficient estimate of the future path of interest rates, look at the market forecast, not the “dot plot”.  The dot plots are primarily useful as a measure of how deluded FOMC members are in their appraisal of the economy.  Because they were too optimistic in late 2015, they set rates too high.  That slowed the recovery, and probably tilted the (very close) election toward Trump.  And now, to quote Williamson, “we’re all in trouble”.

Interest rates are now higher than in 2016, but monetary policy is actually more expansionary than two years ago.  To Williamson’s credit, he is one of the few economists who seems to understand how this can be possible.

HT:  Tyler Cowen.