Here’s Alexander Humboldt:

First they ignore it, then they laugh at it, then they say they knew it all along.

In late 2008, I wrote op eds saying that tight money was driving the US into recession. No newspaper was willing to publish them.  Then in early 2009 I started a blog, and people laughed at my claim that money was very tight.  “How can that be, with ultra low rates and all the QE.”  It was difficult to find anyone who agreed with me—until today. Now it looks to me like Paul Krugman agrees with me.  This is from a recent post entitled, “It’s Getting Tighter.”

When thinking about the market madness and its possible real effects, here’s something you “” where by “you” I mean the Fed in particular “” really, really need to keep in mind: the markets have already, in effect, tightened monetary conditions quite a lot.

First of all, if break-evens (the difference between interest rates on ordinary bonds and inflation-protected bonds) are any guide, inflation expectations have fallen sharply:

Why only go back to 2011?  Let’s see what monetary policy was like in late 2008:

Now that’s tight money!

Krugman continues:

Second, while interest rates on Treasuries are down, rates on private securities viewed as even moderately risky are up quite a lot:

Again, that makes me wonder what real borrowing costs looked like in 2008:

Now you might argue that this isn’t really tight money.  Good borrowers could still borrow cheaply in 2008.  It was default risk.  Nope, good borrowers couldn’t borrow cheaply, as liquidity had dried up.  How do we know?  While yields on conventional Treasuries fell sharply, the real yield on TIPS soared higher during the second half of 2008.  The 5-year TIPS yield soared from 0.57% to over 4%.  There is no default risk with TIPS, it was purely a liquidity story.  Because of the Fed’s tight money policy, liquidity had dried up:

Just to be clear, real interest rates are not a good indicator of whether money is easy or tight.  But the spike in BBB yields was not just a default risk story; it was also a liquidity story.

Over at Econlog I have a post discussing a related issue, could a quarter point interest rate increase later this year do great harm?

I suppose we attach the label ‘crazy’ to people who believe things that are not socially acceptable and seem irrational.  Now that a Nobel Prize winner is making similar claims, I guess I can’t claim to be crazy any longer.

Always dangerous to speculate when the market is changing minute by minute, but a few observations:

1.  Over at Econlog I did a post earlier this morning, suggesting that the China slowdown is reducing the Wicksellian equilibrium global interest rate.  Since central banks foolishly target interest rates rather than NGDP, this makes monetary policy more contractionary.

2.  Why does this seem to affect foreign markets more than the US market?  One possibility that that economies like Germany and Japan are more exposed to a global slowdown, as manufacturing exports are a bigger part of their economies. But that suggests the yen and euro should be falling against the dollar, whereas they are actually appreciating strongly.  Indeed the appreciation is so strong that one could easily attribute much of the recent stock market decline in Europe and Japan to their strengthening currencies.  Now of course I always say “never reason from a price change,” so let me emphasize that I am implicitly assuming the stronger yen and euro reflect tighter money, not surging growth expectations in Europe and Japan.  I don’t think anyone in their right mind believes global growth prospects have been rapidly improving in the last week, especially when you look at commodity and stock prices.

3.  The falling TIPS spreads and real interest rates suggest that AD expectations are falling in the US, but not anywhere near to recession levels.  After all, did anyone expect a recession last time the S&P was at this level?  Obviously not.  The tighter money in Europe and Japan suggests those economies will be hit harder than the US.

4.  If Europe and Japan are facing tighter money than the US, why would that be? Probably because markets think it would be easier for the Fed to at least partially offset this shock, via a delay in the interest rate increase.  Areas already at the zero bound would have to be more creative, and history has shown that central banks tend to be slower to react at the zero bound, especially when there are sudden and unanticipated shocks like this.  (It’s easier to offset anticipated shocks, like 2013’s fiscal austerity.)

This is all very speculative, and I don’t have a lot of confidence on my analysis. And as always, I don’t forecast asset prices, I merely try to ascertain what the market is forecasting.  Unfortunately the Hypermind market is still not very efficient.  It opened this morning at 3.6%, which was actually up slightly in the past few days.  I don’t think that reflects actual NGDP expectations.  Last I looked it was down to 3.4%, but of course efficient markets respond immediately to shocks.  This tells me that while the market is a nice demonstration project, there is no substitute for a very deep and liquid NGDP prediction market subsidized by Uncle Sam.  If it’s not the biggest $100 bill on the sidewalk, it’s right up there.

One other point.  I’m much more concerned by falling TIPS spreads and falling 30-year bond yields, than I am by falling equity prices.  Stocks often show large price breaks, without there being any change in the business cycle.

PS.  I agree with Lars Christensen’s analysis (except the part about China not becoming the biggest economy.  We face this problem because they already are the biggest.)  I think Lars is right about the two key mistakes being the Chinese yuan/dollar peg and Yellen’s tight money policy.

In the past few weeks I’ve done a few posts suggesting that monetary policy in the US is too tight.

A few years ago I did many posts suggesting that monetary policy is too tight.

I wouldn’t blame readers for assuming that I’m still making the same argument, but actually my current argument is quite different.

After late 2008, I thought money was too tight in an absolute sense, that is, according to any plausible Fed target. Unemployment was quite high and inflation expectations were very low.

Today is quite different.  For instance, suppose the Fed announced tomorrow that they had adopted Bill Woolsey’s 3.0% NGDP target, level targeting. That’s certainly a very reasonable target.  In that case I would not argue that money is currently too tight, I’d argue the Fed is right on course.

My current argument is that money is too tight in a relative sense, that is, relative to the Fed’s own announced 2% PCE inflation target.  Now it’s true the Fed has a dual mandate, but nonetheless inflation should be expected to average 2% over the long term.  And right now that’s not the case, PCE inflation is likely to undershoot 2% over the next few decades.

BTW, Here’s an article about the worsening nursing shortage.  And here’s an article about the worsening teacher shortage. These are the middle class jobs that supposedly are no longer available, and yet employers can’t find people to do them at the current (sticky) wage rate.  That suggests to me that we are getting close to the natural rate of unemployment. Maybe not quite there, but close.

PS.  The first article also mentions that there is a shortage of schools to train nurses.  Could this be a planned shortage, to keep salaries higher?  (As with medical doctors)

Brad DeLong has a post discussing a debate between Paul Krugman and Roger Farmer:

I find myself genuinely split here. When I look at the size of the housing bubble that triggered the Lesser Depression from which we are still suffering, it looks at least an order of magnitude too small to be a key cause. Spending on housing construction rose by 1%-age point of GDP for about three years–that is $500 billion. In 2008-9 real GDP fell relative to trend by 8%–that is $1.2 trillion–and has stayed down by what will by the end of this year be seven years–that is $8.5 trillion. And that is in the U.S. alone. There was a mispricing in financial markets. It lead to the excess expenditure of $500 billion of real physical assets–houses–that were not worth their societal resource cost. And each $1 of investment spending misallocated during the bubble has–so far–caused the creation of $17 of lost Okun gap.

(You can say that bad loans were far in excess of $500 billion. But most of the bad loans were not bad ex ante but only became bad ex post when the financial crisis, the crash, and the Lesser Depression came. You can say that low interest rates and easy credit led a great many who owned already-existing houses to take out loans that were ex ante bad. But that is offset by the fact that the excess houses built had value, just not $500 billion of value. I think those two factors more or less wash each other out. You can say that it was not the financial crisis but the destruction of $8 trillion of wealth revealed to be fictitious as house prices normalized that caused the Lesser Depression. But the creation of that $8 trillion of fictitious wealth had not caused a previous boom of like magnitude.)

To put it bluntly: Paul is wrong because the magnitude of the financial accelerator in this episode cries out for a model of multiple–or a continuous set of–equilibria. And so Roger seems to me to be more-or-less on the right track.

DeLong is certainly right that the housing bust is far too small, but it’s even worse than that.  The vast majority of the housing bust occurred between January 2006 and April 2008, and RGDP actually rose during that period, while the unemployment rate stayed close to 5%.  So it obviously wasn’t the housing bust.  On the other hand you don’t need exotic theories like multiple equilibria—the Great Recession was caused by tight money.  It’s that simple.

Or is it?  Most economists think that explanation is crazy.  They say interest rates were low and the Fed did QE.  They dismiss the Bernanke/Sumner claim that interest rates and the money supply don’t show the stance of monetary policy. Almost no one believes the Bernanke/Sumner claim that NGDP growth and/or inflation are the right way to evaluate the stance of policy.  Heck, even Bernanke no longer believes it.

And even if I convinced them that money was tight they’d ask what caused the tight money, or make philosophically unsupportable distinctions between “errors of omission” and “errors of commission.”

In previous blog posts I’ve pointed out that it’s always been this way.  If in 1932 you had said that tight money caused the Great Depression, most people would have thought you were crazy.  Today that’s the conventional wisdom.  If in the 1970s you’d claimed that easy money caused the Great Inflation, almost everyone except a few monetarists would have said you were crazy.  Now that’s the conventional wisdom.  Even the Fed now thinks that it caused the Great Depression and the Great Inflation.  (Bernanke said, “We did it.”)

The problem is that central banks tend to follow the conventional wisdom of economists.  So when central banks screw up, the conventional wisdom of economists will never blame the central bank (at the time); that would be like blaming themselves. They’ll invent some ad hoc theory about mysterious “shocks.”

The other night at dinner my wife told me that the Chinese sometimes say, “If you cannot see the true shape of Lu Mountain, it’s because you are standing on Lu Mountain.”

In modern conventional macro, most people look at monetary policy from an interest rate perspective.  That means they are part of the problem.  They are looking for causes of the Great Recession, not understanding that they (or more precisely their mode of thinking) are the cause.

Only the small number of economists who observed Mount Lu from other peaks, such as Mount Monetarism or Mount NGDP Expectations, clearly saw the role of central bank policy.  People like Robert Hetzel, David Beckworth, Tim Congdon, etc.

PS.  Before anyone mentions the zero bound, consider two things:

1.  The US was not at the zero bound between December 2007 and December 2008 when the bulk of the NGDP collapse occurred, using monthly NGDP estimates.

2.  Do you personally support having the Fed use a policy instrument that freezes up exactly when you need it most desperately?  Or might the problem be that they’ve chosen the wrong instrument?

PPS.  Yes, not everyone on Mount Monetarism saw the problem, but as far as I know no one on Mount Interest Rate got it right.  Perhaps Mount Interest Rate is Lu Mountain.

PPPS.  To his credit, Brad DeLong thought the Fed should have promised to return NGDP to the old trend line.  If they’d made that promise there would have been no Great Recession, just a little recession and some stagflation.

I’ve done recent posts on Neo-Fisherism, and the problem of identifying the stance of monetary policy.  I’ve also pointed out that if we can’t identify the stance of monetary policy, we can’t identify monetary shocks.

This is going to be a highly ambitious post that tries to bring together several of my ideas, in a Grand Theory of Monetary Policy.  Yes, that’s means I’m almost certainly wrong.  But I hope that the ideas in this post might trigger useful insights from people who are much smarter than me and/or better able to handle macro modeling.

NeoFisherians argue that if the Fed switches to a policy of low interest rates for the foreseeable future, this will lead to lower inflation rates.  Their critics claim this is not just wrong, but preposterous—and undergraduate level error.  I think both sides are right, and both sides are wrong.

All of mainstream macro (including the IS-LM model) is built around the assumption of a “liquidity effect”.  That is, because wages and prices are sticky in the short run, a sudden and unexpected increase in the money supply will lower short-term nominal interest rates. Interest rates must fall in the short run so that the public will be willing to hold the larger real cash balances (until the price level adjusts and the real quantity of money returns to its original equilibrium.)

One thing that makes this theory especially persuasive is that it’s not just believed by eggheads in academia.  Pragmatic real world central bankers often see nominal interest rates fall when they inject new money into the economy.  It’s pretty hard NOT to believe in the liquidity effect if you see it in action after you make a policy move.

So the NeoFisherians have both the eggheads and the real world practitioners against them.  And yet not all is lost.  Over any extended period of time the nominal interest rate does tend to track changes in trend inflation (or better yet trend NGDP.)  If I had a perfect crystal ball and saw the fed funds rate rise to three percent and then level off for twenty years, I’d expect a higher inflation rate than if my crystal ball showed rates staying close to zero for the next 20 years.  NeoFisherians are smart people, and they wouldn’t concoct a new theory without some good reason.

In previous posts I’ve found it useful to illustrate where NeoFisherism works with a thought experiment.  I’ll repeat that, and then I’ll take that thought experiment and use it to develop a general model of monetary policy.  Here’s the thought experiment:

Suppose Japan wants to raise their inflation rate to roughly 8%/year.  How do they do this?  This requires two steps.  They need a monetary regime that produces 8% steady state trend inflation, and they need to make sure that the price level doesn’t undergo a one-time jump upwards or downwards at the point the new regime is adopted.

To get 8% trend inflation, they’d need to shift the trend nominal interest rates to a much higher level.  To make things as simple as possible, suppose the US Federal Reserve targets inflation at 2%, and the BOJ has confidence that the Fed will continue to do so.  In that case the BOJ can peg the yen to the dollar, and promise to depreciate it at 6%/year, or 1/2%/month.  The interest parity theory (IPT) assures us that Japanese interest rates will immediately rise to a level 6% higher than US interest rates.  (Note, I’m using the near perfect ex ante version of the IPT, not the much less reliable ex post version.)

We’ve already gotten a very NeoFisherian result.  Currency depreciation is an expansionary monetary policy, and the IPT assures us that this particular expansionary monetary policy will also produce higher interest rates.  And not just in the long run, but right away. Although Purchasing Power Parity is widely known to not hold very well in the short run, expected inflation differentials do tend to reflect the expectation than PPP will hold.  So under this regime not only will Japanese nominal interest rates rise almost exactly 6% above US levels, Japanese expected inflation rates will also rise to roughly 6% above US levels.

Of course actual PPP does not hold all that well (although it does far better under fixed exchange rate regimes, or even crawling pegs like this system, than floating rates.)  But that doesn’t really matter in this case; just getting 6% higher expected inflation is enough to pretty much confirm the NeoFisherian result.

Unfortunately, the immediate rise in interest rates might reduce the equilibrium price level in Japan.  But even that can be prevented with a suitable one-time currency depreciation at the point the regime is adopted.  How large a currency depreciation? Let the CPI futures market tell you the answer.  Make your change in the initial exchange rate conditional on achieving a 1 year forward CPI that is 8% higher than the current spot CPI.  Thus the CPI futures market might tell you that the yen should immediately fall to say 154.5 yen/dollar, and then depreciate 1/2% a month from that level going forward.  Whatever amount of immediate currency depreciation offsets the immediate impact of higher interest rates.

Notice that monetary policy has two components, a level shift and a growth rate shift. This idea will underpin my grand theory of monetary policy.  In this case the level shift was depreciating the yen from 120 yen/dollar to 154.5 yen/dollar.  The growth rate shift was going to a regime where the yen is expected to gradually appreciate against the dollar, to one where it is credibly expected to depreciate at 1/2%/month.

Now think about the expected money supply path that is associated with that new policy regime for the yen.  My claim is that if the BOJ simply adopted that expected money supply path, all the other variables (exchange rates, interest rates, inflation, etc.) would behave just as they did under my crawling peg proposal.

So far I’ve been supportive of the NeoFisherians, but of course I don’t really agree with them.  Their fatal flaw is similar to the fatal flaw of Keynesian and Austrian macro, using the interest rate to identify the stance of monetary policy.  But in some ways it’s even worse than the Keynesian/Austrian view.  Those two groups correctly understand that a Fed rate cut is a signal for easier money ahead.  The NeoFisherians implicitly assume the opposite.

People say that the longest journey begins with a single step.  But what the NeoFisherians don’t seem to realize is that central banks generally signal an intention to go 1000 miles to the west by taking their very first step to the EAST.  (Nick Rowe has much better analogies.)  Thus when Paul Volcker decided that he wanted the 1980s to be a decade of much lower inflation and much lower nominal interest rates, the very first thing he did was to raise the short term interest rate by reducing the growth rate of the money supply.

As soon as you realize that central banks usually use changes in short term nominal interest rates achieved via the liquidity effect as a signaling device, then the NeoFisherian result no longer makes any sense.

But now I’m being too hard on the NeoFisherians.  Look at my crawling peg for the yen thought experiment.  And what about the fact that low rates for an extended period do seem associated with really low inflation, in places like Japan.  That suggests there’s at least some truth to the NeoFisherian claim, and at least some problem with the Keynesian/Austrian view.

In my view the two views can only be reconciled if we stop viewing easy and tight money as points along a line, but rather as multidimensional variables:

Monetary policy stance = S(level, rate)

A change in monetary policy reflects a change in one or both of these components of the S function.  You can have a rise in the price level, but no change in the trend rate of inflation.  You can have a rise in the trend rate of inflation, with no change in the current (flexible price) equilibrium price level.  The beauty of the thought experiment with the yen is that it makes it much easier to see this distinction.  You can imagine once and for all change in the exchange rate, as when the dollar went from $20.67 an ounce to $35.00 an ounce in 1933, and then stayed there for decades.  Or you can imagine a change in the trend rate of the exchange rate, as in my crawling peg example.  Or you can imagine both occurring at once.

When NeoFisherians are talking about higher interest rates leading to higher inflation, they are (implicitly) changing the “rate” component of my monetary policy stance function.  Keynesian and Austrians tend to (implicitly) think in terms of changes in levels, once and for all increases in the money supply that depress short-term interest rates and have relatively little effect on long-term interest rates or long run inflation.

In previous posts I’ve expressed puzzlement as to why easy money surprises lower longer-term interest rates on some occasions, and at other times they raise long-term interest rates.  The “perverse” latter result occurred in January 2001, September 2007, and (in the opposite direction) December 2007.

Indeed the December 2007 FOMC meeting produced the most NeoFisherian (i.e. “rate”) shock that I have ever seen in my entire life.  A smaller than expected rate cut (contractionary shock) led to a huge stock market sell-off (no surprise) but also lower bond yields for 3 months to 30 years T-securities (a big surprise.)  This policy announcement had an unusually large “rate shift” component, whereas most US policy announcements are primarily “level shifts”.  The markets (correctly) saw the Fed’s passivity in December 2007 as indicating that inflation and NGDP growth might be lower than normal going forward.  And not just in 2008, but indefinitely.

Unfortunately, while exchange rates nicely capture the rate/level distinction, they are not ideal for developing a general monetary policy theory, as the real exchange rate is too volatile.  And that brings me to the missing market, NGDP futures.  If this market existed we would have all the tools required to describe the stance of monetary policy in the multidimensional way necessary to sort through this messy NeoFisherian/conventional macro debate.  Suddenly we could clearly see the distinction between level shifts and rate shifts.

Unlike exchange rates, NGDP responds to monetary policy with a lag.  But we could use one-year forward NGDP as a proxy for levels.  Thus if one year forward NGDP rose and longer-term expected NGDP growth rates were unchanged then you’d have a level shift.  If the opposite occurred, you’d have a rate shift.  Or you might have both.  The response of interest rates to the monetary policy shock would largely depend on the response of NGDP futures to the monetary policy shock.

In a richer model there would be more than two dimensions, indeed the expected future NGDP at each future date would tell us something distinct about the stance of monetary policy, and thus more fully characterize any monetary shocks that occurred. But I see great benefits of using the simpler two variable description, levels and growth rates.  This simpler version is enough to address many of the perplexing features of monetary policy, such as why economists can’t seem to come up with a coherent metric for the stance of monetary policy, and why the NeoFisherians reach radically different conclusions than the Keynesians.

Ideally we’d create highly liquid NGDP and RGDP futures market, and then we could easily identify the stance of monetary policy, in both dimensions.  This would also allow us to ascertain the impact of policy shocks on both NGDP and RGDP. NeoFisherians could say, “A monetary policy that raises expected inflation rates and/or expected NGDP growth rates will usually raise nominal interest rates.”  That’s a much more sensible way of making their claim than “Raising interest rates will raise expected inflation and/or expected NGDP growth.

PS.  I’ve benefited greatly from discussions with Daniel Reeves (a Bentley student), and Thomas Powers (a Harvard student).  They understand NK models better than I do, and bouncing ideas off them has helped me to clarify my thinking.  Needless to say they should not be blamed for any mistakes in this post.