Freaking out

Last night JimP sent me a chilling but persuasive article written by the WSJ’s Jon Hilsenrath.  He clearly has good sources:

WASHINGTON””The Aug. 10 meeting of top Federal Reserve officials was among the most contentious in Ben Bernanke’s four-and-a-half year tenure as central bank chairman.

With the economic outlook unexpectedly darkening, the issue was a seemingly technical one: whether to alter the way the Fed manages its huge portfolio of securities.

But it had big implications: Doing so would plunge the Fed back into the markets and might be a prelude to a future easing of monetary policy, moves that divided the men and women atop the central bank.

At least seven of the 17 Fed officials gathered around the massive oval boardroom table, made of Honduran mahogany and granite, spoke against the proposal or expressed reservations. At the end of an extended debate, Mr. Bernanke settled the issue by pushing successfully to proceed with the move.

So it’s not just three, there are no less than seven hawks among the regional Fed Presidents/Board of Governors.  Read the entire piece, it’s scary.  Lots of our most important policymakers don’t understand what the market clearly understands–we have a major AD problem.  Let’s review the facts:

1.  Between 2008:2 and 2009:2 NGDP falls by more than 8% relative to trend.

2.  Since 2009:2 NGDP has grown about 4%, which is still below trend.

3.  All signs point to a recent slowdown from the already anemic 4% rate.

4.  Unemployment is near post-war records, and is not expected to fall.

5.  Core inflation and inflation expectations are well below the Fed’s implicit 2% target, and even farther below the actual average inflation rate over recent decades, which is over 2%.

This isn’t rocket science.  When the AD curve shifts to the left then NGDP falls (relative to trend, as in the excellent Cowen/Taborrok textbook.)  That’s an adverse demand shock.  We have seven members of the Fed who don’t even seem to understand the basics of AS/AD theory.  Who have concocted all sorts of bizarre structural theories to explain away their failure to boost NGDP enough for a robust recovery.  This is EXACTLY what happened at the Fed in the Great Depression.

Some Fed members worry about keeping rates near zero because near-zero rates are often associated with deflation.  Well yes, but raising the short term policy rate doesn’t solve that problem, the Fed tried that in 1931.  They seem unaware that monetary policymakers must have two tools.  If all you have is the fed funds rate, then the price level is intermediate indeterminate.  You also need some sort of nominal target, or a Taylor-rule like reaction function.  If you want higher rates because you’ve noticed that low rates are associated with deflation (which is a reasonable thing to want), then you don’t raise the short term policy rate, you raise your nominal target.  Nick Rowe has done a lot of excellent posts on this subject.  Again, it isn’t rocket science, these principles are well understood.  But when you read comments from some Fed officials, you’d think you are listening to undergraduates trying to grasp these concepts for the first time.  And they are screwing up the entire economy!!!

When I went to bed last night I thought to myself; “Maybe it’s not this bad.  Maybe I shouldn’t freak out over a single article.  After all, I pride myself in taking my marching orders from the markets.  Let’s see how they reacted to the Wall Street Journal story.”

When I woke up this morning I noticed the markets were down sharply.  Then I saw a Yahoo.com story entitled:

Traders Freaking Out Over WSJ Report On The Fed: Here’s Why

Last night, WSJ’s John Hilsenrath reported that at the last FOMC meeting, several of the Fed governors expressed reservations about the plan to maintain the size of the balance sheet, and roll over MBS into Treasuries.

There are a lot of moving parts to the story because there are different reasons for the objections. Some of the Fed governors are hawkish (like Hoenig). Some are more dovish (like Bullard). And some think that the Fed can’t really do anything because our problems are more structural (Kocherlakota).

But here’s what folks are taking away from the article: The Fed is still way behind the curve in terms of how bad the economy is. It’s paralyzed.

It’s funny, because this is the exact opposite of what some people initially thought — there was this fear that the Fed knew something about bad news coming down the pike that the public hadn’t heard yet. In fact, as we now know, the Fed isn’t seeing what everyone else is.

Anyway, this is the talk of the morning, and it’s helping send stocks down again.

I know there will be some saying; “Sure, the stock market likes easy money, stocks are a hedge against inflation.”  Actually no.  The market did horribly in the high inflation period of 1966-81.  Here’s how I look at it:

1.  The market hated inflation in the 1970s.

2.  The market is begging for easier money today.

3.  Put 1 and 2 together–what does that tell you?

This is the last nail in the coffin of the Krugman “depression economics” theory.  Recall that that theory is based on the assumption that everything changes when rates hit zero.  Since monetary policy is (supposedly) completely ineffective, suddenly all he old Keynesian myths come true.  A fiscal multiplier.  Imports are bad.  Saving too much causes recessions.  All the prejudices of the man on the street.

Is monetary policy really ineffective at zero rates?  Try telling that to Wall Street.

PS.  For those who like black comedy, check out this Kevin Warsh statement:

An abrupt change in stance, he argued, could lead the public to believe the Fed was more worried about the economy than it really was.

Update:  I guess I am so freaked out that I have become a bit sloppy with recent posts.  I apologize.  Commenter 123 asked for an example of the interest rate fallacy cite above.  I.e., the idea that since low rates are associated with deflation, raising the short term policy rate can cure deflation.  I suppose this Kocherlakota excerpt is what I had in mind:

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number””in this case, -0.75 percent.

To sum up, over the long run, a low fed funds rate must lead to consistent””but low””levels of deflation. The good news is that it is certainly possible to eliminate this eventuality through smart policy choices. Right now, the real safe return on short-term investments is negative because of various headwinds in the real economy. Again, using our simple arithmetic, this negative real return combined with the near-zero fed funds rate means that inflation must be positive. Eventually, the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level. The FOMC has to be ready to increase its target rate soon thereafter.

That sounds easy””but it’s not. When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation.

I suppose there are different ways of reading this passage, but I find the last two sentences to be very disturbing.  What do you think?  I’d rather stick with “conventional thinking.”

Update:  Andy Harless has a nice post on this quotation.


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32 Responses to “Freaking out”

  1. Gravatar of Jeff Jeff
    24. August 2010 at 08:08

    If all you have is the fed funds rate, then the price level is intermediate.

    I think you meant indeterminate here, no?

  2. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    24. August 2010 at 08:09

    “Some Fed members worry about keeping rates near zero because near-zero rates are often associated with deflation. But when you read comments from some Fed officials, you’d think you are listening to undergraduates trying to grasp these concepts for the first time. And they are screwing up the entire economy!!!”

    Names, please! Kocherlakota, Bullard?

  3. Gravatar of Liberal Roman Liberal Roman
    24. August 2010 at 08:44

    The only thing that comforts me is that the hawks have predicated their arguments on the idea that the economy is recovering just fine and further stimulus would be counter-productive. As we see more and more negative economic data points coming out, how could they still cling to that argument?

    I don’t expect any actions at the late September meeting, but by early November (with at least 2 of Obama’s nominations confirmed) and the economy in a real rot, I hope that there will be an impetus for some action.

  4. Gravatar of Liberal Roman Liberal Roman
    24. August 2010 at 09:37

    http://www.reuters.com/article/idUSTOD00618120100824

    “The Bank of Canada said on Tuesday that changing its 2 percent inflation target could bring economic benefits….The bank has been researching the options of lowering its inflation target…”

    Taking down the goal posts indeed…

  5. Gravatar of scott sumner scott sumner
    24. August 2010 at 09:53

    Jeff, Thanks, it is corrected.

    123, Yikes, I am sloppy today. I added another update with a Kocherlakota quotation. See what you think.

    Liberal Roman, Yes, those are my views as well. And I think Jim Hamilton and Krugman have expressed similar views.

    LR#2, That doesn’t seem well-timed. The only way it would make sense is if Canada went to level targeting. But I am still skeptical.

  6. Gravatar of spencer spencer
    24. August 2010 at 10:10

    I guess those thinking low rates are “associated” with deflation think Volcker should have dropped rates to 1% in 1979-80.

  7. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    24. August 2010 at 10:13

    Scott,
    I have also found this quotation by Kocherlakota very disturbing. Bullard is also toying with the idea here (although in the end he is advocating more QE to fight deflationary expectations):
    research.stlouisfed.org/econ/bullard/pdf/SevenFacesFinalJul28.pdf

  8. Gravatar of Silas Barta Silas Barta
    24. August 2010 at 10:20

    The most important thing right now is for people to _get spending_. It really doesn’t matter whether they would prefer to save their money. It doesn’t matter if they would normally get that good through non-monetary channels (like through marriage). Folks need to take their money OUT and use it to buy things, so that NGDP can be as high as standard monetary macro suggests it should be kept at.

    If people aren’t spending their money, we need to fundamentally change their incentives so that they realize it’s the right thing to do. Rapidly devalue it so they have to “use it or lose it”? Tax savings? Loan on easy terms to wasteful organizations? I don’t care, the money needs to get moving!

    Fiat circulatia lucro ruat caelum!

  9. Gravatar of Contemplationist Contemplationist
    24. August 2010 at 11:00

    Silas try engaging with monetary disequilibrium n sticky wages first. One should try to attack the strongest argument of the opposition not the weakest. What you are attacking is old-style comic keynesianism.

  10. Gravatar of Silas Barta Silas Barta
    24. August 2010 at 11:34

    I thought I was agreeing is scott_sumner…

  11. Gravatar of Benjamin Cole Benjamin Cole
    24. August 2010 at 11:43

    George Melloan wrote an op-ed for todays WSJ, page A15.
    It gets worse and worse…….

  12. Gravatar of Contemplationist Contemplationist
    24. August 2010 at 11:56

    Facetiousness may be mistaken for agreement among the sub-100 IQ horde, but not here.

    But seriously, there are a few commenters here who understand (or at least try to sincerely) the Austrian perspective and even agree with it 90%. But the Austrian critique of monetary policy is attacking strawmen and Old Keynesians.

  13. Gravatar of Silas Barta Silas Barta
    24. August 2010 at 12:05

    @Contemplationist, the last two times I did that, scott_sumner agreed with me. So maybe you could try to appreciate how difficult it is to tell which representations are serious and which aren’t.

    Could you at least tell me how my statement differs in policy re

  14. Gravatar of Silas Barta Silas Barta
    24. August 2010 at 12:17

    Sorry, that should be, “Could you at least tell me how my statement differs in policy recommendations from what a mainstream monetary macroeconomist would advocate?”

  15. Gravatar of Jon Jon
    24. August 2010 at 12:55

    There is a basic problem that many see the theory and the indicators as in conflict and are prefering the theory.

    The trouble is that the IOR policy is unprecedented and misunderstood. So theory and indicators actually agree–policy is tight not loose.

    So I don’t panic here. There is a narrow point of education and advocacy: IOR is making policy tight. If a few respected people swing at that in the wsj, positive action will be forthcoming.

  16. Gravatar of Contemplationist Contemplationist
    24. August 2010 at 13:15

    @Silas

    Lol I understand you now.
    Well my understanding is as follows: Regardless of underlying mechanisms (short of REAL reasons – recalculation), there is a drop in “confidence” which MP simply labels NGDP. Due to this and the sticky nature of wages, unemployment results. If we could wave a magic wand and adjust wages downwards as needed instantaneously, there would be no problem, but we can’t. However, we CAN set MP by targeting what the market participants think NGDP is going to be, by gaining credibility, then doing whatever is needed to bring NGDP to this level (printing money, buying bonds blah blah). This stabilization of nominal GDP ensures depreciation of real wages without nominal cuts, thereby bringing supply and demand of labor closer to each other.

  17. Gravatar of Silas Barta Silas Barta
    24. August 2010 at 14:01

    @Contemplationist: I understand that’s the reasoning used by mainstream economists for this policy, but the question was to explain how my facetious reasoning differs in terms of what policies it would recommend.

    Also, making spending go up means making people buy stuff they wouldn’t otherwise. It does not simply mean all prices for what people would buy anyway just go up.

  18. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    24. August 2010 at 14:06

    Andy Harless does an excellent job with Kocherlakota’s excerpt:

    http://blog.andyharless.com/2010/08/do-umbrellas-cause-rain.html

  19. Gravatar of scott sumner scott sumner
    24. August 2010 at 15:53

    spencer, Good point.

    123, I am relying on memory, but I think Bullard is a bit more reasonable. It is OK to say you don’t want low rates as far as the eye can see, and instead prefer easier money through QE or a higher inflation target. But to say you don’t want low rates, and then vote for tight money, and then think this will stop deflation . . . well I just don’t get it.

    Silas, You are attacking Keynesianism, and I am not a Keynesian. I agree American’s should save more. I simply don’t want them to hoard federal reserve notes. Use the cash to buy financial assets like stocks, bonds, CDs, etc. That’s saving, and that will boost NGDP.

    Benjamin. Yes, it was awful. Saying money stimulus can only work if the extra money supply is met by more money demand? I thought I had already been too negative, so I didn’t comment.

    Silas, Your basic mistake is to equate ‘spending’ with ‘consumption.’ Spending on financial assets is saving. The relevant distinction is hoarding and dishoarding of base money (cash and reserves.) I do not favor more consumption, I favor less hoarding of cash–or an increased supply of cash. If the Fed supplied more cash, then the public could still demand the same real cash balances, and NGDP would still go up. So I am not trying to change any real behavior of the public, just change nominal magnitudes.

    123, Thanks, I added an update.

  20. Gravatar of Joe Joe
    24. August 2010 at 18:54

    Professor,

    Quick question.

    According to the fisher equation, how do you know that creating expected inflation will not simply raise nominal interest rates, instead of lowering real rates?

    Thanks,

    Joe

  21. Gravatar of Mike Sandifer Mike Sandifer
    24. August 2010 at 21:20

    Since monetary policy isn’t going to where you like, how about fiscal proposals such as that of Robert Reich to eliminate payroll taxes for the first $20,000 of income? He would couple this with increasing the payroll taxes on incomes above $250,000, to be more or less deficit neutral. Then, he would extend the Bush cuts for all but the top 3%. This plan has the advantage that it might actually get passed and signed into law.

    BTW, do you buy the Romer conclusion that tax cuts can have stimulative multipliers as high as 3?

  22. Gravatar of David Tomlin David Tomlin
    25. August 2010 at 00:05

    Scott Sumner:

    So I am not trying to change any real behavior of the public, just change nominal magnitudes.

    Huh?

    This reminds me of a line from Atlas Shrugged. It was something like: ‘If nothing is supposed to change, how is the crisis going to end?’

  23. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    25. August 2010 at 04:08

    Scott, you wrote:
    “I am relying on memory, but I think Bullard is a bit more reasonable. It is OK to say you don’t want low rates as far as the eye can see, and instead prefer easier money through QE or a higher inflation target. But to say you don’t want low rates, and then vote for tight money, and then think this will stop deflation . . . well I just don’t get it.”

    Bullard’s conclusion is reasonable, but the way he reaches it is not. For example he explored the refusal to cut rates below 2% as one of the policy options. His model is too similar to Kocherlakota’s.

  24. Gravatar of Floccina Floccina
    25. August 2010 at 05:25

    If this is an argument for free banking. Nobody seems to understand the system well enough to run it least of all the median voter.

  25. Gravatar of Mattias Mattias
    25. August 2010 at 06:42

    Well, I’m afraid that’s the drawback of political nominations. Ideally really important jobs like head of Fema, judges and positions at the Fed should go to the best person available and not to the ones that the party in power think has the right ideas for the moment.

    We’ve had som peculiar job fillings in Sweden too, but I think you’ve taken it to a whole new level the last 10-15 years.

  26. Gravatar of scott sumner scott sumner
    25. August 2010 at 06:50

    Joe, I don’t care if it does. If the SRAS is upward sloping, as I think it is, then higher expected inflation implies higher expected real growth. Real interest rates often go up during economic expansion, and that is fine.

    Of course since short term rates are stuck at zero, in the short run real rates will fall with higher inflation expectations. But real longer term rates may rise, and I’m fine with that.

    Mike, I’d cut the payroll tax rate for all incomes, and extend the Bush tax cuts for all groups. And cut spending. that would do far more.

    I don’t believe in multiplier estimates, it depends on too many conditions. What type of tax cut, for instance. But in general, I prefer tax cuts to spending increases, for supply-side reasons. Payroll tax cuts can also reduce wage rigidity problems.

    David, Good point, and I should clarify. I believe we have involuntary unemployment due to wage stickiness combined with an adverse nominal shock. I am trying to move labor markets to where they would be if we had complete flexiblity, and people could immediately move to their preferred working hours. I worded that poorly.

    I meant that I am not trying to force people to buy junk they don’t want.

    123, I’ll take your word for it. I’ve been so busy I haven’t kept up with my homework–I’m relying too much on memory right now.

    Floccina, I don’t quite follow. How does the median voter relate to free banking?

  27. Gravatar of scott sumner scott sumner
    25. August 2010 at 06:52

    Mattias, That’s a good point.

  28. Gravatar of Doc Merlin Doc Merlin
    26. August 2010 at 00:46

    Woe to us, at the whim of economic planners at the fed!
    If only there was a market alternative to centrally planned monetary policy!

    Scott, you rail at the fed’s incompetence, yet you haven’t come to the free banking side yet. You should join us, we have cookies.

  29. Gravatar of Doc Merlin Doc Merlin
    26. August 2010 at 00:48

    “Floccina, I don’t quite follow. How does the median voter relate to free banking?”
    The idea as that in politics, more or less, the direct will of the median voter gets carried out (roughly). The median voter knows crap about monetary policy, so the fed tends to be pretty bad at monetary policy. We really need a money supply that isn’t controlled by boards or bureaucrats or politicians… and that is what free banking supplies us with.

  30. Gravatar of Doc Merlin Doc Merlin
    26. August 2010 at 00:54

    @Contemplationist

    Sticky wages are completely unnecessary to the story in this recession.
    1. As was pointed out to me on a different thread, per unit labor costs are falling.

    2. Once you allow for very heterogenous labor and expectations of marginal labor cost increases outside of wages (expectations of social security costs increasing and employment taxes increasing)

    3. Wage floors both in the form of the new healthcare legislation and a massive increase in minimum wage, explain a lot of the unemployment.

  31. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    27. August 2010 at 05:04

    Another Kocherlakota-Bullard connection. Bullard says Japan is in a bad unintended deflationary equilibrium. David Andolfatto uses Japan to defend Kocherlakota’s speech:
    http://newmonetarism.blogspot.com/2010/08/how-to-get-worked-up-over-nothing.html?showComment=1282844056026#c3680255490758653977

    Is there a paper available that properly analyzes Japan that could be used in a debate with Kocherlakota/Bullard/Andolfatto?

  32. Gravatar of scott sumner scott sumner
    27. August 2010 at 17:02

    Doc Merlin, I favor having the market set policy.

    123, I left a comment over at the really long Nick Rowe thread. My second comment argues Japan doesn’t support Kocherlakota at all.

    I have some posts on Japan, but I don’t know of a specific paper.

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