Hetzel on monetary policy during 2008:Q3

Because of the recent surge of comments, it has taken me a while to get to the Hetzel paper.  All the comments suggesting that I was nuts defending Rorty have just made me even more ornery.  Thus after returning from China this blog will abandon economics and devote itself full time to:

1.  Showing that Rorty’s argument against objective truth is indisputably correct.

2.  A review of Borges’ A New Refutation of Time, along with some more recent arguments in favor of his view.

3.  A defense of Schopenhauer’s argument that everyone who has ever lived was essentially the same person, the eternal “I.”

4.  Showing the logical impossibility of free will, which you are free to disregard if you’re not interested.

5.  And finally, an argument you have undoubtedly heard ad nauseum, the implication of Nietzsche’s eternal return for the rate of time preference and the time value of money.

.   .   .


Sorry to scare you.  Now on to Robert Hetzel.  Over the years people like Robert Hetzel and Thomas Humphrey published a lot of good stuff on monetary history at the Richmond Fed.  I’ve always believed that one cannot really understand monetary policy without being a student of monetary history.  Only by studying cases such as how FDR escaped the liquidity trap by devaluing the dollar, can one free oneself from the prison of thinking in terms of monetary policy being ineffective when cash and T-bills have the same rate of return.

Let’s start with Hetzel’s discussion of how an interest rate target must work in order to be effective:

The implication is that monetary policy procedures must stabilize expected inflation so that changes in the central bank’s nominal funds rate target correspond to predictable changes in the real funds rate. These procedures must then cause the real funds rate to track the “natural” interest rate.

The Fed lost control of inflation expectations in the late summer of 2008, and that made the interest rate instrument ineffective.  An effective interest rate rule will impact the entire term structure of rates:

These procedures require consistency (a rule-like character) because of the central role of expectations. What is relevant for macroeconomic equilibrium is not only the real funds rate but also the entire term structure of real interest rates. The central bank requires a procedure for changing the funds rate so
that, in response to real shocks, financial markets will forecast a behavior of current and future funds rates consistent with a term structure of real interest rates that will moderate fluctuations of real output around trend. Moreover, these procedures must be credible in that financial markets must believe that,
in response to shocks, funds rate changes will cumulate to whatever extent necessary to leave trend inflation unchanged (Hetzel 2006 and 2008b).

Notice how he has switched from inflation to real output.  Hetzel argues that the central bank should try to keep inflation relatively low and stable, and also moderate fluctuations in RGDP.  An NGDP rule does both of these things.  Of course if you are going to use interest rates, you must remember that they are not a good indicator of the stance of monetary policy.  If you forget that, you are likely to mistakenly think a macro crisis is fundamentally non-monetary in origin:

From the perspective of the quantity theory, the credit-cycle view of the business cycle leads to the mistaken belief that alternating waves of optimism and pessimism overwhelm the stabilizing role of the real interest rate and, by extension, monetary policy. The reason is because of the association of
low interest rates (cheap money) with recession and high interest rates (dear money) with booms. For example, the Board of Governors (1943a, 10) stated:

“In the past quarter century it has been demonstrated that policies regulating the. . . cost of money cannot by themselves produce economic stability or even exert a powerful influence in that direction. The country has gone through boom conditions when. . . interest rates were extremely high, and it has continued in depression at times when. . . money was. . . cheap.”

The mistake lies in thinking of monetary policy as stimulative when the funds rate is low or as restrictive when it is high.

I have argued that backward-looking Taylor rules are flawed; an optimal monetary policy will attempt to target the forecast.  Here is what Hetzel says:

One important reason that estimated Taylor rules do not express a structural relationship is the misspecification that arises from omitting a central variable shaping FOMC behavior in the Volcker-Greenspan era, namely, expected inflation.

So what went wrong in 2008?

What caused the appearance of a deep recession after almost three decades of relatively mild economic fluctuations? The explanation here highlights a monetary policy shock in the form of a failure by the Fed to follow a decline in the natural interest rate with reductions in the funds rate.  Specifically,the absence of a funds rate reduction between April 30, 2008, and October 8, 2008 (or only a quarter-percentage-point reduction between March 18, 2008, and October 8, 2008), despite deterioration in economic activity, represented a contractionary departure from the policy of LAW with credibility.  From mid-March 2008 through mid-September 2008, M2 barely rose while bank credit fell somewhat (Board of Governors 2009a). Moreover, the FOMC effectively tightened monetary policy in June by pushing up the expected path of the federal funds rate through the hawkish statements of its members. In May 2008, federal funds futures had been predicting a basically unchanged funds rate at 2 percent for the remainder of 2008. However, by June 18, futures markets predicted a funds rate of 2.5 percent for November 2008.

The Fed minutes show they had misdiagnosed the problem in August 2008, by which time the US economy had already been in recession for 8 months:

The August 5, 2008, FOMC Minutes noted (Board 2008, 4, 6): “[T]he staff continued to expect that real GDP would rise at less than its potential rate through the first half of next year. . . . [M]embers agreed that labor markets had softened further, that financial markets remained under considerable stress, and that these factors””in conjunction with still-elevated energy prices and the ongoing housing contraction””would likely weigh on economic growth in coming quarters.”
However, the FOMC, focused on a concern that persistent, high headline inflation would raise the public’s expectation of inflation, kept the funds rate unchanged at 2 percent. The August 5, 2008, FOMC Minutes note (Board 2008, 6): “Participants expressed significant concerns about the upside risks to inflation, especially the risk that persistent high headline inflation could result in an unmooring of long-run inflation expectations. . . . [M]embers generally anticipated that the next policy move would likely be a tightening. . . “

If the TIPS markets aren’t worried about inflation, the Fed shouldn’t be either.  But the Fed was aware that the real economy was steadily deteriorating in the late summer, and chose not to react because of a misguided fear of inflation:

Governor Kohn (2008, 1-2) characterized the behavior of the economy during the summer of 2008: “During the summer, it became increasingly clear that a downshifting in the pace of economic activity was in train. . . .[R]eal consumer outlays fell from June through August, putting real consumer spending for the third quarter as a whole on track to decline for the first time since 1991. Business investment also appears to have slowed over the summer. Orders and shipments for nondefense capital goods have weakened, on net, in recent months, pointing to a decline in real outlays for new business equipment. Similarly, outlays for nonresidential construction projects edged lower in July and August after rising at a robust pace over the first half of this year. . . .[C]onditions in housing markets have remained on a downward trajectory.”

When the financial crisis intensified, the Fed did provide some liquidity, but they forgot that they also needed to continue maintaining adequate NGDP growth going forward—liquidity wasn’t enough:

Macroeconomic Advisers (2008b) wrote: “By abandoning its ‘offset’ approach [of lowering the funds rate in response to tightening conditions in financial markets], the Federal Reserve has allowed financial conditions to tighten substantially. . . . Another reason why the Fed abandoned its approach is that it has focused primarily on expanding its liquidity policies in recent months. The FOMC believes that liquidity policies are more effective tools for providing assistance to market functioning. . . . But even if one accepts (as we do) that liquidity tools are better suited for helping market functioning, monetary policy still has to react to changes in the outlook.”

I have consistently argued that if the Fed had maintained adequate NGDP growth, the financial crisis would have been milder and would not have impacted the real economy as much as most people imagine.  Here is what Hetzel says:

Nevertheless, the turmoil in financial markets and the losses incurred by banks would likely have been manageable without the emergence of worldwide recession.

Had the Fed propped up NGDP, then the financial crisis would not have spread to the rest of the economy.  Instead, NGDP fell sharply and the non-financial sector suffered almost as badly as the banks themselves:

In early fall 2008, the realization emerged that recession would not be confined to the United States but would be worldwide. [NB, Bryan Caplan] That realization, as much as the difficulties caused by the Lehman bankruptcy, produced the decrease in equity wealth in the fall of 2008 as evidenced by the fact that broad measures of equity markets fell by the same amount as the value of bank stocks. Between
September 19, 2008, and October 27, 2008, the Wilshire 5000 stock index fell 34 percent. Over this period, the KBW bank equity index fell 38 percent.

Hetzel reached the same conclusion that I did; the intensification of the recession in late 2008, which began before Lehman failed, was misdiagnosed:

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. By then, U.S. financial markets were reasonably calm.  The intensification of the recession began before the financial turmoil that followed the September 15, 2008, Lehman bankruptcy.   Although from mid-2007 through mid-December 2008, financial institutions reported losses of $1 trillion dollars, they also raised $930 billion in capital””$346 billion from governments and $585 billion from the private sector (Institute of International Finance 2008, 2).

And then there is also this:

Payroll employment, which is measured in the first week of the month, declined by 284,000 in September 2008 compared to the average decline of around 60,000 from February through August (11/7/08 BLS release). The decline of 240,000 jobs in October 2008 does include two weeks of the financial turmoil in the last half of September, but the lag is too short to have produced significant layoffs. The Dunkelberg and Wade (September 2008) survey of small business owners did not record deterioration in the availability of credit to small businesses between the first and last part of September 2008.

Because the problem was misdiagnosed, the Fed relied on policies that were ineffective—designed to prop up the financial system—when the deeper problem was sharply declining NGDP:

Perhaps the scale of this intervention in credit markets has simply been insufficient to overcome financial market malfunction. Still, the scale of the intervention has been vast. If the problem has not been financial market dysfunction but rather has been misalignment between the real funds rate and the natural rate, then intervention in credit markets will only increase intermediation in the subsidized markets. Those subsidies will not reduce aggregate risk to the point that the overall cost of funds falls enough to stimulate
investment by businesses and consumers. Government intervention in credit markets is, then, not a reliable tool for the management of aggregate demand because such interventions do little to reduce the public’s uncertainty and pessimism about the future that have depressed the natural rate.

That didn’t work in the Depression, and there was no reason to think it would work this time:

Just as in the Depression with the use of the Reconstruction Finance Corporation to recapitalize banks, the focus of current monetary policy is on encouraging financial intermediation

.   .   .

dealing with the ZLB problem is a deficiency.Two key points; they need an explicit inflation target, and if they don’t have one they will struggle with the zero lower bound on interest rates, aka the liquidity trap.

The alternative road lies with the extension of the policy changes taken in the Volcker-Greenspan era. In this spirit, the FOMC should be willing to move the funds rate up and down to whatever extent necessary to respond to changes in rates of resource utilization. The issue then is credibility. With credibility, in the event of an inflation shock, the FOMC can still move the funds rate down to zero without an increase in inflationary expectations. The absence of an explicit inflation target voted on by the entire FOMC would
appear as a weakness in current procedures. An explicit inflation target then raises the issue of how to interpret the Fed mandate for “stable prices” and whether that part of the mandate conflicts with “maximum employment.” Also, as discussed in the next section, the absence of an explicit strategy for

The entire article is worth reading.  There is a lot more interesting stuff on why the Fed erred in 2008.  Also some good stuff on the Great Depression.  What’s most surprising, however, is that Hetzel reaches the same basic conclusions as I have, without once discussing the idea of targeting financial market forecasts of inflation.  Hetzel was one of less than a dozen people who published papers advocating targeting the forecast, and almost all of them have since argued (at least implicitly) that monetary policy was too tight in late 2008.  It would be interesting to know whether Hetzel’s earlier work on targeting the forecast led him (perhaps only subconsciously) to this critique of Fed policy.



21 Responses to “Hetzel on monetary policy during 2008:Q3”

  1. Gravatar of Paul Paul
    6. August 2009 at 04:05

    Hi Dr. Sumner,

    First I wanted to say thank you. I am a recent grad with a degree in Economics and also in Finance. I started reading your blog about a week ago, and I have loved it so far. I (and I am sure everyone else) really appreciate the fact that you actually respond to comments. I was having a little trouble understanding this last blog (memories from my money and banking class from school came back to me). But specifically I was wondering what you meant by the Fed should have targeted NGDP. Do you mean by open market transactions, like buying treasuries? As opposed to what they did by lowering the Fed Funds Rate?

    And to summarize, is Heztel pretty much saying that an explicit inflation target coupled with open market transactions and a readily adjustable Fed Funds rate would have been the solution (or a better one at least)?

    Thank you again!

  2. Gravatar of ssumner ssumner
    6. August 2009 at 05:11

    Paul, Thanks for the comments. A few months ago I discussed how the Fed could create a NGDP futures market, and target the forecast. If they do not do this, they need to use instruments like interest rates and changes in the monetary base to implement their policy. The target path must be explicit, and also “level targeting” where the entire future target path of NGDP is explicitly laid out. Another key is to promise to make up for any under- or overshooting in the following period.

  3. Gravatar of Bill Woolsey Bill Woolsey
    6. August 2009 at 05:50


    You quote Hertzel as stating that financial markets should forecast future real interest rates as being consistent with real income fuctuating around trend.

    Isn’t it better to say that they forcast real interest rates at levels consistent with real output fluctuating around potential real output?

    Since we are aready describing policy in terms of the unobservable natural interest rate, why not go with unobservable potential income too?

    With index futures targeting for a growth path of nominal income, the forecast of the term structure of interest rates would be consistent with nominal income remaining on target. The price level and the level of real output and income, the inflation rate and the growth rate of real output and real income can all fluctuate.

    At some point, devotion to targeting the nominal federal funds rate and for the price level to rise at a 2% rate from its current level, whatever that is, is going to result in differences in analysis from nominal income targettting.

    Thinking back to your proposal to “abolish” inflation, can you transform Herzel’s argument to nominal interest rates and nominal income?

    Index futures targetting must result in levels of nominal base money so the term structure of nominal interest rates is such that people expect nominal income to remain on the targetted growth path? Can nominal interest rates just be dropped from the account?

  4. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    6. August 2009 at 06:36


    I’m not an economist, but I generally agree with you. This quote from Hetzel interested me:

    “The failure of Lehman Brothers on September 15, 2008, created uncertainty in financial
    markets. Hetzel (2009a) argues that the primary shock arose from a discrete increase in risk due to
    the sudden reversal of the prevailing assumption in financial markets that the debt of large financial
    institutions was insured against default by the financial safety net. A clear, consistent government
    policy about the extent of the financial safety net would likely have avoided the uncertainty arising
    from market counterparties suddenly having to learn which institutions held the debt of investment
    banks and then having to evaluate the solvency of these institutions. Nevertheless, the turmoil in
    financial markets and the losses incurred by banks would likely have been manageable without the
    emergence of worldwide recession.”

    This has been my view. However, unlike you, I’ve focused on the Government Guarantee aspect of our crisis. Yesterday, I posted this on Justin Fox’s blog:

    That led me to finding this:


    Although I remember reading it somewhere else. This article was a major influence on me, because it mentioned the S & L Crisis and Fisher’s Debt Deflation, both of which I had read a lot about, but hadn’t connected so clearly to this crisis. After reading that essay, I felt that I had a much clearer grasp of what we were facing.

    Prior to reading this essay, my opinion was that the govt had implicitly guaranteed everything, and that guarantee would be effective in avoiding a panic or major run on any assets. Boy was I wrong.”

    What I was saying is that, prior to Lehman, I had assumed that the govt had actually explicitly guaranteed everything, and that The Fed had been easing the money supply to avoid a panic. I turned out to be wrong.

    But, I believe that, even though we avoided a Debt-Deflationary Spiral, we’ve had a kind of slow motion version of Debt-Deflation. Although it’s still controversial, I believe that the fact that job losses have been outpacing the drop in Real GDP validates Fisher’s view. Do you see Fisher’s Debt-Deflation model having any value in your views of this crisis?

    I realize that this question largely pertains to me, but even a few quick comments would be much appreciated.

  5. Gravatar of Mesa Mesa
    6. August 2009 at 08:21


    The idea of targeting some macroeconomic observable seems to make sense if the market beleives that’s what the Fed is really doing. But can anyone explain why **nominal** output make sense? The problems with CPI (hedonics, etc) arise over longer periods of time, but surely it’s quite possible to accurately compare this years prices (say GDP weighted) to last years?. So if we accept that, how can a fixed amount of real output with 6% price inflation be the same feedback input to the Fed as a 6% increase in real output with 0% price inflation? Aren’t those very different macro-economic scenarios? What am I missing?

  6. Gravatar of Bill Woolsey Bill Woolsey
    6. August 2009 at 10:53

    Stablizing nominal expenditure or the price level both require avoiding an imblance between the quantity of money and the demand to hold it. A surplus of money raises both the price level and nominal income. A shortage of money lowers both the price level and nominal income. Maintaining a target for either one means that the nominal quantity of money must adjust to the demand to hold money.

    However, if there are changes in the productive capacity of the economy, a stable price level requires flucuations in nominal income and stable nominal income requires fluctuations in the price level.

    In my view, the better rule is the one that provides the best envirornment for proper microeconomic adjustments. If there is a reduction in the productive capacity of the economy, what is it that workers and other resources owners are supposed to do when there are surpluses of their resources at the current growth path of resource prices? Well, what they are supposed to do is lower their resource prices, and so their nominal incomes. Are they supposed to work less? Invest less? Why?

    Suppose productive capacity is growing extra fast. Nominal incomes grow extra fast. How? Well, shortages at the current growth path. What does that signal? Well, raise resources prices and nominal incomes. But are people supposed to work extra hard?

    I think prices rising or falling to reflect a temporarly less porductive or more productive economy provide the better signal–use fewer or more goods.

    I think it is important to think about sectoral shifts and the redeployment of labor and other resources. Surpluses should mean, shift to producing something else. Shortages should mean, expand here. Pull resources away from the rest of the economy.

    If we think of adverse productivity shocks to the system as a whole, surpluses of resources don’t mean, do less of this, do something else. And shortages of products do mean, produce more if you can. Maintaining nominal income growth looks good.

    With a favorable shock, the shortages of resources don’t mean, produce extra here (and less elsewhere.) And the lower prices properly mean, use more.

    But both a stable growth path for prices and nominal incomes avoid the horrible policy of… surpluses of goods and resources.. But don’t produce less of anything. Produce the same stuff, just quote lower prices so the real quantity of money will be higher. People want to hold more money.

    Or conversely, shortages of goods and services, but don’t produce more of anything. Produce the same, but quote higher prices so the real quantity of money is lower. People don’t want to hold as much money.

    Perhaps if you assume that all markets always clear instantaneously, then you would have a different perspective. I realize that real business cycle theorists really believe that recessions involve low real wages and people responding by staying home to paint their houses or take vacations. I do always need to remind myself that it is possible. Just because I and most everyone I know (being middle class types of folks) need to work pretty much all the time to maintain ourselves in the style we think we need, that doesn’t mean that there aren’t people who can afford to take extended periods of unpaid leave to travel the world or lay around the shanty until the money runs out.

  7. Gravatar of Jon Jon
    6. August 2009 at 11:37

    I agree that tight policy in 2008 caused a decline in NGDP, but I disagree strongly that this was necessarily when the policy mistake occurred.

    To continue our previous discussion, you’re suffering a bit of hindsight bias. Had the Fed acted differently we might have had no ‘recession’ and still have had an inflation problem.

    I think that fundamentally the Fed was in a bind. It could not solve both problems: 1) the establishment of an inflation expectation in the range of 5% and 2) the slowdown that resulted when realized inflation broke below expectations but remained above the Fed’s informal target.

    The policy mistake thus occurred much earlier when the Fed allowed inflation expectations to rise. Once this had happened the Fed was in a catch-22.

    Inflation expectations are a one way ratchet unless you are willing to induce recessions. Its not just a question of accepting past above-target increases in the price-level.

  8. Gravatar of ssumner ssumner
    6. August 2009 at 11:42

    Bill, You said,

    “Isn’t it better to say that they forecast real interest rates at levels consistent with real output fluctuating around potential real output?

    Since we are already describing policy in terms of the unobservable natural interest rate, why not go with unobservable potential income too?”

    Yeah, you are right. I guess because he had a lot of things I liked, i kind of went easy on the questionable stuff. As you know I don’t like the Taylor rule approach of segmenting NGDP into inflation and RGDP deviations from the natural rate. Too much guesswork. NGDP is much simpler, and that’s a huge virtue when trying to establish credibility.

    You said:

    “At some point, devotion to targeting the nominal federal funds rate and for the price level to rise at a 2% rate from its current level, whatever that is, is going to result in differences in analysis from nominal income targeting.”

    I have been thinking about this issue. I wish we had a clear market forecast of NGDP. But I’m guessing that within a year I’ll need to make a choice. I can’t be a monetary crank forever, I will need to transition over to advocating a proper diagnosis of what went wrong, and a monetary regime that will avoid repeating these mistakes. But i don’t thin we are there yet, the two year inflation number is too low in my view, and although I think Krugman is right about the recovery likely being slow, I think it could go faster with a more aggressive monetary policy. Only when it is too late to help will I transition over.

    You said:

    “Thinking back to your proposal to “abolish” inflation, can you transform Herzel’s argument to nominal interest rates and nominal income?

    Index futures targetting must result in levels of nominal base money so the term structure of nominal interest rates is such that people expect nominal income to remain on the targeted growth path? Can nominal interest rates just be dropped from the account?”

    It can be transformed into an NGDP argument. And I agree that if you are relying on market forecasts, interest rates just drop out. You do OMOs until expectations are on target, and whatever term structure of interest rates results when you are targeting the forecast, is presumably the term structure that the market thinks is consistent with on-target NGDP growth.

    Don, First, I’m not sure the job losses do outpace the fall in RGDP. Krugman has a recent post where he says they don’t, and while I often disagree with Krugman, he has pretty good judgment about technical issues like Okun’s law.

    I don’t have strong view on the whole debt-deflation thing. I think one of Bernanke’s mistakes was to focus too much on the banking system and not enough about directly stopping the fall in NGDP. But that doesn’t mean debt-deflation is not an important transmission mechanism, it may be important. And the assistance he gave banks may have helped a bit. But my “off the top of my head” view is that the government got LTCM, Bear Stearns, and Lehman all wrong. The first two should have been allowed to fail (to scare investors and reduce moral hazard) and given the first two were rescued, Lehman also should have been rescued because the shock was just too great, and at the worst possible time (when the economy was already starting to fall fast.) That’s a provisional view, and I would gladly reconsider with more information.

    I doubt this answers your questions, but it gives something of my perspective.

    mesa, It’s because we are used to thinking about inflation, not NGDP. but arguably it is NGDP fluctuations that cause business cycles. If NGDP falls then wages need to fall. but because wages are sticky you will get unemployment. In contrast, if the CPI falls you do not get unemployment if it is due to higher productivity. In that case RGDP can rise and prices can fall, and the overall economy can do OK. It is because wage stickiness is the biggest source of unemployment, that I think stabilizing NGDP will best stabilize the economy.

    You are right that the two 6/0 and 0/6 situations you mention are very different. But they are different in ways that monetary policy can do nothing about. If you get 0% RGDP growth and 6% inflation because of a really bad oil shock, the hard truth is that workers will just have to take their lumps and accept lower real wages. No amount of printing money will prevent that. If you get the reverse due to very fast productivity growth, then workers will get real wage increases as nominal wages will greatly outpace the 0% inflation, and that is as it should be when productivity is strong.

    Bill, I have to learn to read your replies first, I could save myself a lot of time replying.

  9. Gravatar of David Beckworth David Beckworth
    6. August 2009 at 13:04

    Bill Woolsey:

    Based on your post above, I am guessing you would support George Selgin’s Productivity Norm Rule
    that has nominal income growing at the expected rate of factor input growth. This approach would stabilize input prices but allow output prices to inversely move with productivity growth. So do you favor nominal income targeting rule simliar to Selgin’s?

  10. Gravatar of Leigh Caldwell Leigh Caldwell
    6. August 2009 at 16:51

    Hi Scott

    As you know, I have been reading for a while and give a lot of credence to your ideas. And the following question is not a disagreement, merely a request for clarification. In the last couple of weeks something has become unclear to me.

    You strongly believe that money is (or has been) tight; the low level of interest rates you see not as a cause of loose money, but a consequence of tight money. Is that correct?

    My question, then, is: what is your evidence that money is tight?

    1. Do you infer that: NGDP has fallen, therefore money must be tight?

    2. Or do you have other evidence that money is tight; which would empirically reinforce your view that tight money is correlated with a fall in NGDP?

    1 is certainly a valid position, but strongly relies on a monetarist macroeconomic model. An economist opposed to your view could simply disagree with that model, and would come to different policy conclusions (just as a random example, we need a bigger stimulus).

    Position 2 would be more convincing because it would provide empirical evidence for your model’s predictive power. If 2 is your position, what is your reason to believe money is tight?

    Again, I don’t necessarily disagree with your point, but I’d like to make sure I understand it fully.

  11. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    6. August 2009 at 18:16


    Thanks for your comments. I used this post for Okun’s Law:


    Maybe I misread it.

    Take care,


  12. Gravatar of ssumner ssumner
    7. August 2009 at 05:55

    David, I don’t know about Bill, but my view is that the key macro problem is the price of labor. Earl Thompson calls for stabilizing a wage index, and I once wrote a paper making a similar argument. But for various reasons I think NGDP targeting would work better in the real world.

    I do think Selgin has a strong argument, however.

    Leigh, Good question. Back in February and March I talked a lot about Lars Svensson’s argument that the Fed should target the forecast. Thus policy should be set in such a way that the forecast of the goal variable equals the target for the goal variable. In even simpler terms, don’t set policy at a level where you expect to fail. If your goal variable is 5% NGDP growth, then money is too tight when expected NGDP growth is below 5% and too loose when NGDP growth is above 5%.

    I also believe in level targeting. So if you fall short one year, you try to catch up over the next 12 months. Because I started the blog in early February, I arbitrarily took 2009:Q1 as the starting point. This was actually a very conservative (or inflation hawkish) starting point to choose as the economy was already severely depressed. As David Glasner has observed we actually needed faster than 5% NGDP growth to catch up. But I didn’t want to confuse the issue by being viewed as an inflationist, so I chose 5% for simplicity. Thus NGDP growth path would be 1.25% per quarter. Since the actual (non-annualized NGDP fell 0.2% in 2009:Q2, we fell 1.45% below the target path. Thus I now call for 6.45% NGDP growth between 2009:Q2 and 2010:Q2, as my new target. Right now inflation expectations over the next 12 months are very low, barely above zero. We don’t know RGDP expectations, but everyone seems to agree that they are far below 6%. Hence the policy stance is now too contractionary, as we are expected to fall short of the policy target. In other words:

    Money is tight.

    A few months ago I looked at 7 indicators of the stance of monetary policy late last summer and last fall. All seven showed money was tight:

    1. TIPS spreads went negative
    2. real rates soared
    3. The dollar surged against the euro
    4. Industrial production plummeted
    5. Non-subprime housing market prices started falling sharply
    6. Stock prices crashed
    7. Commodity prices crashed.

    The other side points to low nominal interest rates, which are a useless indicator. The base, which means nothing now that the Fed is paying banks to hoard reserves, and the broader monetary aggregates, which were discredited in the 1980s.

    Don, You may be right. I recall Krugman responded to a similar argument a few days ago, or maybe a couple weeks back, i am not sure. You might check out what he says, because he was contesting an argument someone else made. So I think it might be an open question.

  13. Gravatar of Jon Jon
    7. August 2009 at 15:23

    The other side points to low nominal interest rates, which are a useless indicator. The base, which means nothing now that the Fed is paying banks to hoard reserves, and the broader monetary aggregates, which were discredited in the 1980s.

    Who points to broad money to defend a “Fed is loose position”? The broad money numbers show a very strong break in the secular trend.


  14. Gravatar of ssumner ssumner
    8. August 2009 at 05:06

    Jon, The Fed no longer tracks M3. But M1, M2 and MZM have all accelerated since the recession began.

  15. Gravatar of Jon Jon
    8. August 2009 at 07:02

    Scott: M3 data is available from several sources other than the Fed–one of which I gave. What’s your point there?

    M1 and MZM are clearly not broad money measures and will rise during any ‘flight to liquidity’. M2 by its components has the same story.

  16. Gravatar of TheMoneyIllusion » The Wizards of Oz TheMoneyIllusion » The Wizards of Oz
    8. August 2009 at 13:59

    […] weren’t doing that bad.  Then the Fed adopted a highly contractionary monetary policy (see Hetzel’s discussion of what they did wrong) and NGDP starting falling fast.  And now we have 9.4% unemployment, and a […]

  17. Gravatar of The Wizards of Oz The Wizards of Oz
    8. August 2009 at 16:49

    […] So we weren’t doing that bad. Then the Fed adopted a highly contractionary monetary policy (see Hetzel’s discussion of what they did wrong) and NGDP starting falling fast. And now we have 9.4% unemployment, and a […]

  18. Gravatar of ssumner ssumner
    9. August 2009 at 05:39

    Jon, You may be right. I think what goes on here is that most economists now pay little attention to the aggregates. So when they read a famous monetarist like Meltzer saying money is easy because the money supply is growing fast, they just assume that the aggregates are not the problem. The argument against monetarism (for which I have some sympathy) is that when one aggregate would fail the monetarists would simply shift to another.

    You may be completely right about M3 being the most appropriate aggregate, but I am giving a sociological explanation of what went wrong. And for better or worse almost all economists did believe the aggregates showed monetary ease. If even the Fed has discontinued M3, then many economists will assume that there is something wrong with M3.

    I completely agree that the rise in M1 and M2 and MZM was heavily driven by a flight to quality.

  19. Gravatar of Jon Jon
    9. August 2009 at 14:13


    I was not trying to particularly take the position of policy-by-aggregate. I was merely responding to the claim that people point to aggregates and claim policy was loose. On which point I have two remarks

    1) M1-M2 seem to exhibit a flight to liquidity effect not a loose policy
    2) M3 does not support the claim

    To be clear here, I’m not advocating M3 as a magical index. Nonetheless, I think certain gross features are noteworthy. M3 growth has very much stalled–which I think its plausible but not dispositive warning that money is tight. Similarly, this comes after a fairly lengthy period wherein M3 grew 10-15% a year. Again, I consider gross features like that to be cause for concern even if they are not QED.

  20. Gravatar of ssumner ssumner
    10. August 2009 at 05:53

    Jon, The difficulty here is that ex post you are probably right, the growth stall may reflect tight money. But ex ante we probably wouldn’t have relied on M3 because obviously the earlier 10-15% growth did not reflect extreme ease, as NGDP grew very slowly between 2007 and 2008.

    Because I don’t trust the aggregates, I ignore them and focus on indicators that I do trust.

  21. Gravatar of economic stability economic stability
    21. August 2009 at 16:13

    economic stability…

    Your topic Internet & Democracy Blog ” Lessig stars at the Stanford FCC hearing was interesting when I found it on Friday searching for economic stability…

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