I wish the Fed would stop toying with us

We know they are anxious to raise rates. Fed officials keep talking about how they’ll act aggressively when the time comes, and hint that it might be sooner that we expected.  What better time than now?  It would give Obama a chance to do another $800,000,000,000 fiscal stimulus, to once again “save or create” 3.5 million jobs.  The BLS just reported the rate of job loss, which had been slowing, is now accelerating again.  There were 200,001 jobs lost in August, and 263,000 lost in September.  Unemployment rose to 9.8%, and is headed over 10% next year.  Manufacturing orders were expected to be up 0.7% and instead fell by 0.8%.  Now’s the time!   Oh, and weekly unemployment claims were also worse that expected.  And it looks like the UAW, oops, I mean GM and Chrysler will need another bailout; expect an announcement one day after the midterm elections.  And to top it all off, here’s what the Wall Street Journal says about the new President of the Minneapolis Fed, who will soon be determining our monetary policy:

In this paper, presented at the International Monetary Fund in April, Mr. Kocherlakota argued in a very theoretical paper that instead of cutting interest rates when the housing bubble burst, the Fed should have raised them

When I tried opening the link my computer froze up.  I’m hoping he said the Fed should have adopted an expansionary monetary policy aimed at boosting NGDP growth to 5%, in the hope that higher inflation and real growth expectations would also raise nominal interest rates.  But somehow I have a feeling that’s not what the WSJ meant by “the Fed should have raised them.”  Let me know if anyone is able to ascertain the reason behind his policy advice.  BTW, I do know that Kocherlakota is a very distinguished economist.  And I know that you can’t rely on press reports like the following tidbit from the WSJ:

The Minneapolis Fed has hired a very unconventional University of Minnesota professor to serve as its new president. Narayana Kocherlakota served as chairman of Minnesota’s economics department for three years. He’s written lots of out-of-the-box papers, including this one in which he argues that money is a primitive form of memory whose main purpose is to help individuals and businesses keep track of their transactions:

If they described my research it would sound equally silly.  The only thing that has me slightly worried is this:

The brainy Ben Bernanke might have somebody in the room who is as smart as him. The new guy graduated from Princeton when he was 19 years old.

One of those guys . . .

Part 2

Another thing that bugs me is when they describe FOMC members as “doves” and “hawks.”  Being an inflation dove or hawk should be an immediate disqualification from being on the FOMC.  The only issue should be whether they are competent or not.  It is not the Fed’s job to determine the goals of monetary policy.  Congress needs to decide what sort of rate of inflation constitutes “price stability.”  That doesn’t necessarily mean the Fed should engage in inflation targeting, there are lots of other options like the Taylor Rule, or NGDP growth targeting, but Congress really should come up with some sort of definition for price stability.  If not, the Fed should decide on it through a vote, which would be completely separate from the day-to-day decisions about monetary policy.  Once the vote is taken, everyone should fall into line like a good soldier.  It doesn’t matter whether a US military officer thinks the Iraq War was a good idea, their job is to carry out policy.  The same should be true of FOMC members.  I am neither an inflation hawk nor dove.  If I was on the FOMC and Congress voted for a 2% NGDP growth target, I’d look for ways to gradually tighten monetary policy.

Part 3

People keep telling me how popular my blog has become, but I still think it is only popular within a very narrow demographic.  Here is a NYT story talking about negative interest rates on reserves.  The point of the story is . . . well, I’m not quite sure.  They say that contrary to popular impression the goal of the policy is not to make market interest rates negative.  So far, so good.  And what is the goal of the policy?  The NYT forgets to answer that question.  I didn’t go to journalism school, but isn’t “why” one of the questions that you are supposed to address?  They could have just asked me.    (BTW, the goal is to raise the money multiplier.)  HT:  Tyler Cowen


I still don’t have an Intrade account, although they keep insisting I do.  As a result I was not able to bet on Brazil today, despite being strangely confident that they would win.  BTW, remember when we were told that the US was unpopular because of President Bush?  I suppose there was a grain of truth, but really, would you cancel a holiday on the Amalfi Coast because Berlusconi was president of Italy?  Anyway, now we have a President who is loved by everyone overseas.  He goes to Copenhagen to persuade the IOC to put the Olympics in Chicago.  We are heavily favored to win.  And we end up in 4th place out of 4 cities, behind even Tokyo?  How does something like that happen?

Part 5

I love hot weather.  But now climate experts are suggesting that there may be one or two decades of cold weather before the heat arrives.  Great, so I get to suffer the adverse economic consequences of futilely trying to stave off global warming, only to drop dead right before it warms up.  And I live in Boston.

Just shoot me.

PS.  For you libertarians, some humor from a Yahoo article discussing America’s richest cities:

The fact that residents of these wealth centers bring in over $100,000 per year is hardly surprising. Some of these places create wealth, like Washington, where the U.S. government is a robust employer, or San Jose, a tech-industry hot spot. Others, like the Bridgeport area, are where powerful executives make their home–and bring their paychecks–after a long week in the big city.



21 Responses to “I wish the Fed would stop toying with us”

  1. Gravatar of Cameron Cameron
    2. October 2009 at 19:19

    Even if the fed is really worried about high inflation in the future wouldn’t eliminating the interest on reserves and reducing the size of the balance sheet now make more sense than raising the fed funds rate in the future?

    This would
    1) allow the fed to have a more stimulative policy right now.
    2) reduce the chance for very high inflation that was created by doubling the size of the balance sheet.
    3) give the fed plenty of time to react to raise interest rates. In 2003-2005, the fed actually cut rates when they should have raised them, left them at 1% for an entire year and raised them too slowly when they finally did start to react… and the resulting inflation was… 4%? (Sure they may have contributed to a housing bubble, but is anyone really concerned about creating another housing bubble now?)

    Apparently the fed believes that the benefits of a bigger balance sheet exceed the costs of potentially much higher inflation and a tighter monetary policy right now. They could be making a huge mistake.

  2. Gravatar of Jon Jon
    2. October 2009 at 19:49

    I’m not familiar with the article in question, but I’ve seen this idea before.


  3. Gravatar of malavel malavel
    2. October 2009 at 22:33

    From the PDF:
    “Bail Out Landowners And Raise Interest Rates

    There are two related, but distinct, problems in the economy after the bubble’s col-
    lapse. First, entrepreneurs have lost wealth. This fall is responsible for the immediate adverse
    impact on aggregate variables. Second, the equilibrium interest rate has fallen from 0 to −δ.
    This fall is responsible for the long-term adverse impact on aggregate variables. The govern-
    ment can readily fix both these problems with a two-part intervention.
    Suppose the bubble bursts at date t. The per-capita wealth loss of the entrepreneurial
    sector equals p∗
    . The government hands out bonds to entrepreneurs. The distribution of this
    handout across entrepreneurs is really irrelevant, as long as the bonds promise to pay p∗
    next period per-capita. Assuming that the interest rate is 0, this injection restores per-capita
    entrepreneurial wealth to what it would have been in the absence of the bubble’s bursting.
    The above injection of wealth cures the first problem created by the bubble’s collapse.
    The second problem is that savers are accumulating wealth through a low rate of return vehicle
    (storable capital goods). The government can cure the second problem by committing itself
    to borrow at the real interest rate 0. The savers will lend to the government at this high
    interest rate, but the investors will not. Now the law of motion of per-capita wealth in the
    29economy mimics that in the deterministic bubbly steady-state:
    Wt+s = βπWt+s−1(1 − δ + α(βπWt+s−1)
    )+ β(1 − π)Wt+s−1
    Assuming ε is small (so that Wstoch is close to Wbub), this law of motion implies that, as in
    the deterministic bubbly steady-state, wealth is constant at Wbub. To implement this policy,
    the government has to repay β(1 − π)Wt+s at each date (t + s). It can readily afford this
    repayment because in period (t + s),itraises β(1 − π)Wt+s in new funds by its debt issue.
    This policy of raising interest rates may strike some readers as counterintuitive. It is
    in fact standard in economies with borrowing constraints. By their very nature, borrowing
    constraints choke off the demand for loans and thereby force down interest rates. A supply
    of outside government debt allows agents to avoid borrowing constraints by accumulating
    enough saving. However, this extra supply of loans also necessarily raises interest rates.”

    Here’s an html version from google:

  4. Gravatar of malavel malavel
    3. October 2009 at 01:37

    Some more in “C. Current Interventions”:

    “The Federal Reserve is currently lowering interest rates. This policy does not work well in the model economy. Lowering interest rates increases the demand for loans. But all of the potential borrowers are already on their borrowing constraint. As discussed above, the correct solution is to raise interest rates after bailing out holders of land. In this fashion, the savers are encouraged to lend to the government, and the government can serve as an intermediary between savers and investors.”

  5. Gravatar of DL DL
    3. October 2009 at 02:28

    Scott, please comment on David Beckworth’s VAR calculation of the contribution of monetary policy and other factors to the crash of NGDP growth as well as to his preferred measure of the stance of monetary policy — the difference between NGDP growth and the Fed funds rate. They make a lot of sense to me and add some further empirical evidence supporting your view of what happened last year.

  6. Gravatar of Bonnie Bonnie
    3. October 2009 at 03:18


    You may be surprised at the different kinds of people who are reading your blog. Using myself as an example, I’m an information technology strategist for a global firm who has an untamed intellect and has taken an interest in macro economics in order to understand, at least in a general way, the pathology of the financial crisis. I have no relation to economic academia or profession, except in the distantly related way that I deal with micro economics as matter of producing coherent and cost effective business technology solutions. I also participate regularly on political activism forums, and have donated time and technology expertise to political campaigns.

    After spending months of independent study of macro economic and the history of the Federal Reserve with a smattering of political economics, such as works by Milton Friedman, I find your blog easy to read and understand. I’d like to thank you for the time and effort it takes to publish it. It’s been a big help to me in understanding some of the competing ideas regarding the financial crisis that are out there. I have on occasion linked to your blog in some of my discussions with my politically active friends and I’m sure it’s been a big help to their understanding of our situation as well.

  7. Gravatar of Rafael Rafael
    3. October 2009 at 07:25


  8. Gravatar of ssumner ssumner
    3. October 2009 at 07:37

    Cameron, I think you are right, particularly as they are gradually replacing their original special loans to help the banks, with more conventional QE (open market purchases of bonds.) So I would like to see a mix of less ERs and no interest on reserves. The mix should be aimed at a somewhat more expansionary total effect. We have fallen so far below trend that we really could use 6% NGDP growth for a year or two, and then 5%.

    Jon, Bob’s reference to the 1921 recession is not a good analogy. The recession officially began in January 1920, but that is very misleading. Industrial production didn’t fall sharply until late in the year. The monetary base kept rising in the first 3/4 of 1920. Inflation was still a problem until late in the year. After output fell sharply the Fed did cut rates sharply in 1921.

    Malavel, Thanks, but why would he want to bail out landowners? Wouldn’t that create all sorts of moral hazard problems?

    I don’t agree with his credit view of monetary policy, so I am not reassured by what you sent to me. He seems to think the recession was caused by a drop in lending, whereas it was actually caused by a drop in NGDP.

    But I do appreciate your talking the time to collect the information. You saved me and other readers a lot of time.

    DL, I have a new post on David’s study.

    Thanks Bonnie, It is good to know I have readers in a wide range of fields.

  9. Gravatar of ssumner ssumner
    3. October 2009 at 07:43

    Congratulations Rafael, I used to live in Chicago, but I will much prefer watching beach volleyball on the Copacabana on my 52-inch hi def TV.

    I think Marcus also lives in Brazil, so congratulations to him as well.

  10. Gravatar of malavel malavel
    3. October 2009 at 08:36

    Scott, I’m not an economist, so that paper is far too much for me to try to parse. It seems like a very simplified model (not so uncommon in economics I suppose) and he just goes where the model leads him. There doesn’t seem to be any discussion outside the model. Here’s a few more quotes that might give you an idea.

    First from the introduction:
    “Housing and housing price derivatives are important sources of collateral for loans in the United States. From July 2006 to October 2008, the twenty-city Case-Shiller houseprice index fell by just under 25%. This price decline is often interpreted as representing the bursting of a bubble. The decline is blamed for significant changes in credit markets that began in the second half of 2007, and to a recession that is now dated as having begun in December 2007. There has been a massive and varied government response to these events.

    Motivated by these observations, in this paper I construct a model in which collateralized borrowing plays an essential role in re-allocating capital to its efficient uses. I show that collateral scarcity can generate a stochastic bubble in the price of collateral. I discuss the implications of this bubble’s bursting for aggregates and for welfare. Using the model, I assess several ongoing policy initiatives and propose a specific superior intervention.”

    “I use these two equilibria to construct another one with a stochastic bubble. (Such equilibria can be quite complicated; I deliberately focus on one that is simple.) In this third kind of equilibrium, there is some small probability of the bubble’s bursting at each date. Before the bubble bursts, the land price is positive and constant. After the bubble bursts, the land price reverts to zero forever. Entrepreneurs can exchange any kind of financial contract that is explicitly contingent on the price of land. However, this kind of financial market completeness is not all that helpful, given the aggregate nature of the shock.

    Immediately after the bubble bursts, the entrepreneurs with good projects have little capital available for investment. Macroeconomic aggregates fall dramatically. Entrepreneurs
    have to self-finance their projects, and begin to accumulate physical capital for this purpose. In any given date, much of the accumulated capital in society is used inefficiently because the owners do not have useful projects. The economy transits to a new lower level of economic activity. Entrepreneurs and workers alike mourn the collapse of the bubble. Nonetheless, from an ex-ante perspective, a positive stochastic bubble expands the social pie.

    I discuss a range of possible interventions in the wake of the bubble collapse. The bubble’s collapse creates two related but distinct problems. First, entrepreneurs have lost wealth. Second, entrepreneurs without good projects are accumulating wealth via a low-return savings vehicle. Successful interventions must cure both problems. I argue that several of the current policy moves (including bailing out financial intermediaries) are poorly designed to meet these objectives.”

    He addresses the moral hazard later on:
    “Now suppose that people are aware of the government’s bailout plan. Lenders can now expect their loans to pay a rate of return equal to 0 regardless of the realization of z. Land is risk-free, and so savers no longer hold any physical capital. The law of motion of entrepreneurial wealth is exactly the same as in the deterministic bubbly steady-state throughout the lifetime of the economy, not just after the bubble bursts. As a result, aggregate
    variables and welfare are higher before the bubble bursts because of the government’s post-bubble intervention.

    In reaching this conclusion, it is important to keep in mind two critical aspects of the intervention. First, the government explicitly allows the bonds used for the bailout to be seized by creditors when the bubble bursts. This feature of the intervention means that the lenders face no ex-ante risk in making their loans against the borrower’s collateral. Second, the government only compensates owners of land. The government does not bail out all holders of Arrow securities.”

  11. Gravatar of rob rob
    3. October 2009 at 09:39

    Re Part 4: I think the unpopularity of Bush-Cheney has had real consequences for the US. Latin America, for instance, (those there can either confirm or deny this point) became much more anti-US than usual. The invasion of Iraq was viewed as part of the same historical continuum as taking Panama from Colombia. We are viewed as imperialists, thanks in part to Bush-Cheney, and this anti-US sentiment has had negative effects,on the margin, of the ability of US companies to do business in, for instance, Latin America. Why is Brazil today looking more toward China to partner in oil projects? And when/if Mexico finally opens up their oil markets, don’t bet on it being to Exxon or Chevron. I voted for Obama because I believed the benefits of the US being viewed by the world as a more morally guided country would outweigh whatever trade his economic policies might destroy. Of course, I could have been wrong.

  12. Gravatar of StatsGuy StatsGuy
    3. October 2009 at 17:33

    Calling Kocherlakota’s paper a toy model is a kindness.

    The whole point of creating a toy model with an economy consisting of entrepreneurial landowners whose only collateral is land and who can only borrow by posting collateral (even though, in reality, we have huge inequalities, uncollateralized loans, and cap/asset ratios of 1/10 or lower) is to create a two state of the world model that supports bubbles and stochastic bubble-popping while keeping the EMH intact.

    I hope and pray that he doesn’t actually believe his research has any application to reality. I do note that even his model insists that prior to raising interest rates, the govt. needed to bail out landowners. Since no (meaningful) bailout of homeowners (e.g. households) occurred, hopefully he would not try to jump right to step 2.

  13. Gravatar of StatsGuy StatsGuy
    3. October 2009 at 17:47

    You’ve probably read this, but just in case you haven’t:


  14. Gravatar of ssumner ssumner
    4. October 2009 at 05:32

    Thanks Malavel, One of the things that bugs me about every single discussion of the housing collapse that I have ever seen, is that economists seem to assume it is a single event. They say “housing prices declined 28%.” But that’s not what happened at all. It was more like “housing prices collapsed 8% when the sub-prime bubble burst, and then fell another 10% when expected NGDP growth fell 10% below trend” Only the first shock was exogenous. In addition, notice that my shocks add up to 18%, not 28%. The C-S index uses great techniques, but selection bias causes it to grossly overstate the size of the national decline.

    rob, I am skeptical on both counts. I think people do business on economic considerations. If the US company has the better product, politics would rarely cause business to go elsewhere. And I am also skeptical that Obama could change this situation (if you are right.) He certainly didn’t have any effect in Copenhagen, and I would expect Olympics votes to be far more political than investment decisions.

    I do think our ridiculous response to 9/11 in terms of security, however, did hurt tourism to the US.

    And I agree that the US is viewed as evil in Latin America, but I have been traveling to Mexico since the 1970s and my impression is that it has always been that way.

    Statsguy, I agree. I might add that all models select and emphasize one or two aspects of the economy that the researcher thinks is particularly important. In general, I think Minnesota economists have rather poor judgment as to which aspects are important. For instance, don’t they emphasize the “store of value” role of cash?

    That’s a great Tim Duy post. I should talk about it.

  15. Gravatar of Jon Jon
    4. October 2009 at 15:28

    In addition, notice that my shocks add up to 18%, not 28%. The C-S index uses great techniques, but selection bias causes it to grossly overstate the size of the national decline.

    In Pasadena house prices actually went up according to the index during the subprime “phase”… is that really so? The short answer is no. The composition of which homes were selling changed though. So yeah, there are methodological problems.

    In this paper, presented at the International Monetary Fund in April, Mr. Kocherlakota argued in a very theoretical paper that instead of cutting interest rates when the housing bubble burst, the Fed should have raised them

    Actually this IS a very interesting claim. His model supports the idea that for those who retain their solvency following the bubble bursting, who continue to generate income, social resources should be as cheap as possible. In this way, those who steered around the bubble gain control of capital at the expense of those did not.

    Thus the monetary pumping economy losses in the long-run because supports every investor, competent and incompetent alike in the short-run.

    This is just the Austrian argument made in the prior link. i.e., that its best to accelerate the liquidation of the incompetent.

    I wonder sometimes whether a market where there appears to be no ‘alpha’ is in fact a bubble market per-se.

  16. Gravatar of Greg Ransom Greg Ransom
    4. October 2009 at 19:15

    “what do we mean by a “constant stance of monetary policy?”

    The original definition of “neutral money” was Hayek’s, which goes something like:

    “a market coordinating money rate of interest which did not create a boom and bust cycle by falsely misdirecting investment through the time structure of production goods”

  17. Gravatar of D. Watson D. Watson
    4. October 2009 at 21:55

    Part 2: I confess, my first reaction was, “spoken like a true dove!” I know you’re not, but it was easy copy.

    More seriously, you write “Once the vote is taken, everyone should fall into line like a good soldier.” This reminds me strongly of how Greenspan ran the Fed, as told by Woodward. Talk to each member individually to ensure their vote and get everyone to behave like a good soldier according to his plan and get unanimity on decisions. I’m not certain that the method didn’t undermine the benefits of having a committee (yes, there are supposedly a few).

    On balance, I’d rather have the Fed determining what monetary policy is rather than Congress because there are very different incentives and knowledge bases going in to each. Putting it to an official vote would improve transparency and ease communication throughout the org, but I would relax the good soldier bit. For something as impossibly complex as a national economy, I’d rather preserve a bit more debate about the what and how.

  18. Gravatar of ssumner ssumner
    5. October 2009 at 05:56

    Jon, You said;

    “In Pasadena house prices actually went up according to the index during the subprime “phase”… is that really so? The short answer is no. The composition of which homes were selling changed though. So yeah, there are methodological problems.”

    I think you are confusing C-S with another index. They only use repeat sales, so there is no composition bias.

    You said;

    “Thus the monetary pumping economy losses in the long-run because supports every investor, competent and incompetent alike in the short-run.”

    This is a good argument against a monetary policy of inflation to bail out bad investments. Of course I oppose that sort of policy, and just favor a neutral policy. But actual policy wasn’t neutral it was highly contractionary as NGDP fell sharply. This took out lots of investors who made quite rational investment decisions. I can’t tell whether Kotherlakota thought monetary policy should have been even tighter and more deflationary, or not.

    Greg, Is this the third straight post where I used that phrase?

    D. Watson, You said;

    “More seriously, you write “Once the vote is taken, everyone should fall into line like a good soldier.” This reminds me strongly of how Greenspan ran the Fed, as told by Woodward. Talk to each member individually to ensure their vote and get everyone to behave like a good soldier according to his plan and get unanimity on decisions. I’m not certain that the method didn’t undermine the benefits of having a committee (yes, there are supposedly a few).”

    No, that misinterprets what I am saying. I totally oppose the dictatorial approach you describe. I believe the policy goals should be determined democratically (like the decision to go to war.) But once the decision is made by vote, each person should try to fulfill that mandate. But how they do so is entirely up to them. They should not let the chairman tell them what to do. They should make their own decision as to how best to achieve the agreed upon nominal target.

  19. Gravatar of Doc Merlin Doc Merlin
    8. October 2009 at 10:57

    I’ve asked other economist professor bloggers this question before, but no one answers me. I was wondering if you could answer this.

    How is the federal reserve setting a target interest rate and inflation not have the same (or substantially similar) problems faced by a central planner (i.e.: the whole socialist calculation debate). I’ve thought a lot about this, and I can’t really see how centrally planned currency is different than centrally planned farming or wheat growing or such.

    I’d like to hear your thoughts on it.

  20. Gravatar of Doc Merlin Doc Merlin
    8. October 2009 at 10:58

    Hrmm, that that sentence was redundant,… should be “centrally planned farming or manufacturing.”

  21. Gravatar of ssumner ssumner
    11. October 2009 at 07:13

    Doc Merlin, The Fed has a monopoly on the supply of base money. In addition, it can be produced costlessly. Thus in principle they can always adjust the money supply to hit any inflation target. And yet there are no artifical “price controls,” the price of each good is determined in the free market.

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