Five years ago today I became a market monetarist.  For the preceding 26 years I’d never really had strong views on monetary policy. Then I became enraged when the Fed refused to ease policy in its September 16, 2008 meeting, two days after Lehman failed.  At the time output was in free fall and inflation was plunging sharply.  Yet the Fed decided to stand pat, citing fears of both recession and inflation.  In fact, five year TIPS spreads showed 1.23% inflation.  I’m told that the Fed didn’t believe these numbers.  Too bad, as they proved to be pretty accurate.

Ironically, at the time this happened I was working on a sort of “monetary offset” paper explaining why economists could not predict recessions.  The basic idea was that:

1.  The Fed does what the consensus of economists wants them to do.

2.  The Fed wants to prevent recessions.

3.  Ergo policy will be set in such a way as to prevent a situation where the Fed expects a recession.

4.  Ergo the consensus of economists will also not expect a recession.

James Hamilton put it more succinctly:

“You could argue that if the Fed is doing its job properly, any recession should have been impossible to predict ahead of time.”

My second blog post was on this topic (the first was on IOR).

The September 16 meeting blew my hypothesis right out of the water.  Which made me angry for three reasons; loss of a clever idea, loss of 401k wealth, and unnecessary suffering caused by mass unemployment.

Yes, the 2007-09 recession was not predicted by economists, so technically my theory was still intact.  But I knew that the September 2008 meeting undercut the spirit of the idea.  Things were going to get a lot worse in 2009, and yet the Fed was going to passively let it happen.  That made me a radical.

PS.  I’d appreciate any information you have on how TIPS spreads of various maturities responded to the Summers news.  BTW, if my calculations are correct the expected yield on a 20 year bond issued 10 years from today seems flat or slightly higher.

PPS.  Saturos sent me a link to a good post by Eliezer Yudkowsky on what this tells us about the prospects for global rationality.

PPPS.  Off topic, people keep asking me about this Tyler Cowen post.  I agree with the summary sentence:

The “nominalist” approach was absolutely correct for 2008-2009, it is simply becoming less correct as time passes, which is exactly what standard economic theory suggests.

I would simply add that “less important” is still very important.  I believe that about 20% our unemployment is caused by tight money, down from 40% in October 2009.

PPPPS.  Even though I didn’t notice that monetary policy was off course until September 2008, a market-oriented approach (NGDP futures targeting) would have noticed sooner, and corrected the problem sooner.

HT:  Kevin Tryon

Update:  In the comment section John Hall has data suggesting not much impact on TIPS spreads, albeit the 10-year may be up a couple basis points.  So real rates fell.  Possible explanations:

1.  Not much impact on NGDP expectations.

2.  Significant impact on NGDP, but fairly flat SRAS.

3.  Some market segmentation—TIPS spreads don’t precisely measure expected inflation changes.

Or perhaps a bit of each.  If I had to guess I’d say NGDP expectations rose, but by a very small amount.

David Levey sent me this David Wessel post.

One leading candidate is Janet Yellen, the Fed’s current vice chairwoman, who has garnered substantial support among Democrats in Congress and among economists. But the public lobbying on her behalf appears to have annoyed the president and may lead him to look elsewhere.

Obama seems determined to prevent an economic recovery.

For weeks I’ve been saying that fear of Summers has been hurting the stock market.  Commenters keep responding with a Justin Wolfers analysis that found markets didn’t care about Fed decision:

President Barack Obama recently said that choosing the next chairman of the Federal Reserve is “definitely one of the most important economic decisions that I’ll make in the remainder of my presidency.” The financial media appear to agree, devoting hundreds of column inches to speculation. Senators, overseas pundits and even Bette Midler have chimed in.

But there’s one group that considers the decision largely inconsequential: investors in financial markets. At least, that’s my initial reading of a revealing natural experiment.

I can’t imagine why they’d accept the views of a famous Ivy League professor over my opinion, but they did.

In any case, Steve just left this message in the comment section:

S&P 500 futures gap up 17 points…

And Reuters confirms the story:

SYDNEY (Reuters) – The U.S. dollar slid while bonds and shares rallied in Asia on Monday after Lawrence Summers dropped from the race to be head of the U.S. Federal Reserve.

Investors wagered that Fed policy would stay easier for longer under the other main candidate, Janet Yellen.

.  .  .

“This move would be consistent with the market re-pricing to reflect a strong probability that Janet Yellen becomes the next Federal Reserve chair.”

The reaction was immediate with the euro jumping over half a U.S. cent to $1.3367 in early trade, its highest in almost three weeks. The dollar likewise slid half a yen to 98.85 and dropped on sterling and the Swiss franc.

Liquidity was somewhat lacking with Japanese markets closed for a holiday on Monday.

Stock futures for the S&P50 mini index climbed 1 percent to 1,705.25, likely setting up a firm start for Asian bourses as well.

In debt markets, futures for the U.S. Treasury 10-year note leaped over a full point, a sizable move for Asian hours, as investors took yields lower.

The more distant Eurodollar contracts rallied sharply as the market pared back expectations for how quickly the Fed might finally start to tighten, as opposed to just tapering its stimulus. Contracts from late 2014 out to 2016 all enjoyed double-digit gains.

Keep in mind that after Senator Tester became the fourth Dem on the Senate Banking Committee to oppose Summers the writing was on the wall.  That means the 1% jump in stock prices is a gross underestimate of the damage Summers would have done as Fed chair.  Much of this was already priced in.

I feel like we dodged a bullet.

God I love seeing financial markets respond to monetary policy news.  Now let’s see the Fed do something exciting on Wednesday.  And for God’s sake, let’s get an NGDP futures market up and running.

Update:  Taking into account the fact that there was already some expectation Summers would drop out, I’d guess his decision created upwards of a trillion dollars in new global stock market wealth.  Not bad!

Monetary policy is really, really important.

So he did the right thing.  Good for him.  Now the Fed has credibility up the wazoo.  Watch them decide not to use.  Which is what they’ve been not doing since September 16, 2008.

More on that date tomorrow.

HT:  David Levey and Steve

PS.  And can we PLEASE stop talking about liquidity traps.  This is getting ridiculous.

Or so says Sean Williams:

Arguably, everything has gone right for investors and the companies that make up those indexes over the past four years. The unemployment rate has fallen in a slow but steady manner as part-time hiring has really picked up year-to-date. Similarly, record-low lending rates have spurred businesses to expand and have allowed both consumers and business to refinance their existence debt at substantially better interest rates. This is one of the many reasons the housing sector has been able to find a bottom and why homebuilders are now able to utilize low inventory levels to their advantage to improve their pricing power. Even the U.S. budget deficit has narrowed from four years ago, as the sequester has required the removal of $85 billion in spending from the federal budget.

It may not seem like the perfect scenario for the U.S. consumer, but all things considered, they’ve been absolutely spoiled since the recession. The Federal Reserve has enacted not one, not two, but three separate monetary easing programs catered to buoying a still fragile U.S. economy, and it has kept its federal funds target lending rate at a historic low to spur commercial and personal spending. And how, you ask, has the consumer acted since May? Like a spoiled brat!

The U.S. consumer says, “I’ll do what I want!”
Since the beginning of May, when the Federal Reserve first hinted that ongoing positive economic data may cause it to begin paring back its $85 billion in monthly bond purchases, 30-year mortgage rates have increased by roughly 120 basis points to 4.57%. Over that same time span, mortgage applications, which include refinancing as well as new home loan originations, have fallen in 15 of the past 18 weeks and are now 59% off their early May high. Furthermore, August’s U.S. retail sales data pointed to an ongoing theme from teen retailers that consumer spending is weak.

In the past 12 months real consumption expenditures are up by about 1.7%. Real disposable income?  Up less than 1%.  The consumers are doing their part, they need more income!!

It’s the nominal income shortfall.  And that means it’s tight money.

But Sean Williams worries that the Fed is running out of paper and green ink:

What we do know is that the Federal Reserve simply doesn’t have the funds (or need) to continue introducing free money into the economy each month.

Or maybe he’s worried about something else.  What do you think?

PS.  Does anyone know how TIPS spreads responded to the taper talk?  Andy Harless pointed out that stocks are a poor indicator, as long term rates also moved on the news.  I’m not looking for TIPS spread movements over a period of months, but rather on the day of major “taper” news stories.