Real interest rates are not much better

It’s widely known that nominal interest rates are not a good indicator of the stance of monetary policy.  Actually it’s probably not widely known, which is a major puzzle in and of itself.

Yes, there is a liquidity effect.  A sudden increase in the money supply will often reduce short term interest rates.  But other factors have a much more powerful impact on rates, and hence the liquidity effect can be very elusive and hard to spot.

Some economists think this can be fixed by looking at real interest rates.  But that’s false.  Soon after I criticized a recent post by John Quiggin, he added a couple more paragraphs, and shifted his argument from nominal rates to real rates:

Update As pointed out by Mark Sadowski in comments, these are nominal rates of interest. To get the real rate, which is more relevant, you need to subtract the expected rate of inflation, which fell from around 7 per cent to around 4 per cent over this period (as measured by surveys, and by the premium for inflation-adjusted Treasury bonds). So, you get a 9 percentage point reduction in the real rate from 10 per cent to 1 per cent. This doesn’t make much difference to the story. Most economists would regard policy as contractionary/expansionary if real interest rates are above/below the long-run neutral level, about 3 per cent. So, we still have a shift from strongly contractionary to moderately expansionary.

That’s sort of like saying “most economists” are ignorant of the basic principles of monetary economics.  But maybe they are.  It is a highly specialized field.

Think about why some economists might prefer using real interest rates to nominal rates.  What is the reason?  Obviously the reason is that economists understand that interest rates don’t just reflect the liquidity effect, expected inflation also influences interest rates.  Fair enough.  But why stop there? Expected income growth as well as the level of income also have powerful effects on interest rates.  Indeed if you go back to the pre-WWI period in America we had almost no expected inflation, and no Federal Reserve to raise or lower interest rates.  And guess what; rates rose and fell with the business cycle, just as they do today.  Income has an incredibly powerful impact on rates, indeed in recent years much more so that inflation.  That’s why Ben Bernanke insists that neither nominal nor real interest rates are reliable indicators of monetary policy, and you must look at NGDP growth and inflation.  But then Bernanke is not “most economists” he’s one of the leading experts in monetary economics.

Quiggin continues:

However, market monetarists want to argue that the stance of policy should be assessed relative to a policy rule (Taylor rule or NGDP) that already incorporates a prescription of cutting rates when GDP falls and unemployment rises. This doesn’t make a lot of sense to me. It’s like arguing that Obama’s stimulus was actually a contractionary policy because it wasn’t as big as (according to a standard analysis based on Okun’s Law) it should have been. It’s partly a question of semantics, but it’s associated with the claim that, if only rates had been cut even more, we wouldn’t have had the recession, or would have recovered quickly. Having been around at the time, I disagree.

No, that’s not the claim.  If rates had been cut to zero I’d guess the recession would have been far deeper.  Zero rate cuts are almost always associated with ultra-deep recessions.  With tight money.  The US in the 1930s.  Japan since 1997.  One more time:

NEVER REASON FROM A PRICE CHANGE

What would have prevented a deep recession would have been a more expansionary monetary policy, not lower rates.  Interest rates tell us almost nothing about whether monetary policy is expansionary or not.  If anything, they tend to be a “reverse indicator.”  If you told me that country X had 40% interest rates, I’d guess they had a highly expansionary monetary policy.

Quiggin seems to think that MMs are sort of oddballs.  OK, but what does he make of the Volcker disinflation?

1980:3 to 1981:3:     NGDP growth = 14.0%

1981:3 to 1982:3:     NGDP growth = 3.2%

Meanwhile nominal interest rates on 3 month T-bills fell from 16.3% in May 1981 to 7.71% in October 1982.  These data are quite similar to the Australian episode considered by Quiggin.  If we use his criterion for easy money then America’s most famous tight money policy since the Great Depression was actually an expansionary monetary policy.

I don’t think so.

PS.  Real interest rates on 5 year Treasury debt (ex ante, risk free) rose from a low of 0.57% in July 2008 to a peak of 4.2% at the beginning of December 2008. Throughout this period the US was NOT at the zero bound.  Maybe you guys can help me.  Find examples from Quiggin or any other Keynesian blogger in late 2008 complaining about the Fed’s ultra-tight money policy.

Can’t find any examples?  Keep trying; they must be out there somewhere.  After all the smarter Keynesians like Quiggin insist that while nominal rates are not reliable, surely real interest rates are.  So find me some examples.  To paraphrase Bob Dole; “where was the outrage?”

PPS.  Quiggin’s fiscal policy analogy makes no sense, as the change in the money supply would be the closest analogy to deficit spending.  Both interest rates and NGDP are market variables that are affected by changes in the money supply.  Of course there are other differences.  Fiscal stimulus is costly whereas monetary stimulus is not.  Hence monetary policy is best viewed as setting the steering on a ship, where no one direction is more costly than another, just different.  And NGDP is the best way of measuring direction; interest rates are almost meaningless.


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40 Responses to “Real interest rates are not much better”

  1. Gravatar of BRD BRD
    31. August 2013 at 10:23

    “If rates had been cut to zero I’d guess the recession would have been far deeper. Zero rate cuts are almost always associated with ultra-deep recessions. With tight money. The US in the 1930s. Japan since 1997.”

    Scott, I’m not sure I understand this. Let’s suppose that if the Fed had dramatically expanded the base in 07-08, the market would have been flooded with easy money and we might have avoided the recession. Would it also be more likely than not that even if they used expansionary (unorthodox) monetary policy that nominal interest rates would be quite low?

  2. Gravatar of ssumner ssumner
    31. August 2013 at 10:41

    BRD, If they had an expansionary monetary policy, and if we avoided recession, then I think rates would have been low, but not as low as they actually were. More like Australia.

    The reason they would have been lower than normal (for 5% NGDP growth) is the depressed condition of housing. It would have been less depressed, but still somewhat depressed.

  3. Gravatar of benjamin cole benjamin cole
    31. August 2013 at 11:37

    The Fed has been so “expansionary” that after five years of expansionism the PCE deflator is near 1 percent and trending down and factory capacity utilization at high 70s and depressed employment ratios becoming chronic.

    Really, does it get more obvious than this?

  4. Gravatar of dtoh dtoh
    31. August 2013 at 13:54

    Scott,
    Again you need to understand the mechanism of monetary policy as an exchange of financial assets for real goods and service.

    If you think about the mechanism graphically as an standard downward sloping convex indifference curve between holding financial assets and spending on real goods and services, higher real asset prices (lower real rates) will result in marginally increased spending on goods and services (i.e. higher NGDP).

    As you often point out however, expectations (more specifically expectations of future NGDP) usually has a more important effect than real rates.

    To continue the graphic analysis, a change in NGDP expectations causes a shift in the indifference curve between holding assets and spending on goods and services in such a way that even at significantly lower asset prices (i.e. higher real rates), you get an increased exchange of financial assets for real goods and services.

    (You could also think about it as an indifference map with NGDP expectations on the z axis…. whatever makes it easier to understand).

  5. Gravatar of Mark A. Sadowski Mark A. Sadowski
    31. August 2013 at 18:30

    Scott,
    I’m not really trying to be a nuisance to John Quiggin, but it doesn’t seem to me he has given his example of the 1990 Australian recession sufficient thought. Here is the latest.

    When he updated his blog post he rewrote the original post (not the update) without labeling it as updated and inserted the following about something called “Working Nation”:

    “Over the same period, unemployment rose from 6 per cent to nearly 11 per cent, a record for the period since the Depression, and stayed around that level well into 1994, until the adoption of the Working Nation package of fiscal stimuuls.”

    In comments I said the following:

    “I’m deeply skeptical that the Working Nation package made much of a difference in terms of aggregate demand stimulus for two reasons:

    1) It’s my understanding that the original committment under Working Nation was for $6.5 billion to be spent over four years. This was at a time when Australian nominal GDP ranged from $480 to $600 billion a year. Thus it comes to about 0.24% of GDP per year on average.
    2) The IMF’s estimates of Australia’s cyclically adjusted general government budget balance (i.e. corrected for the business cycle) shows it decreasing in calendar years 1991, 1992 and 1993 and increasing in 1994, 1995, 1996 and 1997. In other words the period of fiscal stimulus by this measure precedes the implementation of Working Nation, and the period of fiscal consolidation largely overlaps its implementation.

    http://www.imf.org/external/pubs/ft/weo/2013/01/weodata/weorept.aspx?sy=1989&ey=1998&scsm=1&ssd=1&sort=country&ds=.&br=1&c=193&s=NGDP%2CGGSB_NPGDP&grp=0&a=&pr.x=54&pr.y=15

    None of this should be construed as questioning the value or effectiveness of Working Nation. I’m merely pointing out the fact that fiscal policy stance was contractionary during the time that the unemployment rate dropped.”

    Since then the phrase “fiscal stimuuls” has been crossed out and the phrase “active labour market policies” has been added.

    It seems that Quiggin was operating under the asssumption that monetary policy was expansionary in 1990-93 but failed, and the drop in unemployment that occured in 1994 was due to a fiscal stimulus, except that according to IMF data Australian fiscal policy was expansionary during 1991-93 and became contractionary when unemployment dropped. So he has things precisely backwards.

    I’ve left still another comment, this time using the recovery from the 1974-75 recession as an unconventional example of a swift recovery away from ZIRP completely without the aid of fiscal policy. So stay tuned for the continuing John Quiggin saga.

    P.S. I’m talking to him strictly using interest rates because that’s evidently what he’s comfortable with, and as you can see it is apparently having an effect.

  6. Gravatar of Ryan Murphy Ryan Murphy
    31. August 2013 at 18:34

    According to Quiggin, if you don’t believe that higher minimum wages and more union power lead to more employment and growth, you are a neoliberal ideologue. So there’s that.

    If you want to troll a little harder, I HIGHLY recommend renaming the Old Keynesian perspective on interest rates and monetary policy “Zombie Monetary Economics.”

  7. Gravatar of Mark A. Sadowski Mark A. Sadowski
    31. August 2013 at 19:21

    Scott,
    I think have some econometric results that may be of interest to you (and possibly Nick Rowe).

    A couple of weeks ago I was commenting at UnlearningEconomics:

    http://unlearningeconomics.wordpress.com/2013/08/17/market-monetarism-jumps-the-shark/

    And the topic of endogenous money and Granger causality came up. I did some googling and apparently the endogenous money people have been blogging about the empirical evidence supposedly supporting endogenous money for the past few months and it has gone to their heads. Most of this research involves Granger causality.

    As you know I’ve been toying with Granger causality, specifically a technigue I read about on David Giles blog invented by Toda and Yamamato. And on a hunch I started running Granger causality tests between the monetary base and broad money during ZIRP episodes involving QE. I’ve consistently found that monetary base Granger causes broad money but not the other way around. When I brought this up at UnlearningEconomics this was pooh poohed because of all the “empirical evidence supporting endogenous money”.

    Of course, if a central bank is setting interest rate targets one expects loans to Granger cause the monetary base, and broad money, or the broad money multiplier, which is what some of these studies find (almost all of them are published in the Journal of Post Keynesian Economics). But I’ve noticed in ZIRP episodes with monetary base expansion (QE) normally there is corresponding broad money expansion which the endogenous money people say is impossible.

    Well I’ve gone a lot further using US data. What I find is that since December 2008 the monetary base Granger causes loans and leases at commercial banks and that the M1, M2 and MZM money multiplier all Granger cause loans and leases (but neither is the other way around). This is exactly the opposite of what Structural Endogeneity predicts.

    I’m thinking I should repeat the work on the UK and Japan and possibly the US during the Great Depression. It sounds very interesting to me of course, but who would publish research showing money is not endogenous during QE using endogenous money research techniques?

  8. Gravatar of Mark A. Sadowski Mark A. Sadowski
    31. August 2013 at 21:38

    “This is exactly the opposite of what Structural Endogeneity predicts.”

    should read

    “This is exactly the opposite of what Accomodative Endogeneity predicts.”

  9. Gravatar of RebelEconomist RebelEconomist
    31. August 2013 at 22:03

    I can see both your points. It is clearly wrong to use a long run neutral interest rate as a benchmark for monetary policy, because the neutral, natural rate or whatever you call it must change over time (I think?). But I do agree with Quiggin that using NGDP is like presuming what you demand monetary policy should do in judging its setting.

    Analogies over over-used in economic discussion, but I find it helpful to think of a car travelling over hills. NGDP targeting is like judging the use of the engine by the speed of the car, which is fine if you are just a driver trying to run along at the speed limit and the car can cope. But not if you are a mechanic trying to understand how the car is performing and whether the engine is being damaged by the demands made on it when climbing hills.

    This is why I prefer inflation as a measure of the stance of monetary policy, because, to strain my analogy, it is rather like monitoring the exhaust gas to determine the power output of the engine. But that is not to say that inflation is ideal; what I might really want is something like torque.

  10. Gravatar of RebelEconomist RebelEconomist
    31. August 2013 at 22:15

    And to continue my analogy, Mark Sadowski is doing a useful research job in establishing that, even though both go round together, the prop shaft is driving the wheels. Basic stuff to even a lowly mechanic perhaps, but maybe a revelation even for a driver as skilled as Sebastian Vettel!

  11. Gravatar of JohnP JohnP
    31. August 2013 at 23:31

    Actually Rebel, Sandowski isn’t just doing useful work. From what I see, he’s basically destroyed the Keynesian’s argument. In fact it’s basically roadkill.

  12. Gravatar of Annabelle Smith Annabelle Smith
    1. September 2013 at 01:49

    I abandoned Keynesian thinking years ago when Quiggin had his back-side handed to him by Gerry Jackson. I regard him as a Keynesian dinosaur who is buried in his ideology. Just my opinion.

  13. Gravatar of Bill Woolsey Bill Woolsey
    1. September 2013 at 04:16

    John P:

    I am certain that base money can cause broad money. All that is needed is that the changes in base money be sufficiently large.

    However, that doesn’t mean that base money and broad money cause nominal GDP (spending on output.)

    Perhaps you are using the word “Keynesian” to refer to this modern monetary theory. Or maybe all “Post-Keynesians” are more tied to endogenous money than I am aware.

  14. Gravatar of Bill Woolsey Bill Woolsey
    1. September 2013 at 04:36

    Scott:

    Quiggen goes wrong by comparing the real interest rate (ex-post, it looks like,) to the “long run” natural or neutral interest rate. The correct comparison would be between the ex-ante real interest rate and the “short run” natural interest rate.

    Even so, the puzzle is that a monetary regime that will push the ex-ante real interest rate below the short run natural interest rate if necessary to increase nominal expenditure on output to some target, can cause the short run natural interest rate to rise relative to where it would have been.

    So, as you say, real interest rates are not very useful.

    Unfortunately, the monetary base isn’t much better. A quantity greater than the demand to hold is expansionary. But a monetary regime that will increase the quantity of money beyond the demand to hold it if necessary to hit some nominal target can result in a demand to hold base money lower than it otherwise would be.

    A credible commitment to hit a nominal target can result in the paradox where a higher real (and nominal) interest rate and a lower quantity of base money are needed to avoid overshooting the nominal target.

  15. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. September 2013 at 06:41

    Bill Woolsey,
    “However, that doesn’t mean that base money and broad money cause nominal GDP (spending on output.)”

    This is actually a very good point. I’ve already run Granger causality tests on monetary base, M1, M2. MZM with NGDP over 1959Q1 through 2013Q2 using the method of Toda and Yamamato. All of the results show bidirectional causality as I expected. (In fact all of the monetary aggregates are cointegrated with NGDP.)

    I haven’t tried to do the same tests on 2009Q1 through 2013Q2 to check for unidirectional causality yet because there would only be 18 observations and this likely would present technical problems. (Too bad we don’t have official NGDP in monthly frequency, eh?)

  16. Gravatar of ssumner ssumner
    1. September 2013 at 07:01

    dtoh, Your comment made me think of a different way of explaining things. I’ll do a post.

    Ryan, I’m not THAT mean.

    Mark, Thanks for all the good work. As you know I agree that Granger “causality” would run in both directions. And I’d expect this even if actual causality ran solely from MB to NGDP. A good example occurred in 1933 when NGDP started rising before MB, even though (futures expected changes in ) MB caused NGDP to rise. So I have little faith in Granger causality.

    And I think Nick Rowe has done a good job of demolishing of MMTers’ views on “endogeniety.”

    Rebeleconomist, I’m afraid you lost me there.

    Bill, You said:

    “Even so, the puzzle is that a monetary regime that will push the ex-ante real interest rate below the short run natural interest rate if necessary to increase nominal expenditure on output to some target, can cause the short run natural interest rate to rise relative to where it would have been.”

    Yes, that’s an important point that many Keynesians overlook.

  17. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. September 2013 at 07:06

    Bill Woolsey,
    “Quiggen goes wrong by comparing the real interest rate (ex-post, it looks like,) to the “long run” natural or neutral interest rate. The correct comparison would be between the ex-ante real interest rate and the “short run” natural interest rate.”

    In his comments section I talked about the difference between the short run and long run neutral rate. But you needn’t even refer to this difference to realize the example Quiggin has chosen is terrible.

    There is a great deal of asymmetry during the 1990 Australian recession with real rates reaching 7% higher than the real (adjusted by inflation expectations, as he wanted) long run neutral rate (3% was his preferred value) and only falling 2.4% below the real long run neutral very briefly.

    Unemployment reached 9.9% before the real call rate target ever fell below the real long run neutral rate. It’s clear, even trying to be as generous to his viewpoints as possible, that the RBA was disinflating the heck out of the economy.

  18. Gravatar of RebelEconomist RebelEconomist
    1. September 2013 at 07:26

    Well Scott, I suppose you can lead a horse to water…..

  19. Gravatar of Greg Ransom Greg Ransom
    1. September 2013 at 08:55

    The know about a tree-killing frost & the destruction of vast numbers of apple trees, and we see the price of apples doubling.

    We reason from a constellation of background understandings _and_ a price change.

    Everyone reasons from prices changes all of the time.

    Interest rates are low, the government changes policy generating increased moral hazard, regulations make it impossible to match risk to loan rates & eligibility, securitization and bundling radically reduces transparency, a variety of long period production pathways are massively expanding output over a long period horizon which will over time increasingly compete for an ever explaining set of inputs.

    Everyone reasons from prices changes all of the time, as part of a constellation of background facts.

    Economists reason from fake models built of univocal ‘givens’ that could be known to one mind — models which leave out most of the things that make up a production economy with rival production pathways involving learners with alternative and changing understandings of things.

    When an economist reasons like this, he’s not reasoning not using valid back ground understanding of a conciliation of understandings of the word, he’s reasoning from a false model that radically fails to capture the world and radically misrepresents its casual processes.

    Never reason from an economist’s radically false and radically misrepresentation of the causal process of the world.

  20. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. September 2013 at 10:18

    Scott,

    John Quiggin has responded with a blog post:

    http://johnquiggin.com/2013/09/01/market-monetarism-a-first-look/

  21. Gravatar of Saturos Saturos
    1. September 2013 at 10:34

    The interesting remark from Quiggin is here:

    I don’t think the validity of the liquidity trap argument depends on whether interest rates have reached the zero lower bound. The economy is in a liquidity trap when people want to build up money balances, regardless of the consumption and investment opportunities available to them. If central banks face such a situation, they may give up on interest rate reductions, even before the rate hits zero, if only to avoid making their impotence obvious.

    Shall we start commenting on his post, walking him through the counterarguments, starting with the reductio ad absurdum?

  22. Gravatar of ssumner ssumner
    1. September 2013 at 10:53

    Greg, You reason from the cause of the price change. In this case falling NGDP growth was the cause of the price change, whereas Quiggin assumes “easy money.”

    Thanks Mark. Is there anything new?

    Saturos, That’s certainly an “interesting” quotation.

  23. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. September 2013 at 11:45

    Scott,
    “Is there anything new?”

    The thing that caught my eye was the following:

    “I was aware in general terms that Sumner advocated a more expansionary monetary policy in response to the current crisis (I agree), that he prefers Nominal GDP targeting to inflation targeting as the basis for monetary policy (I agree, though I’d prefer targeting levels rather than growth rates) and that he thinks this would be sufficient to fix the problem without any role for fiscal policy (I disagree).”

    I already knew his positions, but evidently he doesn’t know Market Monetarists prefer Level Targeting to rate targeting.

    Other than that there isn’t much that’s glaringly “wrong” in my opinion. It’s mostly an attempt to characterize the views of Market Monetarism.

    I suggest you read it yourself. I’m very interested in knowing your opinion.

  24. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. September 2013 at 15:33

    John Quiggin:
    “The idea that the stance of monetary policy can be assessed as expansionary, neutral or contractionary depending on whether the interest rate controlled by the central bank is at, above, or below its real long run average value isn’t just mine. It’s that of nearly all economists, notably including the US Fed.”

    John Quiggin then links to the Federal Reserve where it clearly says:

    http://www.frbsf.org/education/publications/doctor-econ/2005/april/neutral-monetary-policy

    “In addition, most economists agree that the neutral rate is not constant over time. Just as economic conditions are constantly changing, so does the monetary policy direction at a given time that would be consistent with neutrality. The factors that determine the neutral range are complicated and varying; as Dr. Yellen further noted in the same interview:

    [“The neutral real rate itself depends on a variety of factors – the stance of fiscal policy, the trend of the global economy which shows up in our net exports, the level of housing prices, the equity markets, the slope of the yield curve, or the term premium built into the yield curve. So it changes over time.”]”

    This is something to which I discussed at length in John Quiggin’s post entitled “A note on the ineffectiveness of monetary stimulus”. Simply lowering the policy rate below the long run neutral interest rate does not make monetary policy expansionary. Typically in a recession the short run real neutral rate is lower than the long run real neutral rate.

    I had a hard enough time convincing him that the real call rate target was above the long run real neutral rate in Australia during most of January 1990 through December 1992 that I just gave up on even going there.

  25. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. September 2013 at 15:43

    “Simply lowering the policy rate below the long run neutral interest rate does not make monetary policy expansionary.”

    should read

    “Simply lowering the real policy rate below the long run real neutral rate does not make monetary policy expansionary.”

  26. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. September 2013 at 17:05

    John Quiggin has responded to my above comment in his latest post:
    “Fair enough. I’ll edit to give a more precise statement. But, if you look at the graph included in the Fed piece, it shows very modest and gradual changes in the neutral rate.”

    His edit crosses out the words “real long run average” and inserts the following:

    “UpdateThe neutral value changes gradually over time in response to a variety of factors, but is sufficiently stable that it can be regarded, for most purposes, as a long-term average, typically assumed to be in the range 1.5 per cent to 3.5 percent.End update”

    I think he’s come a long way from just a few days ago when he seemingly thought simply lowering the nominal policy interest rate made monetary policy expansionary. At this rate he may be converted to Market Monetarism by Christmas.

  27. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. September 2013 at 17:51

    Jphn Quiggin has edited his reply to me to read:

    “Fair enough. I’ll edit to give a more precise statement. But allowing for a time-varying neutral rate doesn’t help your argument at all, quite the opposite. The Fed graph shows that the (estimated) neutral rate for the US was higher in the late 80s and early 90s than it is now. That was certainly true in Australia as well, at least in the perception of policymakers. As I said, their guiding assumption was that the economy would recover quickly in response to the interest rate cuts.

    I don’t think people talked in terms of neutral rates at the time – the shift from money supply targeting to inflation targeting based on interest rates was still under way, and the language hadn’t fully adjusted – but there was a definite consensus that monetary policy was expansionary until the tightening in 1994.”

  28. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. September 2013 at 22:15

    Here is my response to John Quiggin.

    The Fed graph (Figure 3) is clearly labeled “Approximate range of estimates for a neutral *nominal* funds rate”. Yes this is not very helpful given the text that immediately precedes it refers to the *real* neutral rate. This is especially true given that inflation was much higher in 1989 than it was in 2004 (the range of the graph).

    The range of estimates goes from about 5.6% to 7.2% in January 1989. The yoy PCEPI inflation rate was 4.4% in January 1989 so the range runs from 1.2% to 2.8% in real terms. In comparison the range of estimates goes from 2.8% to 4.4% in March 2004. The yoy PCEPI inflation rate was 1.8% in March 2004 so the range runs from 1.0% to 2.6% in real terms. The graph would have been much more relevant if it had been corrected for inflation.

    I’ll include a link to the inflation rates in a subequent comment.

    Ian Macfarlane, who was an Assistant Governor from 1990 to 1992, and Deputy Governor from 1992 to 1996 under Governor Bernie Fraser, said the following in one of his 2006 Boyer lectures (I’ll include a link in a subsequent comment):

    “We did not set out to have a recession in order to reduce inflation. … But once it was apparent that it was going to happen, it was reasonably quickly realised that there was an opportunity to achieve something of lasting value out of the unfortunate events.”

    Here is what Governor Bernie Fraser said in August 1992 (I’ll include a link in a subsequent comment):

    “I trust those comments can be made without arousing suspicions of being or going soft on inflation. It should be obvious from the performance of monetary policy over recent years that there is no basis for such suspicions. Australia now has one of the lowest rates of inflation in the world. Inflation has come down faster than everyone expected, but it is not just the recession, or a fluke, that has caused it to decline. Policy has been important, and the costs substantial. Price expectations, which are now seen as occupying a central role in the inflationary process, have been cracked; given this, together with continued policy vigilance, there is no reason why the current underlying inflation rate of 2 to 3 per cent cannot be sustained.”

    Even if was true that policymakers thought monetary policy was expansionary at the time, which I think is highly dubious in light of the above quotes, the important thing is that *we* know that the real call rate was above the long run neutral rate from January 1990 through November 1991, so monetary policy clearly was not expansionary during that time span. And were I to estimate a time varying real neutral rate using conventional econometric methods I am quite confident it would show that the real call rate was above the short run real neutral rate throughout 1993.

  29. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. September 2013 at 22:16

    Here is a link to the yoy PCEPI inflation rates and the fed funds target rate in the US from January 1989 through January 2005:

    http://research.stlouisfed.org/fred2/graph/?graph_id=135203&category_id=0

    Here is a link to Ian McFarlane’s 2006 comments:

    http://www.theage.com.au/news/business/the-real-reasons-why-it-was-the-1990s-recession-we-had-to-have/2006/12/01/1164777791623.html?page=fullpage#contentSwap1

    Here is a link to Bernie Fraser’s 1992 comments (see page 7):

    http://www.rba.gov.au/publications/bulletin/1992/sep/pdf/bu-0992-1.pdf

  30. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. September 2013 at 00:18

    John Quiggen responded in comments:

    “You’re quite right on the neutral rate graph – I was misled by the surrounding text. I think that adjusting for inflation would remove the decline at the beginning of the period. That would leave the range of estimates pretty much constant.

    As regards the views of policymakers, as I’ve already said, I’m much more inclined to place weight on Bernie Fraser’s statements at the time than on the retrospective claims made later on. In Fraser’s speech, the remarks you cite are obviously a defence against the widespread perception that policy was not merely expansionary, but too expansionary. That’s clearer in the following para

    [“As inflation has come down and unemployment has risen, more emphasis has come, understandably, to be placed on growth and jobs. How should the authorities respond? One response is to say that we have never had a single-minded fixation with price stability. That, clearly, has been the situation in recent years. In each of the thirteen announced reductions in cash rates since January 1990, the authorities (meaning the Government and the Bank) have acknowledged the importance of trends in both inflation and activity in those decisions.”]”

    To which I said…

    But the fact that the RBA was concerned about inflation at all was apparently something new. Stephen Kirchner in 1996 (Page 11):

    “The RBA’s current preoccupation with inflation is a relatively new development. Up until the early 1990s, monetary policy had been focused on demand management, with a particular emphasis on reducing the size of the current account deficit (see e.g. RBA 1989: 6-7). This activist and highly discretionary monetary policy was the main contributor to the 1990-92 recession, as the authorities seriously misjudged the implications of high interest rates for the level of economic activity. However the recession also contributed to a substantial reduction in the rate of inflation from the early 1990s, a reduction that was characteristic of many of the world’s industrialised economies.

    The reduction in inflation was accompanied by a significant change in the policy approach of the RBA. The RBA had been traditionally hostile to a single monetary policy focus on inflation and inflation targeting, and still maintains reservations about such an approach (e.g. Fraser 1991: 6-8). This is in contrast to the much stronger focus on price stability and inflation targeting increasingly found in other countries such as New Zealand. However the 1990-92 recession was quickly rationalized as an opportunity to reduce inflation. For example, the RBA Deputy Governor Ian Macfarlane (1992: 77) described the recession as a “once in a decade opportunity to return to low inflation.””

    http://www.cis.org.au/images/stories/policy-magazine/1996-spring/1996-12-3-stephen-kirchner.pdf

  31. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. September 2013 at 01:42

    John Quiggen comments again:

    “A side point on which I need to clarify my own thoughts. In assessing the stance of both fiscal and monetary policy, I tend to think that both the level and the change need to be considered. In relation to fiscal policy, for example, a shift in the primary balance from, say +3 to -2 per cent of GDP seems to me to be a bigger deal than a shift from -2 to -3.

    Similarly, I think the magnitude of the shift in monetary policy over this period is at least as significant as the end point. This depends on a story about expectations, which involves a complex game between the public and the monetary authorities. As a first approximation, and with reference to Sumner’s approach, I’d say the following. Cutting rates by 12 percentage points is a clear signal that the authorities want to raise the level of nominal GDP sufficiently to reduce unemployment and will do what they think is necessary to achieve that. The fact that this didn’t happen suggests to me that the power of the central bank to shift expectations is not that great, once a severe recession is underway.”

  32. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. September 2013 at 01:44

    Here’s my response:

    John Quiggin:
    “A side point on which I need to clarify my own thoughts. In assessing the stance of both fiscal and monetary policy, I tend to think that both the level and the change need to be considered.”

    But there’s a fundamental difference.

    An increase in the cyclically adjusted budget balance (CABB) is contractionary. No change in the CABB does nothing. A decrease in the CABB is expansionary. All of this is true regardless of the size in the change in the CABB.

    On the other hand if a real policy interest rate is 7% above the real neutral rate it is contractionary. An increase in the real policy rate will make it more contractionary. No change in the real policy rate will keep it at the same contractionary level. A reduction in the real policy rate may be contractionary, neutral or expansionary depending on its size.

    John Quiggin:
    “Cutting rates by 12 percentage points is a clear signal that the authorities want to raise the level of nominal GDP sufficiently to reduce unemployment and will do what they think is necessary to achieve that.”

    Not if they take three years to do it during a time of significant disinflation.

    Consider the rate of decline in the three previous nominal declines of 6 or more points in short term interest rates in comparison, and specifically consider how many months it took to decrease short term rates 6 points from peak.

    Short term rates dropped from 19.3% in April 1982 to 13.0% to November 1982, a period of seven months. They declined from 19.4% in December 1985 to 12.8% in April 1986, a period of four months. They declined from 16.6% in January 1987 to 10.5% in October 1987. The average number of months for these three declines to take place was about 6.7 months.

    Now compare that to the 1990 recession. Short term rates peaked at 17.9% on October 1989. It took 14 months for them to drop to 11.8% in December 1990. That’s a period of time over 50% greater than any of the previous three episodes and over twice as long as the average of the previous three episodes.

    What kind of a signal do you think that was sending?

    Here is a link to the data:

    http://research.stlouisfed.org/fred2/graph/?graph_id=135223&category_id=0

  33. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. September 2013 at 02:52

    They declined from 16.6% in January 1987 to 10.5% in October 1987.”

    should read

    “They declined from 16.6% in January 1987 to 10.5% in October 1987, a period of nine months.”

  34. Gravatar of ssumner ssumner
    2. September 2013 at 08:15

    Mark, I left a comment over there. Let me know if he responds.

  35. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. September 2013 at 11:53

    Scott,
    He has responded to your comment.

    John Quiggin:

    “1. Can you provide a link to this? I haven’t seen this idea before.

    2. I discussed Friedman in the OP, and I’m not much impressed by Mishkin as an authority. As far as Bernanke is concerned, I think you’re wrong. Bernanke and Blinder 92 were among the first and strongest advocates of using the Federal Funds Rate as the main measure of the stance of monetary policy. He qualified that a bit in subsequent work (eg Bernanke and Mihov 1998) but still presents FFR as the best measure for the Great Moderation period. Looking at the piece you cite here
    https://www.themoneyillusion.com/?p=13576
    I think you are misinterpreting Bernanke in exactly the way I suggested in the OP. That is, Bernanke agrees that stable NGDP (stable in both components!) is the desired target and says that, since no indicator of the stance of monetary policy is perfect, you have to look at the outcomes to see how things are going. But as I read him, he’s still saying that real interest rates are the best single measure of the stance of policy (away from the zero bound, which wasn’t an issue then)

    This eliminates the contradiction you see in his subsequent writing. I take his current view to be that the Fed is doing all it can, but, with fiscal policy pushing the wrong way, there’s nothing for it but to stick with the inflation target and let real GDP recover by itself.”

  36. Gravatar of Scott Sumner Scott Sumner
    3. September 2013 at 10:07

    Mark, It’s interesting that a quotation where Bernanke says neither nominal nor real interest rates are good indicators of monetary policy, and that you have to look at NGDP growth and inflation, gets interpreted as real rates are an good indicator. I hardly know what to say.

    Maybe you could give him a link to my recent paper on NGDP futures targeting.

  37. Gravatar of Scott Sumner Scott Sumner
    3. September 2013 at 10:09

    I’d add that the reason that economists reject nominal rates as a good indicator, also applies to real rates, they reflect economic conditions. So it’s utterly arbitrary to dismiss nominal rates and embrace real rates. I had thought the smarter NKs looked at the market rate relative to the Wicksellian equilibrium rate. Or is that wrong?

  38. Gravatar of Yet More Sumner Sleight-of-Hand Yet More Sumner Sleight-of-Hand
    3. September 2013 at 11:23

    […] Scott Sumner wrote a post entitled, “Real interest rates are not much better.” He made some decent points about […]

  39. Gravatar of Rodrigo Escalante Rodrigo Escalante
    18. November 2013 at 20:07

    Professor,

    Usually when you mention policy stance in regards to interest rates you claim rates are a “reverse indicator”(low rates indicating tight money and vise versa) but I am little confused at which point you consider this to change. I certainly agree that low interest rates indicate that money has been tight, but wouldn’t cutting rates even lower be considered expansionary or at worse less contractionary? Isn’t possible that interest rates become naturally depressed due to the business cycle (low NGDP) and the fed is forced to cut rates to stimulate the economy, such as the fed should have done after Lehman failed? At which point we would have low interest rates because of low NGDP and because the fed was being accommodative?

  40. Gravatar of ssumner ssumner
    19. November 2013 at 10:17

    Rodrigo, Yes, and unfortunately there is no reliable relationship. For big changes, and over the long run, easy money leads to higher interest rates. For smaller changes and over shorter periods, the correlation is ambiguous.

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