Some graphs

This has been a very busy week.  But I’m not complaining, as I got what I wanted—lots more people paying attention to my views.  I’d like to correct one thing I said in my previous post, it is not true that Earl Thompson has given up on macro.  He has done quite a bit of work that I was not aware of, and you can link to many of his papers by going to his website.  He has some very unconventional views that combine monetary policy, fiscal policy, and politics into an overarching model.

My previous post was my final attempt to sell my view of the crisis.  In the future I will spend more time responding to commenter requests, discussing current events, and other miscellaneous topics.  One request was for more graphs, which might buttress my argument.  Hence today’s post.  Soon I hope to respond to a request for a post on 1932, and then a request for something on monetary policy options in other countries.

One reason that my blog has included relative little data is that I’ve never seen data as being the sticking point; rather people have trouble with the logic of my argument.  The argument that the Fed caused the crisis has three parts:

1.  Monetary policy can be highly effective, even when nominal rates have fallen to zero.

2.  Monetary policy should target the forecast, i.e. should always be set at a level expected to produce on-target nominal growth.

3.  Monetary policy lost credibility in early October 2008, when any plausible forecast of inflation and NGDP growth fell far below the Fed’s implicit target.

Point three is the only one that actually requires data, and it is also the only point on which I find that virtually everyone already agrees with me.  The other two points require discussion of economic theory, logic, monetary history, institutional constraints, etc.  As we will see, when I do introduce data into the analysis, my argument gets stronger, or more precisely, the data allow me to make more sweeping claims.

Previously I had tried to avoid any unnecessary distractions by making the most modest argument possible.  I could have claimed that Fed actions caused the Lehman failure in September, but instead I said that Fed policy was not far off course until early October 2008.  I argued that Fed errors of omission allowed NGDP to fall sharply in the 4th quarter, and that those errors almost certainly made the financial crisis much worse.  But what about the third quarter; is there any evidence that Fed tightening could have worsened the financial crisis even before Lehman?

There are five variables that might provide some indication of the stance of Fed policy:

1.  Short term real interest rates.

2.  Inflation expectations.

3.  Stock prices.

4.  Commodity prices.

5.  Foreign exchange rates.

I should emphasize that each of these variables, by itself, is highly unreliable.  Even combined, they are not necessarily definitive.  But they are all we have.  Let’s start with the most important, inflation expectations.  Jeremy sent me a couple of St. Louis Fed graphs.  The first one shows the short term real and nominal interest rate over the past nine months.  Notice how real interest rates rose steadily throughout in the third quarter.  Inflation expectations can be estimated by looking at the gap between real and nominal interest rates.  Notice how that gap shrinks throughout the 3rd quarter.

Another St. Louis Fed graph shows the same variables but over 5 year maturities.  Unfortunately because of a change in the way the data was collected in early December, this graph exaggerates the speed at which real interest rates fell in late 2008.  But as with the short term rates, the 5 year rates show rising real interest rates and falling inflation expectations in the third quarter.  Five year inflation expectations were already below 2% when the Fed met on September 16th.  A forward-looking Fed would have cut rates.  The actual Fed is occasionally forward-looking, but is still far too often backward-looking.   Because they were spooked by the high 12-month lagging inflation rate (reflecting the earlier oil price bubble) they decided to stand pat in that fateful meeting.  Both graphs show that they should have been far more aggressive by early October, which is precisely when the stock market crashed.  So I hope people don’t think I am just looking at stock prices when I make inferences about policy.

Now let’s look at some other indicators.  Here is a graph of stock prices (as measured by the S&P500) over the past 12 months.  Again, you can see that stocks were drifting lower during the 3rd quarter, even before Lehman.  Here is a graph of commodity prices.  Notice that prices peaked in early July and declined quite rapidly thereafter.  Here is a graph of the value of the euro.  Once again, the euro peaked around early July, and declined sharply until November.  (It may be easier to envision this change if you look at the pattern from the other direction—the dollar soared in value during the 3rd quarter.)

Thus we have five very different indicators of monetary policy, and all five show evidence that monetary policy grew increasing contractionary during the 3rd quarter, even before the failure of Lehman.  In this blog I have not tried to argue that the September crisis was definitely caused by tight money, as I don’t believe the evidence is conclusive.  But there is certainly a lot of circumstantial evidence that points in that direction.



15 Responses to “Some graphs”

  1. Gravatar of Alex Alex
    30. March 2009 at 05:28


    Correct me if I’m wrong. Your argument is that there was a shock to the money demand. People suddenly have a higher preference for liquidity and the Fed did not accommodate the money supply (enough) to neutralize the shock. But if this is the case why didn’t nominal interest rates jump through the roof? I think the shock was not on the money demand alone but on the demand for all government assets. We want more money and more treasury bills, notes and bonds. This higher demand for bonds kept nominal interest rates low but as we know this is only the short term solution. If there is a shock in the demand for (M+B)/P in the long run (holding supply constant) the equilibrium is for P to adjust which in this case this implied a deflation. So nominal rates were low and real went up. Another possibility is to increase M+B so that P does not have to fall. Now in this case there was nothing the Fed could do. Since the Fed can only substitute M for B (notice that actually by substituting M for B the Fed can have effects on the value of M+B but this effects are in my opinion of second order in this case). It was not until the Treasury stared pumping debt through the alphabet soup programs (I liked the term from you previous post) into the economy and congress promised to pump even more in the future with the stimulus plan that the supply (and expected future supply) of M+B increased and deflation fears subsided. What do you think?


  2. Gravatar of JimP JimP
    30. March 2009 at 05:31

    This post on econbrowser:

    is interesting.

    Jim Hamilton in the comments section says:

    “DickF: My position is that paying an interest rate on excess reserves equal to the target fed funds rate was a policy mistake. I believe what the Fed may have been thinking was that they could fund an arbitrarily large amount of lending themselves if they had the flexibility to create new reserve deposits without limit. But if anyone has a better explanation for why the Fed should pay interest on reserves, I’d be interested to hear it.”

    So someone else does agree.

  3. Gravatar of JimP JimP
    30. March 2009 at 05:36

    And he also says this:

    “Felipe quotes Scott Fullwiler as saying, “With interest-bearing reserve balances (IBRBs), absent offsetting Treasury or Fed operations to drain excess balances created by a deficit, the federal funds rate would simply settle at the rate paid on reserve balances.” But this is not correct. Holding excess reserves is risk free, lending them on the fed funds market is not. Why would a bank choose to make a risky loan at the same rate it could earn from a risk-free alternative to the funds? Moreover, insofar as the procedure is being implemented by having the interest paid on excess reserves be the same as the target rate for the fed funds rate, it intentionally in my mind takes away any incentive for banks to lend those available overnight funds.

    Posted by: JDH at March 29, 2009 06:01 AM”

  4. Gravatar of Thruth Thruth
    30. March 2009 at 10:56


    re stock market, I think this is the graph you want:^VIX#symbol=^VIX;range=5y

    evidence still goes either way on the Fed’s role in Lehman

  5. Gravatar of Thruth Thruth
    30. March 2009 at 10:59

    whoops, wrong link (feel free to delete the previous comment)

  6. Gravatar of ssumner ssumner
    30. March 2009 at 12:30

    Alex, The nominal interest rate is a horrible, horrible, horrible, horrible indicator of the stance of monetary policy, or of shifts in money demand. Tight money or increases in money demand (which are essentially the same thing) tend to depress expectations of nominal growth. And slowr nominal growth puts downward pressure on interest rates. You are quite right that more money demand will, ceteris paribus, cause nominal rates to rise. But the ceteris is almost never paribus. My February post on rational expectations provides a good example of how a contractionary policy surprise depressed rates in late 2007. Having said all that, you may be right that the demand for both M and B increased, but it doesn’t change my policy views, as they focus on getting banks to demand less M. I’m not saying that adding more B wouldn’t help a bit, but at the cost of a huge, unneeded, explosion in the national debt.
    Not only did the alphabet soup programs not solve the problem, they made it much worse for 6 months. Only when the Fed announced an intention to going back to buying old-fashioned T-debt 2 weeks ago, did we see even a modest rally in the stock market and inflation expectations. And I am afraid even that announcement is far less than it seems.

    Thanks JimP, I knew that Hamilton also opposed interest on reserves. The Fullwiler quote is interesting–I’m not sure I fully understand the fed funds market today. Is the market rate above or below .25% right now?

    Thruth, Actually, I prefer the level of stock prices to the volatility. I am interested in real (and nominal) growth expectations, and I think the level picks that up better than volatility. Volatility can reflect a sudden inflow of lots of good news, or lots of bad news.

  7. Gravatar of Thruth Thruth
    31. March 2009 at 05:08

    For looking at the *aggregate* stock market, I prefer a *forward looking* volatility measure such as the VIX because:
    1. Changes in levels are much noisier than changes in volatility
    2. Both empirically and theoretically, volatility embeds market expectations:
    a) Looking back in history, market drops are correlated with high levels of volatility
    b) Aggregate good news portends less uncertainty, hence less volatility
    c) As stock prices fall, leverage increases and, hence, stock volatility will rise. Conversely, increasing levels of aggregate uncertainty drive down asset values and, hence, stock prices. (of course, a ceteris paribus increase in asset volatility without a decrease in asset value will of course increase the value of stocks if we recall the Merton-Scholes interpretation of equity as a call option, but I don’t think that’s an issue here)

    I think it’s fair to say that Fed actions fed market uncertainty about the course of monetary policy as much as it changed expectations of the path.

    is this also helpful (log CPI from 2004):

  8. Gravatar of Thruth Thruth
    31. March 2009 at 05:11

    try this link instead:

  9. Gravatar of ssumner ssumner
    31. March 2009 at 13:06

    Thruth, I agree that Fed actions fed uncertainty, but I don’t see why I should focus on that issue. I am trying to show money was too tight, not too uncertain. During high inflation periods when money is not tight enough (1979-81) there is often great uncertainty about monetary policy. Hyperinflation is an extreme case, where you get some very big changes in stock prices, great uncertainty, and yet money is way too expansionary.
    This is not to say that your points lacks merit, I agree that the increasingly contractionary policy was also increasingly uncertain. One of my points is that the Fed lost credibility in late 2008. And when there is less credibility, policy is much more uncertain. Thus one prediction of my theory that the Fed lost credibility is that stock volatility should have increased. So I think your graph is useful, but not in showing money was too tight, but rather showing that the Fed lost credibility. Something similar happened in the 1930s, as I imagine you already know.

  10. Gravatar of Thruth Thruth
    1. April 2009 at 17:09

    Reviewing this post again, I think the Treasury-TIPS graph clearly makes the broader case that the Fed amplified the crisis around Oct 2008. Obviously, there’s no excuse for deflationary expectations (regardless of what Krugman says).

    However, doesn’t it seem a simpler explanation that Lehman’s demise *was* the monetary shock that pushed expectations way off target? (Unwinding Lehman almost surely had big monetary effects) This is not to say that Lehman should necessarily have been bailed out, just that the Fed should have been much better prepared to accommodate the fallout.

    This may be the area where we differ. I can see the need for clear monetary rules, I can see the need to maintain inflationary expectations or even to go above trend, but I’m not sure I buy a constant NGDP growth target from the start of the crisis (mid 2007). I believe the bubble driven growth path pre-2007 had an unsustainable component. If true, a constant NGDP path would likely still result in falling real GDP, but a sharper rise in inflation than a less aggressive policy. Tentatively then, let me suggest that the strategy of sustaining NGDP is the opposite of the current bailout strategy: propping up bank equity at the expense of bank creditors. If that’s right, then this speaks directly to moral hazard and notions of creative destruction.

    ASIDE: Today, it finally dawned on me how simple the connection between the Fed’s quantitative/qualitative easing in the form of purchasing longer term securities and addressing bank solvency really is. (duh?) The banking model is borrow short (liabilities), lend long (assets). The Fed’s easing increases the value of long relative to short term securities and, hence, props up bank assets relative to liabilities.

  11. Gravatar of TheMoneyIllusion » Evidence of Reverse Causality? TheMoneyIllusion » Evidence of Reverse Causality?
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  12. Gravatar of ssumner ssumner
    2. April 2009 at 17:28

    Thruth, I see why people see the Lehman failure as the trigger for the subsequent decline. The events were related. Using my earlier boat analogy, the financial crisis of mid-September was like the wind blowing the boat off course. For several weeks the markets watched the captain to see whether vigorous action would be taken. Only after they saw the captain was going to allow the boat to continue to be blown off course, did the stock market crash.

    I don’t know your background macro, but I know that non-economists often have trouble seeing how a nominal fix can solve a real problem. In the long run it cannot. The problem is that the real problem can trigger a nominal crisis, which makes the real problem vastly worse. And it has. So we can at least prevent that nominal shock. Suppose we had no financial problems at all, a 7% reduction in nominal GDP would have had a devastating impact on real output in the short run (it would fall sharply), although no impact in the long run. I’m trying to prevent that part of the problem. Regarding real shocks its almost the opposite. There is no doubt that the subprime fiasco imposes a serious long term real cost on the economy. But there is no reason for it to cause lower output in unrelated industries like manufacturing, especially worldwide manufacturing (if the Fed keeps AD growing at 5%.) I see the financial crisis evolving into a severe recession as like a cold turning into pneumonia. They are two separate diseases (and the second is much worse.)

    BTW, I see a worst case of 1% real growth an 4% inflation, and I don’t even think it would be that bad. And even if it was, you’d still have 5% nominal growth which is much better for the financial crisis than negative 7%.

  13. Gravatar of Thruth Thruth
    3. April 2009 at 06:09

    >I don’t know your background macro, but I know that
    >non-economists often have trouble seeing how a nominal fix
    >can solve a real problem.

    I still consider myself to be an economist, though not a macro-economist, and I do see the link (or at least have been taught it). As we’ve said, I don’t think we’re that far apart on the bigger picture. I still remain skeptical that maintaining a nominal NGDP target is *necessarily* the right thing to do (whereas, preventing deflation clearly *is*). However, I’ll allow the possiblity that I’m wrong — I need to think about this some more.

  14. Gravatar of TheMoneyIllusion » The League of Monetary Cranks TheMoneyIllusion » The League of Monetary Cranks
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