Super long and variable lags?

For quite some time the old-style monetarists have been warning that all this “easy money” (what would Milton say!) will produce high inflation, with long and variable lags.  The recent passivity by the Fed has caused TIPS spreads to plummet in the last couple days.  Today for the first time that I can recall the 30 year TIPS spread fell below 2%.  Thirty years is a pretty long lag before that high inflation kicks in.

In fact, monetary policy works with leads, not lags.  Markets are plunging right now on expectations that future monetary policy will be tight, will allow NGDP growth to fall well below even the woefully inadequate 4% of this “recovery.”  The Fed has lost control of the nominal economy.

I hope all you hard money fans are happy—this is what hard money looks like.

January 3, 2001

In recent years I have mostly taught Monetary Economics.  I spend precisely zero minutes covering IS/LM, and lots of time covering market responses to Fed announcements.  Based on some of the comments I received from my last post, I thought it might be interesting to examine one of my favorite Fed announcements, the surprise 1/2 rate cut of January 3, 2001.  This was the first rate cut of the 2001 recession, and reduced the fed funds target from 6.5% to 6.0%.  Here were some market reactions:

1.  The S&P 500 soared by 5.0%

2.  T-bill prices rose by 1/32  (yields fell)

3.  28 year TIPS prices fell by 16/32  (yields rose)

4.  28 year T-bond prices plunged by 76/32 (yields rose sharply)

I generally attribute the slight fall in T-bill yields to the liquidity effect, the rise in stock prices and TIPS yields to the income effect, and the sharp rise in T-bond yields to the income and expected inflation effects.  IS/LM says easy money lowers rates.  I say it is much more complicated than that.

I know I am in the minority, because here’s how the Wall Street Journal (1/4/01) described the market reaction:

Treasury Prices Plummet as Stock Prices Soar on Earlier than Expected Fed Interest Rate Cut

.   .   .  “Market participants were remembering history: that when the Fed’s on your side, stocks are the place to be,” said Mark McQueen, executive vice president of Sage Advisory Services.

Traders said the selling in bonds also reflected the fact that the market had been anticipating an easing of Fed policy soon and already had rallied strongly on the expectation.  When the Fed actually cut rates, people were, in bond market terms, “selling the fact.”

Have you noticed that when reporters don’t have a clue as to what is going on, they attribute it all to market irrationality?  No wonder there’s so much hostility to the efficient markets hypothesis.  Reporters are taught that easy money leads to lower interest rates.  When the markets behave in seemingly irrational ways, the natural reaction is to blame the EMH.  Readers of this blog know that easy money often leads to higher long term interest rates, so we don’t have to resort to market irrationality to explain these reactions to Fed announcements.

Some commenters noted that yesterday’s complex bond market reaction reflected changes in the proportions of maturities that the Fed was likely to purchase.  Maybe so, but in qualitative terms the reaction really wasn’t much different from January 2001, a policy move associated with virtually no bond purchases.  (During normal times the level of excess reserves is tiny and the Fed buys only an infinitesimal amount of bonds when it eases policy.)

Of course most Fed moves are widely expected, and elicit no market reaction.  For instance, the Fed did a long series of quarter point increases between 2004 and 2006, which the market took in stride.  The biggest reactions occur at key points in the business cycle, when a significant change in policy is contemplated.

The next key policy move occurred in September 2007, when the Fed did its first rate cut of this cycle.  Again, the cut was larger than expected (1/2 point), and once again short term rates fell and long term rates rose.  Stocks rose a couple percent after the announcement.  Asian stocks soared on the news. (Sound familiar?)

In December 2007, the fed funds futures market showed the cut would be either a quarter or a half point.  The actual 1/4 point cut caused a severe stock price decline.  This time the income effect stretched all the way down to three months, as yields fell from 3 months to 30 years.  And remember, these rate cuts were responding to a contractionary surprise, so the IS/LM model says yields should have risen.  The stock and bond markets turned out to be prescient.  A recession began at exactly that moment, and by January the Fed realized it had blown it.  It did two rates cuts totaling 125 basis points within 2 weeks, which validated the earlier T-bill market reaction in December.

This was enough to prop up NGDP for another 6 months.  But between July and December 2008 NGDP went into free fall, as the Fed became mesmerized by commodity inflation and failed to respond to abundant signs that NGDP growth was plummeting.  Then they became obsessed with the banking crisis.  Indeed the great collapse of July-Dec. 2008 was more than half over before the Fed started doing monetary policy, and the first move was not a rate cut but rather the interest on reserves program of October 2008—a highly contractionary move!

Lessons for the Fed?  Pay attention to markets that provide information about future NGDP growth, and don’t ever let NGDP expectations going 1, 2, and 3 years out collapse to a level far below trend.  And don’t assume that low rates mean easy money.

Why doesn’t the government publish monthly GDP data?

A recent David Beckworth post linked to Macroeconomic Adviser’s monthly nominal GDP series.  Please click on the Macro Adviser’s GDP link and take a look at the graph showing estimated monthly NGDP data.  You will see that almost the entire drop in NGDP during this recession occurred during a brief 6 month period between June and December 2008.  This fact is obscured by quarterly data, which show a very large drop in the average level of NGDP between 2008:4 and 2009:1.  But again, by December 2008 it was almost all over, even though the official recession trough wouldn’t occur until June 2009, at a tad below December NGDP levels.

[Update, 10/25/10:  I erred in telling you to look at the graph, which shows RGDP.  The tab at the bottom opens another page which shows the nominal monthly data.   This is even better—all of the decline in NGDP now occurs between June and December 2008, and almost all between July and December.  This almost precisely aligns with the period of ultra-tight money.]

I wish the Federal government would publish monthly NGDP data.  It can’t be that hard to get estimates; after all, GDP is mostly constructed out of other monthly time series.  And even the quarterly GDP reports are estimates, often sharply revised years after the fact.

The period of June to December 2008 also saw one of the tightest monetary policies in American history.  Between July and late November the real interest rate on 5 year  TIPS soared from about 0.5% to 4.2%.  The dollar soared against the euro.  Stock, commodity, and commercial real estate prices plunged.

And all of this occurred before the Fed ran out of conventional monetary policy ammo.  That’s right, it wasn’t until mid-December 2008 when the Fed reduced rates close to the zero bound (0.25%.)  During the crash rates were always at least 1%, and mostly 2%.  And that’s ignoring the contractionary impact of interest on reserves.

Frequent commenter “123” has studied this period more intensively than I have, and he recently sent me a post that sheds new light on the debate over whether the key problem was solvency or liquidity:

Brad DeLong ponders the issue of the root cause of the crisis. Is it that the full-employment planned demand for safe assets is greater than the supply, or is it that the full-employment planned demand for medium of exchange is greater than the supply? In other words, is it the flight to safety, or is it the flight to liquidity? Brad DeLong argues that we have the flight to safety:

“Thus we would expect a downturn caused by a shortage of liquid cash money to be accompanied by very high interest rates on, say, government bonds–which share the safety characteristics of money and serve also as savings vehicles to carry purchasing power forward into the future, but which are not liquid cash media of exchange.”

The problem is that government bonds serve both as savings vehicles and as medium of exchange. As Gary Gorton said, “it seems that U.S. Treasuries are extensively rehypothecated and should be viewed as money”. You purchase groceries with cash, and you purchase other financial assets with U.S. Treasuries, but in both cases we are dealing with media of exchange.

It is very hard to disentangle these two facets of U.S Treasuries, but we have a great natural experiment. After the collapse of Lehman, TIPS were a perfectly safe savings vehicle, but they were much less liquid than cash or other Treasuries. Lehman has mainly used TIPS as repo collateral, and after liquidation the pattern has shifted, the marginal holder of TIPS was more likely to use it as savings vehicle rather than for transactional purposes. The result was what FT Alphaville has called “The largest arbitrage ever documented”, as the price of TIPS fell by as much as 20 cents on the dollar as compared to much more liquid Treasuries. This gives us a clear indication that post-Lehman panic was a flight to liquidity, and not a flight to safety. This means the best policy response was the expansion of the quantity of liquid, rather than safe assets. After March 2009 QE announcement, the Fed has greatly enhanced liquidity properties of TIPS.

This does somewhat undercut my argument that the TIPS spreads showed inflation expectations falling sharply.  They did fall, but not as sharply as the spreads suggest.  But I’ve always acknowledged that the TIPS spreads might have been distorted by a rush for liquidity, and I’ve also argued that the rush for liquidity shows the Fed was behind the curve just as surely as would lower inflation expectations.  Either way, money was much too tight.

It also seems to undercut my cherished belief in the EMH.  Perhaps someone in the mutual fund industry can tell me why bond funds didn’t just construct a portfolio of TIPS plus inflation futures that was guaranteed to outperform Treasury note funds of equal maturity.  123 linked to an arbitrage paper that seemed to suggest there were lots of $100 bills lying on the ground.

PS.  I’ve been so busy that I haven’t linked to this David Beckworth and William Ruger article on Milton Friedman in Investor’s Business Daily.  Good stuff.

PPS.  I also wanted to link to this good James Hamilton post on QE:

A related complication is the fact that the market has already anticipated substantial additional LSAP [i.e. QE]. My guess is that an additional trillion dollars in purchases is already priced into current bond yields and exchange rates.

For all these reasons, the key message of the November FOMC statement may not be the size of purchases that the Fed announces, but instead the framework it offers as guidance for exactly what such purchases are intended to accomplish.

Exactly.  It’s all about the framework.  In retrospect, the biggest problem in the second half of 2008 was the lack of a policy framework.  The was no indication that the Fed would do anything to stop, or later reverse, the sickening plunge in NGDP.

A few notes on the GDP revisions

The new GDP figures include some pretty significant revisions of the past data.  Most people have focused on the fact that the new figures show a significantly bigger drop in 2009 GDP than originally estimated.  Even the original 2009 NGDP figures showed the biggest drop since 1938, but these have been revised further downward.

It appears to me that most of the revision is based on changes in the third quarter of 2008.  Before discussing those revisions, I’d like to talk about why that quarter is so important.  The standard view of this recession is that the housing slump of 2007 triggered a moderate banking crisis and a very mild recession at the beginning of 2008.  Then after Lehman failed, the banking crisis got much worse, and therefore the recession became much worse.

My view has always been different.  I agree with the standard interpretation of the original, and relatively mild, recession of early 2008.  But I argued that the recession worsened dramatically before Lehman failed, and that this led to a decline in NGDP growth expectations that severely reduced asset prices and made the banking crisis much worse.

One problem with my view is that it seemed like the severe fall in GDP (real and nominal) began in the 4th quarter of 2008, which was after Lehman had failed in mid-September.  Initial reports showed only a 0.3% fall in 2008:Q3 RGDP.  As a result, all I could do was rather pathetically argue that July was a strong month, and point to the fact that industrial production (which is measured monthly) suddenly began falling sharply in August 2008.  And that this showed the economic weakness had spread out of housing even before Lehman failed.

The newly revised GDP accounts paint a very different picture of the recession.  Instead of two quarters of steeply falling RGDP (2008:Q4, and 2009:Q1) there are now three really bad quarters.  The third quarter of 2008 is now estimated to have seen a 4.0% plunge in RGDP.  Nominal growth slowed abruptly from the roughly 5% norm of preceding years, to only 0.4%.  And even that is probably overstated, as the nominal GDP numbers rely on rent imputation values for housing that almost comically overstate inflation during a housing crash (as I’ve discussed in previous posts.)

So now we know that the severe recession of 2008-09 began in the third quarter.  Since Lehman didn’t fail until the quarter was almost over, there is simply no way it could explain why the recession got much worse during those summer months.  What can explain the worsening recession?  How about a Fed that refused to cut rates for nearly 6 months after April 2008, despite a steadily falling Wicksellian equilibrium interest rate.  A Fed focusing on headline inflation numbers driven up by imported oil prices, not the expenditures on American-made goods and services.

BTW, how can the initial GDP numbers be so far off in an economy that is swimming with data and high tech computers?  Four weeks after the quarter ended the RGDP growth was forecast at negative 0.3%, and only now, two years later, we find out it was minus 4.0%?  That’s a pretty major error at a particularly important moment in the business cycle.  Too bad our policy makers were blindfolded as they were making crucial policy decisions.  Time to target the forecast?

One thing that makes me think I am on the right track is that every time I learn something new, it seems to support my view of events.  In many cases this was data that was already out there, but that I had not bothered to look up.  This includes the big drop in TIPS spreads, which began well before Lehman failed.  The huge rise in real interest rates in late 2008.  The huge rise in the dollar in late 2008, the fact that the housing crash spread from the sub-prime markets to the heartland  (and commercial RE) at precisely the moment when the recession spread from housing to industrial production in August 2008.  All of this I discovered in mid-2009, after I had already begun blogging.  But now we have information that neither I nor anyone else had access to until few days ago.  And again, it is strongly supportive of my GDP —-> post-Lehman crisis view of causality, and strongly in conflict with the conventional Lehman crisis —-> falling GDP interpretation.

I eagerly await further data revisions.

PS.  It’s worth looking at the NGDP numbers in the link above.  (Bottom line)  During the 4 quarters from mid-2008 to mid-2009, NGDP actually fell 3%; a bit more than 8% below the 5.2% long run trend, not less as I had assumed.  And during the so-called “recovery” of the past 4 quarters it has fallen another 1% below the 5% trend.  Where’s the effect of that $787 billion in fiscal stimulus?

And for those who believe wage and price flexibility solves all problems, consider that with 4% NGDP growth, we’d need 3.7% deflation to get the 7.7% RGDP growth we saw during the first 6 quarters of the 1983-84 recovery.  That recovery had 11% NGDP growth. When was the last time you saw an economy growing at 8% in a period of 4% deflation?  Never?  There’s a reason for that, wages and prices aren’t nearly flexible enough to overcome that sort of nominal sluggishness.

NGDP expectations: Falling like a stone

Date            S&P500       WTI oil     5-year TIPS spread

May 3        1202.26         86.19         2.00%

May 4        1173.60        82.74          1.94%

May 5        1165.87        79.97          1.89%

May 6        1128.15        77.11          1.79%

May 7       1110.88         75.11          1.75%

May 10    1159.73         76.80          1.85%

May 11     1159.75        76.37          1.86%

May 12    1171.67        75.65           1.92%

May 13    1157.44        74.40           1.89%

May 14    1135.68        71.61           1.83%

May 17   1136.94        70.08           1.81%

May 18   1120.80        69.41           1.77%

May 19   1115.05        69.87           1.70%

May 20   1071.59        68.01           1.60%

May 21   1072.58                            1.56%    (as of 10:30am)

The oil and stock prices (plus falling metals prices) are telling us that real growth expectations are probably falling.  TIPS spreads are telling us that inflation expectations are probably falling.  Anyone want to guess what is happening to NGDP growth expectations?  We can’t know for sure, but I’d wager that if we had an NGDP futures market, NGDP futures prices would have fallen significantly since May 3.  BTW, it is a disgrace that the government hasn’t created one.  It isn’t just me, Robert Shiller has been calling for an NGDP futures market as well.  We are flying half-blind, when we could have extremely valuable market data on NGDP expectations at a trivial cost to the Federal Reserve.  I wish more macroeconomists would speak out on this issue.