The asset markets keep me from going insane

Over at Econlog I have a new post pointing out that negative IOR has had an unquestionably positive impact on asset prices, and yet much of the business press claims exactly the opposite.  This confused thinking makes it more likely that central banks will adopt bad policies in the future.

A similar problem occurred in late 2007 and early 2008, when the media adopted a Keynesian approach to monetary analysis, instead of a monetarist approach.

From August 2007 to May 2008, the Fed repeatedly cut interest rates, from 5.25% to 2.0%. The media treated this as an expansionary monetary policy, even though it was clearly exactly the opposite.  The monetary base did not change, and falling interest rates are actually contractionary when the money supply is stable.  Indeed it’s a miracle the economy didn’t do even worse.  NGDP growth slowed sharply, and I surprised there wasn’t an outright decline.

Here’s the monetarist approach:

NGDP = MB*(Base velocity), where V is positively related to nominal interest rates.

Thus if you cut interest rates without increasing the money supply, then V falls and policy becomes more contractionary. It’s monetary economics 101, but almost everyone seems to have forgotten this simple point.  Market’s responded favorably to larger than expected rate cuts, because they implied a bigger than expected boost to the monetary base, on that day.  But over time the base did not increase at all; the rate cuts were merely enough to keep it from falling.  So do more!!

Because the media wrongly thought money was getting easier, they became (wrongly) pessimistic about the efficacy of monetary policy, which led to President Bush’s failed fiscal stimulus of May 2008.  There is no economic model where Bush’s policy would be effective.  Interest rates were above zero, so monetary offset was fully applicable.  The Fed responded by putting rate cuts on hold, which drove the economy right off the cliff after June 2008.  By September the tight money caused Lehman to fail, as its balance sheet was highly leveraged, and exposed to asset price declines triggered by falling NGDP expectations.  Yet even Ben Bernanke inexplicably endorsed Bush’s tax rebates, even though there is no logical reason for him to have done so.  If more stimulus was needed in May, then the stance of monetary policy should have been more expansionary.  So do more!!

Bush’s policy was a lump sum tax rebate, which doesn’t even work on the supply-side.  And unlike more government spending, there isn’t even a New Keynesian argument that fiscal stimulus might boost aggregate supply by making people work harder.  It was really dumb policy, there’s nothing more to say.

So because the media and many economists wrongly though money was loose, we ended up with really bad macro policy. The recent backing away from additional negative IOR is more of the same.  Just as markets responded to unexpected rate cuts in late 2007 as if they were highly expansionary, markets responded to negative IOR in Europe and Japan as if it is expansionary.  But over longer periods of time the markets were more negative, because investors rightly perceived that central banks would not do enough.  So do more!!  In 2007-08 investors were pessimistic because they thought the Fed wasn’t cutting rates fast enough.  The Fed needed faster rate cuts to enable the monetary base to increase.  So do more!! Similarly, in recent months, markets in places like Japan have become pessimistic because the BOJ is not cutting rates fast enough, or is suggesting it may give up. But the media thinks the market is pessimistic because the BOJ is doing negative IOR, even though asset markets respond positively to negative IOR.

In both cases, people wrongly assumed that the problem was that the measures that were taken were not effective.  Instead of, “So do more!” it became perceived as, “So stop doing that, it’s not working.”  They ignored the fact that markets clearly indicated it was working, but that much more needed to be done.  Did I say, “So do more”?

Sometimes I think I’m going crazy—maybe everything I believe is wrong.  After all, almost everything I read is diametrically opposed to what clearly seems to be happening, or to what our textbooks teach us about monetary policy.  But then I look at the asset markets, and am reassured.  I’m not really losing my mind. Monetary stimulus is effective, and it’s needed in Japan and Europe, and was needed in 2007-08 in America.  No matter how many times the press tells us that the markets hate negative IOR, each new IOR news shock confirms once again that the markets prefer even more negative IOR in Europe and Japan.  I don’t have my head in the sand, it’s the business press that does.


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36 Responses to “The asset markets keep me from going insane”

  1. Gravatar of Kailer Kailer
    15. March 2016 at 09:22

    On the topic of fiscal offset: the press release for the Bank of Canada’s latest interest rate announcement had this little nugget: “An assessment of the impact of the upcoming federal budget’s fiscal measures will be incorporated into the Bank’s April projection.”
    Translation: “We’ll tell you in April how we intend to offset the federal budget’s fiscal measures.”

  2. Gravatar of Dustin Dustin
    15. March 2016 at 09:39

    “falling interest rates are actually contractionary when the money supply is stable”

    Are falling rates directly contractionary in such a scenario, or are they illustrating tightening monetary conditions that the CB is acknowledging and allowing?

  3. Gravatar of marcus nunes marcus nunes
    15. March 2016 at 09:47

    Scott, this sort of “confusion” is what makes me optimistic about the chances of success of NGDPAdvisers, a joint effort of James Alexander, Benjamin Cole, Justin Irving, myself and Mark Sadowski. The company will be up by the end of this month and everyone´s welcome to a two month free trial. Some “departments”, like the blog, will always be freely accessible.

  4. Gravatar of JCM JCM
    15. March 2016 at 10:01

    Scott,

    Roger Farmer was on Bloomberg today advocating raising Fed Funds rates, coupled with additional QE.
    http://rogerfarmerblog.blogspot.com/2016/03/why-fed-should-raise-rates-and-purchase.html

    Do you understand his argument?

  5. Gravatar of Kevin Erdmann Kevin Erdmann
    15. March 2016 at 10:10

    Curiously, the bias doesn’t seem to apply in the other direction. The subprime boom, ARMs,and the price bubble in places like AZ & NV all happened after the Fed initiated rate hikes in mid 2004. Synthetic CDOs like those in the Big Short didn’t really happen at all until after the Fed had pegged the Fed Funds Rate at 5.25%. Yet, most people seem satisfied with a generalized POV that synthetic CDOs, subprime loans, loose money, and rising home prices are all linked.

  6. Gravatar of TravisV TravisV
    15. March 2016 at 11:32

    A couple excellent new posts by Yglesias:

    http://www.vox.com/2016/3/15/11236618/trump-conservatives-working-class

    http://www.vox.com/2016/3/15/11232704/what-trump-supporters-believe

  7. Gravatar of jknarr jknarr
    15. March 2016 at 12:38

    Scott, the primary problem IMHO, is a bad vocabulary / usage of “monetary policy”. Monetary policy is all about base money (reserves+currency), while debt is all about the other M’s.

    More M debt is supposed to reflect loose monetary conditions. It’s the opposite. More debt reflects a scarcity of base money.

    In this topsy turvy world, the price of debt — interest rates — becomes the reified all-important prime mover of the economy. Rates are only prices, however:

    Next to this big, green, and fiery Rate Wizard is a little man watching NGDP and pushing a big red base money button. He’s the guy making you crazy. (IE, don’t fret rates, worry about the base and NGDP.)

    All negative IOR means is: 1) savers get additionally screwed (likely leading them to save more), 2) debt markets get additional re-leverage space (likely capital-destroying malinvestment — more share buybacks, yay!); and 3) the Treasury gets to dip its fat ladle into private bank accounts, illegally expropriate cash, and call it “policy”.

  8. Gravatar of foosion foosion
    15. March 2016 at 12:52

    >>From August 2007 to May 2008, the Fed repeatedly cut interest rates, from 5.25% to 2.0%. The media treated this as an expansionary monetary policy, even though it was clearly exactly the opposite.>>

    Just to be clear, you’re suggesting that the Fed “do more!!!”, not that they shouldn’t have cut?

  9. Gravatar of Gene Callahan Gene Callahan
    15. March 2016 at 12:59

    “Sometimes I think I’m going crazy—maybe everything I believe is wrong. ”

    But wait: I thought that there is no objective truth?! Then there is no objective wrong either.

  10. Gravatar of Christian List Christian List
    15. March 2016 at 15:36


    Yet even Ben Bernanke inexplicably endorsed Bush’s tax rebates, even though there is no logical reason for him to have done so.

    Tax cuts are fiscal policy, right? You pretty much always favor monetary policy over fiscal policy, right?

    So in other words: Do you favor tax cuts at all? Is there a situation in which you would favor tax cuts?

    I’m pretty sure what you would answer but I don’t want to influence a possible answer by you by my possibly wrong forecast.

  11. Gravatar of ssumner ssumner
    15. March 2016 at 15:52

    Kailor, Interesting. Hopefully it won’t change their projection, which means 100% offset.

    Dustin, I’d say they are directly tightening, as they boost the demand for base money, and reduce base velocity.

    Marcus, I look forward to that—keep me posted so I can publicize it.

    JCM, I applaud his effort to bring macro into the 21st century by focusing on asset market prices, but I’m not sold yet on the central bank buying stock.

    Kevin, For some people there hasn’t been any tight money since the early 1980s.

    Travis, Thanks, it may be a mistake to generalize about Trump supporters, he did better in Massachusetts than elsewhere.

    Foosion, I’m saying they should have increased the base faster; what that would have meant for interest rates is hard to say. There is some base increase that would have been fast enough to raise rates, although I wouldn’t have gone that far.

    Gene, You are making progress–keep reading your Rorty.

    Christian, Yes, there are cases where I would favor tax cuts, but that was not one of them, nor was that the sort of cut I’d favor.

  12. Gravatar of Benjamin Cole Benjamin Cole
    15. March 2016 at 16:17

    Nice post. I often wonder if we Market Monetarists need to improve our language, and PR.

    I think we should always speak of QE as “economically bullish” and pro-growth and pro-business.

    People against sound, pro-growth monetary policies are shrieky and we don’t need sanctimonious sermonettes about inflation from little boys in short pants.

    Jeez, the track record of the last 30 years is declining inflation and interest rates towards ZLB or minor deflation. This is an argument we can win.

    Try some PR dudes.

  13. Gravatar of Major-Freedom Major-Freedom
    15. March 2016 at 16:44

    “Here’s the monetarist approach:

    NGDP = MB*(Base velocity), where V is positively related to nominal interest rates.

    Thus if you cut interest rates without increasing the money supply, then V falls and policy becomes more contractionary. It’s monetary economics 101, but almost everyone seems to have forgotten this simple point.”

    ——

    One cannot “forget” to know what is not true. No, a fall in interest rates is not “contractionary” when the money supply is held constant.

    Sumner, you were already corrected on this point more than once, and yet you continue to repeat it. Why do you do that?

    What interest rate changes do in a context of invariable money is that it brings about a redistribution of existing spending. Velocity does not necessarily fall when interest rates fall in a context of invariable money. The historical positive correlation you see is not evidence of A necessarily causing B. It could be B causing A, or changes in C causing a similar effect on both A and B.

    Come on Sumner, this is logic 101.

    Think about it. Imagine you and someone else (this can be expanded for all people) spending $50,000 a year each. If you were to enter into a loan contract of say $10,000, then the difference between a proposed 10% interest rate this year as opposed to an existing 20% interest rate last year is not going to itself “cause” any fall in your combined spending. It will in fact “cause” a shift in spending from the lender to the borrower. Instead of the borrower paying the lender $2,000 in interest, the borrower pays the lender $1,000 in interest. That leaves more money for the borrower to spend and less for the lender to spend. You have no factor here that necessarily implies total spending between A and B will fall.

    What is true here is true for the entire population.

    The reason why you see a correlation between NGDP changes and interest rate changes is because changes in aggregate spending are ONE factor that causes changes in interest rates, not the other way around. The other is of course changes in the supply of money, which affect interest rates both directly through the loan market (liquidity effect), and indirectly through aggregate spending and price changes (inflation premium effect).

    You seem to have a rather mechanistic conception of how the money supply and interest rates are related. It is as if interest rates are somehow a positive addition to total spending. Where if people start paying less in interest, that this means there will be less spending as such.

    You do realize that paying interest is but a CHOICE, and ALTERNATIVE, in how a person and everyone together, can spend their money, right? If A pays less interest to B this year as compared to last year, that leaves more money for A to spend and less money for B to spend. Notice there is no change in money supply in any of these examples.

  14. Gravatar of Major-Freedom Major-Freedom
    15. March 2016 at 17:16

    The claim there is no such thing as objective truth and no such thing as objective wrong is itself a claim to an objective truth, at least with respect to the ability of the human mind.

    Rortyism is abject nonsense.

  15. Gravatar of Gary Anderson Gary Anderson
    15. March 2016 at 22:00

    There has to be a better way to make the economy prosper than asset inflation which has made the rich richer and the poor poorer. Asset inflation also has asset mispriced risk attached according to the Bank of America.

    Asset inflation is a tax on the average guy who uses a greater percentage of his income to procure the assets. The investor benefits, but he doesn’t create jobs.

    I think this is the weakest pillar of the Market Monetarist doctrine. It has hurt the middle class, badly. Maybe Scott makes enough money not to be hurt when assets go through the roof in price. But there has to be a better way. I realize it is better than negative bond interest rates, but there has to be a better way or the 1 percent will own all of America.

  16. Gravatar of Gary Anderson Gary Anderson
    15. March 2016 at 22:05

    How could one increase the money supply in 2007-2008 when Helocs as credit lines were pulled from homeowners? Even Stephen Williamson has said this was a prime method of curtailing lending at the mainstreet level. So, Helocs went away and the desire to own a house where prices weren’t going up and you couldn’t refi or get a Heloc slowed everything down. Considering that prices have bounced back much of the way, due to the rich buying up everything, a bailout of the homeowners, that Rick Santelli opposed, may have preserved the middle class. Certainly, Santelli was wrong when he said the middle class made a bet on housing and lost. He is a wicked and evil man.

  17. Gravatar of Dan W. Dan W.
    16. March 2016 at 05:13

    I applaud Scott for his honesty and his pragmatism. For not only can monetary policy boost asset prices but asset prices are easily measured. So Scott has found his killer argument for defending Monetarism.

    Now for those of you who thought Monetarism was about making the economy better? You’ve been duped. There is no macro-economic lever for fixing the economy. But Conservatives needed an alternative to Keynesianism so they embraced Monetarism and have been selling it as the panacea. Yet as we all can see the Monetarism solution is a trap that requires interest rates to be continually lowered to maintain the illusion of success.

    I invite anyone wishing to defend the Monetarism strategy of the past 10 years to explain the exit strategy. How can interest rates ever rise without creating tremendous economic upheaval? Debt is too high and needs to be revaluated. But the Monetarists do not want to allow that process to play out. So each and every time the pressure of debt climbs the Monetarists cry for more currency devaluation. Crisis averted! But only for the moment.

    The promise from the Monetarists is if interest rates can get low enough than real economic activity can generate the increased profits needed to pay the increased interest costs that will occur as interest rates rise. But the Monetarists are lying. For the reality is that by subverting the business cycle and saving lenders from debt default the Monetarist solution prevents profits from increasing! So while there is a short term pop in asset prices with each monetary intervention the crushing pressure of capitalism always returns. Debt is too high and corporations are over-capitalized resulting in profit margins that are too low. Yet the one thing that needs to happen for renewed growth cannot happen because the Monetarists stand in the way.

    Schumpeter was right. It will be the “Capitalists” who will destroy Capitalism.

  18. Gravatar of Anthony McNease Anthony McNease
    16. March 2016 at 05:51

    Scott:

    “The monetary base did not change, and falling interest rates are actually contractionary when the money supply is stable. Indeed it’s a miracle the economy didn’t do even worse.”

    This point was what I was attempting to get at a couple of weeks back when I asked what the impact would be of raising rates (expansionary) and lowering IOR (expansionary). When I talked about raising rates I should have explicitly said I didn’t want to decrease base money. Instead I inartfully just referenced your older post talking about how higher rates by themselves are expansionary.

    That being said, what would be the effect of a policy of:
    1) higher rates
    2) stable base money
    3) lower IOR

  19. Gravatar of Ray Lopez Ray Lopez
    16. March 2016 at 07:01

    @sumner: (Sumner) “Thus if you cut interest rates without increasing the money supply, then V falls and policy becomes more contractionary” – no, V is endogenous, as is the money supply. It depends on what people do, not what is dictated by a central bank.

    “Sometimes I think I’m going crazy—maybe everything I believe is wrong” – exactly. But your followup sentence quickly nixed this sober point.

    @M. Nunes – you’re hiring B. Cole to blog for you? Who would pay to hear what a Thai turkey farmer has to say about economics?

  20. Gravatar of E. Harding E. Harding
    16. March 2016 at 07:28

    Thomas Friedman is flipping brilliant:

    http://www.nytimes.com/2016/03/16/opinion/let-trump-make-our-trans-pacific-trade-deal.html

    Obama doesn’t know how to defend his agreements.

  21. Gravatar of collin collin
    16. March 2016 at 09:25

    Scott, In terms of monetary policy

    1) The US core inflation is over 2% is centered around housing and healthcare. (Energy and food are down. So basically the 2002/2003 economy) Sounds like we need slight tightening before housing grows too much. (I agree with freeing local housing regulations but I am with Matt Y. the impact is limited.)
    2) In terms of Japan and Europe, I don’t see how the Central Bank can do much against the falling working age population. Central Banks can do more but I think the medicine will create bigger problems than what they are solving for.
    3)

  22. Gravatar of Ghirlandaio Ghirlandaio
    16. March 2016 at 09:56

    Professor Sumner:

    I have enormous respect for you and your decades of experience, this question is in no way meant to be trollish or snarky.

    You said

    “….if you cut interest rates without increasing the money supply…..”

    We know that the phrase “cutting rates ” is an inaccurate shorthand. As you know, The central bank does not cut rates, it trades reserves (base money) for gov’t securities with the 22 primary dealers at the center of the banking system.

    This increase in base money, ceteris paribus, and given the laws of supply and demand, will result in a lower rate of interest on overnight fed funds.

    Using this framework, “cutting rates” would be synonymous with increasing the money supply, and cutting rates without an increase in money supply would be a logical impossibility.

    What am I missing here?

  23. Gravatar of ssumner ssumner
    16. March 2016 at 10:15

    Anthony, You said:

    “That being said, what would be the effect of a policy of:
    1) higher rates
    2) stable base money
    3) lower IOR”

    That’s impossible to do. The events I described in 2007-08 cannot be replicated at the drop of a hat, the Fed was only able to do that because the demand for base money was falling.

    Collin, The markets expect less than 2% inflation going forward, so I don’t agree. Admittedly the markets might be wrong, but you go with the best information you have.

    Also recall the Fed targets headline PCE, not core. So they’ve undershot in the past few years, and the markets think they’ll continue to undershoot.

    Ghirlandaio, You asked:

    “This increase in base money, ceteris paribus, and given the laws of supply and demand, will result in a lower rate of interest on overnight fed funds.

    Using this framework, “cutting rates” would be synonymous with increasing the money supply, and cutting rates without an increase in the money supply would be a logical impossibility.

    What am I missing here?”

    In this case, ceteris was not paribus. (The point missed by Anthony, above) During this period the demand curve for money was shifting left, so even with no increase in the supply of money, the interest rate fell.

  24. Gravatar of ssumner ssumner
    16. March 2016 at 10:40

    Harding, Actually, Friedman’s post is mocking Trump. Trump never, ever could have pulled off a deal that good.

  25. Gravatar of E. Harding E. Harding
    16. March 2016 at 11:01

    “Trump never, ever could have pulled off a deal that good.”

    -Why not? And if he did, he would have found a way to spin it much better than Obama, much along the lines Friedman did. Trump’s a master advertiser. Look at his ads for Trump University.

  26. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    16. March 2016 at 11:04

    The immediate reaction of the stock market to Yellen’s announcement of no interest rate increase was positive.

  27. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    16. March 2016 at 11:15

    http://www.investors.com/market-trend/stock-market-today/stocks-strengthen-a-bit-after-fed-sounds-dovish-tone/?ven=YahooCP&src=AURLLED&ven=yahoo&ref=yfp

    ‘The Nasdaq and S&P 500 rose 0.5% each, and the Dow Jones industrial average added 0.4%. Volume on the NYSE and Nasdaq was tracking lower than Tuesday’s levels in the stock market today.

    ‘The Fed, as expected, left interest rates unchanged, but sounded a bit more dovish than prior statements. The dollar reversed lower and gold rallied on the news. SPDR Gold Shares (GLD) rose 1.2% to $119.34. It’s trying to reclaim a 120.94 buy point.’

  28. Gravatar of TravisV TravisV
    16. March 2016 at 16:09

    Prof. Sumner,

    These comments by Williamson and French in National Review have created a firestorm:

    http://www.nationalreview.com/corner/432796/working-class-whites-have-moral-responsibilities-defense-kevin-williamson

    I’m curious what your take is. It seems to me that people who think like utilitarians aren’t remotely as moralizing and judgmental as Williamson and French.

    Anyway, many people have written about this. Here’s Krugman’s take:

    http://krugman.blogs.nytimes.com/2016/03/15/return-of-the-undeserving-poor/?_r=1

  29. Gravatar of Ray Lopez Ray Lopez
    16. March 2016 at 16:54

    Note Sumner’s answer to Ghirlandaio, a genuine student of monetarism and True Believe. Sumner seems dishonest with words. When he wants to, he will say the Supply and Demand curves for money (IS-LM) are shifting in either Supply or Demand in such a way as to get his preferred answer. He also with improperly toy with the idea of short and long term effects (most of these models, like IS-LM, explicitly don’t model in long-term effects) to get a preferred answer. Sumner toys with words, twisting their meaning, to always be ‘misunderstood’ by even his supporters.

  30. Gravatar of Ray Lopez Ray Lopez
    16. March 2016 at 16:56

    @E. Harding – quit trolling Sumner. Friedman’s argument is meant to be sarcastic, saying it’s Obama’s trade agreement at present that he’s talking about, not Trump’s. He explicitly says so.

  31. Gravatar of E. Harding E. Harding
    16. March 2016 at 17:36

    Ray Lopez remains unable to understand anything. And no, I won’t quit trolling Sumner, just as long as Sumner’s trolling me.

  32. Gravatar of Anthony McNease Anthony McNease
    17. March 2016 at 03:17

    Scott,

    How did the Fed change rates in 07-08 without changing the money supply and why couldn’t they do it again? I honestly don’t know, so this isn’t a snarky ask. Thanks.

  33. Gravatar of Jay Hattler Jay Hattler
    17. March 2016 at 10:57

    “Here’s the monetarist approach: NGDP = MB*(Base velocity), where V is positively related to nominal interest rates.”

    One searches in vain within MM for a reasoned explanation or defense of why V is positively correlated with nominal interest rates. Appeals to being “intuitive” or “self-evident” don’t cut it. Why could V not be *negatively* correlated? Would not lower interest rates promote investment, thus increasing velocity?

    So much of MM seems arbitrary, with the use of “formulas” which cannot be proven.

  34. Gravatar of Anthony McNease Anthony McNease
    18. March 2016 at 06:05

    Jay Hattler:

    “One searches in vain within MM for a reasoned explanation or defense of why V is positively correlated with nominal interest rates. Appeals to being “intuitive” or “self-evident” don’t cut it. Why could V not be *negatively* correlated? Would not lower interest rates promote investment, thus increasing velocity?”

    Lowering rates promotes the liquidity effect which would increase V, but rates approaching zero make the opportunity cost of holding cash versus investing or lending also approach zero (I think this is called the Income Effect). That is positively correlated with V. I don’t think either of these is linear in nature and in my mind close to zero changes in rates will have much bigger impacts from the income effect than the liquidity effect.

  35. Gravatar of Anthony McNease Anthony McNease
    19. March 2016 at 05:43

    Count Grishnackh,

    Oh sorry. The answer is 42.

  36. Gravatar of ssumner ssumner
    20. March 2016 at 16:57

    Travis, It’s generally a mistake to generalize about the life choices of tens of millions of people that you have never met.

    It’s certainly fair to criticize their votes, but I would avoid moralizing about what drugs they do or do not take.

    Anthony, They simply set their fed funds target lower at a time when free market rates were already falling.

    Jay, You said:

    “One searches in vain within MM for a reasoned explanation or defense of why V is positively correlated with nominal interest rates.”

    This blog is aimed at people who already have had some basic economics, at least money and banking. That’s why I don’t explain every detail, from square one.

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