Why does a measly quarter point matter?
I was recently discussing my new book with someone, and he asked why a small difference in the Fed’s target interest rates could have vast effects on the economy, such as the Great Recession. Most people don’t even pay any attention to the fed funds rate, so how could a small misalignment have much impact on aggregate demand?
I’d break this down into two parts. First, what is the actual transmission mechanism between Fed interest rate policy and the economy? And second, how does a change in Fed policy become known to the broader public? I’ll start with the first question.
There are three ways to think about the transmission mechanism between the fed funds target and aggregate demand:
1. Interest rates as an epiphenomenon
2. Interest rates as a signaling mechanism
3. The cumulative process
I will use the example of December 2007 (the beginning of the Great Recession) as an example to illustrate these three concepts. You need to keep in mind that these aren’t really three different transmission mechanisms; they are three ways of visualizing what’s going on.
In December 2007, the Fed cuts rates 1/4%, at a time when markets were hoping for a 1/2% cut. The stock market crashed on the news, ending up almost 5% lower than where it would have ended up with a half point cut (over 2% lower in absolute terms.)
I often argue that interest rates are an epiphenomenon, something that happens as a side effect when monetary policy changes, but not the core of the policy. The core policy is changes in the supply and demand for base money. One way to institute a tight money policy is slowing the growth rate of the monetary base, which is exactly what the Fed did in late 2007. Interest rates may rise or fall in response; it depends on the relative importance of the liquidity, income and Fisher effects. In late 2007, tight money reduced interest rates. The reason the smaller than expected rate cut of December 2007 hurt markets is that the economy needed a bigger monetary base, and if the Fed had given it a bigger monetary base then rates would have fallen a bit faster. The base was the actual problem; interest rates a side effect.
Monetary policy affects all sorts of asset prices. In many cases, such as December 2007, the effect on other assets is much greater than the effect on short-term interest rates. Interest rates aren’t a good indicator of changes in the stance of monetary policy.
That’s a sort of monetarist explanation of how a measly quarter point can matter so much. Now for a Keynesian explanation:
The December 2007 Fed decision was viewed as a policy signal. Even a quarter point rate cut can have a big effect if the markets see the rate cut as signaling important changes in the future path of monetary policy. By itself, overnight interest rates have almost no impact on the economy—what matters is longer-term interest rates and other asset prices. But the way the Fed adjusts a short-term rate can send a powerful signal about the likely future path of monetary policy.
Now for a Wicksellian explanation:
Suppose the policy rate equals the natural rate of interest. Now assume the policy rate is suddenly raised 1/4%. Or if you prefer, assume the natural interest rate falls 1/2% and the Fed only cuts the policy rate by 1/4%. In either case, the policy rate is 1/4% above the natural rate. So what’s the big problem?
The big problem is that this small disequilibrium sets in motion a cumulative process. It slows the economy slightly, which reduces the natural interest rate slightly. Now the policy rate is 1/2% above the natural rate. The economy slows further, and now the policy rate is 3/4% above the natural rate. Eventually the Fed will begin cutting the policy rate, but by this time the natural rate is falling rapidly.
That’s the story of late 2007 and 2008. For instance, the Fed set the policy rate at 2% from late April to early October 2008. But during that period, the natural interest rate was falling sharply. How do we know this? Because NGDP growth was plunging dramatically lower. The Fed was behind the curve.
To most economists, the 2% policy rate did not seem like a big deal. But the financial markets became increasingly alarmed as it became apparent that this rate was too high to maintain adequate NGDP growth.
Again, all three of explanations are describing the same underlying transmission mechanism in different languages: monetarist, Keynesian and Wicksellian.
Now for the second part of the question. How does the broader public become aware of the policy change?
The public doesn’t direct observe monetary policy, but does observe the effect it has on informed observers in the financial markets. Upper middle class people spend less because their stocks go down. Working class people spend less because they lose a job building a commercial development when the high yield bond market tanks. Etc., etc. There are a million transmission mechanisms to the broader public.
So in one sense interest rates matter hardly at all, they are an epiphenomenon. In another sense interest rates can have an impact far beyond what even a Keynesian economist would expect, if the Fed sets its target at the wrong level and sets in motion a cumulative process of depression or high inflation.
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10. December 2021 at 12:50
Scott, would you agree yet that the Fed has abandoned the FAIT framework? They left themselves some wiggle-room on how you define it, but not enough to account for their behavior.
10. December 2021 at 13:07
Effem, It’s increasingly looking that way. We’ll see how things pan out over the next few years.
10. December 2021 at 16:43
Effem, the framework was never worth pursuing in any case!
https://marcusnunes.substack.com/p/is-the-new-monetary-policy-framework
10. December 2021 at 17:38
Marcus, whether you like the framework or not, it’s disastrous for Fed credibility to go to great lengths to design and launch a new framework then almost immediately abandon it (I’m assuming that’s the case but time will tell). You may prefer NGDP targeting but why do you think the Fed can be trusted to adhere to any framework? I’ve long said economists should spend a lot less time debating tweaks to some framework and a lot more time thinking about how to shield the Fed from politics.
Scott, let’s assume they’ve abandoned FAIT. What’s your theory as to why? It can’t be that our understanding of economics has changed in the past 6 months.
My theory, which I presented here years ago, is that the Fed long ago became too dependent on the wealth effect. They now live in fear of upsetting financial markets, which price negative real rates into perpetuity. The stock of wealth to GDP is the highest it’s ever been, which makes the system inherently unstable and creates various powerful constituencies that would rather saddle the public with inflation than risk upsetting the permanent upward trajectory of financial assets. The Fed essentially allowed itself to be captured.
10. December 2021 at 17:43
Effem, Keep in mind that exactly 12 months ago this comment section was full of people insisting that the Fed had abandoned FAIT, and used low TIPS spreads as the evidence. I told people to be patient. So a lot can change in a year.
10. December 2021 at 19:01
Word salad by Scott Sumner skimmed over…
I have a simple answer to why a “small difference in the Fed’s target interest rates could have vast effects on the economy”.
It doesn’t. Money is neutral, pace hyperinflation. If you see a cause and effect, even with variable lags and so forth, you’re being fooled by randomness. Which is most of you.
Now back to your regularly scheduled self-delusion…
10. December 2021 at 21:32
Why do you say they have abandoned FAIT? TIPS spreads suggest that the market believes FAIT.
11. December 2021 at 04:43
Kevin, FAIT is a commitment to achieve a 2% price level trend, with some flexibility to allow for over/under-shoots which are subsequently made up for to get back on trend. The look-back window cited by most on the Fed was 4-6 years. We are currently in the midst of a significant overshoot. FAIT allows for this but then calls for a period of sub-2% inflation to get back on the 2% price level path. Inflation expectations suggest that isn’t going to happen and we will instead experience a permanent jump in the price level. That is not FAIT…it more resembles “make things up as you go.”
11. December 2021 at 04:57
Scott, I agree we need more time to fully understand what the Fed is thinking.
Having said that, we are fast approaching the time when economists need to do some serious reflection on their “science.” Our most important economic institution (the Fed) devotes their resources to designing a new framework. They come up with FAIT, which is generally applauded by the profession. If inflation expectations are correct, they then abandon this mandate less than two years later with little coherent explanation given. The Fed can’t possibly believe the labor market is loose. Nor is it feasible that a small window of modest supply constraints in some goods changed the underlying science. Further, many of the same economists who applauded FAIT are now seemingly fine with it being abandoned – again, with little coherent explanation. This is not how a serious profession conducts itself.
To make matters worse, if my theory is correct, the Fed has abandoned FAIT out of fear of declining asset prices. Which is equivalent to using a regressive tax (inflation) to prop up assets largely held by the top 10%. This is hard to fathom.
11. December 2021 at 05:15
re: “The core policy is changes in the supply and demand for base money”
Base money used to be required reserves, as an increase in the currency component was contractionary (but always offset by concurrent expansions in Reserve Bank credit). And there were two different measures of reserves (notwithstanding the prudential reserves of the E-$ market).
“I know of no model that shows a transmission from bank reserves to inflation” – DONALD KOHN – former Vice Chairman of the Board of Governors of the Federal Reserve System
“Reserves don’t even factor into my model, that’s not what causes inflation and not how the Fed stimulates the economy. It’s a side effect.” – LAURENCE MEYER – a Federal Reserve System governor from June 1996 to January 2002
That put Sumner in a class by himself. But then Powell discontinued required reserves. Now we have to fall back on the money stock, as open market operations don’t differentiate between banks and nonbank counterparties.
11. December 2021 at 07:26
Kevin Erdmann and effem,
Is it possible the Fed believes in FAIT and is trying to achieve its goal, but that it’s difficult to continually identify the precise amount of asset purchases to do so? The ship is always off course, but the captain is always correcting?
11. December 2021 at 08:49
Kevin, You asked:
“TIPS spreads suggest that the market believes FAIT.”
I don’t see that. FAIT would require below 2% inflation going forward, and TIPS spreads predict the opposite.
Effem, I see no evidence that the Fed is motivated by propping up asset prices. The best way to raise asset prices is by doing a good job. Assets did poorly in the 1970s.
11. December 2021 at 10:08
Scott, I’m speculating on the Fed’s thinking because it’s hard to come up with anything that makes sense. I don’t think they are targeting asset prices per se. But I do think they are aware (even if just a gut feel) that with a wealth:gdp ratio so high and expected asset returns so low, that any degree of tightening has the potential to produce a massive rush into safe assets. They are fearful of the fragility of a system which has priced in negative real rates forever.
11. December 2021 at 10:10
I will also point out that we appear to have entered an age when a falling discount rate has been the primary driver of asset appreciation. It’s not like real gdp growth or productivity have been anything special. Quite the contrary.
11. December 2021 at 10:40
Yes, Todd, I think that’s a good description.
11. December 2021 at 13:29
Re:Todd.
Also, I suspect there’s a bit of a backward vs forward looking element here. Currently we probably have a mixture of some inflation that has bumped up somewhat persistently over 2%, some temporary, and some that will reverse. So there are probably some headwinds in near term inflation (used autos, etc) that will naturally bring inflation temporarily lower in the near term. The very sharply leveling off Eurodollar curve suggests that this is what the market expects. The fact that it has flattened quite a bit recently seems to suggest that if the market thinks the Fed won’t keep its FAIT target, it will be on the low side not the high side. There’s a lot to work out over the next year or so on this.
12. December 2021 at 06:01
Kevin, why would we infer what the market thinks of inflation from the Eurodollar curve? We have market prices for inflation (TIPS & inflation swaps).
12. December 2021 at 08:10
Are there any reasons that you support for the Fed to tighten by raising the rate on IOR? Or is the best way to shrink the balance sheet and let the Fed funds rate find a new equilibrium?
12. December 2021 at 09:29
Effem, You said:
“I will also point out that we appear to have entered an age when a falling discount rate has been the primary driver of asset appreciation.”
Yes, but that has nothing to do with monetary policy.
Bill, I’d rather they get rid of IOR entirely, and shrink the balance sheet.
12. December 2021 at 09:38
Interest rates are important if the public believes they are (and strongly enough to defeat expert evidence to the contrary). This also applies to interest changes and announcements of.
So it is important to make sure that that what is being communicated leads to the desired change in beliefs. That is not easy. Despite aurodafe’s duwing te inquisition there were people who did not want to belief that their beliefs were wrong..
It is quite a problem, maybe the most important problem for liberal market economies and assco0ciated democratic political systems. Unless one is a hopeless libertarian, no democratic government can avoid interfereing in the economy when a large enough portion of the electorate feels that something is what the government they want to vote for must do. UNless all candidate participants wouyld unanimously declare that there is nothing they can do to improve the lot of the majority, they will competen on *ususlly barely credible promises) for economists, the best woulod be to have a catalogue of conman who promise to change the flow of the Missouri or the inflow of migrants (equally difficult), but hide their lack of influence over economic policy and leave policy to experts or better robots programmed to perform effective (emphasis) NGDP targeting. Charlatan politicians might actually go for this. Economic acticivists (those stupid enough to commit themselves to some sort of economic policy that will improve welfare for their electorate and disregard the practicalities of institutions in the US) are at a severe disadvantage. That is the lessen of Trumpism. And I guess Trumpism is far more attractive for ambitious politicians than the common good or whatever.
12. December 2021 at 09:40
Apologies, too many typos and no edit function.
12. December 2021 at 09:47
Rien, No idea what you are saying. Can you rewrite that in English?
12. December 2021 at 13:22
I agree. I hate IOR. I was wondering what I’m missing.
12. December 2021 at 20:43
Political power has obviously changed. So either the Fed gets pretty direct political signals that explain its current path.
Or, at the very least, the Fed interprets the current signals in such a way.
13. December 2021 at 07:21
Meanwhile, the BOC appears to be adopting FAIT as well
13. December 2021 at 10:20
Christian, The problem with your theory is that the signals from Trump were more dovish than from Biden.
Garrett, Are you sure? I don’t see that.
13. December 2021 at 13:43
https://www.mpamag.com/ca/news/general/bank-of-canada-announces-inflation-target/319715
Aside from stimulating labour market activity, the BoC will “leverage the flexibility of the 1% to 3% range to help address the challenges of structurally low interest rates by using a broad set of tools, including sometimes holding its policy interest rate at a low level for longer than usual,” it said. “The Bank will utilize the flexibility of the 1% to 3% range only to an extent that is consistent with keeping medium-term inflation expectations well anchored at 2%.”
13. December 2021 at 16:14
sumner is so clueless. the fed does not do money. the fed does reserves. interest rates don’t matter, the quantity of money does, and the banks do money, and they are not lending much relatively. the congress does money, and they did it huge after covid, thus the inflation. sumner does better with movie reviews, which i have thought were quite good.
13. December 2021 at 20:25
Garrett, Thanks, but that doesn’t sound like FAIT. That’s flexible inflation targeting (FIT). Australia’s been doing that for years.
14. December 2021 at 05:11
The 5 year 5year forward inflation expectation is 2.07%. It dropped twice from about 2.40 in the last 2 months—-once before Fed changed its stance (maybe markets believed his transitory beliefs) and now a second time——maybe because he no longer believes his transitory idea and has changed his policy stance. Maybe Covid created and still creates confusion—-as business methods adapt.
I have always thought the AIT was a great —-even an obvious idea—-although I also never understood his time frames and conditions under which such changes would be made. But I assumed he did.
Now we learn he did not. Or it’s just not a good idea anymore (how does that happen so quickly).
Well, it is hard to deny we have higher than expected inflation by a good amount—-but he was hanging in there with “transitory”. The Fed has not had to deal with this issue in a long time.
We will learn more about his thought process shortly. But his rejection of AIT so quickly is disturbing.
14. December 2021 at 05:15
@ssumner, you wrote:
“Garrett, Thanks, but that doesn’t sound like FAIT. That’s flexible inflation targeting (FIT).”
To me it looks more like FAIT than it does to you; I think “only to an extent that is consistent with keeping medium-term inflation expectations well anchored at 2%” is a constraint that would keep them close to running an medium-term average inflation rate of 2%.
14. December 2021 at 07:19
I agree with Brent. My understanding is the “medium-term average inflation rate of 2%” language is new
14. December 2021 at 07:20
Sorry, meant to quote “medium-term inflation expectations well anchored at 2%”
14. December 2021 at 07:54
Garrett, if the short-term never matters are we actually targeting anything? Several years of big inflation or deflation can be safely ignored as long as the market expects to central bank to get back on track in 5 years? That sounds rudderless to me.
14. December 2021 at 11:03
9.6%? How?—The “reason” by the most quoted is because of various “demand-pull” theories. Nominal GDP Q3/Q3–also 9.6%—GDPNow is 8.7%. What is going on?
14. December 2021 at 15:33
Brent and Garrett, That’s not what AIT is. You need a commitment to make up previous mistakes to have AIT, not just a commitment to try for 2% going forward.
Maybe the Canadians will at some point do AIT, but that’s not what they are saying.
Here’s an analogy. You can argue that FAIT is sort of like NGDPLT, and indeed Jim Bullard made that point. But the Fed has not explicitly adopted NGDPLT.
14. December 2021 at 17:59
I doubt that the people standing in bread lines in Turkey are having such nuanced discussions about monetary policy. We’re pretty lucky right now–just need more people vaxxed.
15. December 2021 at 04:51
@ssumner: Thank you for your kind exposition!
15. December 2021 at 05:15
Do you know of a good paper/book/source on a policy like this? Anything in your new book?
15. December 2021 at 09:13
Joshua, My new book discusses these ideas.