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Monetarism and the Great Depression

Last Friday, Scott Sumner posted a diatribe against the IS-LM triggered by a set of slides by Chris Foote of Harvard and the Boston Fed explaining how the effects of monetary policy can be analyzed using the IS-LM framework. What really annoys Scott is the following slide in which Foote compares the “spending (aka Keynesian) hypothesis” and the “money (aka Monetarist) hypothesis” as explanations for the Great Depression. I am also annoyed; whether more annoyed or less annoyed than Scott I can’t say, interpersonal comparisons of annoyance, like interpersonal comparisons of utility, being beyond the ken of economists. But our reasons for annoyance are a little different, so let me try to explore those reasons. But first, let’s look briefly at the source of our common annoyance.

The “spending hypothesis” attributes the Great Depression to a sudden collapse of spending which, in turn, is attributed to a collapse of consumer confidence resulting from the 1929 stock-market crash and a collapse of investment spending occasioned by a collapse of business confidence. The cause of the collapse in consumer and business confidence is not really specified, but somehow it has to do with the unstable economic and financial situation that characterized the developed world in the wake of World War I. In addition there was, at least according to some accounts, a perverse fiscal response: cuts in government spending and increases in taxes to keep the budget in balance. The latter notion that fiscal policy was contractionary evokes a contemptuous response from Scott, more or less justified, because nominal government spending actually rose in 1930 and 1931 and spending in real terms continued to rise in 1932. But the key point is that government spending in those days was too meager to have made much difference; the spending hypothesis rises or falls on the notion that the trigger for the Great Depression was an autonomous collapse in private spending.

But what really gets Scott all bent out of shape is Foote’s commentary on the “money hypothesis.” In his first bullet point, Foote refers to the 25% decline in M1 between 1929 and 1933, suggesting that monetary policy was really, really tight, but in the next bullet point, Foote points out that if monetary policy was tight, implying a leftward shift in the LM curve, interest rates should have risen. Instead they fell. Moreover, Foote points out that, inasmuch as the price level fell by more than 25% between 1929 and 1933, the real value of the money supply actually increased, so it’s not even clear that there was a leftward shift in the LM curve. You can just feel Scott’s blood boiling:

What interests me is the suggestion that the “money hypothesis” is contradicted by various stylized facts. Interest rates fell. The real quantity of money rose. In fact, these two stylized facts are exactly what you’d expect from tight money. The fact that they seem to contradict the tight money hypothesis does not reflect poorly on the tight money hypothesis, but rather the IS-LM model that says tight money leads to a smaller level of real cash balances and a higher level of interest rates.

To see the absurdity of IS-LM, just consider a monetary policy shock that no one could question—hyperinflation. Wheelbarrows full of billion mark currency notes. Can we all agree that that would be “easy money?” Good. We also know that hyperinflation leads to extremely high interest rates and extremely low real cash balances, just the opposite of the prediction of the IS-LM model. In contrast, Milton Friedman would tell you that really tight money leads to low interest rates and large real cash balances, exactly what we do see.

Scott is totally right, of course, to point out that the fall in interest rates and the increase in the real quantity of money do not contradict the “money hypothesis.” However, he is also being selective and unfair in making that criticism, because, in two slides following almost immediately after the one to which Scott takes such offense, Foote actually explains that the simple IS-LM analysis presented in the previous slide requires modification to take into account expected deflation, because the demand for money depends on the nominal rate of interest while the amount of investment spending depends on the real rate of interest, and shows how to do the modification. Here are the slides:

Thus, expected deflation raises the real rate of interest thereby shifting the IS curve to the left while leaving the LM curve where it was. Expected deflation therefore explains a fall in both nominal and real income as well as in the nominal rate of interest; it also explains an increase in the real rate of interest. Scott seems to be emotionally committed to the notion that the IS-LM model must lead to a misunderstanding of the effects of monetary policy, holding Foote up as an example of this confusion on the basis of the first of the slides, but Foote actually shows that IS-LM can be tweaked to accommodate a correct understanding of the dominant role of monetary policy in the Great Depression.

The Great Depression was triggered by a deflationary scramble for gold associated with the uncoordinated restoration of the gold standard by the major European countries in the late 1920s, especially France and its insane central bank. On top of this, the Federal Reserve, succumbing to political pressure to stop “excessive” stock-market speculation, raised its discount rate to a near record 6.5% in early 1929, greatly amplifying the pressure on gold reserves, thereby driving up the value of gold, and causing expectations of the future price level to start dropping. It was thus a rise (both actual and expected) in the value of gold, not a reduction in the money supply, which was the source of the monetary shock that produced the Great Depression. The shock was administered without a reduction in the money supply, so there was no shift in the LM curve. IS-LM is not necessarily the best model with which to describe this monetary shock, but the basic story can be expressed in terms of the IS-LM model.

So, you ask, if I don’t think that Foote’s exposition of the IS-LM model seriously misrepresents what happened in the Great Depression, why did I say at beginning of this post that Foote’s slides really annoy me? Well, the reason is simply that Foote seems to think that the only monetary explanation of the Great Depression is the Monetarist explanation of Milton Friedman: that the Great Depression was caused by an exogenous contraction in the US money supply. That explanation is wrong, theoretically and empirically.

What caused the Great Depression was an international disturbance to the value of gold, caused by the independent actions of a number of central banks, most notably the insane Bank of France, maniacally trying to convert all its foreign exchange reserves into gold, and the Federal Reserve, obsessed with suppressing a non-existent stock-market bubble on Wall Street. It only seems like a bubble with mistaken hindsight, because the collapse of prices was not the result of any inherent overvaluation in stock prices in October 1929, but because the combined policies of the insane Bank of France and the Fed wrecked the world economy. The decline in the nominal quantity of money in the US, the great bugaboo of Milton Friedman, was merely an epiphenomenon.

As Ron Batchelder and I have shown, Gustav Cassel and Ralph Hawtrey had diagnosed and explained the causes of the Great Depression fully a decade before it happened. Unfortunately, whenever people think of a monetary explanation of the Great Depression, they think of Milton Friedman, not Hawtrey and Cassel. Scott Sumner understands all this, he’s even written a book – a wonderful (but unfortunately still unpublished) book – about it. But he gets all worked up about IS-LM.

I, on the other hand, could not care less about IS-LM; it’s the idea that the monetary cause of the Great Depression was discovered by Milton Friedman that annoys the [redacted] out of me.

UPDATE: I posted this post prematurely before I finished editing it, so I apologize for any mistakes or omissions or confusing statements that appeared previously or that I haven’t found yet.

Stephen Williamson Defends the FOMC

Published March 6, 2014 Ben Bernanke , Federal Reserve , Stephen Williamson 12 Comments
Tags: 2008 financial crisis, FOMC, Matt Yglesias

Publication of the transcripts of the FOMC meetings in 2008 has triggered a wave of criticism of the FOMC for the decisions it took in 2008. Since the transcripts were released I have written two posts (here and here) charging that the inflation-phobia of the FOMC was a key (though not the sole) cause of the financial crisis in September 2008. Many other bloggers, Matt Yglesias, Scott Sumner, Brad Delong and Paul Krugman, just to name a few, were also sharply critical of the FOMC, though Paul Krugman at any rate seemed to think that the Fed’s inflation obsession was merely weird rather than catastrophic.

Stephen Williamson, however, has a different take on all this. In a post last week, just after the release of the transcripts, Williamson chastised Matt Yglesias for chastising Ben Bernanke and the FOMC for not reducing the Federal Funds target at the September 16 FOMC meeting, the day after Lehman went into bankruptcy. Williamson quotes this passage from Yglesias’s post.

New documents released last week by the Federal Reserve shed important new light on one of the most consequential and underdiscussed moments of recent American history: the decision to hold interest rates flat on Sept. 16, 2008. At the time, the meeting at which the decision was made was overshadowed by the ongoing presidential campaign and Lehman Brothers’ bankruptcy filing the previous day. Political reporters were focused on the campaign, economic reporters on Lehman, and since the news from the Fed was that nothing was changing, it didn’t make for much of a story. But in retrospect, it looks to have been a major policy blunder—one that was harmful on its own terms and that set a precedent for a series of later disasters.

To which Williamson responds acidly:

So, it’s like there was a fire at City Hall, and five years later a reporter for the local rag is complaining that the floor wasn’t swept while the fire was in progress.

Now, in a way, I agree with Williamson’s point here; I think it’s a mistake to overemphasize the September 16 meeting. By September 16, the damage had been done. The significance of the decision not to cut the Fed Funds target is not that the Fed might have prevented a panic that was already developing (though I don’t rule out the possibility that a strong enough statement by the FOMC might have provided enough reassurance to the markets to keep the crisis from spiraling out of control), but what the decision tells us about the mindset of the FOMC. Just read the statement that the Fed issued after its meeting.

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Strains in financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending. Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

What planet were they living on? “The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee.” OMG!

Williamson, however, sees it differently.

[T]he FOMC agreed to keep the fed funds rate target constant at 2%. Seems like this was pretty dim-witted of the committee, given what was going on in financial markets that very day, right? Wrong. At that point, the fed funds market target rate had become completely irrelevant.

Williamson goes on to point out that although the FOMC did not change the Fed Funds target, borrowings from the Fed increased sharply in September, so that the Fed was effectively easing its policy even though the target – a meaningless target in Williamson’s view – had not changed.

Thus, by September 16, 2008, it seems the Fed was effectively already at the zero lower bound. At that time the fed funds target was irrelevant, as there were excess reserves in the system, and the effective fed funds rate was irrelevant, as it reflected risk.

I want to make two comments on Williamson’s argument. First, the argument is certainly at odds with Bernanke’s own statement in the transcript, towards the end of the September 16 meeting, giving his own recommendation about what policy action the FOMC should take:

Overall I believe that our current funds rate setting is appropriate, and I don’t really see any reason to change…. Cutting rates would be a very big step that would send a very strong signal about our views on the economy and about our intentions going forward, and I think we should view that step as a very discrete thing rather than as a 25 basis point kind of thing. We should be very certain about that change before we undertake it because I would be concerned, for example, about the implications for the dollar, commodity prices, and the like.

So Bernanke clearly states that his view is that the current fed funds target was “appropriate.” He did not say that the fed funds rate is at the lower bound. Instead, he explains why he does not want to cut the fed funds rate, implying that he believed that cutting the rate was an option. He didn’t want to exercise that option, because he did not like the “very strong signal about our views on the economy and about our intentions going forward” that a rate cut would send. Indeed, he intimates that a rate cut of 25 basis points would be meaningless under the circumstances, suggesting an awareness, however vague, that a crisis was brewing, so that a cut in the target rate would have to be substantial to calm, rather than scare, the markets. (The next cut, three weeks later, was 50 basis points, and things only got worse.)

Second, suppose for argument’s sake, that Williamson is right and Bernanke (and almost everyone else) was wrong, that the fed funds target was meaningless. Does that mean that the Fed’s inflation obsession in 2008 is just an optical illusion with no significance — that the Fed was powerless to have done anything that would have increased expenditure and income, thereby avoiding or alleviating the crisis?

I don’t think so, and the reason is that, as I pointed out in my previous post, the dollar began appreciating rapidly in forex markets in mid-July 2009, the dollar euro exchange rate appreciating by about 12% and the trade-weighted value of the dollar appreciating by about 10% between mid-July and the week before the Lehman collapse. An appreciating that rapid was a clear sign that there was a shortage of dollar liquidity which was causing spending to drop all through the economy, as later confirmed by the sharp drop in third-quarter GDP. The dollar fell briefly in the days just before and after the Lehman collapse, then resuming its sharp ascent as the financial crisis worsened in September and October, appreciating by another 10-15%.

So even if the fed funds target was ineffectual, the Fed, along with the Treasury, still had it within their power to intervene in forex markets, selling dollars for euros and other currencies, thereby preventing the dollar from rising further in value. Unfortunately, as is clear from the transcripts, the FOMC thought that the rising dollar was a favorable development that would reduce the inflation about which it was so obsessively concerned. So the FOMC happily watched the dollar rise by 25% against other currencies between July and November as the economy tanked, because, as the September 16 statement of the FOMC so eloquently put it, “upside risks to inflation are . . . of significant concern to the Committee.” The FOMC gave us the monetary policy it wanted us to have.

Why Fed Inflation-Phobia Mattered

Published March 4, 2014 Federal Reserve , financial crisis , monetary policy , Paul Krugman 17 Comments
Tags: Charles Plosser, FOMC, James Lacker, Matthew O'Brien, Paul Krugman, Richard Fisher

Last week I posted an item summarizing Matthew O’Brien’s article about the just-released transcripts of FOMC meetings in June, August and September of 2008. I spiced up my summary by quoting from and commenting on some of the more outrageous quotes that O’Brien culled from the transcripts, quotes showing that most of the FOMC, including Ben Bernanke, were obsessing about inflation while unemployment was rising rapidly and the economy contracting sharply. I especially singled out what I called the Gang of Four — Charles Plosser, Jeffrey Lacker, Richard Fisher, and Thomas Hoenig, the most militant inflation hawks on the FOMC — noting that despite their comprehensive misjudgments of the 2008 economic situation and spectacularly wrongheaded policy recommendations, which they have yet to acknowledge, much less apologize for, three of them (Plosser, Lacker, and Fisher) continue to serve in their Fed positions, displaying the same irrational inflation-phobia by which they were possessed in 2008. Paul Krugman also noticed O’Brien’s piece and remarked on the disturbing fact that three of the Gang of Four remain in their policy-making positions at the Fed, doing their best to keep the Fed from taking any steps that could increase output and employment.

However, Krugman went on to question the idea — suggested by, among others, me — that it was the Fed’s inflation phobia that produced the crash of 2008. Krugman has two arguments for why the Fed’s inflation phobia in 2008, however silly, did not the cause of the crash.

First, preventing the financial crisis would have taken a lot more than cutting the Fed funds rate to zero in September 2008 rather than December. We were in the midst of an epic housing bust, which was in turn causing a collapse in the value of mortgage-backed securities, which in turn was causing a collapse of confidence in financial firms. Cutting rates from very low to extremely low a few months earlier wouldn’t have stopped that collapse.

What was needed to end the run on Wall Street was a bailout — both the actual funds disbursed and the reassurance that the authorities would step in if necessary. And that wasn’t in the cards until, as Rick Mishkin observed in the transcripts, “something hit the fan.”

Second, even avoiding the financial panic almost surely wouldn’t have meant avoiding a prolonged economic slump. How do we know this? Well, what we actually know is that the panic was in fact fairly short-lived, ending in the spring of 2009. It doesn’t really matter which measure of financial stress you use, they all look like this:

Yet the economy didn’t come roaring back, and in fact still hasn’t. Why? Because the housing bust and the overhang of household debt are huge drags on demand, even if there isn’t a panic in the financial market.

Sorry, but, WADR, I have to disagree with Professor Krugman.

The first argument is not in my view very compelling, because the Fed’s inflation-phobia did not suddenly appear at the September 2008 FOMC meeting, or even at the June meeting, though, to be sure, its pathological nature at those meetings does have a certain breathtaking quality; it had already been operating for a long time before that. If you look at the St. Louis Fed’s statistics on the monetary base, you will find that the previous recession in 2001 had been preceded in 2000 by a drop of 3.6% in the monetary base. To promote recovery, the Fed increased the monetary base in 2001 (partly accommodating the increased demand for money characteristic of recessions) by 8.5%. The monetary base subsequently grew by 7% in 2002, 5.2% in 2003, 4.4% in 2004, 3.2% in 2005, 2.6% in 2006, and a mere 1.2% in 2007.

The housing bubble burst in 2006, but the Fed was evidently determined to squeeze inflation out of the system, as if trying to atone for its sins in allowing the housing bubble in the first place. From January to September 10, 2008, the monetary base increased by 3.3%. Again, because the demand for money typically increases in recessions, one cannot infer from the slight increase in the rate of growth of the monetary base in 2008 over 2006 and 2007 that the Fed was easing its policy stance. (On this issue, see my concluding paragraph.) The point is that for at least three years before the crash, the Fed, in its anti-inflationary zelotry, had been gradually tightening the monetary-policy screws. So it is simply incorrect to suggest that there was no link between the policy stance of the Fed and the state of the economy. If the Fed had moderated its stance in 2008 in response to ample evidence that the economy was slowing, there is good reason to think that the economy would not have contracted as rapidly as it did, starting, even before the Lehman collapse, in the third quarter of 2008, when, we now know, the economy had already begun one of the sharpest contractions of the entire post World War II era.

As for Krugman’s second argument, I believe it is a mistake to confuse a financial panic with a recession. A financial panic is an acute breakdown of the financial system, always associated with a period of monetary stringency when demands for liquidity cannot be satisfied owing to a contagious loss of confidence in the solvency of borrowers and lenders. The crisis is typically precipitated by a too aggressive tightening of monetary conditions by the monetary authority seeking to rein in inflationary pressures. The loss of confidence is thus not a feature of every business-cycle downturn, and its restoration no guarantee of a recovery. (See my post on Hawtrey and financial crises.) A recovery requires an increase aggregate demand, which is the responsibility of those in charge of monetary policy and fiscal policy. I confess to a measure of surprise that the author of End This Depression Now would require a reminder about that from me.

A final point. Although the macroeconomic conditions for an asset crash and financial panic had been gradually and systematically created by the Fed ever since 2006, the egregious Fed policy in the summer of 2008 was undoubtedly a major contributing cause in its own right. The magnitude of the policy error is evident in this graph from the St. Louis Fed, showing the dollar/euro exchange rate.

From April to July, the exchange rate was fluctuating between $1.50 and $1.60 per euro. In mid-July, the dollar began appreciating rapidly against the euro, rising in value to about $1.40/euro just before the Lehman collapse, an appreciation of about 12.5% in less than two months. The only comparable period of appreciation in the dollar/euro exchange rate was in the 1999-2000 period during the monetary tightening prior to the 2001 recession. But the 2008 appreciation was clearly greater and steeper than the appreciation in 1999-2000. Under the circumstances, such a sharp appreciation in the dollar should have alerted the FOMC that there was a liquidity shortage (also evidenced in a sharp increase in borrowings from the Fed) that required extraordinary countermeasures by the Fed. But the transcript of the September 2008 meeting shows that the appreciation of the dollar was interpreted by members of the FOMC as evidence that the current policy was working as intended! Now how scary is that?

HT: Matt O’Brien

Exposed: Irrational Inflation-Phobia at the Fed Caused the Panic of 2008

Published February 28, 2014 Ben Bernanke , Federal Reserve , James Bullard , Little Depression , monetary policy 20 Comments
Tags: FOMC, James Bullard, Janet Yellen, Kevin Warsh

Matthew O’Brien at The Atlantic has written a marvelous account of the bizarre deliberations of the Federal Open Market Committee at its meetings (June 25 and August 5) before the Lehman debacle on September 15 2008 and its meeting the next day on September 16. A few weeks ago, I wrote in half-seriousness a post attributing the 2008 financial crisis to ethanol because of the runup in corn and other grain prices in 2008 owing to the ethanol mandate and the restrictions on imported ethanol products. But ethanol, as several commenters pointed out, was only a part, probably a relatively small part, of the spike in commodities prices in the summer of 2008. Thanks to O’Brien’s careful reading of the recently released transcripts of the 2008 meetings of the FOMC, we now have a clear picture of how obsessed the FOMC was about inflation, especially the gang of four regional bank presidents, Charles Plosser, Richard Fisher, James Lacker, and Thomas Hoenig, supported to a greater or lesser extent by James Bullard and Kevin Warsh.

On the other hand, O’Brien does point out that two members of the FOMC, Eric Rosengren, President of the Boston Fed, and Fredric Mishkin of the Board of Governors, consistently warned of the dangers of a financial crisis, and consistently objected to and cogently punctured the hysterical inflation fears of the gang of four. It is somewhat, but only somewhat, reassuring that Janet Yellen was slightly more sensitive to the dangers of a financial crisis and less concerned about inflation than Ben Bernanke. Perhaps because he was still getting his feet wet as chairman, Bernanke seems to have been trying to articulate a position that could balance the opposing concerns of the FOMC membership, rather than leading the FOMC in the direction he thought best. While Yellen did not indulge the inflation phobia of the gang of four, she did not strongly support Rosengren and Mishkin in calling for aggressive action to avert the crisis that they clearly saw looming on the horizon.

Here are some highlights from O’Brien’s brilliant piece:

[FOMC Meeting] June 24-25, 2008: 468 mentions of inflation, 44 of unemployment, and 35 of systemic risks/crises

Those numbers pretty much tell you everything you need to know about what happened during the disastrous summer of 2008 at the Fed

Rosengren wasn’t nearly as concerned with 5 percent headline inflation—and with good reason. He reminded his colleagues that “monetary policy is unlikely to have much effect on food and energy prices,” that “total [inflation] has tended to converge to core, and not the opposite,” and that there was a “lack of an upward trend of wages and salaries.”

In short, inflation was high today, but it wouldn’t be tomorrow. They should ignore it. A few agreed. Most didn’t.

Mishkin, Fed Governor Donald Kohn, and then-San Francisco Fed chief Janet Yellen comprised Team: Ignore Inflation. They pointed out that core inflation hadn’t actually risen, and that “inflation expectations remain reasonably well-anchored.” The rest of the Fed, though, was eager to raise rates soon, if not right away. Philadelphia Fed president Charles Plosser recognized that core inflation was flat, but still thought they needed to get ready to tighten “or our credibility could soon vanish.” Fed Governor Kevin Warsh said that “inflation risks, in my view, continue to predominate as the greater risk to the economy,” because he thought headline would get passed into core inflation.

And let us not forget Richard Fisher of the Dallas Fed who provided badly needed comic relief.

And then there was Dallas Fed chief Richard Fisher, who had a singular talent for seeing inflation that nobody else could—a sixth sense, if you will. He was allergic to data. He preferred talking to CEOs instead. But, in Fisher’s case, the plural of anecdote wasn’t data. It was nonsense. He was worried about Frito-Lays increasing prices 9 percent, Budweiser increasing them 3.5 percent, and a small dry-cleaning chain in Dallas increasing them, well, an undisclosed amount. He even half-joked that the Fed was giving out smaller bottles of water, presumably to hide creeping inflation?

By the way, I notice that these little bottles of water have gotten smaller—this will be a Visine bottle at the next meeting. [Laughter]

But it was another member of the Gang of Four who warned ominously:

Richmond Fed president Jeffrey Lacker suggested, that “at some point we’re going to choose to let something disruptive happen.”

Now to the August meeting:

[FOMC Meeting] August 5, 2008: 322 mentions of inflation, 28 of unemployment, and 19 of systemic risks/crises.

Despite evidence that the inflationary blip of spring and summer was winding down, and the real economy was weakening, the Gang of Four continued to press their case for tougher anti-inflation measures. But only Rosengren and Mishkin spoke out against them.

But even though inflation was falling, it was a lonesome time to be a dove. As the Fed’s resident Cassandra, Rosengren tried to convince his colleagues that high headline inflation numbers “appear to be transitory responses to supply shocks that are not flowing through to labor markets.” In other words, inflation would come down on its own, and the Fed should focus on the credit crunch instead. Mishkin worried that “really bad things could happen” if “a shoe drops” and there was a “nasty, vicious spiral” between weak banks and a weak economy. Given this, he wanted to wait to tighten until inflation expectations “actually indicate there is a problem,” and not before.

But Richard Fisher was in no mood to worry about horror stories unless they were about runaway inflation:

The hawks didn’t want to wait. Lacker admitted that wages hadn’t gone up, but thought that “if we wait until wage rates accelerate or TIPS measures spike, we will have waited too long.” He wanted the Fed to “be prepared to raise rates even if growth is not back to potential, and even if financial markets are not yet tranquil.” In other words, to fight nonexistent wage inflation today to prevent possible wage inflation tomorrow, never mind the crumbling economy. Warsh, for his part, kept insisting that “inflation risks are very real, and I believe that these are higher than growth risks.” And Fisher had more”chilling anecdotes”—as Bernanke jokingly called them—about inflation. This time, the culprit was Disney World and its 5 percent price increase for single-day tickets.

The FOMC was divided, but the inflation-phobes held the upper hand. Unwilling to challenge them, Bernanke appeased them by promising that his statement about future monetary policy after the meeting would be “be slightly hawkish—to indicate a slight uplift in policy.”

Frightened by what he was hearing, Mishkin reminded his colleagues of some unpleasant monetary history:

Remember that in the Great Depression, when—I can’t use the expression because it would be in the transcripts, but you know what I’m thinking—something hit the fan, [laughter] it actually occurred close to a year after the initial negative shock.

Mishkin also reminded his colleagues that the stance of monetary policy cannot be directly inferred from the federal funds rate.

I just very much hope that this Committee does not make this mistake because I have to tell you that the situation is scary to me. I’m holding two houses right now. I’m very nervous.

And now to the September meeting, the day after Lehman collapsed:

[FOMC meeting] September 16, 2008: 129 mentions of inflation, 26 of unemployment, and 4 of systemic risks/crises

Chillingly, Lacker and Hoenig did a kind of victory dance about the collapse of Lehman Brothers.

Lacker had gotten the “disruptive” event he had wanted, and he was pretty pleased about it. “What we did with Lehman I obviously think was good,” he said, because it would “enhance the credibility of any commitment that we make in the future to be willing to let an institution fail.” Hoenig concurred that it was the “right thing,” because it would suck moral hazard out of the market.

The rest of the Gang of Four and their allies remained focused like a laser on inflation.

Even though commodity prices and inflation expectations were both falling fast, Hoenig wanted the Fed to “look beyond the immediate crisis,” and recognize that “we also have an inflation issue.” Bullard thought that “an inflation problem is brewing.” Plosser was heartened by falling commodity prices, but said, “I remain concerned about the inflation outlook going forward,” because “I do not see the ongoing slowdown in economic activity is entirely demand driven.” And Fisher half-jokingly complained that the bakery he’d been going to for 30 years—”the best maker of not only bagels, but anything with Crisco in it”—had just increased prices. All of them wanted to leave rates unchanged at 2 percent.

Again, only Eric Rosengren seemed to be in touch with reality, but no was listening:

[Rosengren] was afraid that exactly what did end up happening would happen. That all the financial chaos “would have a significant impact on the real economy,” that “individuals and firms will be become risk averse, with reluctance to consume or invest,” that “credit spreads are rising, and the cost and availability of financing is becoming more difficult,” and that “deleveraging is likely to occur with a vengeance.” More than that, he thought that the “calculated bet” they took in letting Lehman fail would look particularly bad “if we have a run on the money market funds or if the nongovernment tri-party repo market shuts down.” He wanted to cut rates immediately to do what they could to offset the worsening credit crunch. Nobody else did.

Like Bernanke for instance. Here is his take on the situation:

Overall I believe that our current funds rate setting is appropriate, and I don’t really see any reason to change…. Cutting rates would be a very big step that would send a very strong signal about our views on the economy and about our intentions going forward, and I think we should view that step as a very discrete thing rather than as a 25 basis point kind of thing. We should be very certain about that change before we undertake it because I would be concerned, for example, about the implications for the dollar, commodity prices, and the like.

OMG!

O’Brien uses one of my favorite Hawtrey quotes to describe the insanity of the FOMC deliberations:

In other words, the Fed was just as worried about an inflation scare that was already passing as it was about a once-in-three-generations crisis.

It brought to mind what economist R. G. Hawtrey had said about the Great Depression. Back then, central bankers had worried more about the possibility of inflation than the grim reality of deflation. It was, Hawtrey said, like “crying Fire! Fire! in Noah’s flood.”

In any non-dysfunctional institution, the perpetrators of this outrage would have been sacked. But three of Gang of Four (Hoenig having become a director of the FDIC in 2012) remain safely ensconced in their exalted positions, blithely continuing, without the slightest acknowledgment of their catastrophic past misjudgments, to exert a malign influence on monetary policy. For shame!

George Selgin Relives the Sixties

Published November 29, 2013 Federal Reserve , George Selgin , monetary history , monetary policy 31 Comments
Tags: credit crunch, inflation target, regulation Q

Just two days before the 50^th anniversary of the assassination of John Kennedy, George Selgin offered an ironic endorsement of raising the inflation target, as happened during the Kennedy Administration, in order to reduce unemployment.

[T]his isn’t the first time that we’ve been in a situation like the present one. There was at least one other occasion when the U.S. economy, having been humming along nicely with the inflation rate of 2% and an unemployment rate between 5% and 6%, slid into a recession. Eventually the unemployment rate was 7%, the inflation rate was only 1%, and the federal funds rate was within a percentage point of the zero lower bound. Fortunately for the American public, some well-placed (mostly Keynesian) economists came to the rescue, by arguing that the way to get unemployment back down was to aim for a higher inflation rate: a rate of about 4% a year, they figured, should suffice to get the unemployment rate down to 4%–a much lower rate than anyone dares to hope for today.

I’m puzzled and frustrated because, that time around, the Fed took the experts’ advice and it worked like a charm. The federal funds rate quickly achieved lift-off (within a year it had risen almost 100 basis points, from 1.17% to 2.15%). Before you could say “investment multiplier” the inflation and unemployment numbers were improving steadily. Within a few years inflation had reached 4%, and unemployment had declined to 4%–just as those (mostly Keynesian) experts had predicted.

So why are these crazy inflation hawks trying to prevent us from resorting again to a policy that worked such wonders in the past? Do they just love seeing all those millions of workers without jobs? Or is it simply that they don’t care about job

Oh: I forgot to say what past recession I’ve been referring to. It was the recession of 1960-61. The desired numbers were achieved by 1967. I can’t remember exactly what happened after that, though I’m sure it all went exactly as those clever theorists intended.

George has the general trajectory of the story more or less right, but the details and the timing are a bit off. Unemployment rose to 7% in the first half of 1961, and inflation was 1% or less. So reducing the Fed funds rate certainly worked, real GDP rising at not less than a 6.8% annual rate for four consecutive quarters starting with the second quarter of 1961, unemployment falling to 5.5 in the first quarter of 1962. In the following 11 quarters till the end of 1964, there were only three quarters in which the annual growth of GDP was less than 3.9%. The unemployment rate at the end of 1964 had fallen just below 5 percent and inflation was still well below 2%. It was only in 1965, that we see the beginings of an inflationary boom, real GDP growing at about a 10% annual rate in three of the next five quarters, and 8.4% and 5.6% in the other two quarters, unemployment falling to 3.8% by the second quarter of 1966, and inflation reaching 3% in 1966. Real GDP growth did not exceed 4% in any quarter after the first quarter of 1966, which suggests that the US economy had reached or exceeded its potential output, and unemployment had fallen below its natural rate.

In fact, recognizing the inflationary implications of the situation, the Fed shifted toward tighter money late in 1965, the Fed funds rate rising from 4% in late 1965 to nearly 6% in the summer of 1966. But the combination of tighter money and regulation-Q ceilings on deposit interest rates caused banks to lose deposits, producing a credit crunch in August 1966 and a slowdown in both real GDP growth in the second half of 1966 and the first half of 1967. With the economy already operating at capacity, subsequent increases in aggregate demand were reflected in rising inflation, which reached 5% in the annus horribilis 1968.

Cleverly suggesting that the decision to use monetary expansion, and an implied higher tolerance for inflation, to reduce unemployment from the 7% rate to which it had risen in 1961 was the ultimate cause of the high inflation of the late 1960s and early 1970s, and, presumably, the stagflation of the mid- and late-1970s, George is inviting his readers to conclude that raising the inflation target today would have similarly disastrous results.

Well, that strikes me as quite an overreach. Certainly one should not ignore the history to which George is drawing our attention, but I think it is possible (and plausible) to imagine a far more benign course of events than the one that played itself out in the 1960s and 1970s. The key difference is that the ceilings on deposit interest rates that caused a tightening of monetary policy in 1966 to produce a mini-financial crisis, forcing the 1966 Fed to abandon its sensible monetary tightening to counter inflationary pressure, are no longer in place.

Nor should we forget that some of the inflation of the 1970s was the result of supply-side shocks for which some monetary expansion (and some incremental price inflation) was an optimal policy response. The disastrous long-term consequences of Nixon’s wage and price controls should not be attributed to the expansionary monetary policy of the early 1960s.

As Mark Twain put it so well:

We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and that is well but also she will never sit down on a cold one anymore.

The Internal Contradiction of Quantitative Easing

Published November 18, 2013 Federal Reserve , Fisher equation , Paul Krugman , real interest rates , Scott Sumner 22 Comments
Tags: Barack Obama, FDR, Larry Summers

Last week I was struggling to cut and paste my 11-part series on Hawtrey’s Good and Bad Trade into the paper on that topic that I am scheduled to present next week at the Southern Economic Association meetings in Tampa Florida, completing the task just before coming down with a cold which has kept me from doing anything useful since last Thursday. But I was at least sufficiently aware of my surroundings to notice another flurry of interest in quantitative easing, presumably coinciding with Janet Yellen’s testimony at the hearings conducted by the Senate Banking Committee about her nomination to succeed Ben Bernanke as Chairman of Federal Reserve Board.

In my cursory reading of the latest discussions, I didn’t find a lot that has not already been said, so I will take that as an opportunity to restate some points that I have previously made on this blog. But before I do that, I can’t help observing (not for the first time either) that the two main arguments made by critics of QE do not exactly coexist harmoniously with each other. First, QE is ineffective; second it is dangerous. To be sure, the tension between these two claims about QE does not prove that both can’t be true, and certainly doesn’t prove that both are wrong. But the tension might at least have given a moment’s pause to those crying that Quantitative Easing, having failed for five years to accomplish anything besides enriching Wall Street and taking bread from the mouths of struggling retirees, is going to cause the sky to fall any minute.

Nor, come to think of it, does the faux populism of the attack on a rising stock market and of the crocodile tears for helpless retirees living off the interest on their CDs coexist harmoniously with the support by many of the same characters opposing QE (e.g., Freedomworks, CATO, the Heritage Foundation, and the Wall Street Journal editorial page) for privatizing social security via private investment accounts to be invested in the stock market, the argument being that the rate of return on investing in stocks has historically been greater than the rate of return on payments into the social security system. I am also waiting for an explanation of why abused pensioners unhappy with the returns on their CDs can’t cash in the CDs and buy dividend-paying-stocks? In which charter of the inalienable rights of Americans, I wonder, does one find it written that a perfectly secure real rate of interest of not less than 2% on any debt instrument issued by the US government shall always be guaranteed?

Now there is no denying that what is characterized as a massive program of asset purchases by the Federal Reserve System has failed to stimulate a recovery comparable in strength to almost every recovery since World War II. However, not even the opponents of QE are suggesting that the recovery has been weak as a direct result of QE — that would be a bridge too far even for the hard money caucus — only that whatever benefits may have been generated by QE are too paltry to justify its supposedly bad side-effects (present or future inflation, reduced real wages, asset bubbles, harm to savers, enabling of deficit-spending, among others). But to draw any conclusion about the effects of QE, you need some kind of a baseline of comparison. QE opponents therefore like to use previous US recoveries, without the benefit of QE, as their baseline.

But that is not the only baseline available for purposes of comparison. There is also the Eurozone, which has avoided QE and until recently kept interest rates higher than in the US, though to be sure not as high as US opponents of QE (and defenders of the natural rights of savers) would have liked. Compared to the Eurozone, where nominal GDP has barely risen since 2010, and real GDP and employment have shrunk, QE, which has been associated with nearly 4% annual growth in US nominal GDP and slightly more than 2% annual growth in US real GDP, has clearly outperformed the eurozone.

Now maybe you don’t like the Eurozone, as it includes all those dysfunctional debt-ridden southern European countries, as a baseline for comparison. OK, then let’s just do a straight, head-to-head matchup between the inflation-addicted US and solid, budget-balancing, inflation-hating Germany. Well that comparison shows (see the chart below) that since 2011 US real GDP has increased by about 5% while German real GDP has increased by less than 2%.

So it does seem possible that, after all, QE and low interest rates may well have made things measurably better than they would have otherwise been. But don’t expect to opponents of QE to acknowledge that possibility.

Of course that still leaves the question on the table, why has this recovery been so weak? Well, Paul Krugman, channeling Larry Summers, offered a demographic hypothesis in his column Monday: that with declining population growth, there have been diminishing investment opportunities, which, together with an aging population, trying to save enough to support themselves in their old age, causes the supply of savings to outstrip the available investment opportunities, driving the real interest rate down to zero. As real interest rates fall, the ability of the economy to tolerate deflation — or even very low inflation — declines. That is a straightforward, and inescapable, implication of the Fisher equation (see my paper “The Fisher Effect Under Deflationary Expectations”).

So, if Summers and Krugman are right – and the trend of real interest rates for the past three decades is not inconsistent with their position – then we need to rethink revise upwards our estimates of what rate of inflation is too low. I will note parenthetically, that Samuel Brittan, who has been for decades just about the most sensible economic journalist in the world, needs to figure out that too little inflation may indeed be a bad thing.

But this brings me back to the puzzling question that causes so many people to assume that monetary policy is useless. Why have trillions of dollars of asset purchases not generated the inflation that other monetary expansions have generated? And if all those assets now on the Fed balance sheet haven’t generated inflation, what reason is there to think that the Fed could increase the rate of inflation if that is what is necessary to avoid chronic (secular) stagnation?

The answer, it seems to me is the following. If everyone believes that the Fed is committed to its inflation target — and not even the supposedly dovish Janet Yellen, bless her heart, has given the slightest indication that she favors raising the Fed’s inflation target, a target that, recent experience shows, the Fed is far more willing to undershoot than to overshoot – then Fed purchases of assets with currency are not going to stimulate additional private spending. Private spending, at or near the zero lower bound, are determined largely by expectations of future income and prices. The quantity of money in private hands, being almost costless to hold, is no longer a hot potato. So if there is no desire to reduce excess cash holdings, the only mechanism by which monetary policy can affect private spending is through expectations. But the Fed, having succeeded in anchoring inflation expectations at 2%, has succeeded in unilaterally disarming itself. So economic expansion is constrained by the combination of a zero real interest rate and expected inflation held at or below 2% by a political consensus that the Fed, even if it were inclined to, is effectively powerless to challenge.

Scott Sumner calls this monetary offset. I don’t think that we disagree much on the economic analysis, but it seems to me that he overestimates the amount of discretion that the Fed can actually exercise over monetary policy. Except at the margins, the Fed is completely boxed in by a political consensus it dares not question. FDR came into office in 1933, and was able to effect a revolution in monetary policy within his first month in office, thereby saving the country and Western Civilization. Perhaps Obama had an opportunity to do something similar early in his first term, but not any more. We are stuck at 2%, but it is no solution.

Eureka! Paul Krugman Discovers the Bank of France

Published November 3, 2013 Cassel , currency manipulation , Federal Reserve , gold standard , Great Depression , Hawtrey , monetary history , monetary policy , monetary theory , Paul Krugman 17 Comments
Tags: Doug Irwin, exchange rate protection, Krugman

Trying hard, but not entirely successfully, to contain his astonishment, Paul Krugman has a very good post (“France 1930, Germany 2013) inspired by Doug Irwin’s “very good” paper (see also this shorter version) “Did France Cause the Great Depression?” Here’s Krugman take away from Irwin’s paper.

[Irwin] points out that France, with its undervalued currency, soaked up a huge proportion of the world’s gold reserves in 1930-31, and suggests that France was responsible for about half the global deflation that took place over that period.

The thing is, France itself didn’t do that badly in the early stages of the Great Depression — again thanks to that undervalued currency. In fact, it was less affected than most other advanced countries (pdf) in 1929-31:

Krugman is on the right track here — certainly a hopeful sign — but he misses the distinction between an undervalued French franc, which, despite temporary adverse effects on other countries, would normally be self-correcting under the gold standard, and the explosive increase in demand for gold by the insane Bank of France after the franc was pegged at an undervalued parity against the dollar. Undervaluation of the franc began in December 1926 when Premier Raymond Poincare stabilized its value at about 25 francs to the dollar, the franc having fallen to 50 francs to the dollar in July when Poincare, a former prime minister, had been returned to office to deal with a worsening currency crisis. Undervaluation of the franc would have done no permanent damage to the world economy if the Bank of France had not used the resulting inflow of foreign exchange to accumulate gold, cashing in sterling- and dollar-denominated financial assets for gold. This was a step beyond classic exchange-rate protection (currency manipulation) whereby a country uses a combination of an undervalued exchange rate and a tight monetary policy to keep accumulating foreign-exchange reserves as a way of favoring its export and import-competing industries. Exchange-rate protection may have been one motivation for the French policy, but that objective did not require gold accumulation; it could have been achieved by accumulating foreign exchange reserves without demanding redemption of those reserves in terms of gold, as the Bank of France began doing aggressively in 1927. A more likely motivation for gold accumulation policy of the Bank of France seems to have been French resentment against a monetary system that, from the French perspective, granted a privileged status to the dollar and to sterling, allowing central banks to treat dollar- and sterling-denominated financial assets as official exchange reserves, thereby enabling issuers of dollar and sterling-denominated assets the ability to obtain funds on more favorable terms than issuers of instruments denominated in other currencies.

The world economy was able to withstand the French gold-accumulation policy in 1927-28, because the Federal Reserve was tolerating an outflow of gold, thereby accommodating to some degree the French demand for gold. But after the Fed raised its discount rate to 5% in 1928 and 6% in February 1929, gold began flowing into the US as well, causing gold to start appreciating (in other words, prices to start falling) in world markets by the summer of 1929. But rather than reverse course, the Bank of France and the Fed, despite reductions in their official lending rates, continued pursuing policies that caused huge amounts of gold to flow into the French and US vaults in 1930 and 1931. Hawtrey and Cassel, of course, had warned against such a scenario as early as 1919, and proposed measures to prevent or reverse the looming catastrophe before it took place and after it started, but with little success. For a more complete account of this sad story, and the failure of the economics profession, with a very few notable exceptions, to figure out what happened, see my paper with Ron Batchelder “Pre-Keynesian Monetary Theories of the Great Depression: Whatever Happened to Hawtrey and Cassel?”

As Krugman observes, the French economy did not do so badly in 1929-31, because it was viewed as the most stable, thrifty, and dynamic economy in Europe. But France looked good only because Britain and Germany were in even worse shape. Because France was better off the Britain and Germany, and because its currency was understood to be undervalued, the French franc was considered to be stable, and, thus, unlikely to be devalued. So, unlike sterling, the reichsmark, and the dollar, the franc was not subjected to speculative attacks, becoming instead a haven for capital seeking safety.

Interestingly, Krugman even shows some sympathetic understanding for the plight of the French:

Notice, by the way, that the French weren’t evil or malicious here — they were just adhering to their hard-money ideology in an environment where that had terrible adverse effects on other countries.

Just wondering, would Krugman ever invoke adherence to a hard-money ideology as a mitigating factor in passing judgment on a Republican?

Krugman concludes by comparing Germany today with France in 1930.

Obviously the details are different, but I would argue that Germany is playing a somewhat similar role today — not as drastic, but with less excuse. For Germany is an economic hegemon in a way France never was; it has responsibilities, which it isn’t meeting.

Indeed, there are similarities, but there is a crucial difference in the mechanism by which damage is being inflicted: the world price level in 1930, under the gold standard, was determined by the value of gold. An increase in the demand for gold by central banks necessarily raised the value of gold, causing deflation for all countries either on the gold standard or maintaining a fixed exchange rate against a gold-standard currency. By accumulating gold, nearly quadrupling its gold reserves between 1926 and 1932, the Bank of France was a mighty deflationary force, inflicting immense damage on the international economy. Today, the Eurozone price level does not depend on the independent policy actions of any national central bank, including that of Germany. The Eurozone price level is rather determined by the policy choices of a nominally independent European Central Bank. But the ECB is clearly unable to any adopt policy not approved by the German government and its leader Mrs. Merkel, and Mrs. Merkel has rejected any policy that would raise prices in the Eurozone to a level consistent with full employment. Though the mechanism by which Mrs. Merkel and her government are now inflicting damage on the Eurozone is different from the mechanism by which the insane Bank of France inflicted damage during the Great Depression, the damage is just as pointless and just as inexcusable. But as the damage caused by Mrs. Merkel, in relative terms at any rate, seems somewhat smaller in magnitude than that caused by the insane Bank of France, I would not judge her more harshly than I would the Bank of France — insanity being, in matters of monetary policy, no defense.

HT: ChargerCarl

A New Paper Shows Just How Right Hawtrey and Cassel Were

Published October 10, 2013 Cassel , Federal Reserve , gold standard , Great Depression , James Caton , monetary history , monetary policy 5 Comments
Tags: Cassel, Doug Irwin, Hawtrey, Ron Batchelder, Scott Sumner

I was pleasantly surprised to receive an email a couple of weeks ago from someone I don’t know, a graduate student in economics at George Mason University, James Caton. He sent me a link to a paper (“Good as Gold?: A Quantitative Analysis of Hawtrey and Cassel’s Theory of Gold Demand and the Gold Price Level During the Interwar Period”) that he recently posted on SSRN. Caton was kind enough to credit me and my co-author Ron Batchelder, as well as Doug Irwin (here and here) and Scott Sumner, for reviving interest in the seminal work of Ralph Hawtrey and Gustav Cassel on the interwar gold standard and the key role in causing the Great Depression played by the process of restoring the gold standard after it had been effectively suspended after World War I began.

The thesis independently, but cooperatively, advanced by Hawtrey and Cassel was that under a gold standard, fluctuations in the gold price level were sensitive to variations in the demand for gold reserves by the central banks. The main contribution of Caton’s paper is to provide econometric evidence of the tight correlation between variations in the total gold holdings of the world’s central banks and the gold price level in the period between the end of World War I (1918) to the start of Great Depression (1930-32). Caton uses a variation on a model used by Scott Sumner in his empirical work on the Great Depression to predict changes in the value of gold, and, hence, changes in the gold price level of commodities. If central banks in the aggregate are adding to their gold reserves at a faster rate than the rate at which the total world stock of gold is growing, then gold would be likely to appreciate, and if central banks are adding to their gold reserves at a slower rate than that at which the world stock is growing, then gold would be likely to depreciate.

So from the published sources, Caton constructed a time series of international monetary gold holdings and the total world stock of gold from 1918 to 1932 and regressed the international gold price level on the international gold reserve ratio (the ratio of monetary gold reserves to the total world stock of gold). He used two different measures of the world gold price level, the Sauerback-Statist price index and the gold price of silver. Based on his regressions (calculated in both log-linear and log-quadratic forms and separately for the periods 1918-30, 1918-31, 1918-32), he compared the predicted gold price level against both the Sauerback-Statist price index and the gold price of silver. The chart below shows his result for the log-linear regression estimated over the period 1918-30.

Pretty impressive, if you ask me. Have a look yourself.

Let me also mention that Caton’s results also shed important light on the puzzling behavior of the world price level immediately after the end of World War I. Unlike most wars in which the wartime inflation comes to an abrupt end after the end of the war, inflation actually accelerated after the end of the war. The inflation did not actually stop for almost two years after the end of the war, when a huge deflation set in. Caton shows that the behavior of the price level was largely determined by the declining gold holdings of the Federal Reserve after the war ended. Unnerved by the rapid inflation, the Fed finally changed policy, and began accumulating gold rapidly in 1920 by raising the discount rate to an all-time high of 7 percent. Although no other countries were then on the gold standard, other countries, unwilling, for the most part, to allow their currencies to depreciate too much against the dollar, imported US deflation.

Jim is also a blogger. Check out his blog here.

Update: Thanks to commenter Blue Aurora for pointing out that I neglected to provide a link to Jim Caton’s paper. Sorry about that. The link is now embedded.

Who Sets the Real Rate of Interest?

Published July 3, 2013 expectations , Federal Reserve , Irving Fisher , Martin Feldstein , Milton Friedman , natural rate of interest , natural rate of unemployment , real interest rates , Uncategorized , Wall Street Journal 49 Comments
Tags: Fisher equation, John Taylor, Martin Feldstein, Milton Friedman, Wall Street Journal

Understanding economics requires, among other things, understanding the distinction between real and nominal variables. Confusion between real and nominal variables is pervasive, constantly presenting barriers to clear thinking, and snares and delusions for the mentally lazy. In this post, I want to talk about the distinction between the real rate of interest and the nominal rate of interest. That distinction has been recognized for at least a couple of centuries, Henry Thornton having mentioned it early in the nineteenth century. But the importance of the distinction wasn’t really fully understood until Irving Fisher made the distinction between the real and nominal rates of interest a key element of his theory of interest and his theory of money, expressing the relationship in algebraic form — what we now call the Fisher equation. Notation varies, but the Fisher equation can be written more or less as follows:

i = r + dP/dt,

where i is the nominal rate, r is the real rate, and dP/dt is the rate of inflation. It is important to bear in mind that the Fisher equation can be understood in two very different ways. It can either represent an ex ante relationship, with dP/dt referring to expected inflation, or it can represent an ex post relationship, with dP/dt referring to actual inflation.

What I want to discuss in this post is the tacit assumption that usually underlies our understanding, and our application, of the ex ante version of the Fisher equation. There are three distinct variables in the Fisher equation: the real and the nominal rates of interest and the rate of inflation. If we think of the Fisher equation as an ex post relationship, it holds identically, because the unobservable ex post real rate is defined as the difference between the nominal rate and the inflation rate. The ex post, or the realized, real rate has no independent existence; it is merely a semantic convention. But if we consider the more interesting interpretation of the Fisher equation as an ex ante relationship, the real interest rate, though still unobservable, is not just a semantic convention. It becomes the theoretically fundamental interest rate of capital theory — the market rate of intertemporal exchange, reflecting, as Fisher masterfully explained in his canonical renderings of the theory of capital and interest, the “fundamental” forces of time preference and the productivity of capital. Because it is determined by economic “fundamentals,” economists of a certain mindset naturally assume that the real interest rate is independent of monetary forces, except insofar as monetary factors are incorporated in inflation expectations. But if money is neutral, at least in the long run, then the real rate has to be independent of monetary factors, at least in the long run. So in most expositions of the Fisher equation, it is tacitly assumed that the real rate can be treated as a parameter determined, outside the model, by the “fundamentals.” With r determined exogenously, fluctuations in i are correlated with, and reflect, changes in expected inflation.

Now there’s an obvious problem with the Fisher equation, which is that in many, if not most, monetary models, going back to Thornton and Wicksell in the nineteenth century, and to Hawtrey and Keynes in the twentieth, and in today’s modern New Keynesian models, it is precisely by way of changes in its lending rate to the banking system that the central bank controls the rate of inflation. And in this framework, the nominal interest rate is negatively correlated with inflation, not positively correlated, as implied by the usual understanding of the Fisher equation. Raising the nominal interest rate reduces inflation, and reducing the nominal interest rate raises inflation. The conventional resolution of this anomaly is that the change in the nominal interest rate is just temporary, so that, after the economy adjusts to the policy of the central bank, the nominal interest rate also adjusts to a level consistent with the exogenous real rate and to the rate of inflation implied by the policy of the central bank. The Fisher equation is thus an equilibrium relationship, while central-bank policy operates by creating a short-term disequilibrium. But the short-term disequilibrium imposed by the central bank cannot be sustained, because the economy inevitably begins an adjustment process that restores the equilibrium real interest rate, a rate determined by fundamental forces that eventually override any nominal interest rate set by the central bank if that rate is inconsistent with the equilibrium real interest rate and the expected rate of inflation.

It was just this analogy between the powerlessness of the central bank to hold the nominal interest rate below the sum of the exogenously determined equilibrium real rate and the expected rate of inflation that led Milton Friedman to the idea of a “natural rate of unemployment” when he argued that monetary policy could not keep the unemployment rate below the “natural rate ground out by the Walrasian system of general equilibrium equations.” Having been used by Wicksell as a synonym for the Fisherian equilibrium real rate, the term “natural rate” was undoubtedly adopted by Friedman, because monetarily induced deviations between the actual rate of unemployment and the natural rate of unemployment set in motion an adjustment process that restores unemployment to its “natural” level, just as any deviation between the nominal interest rate and the sum of the equilibrium real rate and expected inflation triggers an adjustment process that restores equality between the nominal rate and the sum of the equilibrium real rate and expected inflation.

So, if the ability of the central bank to use its power over the nominal rate to control the real rate of interest is as limited as the conventional interpretation of the Fisher equation suggests, here’s my question: When critics of monetary stimulus accuse the Fed of rigging interest rates, using the Fed’s power to keep interest rates “artificially low,” taking bread out of the mouths of widows, orphans and millionaires, what exactly are they talking about? The Fed has no legal power to set interest rates; it can only announce what interest rate it will lend at, and it can buy and sell assets in the market. It has an advantage because it can create the money with which to buy assets. But if you believe that the Fed cannot reduce the rate of unemployment below the “natural rate of unemployment” by printing money, why would you believe that the Fed can reduce the real rate of interest below the “natural rate of interest” by printing money? Martin Feldstein and the Wall Street Journal believe that the Fed is unable to do one, but perfectly able to do the other. Sorry, but I just don’t get it.

Look at the accompanying chart. It tracks the three variables in the Fisher equation (the nominal interest rate, the real interest rate, and expected inflation) from October 1, 2007 to July 2, 2013. To measure the nominal interest rate, I use the yield on 10-year Treasury bonds; to measure the real interest rate, I use the yield on 10-year TIPS; to measure expected inflation, I use the 10-year breakeven TIPS spread. The yield on the 10-year TIPS is an imperfect measure of the real rate, and the 10-year TIPS spread is an imperfect measure of inflation expectations, especially during financial crises, when the rates on TIPS are distorted by illiquidity in the TIPS market. Those aren’t the only problems with identifying the TIPS yield with the real rate and the TIPS spread with inflation expectations, but those variables usually do provide a decent approximation of what is happening to real rates and to inflation expectations over time.

Before getting to the main point, I want to make a couple of preliminary observations about the behavior of the real rate over time. First, notice that the real rate declined steadily, with a few small blips, from October 2007 to March 2008, when the Fed was reducing the Fed Funds target rate from 4.75 to 3% as the economy was sliding into a recession that officially began in December 2007. The Fed reduced the Fed Funds target to 2% at the end of April, but real interest rates had already started climbing in early March, so the failure of the FOMC to reduce the Fed Funds target again till October 2008, three weeks after the onset of the financial crisis, clearly meant that there was at least a passive tightening of monetary policy throughout the second and third quarters, helping create the conditions that precipitated the crisis in September. The rapid reduction in the Fed Funds target from 2% in October to 0.25% in December 2008 brought real interest rates down, but, despite the low Fed Funds rate, a lack of liquidity caused a severe tightening of monetary conditions in early 2009, forcing real interest rates to rise sharply until the Fed announced its first QE program in March 2009.

I won’t go into more detail about ups and downs in the real rate since March 2009. Let’s just focus on the overall trend. From that time forward, what we see is a steady decline in real interest rates from over 2% at the start of the initial QE program till real rates bottomed out in early 2012 at just over -1%. So, over a period of three years, there was a steady 3% decline in real interest rates. This was no temporary phenomenon; it was a sustained trend. I have yet to hear anyone explain how the Fed could have single-handedly produced a steady downward trend in real interest rates by way of monetary expansion over a period of three years. To claim that decline in real interest rates was caused by monetary expansion on the part of the Fed flatly contradicts everything that we think we know about the determination of real interest rates. Maybe what we think we know is all wrong. But if it is, people who blame the Fed for a three-year decline in real interest rates that few reputable economists – and certainly no economists that Fed critics pay any attention to — ever thought was achievable by monetary policy ought to provide an explanation for how the Fed suddenly got new and unimagined powers to determine real interest rates. Until they come forward with such an explanation, Fed critics have a major credibility problem.

So please – please — Wall Street Journal editorial page, Martin Feldstein, John Taylor, et al., enlighten us. We’re waiting.

PS Of course, there is a perfectly obvious explanation for the three-year long decline in real interest rates, but not one very attractive to critics of QE. Either the equilibrium real interest rate has been falling since 2009, or the equilibrium real interest rate fell before 2009, but nominal rates adjusted slowly to the reduced real rate. The real interest rate might have adjusted more rapidly to the reduced equilibrium rate, but that would have required expected inflation to have risen. What that means is that sometimes it is the real interest rate, not, as is usually assumed, the nominal rate, that adjusts to the expected rate of inflation. My next post will discuss that alternative understanding of the implicit dynamics of the Fisher equation.

Watch out for that Fed Reaction Function

Published June 26, 2013 Federal Reserve , monetary policy , Scott Sumner 6 Comments
Tags: Paul Volcker

Scott Sumner had a terrific post today. The title said it all, but the rest of it wasn’t bad either.

The stock market wants fast economic growth, and they want the Fed to think economic growth is slow

Eureka! Today we found out that NGDP (which the Fed looks at) grew at a 2.19% rate over the past 6 months and the more accurate NGDI grew by 5.06%.

Stocks soared on the news.

And shhhh! Don’t anyone tell the Fed about NGDI!

Scott hit it right on the nose with that one.

It reminded me of something, so I went an looked it up in a book I happen to have at home.

Here’s what it says about Fed policy coming out of the 1981-82 recession.

The renewed stringency forced interest rates to rise slightly while driving the dollare ever higher and commodities prices ever lower. Yet the recovery, once under way, was too powerful to be slowed down perceptibly by the monetary pressure. . . .

The recovery continued in the first half of 1984. But the amazing strength of the recovery pulled the growth of M-1 above its targets, reviving fears that the Fed would have to tighten. Instead of being welcomed, each bit of favorable economic news – strong growth in real GNP, reduced unemployment, higher factory orders – was greeted with fear and trepidation in the financial markets, because such reports were viewed as portents of future tightening by the Fed. Those fears generated continuing increases in interest rates, appreciation of the dollar, and falling commodities prices. In the summer of 1984, monetary stringency and fears that the Fed would clamp down even more tightly to bring the growth of M-1 back within its targets were threatening to produce a credit crunch and abort the recovery.

With interest rates and the dollar’s exchange rate again starting to rise rapidly, and with commodity prices losing the modest gains they had made in the previous year, the recovery was indeed threatened. In late July of 1984, two years after the Fed had given up its earlier effort to meet its monetary targets, the conditions for a credit crunch, if not a full scale panic, were again developing. The most widely reported monetary aggregate, M-1, was above the upper limit of the Fed’s growth target, and economic growth in the second quarter of 1984 was reported to have been an unexpectedly strong 7.5%. Commodities prices were practically in free fall and the dollar was soaring.

Once again, however, a timely intervention by Mr. Volcker calmed the markets and put to rest fears that the Fed would strive to keep monetary growth within the announced target ranges. Appearing before Congress, he announced that he expected inflation to remain low [around 4%!!!] and that the Fed would maintain its policy without seeking any further tightening to bring monetary growth within the target range. This assurance stopped, at least for a brief spell, the dollar’s rise in foreign exchange markets and permitted a slight rebound in commodities prices. Mr. Volcker’s assurance that monetary policy would not be tightened encouraged the public to stop trying to build up precautionary balances. As a consequence, M-1 growth leveled off even as interest rates fell back somewhat.

All the while Monetarist were loudly protesting the conduct of monetary policy. Before the Fed abandoned its attempt to target M-1, Monetarists criticized the Fed for not keeping monetary growth steady enough. For a time, they even attributed the failure of interest rates to fall as rapidly as the rate of inflation in 1981, or to fall at all in the first half of 1982, to uncertainty created by too much variability in the rate of monetary growth. Later, when the Fed abandoned, at any rate deemphasized, monetary targets, they warned that inflation would soon start to rise again. In late 1982, just as the economy was hitting bottom, Milton Friedman was predicting the return of double-digit inflation [sound familiar?] before the next election.

What book did I get that from? OK, I admit it. It’s from my book Free Banking and Monetary Reform, pp. 220-21. So we’ve been through this before. When the Fed adopts a crazy reaction function in which it won’t tolerate real growth above a certain threshold, which is what the Fed seems to have done, with the threshold at 3% or less, funny things start to happen.

How come no one is laughing?

PS I apologize again for not replying to comments lately. I am still trying to cope with my workload.

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

Uneasy Money