Scott Sumner  

Michael Darda on Alan Blinder

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How shall we define 'liberal'?... Divine coincidence?...

Alan Blinder once served as Vice Chairman of the Federal Reserve Board, and now has a new piece in the Wall Street Journal. Michael Darda sent me the following email in response:

Alan Blinder in today's WSJ, arguing, as some Fed officials have, that it's not the start/timing of the initial rate hike/tightening that matters, it's the trajectory. This is just incredibly wrongheaded in virtually every respect. If the Fed is overlooking a passive tightening in monetary/financial conditions and a concomitant drop in the eq. short rate and then compounds it by actively tightening instead of easing, the "trajectory of short rates" will be very shallow indeed. The "path" of short rates was "only" 25 bps in Japan in 2000, "only" 50 bps in Japan in 2006/7 and "only" 50 bps in the EZ in 2011. And the outcomes were all consistent with monetary policy failure. Memo to Blinder: Never reason from an interest rate path.
This is a very important point. In the three episodes mentioned by Darda, the trajectory of interest rates was extremely flat, after the initial increase. And yet in all three cases monetary policy was far too contractionary, and in all three cases the country (or region) again fell back to the zero rate boundary. The Fed may avoid that mistake, but it won't be because a flat interest rate trajectory means easy money. I'd guess that about 90% of interest rate movements reflect the condition of the economy, and 10% reflect Fed policy.

Blinder's right that the future path of policy is very important, but wrong in assuming that the future path of interest rates tells us anything useful about the future path of policy.


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COMMENTS (5 to date)
ThomasH writes:

A less confusing (to me) way of saying that Blinder is mistaken would be to point out that interest rate increases at this time do not help restore the PL to it's pre-inflation trend (its supposed policy), meaning that we do not know what the Fed is trying to achieve. Markets cannot like that kind of uncertainty.

Dustin writes:

Isn't it really the 'expected' trajectory that matters? The retrospective, concrete steppe assessment of 25 or 50 BP hikes seems to have limited usefulness given that the market reaction was likely driven primarily by the relative uncertainty over what future rates might look like. The degree to which CB decisions are ill-timed and unexpected is directly related to the magnitude of the market reaction. An unpredictable CB is bad.

Dustin writes:

^ disregard. Somehow I didn't initially catch that the criticism is indeed about the importance of expectations.

Scott Sumner writes:

Thomas, I also agree with that comment.

Arthur_500 writes:

When Janet Yellen was in her former capacity she authored a paper on the importance of the signals. In other words it was the perception rather than the action that mattered most. Mr. Blinder is an avowed Keynesian and I hesitate to read too much into his comments on this.

If the economy were in good enough shape for a 3% rate what does it say about an economy that has been sitting at zero for a decade? Certainly many claim that if we raise interest rates the sky will fall because banks will have to pay a higher rate. I reject this argument.

I think if Chairman Yellen were to announce to the media that the economy is doing well and a rate hike was appropriate she could begin to return the economy to a new normal without all the doomsayers killing things off. I'd bet there would be an initial shock that would be negligible as companies cried the sky was falling and then it would be over. This would pave the way for additional increases and within four years we could easily be at 2% or so.

Why is the rate so important anyway? With the sources of financing available now is the Fed Rate really that important any more? Banks seem to be doing fine not making loans so their spread is no longer all that important.

What are your thoughts on this?

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