Scott Sumner  

Everything is back to being the same again

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The long dark age of vulgar Keynesianism is finally over. For 7 long years we've heard economists tell us that the laws of economics don't apply at the zero bound. We are told that "everything is different" at the zero bound. Fiscal stimulus is not offset by monetary policy. Savings is a vice. Chinese trade surpluses cost jobs in the US economy, and paying people not to work for 99 weeks creates jobs. Aggregate demand curves slope upward. Payroll tax cuts are contractionary.

Now the zero bound is clearly gone. Let's hope we can now return to the more sensible economics of the Great Moderation, when the New York Times wrote editorials calling for the abolition of the minimum wage, progressives advocated ending taxes on capital, Keynesians preferred monetary policy to fiscal policy, and Paul Krugman skewered protectionists on the left with "Pop Internationalism." (And to be fair, when conservatives favored carbon taxes, and something very close to ObamaCare. And when conservatives didn't think low rates meant easy money.)

Actually the zero bound has been gone for roughly a year, as this term actually refers to a situation where the Fed would like to cut interest rates, but is unable to do so because of the zero lower bound on nominal interest. The Fed had no desire to cut rates in 2015, even if they had been able to.

And ironically we now find out that all along the Fed was able to cut rates further; it simply didn't understand that fact. In early 2009, I pointed out that central banks could pay negative interest on reserves. Initially people scoffed, but now many European countries have done so. Some argued the effect would be contractionary, but that's not how European markets reacted to the news. Janet Yellen has indicated that negative IOR is an option in the next recession, and Ben Bernanke recently said the following:

I am not aware that ordinary checking accounts are paying negative rates. In the U.S., while I think negative rates are something the Fed will and probably should consider if the situation arises, I think there are limits to how negative rates could go and there are probably special features of the institutional environment in the United States which suggests they couldn't go as negative here as they've gone in some European countries.
Does anyone doubt that "the situation" arose in early 2009 when I suggested negative IOR? I think Bernanke's "will and probably should" statement is an implicit admission that the market monetarists were right and the Fed was wrong about negative IOR in 2009, just as in his memoir he admits that the Fed should have cut rates in September 2008, another key area where market monetarists disagreed with Fed policy.

Look for many more such admissions in the next few years.

The Fed's decision to raise rates today was not unexpected, but the accompanying statement was rather disappointing. Every three months the Fed lowers its projections for future interest rates, gradually getting closer and closer to the market (and hence market monetarist) view of what is likely to happen. Why not just dispense with the forecasts entirely, and suggest that rate increases will depend entirely on progress toward its employment and inflation goals? And while they are at it, why not spell out those goals more precisely---exactly what are they trying to accomplish?

PS. Interestingly, the zero interest rate period lasted exactly 7 years, as rates first fell to the 0% to 0.25% range on December 16, 2008.


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COMMENTS (9 to date)
Britonomist writes:

Does it actually change anything re 'vulgar' Keynesianism? The underlying logic hardly hinders on whether rates are at 0.25% or 0.50%. Does a 0.25% rise significantly impact the extent to which bonds are a substitute for money? Does the possibility of a 0.25% cut really improve the confidence of markets that the Fed can offset any shock more than before?

marcus nunes writes:

Scott, we just dont know if the 7 years that have passed by were the 7 years of plenty or of famine? That´s important for what to expect for the next 7!

Emerson writes:

I am interested in the policy instrument that the Fed uses to raise the Fed funds rate.

Tim Taylor on his blog presented a paper that takes the position that raising IOR would result in an increase in the fed funds rate.

But it seems to me that decreasing IOR to to zero or below (negative IOR) would be more effective.

I've looked but have not found a statement of how exactly the Fed intends to accomplish a rate increase

Scott Sumner writes:

Britonomist, The key is not how low rates are, but rather whether they are higher than the central bank would like. After today, rates are obviously not higher than the central bank would like. Hence the central bank is again steering NGDP.

Marcus, Let's hope it was the seven bad years.

Emerson, It's done through raising the fed funds rate---that's really the only way with so much excess reserves in the system.

Gordon writes:

Emerson, the Federal Reserve is raising interest on reserves to .5% to get the fed funds rate to its new target. And for financial institutions that do not have reserves at the Fed, they'll be doing reverse repo operations in which the Fed borrows money from these institutions and pays them a small amount of interest. The reason for this is to keep these institutions from making short term loans to banks below the fed funds target range.

Personally, I dislike this plan. The Fed could have tightened policy by selling bonds in its portfolio and reducing reserves. It would not have increased the fed funds rate but it still would have been a tightening of monetary policy. I think the Fed went with the plan above because they're still stuck in the mode of thinking that monetary policy is all about interest rates.

Brian Donohue writes:

I always think of vulgar Keynesianism as a fiscal thing. You know, a theory that you deficit spend during recessions and run surpluses in the good times, but the good times are forever around the next bend, so, 13 million new jobs into an economic recovery, you're still running a $440 billion deficit, and NOW, you're raising spending and cutting taxes, NOW!

Vulgar Keynesianism is alive and well.

Emerson writes:

The Fed has stated that with its new Fed Funds target policy, it expects inflation to reach 1.4% in 2016

I don t see how inflation will increase from the current level of essentially zero to 1.4%. The new policy of raising the Fed Funds rate through reverse repo seems , to me , is more likely to keep inflation very low

ThaomasH writes:

What you call "vulgar Keynesianism" is, I think, mainly the result of the implicit assumption that monetary authorities do not operate under the kind or rule that offsets fiscal shocks. And as we see from the Fed's actions yesteerday, they still are not.

Scott Sumner writes:

Gordon, I agree.

Emerson, You are right that yesterday's action will reduce inflation. They think it will rise next year for other reasons.

Thomas, I don't see how the Fed's decision yesterday supports vulgar Keynesianism.

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