Scott Sumner  

NeoFisherian recessions, with and without the confidence fairy

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I have a couple posts over at MoneyIllusion, arguing that lower interest rates are contractionary. The basic argument is that lower interest rates reduce velocity, which reduces NGDP (for any given money supply). Now Nick Rowe has a post which explores some similar themes, but in a different way:

The answer to that third question tells us that the IS curve slopes up. Because the IS curve, by definition, tells us what happens to real interest rate and real output when the central bank changes monetary policy (shifts the LM curve) to create a recession. (Real interest rate on the vertical axis, real income on the horizontal axis.)

But the reason you find it hard to get your head around is that you can't help but think of the central bank as setting an interest rate. And if the central bank wants to create a recession, it needs to raise the rate of interest, right? So how can raising the rate of interest to create a recession cause the rate of interest to fall??

OK, let me work with you. (Though it's a lot easier to get your head around if you think of the central bank as setting the money supply or NGDP rather than a rate of interest.)

There's a big difference between creating a recession from scratch and keeping a recession going so it doesn't get better or worse. The metaphor doesn't work perfectly, but it's a bit like a heavy ball sitting on top of a round hill. It's an unstable system. You have to initially push the ball forward to get it to roll down the hill, but once it is halfway down the hill you need to constantly push it back to keep it from rolling further.

Let's use the term "NeoFisherian recession" for a slump that is triggered by monetary policy so tight that it results in an immediate decline in interest rates. I claim that such an event is much more likely than people tend to assume. First let's see how it works using the "confidence fairy":

The Fed announces a tight money policy. Expectations of recession lead to less demand for credit. The supply of credit also declines, but not as sharply. Thus nominal interest rates fall. The lower level of nominal interest rates reduces velocity, which reduces NGDP. (For simplicity, I assume no change in the monetary base.) Because nominal wages are sticky, the lower NGDP causes a recession. The fears of recession are self-fulfilling. But if this policy had not "worked", then the Fed was quite willing to reduce the base enough to cause a recession. It just so happens that it did not need to do so, the low interest rates (which reduced V) did 100% of the heavy lifting.

Now let's do the same, with concrete steps:

The Fed announces a crawling peg exchange rate system, whereby the dollar will appreciate by 1%/year, relative to the previous expected path of dollar appreciation. Due to the interest parity condition, this reduces nominal interest rates in the US by 1%. The Fed also does an immediate one-time, once and for all appreciation of the dollar, large enough to cause a recession, even with the 1% lower nominal interest rates in the US. (But then I shouldn't have to say "even with", if I've convinced you that lower interest rates are contractionary.)

Both policies produce a recession by reducing NGDP, and both immediately reduce nominal interest rates. Real interest rates don't matter, as the split between inflation and real GDP is entirely arbitrary, not relating to anything more concrete than a fuzzy idea called "utility". Instead, recessions are undesirable reductions in hours worked.

Now let me suggest that something like this happened in 2007-08. The Fed signaled to the markets that it cared more about inflation than NGDP. It signaled that it would allow NGDP growth to slow if that was needed to rein in inflation, which was overshooting the 2% target. The market saw what the Fed was doing, and decided (I'll anthropomorphize markets here) "We see that you care about inflation. We don't. We care about NGDP growth. Because your policy will reduce NGDP growth, we will reduce the Wicksellian equilibrium rate, in expectation of a recession." This occurred around December 2007.

Then during 2008, the Fed signaled to markets that there was inertia in the adjustment of the interest rate target. And also a distrust of market forecasts of inflation. The markets saw this and concluded that the Fed would fail to reduce rates anywhere near fast enough to prevent a deep slump. This made the markets more pessimistic, which reduced the Wicksellian equilibrium rate even faster. This is what occurred in the second half of 2008.

An interesting question is what would have happened if the Fed had done the right thing and aggressively targeted NGDP, level targeting. Would the Wicksellian equilibrium rate have ever fallen to zero? I doubt it.

Most people are skeptical about what monetary policy could have done in 2008, because they view it as being pretty expansionary (even if not quite as expansionary as would have been desirable.) If however, you view it the way Nick and I do (and other market monetarists, and Bob Hetzel, etc.), as being effectively contractionary, then the idea of an alternative policy path saving the day becomes much more plausible.

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COMMENTS (8 to date)
bill writes:

I noticed today that the BLS now estimates that our economy lost about 1.2mm jobs from January 2008 to August 2008. But at the time, the estimate of losses was "only" about 450k jobs. If they believed in the Philips curve (I think they did), I think they might have loosened faster and sooner if they had had accurate data. I bring that up because I bet the Fed could make the same mistake soon with untimely data.

Benjamin Cole writes:

Maybe I understand these posts, sort of.
Print more money and monetize a few trillion more dollars of federal debt still sounds like the right course to me....

James Alexander writes:

I agree with Ben. I think these posts are a little too clever for simple me. They seem to turn on a distinction between lower rates (as a result) and lowering rates (as an action or target of actions). And vice versa.

1. If you try to lower rates when the economy is hot you'll get higher rates.

2. If you try to raise rates when the economy is cold you'll get lower rates.

These apparent paradoxes don't help me today to know whether Scott thinks the economy is hot or cold today. At best, I think the economy is lukewarm and cooling, so we are in 2. And that's a tragedy that should be avoided.

Scott seems to want to see a stock market collapse before he's convinced it's 2. Maybe a quickly reversed collapse wouldn't do much damage, but it seems a big risk to take.

Brian Donohue writes:

Great stuff as usual, Scott.

Scott Sumner writes:

Bill, Good point and important point, It's one more reason why we need NGDP futures markets.

But I'd also point out that the unemployment rate data tends not to be sharply revised, and it showed the economy doing very poorly during April-August 2008, as unemployment soared from 5.0% to 6.1%. That sort of sharp increase NEVER occurs during non-recession periods. The Fed should have known the economy was declining rapidly.

James, Actually I don't want to see a stock market collapse, by then it's too late. The data is what it is, very mediocre---everything else is speculation. My best guess for 2016 is whatever the market forecasts---hopefully we'll have a 2016 NGDP market up and running soon.

Also recall that I do believe that the Fed's decision to raise IOR was contractionary.

Thanks Brian.

James Alexander writes:

I meant to suggest that you'd need to see an actual stock market collapse before being convinced that money was too tight, of course you don't want to see it, almost no one does.

Can't we look at other indicators of NGDP expectations? Already weak base money growth that has become quite negative in the last few weeks, ultra-low inflation expectations, the dollar strength, flattening yield curves seem big enough red flags without waiting for stocks to crash, cash to run to the Fed or unemployment to turn?

You've often correctly written about the nonsense bubble-mongers talk, predicting 10 or 100 bubbles for each one that actually bursts. What would it take to convince you we were on the verge of a new recession without actually having it - apart from NGDP Futures? Or is this an unfair question?

Scott Sumner writes:

James, There's a difference between thinking money is too tight, and thinking there will be a recession. I basically think money's been too tight since 2008, although now it's getting much less so. But recession is a much higher threshold. Unless stocks fall sharply I wouldn't expect a recession. But that doesn't mean money is not too tight. TIPS spreads are useful in determining whether money is too tight.

BJH writes:


Do you know of any formal macro models where tight monetary policy can actually affect the natural rate? As opposed to the NK model, where the natural rate is entirely exogenous and not affected by tight or loose monetary policy.

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