Scott Sumner  

What would an IS shock look like?

Ridley, liberty, optimism and ... The Economist Who Didn't Bark...

One thing that makes it hard to discuss macroeconomics with people is the widely held assumption that changes in interest rates reflect changes in monetary policy. That misconception comes from the fact that people misinterpret the implications of two true facts:

1. In the IS/LM model, an easy money policy lowers interest rates.
2. The Fed targets short term interest rates.

People think that if the Fed is controlling rates, and if an easy money policy causes rates to fall in the IS/LM model, then a fall in rates must be an easy money policy. But of course this doesn't at all follow from the previous assumptions. Recall that in the IS/LM model, low interest rates can be caused by either an increase in the money supply or a leftward shift in the IS curve (perhaps due to bearish expectations). Indeed it's even possible that the IS curve might shift left because the public expected a tight money policy that would produce a depression.

Screen Shot 2016-01-04 at 4.16.12 PM.png
So falling interest rates do not necessarily indicate easy money, they might reflect a decline (shift left) in the IS curve. How could we tell the difference? If the fall in interest rates were caused by a leftward shift in IS, then you'd see GDP growth decline at the same time. If it was caused by easy money, then GDP growth should accelerate. In that case, why not cut out the middleman and simply look at what's happening to NGDP growth?

There's nothing controversial about what I'm saying here. It's simple IS/LM. But for some reason lots of people have a lot of trouble clearly seeing the implications of this model. Thus when rates fell in late 2007 and early 2008, it was clearly due to a decline in the IS curve (or its growth rate to be more precise.) After all, NGDP growth slowed at the same time. The monetary base was stable. And yet I think you could find many people, even professional economists, arguing that the Fed eased policy in late 2007 and early 2008, when they continually cut rates from 5.25% to 2.0%. And they made this claim despite the fact that the LM curve did not shift, rather the IS curve shifted left. It's as if they thought the IS/LM model was simply a fixed IS curve, with movements along the curve. It would be like people who think the supply and demand model is actually a "demand model", and who are puzzled when people drive more "despite" high oil prices.

Is the onset of the 2007-09 recession typical? This graph suggests the answer is yes:

Screen Shot 2016-01-04 at 4.08.13 PM.png
The correlation is far from perfect, but there is a definite tendency for interest rates to fall during recessions (grey bands on the graph). Yet many economists talk about those interest rate declines as if they are "easy money" policies, whereas the IS/LM model implies they are actually caused by a leftward shift in the IS curve. This is a very basic error, made all the time.

The question is why? I think it's due to the fact that the Fed targets interest rates. Since they control short-term interest rates, it seems plausible that any change in interest rates is caused by a shift in monetary policy. Of course this is not true, most changes are simply the Fed adjusting its target to reflect changes in market rates induced by shifts in the IS curve. But that's not how it looks to people.

Is this mistake costly? Previously I've argued that the misdiagnosis of the stance of monetary policy was one of the most important causes of the Great Recession. If nominal short-term rates had risen to 8% during 2008, most people would have viewed monetary policy as getting much tighter, and the Fed might well have been blamed for the recession. That blame would have caused the Fed to shift course. So the fact that people wrongly thought monetary policy was being eased ended up distracting attention from the Fed, and gave them a sort of free pass---even from liberals like President Obama. Of course conservatives were even worse, many of them predicting high inflation.

Supply and demand is a very simple model, but that doesn't stop Nobel Prize winners from making the basic error of reasoning from a price change. And IS/LM is also a very simple model, but once again elite economists often draw the wrong conclusions about the stance of monetary policy. It's an unfortunate mistake, which cost millions of workers their jobs in 2008-09.

PS. Fortunately, the mistake is beginning to be rectified.

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COMMENTS (3 to date)
Brian Donohue writes:

Good stuff as usual, Scott.

I'm a retirement actuary who joined the workforce in 1987, so my fascination with capital markets and interest rates is long-standing, and I've long felt that the peculiar demographics of the developed world (two world wars followed by baby boom) have left all kinds of fingerprints on the operation of capital markets over decades-long horizons. "How would the transition from massive young wealth accumulation to older liquidation play out?" has been a question that has haunted me throughout my career. The "New Normal" in interest rates is, I think, a big part of the story.

I was poking around in history just now and saw that, in July of 1990, the Fed Funds rate was 8%. (I even have trouble getting my head around that number, given that inflation had been mostly whipped by that point, but I was happily locking up a 10.625% mortgage at the time myself, so...)

When the Fed cut rates to 3% in 1992, it felt like crazy talk- lowest rates in 25 years.

Here's a factoid: during the 15 years 1987-2001, you could have earned a 2.6% REAL compound annual return by investing in basically no-risk 1-year Treasuries. From the standpoint of a 2016 investor, this is mind-boggling.

Anyway, people's frame of reference wasn't 2016, it was history, and all of this, like the slashing of the Fed Funds right to 1% in 2003 just seemed like crazy uncharted territory.

Suddenly, real yields on 1-year Treasuries slipped negative. My own naive application of intertemporal preference told me this had to be wrong, an anomaly. We had arrived at the New Normal, but we didn't believe it.

Instead, we tried to get back to the Old Normal, hiking the Fed Funds right back up to 5.25% in 2006. But the baby boomers are 20 years older now.

ThomasH writes:

I think the easier way to think or at least to talk about the recession to someone not already "in on" the MM view is to acknowledge that the Fed did some things to make monetary policy more stimulative (they -- several months too late -- eventually bought enough ST securities so that ST interest rates fell, they did start buying some longer tern securities), but not "enough." The "not enough" is shown by the failure of the NGCP to quickly recover its pre-crisis trend, the fall of the TIPS below 2%, the failure of the price level to its 2% trend, etc. It seem easier to get people to agree that the Fed did not do the right things than to get them to call the omissions "monetary policy." Logic (inaction is as much "policy" as action) may get in the way of communication.

And when we examine the reasons to Fed mistakes, it think it is easier to sell them as facing resistance to actions that would have pushed ST rates negatives and resistance to larger and longer purchases of LT securities.

Scott Sumner writes:

Brian, Here's something even more mind-boggling. At the end of November 2008, 5 years TIPS offered a 4% real rate of return. Risk free.

And even more mindbogglingly, all those economists who think real interest rates reflect the stance of monetary policy, not one offered even a bit of criticism.

Thomas, I think you can make that claim for the latter part of the recession. But the onset of the recession was not accompanied by any monetary injections. There were no concrete actions to stimulate the economy in late 2007 and early 2008.

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