In my previous post I criticized Paul Krugman's claim that monetary policy could not have been tightening significantly during the summer of 2008, as real bond yields remained low. In other words, Krugman claimed that low bond yields were telling us that monetary policy was not becoming contractionary. Yesterday he said something very different, that low bond yields are telling us that the economy is weakening:
I know, Paul Samuelson famously quipped that the stock market had predicted nine of the last five recessions; the wisdom of crowds is often overrated. Still, bond markets are a bit less flighty than stocks, and also more closely tied to the economic outlook. (A weak economy has mixed effects on stocks -- low profits but also low interest rates -- while it has an unambiguous effect on bonds.) What plunging rates tell us is that markets are expecting very weak economies and possibly deflation for years to come, if not full-blown crisis.
Apparently markets are bilingual! Seriously, why might the economy be weakening? Let's put two plus two together. The Fed starts sending out signals in mid to late 2015 that they need to tighten monetary policy. The economy weakens in Q4 after the Fed signals an intention to tighten. Then the economy weakens further in early 2016 after the Fed actually raises its interest rate on reserves. That's right out of textbook macroeconomics. Tight money slows growth, and this often (although not always) reduces bond yields. Krugman is exactly right in suggesting that the falling bond yields are generally an indication of a weakening economy, not easy money. It's too bad that he forgot that when criticizing Beckworth and Punnuru just a week earlier:
I'd just add that if there were anything to this [tight money in 2008] story, we should have seen a sharp increase in long-term real interest rates, as investors saw the Fed getting behind the disinflationary curve.
Krugman was wrong a week ago, and he's exactly right today.
Over at TheMoneyIllusion today I argued that pundits should not be judged by their ability to get lucky in predicting macroeconomic variables, but rather in the overall coherence of their intellectual framework. Krugman's two posts are an example of a lack of coherence. (In fairness, from a blogger that is generally much more coherent than average.)