Scott Sumner  

It takes a regime change

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In the 1970s, the Fed kept tinkering with interest rates, not understanding that high rates don't mean tight money. Inflation and NGDP growth kept soaring higher and higher. Eventually economists came to believe that (old) Keynesian economics was bankrupt. A new regime requires new leadership, not invested in the failed policy. President Carter "promoted" Fed chair G. William Miller (actually he was basically fired), and replaced him with Paul Volcker, who abandoned the interest rate targeting regime. Inflation was brought under control.

It may be too soon for this sort of personnel change today, but it's certainly not too soon to conclude that the current interest rate targeting regime has failed. Consider the following recent statement by Janet Yellen:

Financial conditions in the United States have recently become less supportive of growth, with declines in broad measures of equity prices, higher borrowing rates for riskier borrowers, and a further appreciation of the dollar. These developments, if they prove persistent, could weigh on the outlook for economic activity and the labor market, although declines in longer-term interest rates and oil prices provide some offset.
If falling oil prices and falling bond yields were expansionary, then we'd expect stocks to rally on news of falling oil prices and falling bond yields. But just the opposite is true. When Keynesian policy failed in 1979, economists went back to the equation of exchange:

M*V(i) = P*Y

The monetary base times base velocity (which is positively related to interest rates) equals nominal GDP. In the 1970s, the problem was excessive growth in M, so Volcker slowed money growth. Today the problem is excessively low V, and falling bond yields make this problem worse.

As Marcus Nunes pointed out in a excellent new post, Janet's Yellen's statement is a classic example of reasoning from a price change. There are occasions when falling bond yields are expansionary. That's when they are produced by monetary injections. M goes up by more than V goes down.

But this time the monetary base is not being increased; falling bond yields are being caused by expectations of weaker growth (as Paul Krugman recently pointed out). They are pulling velocity lower. Thus falling bond yields are contractionary. (A leftward shift in the IS curve, if you insist on a Keynesian explanation.) This is monetary economics 101, and it's quite discouraging to me that the Fed chair is making these sorts of elementary mistakes. As far as I can tell, the markets are also discouraged.

Lars Christensen has a similar concern:

In this 2009-article Scott Sumner argued that a key contributing factor to the mistakes of the Fed in 2009 was that the Fed simply misdiagnosed the crisis. Hence, while Scott clearly showed that the crisis was caused by an excessive tightening of monetary conditions, which in turn led to a banking crisis, the Fed was convinced that the banking crisis was the cause rather than the consequence of the crisis.

Furthermore, all through 2008 the Fed continued to argue that monetary conditions were highly accommodative, while in fact if you where tracking market indicators then it was clear that monetary policy had become insanely tight.

I fear that the Fed today is making the same mistake once again. The Fed is convinced that monetary policy is very easy (nominal interest rates are very low), but the fact is that market indicators - as I have shown above - clearly are telling us that US monetary policy not only has become gradually tighter since the announcement of tapering in May 2013, but also that monetary policy has become excessively tight since the autumn of 2015 and that Janet Yellen and her colleagues in the FOMC have been overly focused on labour market conditions and have completely ignored market and money indicators and as a consequence the US manufacturing sector is already in recession and it increasingly seems like that we soon will see an outright recession in the US economy. If the Fed continues to ignore that message from the markets then we might risk this turning into a banking crisis once again.

PS. Over at MoneyIllusion I complain about another recent example of Fed incompetence.

HT: Thomas

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COMMENTS (7 to date)
Alexander Hudson writes:

This is all very discouraging.

If there's a silver lining, it's that the banking system seems to be in much better shape now than in late 2008. I doubt we'd see a repeat of 2008, when the economy was already weak due to real shocks like the housing crisis and high oil prices. So I suspect a recession would be much milder, closer to 1990-91 and 2001 than 2008-09.

That said, in 1990-91 and 2001, the Fed was well above the lower bound, so it could ease policy by lowering its target for the fed funds rate. A recession this time around would require unconventional policy tools, which the Fed has only deployed with great reluctance. And that was with Bernanke at the helm! And now they've essentially ruled out negative rates as a policy tool.

The one hope is that, faced with a recession and the need for more stimulative policy, the Fed will seriously consider a wholesale regime change, e.g., level targeting or something like that. That would be analogous to Volcker's regime change. Keep in mind, too, that Volcker didn't come in intending to switch from interest-rate targeting to money-supply targeting. He did it essentially out of desperation. So maybe there's hope for Yellen and Co. after all.

Scott Sumner writes:

Alexander, Good comment.

Lorenzo from Oz writes:

So, the Obama Administration's incompetence over Fed appointments is making who wins the Democrat nomination irrelevant.

Though I find the notion of a Bernie v Bloomberg v The Donald race fascinating, in a sort of pass-the-popcorn sense.

Jose Romeu Robazzi writes:

Yellen's reluctance in adopting negative IOER is a bit puzzling. After all, everybody is doing it. I don't think supposedly tight labor market is the single explanation for it. But I don't follow the Fed inner workings that closely. Can someone come up with a better explanation ? At least, more QE does not seem to be a great barrier ... or is it?

Alexander Hudson writes:

Jose, I think much of the barrier to more QE is psychological and political. Doing more QE just "seems" like a big deal to people. After all, the Fed is injecting hundreds of billions of dollars into the economy, and massively increasing the size of its balance sheet. Most people have a rigidly mechanical view of how monetary policy works, so they don't understand that what really matters is the Fed's target, and its credibility in hitting that target. I usually think of QE as a way for the Fed to show that it's really serious about wanting higher inflation and nominal growth. But for those who don't understand the role of QE in shaping expectations, it just looks like a huge government intervention (if you're on the right) or a huge giveaway to banks (if you're on the left). So it gets pilloried in the media, the debates, and on Capitol Hill. The Fed is ostensibly independent, but in reality it does respond to external political pressure.

As for why the Fed is reluctant to go negative on interest rates, Paul Krugman had an interesting argument today suggesting that it's because the financial industry really hates the idea. Fed officials obviously talk a lot to people in the financial industry, so the idea that low rates are bad for banks may well hold a lot sway at the Fed. Of course, persistently low rates are usually a sign that money has been too tight, and a sufficiently aggressive monetary policy in the short term will move the economy away from a low-rate environment, so it sounds like what's really hurting banks is tight money. But most people, even in the financial industry (hell, even at the Fed!), don't seem to understand that. So they end up supporting tight money policies that actually hurt them.

Alexander Hudson writes:

Lorenzo, I agree that there's plenty of criticism to level at the Obama administration in its handling of the Fed. They were FAR too slow to fill vacancies, and never showed a sense of urgency in getting their nominees through the confirmation process (obviously there's some blame to go around on that one). And I think Stein and Powell were poor candidates for Fed, though I can understand why they might have seemed like good candidates.

With that being said, it's hard to blame the Obama for the Yellen nomination. In retrospect it's easy to say that Summers would have been the better choice, but at the time of the decision Yellen was clearly the superior candidate. It was exceedingly difficult to find any statement at all from Summers about monetary policy, and what little we could infer about his views suggested he was skeptical of its efficacy. On the other hand, Yellen had a reputation as a dove, and her statements on monetary policy struck me as intelligent and well-informed. I imagine most, if not all, market monetarists viewed Yellen as a better choice than Summers. Yellen has, unfortunately, stopped making sense, but is that really so different from how Bernanke (who, as an academic, was one of the most aggressive supporters of unconventional monetary policy) started to contradict his past statements?

I also think that Fischer has turned out to be a huge disappointment. There were some warning signs, but his stint at the Bank of Israel was so successful that it was hard to argue against his nomination. I recall that even Scott was tentatively supportive of him (albeit with some notable misgivings). The real problem, as I see it, is the Fed itself, which has a very discretionary mindset. That's a very bad thing when your usual policy tool is no longer effective.

Lorenzo from Oz writes:

Alexander H: fair comment re:appointments and yes, the culture of the Fed is a serious problem.

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