Scott Sumner  

The Fed needs a new "theory"

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Caroline Baum directed me to a WSJ article on the Fed. It begins as follows:

The Federal Reserve's interest-rate increases aren't having the desired effect of cooling off Wall Street's hot streak.
That's already got me worried, as "Wall Street" is not a part of the Fed's mandate.
In theory, financial conditions should serve as the conduit between the Fed's monetary policy and the real economy. When the Fed lifts short-term rates, long-term rates should rise also and financial conditions should tighten.
Actually, "theory" predicts just the opposite. Textbook monetary theory suggests that the Fed directly impacts short-term rates, and affects long-term rates by influencing the expected rate of NGDP growth. If the Fed raises interest rates to tighten monetary policy that should reduce expected NGDP growth, which may well reduce longer-term interest rates.
The fact that the central bank and Wall Street are moving in opposite directions suggests limits to the Fed's influence over the economy. If it persists, it could also prompt the Fed to shift its strategy. If your dance partner doesn't follow, you might hold that person tighter.
Actually, it suggests just the opposite---that the Fed has a powerful influence on the economy. It is impacting expected NGDP growth.
"If we decide that we need to tighten financial conditions and we raise short-term interest rates and that doesn't accomplish our objective, then we're going to have to tighten short-term interest rates by more," New York Fed President William Dudley told The Wall Street Journal last year.
That is precisely the policy that was followed in 1928-29. The Fed raised rates, and when Wall Street kept rising they raised rates even more.
It is still too early to say whether officials will raise rates more aggressively than planned. Still, Harvard University economist Jeremy Stein, a former Fed governor, said because financial conditions are so loose after three rate increases, the Fed is less likely to back away from its plan to keep raising rates, even in the face of low inflation.
This is why it's so important to have the right "theory". If the Fed tightens policy, then sees long term rates fall and wrongly assumes it has eased, then it will tighten even further. That may not end well.

Fortunately, the current stance of monetary policy is roughly appropriate. Unemployment is 4.3% and the consensus private sector forecast of inflation is about 2%. If anything policy may be a bit too tight, as TIPS spreads show sub-2% inflation expectations in the bond market. But overall, monetary policy is not currently causing major disruptions to the economy. Unfortunately, until the Fed gets the right model, it's hard to have confidence that they will react any better to the next crisis than they did to the turmoil of late 1929, or 2008.

PS. I am not a Neo-Fisherian, but I wish there was at least one Neo-Fisherian on the FOMC, to clarify the relationship between monetary policy and long-term interest rates. Perhaps James Bullard can fill that role.

PPS. Nick Rowe uses the analogy of balancing a stick in one hand. If you want the top to move left, you move your hand to the right. If you want higher long-term rates, you cut short term-rates.

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COMMENTS (13 to date)
John Hall writes:

Five-year breakeven inflation was around 2% in late January, but has fallen to around 1.70% currently. If I were on the FOMC, I wouldn't vote for a June hike, but apparently the market is still pricing in like a 99% chance of it.

Kevin Erdmann writes:

2008? This was happening in 2005 and 2006. From June 2004 to July 2006, they hiked rates 4.25% and long term forward rates didn't really budge. They interpreted that as stimulative.
Isn't Dudley the official that claimed having a crisis after the Fed held rates at 2% from April to October 2008 and threw in IOR for good measure is evidence that sometimes monetary policy just can't be loosened enough to avoid a crisis?
It's like somewhere along the way a crude Austrian Business cycle theory became everyone's implicit model.

Andrew_FL writes:
It's like somewhere along the way a crude Austrian Business cycle theory became everyone's implicit model.

Inflationists say the wackiest things.

Brian Donohue writes:


I came to make the same point about the last tightening cycle.

It's the new normal people. Get used to it.

Thaomas writes:

Is Fed policy roughly appropriate? No. It has failed for n quarters to hit its inflation target which means that the price level has drifted farther and farther away from the level it would have had if the Fed had a symmetric inflation policy. Hitting the target in one quarter (the haven't yet) or for private expectations for inflation over the short run to be at the target level does not mean the policy is right.

And I am surprised that Scott would cite the unemployment rate as an indicator of whether the inflation target is being met at this time. IF the price level were on target, I agree that today's unemployment rate would not suggest additional stimulus, but it is not. Fulfilling the maximum employment mandate (or at lest not obviously missing it-- the employment rate still looks too low given demographic trends) doe not mean that the Fed should ease up in meeting its price stability mandate.

baconbacon writes:
2008? This was happening in 2005 and 2006. From June 2004 to July 2006, they hiked rates 4.25% and long term forward rates didn't really budge. They interpreted that as stimulative.

According to the stick analogy if you hike short term rates then long term rates should fall. The fact that they barely budged with significant interest rate increases over several years and only fell ~4 years after the increase began and ~ 10 months after rates had started to get cut (slashed).

Up until August 2008 the long term rates moved exactly as the fed would have predicted with near perfect monetary policy. 10 year TIPs spreads never fell below 2% despite a bursting housing 'bubble', a recession and rate increases from 1% up to 5.25% during that time.

Scott Sumner writes:

everyone, I don't disagree with the view that there is little reason for the Fed to raise rates next week.

As far as Fed policy being off course, everything is relative. It's hard for me to see how in a world when the consensus private sector inflation forecast is 2%, and unemployment is 4.3%, they are far off course. If so, how would you describe 9% unemployment and 0.6% core inflation? Very far off course?

Bacon, I meant in an "other things equal" sense. Short and long rates often move together, reflecting factors other than the short term effect of monetary policy

David de los Angeles writes:

Dr. Sumner,

You wrote:"That's already got me worried, as 'Wall Street' is not a part of the Fed's mandate."

The Federal Reserve Bank would seem to have a different notion. They appear to see the "wealth effect" as a mechanism for influencing the economy and the wealth effect would seem to move directly through the stock market.

Dr. Ben Bernanke explained as much in a Washington Post editorial:

"This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."[1]

The Bank of Japan had pioneered this work and the FRB had been studying it long before the Great Crash of 2008 [2]. Inflating the value of stocks to generate wealth which might increase aggregate demand was part of the original idea through "portfolio-rebalancing".

So the FRB would appear to have considered boosting asset prices as part of the mandate, at least as tool to achieve other monetary policy objectives.



Louis Woodhill writes:

Money is much too tight right now, which is why the economy is so sluggish. There is no need to try to sift "the stance of monetary policy" out of interest rates or NGDP numbers. Commodity prices tell you all you need to know, and they tell you every millisecond.

Right now, the CRB Index is at about 175, and it needs to be at 300 for a full economic recovery.

The Fed gave up control of global dollar liquidity when it began paying IOR (October 2008). It needs to take back control, and bring the CRB Index up to 300, and then keep it there forever.

Kevin Erdmann writes:

Bacon, long term rates barely budged from low levels they had fallen to in the previous recession. Improving sentiment should have caused some increase.

Postkey writes:

'That's already got me worried, as "Wall Street" is not a part of the Fed's mandate.'

It is {unofficially?} according to J.Rickards.

If 'Wall Street' 'crashes' then the Fed. will 'act'.

He named 3 factors.

The other two are 'core inflation' and the rate of job creation.

baconbacon writes:

@ Kevin Erdman

10 year tips spreads stayed between 2.1 and 2.9% during that span (numbers from memory), by the specific metric that SS has endorsed (absent a nGDP futures market) as a tool for analyzing Fed actions there was no tightening. By real time metrics (PCE growth) there was no tightening (if anything the numbers imply that the Fed was too loose during this period).

Kevin Erdmann writes:

My original comment was about the 2005 and 2006 period, by which time nominal and real GDP topped and slowly began to decline while ST rates were rising. Greenspan himself called stable LT rates a conundrum because he expected them to rise. The Fed considered those stable rates to be stimulative relative to what the Fed had expected. I contend that this was an error and that to the extent that low LT rates were a conundrum, the Fed should have considered it a problem.

What exactly do you disagree with there? If you don't think LT rates were low, I guess you need to take it up with Greenspan.

When did I lose you bacon? You seem to have become skeptical of my thesis.


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