How the Fed Let the World Blow Up in 2008


The Fed transcripts have been released. What was going on inside the Fed was actually worse than we thought. No, they didn’t have a time machine to see exactly how bad it would be, but some members had read their history and argued for action. Sigh. And it gets worse, as the Fed continues the tight money policy into 2009. Matt O’Brien writes: 

…But the Fed was blinded. It had been all summer. That’s when high oil prices started distracting it from the slow-burning financial crisis. They kept distracting it in September, even though oil had fallen far below its July highs. And they’re the reason that the Fed decided to do nothing on September 16th. It kept interest rates at 2 percent, and said that “the downside risks to growth and the upside risks to inflation are both significant concerns.”

In other words, the Fed was just as worried about an inflation scare that was already passing as it was about a once-in-three-generations crisis.

It brought to mind what economist R. G. Hawtrey had said about the Great Depression. Back then, central bankers had worried more about the possibility of inflation than the grim reality of deflation. It was, Hawtrey said, like “crying Fire! Fire! in Noah’s flood.” 

Note the discussion re Milton (and Scott Sumner), that you can’t judge easy money by short term rates. Here’s Scott Sumner on Matt O’Brien on the Fed’s mistakes during 2008 

…A few comments:

1. The flawed monetary regime (failure to level target NGDP) made these seemingly small tactical errors in mid-2008 much worse than they would otherwise have been.

2. I am pretty sure Matt is not a market monetarist, or at least he’s more Keynesian on issues like fiscal stimulus than I am. Thus it’s heartening to see the MM interpretation of 2008 become increasingly accepted by the mainstream press. When people like David Beckworth and I were starting out on this crusade, the notion that excessively tight money was the problem was almost laughed off the stage. ”Interest rates were 2%, how can you claim money was tight in 2008?” Now the MM narrative is becoming increasingly accepted in the media. That’s great news.

3. Elsewhere Matt praises Frederic Mishkin. He also directed me to a Hilsenrath piece that said Mishkin came off looking relatively bad in the transcripts. But Hilsenrath was focusing on Mishkin’s jocular style. If you look at content of his analysis he was ahead of most of his colleagues. (In terms of forecasting Rosengren seems to have been the best.) I did a post over at Econlog a few days ago praising Mishkin’s farewell comments, but forgot that he had been equally brilliant at the final meeting of 2007.

More from Scott Sumner here:

The market monetarist view that tight money caused the recession is getting some play in the press. Here’s an excellent piece by Ramesh Ponnuru:

There’s another view of the Fed’s role in the crisis, though, that has been voiced by economists such as Scott Sumner of Bentley University, David Beckworth of Western Kentucky University and Robert Hetzel of the Richmond Fed. They dissent from the prevailing view that the Fed has been extremely loose since the crisis hit. Instead, they argue that the Fed has actually been extremely tight, and that when its performance during the crisis is measured against the proper yardstick, the central bank emerges as the chief villain of the story.

In the second half of 2008, housing prices, many commodity prices, inflation expectations and stocks all suggested deflation was coming. Fed officials, though, kept talking about backward-looking measures of inflation that made it look high. Their hawkish pronouncements effectively tightened monetary policy by shaping market expectations about its future direction. In August 2008, the Fed minutes explicitly said to expect tighter money. Even after Lehman Brothers Holdings Inc. collapsed the following month, the Fed refused to cut rates and fretted about inflation (which didn’t arrive). A few weeks later, the Fed decided to pay banks interest on excess reserves, a contractionary move. Only then did it cut interest rates.

Ryan Avent: The negative rates we need

I like this Free Exchange/Beckworth formulation of NGDPLT policy:

The negative rates we need David Beckworth responds to Mr Garcia with an idea to operationalise the fiscalist-monetarist synthesis:

First, the Fed adopts a NGDP level target. Doing so would better anchor nominal spending and income expectations and therefore minimize the chance of ever entering a liquidity-trap. In other words, if the public believes the Fed will do whatever it takes to maintain a stable growth path for NGDP, then they would have no need to panic and hoard liquid assets in the first place when an adverse economic shock hits.

Second, the Fed and Treasury sign an agreement that should a liquidity trap emerge anyhow and knock NGDP off its targeted path, they would then quickly work together to implement a helicopter drop. The Fed would provide the funding and the Treasury Department would provide the logistical support to deliver the funds to households. Once NGDP returned to its targeted path the helicopter drop would end and the Fed would implement policy using normal open market operations. If the public understood this plan, it would further stabilize NGDP expectations and make it unlikely a helicopter drop would ever be needed.

This two-tier approach to NGDP level targeting should create a foolproof way to avoid liquidity traps. It should also reduce asset boom-bust cycles since NGDP targets avoid destablizing responses to supply shocks that often fuel swings in asset prices. This approach is consistent with Milton Friedman’s vision of monetary policy, would impose a monetary policy rule, and provide a solid long-run nominal anchor. Finally, per Cardiff Garcia’s request it would satisfy both fiscalists and monetarists. What is there not to like about it?

Scott Sumner: interest rates and monetary policy (Mishkin forgotten, again)

Reacting to some confusion in the comments, Scott Sumner wrote Further comments on interest rates and monetary policy

People are still confused about my views on monetary policy and interest rates.  First of all, no one should assume that they understand what I’ve said in the past on these issues.  This stuff is very nuanced, very counterintuitive, and I’m not a very talented writer.  So let’s try to first see what is actually true, and then think about what I’ve said:

1.  Interest rates are not a reliable indicator of monetary policy.  I’ve said that 100 times.

2.  NGDP growth is a reliable indicator of monetary policy.  I’ve said that 100 times.

{snip lots of important details}

To summarize:

1.  Over long periods of time long term bond yields do tend to track GDP growth (and levels) pretty well.  So I’m likely to have made some generalizations in that area equating low rates and tight money.  Japan still has tight money! They have low expected NGDP growth.  And they still have low rates.

2.  As far as the immediate market reaction to monetary announcements, I’ve always argued that it is highly unpredictable, but that there are certain principles that seem useful.  An announcement likely to dramatically change the future path of policy is more likely to lead to a ‘perverse’ reaction in bond yields, than would a one-time injection of money.  I wish I could say more, but I’m often just as confused as you are.

{snip lots more important discussion]

As you might expect there is much discussion following Scott’s post – where prof. Sumner commented as follows – this is the point of my post (excerpted)

(…) I’ve often said (and so did Arnold Kling) that much of my thesis is nothing but the NK dogma we’ve been teaching our grad students for 20 years (before 2008):

1. Zero fiscal multiplier.

2. Monetary policy drives NGDP

3. Low rates don ‘t mean easy money.

4. Highly expansionary monetary policy is likely to raise long term rates.

5. Fed is never out of ammo, even when rates are zero.

So why did I start blogging? BECAUSE ALMOST THE ENTIRE ECONOMICS PROFESSION SUDDENLY SEEMED TO FORGET WHAT WAS IN MISHKIN’S TEXTBOOK IN EARLY 2009. That’s why I got into blogging. But yes, nothing new here. There are other aspects of MM that are genuinely new, but not the fact that easy money can raise rates.


Fed NGDP targeting would greatly increase global financial stability

Lars Christensen compares NGDPLT to ‘Adaptive’ policy – these excerpts will hopefully motivate you to read the complete Christensen essay: 

(…) Lets look at two different hypothetical US monetary policy settings. First what we could call an ‘adaptive’ monetary policy rule and second on a strict NGDP targeting rule.

‘Adaptive’ monetary policy – a recipe for disaster 

By an adaptive monetary policy I mean a policy where the central bank will allow ‘outside’ factors to determine or at least greatly influence US monetary conditions and hence the Fed would not offset shocks to money velocity.

(…) under an ‘adaptive’ monetary policy the Fed is effective allowing external financial shocks to become a tightening of US monetary conditions. The consequence every time that this is happening is not only a negative shock to US economic activity, but also increased financial distress – as in 2008 and 2011.

As the Fed is a ‘global monetary superpower’ a tightening of US monetary conditions by default leads to a tightening of global monetary conditions due to the dollar’s role as an international reserve currency and due to the fact that many central banks around the world are either pegging their currencies to the dollar or at least are ‘shadowing’ US monetary policy.

In that sense a negative financial shock from Europe will be ‘escalated’ as the fed conducts monetary policy in an adaptive way and fails to offset negative velocity shocks.

This also means that under an ‘adaptive’ policy regime the risk of contagion from one country’s crisis to another is greatly increased. This obviously is what we saw in 2008-9.

NGDP targeting greatly increases global financial stability

If the Fed on the other hand pursues a strict NGDP level targeting regime the story is very different.

Lets again take the case of an European sovereign default. The shock again – initially – makes investors run for safe assets. That is causing the US dollar to strengthen, which is pushing down US money velocity (money demand is increasing relative to the money supply). However, as the Fed is operating a strict NGDP targeting regime it would ‘automatically’ offset the decrease in velocity by increasing the money base (and indirectly the money supply) to keep NGDP expectations ‘on track’. Under a futures based NGDP targeting regime this would be completely automatic and ‘market determined’.

Hence, a financial shock from an euro zone sovereign default would leave no major impact on US NGDP and therefore likely not on US prices and real economic activity as Fed policy automatically would counteract the shock to US money-velocity.(…) 

Finally and most importantly the financial markets would under a system of a credible Fed NGDP target figure all this out on their own. That would mean that investors would not necessarily run for safe assets in the event of an euro zone country defaulting – or some other major financial shock happening – as investors would know that the supply of the dollar effectively would be ‘elastic’. Any increase in dollar demand would be meet by a one-to-one increase in the dollar supply (an increase in the US money base). Hence, the likelihood of a ‘global financial panic’ (for lack of a better term) is massively reduced as investors will not be lead to fear that we will ‘run out of dollar’ – as was the case in 2008.

 Read the whole thing – I have filed for reference.

Chuck Norris beats Wolfgang Schäuble

Here's excerpts from a recent post by market monetarist Lars Christensen:

So far it is has been a remarkable week in the global financial markets. The ’deposit grab’ in Cyprus undoubtedly has shocked international investors and confidence in the ability of euro zone policy makers has dropped to an all-time low.

Despite of the ‘Cyprus shock’ global stock markets continue to climb higher – yes, yes we have seen a little more volatility, but the overall picture is that of a continued global stock market rally. That is surely remarkable when one takes into account the scale of the policy blunder committed by the EU in Cyprus and the likely long-lasting damage done to the confidence in EU policy makers.

I therefore think it is fair to conclude that so far Chuck Norris has beaten German Finance Minister Wolfgang Schäuble. Or said, in another way the Chuck Norris effect has been at work all week and that has clearly been a key reason why we have not (yet?) seen global-wide or even European-wide contagion from the disaster in Cyprus.

Just to remind my readers – the Chuck Norris effect of course is the effect that monetary policy not only works through expanding the money base, but also through guiding expectations.

When I early this week expressed my worries (or rather mostly my anger) over the EU’s handling of the situation in Cyprus a fixed income trader who is a colleague of mine comforted me by saying “Lars, you have now for half a year been saying that the Fed and the Bank of Japan are more or less doing the right thing so shouldn’t we expect the Fed and BoJ to offset any shock from the euro zone?” (I am paraphrasing a little – after all we were talking on a trading floor)

The message from the trader was clear. Yes, the EU is making a mess of things, but with the Bernanke-Evans rule in place and the Bank of Japan’s newfound commitment to a 2% inflation target we should expect that any shock from the euro zone to the US and Japanese economies would be ‘offset’ by the Fed and the BoJ by stepping up quantitative easing.

Read more


The wisdom of Scott Sumner

Ryan Avent considers The wisdom of Scott Sumner. What would the (US) citizens choose if offered three monetary policy  alternatives? 

BACK in December, Scott Sumner mused:

People form their views of politics and economics when they are young, and are given the reins of power when in their late fifties. Any thoughtful person in the 1930s could have easily predicted what would go wrong in the 1960s. The generation that grew up in the Great Depression would have a single-minded obsession with boosting [aggregate demand] to prevent mass unemployment. They would see everything as a demand issue, and ignore the supply side. Thus the ‘Liberal Hour’ of 1961 turned into the Great Inflation.

Any thoughtful person in the 1970s could have easily predicted the policy mistakes of the 2000s. The generation that came of age during the 1970s would be obsessed with the threat of inflation—seeing it just around the corner whenever there was a spike in the money supply, a dip in interest rates, or a blip in the CPI from commodity prices. The 1970s generation (including me) would overreact until NGDP growth was driven so low that interest rates fell to zero, making conventional monetary policy impotent. The inflation targeting consensus turned into the Great Recession.

The young people today have grown up in a world dominated by two giant bubbles…

Any thoughtful person today can predict that the macroeconomics policy failures of 2040 will be produced by a generation of late middle-aged policymakers obsessed with preventing bubbles.

(…) I suspect that so long as we’re considering hypotheticals Mr Sumner would request that we introduce a third option in which the Fed successfully targeted nominal output, leading to faster growth from 2001 to 2003, slower growth from 2003 to 2006, and a burst of moderate inflation rather than a recession from 2007 on. I feel confident that the typical American would also prefer that to the outcome we actually got. I’m not sure which of the alternative options she’d prefer, though I have my suspicions.

The important point, however, is that this kind of trade-off is not the one thats available in the real world. 


Continue reading Ryan Avent and the thoughtful comments. I’ve contributed one comment to the conversation:

Ryan wrote “The important point, however, is that this kind of trade-off is not the one that’s available in the real world.”

I object. A rule-based central bank executing NGDPLT (nominal GDP level targeting) will dampen the big swings. There will still be surprises but the damages done willbe less severe.

fundamentalist wrote “Monetarists think nothing happens in the economy unless the Fed makes it happen.”

My understanding of the market monetarist thinking is more that the Fed can only impact short term nominal output (NGDP). The Fed cannot plot a path for real GDP. To overstate what Sumner would probably say “everything important for future productivity and wealth happens outside monetary policy”. I would say an economy with long term stable NGDP growth is a good garden for investment and innovation.

PS – one of the frequent commenters hedgefundguy signs his remarks “NPWFTL, Regards”. Like many others I’m wondering what?? I finally found his answer – which refers to disabling the default Economist publish-comment everywhere:  


Cleveland Fed Estimates of Inflation Expectations

This is from the Cleveland Fed Inflation Expectations Estimator, updated through Dec 1, 2012. One of the primary goals of the Fed’s new rule-based QE3 is to reduce real interest rates by increasing inflation expectations. Is it working?

The markets obviously do not agree with the inflation hawks that warn of runaway inflation any day now due to all that “money printing”. Look at the following time series yield curve:

The Most Important Ben Bernanke Speech That No One Heard

Robert Holmes:

(…) But what the Fed chairman hinted at during the conference, overshadowed by the day’s earnings releases and gloomy news from Europe, bears more attention than it received, especially from the protestors.

“With respect to monetary policy, the basic principles of flexible inflation targeting — the commitment to a medium-term inflation objective, the flexibility to address deviations from full employment, and an emphasis on communication and transparency — seem destined to survive,” Bernanke said in his speech.

Though his comments appear innocuous, some investors and economists are wondering whether he was suggesting that the Fed, which has primarily targeted inflation for monetary policy, would instead target nominal gross domestic product, or NGDP. Bill Gross, who manages the world’s biggest bond fund at Pimco, tweeted that “Bernanke’s emphasis on ‘communications’ is likely code for ‘targeting’ nominal GDP or unemployment.”


We can only hope. Read the whole thing.

Bank of England governor Carney talking up NGDP targeting

The Washington Post has another example of the growing momentum behind nominal GDP targeting — the Bank of England! 

(…) But the idea may get a hearing over in Britain. Mark Carney, the new Bank of England governor imported from Canada, has been talking up NGDP targeting of late:

Addressing the Chartered Financial Analyst Society in Toronto, Mr Carney said that in major slumps: “To achieve a better path for the economy over time, a central bank may need to commit credibly to maintaining highly accommodative policy even after the economy and, potentially, inflation picks up. …

He added: “If yet further stimulus were required, the policy framework itself would likely have to be changed. For example, adopting a nominal GDP level target could in many respects be more powerful than employing thresholds under flexible inflation targeting.”

David Beckworth: NGDPLT Capitol Hill presentation

David reports on his briefing:

(…) I have been busy with other projects (…) several trips to Capital Hill to do briefings on nominal GDP targeting to Congressional and Senate staffers.  One of those trips was yesterday, with Scott Sumner and I presenting to a group of about 70 staffers.  Former Dallas Fed President  Bob McTeer moderated.   Here are the slides I used in my talk and here is Scotts new paper on NGDP targeting.


PS. Too bad Bob McTeer is not still the Dallas Fed President.  He is a great monetary economist.  Be sure to check out his blog.