Freaked out by Freakonomics
I have great respect for the work of Justin Wolfers, so it pains me to write this post. But if you read the following, I think you’ll see why I couldn’t let it pass:
Typically, the Fed does this by reducing the Federal Funds Rate, which is an interest rate on overnight loans. Unfortunately, that short-term interest rate is now pretty much at zero, and can’t go any lower. The thing is, no-one actually cares about the Fed Funds Rate. You and I and the businesses we work for don’t borrow using short-term interest rates. Instead, we finance our investments with longer-term loans. The Fed Funds Rate only matters to the extent that it reduces long-term interest rates.
So the key is for the Fed to reduce long-term rates.
Recently, the Fed has been doing this by “Quantitative Easing.” It’s a terrible name for a simple solution. Just as the Fed adjusts short-term interest rates by buying and selling overnight government securities, it can adjust long-term interest rates by buying and selling long-term government securities. That’s what QE2 did.
Many market commentators are disappointed that the Fed didn’t announce “QE3″””a renewed round of quantitative easing. But they shouldn’t be. The Fed still chose to reduce long-term interest rates, they just decided to do it with a different tool. They figured that if you can’t reduce short-term interest rates further, you should reduce ’em for longer. That’s what the Fed was promising, when they said they expect to keep their short-term rate at “exceptionally low levels for the federal funds rate at least through mid-2013.” What does this do? Keeping short-term interest rates lower for longer will also reduce long-term interest rates. And that’s the main game. It has already worked””perhaps even more reliably than following QE2. The interest rate on two-year bonds is down to virtually zero, and the 10-year interest rate is down to 2.2 percent.
So yes, we got lower long-term interest rates. That’s what matters. And it doesn’t really matter how we got there.
I certainly agree that the fed funds rate is unimportant. But I’m afraid Wolfers has violated one of my favorite maxims: Never reason from a price change.
It does matter why rates fall. In December 2007 the cautious Fed announcement so discouraged investors that the stock market crashed and long term interest rates fell (on expectations of recession–which turned out correct.) Obviously I can’t say for sure that this explains the current movement in the long term bond market. But consider the following:
1. When AD is severely depressed, stocks react very positively to monetary stimulus.
2. When AD is severely depressed, stocks tend to move in the same direction as bond yields.
3. QE2 rumors seemed to clearly boost stock prices in the fall of 2010.
4. In recently weeks both stock prices and bond yields have fallen sharply, and the falls have been highly correlated.
Put all those facts together and it seems much more likely that the recent decline in yields is due to fears that the Fed will allow NGDP to plunge, rather than the belief the Fed has adopted a truly stimulative policy.
Wolfers’ mistake is to forget that interest rates can change for many reasons. It might be more demand for T-bonds from the Fed (expansionary) or more demand for T-bonds from people frightened that the Fed will do nothing to prevent a double dip (contractionary.)
HT: JTapp
Update: JTapp told me that Justin Wolfers made the following comment in Twitter: “Scott Sumner failed to read my piece closely: themoneyillusion.com/?p=10422. I didn’t reason from a price change but from a Fed demand shock.”
I understand that Wolfers was assuming the fall in interest rates was in response to a Fed demand shock, but I’m arguing he had no basis for drawing that inference. The Fed did not announce a policy of increasing its purchases of bonds by more than the market expected—if anything, just the reverse. All we really know is that markets are responding to the Fed. We don’t know exactly why. Indeed the Fed’s action was so confusing that the markets initially didn’t even seem to know how to react, gyrating wildly up and down several times in the hours after the 2:15 announcement. And recall that in December 2007 a contractionary surprise caused bond yields to plunge–why is this different? So I’m afraid my criticism stands.
We really, really need a NGDP futures market, which would eliminate all these debates about whether Fed actions are expansionary and contractionary. And who is one of the two most famous proponents of prediction markets? Justin Wolfers. I’m sure Justin and I agree on that issue.
Update#2: I just got an email from Justin Wolfers. Perhaps I created the wrong impression in my “never reason from a price change” comment. Justin certainly understands the distinction between supply and demand shocks, and I didn’t mean to suggest otherwise. But monetary economics adds another degree of complexity. The same action (buying bonds) can raise or lower bond yields, depending on expectations. A one time open market purchase may well lower bond yields. But an announcement that the Fed will buy enough bonds to create Zimbabwe-style inflation will raise bond yields. So even if one knows it’s a demand for bonds shock (and we don’t know in this case) it’s still dangerous to draw inferences from interest rate changes.
Tags: QE 2
11. August 2011 at 06:49
Ha, I thought you’d be concerned about his story of the transmission mechanism.
11. August 2011 at 06:57
Scott: Just so I’m sure I understand your position: Do you agree that the Fed eased relative to the position of Kocherlakota and company, but judging by the reaction the market was perhaps expecting more than that? (As you note, really hard to disentangle just by looking at rates)
Anyway, I agree with your earlier sentiment that couching policy in terms of the future path of the short rate is weak sauce (sending a much less clear signal than asset purchases). At this point though, what is politically feasible and powerful enough to gin up expectations?
11. August 2011 at 07:17
This is so frustrating. I can’t beleive that Wolfers hasn’t noticed that the correlation between stock prices and bond yields has been so much higher since the onset of the 2008 recession than it is in normal times.
It only takes a simple though experiment to shown where he has gone wrong. Suppose that on Tuesday at 2:15 the Fed had come out with a statement that said “All is well in the economy, no need for us to do anything. Our forecast is on track.” does Wolfers doubt that the S&P 500 and bond yields would have both plunged? Would he really have still said “we got lower long-term interest rates. That’s what matters. And it doesn’t really matter how we got there.” ? I somehow doubt it.
11. August 2011 at 07:26
Wolfers responds via Twitter:
“Scott Sumner failed to read my piece closely: themoneyillusion.com/?p=10422. I didn’t reason from a price change but from a Fed demand shock.”
11. August 2011 at 07:41
Jon, You were right.
Thruth, Yes, expansionary relative to the hawks, but much less than the market want. Most importantly, contractionary relative to the Fed’s implicit policy goals.
They need a nominal target, level targeting.
Gregor, I’ve found that most elite economists don’t know the stylized facts of how markets respond to monetary policy. I don’t know whether Wolfers follows this issue closely–he’s not a monetary economist.
JTapp, I understood that, but my criticism is still valid.
11. August 2011 at 08:09
I thought the old Milton Friedman quote that “as an empirical matter, low interest rates are a sign that monetary policy has been tight” would be appropriate here.
11. August 2011 at 08:16
At the close on Tuesday (by the time it finished parsing the Fed’s statement), the stock market was up quite dramatically, with the Fed’s statement as the only reasonable explanation. Meanwhile, at the time the stock market closed (as well as before and after) yields on Treasury securities were considerably lower than they had been at the beginning of the day. Surely these observations are not consistent with the interpretation of falling interest rates as the result of a contractionary shock.
11. August 2011 at 08:35
@Andy Harless: But those gains were unwound Wednesday. Maybe that’s news from Europe, but maybe the market was still parsing the Fed? Anyway, if you look at something like the 5yr/5yr forward, the impact over the last few days of what the Fed announced is barely a blip compared to its volatility over the last few years.
11. August 2011 at 08:40
JTapp, You are right, that would have been a good example.
Andy, You raise a very interesting question, and someone should look closely at the tape. I was on an airplane at 2:15, but here’s what I recall:
A half hour of so after the announcement, stocks had fallen well over 100 points, and the 5 year was trading at 0.86%. When I got home I saw the market had rallied (on second thoughts) and 5 year bond yields were back up to 0.99%. I see that (if my memory is correct) as strongly consistent with my view.
The more difficult question is why the wild swings. The fall after 1/2 hour should have been the reaction–the report could be read in a few minutes. I’m willing to buy the argument that the later upswing was second thoughts on the interpretation (but note that interest rates rose above 0.86%, if I am correct.)
Then I published Epic Fail” and Wall Street woke up to the fact that the Fed’s action was meaningless. And stocks opened much lower the next day. Third thoughts? Which is the real market reaction? In this case it’s impossible to say–usually you just look at whether the fed funds target was set above or below expectations.
(Of course I’m kidding about my blog affecting Wall Street.)
Bottom line, I’m claiming that even during the wild price swings, stock prices and bond yields were closely correlated.
11. August 2011 at 10:16
Wouldn’t it be better in a time of unemployment due to disinflation to have dispersed banks buying what each sees as the most undervalued assets. That is rather than buying t-bills at .5%?
11. August 2011 at 10:20
Wouldn’t it be better in a time of unemployment due to disinflation to have dispersed banks buying what each sees as the most undervalued assets. That is rather than buying t-bills at .5%?
I was just thinking, could the Fed accomplish this by lending money to banks long term at a low rate of interest?
11. August 2011 at 15:38
[…] Scott Sumner says it´s wrong to reason from a price change, something which Wolfers “confirms” he did in the underlined passage above. […]
11. August 2011 at 17:46
Floccina, I’m not sure I follow–the government shouldn’t try to control what banks do–except to the extent necessary to protect taxpayers from raids on the FDIC fund.
11. August 2011 at 17:48
[…] to a peak of 1172 at closing. Then the next day they opened down around 1140. Here’s how Andy Harless described the stock market reaction to the Fed announcement: At the close on Tuesday (by the time […]
12. August 2011 at 11:45
If it’s true that a 0% rate can indicate tight or loose money, the same would be true about any rate, no? Therefore all the fed needs to do is add one piece of information to their target rate announcements: whether they will be buying or selling treasuries until their target is achieved.
It’s not as ideal as level targeting, but at least you don’t have to shift the entire paradigm of the profession. It’s more in the realm of the possible. A conservative institution like the Fed is only going to approach the ideal with baby steps and this would seem to be a useful one.
13. August 2011 at 11:51
jj, If you target rates, the price level is indeterminate.