Reasoning from an interest rate change
I just saw Richard Clarida on CNBC, saying something to the effect that “The bond market is doing the Fed’s job for it”.
No, no, a thousand times no!!! Interest rates are not monetary policy. Interest rates plunged in 2008, but the bond market wasn’t doing the Fed’s job for it. Interest rates plunged in 1929-32. Interest rates are not monetary policy.
Cameron Blank direct me to this Jason Furman tweet:
To be clear, I do not have any problem with Furman’s general view on the current stance of monetary policy, or on the Fed’s decision yesterday. We have similar views. But the sharp fall in long-term rates does not make money easier, it probably makes it tighter.
Here are some things to consider:
Lower fed funds rates achieved through open market purchases are expansionary. M increases.
Lower IOR for any given monetary base is expansionary. V increases.
Lower bond yields for any given IOR and monetary base level is probably contractionary (depending on forward guidance.) Base velocity decreases.
Think of it this way. If you lower the yield on bonds, you probably reduce velocity. If the money supply is unchanged, NGDP tends to fall.
To a very great extent, monetary policy is (hopefully) skillfully adjusting the fed funds target in response to changes in the (unobservable) natural interest rate. A sharp fall in bond yields on a day when the fed funds rate is not adjusted is often a sign that the natural interest rate has fallen, making money effectively tighter. A sign that you are “behind the curve”.
Lower interest rates are not “good for the economy”; that’s reasoning from a price change. It depends on why interest rates are changing.
If I’m wrong, then what would you expect if bond yields fall another 50 basis points tomorrow? Would that be bullish news?
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2. August 2024 at 12:28
If all prices were perfectly flexible in the current economic environment and the current Fed rate forecast, what would happen?
I am guessing:
1. Wage rates would drop
2. Interest rates would drop.
3. Stock prices drop.
2&3 would drop less than they are now, because wage rates would be dropping, ensuring full employment.
Theoretically, with perfectly flexible prices, wouldn’t the economy achieve real growth equilibrium regardless of what the Fed did? With some caveats: menu costs, tax effects from inflation and transaction costs from bankruptcies and subsequent transferring of assets. So in some sense, the interest rate market is cutting for the Fed. It’s just that sticky price markets such as labor aren’t cutting for the Fed. And that’s the problem. If labor prices “cut for the Fed”, interest rates probably wouldn’t fall as much, as there wouldn’t be a negative supply shock due to labor being removed from the market. These are my off the cuff musings. Am I missing something?
2. August 2024 at 13:59
As someone who hasn’t studied economics for about 15 years at this point, my immediate intuition reading this was I’d have thought lower yields would see a substitution from investment to consumption (and V remaining flat or increasing), rather than a straight hoarding of cash leading to decreased velocity. But I guess the mechanism is that the opportunity cost of holding cash has now decreased, so people who want safe monetary assets are no longer incentivised to enter the bond market (or other yielding assets), and that is the mechanism? I checked with Claude and it pointed out it could also be reflective of price level expectations (deflation) and liquidity preference.
2. August 2024 at 14:05
Travis, When people say the bond market is cutting for the Fed, the implication is that it is making policy easier. It is not. Low rates are not easy money.
“Theoretically, with perfectly flexible prices, wouldn’t the economy achieve real growth equilibrium regardless of what the Fed did?”
Yes, but when prices are sticky then monetary policy matters. And lower interest rates don’t represent easier money.
BK, If you look at the data, velocity is positively correlated with interest rates.
2. August 2024 at 17:49
Richard Clarida is an interesting guy, open to money-financed fiscal deficits. I guess he misspoke here.
I think the Fed is perhaps overreacting to inflation modestly above target. A few years of above target inflation is not as important as sustaining economic growth.
Sumner’s NGDP targeting is probably better than inflation targeting. But coming out of the covid pandemic was a very unusual period in both human and economic history. It might be better to be very gradual in returning to original targets.
2. August 2024 at 17:50
Thanks for this.
I normally agree with Furman but this didn’t make sense to me.
2. August 2024 at 22:11
It’s important to look at the bigger picture. Stock and commodity prices ahvae been falling over the past two weeks, along with interest rates, which strongly indicates negative nominal shocks.=
2. August 2024 at 22:42
LOL.
Are you guys going to start color-coding these ridiculous terms?
Mini-recession.
Little-recession.
Recession.
Big-recession.
Bigger-recession.
Depression.
And those who try to differentiate between them, cannot even agree on a definition.
T. Sowell and Walter Williams have a good a name for people who sit around and argue over trivial things.
Busybodies!
3. August 2024 at 06:26
Edward,
I’d consider a mini-recession as a sustained increase of unemployment by 0.6-1.4 percentage points.
A recession would be anything about 1.5 percentage points.
A mild recession is 1.5-2.9 in my view, a severe recession is 3.0+, and a depression I’ll call 10.0+. All sustained increases of course (6 months+ over those thresholds vs cycle lows).
2020 wouldn’t count as a depression as unemployment rapidly fell below the 10.0 percentage point increase threshold, but would count as a severe recession.
3. August 2024 at 07:59
I find all of this really confusing. I think that when people say that lower interest rates are good for the economy, what they mean is that they think that it will increase NGDP relative to a counterfactual in which the monetary authority didn’t lower interest rates. And that they think that in the short run, higher NGDP means higher employment, and also it means higher spending (by definition it must).
3. August 2024 at 08:13
Justin, Using my definitions, we’ve never had a soft landing or a minirecession. This is weird, because both of these do occur in other developed economies. Why not the US?
Perhaps we’ll have both next year. Either way, it will be an interesting year.
Lizard, The mistake people make is to assume that it’s meaningful to speak of the effect of a change in interest rates “other things equal”. Interest rates always change for a reason. And the effect they have depends on why they are changing. Even citing “the Fed” is not enough, as the Fed can make rates fall with both easy and tight money policies.
Even before the Fed existed, interest rates moved around. But of course that was not “monetary policy”, as without the Fed there was no such thing as monetary policy.
3. August 2024 at 19:40
I read on conservative websites that our debt to GDP is 130% and that this is growing steadily due to deficit spending. Does this make it more likely we will have a near term mini or regular recession?
4. August 2024 at 16:19
Bob, No. It’s a problem, but not in that sense.
4. August 2024 at 20:08
@ssumner:
Forgive me if this has been discussed recently, and it probably has been at some point, but could you flesh out in layman’s terms your understanding of the debt “problem”? It seems like something massive that does not get discussed seriously or widely at the levels of power. To me it feels ominous and I’d love to read your thoughts.
5. August 2024 at 08:48
msgkings, The short answer is that it’s leading us toward higher than optimal tax rates in the future, as the best case.
5. August 2024 at 09:14
Swaps market thinks there’s a 50% chance of an emergency cut by the Fed this week. Jeremy Siegel was on CNBC pleading for a 75 bp cut immediately and another 75 bps next month.
Everyone seems to have absolutely lost their minds over the past week because of one smaller-than-expected jobs expected jobs report and disappointment that ‘AI’ has not made big tech trillions of dollars yet.
Insanity. Money does seem to finally be getting a bit tighter, though.
5. August 2024 at 11:59
> msgkings, The short answer is that it’s leading us toward higher than optimal tax rates in the future, as the best case.
Scott, What would be the worst case scenario?
5. August 2024 at 12:06
Bob, Default, or high inflation (which is a sort of like default, but not technically.)
6. August 2024 at 15:34
I’ll never understand why so many economists think high inflation is ‘ sort of like default, but not technically.’ It’s hardly the same thing!
A default by definition is failing to do as promised/agreed/etc. High inflation has nothing to do with that.
6. August 2024 at 19:40
Tacticus, So you loan the German government 1,000,000 marks in 1913, and they give you back a million plus interest in 1923.
But now you can’t buy a cup of coffee with a million marks. Sure, the contract has been honored, but that’s not at all like default?
7. August 2024 at 10:56
No, that’s not at all like default. As I said, a default is by definition a failure to honour a contract. That is the essence of a default. Now, there is often a real loss involved in a default, but that is not what makes a default a default.
There are defaults without real losses and real losses without defaults. They should not be confused.
8. August 2024 at 06:18
Tacticus, So not honoring the spirit of a contract is not a tiny bit like default? We’ll have to agree to disagree.
I think you are too focused on the point that inflation is not actually a default. But we agree on that!
8. August 2024 at 10:53
Oh, I definitely am too focused on that point – because it annoys me to no end!
But I also don’t think the spirit of the contract is broken when there is high inflation. If I did think that, then I’d be more inclined to agree that high inflation was akin to default.