Friday, August 20, 2010

How Low Must It Go?

Recently I noted that aggregate demand forecasts are falling.  Well today I learned that it gets worse: aggregate demand is already falling!  Macroeconomic Advisers just updated its monthly nominal GDP series, a measure of aggregate demand,  and it shows a decline for May and June as seen below (click on figure to enlarge):

I shouldn't be surprised with these numbers since expectations of future economic activity affect current spending decisions and for some time expectations have been deteriorating. Still, I was shocked to see the outright decline in May and June. Let's be clear what this development means: total current dollar spending declined during May and June in the U.S. economy.  And most likely it continued to fall in July and August given the weak economic outlook.  This makes me wonder how low the dollar size of the U.S. economy must go before the Fed gets serious and pulls out its big guns?


  1. David,

    I'm teaching a self designed course called "Issues in Monetary Policy" this fall at Rowan University this fall. The point of my course in part will be to lead students to the conclusion that NGDP targeting is the future of monetary policy. Posts like this help.


  2. " If bankers truly believed in this recovery, they'd be far more generous with loans. They don't, and today's action confirmed their suspicions. Credit is constricting, and with it our consumer based economy. Deflation's Death Grip is here to stay, folks.. especially if November's elections bring divided government, which I fully expect and which will bring gridlock to Washington DC. Stimulus packages will be a thing of the past. Slowly but surely, by way of deflation, we're going from Debt to Dust"

  3. Looks like William White disagrees with you (as does U.Chicago boy Rajan): (Bloomberg, today)
    Low rates are not a free lunch, but people are acting as though they are,” said White, 67, who retired in 2008 from the Basel, Switzerland-based BIS and now chairs the Economic Development and Review Committee at the Paris-based Organization for Economic Cooperation and Development. “There will be pressure on central banks to follow an expansionary monetary policy, and I worry that one can see the benefits, but what people inadequately appreciate are the downsides.”

    I think that would be fine (to raise the interest rate on reserves) provided that it was accompanied by stimulative fiscal policy (cut payroll taxes, build a high speed rail line from Dallas to Houston) and genuine financial reform.

  4. ECB:

    To claim interest rates are too low now, one is implicitly claiming they are low relative to the neutral or natural rate. Do you think the neutral rate has increased enough to justify their claims?

  5. DB:
    Aren't you constraining the debate there to a framework consistent with Wicksell-Taylor-rule type reasoning? I think the White-Rajan camp are saying that is too narrow, that you have to take into consideration the "Greenspan put" or risk channel considerations that Andrew Haldane at the BofE has written about (eg his essay on Doom Loop). Keeping rates low for an extended period forces increased risk taking, with raised probability of another crisis.
    Where I'd differ from them is going for a powerful fiscal stimulus and financial reform.

    (An interesting question is how did the macro debate get so constrained by the way? Where is it written that policy must only work through actions to affect the ultra short end of the yield curve in the context of a 3-eq model with an IS curve and Phillips curve? Sounds like a good PhD thesis for a student in history of econ thought.)

  6. David, as you have pointed out, the way for the Fed to fix things is to publicly commit to an NGDP or price level path. The question you have to ask yourself is why they don't do it. My simple answer is that the first law of bureaucracy is to avoid accountability. But it may go deeper than that. Arnold Kling has pointed out that while a simple public Fed reaction function might be good for the economy, it probably would also reduce the high prestige currently enjoyed by Fed officials. At least until bloggers like you and Scott Sumners embarass them into a better policy.

  7. I've been trying to get a handle on this as an informed lay-person. Way back when I took Intro Econ, I was told that the reason fiscal policy by itself is not sufficient to cure a depression is because once the Fed has reduced it's interest rate to 0% it has reached its practical limit because "you can't push on a string." From what I read, banks currently have about $1.2 trillion in excess reserves sitting with the Fed, but are not lending -- even to other banks. Instead, they are borrowing at the Fed Funds rate and buying long-term Treasuries which are still yielding 2.66%. Meanwhile the Fed is paying 25 or so basis points on those "excess reserves" (which I gather is reserves on deposit in excess of the Fed's reserve requirement). My question is, how could Quantitative Easing help, since it looks like the banks would just add to their "excess reserves?"