Thursday, September 30, 2010

The Passive Tightening of Monetary Policy in 2008

Ryan Avent is sounding a lot like Scott Sumner:
 I like to point out that in June of 2008 the Federal Reserve forecast real GDP growth in 2009 of 2.0% to 2.8%, when in fact the economy shrank in 2009 by over 2%. Of course, this doesn't mean that central banks have no basis on which to make policy. All they need do is look at the evidence in front of them... In late 2008, the Fed might have taken comfort from its forecasts. Had it been looking at market signals—falling equity and commodity prices, a rising dollar, and movements in bond yields—the need for aggressive monetary easing would have seemed clear.
In other words, beginning around  mid-2008 the Fed passively allowed market conditions to deteriorate and did so all the way up to the financial blow-up in September.  The Fed's actions during this time were not enough to stem the growing demand for liquidity.  The Fed, therefore, was effectively tightening monetary policy by failing to accommodate this growth in money demand.  This passive tightening by the Fed prior to the crisis can be seen below:  (Click on figure to enlarge.)

This figure shows the spread between the nominal and real yield on 5-year treasuries.  It fell about 170 basis points during the period leading up to the collapse of Lehman in September.  Normally, this spread is interpreted as the expected inflation rate.  In this case, it shows a decline in inflation expectations that in turn suggests a deterioration in expected aggregate spending (assuming no big increases in expected productivity). It is likely that this spread was also reflecting a heightened liquidity premium during this time. Here, the implication is the same. A heightened liquidity premium indicates increased demand for highly liquid assets like treasuries and money that, in turn, also imply less aggregate spending.  Both interpretations point to the Fed allowing monetary policy to passively tighten during this time. This passive tightening was unfortunate and most likely contributed to the severity of the financial crisis.  That being said, it pales in comparison to the passive tightening of monetary policy that occurred after the Lehman collapse.  Thus, I have classified the July-September period in the figure as the passive mild tightening of monetary policy and the September-December period as the passive sharp tightening of monetary policy.


  1. David,

    While I don't disagree with your observation (passive tightening), there was a broad set of forces at work. The 5yr and 10yr TIPS spreads jumped to (at least) 5 year highs during the early summer of 2008. In the context of a 2% inflation target, expectations were beginning to show signs of a significant overshoot. By the end of August, all that had occurred was that these expectations came down to more normal levels.

    I point this out because it is illustrative of the Fed's potential predicament under an inflation target. If the formal target had been 2% in the summer of '08, then the passive tightening was warranted. Some (James Hamilton) blamed the oil price spike for tilting us back into recession (2q08 growth was first reported as being quite robust), and, at the time, many were blaming Fed policy for that spike. (I realize this is actually a good argument for using an NGDP rather than an inflation target.)

    I think the interesting question is, why were inflation expectations rising so much just prior to the crisis; and, further, how could the Fed have known that this spike would be so short lived?

  2. David:

    Interesting points.

    I was a little hesitant to post this for a related reason: I was critical of the Fed in early 2008 for being too aggressive. I even at one point called it "financial populism" on this blog. I also went off on Jim Cramer's 2007 rant of Bernanke, which now looks prescient (My first post actually!). It wasn't until later in 2008 did I began to see the Fed as possibly being too tight. Since I didn't see it until late in the game I suppose I should be softer on the Fed for missing it. On the other hand, the Fed had far more resources than me and should have been better able to see the passive tightening.

    It will be interesting to read the transcripts during this time when they become available.

  3. I think you're downplaying the liquidity premium issue. It is fairly well-established how much Lehman repos had influenced TIPs over this period. In addition, TIPs have a quirk that if you have one that has already accumulated gains, it can lose gains in a deflation. However, you can never lose the initial principal. This also messed with people's perception of TIPs at the time.
    Other inflation indicators did not show nearly the decline over a 5-year horizon as the breakeven inflation from TIPs did.

    Perhaps a better indication of tighter monetary policy in 2008 is what happened to 1 year nominal GDP forecasts according to the SPF:

  4. Re John: I think David does incorporate the issue of liquidity in influencing TIPS yields (he mentions this explicitly in the middle section of the post).

    Furthermore, the relatively higher liquidity in Treasuries is itself indicative of a decline in "velocity" and hence represents a tightening of monetary policy in the classic sense of the Fed not accommodating the higher demand for safe assets.

    A more powerful argument here is that the Fed's IOR program represented an accommodation of the flight to safety, but perhaps the Fed should have been more aggressive by actually negating the higher demand it through a negative IOR program, or servicing the higher demand through greater purchases of longer-term (riskier) assets