Monday, August 8, 2011

Will the FOMC Repeat the Mistake of September, 2008?

I hope not.  As you may recall, the FOMC met a day after Lehman collapsed on September 16, 2008 and decided against lowering the federal funds rates.  Yes, the Fed decided to keep its targeted interest rate unchanged at 2% just as the financial crisis was reaching its peak.  Amazingly, the reason the FOMC acted this way was its concerns about inflation, which at the time were driven by commodity prices and reflected a backward-looking view of inflation.  Had the Fed given more weight to forward-looking indicators like the expected inflation rate coming from TIPS and a host of other market indicators, the Fed would have realized the market was pricing in a sharp recession.  Even though the Fed intervened more aggressively after this point, it never rose to the point that would restore current dollar spending to a healthy, sustainable level.  The Fed, therefore, effectively tightened monetary policy at that time. 

Though the circumstances are somewhat different today, the same Fed inertia that kept it from responding appropriately in late 2008 could similarly prevent the Fed from getting ahead of the current crisis.  Now is not the time to be conservative and cautious.  It is time for Chairman Bernanke and the FOMC to take the initiative and provide some real "shock and awe" monetary policy stimulus. Adopt the Joseph E. Gagnon program or the quasi-monetarist goal of nominal GDP level targeting.  Yes, both approaches would be very controversial and have many observers freaking out, but that is the point.  It would provide a much needed slap to the face of public's economic expectations.  

Now some observers claim there is nothing more the Fed can do since short-term interest rates are already close to 0%.  Moreover, they argue the Fed already is pushing easy monetary policy without any success.  So why bother trying to do more monetary stimulus?  Two things these folks need to remember.  First, low interest rates are not stimulative if the natural (or neutral) interest rate is low too.  The natural interest rate is driven by the fundamentals of the economy.  When the economy improves the natural rate increases and when the economy falters it decreases.  It is the interest rate that would prevail in the absence of the Fed intervening.  Over the past few years the economy has been weak and appears to be weakening even more.  Thus, the natural rate is low and falling, implying the Fed's low interest rate target isn't very expansionary, if at all.

Second, even though the Fed cannot push the short-run nominal interest below 0% and below the short-run natural interest rate value, it can push the real short-term interest rate below 0% and the real short-run natural interest rate value.  Moreover, if needed, the Fed can start working its way up the term structure of interest rates by purchasing longer-term assets and pushing their yields below their natural interest rate values.  Another way of saying this, is that the Fed needs to keep buying assets until money demand is satiated and nominal spending resumes.  The 0% bound on short-term interest rates is simply a red-herring.  It did not prevent FDR from creating a robust monetary-driven recovery in the Great Depression, it did not prevent the Swedish central bank from spurring a remarkable recovery in this crisis, and it should not prevent Fed officials currently.  

So please FOMC, do not make the September, 2008 mistake again.  Get ahead of this unfolding crisis.


  1. My first time reading this blog and what a brilliant post. I say brilliant, but at the same time think it should be obvious to the Fed. I would like to add that somehow they must convince the ECB of the situation's urgency as well. The ECB should not sterilize its sov bond purchases now, and they need to stop talking about austerity and balanced budgets; this is an emergency: they've got to impress upon the markets that the Italian and Spanish economies are going to grow. Then yields will come down. Otherwise the ECB will fail to bring down yields, and we will have a banking crisis. As Delong says, this isn't rocket science.

  2. Very nice post. One quibble. You say the Fed "can push the real short-term interest rate below 0%." Real short rates are below zero and have been for a while. 5 year TIPS are trading at -0.75% real.

  3. David,

    I believe that it is your contention that the present US economic downturn is caused by a liquidity trap (as discussed in the WSJ of August 8), and that you therefore advocate inflationary monetary policy to produce a jump out of the trap by making the prospective real return on money negative. But can I ask you for a reminder of what your evidence is that the US is in a liquidity trap? It seems to me that for a liquidity trap to be responsible for a downturn in economic activity, we ought to be seeing deflation, as people attempt to build money balances by not buying things, but we are not seeing deflation. This is not so far like Japan, let alone the 1930s. Thanks.

  4. David
    I thought Gagnon´s program to be "off the charts".

  5. Daniel, the ECB has done little to help the crisis. Hopefully it won't sterilize its bond purchases, but that is what they have done to date with their version of QE.

    Foosion, fair point. I should have been more careful on that point.

  6. Rebel, I see the current situation as one of elevated excess money demand. Since money demand is a function of a spectrum of interest rates (not just the short run interest rate) the Fed needs to buy assets other than short-term ones (i.e. tbills) and keep doing so until money demand falls. This is slightly different take than the traditional liquidity trap which focuses on short-term interest rates only.

    With that said, let me respond to your question. The evidence for the ongoing, elevated demand for money assets can be seen in velocity. It tanked during the crisis and has yet to make any meaningful recovery. See the velocity graphs here.

    The elevated money demand can also by looking at the asset side of the household and firm balance sheets. Ever since the crisis in 2008 the share of highly liquid assets has grown inordinately. See the second figure on this post .

    What these figures show is an elevated demand for money and money-like assets since 2008 that has not abated. Monetary policy could fix that.

  7. Marcus,

    Gagnon's proposal is not ideal in my view because it needs to be accompanied by an explicit level target. Still, it would be a big step in the right direction.

  8. Nada. The Fed will do nada. BTW, the CPI-U was at 219.964 in July 2008. It is at 225.722 for June 2011.

    Let's get scared! The CPI up 2.62 percent in three years!! Run for the exits! Your currency is debased and next stop is Sodom and Gomorrah.

  9. Thanks David. So why is that a problem? The public want to hold more money, and, consistent with an interest-rate target, the Fed is passively meeting that demand. Velocity falls because the extra demand for money is as store of value, not as a medium of exchange. And the fact that goods and services prices are not falling suggests that the Fed is supplying enough money to meet the demand for money for both purposes.

  10. Prof. Beckworth,

    Your narrative on Sept 2008 is wrong. The Sept. 16 Fed decision was a non-event. The stock market closed at its high that day, post-Fed announcement.

    Market data suggests the real Fed mistake occurred in Q4 2008, specifically the period when the Fed began paying interest on reserves and abating when the Fed began quantitive easing. This is when inflation expectations (TIPS yields, gold and commodity prices, stock market)turned decisively negative. The second half of September shows relatively no decline in any of these market measures.

  11. Prof. Beckworth,

    The data points you presented to RebelEconomist do not convincingly show "elevated money demand" among households.

    A ratio of household cash to household assets is driven almost entirely by changes in the denominator (household asset values) Household cash has a nominal fixed value and cash balances can only rise through greater accumulation. Other assets can rise or decline in value and hence raise or reduce the ratio of household cash.

    The big spike in the household cash ratio during 2007-2008 which you define as sharply elevated money demand actually appears to be the decline in value of other household assets (stocks, real estate).

    Velocity also doesn't seem to be a clear measure of tight money, because changes in velocity can arise because of increases in the rate of real economic activity, irrespective of monetary policy. In the 2001-2007 real expansion, velocity did not return to late 1990's levels, despite very similar NGDP levels in both periods. It stands to reason that if the real rate of growth is today relatively slow, money velocity will demonstrate some of the same stagnation.

  12. Why not charge banks for their deposits at the Fed rather than paying interest on them?

  13. @TheNumeraire: Interesting points, especially the one about the denominator of the cash to assets ratio. Thanks.

    @Greg Hill: Because if the Fed charged banks for their reserves holdings, the banks would simply withdraw banknotes instead.

  14. Rebel,

    If the Fed were adequately meeting the demand for money as you claim then there should be no fall in velocity. You cannot have it both ways.

    Also, even if folks are turning to money as a store of value it doesn't negate its role as a medium of exchange and that is the key problem. The medium of exchange (money) is the one asset on every market. Thus, when there is excess demand for the medium of exchange it disrupts every other market. The ongoing excess money demand problem means then that there remains insufficient aggregate demand for the other markets.

    Regarding the price level, had there been sufficient adjustment there to offset the excess money demand then current dollar spending would have returned to its trend. It hasn't and moreover, on a per capita basis domestic demand is still below its pre crisis level.

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  16. Numeraire,

    Expected inflation, nominal GDP, and to a lesser stocks had been falling since mid-2008. By allowing these developments the Fed had been effectively tightening all along. My point here is not that the September,2008 was the decisive tightening point of monetary policy, but rather to demonstrate a clear cut case of the Fed making a decision that amounted to a tightening of policy. How important it was relative to the effective tightening before it versus after it is debatable. I do think, though, that it was the cumulative tightening over this period that mattered more than any one single event.

    Regarding household (hh) balance sheets, since 2007:Q3 at their peak, hh have lost about $7.6 trillion of assets, but added about $1.4 trillion of money and money-like assets. So no, there has been a notable build up of hh liquid assets.

    Velocity is driven by multiple factors (e.g. innovations in transaction balances) and thus evolves over time for reasons other than crisis-dirven excess money demand. However, over the past few years I don't see anything that suggests that drop in velocity is anything but an excess money demand. The evidence point the other way. See the figures in following post, for example:



  17. I am puzzled by your argument, David. Surely a characteristic of money being used as a store of value is that it does not turn over, so overall money velocity drops even if the store of value component of money demand is satisfied.

    I don't think that you can automatically assume that if nominal GDP falls, demand must be deficient. It could represent a recalculation-type fall in potential GDP, especially when output prices are not falling.

  18. Prof.,

    The cumulative tightening you refer to from mid-2008 through to the Lehman collapse is not uncommon for a mere recession -- stocks, inf. expectations and NGDP often decline during recession.

    This "passive tightening" did not produce the calamity that would occur in Q4 2008, which is when expectations went from moderating to collapsing.

    You stated;

    "Even though the Fed intervened more aggressively after this point, it never rose to the point that would restore current dollar spending to a healthy, sustainable level."

    In truth, the Fed was not more aggressive, it was merely more active. Medium and long-term inflation expectations and current dollar spending collapsed after the Fed lowered rates and implemented IOR (it appears that the latter counteracted the former and also made future monetary policy less effective). This is the period you refer to as the Fed being more "aggressive" than during its passive tightening stage, despite the fact that market data clearly says otherwise.

    Essentially, you are confusing what events happened when and the significance of those events. The Lehman collapse was not the watershed moment for the economy and NGDP expectations, which is why market behavior was largely benign in the weeks following. Nor was the modest decline in inflation expectations in mid-2008 indicative of economic calamity -- a similar decline was evident in TIPS breakeven rates in 2001-2002 but did not produce a sharp contraction and financial crash.

    The difference between recession and depression, between bear market and financial crash is what the Fed did (and how it did it) in Oct 2008, not what it allegedly failed to do in Sept 2008.

  19. On the subject of household money assets, I notice you include Treasury securities as a money asset. That seems controversial -- bonds do not have a fixed nominal value and it appears that they are recognized on household balance sheets at market value rather than par at issue (if this is true it means that much of the increase in household Treasury holdings is explained by rising bond prices).

    The non-Treasury deposit portion of household money assets grew rapidly during 2008 but has actually shrunk since the bottom in the economy and financial markets.

  20. David, whatever the natural rate may be now, it isn't likely to stay there for two years. Consequently, however "conservative" Bernanke's commitment to hold the FFR near 0% may seem now, it might produce altogether too much "shock and awe" in the coming years, when there's no small prospect that it will end up having the same consequences as the FOMC's 2003 promise to hold the FFR at 1% "for a considerable period."

    I'm not saying that you and Scott should ease up in complaining that money is presently too tight. I am saying that you should also draw attention to the danger inherent in a promise to "peg" the FFR for any prolonged period of time. That's risking another boom in the future, if not a Wicksellian "cumulative" inflation.

  21. RebelEconomist,

    Money demand is money demand, regardless of what is motivating it. The real issue is whether there is excess money demand, which again is disruptive because of the role money plays in every other market. That nominal spending has not fully recovered and that the other indicators of elevated money demand show no sign of pulling back indicate to me that there is still excess money demand.

    I don't find the recalcuation story persuasive for the U.S. economy. Here is one reason why: even though construction employment starts falling in April, 2006 (when the housing market peaked) overall employment less construction employment continues to grow until about mid 2008. This is inconsistent with the recaluclation story. If it were true, then why was employment outside of construction growing long after housing began tanking? What does make sense is that aggregated demand begins to fall after mid-2008 affecting employment in all sectors.

    See this post for more on recalculation:

  22. Numeraire,

    I won't argue with you that the IOR coincided with a sharper downturn. However, I think that the passive tightening from mid-2008 created conditions that made it possible for IOR to have such an event. In other words, had the Fed been more aggressive early on in 2008 then the economy would have been resilient later on in the year. (BTW, I recognized the importance of IOR back in 2008

    Yes, my use of treasuries is controversial. However, total hh deposits (cash, checking, saving and time deposits, money markets) has remained elevated. It did briefly decline, but only temporarily and nowhere back to where it was in 2007. (See here: So, again, I stand my claim that these money balances remain inordinately high relative to the other hh assets. The fact that they do remain elevated through 2011:Q1 (and I suspect will rise in the new data) and that nominal spending has yet to fully recover screams to me there is an excess money demand problem.

  23. George Selgin:

    Fair point. Though, I suspect no one would have foresaw how long the economy and thus neutral rate would have been depressed back in late 2008.

  24. David,

    The significance of housing for the recalculation story extends well beyond construction. The drop in house prices was much more important, and it arguably had a lagged effect.

    A "PSST" was for entrepreneurs to use housing net worth as collateral and/or equity for new start-ups. This pattern changed dramatically post-2008. As a result, net new firm creation -- the principle driver of employment growth -- remained stagnant in this recovery.

    Similarly, credit growth has lagged in this recovery. The reason is partly the demise of the shadow banking system (influenced by house prices again). This was another PSST.

    Yet another PSST was that households chose to draw down liquid savings as home equity lines of credit became more available. Their unavailability today requires that households maintain higher levels of liquid savings.