This has been a very busy week. But I’m not complaining, as I got what I wanted—lots more people paying attention to my views. I’d like to correct one thing I said in my previous post, it is not true that Earl Thompson has given up on macro. He has done quite a bit of work that I was not aware of, and you can link to many of his papers by going to his website. He has some very unconventional views that combine monetary policy, fiscal policy, and politics into an overarching model.
My previous post was my final attempt to sell my view of the crisis. In the future I will spend more time responding to commenter requests, discussing current events, and other miscellaneous topics. One request was for more graphs, which might buttress my argument. Hence today’s post. Soon I hope to respond to a request for a post on 1932, and then a request for something on monetary policy options in other countries.
One reason that my blog has included relative little data is that I’ve never seen data as being the sticking point; rather people have trouble with the logic of my argument. The argument that the Fed caused the crisis has three parts:
1. Monetary policy can be highly effective, even when nominal rates have fallen to zero.
2. Monetary policy should target the forecast, i.e. should always be set at a level expected to produce on-target nominal growth.
3. Monetary policy lost credibility in early October 2008, when any plausible forecast of inflation and NGDP growth fell far below the Fed’s implicit target.
Point three is the only one that actually requires data, and it is also the only point on which I find that virtually everyone already agrees with me. The other two points require discussion of economic theory, logic, monetary history, institutional constraints, etc. As we will see, when I do introduce data into the analysis, my argument gets stronger, or more precisely, the data allow me to make more sweeping claims.
Previously I had tried to avoid any unnecessary distractions by making the most modest argument possible. I could have claimed that Fed actions caused the Lehman failure in September, but instead I said that Fed policy was not far off course until early October 2008. I argued that Fed errors of omission allowed NGDP to fall sharply in the 4th quarter, and that those errors almost certainly made the financial crisis much worse. But what about the third quarter; is there any evidence that Fed tightening could have worsened the financial crisis even before Lehman?
There are five variables that might provide some indication of the stance of Fed policy:
1. Short term real interest rates.
2. Inflation expectations.
3. Stock prices.
4. Commodity prices.
5. Foreign exchange rates.
I should emphasize that each of these variables, by itself, is highly unreliable. Even combined, they are not necessarily definitive. But they are all we have. Let’s start with the most important, inflation expectations. Jeremy sent me a couple of St. Louis Fed graphs. The first one shows the short term real and nominal interest rate over the past nine months. Notice how real interest rates rose steadily throughout in the third quarter. Inflation expectations can be estimated by looking at the gap between real and nominal interest rates. Notice how that gap shrinks throughout the 3rd quarter.
Another St. Louis Fed graph shows the same variables but over 5 year maturities. Unfortunately because of a change in the way the data was collected in early December, this graph exaggerates the speed at which real interest rates fell in late 2008. But as with the short term rates, the 5 year rates show rising real interest rates and falling inflation expectations in the third quarter. Five year inflation expectations were already below 2% when the Fed met on September 16th. A forward-looking Fed would have cut rates. The actual Fed is occasionally forward-looking, but is still far too often backward-looking. Because they were spooked by the high 12-month lagging inflation rate (reflecting the earlier oil price bubble) they decided to stand pat in that fateful meeting. Both graphs show that they should have been far more aggressive by early October, which is precisely when the stock market crashed. So I hope people don’t think I am just looking at stock prices when I make inferences about policy.
Now let’s look at some other indicators. Here is a graph of stock prices (as measured by the S&P500) over the past 12 months. Again, you can see that stocks were drifting lower during the 3rd quarter, even before Lehman. Here is a graph of commodity prices. Notice that prices peaked in early July and declined quite rapidly thereafter. Here is a graph of the value of the euro. Once again, the euro peaked around early July, and declined sharply until November. (It may be easier to envision this change if you look at the pattern from the other direction—the dollar soared in value during the 3rd quarter.)
Thus we have five very different indicators of monetary policy, and all five show evidence that monetary policy grew increasing contractionary during the 3rd quarter, even before the failure of Lehman. In this blog I have not tried to argue that the September crisis was definitely caused by tight money, as I don’t believe the evidence is conclusive. But there is certainly a lot of circumstantial evidence that points in that direction.