Never reason from an interest rate change
By Scott Sumner
I occasionally point out that the European Central Bank raised interest rates several times in 2011, triggering a double dip recession. At other times I argue that interest rates are not a reliable indicator of the stance of monetary policy. So which is it?
Both. Ben Bernanke and I believe that the only reliable indicator of the stance of monetary policy is economic aggregates such as inflation and NGDP growth. (I favor NGDP.) But we live in a world where most people don’t accept this view, and cling to faulty indicators like interest rates and money supply growth. So when Keynesians deny that tight money could have caused the double dip recession in the eurozone, because Europe was at the zero rate bound, I like to point out that monetary policy tightened in 2011 even according to the preferred Keynesian indicator.
It just so happens in that in 2011 rising interest rates reflected the “liquidity effect” of tight money, and hence were a good indicator of tight money at that moment. But our textbooks also tell us that the long run effect of tight money is actually lower nominal interest rates, due to the income effect, the Fisher effect and the price level effect. For instance, the Fed raised interest rates to relatively high levels in late 1929, and then cut rates sharply over the next 3 1/2 years. But no one would claim that money was easy during 1929-33 because of falling interest rates, after all, NGDP fell nearly in half, and monetary aggregates like M1 and M2 also plunged sharply.
Here’s Simon Wren-Lewis:
The ECB raised rates from 1% to 1.5% in 2011, and compared to the US there was no Quantitative Easing. Combining the two, monetary conditions tightened considerably in the periphery as a result of the crisis. There was no comparable crisis in the US, which allowed investment to increase by 5.5%.
Explaining 2013 seems more difficult. Monetary policy had eased in the EZ (although of course not by as much as it should have), and OMT had brought the crisis to an end. In the US there was considerable fiscal tightening. So why did the US continue to grow and EZ GDP continue to fall?
Actually, explaining 2013 is not more difficult. Monetary policy remained tight, no easing occurred. The fall in interest rates represented the long run effects of the tightening of 2011, just as the fall in rates during the early 1930s reflected the long run effects of a tight money policy adopted in late 1929.
If I was a Keynesian who looked at monetary policy through the lens of interest rates I’d be very sympathetic to those who scoff at the omnipotence of the Fed. I’d see the Fed as playing at most a bit part in the grand macroeconomic drama. And that’s because nominal interest rates tend to be highly procyclical. They tend to rise during booms and fall during recessions, even before the Fed existed. If your view of the world equates low rates with easy money, then of course you won’t see monetary policy as playing a decisive role in long drawn out recessions. Perhaps the recession is triggered by a rise in rates, but then rates quickly fall, making monetary policy look ineffective if there is no immediate recovery.
One criticism of the “falling NGDP means tight money” view is that it seems non-refutable. If NGDP falls then market monetarists can simply blame the Fed. And if someone claims the Fed did all sorts of monetary stimulus, we can argue that they must not have done enough. So what would be a reliable indicator of the stance of monetary policy that is definitely controllable by the Fed?
Create a NGDP futures market and use NGDP futures prices as the policy indicator.
It’s also worth noting that the Fed itself insists that it’s never out of ammo. When NGDP falls they do not say “we’ve done all we could.” The say “we could have done more to boost AD, but it would have been unwise.”
The ECB interest rate increases of 2011, as well as the 2000 and 2006 interest rate increases in Japan, as well as the tapering currently taking place in the US, are very important because they show central bank intent. It’s pretty hard to argue that a central bank is incapable of boosting AD when it is engaged in policies explicitly intended to slow the growth rate of AD. This means that many of the real world cases that are widely assumed to show central bank impotence, do nothing of the kind.
Mark Sadowski has an excellent critique of many of the specific empirical claims made in the Wren-Lewis post.
Update: Giles Wilkes has an elegantly written post on the differences between the way that Keynesians and monetarists think about aggregate nominal spending.