Annette Vissing-Jorgensen on Fed policy and interest rates
By Scott Sumner
I attended a recent Fed conference in Chicago, which was charged with the task of re-evaluating the monetary policy regime. I had very mixed feelings about the conference. On the plus side:
1. It’s a very good thing that the Fed is taking seriously the need to re-think policy in light of the zero bound problem.
2. The quality of the presentations and discussion was almost uniformly high.
Thus in an objective sense I had a very positive reaction. Subjectively, I was less pleased. Listening to the discussion reminded me of the heterodox nature of my own views:
1. Monetary policy was mostly evaluated through the lens of interest rate control, which I view as a big mistake.
2. There seemed to be an assumption (either implicit or explicit) that the economy was often hit by “shocks” that disrupted aggregate demand, and that the Fed’s task was to fix the problem by adjusting interest rates (or doing QE). In my view, these “shocks” are actually caused by the Fed holding interest rates stable for an excessive period when the equilibrium market rate is changing (as in mid-2008.) The Fed is more arsonist than fireman.
Perhaps my favorite comment was a remark made by UC Berkeley professor Annette Vissing-Jorgensen, discussing the market reaction to Jay Powell introductory speech at the conference. I don’t recall the exact words, but she suggested something to the effect that the stock market reaction to monetary policy communication is often more informative than the bond market reaction. I found this in her Powerpoint slides:
• If a promise of a lower policy rate in the bad state lowers probability of bad state:
o You may not see the accommodation in futures rates: They could increase, since the policy rate in the good state is high.
o The stock market unambiguously goes up: Removal of the bad state is good for stocks via both lower risk premium and higher expected cash flows.
In the week since Jay Powell’s June 4th remarks, there has been a dramatic change in market sentiment, but only in one market:
While Powell’s dovish comments seemed to trigger a stock market surge, 10-year bond yields show little change, and indeed edged up slightly:
This supports Vissing-Jorgensen’s claim that the stock market provides a less ambiguous signal of market reaction to monetary shocks, a point I’ve made on a number of occasions. Of course a highly liquid NGDP futures market would be even better.
Where have all the recession headlines gone? Have the analysts predicting the recession all gone into hiding? It’s pretty easy to predict a recession when Treasury yields are plunging every day. It’s pretty easy to talk about doom and gloom when the yield curve inverts. All that talk seemed to disappear when Federal Reserve Chairman Jerome Powell opened his mouth last week and said, “…we will act as appropriate to sustain the expansion.”
Just wondering how you feel about a recession now.
Just to be clear, I believe that we still face a somewhat heightened risk of recession. At the same time, the recent surge in equity markets suggests the risk is considerably less than 50-50, at least for the next year or so.
I should add that the resolution of the Mexican tariff issue also helped the market, but much of the surge in stock prices occurred last week, before the tariff crisis was resolved. I suspect that worry over monetary policy plays a bigger role than most pundits assume and trade worries are relatively less important than they assume. Trade wars are easier to see than a divergence between the policy interest rate and the equilibrium rate, and pundits tend to focus on highly visible shocks. Trade wars are unwise in my view, and do hurt the economy, but I don’t see them as the dominant factor driving the business cycle.
I wonder what proponents of MMT, post-Keynesianism, Fiscal Theory of the Price Level, etc., make of the powerful market reactions to seemingly minor comments by Jay Powell. It’s pretty obvious that the market believes that the Fed drives the nominal economy, not Congress. So do I. But then I have to believe whatever the market believes, as I’m a market monetarist.
If market monetarists ever set up a clubhouse, I’d post this on the entrance: “Alpha males not allowed entry.” 🙂