Williamson pulls rank on Yglesias
By Scott Sumner
I’ve often argued that the Fed made a mistake holding rates at 2% at their meeting of September 16, 2008 (right after Lehman failed.) Matt Yglesias has a new piece that is also critical of this decision, and Steve Williamson has a post that is highly critical of the Yglesias piece. However the Williamson piece is riddled with factual and analytical errors.
As an aside, let me just say that I don’t get much enjoyment out of hammering the post of a fellow economics blogger, especially one that calls himself a “New Monetarist.” But when that individual has commented on my blog, and pointed out his sterling research record, and then asks me where I have published . . . well then the job becomes slightly less unpleasant. And when he says this about Matt Yglesias:
Matt Yglesias’s piece is written like a blog, not like a well-researched piece of journalism. He cites the FOMC transcripts, and then provides his own interpretation of what is going on. Apparently, there was no attempt to check this with anyone who might have some expertise. Nevertheless, Yglesias is willing to level the charge that the guy who ran the Fed during the crisis made a “big mistake.” Unfortunately, it’s Yglesias that is making the big mistake.
Well, let’s just say that if you are going to mock people for being unqualified and making mistakes, you really ought to make sure that your own critique is not riddled with errors and shoddy analysis.
Let’s start here with Williamson’s post:
In particular, reserve balances went from $9 billion on September 10 to $47 billion on September 17, to $104 billion on September 24, to $167 billion on October 1. To put this in perspective, daylight financial transactions through the Fed can be supported with a small quantity of reserves. That quantity was sometimes about $5 billion before the financial crisis. So, $47 billion in reserves is a big number. Indeed, it may be a large enough quantity to drive the risk-free overnight rate to its lower bound, which at the time was zero – the interest rate on reserves. On October 1, 2008, the Fed began paying interest on reserves at 0.25%, and that became the floor rate at that time
Williamson is criticizing Yglesias’s claim that Fed policy was insufficiently expansionary, and that the Fed should have cut rates in September. Williamson points to the injection of base money, and the fact that actual market fed funds rates were erratic, and often fell below the 2% target during this period. But Williamson is wrong that the Fed instituted interest on reserves October 1st, or that the rate was 0.25%. The program was actually announced on October 6th, and the rate was set 0.75% below the fed funds target, which became 0.75% on October 8th, when the Fed cut the fed funds target to 1.5%. That’s quite different from 0.25%. The Fed’s explanation for IOR was correctly characterized by Robert Hall and Susan Woodward as follows:
Oddly, he [Bernanke] explained the new policy of paying 1 percent interest on reserves as a way of elevating short-term rates up to the Fed’s target level of 1 percent. This amounts to a confession of the contractionary effect of the reserve interest policy.
Hall has published in some pretty good journals, in case anyone wants to know. Later they said the following:
Raising the reserve interest rate is a contractionary measure. A higher interest rate on reserves makes banks more likely to hold reserves rather than increasing lending. The Fed’s decision to raise the reserve rate from zero to 75 basis points just as the economy entered a sharp contraction in activity is utterly inexplicable. Fortunately, the Fed lowered the reserve rate subsequently, but the continuation of a positive reserve rate in today’s economy is equally inexplicable. Some economists have proposed that the Fed charge banks for holding reserves, an expansionary policy worth considering.
BTW, I believe I was the first to propose a negative interest rate on reserves in a journal article, albeit not one Williamson reads. It’s not a cure-all, but would have helped in 2008.
Stocks fell sharply the day IOR was announced. The announcement didn’t initially attract much attention, but for what it’s worth stocks also fell sharply over the next couple of trading days. Then the Fed increased the rate of IOR on October 22nd, to 35 basis points below the fed funds target. On November 5th the Fed again raised the IOR, to equality with the fed funds target. Here’s Louis Woodhill:
At the time of the Fed’s IOR announcement, the S&P 500 was down by a total of 12.18% from its pre-Lehman close, 15 trading days earlier. However, the day that the Fed announced IOR, the S&P 500 fell by 3.85%, and it was down by a total of 17.22% three days later.
On October 22, 2008, the Fed announced that it would increase the interest rate that it paid on reserves. The S&P 500 fell by 6.10% that day, and it was down by a total of 11.11% three days later. On November 5, 2008, the Fed announced another increase in the IOR interest rate. The S&P 500 fell by 5.27% that day, and it was down by a total of 8.60% three days later.
The bigger problem with Williamson’s post is that he seems to assume that the primary effect of a fed funds target change is the impact of slightly lower overnight bank rates over the next 6 weeks. Or maybe he thinks that worriers like Yglesias and I think that’s the primary impact. But as Michael Woodford showed the main impact of Fed policy announcements is not from the immediate change in interest rates, but rather what it signals about the future expected path of policy. Woodford has also published in some pretty good journals.
The Fed’s decision to cut rates 1/4% rather than a 1/2% in December 2007 destroyed one or two trillion dollars in global stock market wealth within a couple hours, but not because markets cared about where the fed funds rate would be over the next six weeks. Indeed markets were so convinced that the Fed blew it that they actually reduced T-bill yields on the news, despite the rate cut being smaller than expected. And the markets were right. Four weeks later Bernanke saw he was far behind the curve (his words) and had an emergency meeting where the fed funds target was cut another 75 basis points, and then another 50 at the official meeting two weeks later. Markets fell sharply in December because they correctly interpreted the Fed announcement as a signal the Fed was behind the curve on the severity of the situation. The markets sensed that the Fed would not be up to the task.
So all the evidence Williamson presents about the Fed’s decision not to cut the fed funds target in September 2008 is completely beside the point. It was a signal of the Fed not being sufficiently vigilant against a sharp fall in NGDP, a pessimistic view that turned out correct. A surprising large rate cut on that day (say 100 basis points) would have electrified equity markets worldwide, and at least slightly moderated the severe recession that was already underway. So the Fed did make a big mistake, although the main problem wasn’t just the September 2008 meeting, but rather the entire policy regime. There was an unwillingness to be forward looking, to focus on market expectations. Instead the Fed looked in the rear view mirror at past inflation data. There was an unwillingness to do level targeting, to make up for the deflation and falling NGDP of 2008-09. The September decision was a symptom of that flawed policy regime.
Of course I could be wrong. After all, Williamson seems to think that unexpected fed funds target cuts are deflationary, whereas I think they are expansionary. Oddly, asset market prices react to unexpected rate cuts by the Fed as if they are expansionary. But I’d guess that asset market participants don’t read the journals where Williamson publishes. So perhaps they don’t know enough to move prices in the correct direction.
PS. I’d like to thank Vaidas Urba for pointing me to this post, and helping me to better understand IOR. Vaidas believes Williamson made some other serious errors, such as getting the size of daylight credit completely wrong, but I am not qualified to comment on that claim. Perhaps knowledgeable Fed watchers will add information in the comment section.