By “it” I mean the current stance of policy. To see why, we need to review the circularity problem. Asset markets look at the Fed, and the Fed looks at asset markets. When there is enough blood on the floor, the Fed reacts to asset markets by adjusting policy. This reaction reduces the severity of the problem. But of course markets understand this. They see deflationary shocks (actually negative AD shocks), and they see the likely Fed reaction to deflationary shocks. All that gets factored into asset prices.

Let’s suppose that 30-year bond yields fall by 50 basis points, due to a deflationary shock. Also suppose the markets expect the Fed to offset 1/2 of the shock, with easier money. That means the shock is big enough to drive 30-year bond yields 100 basis points lower, if the Fed doesn’t react as expected. Because asset prices already incorporate the expected Fed reaction, they understate the size of demand shocks buffeting the economy.

In a superficial sense the shock looks like it is coming from China. But that’s misleading; nothing in China would have that big a direct effect on the US economy. Instead what’s happening is that the Chinese investment slowdown is reducing the Wicksellian equilibrium interest rate all over the globe. Because central banks foolishly target interest rates rather than inflationNGDP growth, that slowdown is (unintentionally) tightening monetary policy all over the world (even more in Japan and Europe). As an analogy, the drop in housing investment in 2008 lowered the Wicksellian equilibrium rate, and tightened monetary policy in all countries that target interest rates.)

Under similar conditions in 1998, Alan Greenspan reduced the fed funds target and the US avoided any spillover effects. Will Janet Yellen reduce IOR? How about level targeting?

PS. The 30-year bond yield is down to 2.66%. Is there anyone who still doubts my claim that relatively low interest rates are the new normal for the 21st century? The world’s central banks still rely on a 20th century Keynesian interest rate target mechanism that doesn’t really work in the 21st century. How long will it take for them to figure this out? Let’s hope they are getting some sensible advice at Jackson Hole.