Is the economy becoming less interest sensitive? And does it matter?
By Scott Sumner
Answers: Maybe, and no.
Tyler Cowen linked to a recent paper by Jonathan L. Willis and Guangye Cao, out of the Federal Reserve of Kansas City. Here’s the opening paragraph:
Over the past three decades, the U.S. economy seems to have become less responsive to monetary policy. Slow recoveries followed recessions in 1990-91, 2001, and 2007-09, a contrast to the much more rapid recoveries that followed pre-1990 recessions. These slow recoveries occurred despite sizeable monetary accommodation from the Federal Reserve, primarily through reductions in short-term interest rates.
At first glance that looks like reasoning from a price change. But they later provide a standard 3-equation model (IS, Phillips Curve, monetary policy function) and thus I’ll assume that what’s really going on here is that the authors are assuming the economy responds to shocks to the gap between the policy rate (fed funds rate) and the Wicksellian equilibrium rate. That’s a plausible model. And perhaps the economy is less responsive to that gap than before.
Even in that case, however, I have some reservations. There should be no surprise that the recovery from recent recessions has been slower than from earlier recessions such as 1981-82. If it does appear to be a surprise, that’s probably because monetary policy is misidentified. Monetary policy has clearly been less expansionary during recent recessions, and that’s why the recoveries have been slower. I use the Bernanke/Sumner technique for identifying the stance of monetary policy, looking at NGDP growth/inflation, not interest rates.
I see a couple potential problems with this sort of research. Those with a better understanding of modern macro should please correct me if I’m wrong:
1. The authors find a lower level of responsiveness to interest rates after 1985. Does that date ring a bell? One of the most important and surprising developments in modern macro has been the astounding decline in the Wicksellian equilibrium interest rate over the past three decades. We can’t measure that rate with absolute precision, but it has clearly fallen very dramatically. Now think about how that might confuse policymakers. You cut rates the standard X% during a recession. You expect a certain response, assuming that you have not accounted for a long term decline in the Wicksellian equilibrium rate. But in fact, your policy is less expansionary than you assume, as the cut in interest rates is occurring against the backdrop of a declining Wicksellian equilibrium rate.
2. Let’s suppose I’m right, and that expected future NGDP is the best measure of the stance of monetary policy. Then during a recession, when expected future NGDP is also falling, it’s likely that the Wicksellian equilibrium rate is falling faster than the policy rate. So in that case money is actually getting tighter. The Fed sees its interest rate cuts in 2008 and 2009 as rescuing us from a recession caused by bad bankers. I see the Fed as having caused that recession through tight money. During 2008 the Fed cut rates more slowly than the Wicksellian equilibrium rate was falling, and hence money got tighter. BTW, as far as I know I’ve just described the Milton Friedman/Ben Bernanke interpretation of 1930-31. Is it so far-fetched to think that it might also apply to 2008?
On page 20 the authors say:
In comparison, the negative response of the 10-year yield to an unexpected decline in the federal funds rate is significant much earlier in the pre-1985 period than in the post-1984 period. This suggests that the transmission of monetary policy from short-term to longer-term interest rates occurs with a longer lag in the post-1984 period. This evidence is also in line with comments made by then-Chairman Greenspan in 2004 regarding the “conundrum” of longer-term yields not initially moving in the same direction as short-term rates.
Market monetarists would have a very different interpretation. First note that on some occasions long-term rates move in the opposite direction from a surprise move in short term rates. But why do they often move in the same direction? The authors imply that a cut in short-term rates gets “transmitted” to longer-term rates. I think that’s wrong. A truly easy money policy would cause long-term rates to rise, as we saw in the 1960s and 1970s. So what explains the correlation? Suppose AD falls due to some previous error of monetary policy. We start to slide into recession. The Fed cuts rates, but not enough to keep monetary policy from tightening. So short-term rates fall because the Fed is cutting them because there is a recession. And long-term rates fall because there is a recession (because they didn’t cut rates enough). The Wicksellian equilibrium rate is expected to be lower over the next few years, and that leads bond markets to reduce yields on the 10-year. Thus it wouldn’t surprise me at all to see short and long-term rates move in the same direction, as both are responding to the same fundamentals. As a broad generalization, monetary policy is usually too tight when rates are falling, and too easy when rates are rising. Not always (and perhaps not this September) but on average.
What makes the market monetarist explanation better is that we can also explain why long rates sometimes move perversely, the so-called “conundrum.” In January 2001, and September 2007, and December 2007 the long rate moved in the opposite direction from what conventional economists would have expected, given the policy surprise. Easier than expected policy made long-term rates rise (Jan. 2001 and Sept. 2007) and tighter than expected money made long-term rates fall (Dec. 2007.)
To summarize, it’s possible that the economy is becoming less responsive to gaps between the market and Wicksellian equilibrium rates, but it’s very difficult to prove that. Fortunately, even if the economy is becoming less sensitive to interest rate gaps, it’s not becoming less sensitive to monetary policy. Shocks to expected future NGDP impact RGDP just as much as in the old days. The recession of 2009 was about as deep as one would expect, given the amount by which monetary policy reduced NGDP. In that most important respect, monetary policy is just as effective as it’s ever been.