It takes a regime change
By Scott Sumner
In the 1970s, the Fed kept tinkering with interest rates, not understanding that high rates don’t mean tight money. Inflation and NGDP growth kept soaring higher and higher. Eventually economists came to believe that (old) Keynesian economics was bankrupt. A new regime requires new leadership, not invested in the failed policy. President Carter “promoted” Fed chair G. William Miller (actually he was basically fired), and replaced him with Paul Volcker, who abandoned the interest rate targeting regime. Inflation was brought under control.
It may be too soon for this sort of personnel change today, but it’s certainly not too soon to conclude that the current interest rate targeting regime has failed. Consider the following recent statement by Janet Yellen:
Financial conditions in the United States have recently become less supportive of growth, with declines in broad measures of equity prices, higher borrowing rates for riskier borrowers, and a further appreciation of the dollar. These developments, if they prove persistent, could weigh on the outlook for economic activity and the labor market, although declines in longer-term interest rates and oil prices provide some offset.
If falling oil prices and falling bond yields were expansionary, then we’d expect stocks to rally on news of falling oil prices and falling bond yields. But just the opposite is true. When Keynesian policy failed in 1979, economists went back to the equation of exchange:
M*V(i) = P*Y
The monetary base times base velocity (which is positively related to interest rates) equals nominal GDP. In the 1970s, the problem was excessive growth in M, so Volcker slowed money growth. Today the problem is excessively low V, and falling bond yields make this problem worse.
As Marcus Nunes pointed out in a excellent new post, Janet’s Yellen’s statement is a classic example of reasoning from a price change. There are occasions when falling bond yields are expansionary. That’s when they are produced by monetary injections. M goes up by more than V goes down.
But this time the monetary base is not being increased; falling bond yields are being caused by expectations of weaker growth (as Paul Krugman recently pointed out). They are pulling velocity lower. Thus falling bond yields are contractionary. (A leftward shift in the IS curve, if you insist on a Keynesian explanation.) This is monetary economics 101, and it’s quite discouraging to me that the Fed chair is making these sorts of elementary mistakes. As far as I can tell, the markets are also discouraged.
Lars Christensen has a similar concern:
In this 2009-article Scott Sumner argued that a key contributing factor to the mistakes of the Fed in 2009 was that the Fed simply misdiagnosed the crisis. Hence, while Scott clearly showed that the crisis was caused by an excessive tightening of monetary conditions, which in turn led to a banking crisis, the Fed was convinced that the banking crisis was the cause rather than the consequence of the crisis.
Furthermore, all through 2008 the Fed continued to argue that monetary conditions were highly accommodative, while in fact if you where tracking market indicators then it was clear that monetary policy had become insanely tight.
I fear that the Fed today is making the same mistake once again. The Fed is convinced that monetary policy is very easy (nominal interest rates are very low), but the fact is that market indicators – as I have shown above – clearly are telling us that US monetary policy not only has become gradually tighter since the announcement of tapering in May 2013, but also that monetary policy has become excessively tight since the autumn of 2015 and that Janet Yellen and her colleagues in the FOMC have been overly focused on labour market conditions and have completely ignored market and money indicators and as a consequence the US manufacturing sector is already in recession and it increasingly seems like that we soon will see an outright recession in the US economy. If the Fed continues to ignore that message from the markets then we might risk this turning into a banking crisis once again.
PS. Over at MoneyIllusion I complain about another recent example of Fed incompetence.