16 Dec 2015

Quick Response to Market Monetarists on Cruz

Market Monetarism 14 Comments

I really have to be quick because I need to get on the road, so I admit I’m not doing this justice. But I just want to note the progression of the argument here:

1) Ted Cruz said, “In the summer of 2008…the Federal Reserve told markets that it was shifting to a tighter monetary policy.”

2) When I asked Scott Sumner to defend that, he wrote, “Bob, I’d guess he’s responding to Fed statements that they were increasingly worried about inflation, and likely to tighten in the future. (Which of course they did.)”

So already, note that Scott has moved the goalpost. Cruz said the Fed announced it was shifting to a tighter policy, whereas Scott said the Fed told markets it likely would in the future. That’s a weaker claim.

And even that isn’t true; Scott is exaggerating (in his favor) what the Fed actually said. Here are the Fed statements from June and August of 2008: Nowhere in them do they say they are likely to tighten in the future. Notice that not only does the Fed NOT say it is likely to tighten (as Sumner erroneously claimed they said), but the Fed doesn’t even say it’s more worried about inflation than growth! And the Fed also says in these statements that it thinks the spike from energy prices is temporary, and that inflation will moderate in the future. This is remarkably dovish, given that at that point, year/year CPI inflation was the highest since the fallout from the late 1970s, except for one other period around the early 1990s recession.

3) David Beckworth defends Cruz by showing a graph plotting the difference between 1-year and shorter-dated Treasury yields. This graph shoots up in the fall of 2008, and Beckworth says that standard economic theory interprets this as saying that the markets are predicting a future hike in short rates.

Again, I’ll elaborate when I am settled at my vacation spot, but in the meantime, let me just say no, that’s a very misleading way to look at it. (I’m not accusing David–or Scott for that matter–of deliberate obfuscation. I’m saying they are so sure of their framework that they can’t see how everything is pointing against them.) Look at the chart below, where I graph the actual values of the 1-year and 1-month Treasury yields, along with the difference between them:

So the green line in the chart above is what David is focusing on. Yep, it shoots up in the fall of 2008 all right.

But why did it do that? It’s because short rates fell through the floor, while longer rates didn’t fall as much. So how in the world is this proving to us that the Fed tightened?!

I’m asking people to please review the above chronology, if you are on the fence about Market Monetarists versus orthodox Austrians. You have to turn everything upside down if you’re trying to argue that Fed tightening caused the financial crisis of 2008.

14 Responses to “Quick Response to Market Monetarists on Cruz”

  1. Transformer says:

    “But why did it do that? It’s because short rates fell through the floor, while longer rates didn’t fall as much. “.

    Won’t the spread going up in value when a rate rise is expected normally be manifested by a fall in short term rates while longer term rates don’t change as much?

    (Genuine question by the way – I’m not 100% sure the answer is “yes”)


  2. Major.Freedom says:

    The Fed inflated massively up to 2004, thereafter inflating less. By 2007 money was relatively tight, and the economy was in the initial stages of a pronounced correction. By 2008, the malinvestments were learned by enough people such that a sharp series of corrections began 2008.

    Market monetarists seem to have extremely short time horizons for thinking and identifying causal connections. The world’s economy is far more complex, and large scale changes far more long lasting, than “the economy went into recession 2008 because of what the Fed did in 2008.”

  3. David Beckworth says:

    Bob, I think you are guilty of the very charge you lay against Scott and me: “so sure of their framework that they can’t see how everything is pointing against them”. This really isn’t that hard.

    Let’s begin with the statements. First, I have claimed–and I think Scott too–that tightening that turned an ordinary recession into a Great Recession occurred in the second half of the 2008. That gives us August and September FOMC meetings at which to look. Here is the key signal part from the August statement: “Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee.” and Here is the key signal part from the September FOMC: The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee.” In both cases the Fed is very clear that inflation is a “significant” concern to the Fed. Given the context of a weakening economy, these are profoundly strong statements. Markets work through every word carefully and here is no different. It saw a bias to tightening and this lead to expectations of future rate hikes.

    On the interest rate issue, the fact that most of the change occurred in the short-term rate does not change the implication here of expected tightening from standard term structure theory. Plus you conveniently forgot to acknowledge the forecast from the Survey of Professional Forecasters unequivocally shows an increase in forecasted interest rates.

    But back to the expectation theory. Recall that long-term interest rates = average of short-term interest rates over same horizon plus some small term premium. So if the change in the long-term rate (1 year) is less than that of the short-term rate (1 month) it is because the 1-month rate is expected to be higher in the future. Put differently, since the 1-year rate is simply the average of a bunch of 1-month rates over the same horizon, it can only be falling less than the current 1 month rate if some of the future 1-months are higher. There is no way getting around this. It is basic treasury yield curve analysis. (term premium a non-issue here since it is small at this horizon and if anything falling.)

    So both the bond market and on the survey of forecasters show an expectation of rate hikes over next year.

    • Major.Freedom says:

      “Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee.”

      That sounds neutral to me. The Fed here is just saying that even though the continuing downside risks are there, they also wanted the market to know that they will not let inflation get out of control.

      When you put that statement next to “The Committee expects inflation to moderate later this year and next year”, and “The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability”, there is no indication of an imminent tightening at all.

      Or maybe I am just not as wedded to my framework to insist that one sentence about there being a risk of, not actual, inflation from the Fed in the summer of 2008 made the financial markets collapse months later.

      • David Beckworth says:

        Major Freedom, seriously? The economy was tanking and you think the Fed being “significantly” concerned about inflation is neutral? I hope you don’t bet on interest rate movements because you would lost a lot of money.

        But don’t trust me, trust the market. You still believe in markets, right? The yield curve, as I explained above, was screaming higher interest rates as was surveys of forecasters. Do you not understand the expectation theory of interest rates?

        • Major.Freedom says:

          Well, it should be noted it is impossible to have accurate market-based expectations about money because we don’t have a market in money.

          It is impossible for the same reason it is impossible for command economy dictators to have accurate command economy model-based expectations about capital in a free market. Like must go with like.

          When money issuance is determined by the whims of a few individuals whose activities are not subject to market forces, then we cannot go by consumer demands or the activities of competitive money issuers where errors result in bankruptcy and successes result in relative expansion. We also cannot predict where the malinvestment is nor the relative deflationary nexuses that result by using “yield curves”.

          Telling me trust the market, while simultaneously denying me, argumentatively and semantically, the very market that is not only not trusted to issue money but is necessary for me to even form a market expectation of money, and implying that the yield curve data that is available is solely indicative of “market was screaming higher interest rates”, is telling me your theory is unable to explain what took place.

          The market process is the best, but it is not able to transcend an absence of market domains. If it were, then command economies would never suffer from impoverishment or destitution.

          More to your point, do I think that passage you cited is neutral? Of course not! But I never said that passage was neutral, I said the entire publications were neutral. We have to include the other statements.

          Rates on short term t-bills falling greatly while rates on longer term t-bonds falling modestly is not necessarily indicative of only a forecast of mometary tightening. Indeed, it could be a result of bond traders piling into 3 month and 1 year government debt to front run the Fed’s increased loosening, or it could be a flight to safety, or it could be consistent with expectations of rising rates. No model can tell you definitively one way or the other is necessarily true at a given time.

          The survey of professional forecasters is a better source, but even there, neither the Q3 2008 nor the Q4 2008 publications show a “screaming of higher interest rates” on the basis of tightening monetary policy. The Q3 2008 publication shows a forecast of a modest increase – in the bps ranges mind you – of interest rates, concomitant with similarly forecasted modest increases in prices, aggregate spending, and overall output.

          And what are you talking about when you say you hope I didn’t bet on interest rates because I would have lost a ton of money? As it turned out I liquidated my entire risky portfolio in 2007 because the Fed raised the Fed funds rate up to 5-6% by 2007 after being below 2% (which used to be called crazy). M2 plummeted by the time 2008 rolled around and I was safely in money market funds.

          I suspected, but wasn’t sure, that a steep correction was coming because of the Fed funds rate possibly, but not necessarily, indicating tighter money.

          I saved my family’s entire life savings. It was precisely because I went by interest rates, the Fed funds rate, that I did better than the billion dollar managers of Bear Stearns who lost everything.

          I have no idea where you got the notion I lost money by betting on interest rates. Maybe you are, ahem, seeing something again that isn’t there?

    • Bob Murphy says:

      David Beckworth wrote:

      Plus you conveniently forgot to acknowledge the forecast from the Survey of Professional Forecasters unequivocally shows an increase in forecasted interest rates.

      No David, I *inconveniently* didn’t acknowledge that part–I was running around my office to grab stuff for my vacation break, and I literally didn’t even see the part of your post! (I’m not kidding.)

      So once I get settled I will write a better reply. I’m in a hotel right now.

  4. Maurizio says:

    The Fed kept interest rates too low (below the natural rate) before 2008. This in turn lowered the natural rate. So, all of a sudden, the rates set by the Fed became too high, whereas previously they were too low.

    • guest says:

      It’s not that the natural rate lowered in response to artificially low interest rates, as if central planning could directly change consumer preferences (options, yes; preferences, no).

      Rather, as the real purchasing power of artificially printed bank notes is made increasingly apparent as they’re moving into the hands of more people, price inflation forces people to substitute their current investments and purchases for more profitable/satisfying ones.

      This makes the sectors that were artificially propped up by monetary inflation less profitable, and they begin to fail according to real consumer preferences.

      In fact, it’s real consumer preferences that correctly forces price inflation in response to monetary inflation.

      Consumers really prefer to buy something else with their scarce resources than that which “stimulus” would like them to, and price inflation is a reflection of that.

      As the printed money makes its way to the rest of us, more of us think that we can afford more consumer goods, and since the scacity of those goods didn’t directly change with the introduction of printed money, either the supply goes down raising its marginal utility (and therefore the price), or suppliers, not having anticipated the increased demand, realize that there is sufficient demand to not unnecessarily forego a higher profit.

      This raises the costs of living, forcing investors and consumers to eventually move their money out of the artificially stimulated sectors.

      • Maurizio says:

        “It’s not that the natural rate lowered in response to artificially low interest rates, as if central planning could directly change consumer preferences ”

        it’s not because it changes consumer preferences. the mechanism is: you lower rates below the natural rate; you create malinvestment. So a lot of capital is built that cannot be put to good use. The return of capital falls to zero. This is like saying that the natural rate has dropped.

  5. Tel says:

    That embedded graph is really cool, with automatic interactive features. Ten years ago, you never saw stuff like that. Today it’s easy. St Louis Fed deserve a bit of appreciation.

    Getting onto the topic, scroll that graph back to 2007-08-20 and we see that green line spiking right up… indeed that’s the time when the interest rates (which had been stable approx 5% beforehand) started trending downwards. Now note the white background turns to grey background on 2007-12-01 because that’s “officially” the start of the Great Recession…

    Of course at the time, no one (especially not the Fed) had any idea the recession had started. Hmmmm…

    • Tel says:

      From Wikipedia:

      The active phase of the crisis, which manifested as a liquidity crisis, can be dated from August 9, 2007, when BNP Paribas terminated withdrawals from three hedge funds citing “a complete evaporation of liquidity”.

    • E. Harding says:

      The new St. Louis FRED launched on March 17, 2014.

  6. AC says:

    Bob, have you guys discussed interest on excess reserves?

    That is very contractionary and it was implemented on September 2008. The velocity if the based tanked.

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