Question: Should the Fed have been more aggressive with monetary stimulus in September-November 2008? (Scott Sumner, The Money Illusion)John Taylor: I think the Fed cut interest rates during that period just about right. I think it was basically coming down, it could have been a little faster at that point, and of course, GDP did fall tremendously. But I think if they had kept the interest rates along the same path it would have been fine. The problems I see at that period was the tremendous amount of uncertainty added by these new effects, if you like, the quantitative ease, and sometimes I've called somewhat **** mundustrial policy to where the actions went well beyond the usual interest rates. And I don't think they were appropriate. We're still studying them. Some of them were inappropriate. I just finished a study on mortgage interest rates.
Like Sumner mentioned, what is most striking about Taylor's response is that "monetary stimulus" is simply identified as lowering the Fed's target for the federal funds rate.
More troubling, however, is the notion that the targeted level of the federal funds rate was fine, but it was rather uncertainty generated by the financial policy -- the bailouts -- that caused the problem.
Could this mean anything other than that the Fed's target for overnight interbank lending was just fine. The problem is that the natural interest rate was "wrong" because of uncertainty about government action?
This view is wrongheaded. "The" natural interest rate is the interest rate that coordinates saving and investment--given the expectations that households and firms actually have. It is the level of the interest rate that makes total real expenditures equal the productive capacity of the economy--again, given the expectations that households and firms actually have.
If uncertainty about government action raises saving or reduces investment, the natural interest rate is lower. The role of any market price, including the market interest rate, is to coordinate given actual market conditions, not hypothetical ideal conditions.
Suppose there is a shortage in the gasoline market at the current, official, government-fixed price. Taylor might say, the official price of gasoline is just fine. It is all the uncertainty about new environmental regulation that has increased demand and reduced supply, and so we have the shortage on the market. Once all that uncertainty settles down, the rule relating the official price of gasoline to inflation and traffic conditions will work just fine.
While it may be true that uncertainty would raise the demand and reduce the supply of gasoline, the equilibrium price of gasoline isn't the price that makes quantity demanded equal to quantity supplied if there is no uncertainty about future government action. The equilibrium price is the price where quantity supplied equals quantity demanded. The reason for a shortage of gasoline would be that the market price is not allowed to rise because of a price ceiling.
Of course, there is not a federal price floor under interest rates. It is rather than with a regime of interest rate targeting, the Fed creates monetary disequilibrium (or allows it to develop) in order to prevent interest rates from falling below target. The expected effect of that disequilibrium is disruption of the flow of nominal expenditure on currently produced output. For example, the drop in nominal expenditure during the fourth quarter of 2008 and the first quarter of 2009.
Taylor correctly notes that the effective Federal Funds rate had fallen below target for much of the fall of 2008. And then the Fed began paying interest on reserves, specifically to prevent this from happening. Because Fannie and Freddie can't earn interest on reserve balances, it didn't work fully, but both the intention and effect is clear. It was like putting a price floor on gasoline to keep the price from falling. Taylor has no problem with this sort of thing, because it is the equilibrium price (the natural interest rate) that was "wrong.".
While the confused bailout policy of the fall of 2008 was destructive, a sensible free market policy would have also led to uncertainty. Which of the investment banks were insolvent and would go through bankruptcy? When (and if) will expedited bankruptcy legislation pass? How long will traditional bankruptcy take? How many commercial banks are insolvent and how quickly can FDIC reorganize them? How fast will commercial banks learn to fund loans with growing deposits rather than sell them to investment banks? The implications for the interbank lending rate for commercial banks with substantial insured deposits (and likely growing insured deposits) is unclear.
Thoma asked Taylor:
This all relates to the failure of Taylor and other macroeconomists to get beyond thinking about "the" interest rate. The Fed changes the federal funds rates, and that is a change in "the" interest rate. But everyone, even macroeconomists, knows that there are many interest rates in the economy. So while one can say that "the" natural interest rate is the interest rate that coordinates saving and investment and keeps total real expenditure equal to the productive capacity of the economy, which of the many interest rates in the economy would that be?
Since real households and firms (as opposed to representative agents) adjust their saving and investment plans depending on the interest rates they can actually receive and pay--interest rates that include a variety of risk premiums and terms to maturity, (and not the current and expected interest rate on overnight loans between commercial banks,) "the" interest rate, market or natural, is an abstraction.
And so, what happens if there is a shift in risk premiums? What happens if the yield structure changes? What happens if the interest rates firms pay (say on Baa corporate notes) rises relative to the overnight interest rate on interbank loans?
It is wrongheaded to think that the overnight interbank loan rate is somehow "right" and that whatever it is that has caused the change in risk premiums or the yield curve is "wrong." It is the interest rates that people actually pay and receive that must be at the correct levels to coordinate savings and investment.
If there is a long period of time where risk premiums and the yield curve remain stable, and so the relationship between the interest rates people actually pay and receive have a very stable relationship to the interest rates banks pay and receive on overnight loans among one another, that is just fine. Perhaps some simple rule of thumb can be found that relates the level of the federal funds rate to inflation and an estimated output gap. Perhaps, combined with anchored expectations about the rate of change in the core CPI, such a simple rule of thumb can allow changes in the interest rates people pay and receive to change in ways that keep nominal expenditure on a stable growth path.
But that comes close to being good luck. It is similar to the long period where M2 velocity hardly changed. Why would the ratio between the quantity of currency, checkable deposits, savings deposits, and CD's under $100,000 to nominal expenditure remain constant? Well, it did. So maybe a monetary policy based upon keeping that aggregate of monetary assets growing at a slow stable rate could keep nominal expenditure growing at a slow stable rate. Maybe....
But when these chance relationships no longer hold, it is time to return to fundamentals. What is the goal? My view is that a stable growth path for nominal expenditure is the proper goal for monetary policy. What is it that the Fed really controls? Short term lending? No. There are many sources of short term lending. What the Fed controls is the quantity of base money. No doubt manipulating that quantity, particularly varying the amount of overnight and two week loans made to primary security dealers, impacts short term interest rates. There may be no simple rule of thumb relationship between what the Fed controls, base money, and nominal expenditure. Perhaps during some periods, a rule of thumb between the federal funds rate and nominal expenditure will work. Perhaps at other times, a relationship between M2 and nominal expenditure will work.
But if they stop working, the problem is with the rule of thumb. The problem isn't the rest of the economy.