“All in one”

That´s all the information in one chart.

In a recent post Scott Sumner critiques Garret Jones, in particular Garret´s view, widely held, that interest rates were “too low for too long” in the 2002-05 period. Scott writes:

 You probably already know what I’m going to say here.  I always dredge up the Friedman quote that low rates usually mean money has been tight.  Garett may have anticipated that objection, as he referred to the Taylor Rule benchmark when arguing money was easy.  But even that won’t work, as the Taylor Rule is highly unreliable.  For instance, John Taylor has a recent post showing that (according to the Taylor Rule) money was too easy during 2008.  That’s right, even though 2008-09 saw the biggest drop in NGDP since the Great Depression, the Taylor Rule says money should have been even tighter!  And the rule also implies money is too tight right now!!  I wonder how the stock market, and the global economy, would react to a tightening by the Fed at this afternoon’s meeting.  (Hint:  Check out 1937.)

I’m with Ben Bernanke, the only reliable indicators of easy and tight money are NGDP growth and inflation.  (Preferably NGDP growth, but I’ll take the TIPS market if that’s all we have.)  Using those criteria, money during the 2000s was either about right, or a bit too easy. But even if you agree with David Beckworth, who argues that it was a bit too easy, it remains true that NGDP growth during the 2001-07 expansion was (I’m pretty sure) the lowest of any business cycle expansion of my lifetime.  So even if money was a bit too easy, it can’t possibly explain the huge housing bubble.

I believe the chart below helps “solve” the dispute. In the second half of 2001, NGDP falls below the “Great Moderation” trend level and keeps distancing itself from it for the next two years, so the  first falling and then “low” FF Target rate was what´s required. When NGDP growth begins to increase after mid-2003, “travelling back” to trend, rates are gradually increased, and continue to rise for a while after NGDP gets back to trend.

With rates continuing to rise before leveling off, NGDP remains slightly below trend. When the financial crisis hits in August 2007, the Fed starts the rate reduction program, but that barely sustains the level of NGDP relative to trend. The rest is standard Market Monetarist story, with the Fed allowing NGDP expectations to fall and then tank after mid-2008.

I put up the next chart just to show that monetary instability began in 1998, when the Fed allowed (remember the Asia/Russia crisis, LTCM, Y2K, Technology stocks, 9/11 etc.) NGDP first to grow excessively and then “undershoot”. By early 2006, just as he was passing the Fed baton to Bernanke, NGDP was back “on trend”. Bernanke took care of the rest helped by his “IT phobia” (sadly forgetting his earlier view of NGDP growth as the reliable indicator of monetary policy).

Note: Scott is right when he says NGDP growth in 2001-07 (5.2% YoY) was the lowest in post-war business cycle expansions.