Interpreting (or misinterpreting) the Fed

Justin Wolfers put up a “controversial” post:

So the key is for the Fed to reduce long-term rates.

Recently, the Fed has been doing this by “Quantitative Easing.”  It’s a terrible name for a simple solution. Just as the Fed adjusts short-term interest rates by buying and selling overnight government securities, it can adjust long-term interest rates by buying and selling long-term government securities. That’s what QE2 did.

Oh! No, it didn´t. QE1 AND QE2 resulted in higher long term interest rates AND rising stock market indices!

The END of BOTH Qi´s was followed immediately by a fall in BOTH long rates and stock indices.

Justin Wolfers again:

Many market commentators are disappointed that the Fed didn’t announce “QE3”—a renewed round of quantitative easing. But they shouldn’t be. The Fed still chose to reduce long-term interest rates, they just decided to do it with a different tool. They figured that if you can’t reduce short-term interest rates further, you should reduce ‘em for longer. That’s what the Fed was promising, when they said they expect to keep their short-term rate at “exceptionally low levels for the federal funds rate at least through mid-2013.”  What does this do? Keeping short-term interest rates lower for longer will also reduce long-term interest rates. And that’s the main game. It has already worked—perhaps even more reliably than following QE2. The interest rate on two-year bonds is down to virtually zero, and the 10-year interest rate is down to 2.2 percent.

So yes, we got lower long-term interest rates.  That’s what matters. And it doesn’t really matter how we got there.

Scott Sumner says it´s wrong to reason from a price change, something which Wolfers “confirms” he did in the underlined passage above.

In fact, both long term rates and the stock market were falling BEFORE the FOMC meeting of August 9.

After the meeting, on a daily close basis, they seem to be trying to figure out what comes next (Jackson Hole?). In addition to the “another 2 years of “zero” FF rate”, the statement said:

The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability.  It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.

Which is very similar to the Jackson Hole 2010 Bernanke speech:

In particular, the Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly.

In 2010 it was about the “outlook deteriorating”. Now it´s about “promoting a stronger economic recovery”. And as we well know, the economy is in worse shape now than it was a year ago!

Instead of QE which is no more than a “switch” that sometimes is turned “on” and then “off”, i.e not a “policy” but a series of ad hoc “actions”, why not take the opportunity to get rid of “interest rate targeting” and adopt, as Scott Sumner, David Beckworth and a growing “cabal” suggest, an NGDP Target, in which case a “switch” will be “on” until the target is reached.

9 thoughts on “Interpreting (or misinterpreting) the Fed

  1. Pingback: TheMoneyIllusion » Anatomy of a confused market (why real time data is essential)

  2. Excellent blogging. It would make far more sense to target nominal GDP, for extended outlooks.
    Why all the cat-and-mouse coy guessing-game crap?

    The Fed is acting like a teenage girl being asked out on her first date.

    We can forgive a teenage girl her erratic behavior, but why the Fed?

  3. Pingback: Anatomy of a confused market (why real time data is essential)-Economic News | Coffee At Joe's

  4. Catherine Thanks for the link. I found the piece a bit confusing. People, especially someone like Rogoff, should have learned by now that saying “more inflation needed” is an invitation to be called a “crank”. But inflation targeting can also be damaging. That´s where a concept like NGDP comes into the picture.
    The article talks of bubbles and asset price inflation (Minsky even went so far as to say that “economic stability fosters financial instability”. But that´s certainly not correct). I find it hard to believe (and empirically I could not find an association) between economic stability and financial instability, unless for the fact that supervision and incentives get “distorted”, most likely associated with political objectives (see the “homeownership for all” paradigm that started way back in the early 1990s) during long periods of economic stability.
    Bottom line, its not a question of the “left staking out a position in MP”. It´s more a question of being “adaptive in a constantly changing world”. 20 years ago, it was important that worldwide inflation be “conquered”. The IT strategy did a good job (even in Brazil after 15 years of incipient hyperinflation). But that doesn´t mean it will continue to perform AFTER inflation has been “conquered”. A new strategy is called for. The best, so far, especially because (unknowingly) that´s what Greenspan did, looks like NGDP targeting.

  5. saying “more inflation needed” is an invitation to be called a “crank

    My sense is that Rogoff can’t be called a crank; his status within the economics profession is too high & his book too respected. (At least that’s the way it appears to me from afar.)

    btw, I’m not sure he’s left of center; when I mentioned the left, I was referring to the Times. Rogoff seems somewhat skeptical of fiscal stimulus in a period of high household and govt debt.

    One thing I believe I’ve learned about politics at the local level is that if only one ‘side’ is speaking, there’s only one side. Since the crash, the right has been talking about monetary policy, but the left has been silent. (Again, that’s the way it seems to me….)

    If the New York Times is now going to write editorials and articles about monetary policy, the political environment will change.

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