“At the edge” or “A Willy E. Coyote” moment

This is a sample of the high-level discussion in late July 2008:

Following the collapse of Fannie Mae (FNM) and Freddie Mac (FRE), Ben Bernanke’s Congressional testimony last week had Fed watchers predicting interest rates would remain flat, or possibly fall, by the end of the year.

But surging share prices last week and tough talk from two FOMC board members has delivered an expectations U-turn.

According to interest rate futures, investors had priced in a 42 percent chance of a 2008 rate hike following Bernanke’s testimony. But after falling oil prices and not-as-horrible-as-expected earnings from banks drove stocks higher through Thursday, a hike by year-end had been fully priced in by finicky investors.

Then on Friday, Minneapolis Fed President Gary Stern said that the Fed couldn’t wait for the double-threat posed by jittery housing and financial markets to subside in order to fight higher inflation. In similar remarks, the Philadelphia Fed’s Richard Plosser said this morning that rate hikes should be expected “sooner rather than later.”

All of this has helped push up the expectations of higher rates even further with a hike by October almost fully priced in at 90 percent.

What it in fact helped push was the “ball over the edge”.


You want more money? But I won´t give it to you! So while velocity was tanking (money demand soaring) the Fed thought it proper to pull in supply.

6 thoughts on ““At the edge” or “A Willy E. Coyote” moment

  1. One day, individuals will be able to look at a graph of PURPOSELY withdrawn supply and realize: That’s not only lousy for me, it’s not good for anyone I know, either!

  2. Marcus, you end the post saying the Fed restricted the supply of money. You provide a graph showing in green the [annual] rate of change of MZM money, which the Fed does not directly control. The green line falls after peaking above 16% in 2008Q2 but again, the Fed does not directly control MZM money.

    FRED shows the annual rate of change of MZM money, in green, peaking above 16% in 2008Q2, just as your graph does. But the FRED graph also shows the monetary base, which the Fed does directly control, increasing sharply at exactly the same moment MZM is falling.


    Extending the blue line for just one more quarter shows that the Fed’s increase in the monetary base was massive, dwarfing the changes in your MZM.


    So I do not see how it can be correct to say that “the Fed thought it proper to pull in supply.”

    • In effect it did so by paying interest on all reserve balances in October 2008. The rise in the base was more than compensated by the fall in the money multiplier. In other words, paying interest on reserves was contractionary!

      • Good answer! Now, if I take the 9X2 graph, change the frequencies to monthly, and add a line showing excess reserves (also monthly)


        it appears that a significant drop in MZM growth started a month or so before the significant increase in AMBSL.

        It also appears that excess reserves started increasing *after* the MZM decline, but slowly at first. (If I recall, excess reserves started increasing late in the month of September, which makes September’s increase look like a slow start because the data are monthly).

        If these observations are correct, reserves started increasing before the Fed started paying interest on reserves. And MZM started falling even before that. So it still appears to me that the economy started to fall before the change in base money and the start of interest on reserves, and the graphs only show consequences! Consequences and policy responses. Adding NGDP to the graph (black line)


        shows a slowly declining growth rate turn into a more rapidly declining rate at just the same moment as the green MZM decline. Granted, GDP shows quarterly numbers, which blurs everything.

        But to your point: “paying interest on reserves was contractionary”, and the Fed started “paying interest on all reserve balances in October 2008” —
        The red line on these two graphs seems to show that the dramatic increase in excess reserves was about half over by October, 2008. So while paying interest on reserves may have been contractionary, but it was not the original source of the problem.

        Now I need another good answer.

  3. NA, bear with me:
    1. Central Bank (CB) is highly capable of keeping econ. activity stable:
    – Able to monitor appropriate econ. indicators
    – Capable of implementing aggressive policies when needed
    2. Fed´s response to econ. developments during this recession revealed that policymakers were decidedly more cautious (see the July discussion above),
    3. Given the central role of the public´s expectations of future CB policy in the monetary transmission mechanism, an easing or tightening of policy can consist of any action, or inaction, by the CB that alters the public´s expectations , i.e. “aggressive” versus “cautious” character of policy.

    Do you think Fed actions from late 2007 into 2008 constituted an “irresponsible tightening”?

    • Change in response to inaction by the Fed seems to me to be endogenous change arising from people and businesses. Policymakers would need remarkable foresight to circumvent such change. I would not call it irresponsible tightening. But I am now outside the area that I know something about.

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