“What you teach is what you think”

I´ve had Mishkin´s textbook “Macroeconomics – Policy and Practice” since October 2011, soon after it was published. More recently, having to prepare a class on Monetary Policy in the run-up to the crisis, I decided to take a look.

First, a bit about Miskin. From Wikipidea we learn that:

Mishkin has been a full professor at Columbia Business School since 1983. He held the A. Barton Hepburn Professorship of Economics from 1991 to 1999, when he was appointed Alfred Lerner Professor of Banking and Financial Institutions. He was also a research associate at the National Bureau of Economic Research (1980 to 2006) and a senior fellow at the Federal Deposit Insurance Corporation‘s Center for Banking Research (2003 to 2006). Dr. Mishkin was also a professor at the University of Chicago (1976-1983), a visiting professor at Northwestern University (1982-1983), and visiting professor at Princeton University (1990-1991).^[2]

From 1994 to 1997, Mishkin was Executive Vice President and Director of Research at the Federal Reserve Bank of New York and an Associate Economist of the Federal Open Market Committee of the Federal Reserve System. Dr. Mishkin was the editor of the Federal Reserve Bank of New York’s Economic Policy Review and later served on that journal’s editorial board. From 1997 to 2006, he also was an academic consultant to and served on the Economic Advisory Panel of the Federal Reserve Bank of New York. Mishkin has been an academic consultant to the Board of Governors and a visiting scholar at the Board’s Division of International Finance.^[2]

Mishkin has been a consultant to the World Bank, the Inter-American Development Bank, and the International Monetary Fund, as well as to numerous central banks throughout the world. He was also a member of the International Advisory Board to the Financial Supervisory Service of South Korea and an adviser to the Institute for Monetary and Economic Research at the Bank of Korea.

Mishkin was confirmed as a member of the Board of Governors of the Federal Reserve on September 5, 2006 to fill an unexpired term ending January 31, 2014. On May 28, 2008, he submitted his resignation from the Board of Governors, effective August 31, 2008, in order to revise his textbook and resume his teaching duties at Columbia Business School.

So, maybe more than could be said for most living economics professors, the “Policy and Practice” subtitle of his textbook is perfectly apt.

In the Preview to chapter 10: Monetary Policy and Aggregate Demand, Mishkin writes (my bolds):

At the height of the financial crisis in December 2008, the Federal Open Market Committee of the Federal Reserve announced a surprisingly bold policy decision that sent markets into a frenzy. The committee lowered the federal funds rate, the interest charged on overnight loans between banks, by seventy-five basis points (0.75 percentage points), moving the federal funds rate almost all the way to zero. The whole world wondered if this bold move would jolt the economy out of a recession. Would it boost stock market values? Would it trigger higher inflation?

That´s the sort of conclusion you reach if monetary policy is synonymous with interest rate policy. It isn´t, but that´s the way it´s taught. About 13 years ago David Romer wrote  IS without LM, in which the MP (monetary policy curve) substitutes for the LM curve, where the MP curve indicates the relationship between the real interest rate the central bank sets and the inflation rate (assuming sticky prices in the short run).

In a “Policy and Practice Box – Autonomous Monetary Easing at the Onset of the 2007 – 2009 Financial Crisis” a few pages into the chapter, Mishkin writes (my bold):

When the financial crisis started in August 2007, inflation was rising and economic growth was quite strong. A movement along the MP curve would have suggested the Fed would continue to keep hiking interest rates, but instead it did the opposite: it began an aggressive lowering of the federal funds rate, despite the continuing high inflation, as shown in Figure 10.3. The Fed thus shifted the monetary policy curve down from MP₁ to MP₃, as in Figure 10.2. The Fed pursued this autonomous monetary policy easing because the negative shock to the economy from the disruption to financial markets (more about this on Chapter 15) indicated that, despite current high inflation rates, the economy was likely to weaken in the near future and the inflation rate would fall. Indeed, this is exactly what came to pass, with the economy going into recession in December 2007, and the inflation rate falling sharply after July 2008.

The chart below is a replica of Mishkin´s Figure 10.3

But what if, instead of looking at ‘Headline’ inflation the FOMC had focused on ‘Core’ inflation? Probably they could have been much more “aggressive” in their interest rate moves!

And when Mishkin says that in December 2008 the FOMC “announced a surprisingly bold policy decision” the charts indicate that it was in fact very late in trying ‘to close the gates after the horse had bolted away’!

The next chart shows that “the stock market dropped and inflation (expectations) didn´t move much” after the “bold policy decision”. That only happened when in March 2009 the Fed announced QE1.

In reality, neither the late 2007 “aggressive easing” was aggressive nor was the late 2008 “bold policy decision” bold. Why do I say that? From looking at the NGDP gap (distance from the “Great Moderation” trend) chart below we observe that in late 2007 NGDP was already below trend and the “aggressive easing” did nothing to lift spending towards the trend. On the contrary, spending fell further below trend. This fact is consistent with markets being negatively surprised with the meager 25 bp “easing” that took place in the December 2007 FOMC meeting.

It´s also ‘clear’ from the chart that the December 2008 “bold policy move” was in fact “too little, too late” – the ‘economy horse had bolted’ long before.

Some years before, the Greenspan Fed, with Bernanke a BoG member, had also let NGDP fall far below the “Great Moderation” trend level. After bringing the FF rate to its ‘knee’ (1%) without success in turning spending around it adopted “forward guidance”, successfully ‘managing expectations’ and succeeding in ‘turning spending around’.  Note that at the time there was also an oil price shock going on, but that didn´t stop Greenspan from doing (as he called cryptically) “appropriate monetary policy”.

If Mishkin teaches monetary policy as interest policy he must believe it is, but as I´ve tried to show that can be very misleading. I think Tyler Cowen´s and Alex Tabarrok´s “Modern Principles of Macroeconomics”, which analysis the question within a Dynamic AS/AD framework is much more useful. Their framework is not the GDP components and how they are affected by changes in real interests rates, but the QTM, MV=PY.