If you didn´t know, you should

Two researchers at the LSE ‘generalize’ the ZLB and write: “Pushing on a string: US monetary policy is less powerful during recessions:

Governments wary of fiscal expansion have turned to monetary policy to stimulate slowly recovering economies. This column presents evidence that lowering interest rates is ineffective during recessions – just when fiscal policy would be most effective. If this result is robust, we are seeing recent signs of recovery in spite of austerity, not because of it.

And conclude after fiddling with VARS:

What could be driving these results? We do not find evidence that fiscal policy tends to counteract monetary policy more in recessions. Nor do we find the responses of credit spreads or quantities to policy shocks to be magnified more in booms. In line with another recent paper we do find that policy tightenings are more powerful than loosenings (Angrist et al 2013). This provides another reason to doubt the efficacy of a “tight fiscal, loose monetary” policy mix in current conditions. But it does not explain our results, because the past incidence of unanticipated increases in the policy rate is no higher in booms than in recessions.

So, having ruled out a number of plausible candidates, we are left with a puzzle as to the underlying economic reasons for our findings. If our findings are correct, recent signs of economic recovery are there in spite of the current policy mix, not because of it. And if the world economy slips back into recession, we cannot rely on conventional monetary policy to get us out.

Eureka! Fourteen years ago Bernanke had indicated how Japan, mired in the ZLB with little growth, could make “unconventional” monetary policy, exactly because “conventional” monetary policy, confused with interest rate policy, did not work when inflation was ‘down and out’, i.e. ‘conquered’.

The two researchers miss something important when they say: “recent signs of economic recovery are there in spite of the current policy mix, not because of it.” To me that implies that even if done “conventionally”, monetary policy has some power!

Back in 2003, with inflation “too low” and the economy still weak (relative to trend) after the 2001 recession, after some debate the FOMC adopted a ‘light version’ of Bernanke´s recipe for unconventional monetary policy. That came to be known as “forward guidance”, promising to keep rates low (1%) for an extended period of time.

How did that work? It did so basically by showing everyone that the Fed was not content with the level of spending that was taking place, so expectations of higher spending (NGDP) took hold and money velocity took off, lifting spending back to trend.

It´s not working very well now. Probably because the economy is stuck in such a deep hole that no “light” is discernible above to ‘incite’ people to start ‘scrambling up’. To do so the Fed has to switch on a more powerful ‘flashlight’. That could be switching forward guidance from the instrument (which everyone thinks is an ineffective dude who doesn´t have the ‘strength’ to ‘push spending up’ anyway) to the target (thus showing the ‘light’ towards which people can start ‘scrambling’ towards by reducing money demand (increasing money velocity)).

For that to happen, the deliberation process has to change. Maybe, as Benjamin Cole has argued, much more than that has to change.

2 thoughts on “If you didn´t know, you should

  1. Shouldn’t the title of this paper be “*Changes in the Federal Funds Rate* are Less Powerful during Recessions”?

    In this paper the size of monetary policy shocks are defined purely in terms of changes in the federal funds rate.

    The Traditional Real Interest Rate Channel is only one of the nine channels of the Monetary Transmission Mechanism (MTM) as enumerated by Frederic Mishkin. I strongly encourage Silvana Tenreyro and Gregory Thwaites to read the following paper where Mishkin introduces the MTM:


    The Channels of Monetary Transmission: Lessons for Monetary Policy
    Frederic S. Mishkin
    May 1996

    “This paper provides an overview of the transmission mechanisms of monetary policy, starting with traditional interest rate channels, going on to channels operating through other asset prices, and then on to the so-called credit channels. The paper then discusses the implications from this literature for how central banks might best conduct monetary policy.”

    The following table, found in the author’s best selling intermediate monetary economics textbook (“The Economics of Money, Banking and Financial Markets”) is useful to students who are new to monetary policy:


    There is considerable evidence that the other channels are far more significant during periods of aggregate demand shortfalls. Thus the following observation that occurs towards the end of this article:

    “If our findings are correct, recent signs of economic recovery are there in spite of the current policy mix, not because of it.”

    May not be as much of a mystery as the authors imagine.

  2. Egads, what a strange paper. “Conventional” monetary policy? Um, have the authors noted anything going on? Like LSAPs (QE)? IOER?

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