John Taylor was wrong, but so is DeLong

Brad DeLong writes “The Trouble With Interest Rates”, where he strongly and rightly critiques views of John Taylor and concludes:

There is indeed something wrong with today’s interest rates. Why such low rates are appropriate for the economy and for how long they will continue to be appropriate are deep and unsettled questions; they call attention to what MIT’s Olivier Blanchard calls the “dark corners” of economics, where research has so far shed too little light.

What Taylor and his ilk fail to understand is that the reason interest rates are wrong has little to do with the policies put in place by central bankers and everything to do with the situation that policymakers confront.

However, what DeLong fails to realize is that the “situation that policymakers confront” is closely tied to the policies that the central bankers put in place previously!

In the linked Blanchard article, written on December 1 2008, we read:

Third, governments must counteract the sharp drop in consumption and investment demand. In the absence of strong policies, it is too easy to think of scary scenarios in which depressed output and troubles in the financial system feed on each other, leading to further large drops in output. It is thus essential for governments to make clear that they will do everything to eliminate this downside risk.

Can they credibly do it? The answer is yes. With interest rates already low, the room for monetary policy is limited. But the room for fiscal policy is wider, so governments must do two things urgently. First, in countries in which there is fiscal space, they must announce credible fiscal expansions; we – the IMF – believe that, as a whole, a global fiscal expansion about 2% of world GDP is both feasible and appropriate.

Coincidentally, as Blanchard had just finished typing his words, the next day the Fed announced:

that it will extend three liquidity facilities, the Primary Dealer Credit Facility (PDCF), the Asset-Backed Commercial Paper Money Market Fund Liquidity Facility (AMLF), and the Term Securities Lending Facility (TSLF) through April 30, 2009.

I call that QE0 and in fact, according to our proprietary MAST Index, it marked the end of the financial panic!

What´s wrong with Interest Rates_1

Also coincidentally, soon after, on February 17, President Obama

signs into law the “American Recovery and Reinvestment Act of 2009”, which includes a variety of spending measures and tax cuts intended to promote economic recovery.

Even more coincidentally, the deficit quickly goes to the 2% of GDP suggested by Blanchard, and remains at that level for the next three years.

What´s wrong with Interest Rates_2

The panic ended and fiscal stimulus was introduced, but the real economy only began to improve when monetary policy, gauged by NGDP growth turned! Note that the removal of fiscal stimulus, which began in mid-2012, did not affect the NGDP growth-determined pace of the recovery.

What´s wrong with Interest Rates_3

Initially, going into the crisis, monetary policy was very tight. During the past five years, it has remained tight, even if much less so.

Note: The Market Advised Sentiment Tracker (MAST) tracks the coordinated movements of a basket of financial market prices. As such it will respond to rumors, statements by Fed officials or any unexpected asset price move. It is a proprietary index of NGDPAdvisers, a macro consultancy that will begin activities early next year.

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