Lowered Expectations

Over on Matt Yglesias’ blog, commenter DTM does not agree with me on this post:

Good lord, this is getting tedious. Blanchard was simply wrong about the discount rate increase today tightening the monetary supply. I’m not an expert on discount rate raises in 1931, but what he quoted sounds like a case of increasing the discount rate leading to bank failures. The whole point everyone has been trying to get Matt to understand today is that unless there is still an ongoing liquidity crisis among banks, raising the discount rate shouldn’t affect the monetary supply.

And Blanchard basically admitted he blew it in an update. He pivots to some unspecified tightening happening in the past, but as far as I can tell (and it is hardly clear) his unspecified complaint is no longer about the discount rate, and apparently has nothing in particular to do with the markets today–which, I might note, closed mildly up.

Sheesh. Exactly what would it take to get Matt to admit that he simply didn’t understand this action and overreacted?

Of course, I did not say that the action tightened the money supply. The Fed has already indicated that it would like all of the excess reserves to stay exactly where they are. In fact, that is their exit strategy — a policy implemented on October 8th, 2008, with the stated intention of preventing monetary policy from having too expansionary an effect.

From Scott Sumner:

Here is my claim: Suppose that back in 2005 I had asked Bernanke the following hypothetical:

“Mr. Bernanke, suppose we go into a deep recession and employment declines for 24 months in a row. Suppose the total job decline is 8 million. Suppose the most recent monthly core CPI number is negative, for the first time since 1982. Will you respond to that 24 months of continuous job loss as the Fed responded in October 1931, by raising the discount rate?”

Is there any doubt about how he would answer the question? So why did he just do it?

My specific complaint is the Fed signalling the willingness of pursuing an exit strategy. The Fed, or William Dudley, himself may think that raising the discount rate is nothing but a technical issue. But last I checked, William Dudley isn’t a monopoly buyer. Thus it doesn’t matter what the Fed thinks. Furthermore, Dudley claims that there is a commitment to low interest rates for an “extended period”. So Dudley assumes that “easy money” equals “low interest rates”. But of course, “the” nominal interest rate is a very poor indicator of the stance of monetary policy. The only reliable indicator is what the market expects the trend path of inflation/NGDP/the price level to be. According to the TIPS spread, 10yr inflation expectations are around 2.28%, which is too low for a recovery to the previous trend path of NGDP. That means a lower productivity level, and a lower growth level going forward.

Paul Krugman has been all over this today, and is not happy. Neither am I.

Is the Fed Getting Ready to Tighten? Officials say no. But there’s a lot of speculation that the rise in the discount rate presages further action. Let’s hope that this is wrong.

If you happen to advocate fiscal policy, and the monetary authority deems it necessary to hit an explicit or implicit target, fiscal policy can not be large (or credible) enough to overcome that obstacle and have a considerable impact. On the other hand, if monetary policy is working correctly (i.e. targeting NGDP), then there is no role for fiscal policy.

Update: According to the Fed minutes from January, core CPE inflation forecasts for 2012 are in the 1.0-1.7% range. This is a sign of failure.


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