This is a synthesis of a few posts that seem to be converging on a coherent story of the Great Recession.
The Fed both reduced the monetary base (M0 and MB) and raised interest rates (also dependent on MB and M0) starting after 2005 relative to a log linear path of monetary policy from the early 2000s. These effects combine to account for the entire shock that caused the Great Recession, but come from two different views of monetary policy: an interest rate/ISLM view and a quantity theory view.
This post posits the idea that a deviation from a long term path of NGDP vs M0 is an indicator of a recession. What pushes the economy away from the path is an open question.
This post tries to see the relationship between MB (which governs short term interest rates) and M0 (which governs inflation). It shows that QE might have been larger than necessary and that base reserves only seemed to impact currency (M0) -- and therefore inflation -- during QE1.
The first task is to add the monetary base (including reserves) to the graph in the second post above (as was first done here) giving us the left-hand picture below and zoom in on the 1980s and 1990 recessions, giving us the right-hand picture:
In the right-hand graph we can see the NGDP-MB line (dotted blue line) push up closer to the NGDP-M0 trend line (black) during the 1983 and 1990 recession (but there's no recession in the mid-1980s). The NGDP-M0 data line (solid blue) is "repelled' by the NGDP-MB line; the primary reason is reserve requirements (MB - M0 are the central bank reserves).
If these two lines move near or cross each other, according to the interest rate model, the yield curve would invert (short rates determined by MB would be higher than long rates determined by M0). Since the interest rates are stochastic paths following these theoretical trends, we can only say the probability of an inverted yield curve increases as the NGDP-M0 and NGDP-MB paths approach each other.
Interestingly, an inverted yield curve is, according to Wikipedia, is considered by the New York Fed to be "a valuable forecasting tool in predicting recessions two to six quarters ahead." This interpretation of the data gives a foundation for that metric. It looks like the Fed steers the path of NGDP-M0 by adjusting short term interest rates (which depend on MB), pushing the NGDP-MB curve towards or away from it (with a buffer defined by central bank reserves).
How does the Great Recession look in this regard? Pretty shocking:
The Fed begins to effectively raise interest rates (or, from the monetarist view, contract the monetary base relative to its previous trend) in the mid-2000s, steering the NGDP-M0 line representing the economy (solid blue) right over the NGDP-M0 trend line (black). NGDP dramatically collapsed back to the trend in 2008.
After the recession began, the Fed quickly expanded the monetary base (QE1) to allow the economy to fall back to the trend line. But did the Fed need to expand as much as it did? If we take the 2000-2008 average monetary base reserves as a baseline, then the Fed only needed to expand to the purple point to achieve the same relative paths of NGDP-M0 and NGDP-MB with the same average monetary base reserves. The path is shown as a dashed purple line. In the following two graphs, I show what this means in terms of interest rates (only dropping from 4% to 2%) and QE (only about 200 billion dollars) -- the counterfactual is shown in dashed purple:
I think this picture of the economy is a nice synthesis of a couple of views (in terms of the money supply and in terms of interest rates) and seems to explain not only the broad trends of NGDP, but also the major shocks -- even down to a level of detail where I could (probably with a great deal of hubris) say how much QE should have happened.
This picture also explains why interest rates are not necessarily a good indicator of monetary policy. One, the fluctuations in the interest rate data mean the monetary base and currency are better indicators of where the trends should be. And two, the trend of NGDP-M0 moves relative to lines of constant interest rate (see here), meaning that "high" and "low" interest rates are relative terms (i.e. the trend of interest rates rises and falls).
However, we're also left with an issue. If recessions are like avalanches, steering the economy with monetary policy seems to be like pouring more snow on the mountain until an avalanche happens. The problem with that is that you increase the size of the potential recession. The Fed kept trying to cool the economy since the mid-2000s, but there's no telling how much snow will build up before the avalanche kicks in (i.e. how bad the recession will be).
The one thing this story doesn't explain is the prolonged period where the path of NGDP-M0 was persistently below the trend line after the 1990 recession (which is remarkably coincident with the Greenspan Fed). What held the economy below the trend for 10 or more years?
There are still some holes in this emerging story. However, I think it's a remarkably coherent story -- and it points to tight monetary policy as the leading cause of the Great Recession.
"This picture also explains why interest rates are not necessarily a good indicator of monetary policy. One, the fluctuations in the interest rate data mean the monetary base and currency are better indicators of where the trends should be. "
Hmmm, ... does that make you an "info-monatarist?"
Ha! Except there is still a liquidity trap -- I think I fall in the cracks as far as the schools of thought go ...Delete
It does seem somewhat backwards that raising interest rates (relative to the black line above, which could mean that rates are falling more slowly than they should) could generate an overshoot in NGDP ... it's not necessarily generating additional NGDP growth, though (d log NGDP/dt is pretty constant over the 2000s).
I imagine that when you raise rates (relative to ... etc) less of the new NGDP (because it continues to grow) is "supported" by currency (heading to the avalanche metaphor again), which can lead to instability when people demand cash or other liquidity after e.g. a financial crisis.
But I still need to work on a "story" :)
BTW, your avalanche idea of pressure building up until something breaks, is the opposite polarity to that of Vincent Cate's avalanche theory, no? He's worried that we're piling snow on hyper-inflation mountain.ReplyDelete
Yes, it is kind of the reverse of that ... monetary policy that is too contractionary (the NGDP-M0 path moves more vertically in the graphs) sets the economy up for a fall (and deflation).Delete
The QE would be inflationary, but only if we were far from the liquidity trap (information trap) line where dP/dM0 ~ 0 ... like in the 1960s or 70s.
Hopefully I'm not being too dense but I think I have a few issues:ReplyDelete
1. How does the financial crisis (i.e. CDOs, MBSs, AIG and all that good stuff) enter into this view - people (corporations are people my friend...) were really, really bad and did really, really stupid things. Are you treating this as some sort of exogenous shock (that caused the avalanche to fall)? One thing I've never understood about the monetarist view is treating the greatest financial crisis in 70 odd years as a "coincidence" with the biggest recession in 70 years.. while blaming the FED for actions taken in 2004. What's the mechanism/story there?
2. I don't think your associations of recessions as a return to NGDP-M0 trend passes the visual smell test - the only clear example is probably the last one..?
3. Seems to me the economy was on path to the information trap regardless of what happened. Again, seems a little too pat that even if we never had a recession we'd be stuck in the information trap this decade if everything was left as it was..
p.s. this is replication anon, I've just decided to stop being anon :)
Hello Karthik ... And thanks for the questions.Delete
1. I think the financial crisis was the trigger of the NGDP collapse ... And the behavior of financial companies are part of the reason a collapse didn't happen sooner, letting NGDP get well past the trend. But that is personal speculation ... I don't necessarily have data to back that up.
2. With the exception of the early 2000s (which may not be a real recession) recession, all of the recessions are statistically significantly above the curve. If you add the information that NGDP falls during a recession, that implies you are above the curve and returning to it. I agree that it's not blatantly obvious in the pictures ... I'll produce some zoomed in graphs illustrating better.
3. Yes I agree the economy was on that path already, but I think the recession makes the trap stand out more ... I also think that a recession of this magnitude is what happens if monetary policy is ineffective in a trap. This is just the first recession in the trap ... I have a post I did about this that I will look up.
And here is that graph:Delete
For 3, the post I said I would look up wasn't a post, but rather a comment:Delete