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A commenter named “tpeach” recently asked the following:

My question is, what would have happened if the Fed hadn’t cut rates between Dec 07 and Apr 08? What would have happened to the base and velocity if the fed kept the rate stable while the Wicksellian or market rate plummetted during that time? Would the base shrink? If so, what are the mechanics behind that process? Also, how can the fed adjust the rate without changing the base? And why didn’t velocity drop when they cut rates during this time?

I wasn’t able to provide much of an answer. Here I’d like to explain why.

At first glance, the obvious counterfactual would seem to be a smaller monetary base and a higher path of interest rates. But that is a very fragile equilibrium, which could easily spiral off in one direction or another. For instance, suppose the Fed had reduced the monetary base in late 2007 in order to prevent any fall in the fed funds rate. What might have happened next? One possibility is that the economy would have gone into a deep depression in early 2008. Most likely, the Fed would have responded to that deep depression with a big rate cut and a big increase in the monetary base. Thus in this case the counterfactual path of the base would have been a bit lower in late 2007, and much higher in early 2008. Indeed what I just described is roughly what did happen between early and late 2008—I am simply contemplating that scenario playing out 6 months earlier.

Monetary equilibrium often has “knife edge” qualities. Imagine climbing along a mountain ridge with steep drop-offs on both sides. If you are not at the peak of the ridge, you have the option of walking a bit further up the slope. But if you go too far, you risk plunging down the other side. Monetary economics is kind of like that. Small changes are often “Keynesian” in character, meaning slightly tighter money means slightly higher nominal interest rates. But larger changes can easily be “Neo-Fisherian” in character, meaning tighter money leads to lower nominal interest rates. And it’s not just a question of more or less tight money, it’s more about expectations regarding the future path of policy.

Yip Cloud recently pointed me to the latest in his excellent series of interviews of macroeconomists, this one of Atif Mian:

Some people have the 5-year adjustable rate mortgages (ARMs), others have the 7-year ARMs. Let’s say that the mortgages started in 2005. When 2010 comes, in the middle of the slowdown, those with the 5-year ARMs would get the interest rate reduction because the mortgages reset to a lower rate automatically. They get this reduction in the interest rate that the Fed was trying to pass through to the individual households. But those individuals who have a 7-year ARMs still have to wait for 2 additional years before they get a lower interest rate. By taking advantage of this kind of variation in the cross-section, they can actually show the impact of the reduction in interest rate for the 5-year ARMs owners, by comparing them to the 7-years ARMs owners who didn’t receive the same reduction in interest rate just because they have a different kind of financial contract. What they’ve shown with this kind of analysis is that a reduction interest rate is actually beneficial. It actually allows the lenders to boost their spending and improves local economic outcome, in term of employment and aggregate demand. That’s just one example that actually shows monetary policy can be effective. At the same time, that same work also shows why the monetary policy was ineffective. If you think about it, you need to be able to pass through the action of the Fed to the ultimate households. However, if people are struck in the 30-year fixed rate mortgages, they would not be able to take advantage of this lower interest rate environment. As a result, monetary policy is not able to pass through to the ultimate households. It is going to be constrained in the effectiveness. That’s a very important insight that has come about because of this kind of work that I emphasized. That’s a very interesting and useful development. If people have borrowing capacity and willing to borrow, the same monetary policy shock can have more impact on the real economy. When you lower interest rate, for people who are prone to borrow more, they can borrow aggressively against a lower interest rate and that boosts the economy. But if the same individuals have already borrowed a lot in the down-cycle, you can lower the interest rate but those individuals are underwater. They can’t borrow any more. Then the same reduction in interest rate is not going to have much of an impact on the macroeconomy. This kind of logic also suggests that monetary policy itself is going to be insufficient in dealing with the downturn. You need to focus on something that Sufi and I have to try to emphasize in our book.

I can’t emphasize enough that (as Friedman, Bernanke and Mishkin pointed out) changes in interest rates are not the same as changes in the stance of monetary policy, for standard “never reason from a price change” reasons. Thus it’s not possible to draw any conclusions about the effectiveness of monetary policy by looking at the impact of changes in interest rates. To take the most obvious reductio ad absurdum example, a Mexican currency reform exchanging 100 old pesos for one new peso will immediately reduce the price level by 99%, without any significant change in interest rates.

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This entry was posted on May 12th, 2017 and is filed under Monetary policy stance, Monetary Theory. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



