My Reaction to the Fed’s August 10 Decision

After a major policy decision, economists are often asked whether they think it will work or not.  I don’t answer those questions.  Indeed I think my refusal to predict is what is most unusual about my approach to economics.  Not only do I leave the crystal ball stuff to others, I don’t much care whether the action increases NGDP.  I want 12 month forward expected NGDP to grow along a 5% a year growth trajectory.  If actual NGDP fluctuates a bit, it won’t do significant harm as long as NGDP expectations remain well-anchored.

I focus on how policy affects expectations, and we can observe those changes immediately in the asset markets.  If the policy action does not immediately produce a big boost to stock prices, say within 10 minutes, then it will have failed.  Note that I’m not saying it would be likely to fail, I am saying it would have failed; past tense.

It seems to me that the biggest market responses to Fed announcements tend to happen when the economy is about to enter a recession.  The three biggest that I can recall off the top of my head, January 2001, September 2007, and December 2007, all were at the point where we were teetering on the edge of recession.  As far as I know, macro models can’t explain this pattern, but then macroeconomists have never shown much interest in the stock market.  Instead, they generally like to make jokes about how the stock market forecast 11 of the past 6 recessions.  Of course you’d expect the stock market to over-predict recessions, if it was efficient.  Suppose there were shocks that produced a 50/50 chance of recession.  Those shocks would surely depress stock prices, but would not always be followed by recessions.

I seem to recall that the stock market moved in the 2% to 4% range after the 3 key Fed annoucements that I just mentioned.  Presumably the markets expected those decisions to have an unusually strong impact on the near term course of the economy.  And those market responses were in some ways easier to interpret than Tuesday’s decision.  I also recall that in two or three cases the Fed was deciding between 1/4 and 1/2 point rate cuts.  So you’d also need to observe the ex ante odds of each rate cut in the fed funds futures market, in order to estimate the total market response.  If the odds were 50/50 each way, then the actual market response would have been twice the observed move in the S&P500.

Of course you’d also want to look at other market indicators such as TIPS spreads and commodity prices (especially oil.)  In my view a stock market rise of 2% to 4% would be an indication that the Fed had done something significant, making a double dip recession considerably less likely.  But there may also be a great deal of uncertainty regarding the significance of this decision, as it will probably not be the usual change in the fed funds target, but rather something more unconventional, such as a lower interest rate on reserves, or more QE. Tim Duy has a good discussion of recent speculation about what the Fed may do.

And remember that help from Obama’s three new appointees won’t arrive until at least late September, and more likely early November.

So here’s my reaction to the decision:

Very bad: The Fed does nothing significant.  Maybe just a slight change in wording.  The Dow falls several hundred points.

Bad: The Fed does something minor.  Perhaps it promises to maintain the monetary base at current levels by purchasing T-bonds as the more unconventional assets are gradually sold off.  The Dow falls slightly.   (Actually, people are now so discouraged that this might be viewed as good news.)

Good: The Fed promises additional QE.  The Dow rises significantly.

Outstanding: Fed announces both QE and an end to interest on reserves.  The Dow soars by 500 points.

Inception: Leonardo DiCaprio penetrates three layers into the dreams of Hoenig, Fisher and Plosser.  Inserts 500 posts from TheMoneyIllusion.com.  Convinces the three that these are actually their own ideas.  The Fed does QE, ends interest on reserves, and sets an explicit NGDP target, level targeting.  The Dow soars 1000 points.  We get a 1983/84-style recovery.  Obama re-elected and strikes a grand bargain with the GOP to replace the income tax with progressive consumption tax.

Sorry, I got a bit carried away with my dreams.

BTW, I will be in the Jackson Hole area when the annual Fed conference takes place.  Needless to say, I wasn’t invited.  Should I do a sort of Masque of the Red Death gate crashing?  Dress up like a ghoul with the word “deflation” printed all over my costume?  (Note to the Secret Service:  Just kidding.)

This will probably be my last post for a while.  I also may not be able to respond to comments.  I hope something important happens while I am gone.

PS.  I just noticed that Andy Harless endorsed NGDP targeting.  I agree with his claim that it should appeal to people with diverse ideological views.

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