Good News! The World’s Central Banks Boosted (Market) Interest Rates

It’s much too little, but not at all too late.  (No such thing as long and variable lags.)

This morning there was a sudden jump in (Treasury) interest rates all across the yield curve (except the short end where they are pegged at near zero, and were unchanged.)

What caused this good news?  That’s simple, we had an almost perfect example of an event study.  The world’s major central banks did a coordinated easing of monetary policy this morning.

The Federal Reserve and five other central banks agreed to reduce the interest rate on dollar liquidity swap lines by 50 basis points and extend their authorization through Feb. 1, 2013.

The new interest rate has been reduced to the dollar overnight index swap rate plus 50 basis points, or half a percentage point, from 100 basis points, the Fed said in a statement in Washington. The Bank of Canada, Bank of England, Bank of Japan (8301), European Central Bank and Swiss National Bank (SNBN) are involved in the coordinated action, the Fed said.

German stock prices soared 4% on the news, and Wall Street also rose sharply.  With easier money we had a small rise in real interest rates, which mostly reflect expected real economic growth.  Inflation expectations also rose.  Of course this is all completely inconsistent with the Fed’s operating model; they think we need to lower long term rates.  And it’s also completely inconsistent with the standard IS-LM model, as interpreted by Keynesians.  But it’s completely consistent with the market monetarist version of IS-LM, as developed by Nick Rowe:

Brad DeLong’s post on John Cochrane’s upward-sloping IS curve triggered this post. But this is not about John Cochrane. It’s about why tight monetary policy may cause real interest rates to fall, if monetary policy is expected to stay tight for long enough.

The story of an upward-sloping IS curve I’m putting forward here isn’t really new. I read something roughly similar a few months back, but I have forgotten who wrote it. (It was a paper linked by a commenter on a previous post, had “Monetarist” in the title, and was written about 10 years back.)

Authors need to re-write the IS-LM model to show upward-sloping IS curves.

Market monetarism:  Describing the world as it is, not as textbooks say it is.

Update: Today’s stock market reactions understate the actual impact of monetary easing on stock prices, as some sort of move was already anticipated, and priced into stocks.

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About Scott Sumner 492 Articles

Affiliation: Bentley University

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.

Visit: TheMoneyIllusion

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