Krugman and I were both wrong about the Fed and interest rates

In 2011 Krugman wrote (and here)

Like Bernanke, I don’t believe that the flow of Fed purchases has been an important factor holding bond rates down, and hence don’t believe that they will jump when the purchases end.

I don’t think I ever wrote this view up, but I was of the same opinion nonetheless.  It no longer seems this is true.  We’ve had a significant run-up in rates from mere talk about slowing down Fed purchases.

So which other views about the current macroeconomy will we need to revise?  That’s what I’ve been thinking about for most of today.  The major possibilities are not comforting.  I can’t be talked into them by a day or two of market data, but we do need to look more seriously at:

1. The low rates really have been an artifact of Fed policy, at least to a much higher degree than many of us had thought.

2. Emerging markets tanked on the Fed communication, and so we have indeed been exporting bubbles through a “reach for yield” mechanism.

Yikes, and those are not mutually exclusive.  I still don’t see either of these as theoretically strong, for reasons outlined by Krugman and for further reasons outlined by me here, but of course theory has its limits.  In my post from two weeks ago I will raise my p = 0.05 to p = 0.15, at least.

One also might try to argue #3, namely:

3. Interest rates still haven’t moved “a lot.”  Obviously there is no fact of the matter as to what is “a lot,” but I admit to being surprised and Krugman also now seems to have different views, so I don’t think we can throw out the new data as irrelevant.

All of this remains in great flux.


Ah, mixed causation message here and an a totally misleading interpretation of Krugman: instead of flow of funds being held down, and then being altered as a source of rate increases,

What is actually causing the rates to rise is:

An improving economy.

Ta dah.

Did Krugman say that an improving economy would keep interest rates low?

Did Tyler say that rates would not rise if there were an improving economy and the fed continued to purchase. Maybe you did, maybe not.

The economy got that much better right after that Fed communication? Come on...check out the graph of interest rates which is behind one of the links. You are not taking the numbers and their timing seriously, not to mention the data from emerging markets.

It's clear Fed policy is having a strong impact on long rates at the moment ... but it's difficult to separate out the effect of the bond purchases from the effect of the forward guidance. The flow of Fed purchases may have very little impact on rates, *except* as it lends credibility to Fed promises to keep rates lower, for longer. Of course that distinction may have very few practical implications ...

The Fed has been saying all along that they planned to withdraw QE in 2014, or earlier, if the economy got better.

Does someone here believe that MBAs can't discount time periods? What's changing is the economy, and what is also creating risks is the FED possibly believing the economy is turning when its too early to tell.

And, besides, how does an economist take a 3 day reaction by the market to mean much? What if the rates decline next week? Or the stock market increases?

Does turbulence and volatility signal a steady path?

Oh, and by the way, did anything else happen last week? Anything regarding the Chinese banking system...funny how economist seek out the evidence that confirms a view and screen out other evidence of causation that could also explain interest rate changes over a three day period, which could change again tomorrow.

+1. This feels more of a reaction to China than QE, but is likely not really that related to either. Bernanke didn't really say anything that really suggested imminent tapering to me, and who didn't know that China was about to turn down?

You ask me? Everyone thinks the market is overheated, and has been growing well past the sustainable level that could be explained by underlying economic growth.

This is a Gladwellian Tipping Point. Minor actions cause big reactions when the system is in stress.

My understanding is that the carry trade was funding Chinese investments. When that flow of capital dried up we then saw a banking problem in China.

Mr Cowan mentions that in #2.

I think an improving economy is the most likely explanation, but Krugman is saying the economy is terrible.

There was always going to be volatility when QE was withdrawn. It doesn't mean the trend is down for equities from here. We are still near all-time highs.

If the economy was expected to get worse as a result of the FED withdrawing support, people would run to the safety of Treasuries, no? Where are they running to?

+1 The only risk is that the Fed withdaws because of political pressure and not because the economy is improving. Hear that Issa.

"Supply and Demand", chioldren.

By what measure, 'zackly, did the economy get better in three days?

This is how the end of centrally-planned finaqncial repression will look.

" . . .how does an economist take a 3 day reaction by the market to mean much?"

What three days is you tawkin' 'bout?

Anecdotal: I had a mortgage rate lock offer for 3.375% (30-year, fixed rate residential mortgage loan) at end April 2013. By the time both parties had signed the sale contract - May 28, I locked in at 3.875% - that's about $100 a month more interest pament - stil doable. Now, the lock-in rates are 4.25%.

Why don't you save yourself keystriokes and quickly type, "I'm a krugman-worshiping imbecile."

T, Are you having a yin and yang reaction: on the one hand you say..."What three days you talking about" to say this has been occuring over time....and then you did the economy get better in three days, as support for the claim it is all the Fed announcement last week.

The Fed communication wasn't actually news. Everyone expected something along those lines. There isn't anything surprising at all. The "market reaction" is nothing but traders moving markets because they can.

You also just need to look at the price of TBT, an ETF that shorts the 20-year Treasury. The share price took off at the same time.


Oh, jebus, is this funny. The Fed has power, and must use it. And when it does, well, the fact that something predictable happened immediately after isn't related, it's just related to general conditions, if I didn't predict that it taking that specific action would have that specific result.

Krugman really needs to Hubbard it up ASAP to take advantage of this stuff.

"The Conscience of a Cult Leader"

I think its sometimes easy for economists to lose sight of the fact that markets are made up of participants, and what the participants think is important, even if its wrong. "In the short run a market is a voting machine, in the long run its a weighing machine". The incredible selling in every asset class is really just market participants saying "I don't know what is going to happen next" - and choosing the optionality of cash.

In the bond markets this is particularly true, since participants are starkly divided between those who thing that QE raises rates, and those that think that QE lowers rates. What we are seeing is only "evidence that market participants believe that the flow of bonds holds down rates across the curve", and often rates and yields are determined by marginal buyers. If the marginal buyers and sellers are making big changes relative to market liquidity, then it can take weeks for markets to "settle down". Moreover, its clear that bonds have very limited upside, pretty much everyone has been planning to downsize their bond holdings "at the turn", so perhaps we are seeing nothing other than that yields rose a little on more positive Fed forecasts, and that acted like a flash point for selling that everyone knew was coming.

In the equity markets a ten percent correction happens every few years for pretty much no reason at all, so again, after a huge run up this might just be a normal correction based on selling exhaustion.

Exactly. At times like this, the market can be briefly wrong (with apologies to Scott Sumner).

We need to let the dust settle.

The market is not "wrong". The market is a giant casino run by very clever people with very clever computers. They manipulate things based on people's assumption that the market is "always right". They know people believe this so they can manipulate the markets based on this belief. They can also manipulate the press to bolster their agenda.

The quick and dirty relationship between bond yields and the market PE is one-to-one.

That is, a 100 point rise in yields should cause a 100 basis point drop in the market PE.

From the bottom yields have risen around 80 basis points.

If the PE falls from 15.5 to 14.7 is should cause a 5% market correction, almost exactly what we have seen.

Waitaminute: you actually believed that Fed purchases were not supporting bond prices? That every macro hedge fund in the world, fearing getting on the wrong side of the Fed, was merely jumping at shadows? That the "Bernanke put" on bonds was not driving money managers to purchase them far more aggressively than they otherwise would have?

What did you think was happening to yields?

Maybe it's easier sometimes to see clearly if you are not lumbered with too much of an economics education. Maybe studying Advanced Economics detracts from the ability to understand what's happening around you. Or should that have been more precisely "Macroeconomics"?

You know, I frequently say that I don't blame people for being wrong about Macro because it's hard, but... well, sometimes they're just idiots.

Not sure I agree, I intend to write about this. But the question I would ask is that isn't the *expected stock* more important than the actual stock or actual flow? What we're obscuring here is that an expected decrease in flow actually results in a lower-than expected final stock.

Technically, that means flow would be important, but I'd still say that the stock is doing the most work here. Is it possible that the markets, before Wednesday, expected a far larger stock ultimately than they are expecting now, and the resulting turbulence derives from the adjustment of said expectations?

confused for a moment... you intended to write shock rather than stock, correct?

no, he means stock as a synonym for 'level' or 'amount'

Krugman and I were both wrong about the Fed and interest rates

I'm not holding my breath waiting for Krugman's article on having called this wrong.

The linked column instead takes a more Krugman like approach:

You can argue — and I would — that the Fed’s activism, while welcome, isn’t enough, and that it should be doing even more.

My take away from that is that Krugman believes that he could do a better job than Bernanke.

After all, ever since the Fed began its policy of aggressive monetary stimulus, it has faced angry accusations from the right that it is “debasing” the dollar and setting the stage for high inflation

And here, he just attempts to blame everything on his ideological boogie man.

Krugman says "The first thing you need to understand is how far we remain from full employment four years after the official end of the 2007-9 recession. " and at the end of the column says " The fundamental reason our economy is still depressed after all these years is that so many policy makers lost the thread, forgetting that job creation was their most urgent task. "

I think he's right.

I always get a kick out of Krugman calling out the bullies on the right for what they are. And the bullies on the right always, always, get bent out of shape when someone calls them out for doing to them what they routinely to folks they disagree with.

Krugman Derangement Syndrome, KDS for short. I've seen it here many times. Mention Krugman's name and you'll see lot's of KDS. No need to even listen to what he has to say.

And while I think he's right about the lack of job creation and the lack of policies to foster it. I think he's wrong about QE. As far as I am concerned QE only serves to inflate the stock market and make the rich richer and does next to nothing for job creation. But, no matter how confident I am in my judgement, you know, Krugman could just be right.

It's hard to deal with that.

I always get a kick out of Krugman calling out the bullies on the right for what they are. And the bullies on the right always, always, get bent out of shape when someone calls them out for doing to them what they routinely to folks they disagree with. ...Krugman Derangement Syndrome,

That just reads like an ideological rant.

According to a quick Google for "derangement syndrome", it's an incredibly common ideological rant. Just search-and-replace "Bush" or "Obama" or whatever you like for "Krugman", swap "left" for "right" if necessary, and you're done.

It's typically an ad hominem, hypocritical rant, too, pretending to condemn subjectivity while simultaneously serving to derail the subject of a debate from "X is wrong" to the infinitely more pointless "you only think X is wrong because Y said it".

It doesn't help that the rant is so often *true*, though. Just take a look at the poll results on the NSA unwarranted wiretapping. They're pretty damning evidence that at least 23% of Republicans and 27% of Democrats think that questions of civil rights and national security are only important insofar as they signal that you're on the right team.

I always get a kick out of Krugman calling out the bullies on the right for what they are.

Yes, I've been saying for years, that is Krugman's readership and that is why he writes the way he does -- if he didn't, he wouldn't garner the wide audience he does. They want to hear their hated enemies called evil racist monsters. Shrug.

And as I also said, "And the bullies on the right always, always, get bent out of shape when someone calls them out for doing to them what they routinely do to folks they disagree with."

Thanks, TallDave, for proving my point!

And while we're at it, why don't you just admit it. You enjoy Krugman bashing! It's just like Rush says. He believes in the aggressive use of force especially when he's beating up on people like Sandra Fluke and the phony soldiers.

None of us have all the answers.

It's too bad that it's easy for many of us to believe we do. Especially, those of us who have been blinded by the right. (Yes, I know many of us have also been blinded by the left, but that just doesn't have the same ring to it.)

I'm assume you are unaware of the "poisoning the well" fallacy? Or at least unaware that's what it's called? Rational people make their case with reasoned points not with ad hominem arguments.

"Interest rates still haven't moved 'a lot'."

On a percentage basis, 100 basis points in less than two months is a 40% move. I would call that "a lot".

Randy Kroszner taught my Money and Banking course after he left the Fed in 2009. He was absolutely insistent that QE had a large and positive impact on bond rates. Several people in the course prodded him on it, but he was emphatic about the impact of bond-buying.

And, I guess he was right. Same for Bernanke. There's room for some debate on other issues (interest on bank reserves), but we had the right people at the helm in 2008-2009.

Krugman "so many policy makers lost the thread, forgetting that job creation was their most urgent task."

Really? At it's worst U6 was only a fraction of the working age population, at no point did the unemployed outnumber the employed. So far as I can tell at no point did the population of households of the unemployed outnumber the population of households of the employed. Since by definition a politicians' *most urgent task* is to get reelected, his assertion is on the face of it simply wrong.

AND what if the current levels of unemployment are structural and in effect permanent? We're supposed to have 0 real return to lending forever, and expect the economy to function well over the very long term in that circumstance?

Yes, the unemployment is bad and the long term unemployment horrible. That doesn't mean that any amount of easy money or fiscal stimulus will actually affect them very much. We will see.

My cynical self thinks that we will not like what we see.

One thesis is that a Fed announcement, like an earnings report, triggers big trading systems to make big trades but not necessarily based upon the information contained in the announcement.

Think of it as a poker game. You're an expert player whose been dealt a mediocre hand you would normally fold, but there's a much bigger pot than normal on the table and you think you can steal it due to superior skill. So you raise rather than fold. The scared money at the table then folds.

Do the best quant funds make big trades because they care what Bernanke says, or do they do so because the mere fact of Bernanke speaking, regardless of the text, creates a trading situation where they can outsmart the other money in the market? And are they selling because their "cards" are telling them the economy will weaken over the next six months or only because they think the market will weaken over the next three days (partially because their own actions and the actions of some other big, like-minded traders will force the selling on the other side).

Another possibility is that small events can have major effects because they can suddenly reveal the underlying market sentiment. Just as the current crisis in Turkey began as a dispute over a park, the crisis isn't really about the dispute over the park, the park was only a trigger.

So there are a variety of scenarios in which a Fed announcement might coincide with big market movements which have almost nothing to do with the information in the announcement.

and maybe the "poker game" and expectations matters more at the zero lower bound, as Ryan Avent argues:

1. The low rates really have been an artifact of Fed policy, at least to a much higher degree than many of us had thought.
2. Emerging markets tanked on the Fed communication, and so we have indeed been exporting bubbles through a “reach for yield” mechanism.

For those of us who work in credit markets this is not a surprise at all - the difficulty is pin pointing when it's going to happen. The main benefit of QE was low interest rates and it was quite clear that QE1 caused credit compression in emerging markets (chart 7.1 in my book). Credit compression is the result of credit bubbles due to excessively low interest rates- and like all credit bubbles they come to an end with a few winners but mostly losers..

So which other views about the current macroeconomy will we need to revise?

The one about printing money and buying your own debt with it.

(We owe it to ourselves)^2

what about "residual policy uncertainty" as an explanation?

"unconventional policy" implies something new and relatively untested. being surprised should not surprising nor should it be a permanent drag on fundamentals.

Tyler - instead of listening to the Fed, you could have listened to the Bank of England instead. Try this paper which finds a significant reduction in yields in the UK due to QE by the Bank of England :
"The results show that QE reduced long maturity gilt yields by up to 95 basis points"

Bank of England officials, including Mervyn King, have always been very clear that QE reduces both nominal and real interest rates.

I have made this point many times in the past that monetary policy only makes sense when it is seen as an attempt to influence real interest rates .

The real move (pardon the pun!) over the last month has been in real interest rates which have gone up dramatically and turned positive again. A conclusion which I reached in a different context in another post :
"a move back from negative real rates territory towards positive real rates will likely have violent negative consequences for risky asset prices."

If macroeconomic theory cannot incorporate the role of monetary policy in influencing real interest rates, then so much the worse for macroeconomic theory.

In the charged, hostile public intellectual world, it is difficult to write: "I was wrong, I can't blame it on someone else or on facts not-in-evidence, I just was wrong." And it is far more difficult and rare to write: "Because I was wrong on that, I’ve been thinking about my other possible errors and here is a list for you to feed on, you commenters, you tweeters, you bloggers, you surly, ravenous band of miscreants, simonists, mountebanks, vagrants, reprobates, villeins and worse."

In all seriousness, thank you for this. In absence of seriousness, a warning about uncertainty, Professor Cowen: "The best lack all conviction, while the worst are full of passionate intensity, things fall apart; the centre cannot hold; Mere anarchy is loosed upon the world, And what rough beast, its hour come round at last, Slouches towards Bethlehem to be born?”

"I don’t think I ever wrote this view up" Then SHHHHHHHHH! No one knows you were wrong.

If it all comes crashing down, I bet you won't find a self-acknowledged economist anywhere.

Oh you'll find some polite young man who says, with evident satisfaction, "But I was a Transport Economist, actually".

Success has many fathers; failure is an orphan.

Support it or disagree with it, QE on the scale undertaken by the Fed is an experiment without precedent. I find Krugman's line of reasoning akin to a rain dance. If it rains, thank me. If it doesn't, we aren't dancing hard enough. The problem with the "monetary policy as sole determinant of the unemployment rate paradigm" is that it allows for no objective risk vs return evaluation of the Fed experiment. Intuitively the structural dimension of the US unemployment situation appears to warrant more serious attention by policy makers.

For those that do not look closely at global markets, I can say its my experience that the policies of the US Fed have been the major influence in all areas of global investment I can think of ever since QE commenced. That is as true for steel trading in Tianjin province as it is for bond traders in the US. My general concern is we have replaced the global market mechanism of supply and demand for the wisdom of a small group of individuals with US domestic policy goals and a limited toolkit.

How could you ever have thought that Fed policy wasn't driving down bond interest rates? The entire point of Fed policy was to drive down bond interest rates, in particular by purchasing US Federal gov't securities with fiat money (the Fed has been monetizing the deficit for several years now-- and note that other US note/bond buyers are mainly under regulatory coercion to buy) and by accepting bogus securities as collateral for low-interest loans to banks and other large market participants. The Fed drove down interest rates directly (by loaning at low rates) and indirectly (by competing with other sources of capital-- every time some wanna-be lender asked a large borrower for a higher rate than the Fed preferred, the Fed gave the borrower fiat money instead). The Fed has been keeping interest rates down throughout the economy by competing at the margin (with the side-effect of starving little old ladies with their capital in CD's).

The title of my blog would be "Not Even Wrong" but that's my question.

Also, was the economy still getting worse all the while rates kept going lower?

1. The Fed tightened policy before people thought they would, or they "unloosened" policy if you prefer, by reducing bond purchases.
2. If they unloosen purchases with even this anemic recovery, then they will also raise rates sooner than before.
3. Expected future rates are higher.
4. Therefore, long-term rates to up.

Basically, most arguments are 1. Rates are higher, 2. Therefore this. With efficient markets, long-term rates just mean future rates are expected to be higher. That may be due to higher economic growth or that the Fed will raise rates sooner with same conditions. One way of finding out is real rates vs. nominal rates, since inflation correlates strongly with NGDP growth. And real rates have gone up, suggesting that inflation expectations are flat or declining. When the Fed loosened policy like QE2's announcement, rates went up but inflation expectations went up as well.

John Taylor has pointed out that this isn't really a change in the flow, but a change in the expected stock. A change in the flow having an effect would look like a rise in rates after an EXPECTED decrease in purchases. An announcement about a future decrease in purchases decreases the expected future stock of purchases.

What a ridiculous post.

The Fed has not stopped purchasing bonds. So the higher interest rates can not be caused by the Fed reducing bond purchases.

Wait until the Fed stops purchasing bonds to claim that Krugman/Bernanke are wrong.

Interest rates are going up for the same reason the Fed hinted at winding down bond purchases. The economy is improving. Krugman said that this would happen.

So instead of a gotcha, you have the opposite.

Hmmm, expectations don't matter, but investors wait while the economy improves to pile in? That doesn't seem right.

The day economists start mentioning demographics is the day I start paying attention to economists.

Presumably if the tapering of QE purchases were starting when unemployment had fallen and growth was rapid, rates would have risen with the accumulation of good news and the tapering would NOT cause a rise in rates. I think we are seeing market surprise that the program is being interrupted prematurely.

1) In retrospect it shoud have been more obvious to all of us that the Fed owns the interest rates. As long as the Fed is credible, the inflation expectations (particularly in the long-term) set by the Fed control the rate and very little else matters.

2) The emerging markets are saying "We see less growth with this tighter policy." Someday we're going to look back and rue the lost productivity gains of this era.

Here's a fun exercise: imagine rates had just moved the same way, but for a diffferent reason: because the Fed had just raised their long-term inflation target. How do emerging markets respond? How do domestic markets respond?

I am not surprised Krugman took that position. He had to, because otherwise his demand for much greater fiscal stimulus would be absurd.

But I never had a doubt that the Fed was causing the rate curve to be lower. It is just supply and demand. Once we learned - I learned it from John Taylor's blog - that under QE the Fed was buying Treasuries in amounts greater than half of the annual new issuance - how could you not realize this was just a big (and entirely artificial) increase in demand for Treasuries, causing yields to plunge, that would obviously reverse once the surplus demand was removed? I am surprised it happened so fast, but at least I got the direction right. Just another example of Taylor right, Krugman wrong.

Could rising dollar and yields be explained by the Chinese/EM credit bubble bursting? The recent dystrofic credit growth in China has been partly financed by cheap dollars, in ever more leveraged carry trades (WMPs, PM/LCs). Now that these deals are unwound because of the expected end of suppressed UST yield, they create dollar currency demand, while simultaneously forcing the Chinese to liquidate their UST holdings because of bank liquidity fears.
The risk of a Chinese credit crisis now needs to be priced into USTs.

I think this just shows how tightly wound mortgage rates are. If mere talk from Bernanke causes rates to rise nearly 1% in under two months, then that's proof enough for me that the mortgage market is entirely Fed-driven. Not to mention that just buying $85 billion a month in MBS would be added demand that would keep rates down.

What's up to all, because I am actually eager of reading this blog's
post to be updated daily. It consists of fastidious stuff.

+2, Clear evidence that Tyler Cowen is not a ZMP.

Its such as you read my mind! You seem to grasp so much
about this, like you wrote the guide in it or something.
I think that you just could do with some percent to drive the message house a bit, however other
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” but of course theory has its limits.”
“Krugman has changed his views”
“all of this remains in great flux”

I like this link, so much I linked to it on my FB with notes below:

"Behold the wisdom of the Masters of Your Economic Fate [economists] and despair..."

[don't actually..America will be OK. You're fskced though]

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