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cthulu2016

(10,960 posts)
Sun Aug 25, 2013, 04:35 PM Aug 2013

The story told by Fed Interest Rates (2007-2014)

This post is not meant to be contentious, but being a description of history it does feature some good guys and bad guys and value judgments.



(If the chart isn't loading, you can see it here: http://krugman.blogs.nytimes.com/2013/08/24/the-macroeconomics-of-sisyphus/ )

This chart shows the Federal Reserve's efforts to stimulate or depress economic activity in the USA via their effective control of Interest Rates. Fed interest rate policy is the single most powerful economic policy tool in the world. Not the single most powerful force, but a big one and the most powerful thing set up to be used as a policy tool.

The Fed has induced many of our recessions by tightening money (to prevent or restrain inflation). The Fed Funds rate is also the primary recession-fixing mechanism.

The federal government sometimes uses fiscal stimulus to spur the economy when things are really bad, but monetary policy is typically the first and most dramatically effective line of defense. The independence of the Fed is vital because a runaway economy can create destructively high inflation, and no political process is ever going to slow down the economy as a stated goal. Just try running on that platform! (The Republicans are all about wrecking the economy because the President is a Democrat, but they will never state that their policy goal is slowing the economy.)

I want to explain why some people went absolutely ape-shit on the topic of fiscal stimulus (short-hand: Federal borrowing for the purpose of giving the borrowed money to somebody who would spend it in the economy, in the short-term) during the winter of 2008-2009.


Late in 2007 the Fed saw that the housing bubble was deflating and knew that would not end well for the broader economy. Interest rates were cut. Notice that they were cut before the recession started. As the recession took hold (a recession that most people didn't yet know we were in because recessions are defined only in retrospect) the Fed cut rates like crazy, down to 2%, and then dug in at that level. An interest rate below inflation is literally giving away money (people have gone to jail for accepting an interest-free loan as a bribe), and inflation is almost always over 2%, so a 2% Fed Rate seemed very, very low.

Then the investment banks blew up in September, 2008. The Fed reacted (correctly) like a passenger in a hot-air balloon that just ripped open along one side. They threw every bit of ballast overboard, taking rates down to as low as they could possibly go. The absolute maximum stimulus via interest rates.

The preferred and standard policy tool for fighting a recession was kaput, at that point even though the collapse was just getting rolling.
If the economic collapse was The Battle of Britain, the Fed Funds rate hitting zero would represent the destruction of the last RAF fighter plane (first line of defense) with only anti-aircraft guns remaining to defend the island.

The Fed did not cut the Fed Rate by 2% points (from 2% to 0%) because 2% was the right sized cut. It was the maximum possible cut. If the Fed could have cut 5% or even as much as 8% they would have, given the size of the demand shortfall in the economy.

The famous stimulus debate happened in a world where the Fed was already out of bullets. Congress had to take over the Fed's stimulation job in addition to Congresses own stimulation responsibility.

So, of course, being a nation of ninnies, we began debating what "sounded like" a big number to somebody who had never really given it much thought!

The government should have borrowed $2 trillion and dispensed it to the populace in cash and checks as fast as possible, but that idea was obviously crazy... not because there was anything the least bit crazy about it, but because it sounded odd or something.

A congress that had just been handed the Fed's job ON TOP OF their own job was arguing about relative pocket change. Gee, which is right? A stimulus package full of some stuff that would get into the economy for a long time of $650 billion or one of $850 billion?

And this was based on what "sounded" like a big number. The hole blown in the economy was known to be trillions and trillions of dollars and the partisan policy divide was between weak-ass on the one side and lame on the other.

We can quantify how much government borrow-and-disperse it takes to equal a point of interest rate cut and we had to make up for at least 3-5% of such cuts just to simulate the effect of expected, dsired but situationally impossible Fed monetary policy response... before even getting into additional fiscal stimulus.

And this was a housing collapse recession, meaning that residential construction, the sector that usually leads us OUT of recessions, in bioth spending and employment. was as dead in the water as the Fed.

The biggest crisis most of us had ever seen (made 9/11 look like nothing, BTW) and our political system was incapable of even considering anything that could plausibly be a right answer. We didn't reject right answers. Right answers were not even in the mix!

In the Battle of Britain analogy, it would be like the RAF folded up entirely and all war planning became an argument about whether anti-aircraft gun battery should be issued two shells or three shells to fire at Luftwaffe incoming, because issuing more could lead to a shortage of shells.

No shit! You use all your anti-aircraft shells when that thing happens they were made for... being the last line of defense of a nation against brutal nation-threatening aerial attack that was happening right then! What were they waiting for? Godzilla?! (Larry Summers actually said a too-small stimulus would be good since it would make it easier to later ask Congress for more. Really. He did say that.)

Blowing out the deficit in 2008-2009 is why the Federal Government is authorized to borrow money in the first fucking place. Because in an emergency it might need that power! But we had (on both sides of the aisle, though the Republicans were, or course, worse, people fretting about how preventing a jobless lost-decade, preventing the loss of all gains made by minorities since 1992, preventing a potentially permanent revision of American expectations, might make the deficit bigger. Really. That shit happened.

Someday the whole incident will be viewed with amazed horror... like we view the people in the Great Depression who thought the gold standard was the answer.

And that is why some "crazies" were running around with their hair on fire at the time, and who those same "crazies" remain unimpressed with some of the "reasonable stewardship" of our economy.

(And none of this means that Obama could have magically forced Congress to do the right thing, but since he didn't ask, or even contemplate doing the right thing it's a moot point. Almost everyone within our political system flat fucking blew it.)

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The story told by Fed Interest Rates (2007-2014) (Original Post) cthulu2016 Aug 2013 OP
. cthulu2016 Aug 2013 #1
The Fed is actually powerless Benton D Struckcheon Aug 2013 #2

Benton D Struckcheon

(2,347 posts)
2. The Fed is actually powerless
Sun Aug 25, 2013, 05:55 PM
Aug 2013

Point of fact: the Fed Funds rate IS NOT SET BY THE FED. No, I'm not making that up. I worked in a big bank for years, side by side with their Fed Funds traders. It's set by the banks, in a market for funds that the Fed supervises, because it's tied to the banks' reserve requirements.
The Fed sets a target for the rate. But the Fed itself knows it has no real control over the rate itself. If banks need funds, the rate will be bid up. If not, it will collapse.
No one needed funds for lending in 2008, so it collapsed. Actually, even crazier, no one was going to lend to another bank because no one trusted anyone. So the only source of funds was going to be the Fed itself, through its discount window, and through the only rate it directly controls: the discount rate. In that circumstance, the target for Fed Funds could have been -10% and it would have been completely academic. As it was.
The rate will rise when the economy grows to such an extent that there is enough of a demand for funds from the banks to lend out to others that it is forced up. At that point the Fed will step in and set a new target at a higher point. It will be meaningless, because the rate will have already risen to the new target point, and maybe beyond.

Fiscal policy is the only policy that works. Old time Keynesians know this. That knowledge has been lost, unfortunately. Doesn't make it any less true.

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