Thursday, March 26, 2015

Fed has no effect on the economy

The Fed follows the market, and often has no effect on the market. And nobody else than Christopher A. Sims, Nobel Prize in Econ 2011 winner says this (explicitly), in his work, which you can get a sample of online. Sims found a lag between Fed action and an economy’s response, with two key points: often the action and response were uncorrelated (had no effect), and the Fed *reacted* to the market in setting rates. BTW Sims is NOT a ‘real business cycle’ advocate, so you cannot say he is blinded by this framework. Source: – Leeper, Sims, and Zha (1996). “2 Another robust conclusion, common across these models, is that a large fraction of the variation in monetary policy instruments is attributable to systematic ***reaction*** by policy authorities to the state of the economy. This is of course what we would expect of good monetary policy, but it is also the reason why using the historical behavior of aggregate time series to uncover the effects of monetary policy is difficult. The size of effects attributed to shifts in monetary policy varies across specifications of economic behavior. We show, though, that most of the specifications imply that ***only a modest*** portion (or in some cases, ***essentially none***) of the variance of output or prices in the US since 1960 is attributable to shifts in monetary policy. Furthermore, we point out substantive problems in the models that imply large real effects, and argue that correcting these problems lowers the implied size of the real effects.”


  1. From the comments of the paper, Bernanke said this: “monetary policy responds strongly to the economy-that is, there is a large endogenous component to policy”. Simple translation: the Fed *follows* the market, does not lead the market. Hence monetarism is impotent.

    From Bernanke’s response, you can tell he is straining (and clearly uncomfortable) with the main problem of monetarism: there’s no predictive effect between what the Fed does and what the economy does. Only by using VAR techniques can a weak ‘effect’ be teased out of the data, and it’s clearly not what textbooks teach. Despite this important paper, most monetarists have (1) never discussed the work of Sims on this blog, and, (2) think there is a simple ’cause-and-effect’ between what the Fed does and what the economy does, contrary to Sims teachings.

  2. What Does Monetary Policy Do? ERIC M. LEEPER (Indiana University) CHRISTOPHER A. SIMS (Yale University, Winner of the 2011 Nobel Prize in Economics) TAO ZHA (Federal Reserve Bank of Atlanta) P. 17 “ Part of the strength of the view that monetary policy has been an important generator of business cycle fluctuations comes from certain patterns in the data, apparent to the eye. For example, as figure 1 shows, most postwar recessions in the United States have been preceded by rising interest rates. If one therefore concludes that most postwar reces- sions in the United States have been preceded by periods of monetary tightening, the evidence for an important role of monetary policy in generating recessions seems strong. While it can be shown that one variable leading another in timing is neither a necessary nor a sufficient condition for its being predetermined in a bivariate system of the form of equation 1, it is often assumed, probably correctly, that the two conditions are at least likely to occur together; so a graph like this influences beliefs about the effects of monetary policy. But a little reflection turns up problems of interpretation-identification problems-that are pervasive in this area. In general, interest rates were rising from the 1950s through the 1970s, but interest rates fall sharply after business cycle peaks. How much of the pattern that strikes the eye comes simply from the rising trend interacting with the post-peak rate drops? The only cyclical peak that is not preceded by an increase in interest rates is also the only peak since the early 1980s- that is, the only one to occur during a period of generally declining interest rates. Interest rates are cyclical variables. A number of other variables show patterns like that in figure 1. For example, the producer price index for crude materials (PCM), shown in figure 2, presents a pattern very similar to that in figure 1 for the period since 1960, if anything, with more clearly defined cyclical timing. In order to control inflation, monetary policy must set interest rates systematically, react ing to the state of the economy. If it does so, then whether or not it influences real activity, a pattern like figure 1 could easily emerge. In what might be regarded as an early real business cycle model,James Tobin showed that the timing patterns that monetarists had been documenting in order to support models in which monetary policy contributes to generating cycles could also emerge in a model in which monetary policy plays no such role.

    1. Continued...He [Tobin] answered the rich array of informally interpreted time-series evidence presented by Milton Friedman and other monetarists with a simple dynamic general-equilibrium model that provides an alternative interpretation of essentially the same facts. Although both the analysis of the empirical evidence and the theoretical models have since grown more complex, in many respects the interplay between data and models today echoes the Friedman-Tobin debate.

  3. Ray since you were kind enough to stop by at my place I figured I'd respond in kind.

    Just 2 blogs in 7 years-prolific, huh? LOL. You'd probably have more visitors if you wrote more often.

    On the other hand maybe that's not what you're after.

    In reading this I feel like you make a very controversial claim-almost no one believes a CB has no effect whatsoever-as opposed to someone like Major Freedom who thinks all the effects are bad.

    I'm not sure I follow the steps at how you arrive at this view. However, more importantly I feel there is something missing: let's say you're right?

    So what? What changes if we believe the Fed has no effect on anything? If there is no effect why even criticize it at all?

    Major and other hardcore Rothbardians like him think it just destroys price signals. But if it has no effect what do you have left to criticize?

  4. You see, for me that's always the real game. So what? If X is so then so what? So if the Fed has no effect on the economy, positive or negative, then so what?

    How does knowing this change our lives?

    Like with Sumner's NGDPLT futures game there's clearly some implications whether you like them or not. what are your implications?

    1. More evidence, evilsax, that the Great Recession was 'cured on its own'. The implications are enormous...


      Dean Baker
      The Guardian Unlimited, February 16, 2012

      Following this default, Argentina’s economy went into a freefall for roughly three months. Banks were insolvent, families and businesses could not get access to their savings, and normal business-dealing became almost impossible.

      However, by the second quarter of 2002, the government had largely pasted things together to the point that the economy had stabilized. It began growing rapidly in the third quarter of 2002 and continued to grow rapidly until the world recession slowed the economy in 2008. By the middle of 2009, it had recovered all the ground it had lost in the initial crisis after the default.

      Based on the experience of Argentina, we can say that in the case of a full meltdown, we might have seen three months of freefall (even worse that we actually experienced from September of 2008 to April of 2009), followed by three months of stability and then a return to growth six months out. Of course it’s possible that our policy crew of Ben Bernanke, Larry Summers, and Timothy Geithner may not be as competent as the team in Argentina, but even if we double the time periods, we get six months of freefall and three years to get back to pre-crisis levels of output. That’s bad news for sure, but quite a bit short of anything that could merit the title of a “Great Depression.”