Federal Funds Rate: PGL Confuses January and April

Update II: Thanks to Dean, Bill Polley, and K Harris. I knew there was an unscheduled meeting on 4/18/2001 where the FED cut interest rates by 0.5% but it turns out that the 1/31/2001 meeting where they did the same was also unscheduled. It would seem that the FED in 2001 was acting proactively to shore up aggregate demand.

It is a very rare day that Dean Baker makes a mistake but we have him on a minor one:

The coverage of the Fed’s half point cut in interest rates yesterday highlighted the enthusiastic response of the markets. According to much of the coverage, the markets soared yesterday because they are now confident that Bernanke will move aggressively to try to counteract a recession. A bit of history would have been useful to include in this context. As some articles noted, this cut bears a resemblance to the Fed’s 0.5 percentage point cut in January of 2001 at an unscheduled emergency meeting. That cut also led to a very enthusiastic response from Wall Street. The Dow rose 2.8 percent following that cut and the Nasdaq jumped by a record 14.2 percent. In reporting on the significance of the cut, the NYT quoted Bruce Steinberg, chief economist at Merrill Lynch: “there’s a simple message, the Fed will do whatever it takes to keep the U.S. economy from going down the tubes.” Mr. Steinberg may have been right about the Fed’s intentions. It did continue to cut interest rates, lowering the federal funds rate by a total of 5.5 percentage points to 1.0 percent, the lowest rate since the mid-fifties. However, this rate cutting did not prevent the economy from falling into a recession. It began to lose jobs just a month after the January rate cut. In spite of the Fed’s aggressive rate cutting, the economy remained so weak that it took four full years to once again reach the employment levels of February 2001. The lesson from the 2001 experience is that cutting interest rates is not necessarily a very effective tool in counteracting the impact of a collapsing asset bubble.

Dean’s larger point is right so you may have missed the minor point. Fortunately, we have an April 18, 2001 by Anya Schiffrin:

Stock investors are cheering the Federal Reserve’s decision to cut interest rates at a surprise meeting Wednesday, but it doesn’t appear that Alan Greenspan & Co. were talking to them. The Fed, which slashed the federal funds rate to a seven-year low of 4.5% from 5%, and the discount rate to 4% from 4.5%, seems to have been intent on spurring investment by U.S. companies. Getting companies to continue spending is key if the economy is to grow, and the Fed said in its statement that it is worried that capital investment has “continued to soften.” This softening, combined with slow growth overseas and the effect of layoffs and the declining stock market on consumer spending “threatens to keep the pace of economic activity unacceptably weak.”

It seems Dean’s larger point is borne out even if he had the date of this surprise 0.5 percent decline off by a few months. Back then – as is the case now – the fear is that the IS curve has shifted inwards. Lower interest rates are supposed to move us along the IS curve back to full employment but if the inward shift of the IS curve is large enough and if the interest elasticity of the IS curve is small enough, aggregate demand might still decline.

Now you might ask – wouldn’t a large decline in interest rates still reverse the decline in aggregate demand? Maybe but check out our graph of the Federal funds rate from early 2001 to late 2004. The FED did massively lower interest rates and we did eventually see a reversal of weak aggregate demand. But as we noted here, John Cassidy’s claim that we had a robust recovery in 2002 is flat wrong. I wonder if Brad DeLong got this across to Mr. Cassidy when they appeared on Larry Mantle’s radio show?

Update: On January 31, 2001, the FED met and cut the target rate from 6 percent to 5.5 percent and expressed confidence that we would avoid a recession:

Consumer and business confidence has eroded further, exacerbated by rising energy costs that continue to drain consumer purchasing power and press on business profit margins. Partly as a consequence, retail sales and business spending on capital equipment have weakened appreciably. In response, manufacturing production has been cut back sharply, with new technologies appearing to have accelerated the response of production and demand to potential excesses in the stock of inventories and capital equipment. Taken together, and with inflation contained, these circumstances have called for a rapid and forceful response of monetary policy. The longer-term advances in technology and accompanying gains in productivity, however, exhibit few signs of abating and these gains, along with the lower interest rates, should support growth of the economy over time. Nonetheless, the Committee continues to believe that against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.

The FED statement after that surprise decision on April 18, 2001 can be found here and its tone was less optimistic than the tone back on January 31, 2001.