Wednesday, June 19, 2024

The Fed is ‘playing with fire’ by not cutting rates, says creator of ‘Sahm Rule’ recession indicator

By Jeff Cox of CNBC. Excerpt:

"The Federal Reserve is risking tipping the economy into contraction by not cutting interest rates now, according to the author of a time-tested rule for when recessions happen.

Economist Claudia Sahm has shown that when the unemployment rate’s three-month average is half a percentage point higher than its 12-month low, the economy is in recession.

As the jobless level has ticked up in recent months, the “Sahm Rule” has generated increasing talk on Wall Street that what has been a strong labor market is showing cracks and pointing to potential trouble ahead. That in turn has generated speculation over when the Fed finally will start reducing interest rates.

Sahm, chief economist at New Century Advisors, said the central bank is taking a big risk by not moving now with gradual cuts: By not taking action, the Fed risks the Sahm Rule kicking in and, with it, a recession that potentially could force policymakers to take more drastic action.

“My baseline is not recession,” Sahm said. “But it’s a real risk, and I do not understand why the Fed is pushing that risk. I’m not sure what they’re waiting for.”

“The worst possible outcome at this point is for the Fed to cause an unnecessary recession,” she added.

Flashing a warning sign

As a numeric reading, the Sahm Rule stood at 0.37 following the May employment report from the Bureau of Labor Statistics that showed the unemployment rate rising to 4% for the first time since January 2022. That’s the highest the Sahm reading has been on an ascending basis since the early days of the Covid pandemic.

The value essentially represents the percentage point difference from the three-month unemployment rate average compared to its 12-month low, which in this case is 3.5%. A reading of 0.5 would represent an official trigger for the rule; a couple more months of 4% or better readings on the unemployment rate would make that happen.

The rule has applied for every recession dating back to at least 1948 and thus works as an effective warning sign when the value starts to increase."

"“The bad outcomes here could be pretty bad,” Sahm said. “From a risk management perspective, I have a hard time understanding the Fed’s unwillingness to cut and their just ceaseless tough talk on inflation.”

‘Playing with fire’

Sahm said Powell and his colleagues “are playing with fire” and should be paying attention to the rate of change in the labor market as a potential harbinger of danger ahead. Waiting for a “deterioration” in job gains, as Powell spoke of last week, is dangerous, she added.

“The recession indicator is based on changes for a reason. We’ve gone into recession with all different levels of unemployment,” Sahm said."

One possible optimistic data is the % of 25-54 year olds employed.

One weakness of the unemployment rate is that if people drop out of the labor force they cannot be counted as an unemployed person and the unemployment rate goes down. They are no longer actively seeking work and it might be because they are discouraged workers. The lower unemployment rate can be misleading in this case. People dropping out of the labor force might indicate a weak labor market.

We could look at the employment to population ratio instead, since that includes those not in the labor force. But that includes everyone over 16 and that means that senior citizens are in the group but many of them have retired. The more that retire, the lower this ratio would be and that might be misleading. It would not necessarily mean the labor market is weak.

But we have this ratio for people age 25-54 (which also eliminates many college age people who might not be looking for work).

It was 79.875% for all of 2022 & 80.667% for all of 2023. The average over the first five months of 2024 is 80.72%. So it does seem to be trending up, if only slightly.

Related posts:

What Causes Recessions? What Do Recessions Look Like? (2023)

The Sahm rule and recessions (2020) 

What ends expansions? (or what causes recessions according to Alan Blinder and Austan Goolsbee) (2019)

Are business cycles imbedded in longer cycles called financial cycles? (2019)

Monetary Policy and the Great Crash of 1929: A Bursting Bubble or Collapsing Fundamentals? (2018)

Some Bad News for Good News — Optimistic Forecasts Create Recessions (2018)

Tuesday, June 18, 2024

Inflation is mentally taxing

See Americans Really, Really Hate Inflation—and That’s a Big Problem for the Fed by Justin Lahart of The WSJ. Excerpts:

"Recent survey work conducted by Harvard University economist Stefanie Stantcheva and fellow researchers has underscored how much people dislike inflation. They found, for example, that people on average view a one percentage-point increase in the inflation rate as twice as bad as a one percentage-point increase in the unemployment rate. (The Labor Department on Friday reported that the May unemployment rate was 4%. Were that to rise to 5%, the ranks of the unemployed would swell by 1.7 million.)

Survey respondents’ reasons for disliking inflation weren’t just based on worries about rising prices eating into their buying power, but by a view that inflation is mentally taxing. Dealing with a straitened budget exacts a psychological toll as well as a financial one.

“It’s also an issue of complexity,” said Stantcheva. “Even if you didn’t tighten budget standards, inflation still requires you to rethink things all the time, to rebudget things, and it is basically a big cognitive load.”"

Related posts:

Store Brands Are Filling Up More of Your Shopping Cart (2024) 

People are on the look out for cheaper alternatives due to inflation

Consumers Fed Up With Food Costs Are Ditching Big Brands (2024) 

One thing that I always talked about with inflation was that one of its costs was all the things we had to do to avoid it. Consumers are making 8% more trips to different retailers as inflation continues to upend household budgets. They are going to more stores to find lower prices. But it costs time to do that and probably more money on gas.

Are Americans Worrying Too Much About Inflation? Two opposing views (2024)

The Era of One-Stop Grocery Shopping Is Over (2024)

When workers were paid twice a day and given half-hour shopping breaks (Germany, 1923

By mid-1923 workers were being paid as often as three times a day. Their wives would meet them, take the money and rush to the shops to exchange it for goods. However, by this time, more and more often, shops were empty. Storekeepers could not obtain goods or could not do business fast enough to protect their cash receipts. Farmers refused to bring produce into the city in return for worthless paper. The requirements to calculate and recalculate commercial transactions in the billions and trillions made it practically impossible to do business in paper Marks

Sunday, June 16, 2024

Demand & quantity demanded: What do they mean? The case of the oil market

See The World Will Be Swimming in Excess Oil by End of This Decade, IEA Says: Energy watchdog forecasts spare pumping capacity to rise as demand growth wanes and supplies surge. Excerpts:

"Oil-demand growth is set to peak by 2029 and start to contract the next year, reaching 105.4 million barrels a day in 2030 as the rollout of clean-energy technologies accelerates, according to the Paris-based organization. Meanwhile, oil-production capacity is set to increase to nearly 113.8 million barrels a day, driven by producers in the U.S. and the Americas."

Let's look at "oil demand growth." Demand is the relationship that price and quantity demanded have with each other. Think the downward sloping demand line. And quantity demanded is the amount consumers are willing to buy at a given price.

If we take the article literally, it means that every day consumers will be willing to buy 105.4 million more barrels than they did the day before. In a week, it would be over 700 million.

Why? Because an increase in demand means that consumers are willing to buy more at each and every price than they did the day before. When the article says "demand growth" that means demand shifting to the right.

The article probably meant that the total number of barrels of oil bought would be 105.4 million in 2030. But then that is quantity demanded and not demand.

Late the article says

"Despite the slowdown, global oil demand in 2030 is still forecast to rise by 3.2 million barrels a day from 2023"

Earlier it said oil growth would be 105.4 million per day. Now it says 3.2 million. A contradiction. Also, it should say that quantity demanded would be 3.2 million higher in 2030 than 2023, not demand.

"In advanced economies, demand is forecast to fall from around 45.7 million barrels per day in 2023 to 42.7 million barrels per day in 2030. Excluding the pandemic, the last time that oil demand was that low was in 1991, according to the IEA."

Again, they use the word demand when they should use quantity demanded.

"In the short term, the agency cut its forecast for global oil-demand growth to 960,000 barrels a day this year from previous estimates of 1.1 million barrels a day"

Same problem. Do they mean that at each and every price consumers will be willing to buy 960,000 more barrels? I don't think so.

Saturday, June 15, 2024

Tariffs are regressive: they fall more heavily on lower-income families who tend to spend more of their income on cheap imported goods

See Tariffs Are More Than Just Taxes. They Are a Tool of Geopolitics: Duties on Chinese imports may hurt low-income consumers, but something bigger is at stake: U.S. economic security by Greg Ip of The WSJ. Excerpts:

"Two new studies show tariffs are regressive, meaning they fall more heavily on lower-income families who tend to spend more of their income on cheap imported goods."

"In his definitive work “Clashing Over Commerce: A History of U.S. Trade Policy,” Dartmouth College economist Douglas Irwin shows that tariff policy has gone through three distinct phases since the 1700s.

From independence until the Civil War, Irwin writes, the purpose of tariffs was mainly revenue: They accounted for 90% of federal receipts. From the Civil War until the Great Depression, the purpose was restriction: protecting northern manufacturers, then represented by the newly dominant Republican party, from imports. 

A third era began with the passage of the Reciprocal Trade Agreements Act in 1934 empowering the president to negotiate lower duties if other countries did the same. Reciprocity remained the dominant paradigm after World War II as presidents of both parties sought to knock down other countries’ trade barriers through a mixture of carrots (trade deals) and sticks (targeted duties and quotas)."

"The tariffs he imposed on China and to which President Biden just added are a different animal altogether. They are partly about restriction and reciprocity—protecting nascent industries and prodding China to change its ways. But the more fundamental goal is realignment: diversifying U.S. trade away from China. Its dominance in numerous manufactured goods and processed minerals, officials fear, gives China too much influence over the U.S. and its allies’ economies and, ultimately, security. That fear has grown with the threat of a new “China shock” of cheap manufactured exports."

"Who pays tariffs depends on myriad factors. While several studies found U.S. importers did pay more because of tariffs, those costs weren’t necessarily passed on to consumers. Still, some researchers found the surge of imports from China following its entry into the World Trade Organization in 2001, while displacing millions of American workers, benefited most consumers through lower prices. Logically, tariffs would hurt those same consumers.  

Economists Amit Khandelwal of Yale University and Pablo Fajgelbaum of the University of California, Los Angeles illustrate this neatly by studying the increase in the “de minimis” exemption, below which small packages may enter the U.S. duty-free, to $800 from $200 in 2016. 

The authors found that 74% of direct shipments received in the poorest ZIP Code were de minimis, compared with 52% for the richest."

"At present, tariffs represent 2% of the value of imports. That would skyrocket to almost 17%, the highest since the passage of the Smoot-Hawley Tariff in 1930, if Trump is re-elected and carries out his threat to raise tariffs to 60% or more on China and 10% on the rest of the world"

"this would shrink the purchasing power of the 20% poorest households by 4.2%, but the top 1% by just 0.9%."

Related posts:

Life is full of tradeoffs: If we support American workers with trade restrictions it might mean more inflation (2023)

Life Is Full Of Tradeoffs: If We Want To Do More To Fight Climate Change We May Have To Lower Tariffs On Solar Panels Which Might Put U.S. Firms Out Of Business  (2021)

Mark Twain, Free Trade and Tariffs (2019)

What happened in some earlier U.S. trade Wars? (2019)

Abandoning free trade might threaten peace and stability across the globe (2017)

Interesting New Book On Trade And Tariffs By Marc-William Palen (2017)

Before You Criticize Free Trade, You Should Read Douglas Irwin's Book Free Trade Under Fire (2012)

Thursday, June 13, 2024

Thalidomide, The FDA and Type I & II Errors

Thalidomide was sold to pregnant women in the 1950s and early 1960s to cure morning sickness. It was made by the German company Grunenthal. It caused serious birth defects before being taken off the market.

Thalidomide used to come up in my micro classes since we sometimes read a chapter from the book The Economics of Public Issues that discussed the dilemma the FDA faces in approving drugs.

There is a danger that the FDA will make a Type I error, meaning an unsafe drug is allowed onto the market. To try to avoid that, they can test a new drug for a long time to make sure it is safe. But in the mean time people might be dying because they cannot get the drug. When that happens, it is called a Type II error. This happened with Septra, an antibiotic. 

The book reports that "in 2006, the FDA gave physicians the OK to use it (thalidomide) in treating bone marrow cancer.

Now there is a new book about Thalidomide & the FDA. It was reviewed recently in The WSJ. See ‘Frances Oldham Kelsey, the FDA, and the Battle Against Thalidomide’ Review: The Noble Bureaucrat by Sam Kean. The book he reviews is by Cheryl Krasnick Warsh. Excerpt:

"As Ms. Warsh makes clear, Kelsey’s stand against thalidomide helped transform the FDA’s regulation process, and the larger world of medicine. After thalidomide, the FDA instituted far more onerous requirements for drug applications. By 1969, Ms. Warsh notes, “submissions comprised an average of four volumes, each the size of a metropolitan area telephone book.” One application was said to be seven feet thick, a claim Kelsey at once laughed off as a “wild rumor.” But by the 1990s, applications often did reach 250 volumes. Not surprisingly, the approval process for new drugs has slowed drastically.

Ms. Warsh fails to discuss the tradeoffs of the glacial approval process—while we’re certainly spared some thalidomide-like tragedies, beneficial new drugs also take years longer to reach sick patients. During her career, Kelsey often quoted a lawyer who shepherded a drug-reform bill through Congress in 1938: “Conservatism in a scientific world may occasionally deprive the public and delay the acceptance of important discoveries. This loss is more than overbalanced by the immense social harm resulting from undisciplined and unsupported . . . curative claims.” I wonder whether AIDS activists in the 1980s—who excoriated the plodding FDA while waiting for potential treatments—would have agreed about what the true “social harm” was. There may not be any simple answers, but Ms. Warsh never broaches the subject.

To be fair, this book is a biography, not an analysis of drug regulation. But after the drama of the thalidomide scandal, Ms. Warsh’s account starts to read like what it is: the life of a bureaucrat. I was hungry for more analysis of Kelsey’s legacy—mostly positive, but not uniformly so. In the 1960s, Kelsey became a national star: President John Kennedy awarded her a medal at the White House in a ceremony attended by astronauts John Glenn and Alan Shepard. Since then, the sun has clearly set on Kelsey’s fame. But sunset is the time we cast the longest shadows."

Related posts:

The FDA, Masks and Type I & Type II Errors (2020)

Fraction of Covid-19 Rental Assistance Reaches Tenants and Landlords (follow up to a post on June 11) (2021)

Zombies might return and fighting them is art as well as science (2021)

Accommodations for disabled people and Type I & II Errors (2023)

Wednesday, June 12, 2024

The Seasonally Adjusted CPI Was up 0.0057% in May

Which is almost no change. Some news stories said the CPI was flat. In the graph below on the far right you can see that the line for April to May is flat. The numbers I show below will reflect this.

See Consumer Price Index for All Urban Consumers: All Items in U.S. City Average from FRED (Federal Reserve Economic Data) compiled by the Research Division at the Federal Reserve Bank of St. Louis for data on the seasonally adjusted CPI.

That site shows a graph but if you click on the Download button you will get the actual numbers in Microsoft Excel.

The Consumer Price Index for All Urban Consumers: All Items in U.S. City Average (CPIAUCSL) was 313.207 in April and 313.225 in May. Since 313.225/313.207 = 1.000057, that means it was up 0.0057% in May. If we had that every month for 12 months it would be up 0.07%. Which is also basically no change.

The last monthly change that was lower than 0.0057% was the -0.012% change in July 2022 (a slight decrease). 

It was 303.365 in May 2023. Since 313.225/303.365 = 1.0325, that means it was up 3.25% over the last 12 months.

The non-seasonally adjusted CPI was 314.069 in May and 304.127 in May 2023. That was up 3.27% also. So pretty close to the seasonally adjusted CPI. This is still above the Fed's target of 2.0% (although they prefer to use the Personal Consumption Expenditures Price Index which was 2.7% higher in May 2024 than May 2023).

For more information, see Inflation slows in May, with consumer prices up 3.3% from a year ago by Jeff Cox of CNBC. Excerpts:

"The consumer price index showed no increase in May as inflation slightly loosened its stubborn grip on the U.S. economy, the Labor Department reported Wednesday.

The CPI, a broad inflation gauge that measures a basket of goods and services costs across the U.S. economy, held flat on the month though it increased 3.3% from a year ago, according to the department’s Bureau of Labor Statistics."

"Excluding volatile food and energy prices, core CPI increased 0.2% on the month and 3.4% from a year ago"

The article also discusses what is going up and what is going on. There is a graph of the monthly year-over-year percent change in prices and core prices going back almost 3 years.

Other related links:

Consumer Price Index Data from 1913 to 2023

Personal Consumption Expenditures Price Index 

The Bureau of Labor Statistics makes seasonal adjustments. See Consumer Price Index Summary.

Monday, June 10, 2024

Monetary Policy and the Great Crash of 1929: A Bursting Bubble or Collapsing Fundamentals?

By Timothy Cogley. He was then at the Federal Reserve Bank of San Francisco (1999). He is now at New York University.

"In recent years, a number of economists have expressed concern that the stock market is overvalued. Some have compared the situation with the 1920s, warning that the market may be headed for a similar collapse. Indeed, some suggest that lax monetary policy contributed to the Great Crash and have argued that current monetary policy is also dangerously lax. For example, an April 1998 Economist article stated:
In the late 1920s, the Fed was also reluctant to raise interest rates in response to soaring share prices, leaving rampant bank lending to push prices higher still. When the Fed did belatedly act, the bubble burst with a vengeance.
To avoid the same mistake, The Economist suggested that it would be better for the Fed to take deliberate, preemptive steps to deflate the bubble in share prices. It warned that the bubble could harm the economy if it were to burst suddenly, reducing the value of collateral assets and bringing on a recession. The article went on to say that “the longer that asset prices continue to be pumped up by easy money, the more inflated the bubble will become and the more painful the economic after-effects when it bursts,” and it concluded that “the Fed needs to raise interest rates.”

In this Economic Letter, I argue that The Economist has misinterpreted the lessons of the Great Crash. A closer examination of the events of the late 1920s suggests it is mistaken on at least four points. First, stock prices were not obviously overvalued at the end of 1927. Second, starting in 1928 the Fed shifted toward increasingly tight monetary policy, motivated in large part by a concern about speculation in the stock market. Third, tight monetary policy probably did contribute to a fall in share prices in 1929. And fourth, the depth of the contraction in economic activity probably had less to do with the magnitude of the crash and more to do with the fact that the Fed continued a tight money policy after the crash. Hence, rather than illustrating the dangers of standing on the sidelines, the events of 1928-1930 actually provide a case study of the risks associated with a deliberate attempt to puncture a speculative bubble.

Monetary Policy 1927-1930 

In 1927, there was a mild recession in the United States. In addition, Britain was threatened by a balance of payments crisis whose proximate cause was a demand by France to convert a large quantity of sterling reserves into gold. Thus, both domestic and international conditions inclined the Fed to shift toward easing. The resulting fall in interest rates helped damp the decline in domestic economic activity and facilitated an outflow of gold toward Britain and France.

Should the Fed have refrained from easing in 1927 because of concerns that the stock market might be overvalued? Measures of conventional valuation suggest the answer is no, for there was no obvious sign of an emerging bubble at that time. For example, Figure 1 illustrates the price-dividend ratio on the value-weighted New York Stock Exchange (NYSE) portfolio. At the end of 1927, the price-dividend ratio was around 23, which is actually a bit below its long-run average of 25. Although share prices had risen rapidly in the 1920s, so had dividends. Given that the price-dividend ratio was slightly below average, the Fed would have had little reason to refrain from easing in a recession year or to decline assistance to a gold standard partner in maintaining balance of payments equilibrium.


In any case, equity prices began to accelerate in January 1928, and they rose by 39% for the year. Dividend payments also grew rapidly that year, and the price-dividend ratio increased by 27%.
Motivated by a concern about speculation in the stock market, the Fed responded aggressively. Between January and July 1928 the Fed raised the discount rate from 3.5% to 5%. Because nominal prices were falling, the latter translated into a real discount rate of 6%, which is quite high in a year following a recession. At the same time, the Fed engaged in extensive open market operations to drain reserves from the banking system. Hamilton (1987) reports that it sold more than three-quarters of its total stock of government securities: “in terms of the magnitudes consciously controlled by the Federal Reserve, it would have been difficult to design a more contractionary policy.”

Furthermore, as Eichengreen (1992) has emphasized, monetary policy was tight not only in the U.S. but also throughout much of the rest of the world. By that time, roughly three dozen countries had returned to the gold standard, and when the Fed tightened, many countries faced a dilemma: Unless their central banks also tightened, lending from the U.S. would be disrupted and their balance of payments would move toward a deficit. In that case, they would either have to devalue or abandon the gold standard altogether. The former option was unattractive for countries with dollar-denominated debts, and the latter was virtually out of the question at the time, especially for countries where restoration of the gold standard had been painful and difficult.

The alternative was to conform with the Fed. By shifting toward more contractionary monetary policies, other gold standard countries could ensure that domestic interest rates would rise in parallel with those in the U.S. and would be able to maintain balance of payments equilibrium. This explains, for example, why the Bank of England shifted toward tighter policy in 1928, three years after Britain had entered a slump. It also explains why countries still rebuilding from WWI would adopt contractionary policies.

The implication is that monetary policy was far more restrictive than a purely domestic perspective might suggest. In 1928 there was a synchronized, global contraction of monetary policy, which occurred primarily because the Fed was concerned about stock prices. These actions had predictable effects on economic activity. By the second quarter of 1929 it was apparent that economic activity was slowing. The U.S. economy peaked in August and fell into a recession in September.

What were the effects on the stock market? At the beginning of 1929, it seemed that the contractionary measures taken in 1928 were working. The NYSE price-dividend ratio reached a local peak in January and then fell gradually through the first half of the year. Thus, it appeared that stock prices had stabilized. Furthermore, shares still were not obviously overvalued. The local peak was reached at 30.5, which is roughly 20% above the long-term average. Dividends had grown rapidly through 1928, and investors projecting similar growth rates forward may have been willing to settle for dividend yields somewhat below the long-run average.

Monetary policy was on hold during the first half of 1929, and some economists have argued that inaction in this period was responsible for the events that followed. But three observations are relevant here. First, as mentioned above, price-dividend ratios had stabilized and were falling gradually. To a contemporary observer, it would have appeared that the actions of 1928 were having the intended effects. Second, it was becoming increasingly apparent that general economic activity was slowing, and many other countries already had entered recessions. And third, while monetary policy was not becoming tighter, it was still quite tight. Short-term real interest rates were still around 6%, and there was no growth in the monetary base.

Price-dividend ratios continued to fall until July 1929, but then prices began to take off. In August, the Fed raised the discount rate by another percentage point to 6%. The stock market peaked in the first week of September. It is worth noting that at its peak the price-dividend ratio was 32.8, which is well below values reached in the 1960s or 1990s. Share prices declined in a more or less orderly fashion until the end of October, but then the market crashed. From its peak, the price-dividend ratio fell roughly 30%, to a level roughly similar to that prevailing at the beginning of 1928, when the Fed began to tighten.

In the immediate aftermath of the crash, the New York Fed took prompt and decisive action to ease credit conditions. When investors attempted to liquidate their equity holdings, many lenders also called their loans to securities brokers. With the encouragement of officials at the New York Fed, many of these brokers’ loans were taken over by New York banks, who were allowed to borrow freely at the discount window for this purpose. The New York Fed also bought government securities on its own account in order to inject reserves into the banking system. In this way, they were able to contain an incipient liquidity crisis and prevent the crash from spreading to money markets.

But this respite from tight money proved to be temporary. After the liquidity crisis had been contained, monetary policy once again resumed a contractionary stance. Throughout 1930, officials at the New York Fed repeatedly proposed that the System buy government securities on the open market, but they were systematically rebuffed. The reasons other members of the Federal Reserve gave for opposing monetary expansion are instructive. Several felt that much of the investment undertaken in the previous expansion was fundamentally unsound and that the economy could not recover until it was scrapped. Others felt that a monetary expansion would only ignite another round of speculative activity, perhaps even in the stock market. In any event, monetary policy remained contractionary; the monetary aggregates fell by 2% to 4%, and long- term real interest rates increased.

By maintaining a contractionary stance throughout 1930, after a recession had already begun, the Fed contributed to a further decline in economic activity and share prices. By the end of the year, the price-dividend ratio had fallen to 16.6, or roughly 34% below the long-run average. By then, there was a consensus that speculative activity had been eliminated!

Were the Fed’s actions stabilizing or destabilizing?

If one grants that a speculative bubble existed at the beginning of 1928, when the Fed began to tighten, then stocks must have still been overvalued in the aftermath of the crash. After all, price-dividend ratios were about the same in the dark days of November 1929 as at the beginning of 1928, and fundamentals must surely have taken a turn for the worse. If equities were still overvalued, it follows that a further dose of contractionary monetary policy was needed to purge speculative elements from the market. Perhaps this is what motivated the famous advice of Treasury Secretary Andrew Mellon to President Herbert Hoover, to “liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” To argue that the actions of 1928-1930 were stabilizing, one must adopt the liquidationist position.

On the other hand, if one interprets the Great Crash as a bursting bubble, so that shares were more or less properly valued in the aftermath, then it follows that they were probably also not far from their fundamental values at the start of 1928, when the Fed began to tighten. Again, prices and price-dividend ratios were about the same after the crash, and fundamentals had surely become less favorable. According to this interpretation, the Fed’s initial actions may have been destabilizing, and the actions of 1930 certainly were.


In retrospect, it seems that the lesson of the Great Crash is more about the difficulty of identifying speculative bubbles and the risks associated with aggressive actions conditioned on noisy observations. In the critical years 1928 to 1930, the Fed did not stand on the sidelines and allow asset prices to soar unabated. On the contrary, its policy represented a striking example of The Economist’s recommendation: a deliberate, preemptive strike against an (apparent) bubble. The Fed succeeded in putting a halt to the rapid increase in share prices, but in doing so it may have contributed one of the main impulses for the Great Depression."