Arnold Kling  

My Thoughts on Monetary Policy

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1. If you believe that aggregate demand matters, then monetary policy is too tight.

2. We won't know whether or not to believe that aggregate demand matters until we see higher inflation. If we see 3 percent inflation or more for six months and no improvement in unemployment, then those of us who are skeptical of aggregate demand can say "told ya so." But as long as inflation is as low as it is, it remains an open question.

3. I don't understand why the Fed is still paying interest on reserves.

4. Some prominent Republican politicians oppose monetary expansion. I think they are wrong, but I assume that their motives are sincere.

5. Some prominent policy professionals, with names like Volcker, Rajan, and Taylor, also oppose monetary expansion. Again, I think they are wrong, but I assume that their motives are sincere.

6. As Scott Sumner has suggested, there may be a lot of folk economics out there which says that monetary expansion causes inflation but fiscal expansion does not. This is contrary to the theory of AS and AD.

7. I can think of at least three reasons why the Fed is not pursuing expansion with more determination. First, current policy is much closer to optimal for banks than it is for the country as a whole. This suggests a Fed controlled by banks. Second, the Fed may be intimidated by those who oppose faster expansion. Third, the Fed is just very slow to change direction. One story for the 1970s is that the Fed kept under-estimating the shifts in the Phillips Curve and the increases in the natural rate of unemployment. It kept following inflationary policies because it was slow to adapt to reality. Similarly, it appears now that the Fed is slow to adapt to downward shifts in aggregate demand. It is adjusting gradually while conditions are deteriorating rapidly. In the 1970s, the Fed took too long to tighten, and now it is taking too long to loosen.


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CATEGORIES: Monetary Policy



COMMENTS (19 to date)
Ghengis Khak writes:
3. I don't understand why the Fed is still paying interest on reserves.

From a technical standpoint it doesn't make sense, but a cronyism-driven story pretty neatly explains it.

tk writes:

What would be your best guess on number 3? It may be the wrong policy, but there must be some reasoning behind it, right? Is it just to funnel money to a banking sector that may still be more fragile than it appears?

Becon writes:

1.5% inflation (3%/year for six months) is a tiny price to pay to answer the AD question.

brendan writes:

Rajan talked lots about Fed induced asset bubbles in his book and elsewhere. I guess that would be one other potential reason for a reluctance to be more aggressive.

joecushing writes:

Some would say that the inflation rate is already 10%. It's also worth pointing out that the fed created more money in this downturn than in its entire history before. That's the definition of inflation--or at least it used to be. Rising prices are just a symptom of inflation and not inflation itself. I'm not sure inflation would be all that bad though. If my nominal wages doubled in the next 3 years, I could pay off my up side down mortgage in 3 years. That would be a great tranfer of wealth from my lender to me.

B.B. writes:

In a "Ricardian" economy, a fiscal "stimulus" of a tax cut now, funded by a tax hike later, does not change aggregate demand and so does not change the price level.

But a permanent helicopter drop of currency would expand aggregate demand and ultimately the price level.

Also,the issue is what real interest rate equates savings and investment at full employment. Suppose it -5%. The nominal short rate is zero. We need 5% inflation to fix the problem. If we get 3% inflation, that may help, but it won't fix the problem.

andy writes:

Is it possible to not believe AD _and_ at the same agree with monetary expansion? If it is, what would be the arguments for the monetary expansion?

kyle8 writes:

At this time I don't know what to believe, I fear too much money expansion as we have seen some signs of inflation in the last year.

On the other hand, we have not seen nearly as much inflation as we might expect for so much money creation, and the economy is tanking again, everything slowing down.

I just do not think that anything the Fed does at this point will help much and nearly everything they try could cause more harm.

8 writes:

tk:

What would be your best guess on number 3?

Slowly recapitalizing insolvent banks.

Lord writes:

Sincere as in wanting to win the next election?

MikeDC writes:

I was re-read Taylor's latestop-ed this morning and suddenly it blinded me with logic.

The default assumption most knowledgeable folks have made is the Fed hasn't been serious about unemployment and hasn't taken "extraordinary measures" because they haven't generated any inflation. In fact, they've not even hit their inflation targets. So really, their price stability mandate isn't getting much love either.

So what the hell are they doing? Well, Taylor talks about low rates, and it reminds me that the Fed has been going crazy for low rates. To the exclusion of everything else.

And the logic is right there in Econ 101. Low rates -> more borrowing -> more jobs! Unlike real monetary policy, even the guy on the street knows this and might even know the Fed has something to do with interest rates.

So that's what they're doing. Striving to meet their employment mandate to the detriment of everything else, by going balls to the wall over a policy that won't work? Surely they can't be so dumb, but stupidity is usually the more accurate excuse than evil.

And in that context, Taylor's argument to eliminate the employment mandate to boost employment is downright genius. The Fed gets to ignore interest rates and employment rates entirely, and get back to... hitting the inflation target they keep missing in aggregate demand killing ways.

Philo writes:

Like Arnold, and Ghengis Khak, and tk, and (probably) most other people, "I don't understand why the Fed is still paying interest on reserves." (Is it really just cronyism?) Does Bernanke ever get asked about this at his press conferences? If so, what is his answer? If not, why not; is this a failure of the press corps?

@8: the FDIC says almost all the banks are solvent.

Shayne Cook writes:

On #7, and monetary policy conventional wisdom in general ...

Conventional economics wisdom regarding monetary policy - as reflected in texts, this post and several of the comments - assumes that central bank actions directly affect only its national economy. That may be the case in the past, for closed economies or completely dominant economies. But the situation the U.S. Federal Reserve (Bernanke, et.a.l) faces is vastly more dynamic.

Central to the notion of monetary policy is the role of the central bank to estimate the demand for money within an economy and supply a "just right" amount - not too "loose" and not too "tight".

But the U.S. dollar is the global reserve currency as well as the currency denomination for nearly every world-traded commodity (even more so given the problems of the Euro Zone and its currency). That fact requires the U.S. Federal Reserve to estimate global demand, not just national demand, for U.S. dollars, and then attempt to supply a "just right" amount - to the world.

It's a precarious and historically unique position for any central bank. With the BRIC phenomena and all of its implications, the U.S. economy is no longer so dominant that its demand for money alone can suffice as an indicator for appropriate "monetary policy". The Fed's perspective must be globally aware. Global demand for U.S. currency must be considered - and it is dramatic - or the U.S. dollar ceases to be the global reserve and favored world-trade denomination - with attendant drop in purchasing power for U.S. users.

Little "tricks", such as shifting to a gold standard, or changing the Fed mandate, or dictating/legislating some formulaic limits on the U.S. dollar supply will have exactly the same effects - reducing the demand for and purchasing power of the U.S. dollar in global markets. A de facto U.S. dollar devaluation at the present time would not help the U.S. economy.

Dave Schuler writes:

Inflation measured how? Based on CPI the inflation rate has been over 3% since April.

Bryan Willman writes:

Perhaps the issue is not "insolvent banks" but rather "particular insolvent banks"

As in too big to fail, and in particular, perhaps, Bank of America. (But the others have issues as well, no?)

flow5 writes:

If there is an inflation-unemployment trade-off curve, it is ever shifting to the right, and at an accelerated rate. But with demand-side inflation low, & unemployment @ 9.1%, the initial effect of liquidity injections will raise the rate-of-change in real-output at a faster clip (historically for several months), than it will raise the rate-of-change in inflation.

flow5 writes:

IOeRs alter the construction of a normal yield curve, they INVERT the short-end segment of the YIELD CURVE – known as the money market.

The 5 1/2 percent increase in REG Q ceilings on December 6, 1965 (applicable only to the commercial banks), is analogous to the .25% remuneration rate on excess reserves today (i.e., the remuneration rate @ .25% is higher than the daily Treasury yield curve 2 years out - .23% on 9/26/11).

Today, IOeRs are impacting the non-banks (& shadow banks), - the most important lending sector in our economy — or pre-Great Recession, 82% of the lending market (Z.1 release, sectors, e.g., MMMFs, commercial paper, GSEs, etc.).

The remuneration rate is the tipping point at which the FED is forced to offset the resulting deleveraging, refinancing, asset liquidation, & consumer rebalancing in the economy.

I.e., IOeRs are contractive; & cause dis-intermediation (an outflow of funds from the non-banks, i.e., the financial intermediaries). IOeRs stop (or retard), the flow of savings into real-investment. IOeRs induce & hasten, debt deflation.

Indy writes:

"3. I don't understand why the Fed is still paying interest on reserves."

It's a combination of things. Some analysts have said it's about making sure Money Markets never break the buck and banks always have enough to cover minimum business costs and pay their FDIC assessments, as well as a way to collect huge amounts of new cash at the Fed without having to print. Bottom line is that a lot of banks are collecting 0.25% nominal on cash which the Fed turns around and uses to buy short-terms at 0%. If the balance sheet isn't shrinking, then the Fed is printing to cover the gap and handing the new digital bills to the banks, not just the govt. Real rate of return is still negative though, so the banks can't see anything better to do with it and their expected marginal new loan performance would have an even worse negative real rate.

See here for the Fed's explanation from their original announcement.

Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector... Paying interest on excess balances should help to establish a lower bound on the federal funds rate... The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary ...

curmudgeonly troll writes:

If the Fed doesn't pay interest on reserves, banks have to start charging for demand deposits. In some cases they already started due to FDIC fees. It's a subsidy to banks and an attempt to keep some kind of normalcy around the short end while still providing unlimited liquidity.

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