I recently pointed out that Fed officials are becoming more receptive to the market monetarist proposal for negative interest on reserves. Today there is more progress, on an even more important front. First let me provide a bit of background information. Back in late 2008 and early 2009 I argued that monetary policy was extremely tight, despite low interest rates. Most people scoffed at that claim, they'd say, "everyone knows monetary policy is highly accommodative."
A new press report (sent to me by Michael Jurka) suggests that even the Fed is coming around to the market monetarist view that low interest rates don't mean easy money:
Among the biggest questions for financial markets this year has been when the Fed would finally move away from stimulative, ultralow interest rate targets.
But what if those ultralow targets aren't actually stimulative at all? What if, instead, the Fed's current policies are actually contractionary?
That's the surprising case made by a recent paper from the San Francisco Federal Reserve.
"Monetary conditions remain relatively tight despite the near-zero federal funds rate, which in turn is keeping economic activity below potential and inflation below target," writes economist Vasco Curdia.
The insight centers around the concept of a natural rate of interest. This is the hypothetical interest rate at which money would be lent and borrowed in equilibrium, leading the economy to neither grow nor shrink. If actual interest rates are above this natural (or neutral) rate, then less money will be lent out than otherwise might be, leading economic growth to slow. Conversely, if actual interest rates are below this neutral rate, then economic expansion should result.
Seen in this context, we cannot determine whether Federal Reserve policy is expansionary simply by comparing the current federal funds rate target to historical norms. Instead, interest rate targets must be compared to that current neutral interest rate.
And according to Curdia, the neutral rate is currently below zero. Actually, he says it is currently at negative 2.1 percent, in contrast to a long-run level of 2.1 percent. If he's correct, the direct implication is that right now, even a federal funds rate target of 0 percent to 0.25 percent is high enough to slow down the economy rather than contribute to expansion.
. . .
Neil Azous of Rareview Macro points out that Curdia has worked closely with Michael Woodford, "who is widely considered to be the strongest consultant to the Federal Reserve for quite some time, and he's sort of the backbone to modern monetary policy." Further, the San Francisco Fed is "the academic arm of the entire system, and Janet Yellen came from the San Francisco Fed, so it's given additional credence."
When the paper is placed alongside recent dovish commentary from Fed Govs. Daniel Tarullo and Lael Brainard, "we have to acknowledge that the medium-term drivers of policy are shifting," Azous wrote Wednesday. Indeed, the market no longer believes that a rate hike is the base-case scenario this year, placing the chance of a move by December at just 33 percent, according to CME Group's Fed Watch tool.
This is a huge development, suggesting that market monetarism is going increasingly mainstream.
And as if that isn't enough, over at TheMoneyIllusion I have a new post that quotes some surprisingly thoughtful remarks from a key ECB official. And after posting those comments, someone sent me an additional constructive statement from another ECB official:
New instruments are needed to boost growth and inflation in the euro zone, European Central Bank policymaker Ewald Nowotny said on Thursday, suggesting it may be beyond the ECB to achieve its goals using its existing toolkit.
The bloc's economy is slowing again, with even powerhouse Germany seeing a recent string of poor data, while inflation has returned to negative territory and the euro is uncomfortably strong. That raises pressure on the ECB to make good its promise to expand or extend its trillion-euro-plus asset purchase programme if needed.
"We're clearly missing our target," ECB Governing Council member Nowotny said on Thursday. "The ECB is using monetary policy instruments available but in my view it's quite obvious that ... additional sets of instruments are necessary."
Before considering new targets they should increase the pace of monthly QE, and also sharply reduce the interest rate on reserves, which is already slightly negative. Then the ECB needs to consider switching to level targeting. Perhaps a low inflation rate, such as 1.5%, level targeting, would be a good compromise figure, acceptable to the Germans.
Again, I am seeing a rapid global sea change in the consensus view of monetary policy; people are beginning to understand the old regime isn't working. This is exceedingly good news.