I’ve been thinking a lot about monetary policy recently: not so much the question of will they or won’t they -- they being Federal Reserve policy makers -- provide additional stimulus.
Rather, I’ve been wondering how it is that monetary policy stopped being about the quantity of money and started being about something else: financial conditions, credit allocation, long-term interest rates, expectations, investor preferences, the maturity of the Fed’s portfolio and relief for specific sectors of the economy (housing). I’ve also been wondering whether this is a good or a bad thing.
Some of the policy detours have their roots in the 2008 financial crisis. After the collapse of Lehman Brothers Holdings Inc. in September of that year, Fed Chairman Ben Bernanke switched sides. No longer would monetary policy focus on the size of the liability side of the balance sheet (the monetary base), Bernanke explained. From that point on, Fed policy would concern itself with the composition of the asset side of the balance sheet.
The implementation of credit policy, or direct lending to particular sectors (commercial paper) or borrowers (American International Group Inc.), represented a “radical departure from Fed and traditional central bank practice,” writes Robert Hetzel, senior economist and research adviser at the Richmond Fed, in his new book, “The Great Recession: Market Failure or Policy Failure?”
Radical it was: a radical failure, in Hetzel’s view.
“If the problem was the failure of banks to lend to credit-worthy borrowers willing to spend, the scale of Fed and government intervention should have revived both lending and the economy,” he writes.
With the federal funds rate, the traditional policy instrument, close to zero, the Fed embarked on a series of large-scale asset purchases in November 2008, buying Treasuries as well as agency debt and mortgage-backed securities.
Monetary policy had found a new form of self-expression. As Bernanke explained it: The Fed’s purchases of long-term Treasuries affect financial conditions by depressing their yields, forcing investors into riskier assets -- stocks, corporate bonds, mortgage securities -- in search of higher returns. Lower mortgage and corporate bond rates make it cheaper for homeowners to borrow and businesses to invest. Higher stock prices make consumers feel wealthier and encourage them to spend more.
Why, it almost sounds as if the goal of policy is to artificially inflate another asset class!
Money’s real demise, or policy makers disregard for it, predates the crisis by a few decades. (Almost all the monetarists have died or converted in the interim.) Starting in the late 1970s, empirical evidence suggested that money demand and velocity, the rate at which money turns over, were no longer stable, according to Michael Bordo, a professor of economics at Rutgers University in New Brunswick, New Jersey.
When velocity was stable, central banks changed the growth rate of money in order to achieve a similar change in output. Nowadays, it’s not so easy. Velocity plummeted during the crisis as demand for money -- both the public’s and the banks’ -- increased. In fact, Hetzel argues that the explosion in the monetary base starting in September 2008 “simply accommodated the increased demand for bank excess reserves,” which he says is supported by the contraction in bank credit during that period. “The Fed did not conduct a policy with aggregate expenditure as the objective and with money creation as the instrument.”
In the face of a near-zero funds rate and a Fed balance sheet almost 2 1/2 times its original size, monetary policy was tight, not easy, Hetzel says, in what is certain to be a controversial assessment of the Fed’s role in the crisis.
Economists understand that the level of the funds rate per se doesn’t reflect the stance of monetary policy. Both the inflation rate and the economy’s natural rate (an unobservable rate that keeps the economy growing at potential) come into play.
The same holds true for money. If the increase in supply merely satisfies the demand, money growth may not be expansionary. Bernanke admitted as much in a 2003 speech, saying that money growth, as well as nominal and real short-term interest rates, were unreliable measures of the stance of policy.
“Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation,” Bernanke said.
“Bernanke was a market monetarist back then,” says Scott Sumner, a professor of economics at Bentley University in Waltham, Massachusetts, referring to economists who advocate a nominal gross domestic product target for the Fed. “The last four years saw the slowest growth in nominal GDP since Herbert Hoover.”
Using Bernanke’s criteria, the monetary backdrop doesn’t look too stable. And that’s with zero percent interest rates and a $2.8 trillion Fed balance sheet. It makes you wonder if Hetzel isn’t onto something.
Maybe the Fed needs to do less talking (pledging to hold rates at zero until some future date) and less light housekeeping (rejiggering its portfolio) and consider more outright purchases of Treasuries.
Yes, print money. There, I said it. It’s been a long time since anyone talked about monetary policy the way Milton Friedman did: If the Fed prints more money than the public wants to hold, someone will spend it.
I know the risks. I’ve been among those to point them out. In the long run, the Fed can only affect the rate of inflation. Given the Fed’s history of being late to the party -- the funds rate was at a high of 5.25 percent as late as September 2007 -- and monetary policy’s long and variable lags, inflation is a risk, what with so much raw material for credit expansion just waiting for an opportunity.
As I said at the start, I’ve been thinking about monetary policy recently. Thinking differently, that is, although not coming to any conclusions just yet.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own.)
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