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Fed Ignores Money Supply as ECB Uses New Tools: Cutting Research

The Fed on June 20 extended its so-called Operation Twist program through the end of the year while saying a third round of asset purchases may be needed. Photographer: Brendan Smialowski/Bloomberg
The Fed on June 20 extended its so-called Operation Twist program through the end of the year while saying a third round of asset purchases may be needed. Photographer: Brendan Smialowski/Bloomberg

July 20 (Bloomberg) -- Monetary policy should be renamed, according to Federal Reserve Bank of St. Louis Vice President and economist Daniel L. Thornton. The reason: the Fed and most other central banks “pay virtually no attention to money.”

Focusing more on interest rates, which influence the price of credit, rather than monetary aggregates makes the ability of central bankers to affect borrowing costs more limited than they think, said Thornton in a working paper released this week.

That conclusion strikes Thornton as “particularly useful” at a time when central banks are focusing on unconventional policies aimed at bringing down long-term bond yields. Fed Chairman Ben S. Bernanke says the bank’s key interest rate probably will stay near zero at least through late 2014. The Fed on June 20 extended its so-called Operation Twist program through the end of the year while saying a third round of asset purchases may be needed.

Thornton, who joined the Fed in 1981, has queried the central bank’s policies before. In a paper released in February, he said the Fed’s quantitative easing program could spark higher money supply growth that prompts an inflation surge.

In the latest study, he says that most modern policy makers believe monetary policy works through the interest-rate channel, so that by tweaking rates they can affect aggregate demand and in turn economic activity and inflation. Beginning in the late 1980s, the Fed implemented policy by targeting a very short-term interest rate, known as the overnight federal funds rate.

The problem is that the effect is “significantly impaired if policy actions” are not also transmitted through other market rates, he said. That may be the case. As of 2008 the size of the domestic credit market was about $50 trillion, meaning the Fed supplied just 1.5 percent of all credit. There has also been a deterioration in the link between the federal funds rate and longer-term Treasury yields, he said.

It is therefore “hard to see how the Fed could significantly affect the equilibrium level of interest rates,” Thornton wrote. “The Fed’s ability to affect bond yields that matter for economic activity using this procedure is exaggerated.”

The lack of a bigger role for money in current policy reflects a failure by officials to develop models that capture its importance for an economy and for setting prices, as well as the lack of a statistically strong relationship between money measures and inflation, Thornton said.

* * *

Governments of the euro countries begin hurting their economies with every euro of spending that pushes their debt beyond 95 percent of gross domestic product, say European Central Bank researchers.

In a study of the relationship between public debt and economic growth in a dozen euro nations between 1990 and 2010, Anja Baum, Cristina Checherita-Westphal and Philipp Rother found increasing public debt for short periods can boost expansion. The effect ends when debt reaches about 67 percent of GDP and becomes negative as debt approaches 95 percent of GDP.

The paper serves as a rejoinder to economists who have argued cash-strapped economies with debt as high as 160 percent of GDP in Greece should still try to stimulate their way out of recession.

“The short-term economic stimulus from additional debt decreases drastically when the initial debt level is high and might even become negative,” the authors said in a working paper released this month. “In light of the attempt to defend increasing debt with economic stimulus reasons, our results are supportive only if the initial debt level is below a certain threshold.”

Belgium, Ireland, Greece, Italy and Portugal are all projected by the European Commission to run debt beyond the 95 percent level this year.

* * *

The Japanese economy’s lost decades, in which growth averaged just 0.75 percent a year in the past 20 years, were in part to blame on banks using their balance sheets to buy government bonds rather than to lend, according to the country’s central bank.

The need to rid themselves of toxic debt and meet higher capital requirements limited the risk-taking of banks. They were encouraged to tilt “their asset allocation toward government bonds, leading to a decline in output and inflation,” said Bank of Japan economists Kosuke Aoki and Nao Sudo in a paper published this month.

They show how the amount of outstanding government bonds grew more quickly than the economy in the 1990s and 2000s and banks stepped up their accumulation of such assets rather than lend to consumers and companies.

“As a result, an accumulation of government bonds and deflation coexist in the economy,” Aoki and Sudo said.

* * *

The global financial crisis, which began five years ago with a freeze in credit markets, has led to a “loss in the effectiveness” of standard monetary policy in Europe, according to a report published by the Bundesbank this month.

While before the crisis money market rates as measured by so-called Euribor showed significant responses to shifts in monetary policy expectations, the relationship has weakened since August 2007, said Bundesbank economist Puriya Abbassi and Tobias Linzert of the ECB. Higher liquidity and more uncertainty about policy are cited as reasons.

The results suggest that the ECB’s October 2008 shift toward non-standard policies, such as unlimited loans for banks, were effective in addressing some of the disruptions, the authors said. Their estimates showed such policies helped lower Euribor rates by more than 80 basis points.

“These findings show that central banks have effective tools at hand to conduct monetary policy in times of crisis,” they concluded.

To contact the reporter on this story: Simon Kennedy in London at

To contact the editor responsible for this story: Craig Stirling at

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