Tuesday, October 2, 2012

The tools of monetary policy are important

I'm going to third Matt Yglesias and Joe Weisenthal that the recent speech by Bernanke is both good and extremely important. But I want to emphasise a point.

The tools of monetary policy are important.

 Here is Bernanke (emhpasis mine):

By buying securities, are you "monetizing the debt"—printing money for the government to use—and will that inevitably lead to higher inflation? No, that's not what is happening, and that will not happen. Monetizing the debt means using money creation as a permanent source of financing for government spending. In contrast, we are acquiring Treasury securities on the open market and only on a temporary basis, with the goal of supporting the economic recovery through lower interest rates. At the appropriate time, the Federal Reserve will gradually sell these securities or let them mature, as needed, to return its balance sheet to a more normal size. Moreover, the way the Fed finances its securities purchases is by creating reserves in the banking system. Increased bank reserves held at the Fed don't necessarily translate into more money or cash in circulation, and, indeed, broad measures of the supply of money have not grown especially quickly, on balance, over the past few years.
This is a really key point for people suffering from base money confusion syndrome to understand, and this includes Scott Sumner and Matt Yglesias. It's true that an omnipotent (in the legal sense) Fed could lift NGDB and inflation to any level of its choosing. (It's also true that an omnipotent God would never allow an omnipotent Fed to exist in the first place - kidding!) But an omnipotent Fed is not what we have. Rather than directly injecting additional money into circulation - which would very quickly reflected in the price level and NGDP - the Fed is only increasing bank reserves. That is what some refer to as pushing on a string because (1) any increase on money in circulation is only dependent on whether government or private sector are on the whole levering up or delevering (i.e. spending vs saving) and (2) the Fed is only affecting private sector behavior by lowering interests rates which in the current environment is of very limited effect and has no influence at all on government sector behavior (i.e. fiscal policy).

So long as the Fed's tools are limited to reserve creation, even if it adopts a policy of NGDP level targeting as market monetarists want, it will be only marginally successful in hitting that target, because it is unable to increase the amount of money in circulation by any direct means.

And let's look at this from empirical perspective. A Scott Sumner previously announced criteria of success of monetary policy of moving economy forward is that it should raise and not lower government interest rates. Soon after the Fed's announced new policy, the treasury rates have risen, which Prof. Sumner immediately chalked into his "win" column. How are we doing now?

You see those higher interest rates? Thought not.  The financial press actually called this one right from the get go, when it said that treasury rates rose because the Fed's new program was focused on MBS rather than treasuries, as traders had initially expected - and as a result MBS rates went south, while treasury rates went initially up, only to have returned to starting position since.

The contrast of the efffectiveness of the Fed (which is creating bank reserves) and the expansionary fiscal policy (which turns savings into employment very much directly) could not be more stark. And that is before we even get into the distributional effects, which don't get me started on.

No comments:

Post a Comment