How Effective is Monetary Policy?

Nick Rowe reminds us that if a central bank is doing a good job in terms of hitting its nominal target, then both the indicator variables and the monetary policy instrument it uses should not be correlated with the target. For example, say the central bank were targeting a nominal GDP growth of about 5% a year and adjusted the stance of monetary policy to offset velocity shocks so that the 5% target was hit on average.  Though the stance of monetary policy would be systematically related to the velocity shocks it would not be correlated with nominal GDP growth. An observer, not knowing any better, might study the empirical relationship between the stance of monetary policy and nominal GDP growth and conclude monetary policy is ineffective with regards to nominal spending when in fact it is very effective.  

This insight is important for several reasons. First, it helps shed light on why it monetary policy shocks  in empirical studies appear to have less of an effect on the U.S. economy after 1980 than before. For example, below are two figures showing the typical response of real GDP to a 0.25% federal funds rate shock during these two periods.¹ (Click on figure to enlarge.)

Just looking at these two figures could lead one to conclude monetary policy became less important over time.  Some observers, however, argue that during the latter period monetary policy did a better job responding to economic shocks and thus, helped paved the way for the "Great Moderation" in economic activity.  If so, it would make it difficult to find as strong a relationship between the Fed's operational instrument, the federal funds rate, and economic activity during the "Great Moderation" than before.  This is the point Nick Rowe is making.  It is also one that Jean Boivin and Marc P. Giannoni convincingly make in this influential paper (ungated version). 

Second, this line of reasoning also means that one cannot look at measures of money--monetary base, M1, M3, etc.--and conclude they are unimportant for monetary policy.  Adam P. notes, for example, that with an inflation-targeting central bank a zero correlation between the monetary base and the inflation rate does not mean that the monetary base is inconsequential for inflation, but only that the central bank is doing its job well.  Similarly, Nick Rowe explains elsewhere that if a central bank is successfully targeting a nominal GDP growth rate, then one should not expect to find a relationship between the money supply and nominal GDP growth. Again, this does not mean money is unimportant. What it does mean is that the central bank is managing to offset shocks to velocity and money supply such that nominal GDP growth is being stabilized.

Josh Hendrickson makes a strong case that during the "Great Moderation" the Federal Reserve effectively was targeting nominal GDP growth of around 5%.  If so, then the above reasoning implies that during this time there should be a strong negative relationship between the growth rates of the money supply (M) and velocity (V), but little if any relationship between that of the money supply and nominal GDP.  However, this should be less true prior to this time when the Fed was not stabilizing the nominal GDP growth rate--the period of the "Great Inflation"--and there really was no nominal anchor for U.S. monetary policy.  The graphs below provide evidence on this claim.



Using M1 as a measure of the money supply, the first two figures show the relationships in question for the "Great Moderation" period.  They show that there was a strong relationship between the money supply and the velocity growth rates, but essentially no relationship between the money supply and the nominal GDP growth rates:

Now let us look at the period prior to the "Great Moderation."  Here we find that the growth rates of the money supply and velocity are not related, but there is some relationship between the money supply growth rate and that of nominal GDP:

Similar evidence can be found using other monetary aggregates.  Now these graphs should not be interpreted as meaning the Fed should target a monetary aggregate.  Rather, they should be viewed as evidence that it is difficult to assess the effectiveness of successful monetary policy by looking at indicator variables and policy instruments.  What observers should be looking to is the central's bank's nominal target to see if it is being maintained on average.  Ultimately, that is the best indication of monetary policy's effectiveness.



Of course, the problem currently is we do not really know with certainty the Fed's nominal target.  Is it 2% inflation, 5%  nominal GDP growth, a price level target, or something else? Here the Fed could improve.  It should announce an explicit nominal target and commit to maintaining it no matter what.  Obviously, I would like it to announce a nominal GDP level target, but any announcement would be an improvement over the uncertainty we have now.

¹These responses come from a standard structural vector autoregression that included real GDP, commodity prices, CPI, and the federal funds rate. Six lags were used.

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The ECB Monetary Policy Mess in One Picture

San Francisco Fed economist Fernanda Nechio shows us in one picture the ECB monetary policy mess:

If there were any doubt that the ECB is in practice narrowly setting monetary policy for the core countries (i.e. Germany and France) this figure should remove it.  The figure should also nix any doubts as to whether what is good for the core is good for the periphery.  ECB monetary policy was too loose in the early-to-mid 2000s and now it is too tight.  If the ECB really wants to preserve the Eurozone in its current form it must confront this reality.  So far it hasn't and this is why I say the ECB is fiddling while the Eurozone is burning.

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Raghuram Rajam and the Need for More Systematic Monetary Policy

Raghuram Rajan has come out swinging against U.S. monetary policy.  He argues it is wrong to look to the Fed as some monetary wizard who can "revive the economy through a swish of the monetary wand."  He also believes the Fed's monetary stimulus causes more problems that it solves.  In particular, he views the Fed's low-interest rate polices causing excessive risk taking by investors and harm to savers.  On the surface his arguments are consistent with his belief that the housing and credit boom was similarly driven by monetary policy that was too easy back in the early-to-mid 2000s.  I am sympathetic to his views on the Fed's role in the housing and credit boom, but believe his current take on U.S. monetary policy is off.  Let me explain why.

First, a low policy interest rate target by itself does not mean monetary policy is loose, let alone too loose.  Interest rates have to be low relative to the neutral (or the natural) interest rate to be stimulative.  The neutral interest rate, in turn, is closely tied to the performance of the economy.  Thus, given the anemic economic conditions the neutral interest rate is most likely low now.  Estimates of the real neutral interest rate show this to be the case.  For example, the updated estimates for the highly cited Laubach-Williams paper puts the real neutral interest rate at 0.27% for 2010:Q4.  (Aside: I know John Williams is now busy running the San Francisco Fed, but us bloggers need him to keep updating his natural rate estimates!)  Another way of saying this is that interest rates would probably be low right now even if there were no Federal Reserve.  Savers, therefore, are not being harmed by the Fed's low targeted policy interest rate, but by the weakened economy. 



It is true that the real federal funds rate is probably still slightly lower than the real neutral rate, but that by itself still does not mean monetary policy is too loose if it is being eased to close the output gap.  The Taylor Rule, for example, prescribes a federal funds rate target different than the neutral federal funds rate if there is an output gap or if inflation is running too high. Now, I will concede it is difficult, maybe even impossible for the Fed to finely tune its targeted interest rate so as to flawlessly close the output gap or reign in inflation.  But that is not the issue here.  The point is one has to be careful about claiming low interest rates necessarily mean excessively easy monetary policy.



So what can and should monetary policy do?  First, monetary policy can make a big difference even in a 0% interest rate environment. FDR showed us that with his QE program of 1933-1936.  By most accounts it was a smashing success.  Unlike our current QE programs, it worked because it change nominal expectations in a meaningful manner.  FDR effectively created a price level target that convinced everyone he would return the price level to its pre-crisis value. This caused money demand to fall and nominal spending to take off.  Given the large amount of excess slack, this increase in nominal spending caused a sharp recovery in real economic activity.  The same could be done today if the Fed would announce an explicit level target, preferably a nominal GDP level target.  Such a target would create a period of rapid catch up spending--to return spending to its trend--and thereafter stabilize the growth rate of nominal spending around some target growth rate.  If this happened, the neutral interest rate would rise, investors would be less interested in risky investments, savers would benefit, and there would be long-term certainty about the path of nominal spending.  In short, Rajan's concerns would be eliminated. Rajan just needs more faith in the right kind of monetary policy can do.



Now if, on the other hand, the Fed were simply do another round of QE without an explicit level target I doubt it will help much. Such an approach does not shape expectations well, is a lightning rod for criticism, and ultimately could add more uncertainty to markets.  We need to move toward more systematic monetary policy, one that adds plenty of monetary stimulus but does so in a predictable manner.  What we need is a nominal GDP level target.



Update:  Brad DeLong weighs in and Bill Woolsey responds in his comment section.

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