My previous post ended with the following remark:
If not interest rates, what could measure the stance of monetary policy? Several years ago during a conference celebrating the legacy of Milton and Rose Friedman Bernanke himself gave a hint:
The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman . . . nominal interest rates are not good indicators of the stance of policy . . . The real short-term interest rate . . . is also imperfect . . .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.
In this post I hope to make a convincing argument for using NGDP (level and growth) as the best indicator of the stance of monetary policy, or the best way “to check if an economy has a stable monetary background”.
My first step will be to dismiss inflation as a reliable indicator of the stance of monetary policy.
The chart shows that between early 1994 and early 1995, the FF rate was raised from 3% to 6%. Was that indicative of policy being tightened?
Most certainly not. Inflation fell mostly due to a positive supply shock, which, given aggregate demand (NGDP) growth, increases real output growth and reduces inflation.
The chart shows that the behavior of the S&P during this period is consistent with a monetary policy geared (successfully) to maintain a “stable monetary background”. In other words:
Most, if not all, of the seven increases in the fed fund rate associated with FOMC decisions between February 1994 and January 1995 are inappropriately characterized as restrictive monetary policy actions. On the contrary, they can be thought of as defensive moves required by the higher real rates associated with growing confidence in the economy and the resulting strength in private spending. The goal of such actions is not to raise the level of interest rates, but to maintain the desired rate of monetary growth in the face of rates that are rising for reasons unrelated to FOMC policy per se.
It appears that using inflation as an indicator of the stance of monetary policy can “play tricks” (just like interest rates).
In the remainder of this post I argue that, on the contrary, nominal GDP growth and ‘target’ level do not fail to indicate the correct stance of monetary policy.
The panels below indicate, for each period, the growth rate of NGDP and the gap relative to the trend level.
The trend level of NGDP is the trend level of the “Great Moderation” (running from 1987 to 2007). The trend growth rate is about 5.4%. The NGDP Gap is the percent difference of actual NGDP from the trend level. In other words, if NGDP growth has been running around 5.4%, that means the gap is close to zero.
Note that the period already discussed above to eschew inflation as an indicator of monetary policy is repeated, only now in terms of NGDP growth and gap.
Observe that NGDP growth fluctuates narrowly around 5.4% and the gap stays close to zero. In other words, the NGDP growth and level during that time frame is consistent with a “stable monetary background”. Monetary policy was neither “tight” nor “loose”, but “approximately right”.
The 1997 – 2000 period is clearly one of monetary “ease”. NGDP growth rises significantly above trend growth so the positive gap widens continuously. Interestingly, in 1999 – 2000, interest rates increase markedly (from 4.75 to 6.5%) which reminds me of Friedman who once said: “High rates are a sign that monetary policy has been easy and low rates that it has been tight”.
This was followed by a monetary tightening (despite a significant drop in the Fed Funds rate from 6.5% in late 2000 to 1% in mid-2003). NGDP growth falls markedly below 5.4% and the gap becomes significantly negative.
Then, in mid-2003 with the FF rate at 1% the Fed adopted forward guidance. This was the “correct” policy because it increased NGDP growth and began to close the gap (remember that to close the gap NGDP growth has to rise temporarily above the trend rate).
Interestingly the 2002 – 2005 period is labelled one of excessive monetary ease, with “rates too low for too long”. Additionally it is thought to have been responsible for the house price bubble and subsequent financial crisis!
We come to the Bernanke period and it is abundantly clear that for most of his tenure monetary policy has varied among different degrees of tightness!
Sometime in 2007 NGDP growth slowed and dropped below the trend rate so the gap began to increase. This monetary tightening happened despite the FF rate being reduced from 5.25% in August 2007 to 2% in April 2008.
The recently released transcripts from the 2008 FOMC meetings clearly indicate that the Fed was focused on inflation (worse, the headline kind). That´s one more reason to shy away from inflation as an indicator of the monetary policy stance. During much of the year FOMC members were worried that monetary policy was too easy and should be “tightened” soon!
Belatedly, in 2009 the Fed adopted a more expansionary stance. While in 2003 forward guidance was sufficient to bring NGDP back to trend, in 2009 QE1 fell far short of the task. Subsequent QE´s were also insufficient. Although NGDP growth increased, for the last four years it has hugged 4% closely. Since this is significantly below the 5.4% trend growth rate it is not surprising that the gap (relative to the original trend) continues to widen.
If the Fed can keep NGDP growth very close to 4%, why couldn´t it keep it closer to 5.4% (something that had been done before)?
It seems that even if the new trend level for NGDP is below the previous one, we´re still far away from it, so monetary policy remains excessively tight, notwithstanding the “zero” level of the FF rate.