First Milton Friedman:
The Federal Reserve cannot and does not control interest rates, though its actions clearly have an effect – but in a more complex way than would justify the identification of easy money with low interest rates and tight money with high interest rates.
Followed by Bernanke:
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.
What I’d like to spend some time on—because I feel this is sort of my swan song, but maybe because I’m a classy guy, I’ll call this my “valedictory remarks”—are three concerns that I have for this Committee going forward. I’m not going to be able to participate, but I have a chance now to lay them out.
The first is the real danger of focusing too much on the federal funds rate as reflecting the stance of monetary policy. This is very dangerous. I want to talk about that.
So what best defines the stance of monetary policy? Let´s check Bernanke´s alternatives. The charts show NGDP relative to trend, Inflation and the FF target rate for different periods.
In 1992, Friedman wrote about monetary policy being tight with reference to money supply (M2) growth. Unfortunately, that´s not a good measure of the stance. He should have said monetary policy had been tight, because at that moment the Fed was just getting it right given NGDP was fast converging to trend, despite the falling/low FF target rate and falling inflation.
The 1993-97 period describes what a “perfect” monetary policy looks like.
NGDP hugged the trend, the FF target rate initially low, was subsequently raised (does that mean it was initially “easy” and then “tightened”?) and inflation fell throughout (does that mean the stance of policy was “tight”?).
The end of the decade describes what an “easy” stance of monetary policy looks like. Despite the increase in the FF target rate and inflation remaining below the “desired” (2%) level, the fact that NGDP rose above the trend level accurately describes the easy stance of monetary policy.
The subsequent period includes John Taylor´s “too low for two long” level of the FF target rate. According to the deviation of NGDP from trend, monetary policy was initially too tight, only becoming stimulative in the second half of 2003, when forward guidance was introduced, even though the FF target rate soon began to rise.
The following period accurately describes what a very tight monetary policy looks like, despite an initially constant and then falling FF target rate and inflation. Soon after taking the Fed´s helm, Bernanke proceeded to tighten monetary policy, and the “screws” turned until NGDP “crashed”! It looks like Lehman was a consequence and not the trigger.
And monetary policy, despite all the “highly accommodative” talk, has in fact remained pretty tight ever since!