Taper Tantrum 2: Monetary policy is too tight right now

A James Alexander post

“Too tight?” Sounds ridiculous when you listen to 99% of commentators and conventional economists or look at such “obvious” facts as ultra-low interest rates and all the QE, past and present. But why we should listen to conventional macroeconomists is anyone’s guess when they were so dismally useless in spotting the crisis in 2008. Never have so many experts been proved so lacking in expertise.

Only a handful of got the story straight, most prominent was Scott Sumner, a professor at an obscure US college, but also a University of Chicago PhD in Economics. His version of monetarism, christened Market Monetarism was publicised on his blog. And, of course, Marcus Nunes here at Historinhas.

Sumner spotted that nominal growth expectations were falling in 2007 as the housing market in the US and elsewhere came off the boil. Rather than stay committed to maintaining a smooth path of nominal growth, central bankers moved to a tightening bias for monetary policy dazzled by high headline inflation. Their actions, or rather their inactivity, turned stalling growth into a banking crisis and a recession.

The confusion is caused because interest rates, QE and current monetary policy are trapped by the central banks’ love affair with Inflation Targeting. Markets are smart, they are forward-looking, expectations-driven. The “Market” in Market Monetarism.  If the central bankers start fretting about inflation the markets know that rate rises and active monetary tightening is around the corner and respond by buying government bonds, buying the currency and selling equities – all in expectation that the monetary authorities will act sooner rather later. The reaction thus becomes the policy. The central bank action when it comes, if expected, is not accompanied by much market reaction. ‘Buy the rumour, sell the fact’, as any finance professional will tell you on day one.

Hence, we have endless speculation about what the authorities are planning. And in times of stress or uncertainty about the economy, doubled and redoubled attention. The “taper tantrum” was a great example of this. We are probably having a second, “taper (or tightening) tantrum” right now.

Many conventional macroeconomists still cling to the notion of “long and variable lags” before the impact of changes in monetary policy have an impact. One top UK economics prof even names his popular blog  after it. They could not be more wrong. Markets do the heavy lifting, the signalling, the changed expectations, instantaneously. The rest is history, or rather the inevitable playing out of those expectations in terms of high or low inflation, or rather high or low nominal growth. Of course, expectations can change as central bankers shift their views but often they get stubborn, with disastrous consequences.

What we are seeing now is the very long and slow recovery from the Great Recession being threatened precisely because that recovery finally appears to have gathered enough pace to see some modest nominal wage growth, partly due to unemployment having fallen to pre-recession lows.

What both Market Monetarists and markets cannot grasp is why this should lead to active monetary tightening. All monetary theory says that you should tighten when nominal growth is too rapid, too far above trend. There is no conceivable data in the US or UK to show we are at above trend growth. Yet the very same central banks who so messed up in 2007-08 are on the verge of doing it again. Markets can see this and are reacting badly, correctly.