David Beckworth has a new podcast with Ethan Ilzetzki, and it’s one of my favorites. At one point, David asks Ilzetzki about the stance of monetary policy. A long answer is provided—well worth reading—but this part caught my eye:
My best guess of what we will see is that, for the most part, the shocks to monetary policy this past year will be for the most part dovish shocks, they will be negative declines in the fed funds rate.
Ilzetzki: And this is a little mind boggling because the actual interest rate has gone up this whole time. But our measures of monetary policy shocks, I suspect, will say the opposite. Just to give you an example, I didn’t look at futures for today’s meeting yet, but last FOMC meeting, the markets were pricing in, I think it was an 82 basis point increase. What does that mean, because the Fed never moves by 82 basis points. So what does that mean? That means that some people were betting on a 75 basis point increase. Some were betting, taking a contrarian view and saying, I think that Fed’s going to go even harder on the economy. So the monetary policy shock that occurred on the day of the announcement was actually a decrease, a very, very slight one, but a decrease in the interest rate because that was the new news that they went for the expected 75, and not for the contrarian, shocking 100 basis points.
David Beckworth then points out that these things are tricky to measure:
Beckworth: And this is the eternal challenge of macroeconomics identification. How do you truly isolate something caused by monetary policy that wasn’t itself a derivative of some other development in the economy or caused by something else. So macro economists have their work cut out for them, no doubt. . . .
Quickly, the monetarist theory says the nominal quantity of money relative to its real demand. Now, the key hang up in the monetarist model is we don’t observe the real money demand, we have to estimate it. It’s an unobservable. New Keynesian model, it’s the Phillips curve. And in the Phillips curve you have this thing called the output gap, which is also, we don’t observe, you have to estimate it.
Beckworth: Now for the fiscal theory of the price level, they also have this problem. They’ve got to know the net present value or the discounted present value of future real primary surpluses. So all three theories have these unobservables. It’s hard to falsify them in some extent.
Like Ilzetzki, I believe that monetary policy has been pretty dovish in 2022, although I focus more on NGDP growth than event studies. One thing we both agree on is that interest rates are a highly unreliable indicator of the stance of policy.
I’ve argued that the fiscal theory of the price level (which argues that fiscal policy is the dog and monetary policy is the tail), does not explain events in developed countries like the US. Ilzetzki points out that the model also fails to explain the UK. Here he discusses the mini-crisis after Liz Truss took over as Prime Minister:
Ilzetzki: And so if this was sort of an event of bond markets fearing that the government would strong arm the Bank of England into submission, we would not see what we saw. And coming to the policy recommendations, the UK also provides an excellent counter example or a counter-argument to the bank should just roll over and allow a more expansionary policy. I think what that ignores is the strategic game between the Treasury and the central bank. We saw the Bank of England sticking to its guns saying we’re going to have to raise interest rates more because this fiscal expansion is leading to more inflation. And it took about three weeks for the prime minister to resign. So fiscal policy responds to reality and blinked first in this case. So at least 1-0 here in the UK for monetary dominance and I hope it stays that way.
Monetary dominance is both a desirable state of affairs and the way the (developed) world actually works. God help us if we ever end up with the sort of fiscal dominance that you see in Argentina, Venezuela, and Zimbabwe. Just imagine what would happen if we asked Congress to target inflation at 2%!
READER COMMENTS
Spencer
Nov 14 2022 at 3:40pm
re: “we don’t observe the real money demand, we have to estimate it. It’s an unobservable.”
That’s wrong. The FED has the authority to distinguish between, to separate, deposit classifications, money intended for spending, from money intended to be saved (gated deposits).
Alan Blinder says that “food shocks and OPEC ii (supply shocks) deserve much more blame for the alarming rise in inflation in 1979-1980.”
Alan Blinder is ignorant. So was Paul Volcker. William Barnett got it right. The distributed lag effect of money flows hit at the same time, March 14, 1980, a program of Emergency Credit Controls was invoked.
The Federal Open Market Committee (FMOC) controls the money supply through legal reserve management—the only method available in a free capitalistic society. If the Manager of the Open Market Account who operates from an office in the Federal Reserve Bank of New York, and who is in charge of all open market purchases and sales for all 12 Federal Reserve Banks, decides to tighten monetary policy (sale securities), the impact (contrary to the experts) is immediate, i.e., without a lag. As noted above, the initial and immediate market response to a decline in reserves is deflationary.
Thomas Lee Hutcheson
Nov 14 2022 at 4:15pm
Like Ilzetzki, I believe that monetary policy has been pretty dovish in 2022I take this to mean you believe the instrument settings the Fed uses to affect its target variables, employment and inflation, have been incorrect to achieve its stated targets. Do you think this is becasue the Fed has miscalculated in setting its instruments or that it in fact has been targeting something other than the stated targets?As stated, none of the “models” seem reasonable as they do not specify how the Fed responds to the exogenous variables.
Scott Sumner
Nov 15 2022 at 1:38pm
I don’t believe they ever took “average inflation targeting” very seriously.
Thomas Lee Hutcheson
Nov 15 2022 at 9:02pm
So what were they targeting? What would they have done when if they HAD been targeting average inflation? How does one distinguish mistakes in instrument settings from changes in targets?
Scott Sumner
Nov 16 2022 at 11:57am
Under FAIT, monetary policy in early 2022 would have been dramatically tighter. That’s what they would have done differently. Now, there is no intention to offset the inflation overshoot, hence no “inflation averaging”.
Michael Sandifer
Nov 14 2022 at 6:44pm
I also listened to this podcast, and Ilzetki’s conclusion about reasons for market reactions to the Truss budget were somwhat in line with mine, except he apparently did a lot more research. It does seem the energy subsidies played a significant role, exceeding 4% of annual GDP. I never bought the notion that UK solvency was being questioned.
It’s unfortunate the budget had such stupid elements in it such as these subsidies and the tax cuts, as there were some quite good reforms included, as you’ve mentioned. It was also incompetently rolled out, of course.
BC
Nov 15 2022 at 3:57am
“Just imagine what would happen if we asked Congress to target inflation at 2%”
Instead of just 1 Inflation Reduction Act, every bill would be called the Keep Inflation at Two Percent Act.
Daniel
Nov 15 2022 at 9:45am
Doesn’t it feel like reading in to it a bit too much to see a 7 bps spread on a price-implied forecast(!) and claim there is a notable monetary policy surprise? Also seems a bit weird to use the average expectation as the guide here as it implies that anything short of the maximum expectation is a dovish surprise (on average!), even if the modal expectation in a fairly discrete(!) outcome is lower. I’m up for the argument that the Fed may have been dovish this year (see Beckworth’s NGDP gap slowing in growth but not moving down), but the argument should be better than comparing only a piece of monetary policy to an extremely noisy forecast. To a good degree the three of us agree on that (me, Scott, Ethan).From the CME FedWatch Tool:9/20 – the market was 44/39 that the lower bound of the target rate would be 400 bps vs. 425 bps.9/21 – the market was 67/31 that it would be 425 bps vs. 400 bps.10/19 – the market was 77/22 that it would be 450 bps vs. 425 bps.11/2 – the market was 50/40 that it would be 425 bps vs. 450 bps.11/3 – the market was 52/48 that it would be 425 bps vs. 450 bps.Yesterday 11/14 – the market was 81/19 that it would be 425 bps vs. 450 bps.
Sure, compared to mid-October, the market is now expecting a more dovish stance (in interest rates), but compared to mid-September, the market moved around a lot but still expects a less dovish stance (in interest rates). And don’t even get me started on comparing to summertime forecasts.
Scott Sumner
Nov 15 2022 at 1:40pm
Yes, I agree. I would not base any grand claims on a small difference between actual and expected fed funds target.
Spencer
Nov 15 2022 at 12:22pm
N-gDp has been too high in 2022. But long-term money flows are turning down at the same time short-term money flows are headed up. So, stocks rise.
Atlanta’s gDpNow is up to 4%. Cleveland’s’ inflation nowcast is down to 5.4% in the 4th qtr.
But Powell destroyed deposit classifications anyway.
Remember:
#1 “there was a time when monetary policy aggregates were important determinants of inflation and that has not been the case for a long time”#2 “Inflation is not a problem for this time as near as I can figure. Right now, M2 [money supply] does not really have important implications. It is something we have to unlearn.”#3 “the correlation between different aggregates [like] M2 and inflation is just very, very low”.
Capt. J Parker
Nov 16 2022 at 1:23pm
IMHO, this means we should be very concerned if Treasury needs to fork over Billions to the Fed so that the Fed can continue to manage monetary policy in the face of increasing IOR payments. I can’t see congress reacting to that eventuality with anything other than demagoguing and bad policy prescriptions.
(or, maybe I mean: more than the usual demagoguing and bad policy prescriptions)
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