A big question, however, is over how to measure the impact of monetary policy in an environment such as the present one, when short-term interest rates are close to zero and the credit system is damaged.
This is, indeed, the major question of our times. As you may know, I am of the “Scott Sumner” persuasion that the bulk of the recent recession (or the third depression?) was caused by the Fed allowing NGDP to plummet. The really depressing fact is that most commentators stop at “interest rates are at zero”, and thus proclaim that money has been surprisingly easy. Fortunately, Wolf sees through this facade:
The difficulty arises because of the huge divergence between what is happening to the monetary base (the monetary liabilities of the government, including the central bank) and what is happening to broader measures of money (principally the liabilities of the banking system). The former has exploded. But the growth rate of the latter is extremely low.
As has been known for quite some time, the monetary base is a highly misleading indicator of the stance of monetary policy. A slow (and stable) growing base was the essence of the original form of monetarism that was subsequently discarded as unworkable in the 80′s. There is an important implication here: the monetary base is utterly meaningless given endogenous money. When the Fed began a policy of paying interest rates on reserves, this is exactly what happened — the monetary base became analogous to any other risk-free interest-bearing asset. If you have a model of demand shocks based on the supply and demand for government debt, then the base can be counted within those assets. Wolf goes on to talk about the broader aggregates (truncated quote, read the whole thing):
So which measure is relevant? My responses would be as follows:
First, the monetary base does not itself have any impact on spending by the public.
Second, such reserves have no direct impact on lending by commercial banks (their assets) or on the broad money supply (their liabilities).
Third, should commercial banks be stimulated by the possession of reserves to expand their assets and liabilities, it is possible for the central bank to sell bonds to the non-bank private sector, to reduce those reserves.
Fourth, the policy of expanding the balance sheet of the central bank has an inflationary impact if and only if it succeeds in expanding the overall broad money supply beyond what the public wishes to hold, given the levels of economic activity, interest rates and expected inflation.
Finally, such an inflationary impact of “money printing” can indeed only happen if the overall money supply starts to grow rapidly.
But why stop at the broader aggregates? Mishkin tells us that they can be misleading as well. How about prices of various asset classes (that aren’t gold)? Maybe the interest rates on nominal bonds, which are appalling lows (no, fiscal policy is not the solution)? I generally favor the TIPS spread. A lot of the times I just plainly get confused by M3, so I don’t look at it — but it has been in the news as of late, and not good news either.
My conclusion is that what is happening to the balance sheet of the central bank is unimportant, except to the extent that it has prevented a collapse of credit and money. What matters is the overall supply of credit and money in economies. This continues to be stagnant in the developed world. Concern about an imminent outbreak of inflation is consequently a grave mistake. To the extent that there is a danger of “monetisation” of debt, it will emerge only if we fail to return to growth, because that is the situation in which it is most likely that public sector deficits will fail to close. It follows that strong monetary tightening now may increase the long-term threat of inflation, rather than reduce it.
The bolded is a very counter-intuitive point. I think a lot of people, when speaking about monetization, start from the causal perspective of the fiscal authority running up a lot of debt. Of course, true to economics, you have to nearly reverse causality to see the real picture. Sovereign debt crises are the result of stagnation — a period when government is loathe to be able to raise revenue. This can happen from supply-side problems, or a demand-side recession…of the sort we are seeing now, that has consumed Greece and threatens other European countries that do have other supply-side problems, as well. Of course, austerity measures have failed to do anything in Europe…and that’s just as economic theory would predict.* Economic growth can take care of nominal debt on it’s own, no inflation necessary…but if markets are forecasting low growth, that is when governments run into severe problems with large debt-loads.
The irony of the current fear of inflation — and this is key — is that given a widespread “Austerians” view; monetary policy would be especially effective, with just a modest (credible) commitment to inflate.
Dr. Friedman Mr. Wolf, for articulating that so clearly. Fed, are you listening?
*Lest you believe that Krugman is being to hasty, remember that policy actions should have immediate results in even weak efficient markets (like the bond market). Unfortunately, Krugman seems to selectively articulate this point clearly.