A boring post about how monetary policy works
It's important, though!
News organizations tend to write around uncertainty, leaving readers to think that they stupidly do not understand something while the reality is that the journalists writing the story (and sometimes the experts quoted) don’t fully understand it.
We see this time and again in monetary policy coverage. Anyone who pays any attention to politics is aware that there is something called the Fed, that it does things that impact the economy, and that comparable institutions exist in other countries. But how does quantitative easing boost the economy? Why would an increase in interest rates reduce inflation? The truth about these questions is that smart, well-qualified people disagree amongst themselves, and there’s no actual consensus among economists as to exactly how this works.
Every once in a while someone pops up with the neo-Fischerian idea that higher interest rates actually cause higher inflation. Most analysts reject that, and no central bank that I’m aware of tries to make policy in a neo-Fischerian way, but we are talking about a field in which experts don’t have a consensus on the most absolute basic questions you could ask.
Even experts who broadly agree about directions can disagree about mechanisms. Roughly speaking:
One view is that the impact of central banks on the economy is hydraulic. They do things (buying bonds, setting interest rates) that mechanically influence the economy by changing credit conditions.
The other view is that central banks impact the economy primarily by coordinating expectations — they say things that lead to financial market reactions, which in turn influence the real economy.
The hydraulic view has traditionally dominated among the Fed’s professional staff and academic economists. But the expectations view does have some academic support, especially among monetary specialists, and seems to be increasingly influential among central bank leadership.
In my experience writing about monetary policy for Vox or Slate, it’s traffic poison. But here in the paid newsletter game, we don’t need to care about that. And I think it matters a lot. To put my cards on the table, I think the expectations view is right and the hydraulic view is wrong. And I think this has important implications — though interestingly, they are mostly implications for fiscal policy.
Two theories of monetary policy
Part of the appeal of the hydraulic view is that it’s simpler to explain.
The Federal Reserve sets its target interest rate higher. When it does that, other interest rates move in tandem. Mortgages become more expensive and so do credit card overages. So do bank loans for small businesses and the interest rates large businesses need to pay to sell bonds. All these higher costs lead to lower levels of investment and lower purchases of durable goods. That slows economic growth, which is bad. Lower interest rates have the opposite effect, which is good. But if you keep rates too low for too long, the economy might “overheat” and generate inflation. At that point, you need to raise rates to cool things off.
But one problem with this view is that empirically when the Fed cuts its target interest raise or announces some new QE, bond yields sometimes go up rather than down.
One way to deal with this is to invoke Milton Friedman’s idea that monetary policy operates with “long and variable lags,” so you shouldn’t expect any immediate operation of the hydraulic mechanism. The long part could make sense, but long and variable suggests a flight away from inquiry and toward a kind of superstition. “Long and variable” means there is no empirical test of whether or not the mechanism is working. It takes time to operate, and there’s no way of knowing in advance how much time.
And I think it ultimately makes more sense to think of the whole thing as mostly a conjuring trick. A QE announcement can make rates go up because it is creating expectations of faster nominal growth in the future.
The really important thing, though, is that the bond market is not the only financial market. If traders all raise their expectations of nominal growth, the price of commodities and of stock shares will also rise. This generates wealth effects that can fuel spending. It also directly encourages investment in producing commodities and indirectly encourages investment in startups and tangible business equipment.
Now there are lags here, but they are lags in the sense that financial investments (the price of copper going up) happen faster than physical investments (because copper is more expensive now, the copper mines increase production). But the proximate mechanism is essentially instantaneous. If your goal in an inflationary environment is to reduce expectations of future nominal growth, then you can tell more or less immediately whether or not that happened by looking at financial markets. And critically, while doing things can and does influence expectations, so does talking about doing things.
Jay Powell telling Congress that he’s going to discuss accelerating the wind-down of QE is monetary tightening because investors pay close attention to these things. Of course if it turns out to be a huge fake out, that undoes the impact. If Powell were constantly screwing around and bullshitting people, eventually everyone would tune him out. But a credible central banker moves markets with his words as well as his deeds, and the moving of markets is the essence of how the banker does his work.
One technical disagreement
Financial journalists generally try to avoid explicit debate about hydraulic- vs. expectations-centric theories of monetary action because the lack of concrete answers is a little embarrassing.
But here’s one concrete way that it comes up.
For a while now, the Fed has been making purchases of long-dated government bonds — this is called quantitative easing. In the future, the Fed will reduce the number of purchases it makes per month — this is called tapering. Once the Fed has tapered all the way down to zero, it might sell the bonds it bought in the past — unwinding. The stockpile of bonds that the Fed owns and might sell is called its balance sheet.
According to the hydraulic view, the bigger the Fed’s balance sheet, the more stimulative monetary policy is. So when you do QE, you are making monetary policy increasingly stimulative. When you taper, you are slowing the rate at which monetary policy becomes more stimulative, and it’s only when you unwind that policy actually becomes contractionary.
But if you look at actual outcomes over the past 10-15 years, that is clearly wrong. In practice, tapering is tightening. This is what happened during the 2013 “taper tantrum” in financial markets. These days, there probably won’t be a tantrum when tapering starts. But that’s for the very good reason that inflation is high now, so tightening policy is appropriate. In 2013, the Fed tightened policy while thinking to itself that it wasn’t tightening. Today, I think Jay Powell is aware that just talking about tapering has been associated with falling oil prices and inflation expectations and sees that as the desired outcome.
This is one instance where I think past adherence to the hydraulic model has caused real problems. But the biggest thing, to me, is that your view on how monetary policy works should change your view of fiscal policy.
Fear of a tight Fed
One clear implication of the hydraulic view is that fighting inflation is very difficult. When prices are rising at a 4-5% annual rate, you’ve got a big problem on your hands. Sure, you can raise interest rates a little, but what will that accomplish? How do slightly higher interest rates reduce prices?
What you need to do is raise interest rates high enough that homebuilding and durable goods purchases collapse. Then lots of people will be thrown out of work. All those unemployed workers make it hard for service sector workers to bargain for wage increases, and the overall lower output reduces commodity prices. This is a tough, ugly process, and nobody wants to do it. It’s also why central bankers make a kind of a cult out of being hardasses. You need to pump people up psychologically so they think that causing unemployment and misery is actually brave and good, because otherwise nobody will ever nip that 4-5% inflation in the bud. Then the next thing you know it’s 7-8% and then 11-15% and off to the races.
It also means that you ideally want to preempt inflation. When unemployment is low, it’s time to start raising rates even if inflation is still low. It is true that slowing job growth will hurt some people, but needing to hammer the economy 18 months down the road will hurt even more people. The idea is to stay ahead of the curve. And you really, really, really do not want to overdo it with fiscal stimulus because if you stimulate too much and get inflation, then the Fed has to provoke a new recession to stop it. To have long, robust economies you need to pace yourself like a distance runner.
I think that’s all wrong — the Fed can reduce nominal growth expectations relatively easily. Yes, they can do it by making some policy changes, but they mostly can by stating clearly that it is determined to generate lower nominal growth. This need not take the form of a wrenching, disastrous recession. Consequently, there is also no good reason to preemptively tighten monetary policy. This came up a lot in the 2015-18 period when the unemployment rate was low but inflation was also low.
My view was “inflation is low, there’s no need to do anything.” But the Fed, under both Janet Yellen and then later under Powell, took the view of “unemployment is low, it’s safe to start raising rates to head off hypothetical future inflation.” Powell’s big change of heart, which has saved America’s bacon during the pandemic, was to drop preemption.
And by the same token, my view is that when a fiscal policy response is called for as it was in 2009 and again during the pandemic, it’s smart to go really big if you can find a politically feasible way to do so. The cost of undershooting can be very high, but the cost of overshooting is low.
Another implication of my view is that when you have clearly overshot, it’s time to pivot hard. This is why after over a decade of being one of the most dovish figures in the macroeconomic debate, I’m now very much on the hawkish side. Economy-wide nominal spending and nominal income have fully recovered to their pre-pandemic trends. Whatever economic problems we have today are not problems of inadequate demand, and all the talk in the world about supply-chain this and pandemic-specific that doesn’t change the reality that we now need to lower the trajectory of nominal growth. But because I’m a expectationist, I don’t think this is anything to fear or necessarily involves wrenching pain.
What we need is for Powell and company to say clearly, and repeatedly, that they are proud and excited that nominal income has fully recovered but that since it has fully recovered, they want it to grow more slowly in the future than it did this year. They of course hope that the public health situation and various supply chain issues will improve so as to allow a more favorable split between real growth and inflation. But their job is demand, and they want demand to grow more slowly. What will they do to accomplish that? Well, they will accelerate tapering. They will do an interest rate hike or two. If necessary, they will do three or however many are needed to hit their target. They could do 17! They won’t, of course, but they could. And the point is that if people believe they will do whatever it takes, then it won’t actually take much doing — the markets do it themselves.
But how does this actually work?
I think that one big problem with my view is that it sounds like the whole thing is a dumb Wizard of Oz confidence game.
I also think it’s not a coincidence that the great German central banker Hjalmar Schacht titled his memoir “Confessions of the Old Wizard” or that the major biography of Alan Greenspan is called “The Maestro.” It genuinely is, on some level, a series of conjuring tricks. Modern central bankers are not issuing bills of credit based on a national stockpile of gold. The value of the money supply is backed on one level by crude threats of force (unless you produce the U.S. dollars the IRS demands on schedule they will put you in jail), but on another level by coordinated expectations. I want to have this currency because I think other people also want to have it.
In concrete terms, it’s perhaps easier to think about a small country like Israel or New Zealand where exchange rate effects are very important.
If New Zealand is in a recession, then the Bank of New Zealand wants to stimulate the economy by reducing the value of the New Zealand dollar. If the currency gets cheaper, then New Zealand’s agricultural exports get more popular and more tourists come and there is more investment in supporting those industries. So how does the bank reduce the value of the New Zealand dollar? Well, in a way, by cutting interest rates to make New Zealand government debt obligations less lucrative for foreign investors. But mostly, if everyone thinks the government of New Zealand is trying to reduce the value of its own currency, they will sell in anticipation of devaluation, and that will produce the devaluation. So will it plunge down to worthlessness? No, because if it got too low, that would set off inflation and the bank would go in the other direction. If people assume the Bank of New Zealand will act responsibly, they will trade in accordance with that belief — devaluing the currency, but only a modest amount.
The magic of it is that the more people believe you would do X, Y, or Z if you needed to, the less likely it is that you actually need to do the thing.
A large country like the United States doesn’t have the decisive influence of a single foreign exchange market. But dozens and dozens of separate equity and commodities markets accomplish the same thing.
Better sooner than later
I was born in 1981, and the difference between me and the old-timers is I don’t remember the Volcker disinflation.
The big reason lots of people don’t believe in my kinder, gentler versions of expectations-driven monetary policy is that when Paul Volcker wanted to crush inflation in 1980-82, he really did end up crushing the labor market in order to do it. There was no expectations magic, interest rates got really high, tons of people lost their jobs, and there was a huge crisis in the farm economy. Ronald Reagan became super-unpopular and the GOP got crushed in the 1982 midterms.
My answer is that this is what happens when you allow high and rising inflation for over a decade.
By the time Volcker became Chair in the summer of 1979, nobody knew what to believe about anything. There was both a big underlying inflationary trend, a series of nasty oil shocks, and a slowdown in productivity growth all coming at a time when the labor force was expanding due to shifting gender norms. By the end of the ‘70s, it was really hard to convince anyone of anything. The results of the Volcker Recession were tragic and fairly shocking with joblessness peaking at higher than its Great Recession level, and it’s hard to fault people who did not believe ex-ante that anyone would be willing to go that far to bring inflation down.
This is why even though I don’t think 2021 levels of inflation are per se the worst thing in the world (in the context of a hugely disruptive pandemic, it’s a pretty blah problem), it would be correct and appropriate for the Fed to start taking a more hawkish line. You want people to believe that inflation will come down next year and down further the year after that, and the Fed isn’t going to shift into CYA mode if things come in above forecast. So while I was very against fighting inflation preemptively, we’re not talking about preemption anymore, we’re talking about holding the line. And you want to do that pretty aggressively with your words in hopes that you can then back it up with relatively mild deeds.