My Response to Martin Wolf

Martin Wolf has an article where he considers whether monetary policy is currently too tight or too expansionary. He asks his readers what they think. Here is the reply I left at his site:

Dear Martin:

Two points. First, one of the better ways to currently measure the stance of U.S. monetary policy is to look at the market's expectation of future inflation. This can be seen by looking at the spread between the nominal Treasury yield and the real yield on TIPS. Given that productivity is not changing rapidly and affecting the price level, this forward-looking measure of inflation will be implicitly reflecting the market's expectation of aggregate demand in the future. The central bank, if it has the will, can shape total nominal spending and stabilize it. A failure to do so, whether from it being passive (e.g. not responding to declines in velocity) or active in the wrong direction (e.g. tightening when the recovery is still fragile), is a failure of monetary policy.

As shown here, expected inflation in the U.S. has been heading down for the past six months. This implies an effective tightening of monetary policy in the United States. For example, some of this (particularly in May) decline in inflationary expectations may be coming from the uncertainty in the Eurozone and all the austerity talk. This heightened uncertainty has created an increased demand for liquidity and, in particular, an increased demand for money. The Fed has passively sat by and failed to offset this increased money demand and thus is effectively tightening.

Second, I think it is useful to think about what monetary policy should do and how it can do it by taking the equation of exchange, MV=PY, and expanding the money supply or M term in it. (V = velocity, PY = nominal GDP.) Since M = Bm, where B = monetary base and m = money multiplier, the expanded version of the equation of exchange can be stated as follows:

BmV = PY

In this form, the equation says (1) the monetary base times (2) the money multiplier times (3) velocity equals (4) nominal GDP or total nominal spending (i.e. aggregate demand). The Fed has complete control over the monetary base, B. It has less control over the money multiplier,m, but still can shape it to some degree as it is currently doing by paying banks interest payments to sit on excess reserves. (What would happen to m if the Fed started charging a penalty for holding excess reserves?) The Fed could also influence V by setting an explicit inflation, price level or nominal GDP target. In short, the Fed has enough influence that if it really wanted to it could stabilize BmV (or MV). But it isn't and is therefore effectively tightening. (For more on the expanded equation of exchange see here.)

I personally favor the Fed targeting nominal GDP--and if there were a nominal GDP futures market then I would opt for it targeting expected nominal GDP--but I would settle for an inflation or price level target at this time. Anything to stabilize MV.

Update: In an earlier post I explained how this equation of exchange could be used to show that the dramatic increase in the monetary base, B, in late 2008 was largely offset by the collapse in the monetary multiplier, m. Consequently, the decline in velocity at this time was the deciding factor that lead to dramatic collapse in aggregate demand in late 2008 and early 2009. My take on these developments was that the Fed was so narrowly focused on B and m that it lost sight of V.