Friday, July 9, 2010

What is the Current Stance of Monetary Policy?

Mathew Yglesias is making the case that the current stance of monetary policy is effectively tight. He invokes the term structure of interest rates to make his case. While I share his view, I believe a far more intuitive and convincing way to make this point is to look at the difference between the nominal interest rates on regular treasury securities and the real interest rates on treasury inflation protected securities (TIPS). The difference or spread between these two series is the market's expectation of future inflation.* To the extent changes in expected inflation are being shaped by monetary policy via its influence on aggregate demand, this measure provides a real time indicator on the stance of monetary policy. This indicator is graphed below using daily data on 5-year treasuries for the period January 4, 2010 - July 8, 2010: (Click on figure to enlarge.)

There is a clear downward trend. Now changes in expected inflation can come from both aggregate supply (AS) shocks and aggregate demand (AD) shocks. But given the Eurozone uncertainty, weak economic data, and all the austerity talk of late, the most obvious way to interpret this declining trend is that the market expects aggregate demand to weaken. This interpretation is also consistent with all the chatter about deflation noted by Mark Thoma. And since monetary policy has been doing nothing to stop this implied plunge in AD it is effectively tightening.

Now it is possible that an increase in the liquidity premium coming from the heightened uncertainty is driving some of this decline, but even if true it only serves to strengthen my interpretation. For in that case their is an increased demand for liquid assets of which money is the most liquid. Money demand, therefore, would be rising and velocity falling. So no matter what path you follow you end finding weakening AD and an effective tightening of monetary policy.

*This is because of the fisher equation that says nominal interest rates = real interest rates + expected inflation.


  1. I think I made the case better (and sooner) than either one of you. The problem with your argument is that it assumes that the Fed is capable of influencing the expected inflation rate, and that it can do so with sufficient intensity to offset any other factors that may be influencing it. My approach is to look at what the Fed has done in the past (basically, to follow a sort of Taylor rule) and compare that to what the Fed has done recently. What we find is that, when the past pattern would have called for negative interest rates, the Fed moved aggressively into QE mode, just as it should. But then, even though past experience would now call for even lower negative interest rates, instead of QEing even more aggressively, the Fed stopped. The end (or winding down) of QE was a dramatic tightening move at a time when the past pattern would have called for additional easing. Ergo, the Fed is clearly tight now compared to what its usual behavior would be under similar circumstances.

  2. Andy,

    I believe the Fed can largely determine the path on nominal spending or AD. Now it has to want to, but if it commits to doing so there is no reason why it wouldn't be succesful. The problem with the use of my expected inflation series is that it assumes only AD shocks are driving it, but it could well be that AS shocks are driving it too. In the current environment it seems to me that AD are the main driver of inflationary expectations and thus this series for now serves as a good proxy of monetary policy's stance. I would be far less convinced by it we were still having robust productivity gains, but they have slowed down. One of the nicer features is that we can get daily data on this series.

    In my dream world we would have a nominal GDP futures market that would provide a direct, clean signal of the markets expectation of future aggregate demand. Then we could know for sure whether the Fed was stabilizing the expected path of AD.

    At least our two series are complementing each other. Hopefully we are helping turn more folks on to the fact that the Fed can do more.