Bernanke Will Be Watching You

Angus may already have linked this, but I couldn't find it in a minute of looking.  In any case, worth doing again....



With a nod to Matt Y.

Aaargh! Monetary policy is not "tight"

It is certainly true that the nominal interest rate is not a sufficient statistic for the stance of monetary policy, but a low interest rate is NOT somehow prima facia evidence of tight policy!

Let's take an example of how the nominal rate alone is not enough to infer the stance of policy.  If the interest rate is 10% and inflation is running at 20%, the real interest rate is -10% and policy is not tight. If that same 10% interest rate is paired with a 0% inflation rate, then policy would be very tight indeed (real rate of 10%).

So the nominal rate does not in general accurately guide us to a conclusion about monetary policy.

But now consider our current situation. Inflation is around 2%. The Fed has pushed short term rates to around zero. The short term real rate is negative. 10 year government bonds are yielding around 1.6%, so that 10 year rate is slightly negative. According to the email spam I constantly get, 30 year mortgage rates are something like 3.5%, so the real cost of funds to buy a house is 1.5%. That's not negative, but it is low.

Real interest rates that are negative to very low = monetary policy is not tight!

Could monetary policy be even looser? Maybe.

Would it help? Maybe.

If by QE3 the Fed could get mortgage rates down 50 basis points without raising inflation, making the real cost of funds to buy a house fall to 1% would that solve our economic problems? If the Fed could raise inflation expectations to 3% while somehow keeping nominal rates where they are, would that solve our economic problems?

As LeBron pointed out, the costs of trying and failing don't seem to be so high, so why not give it a try? Just don't expect too much.

And please stop railing about tight monetary policy in the US.

Did someone say monetary expansion?

It has become almost fashionable to claim that the Fed is not doing nearly enough to revive the economy. This conclusion follows from the same logic that the "stimulus was too small" meme employs: Has the economy recovered? No? Then policymakers have not done nearly enough.

Check out what's happened to the monetary base since the crisis began:

(clic the pic for a more vertiginous view)

The base has gone from a path of roughly doubling each decade to more than tripling in three years.