Scott Sumner has a post on the Free Exchange explaining how the state of nominal interest rates is not a good indicator of the stance of monetary policy. And unlike many of the posts he has on his blog at TheMoneyIllusion.com that explain this concept well, this one seems to leave behind some confusion.
I wouldn’t presume to be fit enough on the subject, or even more fit on the subject, but from having somewhat comprehended the concept myself, here’s what I would add to make it more understandable for general audiences.
1) The stance of monetary policy at any given point in time is relative to the demand for money. Is there enough medium of account/medium of exchange or near substitutes, the dollar is both MOA and MOE, in the economy to service all of the liquidity needs of the transactions that need to take place?
2) Short term nominal interest rates, such as the Fed Funds Rate, are not the mechanism by which the Fed loosens or tightens policy. Nominal interest rates are a peg, like a point on a yardstick as to where the Fed is aiming policy and desires nominal interest rates to go. It makes this happen by adjustments to the base (or reserves) through Open Market Operations, buying or selling holdings – or in more understandable terms although not entirely accurate terms, printing or destroying “money”. It is a sort of arbitrage against the demand for money that causes the change in nominal rates – thus the level is a derivative of market activity. Unfortunately, the habit of policymakers to use nominal rates as a peg poses a cognitive problem at the zero bound; but not a physical or mechanical problem – Open Market Operations still impact the stance of monetary policy when nominal rates are at zero.
3) Monetary inflation problems are not caused by merely the act of “printing money” relative to money in existence. Monetary inflation problems are caused, in a basic sense, by sustained “printing of money” in excess of the demand for money over the same time period.
4) Inflation problems are not caused solely by monetary policy. Real supply and demand issues also affect prices of goods, such as changes that occur when the supply of gasoline or oil are impacted by factors like an oil embargo or a hurricane in the Gulf of Mexico. But these factors can impact the demand for money, thus the stance of monetary policy without the Fed having done anything, if they are of significance and persistent such as the oil price shocks that occurred in the later part of the 2000s.
5) Productivity issues also impact inflation – there is almost no end to the list of real factors that can cause prices to rise or fall, making the rate of inflation a terrible nominal measure by which to conduct monetary policy.
So, is monetary policy loose or tight at the zero bound? Is it loose or tight after several rounds of QE? Has it been tight or loose when headline CPI reads 4%? There is no way to answer these questions without knowing the context in which these things occur – the supply vs. the demand for money and the real factors impacting prices.
PS: Many of these points are conveyed by the term “Never reason from a price change”
Reasoning from a price can include the following:
Assuming monetary policy is loose because nominal rates have fallen to zero.
Assuming monetary policy is loose because the price of gas and food have gone up 10% in the last few months.
Assuming monetary policy is loose because the prices of things you buy every day have gone up 10% or more over the last year – even though you know ObamaCare is there and tax increases have been enacted.