We market monetarists have frequently argued that the ECB rate increases that took place last spring were a turning point. Now Paul Krugman comments:
Note the peak in April 2011. It wasn’t very high; slightly above the ECB’s target, but arguably still too low to make the needed adjustment within the euro area feasible. Nonetheless, the ECB raised rates — and that was when the euro really began falling apart. The direct effects of the rate increase can’t explain that unraveling, but the effect on expectations — aha, so they really are that fanatical about price stability! — can.
This is a very good post. Note that the direct effect of the change in interest rates is small, it’s mostly about signals of the future path of monetary policy. That explains why rates have fallen over the past year, even as money has gotten tighter. The expectations of weaker NGDP growth have reduced interest rates, and those expectations come from too much policy credibility–the markets trust the ECB’s resolve to destroy the eurozone economy keep inflation below 2%.
In this post Krugman’s policy views are actually very close to market monetarism. If interest rates matter, it is mostly as a signal. I suppose the main difference is that he thinks moves in the expansionary direction would be less credible than we do. But we can both agree that “refraining from insane contractionary moves” is a highly effective policy, at least relative to the alternative!
Update: Tim Duy also sees that there’s more to policy than low rates. Here he responds to Eric Rosengren’s call for lower long term rates:
I guess Rosengren is not seeing the same Bloomberg numbers that the rest of us are getting, but long-term interest rates are already falling rapidly. The ten year rate is holding behold 1.5% as I write. The Fed needs to give up its fetish with low interest rates. Is Rosengren completely ignorant of the situation in Japan? At least I can argue that the Bank of Japan was navigating uncharted territory, which is how they wound up where there are. Sadly, the Federal Reserve has no such excuse. Their leader, Federal Reserve Chairman Ben Bernanke knows what to do, but just won’t do it.
Exactly. (And Rosengren’s one of the good guys.)