Archive for the Category Monetary policy stance

 
 

Counterfactuals are tricky

A commenter named “tpeach” recently asked the following:

My question is, what would have happened if the Fed hadn’t cut rates between Dec 07 and Apr 08? What would have happened to the base and velocity if the fed kept the rate stable while the Wicksellian or market rate plummetted during that time? Would the base shrink? If so, what are the mechanics behind that process? Also, how can the fed adjust the rate without changing the base? And why didn’t velocity drop when they cut rates during this time?

I wasn’t able to provide much of an answer.  Here I’d like to explain why.

At first glance, the obvious counterfactual would seem to be a smaller monetary base and a higher path of interest rates.  But that is a very fragile equilibrium, which could easily spiral off in one direction or another.  For instance, suppose the Fed had reduced the monetary base in late 2007 in order to prevent any fall in the fed funds rate.  What might have happened next?  One possibility is that the economy would have gone into a deep depression in early 2008.  Most likely, the Fed would have responded to that deep depression with a big rate cut and a big increase in the monetary base.  Thus in this case the counterfactual path of the base would have been a bit lower in late 2007, and much higher in early 2008. Indeed what I just described is roughly what did happen between early and late 2008—I am simply contemplating that scenario playing out 6 months earlier.

Monetary equilibrium often has “knife edge” qualities.  Imagine climbing along a mountain ridge with steep drop-offs on both sides.  If you are not at the peak of the ridge, you have the option of walking a bit further up the slope.  But if you go too far, you risk plunging down the other side.  Monetary economics is kind of like that.  Small changes are often “Keynesian” in character, meaning slightly tighter money means slightly higher nominal interest rates.  But larger changes can easily be “Neo-Fisherian” in character, meaning tighter money leads to lower nominal interest rates.  And it’s not just a question of more or less tight money, it’s more about expectations regarding the future path of policy.

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Yip Cloud recently pointed me to the latest in his excellent series of interviews of macroeconomists, this one of Atif Mian:

Some people have the 5-year adjustable rate mortgages (ARMs), others have the 7-year ARMs. Let’s say that the mortgages started in 2005. When 2010 comes, in the middle of the slowdown, those with the 5-year ARMs would get the interest rate reduction because the mortgages reset to a lower rate automatically. They get this reduction in the interest rate that the Fed was trying to pass through to the individual households. But those individuals who have a 7-year ARMs still have to wait for 2 additional years before they get a lower interest rate.

By taking advantage of this kind of variation in the cross-section, they can actually show the impact of the reduction in interest rate for the 5-year ARMs owners, by comparing them to the 7-years ARMs owners who didn’t receive the same reduction in interest rate just because they have a different kind of financial contract. What they’ve shown with this kind of analysis is that a reduction interest rate is actually beneficial. It actually allows the lenders to boost their spending and improves local economic outcome, in term of employment and aggregate demand. That’s just one example that actually shows monetary policy can be effective.

At the same time, that same work also shows why the monetary policy was ineffective. If you think about it, you need to be able to pass through the action of the Fed to the ultimate households. However, if people are struck in the 30-year fixed rate mortgages, they would not be able to take advantage of this lower interest rate environment. As a result, monetary policy is not able to pass through to the ultimate households. It is going to be constrained in the effectiveness. That’s a very important insight that has come about because of this kind of work that I emphasized. That’s a very interesting and useful development.

If people have borrowing capacity and willing to borrow, the same monetary policy shock can have more impact on the real economy. When you lower interest rate, for people who are prone to borrow more, they can borrow aggressively against a lower interest rate and that boosts the economy.

But if the same individuals have already borrowed a lot in the down-cycle, you can lower the interest rate but those individuals are underwater. They can’t borrow any more. Then the same reduction in interest rate is not going to have much of an impact on the macroeconomy. This kind of logic also suggests that monetary policy itself is going to be insufficient in dealing with the downturn. You need to focus on something that Sufi and I have to try to emphasize in our book.

I can’t emphasize enough that (as Friedman, Bernanke and Mishkin pointed out) changes in interest rates are not the same as changes in the stance of monetary policy, for standard “never reason from a price change” reasons.  Thus it’s not possible to draw any conclusions about the effectiveness of monetary policy by looking at the impact of changes in interest rates.  To take the most obvious reductio ad absurdum example, a Mexican currency reform exchanging 100 old pesos for one new peso will immediately reduce the price level by 99%, without any significant change in interest rates.

Stop talking about interest rates

W. Peden directed me to this article:

Andy Haldane said low rates kept some “zombie” firms alive, but the trade off was far more people stayed in work.

A Bank modelling scenario found that years of 0.25% rates probably kept 1.5 million in jobs, he said in a speech.

He would not have sacrificed those jobs for an extra 1% or 2% productivity.

This sort of thing makes me want to pull my hair out.  Start with the fact that he’s reasoning from a price change.  I suppose his defenders would claim he meant “an easy money policy that caused low interest rates also tended to hurt productivity”. But of course that’s not what happened.  In fact, UK interest rates fell to very low levels because of extremely low NGDP growth after 2008, which was in turn caused by tight money.  In a counterfactual where the BoE adopted ECB style policy, NGDP growth would have been even slower, and interest rates would have been ever lower (indeed negative.)

Although BoE policy was far better than ECB policy, it was still too contractionary. But for simplicity let’s assume it was about right—that will make it easier to explain what’s wrong with Haldane’s comments.

Suppose NGDP growth in the UK were appropriate.  And suppose you saw falling interest rates and falling productivity growth in that environment.  How would you interpret those facts?  I’d make the following claims:

1.  The UK was probably hit by an adverse supply shock.  I can think of at least three components; falling North Sea oil output, a big decline in banking jobs in “The City” after the crash of 2008, and a drop in manufacturing jobs because of the collapse in world trade in 2008-09.  Of course the 2008-09 shock is a demand shock at the global level, but at the UK level it shows up as a supply shock.

2.  In oil, banking, and manufacturing, worker productivity is much higher than for the economy as a whole.  So when those sectors suddenly decline, overall productivity will take a hit. This has nothing to do with monetary policy.

3.  If monetary policy is sound (reasonable NGDP growth), then the workers losing jobs in those three sectors will initially re-allocate into less productive sectors, mostly in the service sector.  Again, overall productivity will suffer.

4.  I also suspect that the UK is suffering from some of the same “Great Stagnation” problems that are affecting the US and other developed countries.

If the BoE had adopted a very tight money policy, causing a big drop in NGDP, then the re-allocation of workers from declining sectors to growing sectors would have been less complete.  This might have actually raised productivity slightly, as the least productive workers often are the ones who have the hardest time getting re-employed.

To summarize, neither a low interest rate policy nor monetary policy more generally reduced UK productivity.  Rather productivity fell as part of the natural adjustment process in a free market economy, as workers get re-allocated out of high productivity sectors into lower productivity sectors.  To its credit, the BoE refrained from the sort of tight money policy adopted by the ECB, which would have led to much more unemployment, but which also might have led to slightly higher productivity in the short run.

The BoE is not a fireman that rescued the UK labor market at the cost of lower productivity; rather the ECB is an arsonist who trashed the eurozone labor market.

Nick Rowe on the New Keynesian model

Here’s Nick Rowe:

I understand how monetary policy would work in that imaginary Canada (at least, I think I do). Increasing the quantity of money (holding the interest rate paid on money constant) shifts the LM curve to the right/down. Increasing the rate of interest paid on holding money (holding the quantity of money constant) shifts the LM curve left/up. Done.

It’s a crude model of an artificial economy. But it’s a helluva lot better than a simple New Keynesian model where money (allegedly) does not exist and the central bank (somehow) sets “the” nominal interest rate (on what?).

I think this is right.  But readers might want more information.  Exactly what goes wrong if you ignore money, and just focus on interest rates?  Let’s create a simple model of NGDP determination, where i is the market interest rate and IOR is the rate paid on base money:

MB x V(i – IOR) = NGDP

In plain English, NGDP is precisely equal to the monetary base time base velocity, and base velocity depends on the difference between market interest rates and the rate of interest on reserves, among other things.  To make things simple, I’m going to assume IOR equals zero, and use real world examples from the period where that was the case.  Keep in mind that velocity also depends on other factors, such as technology, reserve requirements, etc., etc.  The following graph shows that nominal interest rates (red) are positively correlated with base velocity (blue), but the correlation is far from perfect.

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[After 2008, the opportunity cost of holding reserves (i – IOR) was slightly lower than shown on the graph, but not much different.]

What can we learn from this model?

1.  Ceteris paribus, an increase in the base tends to increase NGDP.

2.  Ceteris paribus, an increase in the nominal interest rate (i) tends to increase NGDP.

Of course, Keynesians often argue that an increase in interest rates is contractionary.  Why do they say this?  If asked, they’d probably defend the assertion as follows:

“When I say higher interest rates are contractionary, I mean higher rates that are caused by the Fed.  And that requires either a cut in the monetary base, or an increase in IOR.  In either case the direct effect of the monetary action on the base or IOR is more contractionary than the indirect effect of higher market rates on velocity is expansionary.”

And that’s true, but there’s still a problem here.  When looking at real world data, they often focus on the interest rate and then ignore what’s going on with the money supply—and that gets them into trouble.  Here are three examples of “bad Keynesian analysis”:

1. Keynesians tended to assume that the Fed was easing policy between August 2007 and May 2008, because they cut interest rates from 5.25% to 2%.  But we’ve already seen that a cut in interest rates is contractionary, ceteris paribus. To claim it’s expansionary, they’d have to show that it was accompanied by an increase in the monetary base.  But it was not—the base did not increase—hence the action was contractionary.  That’s a really serious mistake.

2.  Between October 1929 and October 1930, the Fed reduced short-term rates from 6.0% to 2.5%.  Keynesians (or their equivalent back then) assumed monetary policy was expansionary.  But in fact the reduction in interest rates was contractionary.  Even worse, the monetary base also declined, by 7.2%.  NGDP decline even more sharply, as it was pushed lower by both declining MB and falling interest rates.  That’s a really serious mistake.

3.  During the 1972-81 period, the monetary base growth rate soared much higher than usual.  This caused higher inflation and higher nominal interest rates, which caused base velocity to also rise, as you can see on the graph above.  Keynesians wrongly assumed that higher interest rates were a tight money policy, particularly during 1979-81.  But in fact it was easy money, with NGDP growth peaking at 19.2% in a six-month period during late 1980 and early 1981.  That was a really serious error.

To summarize, looking at monetary policy in terms of interest rates isn’t just wrong, it’s a serious error that has caused great damage to our economy.  We need to stop talking about the stance of policy in terms of interest rates, and instead focus on M*V expectations, i.e. nominal GDP growth expectations.  Only then can we avoid the sorts of policy errors that created the Great Depression, the Great Inflation and the Great Recession.

PS.  Of course Neo-Fisherians make the opposite mistake, forgetting that a rise in interest rates is often accompanied by a fall in the money supply, and hence one cannot assume that higher interest rates are easier money.  Both Keynesians and Neo-Fisherians tend to “reason from a price change”, ignoring the thing that caused the price change.  The only difference is that they implicitly make the opposite assumption about what’s going on in the background with the money supply. Although the Neo-Fisherian model is widely viewed as less prestigious than the Keynesian model, it’s actually a less egregious example of reasoning from a price change, as higher market interest rates really are expansionary, ceteris paribus.

PPS.  Monetary policy is central bank actions that impact the supply and demand for base money.  In the past they impacted the supply through OMOs and discount loans, and the demand through reserve requirements.  Since 2008 they also impact demand through changes in IOR.  Thus they have 4 basic policy tools, two for base supply and two for base demand.

PPPS.  Today interest rates and IOR often move almost one for one, so the analysis is less clear.  Another complication is that IOR is paid on reserves, but not currency.  Higher rates in 2017 might be expected to boost currency velocity, but not reserve velocity.  And of course we don’t know what will happen to the size of the base in 2017.

How did we end up here?

I’ve finally had a chance to read Paul Romer’s critique of macroeconomics, and it’s every bit as interesting as you might expect.  I’m going to focus on a single issue, which in my view lies at the heart of what’s gone wrong in recent decades—identification.  This issue has been the main focus of my blogging over the past 7 1/2 years, so it’s very dear to my heart. By late 2008, it was clear to me that not only did economists not know how to identify monetary shocks, but also that they were very far off course, and didn’t even understand that fact. Indeed this misunderstanding actually became highly destructive to progress in both economic science and economic policymaking.  One of the two the worst contractionary monetary shocks of my lifetime is generally regarded as “easy money”.  So how did we get here?

1. The earliest monetary shocks were seen as involving the price of money.  Coin debasement was a common example.  No one knew the money supply, and banks did not yet exist. This policy tool was used by FDR in 1933, but today has fallen out of fashion in big economies. Small countries like Singapore still use the price of money (exchange rates) as a policy instrument, but they do not drive the research agenda.  I’m trying to bring it back with NGDP futures targeting.

2.  Although the monetarist approach to identification (i.e. the money supply) dates back at least to Hume, it really came into its own with fiat money, especially during hyperinflationary fiat regimes.  Milton Friedman preferred the M2 money supply as a monetary indicator, at least during part of his career.

3.  Then for some strange reason the profession shifted from the money supply to interest rates, as an indicator of monetary shocks.  But why?

Perhaps you are thinking that you know the answer.  Maybe it had something to do with the early 1980s, when velocity was unstable and monetarism was “discredited”.  If that is indeed what you are thinking, then it merely illustrates that you are even more confused than you know.  Yes, velocity is unstable.  And yes, that means Friedman’s 4% money growth rule might not be a good idea.  But that has absolutely no bearing on the argument for replacing the money supply with interest rates, as an indicator of the stance of monetary policy.

The relationship between i and NGDP is just as unstable as the relationship between M2 and NGDP, probably more unstable.  At least with M2, we generally can assume that an increase means an easier monetary policy, and a reduction means a tighter policy.  We don’t even know that much about the relationship between interest rates and NGDP. Right now, markets expect about a 1% fed funds rate in 2019. Suppose you had a crystal ball that told you that the fed funds rate in 2019 would be 3%, not 1%.  There’s a classic “monetary shock”. The stance of monetary policy changed unexpectedly.  But which way—is that easier than expected policy, or tighter?  I have no idea, and you don’t know either.  Even worse, my best guess would be “easier” but the official model says “tighter.”

Paul Romer says we know that monetary shocks are really important.  I agree.  And he says the Volcker disinflation proves that.  I agree, and could cite many other examples, probably even more than Romer could cite.  So I’m completely on board with his general critique of those who claim we don’t know whether monetary shocks are important.  But Romer then claims that the real interest rate is a useful measure of the stance of monetary policy, and it isn’t—not even close.

Am I denying that if the Fed suddenly raised the real interest rate by 200 basis points, money would be tighter on that particular day or week?  No, I agree that that statement is true.  But it’s also true that if the Fed suddenly raised the nominal interest rate by 200 basis points, money would be tighter on that particular day or week.  Or if the Fed suddenly cut M2 by 10%, money would be tighter on that particular day or week.

So why don’t we use M2 to measure the stance of monetary policy?  Because over longer periods of time, movements in M2 do not reliably signal easier or tighter monetary policy.  But that’s also true of movements in nominal interest rates. If you have a highly contractionary policy, then inflation and nominal rates will fall in the long run.  Hence low rates don’t mean easy money.  And this argument also applies to real interest rates.  If the Fed adopts a tight money policy that drives the economy into a depression, then real interest rates will decline, even as policy is effectively contractionary.  This actually happened in 1929-33 and 2008-09.

All of the traditional indicators are unreliable.  The smarter New Keynesians will say that money is tight when the interest rate is above its Wicksellian equilibrium rate. But how do we know when that is the case?  After all, the Wicksellian equilibrium rate cannot be directly observed.  You need to look at outcomes; Wicksell said interest rates were above equilibrium when prices were falling, and vice versa. But that means we can only identify easy and tight money by looking at outcomes; are prices rising or falling?

Today we would substitute above or below 2% inflation, or 4% NGDP growth, but the basic idea is the same.  Money is tight when it’s too tight to hit your target, and vice versa. Ben Bernanke got this right in 2003, and then lost track of this concept when he joined the Fed:

Do contemporary monetary policymakers provide the nominal stability recommended by Friedman? The answer to this question is not entirely straightforward. As I discussed earlier, for reasons of financial innovation and institutional change, the rate of money growth does not seem to be an adequate measure of the stance of monetary policy, and hence a stable monetary background for the economy cannot necessarily be identified with stable money growth. Nor are there other instruments of monetary policy whose behavior can be used unambiguously to judge this issue, as I have already noted. In particular, the fact that the Federal Reserve and other central banks actively manipulate their instrument interest rates is not necessarily inconsistent with their providing a stable monetary background, as that manipulation might be necessary to offset shocks that would otherwise endanger nominal stability.

Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman’s advice to heart.

Others will object that New Keynesians understand that it’s the level of interest rates relative to the Wicksellian equilibrium rate that matters.  For instance, a recent paper by Vasco Curdia shows that money was actually quite contractionary, during and after the Great Recession.

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Yes, but that paper was written in 2015.  Back in late 2008 and throughout 2009, market monetarists were just about the only people claiming that monetary policy was highly contractionary—and that was the period when we most needed clear thinking.  Others were lulled by meaningless indicators like low nominal and real interest rates, as well as a ballooning monetary base.

How did we end up using interest rates as an indicator of the stance of monetary policy?  Romer provides one possible clue in his paper:

By rejecting any reliance on central authority, the members of a research field can coordinate their independent efforts only by maintaining an unwavering commitment to the pursuit of truth, established imperfectly, via the rough consensus that emerges from many independent assessments of publicly disclosed facts and logic; assessments that are made by people who honor clearly stated disagreement, who accept their own fallibility, and relish the chance to subvert any claim of authority, not to mention any claim of infallibility.

I fear that economists have deferred too much to the “central authority” of central banks.  When I talk to macroeconomists, they seem to think it’s natural to use interest rates in their monetary models because the central banks actually target short-term interest rates.  But that’s a lousy reason.

Another problem may be that some economists are infected by a popular prejudice—that low interest rates are a “good thing” for the economy.  We visualize that we would be more likely to buy a new house if interest rates fell, and extrapolate from that to the claim that low rates would boost GDP.  That’s obviously an example of the fallacy of composition.  Yes, I’d be more inclined to borrow money if interest rates fell, ceteris paribus.  But some other guy is less inclined to lend me the money if interest rates fell, ceteris paribus.  Of course ceteris is not paribus if interest rates fall, and it all depends on whether they fall because of an increase in the money supply (expansionary) or more bearish expectations from the public (contractionary.)

Elsewhere I call this “reasoning from a price change”, and even Nobel laureates do it:

Real interest rates have turned negative in many countries, as inflation remains quiescent and economies overseas struggle.

Yet, these negative rates haven’t done much to inspire investment, and Nobel laureate economist Robert Shiller is perplexed as to why.

“If I can borrow at a negative interest rate, I ought to be able to do something with that,” he tells U.K. magazine MoneyWeek. “The government should be borrowing, it would seem, heavily and investing in anything that yields a positive return.”

But, “that isn’t happening anywhere,” Shiller notes. “No country has that. . . . Even the corporate sector, you might think, would be investing at a very high pitch. They’re not, so something is amiss.”

And what is that?

“I don’t have a complete story of why it is. It’s a puzzle of our time,” he maintains.

Actually there is no puzzle.  Shiller seems unaware that it’s normal for the economy to be weak during periods of low interest rates, and strong during periods of high interest rates.  He seems to assume the opposite.  In fact, interest rates are usually low precisely during those periods when the investment schedule has shifted to the left.  Shiller’s mistake would be like someone being puzzled that oil consumption was low during 2009 “despite” low oil prices.

I know what commenters will say—I’m a pigmy throwing stones at Great Men. They are right.  Guilty as charged.  Look, I’ve made the mistake of reasoning from a price change numerous times—it’s easy to do.  But that won’t stop me from criticizing the ideas of people much more famous than I am.  In Paul Romer I’ve found a kindred spirit.

PS.  Since I’m nearly 6’4″, perhaps I should be PC and add, “Not that there’s anything wrong with being a pigmy”.

PPS.  This link has videos to the recent Mercatus/Cato conference on monetary policy rules.

Bernanke on Brexit

Scott Freelander recently asked me about a Bernanke post, which appears to be guilty of reasoning from a price change:

The U.K. economic slowdown to come will be exacerbated by falling asset values (houses, commercial real estate, stocks) and damaged confidence on the part of households and businesses. Ironically, the sharp decline in the value of the pound may be a bit of a buffer here as, all else equal, it will make British exports more competitive.

Here I’d probably cut Bernanke a bit more slack than Scott, as the phrase “all else equals” seems a nod in the direction of the dangers of reasoning from a price change.  The pound fell sharply when the Brexit vote was announced, because of an anticipated decline in the demand for pounds.  Brexit will reduce the foreign demand for British goods, services and assets.  Since one needs pounds to buy British stuff, this reduces the value of the pound, as well as the quantity of exports. Think of it as a leftward shift in the demand for pounds, on an S&D diagram. Bernanke presumably meant that British exports fall by less than if the BoE had pegged the pound, while demand was shifting left.  That is correct.

One other point.  I recall one recent example where the pound fell a couple of cents on expansionary talk from Mark Carney.  That can be viewed as a positive shift in the supply of pounds, which would indeed boost exports.

Here’s another example that Scott noticed, from the same post:

In the United States, the economic recovery is unlikely to be derailed by the market turmoil, so long as conditions in financial markets don’t get significantly worse: The strengthening of the dollar and the declines in U.S. equities are relatively moderate so far. Moreover, the decline in longer-term U.S. interest rates (including mortgage rates) partially offsets the tightening effects of the dollar and stocks on financial conditions. However, clearly the Fed and other U.S. policymakers will remain cautious until the effects of the British vote are better sorted out.

Long-term rates probably fell due to a decline in expected NGDP growth after Brexit (or maybe a greater preference for safe assets).  Presumably Bernanke meant that the drop in long-term interest rates would be more expansionary than if the Fed had pegged those rates by selling T-bonds, right as expected NGDP growth in the US was declining.  Again I’m cutting Bernanke some slack, as he’s obviously a brilliant economist and in his memoir I recall him saying that rising long-term interest rates during QE could actually be a sign that it was working.  So I think his views are not far apart from mine.

Nonetheless, I’m pretty fanatic on the “never reason from a price change issue”, and I feel that even while Bernanke is aware of all the points I just made, talking about the effect of lower interest rates and lower exchange rates can tend to mislead the public.  In another recent post I said:

I certainly agree with the 38 out of 40 economists who view anti-trade deficit arguments as reflecting ignorance of the most basic ideas in EC101. And yet, according to the Council on Foreign Relations, guess who else is ignorant of EC101?

Since April, Treasury has been applying a quantitative framework to determine if a country is managing its currency inappropriately for competitive advantage–that is, keeping it undervalued. Japan already meets two of the three criteria–a bilateral trade surplus with the U.S. over $20 billion, and a current account surplus greater than 3 percent of GDP–and will meet the third if intervention exceeds ¥10 trillion in a twelve-month period. This is not a high threshold historically–Japan sold ¥14 trillion in 2011 and ¥35 trillion in 2003-4.

So apparently those highly educated bureaucrats at the Treasury, with their 6 figure incomes and their posh DC lifestyles, are actually a part of the ignorant masses that are pushing Trump-style populism. And in fact they are pushing nonsense, the “quantitative framework” has no more support in economic theory than astrology has in high-level physics. So if the public has been reading articles for decades and decades about how our Treasury officials valiantly try to protect us from evil Asian exporters, is it any wonder that the now are susceptible to the arguments of right and left wing populists?

I worry when experts talk about the expansionary impact of a lower exchange rate, or a lower interest rate.  This recent Forbes piece is an example of what may result:

After Friday’s market close, people remarked that both the bond market and the stock market were at all time highs.

It’s not supposed to work that way.  Now, it is a common misconception that bonds always are negatively correlated with stocks.  Actually, over the long term, they have a correlation of zero with stocks.  But they spend most of their time in one of two regimes, either strongly positively correlated or strongly negatively correlated.  Over time it works out to be zero.  Yet here we are, with stocks and bonds on the highs.

David Zervos, market strategist at Jefferies, commented that “Central banks may finally be taking this too far.”  I think central banks started taking things too far in 1913, but yes, with nearly every financial asset in the stratosphere, you could easily come to the conclusion that there has been too much monetary easing.  I am not the first to say that central banks are addicted to higher asset prices.  It’s hard to imagine a scenario where they willingly let the markets deflate.

We’ve been having a lot of bubbles in recent years (a feature of a world populated with central banks), from the dot-com bubble in 2000 to the housing bubble in 2007 to what people are calling the “central bank bubble” or “the everything bubble” now.  Chances are, this could be the biggest bubble of all, and perhaps the most dangerous.

A few years ago, I predicted that in the future there would be almost non-stop complaints about bubbles.  People would see them everywhere.  That’s because low interest rates are the new normal, and thus P/E ratios, price to rent ratios, etc., will be higher than in the past.  It will look like there are bubbles everywhere, but of course bubbles don’t actually exist.

Part of the problem is that the public thinks it’s been told that low rates are easy money, which should boost asset prices.  So they see this as a central bank phenomenon, even though the lowest rates are in places (like Switzerland) where money has been tightest, and the higher rates are in easier money places like Australia.  The public misreads posts like the Bernanke example I just cited, and learns the wrong lesson.  That why I want economists to stop talking about the causal impact of a change in interest rates, inflation or exchange rates, and start talking in terms of the causal impact of changes in NGDP growth, where expected NGDP growth represents the stance of monetary policy.

Let me remind you of some earlier words of wisdom from Bernanke:

The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth. In addition, the value of specific policy indicators can be affected by the nature of the operating regime employed by the central bank, as shown for example in empirical work of mine with Ilian Mihov.

The absence of a clear and straightforward measure of monetary ease or tightness is a major problem in practice. How can we know, for example, whether policy is “neutral” or excessively “activist”? I will return to this issue shortly. . . .

Do contemporary monetary policymakers provide the nominal stability recommended by Friedman? The answer to this question is not entirely straightforward. As I discussed earlier, for reasons of financial innovation and institutional change, the rate of money growth does not seem to be an adequate measure of the stance of monetary policy, and hence a stable monetary background for the economy cannot necessarily be identified with stable money growth. Nor are there other instruments of monetary policy whose behavior can be used unambiguously to judge this issue, as I have already noted. In particular, the fact that the Federal Reserve and other central banks actively manipulate their instrument interest rates is not necessarily inconsistent with their providing a stable monetary background, as that manipulation might be necessary to offset shocks that would otherwise endanger nominal stability.

Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman’s advice to heart.  [emphasis added]

That last sentence seemed true in 2003, but obviously not today.  What happened?