What Does “Easy Money” Even Mean?

Gerald brought up a really good question in my last post on ECB monetary policy stance since the crisis. I’m afraid Buttonwood got a bit trampled there, which in retrospect seems somewhat one-sided, since a big deal of his post is actually very good. Anyways, to the question:

What do you think a really easy monetary policy by the ECB would look like? Is it mostly about increasing the inflation target? Or would your rather have the central bank buy the debt of troubled economies like Greece?

At first I wanted to rush straight into it, but then I noticed that is pointless without clearing up what my definition of “easy money” is in the first place. I’ve spent quite a bit of time in this blog arguing that monetary policy all around the world, but particularly in the eurozone, is much too tight no matter which way you look at it. Let’s see what the ECB announcement brings today. A big issue i have with a lot of the current discussion, particularly in the Media, is that the currently historically low nominal interest rates are assumed to, by themselves, prove that money is “easy”, which is just wrong. So let me try and clarify some of the issues involved from my perspective.

The terms “easy” or “tight” in the area of monetary policy are more often than not misused, mainly because what those terms mean depends on relative, not absolute, comparisons. Also, they are terms that refer to the targets of monetary policy and can thus only be assessed by comparing the status quo with those targets. Interest rates are a mere tool of monetary policy and therefore, taken by themselves,  devoid of any useful information for the issue at hand. Let me repeat that: interest rates have to be looked at in context. Without context they are utterly useless macroeconomic indicators for judging what a central bank is doing. Many people seem to miss this. In fact, i can’t recall reading a single article in mainstream media in the last couple of years that gets this right.

In general, it is fairly easy to find different definitions of what monetary policy that is “just right” would entail. These definitions depend on the targets chosen by central banks, and are thus essentially normative. For the FED this would be achieving its inflation target of 2% and full employment, or at least minimizing the deviations from them if both can’t be achieved at the same time. Alternatively, for the ECB under its current rules, the “correct” monetary policy would be to achieve it’s target of below but close to 2% – call it 2% for simplicity. I am well aware of all the difficulties central banks face when trying to hit their respective targets, but in theory any deviation from them still represents a failure of monetary policy. “Tight” in a euorozone context then describes monetary policy that creates a level of Inflation that is below the target, or worse, that is below the target and is still allowed to fall further, as is the case in the eurozone right now. Not only is monetary policy at the moment too tight to achieve its target of ~2% inflation, it is currently getting even tighter! Remember, in essence inflation is nothing more than the amount of money that is issued above and beyond the amount of real activity generated in any given period of time. Put somewhat simplistically: if inflation falls, less new money (relatively speaking) entered the economy than it did in the last period, and central banks have several channels through which they can control this process.

Ideally we should look at NGDP and not at inflation rates, but the rationale doesn’t change. As a rule of thumb falling NGDP signals monetary policy that is getting tighter, even though this does not necessarily mean it is at the same time “tight” in any meaningful way the word should be used, while rising NGDP signals monetary policy getting easier. In other words, there is no “sufficiently loose” monetary policy, as both “loose” and “tight” refer to deviations from the optimal policy. Nominal interest rates might be at historic lows, but that doesn’t mean monetary policy is not at the same time incredibly tight by historic comparisons.

Why does this playing with words even matter? It matters because articles that state that “money is easy” imply that central banks all around the world have already done enough, and doing more would probably be too much, which is just wrong. Getting back to the original question: we do not want “really easy monetary policy”. We want monetary policy that is just right to at least achieve the intended targets, never mind the fact that those target are probably the wrong ones as well. What is needed for this to happen, however, I will have to leave for another post.


10 thoughts on “What Does “Easy Money” Even Mean?

  1. OK, I agree that the current policy stance of the ECB is too tight (although I think the main constraint on the ECB right now isn’t its inflation targeting policy strategy, it’s the ZLB). But I wonder if your definition of monetary tightness/looseness is really useful.

    According to your criterion monetary policy is too loose/tight when inflation is above/below target. Remember 2011 when we had surging commodity prices and Monsieur Trichet was going in “strong vigilance mode”, raising rates for fear of above-target inflation? Would you really call the ECB’s monetary policy too loose in that period, given that unemployment was at a record high in major parts of the Eurozone?

    My point is that “too loose”/”too tight” is not an easy concept if you are facing a supply side shock (as in 2011). Merely looking at whether the inflation target is met doesn’t seem quite right to me.

    • Let’s start with some links (I don’t know why I have to post these in full in the comments section, unfortunately): http://www.tradingeconomics.com/euro-area/inflation-cpi and http://www.tradingeconomics.com/euro-area/core-inflation-rate

      You are indeed correct in saying that, by my definition and given the ECB target, the HCPI was too high in the period you mention, and given this metric monetary policy to lose, which makes the interest rise merited on these grounds. But on the other hand, the rise in the HCPI was mostly due to commodity prices, as you point out. The Eurozone might be the second biggest economy in the world, but that does not change the fact that at the margin the ECB has basically 0 influence on commodity prices in general and oil prices in particular. Thus, the ECB is targeting something which it cannot really influence, which makes little sense. The Core inflation rate, something the ECB can actually influence quite nicely, never even exceeded 1.8% over the period of time we are talking about. As such, if the ECB would target an inflation measure that it actually makes sense to target, monetary policy was too tight. The target is broken, not my definition I would say.

      Also, the ECB does not target unemployment, so given the circumstances this variable has no relevance to the discussion regarding on whether, given the current target of the ECB, monetary policy should be different or not. I would say that of course it should also target unemployment (or something related), but that is precisely the point of my post: all this has to be viewed in context. Right now, the ECB is pursuing tight monetary policy compared to the targets I would prefer to the current one (which is strictly normative) but even compared to its own target (which is strictly objective), no matter how flawed it is.

      Also, whether a shock is supply side or demand side only matters if you’re using the wrong target. If we used NGDP we would not have not speculate on what kind of shock we experienced, and monetary policy would not react by doing exactly what it should not be doing.

      PS: I think the ZLB problem to monetary policy in general, but particularly for the ECB, is vastly overblown.

      • I think it doesn’t make much sense to say monetary policy is wrong if it doesn’t achieve its own target however stupid that target is. Monetary policy is too easy, conceptually, if the welfare maximizing policy stance is tighter than the actual stance. What exactly that policy is depends, of course, on your model. And the model should be chosen on empirical grounds, ie which model can explain the current reality best?

        PS: I think the ZLB is very real and the ECB is equally constrained by it as practically all other CBs in the “developed” world. I have little doubt that Draghi would, if he could, cut rates much more. But I guess we’ll soon find out.

      • I’m not sure I understand your first sentence, but in the end monetary policy targets are nothing but a proxy for “welfare maximizing”. We do not know what welfare maximizing really is because we do not know what welfare really is. If we knew, we would not have the need for targets expressed in terms of inflation or alternative variables. Clearly whoever determined that the ECB should use its current target thought that target is the one that will lead to welfare maximization, and by the observation that they are reluctant to change the target we can also conclude that there are plenty of people who still share that view. Thus the best thing we can do is compare actual policy with our best guesses of what “maximizes welfare”, and those best guesses are expressed in our monetary policy targets. I do not disagree with your definition of what “easy” money means, and as far as I can tell it does not differ from mine given what I tried to explain above. I would just argue that in practice it unfortunately isn’t of much use.

        On Draghi: I would love to believe so as well, but simple observation tells me this is clearly not the case. If it was, wouldn’t he have cut interest rates by 0.5% rather than just by 0.25% today?

      • Flo, it seems there is no real disagreement between us. Monetary policy should not be judged by its own target but by some kind of welfare criterion. And it seems that the ECB is far away from the optimal policy stance right now. You are arguing that NGDP targeting would bring us closer to optimality. And I agree, although simply raising the inflation target would also do the trick in the current situation.

        Well, Draghi is not a dictator. He has to compromise with the hawks in the Governing Council. But I think even if he were a dictator he couldn’t use the conventional tools to do much more. That’s because of the ZLB. He’d have to do some kind of QE. Agreed?

  2. First of all, thanks for the quick answer to my inquiry! So, do you think that momentarily troubled economies can get out of the liquidity trap and reach their policy targets just via monetary policy alone? And I don’t include an increase in the inflation target to those tools, as this, as you rightly said, would be just a change of the target, and not a means to reach it. (Cause in my opinion increasing the inflation target was the only credible way, central banks could reach positive nominal interest rates…)
    I don’t expect an answer from you on this one right now, I just ask you to include my thoughts as soon as you right your post about the tools you think central banks should make use of more intensively!

    • Essentially, yes. Potentially even without changing their target. But in any case, a change of target is a very legitimate monetary policy tool, so I’m not sure if it would make sense to exclude it from the set of tools at the disposition of central banks.

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