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.