Monetary Policy is Not Interest-Rate Policy

(The FOMC Should Start Making that Distinction)


Monetary policy is not interest-rate policy. Neither is it Fed balance-sheet policy. Monetary policy is money-supply policy.

Sometimes these distinctions aren't important, but they are important now, and the Federal Open Market Committee (FOMC) should begin educating the public on them because soon it may need to allow interest rates to rise a bit to reduce market distortions without easing money (the money supply) in an inflationary way.

Similar distinctions between monetary policy and the Fed's balance sheet, the monetary base, and excess reserves should be understood. A large balance sheet, monetary base, and excess reserves are not inflationary unless they lead to too rapid an expansion of the money supply given the state of money velocity.

All these things have become blurred and confused because they normally work in the same direction, at least roughly. Generally, policies that push down short-term interest rates via the Fed Funds rate will also make the money supply grow faster. The FOMC quit trying to target the money supply directly and reverted back to indirect control over money via interest rates in the early 1980s, not because it believed money was less important to the economy than interest rates, but because the velocity of money had become unpredictable in the short run. It focused on interest rates as an operational target, but never abandoned Friedman's monetarist mantra that "inflation is always and everywhere a monetary phenomenon." Likewise for deflation.

Since open market operations involve buying or selling assets– usually Treasury bills– to speed up money growth or slow it down, they usually involved an expansion or contraction of those assets on the balance sheet. Hence, recently, balance sheet expansion has been taken as reliable evidence of easy money. But the correlation is not 100 percent since the composition of the balance sheet matters as well.

For many years students of money and banking have learned about "factors affecting reserves," which has been the basis of the format of the Fed's H-4 release. Simply put, some asset expansion is offset by non-monetary Fed liabilities, such as amounts owed to foreign central banks in swap agreements.

So, Fed balance sheet expansion is expansionary (or inflationary) only to the extent that it increases its monetary liabilities, consisting of currency and bank reserves, especially bank reserves, together constituting the monetary base. Monetary base expansion, in turn, is expansionary (or inflationary) only if it causes growth in the public's money supply. Money supply expansion is expansionary (or inflationary) only if it is not fully offset by a decline in velocity, which it has been lately. Finally, growth of money and velocity (MV) together is primarily expansionary or inflationary depending on the degree of slack in the economy (unemployment and capacity utilization).

(I will leave for another time the issue of money expansion versus credit expansion, which is also important for current circumstances.)

The bottom line here is that ultimately money growth under the right circumstances is the power behind monetary policy. These other things, especially interest rates right now, but also the balance sheet, are relevant but not crucial. It would behoove the FOMC to start clarifying these distinctions because it may well be that interest rates need to be raised a tad before it's time to ease monetary policy in any meaningful way. Zero Fed funds rates are distortionary. I can foresee a need to raise the Fed funds rate at least to one percent without easing monetary policy, i.e. without making money grow too fast. Unless the public and the financial markets are educated on these points, they could panic in response to what they perceive to be a premature tightening, or the Fed will forgo a needed adjustment fearing that outcome.

Comments (1)

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  1. John Booke says:

    Bob is the Fed rate really “zero?” Lately doesn’t it shift around .15 to .25% on a daily basis? Anyway how is the rate “distortionary?” The Fed Funds futures prices don’t seem to be pricing in a higher rate. You have said in the past that even at this very low Fed rate banks are not lending very much money. And it seems like businesses and consumers aren’t interested in borrowing even at the “zero” rate. Are you saying that we need to move “quantitative easing” off the table at this time? Should the Fed be talking about that? How will the currency markets react if the Fed even hints at such a notion?