David Beckworth has a new podcast with Ethan Ilzetzki, and it’s one of my favorites. At one point, David asks Ilzetzki about the stance of monetary policy. A long answer is provided—well worth reading—but this part caught my eye:
My best guess of what we will see is that, for the most part, the shocks to monetary policy this past year will be for the most part dovish shocks, they will be negative declines in the fed funds rate.
Ilzetzki: And this is a little mind boggling because the actual interest rate has gone up this whole time. But our measures of monetary policy shocks, I suspect, will say the opposite. Just to give you an example, I didn’t look at futures for today’s meeting yet, but last FOMC meeting, the markets were pricing in, I think it was an 82 basis point increase. What does that mean, because the Fed never moves by 82 basis points. So what does that mean? That means that some people were betting on a 75 basis point increase. Some were betting, taking a contrarian view and saying, I think that Fed’s going to go even harder on the economy. So the monetary policy shock that occurred on the day of the announcement was actually a decrease, a very, very slight one, but a decrease in the interest rate because that was the new news that they went for the expected 75, and not for the contrarian, shocking 100 basis points.
David Beckworth then points out that these things are tricky to measure:
Beckworth: And this is the eternal challenge of macroeconomics identification. How do you truly isolate something caused by monetary policy that wasn’t itself a derivative of some other development in the economy or caused by something else. So macro economists have their work cut out for them, no doubt. . . .
Quickly, the monetarist theory says the nominal quantity of money relative to its real demand. Now, the key hang up in the monetarist model is we don’t observe the real money demand, we have to estimate it. It’s an unobservable. New Keynesian model, it’s the Phillips curve. And in the Phillips curve you have this thing called the output gap, which is also, we don’t observe, you have to estimate it.
Beckworth: Now for the fiscal theory of the price level, they also have this problem. They’ve got to know the net present value or the discounted present value of future real primary surpluses. So all three theories have these unobservables. It’s hard to falsify them in some extent.
Like Ilzetzki, I believe that monetary policy has been pretty dovish in 2022, although I focus more on NGDP growth than event studies. One thing we both agree on is that interest rates are a highly unreliable indicator of the stance of policy.
I’ve argued that the fiscal theory of the price level (which argues that fiscal policy is the dog and monetary policy is the tail), does not explain events in developed countries like the US. Ilzetzki points out that the model also fails to explain the UK. Here he discusses the mini-crisis after Liz Truss took over as Prime Minister:
Ilzetzki: And so if this was sort of an event of bond markets fearing that the government would strong arm the Bank of England into submission, we would not see what we saw. And coming to the policy recommendations, the UK also provides an excellent counter example or a counter-argument to the bank should just roll over and allow a more expansionary policy. I think what that ignores is the strategic game between the Treasury and the central bank. We saw the Bank of England sticking to its guns saying we’re going to have to raise interest rates more because this fiscal expansion is leading to more inflation. And it took about three weeks for the prime minister to resign. So fiscal policy responds to reality and blinked first in this case. So at least 1-0 here in the UK for monetary dominance and I hope it stays that way.
Monetary dominance is both a desirable state of affairs and the way the (developed) world actually works. God help us if we ever end up with the sort of fiscal dominance that you see in Argentina, Venezuela, and Zimbabwe. Just imagine what would happen if we asked Congress to target inflation at 2%!
