Monetary policy and inflation

It's not monetary policy determining inflation and employment rates; it's the other way around

Recent experience in both emerging and advanced economies seems to suggest that the theories and rules of inflation, money supply and interest rates no longer seem to be working. One example is our own experience where inflation seems to be consistently undershooting expectations of the central bank. This is often blamed by policy makers on the inefficiency of monetary transmission; in other words, the signals from the central bank are not getting properly reflected in the price of money in the banking market. 

The experience of advanced economies is also not very supportive of the basic theories. I had quoted one reductio ad absurdum of the standard DSGE model in my article of June 15. Another example is the breakdown of the linkage between money supply and inflation. Milton Friedman, the original guru of free markets and monetary theory, had argued that “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”. (After his death in 2006, the then Federal Reserve Chairman Ben Bernanke remarked that the “direct and indirect influences of his thinking on contemporary monetary economics would be difficult to overstate”). The other side is that the experience of the advanced economies over the last decade is different: Since 2007, the US, Eurozone, Japan and the UK have all followed unprecedentedly loose monetary policies and ultra-low to negative interest rates with inflation nowhere in sight, and output practically stagnant — and monetary transmission is supposed to be far more efficient in these sophisticated financial markets. (Incidentally, the negative interest rates have also overturned another assumption of traditional theory that zero is the lower boundary for interest rates).

In the process, the central banks of these countries have increased their balance sheet sizes to gigantic levels: The total is now around $12 trillion! The dilemma before policy makers is how to make inflation understand that it is supposed to go up when money is loose. More seriously, as most of the advanced economies are doing a little better than they have for 10 years — and, in a couple of cases even better than the pre-2008 highs — the big dilemma is how to shrink the balance sheets to normal levels. Obviously, bond yields will shoot up if the central banks start unloading their holdings. The US Federal Reserve holds not only Treasuries, but also mortgage-backed securities which it purchased at the time of the 2008 crisis. The European Central Bank has on its books bonds of several over-indebted member countries like Greece and Italy — and the Bank of Japan holds even equity investments. 

One other interesting point is worth noting. Instead of monetary policy and money supply determining inflation and employment rates, it is inflation and employment numbers which seem to be guiding interest rates. In other words, the distinction between what is the dependent variable and what is the independent variable seems to be vanishing fast. To be sure, this has been true of the financial markets for a long time: The increasing price of a share attracts speculators leading to a further hike in prices, with no change in fundamentals. Such feedback loops (or “reflexivity” an expression often used by George Soros, the famous hedge fund manager) are a common feature of price movements. 

Apart from the Friedmanite relationship between money supply and inflation, the other two long held tenets of monetary policy are the so-called “Taylor rule” (a model for calculating the real short term interest rate to achieve the inflation target) and the Phillips curve. Few central banks seem to be paying much attention to the first these days —perhaps the problem is that nobody knows whether the rule applies when the target is higher than the current inflation. The second is the so-called “Phillips Curve” which illustrates that while higher inflation may lead to higher employment in the short term, in the long run, inflation expectations lead to higher demand for wages and employment ceases to grow. 

Unfortunately, the “long term” remains unquantified: As Keynes once said, the only sure thing about the long term is that, in it, all of us are dead anyway. Compared to all the theories and curves and rules and models, is inflation the result more of “animal spirits” than anything else? 

avrajwade@gmail.com