Monday, November 22, 2010

Monetary Policy Confusion

by Bill McBride on 11/22/2010 03:17:00 PM

An editorial in the WaPo yesterday - and some recent emails I've received - indicate there is some confusion on the difference between monetary and fiscal policy.

From the WaPo yesterday: Kicking the Fed

[B]uying hundreds of billions of dollars worth of federal debt in a deliberate effort to lower long-term interest rates and boost employment looks to many economists, market participants and politicians like fiscal policy by another name.
Well, these "economists, market participants and politicians" are confused.

The NY Fed's Terrence Checki provided a succinct description of monetary policy in a speech last Friday: Challenges Facing the U.S. Economy and Financial System
Monetary policy works by influencing the level and shape of the domestic yield curve. In normal times, the Fed does this by buying and selling Treasury securities at the short end of the curve, thereby influencing short-term rates. The Fed's purchase of Treasury bonds (under quantitative easing "QE" or LSAP) simply extends classic open market operations to longer duration securities, to produce similar results: a shift in the yield curve consistent with desired financial conditions.

While I have some sympathy for those who question the degree to which this will ultimately be successful in producing the desired real economy effects, I am not sure what to make of the fact that a change in operating procedure per se could have generated such an uproar ..

Regarding the external implications of the policy, several points are worth keeping in mind. One is that the goal of policy is to stimulate demand in the United States by encouraging lower real yields. To be sure, the dollar has weakened of late, but as a side effect of policy, not as a goal, and not by more than might be expected in light of our recent slowing and recent changes in interest rates and inflation expectations. And as growth strengthens, the value of the dollar should adjust accordingly.
That is monetary policy, not fiscal policy which is related to government revenue collection and expenditures.

It seems valid to question the effectiveness of QE2 (aka LSAP), but confusing monetary and fiscal policy is not helpful.

The Milwuakee Journal Sentinel provides an example of a confused politician: Ryan leads opposition to Fed's economic efforts
"There is nothing more insidious that a government can do to its people than to debase its currency," [U.S. Rep. Paul] Ryan said.

Just as harmful, Ryan warns, is that the proliferation of newly printed dollars inevitably unleashes inflation and throws the economy out of kilter in other ways.

"Inflation is a killer of wealth. It wipes out the middle class. It eviscerates the standard of living for people who have retired or are living on fixed incomes," he said.
Ryan is correct about the dangers of inflation, but that isn't a concern right now. And if Ryan means what he says about the debasing the currency, he should be opposing the proposed extension of the tax cut for higher income earners. That is fiscal policy. What will debase the currency is long term government spending far in excess of revenue.

Ryan then argues for eliminating the Fed's dual mandate of price stability and maximum sustainable employment. There are times when the two mandates are in conflict - like during periods of stagflation - but not right now.

Currently inflation is below the Fed's target of around 2%, and the unemployment rate is unacceptably high at 9.6%. So both "mandates" argue for further FOMC action.

I would support further fiscal policy aimed directly at the unemployed (an extension of benefits - or even directly hiring some of the unemployed). I think that would be more effective than monetary policy right now.