What is monetary policy?

Thanks to the Atlas Network for inviting me to join the Sound Money Project blog. I want to start by discussing a question that may seem obvious but can actually be somewhat complicated: “What is monetary policy?” Or, more specifically, “when is monetary policy loose or tight?”

Consider the debate between Scott Sumner and John Taylor. Taylor advocates the Fed’s monetary policy focus on targeting interest rates based on a Taylor Rule. Sumner would prefer the Fed target some rate of nominal GDP growth. From these perspectives, Taylor finds the Fed’s monetary policy during the financial crisis was too expansionary, while Sumner believes monetary policy was not expansionary enough.

What actually happened to the money supply in 2008 and 2009? The Fed engaged in a series of quantitative easing (QE) programs that created trillions of dollars in base money. At the same time, however, the Fed instituted the regulatory policy of paying banks interest on their reserve balances. The result, as seen in the figure below, is that since 2008, over 84% of the base money created by the Fed’s QE spending was absorbed onto banks’ balance sheets as reserves rather than entering the economy through bank loans.

Oddly, Taylor and Sumner both agree with the description above. How is it, then, that they come to opposite conclusions about whether monetary policy was loose or tight? Basically, Taylor is judging the Fed by its actions of creating new base money, while Sumner is judging by what happens to money in the economy as a result of the Fed’s actions. So is “monetary policy” the action or the result?

Although I favor Sumner’s approach to understanding the economy, it may be a mistake to label the Fed’s actions in post-crisis period as tight monetary policy. This case may be more accurately described as expansionary monetary policy combined with contractionary regulatory policy, or as Taylor calls it “mondustrial” – the combination of monetary and industrial – policy.

In other words, “money” is not the same as “monetary policy.” Saying that “money was tight” during the crisis (which I think is correct) is different from saying “monetary policy was tight” (which I think is not correct). We should evaluate monetary policy by the Fed’s actions rather than looking at any single outcome such as interest rates, M2, or NGDP.

This distinction is important because if banks continue to absorb 80% of the new money the Fed produces, then the Fed’s QE programs need to be roughly 5 times as large as would normally be necessary in order to achieve the growth rates in NGDP for which Sumner is calling. I think economists should instead be calling to end a terrible and counterproductive regulatory policy (more on this in a future post) of paying interest on bank reserves. Focusing on NGDP alone overlooks the bigger problem: a malfunction in the mechanics of monetary policy created by poor regulatory policy.

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