Sunday, January 3, 2010

It's Official, Bernanke Is Confused as to What Monetary Policy Is

Federal Reserve Chairman Ben Bernanke spoke today in Atlanta, Georgia at the Annual Meeting of the American Economic Association.

During his speech, he discussed what he called "monetary policy". However, throughout the speech what he really discussed was interest rate policy, not monetary policy.

This has significant ramifications with regard to how the Federal Reserve will conduct its activities. Specifically, during a period when the real interest rate is low, and by "real interest rate" I mean the rate that would appear on the market if there was no interest rate manipulation by the Federal Reserve, the Fed dropping the Fed funds rate, but not below the real rate, in my view is not a period of monetary ease, since during such a period the money supply would not be growing.

In similar fashion, if the real rate is extremely high, say 15%, and the Fed raises the Fed funds rate to, say, 13% from 1%, Bernanke would consider this a tight monetary policy. However, since the money supply would be expanding (since it would be profitable for banks to borrow from the Fed and loan out at the higher rate), in my book this woulod be a period of expansive monetary policy.

What is particularly odd about Bernanke's use of the term "monetary policy" when he really is discussing "interest rate policy" is that when he switches to commentary about the Great Depression, where he considers himself an expert, he uses the term "monetary policy" in the sense I use it.

As I previously pointed out:
...during the Q&A that followed his speech today [December 7, 2009] before the Economic Club of Washington D.C.

At one point, in answering a question he said that the Great Depression was prolonged because of the Federal Reserve's "tight monetary policy", which he said was a period of declining money supply (He didn't mention interest rates at all.) Then in the next sentence he said the Fed was not making that "error" in monetary policy, pointing to the fact that the Fed has pushed interest rates low.
The policy ramifications to this sliding Bernanke meaning of the term "monetary policy" are as follows. During a period of very low real rates, the Fed is likely to maintain a tight monetary policy, i.e., in my sense of the term of no or little money supply growth. This will occur because the Fed's pushing the Fed funds rate lower may still not be below the real rate. Since, I always prefer a no growth money policy, this actually results in a preferable outcome in my view.

On the other hand, during a period of high real rates, the Fed may raise rates to fight inflation, but if their rate hikes do not push above the real rate, money supply will continue to grow and thus, depending upon how far off they are from the real rate, it would push price inflation even higher even though they think they are fighting inflation. This is the danger during any future inflation period. It would take a Paul Volcker type as Fed chairman to come in and say, as he did, we are not targeting interest rates any more, we are targeting money supply (although he did not completely kill inflation and ended up in the end printing money like all Fed chairman).


  1. Very enlightening. Your focus on using money supply to tell you if the Fed is above or below the real rate opens the eyes of this armchair economist and makes perfect sense. Thanks!

  2. But shouldn't the money supply - all other things being equal - be shrinking at an enormous rate right now (if it wasn't for Bernanke&Co)? Doesn't this mean that the monetary policy is - compared to a market-rate scenario - still easy right now?

    And isn't this what should be allowed to happen, namely that banks fail, credit gets revoked, debt wiped and the system resets to a sustainable level?

  3. @savecapitalism

    If there was no central bank, or if the central bank maintained a fixed money supply. Then there would be no manipulations of interest rates and the money supply would remain constant, neither increasing or decreasing.

  4. Looks like Dr B.S. just does not want the phrase "interest rate" to come out of his mouth in public. Since it's near zero now, there could be only one perceived reason for him to mention the phrase, or so the markets may interpret it. Also you forget about his poker skills that you mentioned earlier. And then it is always possible to say one was misunderstood, especially for the fed head. Remember who said this? "If I seem unduly clear to you, you must have misunderstood what I said."