How should one evaluate the stance of monetary policy?

This is the burning question that underlies all the arguments for and against more expansionary monetary policy. If the current discourse among economists is any indication, there are wide-ranging views as to how to properly evaluate the stance of monetary policy. Part of the problem is that the assessment of monetary policy is the United States is inherently difficult. The Federal Reserve has no explicit goal for monetary policy. As a result, the stance of monetary policy is usually determined by a particular variable (or set of variables) that are able to capture most effectively the transmission of monetary policy. For Keynesians, this is often the short-term interest rate. For monetarists, the indicator is money balances. For many supply-side folks, the key indicator is commodity prices; namely, precious metals.

Thus, when the central bank doesn’t have an explicit nominal target for monetary policy, there are many ways to assess the stance of policy. But what happens if the central bank has an explicit target?

When the central bank has an explicit target, the stance of monetary policy is clear. For example, suppose the Federal Reserve announced an explicit inflation target of 2%. In this case, the stance of monetary policy is determined by:

P – P*

where P is inflation and P* is the 2% target.

If inflation exceeds the target rate, monetary policy is too loose. If inflation is less than the target rate, monetary policy is too tight. It is literally that simple. Don’t believe me? Pick up a UK newspaper (or just read it in your web browser). The Bank of England has an explicit target for inflation. As a result, when one reads financial news in UK newspapers, assessments of monetary policy are always framed in the context of the inflation target.

Still don’t believe me? Here is an excerpt from an article in the UK Telegraph:

The MPC’s mandate makes it clear the best contribution it can make to economic growth is via stable prices, specified in terms of a 2pc target for CPI inflation, Mr Sentance said. However, latest inflation figures this week showed that inflation remained at 3.1pc in September, exceeding the Government’s 3pc limit for a seventh month. “The current period of above-target inflation risks being prolonged by monetary policy which is too lax – creating a climate in which higher inflation is not just the product of one-off shocks but becomes more deeply ingrained,” Mr Sentance said.

Search the article. There is no mention of money growth or commodity prices. The only mention of the interest rate is in reference to whether or not the Bank of England should increase the interest rate to stem rising inflation — there is no mention of whether the current interest rate implies that monetary policy is too loose or too tight.

So why am I wasting all of this time talking about what happens under an inflation targeting regime when there is no such target in the United States? Because the worst kept secret in the world is that the Federal Reserve has an implicit target for inflation of 2%. It would therefore make sense for us to start assessing the stance of monetary policy in terms of the implicit target. If inflation is below 2%, then the monetary policy is too tight.

I am puzzled why others are thinking in different terms. For example, Stephen Williamson seems to suggest that the inflation risk is on the upside and that Bernanke is using “Phillips curve logic.” While I share Williamson’s displeasure with the Phillips curve, I am skeptical of his evidence. For example, he plots M1 and currency to show that the rate of growth has increased recently for each. This is fine, but M1 does a poor job of forecasting inflation — at least post-1979 (Divisia M1 does a good job). In addition, this ignores what is happening to velocity and, for the analysis of currency, the money multiplier. I know that Williamson disdains the equation of exchange, but sole reliance on monetary aggregates is not always sufficient.

In addition, Williamson plots the TIPS spread for the 10-year Treasury and suggests that inflation expectations are close to 2%. Of course, if one looks at the TIPS on the 5-year Treasury as David Beckworth has done, expected inflation is below 1.5%.

I should note that I believe that it is important to look at other monetary indicators to provide guidance as to the future path of inflation — as Williamson is clearly indicating. However, when there is an explicit target (or an implicit target that really isn’t that implicit), the main indicator of the stance of policy should be the deviation of policy from its target.