Brad, the market will tell you when monetary policy is easy
The IS/LM debate continues. Scott Sumner and Brad DeLong now debate how to define “easy money”. Here is my take on how to identify easy and tight money. In a world of monetary disequilibrium, one cannot observe directly whether monetary conditions are tight or loose. However, one can observe the consequences of tight or loose monetary policy. If money is tight then nominal GDP tends to fall – or growth is slower. Similarly, excess demand for money will also be visible in other markets such as the stock market, the foreign exchange market, commodity markets and the bond markets. Hence, for Market Monetarists, the dictum is money and markets matter. Furthermore, contrary to traditional Monetarists, Market Monetarists are critical of the use of monetary aggregates as indicators of monetary policy tightness because velocity is unstable – contrary to what traditional Monetarists used to think. As Scott Sumner states: “Monetary aggregates are neither good indicators of the stance of monetary policy, nor good policy targets. Rather than assume current changes in (the money supply) affect future (aggregate demand) with long and variable lags, I assume current changes in the expected future path of (the money supply) affect current (aggregate demand), with almost no lag at all.” Hence, contrary to Milton Friedman’s dictum that monetary policy works with “long and variable lags”, Scott Sumner argues that monetary policy works with “long and variable leads”. Hence, the expectation channel is key to understanding the impact of monetary policy. Market Monetarists basically have a forward-looking view of monetary theory and monetary policy and they tend to think that markets can be described as efficient and that economic agents have rational expectations. Therefore, financial market pricing also contains useful information about the current and expected stance of monetary policy. Market Monetarists therefore conclude that asset prices provide the best – indirect – indicator of the monetary policy stance. Market Monetarists would like to be able to observe the monetary policy stance from the pricing of a futures contract for nominal GDP. However, such contracts do not exist in the real world and Market Monetarists therefore suggest using a more eclectic method where a more broad range of financial variables is observed. Generally, if monetary policy is “loose” one should see stock prices rise, the currency should weaken and long-term bond yields should rise (as nominal GDP expectations increase). For a large country such as the US, a loosening of monetary policy should also be expected to increase commodity prices. The opposite is the case if monetary policy is tight: lower stock prices, strong currency, lower long-term yields and lower commodity prices. Market Monetarists only favour “looser” (tighter) monetary policy if NGDP expectations are below (above) the central bank’s policy objective. Hence, Market Monetarists would always conduct monetary analysis by contrasting the signals from market indicators with how far away the objective is from the “bull’s eye” (the policy objective). This is illustrated in this chart.