Tight money = low yields – also during the Great Recession

Anybody who ever read anything Milton Friedman said about monetary policy should know that low interest rates and bond yields mean that monetary policy is tight rather than easy. And when bond yields drop it is normally a sign that monetary policy is becoming tighter rather than easier.

Here is Friedman on what he called the interest rate fallacy in 1997:

“After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

Unfortunately the old fallacy is still not dead and it is still very common to associate low interest rates and low bond yields with easy monetary policy. Just think of the ECB’s insistence that it’s monetary policy stance is “easy”.

In my previous post I demonstrated that all the major changes in the S&P500 over the past four years can be explained by changes in monetary policy stance from either the ECB or the Federal Reserve (and to some extent also PBoC). Hence, it is not animal spirits, but rather monetary policy failure that can explain the volatility in the markets over the past four years.

What holds true for the stock market holds equally true for the bond market and the development in the US fixed income markets over the past four years completely confirms Milton Friedman’s view that tighter monetary policy is associated with lower bond yields. See the graph below. Green circles are monetary easing. Red circles are monetary tightening. (See more on each “event” in my previous blog post)

I think the graph very clearly shows that Friedman was right. Every time either the ECB or the Federal Reserve have moved to tighten monetary policy long-term US bonds yields have dropped and when the same central banks have moved to ease monetary policy yields have increased.

Judging from the level of US bond yields – and German bond yields for that matter – monetary policy in the US (and the euro zone) can hardly be said to be  easy. In fact it is very clear that monetary policy remains excessively tight in both the US and the euro zone. Unfortunately neither the Fed nor the ECB seem to acknowledge as they still seem to be of the impression that as long interest rates are low monetary policy is easy. I wonder what Friedman would have said? Well, I fact I am pretty convinced that he would have been very clear and would have been arguing with the Market Monetarists that monetary disorder is to blame for this crisis and we only will move out of the crisis once the Fed and the ECB move to fundamentally ease monetary conditions and adopt a rule based monetary policy rather than the present zig-zagging.

PS See also my early post on the connection between monetary policy and the bond market: Understanding financial markets with MV=PY – a look at the bond market
Update: Scott Sumner just made me aware of one of his post addressing the same topic. See here.

Update 2: Jason Rave has kindly reminded me of this Milton Friedman article, which also deals with the interest rate fallacy.

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26 Comments

  1. bpabbott

     /  May 27, 2012

    The Fed announced a 3rd round of QE a few months back. Have their actions been ineffective?

    Reply
  2. bpabbott,

    Yes, to some extent the Fed pre-announced announced QE3 a couple of months ago. However, the Fed has not been very clear in explaining it’s “reaction function”. Under what conditions would it actually initiate QE3? I think that explain why it is not “perfect”.

    Second, I would note that despite of the renewed euro zone jitters the dollar did not start to strengthen until recently. That can be explained by the fact that there have been some effect of the quasi-announce of QE3. The same can be said for the outperformance in US stocks relative for European stocks.

    So the conclusion is that, yes there has been an “announcement effect”, but as the dollar has been strengthening quite significantly recently and US bond yields have dropped we will have to conclude that it has not been enough to avoid an effective tightening of US monetary conditions.

    Had the Fed instead operated a completely rule based NGDP level targeting regime then the markets would not have to speculate about possible discretionary decision on US monetary policy. The example of the uncertainty about QE3 pretty hence pretty clearly demonstrates that a set-up where the Fed is highly discretionary and conduct monetary policy by from time to time in rather unpredictable way announce that it will buy X bn dollar of assets is not near as effective as it could be if it instead said “we, the Fed, will buy or sell unlimited amounts of assets to always ensure that our forecast (the markets’ forecast) for NGDP stay on our pre-announced target for the NGDP level.”

    Reply
  3. Yet another clear, informative and sensible post. I suspect that the simple reasoning that “interest rates are the price of money and low price means something is plentiful compared to demand” is behind the persistence of the fallacy. Of course, that interest rates are the price of credit, not money, and credit is money on offer because it is not being spent (in the first instance) and/or people are not lining up to go into debt (i.e. the supply of credit is up and the demand for it is down because–guess what!–money is tight) means that the simple reasoning is a fallacy.

    Reply
  4. Thanks Lorenzo – you are up early in Australia;-)

    And yes, I think the problem very much is that people have a hard time differentiating between money and credit. Our friend Bill Woolsey knows this better than anybody else. He have done a number of interest blog posts on that topic over the last couple of years.

    Reply
  5. dwb

     /  May 27, 2012

    yep, good post. keep beating the drum!

    I agree: I think that QE(n+1) or not, nothing the Fed does will have much impact until we have a clear set of expectations. If the main mechanism through which monetary policy works is expectations, and expectations are muddled or unknown, then the transmission mechanism of monetary policy is broken (or very weak).

    The Fed is having an internal debate as to whether unemployment is “structural” or “cyclical,” which is a distraction: a) you cant tell the stance of policy by interest rates; and b) you can’t tell the size of the output gap when the CB is inflation targeting (because wages are set based on expected future inflation for those in the workforce, so the CB target inflation level is consistent with any level of UE, thats just the “expectations augmented Phillips Curve”). Its sad that we have to teach 17 highly educated central bankers macro 101 all over again.

    I don’t know that i would personally call monetary policy “tight” per se, they clearly seem comfortable with about 4.5% ngdp growth. That’s enough to keep up with productivity/population growth, just not enough to close the output gap (if we were at full employment, I would call policy “neutral”). But that’s just a minor quibble. My real worry right now is not that US policy is too tight so much, but that as the housing market rebounds (which it finally is in hard-hit places) that they will not tolerate enough growth to close the gap.

    I wish i knew what to say about the ECB. One of two impossible things must happen, i just don’t know which it is, and i fear that the end is denominated in “weeks” not months.

    Reply
    • Dwb,

      Thanks for the feedback.

      In terms of US monetary policy I think we can conclude two things at the moment. 1) Monetary conditions are getting tighter as we speak: The dollar is stronger, stock prices are down and so are bond yields and inflation. That is the MM description of tighter monetary conditions. 2) The Fed has been more increase done more than the ECB to ease monetary conditions, but that is a pretty bad benchmark.

      Whether monetary policy is tight is another question. I believe it is if you compare with what were the market expectations for Fed action prior to the crisis, but of course we should judge monetary policy on what the Fed want to achieve and it is clear that the Fed have no plans or official target to bring back NGDP to the pre-crisis trend. I would prefer that, but would be pretty happy if just the Fed would announce some kind of nominal measurable target. The Fed seems to be far from doing that.

      The ECB? Don’t mention the war! Monetary policy in the euro zone very clearly is too tight – even judging from the ECB’s own misguided HICP inflation target.

      Reply
      • dwb

         /  May 28, 2012

        i agree, the Fed is passively tightening, but things aren’t bad enough for them to do anything either, yet. I would love to have some nominal target and to know what the Fed wants to achieve.Judging from their actions I’d say they want to achieve about 4.5% nominal growth.

  6. Lars,

    I’m sure you’re probably aware of this short paper, but incase you were not (or for the benefit of anyone else interested) there’s a great explanation of this interest rate fallacy by Friedman in this address to the AEA…

    http://www.aeaweb.org/aer/top20/58.1.1-17.pdf

    Reply
  7. Diego Espinosa

     /  May 27, 2012

    A few more questions on the subject of market responses to Fed policies:

    If too-tight money accounts for the 2010-2012 drop in bond yields, then wouldn’t it also have taken stock prices down over the same period? Are the following also consistent with the too-tight money thesis?
    -peak NIPA corporate profits
    -record quality corporate bond issuance
    -robust subprime auto issuance
    -record low commercial REIT cap rates
    -robust recovery in business equipment and software investment

    etc.

    Reply
    • Diego,

      Two points. First, I think it is important to differentiate between “tight” and “tighter”. Second, I think the bond markets, the equity markets, the commodity and FX markets TOGETHER is telling us whether monetary policy is getting tighter or looser. At the moment US monetary policy certainly is getting tighter.

      Furthermore, we should also see whether we are talking about global or US monetary conditions. I think it is pretty clear that euro zone monetary conditions certainly is not getting any looser. In fact we are undergoing yet another monetary contraction – courtesy of the ECB.

      Reply
  8. Thanks Lars; actually, I am in Venezia at the moment :) Spending a week here after a day and a half in Padova, 6 days in Catania and 5 days in Malta.

    Malta (a Mediterranean Eurozone country that gets overlooked) is much better organised than Sicily; Northern and Southern Italy are culturally very different places. These are my startling economic observations from my trip ;)

    Reply
    • Lorenzo,

      The best way to study the economy of a country is to go there.

      I agree on the differences between Northern and Southern Italy. Could you imagine that country splitting into two if the crisis would escalate?

      Reply
  9. If I were asked whether a private bank was being tight or easy, I wouldn’t judge based on market interest rates, but based on that bank’s rate relative to other banks, along with its collateral requirements. The Fed’s large size makes it hard to judge whether the rates it charges are tight or easy in this sense, but the Fed’s rates can at least be compared to rates charged by other banks, both private and public. This is an imperfect measurement of tightness/easiness, but it seems better than looking only at market rates.

    Reply
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