If one reads through the financial media on a random day it is likely that market participants will be quoted for saying that it is either a “risk on” or a “risk off” day in the markets. (Today surely looks like a risk off day, but that’s is irrelevant to the discussion below).

What are the signs that the markets are in a “risk off” mode? Normally we would see stock markets drop, the dollar, the yen and the Swiss franc would normally strengthen, bond yields (especially US, German and Swiss) will drop and commodity prices will tumble.

If a Market Monetarist sitting in the US observed these market movements he or she would say “US monetary policy is becoming tighter”. Why is that? Well, we can define a tightening of monetary policy as a situation where money demand grows faster than money supply.

Since we cannot directly observe the demand for money and the money supply (we can only directly observe what happens to certain monetary aggregates like M2) we can use market movements and changes in asset prices to judge what is happening to monetary conditions.

If the demand for dollars increases relatively to the supply of dollars then the dollar should strengthen. This is what we normally see on a “risk off” day. Similar if investors try to increase their cash holding (how much dollar liquidity they demand) then they will decrease their holdings of other assets – for example equities and commodities. So when dollar demand increases relative to the dollar supply equity prices and commodity prices would tend to drop. That is also what we observe on “risk off” days.

When monetary conditions tighten (money demand growth outpaces money supply growth) we would expect that to be deflationary. Hence, tighter monetary conditions should lead to lower inflation expectations. This is also what we see on “risk off” days – bond yields drop and so-called breakeven inflation expectations in inflation-linked bonds (in the US this is called TIPS) tend to drop.

So when market participants and financial media reporters talk about “risk off” or rising risk aversion Market Monetary is likely to talk about tighter monetary conditions.

This illustrates that monetary policy or maybe we should call it monetary conditions can get tighter even without any central banks actively change it’s stated policy. David Beckworth calls this a “passive” tightening of monetary policy. Hence, the central bank (the Federal Reserve) allows monetary conditions to tighten by not increasing the money supply to meet the increase in money demand.

So next time somebody is talking about whether monetary policy is tight or loose, then ask him or her to have a look at asset markets. If we are on a “risk off” mode with falling equity and commodity prices, lower bond yields and a stronger dollar – then it is fair to say that US monetary conditions are getting tighter.

In future blog posts I will discuss why it is the dollar, the yen and the Swiss franc, which typically strengthen on “risk off” days. Hint: think money demand and funding…