Long and variable leads and lags

Scott Sumner yesterday posted a excellent overview of some key Market Monetarist positions. I initially thought I would also write a comment on what I think is the main positions of Market Monetarism but then realised that I already done that in my Working Paper on Market Monetarism from last year – “Market  Monetarism – The  Second  Monetarist  Counter-­revolution”

My fundamental view is that I personally do not mind being called an monetarist rather than a Market Monetarist even though I certainly think that Market Monetarism have some qualities that we do not find in traditional monetarism, but I fundamentally think Market Monetarism is a modern restatement of Monetarism rather than something fundamentally new.

I think the most important development in Market Monetarism is exactly that we as Market Monetarists stress the importance of expectations and how expectations of monetary policy can be read directly from market pricing. At the core of traditional monetarism is the assumption of adaptive expectations. However, today all economists acknowledge that economic agents (at least to some extent) are forward-looking and personally I have no problem in expressing that in the form of rational expectations – a view that Scott agrees with as do New Keynesians. However, unlike New Keynesian we stress that we can read these expectations directly from financial market pricing – stock prices, bond yields, commodity prices and exchange rates. Hence, by looking at changes in market pricing we can see whether monetary policy is becoming tighter or looser. This also has to do with our more nuanced view of the monetary transmission mechanism than is found among mainstream economists – including New Keynesians. As Scott express it:

Like monetarists, we assume many different transmission channels, not just interest rates.  Money affects all sorts of asset prices.  One slight difference from traditional monetarism is that we put more weight on the expected future level of NGDP, and hence the expected future hot potato effect.  Higher expected future NGDP tends to increase current AD, and current NGDP.

This is basically also the reason why Scott has stressed that monetary policy works with long and variable leads rather than with long and variable lags as traditionally expressed by Milton Friedman. In my view there is however really no conflict between the two positions and both are possible dependent on the institutional set-up in a given country at a given time.

Imagine the typical monetary policy set-up during the 1960s or 1970s when Friedman was doing research on monetary matters. During this period monetary policy clearly was missing a nominal anchor. Hence, there was no nominal target for monetary policy. Monetary policy was highly discretionary. In this environment it was very hard for market participants to forecast what policies to expect from for example the Federal Reserve. In fact in the 1960s and 1970s the Fed would not even bother to announce to market participant that it had changed monetary policy – it would simply just change the policy – for example interest rates. Furthermore, as the Fed was basically not communicating directly with the markets market participant would have to guess why a certain policy change had been implemented. As a result in such an institutional set-up market participants basically by default would have backward-looking expectations and would only gradually learn about what the Fed was trying to achieve. In such a set-up monetary policy nearly by definition would work with long and variable lags.

Contrary to this is the kind of set-up we had during the Great Moderation. Even though the Federal Reserve had not clearly formulated its policy target (it still hasn’t) market participants had a pretty good idea that the Fed probably was targeting the nominal GDP level or followed a kind of Taylor rule and market participants rarely got surprised by policy changes. Hence, market participants could reasonably deduct from economic and financial developments how policy would be change in the future. During this period monetary policy basically became endogenous. If NGDP was above trend then market participant would expect that monetary policy would be tightened. That would increase money demand and push down money-velocity and push up short-term interest rates. Often the Fed would even hint in what direction monetary policy was headed which would move stock prices, commodity prices, the exchange rates and bond yields in advance for any actual policy change. A good example of this dynamics is what we saw during early 2001. As a market participant I remember that the US stock market would rally on days when weak US macroeconomic data were released as market participants priced in future monetary easing. Hence, during this period monetary policy clear worked with long and variable leads.

In fact if we lived in a world of perfectly credible NGDP level targeting monetary policy would be fully automatic and probably monetary easing and tightening would happen through changes in money demand rather than through changes in the money base. In such a world the lead in monetary policy would be extremely short. This is the Market Monetarist dream world. In fact we could say that not only is “long and variable leads” a description of how the world is, but a normative position of how it should be.

Concluding there is no conflict between whether monetary policy works with long and variable leads or lags, but rather this is strictly dependent on the monetary policy regime and how monetary policy is implemented. A key problem in both the ECB’s and the Fed’s present policies today is that both central banks are far from clear about what nominal targets they have and how to achieve it – in some ways we are back to the pre-Great Moderation days of policy uncertainty. As a consequence market participants will only gradually learn about what the central bank’s real policy objectives are and therefore there is clearly an element of long and variable lags in monetary policy. However, if the Fed tomorrow announced that it would aim to increase NGDP by 15% by the end of 2013 and it would try to achieve that by buying unlimited amounts of foreign currency I am pretty sure we would swiftly move to a world of instantaneously working monetary policy – hence we would move from a quasi-Friedmanian world to a Sumnerian world.

Without rules we live in Friedmanian world – with clear nominal targets we live live in Sumnerian world.

PS Today is a Sumnerian day – hints from both the Fed and the ECB about possible monetary tightening is leading to monetary policy tightening today. Just take a look at US stock markets…(Ok, Greek worries is also playing apart, but that is passive monetary tightening as dollar demand increases)

Leave a comment


  1. Lars, one question for you.

    Scott wrote: “Money matters because of the “hot potato effect. That is, the Fed determines the supply of base money…”

    You don’t believe the Fed always determines the supply of base money, do you? Say the Fed is setting the fed funds rate at 2%. Then introduce a large increase in demand to hold overnight funds. In order to defend the 2% rate, the Fed has to increase the amount of reserves. In this case, the Fed isn’t determining the supply of reserves. At the 2% rate, the public is determining it.

  2. JP,

    Well, in my book that is basically a operational issue of how the Fed decides to control the money base. In fact under a perfect NGDP futures scheme as suggested by Scott the determination of the money base would also be endogenous and hence determined by the public’s demand for base money. I believe Scott would agree on that.

  3. Thanks. My reading of old school monetarists is that they almost always treat money creation as an exogenous process, not endogenous. In terms of history of thought, they always seem to fall on the side of the currency school in the great currency school vs banking school debates. But the fact that market monetarists are willing to entertain the idea that the money supply is in many cases demand-driven seems to differentiate them from monetarists. What do you think?

  4. JP, I feel uncomfortable in abandoning the traditional monetarist views. However, as it is with lead versus lag it is mostly about the institutional structure. Under Free Banking or a futures based NGDP targeting system the money base is fully elastic. However, the central bank can of course alway decide to change the system so it fully controls the money base. If the Fed wants to double the money base tomorrow – then it can do it.

  5. jpirving

     /  March 7, 2012

    Interesting how the more forward looking monetary regimes seem to show “long variable leads” in their FX markets. Note the SEK/EUR and NOK/EUR rates today. Even as the euro fell vs the dollar, and Italian yields rose, traders were already discounting Riksbank easing, doing the bank’s job for them in some sense. Aussie dollar was down over 1% too. One can almost rank central bank competency by how the currency moves on a lousy worldwide trading day.

  6. Jp, totally agree.

  7. “In my view there is however really no conflict between the two positions and both are possible dependent on the institutional set-up in a given country at a given time.”

    Thank you for this. Some time ago, over at Sumner’s blog, I tried to subtly demonstrate this as something of which Friedman himself was aware — but as with most forms of subtlety, it was more or less lost on the internet commentariat.

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