Tyler Cowen is very impressed with a new paper by Jeremy Stein, of the Board of Governors. I see why, as I was also very intrigued by this finding:
In our paper, Sam and I begin by documenting the following fact about the working of conventional monetary policy: Changes in the stance of policy have surprisingly strong effects on very distant forward real interest rates. Concretely, over a sample period from 1999 to 2012, a 100 basis point increase in the 2-year nominal yield on FOMC announcement day–which we take as a proxy for a change in the expected path of the federal funds rate over the following several quarters–is associated with a 42 basis point increase in the 10-year forward overnight real rate, extracted from the yield curve for Treasury inflation-protected securities (TIPS).
On the one hand, this finding is at odds with standard New Keynesian macro models, in which the central bank’s ability to influence real variables stems from goods prices that are sticky in nominal terms. In such models, a change in monetary policy should have no effect on forward real rates at a horizon longer than that over which all prices can adjust, and it seems implausible that this horizon could be on the order of 10 years. On the other hand, the result suggests that monetary policy may have more kick than is implied by the standard model, precisely because long-term real rates are the ones that are most likely to matter for a variety of investment decisions.
And I agree that Stein has some very interesting and plausible explanations for this phenomenon. But the final sentence in the quotation is unwarranted; it doesn’t tell us much of anything about the potency of monetary policy. A perfect example of why it doesn’t occurred in December 2007, when the Fed adopted a more contractionary policy than markets expected. Both the two-year and the 10 year Treasury bond yield fell on the announcement. Stocks also declined sharply. I don’t have data on the real bond yields but I presume those fell as well.
You might want to reread what I just wrote. Bond yields fell on a more contractionary than expected policy. In contrast in January 2001, and again in September 2007, long term bond yields rose on more expansionary than expected policy. Bond yields often move in a “perverse” direction. Obviously, the more contractionary than expected policy announcement of December 2007 was not made even more contractionary by the decline in long-term interest rates. Stein made the mistake of jumping to the conclusion that two-year bond yields move in a predictable fashion after monetary announcements. He assumed that an easier than expected monetary policy stance would make two-year bond yields fall. That often does occur, but not always.
You might wonder if the three unusual cases that I just cited are really all that important. It turns out they are. In those three cases the movement in stock prices was far more dramatic than usual. Most Fed announcements are relatively predictable and the stock market doesn’t respond very strongly. But in those three cases the implied swing in stock prices (after the announcement) was in the 5 to 10% range over a mere quarter point differential in the Fed funds target. That’s huge. So movements in long-term bond yields actually undermined monetary policy during exactly those times when it was most powerful (as indicated by the stock market.)
What’s the take-away from all this? It’s not that monetary policy is unimportant, just the opposite. Monetary policy is much more important than Stein realizes. But it’s not important because of the effect it has on interest rates, they are not an important part of the monetary transmission mechanism. If economists focused more on stock price movements and less on interest rate changes they would notice that monetary policy is extremely important even at the zero bound. Monetary policy is very important because it affects the expected path of nominal GDP. An expansionary monetary policy might raise or lower long-term bond yields, but it will always increase expected NGDP growth.
You might wonder how monetary policy can be so important during periods where it doesn’t even move interest rates in the “correct” direction. The answer is that important monetary policy decisions are decisions that impact the expected future path of the monetary base relative to the demand for base money, and hence the future path of nominal GDP.
Some people tell me “Sumner, come on, the markets don’t care about the monetary base.” That’s right, I don’t care either. But they care a lot about M*V. So do I. And the Fed controls M*V by controlling M.
And as my previous post showed, M is the base.