Tags: Financial Markets | Money | ecb | interest | rates | eichengreen

Four Big Myths of Monetary Policy Are Spooking Markets

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By Tuesday, 06 August 2019 01:25 PM Current | Bio | Archive

If we are at a moment of economic peril, as stock markets seem to be telling us, it’s a good time to clear our heads. Unfortunately, it’s also a moment when several misconceptions are clouding our thinking about monetary policy, trade and how they intersect.

Perhaps the most widespread of these misconceptions is that low interest rates mean that money is easy, and that a drop in interest rates means money is getting easier.

These relationships don’t necessarily hold — and they haven’t over the last few weeks.

When an economy is weakening, the "natural" or "neutral" interest rate, the rate that neither expands nor contracts the economy, will drop.

If the Federal Reserve drops actual interest rates but the natural rate drops faster, then monetary policy has gotten tighter rather than looser.

If the Fed drops rates but by less than expected, so that expectations rise that interest rates will be higher than the neutral level in the future, monetary policy has also gotten tighter.

Scratch those "ifs."

Money has gotten tighter, even though the central bank just reduced the federal funds target by 0.25 percent. Inflation expectations, as measured by spreads between bonds indexed for inflation and those not so indexed, are significantly lower than they were before the Fed acted.

Stocks fell on the announcement of the reduction. In the federal-funds futures markets, over the last month traders have been revising down their bets about interest rates in April 2020. All of this suggests that the neutral rate is falling and the Fed isn’t keeping up.

A second misconception, related to the first, is that the trade war with China is helping the economy by pushing interest rates down. It’s a theory making the rounds, as my Bloomberg Opinion colleague John Authers has noted. The idea is that by threatening to levy more tariffs on Chinese exports, President Trump scares the Fed into complying with his goal of lower interest rates.

Maybe the president is writing his trade tweets with this strategy in mind, or maybe he will retrospectively embrace it after someone on TV calls it a stroke of genius.

It is not one.

It amounts to assuming that the country will come out ahead if lower growth prospects pull the neutral interest rate downward, because the Fed will then have to follow it downward. As we have seen, the result may not even be a more expansionary monetary policy.

Trump has complained that the European Central Bank (ECB) and other monetary authorities are devaluing foreign currencies against the dollar. Judy Shelton, whom he has said he will nominate to the Fed, has echoed the point, claiming that we are seeing “1930’s-style beggar-thy-neighbor competitive depreciations.”

This is a third misconception. As the economist Barry Eichengreen has argued, the fear of repeating the currency wars of the 1930s isn’t even right about the 1930s.

It’s true that many countries then adopted expansionary monetary policies that weakened their currencies. But these policies helped these economies chiefly by countering deflation at home, not by stimulating exports.

Today, too, the ECB and the Fed are cutting interest rates out of fear of recession. They’re not cutting interest rates to boost exports and reduce imports.

A fourth misconception is that we should do just that. Trump and Shelton seem to want us to play the same game they think other countries are playing: running a more expansionary monetary policy to lower the trade deficit.

A more expansionary policy may indeed be called for — but not for that reason.

Leave aside the question whether reducing the trade deficit should be a priority for policymakers in the first place. Even if it is, an expansionary policy can have that effect only temporarily. As prices adjust, eventually exporters end up right back where they started.

Shelton’s invocation of the 1930s was alarmist. But there is a similarity. There was a lot of confusion about economic policy among influential people back then too.

Let’s hope there’s quicker learning today.

Ramesh Ponnuru is a Bloomberg View columnist. He is a senior editor of National Review and the author of "The Party of Death: The Democrats, the Media, the Courts, and the Disregard for Human Life." To read more of his reports — Click Here Now.

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Today, too, the ECB and the Fed are cutting interest rates out of fear of recession. They’re not cutting interest rates to boost exports and reduce imports.
ecb, interest, rates, eichengreen
Tuesday, 06 August 2019 01:25 PM
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