Limits of monetary policy in theory and practice.

• Author: Reinhart, Carmen M.
• Position: Essay

The Federal Reserve's conduct of monetary policy casts a spell over market participants, commentators, and academics. The pages of financial newspapers parse subtle differences among the comments of Fed officials and delve deeply into potentially multiple meanings of official statements. Academic discussions argue that the path of the policy rate may (as in Taylor 2009) or may not (as in Bernanke 2010, and Greenspan 2010) have fueled a home-price bubble in the United States.

The view that modest alterations to monetary policy have vast consequences for national economies would seem to be inconsistent with theory and evidence. Most modem economic models (represented authoritatively by Woodford 2005) offer limited scope for policy surprises. The basic logic is that spending depends on decisions capitalized over the longer term, and small perturbations in the level of the short-term interest rate do not matter much to those values. More fundamentally, the prominence accorded to authorities controlling nominal magnitudes seems to undervalue the resilience of market economies, which are supposed to be efficient in grinding out appropriate relative prices so as to employ resources efficiently. In other words, if central bankers are crucial to moderating the operations of capitalist economies, then capitalist economies may have serious drawbacks.

We will argue that this fascination with the Fed is also at odds with the evidence by taking a close look at the responses of asset markets to changes in the short-term interest rate since the founding of the Fed in 1914. In fact, there are no apparent effects on either long-term interest rates or housing prices. We will also show that the policy rate more recently had no systematic relationship with long-term interest rates. A global view of capital markets casts doubt on those arguing that a different policy path might have crucially mattered.

The conclusion is similarly wary of outsized expectations of monetary policymakers and explains why pride goes before a fall.

Saying that modest changes in monetary policy would not matter much does not imply that monetary policymakers are irrelevant. They can do great ill by losing the story line and forgetting their role in providing a stable backdrop of price stability. Small mistakes also cumulate. Monetary policy was probably too easy from 2002 to 2006. It was also too predictable, encouraging a short-termism in financial markets, and was not sensitive to the dangers posed by a buildup of credit. But were we able to walk back the path that the world took, changes to supervision and regulation would most likely loom larger still in shaping economic outcomes in the 2000s.

Limits of Monetary Policy in Theory

Two properties of most macroeconomic models are especially relevant to the conduct of monetary policy. First, spending and pricing decisions are assumed to be based on long-term assessments of real income and real rates of return. Second, changes in monetary policy can change real interest rates only temporarily. Ultimately, the forces of productivity and thrift determine them, not changes in nominal magnitudes on the central bank balance sheet. (1) Combining the two propositions implies that the Federal Reserve's interest rate policy, as long as it stays within the narrow range of experience, would not be expected to have a significant or long-lasting imprint on markets or activity.

John Taylor (2009), among others, demurs in that view. In particular, the Federal Reserve is held to have systematically run policy too loose from around 2002 to 2006, which encouraged the housing boom and file related financial market excesses. However, the deviations from Taylor's preferred policy were modest. Such sensitivity of outcomes to those misses is hard to square with the propositions that the Fed can only keep the short-term real interest rate low for a limited time and that it is long-term values that matter.

An example can make the point clearer. Finance theory posits that a capital asset is valued as the present value of expected future income. Such assets include homes, long-term government and corporate debt instruments, and durable...