Rethinking the Monetary Transmission Mechanism.

• Author: Jordan, Jerry L.

In recent decades, the big debate among monetary economists and policymakers was over rules-based monetary regimes versus ones based on discretion. That debate accepted that the various tools and instruments available to monetary policymakers were well known. Implicit in this was the idea that the linkages between the open market operations conducted by a central bank's trading desk, on the one hand, and the objectives of monetary policies, on the other, had been defined and measured and that differing judgments about lags nonetheless fell within a narrow range. According to this view, central banks bought and sold securities with the intention of affecting either interest rates or monetary growth, and these financial measures were linked to economic activity.

The debate on rules versus discretion took as settled an earlier debate about the targets and indicators of monetary policy (Brunner 1969, Saving 1967); this left only the empirical estimates of parameters and lag coefficients to be constantly updated and revised, alongside individual policymakers' personal preferences about tradeoffs among multiple objectives.

The global financial crisis of 2008-09 changed all that. None of what was generally accepted pre-2008 applies to the monetary regime of recent years. The thrust of policy actions is no longer gauged by measures on the price axis (interest rates) or the quantity axis (bank reserves and money supply). In the absence of useful, reliable measures of the degree of stimulus or restraint implied by the behavior of any price or quantity measures (indicators), it is not possible to establish appropriate near-term objectives for the central bank's balance sheet or administered interest rates (targets). And without consensus about the relevant targets and indicators of monetary policies, the debate about rules versus discretion is without a useful reference point.

At the end of every meeting of policymakers, a directive or set of instructions must be approved and issued to those responsible for daily and/or weekly implementation. It would not be useful for policymakers simply to issue instructions to achieve some desired range of nominal GDP growth, or some particular rates of inflation and unemployment. Those may be appropriate intermediate or longer-term objectives for policymakers to consider, but translating them into a policy that can be implemented requires some identifiable linkages between what can be controlled--the size and composition of the central bank balance sheet, and administered interest rates charged to borrowing banks or paid on reserve balances--and financial indicators of the stance of policy.

Legacy linkages--the traditional targets of monetary policy actions--stopped working in the aftermath of the global financial crisis. Now, new instruments and techniques are being introduced and tested. But there is no historical track record available to guide policymakers in the formulation and implementation of policies that rely on new tools and instruments. As such, resumption of the rules-versus-discretion debate will be useful again only after a new debate about targets and indicators has been conducted (Belongia and Ireland 2016).

Macroeconomic Policies: Are They Monetary or Fiscal?

It is customary to think about a government's macroeconomic policies as consisting of some actions that are considered monetary and other actions that are considered fiscal. Of course, governments take all kinds of actions that affect the economy (e.g., regulatory, energy, environmental, agricultural, international trade, and transfer payments), but those viewed as stabilization or countercyclical policies are generally characterized as either monetary or fiscal. It also is usual for decisionmakers to be seen as either monetary policymakers or fiscal policymakers. The former are typically associated with the decisions of a central bank, while the latter tend to be associated with the national treasury--or ministry of finance--and the national legislature.

Policy actions of either a monetary or fiscal nature will have allocative and redistributional effects, but those are often unintentional and certainly not the primary objectives of policymakers. Instead, the people responsible for formulating and implementing both monetary and fiscal policy actions concentrate primarily on aggregative objectives. Generally, that means they care mostly about how rapidly national output and employment are growing, and how much inflation is occurring. It is well understood that unanticipated accelerations of inflation will have allocative effects. As a result, policymakers most often seek to achieve announced targets for inflation so as to minimize the associated redistribution.

Economics textbooks teach that there can be an optimal mix of monetary and fiscal policy actions, with one set of actions deliberately countering the effects of other actions (Sims 2016). To illustrate intentions gone bad, economists sometimes cite the income surtax that was adopted during the Johnson administration to combat inflationary pressures. Central bank decisionmakers believed that the new taxes constituted a massive dose of fiscal restraint that would turn out to be overkill. Accordingly, the Federal Reserve adopted expansionary policy actions to counter the restrictive fiscal actions. At the time, there was not much dispute about the tax increase being fiscal and being restrictive, and central bank interest rate reductions being monetary and being stimulative.

Yet such distinctions are not always so clear. Increasingly, in recent years, the actions taken by monetary policymakers can more accurately be described as fiscal in nature, while actions taken by fiscal authorities may have monetary components (Saving 2016). For example, if the fiscal authorities adopted a new surtax, the proceeds of which would be sterilized in an account at the central bank (as actually happened in Germany on one occasion), the policy might be called "fiscal" because it involved taxation and was implemented by fiscal authorities. But it would more properly be interpreted as "monetary" because the transmission effects were via contraction of central bank money and the nation's money supply. Similarly, actions by monetary policymakers undertaken in a large-scale asset purchase program effectively retire net national debt and reduce the interest expense of the government, and so would be more accurately analyzed as fiscal in nature, even though formulated and implemented by monetary authorities (Greenwood, Hanson, and Stein 2016).

As these two examples illustrate, policy actions that alter the central bank's balance sheet can be taken by either monetary or fiscal decisionmakers, and can be viewed as either fiscal or monetary in nature--regardless of whether those formulating the policies are considered to be fiscal authorities or monetary authorities. Furthermore, the ultimate transmission of monetary and fiscal policy actions involves the consequent actions of both domestic and foreign private decisionmakers--and sometimes policy responses of foreign official policymakers. In a world of floating exchange rates, responses to policy decisions and actions can have pronounced effects on a currency's foreign-exchange value, which can enhance or mitigate the intended aggregative effects.

Conventional Monetary Policy

Traditionally, any actions taken by a central bank are referred to as monetary policies (Lonergan 2016). The actions taken usually have been thought to affect the macroeconomy through an interest rate channel or a money supply channel. Both channels are typically thought to involve the spending behavior of households and businesses--lower interest rates make it cheaper to borrow and spend, while more money becomes a "hot potato" that gets spent. The debate among economists was about, first, whether the central bank had more control over relevant interest rates or over the nation's money supply and, second, whether the level of interest rates or the growth of the money supply was more reliably related to spending by households and businesses.

The quantity of money school of thought involved actions to control the central bank balance sheet, estimation of money multipliers to affect the growth of the nation's money supply, and predictions of income velocity in order to influence the pace of total spending in the economy. There were time periods in the United States and other countries when this framework provided reasonably reliable results. However, since 2008 several of the linkages in this framework have broken down. (1) Massive increases in the size of central bank balance sheets in recent years have been accompanied by corresponding declines in the respective money multipliers with no consequent increases in the growth rates of money supply measures. Furthermore, the pace of growth of measures of the money supply has not been mirrored by growth of total nominal spending, which is to say that the income velocity of money fell.

The alternative--focusing on the setting by policymakers of interest rate targets--involved the creation of a central-bank-provided monetary base as "endogenous" to the financial system. That is, close control over a targeted interbank rate meant that policy actions to add to or to reduce the central bank balance sheet simply reflected the increased or decreased demand for bank reserves on the part of commercial banking companies, which in turn depended on their lending and deposit-creation activities. This framework focused on the incentives for private-sector banks to lend more (or less) that resulted from lower (or higher) interest rates set by the monetary authorities, as well as on the pace of money creation reflected in the supply of and demand for bank loans. According to this view, the growth of the money supply was not under the control of the central bank and did not cause faster or slower spending by businesses...