The End Of Monetary Policy As We Knew It, Part 1

The Fed claims to be steering the economy based on the incoming data, but there are just two things wrong with that claim:

1. The Steering part…

2. The Incoming Data part….

The deficiency of the “steering” part goes back to professor Milton Friedman himself. In his famous quote about the monetary policy lag, he more or less conceded that central bankers would forever get it wrong because they wouldn’t really know if they did too much for too long or if they stopped with too little too soon, or, actually, had chosen any other erroneous combination of policy amount and duration of effect.

Thus, opined the good professor:

“There is much evidence that monetary changes have their effect only after a considerable lag and over a long period and that the lag is rather variable.“

Well, thanks for the monetary driving instructions, Uncle Milton!

Then again, Friedman never professed to embrace activist central bank policy, wherein each monthly meeting and the public airwaves in between become the occasion for a new policy calculus or actual twist of the policy dials. Instead, he advocated essentially a fixed money growth rule—steady as she goes at a 3% to 5% annualized growth rate month-after-month. The leads and lags would therefore take care of themselves, come what may.

That this patron saint of Ben Bernanke and the lot of present day central bankers ended up being a thinly disguised beard for plain old Keynesian economics is surely one of the great ironies of present times. Yet it is evident from the rest of Friedman’s quote that he wouldn’t have had the slightest idea about how to make the leads and lags work on a real-time, discretionary policy basis.

In the National Bureau study on which I have been collaborating with Mrs. Schwartz, we found that, on the average of 18 cycles, peaks in the rate of change in the stock of money tend to precede peaks in general business by about 16 months and troughs in the rate of change in the stock of money to precede troughs in general business by about 12 months…….For individual cycles, the recorded lead has varied between 6 and 29 months at peaks and between 4 and 24 months at troughs.

Good to know!

What that actually tells central bankers is that they are very apt to drown in a river with an average depth of two feet if they don’t know where the vicious eddy currents and deep bottoms are located.

For crying out loud, if the lags vary by 5:1 and 6:1 for business cycle peaks and troughs, respectively, what good are the averages? What the latter actually tell you about the effects of discretionary monetary policy action is nothing useful at all.

What is worse is that you are relying upon monetary theory and history that is utterly irrelevant to today’s conditions.To wit, the reason for the Fed’s original creation in 1913 was to supply the banking system with freshly minted reserves if needed to keep Member banks liquid and lending, especially during harvest times and other episodes of so-called monetary stringency.

Accordingly, Friedman’s whole historic analysis, and that of Bernanke et. al. too, was based on the to-and-fro of legally required reserves (purple line) versus actual reserve balances (black line) in the banking system. In this context, the Fed’s policy tool was too add or drain reserves based on its collective judgement about the relationship between the purple and black lines in the chart below and their impact on interest rates and other financial variables.