The Long-Run Effects of Monetary Policy on Interest Rates

After reading Scott Sumner’s recent paper on the Princeton School of Macroeconomics and Zero Lower Bound, I revisited papers of other Princeton economists.[1]Sumner, Scott, The Princeton School and the Zero Lower Bound (October 2021). Mercatus Center Working Paper, https://www.mercatus.org/publications/monetary-policy/princeton-school-and-zero-lower-bound In the second part of the paper, Sumner discussed the Princeton School’s relationship with new schools of thought such as Market Monetarism and NeoFisherianism. In this regard, I examined how the work of the Princeton economists relates to some of the key ideas of market monetarism.

The Princeton School has many economists who have changed the course of macroeconomics. Almost everyone knows most of them today, whether they are familiar with macroeconomics. One of them is Refet Gürkaynak. I think his studies, examining the effects of monetary policy statements on markets and interest rates, should be one of the most significant studies in the field.

Refet S. Gürkaynak, Brian P. Sack, and Eric T. Swanson have a particularly interesting 2005 paper.[2]Gürkaynak, Refet S. and Sack, Brian and Swanson, Eric T., Do Actions Speak Louder Than Words? The Response of Asset Prices to Monetary Policy Actions and Statements, International Journal of Central … Continue reading As they write in the abstract:

We investigate the effects of U.S. monetary policy on asset prices using a high-frequency event-study analysis. We test whether these effects are adequately captured by a single factor—changes in the federal funds rate target—and find that they are not. Instead, we find that two factors are required. These factors have a structural interpretation as a “current federal funds rate target” factor and a “future path of policy” factor, with the latter closely associated with Federal Open Market Committee statements. We measure the effects of these two factors on bond yields and stock prices using a new intraday data set going back to 1990. According to our estimates, both monetary policy actions and statements have important but differing effects on asset prices, with statements having a much greater impact on longer-term Treasury yields.

The perspective that Gürkaynak et al. examine the effects of policy shocks is incredibly useful in evaluating monetary policy statements. Because, as Sumner argued in a recent paper, monetary policy works in two dimensions: by the changing levels of key macro variables and by the changing expected growth paths of these variables.[3]Sumner, Scott, A Critique of Interest Rate–Oriented Monetary Economics (November 2020). Mercatus Center Working Paper, … Continue reading Gürkaynak et al. show that the latter effect mostly comes from policy statements.

In another paper, Gürkaynak, Sack, and Swanson discuss the impact of surprise policy shocks on interest rates in the short and long term.[4]Gürkaynak, Refet S. and Sack, Brian and Swanson, Eric T., The Sensitivity of Long-Term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models, American Economic Review, … Continue reading The importance of this study is better understood after seeing their findings:

Since the federal funds rate has some persistence, as noted by many authors, tighter policy today leads to expectations that the federal funds rate will remain higher in the near future, thus pushing near-term forward rates in the same direction as the policy surprise. At longer horizons, however, forward rates actually move in the direction opposite to that of the policy surprise, i.e., a surprise policy tightening actually causes long-term forward rates to fall.

In fact, their findings seem consistent with market monetarism’s claim that interest rates can be a misleading indicator of the stance of monetary policy(see image below). The news in the media interpret a cut in the federal-funds target as easy money, and vice versa. Even worse, most of the resources you can find online fall into the fallacy of “reasoning from a price change” when defining monetary policy.

Partly, this mistake seems to stem from confusing the short-term and long-term. When interest rates change today, it simply shows the long-term response of interest rates to earlier actions taken by the Fed. Many of your comments about the monetary policy stance will be wrong if you ignore the long-term effects. A fall in nominal interest rates may indeed indicate easier monetary policy, but it may likewise be falling due to other factors.[5]Scott Sumner, The Money Illusion: Market Monetarism, the Great Recession, and the Future of Monetary Policy, The University of Chicago Press, 2021, 166-168.

It can be enlightening to think about the response of interest rates with the example of the Great Recession. Recall that the ECB tightened its monetary policy by raising interest rates in 2008. This caused the eurozone’s recession to deepen, and the consequences were catastrophic.[6]Politano, Joseph, The Great European Undershoot, Apricitas – an Econ Blog (blog), (August 7, 2021). https://apricitas.substack.com/p/the-great-european-undershoot What were the long-term effects of tight money? Lower income, lower inflation, and lower interest rates. If you want high rates over a long period, you must keep interest rates low for an extended period; the long-term response of interest rates will be the opposite direction, as Gurkaynak et al. have shown.

For the same reason, we can better interpret the Great Recession when we consider the cut in 2008 as the long-term response to the Fed’s previously unreasonable tight monetary policy. That’s what many people confuse: When the Fed cut the interest rates in late 2008, the media looked at it as the Fed eased the policy, not as the long-term effect of earlier tight money. If you think about it that way, it’s easy to believe that the Fed had nothing more to do, and it wasn’t Fed policies that triggered the recession. But when you look at it from a long-term perspective, the Fed should have worsened the financial crisis and triggered the Great Recession.[7]Halperin, Basil, Recessions Are Always and Everywhere Caused by Monetary Policy, Basil Halperin (blog), October 28, 2021. … Continue reading

Consequently, it seems quite misleading to interpret the stance of monetary policy by looking only at the changes in interest rates. Changes in interest rates may be due to other factors, or we may be seeing long-term responses. It’s wrong to draw conclusions about the stance of monetary policy without knowing why exactly rates have changed. That’s an essential point,[8]Sumner, Scott, The Dead Horse I’m Beating Is Very Much Alive, The Money Illusion (blog), October 3, 2021. https://www.themoneyillusion.com/the-dead-horse-im-beating-is-very-much-alive/because underestimating the long-term effects can cause a lot of confusion and mistakes, which has already triggered a recession a decade ago.

References

References
1 Sumner, Scott, The Princeton School and the Zero Lower Bound (October 2021). Mercatus Center Working Paper, https://www.mercatus.org/publications/monetary-policy/princeton-school-and-zero-lower-bound
2 Gürkaynak, Refet S. and Sack, Brian and Swanson, Eric T., Do Actions Speak Louder Than Words? The Response of Asset Prices to Monetary Policy Actions and Statements, International Journal of Central Banking, International Journal of Central Banking, vol. 1(1), (May 2005). https://ideas.repec.org/a/ijc/ijcjou/y2005q2a2.html
3 Sumner, Scott, A Critique of Interest Rate–Oriented Monetary Economics (November 2020). Mercatus Center Working Paper, https://www.mercatus.org/publications/monetary-policy/critique-interest-rate%E2%80%93oriented-monetary-economics-0
4 Gürkaynak, Refet S. and Sack, Brian and Swanson, Eric T., The Sensitivity of Long-Term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models, American Economic Review, 95 (1): 425-436. (2005). DOI: 10.1257/0002828053828446
5 Scott Sumner, The Money Illusion: Market Monetarism, the Great Recession, and the Future of Monetary Policy, The University of Chicago Press, 2021, 166-168.
6 Politano, Joseph, The Great European Undershoot, Apricitas – an Econ Blog (blog), (August 7, 2021). https://apricitas.substack.com/p/the-great-european-undershoot
7 Halperin, Basil, Recessions Are Always and Everywhere Caused by Monetary Policy, Basil Halperin (blog), October 28, 2021. https://www.basilhalperin.com/essays/recessions-are-always-everywhere-caused-by-monetary-policy.html
8 Sumner, Scott, The Dead Horse I’m Beating Is Very Much Alive, The Money Illusion (blog), October 3, 2021. https://www.themoneyillusion.com/the-dead-horse-im-beating-is-very-much-alive/
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