Thursday, March 17, 2011

How to recognize tight monetary policy

“You know ECB monetary policy is tight when… local communities … resort to using old currency to stabilize spending … the ECB President says interest rates will be increased soon even though the core inflation rate declined in Jnuary and inflation expectations remain stable….”

Or you can observe what the stock market does the three times the Fed decided to pay interest on reserves (IOR) and ponder on correlation vs. causality. The Five Second Sumner version says "The markets seemed to think the IOR program was a big mistake, and the QE2 program was an important step in the right direction.  That’s all we know right now, and probably all we’ll ever know." A longer snippet below the fold:
A new paper by P. Ireland shows that paying interest on reserves (IOR) makes liquidity effects “vanish,” but money and monetary policy remain linked in the long run … since policy actions that change the price level must change the supply of reserves proportionately.” IOR also has little effect on inflation or growth – at least in normal economic times.

Sumner, however, points out that introducing IOR also changes expectations about the path of future monetary policy and the likely effects those policies (banks hoarding quantitative easing, for instance).
Since the impact of a policy depends on its impact on the expected future path of policy, it is almost impossible to model these effects. “

Does this mean there is no hope of ever being able to estimate the impact of policy decisions?  Far from it.  Louis Woodhill looked at the only three IOR decisions in the Fed’s 98 year history.  In each case stocks fell very sharply around the time of the decision:
At the time of the Fed’s IOR announcement, the S&P 500 was down by a total of 12.18% from its pre-Lehman close, 15 trading days earlier. However, the day that the Fed announced IOR, the S&P 500 fell by 3.85%, and it was down by a total of 17.22% three days later.

On October 22, 2008, the Fed announced that it would increase the interest rate that it paid on reserves. The S&P 500 fell by 6.10% that day, and it was down by a total of 11.11% three days later. On November 5, 2008, the Fed announced another increase in the IOR interest rate. The S&P 500 fell by 5.27% that day, and it was down by a total of 8.60% three days later.
… even using the more conservative one day window, what are the odds of three drops like that occurring on the only three days in history when the IOR was raised?  I’d guess no more than 1 in 10,000.  Economists get published with results no more unlikely than 1 in 20, and yet I am so skeptical of statistical significance that even 1 in 10,000 seems merely suggestive to me.  I think IOR might have had a significant contractionary impact, but I am not certain.

Whenever the model says one thing and the markets say another, I always go with the markets.  The markets seemed to think the IOR program was a big mistake, and the QE2 program was an important step in the right direction.  That’s all we know right now, and probably all we’ll ever know.

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