Time For A Change In Monetary Policy

by: Paul Nathan

There's a lot of confusion about monetary policy and monetary terms used lately. For example, the term "dove" is applied to those that believe that monetary policy is too tight and needs to remain easy. But to advocate a monetary policy that is anti-deflationary is not the same as advocating inflation. It's the job of the Fed to be loose in times of a deflationary threat and tight in the face of an inflationary threat. This task is neither dovish nor hawkish - it's neutral.

Contrary to political wisdom, there is no such thing as conservative economics or liberal economics, just as there is no such thing as conservative science and liberal science. There is simply right and wrong science, and that's true of economics. Economics is a social science and has to do with human values, choices, and actions. It isn't right or wrong as such, it simply IS. The task of economics is to understand what "is" at any given time. The state of monetary policy at any given time consists of exactly the same exercise.

For example, many say that we have "easy money" today because the Fed is adding to its balance sheet. But look around. Do you see easy money anywhere? Half the homes today are being bought with cash because credit is so tight. Consumers are reducing their indebtedness, not increasing it. Many cities are out of cash; there's no easy money for them. And look at the inflation rate -- it's at an historic low. Then there are interest rates which are at historic lows as deflation and recession plague many nations throughout the world. And we have had 2% growth for years, the lowest running rate in post war history.

We are in a de-leveraging world, not an inflationary world. All of the increases by the Fed have not affected either the money supply or the velocity of money. The fact is that the Fed's monetary policy has been neutral. The Fed has neither caused inflation or deflation - yet.

I've contended for some time that if the US were to move into recession and deflation - which we are not far from statistically - the Fed would need to find some other way to combat deflation; that is their mandate. If quantitative easing is not working to alleviate the deflationary bias in the system, it is the Fed's job to find a policy that works to neutralize that bias.

So, a case can be made for the Fed to further increase the money supply in the face of falling inflation, falling commodities, and falling growth rates. This is not a matter of conservative or liberal, dovish or hawkish positions. It's a matter of fulfilling the Fed's mandate to maintain price stability. The question is, will the Fed be forced to abandon its present bond buying program in favor of a new more direct way of combating deflation if it should develop? I believe so. (See my articles addressing this subject on paulnathan.biz)

The debate over when and to what degree the Fed will taper is premature. We would need to be growing at 2.5 to 3% rates, inflation rising rather than falling, and total employment increasing, before the Fed could justify such a move.

There are some that are advocating an outright inflationary policy to get the economy growing. But history shows that any burst of growth from inflation is temporary at best and usually ends up in lower growth and higher unemployment over time. The Fed knows this. They've learned the lessons that Milton Friedman so eloquently taught us in the 70's. And since that time inflation has never again been a national problem.

I am not a monetarist. Monetarists from the left as well as from the right, believe that it is the increase in the money supply that causes inflation. This is true in part. But an increase in money supply isn't inevitably inflationary. The more important question is what are those receiving the new money doing with it? Obviously in today's world money isn't chasing goods. That's why prices are behaving themselves. And if and when money does start chasing goods, it will be the Fed's job to contract the money they've created and allow interest rates to rise. That will put the brakes on any potential inflation. That will also be neutral.

For at least the near term it isn't inflation we have to worry about; it's deflation. Janet Yellen is considered to be more "dovish" than Ben Bernanke, but I think Yellen will have no problem contracting the money supply if and when necessary. Alan Greenspan said he thought Janet Yellen will surprise many people, and I think her willingness to take away the punch bowl at the proper time is what he was referring to.

In my last articles I've pointed out that the price of gold is an excellent barometer of coming inflation and deflation. Gold is trading within a defined trend of $1270 to $1430, which indicates to me that the Fed's monetary policy is about right at the moment. The dollar has held support and gold has bounced back as the deflation threats have eased.

Tapering is not justified at this time according to the Fed's own criteria, and should be off the table until such time that the data supports tighter money. Yet I can't help thinking that the Fed will be forced to re-direct its efforts to increase the money supply while decreasing its bond purchases. You see, the rate of the money supply as defined by M2 has actually been declining since the beginning of the year - and this even as the Fed increases its balance sheet at a record pace. The fact is that the Fed has not yet been able to create higher inflation, just as Japan was not for 25 years.

This is not just true here in the US and Japan. The inflation rate in Europe has fallen to .07, a 4 year low even as they pursue vigorous QE. Draghi said just today that he's concerned about deflation. Clearly, with all the so called "easy money" around, we should be seeing progressive inflation, but we're not. Central banks must prevent de-leveraging from turning into a full-fledge deflation world-wide. If buying bonds and mortgage-backed securities, and low interest rates are not accomplishing this, then the policy is wrong and must be changed.

Perhaps it's time for central banks to re-examine their monetary goals and policies and consider a new direction that more effectively combats the disinflationary/recessionary trends plaguing the world. One suggestion being discussed within the Fed is to reduce the interest rate on excess reserves in order to entice banks to increase lending and push the dormant money in banks into the economy. While this would be perceived as ultra-stimulative, if it works to push the inflation rate higher, the Fed can then reduce its bond purchases, thereby neutralizing inflationary pressures.

If the goal of the Fed is to maintain a 2% inflation rate, they need to ask themselves why have they not been able to achieve what seems like a simple task. Perhaps it's time to question the efficacy of their monetary policy and look for an alternative.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.