There’s more to monetary policy than interest rates

(Tim Pohl/iStockphoto)

Many readers are objecting to my assertions that Canadian monetary policy is excessively tight by pointing out that the overnight rate is sitting at a near-historic low of 1 per cent. This, however, is an ineffective way to measure monetary policy. As Milton Friedman said in 2000:

“We know from the past that interest rates can be a very deceptive indicator of the state of affairs. A low interest rate may be a sign of an expansive monetary policy or of an earlier restrictive policy. And similarly, a high rate may be a sign of restriction, of trying to hold things down; or it may be a sign of past inflation.”

It is a mistake to believe monetary policy is solely about interest rates. During the German hyperinflation when wheelbarrows of cash were needed to buy a loaf of bread, nominal interest rates were exceptionally high. If we use interest rates to judge the stance of monetary policy, then we would have to conclude that when the German central bank was printing out trillion mark bills by the second they were engaged in tight monetary policy.

A traditional monetarist would judge the stance of monetary policy by the growth rate of broad monetary aggregates such as M2 and M3. This view has weakened over time; in 1960, Mr. Friedman published A Program for Monetary Stability, where he advocated that central banks should increase the growth rate of M3 by a constant rate each year (called the k-per-cent rule). Western University’s David Laidler recently examined Canadian M2 dataand found that the M2 money supply grew less than 5 per cent a year in 2010-2011, which issomewhat slower than average.

While I consider myself to be a traditional monetarist, I am open to alternate points of view. One was provided in 2003 by current Federal Reserve chairman Ben Bernanke, who stated that both the money supply and interest rates are poor indicators of the stance of monetary policy. Rather, Mr. Bernanke says, we should be looking at inflation and the growth rate of Nominal Gross Domestic Product (NGDP).

Thanks to the Great Recession, the growth rate of Canadian NGDP has been incredibly slow at 2.65 per cent per annum since 2009, as compared to the 5 per cent annual growth the country has averaged since 1991, when the era of targeting inflation at 2 per cent annually began. From this perspective, it looks like the Bank is doing a terrible job.

Mr. Bernanke’s other indicator, inflation and the growth rate of the price level is, I feel, a more-fair comparison. Using the latest Statscan Consumer Price Index release, I compared the price level relative to what the price level would have been if it had grown at a constant 2 per cent annual growth rate since mid-2007. The figures show that the price level went way above trend during 2008 and fell sharply during the Great Recession. It started to revert back to trend in 2009, nearly reaching the trend line in mid-2011 (see the attached chart). It has fluctuated under the trend line since that date, falling sharply away from trend in early 2012. If monetary policy were too loose, we would see the current price level well above the 2 per cent trend line. Instead it is somewhat below.

Using any reasonable definition of tight money, whether it be a monetarist definition of Friedman and Laidler or a New Keynesian position such as Mr. Bernanke’s, Canadian monetary policy has erred on the side of being too tight. Not outrageously tight, mind you, but given the Bank’s mandate it is has not erred on the side of being too loose.

Mike Moffatt is an Assistant Professor in the Business, Economics and Public Policy (BEPP) group at the Richard Ivey School of Business – Western University

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