Should Money Help to Guide Monetary Policy?

Jean-Claude Trichet, president of the European Central Bank, argues that money should play a role in monetary policy:

Money’s vital role in monetary policy, by Jean-Claude Trichet, Commentary, Financial Times: ...Over the next two days, the European Central Bank will host a conference to discuss the role of money in monetary policymaking. At present, the dominant academic view seems to be that monetary aggregates should have no part in monetary policy decisions. ... I do not share this view. ...

Do not mistake me for a monetary Luddite: I have immense appreciation for the intellectual elegance and sophistication of modern monetary policy models that leave no room for money. In many respects, I fully agree with their implications regarding the benefits of price stability, the crucial importance of central bank credibility, the advantages of pursuing a clear and predictable policy and the centrality of private inflation expectations. ... These ... considerations have ... strongly influenced the design of the ECB’s policy framework. Yet, I cannot dispel my doubts that a model of monetary policy that includes no role for money is incomplete in some important respects.

Academic research is starting to address some of these shortcomings. By introducing financial markets, informational asymmetries and transaction costs into the benchmark model, money and credit developments are given a role in determining macroeconomic outcomes. Moreover, empirical literature has emerged suggesting that monetary developments may be associated with asset price dynamics.

More fundamentally, the European experience – both before and after the introduction of the euro – suggests that assigning an important role to money in monetary policy deliberations and communication has, in practice, helped to serve precisely those principles that modern monetary policy literature holds dear. To take just two examples: I am convinced that an important role for money helps to give the policy discussion an appropriate medium- to longer-term orientation. ... Equally, in our own recent experience, when the economic analysis is complex and its conclusions uncertain, cross-checks with the monetary analysis have proved extremely useful. ...

Monetary policy ... research may offer some lessons for a better understanding of our own decision-making process. In monetary policy, the fact that the pooling of experience and diversity of points of view are deemed essential for reaching the right decision is illustrated by the use of collegial decision-making in all main central banks. Similarly, a pillar based on monetary analysis calls for central banks to consider the outcome of their decisions within a longer-term context; to take due account of past experience and insights accumulated over time; and not to follow too slavishly the latest analytical techniques. Monetary analysis was central to the strategies of the most successful European central banks before the euro ... This legacy cannot be disregarded lightly. Rather, we should strive to use the new and more sophisticated techniques that are being developed to enhance and complement the principles underlying our past successes. ...

This topic has been covered here many times. As I've noted before, my mind is open on this, but even measuring monetary aggregates accurately is problematic so I would not assign them much weight in the decision making process:

• Bernanke on Interest Rates, Monetary Aggregates, and How Monetary Policy Impacts the Economy
• Using Monetary Aggregates to Overcome Model and Data Uncertainty
• The Declining Role of Money in Monetary Policy
• The Use of Monetary Aggregates as a Guide to Policy
• Will the Fed Abandon Open Market Operations?
• Did Monetary Policy Change Permanently in 1979?
• Greenspan Sums It Up
• Will the ECB Abandon Its Monetarist Tradition?

Comments

[evagrius]

I found this humourous since I'm not an economist nor trained in it.

Monetary policy without money?

It reminds me of scholastic theology- highly rational, complex and convoluted- with not an iota of the "experience" of God- theology- God-talk without God.

[crack]

Ritholz is pointing to recent Treasury Department "repo" agreements that may have inflated money supply right before the election.

http://bigpicture.typepad.com/comments/2006/11/us_treasury_dep.html

[ned]

Crudele in NY post today:

November 7, 2006 -- FOR the past few years the U.S. Treasury has been quietly involved in what the financial markets call "repo" agreements and this near-secret operation could explain why the nation's money supply seems to be confoundingly large.

It might also explain why Washington decided earlier this year to stop publishing M3 money supply figures, the broadest and most popular measure of money in circulation.

Repurchase agreements - or repos - have long been used by the Federal Reserve to get money quickly into the hands of financial institutions, which in turn can put the money into circulation in the form of loans.

...

But even more worrisome for the financial markets than too much liquidity would be an inability to track the amount of money being pumped into the financial system.

Unless I find out differently, it looks as if the Treasury has created a way to duplicate the Fed's power. And that is a disturbing possibility unless it is somehow monitored.

[rybinski]

The role of money in monetary policy is an open issue indeed. Benati (2006) shows that for low frequencies (8-30 years) the correlation between money and inflation is surprisingly strong. But does it offer any guidance, if central banks want assess the future inflation risks in 2-3 year horizon. Many papers show that money affects inflation over the shorter-horizons only on a global scale. I discuss these issues on my blog www.rybinski.eu (probably first ever central banker's blog).

[Cassandra]

OK I DO like and agree with Issing. So shoot me! But really, this debate reminds me of Rumi's parable of The Blind Men and the Elephant in a room, each touching only one, but a different part of the animal, then disagreeing with each other over what they've "seen".

What should be apparent is that there is no "Off the Shelf" kit that central bankers can buy from the corner-shop. There are times when money and liquidity can grow profusely without apparent inflation, while others where inflation may be apparent with little money/liquidity growth. The web of dependancies, lags, offsetting policy neutralizers & multipliers, not to mention the entire political dimension, makes Central Banking by definition a multi-faceted approach requiring careful observation, keen analysis & wisdom.

Having said all that, a blind man who knows elephants, walking in to a room, hearing their breath and their bellows, feeling their rumbles and smelling their odour will know with absolute certainty that it's an elephant, in the same way as any credible witness observing the fact that prices of assets globally in every single asset class (from equities to industrial commodities & gemstones, commerical real estate to timberland, Art, Antiques to Curios & Sports Memorobilia) is galloping and vaulting higher and higher will know, with certainty, that some monetary spigots have been broken and the inflation genie is out of the bottle.

[evagrius]

Gee, elephants seem to be getting popular around here.