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The guest commentary below was written by Dr. Daniel Thornton of D.L. Thornton Economics.

The Limits of Monetary Policy: Can the Fed Affect Economic Growth? - Fed cartoon 05.04.2016

This essay explains why monetary policy actions will not have a persistent effect on economic growth. Before I explain why, it is instructive to look at economic growth in the wake of the actions the FOMC has taken since the beginning of the financial crisis.

The decline in house prices which began in 2006 set the stage for the financial crisis. However, awareness of the crisis began on August 9, 2007, when BNP Paribus suspended redemption of three of its investment funds. The FOMC responded by reducing its target for the federal funds rate, which had been 5.25% since June 30, 2006, to 2% by May 2008.

These actions had no apparent effect.

The financial crisis intensified and the economy went into a recession. Following Lehman Bros.’ bankruptcy announcement on September 15, 2008, the severity of both increased dramatically. The Fed then began lending heavily to banks and other financial institutions. The increase in banks’ reserves that accompanied this lending caused the federal funds rate to decline dramatically. However, the FOMC didn’t reduce its federal funds rate target until October 8. As the federal funds rate declined toward zero, the FOMC was forced to reduce the target to zero, which it reluctantly did on December 15, 2008.

The FOMC then switched its monetary policy strategy. It then engaged in so-called unconventional policies (quantitative easing, forward guidance, and maturity extension, aka, operation twist. The FOMC kept the funds rate target at zero until December 2015 and increased it slowly since then to the current level of 1%. All of these actions were taken in an attempt to reduce private longer-term interest rates in order to stimulate spending and economic growth.

“How did this work?” Not well.

The recession ended in June 2009. But economic growth has been far below expectations. From the recession’s end to 2017Q2, output has increased at the average rate of just 2.2%; since 2015Q1 it has increased at just a 1.9% rate. Some have attempted to salvage the FOMC’s policy from ineffectiveness by suggesting that economic growth would have been much slower had it not been for the FOMC’s unconventional monetary policies. But, an assertion without facts is just that, an assertion.

The conclusion of my first two essays (that interest rates are not important for spending decisions and the FOMC’s actions have little effect on interest rates that matter most for spending) is sufficient. But it’s not necessary. The FOMC’s actions would have no persistent effect on output growth even if my conclusion was materially wrong.

The monetary policy actions will have no persistent effect on output growth because output growth depends on the growth of the inputs to production and technology which monetary policy actions cannot affect. For example, auto producers need capital (man-made factors of production—buildings, machines, robots, etc.), workers (labor) and technology (know how) to produce cars. Hence, in order for monetary policy actions to have a persistent effect on output growth, they would have to have a persistent effect on the rate at which producers’ utilize these factors of production.

To better understand why monetary policy actions cannot persistently affect the growth rates of labor, capital, and technology, it is useful to understand exactly what actions policymakers can take.

  1. The Board of Governors can set the interest rate it charges when banks borrow from the Fed (previously the discount rate, currently the primary credit rate).
  2. The Board can also set the term for such loans and initiate other new bank lending programs.
  3. The Board can set the level and structure of reserve requirements within the limits set by the Federal Reserve Act.
  4. The Board can also decide what assets and how much of those assets the Fed will purchase.
  5. However, since 2009 such decisions have been made by a vote of the FOMC and not made independently by the Board. The FOMC decides on where to set the target for the federal funds rate.
  6. Finally, the Board can set the interest rate it pays banks to hold excess reserves, the IOER.

That’s it. Policymakers’ actions affect the quantity of reserves that banks hold and the costs of holding those reserves. It should be clear that by their nature none of these actions have a direct effect on the growth rates of labor, capital or technology.

Any effect of these actions on the factors of production must be due to the effect of policy actions on something else and then on output, a secondary effect. For example, if monetary policy worked through the interest rate channel, policy actions could reduce interest rates which would increase spending, i.e., the demand for goods and services. This could, in turn, cause producers to hire more labor and invest in more capital. Policy actions would have a secondary effect on firms’ utilization of capital and labor by their effect on interest rates.

Such actions could also have a secondary effect on technology if the new capital was technologically superior, i.e., more efficient. In models that economists and policymakers use to consider the effects of monetary policy, there is a proposition call monetary policy neutrality. The proposition says the actions policymakers take (described above) cannot have any effect on real variables, including the real interest rate (if you don’t understand real interest rates, read the description following this essay).

The reason is that these policy actions increase the supply of money and, subsequently, inflation. For example, assume that the nominal rate is currently 5% and inflation is currently 2% so the real rate is 3%. Now the FOMC takes actions to reduce the nominal rate to 3%, but these actions cause the expected inflation rate increase to 4%. Hence, the nominal rate will rise to 7%; the 3% real return that investors demand plus 4% to compensate investors for the higher expected inflation.

The same thing happens to wages: Nominal wages will rise but real wages will remain unchanged But of course, this hasn’t happened. The FOMC’s QE policy has produced a massive increase in the money supply, (which I note in The Fed’s Impending Inflation Disaster? and several other essays), but no corresponding increase in consumer price inflation. The year-over-year increase in the PCE less food and energy (the FOMC’s preferred inflation measure) has been consistently below the FOMC’s 2% inflation objective since 2009, in spite of the FOMC’s efforts to increase it. The only signs of inflation are in asset prices, primarily, stock and real estate prices.

“What went wrong?”

Well, the problem is things that work very well in models very often don’t work well in realworld economies. The reason, of course, is models are simple, but real-world economies are extraordinarily complex. Indeed, as I have noted here, economists have two theories of inflation, but neither is useful for predicting future inflation.

Conclusion: Economists don’t have a workable theory of inflation.

But monetary policy actions cannot have a persistent effect on economic growth for another simple reason—the effect of monetary policy actions on interest rates or whatever is a one-time event. For example, QE might cause long-term real rates to be lower and, hence, firms to purchase more capital and hire more workers. But such actions cannot have a permanent effect on the growth rates of capital and labor. The level of output increases to a new higher level, but once the new level is achieved, output growth returns to its previous path which is completely determined by a number of other real variables (productivity growth, the labor force participation rate, the population growth rate, technological innovation, etc., etc.) that are independent of monetary policy actions.

This is well known even by policymakers, e.g., see Patrick Harker. However, Janet Yellen has recently suggested the possibility that there may be circumstances where monetary policy can have appreciable, persistent effects on output.

Consequently, one might ask: Why did the FOMC keep the federal funds rate at zero for 6.5 years into the economic expansion? Why has the FOMC continued its aggressively expansionary monetary policy for 6 years after output returned to its pre-recession level? Why do policymakers continue to believe that the Fed’s massive balance sheet is doing more good than harm when it caused a massive and unprecedented increase in the money supply (M1 has increased 250% since August 2008), distorted the allocation of economic resources, inflated equity and real estate prices, caused excessive risk taking by pension funds and households, and forced those on fixed incomes to select between two undesirable alternatives—living on less or taking more risk?

But the unprecedented aggressive policy pursued since the recession’s end has been motivated by the economy’s slow growth relative to policymaker’s estimates of potential output growth (for a critique of potential output, see Why the Fed’s Zero Interest Rate Policy Failed). Policymakers should never try to do things that monetary policy cannot do. This is why I recommend that Congress require the FOMC to adopt Economic Reality-Based Monetary Policy, ERMP.

Nominal and Real Interest Rates:

The nominal interest rate (the one reported in the newspaper) is composed of two parts: the real interest rate (which is not directly observable) and the expected rate of inflation (which is also not directly observable). For example, if the nominal rate on a 1-year bond is 5% but you expected prices will increase by 3% during the year, your expected real interest rate is only 2%. Hence, you expect to receive a real rate of 2%. This is called the ex-ante real rate. However, the real interest rate you actually receive—the ex-post real interest rate—depends on whether inflation during the year was higher or lower than 3%. Hence, your ex-post real rate you actually get—could be lower or higher than you ex-ante real rate.


This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.