One sign is that banks are calling in loans without extending new ones. Ramesh Ponnuru thinks that monetary policy isn't tight enough yet. He worries, based on recent data on current-dollar GDP, that we are continuing in a persistently loose monetary environment. That means future economic pain is all but certain, whether in the form of persistently high inflation or further interest-rate hikes.
We aren't so sure that Fed policy is still loose. Tuesday's Consumer Price Index figures showed virtually zero headline inflation in October. Core inflation was down to 2.7 percent, meaning broad-based price pressures are easing. Ongoing disinflation suggests that monetary policy is restrictive.
Of course, we should be wary of Monday-morning quarterbacking after a single promising data release. Other figures tell a different story. Last quarter's 8.5 percent current-dollar GDP growth, along with the implied annual inflation rate of 3.6 percent, suggests we have a ways to go. Nonetheless, there has been significant tightening over the past year. Making policy even more restrictive could do more harm than good.
Even if we restrict our analysis to data available when Ponnuru wrote his article, we contend that there is a strong case for tight money. The Federal Open Market Committee decided not to raise its rate target in early November. The federal funds target range remains 5.25–5.50 percent. Assuming that the recent figure from the Bureau of Economic Analysis is accurate, the inflation-adjusted range is 1.65–1.90 percent. Is this tight money? We need to compare this to the natural rate of interest: the inflation-adjusted rate that keeps the economy as close as possible to maximum sustainable output. We can't observe this rate directly, but we can estimate it based on economic fundamentals. The New York Fed's estimates put the natural rate of interest between 0.57 and 1.14 percent. The market rate is significantly above the natural rate, indicating restrictive monetary policy.
This method isn't foolproof. It's possible that we've persistently underestimated the natural rate of interest. Furthermore, the natural rate of interest is probably rising, since Uncle Sam is borrowing a great deal of money to pay for ongoing deficits. However, monetary policy could be loose only if our estimates were wildly off. Market rates are between 145 and 333 percent (!) higher than the estimated natural rate. Bias matters, but so do magnitudes. It's hard to see how we could be this wrong.
Monetary data tell a similar story. M2, the most commonly cited measure of the money supply, is 3.58 percent lower today than a year ago. Broader measures of the money supply, which also weight their components based on liquidity, are falling between 1.73 and 2.62 percent annually. It's been decades since we've seen the monetary aggregates shrinking like this. Granted, the money supply by itself doesn't show the whole picture. But given the rapid increase in interest rates, it's reasonable to suppose these data reflect significant financial disintermediation: banks calling in loans without extending new ones, at least not as quickly. This certainly looks like tight money.
Yet for all this, current-dollar GDP is still growing quickly. Isn't this an obvious sign that money is loose? The answer is yes – provided it's growing faster than expected and that those expectations are measured properly. The gap in current-dollar GDP that Ponnuru cites is a helpful indicator, one we often use in our own work. But it might not be giving us an accurate picture here.
The report to which Ponnuru refers, which David Beckworth of the Mercatus Center produces, measures the gap between current-dollar GDP and market participants' expectations. Beckworth refers to these expectations as the neutral level of current-dollar GDP. Intuitively, if current-dollar GDP grows faster than people expect, monetary policy is too loose. Alternatively, monetary policy is too tight if it grows slower than people expect. Beckworth's measure thus helps us judge whether monetary policy is on the right path.
One potential issue with this estimate is that the lags between changes in current-dollar GDP growth and behavioral adjustments in the market seem implausibly large. For instance, Beckworth's measure suggests that monetary policy was too tight for almost ten years following the Great Recession. That's a very long time for market actors not to update their beliefs. Once market participants gauge a shift in the stance of monetary policy, they should incorporate their new expectations in the contracts they write. Hence we should be skeptical of exceptionally long periods of tight or loose money. People and businesses do not respond instantly to unexpected changes in the path of current-dollar GDP, but it seems unlikely that it would take them nearly a decade to do so.
If this measure of the neutral level of current-dollar GDP updates more slowly than people and businesses, it will tend to overstate how far monetary policy is off track. This makes it appear as if money remains too loose, which, as we already discussed, is inconsistent with other indicators. None of this means that Beckworth's estimates should be disregarded. They are valuable measures, but as with all data, we should consider them alongside other kinds when making policy generalizations.
It might be helpful to consider what factors are driving spending higher despite the Fed's efforts to tighten monetary policy. While the money supply has been shrinking over the past 18 months, total spending is speeding up. It seems there's a portfolio-adjustment effect here: As a share of total income, the stock of liquid assets remains well above its pre-pandemic level. People's money balances rose dramatically during the pandemic, and they are still in the process of spending down the excess balances. How long this adjustment process will take is difficult to predict, but, in our view, trying to offset its effects by tightening monetary policy would be a mistake, as it risks a recession.
Even with highly liquid and responsive financial markets, the effects of monetary policy will not be felt instantaneously. The lags, though not as long and variable as they once were, imply a wedge between policy action and market reaction. We must be careful not to jump the gun before the recontracting period, when agents incorporate new expectations into new contracts.
We must never make peace with the scourge of inflation. But that doesn't mean we should overtighten, which would throw a wrench in the economy's gears. There are good reasons to suppose that monetary policy is restrictive. Let's not raise interest rates further or shrink the balance sheet faster unless we get more reliable indicators that previous tightening has failed.
Bryan Cutsinger is an assistant professor of economics in the Norris-Vincent College of Business and a research assistant professor at the Free Market Institute at Texas Tech University.
Alexander William Salter is the Georgie G. Snyder Associate Professor of Economics in the Rawls College of Business at Texas Tech University, a research fellow at TTU's Free Market Institute, a Sound Money Project senior fellow, and a Young Voices senior contributor.