Amid much hoopla from pundits, the Federal Reserve’s policy-making Open Market Committee met this week and left its policies largely unchanged. It will continue to reduce the rate at which it increases our nation’s money supply by buying bonds — so-called “quantitative easing,” until it discontinues the program next month.
And it hinted that at some point fairly far ahead, it will continue monetary tightening so that its targeted interest rate will rise from the historic lows at which it has been for nearly six years. Might I say “Ho, hum”?
Given that the Fed has been remarkably consistent in only very gradual and pre-announced changes in policies since the end of 2008, why all the media attention and the minute parsing of individual adjectives in the committee’s news release? Should this really matter to the average citizen? And if not, to whom does it matter?
To answer that, I recall a metaphor used by economist Josef Schumpeter, who spoke of the “veil of money” that causes confusion between the “monetary economy” and the “real economy.”
People don’t eat money, it doesn’t protect them from the weather or move them around or cure their illnesses or even entertain them. For these real human needs and wants, they need physical food, houses, cars and medicine. They need the services of carpenters, mechanics, doctors, writers and actors.
In this real economy, resources like raw materials, labor, machines and buildings are used to produce goods and services that satisfy human needs and wants.
In the monetary economy, money serves to buy and sell things and to store value in bank accounts, stocks, bonds and other financial instruments.
The two economies are related. The real economy needs the monetary economy to function efficiently. Bartering one good or service for another rather than using money is highly wasteful. However, the monetary economy is only a means to an end, a way of facilitating the much more vital real economy. And money, according to Schumpeter, often acts as a “veil” that obscures what is going on in this underlying economy of real resources and real goods and services that meet people’s needs. That is precisely what is going on in much of the punditry surrounding contemporary Fed policy making.
From the point of view of U.S. society as a whole, what matters is the real economy. How many goods and services will it produce to meet our needs and wants? And how many of us will have jobs, and thus income, from producing these goods?
From the point of view of the “financial industry” centered on Wall Street and that of people, including me, who own financial or physical assets, what matters is different: How will changes in Fed policy affect the value of the stocks or bonds or farmland that I own?
There are areas of overlap between the two, including important ones. But they are not the same.
For the real economy the crucial question is the degree to which continued low interest rates foster greater growth of real output and employment. Many economists, including Fed Chairwoman Janet Yellen, Minneapolis Fed President Narayana Kocherlakota and Nobel Prize winners like Paul Krugman and Joseph Stiglitz, think that the Fed’s policies of very easy money have been a key factor in our economy’s movement back from the edge of the abyss we found ourselves on six years ago.
To them, the low inflation, as measured by the Consumer Price Index for example, is a warning sign that the economy could slide back into deflation and recession, just as Japan’s did in the 1990s when it fitfully alternated expansionary and contractionary policies.
They accept the view that a more lax monetary policy fosters growth in several ways. It makes it easier for businesses to borrow money to build new plants and equipment or to invest in developing new technology. These investments prompt greater output and higher employment. More available money makes it easier for consumers to spend, not least because lower mortgage payments free up monthly cash flow to buy goods and services.
Their opponents, including the two Fed district bank presidents who dissented from this week’s vote, several prominent conservative Keynesians who served in past Republican administrations and many in the anti-Keynesian Rational Expectations school of economic thought, are skeptical about the degree to which continued easy money will foster growth of output or jobs. They are more concerned that too-rapid money growth eventually will fuel consumer inflation, although they have been making that warning for five years and have been wrong so far. And they warn that current monetary growth is fostering an unsustainable bubble in asset prices, especially stocks.
Both groups among economists in general and on the FOMC weigh factors that are a mix of the “real economy” and the “monetary economy,” but the weight of their concern is on the first. Wall Street operators, and the pundits who comment on them, don’t penetrate Schumpeter’s “veil of money,” and focus nearly entirely on the second.
One key difference is that the second is much more concerned with short-term timing. Tightening prematurely may indeed be a mistake for the real economy, but it doesn’t make much difference if that tightening starts in January or June. Nor does it matter if the Fed’s forecast for output growth in 2017 is one-half percentage point higher or lower. Most Wall Street trading is extremely short term, seconds or minutes instead of months or years. Much of the buzz around specific words in the FOMC’s statement derives from financial stakes in how such phrasing will immediately affect stock or bond or foreign currency prices and not on even medium-term prospects for the U.S. economy.
Monetary policy is an issue on which economists are genuinely divided, with the majority still probably leaning toward the view of the majority of the FOMC. But the extreme focus of financial markets on short-term timing is a measure of their continued disfunctionality. Changing that is a knottier problem than in Fed policymakers deciding when and how to tighten.