Monetary policy: Questioning Bridgewater's thesis (Part 2 of 2)
In the previous article in this series, I argued that investors shouldn’t focus on interest rates when analyzing monetary policy. Doing so would lead to very strange conclusions when looking at cases such as Japan and Zimbabwe. Instead, it’s important to understand the role prices play in financial markets in order to see why monetary policy has the effects it does.
Is it sticky?
Asset prices are driven by investors’ expectations for the future—animal spirits, confidence fairies, or whatever you want to call it (I prefer “nominal growth expectations”). Financial markets are a lot more flexible than the real economy, meaning asset prices adjust to changes in outlook nearly immediately. On the other hand, labor markets are sticky, meaning they adjust slowly. The result is that the stock market and other asset prices tend to lead changes in economic fundamentals.
Monetary policy changes, such as the significant shift in policy in the spring of 2009, affect asset prices because investors’ growth expectations change. But it’s also possible for seemingly expansionary monetary policy to have no effect on growth expectations. This can occur if investors anticipate that increases in the money supply will be withdrawn if inflation begins to pick up.
To understand business cycle economics, it pays to research Japan’s history
Japan is a great example of a situation where the market correctly identified the central bank’s deflationary motivations. In the 2000s, the Bank of Japan increased the money supply only to take it all back out of circulation at the first sign of inflation.
The takeaway is that quantitative easing, or any monetary policy, derives most of its power from its signaling effect, which changes investors’ expectations for growth. Whether or not QE is effective isn’t determined by the level of asset prices, but by the market’s interpretation of central bankers’ motives.
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