The Corner

Who Sets Monetary Policy?

The ECB cut interest rates, and the euro sharply appreciated while stocks fell. The generally accepted story is that the markets expected the ECB to cut interest rates by more than they did.

If you read much about monetary policy, you will often run into claims that reductions in the interest rates over which central banks have relatively direct control amount to looser money. Here, though, a reduced interest rate seems effectively to have tightened money. The same thing happened in the U.S. in late 2007—but few people even in hindsight have pointed out that the Fed was tightening at that time, because it was cutting rates. Evidently what matters is not the concrete step that the central bank takes but how the markets react to it; or at least that’s what mattered here. And the central bank’s action does not just affect the economy after a long time, but affects it nearly instantly as markets react to it. Shaping market expectations is the goal of the policy. One could even say that the market reaction is the policy.

Tighter European policy also appears to have been modestly harmful for U.S. stocks. That suggests that the premises behind the oft-expressed fears of a “currency war,” in which countries devalue their currencies to gain advantage over one another, are mistaken

These are all themes of the “market monetarism” associated with such economists as  Scott Sumner, David Beckworth, Nick Rowe, and Lars Christensen. Today’s developments don’t prove that they’re right, but they do illustrate their points.

Ramesh Ponnuru is a senior editor for National Review, a columnist for Bloomberg Opinion, a visiting fellow at the American Enterprise Institute, and a senior fellow at the National Review Institute.


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