No Mere Trivia

We are at the stage ten years later where it is still necessary to define terms. In every finance and economics textbook, the chapter on monetary policy defines “tight” money as when the Federal Reserve (or whatever central bank) raises its policy rate(s). Conversely, “accommodative” money is where it lowers the rate(s). In the US system, the technical reason given is open market operations, where the FOMC acting through the Open Market Desk of its New York Branch (FRBNY) will buy and sell securities as necessary to achieve the target rate.

From the perspective of the banking system, that means the Fed will, if pushed, provide whatever level of bank reserves necessary to keep the Effective Federal Funds rate sufficiently near the policy rate. When the policy rate is being raised, as it was in the middle 2000’s, it was in theory moving upward because money market participants fully believed that the Fed would sell bonds into the market (if needed) to reduce the level of available reserves – “tightening.”

That policy was instituted at that time because the FOMC felt the change in stance was warranted given an economy that finally appeared to be recovering from the unusually durable after-effects of the unusually mild dot-com recession. The Fed raised the federal funds rate to achieve that “tightening” so as to reduce economic momentum before it became overly inflationary. It is this assumed set of conditions which are used today to characterize the current action of monetary policy.

But on the most basic level, is that what happens? Is raising the federal funds rate truly equivalent to tightening? The answer is emphatically, unequivocally no.

Starting in the middle of 2004, Alan Greenspan’s Fed began a series of “rate hikes” meant to accomplish a “tighter” monetary stance for the reasons stated above. Between June 2004 and June 2006, the FOMC voted 17 times to increase the federal funds target, bringing it up from 1.00% to 5.25%. During that time, inflation continued to accelerate, as did all manner of other monetary indications outside of the traditional money supply statistics (the M’s, including the drastically incomplete M3). There is no way to characterize that period or the year immediately thereafter as “tight.”