Don’t follow the money, by Scott Sumner

I’d first like to thank David for his very kind introduction.  It’s an honor to be invited to do a stint as a guest blogger at one of my favorite blogs.  I do plan to keep my other blog (TheMoneyIllusion.com) going, but at a reduced rate.  I won’t be able to answer all the comments at both blogs, but will answer some.  

I always get a bit annoyed when I hear people talk about investors putting money "into" markets. I suppose that at an individual level this might make some sense. You could take some of your money and purchase stocks. But is the money actually going "into" the stock market? If so, where does the stock market keep all the money that people invest?  In a box? Or does money simply go through markets, as the person selling me the stock is presumably taking an equal amount of money out of the market?
On October 19, 1987, a record number of shares of stock were purchased on Wall Street. Does this mean that investors put a lot of money "into" the market that day? If so, why did stock prices fall by 22%?
Some might argue that the phrase "putting money into a market" is a harmless metaphor for describing rising asset prices. But why not just say "rising asset prices"?  And I’m not at all sure that it is harmless. I also see people discuss monetary policy from the perspective of where the money goes, not just the supply and demand for money itself. And yet if existing money doesn’t actually go into markets, then newly created money doesn’t either.
Of course central banks generally inject new money by purchasing assets. So the effect of monetary policy might depend in some important way on the choice of assets being purchased. After all, doesn’t the law of supply and demand predict that an increased demand for an asset will raise its price?
At a recent conference Larry White mentioned that Milton Friedman had argued that the gold standard was wasteful, as it led to a higher real price of gold and thus socially unproductive gold mining activity. Larry pointed out that real gold prices actually rose after the government stopped buying gold at $35 an ounce. Friedman had forgotten that switching to a fiat money system might lead to higher inflation, which would encourage more private demand for gold (as an inflation hedge.)
The same process may occur when the Fed purchases Treasury securities. During the 1950s the Fed purchased relatively few Treasuries. Then during the 60s and 70s there was a dramatic increase in the rate at which the Fed bought Treasury securities. So what happened when the Fed put all this money "into" the Treasury market? Surprisingly, T-bond prices plummeted between the 1960s and early 80s. This occurred because monetary policy doesn’t just affect the Treasury market, it also affects the "money market". And by ‘money’ I mean the monetary base, the type of money directly produced by the Fed. The base began increasing rapidly in the 1960s and 70s, boosting inflation and nominal GDP (NGDP) growth, which pushed nominal interest rates sharply higher. So talk of the Fed putting money "into" markets is not a harmless metaphor for rising asset prices, it can lead to very serious errors. People think that monetary injections boost NGDP because they raise bond prices, whereas they actually boost NGDP even more on those occasions where the policy reduces bond prices.
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When interest rates are close to zero, Fed purchases of Treasury securities are a drop in the bucket. There’s very little direct impact on Treasury prices. However Fed policy has an enormous impact on NGDP growth, which then impacts T-bond prices indirectly. At the zero interest rate bound the Fed purchases much larger quantities of Treasury securities, but even in that case the major factor driving T-bond yields and prices is the level and growth rate of nominal GDP. Low nominal interest rates result from a low level of NGDP relative to trend, and/or a low growth rate of NGDP.
As a first approximation, at the macro level it doesn’t much matter what the Fed purchases. Nor does it matter who gets the money "first." There is no advantage from getting the money first. Whatever impact monetary policy has on Treasury prices, the effect will occur regardless of whether the Fed buys Treasury securities or rare earth metals. Interest rates might go up or they might go down, but that will be because of what’s happening in the money market, not the Treasury market. Short-term interest rates often decline when the Fed injects new money into the economy, but that was equally true back in the days when the Fed purchased gold. 
Of course if the Fed bought a thinly traded good such as a rare earth metal, that market would be distorted. But the macro effects would be roughly the same. We don’t know exactly why home prices rose so much in America, Australia, New Zealand, Britain and Canada around 2001-06. Nor do we know why prices subsequently plummeted in the US, but not the other 4 countries. But you can be sure that it was not because newly created money was going "into" the 5 housing markets during 2001-06.

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