One argument that monetarist economists like myself often make is that what matters is not so much the central bank's policy now, as what the central bank is expected to do in future years. The Bank's base rate might be low right now, and the Bank may hold rather a lot of government bonds in a big quantitative easing programme—but if it's expected to offload the gilts and hike rates tomorrow, markets will react today. Macro conditions are tight now if monetary policy is expected to tighten soon. A new paper (pdf) from Stefania D'Amico and Thomas B. King of the Federal Reserve Bank of Chicago, and entitled "What Does Anticipated Monetary Policy Do?" tackles this question empirically, looking specifically at 'forward guidance' over rates—where central banks tell markets they will keep policy interest rates at a certain level for a certain amount of time in the future.
They use a methodology similar to earlier papers, including one that I wrote about earlier, using surveys of financial market actors to work out whether a given change in rates (or planned future rates) is a shock or not.
They identify this difference by looking at expectations of inflation and GDP. If lower forward rates coincide with lower expected inflation and GDP, they reason that rates are being lowered to counteract some external factor driving inflation and GDP down. If lower forward rates coincide with higher expected inflation and GDP, they reason that the rate lowering signals an easier monetary policy overall, higher future aggregate demand, and thus higher nominal variables (and if there's any demand deficiency, higher real variables).
It's the second kind—where rates and inflation/GDP move in opposite directions—that signals a change in policy. And this policy change, according to D'Amico and King's data, feeds through into real outcomes. Promising easier policy does lead to easier conditions now—raising inflation and real GDP right away—and in fact it does so substantially. In their own words:
We find that when survey respondents anticipate a monetary policy easing over the subsequent year (controlling for past macro data and the current policy stance), this leads to an immediate and persistent increase in both prices and output.
For example, a decrease of 25 basis points in expectations for the average short-term rate over the next year, holding all else constant, results in a short-run increase in both GDP and the price level of about 1 percent.
These effects occur much faster than those of a conventional monetary-policy shock, which we identify in the same VAR. After about two years, a given shock to policy expectations has about the same effect on output as a conventional policy shock of the same size and an effect on inflation that is 2 to 3 times as large.
Shocks to expectations beyond the one-year horizon still have effects in the same direction, but they are smaller, less persistent, and not always statistically significant
Now, this doesn't necessarily mean we want central banks to do forward rate guidance. We might reasonably want them to get out of the business of setting any of the lending rates in the economy, and simply adjust the supply of money to meet demand, as private banks would do under a free banking system. But this does give us an extra reason to be wary of fiscal policy in slumps—monetary policy is enough.