Is Monetary Policy alone enough to stimulate Economic Recovery?
These are unusual times. In the last five years we have seen country after country around the world veer from a financial crisis to a sovereign debt crisis. The US and Europe find themselves on the edge of the precipice, caged in a liquidity trap. Conventional monetary policy is no longer effective. But there are still a few arrows in the monetary policy quiver, and while unconventional, this essay posits that they could stimulate economic recovery. Focusing on the two major central banks for which this crisis is most pressing, this paper argues that for the Fed, monetary policy may be enough to escape the current crisis. For the ECB, it will not.
II. Usual Times
Most economies operate a dual pillar monetary policy, focusing on stabilizing inflation and unemployment around its natural rate. Simple analysis suggests that monetary policy, in the form of money supply, can temporarily stimulate the economy and act to re-boot output towards its natural rate, via lower interest rates. However, these are unusual times, constrained by the fact that the nominal interest rate cannot go below zero. While the ECB’s official policy rate is 1 percent, the inter bank lending rate is currently around 1/3 percent. At the end of January, the Fed announced that they would keep the target range for the federal funds rate at 0 to 1/4 percent and expect that this low level rate will last at least through late 2014.
Interest rates as an indirect policy tool have become ineffective, and fiscal policy is severely constrained. At this point, monetary policy will only work as an output stimulus if real interest rates were negative. Conventional monetary policy no longer exists in the manner it has over the last few decades.
III. What options remain?
Generally, the interest rate is defined indirectly by bank reserves, as excess reserves set the market-clearing rate. However, at the zero bound, the relationship between reserves and interest rate is decoupled. At this point, central banks have two main policy tools open to them: forward guidance and quantitative or credit easing. What this means is that banks can affect economic activity by influencing expectations or altering the balance sheet of agents.
i. Forward Guidance
There are two elements to monetary policy: signalling a stance, and making it effective. The credibility of a central bank is a crucial part of how a policy signal feeds into expectations. Generally, expectations are modelled as backward looking. However, if the central bank is credible, then people may form their expectations based on announced policy. Dotsey argues that the most effective course of action for a central bank is to attempt to influence future policy, as a credible commitment of a central bank to high future inflation will act as a self-fulfilling prophecy and guide the economy on to the path of recovery.
This line of reasoning only works if inflation expectations are forward looking and the central bank is entirely credible. However, such a stance will never be credible because it is not time consistent. Once the economy emerges from its recession, the central bank has every incentive to renege on its promise and prevent inflation from going too high. The markets and the public know this, and so the policy announcement has no effect.
Because of lags in monetary policy, inflation targeting has to rely on forecasting – expectations play a major part in forecasting and hence how expectations are formed is of utmost importance to how monetary policy affects the economy. The fact that inflation expectations have thus far adjusted only modestly may not reflect the credibility of the central banks, but the fact that inflation in the past has been modest. If this is the case, then expectations of disinflation may become entrenched, as in Japan. Fed inflation forecasts put future inflation short of the 2 percent target, despite the fact that current inflation is around 3 percent. The Fed is banking on a version of inflation inertia. This implies two things: firstly, that the Fed itself recognizes inflation inertia, rendering forward guidance less effective; and secondly, that the Fed cares less about inflation targeting than it does unemployment. e policy announcement has no effect.
Central bank announcements can play some role – for example in the case of the ECB, a statement of open rhetorical commitment to providing support to vulnerable sovereigns and banks would serve to stem financial contagion from a potential Greek exit . However, to consider forward guidance the silver bullet is to place your faith in the irrationality of all citizens. A commitment to high inflation is time inconsistent and simply not credible. For these reasons, this paper argues that forward guidance has little role to play in mediating the current economic crisis.
ii. Quantitative and Credit Easing
Quantitative easing (QE) is the process of trying to inject liquidity into the economy through open market operations. These tools - printing money and supporting the nominal value of private and public debt - are independent of credibility or expectations. There are those that argue that at the zero bound, current injections of money have little impact on prices or inflation. However, this reasoning ignores the impact on nominal value of debt and on the risk bourn by the public and private sectors. A large-scale purchase of assets, such as treasury bonds and mortgage-backed securities, shifts the risk of default on such assets from the public and private sectors respectively. A central bank’s only liabilities are banknotes, which they can fulfil as long as they can print money, and perhaps some deposits from commercial banks.
This is where the difference between the Fed and the ECB is particularly interesting. The Fed’s announcements last month set the stage for QE III. Such a move would shift further risk from the strained public and private sectors. Both the Fed and the Bank of England have since the start of the crisis purchased assets and hence removed risk from financial markets – assets come off private sector balance sheets, and the risk in those securities is eliminated from the financial system.
The ECB is unable to embark on quantitative easing because they are constrained by law. Instead of buying treasury bonds from government, the ECB has purchased credits in the secondary market. These are not outright purchases, but repurchase agreements, lending to banks against a pledge of collateral. Milton Friedman would argue that these two actions have the same implications (in that they constitute an increase to the money supply). However, this ignores the implications for the allocation of risk. In the case of the ECB, the risk attached to securities does not shift from the public or private balance sheet, as banks are still responsible in the case of a default. James Tobin would counter that ECB credit easing operations are not as effective in mediating the economic crisis at the quantitative easing of the Fed, as they do not remove interest rate or default risk from the strained system. There is still an effect, as such purchases allow private banks to be financed at a time of great financial strain, but it is limited.
iii. Moving Forward with QE
There are of course long-run risks associated with such a strategy. In the future, should the nominal interest rate rise above zero, bank reserves will once again become important for reaching the target federal funds rate. Currently, the Fed can expand their balance sheet without limit, and shrink it by selling securities. However, this encapsulates an asymmetric risk. On the asset side of the balance sheet are treasury bills and mortgage-backed securities, and on the liabilities side there are banknotes. The problem is that a central bank can't shrink its balance sheet and reduce the money supply if the securities it owns decline in value. Currently, central bank portfolios “are chock full of assets of dubious quality” . However, this is a problem for tomorrow – positive growth is the problem for today.
This crisis has political origins, and politics must necessarily be part of the solution. In Europe, there are so many confluencing factors that monetary policy will never be enough. A cogent path for recovery will involve the co-ordination of multiple national, supra-national, and sub-national governing bodies along with complimentary private sector activity and a good dollop of luck. However, for the Fed, monetary policy may have a hope. This paper argues that quantitative easing may be sufficient to temporarily ease the strain on the public and private sector, restore some confidence in market debt, and serve to boost the American economy onto a growing path. This will not be without huge costs, as monetization of the debt has many negative consequences. It will come with future complications down the road, as falling asset prices may obstruct the Fed’s ability to reduce the money supply in the future. But we are at a junction at which there are only difficult choices, and monetary policy, in the case of the US, may be the least painful road to recovery.
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- Dotsey, Michael (2010) Monetary Policy in a Liquidity Trap. Philadelphia Fed, Business Review Q2 2010
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