Monday, December 28, 2009

Monetary policy options at zero-bound

The simplest intuitive case for the superiority of fiscal policy over monetary policy in retrieving a recession-hit economy, especially in the major economies, comes from the fundamental reality that the economy is ravaged with over-capacity across most sectors and private consumption demand is extremely weak. The only way out of this is to generate enough aggregate demand to first absorb the slack and in the process instill enough confidence among businesses to then invest in expanding capacity.

Monetary policy, through lower long term real interest rates, seeks to incentivize businesses to invest by lowering their cost of capital. But, as discussed above, the challenge is not to expand capacity as to fully utilize the existing capacity. The demand side stimulus by way of lower rates (on say hire purchase schemes for consumer durables etc) is marginal and takes effect with a lag. In contrast, fiscal policy, especially those that puts disposable income in the hands of people who are likely to spend it, has an immediate impact on boosting aggregate demand.

Monetary policy becomes even more ineffectual when the economy is facing the zero-bound interest rate and deflation has taken hold (or even when inflationary expectations are firmly under control). In the circumstances, the deflationary shock will lower short-term inflation expectations and therefore increase the real interest rate. Further, with nominal rates touching zero, the real interest rates cannot be lowered beyond a level and remains higher than desired. Even with massive purchases of long-term securities through quantitative easing, real interest rates on them will remain high.

Though economists like Brad De Long and Paul Krugman have advocated fixing a high enough inflation target to generate inflationary expectations and thereby put upward pressure on real long-term rates, the Fed Chairman Ben Bernanke fears that it could undermine the Central Bank's credibility. But the danger with such conservatism during such times is that the deflation may set in motion a self-fulfilling spiral of entrenching deflation and falling output, like that what gripped Japan in the nineties. It has also been suggested that Central Banks should communicate specific interest rate targets or bands, though its success is a function of their existing credibility. Further, the results of this has been mixed to give any meaningful lessons.

Charles T. Carlstrom and Andrea Pescatori of the Cleveland Fed advocate price-level targeting to demonstrate an unequivocal commitment to preventing deflation, "With a price-level target, the central bank commits to sticking to a given path for the level of prices over some horizon. If prices start rising faster than a pre-specified rate, policymakers must lower inflation in the future to get the price level back to the target. Similarly, if there is a deflationary shock, the central bank must inflate in the future because it has to bring the price level back up".

And about the different between inflation target and price-level target, they write,

"There is an important difference between an inflation target and a price-level target. An inflation target 'lets bygones be bygones', while a price-level target corrects for past misses. If prices fall on a year-over-year basis, a price-level target requires the central bank to reinflate prices until they are back to the target. An inflation target requires only that the rate of inflation be returned to its target rate from the present onward. A price-level target is essentially a promise that a deflationary shock today will increase inflation in the future and thus expected inflation today. This promise of future inflation will lower real interest rates even when short-term nominal rates are zero. Long-term inflation is still pinned down as it is with an inflation target."


Economists like Paul Krugman (and here, here, and here) have argued that at the zero-bound since banks’ cash reserves and short-term securities are perfect substitutes, banks have no incentive to lend the money out, and therefore any quantitative easing that focuses on purchasing short-term securities will fail. They simply substitute the cash they receive from the central bank for the securities they were holding in reserves, and therefore the supply of money in circulation is not affected. In other words, they attach no value whatsoever on any liquidity or safety advantage that might be had from holding assets in the form of cash.

Carlstrom and Pescatori however argue that even purchases of long term securities are not likely to yield the desired results in getting banks to lend money since the banks are more likely to sit on the cash they receive from the sales of those securities than lend them out. Even if there is some immediate impact by way of decrease on long-term interest rates (as evidenced in the yields of those securities), it is not likely to be large enough and lasting as long-term inflation expectations take hold.

Further, even if banks transact with the cash available, they are likely to use it to purchase short-term treasuries, whose relative risk-adjusted returns increase. Expectations on long term rates are also likely to keep banks invested in short-term instruments. The long-term interest rates are eventually determined by market fundamentals, namely long-term inflation expectations in conjunction with expected long-term economic growth, which are non-monetary factors. In any case, given the aforementioned excess capacity problems and weak consumer demand, the demand for borrowings is likely to be subdued.

Update 1
Andy Harless feels that one way to have adequate fire power in central bank arsenal to respond to severe financial crisis induced deep recession is to "target an inflation rate that is high enough to give it a lot of room to respond to a crisis (or an incipient crisis) by cutting interest rates far below the inflation rate". He argues that such an arrpoach ensures long term financial stability and minimizes the damage without relying on authorities to behave better or more presciently than they normally do behave.

Update 2
Mark Thoma points to a working paper by Chris Sims about difficulties of policy at the zero lower bound - the difficulty of credible commitment to higher future inflation that is necessary in most New Keynesian models, the difficulty in achieving fiscal and monetary policy coordination, and the problems that may arise when the central bank takes quasi-fiscal actions

Update 3 (17/3/2010)
Paul Krugman has a nice explanation of liquidity trap. He defines liquidity trap as one where conventional open-market operations — purchases of short-term government debt by the central bank — have lost traction, because short-term rates are close to zero. Apart from the liquidity expansions, Central banks can also purchase longer-term government securities or other assets (so as to bring down long term rates), and they can try to raise their inflation targets in a credible way.

Update 4 (23/3/2010)
More evidence of the claim that central banks can apply further monetary stimulus by lowering long-term borrowing costs even when short-term interest rates are stuck at zero.

A New York Fed assessment of the Fed's purchases of medium and long-term maturity assets since December 2008 by Joseph Gagnon, Matthew Raskin, Julie Remache, and Brian Sack find evidence that it led to economically meaningful and long-lasting reductions in longer-term interest rates on a range of securities, including securities that were not included in the purchase programs. These reductions in interest rates primarily reflect lower risk premiums, including term premiums, rather than (normally expected) lower expectations of future short-term interest rates. It found that the Federal Reserve lowered long-term interest rates about 50 to 60 basis points last year through its purchases of $1.7 trillion of longer-term bonds. Joe Gagnon writes,

"The reduction in long-term interest rates applies not only to Treasury securities, but also to mortgages and corporate bonds. Households buying and refinancing their homes took out mortgages worth over $2 trillion in 2009 and they will save about $11 billion in interest payments each year because of the lower interest rates. With interest rates remaining low for new borrowers in 2010, these benefits will continue to grow and will help to support consumer spending and economic recovery. Thanks to the low interest rate environment, corporate bond issuance (net of redemptions) reached a record $381 billion in 2009, helping to finance a turnaround in capital spending late last year that exceeded most private forecasts."

Gagnon had earlier advocated (see also this and this) that the "Fed could push down long-term yields another 75 basis points by buying a further $2 trillion of long-term bonds. Current yields on 10-year Treasury notes, at 3.7 percent, are far above the zero rates on short-term Treasury bills. The benefits to the economy would be rapid and similar to those already observed from the first round of Fed purchases. Moreover, lower long-term interest rates and a faster recovery would also reduce our national debt."

See also this post by Mark Thoma.

Update 5 (13/7/2010)
Paul Krugman advocates buying longer-term government debt and private sector debts, moving expectations by announcing intent to keep interest rates low for a long time, raising long-term inflation target. All this would "convince the private sector that borrowing is a good idea and hoarding cash a mistake".

Scott Sumner too feels that central banks have insufficiently boosted expectations for businesses to have enough confidence to start making investments.

Update 6 (22/7/2010)
Ben Bernanke discusses four options to increase monetary accommodation when faced with the zero-bound

1. The Fed could signal to the markets that it intended to keep its benchmark federal funds rate at zero to 0.25% for even longer than the "extended period" the Fed has been projecting.

2. The Fed could lower the interest rate it pays on excess reserves, the deposits that banks keep at the Fed in excess of what they are required to keep, from its current level of 0.25%.

3. The Fed could again expand the size of its balance sheet, which stands at about $2.3 trillion, by buying additional Treasury debts or mortgage-backed securities, or even other classes of assets, like municipal bonds.

4. On a smaller scale, the Fed could also reinvest the cash it received when the underlying principal on mortgage bonds on its books was repaid, a step that would also keep the Fed’s balance sheet from shrinking.

See also Joseph Gagnon's suggestions on the same issue.

Update 7 (28/8/2010)

Bernanke has this speech outlining his monetary policy options if further accommodation is called for - conducting additional purchases of longer-term securities, modifying the Committee’s communication, and reducing the interest paid on excess reserves.

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