ZLB

Fed Monetary Policy in Crisis

The Federal Open Market Committee (FOMC) is facing a crisis of its own making. The crisis has four elements. Policymakers failed to forecast the rise in inflation. They failed to appreciate how persistent inflation can be. They are failing to articulate a credible low inflation policy. And, so far, there is little sign that monetary policymakers recognize the need to react decisively.

Our fear is that matters have now progressed to the stage where the Fed’s credibility for delivering price stability is at serious risk. And, as experience teaches us, the less credible the central bank, the more painful it is to lower inflation to target.

In this post, we discuss the policy crisis and suggest how to respond. In our view, the FOMC needs a plan to raise rates quickly and substantially. For the FOMC to ensure inflation returns to its target of 2%, policymakers likely will need to bring the short-term real interest rate into significantly positive territory. Put slightly differently, we suspect that the policy rate needs to rise to at least one percent above expected inflation.

Won’t a sharp policy tightening trigger a huge recession? In our view, credibility is the key to how much pain disinflation will cause. Applying the painful lesson of the 1970s and early 1980s leads us to conclude that the FOMC now needs to show clear resolve. Inflation rose very quickly over the past year, so it may still be possible to bring it down sharply without a recession. The more decisively policymakers act, the lower the long-run costs are likely to be. Failure to restore price stability in a timely way would almost surely render this expansion disturbingly short compared to recent norms.

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The Fed's New Strategy: More Discretion, Less Preemption

On August 27, marking the conclusion of the Fed’s first strategic review, the Federal Open Market Committee released an amended version of their fundamental policy guide—the Statement on Longer-Run Goals and Monetary Policy Strategy. The FOMC adopted a form of flexible average inflation targeting (FAIT). Partly because the new strategy largely confirms recent Fed behavior, the response in financial markets was minimal. Indeed, market-based long-run inflation expectations were virtually unchanged this week. Perhaps the only noticeable development was a modest steepening at the very long end of the yield curve.

In this post, we identify three key factors motivating the Fed review and highlight three principal shifts in the FOMC’s strategy. In addition, we identify several critical questions that the FOMC will need to answer as it seeks to implement the new policy framework. Specifically, the shift to FAIT implies a change in the Committee’s reaction function. How does this reformulated objective influence the FOMC’s systematic response to changes in economic growth, unemployment, inflation and financial conditions? Under FAIT, the effective inflation target over the coming years also now depends on past inflation experience. What is that relationship?

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Negative Nominal Interest Rates: A Primer

Many people find negative interest rates confusing. Why should anyone pay a bank to make a deposit? Why should a bank pay someone to borrow? How can we value an asset with a future cash flow when the interest rate is negative?

Policymakers also wonder whether the effects of negative interest rates on the economy are favorable or unfavorable. Do negative interest rates help central banks achieve price stability by stimulating economic activity? Do negative rates spur banks to make more good loans or to evergreen bad ones? Will borrowers and banks take on too much risk because they can fund investments at a negative rate? Will households reduce their saving rate because the return is so low, or raise it because low returns leave them farther from their wealth target? Will negative rates influence the ability of pension funds, insurance companies and governments to make good on their long-term promises to future retirees?

In this primer, we examine these questions, starting with key facts about negative nominal interest rates. Our conclusion: there is little magic about having a slightly negative, as opposed to slightly positive interest rates. Thus, much of the criticism of persistently negative nominal interest rates applies similarly to very low, but positive rates. That said, financial system frictions limit the favorable impact from modestly negative nominal rates, but our experience with them remains limited. Given the likely need for unconventional policy tools to address the next recession, learning more about the benefits and costs of negative nominal interest rates is a high priority….

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The Case for Strengthening Automatic Fiscal Stabilizers

For decades, monetary economists viewed central banks as the “last movers.” They were relatively nimble in their ability to adjust policy to stabilize the economy as signs of a slowdown arose. In contrast, discretionary fiscal policy is difficult to implement quickly. In addition, allowing for the possibility of a constantly changing fiscal stance adds to uncertainty and raises the risk that short-run politics, rather than effective use of public resources, will drive policy. So, the ideal fiscal approach was to set policy to support long-run priorities, minimizing short-run discretionary changes that can reduce economic efficiency.

Today, because conventional monetary policy has little room to ease, the case for using fiscal policy as a cyclical stabilizer is far stronger. Unless something changes, there is a good chance that when the next recession hits, monetary policymakers will once again find themselves stuck for an extended period at the lower bound for policy rates. In the absence of a monetary policy offset, fiscal policy is likely to be significantly more effective.

Against this background, a new book from The Hamilton Project and the Washington Center for Equitable Growth, Recession Ready: Fiscal Policies to Stabilize the American Economy, makes a compelling case for strengthening automatic fiscal stabilizers. These are the tax, transfer and spending components that change with economic conditions, as the law prescribes….

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Inflation Policy

Inflation in the United States remains at levels that most people don’t really notice. Overall, the consumer price index rose 2.8 percent from May 2017 to May 2018. And, when you look at core measures, the trend is still below 2 percent.

With inflation and inflation expectations still so benign, it is no wonder that despite solid economic growth and the lowest unemployment rate in 50 years the Federal Open Market Committee continues to act quite gradually (see their June 2018 statement). Inflation could well turn up in the near term—perhaps by more than the policymakers expect. But, for reasons that we will explain, if we were on the FOMC, we would stay the planned course: remain vigilant, but certainly not panic.

We start with a look at the data. What we see is that trend inflation has stayed reasonably close to the Fed’s medium-term target of 2 percent for the past two decades. There have been occasional deviations, like the temporary rise in 2008 and again in 2011, but overall, the path is remarkably stable….

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Banks and Money, Or Watch out What You Wish For

On 10 June 2008, a large majority of voters in Switzerland rejected a proposal that all commercial bank demand deposits be held at the central bank. This Vollgeld referendum was another incarnation of the justifiable public revulsion to financial crises and the bailouts that inevitably accompany them. Vollgeld proponents claimed that a system in which the central bank is the sole issuer of “money” will be more stable.

Serious people debated the wisdom of this proposal. One of Switzerland’s premier monetary economists, Philippe Bacchetta, wrote passionately in opposition. Martin Wolf, chief economics commentator at the Financial Times, argued in favor. And Swiss National Bank Chairman Thomas Jordan discussed the many dangers in detail.

It should come as no surprise that, had we had been among the Swiss voters, we would have voted “no.” In our view, the Vollgeld (sovereign money) initiative combined aspects of narrow banking with those of retail central bank digital currency. We see these as misguided, distorting the credit allocation mechanism and more likely to reduce than improve financial stability (see here and here). In the remainder of this post, we explain why….

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Relying on the Fed's Balance Sheet

Last week’s 12th annual U.S. Monetary Policy Forum focused on the effectiveness of Fed large-scale asset purchases (LSAPs) as an instrument of monetary policy. Despite notable disagreements, the report and discussion reveal a broad (if not universal) consensus on key issues:

In a world of low equilibrium real interest rates and low inflation, policymakers could easily hit the zero lower bound (ZLB) in the next recession.

At the ZLB, the Fed should again use a combination of balance-sheet tools and interest-rate forward-guidance to achieve its mandated objectives of stable prices and maximum sustainable employment (see our earlier post).

Yet, significant uncertainties about the impact of balance-sheet expansion mean that LSAPs may not provide sufficient stimulus at the ZLB.

Fed policymakers should undertake a thorough (and potentially lengthy) assessment of alternative policy tools and frameworks—ranging from negative interest rates to a higher inflation target to forms of price-level targeting—to ensure they remain as effective as possible.

The remainder of this post discusses the challenges of measuring the impact of balance-sheet policies. As the now-extensive literature on the subject implies, balance-sheet expansions ease financial conditions. However, as this year’s USMPF report emphasizes, there is substantial uncertainty about the scale of that impact.... 

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A Monetary Policy Framework for the Next Recession

Hope for the best, but prepare for the worst. That could be the motto of any risk manager. In the case of a central banker, the job of ensuring low, stable inflation and high, stable growth requires constant contingency planning.

With the global economy humming along, monetary policymakers are on track to normalize policy. While that process is hardly free of risk, their bigger test will be how to address the next cyclical downturn whenever it arrives. Will policymakers have the tools needed to stabilize prices and ensure steady expansion? Because the equilibrium level of interest rates is substantially lower, the scope for conventional interest rate cuts is smaller. As a result, the challenge is bigger than it was in the past.

This post describes the problem and highlights a number of possible solutions.

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The case for a higher inflation target gets stronger

For several years, economists and policymakers have been debating the wisdom of raising the inflation target. Today, roughly two-thirds of global GDP is produced in countries that are either de jure or de facto inflation targeters (see our earlier post). In most advanced economies, the target is (close to) 2 percent. Is 2 percent enough?

Advocates of raising the target believe that central banks need greater headroom to use conventional interest rate policy in battling business cycle downturns. More specifically, the case for a higher target is based on a desire to reduce the frequency and duration of zero-policy-rate episodes, avoiding the now well-known problems with unconventional policies (including balance sheet expansions that may prove difficult to reverse) and the limited scope for reducing policy rates below zero.

We have been reticent to endorse a higher inflation target. In our view, the most important counterargument is the enormous investment that central banks have made in making the 2-percent inflation target credible. Yet, several lines of empirical research recently have combined to boost the case for raising the target….

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Connect the Dots

How and what should the Federal Open Market Committee (FOMC) communicate to make monetary policy most effective? That is the question addressed by this year’s U.S. Monetary Policy Forum report (Language After Liftoff: Fed Communication Away from the Zero Lower Bound).

Over the past two decades, the FOMC has made enormous strides in promoting transparency. In sharp contrast to most of its previous history, the Fed now emphasizes that transparency enhances the effectiveness of monetary policy.

Yet, central bank communication is a work in progress. And, as the new USMPF report argues, there remains scope for improvement. In our view, the simplest and most useful change that the authors recommend, and that the Fed could implement—immediately and without cost—is to “connect the dots:” that is, to link (while maintaining anonymity) the published interest rate forecasts of each FOMC participant that appear in the quarterly “dot plot” (found in the Summary of Economic Projections, or SEP) to that same person’s projections of inflation, unemployment, and economic growth.

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How Low Can They Go?

Not long ago, nearly everyone thought that nominal interest rates could not go below zero. Now, we have negative policy rates in the euro area and Japan, while in Sweden and Switzerland, the lowest controlled rate is below -1%. And government securities worth trillions of dollars bear negative rates, too.

When we first wrote about negative rates a year ago, we argued that the effective lower bound (ELB, rather than ZLB) for nominal rates was determined by the transactions costs of storing and transferring cash. We reasoned that the ELB might be in the range of -0.50% (minus one-half percent). Below that, we thought, there would be a move into cash, facilitated by banks and others who efficiently manage the notes for clients.

But, at the negative rates that we have seen so far, cash in circulation has not spiked. So, how much further can nominal interest rates fall? And what role should negative interest rates play in the future?

 

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Falling Interest Rates and Government Investment

Switzerland is an amazing place, not least the skiing, the chocolate, and the punctual trains. The latter is part of the country’s exquisitely maintained infrastructure: there are no potholes, and no deferred maintenance of train tracks, tunnels, airports, or public buildings. Few countries go so far, but many can take a lesson: it pays to maintain infrastructure at least so that it doesn’t fail.

We bring this up now because financial markets are telling us that it’s a very good time to build and repair infrastructure: real (inflation-adjusted) interest rates have fallen so low that it has become exceptionally cheap to finance the improvement and repair of neglected roads, bridges, transport hubs, and public utilities. Yet, in the United States, we are doing less public investment than ever: net government investment has fallen to what is probably a record low...

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Unconventional monetary policy through the Fed's rear-view mirror

On December 16, the Federal Open Market Committee is poised to hike interest rates, putting an end to the near-zero interest rate policy that began in December 2008. So, it’s natural to step back and ask what this episode has taught us about monetary policy at the near-zero lower bound for nominal interest rates. This is not merely some academic exercise. The euro area and Japan are still constrained by the zero bound. And, in this era of low inflation and low potential growth, policy rates in advanced economies are likely to hit that lower bound again (see, for example, here). How the Fed and other central banks respond when that happens will depend on the lessons drawn from recent experience...

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The ECB's Not-So-Sweet 16th

Sixteenth birthdays can be momentous occasions. A coming of age of sorts. Well, New Year’s Day 2015 the European Central Bank turned 16. It is a momentous birthday, but not all that sweet.

To be sure, there is notable good news. The new headquarters in Frankfurt recently opened. Lithuania has entered the euro area. The frequency of ECB monetary policy meetings is about to decline. And there will soon be timely publication of minutes of these meetings.

But the risk of deflation amid sustained economic weakness makes for a very anxious birthday...

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Should we really worry about currency wars?

In September 2010, Brazil’s former finance minister, Guido Mantega, made headlines when he accused the Federal Reserve, the European Central Bank and the Bank of England of engaging in a currency war.  The complaint was that easy monetary policy was driving down the value of the dollar, the euro and the pound, at the expense of his country and those like it. More recently, similar charges have been levied against Japan: namely, that the Bank of Japan’s extraordinary balance sheet expansion is aimed at driving down the value of the yen, damaging the country’s trading partners and competitors...

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How big should central bank balance sheets be?

In 2007, the Fed’s balance sheet was less than $1 trillion. Today, it is nearly $4.5 trillion. The U.S. experience is far from unique. Since 2007, global central bank balance sheets have nearly tripled to more than $22 trillion as of mid-2014. And, the increase is split evenly between advanced and emerging market economies (EMEs).

So what’s the right size? The answer depends on the policy goals and the nature of the financial system. In the case of the Fed, we expect that it will be able to achieve its long-term objectives with fewer than half of its current assets...

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The ECB plans to ease, but how? 

The European Central Bank is nervous. Inflation in the euro area has fallen to 0.5 percent (see chart), well below the ECB’s objective of slightly below 2 percent. Not only that, but most of the peripheral countries (including Cyprus, Greece, Slovakia. Spain, and Portugal) are now experiencing deflation. What to do?

Last week, President Mario Draghi signaled that the ECB Governing Council is likely to ease policy at its June 5 meeting. How?...
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ECB Minute by Minute 

Central bank communication is a work in progress everywhere, but particularly so in the euro area.

Unlike the Fed, the Bank of England, and the Bank of Japan, which all publish minutes of their policy meetings with a lag of a few weeks, current ECB rules anticipate releasing summary records of Governing Council meetings only 30 years after they occur.
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