QE

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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Central Banks and Systematic Risks

Modern economies are built by businesses that take risk. As Edison’s defense suggests, successful risk-takers need scope to experiment without distraction. Economies lacking institutions to support risk-taking are prone to stagnation.

By securing economic and financial stability, central banks play a key role in promoting the risk-taking that is fundamental to innovation and capital formation. On rare occasions, it is officials’  bold willingness to do “whatever it takes” that does the job. More often, it is a series of moderate, gradual actions. Yet, even then, the understanding that the central bank has the broad capacity to act—and, when necessary, to do so without limit—is a key factor underpinning the stability of the system...

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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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Learning from Japan: It's Hard to End a Deflation

In 1974, when the Fed faced rising inflation, the U.S. government sought to “Whip Inflation Now” by encouraging people to wear “WIN” buttons. Today, the problem is reversed. Several central banks are having trouble creating inflation. Unfortunately, we doubt that “SIN” buttons – “Support Inflation Now” – will be any more effective than the earlier variety, which served mainly as fodder for late-night comedy.

As has been the case for some time, Japan is blazing the trail into the monetary and fiscal unknown. Today's Bank of Japan's (BoJ) leadership is far more determined to promote price stability than its predecessors over the past two decades. But the deflationary hole that Japan is climbing out of is so deep that the BoJ may need some help...

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