Monetary Policy Rules? Can Monetary Policy solve the crisis on its own?

This essay on monetary policy was written in December of 2008. It gives a nice introduction to monetary policy in the current context for the United States. In future posts I will go into more detail on some of the aspects of this essay.

There is increasing anxiety and a resulting diversity of opinions on the efficacy of fiscal and monetary policy in depression like conditions. Is fiscal or monetary policy at the forefront? These are questions I have been pondering over the past few months, and I have accumulated a variety of propositions that I will describe before reaching a personal opinion on this subject.

What is the opinon on the role of Monetary and Fiscal policy in non-depression conditions?Over the long boom years very little of the economy’s success has been attributed to sound fiscal policy, if any. This is mainly because in the 1990s and the best part of 2000s, a period of strong growth for the majority of the OECD countries, there was little correlation with public debt. Though high fiscal debt has led to the downfall of many emerging market economies (Argentina, Brazil, Mexico), some countries (like the US) managed co-existing strong growth and high fiscal debt.

This fact has ruled out fiscal policy as playing a dominant role in explaining economic success, and instead the world has turned to monetary policy, with expectations- anchoring regimes of inflation targeting sweeping the world with low inflation and a structure of low interest rates. The ability of monetary policy to minimise fluctuations in the business cycle by simply providing price stability is rendered as one of the policy changes that have fuelled the long boom. It is a testament to monetarists who long argued that inflation is solely and wholly a monetary phenomenon, and gave composure to the Rational Expectations group by giving importance to expected values of variables.

The problem of course is that, under the realm of ‘Depression economics’, the doctrine of all-empowering monetary policy and irrelevant public finances no longer fits the puzzle. There are two cases in which we can draw some knowledge from, the Great Depression in the 1930s and the Japanese Slump of the 90s and the early 2000s. The commonality rests on a prolonged deflation, together with a liquidity trap (the condition of reaching the 0 lower bound), meaning that conventional monetary policy does not work (discussed in depth in my previous post). With nominal interest rates at a floor of 0, a problem arises when coinciding with deflation, as it produces a high real interest rate. It could be that to maintain demand at the natural level of output, a low or negative real interest rate is required, but cannot be achieved due to the downward rigidity of the nominal interest rate.

This attack of monetary policy has a fair claim to both historical scenarios, particularly in Japan when even non-conventional monetary policies could not work. Even now, policies like Quantitative easing, in which the Federal Reserve takes securities as collateral for loans at essentially 0 interest, and by purchasing large quantities of private market securities and long-term government bonds in the hope of lowering yields on these debt instruments, has minimal effect. In fact, according to Krugman’s parallel of sterilisation of currencies, Central banks’ are funding the purchase of these private securities by selling treasury bills, which is in fact a reverse of the ‘flight to quality’ , where private investors sell their Mortgage Backed securities (and other private assets) and purchase safe treasury bills. The ‘Slap on the face’ effect has had minimal effect and yields on treasury bills have bottomed out. Consequently, the spreads between corporate bonds and treasury securities has in fact widened, as has the mortgage-treasury spread, implying that the credit crunch has not been remediated fully by the Federal Reserve.

A lot of the quantitative easing has led to little expansion of lending by the banks, but rather the excess reserves (valued up to $600B) has been used to fund debt repayment and as a safety valve for any further asset damage. The excess reserves are used as a means of financing the Fed’s investments in private market assets, such as the Term Auction Facility (TAF) program. Essentially we are seeing a great structural change to the Fed’s balance sheet in response to this crisis.

This reversing of the ‘flight to quality’ is seen as essential by monetary policy advocates such as Lucas and Mishkin to prevent ‘adverse feedback loops’, in which, had these unconventional balance sheet operations not been conducted, there would be increased uncertainty in asset values, causing further contraction in credit, causing more uncertainty in asset values, leading to a vicious cycle of falling asset prices and confidence. Thus advocates of the ‘potency of monetary policy’ dictate that unconventional practices at the 0 lower bound are vital to the health of the financial system, and in fact are doing a great deal by providing ample liquidity and enabling firms to raise capital, to be able to continue lending practices despite the paralysis in credit markets. However, there are critics, such as Krugman, who persist in their criticism of the stagnation of monetary policy in ‘Depression conditions’.

These unconventional practices do little, according to him, because it does not change the price of assets enough to create a new equilibrium at which investors are confident in the value of private assets. This is because the markets for private assets are of a much greater magnitude that the $2 Trillion worth of private assets bought by the Fed, and the increase in demand is not enough to significantly increase the price of such assets. Also, given that another feature of the Fed operations is to purchase long-term government bonds, the fact that they are relatively close substitutes with treasury bills means that a significant wedge in the demand for long-term government bonds to treasury bills must occur for the relative prices to change. Lastly, the Fed is taking the role of a private bank- by investing in assets with much higher risk than its non-risk counterpart treasury bills. Lucas says this fact means it is a bailout- the fed is willing to lend on terms the private market does not offer- and that we should neglect the downside risk associated with the large purchase of assets. What Lucas emphasises is that quantitative easing comes at no contingency cost- there is no equity stake, no government enterprise to monitor how the banks use the excess reserves. The beauty of Fed intervention lies in providing non-contingent loans- leaving the private market to figure out how to expand credit.

Government measures aimed at repairing the financial system include direct recapitalisation via the TARP (Troubled asset relief program). Mentioned in previous posts (Fiscal policy responses), the TARP is aimed at purchasing toxic assets, with the added criteria of an equity stake, and perhaps a necessary loan requirement- where the purchasing of preferred stock requires a 1:1 increase in loans. Contingency plans can be seen as positive, making the private market ‘earn’ the TARP by increasing their credit capacity, but these contingencies may not lead to an equitable outcome if it restricts the quantity of capital raised to meet future losses; if the increase in loans are loans that do not qualify as passing the asset tests etc, and if it prevents mergers due to banks not being able to raise enough capital for the purchase of a weaker bank. Thus the TARP, in being a contingency program, can come at the cost of an increase in systemic risk and an insufficient re-capitalisation, which is what such programs are intended to achieve. Thus both the Fed and the Treasury have similar programs aimed at providing liquidity and re-capitalising the firms, but both policies cannot alone repair the financial system, and the flow of credit cannot return to normal levels until the crisis of confidence wanes.

Now, so far I have been deliberating upon the financial system stability role of monetary policy, but little of its macroeconomic role of price stability, along with strong growth and low unemployment. Now, operations such as purchasing the long-term bonds and private market securities under ‘quantitative easing’ are policies aimed at being expansionary, by trying to enhance the pace of credit and thus money creation needed to reach full employment. However, the pace of credit has been paralysed by the financial crisis, as evident in the increasing credit spreads despite the large increase in excess reserves. In fact, according to the St Louis Fed, the Money Multiplier (Ratio of Money Supply (Curr Acc deposits + currency in circ)/ HP Money) is less than 1, meaning that despite the increase in excess reserves, the loan creation has been less than the increase in the amount of reserves. This is reminiscent of the Japanese slump and the Great depression, both examples slightly worse as the quantitative easing policies were nowhere near as exemplary in the current case. Also, one must pay attention to the velocity of money, which is decreasing, and accounts for why an increase in the supply of money is not leading to increased output (what a constant velocity would imply), even in the short run.

The threat of deflation is certain, and is something the Fed is trying to avoid with such unconventional policy; however it is not so easy an ailment to get rid of. Deflationary expectations are being seen through the spread of TIPS over nominal treasury securities at a 10-year maturity. The pigou effect; of how lower prices lead to an increase in real money supply and provide lower interest rates do not work- as it is at the 0 lower bound, and the wealth effect is negligible (Given that there has been a huge reduction in wealth on the onset of the crisis) and is outdone by the balance sheet effect of deflation and the leftward shift of IS curve with increasing real interest rates.

The real problem lies in that, neglecting a change in fiscal policy; full employment can be maintained with a low or negative real interest rate. Unfortunately the 0 lower bound prevents this equilibrium at natural output from being attained, unless real interest rates can be reduced via increased inflationary expectations. This is a policy put forward by both Krugman, Mankiw, and has even been suggested by Bernanke. Krugman, in his studies of the liquidity trap, believes that an expectations anchoring regime (such as IT…or PLT) is better, where the Central Bank must convince the public that it will raise not only the current money supply but all future expected money supplies. At a more practical level, the Fed, according to Mankiw, should commit itself to a policy of a low long-term structure of interest rates; i.e., it should say that it would continue to keep interest rates low until recovery and subsequent over-heating occurs. By aiming to anchor nominal rates, it indirectly tries to anchor positive inflation by its easy stance of policy. Krugman jokingly says that, where governments in 3rd world and many developing countries, when under hyperinflation, have to practise fiscal restraint (ie reduced monetisation of deficit), in this case the Fed has to practise monetary freedom, where they, and the Government (through a possible monetising of deficit) commit themselves to irresponsible behaviour to create a wee bit of inflation.

A lot of these expectations anchoring policies are very hard to put into practice. What they are essentially advocating is a price-level target (PLT), but the problem of such a regime is that anchoring inflation comes at a cost of larger deviations in output than in a multiple objective regime like the US, and it is impractical when in the reverse scenario of inflation above target, where the PLT may induce a disinflationary recession akin to the Volcker disinflation of the 80s. Certainly, when looking at price stability in the current situation, the main objective is to prevent deflation in the short-term, and to rein in the excess liabilities (excess reserves) and sell back the private securities collected by the Fed, to prevent inflation in the long-term. Reining in excess reserves is required as the excess reserves can result in a large increase in money supply once the money multiplier returns to normal levels- and credit expansion begins once again.

My main concern is that Monetary policy, despite the quantitative easing and anti-deflationary policies pursued, has little transmission mechanism left in terms of affecting aggregate demand- output and unemployment. Though it is alleviating pressure on the financial system indirectly it aids macroeconomic variables through reducing credit spreads over what might have been in the absence of unconventional policy, one transmission mechanism, the exchange rate, for example, is having little effect due to the ‘safe haven theory’ of US as being a more stable currency leading to large inflows and a net appreciation of the $US. Thus both the interest and exchange rate channels have been somewhat stemmed- and has changed the economic outlook from stabilising monetary policy to one of bailing out financial institutions and a turn to …the Keynesian moment- a fiscal frenzy! (To be discussed in future posts)