Monetary Policy

Potential Limits on Monetary Transmission

In the classical model of monetary theory, central banks are able to affect real economic activity through control of interest rates. In practice, it is thought that control over short-term rates such as the cash and federal-funds rates is potent due to a mechanism known as the ‘lending channel’.

According to the lending channel model, central bank control of reserves affects the supply of deposit financing available to banks. In turn, this allows the commercial banks to greatly expand their lending capacities.

Whilst this mechanism is widely known by economists, the assumptions that underlie it are not so familiar. In particular there are 3 critical requirements for the model. (I use vocabulary corresponding to a contraction in reserves)

  • banks can do stuff. The neutrality postulate of money breaks down in the short term. Price adjustments are imperfect such that that nominal changes have large bearings on real outcomes.

  • Demand for banks. Firms in the economy are reliant on the efficiency of banks such that bank loans and public finance via bonds are not perfect substitutes. In other words, the Modigliani-Miller theorem breaks down in a particular way implying firms cannot offset decreased credit from commercial banks with public credit.

  • Supply of bank credit is affected by the Central Bank. Commercial banks do not insulate their lending actions from central bank operations. This is interpreted as a reluctance from the banking sector to switch from deposit funding to other forms of finance such as commercial paper and equity which are less reserve-intensive.

(These assumptions were identified by Kashyap and Stein (1994))

Both empirically and intuitively conditions 1) and 2) are likely valid, but the 3rd is not self-evidently sound. In fact, it relies on the assumption that for commercial banks debt instruments such as commercial paper are not good substitutes for reserves. The substitutability between these two instruments is thus the focus of this post.

Luckily, the extreme monetary conditions of this decade have provided a clearer view of the situation which I hope will become the topic of more analysis going into the future.

To see how extreme monetary conditions can give us a clear view of the fault lines in condition 3, we must first look at how Quantitative Easing (QE) worked in the U.S. I will not give the full mechanistic exposition (though at some point I probably should since it is a frequently asked question), but rather will attempt to explain some stylistic elements which shed light on the Monetary Transmission mechanism.

When the Federal Reserve embarked on QE3, the most expansive and concentrated of the QE iterations, it underwent a series of huge purchases of long term government debt (to the tune of $80 billion per month). In exchange for these purchases of government debt it credited the equivalent amount of reserves into the banking sector. In addition, as a precaution to stop runaway credit growth, the Fed paid 0.25% interest on ‘excess reserves’ (the reserves that banks held above their 10% requirement).

The goal of course was to reduce long term rates via the purchase of long term assets. But there is something else here. Now that the Fed was paying 0.25% interest on excess reserves, reserves themselves had become a highly liquid asset that in all but name resembled short-term bonds issued by the Fed. Hence, what we would expect to see is not just a series of purchases that pull down the yield curve on the long end; but rather a series of purchases balanced by sales which should push up the yield curve on the short end. In other words, this operation should not have just compressed the term structure of interest, but actually twisted it. One can think of it as an increase of short term debt supply as well as an increase in long term debt demand.

Nevertheless, throughout QE3 there was a persistent fact that came to the surprise of quite a few monetary economists. Namely, the yield curve in the US did not actually twist, but in fact was compressed in many markets- contrary to expectations. Commercial paper markets for example in commercial banks fell quite dramatically over the period 2011-13. Thus, on balance there was likely a reduction in the issuance of commercial paper by financial institutions who instead financed operations through the deposit account as availability of reserves increased. Thus, the new reserves served simultaneously as debt issuances by the Fed but to some extent also capitalised bank balance sheets just as commercial paper would in other contexts. Remarkably, the increased issuance of debt by the Fed via QE was offset by decreased issuance of commercial paper by banks to fund their assets.

If this analysis is right, and there are no other factors at work, (even if there are I think the scope of QE3 would be enough to swamp most other financial forces) the conclusion of such an unexpected repression of the yield curve is that financial institutions may perceive commercial paper issuance as a substitute for deposit funding. This gives a view into the financing of assets which actively undermines the idea that banks do NOT insulate their balance sheets from central bank operations. The lending channel may be less potent than we think.

The Return of MMT at the ANU

I recently saw a very interesting debate over the merits of Modern Monetary Theory and Post-Keynesian ideas amongst some economics students at the ANU. The Modern Monetary Theorist (MMTer) claims can be summarised as follows:

Government taxation need only be driven by the need to force convertibility of the currency. Past that point, taxation as a means of revenue sourcing is unnecessary since the central bank can just monetise debt. Given that under MMT models, monetary policy is just an exchange of financial assets, such monetisation would not have an inflationary impact as long as the economy stays just below the NAIRU. Furthermore, if there were a small inflationary impact resulting from such policy, the evidence suggests that unemployment is a far greater burden on society than inflation.

I will not go over the basic principles of MMT. Such resources can be found here. Rather, I wish to respond more broadly to the debate at hand, without delving too much into the specifics.

As I perceive it, the crux of this argument stems from a misunderstanding of monetary theory that ignores the role of expectations and confuses the definitions of credit and money. My aim is to illustrate some of the nuance lacking in the argument above, whilst also confirming that once we look at the situation from the framework of modern macroeconomics the inflationary impacts of such an MMT policy proposal would be far more severe than alleged.

Firstly, the idea that government debt can be monetised without inflationary impact is one that can be answered by monetary theory alone. When we discuss the monetisation of deficits we are talking uniquely about the creation of base money in exchange for Treasury bills that would otherwise be sold to the market. Thus, the tangential idea that government spending cannot be inflationary since any government deficit must imply a foreign/private surplus is not relevant. This common retort, simply uses real demand side analysis to peer into the world of nominal relationships, and in facts relies on the assumption that the deficit itself is not being funded by seigniorage.

In this light, one does not need to talk about the monetisation of deficits in some isolated theoretical vacuum; rather we just need to look at the conduct of monetary policy more generally and in particular the theory underlining Quantitative Easing (QE). As I see it, the monetisation of a government deficit over time is the effective equivalent to a bout of QE, with the added proviso that the central bank commits to never unwinding the purchase.

With this clarification comes what Scott Sumner coined as ‘The Achilles Heel of MMT’. Let’s assume that the central bank opted to monetise a deficit via an expansion of its balance sheet that would never be unwound. As an example, let’s say they doubled the stock of base money. Neither banks nor the public are going to hold twice as much base money at the same interest rate, the opportunity cost is too high. Additionally, anticipating that such injections are permanent with other agents rebalancing their portfolios to clear off excess liquidity one would expect a flow of funds into asset and debt markets. This would irrefutably drive interest rates down to zero and inflate asset prices across the economy. Hence, we are left with an economy far outside its Wicksellian equilibrium. Continuing in this vein Sumner has noted:

 “MMTers forget that the nominal interest rate is the price of credit, not money.  The Fed can’t determine that rate, it reflects the forces of saving supply and investment demand.  Hence an attempt to set interest rates far below their correct level in savings/investment terms (the Wicksellian natural rate), would trigger an explosion in AD, and much higher inflation.  Central banks know this, which is why after the inflationary 1965-1981 period they adopted the Taylor Principle.”

In response to this argument, many MMTers would cite cases of Japan post 1990 and the USA in 2009, situations where the economy was far below the NAIRU. But this is a dishonest citation with an insincere framework. Before these case studies can be addressed, two fundamental distinctions have to be made. Firstly, the process of expanding central bank balance sheets is one that is primarily concerns bond, not labour, markets. Thus, the NAIRU framework for looking at monetary operations is not an accurate one. Rather, we need to look at these cases through the lens of a good ol’ fashioned liquidity trap. Whilst changing this criteria may seem somewhat trivial, when it comes to the distortion of facts it is an important distinction. MMTers assert far too often that since an economy is almost never at the NAIRU inflationary pressures are not a concern. From the perspective of monetary policy nevertheless, inflationary concerns are always present when expanding the balance sheet unless the economy is in a liquidity trap. Liquidity traps however, are a far rarer observation than economies with employment below the NAIRU. Thus, MMTers claiming that balance sheet expansions are anywhere and everywhere inflation neutral are either insane or dishonest.

The second distinction however is even more important. It is true that in both Japan’s lost decade and the US’ post-GFC stagnation central banks greatly expanded their balance sheets, increasing the supply of base money by trillions of dollars. Nevertheless, in both these situations the QE operations were perceived by the market to be temporary operations. The distinction between temporary central bank expansions of the balance sheet and a permanent increase via the monetisation of deficits is an important one. Let us consider an example.

In the first case, consider a financial institution temporarily credited by the central bank with base money. Optimally, it wants to profit off of this credit, and as such it may purchase some financial assets. Given that this operation is temporary though, at some point this purchase must be unwound with a corresponding sale. As a group, all financial institutions will have to unwind purchases with sales at some point. With arbitrage accordingly the fundamental demand for assets over time will remain unchanged.

Now consider a financial institution that is permanently buffeted by central bank liquidity injections. In this case, the purchase of an asset doesn’t have to be unwound at any point, so any current purchases need not be met by future sales. Here, there is no scope for arbitrage and asset markets witness a tangible increase in demand.

Consequently, the difference between a temporary and permanent expansion of central bank balance sheets is immense. Since monetisation of fiscal deficits must imply a permanent iteration of QE the effects would diverge considerably from those observed in Japan and the US.

At this point we are left with just a reiteration of the standard rebuttal that “unemployment is worse than inflation, so even if MMT policy proposals would result in higher inflation, the benefits of reducing unemployment would far out-weigh the costs.” At this point we are beating a dead horse. The notion that there is a long-run trade-off between inflation and unemployment is one that has been repeatedly rejected by both theory and empirics since the 1950s. In the short run, I am sure that MMT proposals could boost output, especially in Europe where a credible commitment to increase the money supply is desperately needed. But in the long run, such ideas are of no merit whatsoever.

It is for these reasons that I see the position of MMTers as untenable when it comes to deficit monetisation. The proposals put forward are invariably inconsistent with the current monetary theory and offer no alternative framework of their own.

A Word Against the Gold Standard

Now that we’re now warming up for another GOP and democrat debate in the US, I thought it was time to expound some more economic consensus. Namely, discussion over the Gold Standard.

To be honest, I find it surprising that the Gold Bug continues to consume many fringe elements of the political spectrum given what we’ve observed in Europe since 2009. Economically, Europe’s problems are almost wholly due to the difficulties of holding a fixed exchange rate over sub-optimal currency zones. The Gold Standard, in light of this, has all the features of such a fixed exchange rate with the added inflexibility of weakened central banks. Is this what the world needs in the future? The contention of most economists is that it is not; that it is a ‘barbarous relic belonging to the dustbin of history’. This is insisted for the following reasons:

  • Capital flow Bias.
    As suggested by Peter Temin, a fundamental structural flaw of the Gold Standard was the asymmetry of price-specie flows between surplus and deficit countries. In theory, the Gold Standard should have corrected trade imbalances since a country with trade surpluses (deficits) would receive capital inflows (outflows) in the form of gold. These specie inflows in turn would expand (contract) the money supply and raise (dampen) the price level. Thus, correcting the imbalance of competitiveness between countries and balancing trade. In practice however, it was very easy for trade surplus nations to sterilise inflows whilst deficit nations were forced to contract the domestic money supply in an effort to ‘catch-up’. Overall this had the effect of pronouncing the demand-side impact of trade imbalances rather than alleviating them, in turn creating a deflationary bias.Sound familiar? This line of thought, whereby deficit nations are forced into internal devaluation as surplus nations sterilise the inflows, is the key issue underlying Europe’s sovereign debt crisis.
  • Macroeconomic contagion.
    Picture what happens when an economy that forms part of the Gold Standard enters a recession. Wages and prices fall as per usual, and competitiveness is increased. This all happens under floating exchange rates as well. The difference in the Gold Standard however is that this fall in wages and prices, through the trade account, creates an inflow of specie domestically that must be matched by a global outflow. Thus, though the domestic money supply may be allowed to expand as per usual, overseas markets are forced into a contraction. In this sense, economic contraction in a few major markets has an added contagion effect that is wholly divorced from economic fundamentals; caused instead by monetary rigidities.
  • Short-Term Volatility.
    Whilst it is true that the under the Gold Standard the world witnessed a more stable long-run price level, in the short run there was far greater volatility. This came from the fact that the conduct of monetary policy would be subjected to supply-side concerns amounting from the industrial demand and supply of gold.  In addition, financial speculation on commodity prices would tangibly affect coverage ratios and thus monetary policy. Overall, this had the effect of destabilising commercial balance sheets and frustrating macroeconomic management.
  • Practicality
    According to recent estimates by the Federal Reserve, M2 in the U.S alone today is estimated at about $10.5 trillion, whilst the value of all gold ever mined amounts to around $8.2 trillion. If the Gold Standard were to be implemented today, it would require one of two things. In the first instance, central banks across the globe could contract the money supply by a huge quantity and inflate the price of gold past all industrial applications. Or, central bank reserve requirements could fall precipitously. The trade-off is most definitely between a calamitous recession on the one hand and a destabilisation of global finance on the other.
  • Speculative Attack.
    We’ve all seen what happens to central banks that can’t maintain their pegs, or fall victim of severe financial speculation. It has happened in both the developed and developing economies in the post-war era. When foreign reserves fall to levels that make effective coverage of the exchange rate impossible they fall victim to sharp and intense financial panics. The Gold Standard would entail a Global Return to policies that risk the same situation.

Long-Run Price Level Growth Vs Inflation Targeting

Recent debate seems to have briefly picked up again between the Market Monetarists and their Classical counterparts in an important topic. Namely, should central bankers be targeting long-run price levels or annual inflation rates? Much of the blogosphere in the realm of monetary policy seems to be dominated by economists aiming their fight towards other economists. The pleasure thus falls to me to explain some of the basics behind this important fight that divides two streams of modern monetary thought.

The difference between long-run price-level targeting (LRPT) and inflation rate targeting is a simple one. Inflation rate targeting, championed by Ben Bernanke (and implicitly by Scott Sumner), is the simple notion that a central bank should aim for a constant rate of inflation. For example, if the inflation target is 2%, and in year 1 inflation hits 2.3%, in year 2 policy makers should aim for 2% inflation again. LRPT on the other hand draws from the policy prescriptions of Alan Greenspan and targets a long-term rate of inflation. So to use the same target, if in year 1 inflation hits 2.3%, in year 2 the central bank should aim for 1.7% inflation.

Whilst this debate seems overly theoretical, it brings us to one of the cornerstones of macroeconomic thinking- the problem with inflation.

An annual inflation rate target represents a desire for minimal short-term inflation rate volatility. It is for this reason that those advocating inflation rate targets implicitly perceive inflations rate shocks to be the main problem with inflation. Here, if inflation comes under the market’s forecasts, interest rates determined in that year will be too high, and investment will be misallocated. In the case of a major shock, this temporary wrong-footedness can put the whole financial sector at risk. Hence, policy makers should focus primarily on embedding market expectations for annual inflation rates, and if inflation is off target, expectations should be that normality will return next year. And since short-term inflation volatility is reduced, the shocks to the system should be smaller.

According to the LRPT advocates however, this concern for short-term shocks, and the subsequent obsession with minimising short-run volatility leads to a more variable long-term rate of inflation. LRPT is the way to solve this. If one year inflation comes over the mark, the next year it should come under. Over a period of two years in this scenario the price-level will be closer to the target price level of the previous year. But whilst long-run contracts and loans on fixed rates may be more accurate, the nominal income shocks will be exaggerated. The LRPT supporters in this case implicitly believe that the problem with inflation, is not the nominal shock, but rather the role inflation plays in the distortion of relative prices. To their mind, as long as the market understands the short-term variability problem then the shocks will not materialise at all, and the real income transfers that result from inflation volatility will be corrected.

In this light, one can see that the contemporary debate over inflation rate, versus long-run price growth stems from the very nature of the ‘inflation evil’. To my mind LRPT is by far the inferior monetary policy strategy for 1 simple reason- It is incompatible with the nature of monetary policy.

It is common knowledge that there is a substantial time lag between the implementation of monetary policy and the realisation of their effects. When unplanned for inflation rates are posted, it is normally the case that the monetary base (or interest rates?) has already been set for the following 18 or so months. The new level of reserves in the system aim for whatever nominal targets the central bank has set; but if last year’s results are lacklustre, the ability to compensate by changing the following target rate becomes substantially impeded. The constant contradictions and attempts to routinely adjust the nominal anchor under an inexperienced institution could easily develop into a mini-business cycle that operates in a sort of “see-saw” fashion, and exacerbates the dreaded shocks that inflation target supporters endeavour to avoid.