Tag Archives: monetary policy

Monetary offset has been on my mind for a while now. Scott Sumner (among other market monetarists) are running victory laps (and to an extent, rightfully so) considering the relatively healthy growth last year despite significant fiscal drag. There’s no doubt, as stock and bond market reactions prove, that monetary policy has been helpful. But both the theory and empirics behind a strong and automatic offset – as favored by market monetarists – is weak. I should preface this by noting I’m largely in agreement with the market monetarist argument for nominal income targeting.

Let’s imagine (for now) that the zero bound did not bind – whether that be through the efficacy of unconventional monetary tools, a higher inflation target, or a Herculean ability for the Fed to handcuff its own hands years into the future and convince the market that it threw away the key. Standard economic theory supposes that in this world fiscal policy does not determine the price level given an inflation-targeting central bank arguing that if the government increases its budget and hence aggregate demand, the central bank will increase rates to maintain credibility. Hence government spending cannot decrease unemployment.

If we’re talking about totally discretionary stimulus this may be true. But consider a government that offers generous unemployment insurance (UI) with reemployment credits or guarantees employment (either generally or in a recession). Soon after recession, the government institutes very long UI and, in doing so, increases its primary deficit from 2% to 10%. Let’s say hysteresis effects are minimal and expansionary policies don’t simultaneously increase aggregate supply. Expansionary spending then, by Law of the Excluded Middle, either increases the price level or it does not. Given an upward-sloping supply curve (depressed as the economy might be), the former case is more likely. Monetarists argue that an independent central bank offsets policy in one of the following ways:

  • By force of expectation, given its credibility to an inflation target.
  • By being more cautious with its stimulus programs (or halting them altogether, depending on relevant magnitudes) than the counterfactual without stimulus or deeper austerity.

It feels like the first point used to be more popular than it is now, given that the Fed has zilch credibility on its inflation target (by definition, if it had any credibility, long term expectations wouldn’t be as low as they are). The second point is pretty fragile given behavioral features, decentralization of central banking decisions, and the need to have a precise ability to estimate price level elasticity of aggregate supply if it is low (which it is in a weak economy).

So after the government promises insurance to layoffs and credits to employers who hire said layoffs the central bank estimates the effect this has on the price level and accordingly decreases the rate at which it purchases assets. This creates a new wave of unemployed workers – that, after all, is the core of monetary offset models – which would require even more deficit spending to finance the promised unemployed benefits. This would require an even greater offset, requiring even more stabilization.

In this case two things can happen. Either the value of a credit default swap on Treasuries increases, as the market starts loosing confidence that we can service future deficits, or prices rise as markets expect the Fed to monetize deficits in an effort to prevent default. In a world where bond yields and CDS values aren’t soaring, the only possible conclusion is that the Fed stops offsetting government spending.

In fact, to the extent the market knows the Fed would never let the government default, the Fed’s offset would be offset by expectations of its future relaxation of its offset. This sounds a lot like the fiscal theory of the price level, and in some sense it is, but the distinction is that there must be some mechanism in place that requires the government to increase its deficit in response to monetary contraction. If there was no such mechanism – i.e. fiscal policy was only a one time, discretionary cash hand out – monetary policy could offset austerity perfectly well. (A helicopter drop of money and cash hand out financed by bond buying is actually the same thing, so offset could be surgically precise, as both Keynesians and monetarists agree). The only way fiscal theories could work in this environment is a government that engages in discretionary policy every time the central bank tightens policy which is unrealistic and, by definition, not rules-based. So the possibility of hyperinflation from ARRA was well, nonexistent.

There are second order effects too. If the interest elasticity of government spending is higher than the interest elasticity of investment (and studies suggest that this is probably the case), much of the benefit from easier money comes from cheap finance to beneficiary governments, reducing net outlays. Therefore tighter policy would decrease both the government’s primary and non-primary balance. This, by the way, is not negligible – the United States may face $75 billion in increased debt servicing to finance the same level of operations.

If the political situation is such that the government may only engage in a certain level of deficit spending (either by law as in Europe or institutional arrangement as in the US) offset would require the government itself to tighten its budget.

The point of the post so far is that monetary offset cannot be as theoretically sound as its proponents make it seem. There are multiple sources of positive and negative feedback, and actual results depend on the precise role of each which itself depends on the complex slew of automatic stabilizers, central bank learning mechanisms, and so forth. However, as outlined above, that economic conditions today resemble that setup seem unlikely given the preponderance of automatic stabilizers.

The empirical case for full monetary offset is stronger, but still wanting. Yes growth was a lot stronger than some Keynesian models suggested. That itself doesn’t mean anything, especially for anyone that (like me) believes in an at least approximate efficient market hypothesis. No model that can predict growth can exist. The question is whether growth today violates the Keynesian story. Perhaps a macroeconometrician will answer this better than I, but frankly the magnitudes don’t justify that explanation either. While fiscal drag was unfortunate, the United States certainly didn’t succumb to the same austerity as Europe and within the margin that it did plenty of other factors, including an improving supply side, can explain strong growth beyond monetary offset. As for Europe, where’s the offset?

Let me end this post with a final example which captures the point of the above reasoning. Imagine the government guaranteed employment at below market wage rates as a primary automatic stabilizer. In a recession, as deficits increase, monetary offset would force a growing number into government employment. The logical conclusion would be a huge deficit and huge government work force, but not unemployment by virtue of the government’s promise to employ. The only way total GDP would be affected would be a decreased output per worker, a supply-side phenomenon because the government makes for a bad employer. But supply-side concerns are not market monetarists’ concern. Is there any model with guaranteed employment monetary offset decreases total employment?

Of course, deficits would never get so out of hand before the central bank stopped offsetting. But even monetarists agree that monetary offset would not increase employment, only government deficit. By virtue of that transfer of liabilities, the private sector is allowed to deleverage which itself increases aggregate demand.

The feedback loops here are just way too complicated for the simple monetary offset story to be true.

Late Addendum: Scott Sumner comments on his blog (in response to another):

I’ve always argued that zero is a sort of benchmark, a starting point in the analysis. If the fiscal stimulus is large enough to bankrupt a country, then for fiscal theory of the price level reasons I’d expect a positive multiplier. In not (i.e. in the US) I expect the multiplier is zero on average, but may be above or below zero for the reasons you indicate. What matters is the expected multiplier, not the actual multiplier, and I see no reason to expect a multiplier that is significantly different from zero. In 2013 we saw about what I expected.

That’s fair enough. But the point here is bankruptcy conditions are non-negligible with automatic stabilizers. Not in general, but certainly if the offset is persistent (that is if the “expected multiplier” remains at or near zero).

It is common to hear, in the best arguments against a higher inflation target, that the costs outweigh the benefits. For a representative example, Coibion, Gorodnichenko, and Wieland argue that within a New Keynesian model, the distortions higher steady-state inflation creates among the relative prices of goods and services are high – exceeding the benefit of avoiding a liquidity trap in the future. I don’t have much in the way of technical expertise to critique this model, though I am skeptical of the calibration – they assume that the frequency with which we will hit the zero bound in the future may be extrapolated from historical tendency. However, if the Wicksellian interest rate is on average lower now than in the past, this calibration would be optimistic.

But that is beside the point. Let’s assume that the costs of inflation outweigh the benefits.

How would you react if someone advised against purchasing health insurance because the cost outweighs the expected benefits. Many people pay heavy monthly premiums to avoid calamity in the event of a worst-case event. There are many models you can use to justify this insurance. Maybe costs are not linear. That is, the closer one gets to the bottom of his bank account, the more utility the marginal dollar brings. So long as the premium itself is not forcing him to dissave, it is not hard to imagine the value of insurance. Perhaps uncertainty itself is costly. This is a well-established behavioral phenomenon. Go ask a stranger whether he wants $500 in cash or $1,500 if he wins a coin flip.

A liquidity trap is not perfectly analogous, but it’s not hard to see its similarity with a heart attack. While there is debate among some as to whether the zero bound binds – Bernanke in his academic research is a great example – the performance of Western economies in wake of the crisis, not to mention Japan over the past decade, suggests monetary policymakers either lack the will, knowhow, or confidence to implement such policies.

Instead we get risky and untested asset purchase programs as well as forward guidance which suffers from time inconsistency and relies heavily on the credibility of a decentralized institution. We get political dysfunction and immobility. The Tea Party and Occupy Movements are at least second cousins of the liquidity trap – enough political science research suggests a bad economy engenders extremism.

My point here is that including political and social costs of mass unemployment, it is not enough to say the costs of inflation outweigh the benefits. The Fed understands this, to some extent, considering its heroic effort to stimulate the economy with unconventional tools. But even assuming they worked perfectly, is the cost of removing high quality collateral from the financial system worth the benefit of a slightly lower inflation rate?

This whole post is a contingency. I don’t think the costs of inflation outweigh the benefits, but I can’t construct a fancy model to prove that. It is worth asking why we target a lowly 2% to begin with. Because New Zealand did it?



I’ve read a lot of posts recently claiming that the Fed should throw in the towel, because “US growth is not what it used to be”. That could be true. It’s very difficult to suss out structural changes, but it’s unreasonable to be puritanical that our problems can be solved with, and only with, more aggregate demand. At least if you define “solve” as returning to the 1990s boom. However, it’s a bit aggravating when people insist that this has anything to do with what the Fed should or should not be doing.

The Fed’s not in the business of increasing productivity growth or managing real GDP. As far as I know, no model suggests that the economy is hitting its potential when inflation is unanchored well below its long-run trend. In fact, aggregate supply doesn’t even matter right now. When consumers are leveraged to the hilt a fall in prices from a productivity boom would just increase balance sheet constraints in the economy as the real-value of debt rises. 

The camp of economists that talks about monetary policy juicing up a dead economy – or whatever it is – likes model heuristics like NAIRU or the natural rate of unemployment, potential output, whatever:

Weak payroll growth, despite a speedy drop in joblessness, forced Bernanke in September to backtrack from a June statement in which he said the Fed expected to halt its bond-buying by mid-2014, when joblessness would be around 7 percent.

But some economists argue easier policy is not the answer given the economy’s shifting fortunes.

“Easy money will likely lead to asset bubbles or higher inflation, because policy is miscalibrated relative to … the economy’s underlying potential,” said Joseph LaVorgna, chief U.S. economist at Deutsche Bank.

He said potential GDP growth had “meaningfully downshifted” and warned of “potentially serious negative long-run implications” of current monetary policy.

It’s not clear to me what monetary policy has to do with asset bubbles. We should either not care about those or, preferably, outsource that to the macroprudential regulators. Asset prices shouldn’t be a cornerstone of any monetary policy (which, incidentally, is why we should be skeptical of the wealth effect from quantitative easing). But let’s go back to what Deutsche Bank is saying. Quantitative easing and zero interest rates will cause inflation because potential GDP isn’t what it was. However, this would require accelerating inflation as “artificial” demand competes for a shrinking stock of free labor. We’ve got precisely the opposite phenomenon. Either demand is not high or the growth potential of the US economy has surged (and while that’s good for the future, it doesn’t do squat for us today).

More importantly, people obsessed with asset markets are confusing noise and signal. Yes, real estate and equity markets have picked up much quicker than the economy itself. This is a byproduct of their own demon – slowing population and productivity growthLet’s go back to the simple and elegant Harrod-Domar-(Solow) model. The wealth-to-income ratio (which determines asset prices) is determined as:

b = s/g where s is the national savings rate and g is the growth rate. The lower the growth rate the higher the wealth to income ratio. This is important because it suggests all this whining about interest rates and asset prices has very little to do with monetary policy. Interest rates have been in secular decline since the ’80s:



As Piketty and Zucman thoroughly confirm, the wealth-to-income ratio increases as would be expected under conventional models. Any observer notices that this trend in interest rates is completely independent of monetary policy in the past few years. Growth has been slowing down which means much more wealth is chasing much less capital, resulting in a falling labor share, and low interest rates.

It is a tautological position to suggest the Fed should change course because low growth will cause asset market bubbles and hyperinflation. However, with the long-run supply side costs of persistently low demand (hysteresis) it might just be self-fulfilling. Let’s hope it doesn’t get there.

A fantastic new paper from Dave Reifschneider, William L. Wascher, David Wilcox – all economists at the Federal Reserve – tries to put some numbers on something economists have been worried about for a while: hysteresis, or the gradual contraction of labor supply due to deficient demand. (John Cassidy has a good rundown). The upshot is that hysteresis over the past five years may halve growth potential. This is (or at least should be) the most urgent, if not important, issue for policymakers.

The standard story will tell you this is, keeping structural constraints constant, an irreversible trend. As price level increases with a higher aggregate demand, the cost of production rises contracting aggregate supply. This is almost certainly a fairy tale. Consider why workers exit the labor force. After a point, the monetary and psychological cost of searching for a job exceeds the expected benefit –  ∫(chance of being hired at a given wage rate * wage rate) over all wage differentials. Assuming the costs remain constant, the best way to expand the labor force is to increase the opportunity cost of remaining outside: that is either increase the chance of being hired or the nominal wage rate.

A naive analysis would suggest monetary policy can’t do much in the way of the former, and that the nominal above should be replaced with real. (To some extent, this would be correct, the best thing we can do right now is offer reemployment credits and a payroll tax holiday). Indeed, the opportunity cost of a certain wage rate shouldn’t really be measured in the dollars I could earn, but the purchasing power thereof. However, those who exit the labor force have some form of support system: savings, welfare, and help from friends among others. It would not be unreasonable to assume that except for the most basic needs (catastrophic healthcare, charity, and certain welfare programs) none of this support is, unlike the wage rate, inflation protected. The nominal wage rate is the price level * real wage rate. By definition, increasing the real wage rate increases the cost of remaining out of the labor force. But clearly increasing the price level does as well.

There’s another, possibly deeper, reason: the money illusion (not the blog). People think in nominal terms. If you don’t believe this consider the fact that people across the world are simultaneously worried about both inflation and wage stagnation, even though my raise is your inflation. Increasing the nominal wage rate would give workers the perception that they are actually earning more in real terms. That’s all that matters as far as the decision to reenter the labor force goes. Anyone who believes in nominal wage rigidities for behavioral reasons (and, seriously, why wouldn’t you) should accept this as a natural extension of that irrationality.

And directly capitalizing on this, monetary policy can increase the chance that a given worker is hired. I touched on this earlier, but in brief downward wage rigidities are an important concern at all times, not just during a recession:

Firms that want to expand employment don’t have perfect information about the quality of potential workers. There’s the chance they may be way better than expected, in which case raising relevant wages to keep the worker is quite easy. But what if they’re not as productive as the firm wished? Heaps of empirical evidence shows that firms just don’t like cutting nominal wages. Inflation, then, is an insurance policy against imperfect information. Conversely, a firm that is downsizing because of changing (microeconomic) demand can choose to inflate away a workers’ wage rather than laying off employees en masse.  This is more relevant to the poor and casually employed where large-scale employers face more informational uncertainty.

These two effects – both derivative of higher inflation – are self-reinforcing. As the chance of being hired increases, the stock of free labor will fall increasing real wages further. As these together increase aggregate supply and aggregate demand at the same time, real wages will increase without a substantial increase in the price level (above that which is dictated by a expansionary central bank). This encourages more entry into the labor force, and the process fulfills itself until a wage-price spiral forces the central bank to increase interest rates. And farewell to the liquidity trap.

In the short run – and only in the short run – there is a risk of overshooting. That is, in the period where all savers adjust to a higher inflation rate, those who left the labor force for life cycle reasons may feel compelled to return as their savings are eroded. However this is, to a large extent, stemmed because most seniors at risk rely primarily on Social Security, which is inflation protected. More importantly  this – like anything else – requires a judgement call on behalf of policymakers about the composition of labor force exit – between retirees and discouraged workers. It would be smart to use the employment to working population rate, rather than U3 unemployment, as a key indicator of labor market health. 

This gets to the final point. If we’re going to stick to the current, state-contingent forward guidance, it makes little sense to consider the unemployment rate at all – doing so presumes knowledge of the natural rate of unemployment, which may have changed. Rather, the central bank should determine a rate of inflation with which it is comfortable – even something stupidly low like 2% – and focus. This doesn’t make monetary policy “easier” or “tighter” per se, only more accurate. For example, a concern some economists (see this interview with Barclay’s Michael Gapen) have with a lower unemployment threshold, signaling a longer period of low interest rates, is that if the natural rate of unemployment has increased, then the economy will overheat before the threshold is reached, forcing the Fed to increase interest rates and compromising its credibility:

That said, we emphasize that the benefit of this action is linked to the assumption that NAIRU is within the FOMC’s central tendency. Our own view is that NAIRU is higher, which would imply higher potential inflationary costs from lowering the unemployment threshold and a worse cost-benefit trade-off. San Francisco Fed President Williams has made similar arguments, saying that uncertainty around any NAIRU estimate is high and that policymakers may be better served by keeping the 6.5% threshold in place and conducting policy in a more discretionary manner once the threshold has been reached. Other center-leaning FOMC participants may also share this view and we read staff conclusions in this regard as providing justification for a lower unemployment rate threshold, but that view need not be binding on policymakers.

That’s curious, because it seems like they cite NAIRU either without realizing what it is and what it means, or without realizing that the Evans Rule has a clause for inflation and is constructed disjunctively. If the unemployment rate falls below the NAIRU, and inflation doesn’t pick up, THEN IT’S NOT THE NAIRU. If unemployment falls below the NAIRU, and inflation does pick up, the Fed has every right to increase the interest rate given the Evans Rule without compromising credibility.

If the Fed believes in any natural rate of unemployment – and, clearly, it does – the dual threshold of unemployment and inflation is completely tautological, as one implies the other. This presumes that the theory behind NAIRU holds. And if it doesn’t, having an unemployment threshold is completely useless because what the Fed really wants – for any given inflation rate – is maximum employment. 

Consider the uncertainty the unemployment threshold creates in financial markets. For one, it adds one more variable to be monitored whose interpretation by the central bank must be monitored. But there’s already so much talk that this threshold will be lowered that markets have no idea how to read the Fed’s reaction function. 

If the NAIRU is 0% and the Fed increases rates before we get there, then policy will be unnecessarily contractionary. If the NAIRU is 15% then by definition the Evans Rule will require an increase in rates until inflation falls to the target. All we know for certain is that inflation is well below target today, and so monetary policy is insufficiently aggressive. 

Just a short note this time. (Also see Scott Sumner on this.)

Excerpted from a recent St. Louis Fed Note:

Getting policymakers to agree on a specific rule of this form would seem relatively easy because GDP is well defined; there would be no debate about the variables as there would be with the Taylor rule. Moreover, the range of disagreement aboutgdpT also seems relatively small. The FOMC has already agreed on a 2 percent inflation objective, and there appears to be a consensus that potential output growth is probably in the range of 2.5 to 3.5 percent. The disagreement about nominal GDP target would be relatively narrow, in a range from about 4.5 percent to 5.5 percent.

So what prevents the Fed and other central banks from adopting nominal GDP targeting? Again, there are a number of reasons, but an important and sufficient reason is that nominal GDP targeting requires policymakers to be indifferent about the composition of nominal GDP growth between inflation and the growth of real output, and, in general, they are not. For example, let’s assume the target is 5 percent and nominal GDP is growing at 6 percent. Would policymakers react the same if the composition was 1 percent inflation and 5 percent real growth, or 5 percent inflation and 1 percent real growth? It seems unlikely. In addition, nominal GDP targeting suffers from the other considerations that prevent policymakers from adopting policy rules. For example, policymakers’ response to the alternative situations would depend on current labor and financial market conditions and activity; the composition of GDP, especially between consumption and investment; global economic conditions; and so on. In short, adopting a nominal GDP target is unlikely for many of the same reasons policymakers are unlikely to adopt a traditional Taylor rule—or indeed, any specific policy rule. The economy is too complex to be summarized by a single rule. Economies are constantly changing in ways difficult to explain after the fact and nearly impossible to predict. Consequently, policymakers seem destined to rely on discretion rather than rules.


Most of the piece is a good discussion of “rules vs. discretion” in monetary policy. That’s something I’m not going to get into right now. I was, however, a little surprised to see economists at the Fed mistake nominal income targeting for an indifference between inflation and growth of real output.

This is rather absurd claim because the (well argued, if disagreeable) thesis of the article is that changing dynamics of the economy undermines the efficacy of rules relative to discretion. But for policymakers to be indifferent between inflation and real output under a nominal income target, the economy must be perfectly static. An economist is indifferent between the two if and only if he believes that the rate of inflation will be constant, and the rate of real growth will be constant. In effect, he must ignore completely the possibility of severe demand shocks. But the possibility of severe demand shocks was the whole point said policymakers opted for discretion over rules. Being indifferent between inflation and output at a given point in time is completely different from being indifferent between inflation and output.

In reality, inflation changes relative to real growth all the time. The whole idea behind a nominal income target is its flexibility to these changing conditions allowing policymakers the ability to have different preferences for inflation and output given different economic dynamics. More importantly, individuals are – at some point – always indifferent between two quantities, given a certain level of each.

Ultimately, nominal GDP targeting is prone to structural changes. Lucky for the Fed, it’s their job to deal with aggregate demand.

So what if I told you the more expansionary monetary policy is, the smaller the Fed’s expected balance sheet will be. And, more curiously, the smaller the Fed’s expected balance sheet will be, the more expansionary current policy will become. These two forces build off each other into perfectly expansive monetary policy. Let me explain why.

Consider two policies. In one, the Fed continues to buy n dollars of Treasuries and mortgage backed securities each month until its expected loss – at any arbitrary sensitivity to deviation from its dual mandate – is minimized. In the other, the Fed continues to buy n dollars of assets each month but, at the end of the year if its target is missed, n becomes kn. This continues ad infinitum.

You would be mistaken to think these policies are functionally equivalent even in the first year. Even though the monetary base would be the same at month 12 under both, inflation would be higher and unemployment lower under the second. Markets know that if the Fed misses its target, purchases will increase substantially in pace next year, which would drive money demand down in the latter months of the year after it becomes clear the Fed’s mandate is missed.

Of course, since deviation from the Fed’s target is falling more rapidly under the latter policy, the expected time of exit from monetary stimulus is also smaller. If k is large enough, markets would expect the Fed to “taper” purchases before the end of year one.

Hence the expected size of the Fed’s balance sheet is smaller under the more aggressive policy, for some parameters and n.

This deals with almost all the “negative” aspects of quantitative easing suggested by other critics. When more is less, its safer to do more. The scarcity of safe assets, as many worry, would be significantly lower if the Fed’s balance sheet was smaller. Therefore we should be talking about increasing the extent of purchases to the level where people expect a taper because of too much inflation. It’s like walking in a circle.

But the expansionary nature of this is greater still. Paul Krugman, and most Keynesians, correctly worry that expansionary policy isn’t determined by the size of the Fed’s current balance sheet, but expectations of the terminal money base. That is, because Krugman among others believe markets believe the Fed will vacuum money out of the system in the future, there’s a de facto floor on money demand.

Let’s say the Fed can’t really change expectations of its long run “sensibilities” (tolerance of inflation, etc.) without regime change. (This is a point deeply felt in the work of Christina Romer who should be our next chairwomen of the Federal Reserve). That’s not a perfectly true statement, and the expectations channel of monetary policy is still intact, but it still poses an important “drag” on the efficacy of monetary policy. This implies the market would expect a contraction in future money base proportional with the size of the balance sheet. However, if the expected balance sheet at the end of stimulus is smaller, so too is the expectation of future tightness.

So I don’ t think people like Krugman get it all right when they write that quantitative easing works only through signals of “willingness to be easy”. That’s part of it, but more aggressive quantitative easing not only signals a “willingness” on side of the Fed, but more bullish expectations on part of the market that the Fed won’t tighten, not because it doesn’t want to, but because  it doesn’t have to.

In fact, there’s a sweet spot where if k is high enough, markets won’t expect any contraction in money base at all, because the period of expansion would cause inflation so quickly that the Fed can slowly exit its stimulus program without a bloated balance sheet at all.

Because tapering quantitative easing won’t end it completely, there’s a good chance the Fed’s balance sheet is going to end up far larger than it needs to be. It’s about time for the hawks to call for aggressive easing.

A surprising number of people tell me that quantitative easing is deflationary. Their reasons and political affiliations are diverse but, a comment like this left on Scott Sumner’s blog, captures that sentiment well:

Why would investors be convinced of inflation? Mortgage rates going down and longer term rates going down as a result of QE might not be enough to make people confident at all. Maybe prices go down instead of up because of lower interest costs. The private sector may want to deleverage so lower rates might not help at all.

Economics is all about identifying the “perverse consequences” of straightforward policy. So it’s also remarkably easy to contrive an example where something like quantitative easing – through various effects, expectations, etcetera – ends up making “prices go down instead of up because of lower interest costs”. Normally you’d argue back with empirical evidence to the contrary. 

But that quantitative easing can be inflationary isn’t even about economics. It’s about physics. 

All wealth, including the Fed’s balance sheet, is a claim on future returns from land, labor, and capital. Therefore, when the Fed purchases assets, it is increasing its claim on future output, denominated in some nominal aggregate. As the Fed continues its purchases, literally only two things can happen: we get inflation, or violate the Laws of Physics. 

Imagine that quantitative easing is not inflationary and the rate at which the Fed’s balance sheet grows exceeds the income deflator. Not too long from now, the Fed’s claim on future income will exceed what is physically and scientifically possible under standard physical laws.

The real value of the Fed’s claim on future activity is limited by inflation. And since we can’t violate physics, it stands to reason that quantitative easing must cause inflation. Think about it this way. Imagine the government cut every existing tax and met its obligations by printing money. Either we get inflation, thereby foiling the plan, or we find a way to finance the world’s biggest army, most extensive insurer, most expensive healthcare system, and strictest jailor with pieces of paper. 

Or, as Scott Sumner puts it, prices will either increase, or the Fed will own the universe. I honestly prefer the latter. 

Matt Yglesias writes that paper money kills economies because it institutes an effective lower bound on interest rates, the primary instrument of monetary policy. People like Miles Kimball have long argued that the “zero lower bound” and, hence, liquidity trap is basically a “policy choice” – a consequence of our cash economy. That is to say, under an electronic money system, we can easily implement negative nominal interest rates, giving monetary policy infinite power at all times.

The best way to think about this is imagine we all had dollar bills whose purchasing power was proportional to the length of the note, and the government can change the rate at which the note evaporates at will. If the rate of paper evaporation is increased, money demand will fall as consumers and investors across the world will throw cash for goods, services, and assets propping up a rapid recovery. In fact, the government doesn’t even have to increase the rate of evaporation, as long as it merely announces a credible intention to do so in the future.

But central banks can’t credibly announce the coming of negative interest rates, not the least because it isn’t physically possible in our current paradigm. Does that mean paper money is killing the economy…? I think not, for several reasons. Primarily, paper electronic money would be a superior choice to current monetary policy (and I, personally, have no animus towards accepting the future. Note that I’ve always hated carrying around cash, and don’t even have a wallet, so I love my electronic money, also known as Visa. But a lot of people use cash, and this would distributionally hurt them the most). But what we might call “conventionally unconventional” policies of quantitative easing are not out of steam.

Even Paul Krugman, the high priest of “monetary policy probably can’t gain traction in a liquidity trap”, agrees this has nothing to do with economic constraints of monetary policy as much as the conservatism of the central banking profession. That is to say, no one believes the central bank is sufficiently radical. In which case, we ask, what exactly is the point of militating for the abolishment of paper money – which is a far more radical experiment altogether?

Kimball – and maybe Yglesias – might argue that bringing it to the front of economic dialogue will make it easier for future crises to be handled effectively. But that would suppose getting rid of paper money is somehow fundamentally better than other unconventional options – given central banks were the right level of radical. We must make this stipulation because it makes no sense comparing a world where we are too timid to follow the policies proposed by Scott Sumner or Paul Krugman, but crazy enough to burn away paper.

And this contention is questionable at best. For example, even with negative interest rates, the central bank would need to set some sort of policy target. A lot of bloggers and forward-thinking economists like the idea of a nominal income target. I think Paul Krugman prefers a 4% inflation target (I don’t really know). If the latter – a higher inflation target – was the “optimal” solution between the two, then electronic money is most likely superior. The only point of a higher inflation target is to vastly reduce the risk of future recessions driving the equilibrium interest rate to the point of liquidity trap (and maybe reducing the effect of wage rigidities, but nominal targeting would accomplish this as well), and there’s some evidence that this is not optimal. (Edit: though still far, far better than current policy).

For reasons noted here, I don’t think a higher inflation target is superior to nominal income level targeting. In this case, it’s worth wondering whether negative interest rates really add a whole lot to the monetary policy arsenal, again, provided, markets didn’t think the central bank was skittish about its policies. The answer, I expect, is a probable “no” for reasons listed below:

  • A nominal income target works as much through expectations of action as much as action. So once such a regime is credibly instituted, money velocity is unlikely to fall as much as it did even during a pretty serious crash. This doesn’t require lower interest rates.
  • proper quantitative easing plan can very easily provide above expectations with adequate firepower. What would such a plan look like? A symmetric Evans Rule. That is, for every month that the Federal Reserve misses its nominal income target, the scale of asset purchases are increased by some percent n. The exponential growth here would immediately convince investors that inflation is coming, stabilizing nominal income growth.

The only reason we would need negative interest rates under a nominal income target is if quantitative easing was somehow less welfare efficient than negative interest rates. This is likely to be the case if the central bank was forced to inject liquidity via the purchase of many private assets. However, with government debt levels where they are, this is not a significant concern, and can always be fixed with the issuance of higher maturity debt.

Another contention might be that it is easier to implement a “rules based” rather than “discretionary” monetary policy with the ability to vary interest rates below zero. While there is a sense that quantitative easing is discretionary, that only has to do with the conservative nature of the Federal Reserve, and there’s no reason why following a Taylor Rule when rates exceed zero, and an “exponential growth of asset purchases” when rates fall below zero is any more discretionary. It’s just as algorithmic, but with one extra condition. Die hard monetarists even want to institute a “nominal income prediction market” which would remove the discretionary element of maintaining the rule entirely.

Michael Woodford or Paul Krugman’s preferred monetary policy – “credibly promising to be irresponsible” – might be better achieved under negative interest rates but, even then, that’s not a clear conclusion. If central banks can’t credibly commit to keep interest rates at zero for a long time due to institutional conservatism, I’m not sure how we could a) abolish paper money, and b) credibly convince the market that we’ll bring them below zero for long enough. That the Bank of Japan increased interest rates whenever the economy was just about to recover is an example of this difficulty.

Anyway, if Bernanke could somehow promise that interest rates will be zero on January 01, 2017 there’s a very good chance we’d hit escape velocity from the liquidity trap. And that’s a less radical promise than getting rid of paper money altogether. (Can you imagine what Austrians and their ilk who dominate America’s policy minds on both sides of the aisle would say about NEGATIVE interest rates?) By the time we reach a political consensus that paper money is archaic, we’ll have a far better monetary policy to begin with by virtue of the fact that it is less radical. (Not to mention the fact that in modern markets simply holding a foreign currency won’t be a bad choice, either).

I sometimes feel arguments for a negative interest rate are substituted in place of arguments for a better policy target. But the latter is the important debate, and the former is only a tool to achieve the latter. If an optimal target necessitated negative interest rates, I’d be writing about them every day. But I’ve yet to see an argument why a nominal income level target requires negative interest rates. Importantly, the central bank can technically levy a penalty on excess reserves which has the same benefits.

Paper money is killing the economy, but so is central bank conservatism. The former is just a symptom, the latter a disease.

The recent emerging markets crisis – one a long time coming, depending on who you ask – started on cue from Ben Bernanke that the Fed would “taper” its unprecedented injection of liquidity into international markets. That emerging markets responded so poorly tells us something important: they expect the taper to come much too soon.

In principle, the Fed wants to continue with its “expansionary” program until the United States is growing quickly again. The “Evans Rule” ensures we will keep a zero interest rate policy until unemployment has fallen below 6.5%, though no such forward guidance exists for QE. 

In reality, if emerging markets expected QE to come only after the US economy was healthy again, this kind of depreciation of currency and fall of stock would be very unlikely. A robust US economy implies a growing demand for exports denominated in EM currencies: boosting both the currency and stock market. While the expectation of future growth probably wouldn’t offset entirely the effect of curtailed liquidity, it would have likely contained much of the depreciation.

Emerging markets are a more informative tool to this effect than American stocks. While  we can infer the same conclusion – that tightening will be premature – from our stocks’ sensitivity to QE, US markets are too closely connected with QE’s direct wealth effect, obscuring observation of expectations.

Of course, the massive liquidity from QE also plays a direct effect on emerging market currencies, but it’s fair to guess the relative sensitivity of EM currencies is lower than that of American stocks. (For example, a good jobs report might actually freak Wall Street out, whereas emerging markets are relatively insulated from that).

This is a somewhat contrived argument, still, the magnitude of currency deterioration across Asia should somewhat revise our beliefs that tapering is coming sooner than it should. 

The whole problem with monetary policy in a liquidity trap is the inability for a central bank to commit to a permanently expanded monetary base. Iterations of this dilemma are captured best by Paul Krugman’s quip that the Fed cannot “credibly commit to be irresponsible”.

Actually, it can. We have a Fed that cannot actually be irresponsible. Markets know the second inflation hits 3-5% the brakes are coming hard, which asphyxiates expansionary fire today. Nothing short of complete institutional change of a decentralized system like the Federal Reserve can change it’s limitation.

But the Fed doesn’t actually need to be irresponsible, it must only convince markets that it can be. I suggest Ben Bernanke release a statement – or, better, the FOMC as a whole in its minutes – that he is expecting 5% annual inflation, even if he is expecting far less. That way, the FOMC privately knows deflation exists and quantitative easing will not do anything, and continue the huge asset purchases. But the market will be confounded. The world’s most conservative institution is ignoring inflation at even 5% – surely that means the brakes won’t come down all too hard in the future.

This will immediately provide traction to monetary policy even at the zero lower bound and will prevent the complete sterilization of expanded base as we currently experience.

In fact, even a Federal Reserve of many inflation hawks can do this successfully. They personally know deflation is real, but they can hide that private knowledge. Of course the markets will know the real PCE and CPI, but the only metric that’s important is the Fed’s own expectation.

Or we could completely reform the Federal Reserve, but that’s the real #slatepitch here.