Orthodox and Heterodox Monetary Policies

The financial crisis has shaken some core beliefs of central bankers as they find themselves running increasingly heterodox policies. Having spent much of the last two decades developing simple rules about the operational conduct of monetary policy, they now find that this new rule book has to be torn up. Although initially controversial, the adoption of the interest rate as the main operational instrument in pursuit of a clearly defined policy objective had become a near universal article of faith.

But with interest rates heading towards zero and having little impact on lending behaviour, because a freeze in financial intermediation, central bankers have had to think of new policy measures. Attention is moving from the price of money to ensuring that a sufficient quantity of money is held by the private sector in order to effect transactions. In this blog I outline the crossing of the central bank Rubicon.

The nice, linear story central banks liked to tell about monetary policy was illustrated in my blog: Deflation: A Real Problem and a Possible Cure and also in a recent working paper. The policy rate sets the base level for the funding costs of the banking sector and acts as the floor to financing in a given currency. Central banks ensure that the policy rate remains at or near the floor by draining the overall banking system of reserves and selling these back at the policy rate via open market operations, which have no monetary consequences. The hidden assumption in this framework is that the constellation of all other market interest rates, from interbank to long term corporate bond rates and beyond, will respond proportionately to any impetus from the central bank’s policy rate. The set of market interest rates are thus thought to be akin to a sequence of mark-ups over costs, related to the costs of monitoring credit and market risk. And so much of the transmission of monetary policy operates through its impact on other market interest rates.

When setting the policy rate, the central bank commits to supplying central bank money perfectly elastically at that interest rate to commercial banks. At lower interest rates, the demand for narrow money should increase, as the opportunity cost of its holding has fallen, and this extra demand is satisfied by central bank provision of base money. The expansion in narrow (central bank) money is multiplied through the economy by the money multiplier, which is the extent to which commercial banks increase their balance sheets by more than the amount of narrow money alone by extending bank credit to the private sector. And it is arguably this money multiplier that has collapsed in the current banking crisis.

In the stylised balance sheet of a fractional reserve commercial banking sector, commercial banks hold central bank money as liquid assets and loans as illiquid assets. Loans to the private sector will ultimately correspond to deposits by the private sector in the banks, which are liabilities. The ratio of broad to narrow (base) money is the money multiplier and so we can observe that when the market for central bank money clears at a higher quantity and if the money multiplier remains constant, then broad money will expand by the change in the central bank money times the money multiplier. To the extent that broad money is required to fund private sector transactions, a change in broad money will correspond to a given level of nominal transactions. If the banking system is unable to convert base money into a sufficient quantity of broad money activity may suffer in the short run and over the longer run a deflationary impetus will be established.

Clearly when and if interest rates arrive at zero, central banks can no longer control the policy interest rate via open market operations and so monetary policy is driven by the need to set the quantity of base money in circulation directly. Furthermore if financial intermediation is severely impaired, policy may also have to provide a direct impetus for the creation of broad money liabilities and this is our working definition of quantitative easing.

The central bank balance sheet typically comprises assets of foreign exchange reserves, loans to the government, bonds, claims on banks and on the private sector. Liabilities comprise currency, commercial banks’ reserves deposited with the central bank, central bank securities, government deposits and any capital reserves. Central bank balance sheets are typically dominated by the main liabilities of base money (notes, and in some cases coin, on issue) and foreign assets and claims on financial institutions.

When the central bank effects a purchase of government bonds, the following changes to the balance sheet occur. Central bank assets will rise and liabilities will expand by the exact amount of currency issued to pay for the bonds. The currency is remitted to the commercial bank, government or insurance company from whom the central bank has bought the asset and this will be measured as a commercial bank deposit. And so the purchase of government bonds will show up as both an expansion of the central bank balance sheet, an increase in base money and an increase in broad money.

At some point in the future, the central bank can close out its position in government bonds by selling back to the private sector the bonds it holds on the asset side of the balance sheet, soak up the currency created and deflate its balance sheet. This begs the question of what is the initial purpose of buying government bonds? The hope is that by creating more short-term deposits in the commercial bank sector, this will generate commercial bank lending, given a reasonably stable money multiplier. The problem is that when commercial banks are uncertain about both the availability of future liquidity, losses from past lending and the riskiness of new lending in a recession, the new monetary liabilities may not translate very easily into new lending.

And so central banks have already gone further. The purchase of commercial bank assets and mortgage backed securities at discount provide both succour to commercial banks’ balance sheets by providing liquidity against possibly undervalued long term assets, as well as expanding broad money, and the possibility that central banks may profit from the resale of these assets. The open questions here are then at what price are these assets bought – not so high as to endanger the sustainability of the central bank balance sheet but not so low as to question the sustainability of the commercial banks and to discourage their future lending.

With such a large expansion of the central bank balance sheet, central banks increase the relative supply of short term debt (including central bank debt) to long term debt, which should lead to a change in the relative price of short to long term debt, with the latter becoming relatively expensive. And if long term interest rates do indeed fall during a quantitative easing then the private sector will have an incentive to invest as the user costs of capital falls, household balance sheets should be ameliorated with lower interest and debt burdens and asset prices should be stabilised, underpinned by lower long term rates. The question then is when all this activity starts to take off when will inflationary pressures start to re-emerge?

Deflation - a real problem and a possible cure

I ended my previous post with the question: so what’s the problem? And I suppose it is Deflation. A persistent deflation poses particular problems for monetary policymakers because with nominal policy rates facing a lower bound of zero, central banks can, in principle, lose control of real rates that will continue to rise if inflation expectations follow inflation down. Deflation is, of course, not a new phenomenon and prior to WWII year on year deflation was over the long run as likely as inflation but as long as inflation expectations remained in line with notions of long run price stability real rates would perhaps not destabilise the economy. The real worry for policymakers as we head into a deep recession is that inflation expectations fall markedly in line with deflation. Wide-ranging monetary and fiscal policy responses will then be designed to try and prevent a significant and persistent fall in inflation expectations.

Over the past decade or so we had become used to the following story about monetary policy. Short-term policy rates are nudged, with some reluctance, in one direction or another in order to limit the deviation of short-term inflation forecasts from an explicit (or implicit target). These short-term inflation forecasts are projections of the output gap and so the basic story says that by stabilising inflation, output is kept as close to potential as possible at the same time. The parable finishes by soothing us with the observation that providing the economic shocks are not too large and monetary policy continues to have traction on the economy via its influence on financial prices, then the economy should tend towards stable outcomes.

This nice, linear story is illustrated in Chart 1 (see http://econpapers.repec.org/paper/ukcukcedp/0815.htm for more details). Here we show a Fisher equation, which relates short-term nominal rates equiproportionally to inflation (or inflation expectations). The intercept corresponds to the economy’s natural real rate, which is essentially exogenous to monetary policy and is closely related to the expected growth of per capita consumption. The inflation target determines the long-run expected level of nominal rates, which are equal to the natural real rate and the inflation target. The central bank’s policy reaction function is to respond actively to any expected deviations in inflation from target and so is drawn steeper than the Fisher equation line so as to suggest policy induced real rates that are lower or higher than the natural rate, when inflation is correspondingly lower or higher than target, which acts to boost or bear down on demand as required.

But things can change quite radically once we move out of this comfortable little space. Specifically, if inflation starts to decelerate quickly, the central bank can find itself bumping near to its zero bound on nominal rates and might, in principle, lose control of its ability to set real interest rates. At this point short-term debt instruments and money yield near-identical nominal returns, and given that bonds bear a default risk, there will be a strong preference to hold liquidity in the form of cash. This means that even though the central bank will continue to supply private agents with escalating levels of narrow money to meet this increased demand, it will not be spent and demand will not emerge to chomp up the large output gap.

Chart 2 shows the limits to the standard mode of interest rate control. Once nominal rates hit zero at Point A, if inflation continues to fall real rates will then start to rise. And so there is a possibility that the output gap will get even higher as rising real rates bear down even further on demand, leading to a loop of lower inflation, higher real rates, lower demand and even lower inflation. The classic answer to the deflation trap is that at some point money demand will be sated and the decrease in the price level will mean that money holders will feel wealthier and start to spend. But in a world of debt that may not be sufficient because if those money holders are also indebted, the fall in the price level will increase the real value of their debt and so ultimately the existence of a deflationary trap will depend on whether the increasing indebtedness of debtors outweighs the increasing wealth of money holders.

So will a deflation lead to a complete economic collapse? Not necessarily. Chart 3 shows two annual inflation distributions in the UK from 1800 to 1947 and again from 1948-2007. The first distribution seems reasonably symmetric around zero and suggests that deflationary years approximately matched inflationary years in the nineteenth century and the first half of the twentieth century. Subsequently, we have hardly any evidence of deflation to draw upon, with inflation mostly moderately positive (with occasional lapses in good behaviour). It is not at all clear that we can make a simple comparison between a financially complex economy and one that was still in the midst of industrialisation. But one clear distinction can be made as there seems to have been long-run price stability in Britain in the earlier period: which implied offsetting years of positive and negative inflation, but these did not necessarily bring about sustained economic crises. Why?

One reason might be that the maintenance of long-run price stability means that a temporary deflation, which lowers the price level, was also accompanied by expectations of an inflation, which would return the price level back to its long-run average. The advantage of a positive inflation expectation during a deflation is clear because even though current inflation falls, expected inflation rises and this means that the expected real return on stable nominal rates falls. And so the likelihood of a deflation taking hold in a persistent manner may be significantly mitigated.

Unfortunately, in the current deflation scare, in the UK inflation expectations have moved very much in line with current inflation, which is rather unfortunate and suggests that credibility, the belief in the inflation target, may be less than complete. The rise in CPI inflation from 2004 to 2008 was accompanied by an increase in both breakeven inflation and NOP inflation expectations and as CPI inflation has started to decelerate in the second half of this year we have almost immediately noticed a decline in inflation expectations. The nominal anchor seems to be being dragged around by contemporaneous developments and hence the monetary constitution may ultimately be in need of some reform.

An important part of the answer in dealing with a deflation is to conduct monetary and fiscal policy in such a manner that inflation expectations do not fall along with prices: that, in fact, as far as possible they remain at or near the inflation target. Convince agents that inflation will be higher in the future than it is now, so enabling real rates to fall as nominal rates fall to zero. And so if the risk of deflation is real, and in the most recent Inflation Report the Bank of England placed the probability at around 20%, we can expect a highly accommodative monetary and fiscal policy stance to be maintained.