If you just knew two things about the current state of the US economy — that unemployment was unacceptably high and that inflation was subdued — you’d suggest that the proper course for the Federal Reserve would be to lower interest rates, and make money cheaper.
The problem is: interest rates are at ~0%.
This is the defining monetary puzzle of our time.
Since the crisis hit, the Federal Reserve has attempted to juice the economy through a program that’s called Quantitative Easing, which is buying long-dated government bonds and mortgage backed securities It’s the same scheme that the Bank of Japan has tried in its long battle against saggy growth and deflation.
The effect has been to balloon the size of the Federal Reserve Balance Sheet, as you can see in this chart, which comes from The Cleveland Fed.
Photo: Cleveland Fed
In his Jackson Hole speech in 2010 (.pdf), Ben Bernanke explained how the program worked.
Specifically he cited the “portfolio balance channel”, which means that QE would work by reducing the supply of super-safe Treasuries and Mortgage Backed Securities, and instead push investors into other areas (like corporate bonds), thus depressing yields and borrowing costs in the private sector. Think of it this way: During the crisis, everyone sought refuge in the safety of Treasuries. Bernanke was now seeking to deprive them of this safety valve, and force their cash into areas where it might do some good in the economy.
Here are his words:
The channels through which the Fed’s purchases affect longer-term interest rates and financial conditions more generally have been subject to debate. I see the evidence as most favourable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short- term interest rates have reached zero, the Federal Reserve’s purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed’s strategy relies on the presumption that different financial as-
sets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.
It’s worth noting that although this was all new territory for the Fed, this wasn’t new territory for monetary economists, who had spent a lot of time talking about what Japan could do to get itself out of its post-crisis funk. One of the economists who wrote a lot about Japan was Ben Bernanke.
Two years later, the jury is still out on QE. The fact that unemployment is high, inflation is subdued, and growth is mediocre implies it hasn’t been a raging success. Also the fact that we’re talking about doing QE3 is a little bit damning.
Nonetheless, at Jackson hole this year, Bernanke gave a vigorous defence of QE, meaning that not only does he believe it worked, he believes it’s appropriate for the ongoing labour crisis we’re experiencing today.
Model simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy. For example, a study using the Board’s FRB/US model of the economy found that, as of 2012, the first two rounds of LSAPs may have raised the level of output by almost 3 per cent and increased private payroll employment by more than 2 million jobs, relative to what otherwise would have occurred.
So Bernanke talked about the dismal state of the economy, and he insisted that QE works, which is why so many people believe that another round is coming, if not in September, then at the December meeting.
And now here’s where things get interesting…
Following Bernanke’s speech at Jackson Hole, a paper was delivered at the conference by Michael Woodford, a Columbia economist who is considered to be one of the world’s foremost experts on monetary policy and interest rates.
The title of the paper was Accommodation at the Zero Lower Bound and clocking in at 97 pages, it provides an exhaustive overview of which monetary stimulus techniques really work when the Fed’s official interest rates have hit ~0%.
Woodford’s paper was a rebuke to Bernanke. What it says is that asset purchases have modest, difficult-to-quantify effects, and are not even theoretically robust. Instead, what really works, are verbal commitments by central banks to target a certain economic or financial outcome. Woodford ends up coming out in support of Nominal GDP Level Targeting, one of the buzziest ideas in academic economics, which we’ll go explain below.
First, he builds the case that what central bankers say and target actually matters. Why do people obsess so much about whether the Fed says it expects to hold rates low until 2014 or 2015? This is why.
Woodford presents a clear-cut example of a central bank making a forward-looking statement, and then watching it play out in financial markets.
What follows is a chunk from Woodford’s paper where he describes a particular example of a bank (in this case the Bank of Canada) making an explicit conditional statement about future policy, wherein it essentially promised not to raise a specific interest rate until a specific date, so long as inflation doesn’t rise above its target levels. What Woodford observes through the data is that financial contracts immediately reflected the Bank of Canada’s conditional promise not to raise the rate:
The occasions during the recent crisis on which central banks have indicated that they expected to maintain a ﬁxed policy rate for a speciﬁc period of time are of particular interest for purposes of our inquiry. These are especially dramatic examples of attempts at forward guidance, making a clear break from “business as usual;” moreover, the import of what is said for the future path of the policy rate is quite explicit and easily summarized. It is therefore of interest to consider what has happened on these occasions, even if one cannot do formal hypothesis tests with such a small sample of events, each rather unique.
A particularly explicit example of forward guidance was the Bank of Canada’s statement on April 21, 2009, which announced the following:
The Bank of Canada today announced that it is lowering its target for the overnight rate by one-quarter of a percentage point to 1/4 per cent, which the Bank judges to be the eﬀective lower bound for that rate…. With monetary policy now operating at the eﬀective lower bound for the overnight policy rate, it is appropriate to provide more explicit guidance than is usual regarding its future path so as to inﬂuence rates at longer maturities. Conditional on the outlook for inﬂation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inﬂation target.
While the statement included the announcement of a reduction in the current target rate, it also oﬀered explicit guidance about where the target should be expected to be, extending more than a year into the future. The release of the statement had an almost instantaneous eﬀect on market expectations about the future path of the policy rate, as indicated by trading in overnight interest-rate swap (OIS) contracts
The tick-by-tick transactions data plotted in the ﬁgure show that market OIS ratesfell almost instantaneously at the time that the announcement was made (9:00 AM EST, shown by the vertical line). This was evidently an eﬀect of the statement; yet since the statement included the announcement of an immediate target rate reduction, one might wonder if themoves in the OIS rates reﬂected simply the typical implications of a cut in thecurrent target forrates months in the future, rather than anya dditional eﬀects of the “conditional commitment.” It is useful to note not only that OIS rates for maturitiesas long as six totwelve months fall, but that the longer maturities fall more; that is, not only does the OIS yield curve fall in response to the announcement, but it ﬂattens. This implies eitherthatexpectations of policy rates for months in early 2010 fall even more than do nearer-termexpectations, or that uncertainty about the path of the policy rateo ver the coming year has been sub stantiallyreduced (reducing the term premium).
That’s just one tiny example, and Woodford walks through several more, but the evidence he presents suggests that forward statements like this do matter.
The second half of his paper explains why asset purchases are of only modest value.
First, he rebutts an idea put forth by Milton Friedman, that if the Fed just expanded its balance sheet aggressively, then that money would eventually flow into the broader economy, boosting the amount of money out there, and boosting total spending.
But as this chart shows, even though the size of the Fed’s balance sheet (the dark black line) exploded, all of the other measures (including the amount of currency out there) remained subdued through the QE periods (which are shaded in grey).
Photo: Michael Woodford
There has similarly been as yet little sign of any acceleration of inﬂation, despite the warnings of some monetarists. Thus such eﬀects as the programs have had do not seem to support the theory of pure quantitative easing.
He then takes on directly Bernanke’s preferred explanation of how QE “works” — the portfolio balance channel, the idea that by buying Treasuries, the Fed is pushing investors into riskier areas of the economy, where their investments will do more good, or at least lower rates for private borrowers.
Woodford’s argument goes into a lot of theoretical finance, and basically suggests that the mere “mix” of assets shouldn’t really change their price (if markets are somewhat efficient) and that there’s no good data to suggest that asset purchases have actually changed prices of various market securities.
Woodford makes a point that we’ve made several times, which is that during periods of QE, Treasury yields have actually gone up, undermining the idea that the scheme pushes rates lower. Conversely, there are studies which show that on the days that QE programs have been announced, yields have indeed fallen — but even this evidence is muddled by the fact that a the same time QE programs have been announced, the Fed has also engaged in changing its forward outlook/commitments, therefore calling into question whether it was the purchases or the language that really moved the market.
Woodford’s Big Conclusion
You’ve probably seen this chart several times in recent years.
The red line represents the potential nominal GDP for the economy (which is calculated making a few assumptions about stuff like full employment). The blue line is the actual nominal GDP.
What’s defined the crisis, and post-crisis periods is the huge gap that has emerged between total output, and total potential output.
What Woodford concludes is that the Fed ought to say this:
We are going to keep rates low until the blue line comes back and touches the red line.
It’s not that the Fed will keep rates low until the economy improves, or unemployment falls below 6%, or until inflation really starts picking up, it’s only that the Fed won’t ease up on the gas pedal until the economy is fully at its full output potential. The idea is that the Fed is sending a huge signal to businesses: We’re going to keep money cheap for a long time, even once the economy is gaining steam, so that if you’re in the game then, you’re going to make huge profits. All uncertainty about when rates are raised is taken off the table, and the Fed maintains all the credibility in the world, so long as it just sticks to that goal.
An elegant thing about this plan is that the weaker the economy gets (the more the blue line deviates from the red line) the stronger the implied promise of future easing is, making the policy automatically course-correcting.
Standard New Keynesian models imply that a higher level of expected real income or inﬂation in the future creates incentives for greater real expenditure and larger price increases now; but in the case of a conventional interest-rate reaction function for the central bank, short-term interest rates should increase, and the disincentive that this provides to current expenditure will attenuate (without completely eliminating) the sensitivity of current conditions to expectations. If nominal interest rates instead remain unchanged, the degree to which higher expected real income and inﬂation later produce higher real income and inﬂation now is ampliﬁed. If the situation is expected to persist for a period of time, the degree of ampliﬁcation should increase exponentially. Hence it is precisely when the interest-rate lower bound is expected to be a binding constraint for some time to come that expectations about the conduct of policy after the constraint ceases to bind should have a particularly large eﬀect on current economic conditions — to the extent, that is, that it is possible to shift
expectations about conditions that far in the future.
Matt Yglesias had a good post putting this into a real-world example:
…you’re considering borrowing some money to build a big apartment complex. One relevant issue is the prevailing interest rate. But another relevant issue is how much money you think people are going to have to spend on rent. If someone tells you real incomes are going to rise faster than you’d previously expected, building the apartment looks better. But then again, if real incomes rise faster than expected you’ll also expect interest rates to rise which cuts in the other direction.
So if someone comes along and says “this is a special case—rates are staying ultra-low even if some unexpected good news shows up” that has a big impact on your thinking. And since the very act of building the apartment tends to increase real incomes (gotta hire people) the commitment serves to supercharge the impact of any good news.
So this is the idea Woodford’s getting behind. Making a credible promise not to raise rates until a clear moment that will occur well after the recovery has really gathered steam.
It’s worth noting that this isn’t an idea that’s new to Woodford at all. Other economists (notably Scott Sumner) have been talking about similar ideas for a long time. Even Goldman has advised the Fed to set a Nominal GDP target.
But this is a major moment, when a top economist at one of the world’s foremost monetary policy settings made this case (and in a very thorough manner).
In a note put out on Friday, JPMorgan’s Michael Feroli wrote:
What can be gleaned from all of this about the current thinking on monetary policy at the zero lower bound? While some of Woodford’s characterizations are idiosyncratic to his own biases, many are probably indicative of where the profession is drifting.
The emphasis on communication is consistent with how the minutes have been characterising the internal Fed debate; while the market only wants to talk about QE, the Fed seems equally focused on refining their communication tools.
Second, his observation that communication tools are more effective when they conditionally commit policymakers to a certain path of action also appears consistent with where the policy debate is eventually heading.
Third, Woodford’s criticism of balance sheet policies are probably more extreme than most researchers, as evidenced by Bernanke’s strong defence of the effectiveness of such action, though the profession may be nudging closer to his position. For example, some recent research — which Woodford cites — is consistent with the view that much of the QE effect comes from signaling, which presumably is better done directly through communications. Even so, in his earlier talk Bernanke sounded content with conducting asset purchases even if they operated primarily through a signaling channel. Moreover, some recent internal Fed research (Kiley 2012) suggests that lowering the path of short-term rates will do more to stimulate the economy than lowering longer-term interest rate term premium — which is arguably the path through which QE works.
It should be noted that Woodford offers some lukewarm support to purchasing MBS as an adjunct to a conditional commitment on short rates — and even more support to the idea of following the BoE’s Funding for Lending Scheme — so his talk shouldn’t be construed as ruling out any usefulness for asset purchases, but rather that a conditional commitment on interest rates should form the backbone of Fed strategy in its current predicament. We may still be many months away from an Evans-like rule being implemented, but Woodford’s paper is further evidence of the favour this approach is gaining in policymaker circles.
We’d also point out that Feroli’s note is titled: Don’t forget the undercards at Jackson Hole — the boxing metaphor is pretty much perfect given that Woodford afford a major rebuke to the big guy.
Bottom line: Ideas that had been buzzy and fringy not long ago are now very close to the centre of the profession of monetary policy.
Download the whole Woodford paper here. Makes for some great labour Day reading.
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