Monetary Policy in a Low‐Interest‐Rate Environment

Abstract

Previous articleNext article FreeMonetary Policy in a Low‐Interest‐Rate EnvironmentVincent ReinhartVincent ReinhartAmerican Enterprise Institute Search for more articles by this author PDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreI appreciate this opportunity to discuss aspects of quantitative easing (QE) with some former central bank colleagues on this panel. Today’s topic is monetary policy in a low‐interest‐rate environment. For the Federal Reserve, which will be my main focus, that means QE because the federal funds rate has already been effectively brought to zero. My presentation today will have three parts. First, I will discuss the channels through which QE works, because that sets up a basis to evaluate the policy. Second, and what may sound ironic, I will explain why QE is hard to quantify. That will say something about the ways central banks operate and about the current state of economics and finance. Finally, I shall discuss the risks associated with QE. This will highlight the importance of having an exit strategy. In that regard, this discussion should not be viewed as relevant exclusively to the Federal Reserve. Any central bank confident in its ability to exit might be more willing to enter a period of very low interest rates.I. QE, QEDQuantitative easing holds that the size and composition of the central bank’s balance sheet influences financial markets and the economy over and beyond the level of the policy rate. One consequence of this definition is that policy does not necessarily run out of ammunition at the zero bound. That is, the central bank can still manipulate its balance sheet even as its policy rate is pinned at zero. This definition also implies that QE is not just about the level of reserves. The level of reserves is one portion of a central bank's balance sheet, but other liabilities and the size and composition of its assets can also influence the macro economy. In addition, this definition implies that QE can be undertaken at a nonzero policy interest rate. This is relevant both for the central banks that have not already put the pedal fully to the metal, such as the European Central Bank, and for those that have but that are planning now how to unwind policy stimulus.Quantitative easing potentially works on both sides of a central bank’s balance sheet in the manner described by Bernanke and Reinhart (2004). 1. The large provision of reserves may induce banks to make use of idle balances, which is the traditional money multiplier effect. Even as the policy rate is pushed to zero, reserves can expand, potentially massively, providing banks the wherewithal to support deposit creation, if they are so inclined.2. The overprovision of reserves also could help convince market participants that the policy interest rate will be low for a long time. This is known as the policy duration effect. This simply recognizes that the bigger is the balance sheet, the longer it will likely take to shrink (in the manner described by Auerbach and Obstfeld [2004]).3. On the asset side, the accumulation of portfolio holdings might influence relative spreads and the function of markets, which is an asset substitution effect (in the manner of Tobin [1970]).4. A central bank holding more assets, particularly those that have higher returns than typical and importantly above the remuneration on deposits, should generate additional income. This central bank profit may encourage the government to spend more or to cut taxes, which is known as creating fiscal space.As an aside, Federal Reserve officials apparently had a stab at rebranding QE. The Fed started QE in October 2008, as seen in figure 1a as the massive increase in reserves. That provision of liquidity drove the funds rate effectively to zero (fig. 1b), even as the official target was still 1%. Despite both the evidence in quantities and prices, officials seemed reluctant to describe their policy as QE.1 It might have been because QE was thought to describe the narrow provision of reserves. More likely, I believe, is that the Fed expanded its balance sheet as its microeconomic programs ballooned, so it saw this as an extension of its credit policies. The Fed did not formally embrace QE for macroeconomic reasons until mid‐December, when the Federal Open Market Committee officially pushed its target rate to 0%–0.25%.2Fig. 1. a, Reserve balances at the Federal Reserve. b, Effective federal funds rate. Source: Federal Reserve Bank of St. Louis, Federal Reserve Economic Data (FRED).View Large ImageDownload PowerPointII. Quantifying QEMy second topic is the ongoing crisis and the quantification of QE. This is not just a crisis in global financial markets and economies; it is also a crisis in economics and finance. The models we have been using do not adequately capture QE. Modern macroeconomic models used to evaluate policy have three main features. First, they net across entities and describe the behavior of the representative agent. Thus, gross positions do not matter. Second, quantitative models tend to assume arbitrage across markets. This means that a small set of financial market prices, perhaps even a single one, can describe the whole spectrum of financial market returns. Third, and as a result, these models reduce monetary policy making to the control of the short‐term interest rate.As a consequence, the evaluation of QE has thus far focused on what can be explained internally in these models, what can be imposed from the outside on these models, and what can be observed in a model‐free manner.Internal to models. To be a bit more specific, the policy duration effect is the main channel that can be measured internally to most models. If interest rates are expected to stay pinned at zero for longer than previously expected, a researcher can show how that surprise plays through the yield curve and influences the economy. Most of the work on the Bank of Japan experience has emphasized this policy duration effect (as discussed in Bernanke, Reinhart, and Sack [2004]).External to models. The same models can be used in an ad hoc manner to consider the effects of external forces. For instance, what happens if a particular relative spread widens? “Ad‐factoring” one of the equations explaining spending proxies this event, much in the manner decried by Sims (1980) almost 30 years ago. Implicit in that implementation of a shock is the view that the cost of intermediation rises in a crisis, and that is probably right. More problematic is the incidence of the shock. How those higher costs are passed along in terms of rates and quantities—that is, the cost and availability of funds—depends on the structure of the industry. In Reinhart and Reinhart (1999), for instance, the effects of an increase in reserve requirements in a small open economy are shown to depend on whether banks have market power in deposit creation or lending.Event studies. Finally, event studies around policy announcements quantify policy effects outside any one particular model (exercises that are also considered in Bernanke et al. [2004]). The problem with event studies, of course, is the questions that remain implicit. How much of the announcement was expected? How effectively was the policy explained? What happened outside the window? Indeed, the tyranny of event studies tends to focus attention on what central banks do because the reaction can be measured in a narrow window. Less well understood, then, is the consequence of policy inaction, or the dog that did not bark, which plays out at a vague and hard‐to‐measure pace.This perspective helps to explain the macro model U.S. policy makers must have in the recesses of their minds. In particular, their model must allow some role for imperfect asset substitutability. That is the only way that purchasing Treasury securities, as the Fed has done, would be expected to lower private spreads. Bank profits must also enter that model. The stress tests of the banking system emphasized flow profits rather than legacy losses.3 If it was important to shift the focus of financial market participants to ongoing profits, implicitly profits must matter. Finally, officials must hold the view that central bank profits matter. If not, we would not hear all this talk about concerns over potential losses.4III. Risks Associated with QEGiven the venue for this conference, here on the Mediterranean island from which Aphrodite emerged from the sea, it is reasonable to ask two fundamental questions found in the classics. Those questions concern risks associated with QE.First, does QE risk flying too close to the sun, in the manner of Icarus? Policy makers and outside observers often voice reservations about the longer‐term consequences of QE. There seems to be a fear that policy will be decidedly asymmetric. Reluctantly removing massive accommodation that was put in place aggressively might risk longer‐term inflation prospects. Implicit in this view is a dark interpretation of the political economy and a fear that inflation expectations are changeable.Second, and in contrast to the threat from the sun, is not resorting to QE living fearfully in the shade? In that regard, consider the words of Aristophanes in his play The Wasps. He wrote, “Why do we delay to let loose that fury, that is so terrible, when our nests are attacked?”5 This aptly summarizes a threat to a central bank’s legitimacy from another direction: What would happen if it were seen as not using the policy tools at its disposal in a time of great risk to society?When considering the risks of QE, it is important to remember that the tools that allow the expansion of the central bank's balance sheet are not inherently asymmetric. Mechanically, the central bank can shrink its balance sheet just as fast as it was expanded. Rather, the question is about the willingness of the central bank to be symmetrically aggressive, not the ability. In that regard, QE is probably most effective when there is a well‐defined exit strategy. The anchoring of inflation expectations in the long run at an appropriate level gives policy makers leeway to be aggressive in the short run.Some comfort can be taken from the fact that the Bank of Japan was able to unwind its balance sheet relatively quickly. In five remarkable months in 2006, the Bank of Japan shrank total assets by about a fifth. As seen in figure 2, that contraction came mostly from its portfolio of government securities. The short average maturity of that portfolio allowed the asset stock to contract by merely rolling off maturing obligations.Fig. 2. Assets of the Bank of JapanView Large ImageDownload PowerPointWhile this has been done before, there are reasons to be concerned about the Federal Reserve’s willingness to head for the exit. There are four sources of concern. First, policy makers might be unwilling to test the resilience of markets. They might easily convince themselves that the improvement in markets and the economy is due to the massive size of the Fed’s balance sheet. While financial markets and the economy might be better, they might not be strong enough to withstand the removal of that accommodation. A regular tendency over time and across countries is that policy rates move asymmetrically. Policy rates tend to decline quickly and increase slowly. This is referred to as going up by the escalator and down by the elevator.6 If policy rates are asymmetric even though there is no obvious cost to adjustment, we should not be surprised to find that changes in the balance sheet are similarly asymmetric.Second, some long‐lived assets on the Fed’s balance sheet might no longer have markets when the time comes for the Fed to want to sell them. This mostly holds for the assets in the special purpose vehicles and the potential purchase of legacy securities as part of the Treasury’s rescue plan.7Third, the Treasury has funded a portion of some Fed programs by providing a first‐loss tranche. If the Treasury was present at the creation, does it also have to be amenable at the closure?Fourth, political pressures might be intense. The Fed has been able to play a forceful role in affecting private credit markets. The Congress might view this as the purview of fiscal policy and be more willing to interfere with those decisions going forward.My preferred solution is not to let the possibility that the Fed might fail to do the right thing in the future prevent it from doing the right thing now. As long as resource slack is considerable and deflation is a palpable threat, the right thing is to keep the Fed's balance sheet massive. At a later date, the Fed will have to be forceful in exiting that position. Investors can be provided reassurance now by putting mechanisms in place that force good behavior in the future. Three items come to mind. First, the Fed could be given a formal inflation goal by the Congress. That would help anchor inflation expectations and prove that the Congress will not be recalcitrant at a later date.8 Second, the Fed could change its regulations to harden the floor on deposit rates. Back in November and December of 2008, the federal funds rate often traded below the deposit rate. That is, some market participants were willing to lend funds into the market for a lower rate than they could receive on deposits at the Federal Reserve. The reason behind this phenomenon is that not every reserve holder receives interest on reserves. That can be changed. Third, a term limit on holding private credit risk funded with reserves would force the Federal Reserve to either seek funding from the Treasury or to sell those assets.IV. ConclusionCentral banks in many countries are in uncharted waters. Their task is made more difficult by the lack of tools provided by the economics and finance professions. The experience of 2008 and probably the next few years will be challenging. But it will also enrich our understanding of how monetary policy and economies work.NotesThis paper was prepared for a panel discussion at the 2009 NBER International Seminar on Macroeconomics in Lemesol, Cyprus.1. Note, e.g., that Chairman Bernanke’s testimony on monetary policy and the outlook on October 20, 2008, was silent on the level of reserves and the federal funds rate, at http://www.federalreserve.gov/newsevents/testimony/bernanke20081020a.htm.2. This is noted in the statement of the Federal Open Market Committee at the conclusion of its year‐end meeting on December 16, 2008, at http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm.3. The stress tests are described at http://www.financialstability.gov/latest/tg91.html.4. This is not an area the academic profession has directed much attention toward in the past two decades. For an earlier generation, including Metzler and Mundell, the treatment of central bank profits was an important mechanism in the transmission mechanism, as is shown rigorously in Obstfeld (1982).5. The text of the play can be found at http://classics.mit.edu/Aristophanes/wasps.html.6. For example, Fed Vice Chairman Donald Kohn made this observation in a speech, “Monetary Policy over Fifty Years,” at a conference to mark the fiftieth anniversary of the Deutsche Bundesbank in Frankfurt, Germany, on September 21, 2007, at http://www.federalreserve.gov/newsevents/speech/kohn20070921a.htm.7. In that regard, the Fed has already reached an accord with the Treasury for it to assume those special purpose vehicle assets when the time comes.8. This is an initiative discussed by Bernanke et al. 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