Treasury Market Dysfunction and the Role of the Central Bank

Japan’s encounter with deflation and near‐zero‐interest short‐term interest rates in the 1990s led to a surge in research on the implications of the zero lower bound (ZLB) on nominal interest rates for monetary policy around the end of that decade. Based on model simulations, the literature at that time identified a number of key implications of the ZLB (see Orphanides and Wieland [2000], Reifschneider and Williams [2000, 2002], Eggertsson and Woodford [2003], and references therein). First, with low inflation targets of the kind followed by many central banks, the ZLB will frequently be a binding constraint on monetary policy. That is, Japan’s example is not an outlier but rather a harbinger for the future. Second, at inflation targets of 1% or lower, lowering the inflation target comes at a cost of higher variability of output and inflation, although the effects on inflation variability are relatively small. This analysis provides an argument for maintaining a positive inflation target cushion above 1%. Third, in rare instances of severe prolonged recessions accompanied by deflation, standard open market operations will be insufficient to bring the inflation rate back to target, andalternative sources of stimulus to the economy, such as fiscal policy, will be needed. Fourth, central banks can significantly reduce the effects of the ZLB onmacroeconomic stability by modifying their policy actions and communication to the public when the ZLB threatens to constrain policy. Specifically, policies that cut rates aggressively when deflation is a risk and promise to temporarily target a higher rate of inflation following episodes where the ZLB binds were found to greatly reduce the effects of the ZLB in model simulations. In the decade since this researchwas initiated, the ZLB has gone froma theoretical issue applying to Japan to one that plagues many industrialized economies. Indeed, an era of overwhelming confidence in monetary policy’s power to tame the business cycle while delivering low and stable inflation has been replaced by fears that the global economy could

Last week, we witnessed one of the most exciting developments in monetary policymaking since the 1930s. The Japanese central bank staged an honest-to-goodness regime shift. The Bank of Japan went beyond vague promises and cheap talk. As I will describe in more detail later, it took dramatic actions and pledged convincingly to do whatever it takes to end deflation in Japan. The theoretical reasons why this regime shift may be important are well understood by economists. Persistent deflation and anemic growth suggest that Japan continues to suffer from a shortfall of demand. But their policy interest rate is already at the zero lower bound. Furthermore, riskier, long-term rates are also very low— suggesting that unconventional policies such as large-scale asset purchases are unlikely to do much to further reduce nominal rates. As discussed by Paul Krugman, Gauti Eggertsson and Michael Woodford, and others, if unconventional monetary policy can raise expected inflation, this can push down real interest rates even though nominal rates cannot fall. 1 This, in turn, can raise aggregate demand by stimulating interest

Monetary policy in a world of radical uncertainty

Nothing but the Facts: The U.S. Treasury Market During the COVID-19 Crisis

This paper starts from the theoretical observation that simple rules-based monetary policy will result in good economic performance in a globalized world economy and the historical observation that this occurred during the Great Moderation period of the 1980s and 1990s.It tries to answer a question posed by Paul Volcker in 2014 about the global repercussions of monetary policies pursued by advanced economy central banks in recent years.I start by explaining the basic theoretical framework, its policy implications, and its historical relevance.I then review the empirical evidence on the size of the international spillovers caused by deviations from rules-based monetary policy, and explore the many ways in which these spillovers affect and interfere with policy decisions globally.Finally, I consider ways in which individual monetary authorities and the world monetary system as a whole could adhere better to rules-based policies in the future and whether this would be enough to achieve the goal of stability in the globalized world economy.

Comment

Crises in Economic Thought, Secular Stagnation, and Future Economic Research

Previous article FreeCosts and Benefits to Phasing out Paper CurrencyKenneth RogoffKenneth RogoffHarvard University and NBER Search for more articles by this author Harvard University and NBERPDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreThis paper explores the costs and benefits to phasing out paper currency, beginning with large-denomination notes, later extending to all but small coins and bills, and eventually those as well. It is hardly a simple issue; paper currency is deeply ingrained in the public’s image of government and country, and any attempt to change long-standing monetary conventions raises a host of complex issues. The symbolic value of the euro, for example, as a flag for nascent European institutions, is hard to overstate. Nevertheless, it is important to ask whether currency in paper form has outlived its usefulness. Today, credit and debit cards are increasingly being used for even small transactions. And although today’s cryptocurrencies fall far short of being true currencies—for one thing their prices are simply too volatile—the underlying technologies may ultimately strengthen the menu of electronic payments options.1Zero-Interest Negotiable Bonds as an Obstacle to Negative Policy Interest RatesPaper currency has two very distinct properties that should draw our attention. First, it is precisely the existence of paper currency that makes it difficult for central banks to take policy interest rates much below zero, a limitation that seems to have become increasingly relevant during this century. As Blanchard, Dell’Ariccia, and Mauro (2010) point out, today’s environment of low and stable inflation rates has drastically pushed down the general level of interest rates. The low overall level, combined with the zero bound, means that central banks cannot cut interest rates nearly as much as they might like in response to large deflationary shocks.If all central bank liabilities were electronic, paying a negative interest on reserves (basically charging a fee) would be trivial. But as long as central banks stand ready to convert electronic deposits to zero-interest paper currency in unlimited amounts, it suddenly becomes very hard to push interest rates below levels of, say, −0.25 to −0.50%, certainly not on a sustained basis. Hoarding cash may be inconvenient and risky, but if rates become too negative, it becomes worth it.2In a series of insightful papers, Willem Buiter ([2009], and citations therein) has discussed whether it might be possible to find devices for paying negative interest rates on currency.3 Buiter notes that there were experiments with stamp taxes during the Great Depression (currency would remain valid only if it were regularly stamped to reflect tax payment). There are a variety of other ideas. For example, Mankiw (2009) points out that the central bank could effectively tax currency by holding lotteries based on serial numbers, and making the “winners” worthless.Paying a negative interest rate on currency, or on electronic reserves at the central bank, may seem barbaric to some, but it is arguably no more barbaric than inflation, which similarly reduces the real purchasing power of currency. The idea of raising target inflation to reduce the likelihood of hitting the zero bound is indeed an alternative approach. Blanchard et al. point out that if central banks permanently raised their target inflation rates from 2% to 4%, it would leave them scope to make deeper cuts to real interest rates in severe downturns. Arguably, paying negative interest rates is a better approach if, as many believe, inflation becomes more unstable as the general level of inflation rises. Robert Hall (1983) argues forcefully that the central role of monetary policy should be to provide a stable unit of account, and in principle the ability to pay negative interest rates facilitates its ability to achieve this in today’s low inflation environment (Hall 2002, 2013).Even if there is a good case for allowing the central bank to pay a significant negative interest rate to fight a large deflationary shock, what is to stop a government from using negative interest rates as a wealth tax in normal times? This is a complex issue that parallels many of the problems in trying to design central bank institutions that will resist the temptation to inflate. Nevertheless, the challenges of conducting monetary policy at the zero bound force consideration of alternatives to the status quo. If, as Reinhart and Rogoff (2014) conjecture, business and financial cycles in the twenty-first century may produce larger fluctuations than they did in the last part of the twentieth century, the issue of hitting the zero bound may indeed remain a recurrent one.Anonymous Money as a Vehicle for Facilitating Tax Evasion and Illegal ActivityWe now turn to a second drawback to paper currency. Paper currency facilitates making transactions anonymous, helping conceal activities from the government in a way that might help agents avoid laws, regulations, and taxes. This is a big difference from most forms of electronic money that, in principle, can be traced by the government. (The issue of substitute anonymous transactions vehicles, such as Bitcoin, is discussed later on.)Standard monetary theory (e.g., Kiyotaki and Wright 1989) suggests that an essential property of money is that neither buyer nor seller requires knowledge of its history, giving it a certain form of anonymity. (A slight caveat is that the identity of the buyer might be correlated with the probability of the currency being counterfeit, but until now this is a problem that governments have been able to contain.) There is nothing, however, in standard theories of money that requires transactions to be anonymous from tax-or law-enforcement authorities. And yet there is a significant body of evidence that a large percentage of currency in most countries, generally well over 50%, is used precisely to hide transactions. I have summarized the international evidence in earlier research (Rogoff 1998, 2002). Other than the introduction of the euro, rather little has changed except that, if anything, anonymous currencies have continued to grow at a faster rate than nominal gross domestic product (GDP).Given that banks and businesses are typically quite efficient in their cash management (as evidenced by several central bank surveys), the most surprising fact about currency is the sheer extant amount that most Organisation for Economic Co-operation and Development (OECD) countries have in circulation, far in excess of anything that can be traced to legal use in the domestic economy. Table 1 gives data on currency by denomination and as a share of GDP for the United States, the Eurozone, Japan, and Hong Kong. For example, as of December 2013, there was roughly 1.2 trillion dollars in US currency in circulation, or roughly $4,000 for every man, woman, and child living in the United States. Moreover, 77% of the total value is in $100 bills, meaning more than thirty $100 bills per person. By contrast, denominations of $10 and under accounted for less than 4% of the total value of currency in use.Table 1. A. Europe: Currency in Circulation (February 20, 2014)Denomination (€)Value (In Thousands of Euros)Value (% of Total Currency)Value (% of 2013 GDP)58,028,790.80.8380.0841020,115,075.42.1000.2102057,254,121.05.9780.59850335,791,854.335.0633.507100183,322,233.019.1421.91520039,428,190.44.1170.412500289,720,996.030.2523.026Total (banknotes)933,661,260.8997.4919.752All coins24,029,083.22.5090.251Total (incl. coins)957,690,344.010010.003B. Hong Kong, Currency in Circulation (end of 2012)Denomination (HK$)Value (in Billions of HKD)Value (% of Total Currency)Value (% of 2012 GDP)102.920.9670.1432011.383.7730.558507.002.3220.34410027.138.9981.33250074.0924.5743.6371,000169.1956.1158.305Total (banknotes)291.7096.75014.319All coins9.803.2500.481Total (incl. coins)301.5010014.800C. Japan, Currency in Circulation (February 2014)Denomination (¥)Value (in 100 Millions of Yen)Value (% of Total Currency)Value (% of 2013 GDP)5001,0660.1180.0221,00038,0364.1930.7952,0001,9950.2200.0425,00029,5953.2620.61910,000790,19687.10116.519Total (banknotes)861,33594.94218.006All coins45,8845.0580.959Total (incl. coins)907,22010018.965D. United States, Currency in Circulation (December 31, 2013)Denomination ($)Value (in Billions of Dollars)Value (% of Total Currency)Value (% of 2013 GDP)110.60.8850.06322.10.1750.013512.71.0600.0761018.51.5440.11020155.012.9350.9235074.56.2170.443100924.777.1685.504500 to 10,0000.30.0250.002Total1,198.31007.133Source Panel A: European Central Bank; Panel B: Hong Kong Monetary Authority; Panel C: Bank of Japan; Panel D: Board of Governors of the Federal Reserve Sytem.View Table ImageThe size of dollar currency holdings, relative to GDP or per capita, is hardly unique. Indeed, in the United States the currency supply is 7% of GDP, in the Eurozone 10%, and in Japan 18%. Despite having lower per-capita income, the Eurozone also has roughly $4,000 in euros for every one of its citizen (valued at the April 2014 euro-dollar exchange rate). The euro has a much greater range of high denominations, so the value is not as concentrated in a single denomination as in the United States. Nevertheless, the same basic phenomenon holds, with roughly a third of the value of euro currency held in 50 euro notes (roughly $70), and another third in 500 euro notes (roughly $700). Adding in 100 and 200 euro notes brings the percent of high-denomination notes above that of the United States. In Japan, the total amount of currency outstanding is similar to that in the United States and Europe, despite having a population size only 40% as large. The concentration in the highest denomination is even more acute, with 87% of the value of notes being in 10,000 yen notes, the largest denomination, roughly $100 at April 2014 exchange rates.4It is true that in the case of the United States and the euro area, there is fairly convincing evidence that a large share is held abroad. Porter and Judson (1996) use seasonal comparisons with Canada and biometric techniques to infer that roughly 70% of US currency is held abroad. It should be noted that Canada is a country that has relatively low currency use compared to many other advanced countries. However, the fact that currency outstanding is comparable to the United States in so many other OECD countries, most of whose currencies are used only domestically, suggests that perhaps the size of currency holdings in the United States is similarly quite large; Rogoff (1998) speculates that the ratio of US currency held internationally may be closer to 50%. Of course, as interest rates have fallen to near zero in recent years, it is not surprising that the demand for currency in the domestic US economy appears to have risen; using similar techniques to her earlier work, Judson (2012) estimates around 50% of US dollars are held domestically postfinancial crisis. Even if foreign holdings of currency are important for a few countries (including also Hong Kong and Switzerland), this is not thought to be the case for most OECD countries. The Japanese yen does not appear to be a significant international currency.In any event, it is clear that the long-term trend domestic demand for currency in the legal economy is dwindling, due in part to advances in cashless payments.5 As already noted, the small number of central bank surveys that have been performed to measure domestic use of currency in the legal economy typically find very low percentages, on the order of 10–15% of total extant currency in the case of the United States (see also Feige 2012a, 2012b). Cash is used more intensively in some Eurozone countries. Fischer, Köhler, and Seitz (2004) use a wide range of methods to estimate the transactions demand for currency within the euro area to be 25–35% of total euro currency in circulation. This estimate is broadly in accord with European Central Bank surveys taken after the financial crisis (ECB 2011) that reported holdings and demand for euro in the legal domestic economy of roughly one-third of total euros outstanding. Of the remainder, Bartzsch, Rösl, and Seitz (2011) look at euro notes issued by the Bundesbank and find that between 40 and 55% are held outside of Eurozone countries. (It is quite possible that the overall level of euro notes held outside the Eurozone is lower, since Bundesbank-issued notes are particularly popular, even if in principle all the Eurozone central bank notes should be perfect substitutes.)Presumably, currency that is not held in the domestic legal economy or in the global economy (legal and underground) is mainly held in the domestic underground economy.6 The underground economy includes agents evading taxes, laws, and regulation. The size of the underground economy is not known within any precision, though estimates for the United States are on the order of 7–10% of GDP (e.g., IRS 2012, Feige 2012a, b). The IRS estimates that for the benchmark year 2006, the tax gap (tax not paid voluntarily) is over $450 billion, with a gap of $385 billion still remaining after tax collection efforts. Importantly, this estimate does not include the informal economy (US Treasury Inspector General 2013). In Europe, where taxes are higher and regulation is often more onerous, most estimates suggest that the size of the underground economy is considerably larger than in the United States (see Schneider, Buehn, and Montenegro 2010).Summing up, currency should be becoming technologically obsolete. However, in no small part due to its association with the underground economy, it is not.Arguments against Phasing out Paper CurrencyThe arguments for eliminating paper currency are impressive, but there are important points on the other side of the equation. The most straightforward is seigniorage. The United States’ money supply increased by an average of roughly $30 billion per year from 2002–2007, and averaged roughly $70 billion per year in the years immediately following the financial crisis. The magnitudes are similar in many other large advanced countries. If a phase-out of paper currency were simply met by an increased demand for electronic central bank reserves, there would, of course, be no significant loss. However, precisely because paper currency is anonymous, replacing it with nonanonymous electronic money would likely lead to a large shrinkage in demand, and treasuries would have to absorb the loss. Rogoff (1998) conjectures that this cost might be fully compensated if a modest fraction of the underground economy is induced to pay taxes and, of course, there are also potential gains from reduced law-enforcement costs. It is unclear how easily these activities could substitute into other transactions media, but presumably this could be made difficult by restricting other potential anonymous transactions vehicles.Of course, if the government simply replaced paper currency with electronic currency that it could somehow credibly make anonymous, there would not necessarily be any long-run shrinkage in demand. The government would continue to garner seigniorage revenues from the underground economy and the problem of the zero bound on nominal interest rates would be effectively eliminated. That said, it is far from clear that the government can credibly issue a fully anonymous electronic currency and even if it could, anonymous electronic fiat money has all the drawbacks of an anonymous paper currency in facilitating tax evasion and illegal activity.There is also a question of how forcing a more rapid shift to cashless payments would affect transactions costs. Retailers are typically forced to pay a pro-rata fee to companies such as MasterCard and Visa for credit card services, but handling paper currency also entails substantial costs to protect against theft and pilferage. Also, in principle, the federal government could allow individuals to maintain ATMs and debit cards at the Federal Reserve, and arguably these could be serviced by private subcontractors at lower cost than conventional bank services.Another important argument for maintaining the status quo is that eliminating a core symbol of the monetary regime could disrupt common social conventions for using money, possibly in unexpected ways. For example, it could lead to a precipitous decline in demand for debt and not just for fiat money. This need not happen. In his hugely influential book on monetary policy, Woodford (2003) shows that central bank stabilization policy can work perfectly well in the limit as money’s role in transactions goes to zero. As long as social price-setting convention remains, and as long as the central bank can manipulate banks’ reserves to set the price level, monetary stabilization policy can still operate with full force. However, one must be careful that just because a similar equilibrium can be obtained with or without a significant transactions role for money, it does not necessarily mean that private agents will focus on the same equilibrium as they would when there exists paper currency. Yes, the government can help coordinate expectations by insisting that taxes are paid in the electronic fiat currency and that all state contracts be denominated in this currency, but it is important to acknowledge that there is at least an outside risk that if the government is too abrupt in abandoning a century-old social convention, it will destabilize inflation expectations, introduce a risk premium into bond pricing, and generally induce unexpected macroeconomic instabilities.There is also a potential risk to central bank independence. Even if eliminating currency is at least revenue neutral for the government as a whole, the central bank is the one that will lose seigniorage revenue. The Treasury is the one that will correspondingly gain through higher tax revenues and lower law-enforcement costs. Under longstanding institutional relationships, the ability to self-finance has put central banks in a privileged position. Although governments typically maintain oversight of central bank budgets, the fact that the central bank nominally appears to be a “profit center” considerably strengthens its hand in maintaining operational independence. In recent years, quantitative easing has been a massive money maker, but this is not the normal state of affairs when currency provision is a key source of revenue.Another argument for maintaining paper currency is that it pays to have a diversity of technologies and not to become overly dependent on an electronic grid that may one day turn out to be very vulnerable. Paper currency diversifies the transactions system and hardens it against cyber attack, electromagnetic pulse (EMP) blasts, and so forth. This argument, however, seems increasingly less relevant because economies are so totally exposed to these problems anyway. With paper currency being so marginalized already in the legal economy in many countries, it is hard to see how it could be brought back quickly, particularly if ATM machines were compromised at the same time as other electronic systems.7A different type of argument against eliminating currency relates to civil liberties. In a world where society’s mores and customs evolve, it is important to tolerate experimentation at the fringes. This is potentially a very important argument, though the problem might be mitigated if controls are placed on the government’s use of information (as is done, say, with tax information), and the problem might also be ameliorated if small bills continue to but not if any country to reduce the use of its currency, there is a risk that another currency would be used within domestic Even if that risk is not for a country like the United States, there is still the of revenue from foreign of currency of may be in underground or illegal activities within their even if not within US any attempt to large-denomination currency would be taken in a that at the very least the global currency into use at the time of and has a role in the global of the last 100 Despite and advances in electronic transactions it has even if its seem to be in the world underground and illegal economy. With many central banks now near or at the zero interest rate bound, there are increasingly arguments for how it might be out of there are many arguments for not the status from the of seigniorage revenues to civil in from to may already in the of the paper currency anyway. Nevertheless, the role of paper currency large-denomination in facilitating tax evasion and illegal and the and perhaps problem of the zero bound on nominal interest it is to the costs and benefits to a more for phasing out the use of paper earlier of this paper the for a at the April NBER in The author is to Judson and as well as to NBER for and to and for research For of research and of the financial relationships, if see may use the and but central banks typically several of money, from a one that includes only currency and bank reserves at the central bank, to increasingly that for example, transactions deposits at financial institutions (e.g., time and holdings of at money Currency in the United States for roughly of the Federal monetary course, central banks can and reserves at interest rates as a tax on The problem is when the interest rates for turn (2009) as the to the idea of currency. also Buiter and at a wide range of OECD countries, and indeed the United States does not particularly stand out as having high per-capita GDP currency and (2014) use data from a large to that the cash share of in the United States will decline by per is possible that even those cash holdings that are for for by individuals simply not I this is not nearly as important as cash holdings used to avoid taxes or to in illegal is true that nearly all holding though individuals are following this there would still need to be a for currency after a that if only small bills remain in circulation, the central bank would still have the to lower interest rates to more negative levels than if large bills continue to since costs are much greater for any large some foreign use of dollar and euro currency is to the even if a significant share goes to facilitating illegal and underground some countries may it to their to see phasing out of dollar and euro paper currency. However, in an where inflation rates in most countries have fallen over the two currencies more the benefits of being able to use dollar and euro paper currency in the legal economy has presumably been and will continue to Rösl, and for in Economic in Dell’Ariccia, and Monetary in Willem Interest to the Paper in Willem and the on Interest with Negative Interest on Economic in Central of of and in of the of Currency is paper University of in of US Currency the Money and the and in Köhler, and for and Paper European Central in in as The Economic in Robert Monetary of Monetary in the to in into and out of the Paper at the Federal Reserve Economic Policy on of Monetary in Tax from Previous in and for US Currency at and from the of the to Paper Board of Governors of the Federal Reserve in for the to April in and Money as a of of in and of US Federal Reserve in and from from 100 Economic in and for or Economic Policy in of Paper and Development in Buehn, and for the all over the Economic in Inspector General for Tax to the and of the Tax in and and the of from Paper Federal Reserve Bank of in Interest and of a of Monetary University in Previous article by NBER

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. (2001), among others.ReferencesAuerbach, Alan J., and Maurice Obstfeld. 2004. “Monetary and Fiscal Remedies for Deflation.” American Economic Review 94, no. 2:71–75.First citation in articleGoogle ScholarBernanke, Ben S., Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen. 2001. Inflation Targeting: Lessons from the International Experience. Princeton, NJ: Princeton University Press.First citation in articleGoogle ScholarBernanke, Ben S., and Vincent R. Reinhart. 2004. “Conducting Monetary Policy at Very Low Short‐Term Interest Rates.” American Economic Review Papers and Proceedings 94, no. 2:85–90.First citation in articleGoogle ScholarBernanke, Ben S., Vincent R. Reinhart, and Brian P. Sack. 2004. “Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment.” Brookings Papers on Economic Activity, no. 2:1–100.First citation in articleGoogle ScholarObstfeld, Maurice. 1982. “The Capitalization of Income Streams and the Effects of Open Market Policy under Fixed Exchange Rates.” Journal of Monetary Economics 9, no. 1:87–98.First citation in articleGoogle ScholarReinhart, Carmen M., and Vincent R. Reinhart. 1999. “On the Use of Reserve Requirements in Dealing with Capital Flow Problems.” International Journal of Finance and Economics 4, no. 1:27–54.First citation in articleGoogle ScholarSims, Christopher A. 1980. “Macroeconomics and Reality.” Econometrica 48, no. 1:1–48.First citation in articleGoogle ScholarTobin, James. 1970. “A General Equilibrium Approach to Monetary Theory.” Journal of Money, Credit and Banking 2 (November): 461–72.First citation in articleGoogle Scholar Previous articleNext article DetailsFiguresReferencesCited by Volume 6, Number 12010 Article DOIhttps://doi.org/10.1086/648714 Views: 113 © 2010 by the National Bureau of Economic Research. All rights reserved.PDF download Crossref reports no articles citing this article.

The 1951 Accord between the Treasury and the Federal Reserve was one of the most dramatic events in U.S. financial history. The agreement liberated monetary policy from the commitment, dating from World War II, to support government bond prices. It reasserted the principle of Federal Reserve independence so that monetary policy might serve primarily as an instrument for macroeconomic stabilization. The Federal Reserve, however, executes both monetary and credit policies, and no Accord has yet been established for its credit policies. The reason is that, until recently, fiscal concerns have not threatened the misuse of Fed credit policies in the way that bond price supports did for monetary policy. Large federal budget deficits, a deposit insurance crisis, or significant foreign exchange market intervention could change that.1 Just as the 1951 Accord greatly improved monetary policy, an Accord for Fed credit policy established today, while fiscal concerns are still relatively small, could yield significant benefits in the future. 1. MONETARY VERSUS CREDIT POLICY Distinguishing between monetary and credit policy is straightforward.2 Monetary policy refers to changes in the stock of high-powered money, that is, currency plus bank reserves, accomplished by open market operations in domestic securities or foreign exchange. For example, a central bank takes a monetary policy action if it increases bank reserves by purchasing securities. Credit policy, on the other hand, changes a central bank's assets while holding the stock of high-powered money fixed. For example, a central bank takes a credit policy action when it uses funds obtained by selling Treasury securities to acquire other assets. Credit policies also include regulation and supervision of the banking system, but such aspects of policy will not be discussed here. 2. THE ACCORD PRINCIPLES FOR CREDIT POLICY The 1951 Accord established the principle that monetary policy should be used to stabilize the macroeconomy, regardless of the fiscal concerns of the Treasury. It restored the idea that a fully independent central bank contributes importantly to economic stability.3 Independence insulates the Fed from shortrun inflationary pressures to stimulate employment and help finance the Treasury. It also frees the Fed from having to get Congressional or Treasury approval for its policy actions, enabling the Fed to react quickly to short-run macroeconomic or liquidity shocks. Congress bestows such independence only because it is necessary for the central bank to do its job effectively. Hence, the presumption ought to be that the Fed should perform only those functions that must be carried out by an independent central bank. Monetary policy is both necessary and sufficient to pursue macroeconomic stabilization policy and to deter system-wide liquidity crises. Credit policy directs funds promptly to illiquid institutions when macroeconomic conditions do not call for a change in high-powered money. This suggests the following Accord principles for Fed credit policy: (1) liquidity assistance should not fund insolvent institutions; (2) credit policy should not fund expenditures that ought to get explicit Congressional authorization; (3) Congress should not direct the Fed to transfer assets to the Treasury in order to reduce the Federal deficit. Three Fed credit policies discussed below illustrate the above concerns. First, liquidity assistance potentially provides funds to insolvent institutions and raises the cost of deposit insurance. Second, Fed credit policy may inappropriately finance sterilized foreign exchange market intervention and some foreign expenditures of the Treasury. Third, the transfer of Fed surplus assets to the Treasury, as directed by Congress, potentially weakens Fed independence. In each case, an Accord for Fed credit policy would help implement the above principles. 3. LIQUIDITY ASSISTANCE As a rule, the Fed finances liquidity assistance to depository institutions with funds acquired by selling Treasury securities-leaving high-powered money unchanged. …

The fallacies of central bank independence

Previous articleNext article FreeCommentBennett T. McCallumBennett T. McCallumCarnegie Mellon University and NBER Search for more articles by this author Carnegie Mellon University and NBERPDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreI. IntroductionThis is an interesting and challenging paper, in which Atkeson and Kehoe put forth a very strong critique of current mainstream monetary policy analysis. Monetary economists have, of course, been rather pleased with the development of their subject over the past 10–15 years, current U.S. policy difficulties notwithstanding. Indeed, the tone of a prominent recent expository paper by my colleague, Marvin Goodfriend, is somewhat triumphal in spirit.1 The spirit of the Atkeson and Kehoe paper, by contrast, is conveyed by a recent publication of theirs, together with coauthor Fernando Alvarez, which bears the title “If Exchange Rates Are Random Walks, Then Almost Everything We Say about Monetary Policy Is Wrong” (Alvarez, Atkeson, and Kehoe 2007). That paper focuses on exchange rate failures, whereas the current one stresses the term structure of interest rates, but the line of argument is basically the same.The title of the 2007 paper leads me rather naturally to ask myself what it is that I would say in answer to the implied question, “What important things do monetary economists really know—or at least believe—about monetary policy?” My own answer to that question would go along the following lines: (i) We believe that if the monetary authority keeps monetary policy expansionary for a substantial length of time, the main effect will be to generate a higher inflation rate than would have prevailed otherwise, with little or no overall effect on aggregate production and employment. (ii) Nominal interest rates will be higher, also, with real rates being affected very little. (iii) If, however, the monetary authority changes policy unexpectedly and abruptly in an expansionary direction, there will most likely be an expansion in aggregate output and employment—but it will be only temporary. (iv) If these changes are in the direction of tighter policy, the signs of the above‐mentioned effects will be reversed. (v) In particular, the monetary authority has the power to generate a recession, in which output and then the inflation rate will fall. (vi) The precise nature of the mechanism that generates the real effects of monetary policy changes of this type is not very well understood. Then, if my questioner had not wandered away in boredom, I would want to add something like the following: (vii) The foregoing points refer to an expansionary or contractionary monetary policy stance—loose or tight—but how is this measured? Well, a sustained high growth rate of the stock of base money will (under most institutional arrangements) be expansionary, but matters are a little less clear‐cut when the central bank actually carries out its policy by manipulating overnight interest rates. Nevertheless, there are ways in which we can characterize tighter versus looser policy in terms of interest rate rules by reference to the implied target inflation rate, the strength of responses to deviations from target, and so forth.Now, I suspect that Atkeson and Kehoe probably do not disagree with most of these statements as to what monetary economists know (or believe), even on a substantive basis.2 But their title of the current paper, as distinct from the 2007 item, refers to a need for a new approach to monetary policy analysis. So let us turn to a consideration of what today’s mainstream approach is. As it happens there is a short statement of that type, in a paper of mine, that gives the following description. The approach is one in which “the researcher specifies a quantitative macroeconomic model that is intended to be structural (invariant to policy changes) and consistent with both theory and data. Then, by stochastic simulation or analytical means, he determines how crucial variables (such as inflation and the output gap) behave on average under various alternative policy rules. Usually, rational expectations (RE) is assumed in both stages. Evaluation of the different outcomes can be accomplished by means of an optimal control exercise, or by reference to an explicit loss function, or left to the judgment (i.e., loss function) of the implied policymaker” (McCallum 2001, 258). Here, too, I doubt that Atkeson and Kehoe have any major disagreement with this general approach. What they do disagree with, if I understand at all, is the model that is typically used in recent work and taken to be structural.3In a sense my last statement could be regarded as merely quibbling over their title. But the point seems to be one of some importance: if Atkeson and Kehoe can generate an optimizing model that incorporates reliable, quantitative estimates reflecting time‐varying “risk” (i.e., state‐dependent variances and covariances) and endogenously explains inflation and output fluctuations, then monetary economists would presumably be happy to incorporate such features in their models—and would not consider this to reflect any basically new approach. Be that as it may, in what follows I will briefly review their featured empirical regularities, discuss issues concerning their suggested modeling strategy, and provide a brief conclusion.1See “How the World Achieved Consensus on Monetary Policy” (Goodfriend 2007).2They would probably grumble, justifiably, about the vagueness of point vii.3McCallum (2001, 258) goes on to say: “There is also considerable agreement about the general, broad structure of the macroeconomic model to be used.” Atkeson and Kehoe clearly would not share in this agreement.II. Empirical RegularitiesAtkeson and Kehoe begin, in Section I, with “four key regularities regarding the dynamics of interest rates and risk that we use to guide our construction” of a model and its pricing kernel. The first two pertain to a principal components analysis of a collection of interest rates, specifically, a 3‐month T‐bill rate and zero‐coupon yields on U.S. Treasury securities with k‐year maturities for $$k=1,$$ 2, …, 13. Time series observations are monthly over 1946.12–2007.12. The first regularity is that “the first principal component accounts for over 90% of the variance of the short rate [i.e., the 3‐month rate].” The second regularity is that “the second principal component is very similar to the yield spread between the short rate and the long [i.e., 13‐year] rate.” Having demonstrated these facts—and also that the first component is correlated even more strongly with the long rate—the authors henceforth use just the short and long rates.More substantively (and more questionably), the third and fourth regularities pertain to expected excess returns in the context of term structure and international exchange rate contexts. Specifically, movements in yield spreads and exchange rate premia are “associated with movements in risk.” The way in which these regularities might be regarded by some readers as questionable is that, in many studies, “risk” is operationally the name that is given to differentials in expected returns that the analyst’s model is not able to explain.Later in the paper, in Section V.A, Atkeson and Kehoe plot short‐rate and long‐rate time series for the United States over an extended period from 1836 through 2007. In addition, they include analogous plots for the United Kingdom, France, Germany, and the Netherlands. In all of these, the fluctuations of the long rate represent “a much smaller fraction of overall fluctuations in the short rate than they are in the postwar period.” Thus, they state: “A central question in the analysis of monetary policy at the secular level then is, What institutional changes led to this pattern?” In the preliminary version of this comment, I responded to a more pointed and strongly emphasized version of this query by stating that, to me, it is no surprise that expectations of future interest rates became unanchored during the post–World War II period, because, to again quote myself,[the] collapse of the Bretton Woods system created, for the first time in history, a situation in which the world’s leading central banks were responsible for conducting monetary policy without an externally imposed monetary standard (often termed a “nominal anchor”). Previously, central banks had normally operated under the constraint of some metallic standard (e.g., a gold or silver standard), with wartime departures being understood to be temporary, i.e., of limited duration. Some readers might not think of the Bretton Woods system as one incorporating a metallic standard, but by design it certainly was, since the values of all other currencies were pegged to the U.S. dollar and the latter was pegged to gold at $35 per ounce. (McCallum 1999, 175–76)All in all, it seems that there is no difficulty in understanding why an altered monetary policy regime generated different expectations regarding inflation and therefore future short interest rates in the post–World War II era. The variability in long rates during the 1960s developed as market participants began to see that the United States was not going to be bound by its commitment to maintain the $35 per ounce price of gold. Then the variability jumps up around the time of the Bretton Woods collapse in 1971—see Atkeson and Kehoe’s figures 6A–6E—and continues to rise into the Volcker disinflation that was painful (with extremely high nominal interest rates) but that ultimately succeeded in restoring some semblance of a nominal anchor.What about the return to stability that may have occurred around 1990? That year is, of course, the year in which the first central bank (New Zealand) officially adopted a monetary policy regime of “inflation targeting” (IT). At that time, this was taken to mean a policy whose only objective was a low and stable inflation rate. Since then, the IT term has come to be applied to regimes that give more weight to output/employment stabilization, but most monetary economists understand it as continuing to emphasize, as the primary goal, inflation control. So again the timing is about right for the possible recovery of anchored expectations that the first empirical regularity is said to reflect.To this general line of argument, Atkeson and Kehoe object: “But this answer is, at best, superficial. In the prewar era, countries chose to be on the gold standard most of the time and chose to leave it when it suited their purposes. Thus, the relevant questions are, rather, What deeper forces led agents to have confidence that their governments would choose stable policy over the long term? And what forces led them to lose this confidence after World War II? Only if we can quantitatively account for this history can we give advice on how to avoid another great inflation.”In this regard it must be said that I consider an explanation of the evolution of beliefs regarding the monetary standard, held by citizens of the United States, Great Britain, Germany, and so forth, to be somewhat beyond the scope of monetary policy analysts. To think about this issue, one must recognize that historically “the gold standard” required not just that the monetary authority would stand ready to exchange gold and currency at a specified rate but also that this rate should be unchanged “forever.” That arrangement made it such that severe inflation would not occur—even the major historical gold discoveries did not generate sustained inflation on the order of 10% per year—but it did generate more cyclical instability of real variables than we have had in the postwar era. Could policy of that type win popular support in today’s environment in the United States? If not, which would be my answer, then we need an entire unified social science to provide an explanation at “a deeper level.” And such an explanation—which would need to emphasize enormous developments in the media, extensions of suffrage, evolution of religious beliefs, attitudes toward the role of government, and so on—would not be of much help to central bankers. Let us turn then to monetary policy analysis considered more narrowly.III. Basic AnalysisThe heart of Atkeson and Kehoe’s paper is a recommended response to the third and fourth of the regularities mentioned above, that is, that measured excess returns on multiperiod bonds fluctuate strongly with yield spreads for bonds of different maturities and for international exchange rates. These regularities are translated by Atkeson and Kehoe into an argument that the consumption Euler equation, some version of which (often termed an expectational IS equation) is one basic ingredient of current macro‐monetary models, performs very poorly empirically. This is, of course, true for the simplest versions, but that problem has been widely recognized by monetary economists. A nice overview of empirical weaknesses of so‐called New Keynesian models was provided some years ago in a working paper by Richard Dennis (2003), which is briefly and nontechnically summarized in Dennis (2004). (The weaknesses discussed there relate to the Calvo‐style price adjustment relation, as well as the consumption Euler equation.) Dennis distinguishes between the bare‐bones “canonical model” and a “hybrid” version that adds habit formation in consumption behavior to the basic consumption‐saving relationship and also adds a somewhat dubious dependence on lagged inflation to the basic Calvo price adjustment relation. He recognizes, following Estrella and Fuhrer (2002), that “the problem with the canonical model is that the behavior of output, consumption, prices, and interest rates suggested by the model are fundamentally at odds with observed data” (Dennis 2004, 1). The hybrid model performs better, in terms of matching quarterly data, but “there are a number of areas where the hybrid model’s responses differ importantly from” impulse responses of an identified vector autoregression (VAR; Dennis 2004, 3).The point here is that monetary economists are quite aware that current models, even with elaborations of the type utilized by Christiano, Eichenbaum, and Evans (2005) or Smets and Wouters (2007), have empirical weaknesses, and they have been active in trying to eliminate these problems by improved specification. One pertinent and recent example concerns the discouraging results reported by Canzoneri, Cumby, and Diba (2007), that is, that inclusion of habit formation in consumption behavior unrealistically increases the variability of interest rates.4 Subsequent results by Collard and Dellas (2007) indicate, however, that this deterioration obtains when the household utility function is taken to be additively separable in consumption and leisure. If instead consumption and leisure enter the function in a Cobb‐Douglas manner, then inclusion of habit results in an improved—not worsened—match of the model’s interest rate variability to that of the data.I might also remark that Atkeson and Kehoe’s way of considering the empirical failure of the Euler equation seems questionable. Specifically, they discuss the relationship in a manner that would be appropriate if the role of this equation were to explain movements in nominal interest rates of various maturities. In fact, however, the role of this equation in standard monetary policy models is to explain consumption in response to (real) interest rates and expected future consumption (and, in habit specifications, lagged consumption). No mention of the adequacy or inadequacy of the standard model’s properties with regard to consumption is provided.5Be that as it may, it is essential to consider the analytical heart of Atkeson and Kehoe's paper, which is their presentation of “a simple model of the pricing kernel that is consistent with these [observed] dynamics” pertaining to interest rates. For the one‐period nominal interest rate, it in their notation, the pricing kernel mt+1 is an unobservable random variable that is generated by a stochastic process such that the interest rate it can be determined by a relation of the form $$i_{t}=-\mathrm{log}\,E_{t}\mathrm{exp}\,( m_{t+1}) .$$ Assuming conditional lognormality, then, we have (1)it=−Emt+1−0.5Vartmt+1. Except for lognormality, the content of their model for it is then the specification of the stochastic process generating mt+1. They take it to be (2)−mt+1=δ+z1t+σ1ε1t+1=1−λ2/2z2t+z2t0.5λε2t+1+σ3ε3t+1, where $$\varepsilon _{1t},$$ $$\varepsilon _{2t},$$ and $$\varepsilon _{3t}$$ are independent, standard normal, white‐noise innovations and where (3)z1t+1=z1t+σ1ε1t+1. (4)z2t+1=1−φθ+φz2t+z2t0.5σ2ε2t+1. These processes are chosen with an eye to their implications for the term structure via the relation (5)1=Etexpmt+1+pt+1k−1, which characterizes an absence of arbitrage possibilities for k‐period bonds with prices, $$p^{k-1}_{t+1}$$. From these prices the analyst can calculate term structure measures.Finally, Atkeson and Kehoe calibrate the model by assuming that $$\lambda =\sqrt{2}$$, $$\varphi =0.99,$$ and $$\sigma _{2}=0\mathrm{.}\,017$$. This specification suffices, they report, to generate interest rates of different maturities such that the term structure features long and short rates that possess properties that have the general characteristics found in their exploration of monthly data for rates of various maturities in the U.S. data.How does this model compare in specification with the standard three‐equation framework used in recent years to model one‐period interest rates, consumption (and/or output), and inflation by Clarida, Gali, and Gertler (1999), McCallum (2001), Woodford (2003, 238–47), and dozens of other monetary economists? That framework, as is well known, consists of (i) a consumption Euler equation (aka expectational IS relation), (ii) a price adjustment relation (usually of the Calvo variety), and (iii) a monetary policy rule that specifies adjustments of the one‐period nominal policy rate it to its determinants, which include the steady state real interest rate, the central bank’s inflation target, departures of inflation from target, and departures of output from its natural (flexible price) rate. (The lagged rate it‐1 is often included as well to represent smoothing.) This framework implicitly adopts the expectations theory of the term structure, which is known to be inconsistent with the data. Notable examples of larger models that include more variables and equations but that have the same basic underlying logic are provided by Christiano et al. (2005) and Smets and Wouters (2007).One aspect of the comparison is that the Atkeson‐Kehoe model, since it pertains to an “endowment economy,” implicitly assumes that price level adjustments are complete within each period so that output is always equal to its (exogenous) natural rate, flexible price value. Only a degenerate version of the Calvo equation component of the standard model is therefore present. That removes one endogenous variable, output/consumption. For some purposes, a flexible price model can be useful for monetary policy principles, as in Woodford (2003, chap. 2). But Atkeson and Kehoe also treat inflation as exogenous. Thus, there is no possibility remaining for conducting monetary policy analysis, and it is not determined by central bank behavior. Those features are consistent with their expressed view that the central bank “simply responds to exogenous changes in real risk—specifically, to exogenous changes in the conditional variance of the real pricing kernel—with the aim of maintaining inflation close to a target level.” But this seems highly unsatisfactory. It is probably true that a substantial portion of the meeting‐to‐meeting variations in the federal funds rate in the United States represents adjustments that are responses to changes in real rates that are brought about by changes in tastes, technology, shocks from abroad, and even perhaps some random behavioral errors by private agents. In fact, this is implied by much of the analysis that represents today’s mainstream monetary policy analysis—see, for example, Woodford (2003, and But the modeling approach suggested by Atkeson and Kehoe that the its for a random that is it no in a no is provided that their model would do a of matching data on much less two variables as endogenous and by central bank by a policy rule for a variable, the model is not in for monetary et al. (2007) paper is by Atkeson and and Kehoe to believe that standard have Euler equations that include no term reflecting and Kehoe are to say that the Euler equation specification in many monetary models does not well empirically. In addition, their specification of stochastic processes for the and variables that yield a pricing kernel that term structure features that the data in important ways is and They in that models in which conditional variances of returns are variable provide an possibility for improved model specification. This is not of course, and does not of inflation and output as exogenous or to a model that leads to their highly about the nature of monetary policy in the United States (and, other and currency is a of the monetary policy that term structure that pricing with time‐varying risk premia in models along with endogenous price and monetary policy rules. Some leading examples are provided by and and et al. (2007), and These have beyond Atkeson and Kehoe in to models that the term structure regularities maintaining a framework for monetary policy analysis. the approach time‐varying conditional is not the only one of as the Collard and Dellas (2007) example In I by of the Atkeson and Kehoe critique of some features of today’s New Keynesian monetary policy models, but I their current to be in essential their of U.S. monetary policy to be and their critique of current monetary policy analysis to be a brief see Atkeson, and 2007. “If Exchange Rates Are Random Walks, Then Almost Everything We Say about Monetary Policy Is and in Cumby, and T. 2007. and of Monetary in Eichenbaum, and and the of a to Monetary of in Gali, and of Monetary A New Keynesian of in and 2007. and Monetary paper, of in Keynesian Empirical of in Keynesian and to the of in and of a of in and 2007. with of in and McCallum and the of of Monetary in 2007. “How the World Achieved Consensus on Monetary of in T. in Monetary Policy The of and of in of in Monetary Policy to and in 2007. and Monetary paper, of University of in and in and 2007. and in A in and of a of Monetary University in Previous articleNext article by NBER by the of on this by the of no articles this

Unconventional Monetary Policies and Central Bank Profits: Seigniorage as Fiscal Revenue in the Aftermath of the Global Financial Crisis

The full-scale financial crisis in 2008–2009 years caused serious challenges for governments and central banks responsible for general economic policies and especially monetary policy measures. The Federal Reserve System of USA (or Fed) turned out to be among the most successful players who reacted adequately to the crisis. That’s why the evolution of monetary policy approaches in the USA during the last decades is of great theoretical and practical interest. The grounds of monetary policy in the USA can be studied within the analysis of the federal funds market, where the interaction of demand for and supply of reserves determines the federal funds rate. Since 1989 Federal Reserve used federal funds rate targeting, keeping this rate lower than the discount rate. In those times the main monetary tools of Fed were represented by open market operations, required reserves changes and discount rate changes. In January 2003 the role of discount rate had changed substantially. Since then Federal Reserve has kept the discount rate higher than the target for federal funds rate and treats it as a tool for limiting federal funds rate fluctuations and means of liquidity providing. The next important change was dated by October 2008, when the Fed decided to pay interest on reserve balances held by banks. The rate on reserves became an efficient low bound for the federal funds rate. By this Federal Reserve to a great extent copied the channel/corridor system for its basic short-term interest rate used earlier in Canada and some other countries. Under such conditions, the role of reserve requirements declined as the central bank received alternative means for controlling federal funds rate fluctuations. Summarizing the dynamics of monetary tools application by Federal Reserve we can conclude that during the last 30 years the situation has changed dramatically. Only open market operations are still used as a primary tool of monetary policy in the USA, because of their full control by Fed, flexibility, and quickness in implementation. Changes in reserve requirements are no used more. The role of discount rate evolved and together with the newly created tool – the interest rate on reserves paid by Federal Reserve – it is used today to determine the bounds for federal funds rate fluctuations. From the other hand, discount lending enables the Fed to perform its role of lender of last resort efficiently. During the year 2008 as crisis exploded, Federal Reserve used all the potential for interest rate decrease and faced the so-called zero-lower-bound problem. As a result, some nonconventional monetary policy tools such as quantitative easing (massive asset purchase programs) and forward guidance (management of economic agents’ expectations using commitments to future monetary policy actions) were proposed. Such measures turned out to became efficient enough to stabilize the economy of the United States. Key words: monetary policy, Federal Reserve, federal funds market, federal funds rate, open market operations, discount rate, reserve requirements, the rate on reserves.

oday, it is widely acknowledged that thefundamental mission of monetary policy isto maintain the long-run stability of theprice level. Economists and policymakers generallyagree that persistent changes in the price level(inflation and deflation) are, in the long run, causedby growth of the money stock in excess of thegrowth of total output. It is thought, moreover, thatmonetary policy can best promote high employ-ment and maximum sustainable economic growthby maintaining reasonable stability of the pricelevel. The charter of the European Central Bank, aswell as legislation governing the behavior of centralbanks in several countries, specifies price stabilityas the sole objective for monetary policy. TheFederal Reserve, by contrast, is assigned multiplepolicy objectives—“maximum employment, stableprices, and moderate long-term interest rates”(Federal Reserve Reform Act of 1977). Nevertheless,in recent years U.S. monetary policy has been con-sistent with a gradual reduction in the rate of infla-tion to the point where many economists believethat price level stability, for practical purposes, hasbeen achieved.The consensus about the importance of pricelevel stability and the role of monetary policy is afairly recent development. The macroeconomicparadigm that emerged from the Great Depressionand dominated from the 1940s to about 1980 heldthat full employment should be the primary objec-tive of monetary and fiscal policy. Stabilizationpolicy was viewed as choosing from among a menuof unemployment and inflation rates along a stablePhillips curve. Many economists and policymakersviewed moderate inflation as an acceptable cost ofmaintaining full employment. During the 1950sthe Federal Reserve frequently was criticized forpaying “excessive” attention to inflation, to thedetriment of employment and output growth.Perhaps in part a response to such criticism, inthe early 1960s the Fed’s monetary policy generallybecame more expansionary. Inflation began to risein 1965 and continued to increase through the1970s. Unemployment fell at first, but during the1970s the average rate of unemployment was higherthan it had been during the preceding two decades.Moreover, inflation, unemployment, and real outputgrowth all became more variable as the average rateof inflation increased.Not surprisingly, the poor performance of themacroeconomy during the 1970s brought theFederal Reserve much criticism. Among profes sionaleconomists, once-dominant views about the roles ofmonetary and fiscal policy began to shift. Experiencedemonstrated the folly of those policies designedto exploit a tradeoff between unemployment andinflation and showed that expansionary monetarypolicy could not permanently lower the unemploy-ment rate or increase the growth rate of real output.By October 1979, when Federal Reserve officialsfinally resolved to bring inflation under control, thecosts of disinflating were substantially higher thanthey would have been earlier in the decade wheninflation was lower and less entrenched. This paper examines alternative views aboutmonetary policy within the Federal Reserve Systemfrom the mid-1960s to the mid-1970s. We highlightthe views of Darryl Francis, president of the FederalReserve Bank of St. Louis from 1966 to 1975. Incontrast to most of his Fed colleagues, Francis arguedthat monetary policy should concentrate on haltinginflation. He believed that the influence of monetarypolicy on the unemployment rate was unpre dictableand at best temporary. He was an early proponentof the view that the unemployment rate (and realoutput growth) tends toward a “natural” rate deter-mined by factors outside the control of monetarypolicymakers. Francis argued that the Fed shouldmaintain a steady growth rate of the money stockand blamed the Fed’s targeting of interest rates andmoney market conditions for producing destabilizingswings in money stock growth.