In normal times, the FED steers the economy through changes in the so-called federal funds rate. All else equal, if the FED wants to decrease the federal funds rate from i* to i’, for example, is has to buy a certain amount of bonds in so-called Open Market Operations (OMOs) until the new desired equilibrium is reached.
Another transmission mechanism of monetary policy involves wealth effects that arise through changes in various asset prices, such as stocks, housing, and exchange rates.
I will not discuss the various channels through which monetary policy operates in further detail this time. Suffice it to say that in normal times Central Banks effectively have the power to regulate and stabilize aggregate demand (nominal spending) in the economy.
The following graph, however, shows that monetary policy has been constrained in recent times by the ZLB (zero lower bound). This means that the FED can only decrease the nominal interest rate to 0 and conventional monetary policy is ineffective once it has so. One can clearly see from the graph that the federal funds rate has been at the ZLB ever since December 2008. This implies that the FED has been unable to use the interest rate as its policy tool for 5 consecutive years now.
Another tool of unconventional monetary policy has just been implemented fairly recently. In December 2012, the FED announced the so-called Evan’s rule:
The FED promised to keep the funds rate at 0 as long as unemployment is above 6.5% and inflation no more than 0.5% above it’s the FED’s long-term target of price stability (2%). Furthermore, the FED stated that these thresholds are consistent with their earlier guidance that interest rates are to remain low until mid 2015.
This policy of “forward guidance” is basically a tool employed by the FED to guide market expectations and to reduce uncertainty associated with future monetary policy. The FED basically pledges through forward guidance to keep interest rates at a very low level and markets know what to expect from monetary policy in the close future. This is important as one of the main channels through which monetary policy works is expectations, and more specifically, expectations about future policy
Very low interest rates since 2009, large increases in the monetary base (see below), massive QE programs, and other unconventional monetary policy tools have led to very heated debates about the danger of inflation since the beginning of the Great Recession. Some economists (mainly Austrians) and other popular voices seemed to believe that the FED’s action would result in massive inflation. These “inflation hawks” believed, and some of them still do, that inflation is lurking around every corner. More reasonable voices like Krugman, DeLong, and obviously Bernanke himself as well claimed that inflation would not occur. They knew that the U.S. economy suffered from a huge AD shock (aggregate demand) resulting in massive unemployment. Drawing lessons from the Japanese experience (Japan experienced in the early 90ies the burst of a huge real estate and stock market bubble followed by a period of deflation), Krugman predicted that the US would closely follow the Japanese experience and that deflation or at least very low inflation is what one should expect in the follow-up years of the financial crisis. And obviously he was right.
The second graph below clearly indicates that the U.S. economy experienced a period of deflation in late 2009 and that inflation has been very modest ever since. The facts are therefore in direct opposition to what inflationists predicted.
This is exactly where the writings of on of the founding fathers of monetarism, Milton Friedman, can weigh in. In 1968, Friedman wrote an article called “The role of monetary policy” in the American Economic Review where he mentioned the following:
As an empirical matter, low interest rates are a sign that monetary policy has been tight – in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy – in the sense that the quantity of money has grown rapidly.
…interest rates are such a misleading indicator of whether monetary policy is “tight” or “easy”. For that, it is far better to look at the rate of change of the quantity of money.
That is why Friedman was for a very long time a proponent of a stable money growth rule where the FED would increase the amount of money in circulation every year by 5%. He thought that such a rule would stabilize output, as he believed the velocity of money, the speed at which money is spent in a specific period of time, to be constant.
This assumption, however, turns out to be false. The velocity of money can fluctuate wildly at times. Indeed, the beginning of the Great Recessions has been characterized by one of the sharpest drops in money velocity V. This explains the sudden fall in nominal GDP (= PY = prices * real output) in 2009 since the drop in velocity was not offset by an increase in money M to keep nominal spending in the economy constant.
MV = PY (Equation of Exchange)
The second flaw in Friedman’s analysis is based on the belief that the Central Bank can always target some monetary aggregates. Indeed, Central Banks only tried to target monetary aggregates during a brief period in the 1980s, but soon abolished this practice because it turned out not to be useful. Furthermore, Krugman demonstrated in his Japan paper that the Central Bank looses control over broader monetary aggregates in a liquidity trap environment.
The Return of the Liquidty Trap, the fear of any Central Banker
As shown above, the U.S. and other advanced economies have operated in a world of zero nominal interest rates (the ZLB) in recent years. Such a situation, sometimes called liquidity trap, has not occurred since the Great Depression.
The world of the liquidity trap is a very strange world. It is the world of “Depression Economics” (a term coined by Krugman) where normal rules don’t apply anymore.
More specifically, a liquidity trap is the situation where any injection of base money into the economy has no effect whatsoever. That is because bonds and base are viewed by the private sector as perfect substitutes. Any OMO (Open Market Operation) carried out by the Central Bank thus only swaps one zero-yielding asset for the other, with no impact on economic activity or prices. In this situation, any injection of base money will just add to reserve holdings by banks or currency holdings by the public because in a zero-interest environment banks are indifferent between holding bonds and base, and consumers are indifferent between both of these and bank deposits.
One should note that this failure of the Central Bank to expand some broader monetary aggregates does surprisingly not rely on the health of the financial sector, but simply results from the condition of perfect substitutability mentioned above. Indeed, banks and other financial intermediaries can be perfectly healthy and the same phenomena would still occur in a zero interest rate environment (see Krugman on Japan, reference at the end).
Distress in the financial sector in the U.S. was basically limited to a relatively brief period, the financial crisis of 2007-2008. However, soon enough many banks reported healthy profits again despite a very slow recovery. The graph below shows that the broader money stock M2 rose along a very smooth path since 2008 even though the FED quadrupled the monetary base in the same period. These observations are thus very much in accordance with the theory stated above.
That is because the public (certainly correctly) expects that the Central Bank would reduce the amount of base money as soon as the economy recovers and inflation starts to accelerate. The public thus expects the current expansion of the base to be only temporary. It is easy to see that any expansion of base money, such as doubling the monetary base, would have no impact on prices and economic activity if it were completely reversed in the foreseeable future. Consequently, only permanent increases in the base would be effectual in rising prices.
The liquidity trap thus involves a credibility problem. The Central Bank cannot convince the public that its current actions (expansion of the base) will not be reversed as soon as inflation accelerates.
Theory and experience from the last couple of years thus suggest that Central Banks face an enormous challenge when constrained by the ZLB. There are, however, a variety of economic policies that can get the economy out of the liquidity trap. They consist mainly of government stimulus, unconventional monetary policies, and credibly raising inflation expectations to lower the real rate of interest. There is a great paper by Lars Svensson, a Swedish economist and one of the most famous monetary economists, that is called:
“Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others”
It is a very interesting read. His policy recommendations on how to escape the liquidity will maybe the subject of another blog.
Summing up the main points raised above:
It is indeed a fallacy that low interest rates correspond to easy money. Scott Sumner, one of the most popular market monetarists in the world, states frequently on his blog (http://www.themoneyillusion.com/) that money has actually been extremely tight since the beginning of the crisis. Indeed, low nominal GDP growth far below trend is actually an indicator of tight monetary policy. The liquidity trap environment, however, means that conventional monetary policy (OMOs) has no traction and is ineffective in stimulating economic activity. This, however, does not imply that monetary policy is completely out of power at the ZLB. Indeed, there are a variety of unconventional policies that could stimulate aggregate demand even in a zero nominal interest rate environment.
FED on Forward guidance:
Friedman on monetary policy (pdf):
Krugman on Japan (pdf):
Svensson on escaping the Liquidity Trap (pdf):