The Future of Monetary Policy / Classic Doctrines Overturned
Everyone is hanging on will-she or won't-she raise rates by 25 basis points.
I think this focus misses the more interesting questions for current monetary policy. The last 10 years or so are a remarkable experience, a Michelson-Morley1 moment, which overturn long-held monetary policy doctrines. The plan to raise rates via interest on reserves in a large balance sheet completely changes the basic mechanism by which monetary policy is said to affect the economy.
Controlling inflation is the first main task of monetary policy. Inflation, in the blue line below, has been slowly and inexorably declining over the last two decades, from 3% in 1995 down to a bit under 2% now. Inflation declines just after recessions and rises again as the economy recovers.
Long term interest rates, in green, are a good measure of long-term inflation expectations. Long-term rates basically follow a linear downward trend, barely interrupted by economic events or short term interest rate movements. When Fed officials say "expectations are anchored" or "trending down" this is one of their main indicators. If you, like me, believe in low inflation, it's awfully hard to complain too loudly about the Fed!
Short-term interest rates, in red, fall reliably in recessions, stay at zero while output and employment remain low, and then rise as the economy recovers.
However, the short rate hit the "zero bound" in 2008 and has been stuck there ever since.
When rates hit zero, the Fed started buying assets and issuing bank reserves in return. In this action, the Fed is pretty much just acting as a huge money market fund that invests in Treasuries. You can see the big upward jump in the recession, and then the QE2 and QE3 episodes.
Reserves were a few tens of billions before 2007. Their expansion is thus really breathtaking.
These are our Michelson-Morley observations. We hit the zero bound and... nothing happened. We expanded money -- reserves -- from tens of billions to nearly 3 trillion and... nothing happened.
The traditional view of monetary policy, including both "Monetarists" and "Keynesians," (bad labels, but they'll have to do for now) agrees on some core doctrines:
- The economy is unstable. If the Fed pegs the interest rate at a fixed value, either expanding inflation or spiraling deflation will follow.
- Raising interest rates lowers inflation. Lowering interest rates raises inflation.
The top left pictures illustrate the instability proposition. Peg interest rates, and inflation or deflation will explode. On the bottom left, I graph how rising interest rates are thought to lower inflation, and answer why we don't see the unstable inflation or deflation of the top graph: Because, if inflation breaks out, the Fed really raises rates fast and bring it back down. Or vice versa as I have graphed it.
But if the Fed can't lower interest rates past zero, the unstable deflation breaks out.
It's like balancing an umbrella in the palm of your hand. If you hold your hand still, the umbrella tips over. If you want to move the umbrella to the left, move your hand to the right. But then move it fast to the left to keep it from tipping over. If your hand gets stuck, the umbrella will crash to the floor.
The last 10 years deeply challenge this view. Interest rates got stuck at zero. No spiral broke out. Inflation just calmly came down to join the interest rates. The economy is stable, as graphed in the top right.
That means that if the Fed raises interest rates and sticks them at a higher level, bottom right, inflation will eventually rise to meet it as well, as graphed in the bottom right.
Our experiment exactly overturns the classic doctrines:
- An interest rate peg, if credible and expected to last for a long time, and if people trust the government to pay its debts, is stable.
- In the long run, raising interest rates to a new peg must raise inflation (and vice versa).
Much new-Keynesian research has focused on the "indeterminacy" problem: The models don't pin down which of the red lines in the top right of my graph will emerge. But that's beside the point here. And most new-Keynesian research models away from the zero bound where the theories imagine the Fed deliberately reintroduces instability, in order to produce results that look like the older theories. That's why less attention has been paid to the remarkable fact that this modern theory overturns the classic peg results.
That theory accounts for the caveats in my statements of new doctrine. Expectations matter in these models, and the stability result only occurs if everyone knows the peg will be there for the foreseeable future. Also, the result only holds when people are not worried about the government's ability to pay its debts. Sorry, Russia, Argentina and Venezuela. A zero peg will not stop your inflations.
You'd think we know the answers to simple questions like these. But empirical work in economics is always dreadfully hard because we don't usually see simple experiments. Look again at the graph of interest rates and inflation,
Interest rates and inflation are already positively correlated until 2007. So where do we get the idea that lowering rates raises inflation, if the correlation goes the other way?
Well, other things aren't constant. In the conventional view, recessions come along and drive down inflation. The Fed lowers interest rates to head off even worse deflation. When inflation comes back up again, the Fed aggressively raises rates to stop it from getting out of control. That ends up looking just like inflation following interest rates.
The conventional view may even be right (and likely was, in the past) in the short run, as indicated by the question mark in the bottom right hand graph. If that's our world, we never see the long run, since the Fed is always using the short run effect to move inflation around.
That's why the zero bound is so dramatic. It's not so much the bound, as it is a unique period in which interest rates are pegged, and everyone knows they will remain pegged for a long time. Now we get to measure the long run effect at last. And lo and behold, it's stable!
Quantitative easing also gave us as clean an experiment as we could hope to see on the effects of money. The Fed raised reserves from the tens of billions to the thousands of billions and.. basically nothing happened.
Yes, there is an ongoing argument about whether QE might have lowered interest rates a few tenths of a percentage point, and whether it did so by actual portfolio effects or just by signaling that the Fed was going to keep interest rates low for a very long time. But that's not really relevant here. That argument is about whether the Fed affected bond markets by what it bought. The issue here is about the other side, whether expanding reserves are inflationary.
Again, before we saw it, reasonable people could disagree. We didn't really know what would happen when the interest rate hit zero, or equivalently, when bonds and money pay the same interest rate. We hadn't seen zero rates since the 1930s. (OK, Japan, but let's keep going.)
Monetarists (I don't like labels, but whoever thought the reserve expansion would lead to a lot of inflation) thought that "velocity is stable." Meaning, that there is a limit to how much money people want to hold, even when money pays the same interest rate as bonds. V will decline at zero rates, and M will rise without causing inflation. But at some pointV will stop declining, and more M through MV=PY will cause more P, inflation. The money demand curve hits the vertical axis and stops. With a doctrinal bullet point,
- Velocity is stable. Even at zero interest rates, past some point, additional money (reserves) must cause inflation.
Well, we got about the best experiment we'll ever see. The sheer size of the experiment is just overwhelming. MV = PY. M increases, not by 10%, not by 100%, but by 10,000% ($30 billion to $3000 billion). And inflation goes slightly down. V just took up all the slack. It turns out the equation is V = PY/M when money and bonds pay the same interest.
So once again we have a classic doctrine decisively overturned. In its place let me offer
- Reserves that pay market interest are not inflationary. Even in enormous quantities.
Another huge change lies ahead. When it finally is time to raise rates, The Fed will not sell off the balance sheet. Instead, the Fed will simply pay more interest on reserves, and trust that this interest rate spreads to the rest of the economy.
This change marks a fundamentally different mechanism for monetary policy. Recall the standard story for how monetary policy works: Banks are holding as few reserves as they can, because reserves don't pay interest. The Fed reduces the amount of reserves by a few billion dollars. Now banks don't have enough reserves. They try to borrow reserves from each other, raising the interest rate. But collectively they can't get more reserves, so they have to cut lending and deposits to get back in line with reserves. Less lending or deposits cools the economy and eventually inflation.
I say "story" because I don't think that's how in fact things used to work. But we can't even pretend that's how things will work now. The Fed will just pay more interest on reserves. Banks will have trillions more reserves than they need. Raising the rate on abundant excess reserves has no direct connection at all to lending or deposits.
We're going to have "tightening" (interest rate rise) without any actual "tightening" (reductions in money, reserves.) The only way that monetary policy can work at all is from interest rate effects. Higher interest rates might induce people to spend less today and save more, and this will reduce output and then (somehow) inflation.
So, that leaves us with big open questions. Can the Fed raise rates by just raising interest on reserves? Will the effects on the economy be the same if the Fed raises rates by raising interest on reserves as it was when the Fed raised rates by rationing reserves?
By analogy, money is like oil in cars. In the old days, if traffic on the freeway was too fast, the Fed would ration oil. Running on two quarts slowed the cars down. It also led to higher motor oil prices (interest rates) as drivers tried to buy oil from each other. But now each car has thousands of quarts of oil, and the Fed isn't going to try to throttle the cars with oil at all. The Fed is just going to manipulate the price of motor oil, and count that drivers will slow down because they find it more expensive to drive. That's great for efficiency and financial stability. Throttling cars with oil starvation is not good for the cars. But one may wonder if the effects of a motor oil price increase will be the same under the new mechanism.
Can the Fed raise rates?
This seems like a silly question, how can academics question such an obvious proposition. But it's not so obvious, and if you read between the lines the Fed is deeply worried about it. Will just raising interest on reserves be enough to raise all interest rates?
To give some sense of the issue, I made the following little picture of the financial system. (Yes this is almost a parody of economist charts. )
On the left, the Treasury issues debt. About $11 trillion is held directly by you, me (through private financial intermediaries including pension funds) and by foreigners including the Chinese central bank. About $4 trillion is held by the Fed, and about $2 trillion is held directly as assets by the banking system. Like any bank, the Fed just passes through assets to liabilities. Its liabilities are about $1 trillion of cash, and $3 trillion of reserves. (This is all very simplified of course.) Banks also hold about $6 trillion of commercial and real estate debt. And we hold stocks, bonds, mortgage backed securities, houses, businesses and so forth worth tens of trillions.
OK, now, the Fed wants all the interest rates in this picture to go up, by raising interest rates on reserves.
"Honey, low-wage people in this country don't get paid enough. Let's pay the nanny $50 per hour."
"Well, the nanny will be happy, but how is that going to help everyone else?"
"Don't you see? When our nanny gets $50 an hour, then the others will demand that much, and workers at Walmart and MacDonalds too, and next thing you know everyone will get $50 per hour more."
"Hmm. That's not one of your brightest ideas. But tell me please where are we going to get the extra $50 per hour?"
"That's the beauty of the whole thing. When all wages go up $50 per hour, we'll be earning $50 per hour more, and we just pass that on to the nanny!"
You can see why the Fed might be up at night worrying that it will work.
I think it should work, despite this funny story. Banks should compete for deposits, sending deposit rates up. Treasury holders should try to dump treasuries to hold deposits, until those rates rise. And so on. But "compete" and "banks" don't sit well in the same sentence these days, so you can see why the Fed might be a bit nervous about it.
How will raising rates affect inflation?
How will raising rates affect inflation? Again, there will be no reduction in reserves, no reserve requirement tightening, no scramble to borrow reserves from other banks. There will just be a carrot of higher rates. Will tightening without tightening, but just through rates, have the same effects?
Hence the question mark in my four-graph picture. Monetary policy with interest on reserves worked through a simple off-the-shelf new-Keynesian model. It finds that there isn't even a short run contractionary effect on inflation, and an increase, not a decrease, in output. I'll leave that for another day. For now, recognize that history and theory do not definitively answer the question posed by the question mark, because the mechanism is entirely different.
This is a pretty radical blog post. Most of the monetary economics used by our policymakers is wrong*. That would seem to forecast disaster. But I don't think it does.
Suppose I am right, and the Fed starts very slowly and gradually raising rates, as they promise to do. The result will be a slight increase in growth and after a delay, a slight increase in inflation. The Fed will feel reassured that it raised rates at the right time in advance of the growth and inflation, not recognizing that it caused the growth and inflation. Still, though I'd rather have zero inflation rather than 2% inflation, a period of slightly greater growth and a return to 2% inflation would not be a disaster.
Despite my view that standard doctrines are completely upended by recent experience, the Fed is following a path that works well under lots of different models of the economy, a wise robustness. If it listened to people with extreme views like mine, it would have put more credence in the hyperinflation or deflationary spiral camps, to our detriment.
If you want to worry, worry about shocks that might hit the economy or the government, not the results of the Fed's slow and deliberate interest rate increases in a background of steady if too-slow growth and low inflation. Worry about Grexit, Putin, sovereign default, some new credit crisis. If you want to worry about the Fed worry about reactions to such crises, or worry about regulation gone wild.
The last big lesson we learn from recent experience is
- Monetary policy is a lot less powerful than most people think it is.
(1) In case you don't know, this is the famous physics experiment that measured the speed of the earth through ether by measuring the difference in speed of light looking forward vs. sideways given the earth's motion. The experiment found the speed of light the same in all directions. It's a famous negative result -- nothing happened, the dog did not bark -- with momentous consequences, in this case the theory of relativity.
*Update: A friend wrote to upbraid me a bit:
"Not sure why you want to try so hard to label yourself radical. Much of what you said was conventional wisdom among the folks I talked to at the Fed. Perhaps you should try 'The best minds at the Fed and other radicals like me think....'"
I'm happy for any company!