By Joseph E. Gagnon
Today, we’re fortunate to have Joe Gagnon, senior fellow at the Peterson Institute for International Economics, as a guest contributor.
With short-term risk-free interest rates essentially at zero in the major developed economies, conventional monetary policy is in a liquidity trap. As a number of commentators have observed, printing zero-interest-rate money to buy zero-interest-rate assets has no real economic effect because the assets are near-perfect substitutes for money. But does that mean that central banks have lost their power? Jim Hamilton asserts that central bank purchases of other assets, with positive yields, can always create inflation, though he is silent as to whether they can affect output. Building on Gauti Eggertsson and Michael Woodford, Scott Sumner argues that central banks can boost output and inflation despite zero interest rates by raising the public’s expectations of future inflation and thus lowering the real rate of interest. According to Sumner, purchases of a variety of assets are one way central banks can bolster these expectations.
Is there any evidence on the effect of central bank purchases of longer-term or riskier assets?
In recent months, central banks have purchased large quantities of longer-term assets. These purchases appear to have been effective at pushing down longer-term interest rates, which should stimulate economic activity. For example, the Federal Reserve (Fed) has purchased large quantities of longer-term agency-backed securities and Treasury bonds. The following table shows that Fed communications about such purchases had substantial effects on a range of long-term interest rates, including on assets that were not included in the purchase program, such as interest rate swaps and corporate bonds.
Since March 19, the Fed has not made any substantive changes to its planned purchases of longer-term assets. Over this period, the 10-year Treasury yield has risen about 75 basis points and the corporate yield has fallen about 200 basis points, reflecting a relaxation of the extreme financial strains and flight-to-quality that characterized the first few months of this year. Conventional fixed mortgage rates, a key target of the Fed’s policy easing, have changed little on balance since late March.
Paul Krugman has argued that potential gains and losses when long-term interest rates move make a policy of purchasing such bonds especially risky, and that fiscal stimulus is a safer bet.
However, central banks, including the Fed, have always held risky assets, including long-term bonds, foreign exchange reserves, loans to private banks, and even equities. In many cases, such assets comprise the bulk of the central bank’s portfolio.
A good definition of expansionary monetary policy is the printing of money to purchase financial assets. Expansionary fiscal policy is the selling of financial assets to purchase goods and services, to cut taxes, or to increase transfers. On these definitions, both monetary and fiscal policy can be effective when short-term interest rates are zero.
This post written by Joe Gagnon
He states & provides some evidence of the obvious.
If potential investors in businesses that supply goods and services to the U.S. customer ALL agree that the potential for return on investment is zero, we will have zero investmnet, regardless of what happens in the financial sector. Whether long term interest rates will stimulate investment depends upon conditions as viewed by potential investors. Said perceptions change with time. Looking only at the costs of capital is unsatisfactory.
We have alternative uses of money other than investment in productive enterprises. We can use money to gamble in the stock market or elsewhere. Gambling seems more popular today than investing in a new company.
“printing zero-interest-rate money to buy zero-interest-rate assets has no real economic effect”
That’s a bizarrely silly statement. The Fed was printing money to buy Treasuries and is continuing to print money to buy the debt of and mortgage-backed securities issued by public mortgage agencies. These assets were and are being created in coordination with the Fed’s creation of money to purchase them. In essence, the US government and the public mortgage agencies that it controls have been spending newly created money. Tracing the economic effects is basically a matter of tracing how thet money is spent and its chain of custody thereafter, which of course isn’t at all easy.
The best known effect is to push down the effective federal funds rate. By the way, this rate recently dropped to around 0.11%-0.12%, from the range of around 0.15%-0.22% that it had been in for almost a year. That drop was the result of the government recently increasing the rate at which it was spending newly created money as it redeemed the last $200 billion of “supplementary financing” bonds. With that and the Fed’s planned $300 billion purchases of Treasuries now done, there will be upward pressure on the effective federal funds rate in the weeks ahead, unless the Fed spends newly created money some other way. I suspect the Fed will continue buying Treasuries despite the end of its explicit purchase program, to keep the effective funds rate under 0.25%. I have a hard time understanding how anyone could argue that there is no economic difference between a situation where major banks must borrow from private sources at, say, 5%, and a situation where thay can borrow for 0.15% from a pool that is constantly having newly created money poured into it.
The next most obvious effects are all the things the government is spending the money on – at least 3/8 of the ARRA, and more than $1.4 billion worth of mortgages.
Then there is the devaluation of the pool of dollars that existed before the creation spree. This process is difficult to see because it works slowly and unevenly and alongside other processes. But it works as certainly as any law of physics.
And there are countless other effects, many much harder to trace. The most important of these that I see working is that much of this newly created money is going into short-term speculation on equities, commodities, and emerging markets assets.
Isn’t the QE program’s purchase of long term Treasuries and other bonds causing a distortion in market yields, causing investors to underestimate actual credit risks and interest rate risks?
My take is that the Treasuries’s intervention is effective if the US is entering a deflationary period and thus, reflationary policies to create asset inflation are necessary to keep US economy afloat.
Longer term (e.g. 2011 when several issues such higher taxes will need to be considered), this policy is not viable because excess money supply and rising debt levels that fails to create new jobs and real goods and services will lead to a sharp decline in the US$ and the stock market.
The other consequence of an unofficial policy to devalue the US$ is that it encourages the carry trade against the Dollar and in favour of foreign assets such as emergign stocks and commodities.
So is such a policy really good for the US, for the man-in-the street? It may be good for Wall Street as long as the liquidity bubble continues.
But the end game starts when bond investors start fretting about a dollar-induced imported inflation.
When Krugman writes “there’s a much stronger case for fiscal policy than in normal times, because we don’t know how well these unconventional measures will work” that suggests, to me, that his concern is that purchases of scruffy paper by the Fed may not help the economy very much. I don’t think it’s the Fed’s balance sheet that he’s worried about, but that’s how Joe Gagnon seems to be interpreting his remarks.
However I do think that Krugman could be a bit clearer about where he stands on all this. It’s one thing to say that unconventional policy may not be all that effective, it’s quite another to say that it shouldn’t be tried on a larger scale.
Bryce,
You say, “He states & provides some evidence of the obvious.” Really? What is so obvious?
There is one apple for sale for $.50. I give you 4 quarters and you pay $1.00 for an apple. Have I increased consumption? The government (and too many economists) thinks so.
Thanks for citing my work Joe. I should clarify that I don’t regard purchasing a variety of assets as being the key to making monetary policy effective in a liquidity trap, although it may help. Instead, I think the key is to set an explicit 5% growth NGDP target and engage in “level targeting” which means making up for any near term NGDP shortfall with a more aggressive policy later. I just read a paper by Mishkin (I believe delivered in Canada in 2005) where he made a strong argument that level targeting would be especially helpful in a liquidity trap. A policy of a 5% NGDP growth trajectory, level targeting, would have prevented the sharp break in NGDP in the second half of last year.
If the Fed stopped paying interest on reserves the risks of monetary stimulus would be tiny, as very little in actual open market purchases would be required to make a higher NGDP target effective (again assuming level targeting.)
Krugman’s argument that quantitative easing is risky is hard to take seriously. If we assume the Fed stopped paying interest on excess reserves, the amount of purchases needed would be tiny compared to the fiscal deficit. Even more importantly, an $800 billion dollar fiscal stimulus raises the national debt by $800 billion. Since bond prices follow something close to a random walk, an $800 billion dollar OMO that is temporary has an expected fiscal cost of roughly zero, and the risks either way are comparatively small.
Scott – I take it your plan to stop paying interest on reserves involves first making the current trillion or so of excess reserves somehow disappear. So can I have them?
Bernanke has written that when the Fed tightens it will raise the rate it pays on reserves. Stopping paying is pretty much inconceivable for the forseeable future, as the conversion of excess reserves into currency plus commercial bank money would be insanely overstimulative.
Nope, nope, nope, no risks at all to large-scale money creation or government spending almost twice revenues. You gotta believe.
There is no such thing as a liquidity preference curve (or trap), anyway. Keynes, Krugman, et al, are wrong. It is an absolute contradiction to Alfred Marshall: Money thus is truly a paradox – by wanting more, the public ends up with less, and by wanting less, it ends up with more.
I.e., Gagnon is as correct as an economists gets.
“central banks can boost output and inflation despite zero interest rates by raising the public’s expectations of future inflation and thus lowering the real rate of interest.”
Ok – but where is the evidence that expectations of future inflation have increased? There is a direct measure of inflation expectations from the spread between TIPS and non-indexed treasuries – which currently gives 10-year expected inflation of 2%.