Well at least we are seeing progress. The highly visible market response to rumors of QE tapering has led many economists to begin wondering why QE has such a strong impact. Ditto for the powerful reaction to monetary stimulus in Japan. There’s a sort of “it works in practice but not in theory” meme circulating. I find this really frustrating, but I guess I should be happy that we no longer have to worry about the far more absurd notion that QE doesn’t work at all.
It’s long been known that temporary currency injections are not effective at the zero bound. Less well known is that fact that temporary currency injections are not very effective when not at the zero bound. And that has led to some confusion about the applicability of the “Quantity Theory of Money” to the zero bound situation. People might say “Yes, doubling the money supply will normally have a big impact on the price level, but not at the zero bound.” I’ve probably said similar things. But that’s actually slightly misleading; the real problem is the temporary nature of the injections, not the zero bound. Consider:
1. Interest rates are 7.8% on T-bills. The Fed suddenly doubles the monetary base, and simultaneously announces the money will be withdrawn from circulation two weeks later.
2. Tomorrow Janet Yellen announces that the monetary base will be doubled, IOR will be eliminated, and the Fed will maintain the enlarged base even after it exits the liquidity trap in a few years.
In case one the price level doesn’t change. In case two the price level doubles (or more if you include the QE already done.)
And yet in case one the action was done while rates were positive (although they’d immediately go to zero and stay there for two weeks.) In case two the action was done when rates were zero, but the impact depends crucially on the base being expected to stay enlarged after rates rise.
It’s clear from these two examples that the real issue is not zero rates; it’s the difference between temporary and permanent currency injections.
Miles Kimball has a new post on this topic, which cites Richard Serlin citing Brad DeLong citing Ben Bernanke:
Brad DeLong: Richard points to this from Brad DeLong as some of the best intuition for Wallace Neutrality that he had found up to that point:
Long ago, Bernanke (2000) argued that monetary policy retains enormous power to boost production, demand, and employment even at the zero nominal lower bound to interest rates:
The general argument that the monetary authorities can increase aggregate demand and prices, even if the nominal interest rate is zero, is as follows: Money, unlike other forms of government debt, pays zero interest and has infinite maturity. The monetary authorities can issue as much money as they like. Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero. This is an elementary argument, but, as we will see, it is quite corrosive of claims of monetary impotence…
His argument, however, seems subject to a powerful critique: The central bank expandeth the money stock, the central bank taketh away the money stock, blessed be the name of the central bank. In order for monetary policy to be effective at the zero nominal lower bound, expectations must be that the increases in the money stock via quantitative easing undertaken will not be unwound in the future after the economy exits from its liquidity trap. If expectations are that they will be unwound, then there is potentially money to be made by taking the other side of the transaction: sell bonds to the central bank now when their prices are high, hold onto the cash until the economy exits from the liquidity trap, and then buy the bonds back from the central bank in the future when it is trying to unwind its quantitative easing policies. A Modigliani Miller-like result applies.
This argument seems to impress a lot of people who are much smarter than me, but the sad truth is that it’s wrong. They only think it’s right because they aren’t paying close enough attention to the real world. To a casual observer it looks like there are central banks that are trying to inflate but failing, due to credibility problems. In fact, in all of world history no fiat money central bank has ever tried to inflate and failed. Elite economists glance at the WSJ or NYT, see something about the BOJ doing QE and having trouble getting out of deflation, and murmur to themselves; “someone really needs to model that.”
In the 1980s we had lots of popular “credibility” papers explaining why central banks had so much trouble controlling inflation. So the “credibility” explanation also seemed like a logical solution to the Japanese liquidity trap. There is just one problem. We now know those credibility papers are wrong. It’s not difficult for central banks control inflation. It’s easy. And it’s not difficult for central banks to create inflation either. Elite economists were simply not paying attention to the concrete steps for the Bank of Japan took to tighten monetary policy despite being far short of their (ostensible) policy goals. Or the concrete steps that the European Central Bank took in 2011 to tighten monetary policy. Or the concrete step the Fed would have taken last month if not for concern about the government shutdown.
People who follow central banks closely know that the slow pace of nominal GDP growth does not reflect policy impotence but rather policy hawkishness. Watch what they do, not what they say.
So QE works for very simple reasons. Permanent monetary injections are effective even at the zero bound. QE programs are a signal that central banks would prefer at least slightly faster nominal GDP growth. Slightly faster nominal GDP growth requires that at least a small portion of the currency injection be permanent. So by signaling a preference for slightly faster nominal GDP growth, central banks are implicitly signaling a preference to have at least a small portion of the QE program be permanent (for any given IOR rate). Markets believe the central banks (and why shouldn’t they?) And hence asset prices react to the QE program.
No new theory is needed. Permanent monetary injections are inflationary, and always have been. Contrary to elite opinion, central banks have no difficulty convincing markets that they wish to boost nominal GDP growth, when they actually do wish to boost nominal GDP growth. Rather the problem is internal. The problem is that people like Janet Yellen have difficulty convincing her colleagues within the central bank that faster nominal GDP growth is desirable.
I think these issues would be much easier to understand economists would look at monetary policy in the reverse direction. Stop thinking about QE as some sort of lever to move nominal GDP in the desired direction. Instead think about where you central banks want to end up, and how much base money the public demands when nominal GDP growth expectations are on target. This can be done most effectively by the thought experiment of a nominal GDP futures market. Have the central bank peg the price of nominal GDP futures at a level equal to the policy target, and the actual level of base money consistent with that equilibrium becomes endogenous. It might be either higher or lower than the demand for base money when the economy falls short of its nominal GDP target. In other words it’s not even obvious whether positive or negative QE is needed to hit the target. Start with the target and then work back to the size of the monetary base.
When policy is viewed in this framework all worries about “Wallace Neutrality” vanish into thin air. Instead the real problem is highlighted—if there is a real problem. That is, does the central bank need to buy “unconventional assets” in order to meet the demand for base money when expected nominal GDP growth is on target? In most cases the answer is no.
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