What Would Be the Effect of Monetary Stimulus?

Suppose the ideas in my previous post were implemented.  What impact would they have on the financial markets, and the economy?

The place to start is not with the QE, which is the least important part of the proposal.  Instead, consider the impact of price level targeting.  This should raise the two-year expected inflation rate to about 2.7%, and raise the expected two year NGDP growth rate by even more.  The problem is to determine the demand for base money at that higher expected inflation rate.  This turns out to be very difficult, particularly if the IOR is reduced to zero.  During normal times the demand for base money is less than 10% above currency in circulation, not more than double the currency stock, as it is today.  The reason is simple, during normal times the interest rate on T-securities is high enough to make it very unattractive for banks to hold excess reserves, which normally earn no interest.

So the answer to the demand for base money question hinges partly on the demand for excess reserves, and that depends on nominal interest rates.  We normally think of monetary stimulus as reducing interest rates, and vice versa, but that is not always the case.  Indeed, I’d be surprised if two year T-note rates stayed as low as 0.5% if the Fed committed to 2.7% inflation over two years.  Is it possible they’d fall even lower?  Certainly.  But I think it unlikely.  Thus it is quite possible that the Fed would actually have to sharply reduce the monetary base after committing to higher inflation.  Because the policy has never been tried, we simply don’t know.

I suggested the Fed buy T-bills and short term T-notes partly because I see the price level target as the key policy and the QE as just a method of accommodating the demand for base money at the new price level target.  It doesn’t do any of the heavy lifting.  That’s why buying longer term bonds (as recommended by Andy Harless in the comment section) wouldn’t do much better in my view.  If the policy was not credible, and markets did not expect higher inflation, then the OMOs would be viewed as temporary, and prices wouldn’t rise regardless of what type of bond was purchased.  If they were viewed as credible, then the policy would be expected to persist until we escaped the liquidity trap at some future date.  But in that case it also wouldn’t matter which type of bond was purchased, as OMOs would be effective with any security once we had exited the liquidity trap.

I suppose the key difference is the way we visualize the transmission mechanism.  I see policy boosting expected future NGDP, then current asset prices, then current AD.  Keynesians see it reducing real interest rates, boosting investment, then boosting AD.  Another difference might be credibility.  Perhaps markets might be more impressed by the purchase of long term bonds, as Andy suggests, and thus more confident that the Fed would persevere with its plan to boost prices.

Because of all this uncertainty, I’m not opposed to Andy’s suggestion that the Fed purchase of longer term bonds.  I suppose my suggestion was motivated by the fact that Krugman once mentioned the risk of capital losses from QE.  This is actually a fascinating issue, which involves everything from rational expectations to insider trading.  In a basic ratex model, a fully announced program of inflation should not imply any expected capital losses for the Fed, even if it lowered long term rates in the short run and raised them in the long run.  Indeed, if this were not the case there would be lots of $100 bills lying on the sidewalk, for anyone who went short on government bonds right after the QE was announced.

On the other hand one can imagine a scenario where the Fed knows more about its determination to carry through with the policy than the markets do.  So short rates fall due to the liquidity effect, but long rates don’t rise due to the expected inflation effect.  In that case if the Fed bought L-T bonds they’d be insider trading against their own interest.  I seem to recall Nick Rowe discussing this point, and recommending they buy equities or something else that would do well if the economy recovered.

Thinking about these issues can be depressing, as it makes clear just how daunting the challenges ahead really are.  To get the sort of recovery we really need, the Fed would have to really surprise the markets, in some sense be smarter than the markets about the future direction of Fed policy.  In fact, the reverse is usually true.  My favorite example is December 2007, when a smaller than expected rate cut led to a plunge in stock prices, and a drop in bond yields (the opposite of what the Keynesian model predicts) as the markets correctly understood that the Fed had erred, and that as a result the economy would weaken so much that they’d have to reverse course quickly and cut rates very sharply.  And within weeks this happened, another 125 basis points in fed funds rate cuts.

That shows how sophisticated the bond markets are.  To get a robust recovery we need the Fed to be even smarter than those very smart bond markets, to do more than what is currently expected.  They have the advantage of insider information, but I’m just not sure that’s enough.

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