Thoughts on Ultra-Low Interest Rates

Philip Turner asks \”Is the long-term interest rate a policy victim, a policy variable or a policy lodestar? in a December 2011 working paper for the Bank of International Settlements.

Not all long ago, a number of papers tried to estimate the \”normal\” long-term real interest rate on safe assets. Estimates were typically in the range of 2-3%, which is a substantially higher than the barely-above zero percent rates of interest on safe borrowing, like 10-year U.S. bonds that pay an interest rate above the rate of  inflation.  Here\’s Turner: \”There has been much debate among economists about the “normal” long-term interest rate. Hicks (1958) found that the yield on consols over 200 years had, in normal peacetime, been in the 3 to 3½% range. After examining the yield on consols from 1750 to 2006, Mills and Wood (2009) noted the remarkable stability of the real long-term interest rate in the UK – at about 2.9%. (The only exception was between 1915 and 1964, when it was about one percent lower). Amato’s (2005) estimate was that the long-run natural interest rate in the US was around 3% over the period 1965 to 2001 and that it varied between about 2½% and 3½%.\” [For the record, a \”consol\” is a kind of perpetual bond issued by the British government: that is, it paid interest but had no date of maturity.]

Here\’s a figure showing the U.S. federal funds rate, as well as yields on 10-year inflation-linked Treasuries in the U.S. and the UK:

Turner sorts through the possibilities: Are these ultra-low interest rates a result of U.S. monetary policy? Are they a result of a \”savings glut\”–historically high rates of saving in the global economy, driven primary by the growing and high-saving economies of Asia, which drives down interest rate? Or are they the result of the ability of private financial markets to produce a huge supply of \”safe\” financial assets–although many of those assets then turned out not to be so safe.

My own sense is that although other explanations may have been more relevant a few years ago, longer-term interest rates now are low largely as a result of policy decisions, and that the \”quantitative easing\” policies in which central banks buy and hold government debt are a sign that such debt would not be sold at the same low interest rate without a policy intervention. However, as Turner rightly points out after a discussion of the relevant theory:  \”This paper argues great caution is needed in drawing policy implications based on the real long-term interest rate currently prevailing in markets. This interest rate has moved in a wide range over the past 20 years. At present, it is clearly well below longstanding historical norms. Several explanations come to mind. But not enough is known about how far the long-term rate has been contaminated by government and other policies. Nor is the persistence of such effects clear. And the various policies will have impacted different parts of the yield curve in ways that are hard to quantify.\”

But whatever the reason behind the ultra-low long-term interest rates, what possible risks do they raise? The obvious possibility is that low interest rates encourage borrowing and discourage saving. At present, the ultra-low interest rates are keeping debt payments low, despite the historically high underlying levels of debt. Turner touches on this point in several places:

\”From the mid-1950s to the early 1980s, this aggregate [debt of domestic US non-financial borrowers – governments, corporations and households] was remarkably stable – at about 130% of GDP. It was even described as the great constant of the US financial system. The subcomponents moved about quite a bit – for instance, with lower public sector debt being compensated by higher private debt. But the aggregate itself seemed very stable. During the 1980s, however, this stability ended. Aggregate debt rose to a new plateau of about 180% of GDP in the United States. At the time, this led to some consternation in policy circles about the burden of too much debt. It is now about 240% of GDP. Leverage thus measured – that is, as a ratio of debt to income – has increased. Very many observers worry about this. Whatever the worries, lower rates do make leveraged positions easier to finance. Once account has been taken of lower real interest rates, debt servicing costs currently are actually rather modest: Graph 3 illustrates this point.\”

Graph 3 shows nonfinancial debt in the U.S. economy as a share of GDP with the solid line, rising to aboug 240% of GDP as measured on the right-hand axis. It shows the falling real long-term Treasury yields as a measure of interest rates on the left-hand scale, with the thin dashed line. And it shows interest expenses as a share of GDP with the thick dashed line, measured on the left-hand axis. Notice that even thought debt is historically very high, interest payments are historically low.\”

In this setting, an ever-larger share of private assets are locked into very low real returns. Institutions that have liabilities far into the future, like insurance companies and pension funds, suffer greatly when interest rates are so low. It becomes much easier for the federal government to finance its huge budget deficits with such low interest rates. The pressure on households and firms to reduce their borrowing and to save more is greatly reduced, too.

This combination of high debt and low interest rates creates a potentially unstable situation. If or when interest rates rise again, the oversized debt burdens will be tougher to finance. All of those who are locked into long-term low interest rates–including large financial institutions and the Federal Reserve–would see the value of those investments fall if higher interest rates become available. Turner concludes:

\”The concluding note of caution is this: beware of the consequences of sudden movements in yields when long-term rates are very low. Accounting and regulatory changes may have made bond markets more cyclical. There is no evidence that bond yields have become less volatile in recent years. Indeed, data over the last decade or so mirror Mark Watson’s well-known finding that the variability of the long-term rate in the 1990s was actually greater than it had been in the 1965–78 period. A change of 48 basis points in one month …  would have a larger impact when yields are 2% than when they are 6%. With government debt/GDP ratios set to be very high for years, there is a significant risk of instability in bond markets. Greater volatility in long-term rates may create awkward dilemmas in the setting of short-term rates and decisions on central bank holdings of government bonds. Because interest rate positions of financial firms are leveraged, sharp movements could also threaten financial stability.\”

One sometimes hears the argument that as long as inflation isn\’t noticeably rearing its head, ultra-low interest rates should continue onward, for years if necessary. I quite agree that inflation isn\’t a threat just now, or in the near future. But historically ultra-low interest rates raise other dangers, too.

New Fed Nominee Jeremy Stein, Rethinking Monetary Policy

Jeremy Stein is always worth reading, but when President Obama nominated him in late December for a seat on the Federal Reserve Board of Governors, he became must-reading. In the latest issue of the
American Economic Journal: Macroeconomics (2012, 4(1), pp. 266–282), Stein and co-author Anil Kashyap discuss \”The Optimal Conduct of Monetary Policy with Interest on Reserves.\”  In particular, they are thinking about how it might be possible to use monetary policy for two purposes: both in its traditional role of keeping inflation low and stimulating the economy in recessions, and also in an untraditional role of reducing the chance of future financial crises. The article isn\’t freely available on-line, although many students and faculty will have access to it through library subscriptions or membership in the American Economic Association.

When teaching the basics of monetary policy a few years ago, the emphasis was on how the Fed used \”open market operations\”–that is, buying and selling government bonds to banks–to make interest rates rise or fall. When the Fed bought bonds from banks, then the banks had more cash to lend out, and interest rates would fall. When the Fed sold bonds to band, and received cash from the banks, then the banks had less cash to lend out, and interest rates would rise. Through these open market operations, the Fed reacted to risks of higher inflation or economic slowdown, adjusting the lendable funds available to banks to achieve its desired level of interest rates.

This basic exposition pointed out that in theory the Federal Reserve had other policy tools, like adjusting the level of reserves that banks were required to hold with the Fed, but because those tools received little use in recent decades, little attention was paid to them.

But when the financial crisis hit in fall 2008, the Fed got a new policy tool: it can pay interest on the reserves that banks are require to hold at the Fed. Kashyap and Stein explain: \”In October of 2008, the US Federal Reserve announced that it would begin to pay interest on depository institutions’ required and excess reserve balances, having just been authorized by Congress to do so. The Fed thereby joined a large number of other central banks that were already making use of interest on reserves (IOR) prior to the onset of the global financial crisis. Given the Fed’s current policy of keeping the federal funds rate near zero, IOR has not been a quantitatively important tool thus far. As of this writing, the rate being paid is only 25 basis points. However, IOR may turn out to be extremely useful going forward …\”

Thus, in the future, when the time comes for the Fed to raise interest rates, how should it do so? As Kashyap and Stein write: \”When the Fed seeks to tighten monetary policy, should it raise the rate paid on reserves, contract the quantity of reserves, or some combination of the two?\”

I had not known before reading this article that many central banks around the world have both tools available to them. Of course, because it’s a research journal of economics, Kashyap and Stein feel compelled to explain algebraic labels rather than using words: in particular, they discuss the level of interest on reserves,  which they label rIOR, and the “scarcity value of reserves,” which they label as keep ySVR and can be thought of as the interest rate that would result from the level of reserves created by the traditional system of open market operations. They write:
\”This question can be further motivated by observing the diversity of central bank practices before the financial crisis. At one extreme of the spectrum was the Federal  Reserve, which set rIOR to zero, so that any variation in the funds rate had to come from quantity-mediated changes in ySVR . At the other extreme was the Reserve Bank of New Zealand, which in July 2006 adopted a “floor system” in which reserves were made sufficiently plentiful as to drive ySVR to zero, meaning that the policy rate was equal to rIOR . And in between were a number of central banks (e.g., the ECB and the central banks of England, Canada, and Australia) which used variants of a  “corridor” or “symmetric channel” system. One approach to operating such a system is for the quantity of reserves to be adjusted so as to keep ySVR at a constant positive level (100 basis points being a common value), with rIOR then being used to make up the rest of the policy rate.\”

\”Note that these corridor systems share a key feature with the floor system used by New Zealand. In either case, all marginal variation in the policy rate comes from variation in rIOR , with no need for changes in quantity of reserves. In this sense, the pre-crisis US approach was fundamentally different from that in many other advanced economies.\”

Kashyap and Stein point out that with these two separate policy tools–that is, the new tool of interest paid on reserves and the old tool of managing the level of bank reserves–it becomes possible for a central bank to tackle two goals. \”We argue that, in general, it will be optimal for the central bank to take advantage of both tools at its disposal by varying both  rIOR [the level of interest paid by the Fed to banks on their reserves] and ySVR [the \”scarcity value\” of reserves], with the mix depending on conditions in the real economy and in financial markets. The two-tools argument begins with the premise that monetary policy may have an important financial stability role in addition to its familiar role in managing the inflation versus output tradeoff.\”

During the financial crisis, banks and other financial institutions found themselves in trouble because they had all ramped up their level of short-term debt–that is, debt which came due quite soon on a daily or monthly basis and was commonly being rolled over (and over and over) each time it came due. When the financial crisis hit, it became impossible to roll over all this short-term debt, and so many financial institutions suddenly found themselves without funding. Kashyap and Stein argue that financial institutions will often have a tendency to take on too much short-term debt from society\’s point of view, because individual financial institutions are looking only at their own finances and not taking into account the risk that if they all take on too much short-term debt, the risk of a system-wide financial crisis goes up. Thus, a way to reduce the risk of financial crisis is to put limits on bank holdings of such short-term debt.

One way to do this is to use a broad notion of \”reserve requirements.\” In theory, banks wouldn\’t just hold reserves based on the deposits from customers, but on any debt that they are depending on renewing in the short run. Kashyap and Stein explain: \”First, within the traditional banking sector, reserve requirements should in principle apply to any form of short-term debt that is capable of creating run-like dynamics, and hence
systemic fragility. This would include commercial paper, repo finance, brokered certificates of deposit, and so forth. …  Going further, given that essentially the same maturity-transformation activities take place in the shadow banking sector, it would also be desirable to regulate the shadow-banking sector in a symmetric fashion. This suggests imposing reserve requirements on the short-term debt issued by nonbank broker-dealer firms, as well as on other entities (special investment vehicles, conduits, and the like) that hold credit assets financed with shortterm instruments, such as asset-backed commercial paper and repo. Alternatively, to the extent that many of these short-term claims are ultimately held by stable value money market funds that effectively take checkable deposits, a reserve requirement could be applied to these funds.\”

Kashyap and Stein explain that central banks around the world have been using changes in the reserve requirement as a policy tool to limit bank holdings of short-term debt, and to assure that banks have a sufficient capital cushion. \”[A] number of central banks around the world use changes in reserve requirements as a key policy tool. For example, the Chinese central bank changed the level of reserve requirements six times in 2010, while moving their policy interest rate just once. … India offers another intriguing case study. Since November 2004, the Reserve Bank of India has operated a corridor system of monetary policy. In the aftermath of Lehman Brothers’ bankruptcy filing, the Reserve Bank cut reserve requirements from 9.0 percent to 5.0 percent in a series of four steps between October 2008 and January 2009….  Finally, Montoro and Moreno (2011) study the use of reserve requirements in three Latin American countries: Brazil, Colombia, and Peru. They note that central banks in these countries raised reserve requirements in the expansion phase of the most recent credit cycle, and then, like the Reserve Bank of India, cut them sharply
after the bankruptcy of Lehman Brothers. They also argue that the motivation for this approach was explicitly rooted in a financial stability objective …\”

However, Kashyap and Stein suggest that rather than varying reserve requirements to limit short-term debt of financial institutions, instead the same goal can be accomplished by using the quantity of reserves that the Fed encourages financial institutions to hold. They conclude: \”The introduction of interest on reserves gives the Federal Reserve a second monetary policy tool that, used properly, may prove helpful for financial stability purposes.By adjusting both IOR [interest paid to banks on their reserves] and the quantity of reserves in the system, the Fed cansimultaneously pursue price stability, as well as an optimal regime of regulating the
externalities created by short-term bank debt. Though to be clear, the latter would also require, in addition to the use of IOR, a significant expansion in the coverage of reserve requirements, as well as possibly an adjustment to their level.\”

Assuming that Stein makes it through the confirmation process and ends up on the Fed Board of Governors–which in a just world will happen more-or-less instantaneously–it will be interesting to see how these issues emerge. Will the Fed begin to focus on how to reduce the systemic risk of another financial crisis? Will it revive changes in reserve requirements as an active tool of monetary policy? Will the Fed\’s reserve requirement be expanded so that it is based not just on deposits but on all forms short-term borrowing, and for all financial institutions (not just banks)? Will it start to use interest paid on bank reserves as a way of moving interest rates, while controlling the quantity of bank reserves as a way of holding down on the amount of short-term debt in the financial sector? Will the central bank perhaps decide to pay different rates of interest on those bank reserve it requires from those bank reserves that are held in excess of the requirement?

Leave aside all the potential complexities here, many of which are discussed in the article, and which are certainly real enough. The most basic ways that we have thought about and taught monetary policy in the last few decades may be on the verge of change.

(Full disclosure: Jeremy Stein was a co-editor of my own Journal of Economic Perspectives from 2007-2009.)


How Alexander Del Mar (Who?) Scooped Milton Friedman

Milton Friedman famously proposed in the 1960s that rather than having a central bank pursue a discretionary monetary policy, and thus in a world of time lags and policy uncertainties end up contributing to economic booms and busts, it would be better if the central bank just managed the money supply to grow at a constant rate of 3% per year. Unknown to Friedman, Alexander Del Mar made this same proposal in 1886.

Which raises the question, \”Who the heck was Alexander Del Mar?\” George S. Tavlas gives an lively and readable overview in \”The Money Man\” in the November/December issue of the American Interest.

Those who have heard of Del Mar make some striking comments about him. According to Tavlas, James Tobin called him \”one of the most important U.S. monetary economists of the 19th century,\” while Robert Mundell called him “too hot to handle.” Among other professional accomplishments, Del mar was a co-founder in 1865 of the New York Social Science Review: Devoted to Political Economy and Statistics, often thought of as one of the first economics journals published in the United States. He was also the first director of the U.S. Bureau of Statistics in 1866–which later evolved into the U.S. Department of Commerce. 

But among students of monetary history, Del Mar is best-known for having challenged the prevailing view of his time that money needed to be something with intrinsic value, like gold or silver. Tavlas explains:

\”He [Del Mar]  referred to the example of the ancient states of Ionia, Byzantium, Sparta and Athens. As far back as the 10th century BCE, these states created huge discs of sheet iron or bronze that had no practical value but served as common measures of value against which all exchanges of goods could take place. In other words, Del Mar realized that money originated not to serve as a medium of payment in purchases (these discs were too heavy and bulky to be exchanged for goods), but to serve as a measure of value, or what economists call “a unit of account.” By establishing common units of account, early societies enabled the direct exchange of goods against goods to take place without the need for a physical object to be interposed as a medium of exchange. Del Mar saw that the existence of a unit of account is a necessary condition for the emergence of a full-fledged money economy …\”

\”The observations—first, that the function of money is to measure value rather than itself be value, and, second, that in advanced societies the state determines what is used as money—allowed Del Mar to develop a further insight. Since money measures value, if the state creates too much money, then it can cause an inflation of prices. In such a circumstance, the valuableness of money diminishes because its ability to perform its primary function degrades—that of measuring the value of one good against another. Money, he argued, is a measure like a yardstick.\”

Thinking of money as a unit of account for transactions and as a yardstick of value is standard fare in modern economics, but it was radical in Del Mar\’s time. However, these ideas are what led Del Mar to propose his rule that the government should guarantee that the supply of money would rise at 3% per year–which was Del Mar\’s estimate of the annual increase in the supply of goods and services each year. His proposal was well-timed, since in 1886 the U.S. economy was living through a period of ongoing deflation with periodic severe recessions. But his advice was ignored.

Why is Del Mar so little-known? Tavlas makes a case that part of the reason may be that Del Mar was Jewis, and overt anti-Semitism was common at the time among many economists and universities. Another reason is that, when it came to monetary theory, Del Mar was too far ahead of his time.

Can You Push on a String? Should You?

It has been a commonplace observation about monetary policy for decades that \”you can\’t push on a string.\” That is, while monetary policy can definitely slow down an economy during an inflationary period by using higher interest rates, it may no work as well to use low interest rates to stimulate an economy during a period of high unemployment. The problem is that although a central bank can make reserves available to banks, it cannot force banks to want to lend nor households and firms to want to borrow.

However, some would argue that we haven\’t yet pushed hard enough or long enough. As I will explain, I\’m dubious about this argument. But for an example, Charles L. Evans, President and Chief Executive Officer of the Federal Reserve Bank of Chicago, gave a talk on September 7 advocating a more aggressively expansionary monetary policy in \”The Fed\’s Dual Mandate Responsibilities and Challenges Facing U.S. Monetary Policy.\” Here is some of the flavor of his argument:

\”Suppose we faced a very different economic environment: Imagine that inflation was running at 5% against our inflation objective of 2%. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market. …

It is painfully obvious that the large quantities of unused resources in the U.S. are an enormous waste. And it’s not just the current loss—over substantial periods of time, the skills of long-term unemployed workers decline, their re-employment prospects for similar jobs fade, and these reductions in skills have a lasting effect on the future growth potential of the economy. …

One way to provide more [monetary] accommodation would be to make a simple conditional statement of policy accommodation relative to our dual mandate responsibilities. … This conditionality could be conveyed by stating that we would hold the federal funds rate at extraordinarily low levels until the unemployment rate falls substantially, say from its current level of 9.1% to 7.5% or even 7%, as long as medium-term inflation stayed below 3%. … [I]t would not be unreasonable to consider an even lower unemployment threshold that would be enough progress to justify the start of policy tightening. There are other policies that could give clearer communications of our policy conditionality with respect to observable data. For example, I have previously discussed how state-contingent, price-level targeting would work in this regard. Another possibility might be to target the level of nominal GDP, with the goal of bringing it back to the growth trend that existed before the recession.\”

As I read it, Evans\’s argument is based on two claims: 1) A truly aggressive monetary policy could bring down the unemployment rate; and 2) The costs of continued high unemployment are enormous, and the risk of significantly higher inflation is low, so uncertainty should be resolved in favor of a more aggressive monetary policy. I am dubious of both these claims. 

Will a more aggressive monetary policy reduce unemployment? 

Evans implies that the Federal Reserve hasn\’t really done all that much to fight unemployment: he says that if inflation were up, central bankers \”would be acting as if their hair were on fire,\” and says that similar urgency is needed in fighting unemployment.

It seems to me that the Fed has been acting as if its hair was on fire! If you had asked me, circa 1986 or 1996 or 2006, about how I would describe a Federal Reserve which dropped the federal funds rate to near-zero, held it there for three years (since late 2008), and promises to keep it there for another two years (as it did at its August meeting of the Open Market Committee), and at the same time creating money to buy a couple of trillion dollars worth of federal debt and mortgage-backed securities, I would called it an extraordinarily and unimaginably extreme monetary policy. I have supported that extreme reaction, given the extreme circumstances of the U.S. economy in late 2008 and into 2009. But to claim that the Fed hasn\’t been very aggressive in fighting unemployment is ridiculous.

Milton Friedman once famously said: \”Inflation is always and everywhere a monetary phenomenon.\” At this point, the argument in favor of a more aggressive monetary policy comes close to making the extraordinary claim: \”Unemployment is always and everywhere a monetary phenomenon.\” But is it always possible to fix unemployment with an appropriately strong dose of monetary policy? The answer seems obviously \”no.\” Unemployment is sometimes rooted in structural characteristics of an economy as it slowly adjusts to a severe negative shock.
Evans talks about whether the Fed should move to targeting the price level, or to targetting a level of nominal GDP. Whatever the theoretical arguments for such steps, the Fed\’s extreme easing has been unable to push up inflation substantially. The central bank certainly seems to have been pushing on a string. And we have the looming example of Japan, where the central bank has been running a near-zero target interest rate for almost 15 years at this point, without successfully stimulating a higher price level. The Fed has already promised to extend the near-zero federal funds interest rate for two years. I just don\’t believe that promising to keep it there indefinitely, until unemployment falls, is the magic key to stimulating economic recovery.

It doesn\’t seem pragmatic to say that highly expansionary Fed policies for about four years, since late 2007, haven\’t worked to reduce unemployment or to create a higher price level, so we must continue those same policies of near-zero interest rates indefinitely. In a previous blog post about a month ago, \”Can Bernanke Unwind the Fed\’s Policies?\” , I offered an overview of what the Fed has done and raised some of these issues.

Is there little risk to pursuing an even more aggressive monetary policy?

Sustained high unemployment is a terrible social illness. If it\’s true that an aggressive monetary policy might help, and at least would be unlikely to harm, then there would be a case for proceeding. But there is at least some chance that harm is being done. Here are three possible risks:

1)What if inflation remains bottled up for some time, but then arrives very quickly over a few months? Or what if the U.S. dollar begins to sink in value very rapidly? After all, we have no real experience with the kind of monetary policy we are conducting. A burst of high and sustained inflation would mean that all the banks and financial institutions which have been holding low-interest debt from the last few years would face huge losses on their portfolios. The Federal Reserve would face such losses on its holdings of debt, too.

2) When the Fed engages in quantitative easing, it is essentially using its power to create money as a way of financing federal government borrowing and mortgage-backed lending. In the middle of the financial crisis in late 2008 and early 2009, this step made sense to me. But if this policy is extended over a period of years, well after the actual financial crisis has ended, surely these trillion-dollar interventions have some possibility of creating lasting distortions in the housing market or in markets for government debt?

3) Perhaps most concerning, the aggressive monetary policy of near-zero interest rates may be locking the economy into slow growth. James Bullard is president and CEO of the Federal Reserve Bank of St. Louis, wrote about this about a year ago in an article called \”Seven Faces of `The Peril\’\”.

Bullard argues that there may be two stable equilibria with regard to monetary policy: One equilibrium involves an inflation rate around 2-3% and a nominal interest rate that is slightly higher. This was the situation in the U.S. economy for much of the 2000s, before the financial crisis. The other equilbrium involves an inflation rate of near-zero and nominal interest rates of near-zero. This has been the situation of Japan in the last 15 years or so, and arguably, it is the situation in which the U.S. now finds itself.

Bullard argues that in this situation, the central bank never raises the interest rate, because inflation is low, but it also can\’t lower the interest rate, because that rate is already near-zero. Thus, the interest rate stops being a tool of monetary policy, and instead is passive and useless. He writes of this situation: \”The policymaker is completely committed to interest rate adjustment as the main tool of monetary policy, even long after it ceases to make sense (long after policy becomes passive), creating a second steady state for the economy. Many of the responses described below attempt to remedy the situation by recommending a switch to some other policy when inflation is far below target. The regime switch required must be sharp and credible— policymakers have to commit to the new policy
and the private sector has to believe the policymakers.\”

Bullard\’s suggested policy response is to expand quantitative easing by having the Fed purchase additional Treasury securities, but also to get the interest rate back up. He writes:

\”The United States is closer to a Japanese-style outcome today than at any time in recent history. In part, this uncomfortably close circumstance is due to the interest rate policy now being pursued by the FOMC [Federal Open Market Committee]. That policy is to keep the current policy rate close to zero, but in addition to promise to maintain the near-zero interest rate policy for an “extended period.” But it is even more than that: The reaction to a negative shock in the current environment is to extend the extended period even further, delaying the day of normalization of the policy rate farther into the future.
Promising to remain at zero for a long time is a double-edged sword. … Under current policy in the United States, the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.\”

 I haven\’t figured out whether I believe the Bullard-style model. In the U.S., we don\’t have enough experience with a near-zero federal funds interest rate to be highly confident about what will happen. But it is at least possible that those who advocate extending near-zero interest rates are doing more to trap the U.S. economy in Japan-style stagnation than to stimulate a robust recovery.

Narayana Kocherlakota on Rigidities, Adjustments, and Monetary Oolicy

Narayana Kocherlakota writes on \”Labor Markets and Monetary Policy\” in the 2010 Annual Report of the Minneapolis Fed.

Monetary policy can address nominal rigidities, but should not seek to overcome standard economic adjustments

\”Suppose that the cost of energy rises suddenly. This increase influences the economy through rather standard demand-and-supply forces. With higher input costs, firms cut back on production and demand less labor, creating higher unemployment. The first lesson from the modern macroeconomic research is that trying to use monetary policy to eliminate this increase in unemployment, generated by the firms’ natural market response to changes in input costs, leads to rates of inflation that are too high relative to the Federal Reserve’s price stability mandate.
     But the modern macroeconomic research also emphasizes that this standard demand-and-supply story captures only part of the effects of the energy price shock. Implicitly, the standard story assumes that the fall in labor demand triggers an immediate fall in wages. This assumption is contradicted by considerable evidence that firms are often unwilling to cut wages by much in response to shocks. Since wages don’t fall sufficiently quickly in response to the change in energy prices, firms cut back even more on labor, and unemployment is even higher than would be implied by the standard demand-and-supply story.
     The second lesson from the modern macroeconomic research is that accommodative monetary policy can offset this additional increase in unemployment, caused by sluggish wage adjustment, without generating unduly high inflation. Intuitively, the additional increase in unemployment occurs only because of the downward pressure on wages, which eventually manifests itself as downward pressure on prices of goods. Accommodative monetary policy is able to offset this increase in unemployment and keep inflation from being too low.
     This story about the consequences of a change in energy prices is only an example, but its lessons apply much more generally. The impact of any macroeconomic shock can be divided into two components. One component is the effect of the natural demand and supply adjustments that would occur if prices and their expectations were to adjust continuously. Monetary policy cannot be used to offset this natural consequence of the shock without creating inflation that is either too high or too low. The other component is the consequence of what economists call nominal rigidities—the sluggish adjustment of prices (including wages, the price of labor) and price expectations. Monetary policy can be used to offset this latter component of the shock’s impact without creating undue pressures on inflation. The challenge for monetary policymakers is to figure out how to divide the observed movements in the unemployment rate into these two components.\”

Core inflation is more informative than labor market data in setting monetary policy

\”Is the unemployment rate high because of nominal rigidities, or is it high because of other factors? That is a central question that confronts monetary policymakers seeking to set the appropriate course of monetary policy. In this essay, I’ve argued that data on aggregate labor market variables like unemployment rates and vacancies are insufficient to reach a sharp answer. Other information, including survey responses and inflation data, suggests that nominal rigidities are having a substantial impact. This conclusion, combined with the low level of inflation itself, implies that it is appropriate for monetary policy to be highly accommodative—as indeed it was at the end of 2010.
     As always, monetary policy will need to evolve in response to ongoing shocks and new information. But I suspect that information about aggregate labor market quantities like unemployment will remain—at best—a noisy indicator about the appropriate stance of policy. Instead, I will be paying close attention to the behavior of core inflation. As the preceding analysis suggests, the changes in this variable appear to provide critical information about the empirical relevance of nominal rigidities, and therefore about the appropriate stance of monetary policy.\”

In the August meeting of the Open Market Committee, Kocherlakota was one of three dissenters against announcing a policy that near-zero interest rates would continue for the next two years. For my post agreeing with his dissent and laying out how I see the evolution of monetary policy in recent years, see \”Can Bernanke Unwind the Fed\’s Policies?\”

Can Bernanke Unwind the Fed\’s Policies?

The Federal Reserve has taken five main policy steps since the financial crisis started to become apparent in late 2007. I supported each of those five steps when they were taken, given the economic situation at the time. But the recession and financial crisis were largely over in June 2009, even if what followed has been an unpleasantly stagnant recovery. The Fed needs to be clear that as conditions warrant, it will be willing to unwind its earlier policies. Thus, when the Fed Open Market Committee announced last week on a 7-3 vote that it would extend its near-zero federal funds interest rates for the next two years, it seemed to me a misstep.  Narayana Kocherlakota, who moved from a position as professor of economics at the University of Minnesota to become President of the Minneapolis Federal Reserve, took the unusual step of explaining publicly why he dissented, and even recording a short video clip of his explanation, which is posted at the Minneapolis Fed website.

But I\’m getting ahead of the story. Here are the Fed\’s five main policy steps since 2007.

1) From May 2006 through September 2007, the federal funds interest rate was about 5%. As the financial crisis began to become apparent in fall 2007 and as the recession started in December 2007, the Fed cut the federal funds rate to 2% by April 2008, where it remained until September 2008. This change can be thought of as the standard Fed reaction to a recession. As Rick Mishkin, who was a member of the Fed Board of Governors at the time, notes an article in the Winter 2011 issue of my own Journal of Economic Perspectives, even in late summer 2008 mainstream forecasters like the Congressional Budget Office were predicting only a short, shallow recession. Rick wrote: \” In summer of 2008, when I was serving on the Federal Reserve Board of Governors, there was even talk that the Fed might need to raise interest rates to keep inflation under control.\”

2) When the financial crisis hit with hurricane force in September 2008, the Fed then took the federal funds target rate down to near-zero. As noted earlier, at its August 9 meeting last week, the Open Market Committee voted to keep this interest rate target for two more years, at which time the policy of a near-zero federal funds rate would have lasted about five years. 

3) Starting in late 2007, the Fed created a veritable alphabet soup of lending agencies to provide short-term credit lines to banks, other financial institutions, and players in key credit markets. These include: the Term Auction Facility (TAF); the Term Securities Lending Facility (TSLF); the Primary Dealer Credit Facility (PDCF); the Asset-Backed Commercial Paper Money; the Market Mutual Fund Liquidity Facility (AMLF);
the Commercial Paper Funding Facility (CPFF); the Money Market Investor Funding Facility (MMIFF); the and Term Asset-Backed Securities Loan Facility (TALF). For a readable overview of these efforts aimed at teachers of economics,  this is a good starting point. From my point of view, the key fact about all these agencies is that they have all been closed down. Thus, I consider them a success. They helped to assure that short-term credit was available during a financial crisis, and then they went away.

4) The Fed started buying mortgage-backed securities early in 2009. At this time, in the depths of the financial crisis, the high level of uncertainty over what these securities were truly worth was in danger of making the market for these securities illiquid, which in turn could have made the financial crisis even worse. As the New York Fed explains: \”The FOMC directed the Desk to purchase $1.25 trillion of agency MBS [mortgage-backed securities]. Actual purchases by the program effectively reached this target. The purchase activity began on January 5, 2009 and continued through March 31, 2010. … On August 10, 2010, the FOMC directed the Desk to keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency MBS in longer-term Treasury securities. As a result, agency MBS holdings will decline over time.\”

5) The Fed started buying and holding new Treasury debt. The Fed has always held some Treasury debt as part of its normal operations, and in particular as part of carrying out its open market operations and buying and selling bonds. But that amount swelled from about $480 billion back in summer 2008 to about $1.6 trillion now. The Federal Reserve now holds more in U.S. Treasury debt than the China and Japan combined. While the plan to purchase more Treasury debt known as QE2 (that is, \”quantitative easing part 2\”) officially stopped at the end of June, as noted a moment ago, the Fed is now moving from holding mortgage-backed securities to holding Treasury debt, in such a way that its overall holdings of financial securities does not decline.  

Overall, here\’s where the Fed stands in unwinding the crisis-driven policies enacted since 2007. The many short-term lending facilities have been phased out. The ownership of mortgage-backed securities is being phased down. What is not yet being phased down are the ultra-low interest rates and buying Treasury securities. I\’m not brash enough to say just when these policies should be reversed, but I do know this: A central bank can\’t just keep pumping out money and credit until  unemployment is back to normal levels and hearty growth has resumed. At that point, the central bank has overreacted, potentially by a lot. When the Fed decides that it is time to change these policies, the U.S. probably won\’t be at full employment and resurgent growth–and so its decision is certain to be controversial.

Here\’s a graph showing the effective federal funds interest rate since the 1950s, using the ever-helpful FRED website at the St. Louis Fed. Notice that when recessions (the shaded bars) occur, the Fed typically cuts this interest rate, but then when recovery has begun, it raises the rate again. But now the federal funds rate has been at a rock-bottom near zero for more than two years, and in its August 9 meeting, the Federal Open Market Committee voted to leave the rate near-zero until summer 2013. Kocherlakota of the Minneapolis Fed explained his dissent from the policy this way: \”I believe that in November [2010], the Committee judiciously chose a level of accommodation that was well calibrated for the prevailing economic conditions. Since November, inflation has risen and unemployment has fallen. I do not believe that providing more accommodation—easing monetary policy—is the appropriate response to these changes in the economy.\”

From an outsider\’s point of view, it sure looks as if the Federal Reserve action at its August 9 meeting was a response to headlines from the week before: headlines about the difficulties in hashing out an agreement to raise the federal borrowing ceiling, headlines about Standard & Poor\’s downgrading the credit rating of the federal government, headlines about the stock market falling.  But monetary policy decisions setting expectations for the next couple of years shouldn\’t be responding to yesterday\’s headlines.

As one looks at the federal funds interest rate over time, other troubling issues become apparent. One is that the federal funds interest rate has been gradually moving downward, a step at a time, since it was raised sky-high to stop the inflation of the 1970s. With the federal funds rate at near-zero, this process of stepping interest rates lower and lower has now stopped. Another concern is that the Bank of Japan has run a near-zero interest rate for more than a decade, while failing to stimulate its economy. There is a possible theoretical argument–far from proven, but still a concern–that an economy can get stuck in a situation with near-zero interest rates and stagnant growth. In this kind of model, explained for example by James Bullard of the St. Louis Fed, \”Seven Faces of `The Peril\’\”,  a central bank can\’t wait for a full recovery before raising interest rates, because the hyper-low near-zero interest rates are part of what\’s blocking the economy from resuming growth.

I wouldn\’t advocate a sharp or immediate rise in the federal funds interest rate. But I would have voted with Kocherlakota against committing to two more years of near-zero rates. After all, part of what encouraged so much overborrowing in the years leading up to the financial crisis was that the Fed kept interest rates so low for a couple of years after the end of the 2001 recession. The answer to a financial crisis rooted in overborrowing is not to encourage the next wave of overborrowing! The Fed should be thinking about when and how it could get the federal funds target rate up into the 1-2% range–which after all seemed a reasonable interest rate when the economy was in an actual recession back in 2008.

The Federal Reserve buying Treasury bonds is another tough issue. Officially, the Fed\’s QE2 program of purchasing Treasury securities finished at the end of June, although as noted earlier, the Fed is still using money freed up by winding down its mortgage-backed securities to buy Treasury bonds. Back during World War II, which was fought largely with borrowed money, the mission of the Fed was to keep interest rates low so that federal borrowing costs could stay low. But in 1951, the Fed announced that it was done with that mission, and would instead focus on growth and low inflation. After a battle of bureaucracies, the Fed won its independence. (For an overview and discussion of what happened in the 1951 agreement, one useful starting point is this issue from the Richmond Fed in 2001.)

Having the Fed buy Treasury debt starting in 2009 during the worst of the financial crisis and its aftermath was a fully defensible decision. I sometimes say that it\’s generally a bad idea to shoot torrents of water at high speed through an office building–but if there\’s a fire, it\’s a policy that can make sense. During an emergency, steps that wouldn\’t make sense at other times sometimes need to be taken. But the recession has now been over for a couple of years. If the U.S. government wishes to run continuing large deficits, it needs to start facing the economic consequences of doing so. The Fed is already helping the federal government to borrow this money by holding interest rates so low, and in time will probably help the federal government further by creating some inflation to reduce the real value of what has been borrowed. It\’s time for the Fed to back away from being the actual default buyer for new federal debt. This step doesn\’t require any big announcement, only that the Fed refrain for now from announcing a QE3 program for buying more Treasury debt. If another financial crisis surfaces, after all, the Fed should try to hold something in reserve.