The zero rate bound in economics plays much the same role as black holes (or “singularities”) play in physics. It is the point where all the laws of macroeconomics break down. Quantitative easing doesn’t work, the central bank can’t ease policy by cutting rates, increased saving no long leads to more investment, wage cuts don’t boost employment, and the AD curve may slope upward.
I’ve never believed most of this Keynesian nonsense, but as I argued in the previous post, if other people believe it, especially other people who are central bankers, then it matters. But within months the zero rate bound will be a thing of the past, merely of interest to antiquarians. What will cause this momentous change? The Fed is about to drop the use of the fed funds rate as its short run target (sometimes called “instrument”) of policy. It will be replaced with the interest rate on excess reserves. Because that is an administered rate, it really will be an instrument of policy. And it can be either positive or negative.
Jan. 26 (Bloomberg) — Federal Reserve policy makers are considering adopting a new benchmark interest rate to replace the one they’ve used for the last two decades.
The central bank has been unable to control the federal funds rate since the September 2008 bankruptcy of Lehman Brothers Holdings Inc., when it began flooding financial markets with $1 trillion to prevent the economy from collapsing. Officials, who start a two-day meeting today, have said they may replace or supplement the fed funds rate with interest paid on excess bank reserves.
“One option you might want to consider is that our policy rate is the interest rate on excess reserves and we let the fed funds rate trade with some spread to that,” Richmond Fed President Jeffrey Lackertold reporters on Jan. 8 in Linthicum, Maryland.
The central bank needs to have an effective policy rate in place when it starts to raise interest rates from record lows to keep inflation in check, said Marvin Goodfriend, a former Fed economist. Policy makers are concerned that the Fed funds rate, at which banks borrow from each other in the overnight market, may fail to meet the new target, damaging their credibility and their ability to control inflation as the economy recovers.
The choice of a benchmark is the “front line of defense against inflation, and also it’s at the heart of the central bank being able to precisely and flexibly guide interest-rate policy in the recovery,” said Goodfriend, now a professor at Carnegie Mellon University in Pittsburgh.
The Federal Open Market Committee is likely to maintain its pledge to keep interest rates “exceptionally low” for an “extended period” in a statement at about 2:15 p.m. tomorrow, economists said. The Fed probably won’t raise interest rates from record lows until the November meeting, according to the median of 51 forecasts in a Bloomberg survey of economists this month.
Fed Chairman Ben S. Bernanke, in July Congressional testimony, called interest on reserves “perhaps the most important” tool for tightening credit.
OK, it doesn’t say it’s definite. But let’s face it; these sorts of highly coordinated “trial balloons” aren’t accidental, especially when Bernanke’s name is attached.
This is a huge policy shift. Since 1913 the Fed had mostly conducted monetary policy by changing the supply of the medium of account. (The exception was the 1936-37 RR increase.) In the US the medium of account is called the monetary base, and is composed of bank reserves and currency held by the public. It looks like (starting later this year) monetary policy will be implemented through changes in the demand for base money. The Fed will adjust the demand for base money by adjusting the rate that they pay on excess reserves. This fulfills one part of Robert Hall’s radical policy proposal of 1983. The other part is to have the interest rate adjust ex post in such a way as to keep the expected future price level stable.
I think the profession as a whole used to think that Hall’s many “optimal monetary regimes” were a bit silly. “How can there be more than one,” was a joke I once heard. Maybe it’s time to take another look at his innovative work on monetary economics.
Up until now “conventional” monetary policy has been defined as adjustments in the fed funds target rate. This rate cannot go below zero, otherwise banks would simply hold on to the reserves. And this explains why people like Paul Krugman often emphasized that conventional policy became ineffective at the zero bound:
I keep seeing economics articles and blog posts that insist that we’re NOT in a liquidity trap (and, of course, that yours truly is all wrong) because the situation doesn’t meet the author’s definition of such a trap. E.g., the interest rates at which businesses can borrow aren’t zero; or there are still things the Fed could do, like buying long-term bonds or corporate debt, or something.
Well, my definition of a liquidity trap is, purely and simply, a situation in which conventional monetary policy — open-market purchases of short-term government debt — has lost effectiveness. Period. End of story.
Now, if you prefer a different definition of a liquidity trap, OK; call our current situation a banana, instead. But changing the name does not change the essential fact — namely, conventional monetary policy has lost effectiveness.
Within a few months Krugman’s statement will become “inoperative,” as “conventional monetary policy” will be adjustments in the rate paid on reserves, which obviously can be negative. Krugman may reply that this doesn’t eliminate the problem of the liquidity trap. The public can still hoard currency. He’s fond of pointing to the fact that in the late 1990s large safes were the most popular consumer durable in Japan. But rates are near zero in America, and the main problem with hoarding is banks holding excess reserves, not the public holding currency. I won’t get into all the minutia of this issue; I discussed them in another post. The bottom line is that negative rates on reserves don’t completely eliminate the need for the central bank to manage expectations, but they make it easier to use their policy lever as a means of doing so. Alternatively, you might say that it doesn’t eliminate the liquidity trap, but it cuts it in half.
[Technically it cuts it in half from the monetarist perspective; from the Keynesian perspective it may have no impact, as short term rates stay near zero. But you know what I think of the Keynesian perspective.]
Part 2. Dr. Stranglelove and the Doomsday Machine
For some reason I often think of this line from Dr. Strangelove:
Dr. Strangelove: Of course, the whole point of a Doomsday Machine is lost, if you *keep* it a *secret*! Why didn’t you tell the world, EH?
Ambassador de Sadesky: It was to be announced at the Party Congress on Monday. As you know, the Premier loves surprises.
I guess the Fed also like surprises. But perhaps someone can explain this to me. Why would the Fed adopt a new policy ideally suited for overcoming the zero rate bound, at the very moment that they are about to embark on a policy of gradually raising interest rates? Isn’t the whole point of the interest on reserve program that it allows you to cut the policy rate below zero, and prevent banks from hoarding ERs? (Something that can’t be done with a conventional Fed funds target.)
And for you conspiracy buffs, how about this little nugget from the Bloomberg article I linked to at the top:
The new reliance on reserve interest could also increase the policy clout of Fed governors in Washington at the expense of the 12 regional Fed bank presidents, Reinhart said.
Congress gave only the Fed governors the authority to set the deposit rate. The presidents have historically favored higher rates and voiced more concern about inflation.
“The Federal Reserve Act puts a very high weight on comity,” said Reinhart, now a resident scholar at the American Enterprise Institute in Washington. Using interest on reserves for setting policy “can change the tenor of the discussions, and I don’t know how they get around it.”
If you’re wondering what this means, you might want to go an re-listen to the first 20 minutes of Michael Belongia’s interview with Russ Roberts on Econtalk.
HT: Daniel Carpenter