Did the monetary policy environment change in 2011?

Lots of people have pointed me to an article on the zero bound by Eric Swanson:

According to traditional macroeconomic thinking, once monetary policy hits the zero lower bound, there is nothing more the Committee can do to stimulate the economy – monetary policy is essentially ‘stuck at zero’. A corollary of this observation is that fiscal policy becomes more powerful than in normal times because any stimulus from fiscal policy on output or inflation will not be partially offset by monetary policymakers raising interest rates to keep inflation in check. In other words, monetary policy will not act to ‘crowd out’ fiscal policy because interest rates will remain stuck at zero as long as the economy is weak (see, e.g., Mankiw 2013, Chap. 12).

The role of monetary expectations

More recent research, however, has emphasised how monetary policy expectations can alter this reasoning. Reifschneider and Williams (2000) and Eggertsson and Woodford (2003) show that, if the Federal Committee can credibly commit to future values of the federal funds rate, then it has the power to largely work around the zero lower bound constraint. As these authors point out, the economy depends not just on the current level of the federal funds rate (a one-day interest rate), but rather on the entire path of the expected future federal funds rate over the next several years. Put differently, businesses and households typically look at interest rates with maturities out to several years when making investment and financing decisions. Even if the current federal funds rate is stuck at zero, the Committee could continue to push longer-term interest rates lower by promising to keep the federal funds rate low for an extended period of time. In this way, the Committee could continue to stimulate the economy even when the current federal funds rate is constrained by the zero lower bound.

This line of reasoning suggests that monetary policy has probably not been as constrained by the zero lower bound as the traditional way of thinking would imply.  Figure 1 plots the federal funds rate along with the one-, two-, five-, and ten-year Treasury yields. Although the funds rate (solid black line) is essentially zero from December 2008 onward, even the one-year Treasury yield averages close to 0.5% throughout 2009 and 2010, and fluctuates noticeably as the outlook for the economy and monetary policy rose and fell over this period. The two-year Treasury yield is even higher and more volatile. Thus, Figure 1 suggests that monetary policy might not have been very constrained by the zero lower bound until at least mid-2011.

I certainly agree with the primary claim of this article–monetary policy was not very constrained by the zero bound in 2009-10.  But it’s disappointing to see someone call the wacky liquidity trap view “traditional macroeconomic thinking.” Perhaps it could be called traditional old Keynesian thinking, but it was certainly a discredited model by the 1980s, if not earlier.

I’m also a bit uncomfortable with focusing on mid-2011, when 1 and 2-year T-bond yields fell close to zero.  There is nothing special about that date, because there is nothing special about 1 and 2 year T-bonds.  Three-month yields were close to zero throughout 2009 and 2010, and 5-year yields have been well above zero since 2011.  Nothing of importance changed in 2011.  The Fed always has the ability to adopt monetary stimulus if it chooses to do so, as interest rates are not an important part of the monetary policy transmission mechanism.  Of course the Fed ended QE1 and QE2 and QE3 because each time they (wrongly) thought the economy didn’t need any more stimulus.

The paper uses a rather indirect method of trying to ascertain whether monetary policy is constrained.  Swanson looks at whether longer-term bond yields are impacted by economic news. But why not look at whether longer-term bond yields are impacted by monetary news?  And why pick a highly ambiguous indicator like interest rates? Why not look at whether forex prices and stock prices and TIPS spreads are impacted by monetary news?

Nonetheless, I’m pleased that a distinguished economist like Eric Swanson has concluded that monetary policy was much less constrained than many pundits assumed.  At the end of the article, Swanson notes that this implies that crowding out continued to apply after 2008, thus weakening the impact of the ARRA stimulus program.  But crowding out assumes a constant money supply, which is obviously unrealistic.  In fact, “crowding out” depends almost entirely on the degree of monetary offset. I’d like to see the profession stop talking about the crowding out of aggregate demand and move on to the real issue; how do central banks respond to fiscal initiatives?


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17 Responses to “Did the monetary policy environment change in 2011?”

  1. Gravatar of Kenneth Duda Kenneth Duda
    9. November 2014 at 07:08

    This is so frustrating at so many levels.

    “once monetary policy hits the zero lower bound, there is nothing more the Committee can do to stimulate the economy”

    That’s only true if you’re targeting the federal funds rate. But what a silly thing to target (who cares what the fed funds rate is). How about target something else, like NGPT level? Then there *is* something you can do, like the same thing you always do, which is create more money (OMO’s), and more importantly, tell the market that you will keep creating more money until the market forecasts that NGDP will hit its target.

    “Even if the current federal funds rate is stuck at zero, the Committee could continue to push longer-term interest rates lower by promising to keep the federal funds rate low for an extended period of time.”

    Sounds great except for how much time? If expectations take off and NGDP starts leaps, you have two choices and they are both bad. 1) leave money too lose. 2) break your word and reduce your tools for forward expectations in the future. Then you realize this idea of “promise to keep the fed funds rate zero for X amount of time” is a silly promise. How about instead, promising to create as much money as needed for as long as needed until the market predicts that NGDP will hit its level target?

    “I’m pleased that a distinguished economist like Eric Swanson has concluded that monetary policy was much less constrained than many pundits assumed.”

    I appreciate your optimism, but I must admit, I feel like I’ve met Cassandra and somehow escaped her curse, yet nearly the entire mainstream monetary economics community remains under the spell.

    -Ken

    Kenneth Duda
    Menlo Park, CA

  2. Gravatar of bill bill
    9. November 2014 at 08:45

    Related tangent. It might help people if they think about the price of other things and of interest rates as the price of money. We can all imagine the difference between having an inch of topsoil dropped everywhere for free and 1000 feet of topsoil dropped (from some helicopters, perhaps?) everywhere for free. The price of both is still zero. The Fed could have given us all a million dollars (not that it should have, but it could have). I wonder if Krugman is still convinced that even in that case, we couldn’t have some inflation? I wish that in the summer of 2008, the Fed had given us all $100 and said that we’d keep getting monthly checks (increasing exponentially, if necessary) until we were back on a 5% NGDPLT track. My guess is that one round of checks along with that statement would have been enough.

  3. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    9. November 2014 at 08:48

    I have to ask, Kenneth, did you actually read Swanson’s piece?

    If you do, you’ll see that Swanson takes a different route than the QTM, but gets to the same destination (conclusion) as Scott; the The Fed was too tight.

  4. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    9. November 2014 at 08:50

    ‘It might help people if they think about the price of other things and of interest rates as the price of money.’

    That would be the worst people could do.

  5. Gravatar of ssumner ssumner
    9. November 2014 at 09:25

    Ken, Completely agree. Promising to hold rates low for an extended period raises more problems than it solves. Of course you could promise to hold rates low until you hit some nominal target path, but then why not cut out interest rates entirely and focus on your nominal target path.

    I’m not too clear as to whether Swanson is setting up fed funds targeting as a sort of straw man that’s easy to shoot down, or whether he thinks that’s currently state of the art monetary policy.

    Bill, In fairness, Krugman never denied that the helicopter drop approach would work.

    Patrick, Yes, I prefer to regard interest rates as the price of credit.

  6. Gravatar of Kevin Donoghue Kevin Donoghue
    9. November 2014 at 09:28

    But it’s disappointing to see someone call the wacky liquidity trap view “traditional macroeconomic thinking.” Perhaps it could be called traditional old Keynesian thinking, but it was certainly a discredited model by the 1980s, if not earlier.

    If it’s in Mankiw’s Macroeconomics (2013), as Swanson’s cite implies, that suggests it’s been un-discredited. Traditional thinking may be wrong, indeed it often is, but there’s no point in pretending that Keynesians were routed when in reality Keynesian thinking was never expunged from best-selling textbooks. (Barro tried his luck with a freshwater-macro textbook, which flopped.) Dornbusch & Fisher, Mankiw, Krugman and Bernanke all continued to teach Keynesian economics long after the 1980s and interest in liquidity traps has grown steadily since Krugman’s Brookings paper.

    By all means argue against ideas you despise, but these Bob-Lucas-style declarations of victory for Monetarism Mark-n are just whistling Dixie.

  7. Gravatar of ThomasH ThomasH
    9. November 2014 at 11:49

    Swanson fails to see the POLITICAL opposition to additional monetary stimulus as there was to governments’ increasing investments in projects that become profitable at lower borrowing costs. A quick recovery was not in the interest of some politicians and their media allies. Some commentators point the finger of blame more at monetary policy and some at fiscal policy, but I think both were blameworthy,

  8. Gravatar of Don Geddis Don Geddis
    9. November 2014 at 14:32

    @ThomasH: But if monetary policy is competent, then fiscal policy is irrelevant (for managing AD). This fact makes it hard to consider both equally “blameworthy”.

  9. Gravatar of benjamin cole benjamin cole
    9. November 2014 at 15:41

    Yeah, I heard about that QE stuff.

  10. Gravatar of CMA (@CMAMonetary) CMA (@CMAMonetary)
    9. November 2014 at 18:17

    How do we know if people expect the money supply increase to be non permanent? Could it be simply that money demand has increased because the monetary system is too ineffective and dysfunctional?

  11. Gravatar of David Hitchcock David Hitchcock
    9. November 2014 at 19:21

    “…But it’s disappointing to see someone call the wacky liquidity trap view “traditional macroeconomic thinking.” Perhaps it could be called traditional old Keynesian thinking, but it was certainly a discredited model by the 1980s, if not earlier.”

    I know someone that attended a Paul Krugman speech recently about how we are stuck in a ‘liquidity trap’. As a consequence, my colleague views this as mainstream thinking today. I would be interested in web-links to academic papers that discredit the ‘liquidity trap view’.

  12. Gravatar of ssumner ssumner
    9. November 2014 at 20:44

    Kevin, Nice try, but he never says it’s in Mankiw’s textbook (that cite was in reference to a different point), and Krugman’s famous 1998 paper does not imply there is nothing central banks can do. Indeed in the next few years Krugman would argue for the Japanese using monetary stimulus (“promising to be irresponsible”), and he argued against fiscal stimulus in Japan.

    BTW, if Krugman thought there was “nothing” central banks could do, why does he advocate QE? Why does he advocate forward guidance? Why does he praise the recent moves of the BOJ?

    You said:

    “By all means argue against ideas you despise, but these Bob-Lucas-style declarations of victory for Monetarism Mark-n are just whistling Dixie.”

    That’s just silly. Nowhere in this post do I even imply that monetarism won any sort of victory, as you surely must know. Old monetarism is almost dead and market monetarism is a tiny minority. Not sure what you are trying to do here, but it sure doesn’t involve honesty.

  13. Gravatar of John Becker John Becker
    9. November 2014 at 20:58

    Scott

    It seems like promising to keep interest rates low for an extended period is the weakest weapon the Fed has in their arsenal at the zero bound. It’s basically a promise to fail (stimulate demand until they have to raise interest rates). The fact that Swanson is talking about this as though it is the Fed’s primary weapon means that he doesn’t understand anything that you’ve said. The intellectual movement from the Fed is stuck to the Fed can promise to keep rates low is almost non-existent. This is even more outrageous given that the Fed has literally about 100 better options at the zero bound: reserve requirements, 0 IOR, negative IOR, negative interest rates, raise the inflation target, NGDP targeting, QE to infinity, etc.

  14. Gravatar of Kevin Donoghue Kevin Donoghue
    10. November 2014 at 02:39

    Scott: “that cite was in reference to a different point” — it was?

    Swanson: “[at the ZLB] monetary policy will not act to ‘crowd out’ fiscal policy because interest rates will remain stuck at zero as long as the economy is weak (see, e.g., Mankiw 2013, Chap. 12).”

    I’m unclear what “different point” is being discussed; I took you to be castigating Swanson for implying that the idea of a liquidity trap is taken seriously by the mainstream. Perhaps by the “wacky liquidity trap view” you mean the very first sentence you quote from Swanson? If so, fair enough; I don’t suppose Mankiw would endorse the claim that there’s literally nothing the FOMC can do at the ZLB. In fact I doubt that even Nicholas Kaldor would have gone that far.

    Krugman never said there was nothing central banks could do in a liquidity trap. For that matter, neither did Keynes or Hicks. A liquidity trap is a situation where conventional open market operations are ineffective. You know that, of course. You also know Krugman’s view and I’m pretty sure you know by now that I know it too.

    “Nowhere in this post do I even imply that monetarism won any sort of victory, as you surely must know.”

    When you say “traditional old Keynesian thinking…was certainly a discredited model by the 1980s” of course you’re not claiming victory for either Old Monetarism or Market Monetarism. I took you to be claiming victory for the New Classical school, which Tobin famously labelled Monetarism Mark II. But perhaps you’re not claiming victory for anyone at all? Maybe you merely meant that Arthur Burns and Harold Wilson were looking a bit silly, which is undeniable.

    “Not sure what you are trying to do here, but it sure doesn’t involve honesty.”

    Jesus wept.

  15. Gravatar of ssumner ssumner
    10. November 2014 at 07:13

    CMA, What is a dysfunctional monetary system?

    John, Good point.

    Kevin. Wouldn’t it be odd for me to claim victory for New Classical economics when I am not a New Classical economist and that movement has very little influence, if any? I can’t even imagine where you got that idea.

    Yes, I was referring to the claim that there is “nothing” that can be done at the zero bound. And one most certainly can find Keynes suggesting that monetary policy was ineffective at zero interest rates, at various times in the early 1930s. His followers believed that even more strongly than Keynes himself, especially during the late 1930s. That’s the intellectual tradition behind old Keynesianism. The movement that displaced it was New Keynesianism (not monetarism or New Classical economics), which argued that monetary policy not fiscal policy should be used to stabilize the economy.

    By the way, when Lucas claimed Keynesianism was dead he was referring to old Keynesianism. And at the time it was effectively dead. (Obviously the zombie has come back to life.)

  16. Gravatar of Majromax Majromax
    10. November 2014 at 08:50

    What’s all this about “targeting” the Federal Funds Rate? As far as I’m aware, that’s never been a target of the US Fed — it’s been the policy instrument.

    The Fed could be targeting NGDP level and still run into a zero lower bound, if it feels that its only policy instrument is to set the funds rate.

    However, this comes with two caveats:

    *) The first is that the rate itself is clearly not the only channel. Expectations do matter, and changing the target changes people’s expectations. (We could also re-phrase this as “interest rates do matter, but there are more relevant interest rates than are directly controlled by Fed policy.”)

    *) The second is that a level target, either of the price level or NGDP, builds in future expectations in a systematic rather than ad-hoc manner. Some of this arises because a level target is ultimately forced to “target the forecast,” since errors are corrected over time.

  17. Gravatar of Scott Sumner Scott Sumner
    10. November 2014 at 19:31

    majromax, (majormax?) The ffr can be viewed as either a target or an instrument of both. The language here is unfortunately vague.

    I would say that technically the monetary base or the IOR is the instrument, the ffr rate is the short term target, and the CPI or NGDP is the long term target.

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