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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11 Responses to “What would be the effect of monetary stimulus?”

  1. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. September 2010 at 18:36

    This is the empiricist in me speaking, but Scott, let’s just see where the money flows. We can always adjust it later. The important thing is to open the floodgates now!

  2. Gravatar of dlr dlr
    2. September 2010 at 18:51

    I’m still not sure I understand the function of QE in your framework. You say it is to supply enough money to meet demand at the new inflation target, but if the new inflation target is credible and does all the heavy lifting, the Fed shouldn’t have to inject any new money at all to meet demand. Probably, it will have to withdraw some money. If the Fed promised to permanently quadruple the money supply in two years and that promise was credible, I don’t see why it would also have to supply more money today to create inflation. Unless, that is, you thought the hefty lifting from the non-verbal component to monetary policy might fail in controlling the demand for money (including the expected supply for future money). But in that case, you are back to caring about whether the QE is going more than swapping like for like. I don’t understand your “halfway” QE.

  3. Gravatar of Jon Jon
    2. September 2010 at 20:29

    The purchase of bills signal a temporary injection and consequently have little effect on AD or inflation.

    This is a common point of confusion: Just because short-rates are used as the near-term target does not mean short-dated debt is actually the instrument of policy.

  4. Gravatar of Symplectic Slacker Symplectic Slacker
    2. September 2010 at 23:11

    A question from a non-economist…

    What are the possible downsides to a drastic monetary stimulus? I mean, suppose we go back in time by 1.5 – 2 years and we are debating possible stimuli for the economy. As I recall, Krugman’s basic argument was that once interest rates are sufficiently close to zero, the Fed is out of options, (so monetary theorists are out of solutions), and thus the only solution is a Keynsian type fiscal stimulus. And here we are now, another trillion in debt and not much to show for it other than more strain on the budget. So what I want to know is if Obama was less Keynsian and more Friedman (or Lucas or Sumner or whoever) and pushed for monetary stimulus instead of fiscal, and if that stimulus was only as successful as the one we actually got, what would be some of the potential consequences of implementing such a monetary stimulus?

  5. Gravatar of scott sumner scott sumner
    3. September 2010 at 04:39

    Mark, I agree. But would the Fed agree? I’m trying to sell this to the Fed.

    dlr, You said;

    “I’m still not sure I understand the function of QE in your framework. You say it is to supply enough money to meet demand at the new inflation target, but if the new inflation target is credible and does all the heavy lifting, the Fed shouldn’t have to inject any new money at all to meet demand. Probably, it will have to withdraw some money.”

    I’m pretty sure I do understand, as I said exactly the same thing:

    “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.”

    Jon, Are you saying the Fed usually purchases long term bonds?

    Symplectic Slacker, I don’t see any big downside. My critics would say there is a risk of high inflation. But if inflation expectations begin rising too high, the Fed can raise rates as high as they want. It least we’d be out of the liquidity trap.

  6. Gravatar of dlr dlr
    3. September 2010 at 05:47

    Okay, I guess your metaphor is what threw me off. I think identifying QE as either the “engine” or one of your three main prongs is a little misleading given your framework, under which QE is highly unlikely to be necessary at all as in your $100 billion per month example. It seems more like the spare tire. Or maybe fuel, but only in a car with so much fuel that the engine would flood if it got going.

  7. Gravatar of JL JL
    3. September 2010 at 06:06

    Scott,

    One aspect of stimuli I have not seen discussed is: who is the recipient?
    A fiscal stimulus that cuts payroll taxes benefits employers and employees by lowering the real wage at the expense of our children, who will have to pay off and service more debt in the future.

    Nominal inflation decreases the real size of the non-TIPS debt, benefitting the taxpayer. But it also increases the nominal interest rate, and thus the costs of the debt.

    Suppose we wanted to shrink the debt and end the current recession (can we call it a depression yet?). Is that possible?

    My intuition says: monetize the debt. That would increase NGDP and decrease the debt. The Fed’s not going to do it, but is there any downside?

  8. Gravatar of JL JL
    3. September 2010 at 06:07

    Scott,

    One aspect of stimuli I have not seen discussed is: who is the recipient?
    A fiscal stimulus that cuts payroll taxes benefits employers and employees by lowering the real wage at the expense of our children, who will have to pay off and service more debt in the future.

    Nominal inflation decreases the real size of the non-TIPS debt, benefitting the taxpayer. But it also increases the nominal interest rate, and thus the costs of servicing the debt.

    Suppose we wanted to shrink the debt and end the current recession (can we call it a depression yet?). Is that possible?

    My intuition says: monetize the debt. That would increase NGDP and decrease the debt. The Fed’s not going to do it, but is there any downside?

  9. Gravatar of Symplectic Slacker Symplectic Slacker
    3. September 2010 at 09:20

    Scott,

    Thanks for the response. If a monetary stimulus did result in high inflation, but if gdp growth was as tepid as it is currently, doesn’t that put us in stagflation? Once out of the liquidity trap, the Fed could try to head off inflation by increasing interest rates, but wouldn’t that further hinder economic growth, resulting in a deeper recession?

    Really, I’m just trying to gauge the effects of a failed fiscal stimulus to a failed monetary stimulus. I mean, if the monetary stimulus posed no negative threats to the economy, it would seem like a no-brainer to implement it, but that was not the route taken.

  10. Gravatar of Jon Jon
    3. September 2010 at 20:26

    Scott asks: “Jon, Are you saying the Fed usually purchases long term bonds?”

    The usually purchases notes. As I’ve said many times before, the average maturity of the Fed’s portfolio used to be 4yrs.

    If they want to engage in a lot of QE, I see little reason to alter that average. If it worked before, it should work now.

  11. Gravatar of scott sumner scott sumner
    4. September 2010 at 05:16

    dlr, Good point, it’s not the right metaphor. Back to the drawing boards.

    JL, You asked;

    “My intuition says: monetize the debt. That would increase NGDP and decrease the debt. The Fed’s not going to do it, but is there any downside?”

    My proposal envisions a little bit of monetizing the debt, but not too much. If we did a lot, we’d get hyperinflation.

    Symplectic Slacker, In my view the Fed should aim for steady
    GDP growth, because that’s the goal of monetary policy, not as a means to an end. If that creates stagflation, then we need to look for non-monetary remedies to stagflation, (actually non-AD remedies, as fiscal stimulus also would not help in that case.)

    So I wouldn’t consider stagflation to be something going wrong, as long as NGDP was on target. Something going wrong would be if NGDP expectations moved away from the target.

    Jon, Fair enough.

    BTW, Does that number measure the original maturity of the bond, or years remaining to maturity? If it is years remaining, that suggests the average original maturity is more like 8 years, which is a rather long term note.

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