Monetary Policy at the Zero Bound

I am a financial economist and I’ve been through most phases of my career one that applies the trade in banking. That’s because my first economics specialty was monetary economics. I still have my original copy of Patinkin’s Money, Interest and Price sitting next to my dad’s original copy of Keyne’s The General Theory of Employment, Interest and Money. My grandfather was one of the first Fed lifer’s having been in charge of the bond area in the Kansas City District for both world wars. My ex-husband’s first job out of college was with that Fed. I worked for the Atlanta District Fed before retreating back to academia. So, in this day and age, with all the unpopularity that entails, I have to confess to being a banker of sorts. I hope you won’t hold that against me.

Today, there is more evidence that this is not my Grandfather’s Fed and it’s not completely the Fed I worked for either during the Greenspan years. When I was there, the emphasis was consolidating functions to various branches and realizing that check clearing and wire transfers, the main source of revenues for the branches, were being taken up by big money center banks and clearing houses. Clinton was President and the economy was good so there wasn’t much dithering about the technical things done up there at the desk in NYC. I just had my staff transmit the bond sells every Tuesday (even on Mardi Gras) dutifully.

Much consolidation has taken place and many traditional Fed services have been privatized. Oh, and then there’s that one other difference, Ben Bernanke and his realization that traditional monetary policy is pretty useless when interest rates are close to zero. Welcome to the world of Monetary Policy at the Zero Bound which is actually something we talked about last fall. I’m going to point you again to Ben Bernanke’s treatise again because it explains a lot of what we’re going to discuss. It’s written for wonks, but if you read the first few pages, you’ll get the basic idea.

The Fed’s upcoming retreat from its current position has been a topic of much discussion and speculation. That’s because every one has some concern that they will be accommodating for way too long and it may lead to another Bubble or to general inflation (instead of price increases in a specific market like housing). That’s pretty much the consensus of what happened post 9/11 when Greenspan left interest rates extremely low and we developed a speculation crazed housing market. For some reason, he popped the bubble of excessive exuberance during the Clinton years and the Tech stock run-ups, but let the mortgage market baste in low interest rates for way too long. My guess is that he was more accommodating to Republicans because he himself was one of them, but that’s a discussion for his biographer and just a source of speculation for me.

So, Ben used his platform as the second most powerful man in the US today to reduce the information asymmetry surrounding the Fed’s exit strategy. Again, if you check the link to his academic paper above, you’ll see that’s one of the things he believes is necessary when monetary policy hits the zero bound. He basically calls this “using communications policies to shape public expectations about the future course of interest rates” and that’s exactly what he’s doing in today’s Op-Ed piece in the WSJ.

I’m not sure how many people wrote and edited this piece, but it is a brilliant discourse that explains in a very succinct and clear way what the FED will do in the coming recovery to ensure that we won’t get inflation. He also reassures that they won’t reverse the course of any improvement either as was done in 1937 to cause a double dip depression. This Op-ed is historic in nature, although I’m sure only those of us steeped in Fed lore, culture and history will realize what’s going on here. Ben is opening up the some what secret world of the Federal Open Market Committee (FOMC) to those with the need to know.

The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages.

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. The Federal Open Market Committee, which is responsible for setting U.S. monetary policy, has devoted considerable time to issues relating to an exit strategy. We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

We know that they’ve been picking up a lot of garbage from the banks by using two other points elucidated in that academic paper written in 2o04. That would be “increasing the size of the central bank’s balance sheet” and “changing the composition of the central bank’s balance sheet”. These moves are called quantitative easing and come from the policies used by the Japanese Central Bank in attempts to get out of their Lost Decade. Bernanke is trying to shorten ours but can and will he do it? In this Op-Ed Piece, he lays out the rational and the commitment on the part of the FOMC. You see, the Japanese Central Bank started out doing that, then changed course and lost credibility. This loss of credibility made it difficult for any of their moves to be taken seriously after that and lengthened their recovery. Bernanke is laying it right out there to say that the Fed is committed to not doing that.

The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions, banks have generally held their reserves as balances at the Fed.

But as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.

The Fed’s been taking on a lot of criticism recently for its role in the financial crisis. To a certain extent, they were brought in late to the party because much of the preventative oversight should’ve have come from the SEC instead. However, as the banks have failed, and as the nonfiduciary financial institutions have morphed into bank holding companies, the FED has clearly been the quasi-agency in the catbird seat. This brings me to another topic which has been percolating around my threads recently. That would be Fed independence.

It is interesting that the other article today that caught my eye came from libertarian Megan McArdle’s Asymmetrical Information at the Atlantic. It is titled How Much Does Central Bank Independence Matter? Usually, libertarians, like Ron Paul, are the first to attack the Fed when any thing remotely weird happens because they still live in the land of gold. McArdle criticizes fellow libertarian Alex Tabarrok for saying ‘not much’ in an article putting down those of us that continue to cry out for Fed Independence. I agree with Megan.

Start with a stylized fact: in a democracy, there will be a strong tendency for monetary policy to favor debtors, because there generally more debtors than creditors. This is particularly true of America, with its lavish credit markets.

In the long run, however, strongly inflationary monetary policy makes everyone worse off; it impedes capital formation, lowering productivity.

Central bank independence works, not because the bankers aren’t accountable to Congress (they are, after all, reappointed every so often), but because Congress is only weakly accountable for the actions of the central bank. If Congress were held to account for the actions of the central bank, Congress would appoint bankers who would do populist things that would make us all worse off. Most of the financial policy journalists I know have the sense that Congress actually supported most of what Paulson/Bernanke/Geithner did, but knew they did not dare enact it. They don’t want a more accountable central bank.

So there is something magical about bank independence. It lets Congress cut against its basically populist political interests. You may think that makes it too bank-friendly. But it also means we don’t have double-digit inflation, which is where we were headed before Volcker.

It is true that academic, peer-reviewed studies show overwhelmingly that central bank independence is a key factor in inflation prevention. It’s hard to not look at the literature and get any other conclusion. Bernanke is in a party with a nest of political vipers looking for quick policy fixes to enable midterm election maneuvers. I’m am supremely disappointed in Timothy Geithner and Christine Romer who seemed to have gone down the rabbit hole with Larry Summers. I’m still not willing to give up on Bernanke because I still see glimpses of the guy that wrote that academic paper. I believe the FOMC folks are keeping him honest. I hope I’m not wrong.