A new commentary from the Cleveland Fed by Charles Carlstrom and Andrea Pescatori received some attention from Mark Thoma and Scott Sumner. On the bright side, they recognize that "level targeting" is desirable when short term nominal interest rates reach the zero nominal bound. They also understand that the Fed must be willing to purchase something other than T-bills if their yields have reached the zero bound.
However, I was surprised by what I believe were some errors in their analysis. Most importantly, they confuse money and credit. They argue that if the interest rate on T-bills is zero, and the Fed makes open market purchases of T-bills, then because those T-bills are perfect substitutes for the banks' cash reserves, the banks will not increase lending.
While this argument is plausible enough if the Fed purchases the T-bills from banks, if the Fed purchases T-bills from someone other than banks, then the quantity of money increases when the seller's bank credits the seller's deposit. Even if the banks are willing to hold the increased reserves, rather than purchase some other assets, the quantity of money has increased.
By definition, open market purchases involve the Fed purchasing assets from whoever is willing to sell. If the Fed is buying T-bills, it may buy some from banks, but eventually the banks will run out, and then any further purchases come from someone other than banks, leading to increases in the quantity of money regardless of whether or not banks want to expand lending.
Unfortunately, Carlstrom and Pescatori seem focused on what happens to bank lending, rather than on the quantity of money created by the Fed and the banks. A zero nominal bound, however, isn't a problem of an inadequate supply of credit. Low interest rates are a sign of an adequate supply of credit. The problem is an excess demand for money. The quantity of money is less than the amount people want to hold at a level of real income equal to the productive capacity of the economy. As long as the open market operations increase the quantity of money, they help clear up the excess demand for money.
Carlstrom and Pescatori then describe the alternative of open market purchases of long term securities. They correctly explain that by purchasing them, the Fed will raise their demands and prices, and so lower their yields. I think the key point here is that the entire notion that the economy was at the zero nominal bound is just a strange illusion. The interest rates that the Fed traditionally targets are near zero, but there are many interest rates. Most of them are nowhere near zero. Macroeconomists are in the habit of modeling the economy with a single interest rate. For many purposes, this may be a useful abstraction. However, treating a situation where some nominal interest rates are zero as being the same as "the" interest rates is zero, confuses models with reality.
Carlestrom and Pescatori discuss how purchasing longer term securities will be effective because banks will not treat these securities as perfect substitutes for their cash reserves. The banks will be motivated to expand lending when they receive additional reserves in place of long term securities. Again, they are assuming that the Fed purchases securities directly from banks and their focus is on getting banks to expand lending. The Fed might purchase long term securities from banks, and regardless from whom the Fed purchases securities, bank lending would certainly be helpful in multiplying the impact of the open market purchase on the quantity of money, but this isn't necessary. When the Fed purchases long term securities from someone other than banks, the quantity of money expands. The problem isn't that banks aren't lending, it is rather than the quantity of money is less than the demand to hold money and expanding the quantity of money helps solve the problem.
Perhaps the core idea of monetary disequilibrium theory is that undesirable changes in nominal expenditure must be due to an imbalance between the quantity of money and the demand to hold money. The response to this strong claim is usually some particular scenario where someone spends less on final goods and services. The rejoinder is always, what do they do with the money instead? Hold it? There is the problem. Spend it? Then what does the recipient do? Hold it? See, excess demand for money.
Yeager has always emphasized that if there is a shortage of some nonmonetary asset, the only way this could generate a general glut of goods--an excess supply of current output--is if the excess demand for the nonmonetary goods spills over into an excess demand for money. For example, people want to produce and sell apples, and then use the income earned from the apples to purchase "old masters." No new old masters can be produced, so wouldn't this cause a general glut of goods?
Of course, there is no reason why the prices of old masters cannot rise, closing off the shortage for them and at the same time ending the surplus of currently produced goods. But suppose that is impossible. Suppose there is a price ceiling on old masters. Is there a perpetual excess supply of goods matching the shortage of old masters? As Nick Rowe frequently explains, the frustrated buyers either purchase something else or maybe even no longer want to produce and sell products if there is nothing they want to buy. No general glut of goods results from even a persistent shortage of nonmonetary assets.
The problem develops if the shortage of nonmonetary assets spills over into an increased demand for money. There is a shortage of some nonmonetary asset, and the frustrated buyers simply hold onto money. The individual can produce and sell goods, and being unable to find the desired nonmonetary asset, just holds onto increased money balances. Of course, given the quantity of money, this cannot be done by everyone at once. The result is an inability to sell--a general glut of goods.
And that is how the zero nominal bound on interest rates impacts nominal expenditure and why it is relevant for the type of assets purchased by the Fed. Suppose there is a flight to safety and an increase in the demand for short and safe assets. The increased demand for these assets raises their prices, and lowers their yields. When the yields on those assets hits zero, and an excess demand remains, a shift of that excess demand to an increased demand for money not only is possible, it is likely. In the final analysis, zero-interest currency provides a prefectly liquid and safe haven.
If there is an excess demand for money due to a spillover from an excess demand for short and safe nonmonetary assets, and the Fed responds by purchasing safe and short nonmonetary assets, it will fail to solve the problem. While the increase in the quantity of money will help meet the excess demand as usual, the Fed's purchases of the nonmonetary assets increases the demand for them, and as that excess demand is shifted to an increased demand for money, the Fed is left where it started.
What is the solution? The Fed needs to purchase nonmonetary assets than aren't in excess demand. That is, monmonetary assets that are not at the zero nominal bound. This will increase the quantity of money without exacerbating the excess demand for safe and short assets at the zero nominal bound. Like usual, the process will increase the reserves of banks, and if banks choose to purchase assets, then the direct impact of open market operations by the Fed on the quantity of money will be multiplied. However, to identify the increase in bank lending with the increase in the quantity of money is--money and credit, still confused.
P.S. Carlstom and Pescatori point out that targeting the price level implies that the Fed will reverse any deflation that occurs. As deflation lowers the price level, the expectation will be ever faster (or more lengthy) inflation to return the price level to target. A lower price level, then, implies higher expected inflation, and lowers the real interest rate consistent with any given nominal interest rate, particularly one at zero. They then point out that targeting the price level requires that the central bank offset productivity shocks, which would be disruptive.
What is the answer?
Target a growth path for nominal expenditure! How about 3 percent?