Thursday, December 27, 2012

Why Do I Believe Monetary Policy is Always Enough?

Tim Duy argued that the real news about Japan was not just the commitment to raise the inflation target to 2% or 3%, but rather the commitment to combine fiscal and monetary policy.   He went on to argue that Bernanke never claimed monetary policy can generate inflation alone, but only in combination with fiscal policy.  The "helicopter drop" monetary policy would be a tax cut nominally funded by government borrowing, but with a parallel open market operation, it would be effectively funded by money creation.   He quotes Bernanke as claiming that the Fed cannot offset the fiscal cliff.   Duy claims that since the Bank of Japan cannot hit its 1% inflation target, simply promising a higher inflation target will be so much empty talk.

Japan already has a budget deficit of nearly 10% of GDP, but the only way an expansion of the quantity of money can have an impact is if it is matched an increase in that deficit?   I don't think that makes sense.

I believe that a monetary regime can generate a 2 or 3% target inflation rate regardless of fiscal policy.     Of course, if other constraints are added, such as the exchange rate can't fall too low, or nominal or real interest rates can't fall too low, or only certain assets can be purchased by the monetary authority, or some measure of the quantity of money can't be allowed to grow too fast or rise too high, then some inflation target may be completely unfeasible.

Like most Market Monetarists, I also think that growth rate nominal anchors are a bit harder to hit.   If the Bank of Japan targeted a 1% growth path for the price level, rather than a 1% inflation rate, it would have more success.   A central bank willing to forgive and forget its own errors receives less help from firms and households in achieving its goal.

But leaving aside other contradictory goals and the problems of growth rate targets,  it is foolish to even start to claim monetary policy is inadequate before reserve balances have negative nominal interest rates matching the cost of storing currency, currency is only issued in denominations useful for small face-to-face transactions (rather than large denominations useful for saving,) and the monetary authority has purchased the entire national debt, including agency issues.     If that has occurred, and the government is running budget deficits, then the monetary authority would be purchasing all of bonds issued, effectively funding them by money creation.  

At this point, monetary policy would not be "ineffective."  It is rather than some constraints have become binding.    The monetary authority could still expand the quantity of base money by purchasing foreign government bonds or private securities--commercial paper or bonds and notes.   The charges on holding base money could be increased, but further restrictions would need to be be placed on the withdrawal of hand-to-hand currency.   

It is only in this context, when limits on the issue of hand-to-hand currency, the purchase of foreign bonds with exchange rate risk, and the purchase of previously off-limits assets are required because all of the others have been bought are on the table, should there be a fourth alternative put on the table-- a request to the politicians to borrow more (and lower taxes or spend the money.)

Again, it isn't that monetary policy is "ineffective," but rather that some existing constraint on monetary policy must be changed.  In my view, purchasing private debt instruments, such as AAA commercial paper and corporate notes and bonds is just a no brainer.  That should already be on the usual list of assets to be purchased, along with government bonds.   In my view, the monetary authority should be diversified rather than operating as an effective branch of the Treasury and ignoring the risk of default by the "fiscal authority" (the politicians.)  

But, if the situation  arises where all high quantity private securities are purchased, and all the government debt is purchased, then the situation could arise where all that is left is the purchase of securities denominated in foreign currency, restricting the issue of hand-to-hand currency, or going to the government with a request that it borrow more.

Since I believe the monetary authority should get out of the hand-to-hand currency business anyway, there is never any need to request aid from the fiscal authority.  Naturally, I would advocate restrictions on the issue of government currency before proposing that the government borrow more money for the purpose of stabilizing nominal expenditure on output.   

If there is an excess demand for base money, the only issue is whether the yield on base money be reduced and so reduce the demand, or else assets be purchased to expand the quantity.   If all of the appropriate assets have been purchased, then reducing the yield on base money is the only alternative.    This might involve paying a lower positive nominal interest rate on base money, but if needed, it could involve negative interest rates--charges to hold base money.   And there is no lower bound on that.


  1. In my view, the monetary authority should be diversified rather than operating as an effective branch of the Treasury and ignoring the risk of default by the "fiscal authority" (the politicians.)

    I am not sure what this means. I understand that you think the Fed should buy a variety of debt instruments. (I believe in only government bonds).

    The end result, barring a huge wave of defaults in the bonds that Fed buys, would still be huge tax relief for taxpayers. When the Fed either sells or holds to maturity private-sector bonds, the extra money is funneled into the Treasury.

    So, the Fed becomes a revenue function---and thus should be placed within the Treasury, and subject to democratic control. (That's democratic with a small "d"!)

    The real question is this: How long will the Fed have to conduct QE, and are we talking trillions of dollars? I think we are, but no one wants to admit it. It no longer makes sense to have an independent central bank---it is poor governance, not transparent, not accountable, not providing clarity.

    As for providing clarity, I think the Fed should, as it is part of good governance.

    But I doubt it matters much. The public places little trust in any federal officials, central bankers to boot. No one believes a Fed promise to do something. That is, if they even know what is the Fed, or who Bernanke is, or what is QE.

    So we come back to sustained QE as the only course for the Fed. Print money until the plates melt. Then issue scrip.

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