Saturday, April 6, 2013

Expansionary Monetary Policy and Interest Rates

The Bank of Japan promised to undertake substantial quantitative easing recently and long term interest rates fell at first and then rose back.    Scott Sumner has become embroiled in a debate as to whether these changes in long term interest rates are consistent with Market Monetarism.  

In my view, Market Monetarists insist that it is possible that an expansion in the quantity of money can increase all interest rates.   This is one reason why Market Monetarists have been very critical of Bernanke's rationale for quantitative easing--that its purpose is to lower long term interest rates.   More fundamentally, it is a reason why Market Monetarists are skeptical of interest rate targeting.    Having a central bank manipulate the quantity of money (or its own yield,) so that short and safe interest rates are pegged at some periodically changed level has some disadvantages.   (Unfortunately, there is no perfect alternative.  All alternatives have disadvantages and advantages.)

With a simple monetary thought experiment, where there is a permanent increase in the growth rate of the quantity of money, the long run impact on long run nominal interest rates is positive--roughly proportional to the increase in the growth rate of the money supply.   If there were an an equilibrium with a 2 percent growth rate of the money supply and a 5% long term nominal interest rate, then raising that growth rate of the money supply to 3%, will roughly result in  a 6% long term nominal interest rate.  

What about short term interest rates?   Eventually, they will rise by 1% as well.   However, during the adjustment process, they might fall at first and then only later rise.   Any such short term perverse change in short term nominal (and real) interest rates should be slightly reflected in long interest rates as well.

If instead of a permanent increase in the growth rate of the money supply, the thought experiment is a permanent increase in a target for the inflation rate, then the long run equilibrium result is the same.   Interestingly, if the shift is well known and credible, the temporary distortion of interest rates -- lower short term interest rates in the short run, should be lessened.   In the limit, all nominal interest rates increase with the increase in the inflation target with no change in real interest rates.

But suppose there is a credible unchanged inflation target, and an increase in the quantity of money.   If "the" market believes that inflation will always remain on target, then nothing of the thought experiment of a permanent increase in the growth rate of the money supply would apply.   There is no proportional increase in nominal interest rates due to the Fisher effect because there is no increase in the inflation rate. 

 If "the" market believes that this increase in the quantity of money is inconsistent with the inflation target, then "it" will expect this increase in the quantity of money to be reversed in the future.   The immediate impact of the increase in money growth could still be a liquidity effect on short term nominal and real interest rates.   And further, that effect would be slightly reflected in both real and nominal long term interest rates.   If the reverse of this excessive money growth simply returns short term interest rates to where they would have been anyway, then long term bonds have slightly lower real and nominal yields due to the excessive money growth.     On the other hand, if reversing the excess growth in the money supply required higher interest rates than would otherwise be necessary, then this would partially or perhaps fully offset the tendency of the liquidity effect to lower nominal and real long term interest rates.  

Where does this leave us with Japan?    If the proposal to increase the inflation target was fully credible, then that should have been sufficient to raise long term nominal interest rates.   If "the market" expected firms to immediately begin raising prices at the new rate, then it would have the same effect on short term rates as well.     The later announcement of large amounts of quantitative easing would have no impact on expected inflation and so no "Fisher effect" raising long term interest rates.

Only if the announcement of the new inflation rate was not credible because "the" market believed that the central bank would not increase the quantity of money enough to reach the new inflation target, would the added information that the Bank of Japan would make these purchases have a positive effect on expected inflation (moving it towards the target) and so a positive "Fisher effect" on long term interest rates.  

Suppose the Fed answered Market Monetarist prayers and announced a target 5% growth path for nominal GDP, commencing in a year at a level about 10% higher than its current value.   Many Market Monetarists have argued that if the Fed's actions are credible, then the demand for base money would fall.   Further, "Wicksellian" natural interest rates would rise at all maturities.    In our view, the Fed should reduce the quantity of base money and allow market interest rates to rise with growing demands (and reduced supplies) of credit.    This effects should happen with the announcement of the new policy.

But suppose that after a month or two the Fed  announces that it remains recommitted to keep interest rates at zero for an extended period of time and further, commits to some large increase in the quantity of base money, specifying that it will purchase long term government bonds.    With the policy of nominal GDP level targeting being fully credible (by assumption,) these increases in the quantity of base money would be expected to be temporary.  The demand for base money has fallen.   But the effect of the large temporary increase in base money (expanded from an already greatly excessive level) should be short run liquidity effects that depress short term interest rates.   And lower short term interest rates for a time should slightly lower long term interest rates.  

The announcement of the nominal GDP level target regime could cause increases in long term nominal and  real interest rates--if it was credible.   But if that is true, a subsequent announcement of quantitative easing would lower nominal and real interest rates again, at least partially reversing the initial increases.   As for exchange rates and stock prices, the lower real interest rates would tend to lower the exchange rate and raise stock prices.

Of course, if the Fed announced the new target, and it was not credible because "the" market doesn't believe that the Fed will increase base money enough when necessary or allow interest rates to fall low enough, then the Fed's announcement of the large increases in base money or its commitment to keep interest rates very low could raise long term nominal interest rates.   In other words, as Sumner explained, "it's complicated."


  1. Whether long term rates go up or down, one thing that definitely 'should' happen is that the yield curve should get steeper. That's because the farther out on the yield curve, the less relevant the current central bank interest rate target is.

    I think that's a useful definition of "easy money": a yield curve that is abnormally steep. ("Tight money" would be a yield curve that is abnormally flat or inverted).

    In other words, money is easy if the short rate is expected to increase; tight if expected to decrease.

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