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Friday, March 21, 2008

Monetary Policy at the Zero Interest Rate Bound

If Bernanke believes his own research, and if the zero interest rate bound begins to come into play, we should expect to hear lots of discussion from FOMC members about the future course of monetary policy. Here are a few excerpts from papers on the topic of "Monetary Policy Alternatives as the Zero Bound":

Bernanke, Reinhart, and Sack:

Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment (2004): Non-technical summary ...[S]uccess over the years in reducing inflation and, consequently, the average level of nominal interest rates has increased the likelihood that the nominal policy interest rate may become constrained by the zero lower bound on interest rates. When that happens, a central bank can no longer stimulate aggregate demand by further interest-rate reductions and must rely instead on “non-standard” policy alternatives. ...

In this paper, we apply the tools of modern empirical finance to the recent experiences of the United States and Japan to provide evidence on the potential effectiveness of various nonstandard policies. Following Bernanke and Reinhart (2004), we group these policy alternatives into three classes: (1) using communications policies to shape public expectations about the future course of interest rates; (2) increasing the size of the central bank’s balance sheet, or “quantitative easing”; and (3) changing the composition of the central bank’s balance sheet through, for example, the targeted purchases of long-term bonds as a means of reducing the long-term interest rate. We describe how these policies might work and discuss relevant existing evidence. ...

Our results provide some grounds for optimism about the likely efficacy of nonstandard policies. In particular, we confirm a potentially important role for central bank communications to try to shape public expectations of future policy actions. Like Gürkaynak, Sack, and Swanson (2004), we find that the Federal Reserve’s monetary policy decisions have two distinct effects on asset prices. These factors represent, respectively, (1) the unexpected change in the current setting of the federal funds rate, and (2) the change in market expectations about the trajectory of the funds rate over the next year that is not explained by the current policy action. In the United States, the second factor, in particular, appears strongly linked to Fed policy statements, probably reflecting the importance of communication by the central bank. If central bank “talk” affects policy expectations, then policymakers retain some leverage over long-term yields, even if the current policy rate is at or near zero.

We also find evidence supporting the view that asset purchases in large volume by a central bank would be able to affect the price or yield of the targeted asset.

Since the Federal Reserve has not engaged in such purchases in the past fifty years, our evidence for the United States is necessarily indirect. Three recent episodes, however, provide important insights. In each, financial market participants received information that led them to expect large changes in the relative supplies of Treasury securities. These episodes include (1) the Treasury’s announcements of “debt buybacks” that followed the emergence of budget surpluses in the late 1990s; (2) the massive foreign official purchases of U.S. Treasury securities over the past two years; and (3) the apparent belief among market participants in 2003 that the Federal Reserve was actively considering targeted purchases of Treasury securities as an anti-deflationary measure. Event-study analyses of these episodes, as well as the comparison of actual Treasury yields during these periods to our estimated benchmark for the term structure, suggest that large changes in the relative supplies of securities may have economically significant effects on their yields.

Our analysis of the recent experience in Japan focuses on two non-standard policies recently employed by the Bank of Japan (BOJ): (1) the zero-interest-rate policy (ZIRP), under which the BOJ committed to keep the call rate at zero until deflation has been eliminated; and (2) the BOJ’s quantitative easing policy, which consists of providing bank reserves at levels much greater than needed to maintain a policy rate of zero. Our evidence for the effectiveness of these policies is more mixed than in the case of the United States. The event-study analyses, which may be less informative in Japan because of small sample sizes, do not provide clear conclusions. ...

Despite our relatively encouraging findings concerning the potential efficacy of non-standard policies at the zero bound, caution remains appropriate in making policy prescriptions. Although it appears that non-standard policy measures may affect asset prices and yields and, consequently, aggregate demand, considerable uncertainty remains about the size and reliability of these effects under the circumstances prevailing near the zero bound. The conservative approach—maintaining a sufficient inflation buffer and applying preemptive easing as necessary to minimize the risk of hitting the zero bound— still seems to us to be sensible. However, such policies cannot ensure that the zero bound will never be met, so that additional refining of our understanding of the potential usefulness of nonstandard policies for escaping the zero bound should remain a high priority for macroeconomists.

Bernanke:

Central Bank Talk and Monetary Policy: ...Central Bank Talk when the Policy Rate Is Near the Zero Bound ...Although effective communication by the central bank is always important, it becomes especially important when the rates are near zero. Indeed, when the proximity of the zero bound prevents further rate cuts to stimulate the economy, talking about future policy actions may be one of the few tools at the central bank's disposal by which to influence conditions in financial markets.

Eggertsson and Woodford:

Policy Options in a Liquidity Trap, by Gauti B. Eggertsson; Michael Woodford, The American Economic Review, Vol. 94, No. 2, Papers and Proceedings, (May, 2004), pp. 76-79: The specter of a "liquidity trap," originally proposed as a theoretical possibility by John Maynard Keynes (1936) but long considered to be of doubtful practical relevance, has recently created alarm among the world's central banks. In Japan, the overnight rate has been essentially at zero for most of the time since February 1999, making further interest-rate cuts impossible. Yet until well into 2003, growth remained anemic while prices continued to fall, suggesting a need for further monetary stimulus. Since March 2001, the Bank of Japan has supplemented its "zero-interest-rate policy" with a policy of "quantitative easing," under which additional bank reserves are supplied beyond those needed to keep overnight interest rates at zero. Yet an increase in base money of more than 50 percent failed to halt the deflation, suggesting a liquidity trap. More recently, other central banks, including the Fed, have come close enough to the zero bound to worry about how they would deal with a similar predicament. Here we first discuss whether monetary policy should actually become ineffective when the zero bound on interest rates is reached. We argue that open-market operations, even of "unconventional" types, will be ineffective if they do not change expectations about the future conduct of policy; in this sense, a liquidity trap is possible. Nonetheless, a credible commitment regarding future policy can largely mitigate the distortions created by the zero bound. We fully characterize the optimal commitment in a simple example.

Ueda:

Kazuo Ueda (2005) The Bank of Japan's Struggle with the Zero Lower Bound on Nominal Interest Rates: Exercises in Expectations Management, International Finance 8 (2) , 329–350: I. Introduction This paper aims to carry out an informal review of the Bank of Japan (BOJ)’s monetary policy during the last six to seven years. This has been an interesting period for any student of monetary policy. ... The BOJ roughly doubled base money during the period with no discernible effects on nominal gross domestic product (GDP) or the price level..., contradicting the standard prediction of monetarism. As a result, the velocity of money has declined sharply... More importantly, the period has been one of near-zero nominal short-term interest rates. The BOJ has adopted a number of non-traditional monetary policy measures to get around the difficulties generated by near-zero interest rates – not just an expansion of base money. The impaired financial system, however, as indicated by declines in bank loans in the chart, has severely limited the effectiveness of the BOJ’s policy measures. A brief survey of the measures adopted by the BOJ and the discussion of their effects are provided in this paper. ...

The paper begins, in the next section, with a brief historical summary of the evolution of the economy and the BOJ’s monetary policy during the period. The core of monetary policy during the period has been the so-called Zero Interest Rate Policy (ZIRP) introduced early in 1999. The ZIRP has been an attempt to affect expectations of future monetary policy, rather than to change today’s policy instrument. In this sense, such a policy is often called an exercise in expectations management or in shaping expectations. The section explains how the BOJ had arrived at the idea of the ZIRP. The BOJ terminated the ZIRP in 2000, but introduced the Quantitative Easing Policy (QEP) in early 2001. I explain what the QEP has been and point out that it has included a version of the ZIRP, which in fact may have been the most important aspect of the QEP.

In Section III, I summarize what now appears to be the academic consensus concerning what central banks can do at or near the zero lower bound (ZLB) on interest rates. [Insert section III: ‘State-of-the-Art’ View on Monetary Policy at the ZLB ... A large literature, however, has now developed on this. A useful survey of the literature is provided in Bernanke and Reinhart (2004), who present what now appears to be roughly the consensus view on the issue. They discuss three alternative monetary policy strategies for stimulating the economy without lowering the current policy rate. They are: (i) shaping or managing interest-rate expectations – that is, providing assurance to the private sector that policy rates will be lower in the future than currently expected; (ii) altering the composition of the central bank’s balance sheet to change the relative supplies of securities in the market (targeted asset purchases); and (iii) expanding the size of the central bank’s balance sheet beyond the level required to set the short-term policy rate at zero. ...

On strategy (ii), many concrete proposals have been made, including buying long-term government bonds, equities and foreign exchange. The rationale behind these proposals is not always clear. Most proponents of the approach, however, seem to assume that changes in the relative supplies of assets generate asset price changes, which in turn affect aggregate demand. ...

The rationale behind strategy (iii) is also not very clear. Bernanke and Reinhart (2004), however, discuss three possible channels through which strategy (iii) may affect the economy: (a) the portfolio rebalancing effect, whereby increases in the monetary base would lead the private sector to rebalance its portfolios, lowering yields on alternative, non-monetary assets; (b) altering expectations of the future path of policy rates by a visible act of setting and meeting a high reserve target; and (c) the expansionary fiscal effect, whereby the central bank replaces public holdings of interest-bearing government debt with non-interest-bearing currency or reserves, thus replacing the expected future tax liability for the public with an inflation tax. For channel (c) to produce meaningful effects, the growth rate of base money, however, has to be unusually high. Also, the liquidity supplied will have to be in the economy permanently. Otherwise, there will be a period of negative seigniorage growth. ...

In addition to the above three strategies, some have argued for guiding short rates into negative territory. This would generate obvious effects on the economy. Beyond a certain point, this strategy, however, will require taxing currency. The practical and socio-psychological difficulties involved seem daunting.

The BOJ can be seen to have adopted all three of the strategies as summarized above. ...] ...

In Section V, I go on to discuss in more detail the academic background for the ZIRP. I argue that, among others, a series of work by Krugman was the origin of the ZIRP. Since at the ZLB nominal interest rates cannot be lowered, further stimulus must come through changes in expectations about policy or interest rates when the economy is no longer stuck at the ZLB. Krugman had explained the idea in terms of the quantity of money, not nominal interest rates. The two are, however, two sides of the same coin. The BOJ has been the first central bank to implement such a policy. The BOJ, however, initially carried out something close to what Krugman was proposing with reference to interest rates, and not to the quantity of money. Perhaps, this is one of the reasons for the apparent communication failure between the BOJ and the outside world in the early stages of the ZIRP. ...

[T]he BOJ’s policy has failed to stop the deflation of the economy within a short period of time. In the last section of the paper, I speculate on the causes of the weak effects of the BOJ’s policy on the economy. The discussion is divided into two parts. In the first, I point out some of the weaknesses of the ZIRP and other attempts at expectations management. These include the need for non-monetary policy forces to lift the economy and the possible time-inconsistency problem of the approach. In the second part, I discuss the way in which problems in the financial system have hindered the effectiveness of the BOJ’s policy. ... I argue, however, that the BOJ’s policies eased problems for the relatively healthier part of the financial system and for banks, but not for the rest, especially borrowers with low credit standings. As such, they may have fallen short of lifting the economy into positive inflation territory, but at least contributed to avoiding a meltdown of the financial system and an accompanying deflationary spiral.

McCallum:

Misconceptions Regarding the Zero Lower Bound on Interest Rates, by Bennet T. McCallum (2006): 1. Introduction ...There has been much progress during the past few years in the economics profession’s understanding of the zero-lower-bound (ZLB) constraint on nominal interest rates and its implications for the conduct of monetary policy. Recent work by Auerbach and Obstfeld (2003, 2004), Eggertsson and Woodford (2003, 2004), Svensson (2001, 2003), Iwamoto (2004), Baba et. al (2004), Fujiwara et. al. (2005), Jung, et. al. (2005), and others has been noteworthy and constructive in this respect. There are still a few impressions, however, that seem to me to be rather widely-held and yet somewhat misleading. My talk will be about these. It will draw upon useful recent overview papers by Bernanke and Reinhart (2004) and Ueda (2005). I will not be offering any fundamentally new theoretical results, but will try to mention some points that might be of relevance in interpreting the experience of the past decade in Japan.

The main objective will be to argue that all of the following propositions are invalid or at least dubious: (i) in a zero-lower-bound (ZLB) situation, “shaping interest rate expectations is essentially the only tool that central bankers have” (Bernanke, et.al., 2004); (ii) fiscal policy actions such as “helicopter drops” are in theory more effective than monetary policy actions; (iii) the prominent “Foolproof Way” policy rule of Svensson (2001, 2003) is applicable generally—i.e., even when exact uncovered interest parity holds—than the alternative exchange- rate policy rule of McCallum (2000); (iv) both of the exchange-rate strategies described in (iii) are open to the objection that they constitute “beggar-thy-neighbor” approaches, and (v) there is a significant danger of ZLB difficulties stemming from a “deflationary trap” type of equilibrium, as distinct from a situation involving a “liquidity trap.”

    Posted by on Friday, March 21, 2008 at 12:12 AM in Academic Papers, Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (6)

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