The Shadow Open Market Committee is scheduled to meet next week in New York City. In anticipation of the meeting, I would like to draw attention to SOMC member Peter Ireland’s position paper on Federal Reserve policy that he recently posted on his website. The paper is excellent and I would like to quote a few passages at length.
With their federal funds rate target up against its lower bound of zero, Federal Reserve officials have been led — some would say forced — to experiment with a variety of new approaches to policymaking. Chairman Bernanke (2012) mentioned several of these novel strategies in his comments at Jackson Hole this past August; the minutes from the September meeting of the Federal Open Market Committee (2012) mention them again. They go by the names “maturity extension,” “forward guidance,” and “large-scale asset purchases.”
To be honest, the whole situation seems really, really complicated. But does it have to be? Or might the apparent limitations of more conventional policy measures reflect, not so much the constraints imposed by the zero lower bound on nominal interest rates, but instead the inadequacies of common intellectual framework that places far too much emphasis on the behavior of interest rates to begin with? Might it be more helpful, in these circumstance, to refocus on other variables that have always played key roles, but have been neglected in popular discussions for far to long?
Ireland’s paper does a great job of answering these questions. For example, changes in Federal Reserve policy are often communicated through changes in the federal funds rate in normal times. However, as Ireland points out, the fact that changes in the federal funds rate communicate policy changes does not mean that the federal funds rate is the only tool of monetary policy or the only variable capable of communicating the stance of policy. In fact, interest rates might provide incorrect interpretations about the stance of monetary policy. Ireland explains:
Under ordinary circumstances, like those that prevailed in the halcyon days pre-2008, the Federal Reserve eased monetary policy by lowering its target for the federal funds rate and tightened monetary policy by raising its target for the federal funds rate. That is why most economists and financial market participants, even now, associate Federal Reserve policy most closely with changes in interest rates.
But it is important to recall that even during normal times, the Fed does not control market rates of interest like the federal funds rate by fiat. Instead, Federal Reserve officials must act to bring about their desired outcomes, in which the actual federal funds rate moves in line with changes in their target. These monetary policy actions take the form of open market purchases and sales of US Treasury securities that change the dollar volume of reserves supplied to the banking system. That is, first and foremost, what a modern central bank does, as the one and only agent in the economy with the authority to change the supply of bank reserves.
And so it is the dollar quantity of reserves supplied that the Fed really controls.
Thus, during normal times, interest rates and money offer two ways of looking at exactly the same thing. One can view a monetary policy easing as either a decline in short-term interest rates or as an expansionary open market operation that increases reserves and the money supply. And one can view a monetary policy tightening as either an increase in short-term interest rates or as a contractionary open market operation that decreases, or at least slows down the growth rates of, reserves and the money supply.
Under more extreme circumstance, however, these tight links between interest rates and money may break down. An economy experiencing chronically high inflation, for instance, will very likely have high nominal interest as well, as these become necessary to compensate investors for the loss in purchasing power they would otherwise experience while holding nominally-denominated bonds. But those high interest rates certainly don’t signal that monetary policy is too tight! To the contrary, rapid growth in bank reserves and the broader monetary aggregates will correctly reveal that the inflation itself is being driven by an inappropriately expansionary monetary policy. At the opposite extreme, Milton Friedman and Anna Schwartz (1963) observe that when deflationary expectations take hold, as they did in the United States during the Great Depression, nominal interest rates can be very low. But these low interest rates do not mean that monetary policy is too loose. Instead, declining growth rates or even levels of reserves and, especially, the broader monetary aggregates will correctly indicate that monetary policy is much too tight.
Those who keep these considerations in mind will then feel puzzled that new terms like “quantitative easing” are even needed to describe some of the Federal Reserve’s policy actions over the recent period when the funds rate has been stuck at zero. For those observers will be quick to remind us that in both normal and extreme times, all monetary policy easings are quantitative,” in that they are associated with — and, in fact, originate in — expansionary open market operations that increase reserves and the money supply.
One reason that focus on the interest rate has become paramount is because of the logic of the New Keynesian model. According to the standard NK model, the interest rate is the sole mechanism available for monetary policymakers. When the nominal interest comes up against the zero lower bound, this model suggests that the main tool of monetary policy is in communicating the future time path of the nominal interest rate. Ireland, drawing on some of his own recent work, argues that this story is incomplete:
Furthermore, while Federal Reserve statements providing forward guidance have mentioned only short-term interest rates, they can be read as having implications for open market operations and the supply of reserves in the future as well. In particular, although these details are typically relegated to the background in most New Keynesian analyses, my own recent work (Ireland 2012) extends the basic model to account for the activities of a private banking system that demands reserves, accepts deposits, and makes loans. This extended model highlights that even under New Keynesian assumptions, movements in the federal funds rate are associated with — some might even say caused by — open market operations that add or drain reserves from the banking system, give rise to subsequent movements in the broader monetary aggregates, and lead ultimately to changes in the price level and all other nominal variables. Viewed from this broader perspective, forward guidance regarding the future path of the funds rate also signals the Fed’s intentions for future open market operations and the future path for the money supply. Unlike
maturity extension, therefore, forward guidance appears as a coherent part of a genuine monetary policy strategy.
But while the logic behind forward guidance certainly seems strong, one might still worry that, when it comes to a policy initiative that relies exclusively on promises for the future, the devil is in the details. Even as it argues, most forcefully and persuasively, in support of stronger and sharper forward guidance, for instance, Michael Woodford’s (2012) own paper from the Jackson Hole symposium must concede that central banks around the world have had mixed success in using their words alone to influence expectations of future monetary policy actions. Reflecting on this, one might wonder, as well, if the New Keynesian view that the short-term interest rate is all that matters is excessively narrow. To cite just one alternative: a long traditional of monetarist thought, summarized by Allan Meltzer (1995), asserts that the channels through which monetary policy actions impact on the economy are far too varied and complex to summarize using a single variable like the short-term interest rate. Efforts to encapsulate these monetarist ideas into a modern macroeconomic model that might compete more directly with the New Keynesian framework has thus far yielded mixed results — here again, therefore, we have an important topic for future research! Yet, consistent with the monetarist view, Eric Leeper and Jennifer Roush (2003) and my own paper with Michael Belongia (Ireland and Belongia 2012c) show that even in the most recent data, strong statistical information about the stance of monetary policy appears in the monetary aggregates that is not in contained in interest rates alone. But, above all, one might ask: why try so hard to finesse things, by making ever more audacious promises about future open market operations, when it remains perfectly feasible, even with short-term interest rates stuck at zero, to conduct those same open market operations today, for all to see as well as to believe?
In addition to the passages quoted above, the paper also addresses large-scale asset purchases, maturity extension through operation twist, and how the Federal Reserve can re-focus itself on nominal variables. I realize that I have quoted this paper at length, but I would encourage blog readers to read the paper in its entirety.