David Andolfatto is a very knowledgeable monetary policy blogger, and here he interviews Michael Woodford, perhaps the world's leading monetary theorist. I'll just focus on one issue:
There is a conventional wisdom of how these tools might work. Can you explain to us the findings of your own research, how they might corroborate these findings or these beliefs? Or go against them in some manner? Is there something surprising that emerges from what you've discovered?
I think so. I think a lot of the discussion that you see of the point of asset purchases suggests that there should be a lot of similarity between the effects of purchasing long-term assets and the effects of cuts in the federal funds rate, the Fed's traditional tool. People say the whole point of cutting the federal funds rate is longer-term bond yields would also go down, and if you can just buy longer-term bonds, push up their prices, that's doing the same thing with a different mechanism. It's a different way of doing the same thing. And if you can't cut the federal funds rate further, then there's an obvious reason to use the other method.
And our analysis suggests that this analogy between the two tools is not nearly as strong as you might have expected.
Why is that exactly?
Well, one reason is that the question of whether it's clear that Fed purchases of longer-term assets can affect the prices of those assets as directly as traditional interest rate policy would. But I think the more surprising thing is that our analysis suggests that even under circumstances when the central bank finds that its purchases do affect the market price of the longer-term assets, the connection between that and spending in the economy, and then the effects on inflationary pressure, are not necessarily at all similar to those of conventional interest rate policy.
So you're suggesting that it is possible, at least in theory, that the Fed engages in the large purchase of a certain class of assets? Injects money into the economy by purchasing a particular class of assets? And that this may, in fact, have very exact opposite sort of effects than conventional data might suggest?
Right. We clearly show that that's at least a theoretical possibility. And obviously then deciding whether you think that's actually happening is another thing. But I think the analysis points out that you shouldn't assume that the mere fact that you could raise the price of the bonds answers then the question about what effect you're having on the economy.
So can you explain the economic intuition for that effect and whether or not it has some bearing as to the conduct of Fed policy today?
I think the point is a fairly simple one, and it has to do with the question of why the central bank purchases should be able to move the market price anyway, which, again, people thought was kind of obvious. They said if you're buying more of something, surely that will tend to make it more expensive. But when you ask whether that should actually happen with a lot of sophisticated traders out there in the market that are also trading against the central bank, what we argue is that if the other traders in the economy aren't constrained in the financing they can mobilize to take the positions that make sense for them, they will tend to automatically have an incentive to trade against the central bank and to neutralize then the effects of the central bank's trades.
Two things struck me. First, Woodford has a contrarian view of the effects of QE on long-term interest rates. Second, market monetarists have a similar counterintuitive view, but for very different reasons.
Woodford starts by pointing out that people expected QE to reduce long-term rates, just as traditional fed funds rate cuts reduce long term rates. But MM doesn't even accept the premise. Some of the most dramatic Fed moves toward cutting short-term rates have actually boosted long term rates, via the inflation and income effects. We think QE also has an ambiguous impact on rates, for similar reasons. In contrast, Woodford focuses on the risk channel (you should read the whole thing to get his explanation).
Then Woodford suggests that the relationship between long-term rates and the economy is not as clear as with traditional tools. We agree that it's not at all clear (never reason from a price change), but we think that's also true of traditional tools. One cannot assume that lower interest rates produced by the Fed will lead to strong growth in AD. It depends on the relative strength of the liquidity, income and Fisher effects.
In the final paragraph I quote, Woodford points out that most people think that Fed purchases "obviously" boost the price of the asset being purchased. They misuse the S&D model. Some commenters are outraged that the Fed is helping group X, because group X owns lots of the assets that the Fed is buying. They see dark conspiracies. But the purchase of bonds is also the sale of cash. And more cash boosts inflation, which reduces bond prices. During the 1964-81 period the Fed radically increased the amount of bonds it was buying, this led to rapid growth in the monetary base, higher inflation, and much lower bond prices. So much for Cantillon effects.
Yes, there are cases where large asset purchases are associated with low inflation (such as recently); my point is that there is no consistent relationship between Fed asset purchases and the price of that asset.