Monetary Policy With Interest On Reserves

by: John Cochrane

Or, Heretics Part II

I just finished a big update of a working paper, "Monetary Policy with Interest on Reserves." It also sheds light on the question, what is the sign of monetary policy? (Previous posts here, here and here).

Again, the big issue is whether the "Fisherian" (Shall we call it "Neo-Fisherian?") possibility works. The Fisher equation says nominal interest rate = real interest rate plus expected inflation. So by raising nominal interest rates, maybe expected inflation rises?

The usual answer is "no, because prices are sticky." So, I worked out a very simple new-Keynesian sticky price model in which prices are set 4 periods in advance.

The top left panel of the graph shows the heretical result. I suppose the Fed raises interest rates by 1 percentage point for two periods, then brings interest rates back down (blue line). Prices are stuck for 4 periods (red line) so don't move. After 4 periods prices fully absorb the repressed inflation -- the Fisher equation works great, only waiting for prices to be able to move.

In the meantime the higher real interest rates (green) induce a little boom in consumption. So, raising rates not only raises inflation, it gives you a little output boost along the way. Raising rates forever does the same thing, but sets off a permanent inflation once price stickiness ends.

Why do conventional models give a different result?

There are two big reasons. If the Fed raises interest rates, and this causes a deflation, then the Treasury has to raise taxes to pay bondholders the greater real value of their debt. Most models implicitly pair monetary policy shocks with fiscal policy shocks of this sort. In this model, I kept monetary and fiscal policy shocks separated. In the top left panel, I asked, what if the Treasury doesn't go along -- or can't -- and the stream of real surpluses or deficits does not change when the Fed changes monetary policy?

The top right hand panel shows a pure fiscal policy shock. Here the Fed leaves nominal interest rates alone, but there is a positive fiscal shock, raising the value of future surpluses by 3%. This is a deflationary shock, and as soon as prices can move they jump down 3%. In the meantime, consumption falls. The "austerity" if you will (we should banish this horribly misused word, but only after I use it here for effect) induces a recession and deflation.

The bottom panels show a conventional new-Keyensian style prediction. Here I paired the higher interest rate -- monetary policy of the top left panel -- with a deflationary fiscal shock, as in the top right panel. Now you see the "conventional" pattern emerging. The higher interest rate is associated with higher real interest rates and lower consumption, and lower output (the same thing here). In fact, here there is no long-run inflation effect. This combined monetary - fiscal policy shock is a purely real "cooling off" policy, and its opposite a pure "stimulative policy" with no effect on inflation. That may explain why so many actual policies in the data, which we think of as just "monetary policy" are in fact coordinated monetary - fiscal policies of this sort. The government wants to smooth output without causing inflation, and this coordinated monetary-fiscal policy shock does the trick

The system is linear, so you can eyeball what happens by mixing different amounts of the two shocks. I wanted to produce an interest rate rise that leads to less inflation, and the bottom right picture does it by adding a larger fiscal shock to the monetary shock. This picture accords with the textbook "response to a monetary policy shock" in textbooks. By the "passive fiscal" assumption, the textbook response is paired with contractionary fiscal policy. But you can see, when we break it apart, that it's the fiscal policy doing the deflating, and the monetary policy is actually pushing the opposite way.

While the bottom right response is a sensible thing that a government might want to do to offset an output shock, the bottom right one does not look like a very sensible way to cause more or less inflation. If you want only to cause inflation, the top left looks like a better possibility.

In sum, this graph suggests that monetary policy alone could well be "neo-Fisherian," that a rise in interest rates, even with sticky prices, might produce larger output, and eventually inflation, not the opposite. It suggests that we think otherwise, because our past interest rate increases have been been coordinated with fiscal tightening. They have done so, because they wanted to affect the economy and not cause inflation. If you want just to cause inflation, maybe do something different.

The paper suggests another reason why we may be in a "Neo-Fisherian" moment, unlike past experience. In the past, to raise interest rates, the Fed had to lower reserves, lower the money supply. This worked through the money multiplier, lower lending, and all that standard story. Now, the Fed will raise interest rates by simply raising the interest on reserves, without "rationing liquidity" at all. An interest rate rise with no change in money supply, with no rationing of liquidity, with no impact on reserve requirements, etc. may have much more "frictionless" effects than past interest rate rises that went with all this money-rationing.

Before my favorite blog antagonists go all nuts about this and campaign for a quick public stake-burning of heretics, let me clarify that I think this is a fun idea to investigate, but not nearly ready for policy. I spend so much time bemoaning my colleagues' well intentioned but hubritic tendency to fly to Washington and advocate for a trillion dollars to be spent on the latest clever idea they worked out on the plane, that I want to keep some scientific reserve on how quickly this idea translates to op-eds and policy advice.

But it is an interesting idea to think about. Needed: more realistic models, better understanding of the fiscal coordination and communication mechanism (the paper suggests that inflation targeting is a fiscal communication device, a constraint on the Treasury, not the central bank), and a follow-up on this idea that perhaps interest rate rises that do not ration liquidity are more neo-Fishererian.