Zero-Bound Interest Rates

This week’s post wraps us our three weeks of attention to the New Keynesian thinking of Michael Woodford, this time examining monetary-policy recommendations he has made to help manage the extreme instability that characterized the Great Recession. The exercise demonstrates, once again, how mainstream general-market-equilibrium modeling leads respected theorists badly astray.

Zero-Bound Interest Rates

In today’s example of harmful policy advice, Eggertsson and Woodford (2003) and Evans (2011) seriously promote an ill-considered tool for central banks wanting to stimulate investment when operational (overnight) interest rates are near zero. Authorities should adopt, and loudly proclaim, a temporary increase in their inflation regime.

In  the micro-coherent, market-centric general-equilibrium model class, the real interest rate equilibrates desired saving and investment; saving is increasing, and investment decreasing, in the dominant inflation-adjusted rate. The proper inflation adjustment is to deduct anticipated price change from the nominal interest rate, with rationally expected inflation determined by the monetary authority’s credible price regime. The central bank can then effectively stimulate investment and overall spending, even if the overnight nominal rate is zero-bound, via announcing a temporary increase in its inflation regime, thereby reducing the real interest rate that governs capital outlays.

In the more evidence-consistent generalized-exchange model class, the Woodford-Eggertsson-Evans  strategy encounters debilitating problems, wholly rooted in the inherent policy irrelevancy of the mainstream macro thinking. Most important, the empirical/logical fact of meaningful wage rigidity is the keystone for a set of price inflexibilities that chronically restricts markets’ capacity to clear, compromising the ability of real interest rates to equilibrate desired saving and investment. The power of interest rates is generally, and greatly, diminished, especially in circumstances of extreme instability. Most relevant to the Woodford-Eggertsson-Evans proposed policy tool, expectations of nominal demand growth wholly dominate zero-bound interest rates in rational choices to invest versus hoard liquidity. Even if the announcement effect actually lowered expected real interest rates, the reduction would be ineffective in reversing investor reluctance in circumstances of (widely anticipated) chronically slow or contracting nominal demand growth.

Moreover, in the context of zero-bound restrictions, the announcement effect would not reduce expected real interest rates. Given weakening aggregate demand, the efficacy of the proposed increase in the established inflation regime would be frustrated by both its promised temporary status and its lack of credibility. The latter is largely rooted in the absence of companion policies that would actually stimulate total spending, reduce excess supply, and eventually put upward pressure on price inflation. Finally, the problem of dubious benefits is compounded by the transparently significant costs of the announcement policy. Credibility for an inflation regime is hard won and requires careful maintenance. A temporary upward-violation of the established regime reintroduces the time-inconsistency problem into central-bank policymaking and its management of expectations throughout the economy. The result must be some weakening of the credibility of the monetary authority’s commitment to low inflation.

More Robust Tool Kit

What does generalized-exchange modeling indicate as effective policy instruments in the context of extreme instability and its concomitant zero interest-rate restrictions? Stanley Fischer, a veteran central banker as well as a proficient macroeconomist, provides an experienced-based identification of monetary-policy options in such circumstances that are consistent with two-venue theory.

Fischer (2013, p.2) first identifies “… the policy of quantitative easing – the continuation of purchases of assets by the central bank even when the central bank interest rate is zero. Although these purchases do not reduce the short-term interest rate, they do increase liquidity. Further, by operating in longer term assets, as in QE2, the central bank can affect longer term interest rates, which may have an additional impact on the private sector’s demand for longer term assets, including mortgages and corporate investment.

“Second, there is the approach that the Fed unsuccessfully tried to name ‘credit easing’ – actions directed at reviving particular markets whose difficulties were creating serious problems in the financial system. For instance, when the commercial paper market in the United States was collapsing, the Fed entered on a major scale as a purchaser, and succeeded in reviving the market. Similarly, it played a significant role in keeping the mortgage market alive. In this regard, the Fed became the market maker of last resort.” In particular, the various market breakdowns critically aggravated the collapse in total nominal spending that, via the MWR Channel, generated involuntary lost jobs and income and its associated multipliers. They were a central part of the acute-instability mechanics of 2008-09.

The GEM Project demonstrates that the effective stabilization-policy approach in the extreme instability that characterized the Great Recession is to do whatever it takes to halt and reverse collapsing nominal demand. Fischer appears to adopt that strategy, especially when he identifies an interesting intervention that has never been used by the Fed. “In a well-known article, James Tobin in 1963 asked in which assets the central bank should conduct open market operations. His answer was the market for capital – namely the stock market…. Although central banks have occasionally operated in the stock market – notably the Hong Kong Monetary Authority in 1997 – this has not yet become an accepted way of conducting monetary policy.” (pp.2-3) The GEM emphasis on confidence and uncertainty in episodes of extreme instability demonstrates that equity-market intervention can be a powerful response to brewing nonstationary demand collapse, uniquely capable of preventing huge welfare loss. (Chapter 6)

Blog Type: New Keynesians Saint Joseph, Michigan