We need a modern monetary policy (MMP). Policy needs redesigning for three fundamental reasons:
Firstly, the mental models for thinking about how the macro-economy in the developed world works have been broken for at least a decade, as some Fed policy makers are now recognising. If there is structural price stability – i.e. never an inflation problem – what should the focus of central banks be?
Secondly, the traditional tools used by central banks are ineffective. I have discussed the relative merits of monetary and fiscal policy before, the challenge is to devise policy tools which can be deployed very quickly – i.e. in a matter of days – and which impact demand directly. A single policy rate and asset purchases do not meet this criteria.
Thirdly, a series of genuinely new, effective, monetary tools have been identified and their significance is under-appreciate – dual interest rates, cash transfers to households, and ‘the Bernanke drop’. Fortunately, we have a policy for all jurisdictions. Unfortunately, divergent legal and institutional frameworks imply different policy tools for different central banks, this makes it harder to build consensus.
Let’s start with how the world works. I am going to make a series of statements about the structure of the developed world. I think (most) macro-economists will disagree with these, but I believe the empirical evidence is over-overwhelming, and I shall back up the claims in future posts. I also think major policy makers are now accepting these observations as irrefutable facts, even if they don’t really have models to explain them.
The most important fact is that the system doesn’t generate inflation. This is because of fundamental changing in the micro-economy – firms and workers are price takers – and in the macro economy – after a long period of no inflation, people expect no inflation (the concept of ‘inflation expectations’ is almost certainly redundant). This is true across the developed world. the opposite is the defining characteristic of an ‘emerging market’.
Whether or not you agree with this statement of structural change, bear with me, it is not necessary to believe this to support what follows, but it gives it added urgency.
If we live in a world where inflation is to all practical intents and purposes zero – or on Greenspan’s definition, people act as if it zero – what should a central bank do. I think it is clear that its central purpose is to avoid recession. Not recognising this is a failure to understand how the world works. Central banks job now is to prevent recessions.
Preventing recessions is the same as controlling nominal demand. So central banks need to target nominal demand directly. How should they do this? I will not rehearse the arguments as to why a single policy rate is a busted flush – I think this is now obvious to all. Simply put, the marginal impact of declining rates falls and at some point the sign becomes ambiguous – i.e. when rates get close to zero, further rate reductions are as likely to depress as stimulate demand. The marginal impact of asset purchases is similar.
What are the alternatives? The most important alternative, which remains unrecognised, is dual interest rates. The inventor of the TLTRO and Japan’s tiered reserves deserve a joint Nobel in economics. Its the first dramatic policy innovation in decades. How can dual interest rates *always* stimulate demand? By cutting the lending rate and raising the deposit rate. If there is a single interest, logic holds that the interest payment of a borrower falls by the same amount as the interest income of the lender, so one needs to rely on effects like inter-temporal substitution, different marginal rates of consumption, or effects of intermediation, to create a stimulus from lower rates. But if lending rates fall and deposits rates go up, everyones income rises. The TLTRO has made this possible. TLTROs are loans, and the interest rate has been decoupled from the ECBs deposit rate. This means that the ECB could announce TLTROs with steeply negative interest rates, while keeping the deposit rate at, say zero. If you don’t think this works, go straight to an extreme – a perpetual TLTRO distributed by banks available to all adult citizens in the Eurozone. This targets nominal income directly, and could be implemented within days.
Whether this is permitted in all jurisdictions is unclear. Fortunately there are alternatives. The proposal by the Czech central bank, and one I have advocated for a long time – direct consumption support or a cash transfer to households – is likely the optimal new tool. It is more direct that ‘super-TLTROs’. Under this proposal, central banks, instead of messing around with interest rates, would simply transfer cash directly to adult citizens, or use the banks as their agents. The sole objective of this tool is to prevent recessions, or keep them as short as possible.
Finally, we have the ‘Bernanke drop’. This radical proposal, set out in Bernanke’s Brookings Institute articles on monetary policy tools has been bizarrely under-discussed. It is really a variant of the first two proposals, but designed to meet the institutional and regulatory framework of the US. Under Bernanke’s proposal, the Fed would make a ‘transfer’ of a quantity of reserves which the Treasury and Congress could determine how to spend or transfer. I like this least of the options, because its impact on demand would be caught up in political process and gaming. And I am not clear why the Fed cant do TLTROs – if it can, it should. As a worst best solution, Bernanke’s is worth a go.
In conclusion, central banks should move to managing nominal demand directly, through dual interest rates or direct transfers – ideally directly to households, or if necessary via the Treasury. In addition they should alter the focus on interest rates and the confusion generated by overly frequent policy changes and pedantic ‘communication’. Recessions are infrequent. Central banks should leave interest rates at a low level and explain to markets and the broader population that changes will be very rare. The Fed and ECB could leave rates at current levels indefinitely. They should explain that once every four or five years, or perhaps once a decade, they will intervene with an aggressive helicopter drop to prevent or shorten a recession. In the interim their focus will be financial stability. A debate should occur over what level of the policy rate is most appropriate to these goals, although it probably does not matter very much.
I somewhat disagree. I actually believe that “fighting recessions” got us where we are.
I believe that changes in consumption are asymmetric with respect to wealth shocks: consumption increases slowly as wealth increases, but falls sharply as wealth falls. Fighting recessions therefore necessitates a large policy asymmetry: the ratio of “wealth” to underlying economic is allowed to increase during an expansion, but then policy makers are forced to short-circuit any mean reversion. Therefore the ratio of wealth / GDP can only grow over time…this compresses future returns on all assets, which creates an unstable system (ever smaller sources of risk are required for mass flight into safe assets). The expected return on future assets is unobservable of course but I believe it plays a key role in the business cycle (and no, something like a simple P/E ratio is not a proxy).