Conducting Monetary Policy at Very Low Short-Term Interest Rates
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Conducting Monetary Policy at Very Low Short-Term Interest Rates By BEN S. BERNANKE AND VINCENT R. REINHART* Can monetary policy committees, accus- the costs and benefits of very low interest rates, tomed to describing their plans and actions in an issue that bears on the question of whether terms of the level of a short-term nominal in- the central bank should take the policy rate all terest rate, find effective means of conducting the way to zero before undertaking alternative and communicating their policies when that rate policies. is zero or close to zero? The very low levels of interest rates in Japan, Switzerland, and the I. Shaping Interest-Rate Expectations United States in recent years have stimulated much interesting research on this question and The pricing of long-lived financial assets, have led some central banks to make changes in such as equities and mortgages, depends in part their operating procedures and communications on the entire expected future path of short-term strategies. In this paper, we will give a brief interest rates, as well as on the current short- overview of current thinking on the conduct of term rate. Hence, a central bank can affect asset monetary policy when short-term interest rates prices and economic activity by influencing are very low or even zero.1 market participants’ expectations of future Monetary policy works for the most part by short-term rates. Recent research has examined influencing the prices and yields of financial this potential channel of influence in fully artic- assets, which in turn affect economic decisions ulated models (see Lars Svensson, 2001; Gauti and thus the evolution of the economy. When Eggertsson and Michael Woodford, 2003; the short-term policy rate is at or near zero, the Woodford, 2003 Ch. 6). This literature suggests conventional means of effecting monetary ease that, even with the overnight nominal interest (lowering the target for the policy rate) is no rate at or near zero, additional stimulus can be longer feasible. However, it would be a mistake imparted by offering some form of commitment to think that monetary policy was impotent. We to the public to keep the short rate low for a discuss three strategies for stimulating the econ- longer period than previously expected. This omy at an unchanged level of the policy rate: commitment, if credible, should lower yields these involve (i) providing assurance to inves- throughout the term structure and support other tors that short rates will be kept lower in the asset prices. future than they currently expect, (ii) changing In principle, the central bank’s policy com- the relative supplies of securities in the market- mitment could be either unconditional or con- place by altering the composition of the central ditional. An unconditional commitment is a bank’s balance sheet, and (iii) increasing the pledge by the central bank to hold short-term size of the central bank’s balance sheet beyond rates at a low level for a fixed period of calendar the level needed to set the short-term policy rate time. In this case, additional easing would take at zero (“quantitative easing”). We also discuss the form of lengthening the period of commit- ment. However, given the many uncertainties that affect the outlook, a policy-making com- * Board of Governors of the Federal Reserve System, mittee might understandably be reluctant to Washington, DC 20551. We have benefited from the re- make an unconditional promise about policy search of, and many discussions with, numerous colleagues, actions far into the future. An alternative is to as well as the comments of our discussant Carl Walsh. make a conditional policy commitment that However, the views expressed here are our own and are not links the duration of promised policies not to necessarily shared by anyone else in the Federal Reserve System. the calendar, but to economic conditions. For 1 See Bernanke (2002) and James Clouse et al. (2003) for example, policy ease could be promised until earlier discussions of these issues. the committee observes sustained economic 85
86 AEA PAPERS AND PROCEEDINGS MAY 2004 growth, a decline in resource slack, or inflation the government debt is large and not indexed to above a specified floor. inflation, and (ii) the central bank values the In practice, central banks appear to appreciate reduction in fiscal burden that reflationary pol- the importance of influencing market expecta- icies will bring (for example, because it may tions about future policy. For example, in May reduce the future level of distortionary taxa- 2001, with its policy rate virtually at zero, the tion). Ultimately, however, the central bank’s Bank of Japan promised that it would keep its best strategy for building credibility is to build policy rate at zero as long as the economy trust by ensuring that its deeds match its words. experienced deflation—a conditional policy Hence, the shaping of expectations is not an commitment. More recently, the Bank of Japan independent policy instrument in the long run. has been more explicit about the conditions under which it would begin to raise rates; for II. Altering the Composition of the Central example, it has specified that a change from Bank’s Balance Sheet deflation to inflation that is perceived to be temporary will not provoke a tightening.2 In the Central banks typically hold a variety of as- United States, the August 2003 statement of the sets, and the composition of assets on the cen- Federal Open Market Committee (FOMC) that tral bank’s balance sheet offers another “policy accommodation can be maintained for a potential lever for monetary policy. For exam- considerable period” is another example of a ple, the Federal Reserve participates in all seg- commitment by policymakers. The close asso- ments of the Treasury market, with most of its ciation of this statement with the FOMC’s current asset holdings of about $650 billion expressed concerns about “unwelcome disinfla- distributed among Treasury securities with ma- tion” implied that this commitment was condi- turities ranging from four weeks to 30 years. As tioned on the assessment of the economy. The an important participant in the Treasury market, conditional nature of the commitment was the Federal Reserve might be able to influence sharpened in the FOMC’s December statement, term premiums, and thus overall yields, by which explicitly linked continuing policy ac- shifting the composition of its holdings, say, commodation to the low level of inflation and from shorter- to longer-dated securities. In sim- the slack in resource use.3 More generally, in ple terms, if the liquidity or risk characteristics recent years central banks have worked hard to of securities differ, so that investors do not treat improve communication with the public; a key all securities as perfect substitutes, then changes objective of this effort is better alignment of in relative demands by a large purchaser have market expectations of policy with the policy- the potential to alter relative security prices. The making committee’s own intentions. same logic might lead the central bank to Of course, policy commitments can influence consider purchasing assets other than govern- future expectations only to the extent that they ment securities, such as corporate bonds or are credible. Various devices might be em- stocks or foreign government bonds. (The Fed- ployed to enhance credibility, including trans- eral Reserve is currently authorized to purchase acting in financial markets in ways that makes it some foreign government bonds but not most costly to renege, such as writing options private-sector assets, such as corporate bonds or (Clouse et al., 2003). An objection to this strat- stocks.) egy is that it is not obvious why a central bank, An extreme example of a policy keyed to which has the power to print money, should be the composition of the central bank’s balance overly concerned about financial gains and sheet is the announcement of a ceiling on some losses. Eggertsson and Woodford (2003) point longer-term yield below the prevailing rate. out that a government can more credibly prom- This policy entails (in principle) an unlimited ise to carry out policies that raise prices when (i) commitment to purchase the targeted security at the announced price. (To keep the overall size 2 of its balance sheet unchanged, the central bank For a recent appraisal of monetary policy options in Japan, see Bernanke (2003). would have to sell other securities in an amount 3 FOMC statements are available at 具www.federalreserve. equal to the purchases of the targeted security.) gov/boarddocs/press/monetary典. Obviously, this policy would signal the policy-
VOL. 94 NO. 2 POLICIES TO DEAL WITH DEFLATION 87 makers’ strong dissatisfaction with current mar- constraint. In contrast, the Federal Reserve’s ket expectations of future policy rates. relative holdings of longer-dated Treasury notes Whether policies based on manipulating the and bonds fell over the period, although the rate composition of the central-bank balance sheet ceilings at these longer maturities were not can be effective is contentious. The limited em- breached until inflation pressures led to the pirical evidence suggests that, within broad Fed–Treasury Accord and the abandonment of classes, assets are close substitutes, so that the pegging policy in 1951. The conventional changes in relative supplies of the scale ob- interpretation is that long-run policy expecta- served in U.S. experience are unlikely to have a tions must have been consistent with the ceil- major impact on risk premiums or term premi- ings at the more distant points on the yield ums (Reinhart and Brian Sack, 2000). If this curve. Less clear is the extent to which the view is correct, then attempts to enforce a floor pegging policy itself influenced those policy on the prices of long-dated Treasury securities expectations. (for example) could be effective only if the Probably the safest conclusion about policies target prices were broadly consistent with in- based on changing the composition of the cen- vestor expectations of future values of the pol- tral bank’s balance sheet is that they should be icy rate. If, to the contrary, investors doubted used only to supplement other policies, such as that short rates would be kept low, the central an attempt to influence expectations of future bank could end up owning all or most of the short rates. This combined approach allows the targeted securities. Moreover, even if large pur- central bank to enjoy whatever benefits arise chases of, say, a long-dated Treasury security from changing the relative supplies of outstand- were able to affect the yield on that security, the ing securities without risking the problems that policy may not have significant economic ef- may arise if the yields desired by the central fects if the targeted security becomes “discon- bank are inconsistent with market expectations. nected” from the rest of the term structure and from private rates, such as mortgage rates. Yet III. Expanding the Size of the Central Bank’s another complication affecting this type of pol- Balance Sheet icy is that the central bank’s actions would have to be coordinated with the central government’s Besides changing the composition of its bal- finance department to ensure that changes in ance sheet, the central bank can also alter policy debt-management policies do not offset the at- by changing the size of its balance sheet, that is, tempts of the central bank to affect the relative by buying or selling securities to affect the supplies of securities. overall supply of reserves and the money stock. Despite these potential pitfalls, policies based Of course, this strategy represents the conven- on changing the composition of the central tional means of conducting monetary policy, as bank’s balance sheet have been tried in the described in many textbooks. These days, most United States. From 1942 to 1951, the Federal central banks choose to calibrate the degree of Reserve enforced rate ceilings at two and some- policy ease or tightness by targeting the price of times three points on the Treasury yield curve. reserves—in the case of the Federal Reserve, This objective was accomplished with only the overnight federal funds rate. However, noth- moderate increases in the Federal Reserve’s ing prevents a central bank from switching its overall holdings of Treasury securities, relative focus from the price of reserves to the quantity to net debt outstanding; moreover, there is little or growth of reserves. In particular, even if the evidence that the targeted yields became “dis- price of reserves (the overnight rate) becomes connected” from other public or private yields. pinned at zero, the central bank can still expand The episode is an intriguing one, but unfortu- the quantity of reserves beyond the level re- nately the implications for current policy are not quired to hold the overnight rate at zero, a entirely straightforward. We know that, by policy sometimes referred to as “quantitative 1946, the Federal Reserve System owned al- easing.” Some evidence exists that quantitative most nine-tenths of the (relatively small) stock easing can stimulate the economy even when of Treasury bills, suggesting that, at the short interest rates are near zero (see e.g., Christina end, the ceiling on the bill rate was a binding Romer’s  discussion of the effects of
88 AEA PAPERS AND PROCEEDINGS MAY 2004 increases in the money supply during the Great replaces a direct tax, say on labor, with the Depression in the United States). inflation tax.) Alan J. Auerbach and Maurice Quantitative easing may affect the economy Obstfeld (2003) have analyzed the fiscal and through several possible channels. In particular, expectational effects of a permanent increase in if money is an imperfect substitute for other the money supply along these lines. Note that financial assets, then large increases in the the expectational and fiscal channels of quanti- money supply will lead investors to seek to tative easing, though not the portfolio substitu- rebalance their portfolios, raising prices and re- tion channel, require the central bank to make a ducing yields on alternative, non-money assets. credible commitment not to reverse its open- In turn, lower yields on long-term assets will market operations, at least until certain condi- stimulate economic activity. The possibility that tions are met. Thus this approach also poses monetary policy works through portfolio substi- communication challenges. tution effects, even in normal times, has a long Japan once again provides the most recent intellectual history, having been espoused by case study. In the past two years, current- both Keynesians (James Tobin, 1969) and mon- account balances held by commercial banks at etarists (Karl Brunner and Allan Meltzer, 1973). the Bank of Japan have increased about five- Recently, Javier Andres et al. (2003) have fold, and the monetary base has risen to almost shown how these effects might work in a 30 percent of nominal GDP. While deflation general-equilibrium model with optimizing agents. appears to have eased in Japan, it is difficult Quantitative easing may also work by alter- to know how much of the improvement is due ing expectations of the future path of policy to monetary policy and, of the part due to rates. For example, suppose that the central monetary policy, how much is due to the zero- bank commits itself to keeping reserves at a interest-rate policy and how much to quantita- high level, well above that needed to ensure a tive easing. zero short-term interest rate, until certain eco- nomic conditions obtain. Theoretically, this ac- IV. Sequencing and the “Costs” tion is equivalent to a commitment to keep of Low Interest Rates interest rates at zero until the economic condi- tions are met, a type of policy we have already The forms of monetary stimulus described discussed. However, the act of setting and meet- above can be used once the overnight rate has ing a high reserves target is more visible, and already been driven to zero or as a way of hence may be more credible, than a purely driving the overnight rate to zero. However, a verbal promise about future short-term interest central bank might choose to rely on alternative rates. Moreover, this means of committing to a policies while maintaining the overnight rate zero interest rate will also achieve any benefits somewhat above zero. For example, an attempt of quantitative easing that may be felt through to influence market expectations of future short non-expectational channels. rates by means of a policy commitment or to Lastly, quantitative easing that is sufficiently affect term premiums by changing the compo- aggressive and perceived to be long-lived may sition of the central bank’s balance sheet does have expansionary fiscal effects. So long as not require that the policy rate be at zero. market participants expect a positive short-term (Quantitative easing, of course, is not compati- interest rate at some date in the future, the ble with a positive overnight rate.) The appro- existence of government debt implies a current priate sequencing of policy actions depends on or future tax liability for the public. In expand- the perceived costs associated with very low or ing its balance sheet by open-market purchases, zero overnight interest rates, as well as on op- the central bank replaces public holdings of erational considerations and estimates of the interest-bearing government debt with non- likely effects of alternative combinations of pol- interest-bearing currency or reserves. If the in- icies on the economy. crease in the monetary base is expected to What costs are imposed on society by very persist, then the expected interest costs of the low short-term interest rates? Observers have government and, hence, the public’s expected pointed out that rates on financial instruments tax burden decline. (Effectively, this process typically priced below the overnight rate, such
VOL. 94 NO. 2 POLICIES TO DEAL WITH DEFLATION 89 as liquid deposits, shares in money-market mu- impression that monetary policy is ineffective. tual funds, and collateralized borrowings in the As we have stressed, that would indeed be a “repo” market, would be squeezed toward zero misimpression, as the central bank has means of as the policy rate fell, prompting investors to providing monetary stimulus other than the con- seek alternatives. Short-term dislocations might ventional measure of lowering the overnight result, for example, if funds flowed in large nominal interest rate. However, it is also true amounts from money-market mutual funds into that policymakers’ inexperience with these al- bank deposits. In that case, some commercial- ternative measures makes the calibration of pol- paper issuers who have traditionally relied on icy actions more difficult. Moreover, given the money-market mutual funds for financing important role for expectations in making many would have to seek out new sources, while of these policies work, the communications banks would need to find productive uses for the challenges would be considerable. Given these deposit inflows and perhaps face changes in difficulties, policymakers are well advised to act regulatory capital requirements. In addition, li- preemptively and aggressively to avoid facing quidity in some markets might be affected (for the complications raised by the zero lower example, the incentive for reserve managers to bound. trade federal funds diminishes as the overnight rate falls, probably thinning brokering in that REFERENCES market). In thinking about the costs associated with a Andres, Javier; López-Salido, J. David and low overnight rate, one should bear in mind the Nelson, Edward. “Tobin’s Imperfect Asset message of Milton Friedman’s classic essay on Substitution in Optimizing General Equilib- the optimal quantity of money (Friedman, rium.” Unpublished manuscript presented at 1969). Friedman argued that an overnight inter- the JMCB/Federal Reserve Bank of Chicago est rate of zero is optimal, because a zero op- James Tobin Symposium, 14 –15 November portunity cost of liquidity eliminates the 2003. socially wasteful use of resources to economize Auerbach, Alan J. and Obstfeld, Maurice. “The on money balances. From this perspective, the Case for Open-Market Purchases in a Liquid- costs of low short-term interest rates can be seen ity Trap.” Working paper, University of largely as adjustment costs, arising from the California–Berkeley, 2003. unwinding of schemes designed to make hold- Bernanke, Ben. “Deflation: Making Sure ‘It’ ing transactions balances less burdensome. Doesn’t Happen Here.” Remarks before the These costs are real but are also largely transi- National Economists’ Club, Washington, tory and have limited sectoral impact. More- DC, 21 November 2002. over, to the extent that the affected institutions . “Some Thoughts on Monetary Policy have economic functions other than helping in Japan.” Address to the Japan Society of clients economize on money balances (for Monetary Economics, Tokyo, 31 May 2003. example, if some money market mutual funds Brunner, Karl and Meltzer, Allan. “Mr. Hicks have a comparative advantage in lending to and the ‘Monetarists.’ ” Economica, Febru- commercial-paper issuers), there is scope for ary 1973, 40(157), pp. 44 –59. repricing that will allow these services to con- Clouse, James; Henderson, Dale; Orphanides, tinue to be offered. Thus, there seems to be little Athanasios; Small, David H. and Tinsley, P. A. reason for central banks to avoid bringing the “Monetary Policy When the Nominal Short- policy rate close to zero if the broader economic Term Interest Rates Is Zero.” Topics in Mac- situation so warrants. roeconomics, 2003, 3(1), article 12. Perhaps the more important argument for en- Eggertsson, Gauti and Woodford, Michael. “The gaging in alternative monetary policies before Zero Bound on Interest Rates and Optimal lowering the overnight rate all the way to zero is Monetary Policy.” Brookings Papers on Eco- to ensure that the public does not interpret a nomic Activity, 2003, (1), pp. 139 –233. zero reading for the overnight rate as evidence Friedman, Milton. The optimum quantity of that the central bank has “run out of ammuni- money and other essays. Chicago: Aldine, tion.” That is, low rates risk fostering the mis- 1969.
90 AEA PAPERS AND PROCEEDINGS MAY 2004 Reinhart, Vincent and Sack, Brian. “The Eco- Economic Studies, February 2001, 19, Spe- nomic Consequences of Disappearing cial Edition, pp. 277–312. Government Debt.” Brookings Paper on Tobin, James. “A General Equilibrium Ap- Economic Activity, 2000, (2), pp. 163–209. proach to Monetary Theory.” Journal of Romer, Christina. “What Ended the Great De- Money, Credit, and Banking, February 1969, pression?” Journal of Economic History, De- 1(1), pp. 15–29. cember 1992, 52(4), pp. 757– 84. Woodford, Michael. Interest rates and prices: Svensson, Lars E. O. “The Zero Bound in an Foundations of a theory of monetary policy. Open Economy: A Foolproof Way of Escap- Princeton, NJ: Princeton University Press, ing from a Liquidity Trap.” Monetary and 2003.
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