Macro - Macroeconomics at the Zero Lower Bound

Objections to forward looking policy from Rudebusch, G. and J. Williams (2006)

1) Institutional objection - The first objection is an institutional one. Many have argued that forward-looking policy signals are very difficult, if not impossible, for monetary policymakers to produce; that is, a committee of monetary policymakers may be unable to agree on a likely future path. View of Goodhart - former member of MPC. 2) Financial market participants will inevitably misinterpret the central bank's signals. Don Kohn noted that a forward-looking policy announcement "could lock in market expectations and reduce flexibility because it would set up situations in which the market expected some action and the Committee would then have to worry about disappointing those expectations." So is it only useful at ZLB times, not more generally?

3 reasons monetary policy can fail to have desired effect on output

1) Investment is insensitive to real interest rate. 2) The long-run real interest rate does not move in line with changes in the short-term nominal interest rate. 3) The central bank wishes to stimulate demand but nominal interest rate close to zero.

The control problem of PP targets.

1) Practical obstacle to PP targeting is that inflation is not perfectly controlled by CBs. Policy-makers therefore prefer the simplest possible adjustment path for π. 2a) At points much as B there is risk of positive cost-push shock occurring resulting in significant overshoot that undermines CB credibility. 2b) And at D, there is a risk that whilst correcting a previous inflation overshoot (C), a shock drives inflation negative. 3) Public/interest group may not accept continuation of tight monetary policy when at E!

Methods of Escaping Liquidity Trap

1) announcing positive inflation target 2) announcing price-level target path 3) expanding the monetary base via open market operations 4) reducing long interest rates via ceiling on long rates or via a commitment to keep instrument rate equal to zero for substantial time 5) depreciating currency by forex interventions 6) Introducing time-varying exchange rate target 7) introduce tax on money 8) introduce expansionary fiscal policy 9) Affect intertemporaly substitution of consumption and investment by time variable tax rates.

How to get out of deflation Trap (Carlin and Soskcie)

1) successful fiscal expansion or recovery of autonomous investment or consumption that shifts IS curve right 2) Creation of more positive inflation expectations - Sptting in the wind?

Optimal Policy at ZLB - raising inflation expectations.

A commitment to irresponsibility may be necessary. CB pledge to keep policy rates not only until economy equilibrates but instead until a temporary increase in inflation target is achieved. This raises inflation expectations and lowers long-run real interest rates as a result. Required decrease in long real rates achieved through working on other term in definition of real interest rates. Think it works through consumers realising the cost of long term fixed mortgages fallen so increase consumption now due to consumption smoothing Examples - Fed vowed to keep rates at ZLB for extended period after full employment reached. Tempting to look at fig 33 and say commitment to irresponsibility using future rate delivers point B. But recall rate on vertical access is real short rate defined by policy rate minus expected inflation. Whereas here it is expected inflation and hence real rates over some long horizon doing the work. Hence model commitment to irresponsibility as outward IS shift.

Gaspar, Smets, Vespin (2007)

According to the conventional wisdom in central banking circles, price level path stability is not an appropriate goal to delegate to an independent central bank. This is mainly because price level path stability would induce increased volatility of inflation and output gaps compared to a regime of inflation targeting. Stanley Fisher contributed to the conference celebrating the tercentenary of the Bank of England in 1994, where he said: "Price level targeting is thus a bad idea, one that would add unnecessary short-term fluctuations to the economy." 2 main arguments in favour of price path targeting regime: 1) First, under rational expectations price level stability helps overall macroeconomic stability by making expectations operate like automatic stabilizers. After a positive (negative) shock to the price level, firms, correctly anticipating a persistent policy response that will reverse the effect on the price level, adjust their inflation expectations down (up), thereby mitigating the impact of the shock. 2) Second, a commitment to a reversion to a price level path helps to alleviate the zero bound on nominal interest rates. Here the reason is that the changes in the price level help the inter-temporal adjustment. 2 main arguments against price path targeting. 1) It is argued that if expectations are mainly backward-looking, the additional benefits of price-level stability will be small. Moreover, the transitional costs of establishing the credibility of a regime of price level path stability may be too large. Counter to 1) We show that, under adaptive learning on the part of firms, the track record obtained under such a regime leads to a similar case for price level path targeting. 2) A second argument is that the benefits of price level targeting depend too much on unrealistic assumptions regarding central bankers' ability to control the price level. The idea here is that, because of uncertainty about the state and the functioning of the economy, policy makers make mistakes and generate volatility in the price level (when prices are sticky). Moreover PP targeting increases the cost of mistakes. Counter to 2) Argumentonly partially true - does not take into account the positive ex ante effects price level stability may have on expectation formation by private sector in response to such mistakes. Moreover, one should take into account the positive effect of commitment to price level stability on CB's incentive not to make mistakes.

Nominal GDP targets

Alternative to a PP target. In times of pure demand shocks both price level and output fall, inducing low nominal GDP growth which must be offset by rapid nominal GDP growth (and hence loose monetary policy in future) so thus advantage of PP target retained. However, following stagflation shocks, output falls and price levels rise, leaving nominal GDP roughly stable. So nominal GDP target would not induce unnecessary tightening of policy that PP target would have in 2008/09. OR - still doesn't solve problem? Problems 1) nominal GDP target leas easy policy anchor as GDP observed quarterly and frequently revised several years after the event. Thus CB may respond to false signals 2) Nominal GDP/ real GDP is GDP deflator and is different concept to CPI. GDP deflator excludes imports (consumed by UK households) and includes exports (not consumed by UK households). This i problem if ultimately it is CPI that matters - CPI is that which defines cost of living for households and thus is a better measure of household welfare

Interesting point regarding solving ZLB problem with PP targeting.

Announcement of PP target may not be credible! Rational agents may suppose that such a change in target is only temporary, and adopted in order to try and convince them to change their expectations. This is a reasonable deduction as central banks are averse to inflation volatility which is necessarily increased when adopting a price path target in place of an inflation target.

Countries that have used forward guidance

BoJ - announcement in autumn 2003 that it promised to keep interest rate low until deflationary pressures had subsided and CPI inflation was projected to be in positive territory.

The Case for PP targets

CB mandate to PP target would commit policy to irresponsibility of raising future inflation. This in turn locks in long-term real rates and induces expenditure necessary to raise y to ye. Mankiw supports PP targeting and Bank of Canada commissioned a review of case for them (but not implemented them. Blanchard has advocated too. PP targets also ensure there is no delay in monetary stimulus which allows adverse demand multipliers to set in. PP target induces expectations of π in t+1 to rise and thus a fall in real interest rates today. PP targets also ensure targets are viewed symettrically (rather than asymmetrically which is often claimed to be the case for inflation targeting banks). Bias to π < 2% which results from asymmetric targeting can lead to secular demand deficit e.g. if debt contracts written on 2% inflation assumption but average inflation < 2% then real income transferred from borrowers to savers. The latter have lower MPC. We assume here that savings ≠ investment.

Stagflation shocks.

Can cause problems for PP targets. Eg in UK recession, UK inflation did not fall below 2% in early years of recession. So a PP target for CPI would not have induced decline in real rates needed to tackle recession! Would have actually made maters wrose. Solution: Specify PP in terms of refined price measure that excludes stagflation drivers. Just include domestically generated inflation? But coming up with refined price measure that works well in all circumstances is difficult.

Krugman (1998)

Coined the term of 'commitment to irresponsibility' The central new conclusion of this analysis is that a liquidity trap fundamentally involves a credibility problem-but it is the inverse of the usual one, in which central bankers have difficulty convincing private agents of their commitment to price stability. In a liquidity trap, the problem is that the markets believe that the central bank will target price stability, given the chance, and hence that any current monetary expansion is merely transitory. The traditional view that monetary policy is ineffective in a liquidity trap, and that fiscal expansion is the only way out, must therefore be qualified: monetary policy will in fact be effective if the central bank can credibly promise to be irresponsible, to seek a higher future price level. A liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes. The qualitative question is whether a temporary fiscal stimulus can have permanent effects. If current income has very strong impacts on spending, so that the marginal propensity to spend (consumption plus investment) is actually greater than one over some range, there can be multiple equilibria. A liquidity trap may therefore represent a low-level equilibrium, and a sufficiently large temporary fiscal expansion could jolt the economy out of that equilibrium into a region where conventional monetary policy worked again. Only temporary monetary expansions are ineffectual. If a monetary expansion is perceived to be permanent, it will raise prices (in a fullemployment model) or output (if current prices are predetermined). If the central bank can credibly promise to be irresponsible-that is, convince the market that it will in fact allow prices to rise sufficiently-it can bootstrap the economy out of the trap.

Time inconsistent of optimal monetary policy at ZLB

Committing to a rise in inflation above existing target through period of policy rates at ZLB is time inconsistent. If commitment to irresponsibility shifts IS out now as a result of increased consumption from those whose mortgage costs have fallen. But if this shifts IS such that y = ye and π = πT then CB is at bliss point and no incentive to follow through with irresponsibility of raising inflation. As such, private agents do not act upon forward guidance.

The Tragedy of the zero lower bound (ZLB)

Conventional monetary policy loses traction when it is most needed.

Quantitative easing

Creation new money balances for purchase of assets such as government and corporate bonds which boosts money supply. Assuming assets are purchased at a fair price then the net worth of the financial sector is actually unchanged, but bank and investor balance sheets are more liquid such that they can boost lending and trigger increased expenditure to raise inflation. The cash goes from the financial sector to the corporate sector which then invests and employs resulting in inflation! If QE is reversible, its only reversible slowly because rapid sale of assets would lower prices and imposed capital losses on CBs. As such, if QE is on a sufficient scale, it can be interpreted as a commitment technology for optimal monetary policy. Egrets' (2013) If the public expects the central bank to follow the Taylor rule, it anticipates an interest rate hike as soon as there are inflationary pressures in excess of the implicit inflation target. If the target is perceived to be price stability, this implies that quantitative easing has no effect, because a commitment to the Taylor rule implies that any increase in the monetary base is reversed as soon as deflationary pressures subside.

Currency Depreciation

Discussed by Svensson (2003) Even if the nominal interest rate is zero, a depreciation of the currency provides a powerful way to stimulate the economy out of the liquidity trap (for instance, Bernanke, 2000; McCallum, 2000; Meltzer, 2001; Orphanides and Wieland, 2000). A currency depreciation will stimulate an economy directly by giving a boost to export- and import-competing sectors. Exchange rate peg can induce private sector expectations of a higher future price level and create the desirable long-term inflation expectations that are a crucial element of the optimal way to escape form liquidity trap. This insight has the important consequence that the current exchange rate immediately reveals whether any policy to escape from a liquidity trap has succeeded in creating expectations of a substantial increase in the future price level. If it has, this appears as a substantial current depreciation of the currency. Consequently, if the currency does not depreciate substantially, the policy has failed. Problems: 1) Requires RELATIVE depreciation. Won't work if all regions simultaneously fall into depression. 2) Negative consequences for trading partners of a competitive devaluation invoking sanctions or other negative sanctions.

Fiscal Policy

Discussed by Svensson (2003) The effectiveness of this policy depends to a considerable extent on the reactions of the private sector. • For example, if the initial level of government debt is high and a higher debt is deemed unsustainable, a policy of higher government debt may cause the private sector to anticipate tax increases or government benefit reductions in the near future. A resulting increase in private sector saving will then reduce any impact of the expansionary fiscal policy.

A Tax on Money

Discussed by Svensson (2003). Tax allows negative nominal interest rates in equilibrium and allow the CB to achieve the stimulating negative interest rate. It is technically feasible to introduce a tax on commercial bank reserves in the central bank and on electronic money, such as consumer cash cards. However, introducing a tax on currency requires technological innovations like electronic chips in the notes or a lottery that determines what numbered notes in a series become worthless in each period.

Pigou's theory of equilibration

Falling prices would ultimately be stabilising as the real value of private sector assets would rise creating a positive wealth effect on consumption and shifting IS right faster than minimum real interest rate spiralled upwards. Problems: Pigou's mechanism is fragile - it relies on sufficiently large stocks of private sector assets! Think - in debtor economies falling prices will raise real value of debts and cause IS to shift left while r min rising! This can steepen IS curve and weaken the investment response even if positive inflation expectations are generated

Rudebusch, G. and J. Williams (2006)

Faust and Leeper 2005 - one of the strongest central banking taboos is the prohibition against talking publicly about future interest rates. Why? This taboo largely arises from the belief that financial markets would tend to interpret any central bank statements about the likely future path of policy as commitments to future action, as opposed to projections based on existing information and subject to considerable change. Thus, many central banks will at best only give indirect hints or use coded language about policy inclinations in order to retain a plausible deniability.

Alternative view of UK recession

Financial crisis left scar of lower equilibrium output. Decline in supply form impaired capital stock, resource mis-match, tech regress in sectors like financial services

Evidence for QE

Hard to find evidence of the mechanism described. In second half of 2014 inflation below 2% in UK, US, Japan etc. One may argue that QE has just boosted narrow money supply but not induced bank lending required to conveyed this into broad money supply, demand and inflation. Monetarists argue QE practised not aggressive enough because ultimately assets could be sold. To credibly commit to irresponsibility, CBs must 'kiss the cash goodbye'! Eg Friedmanite helicopter drop or use the QE money to buy up government bonds and then cancel them. Permanent increase would surely raise long-term inflation expectations.

Impact of non-linearities

Idea of convex PC has long history in macro. Often observed in practice due to obstacles to deflation such as unions ensuring downward nominal wage rigidity. For a given fall in output, a convex PC implies a smaller fall in inflation. This may cause problem for PP regime as it limits rise in future expected inflation and hence declines in current real long rates! However this may not be a problem - if decline in real rates insufficient for full employment then inflation undershoots ltargets and this shortfall would further increase expected future inflation until demand rises sufficiently - rational agents infer this would happen and act on implied lower real interest rates immediately. Only time it fails is a completely elastic PC. But again this requires RE in consumer sector.

The ZLB problem (1)

If policy rates subject to ZLB then lowest feasible real rate is negative of expected inflation over duration of a loan. See picture

The ZLB problem (2)

It may be the case that the stabilising rate of interest is below the minimum rate of interest. Moreover, point A in figure 33 is unstable. At A, y < ye and thus there is downward pressure on inflation! expected inflation will fall (gradual under AE but rapid under RE). The falling of inflation expectations increases the minimum real interest rate, further depressing y. This causes a deflationary spiral. Note that the fast the adjustment of prices ( the larger alpha in PC) and the fast the adjustment of expectations (larger fraction of RE agents) the faster the deflationary spiral. Krugman and others call this latter point the curse of flexibility.

Secular Stagnation

Krugman, Summers and other argue that economies face ever lower demand meaning IS further left and lower rs. Impact of this is that at any point in time, economies start closer to ZLB and thus most of the time economy is left at ZLB.

Quantitative Easing Transmission Mechanisms

Majority of channels work through raising asset prices which increases total wealth and reduces cost of borrowing as bond prices inversely related to the interest rate - can raise consumption and investment. QE aimed at long term interest rates not short-term ones. Mechanisms: 1) Confidence - may help improve public's perception of economic outlook. Higher confidence could, in addition, directly affect asset prices. 2) Policy Signalling - Introduction of QE signals CB's commitment to seeing inflation target and helps anchor inflation expectations. Demonstrates commitment to avoiding/escaping deflation trap! 3) Portfolio Rebalancing - Purchasing of gov bonds by CB pushes up price of gov bonds but indirectly raises price of other assets. Firms that sell bonds left with money. T0 extent that money and assets are not perfect subs, sellers will rebalance their portfolios, buying other financial assets and pushing up their prices. 4) Market Liquidity - QE can actively encourage trading in times of financial market distress which increases liquidity in temporarily dysfunctional markets. This can influence asset prices by reducing premier associated with illiquidity. 5) Money - Sellers of government bonds to CB will have cash which they can deposit in financial institutions. Higher levels of liquid assets may induce such institutions to lend more stimulating activity. NB - this route less likely to take place during financial crises when financial institutions are under pressure to reduce size of their balance sheets. 6) Increase in price of gov bonds reduces yields. Gov bond yields are the risk free rate. This means investment goes towards other things.

Hysteresis

Negative output shock aggravated by ZLB problem. Equilibrium output shifts downwards in direction of actual output. As such, temporary low output levels locked in following failure to stabilise. Channels for hysteresis: 1) Capital scrapping as unprofitable firms suspend investment and allow depreciation to take effect (PS shifts left) 2) long-term unemployed stop seeking work (WS shifts left) Ye shifts left as a result!

Optimal Policy at ZLB - reducing long rates

Nominal and real reductions in interest rate cannot be achieved at ZLB, however monetary policy can still be loosened through forward guidance. Long term interest rate is equal to the average of the expected interest rate on one-year bonds for next X years plus uncertainty term. In calm times expect LR rate to exceed SR interest rate. Signals regarding future policy rates feed into current long-term rates. Whilst i may be at ZLB, i^n may not and signals of low future policy rates help reduce long rates. Lower long rates matter because banks often source funding for mortgages and loans in money markets in which opportunity cost of money is long-term gov bond yield. Lower long rates mean cheaper financing for banks and (as a result) cheaper financing for firms and households. Reducing lower nominal and real long rates will shift IS right as IS is a function of real short rate. This may allow y = ye to be achieved at rmin. CRUCIAL POINT - this is a rational expectations argument, it depends on rational expectations in financial markets which bring future policy rate signals into current long rates and hence lending rates. It is in such markets where RE evidence is strongest.

What is the Zero Lower Bound?

Nominal interest rates have a lower bound in neighbourhood of zero. Most CB policy rates are rates at which CB will lend short-term to commercial banks. Negative lending rates would expose CBs to losses. CBs also set deposit rates at which commercial banks can invest funds overnight. CB deposit rates just below zero.

Will PP targets work in practice?

PP targets imparts two types of stimulus at ZLB: 1) expectations over low future nominal policy rates force down current long rates and 2) rise in expected future inflation reduces current real long rates. 1) depends on RE in financial sector 2) depends on RE in consumer/ corporate sectors in that when expected future inflation rises borrowers must infer existing loan offers are more attractive in real terms.

What if its a supply shock?

Policy of committing to future inflation will not restore output to pre-recession levels if recent downturn.

Term structure of interest rates

Relationship between short and long term interest rates

Risk Premiums and solutions to ZLB

Short and Long rates discussed so far are effectively risk free since short rate is CB policy rate and long rate is gov bond yield. In practice demand demands commercial rates which = gov bond yield + risk premium. Real commercial rate defines expenditure in IS and is a markup on risk free rate to compensate for possible loan default. We have implicitly assumed that risk premier are constant so commercial rates are proportional to risk free rates. In practice risk premia are variable ad depend on i) perceived risk of lending; ii) lend risk appetite, iii) collateral that borrowers can offer on loans. As such, monetary stimulus may be impart through measures to reduce such risk premier. CBs could enter market as a lender with greater risk tolerance than market average. In practice, both Fed and BoJ did this through purchasing corporate bonds and mortgage bonds at prices implying lower interest rates than could be achieved in market

Is Time Inconsistency important in practice?

Surely CBs stick by their word? Maybe - but not just preferences of CBs that matter! Interest group pressure may force early exit of loose monetary policy - pressure from those whose savings are 'being taxed away' and right wing economists claiming low rates feeling asset price bubbles or keeping zombie firms again.

Eggertsson 2013

The modern literature emphasizes that, even if increasing the current money supply has no effect, monetary policy is far from ineffective at zero interest rates. What is important, however, is not the current money supply but managing expectations about the future money supply in states of the world in which interest rates are positive. The modern view of the liquidity trap is more subtle than the traditional Keynesian one. It relies on an intertemporal stochastic general equilibrium model whereby aggregate demand depends on current and expected future real interest rates rather than simply the current rate as in the old Keynesian models. In order to be effective, expansionary monetary policy must change the public's expectations about future interest rates at the point in time when the zero bound will no longer be binding. Thus, successful monetary easing in a liquidity trap involves committing to maintaining lower future nominal interest rates for any given price level in the future once deflationary pressures have subsided. "The Keynesian liquidity trap is therefore only a true trap if the central bank cannot to stir expectations." In the optimal solution the central bank commits to keeping the nominal interest at zero for a considerable period beyond what is implied by the discretionary solution; that is, interest rates are kept at zero even if the deflationary shock re has subsided. Similarly, the central bank allows for an output boom once the deflationary shock subsides and accommodates mild t inflation. Such commitment stimulates demand and reduces deflation through several channels. ***Eggertsson and Woodford (2003) and Wolman (2005). They show that, if the government follows a form of price level targeting, the optimal commitment solution can be closely or even completely replicated, depending on the sophistication of the targeting regime. ****Why may government lack credibility: 1) The deflation bias implies that government has incentive to promise to deliver future expansion and higher inflation, and then to renege on this promise. 2) Deflationary shocks that give rise to commitment problem are rare (not anymore? - OR) and therefore hard for CB to build up reputation 3) Problem aggravated at ZLV as CB cannot take any direct actions (such as cutting interest rates) to show commitment. Most straightforward commitment mechanism - issue debt! Taxation is costly, so unlikely to renege on commitment after deflationary pressures subside. FDR not only announced measures, but acted to demonstrate credibility. Massive deficit spending, higher real government spending, foreign exchange interventions, and even policies that reduced the natural level of output.

Svensson (2003)

The problem is that the economy is then satiated with liquidity, and the private sector is effectively indifferent between holding zero interest rate Treasury bills and money. When this "liquidity trap" occurs, expanding liquidity (the monetary base) beyond the satiation point has no effect. 'Foolproof Way to escape liquidity trap' 1) Price Level Target Path 2) Currency Depreciation 3) Crawling peg 4) Exit strategy - of the form of abandonment of of peg in favour of inflation or price level targeting

Mishkin (2004) Can Central Bank Transparency go too far?

This paper argues that some suggestions for increased transparency, particularly a central bank announcement of its objective function or projections of the path of the policy interest rate, will complicate the communication process and weaken support for a central bank focus on long-run objectives. Problems: 1) Although committee members might have some idea of a future direction for policy rates, they are like to have trouble thinking about a precise policy-rate path than just setting rate today - may be v contentious. 2) Announcing projection of policy rate path complicates communication with public. Although economists understand that any policy path projected by the central bank is inherently conditional because changes in the state of the economy will require a change in the policy path, the public is far less likely to understand this. Even when central bank is conducting policy in an optimal manner, deviations from projected policy path may be viewed as a CB failure and could hurt CB's credibility.

Summary of PP targeting mechanism from Gaspar et al (2007)

When the central bank is committed to stabilize the price level, rational expectations become automatic stabilizers. The mechanism operates as follows. Assume that a deflationary or disinflationary disturbance leads to a fall in the price level relative to target. Economic agents observing the shock understand that the central bank will correct the disturbance through higher inflation than otherwise in the near future. As a result, inflation expectations increase, which helps to mitigate the initial impact of the deflationary shock, spreads it over time and contributes to overall stability. Under a credible regime implying reversion in the price level, inflation expectations operate as automatic stabilizers.

Examples of forward guidance

read Dan's notes