Tuesday, June 16, 2009

Central bank policy: too little or too much?

Global central banks have cut policy rates to near-zero levels (or in the case of the ECB, 1%), and in most cases, vowed to keep short-term rates low for some time (the Fed calls this an "extended period"). And as bond markets price inflation into the yield curve, the question that comes to my mind is: have central banks done "enough"? Perhaps for the financial markets, but not for the economy.

The chart illustrates the growth in asset holdings since the beginning of 2008 by the Federal Reserve (Fed), the Bank of England (BoE), and the European Central Bank (ECB) as of June 10, 2009 (if available). Each central bank has cut policy rate to the near-zero bound by increasing the liquidity in their respective banking systems; this is what drove the surge in assets across all three banks. However, the Fed and the BoE took the quantitative/credit easing path, which is why their asset bases are monstrous compared to that of the ECB.

But asset holdings have plateaued. The Fed, BoE, and ECB are in a mode of shifting portfolio composition rather than growing their balance sheets. To be sure, massive expansionary policy has helped to keep financial markets from collapsing, but a sense of urgency remains in the economic data...the worst has passed, but the economy still contracts.

There is a host of slack built into the system. In the US, the unemployment rate is 3.9% above its level just last year, and almost double its value at the beginning of this darned recession, 4.7%. Unemployment claims have likely peaked. But as James Kwak points out, they are not really falling; and unless there is a positive and extremely unexpected shock to the labor system that drops claims quickly, there will be slack building in the labor market for quite some time.

Perhaps central banks should shift focus again, making a real attempt to stimulate the economy (yes, in spite of the infamous liquidity trap).

I like what Scott Sumner at the MoneyIllusion blog has to say about furthering monetary stimulus:
There are three ways to make monetary policy more stimulative. Unfortunately the political viability of each approach is inversely related to its effectiveness. The most effective but least likely option would be for the Fed to commit to a NGDP target path, with level targeting (i.e. a growth path that they commit to catching up to if they fall short (and vice versa).) The second most effective option would be a modest interest penalty on excess reserves, perhaps 2%. The least effective option is quantitative easing. A bit of QE has been tried in the past few months, although less than many people realize. Again, there are far more effective monetary policy tools, but as the Fed seems unwilling to use them, it looks like QE is all we have for the moment.
Financial markets and the overall banking system are very different today than they were during Keynes' days. As Scott Sumner suggests, why not take advantage of these "alternative tools", like INTEREST ON RESERVES!

Rebecca Wilder


  1. Did you read John Hempton's take on rational inflation expectations and monetarism (eg the Policy Irrelevance Proposition)?

    Seems like a reasonable case that monetary policy can be modeled with long and short term interest rate expectations, except near the zero bound... just read the wonkyness >:)

    Love to hear what you think.
    Is it reasonable?
    How useful is it... now? :^O

  2. Unlike his predecessors, Bernanke is exceptionally gifted; he just matriculated at the wrong universities. As soon as Bernanke was appointed to the Chairman of the Federal Reserve, the rate-of-change in legal reserves , (the proxy for inflation), dropped for 29 consecutive months (out of a possible 39, or sufficient to wring inflation out of the economy).

    It’s only been in the last 10 successive months (since Aug 2008), that the FED’s “tight” monetary policy was finally reversed.

    An overcautious Federal Open Market Committee acted too late to prevent the extremely high transactions velocity of money from declining (such a high velocity is required just to maintain prices at their current levels). In the longest recession since the Great Depression, it is obvious that money has no significant impact on prices unless it is actually being exchanged.