The Swiss National Bank and Bank of Japan’s New Tool to Block Massive Paper Currency Storage

Haruhiko Kuroda, 31st Governor of the Bank of Japan

The Bank of Japan’s New Negative Interest Rate Policy 

The Bank of Japan surprised the world by going to negative interest rates on January 29, 2016. You can read more about that move in Reporting on Japan’s Move to Negative Interest Rates and in these 3 news articles (1, 2, 3). But there are important aspects of the Bank of Japan’s new policy that are only now being appreciated. 

I have written a great deal about negative interest rate policy. (I have organized relevant links here.) But, thanks to Noah Smith pointing me to Martin Sandbu’s February 4, 2016 article in the Economics “Free Lunch: There is no lower bound on interest rates,” I realize that the Swiss National Bank–with the Bank of Japan following in its footsteps–has hit upon an additional tool for blocking massive paper currency storage that I hadn’t thought of. Here is how Martin Sandbu describes it:

But the Bank of Japan’s set-up for negative rates, which apparently follows the Swiss National Bank’s, casts doubt on the premise that the nominal cost of holding cash is zero. As we have explained, if a private Japanese bank wishes to exchange its central bank reserves for cash, the BoJ will adjust the portion of its reserves to which negative rates apply by the same amount. That means any extra cash that a bank wishes to hold will cost it as much as if it kept it on deposit at the central bank.

And here is the description from the Bank of Japan’s official statement about its new negative interest rate policy:

2. Adjustment concerning a significant increase in financial institutions’ cash holdings 

In order to prevent a decrease in the effects of a negative interest rate due to financial institutions’ cash holdings, if their cash holdings increase significantly from those during the benchmark reserve maintenance periods, the increased amount will be deducted from the macro add-on balance in (2). In cases where the increased amount is larger than the macro add-on balance, the amount in excess of the macro add-on balance will be further deducted from the basic balance in (1).

A Negative Paper Currency Interest Rate on Cumulative Net Withdrawals from the Cash Window

What is fascinating is this: a central bank can effectively impose a negative interest rate on additions to cash holdings by saying that any bank with access to the cash window is on the hook for whatever paper currency interest rate the central bank decides to charge on cumulative net withdrawals of paper currency by that bank after a certain date regardless of who actually ends up with that paper currency. Then it is up to the bank to figure out how and whether to pass on to its customers the negative paper currency interest rate it faces on that extra paper currency. Martin Sandbu’s article has a nice discussion of how pass-through might work. 

One chink in the armor of this mechanism for imposing negative interest rates on cumulative net withdrawals of paper currency would be if a bank went bankrupt after withdrawing a huge amount of cash at the cash window and handing off that cash to favored individuals. But that doesn’t seem like a big issue. Surely the number of banks that have access to the cash window willing to intentionally go bankrupt to help favored individuals get paper currency not subject to the negative interest rate is limited, and there may be some way for the government to prosecute the individuals who organized this scheme of using bankruptcy to circumvent the negative interest rate on additional paper currency.     

No Limit to How Low the Marginal Paper Currency Interest Rate Through the Negative Rate on Cumulative Net Cash Withdrawals Mechanism Can Go

One thing that the Bank of Japan may not yet have realized is that banks can be charged for net cash withdrawals even beyond an amount equal to the bank’s initial reserves. As it is now, the policy is represented as a policy about how much of reserves is exempted from the negative interest rates, or even receives a +.1% interest rate, but that need not be the case. Banks can be charged interest on cumulative net cash withdrawals quite apart from how their reserve accounts are handled. For now, the Bank of Japan has made a good choice to charge the negative paper currency interest rate through the formula for interest on reserves, but it should not stop there if very large amounts of paper currency are withdrawn. 

The Central Bank Can Limit Cash Withdrawals by Limiting the Total Size of the Monetary Base

Speaking of the possibility of cash withdrawals exceed initial reserves, another additional tool that I will mention only briefly is that if negative interest rates are adequate to get velocity up on a given monetary base, limits on the monetary base may limit the total amount of paper currency that can be withdrawn. This is a point I take from Martin Sandbu, who wrote in “Free Lunch: There is no lower bound on interest rates”:

And how could private banks honour mass withdrawals of cash even if they wanted to? No law provides for the central bank to swap client deposits for cash; only central bank reserves. And despite the huge growth of reserves in recent years, these still amount to only a fraction (about one-fifth in the UK) of bank deposits.

What If the Paper Currency Interest Rate is Lowered in the Future?

It might seem unfair for a central bank to lower the interest rate on cumulative net cash withdrawals that are already out there. There is a flavor of retroactivity to it. But if a bank only gets a -.2% rate on net withdrawals after a certain date and -.1% before, then it might try to withdraw a lot of paper currency right before it predicted the paper currency interest rate on further net withdrawals after would be cut. If it knows the rate can be cut on what is already out there, there is no such incentive to pull out cash under the wire. 

An alternative to making rate cuts on net paper currency withdrawals retroactive to the inception of the negative interest rate policy would be to have a schedule saying that, for example, a bank gets -.1% on the first 5% of its previous year’s reserve balance in cash, -.2% on the next 5%, -.3% on the next 5% after that, etc.  

A Warning: Side Effects of a Negative Paper Currency Interest Rate on Cumulative Net Withdrawals from the Cash Window

Although the central bank can easily do so to the private bank, it is probably not as easy for that private bank to keep charging a retail customer a negative interest rate month after month on cumulative net cash withdrawals. In principle, a bank could keep charging such a “rental fee” on net cash out to a customer, but what is to stop a customer from withdrawing a lot of cash, and then cutting all ties to the bank? (This is analogous to the intentional bankruptcy discussed above, but much easier.) Even if a contract still obligated the former customer to keep paying the rental fee on the net cash out, it is a lot of trouble for the bank to track that customer down and collect the fee–especially for modest amounts. 

As a result, private banks are likely to charge a substantial one-time fee on withdrawal of cash to make it worth their while to give out cash, or impose severe restrictions on cash withdrawals. This will interfere with the normal use of paper currency. This may not happen immediately, but is likely to emerge over time (and of course depends on exactly what interest rate the Bank of Japan is imposing, and how long banks expect negative interest rates to last). 

What is worse, restrictions or fees on withdrawals by themselves will tend to push the value of paper yen in circulation–on which fees have already been paid–above the value of electronic yen. If banks charge a fee for giving out paper currency, so can retailers. In Japan, many, many retailers only accept paper currency even now. If paper currency is going at a premium, more and more retailers are likely to declare that they only accept paper currency. This further paperization of the Japanese economy will make negative electronic interest rates less effective. (The negative paper currency interest rates don’t do the trick because they are not passed through; therefore, the burden falls on the negative electronic interest rates and on transactions made in electronic form.)

In addition to these serious problems from a paper currency policy that pushes paper currency above par, the exact exchange rate between paper currency and electronic money could be quite volatile. That is, the effective exchange rate between paper currency and electronic money that follows a jagged path over time like a stock price plot as people get new information about the future. 

By contrast, in my main proposal of a time-varying paper currency deposit fee at the cash window, if a private bank passes the time-varying paper currency deposit fee to retail customers (including extra cash upon withdrawal), the effective exchange rate between paper currency and electronic money at the bank will follow a very smooth, sedate path. I recommend that smooth, sedate path–with a below-par rather than above-par value for paper currency.    

How the Bank of Japan’s Policy Uses Two Key Innovations I Have Made in Negative Interest Rate Paper Currency Policy

In addition to giving a well-attended presentation on “Breaking Through the Zero Lower Bound” at the Bank of Japan on June 18, 2013 (and on June 24, 2013 at Japan’s Ministry of Finance), I spent 2 weeks each in the summers of 2008 and 2009 as a visiting research fellow at the Bank of Japan, and have several former students on staff there. I also made a point of arranging a seminar at the Bank of Japan on June 8, 2010 (on an unrelated paper) in order to have a chance to remind the staff at the Bank of Japan about the potential of negative interest rate policy. So I am confident that some staffers within the Bank of Japan have read my work carefully (including my work with Ruchir Agarwal on the IMF Working Paper “Breaking Through the Zero Lower Bound,” which is prominently featured here). 

I have no idea whether those who actually designed the Bank of Japan’s new policy have read my work or not. Nevertheless the Bank of Japan’s new policy has the two key features that are my innovations over the negative interest rate paper currency policy tools laid out by Willem Buiter: 

1. Existing paper currency is used.
2. The policy is focused on the central bank’s interaction with private banks. The private banks are left to decide pass-through on their own.

The advantage of using existing paper currency is obvious. The advantage of letting private banks handle pass through is that the private banks, for their own benefit, will be inventive at trying to minimize the annoyance to customers from the negative interest rate policy as much as possible given what the central bank has done. In addition, having the central bank focus only on its interaction with private banks makes the central bank’s job more manageable. It doesn’t need to think through quite as many things, since the private banks have, in effect, been deputized to work out the details of what happens at the retail level. (One limitation to this principle is that there has to exist some way for the private banks to pass the policy through–or not–that goes some distance toward achieving the macroeconomic goals without serious side effects.)  

How the Bank of Japan’s Paper Currency Policy is Different from the One I Recommend

In my presentations to central banks around the world, I warn of the problems that arise from trying to restrict or penalize withdrawal of paper currency. We may soon learn more about these problems from experience. And of course the details of the policy matter. In the case of the Bank of Japan’s policy, the emergence of an above-par, jagged price of paper currency and further paperization of the economy by more and more retailers only accepting paper currency are the most worrisome problems.

Note that–as discussed above–these problems have to do with the particular difficulties private banks will have in passing through the negative paper currency interest rates in the form that the Bank of Japan is imposing them on the banks. If the banks could pass the negative paper currency interest rates on in a similar form, there would be no great problem.   

The best course would be to follow my recommendation of a gradually changing below-par value for paper currency at the cash window of the central bank. If restrictions, penalties or fees on withdrawals–or what will result in private banks imposing restrictions, penalties or fees on withdrawals–must be used, they should be used in combination with other policies, including policies that tend to push the price of paper currency down. The possibility of second- or third-best negative interest rate paper currency policies that try to keep the relative price of paper currency close to par is the subject of an upcoming post. 

Why the Bank of Japan’s Move is So Remarkable

I thought it would be at least another year–into 2017–before the Bank of Japan went to negative interest rates–partly because to do so would be a tacit admission that its previous QE-only policy was not working as hoped. It was a genuine act of courage for the Bank of Japan’s monetary policy committee to admit that it needed something more. I applaud them. 

But what is even more remarkable is that they were willing to begin to modify paper currency policy. And make no mistake, as a practical matter, it is paper currency policy traditions that create the zero lower bound. So the Bank of Japan has made a small step down the road toward abolishing the zero lower bound–a small step that could ultimately be part of a giant leap for humankind.

Update 1: A reader points out that the Bank of Japan’s statement of its policy above can easily be interpreted as applying only to a bank’s own holdings of paper currency, which would not include paper currency it passed on to customers. (Many people have, in fact, interpreted it that way.) In that case, this would be a charge for storage of paper currency rather than a charge for cumulative net withdrawals of paper currency by banks. If that is the right interpretation, I am glad I misunderstood the statement so I could see the interesting possibility of a charge on cumulative net withdrawals. But I am also glad to be corrected about what the actual current policy is.  

In the event, if a bank made large paper currency withdrawals to pass paper currency on to customers, I suspect the Bank of Japan would try to do something to discourage that flow. Since the Bank of Japan is making the policy itself (and there is a tradition in Japan of administrative discretion) a private bank should worry about what the Bank of Japan would do if the private bank became a conduit for a large amount of paper currency to customers. 

Update 2: The Swiss National Bank’s corresponding statement for its policy (on which the Bank of Japan’s policy is probably modeled) is clearer:

Minimum reserve requirement of the reporting period 20 October 2014 to 19 November 2014 times 20 (static component). –/+ Increase/decrease in cash holdings resulting from comparison of cash holdings in current reporting period and corresponding reporting period in given reference period (dynamic component) = Exemption threshold

Thanks to JP Koning for this point.

Update 3: Makoto Shimizu gives an answer to Update 1. This is so important, it has its own post. Don’t miss “Makoto Shimizu Reports on the Bank of Japan’s New Tool to Block Massive Paper Currency Storage.”

Reporting on Japan’s Move to Negative Interest Rates

Link to the article on wsj.com

Anjani Trivedi, Eleanor Warnock and Greg Ip’s Wall Street Journal article “Central Banks Go to New Lengths to Boost Economies: Bank of Japan’s move to negative rates is the latest attempt to spur growth,” is a good example of the still inadequate reporting about negative interest rates. The revision noted that it had input from Tommy Stubbington, whom I praised in “The Wall Street Journal Gets It Right On Negative Interest Rate Policy, Thanks to Tommy Stubbington,” and was noticeably better, though in a spotty way. Let me give my reactions to some important passages.

Basic Reporting

The reporting at the beginning of the article is well done. I particularly appreciated the discussion of international linkages:

Japan’s move washed through currency markets, driving the yen down by as much as 2.2% against the dollar, and showed how easing by one central bank puts pressure for similar moves by others.

By strengthening the dollar, the continued loosening of monetary policy in Japan and Europe could complicate the Fed’s aim of gradually notching up interest rates this year. Measured against a basket of 16 currencies, the dollar this week hit its highest level in more than 13 years.

and how massive paper currency storage has not yet appeared in Europe:

… the move in Europe into negative rates has so far created no evident disruptions for money-market funds or a flight to cash by depositors, giving a green light for banks to consider going further.

“Adverse effects on money market functioning have been limited,” Stanley Fischer, the Fed’s vice chairman, said in a speech this month. “Cash holdings have not risen significantly in these countries, in part because of nonnegligible costs of insuring, storing, and transporting physical cash.”

I was surprised by how low Sweden has gone:

No one knows how low negative rates can get before those costs become an inducement to hold cash, but probably beyond the minus .75% rate now charged in Denmark and the minus 1.1% in Sweden.

And the article pointed out an important fact, which I discussed on Wednesday in relation to two-tiered negative deposit rates in the euro zone:

Few banks have so far passed on those negative rates to small retail depositors.

Looking forward, this is an interesting prediction:

In a note to clients Friday, Citigroup economists predicted the ECB and the Swedish and Danish central banks would cut their policy rates even further into negative territory in coming months, and their counterparts in Canada, Australia, Norway and even China may do so “should macroeconomic conditions turn out even weaker than currently expected.”

Analysis

As the article moved from reporting to more analysis, the quality declined. For example, the authors needed a counterpoint to Raghuram Rajan’s declaration

… stimulus doesn’t cut it anymore and certainly monetary policy has largely run its course. 

Guess what–monetary policy hasn’t run its course at all. In my most recent visits to central banks, my advice has been to choose the policy rate as if there were no zero lower bound–because there isn’t a zero lower bound for any central bank that knows what it is doing. And increasingly, central banks do know how to defeat the zero lower bound. My bibliographic post “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide” gets a steady stream of pageviews, many of which I am confident are from central bank staff around the world. And I have been to a fair number of central banks in person. For journalists to understand everything central bankers are thinking, they need to read some of what I have written. Otherwise, they will get things wrong.

Even more misleading is this quotation with no counterpoint:

Central bankers “are running out of things to do,” said Sean Yokota, head of Asia strategy at Nordic bank SEB.

This is first, false, since a lot remains to be done in the direction of negative interest rates. Secondly, it seems to suggest that negative interest rates are a last resort. No! Negative interest rates were always likely to be much more effective than quantitative easing. Quantitative easing was tried first primarily because the intellectual preparation for quantitative easing was further along than the intellectual preparation for negative interest rates when central banks felt the need for another tool.

The Power of Negative Rates

The reporting was fully appropriate in giving this quotation,

Despite the day’s surge, some investors remained skeptical about the lasting impact of the central banks’ efforts. “People are starting to feel more and more that central bank action is having less and less fire for effect,” said Ian Winer, head of equities at Wedbush Securities.

but I want to take issue with Ian Winer himself. I want to insist that the power of negative interest rates be judged per basis point. Given the mild negative interest rates so far, the effects have been substantial per basis point reduction. The size of the effects is especially impressive when one realizes that only the weak version of negative interest rates has been used so far. As I wrote in “The Swiss National Bank Means Business with Its Negative Rates,”

There is a world of difference between a central bank that cuts some of its interest rates, but keeps its paper currency interest rate at zero and a central bank that cuts all of its interest rates, including the paper currency interest rate. If a central bank cuts all of its interest rates, including that paper rate, negative interest rates are a much fiercer animal.

The ability to reduce the paper currency interest rate using the tools you can see discussed here makes it so that interest rates can be reduced by as many basis points as needed.

How Much More Slack Is There There in Japan’s Economy?

It is very difficult to know exactly how much slack is left in Japan’s economy. I lean toward the view that there is still substantial slack left. Try this thought experiment on for size. Suppose that, instead of trying with all its might to talk inflation up, the Bank of Japan were doing everything it could to keep inflation expectations down while using negative interest rates to stimulate the economy as much as it is being stimulated under current policy. Would inflation now be rising? If your answer is no, then you think the Japanese economy has slack. 

Even if, contrary to my own guess, the Japanese economy is already at its natural level of output or a little beyond, given the objective of raising inflation, it doesn’t make sense to think that monetary policy has been too stimulative until there is more inflation than desired, or a path that looks as if it will lead to more inflation than desired. One of the reforms mentioned in the article is really about trying to raise inflation:

Labor reforms that give benefits to contract workers so wages can rise more broadly

This seems like a reform aimed at getting more inflation. But given that as much monetary stimulus as desired can be provided by negative interest rates, there is really no reason to desire more inflation. Japan can stimulate its economy as much as desired without any extra inflation. It certainly should be willing to risk more inflation than the current level of inflation in order to learn more about what its natural level of output is, but if negative interest rate policy is fully embraced in the way I have recommended, there is no longer a strong reason to desire more inflation. Other than the neutering of monetary policy by the zero lower bound, low inflation has not caused Japan serious problems (perhaps in part because its annual bonus system reduces downward nominal rigidity of wages in Japan). And the zero lower bound is a dragon that can easily be slain now that the soft underbelly of the zero lower bound has become fully apparent.

Thinking About New Financial Technologie—Izabella Kaminska and Gillian Tett on Excitement about Fintech Eclipses Basel III at Davos →

Financial technology could take over an important part of the market fast. It is important that regulations not be used to stop progress. To make sure of that, there should be a regulatory safe harbor saying any financial technology that meets three conditions beyond the usual one of in fact doing what it seems to be telling users that it is doing should definitely be allowed: 

1. The technology is based on accounts that are 100% backed by central bank reserves. Obviously, this means that central banks have to make reserve accounts readily available to new fintech companies. 
2. All records of all transactions using the technology, and all complaints received by the company are immediately available in easy-to-read electronic form and can be freely inspected by the government without a warrant. That is, everyone using the technology signs a contract that makes everything they do with the technology totally transparent to the government.
3. Funds held on behalf of customers have a nonzero interest rate tied to a market-based measure of prevailing short-term interest rates. (This is to make sure the technologies are robust to possible negative interest rate situations.) 

This is not at all to say that all new financial technologies must meet these three criteria. But there should be absolutely no prior restraint of anything that does meet these three conditions and the usual “doing what you seem to be saying you will do” condition. The “total transparency to the government” rule should make it easy to detect problems as they arise.

How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies

In a January 25, 2016 Goldman Sachs bulletin, analyst Dirk Schumacher writes:

We expect the ECB to ease monetary policy further at the March meeting via an extension of the APP programme until September 2017 and a cut in the deposit rate by 10bp to -0.4%.

I think it would be better policy for the ECB to go straight to the -.75% that has been pioneered by the Swiss National Bank, but every bit of interest rate cuts helps at least some in the current situation where the eurozone needs so much additional stimulus. 

The Goldman Sachs report also has a long discussion of the worries members of the European Central Bank’s monetary policy committee have about the effect of lower interest rates on bank profits. In the extreme, if bank profits go down too much, banks may exert their oligopoly power to raise lending rates to raise earnings in the short-run to compensate. The issue is that banks will want to shield some of their depositors from the negative rates, so they don’t want to fully pass through negative rates to their customers.

A “two-tiered system” in which a certain amount of deposits at the central bank get a zero interest rates and amounts above that get a lower interest rate seems hard to some of the ECB’s central bankers because that might hit banks harder in some countries than others. To me, the basic solution if a two-tiered system is desired is fairly straightforward: the two-tiered system should be designed to be equivalent to a subsidy to the deposit rates for household accounts below a certain size–say enough to provide a zero interest rate on an average balance over a month of 1000 euros worth of bank deposits per adult, for that adult’s main bank. (Those with more than one bank would have to designate one bank for this effective subsidy.) 

The value of tying the amount of deposits with the European Central Bank that a private bank can get zero interest rates on to the amount of household balances from accounts with 1000 euros or less is that this makes it natural for the private banks to pass on the negative interest rates to commercial and to the excess over 1000 euros in large accounts (which is helpful for transmission of the effects of the negative interest rates) while small household account are shielded from the negative interest rates (which is helpful politically). And it is easy enough to understand the rule and its intent that banks will be able to explain why they need to transmit negative interest rates to those with large accounts. (Of course, the cutoff could be set at some other level than 1000 euros, if desired.) And this policy is fully consistent with keeping bank profits unharmed by negative interest rates as long as they do pass on negative interest rates to large accounts and commercial accounts as they are supposed to.  

Experience in Switzerland, Denmark and Sweden suggests that the more sophisticated bank customers who have large accounts or have commercial accounts adjust quickly to negative interest rates after a few weeks of bitter complaining. The objective of a two-tiered system is to have negative interest rates prevail generally in the markets, but shield from negative interest rates those who are the least able to understand negative interest rates and perhaps to accomplish a bit of redistribution as well–though clearly not redistribution toward the poorest of the poor, who may not have bank accounts at all. 

Note that by buying enough bonds and crediting the sellers with reserves–or by lending reserves–the European Central Bank can guarantee that there are much more reserves in the system than would be subject to the zero interest rate. Thus, the other interest rate will be the marginal one. And it should go without saying that the rate on short-term bonds should be pushed close to the most negative deposit rate. Keeping the bond rate at zero would not be cutting rates enough.

Gauti Eggertsson and Miles Kimball: Quantitative Easing vs. Forward Guidance

image source

In my October 5, 2012 post Ryan Avent on the Fed’s Plans to Keep Rates Low Even After Recovery is Underway I wrote

I had an extended email discussion with an economist in the Federal Reserve System (whom I will not name) who argued passionately that, given our lack of knowledge about what will work and what won’t, the Fed should be using both large-scale asset purchases and promises that it will keep stimulating the economy even after it has reached the natural level of output—planning to push the economy above the natural level of output for a while.

Now that Gauti is at Brown rather than inside the Federal Reserve System and the Fed has raised rates, the identity of this economist can be revealed: Gauti Eggertsson. Gauti was delighted by the idea of publishing our correspondence when I suggested it the other day. 

I think you will find this discussion interesting. For me, it is very close to the last moment before my efforts to advocate the elimination of the zero lower bound crowded out efforts to urge the merits of quantitative easing (though I did defend when Martin Feldstein criticized it the following June). For Gauti, these thoughts are a reflection of a large body of academic research he has done on these topics, as you can see from Gauti’s CV.  

You can tell we are both thinking things through, because both of us often follow up an email with another one giving additional thoughts. 

Gauti: Hi Miles,

So I just don’t get your objections to the Feds recent use of forward looking language and commitment. The Fed is after all legally mandated to trade off inflation and output (dual objective). It seems you base this objection is based upon that “Wallace Neutrality” does not hold and hence The Fed should focus on the balance sheet. This objection does not make sense to me.

So I think many people may be sympathetic to the notion that full neutrality may not hold – including myself – and I say this even as being one of the author of a proposition that extends Wallace original neutrality proposition to show that it even still holds in a DSGE model with New Keynesian frictions provided that we are at the zero bound (see first proposition in Eggertsson and Woodford  Brookings Papers on Economic Activity (2003)

http://www.ny.frb.org/research/economists/eggertsson/BrookingsPaper.pdf. 

In fact I think this proposition describes the neutrality people have in mind a bit better than Wallaces original one, as he was claiming it applied to all open market purchases even at positive interest rates).

The point is just that we just don’t know how much this proposition does not hold, i.e. all empirical evidence suggest that there is a great deal of uncertainty about by how much “buying stuff” increases demand.

The point in my original paper with Mike is that one important dimensions which the neutrality proposition DOES  fails, is that you can affect demand by changing expectation about future interest rate, even in the New Keynesian model (but we assumed a fixed interest rate policy rule in our proposition). Moreover, this channel is extremely strong according to that model which we illustrate in a simple model.

It seems to me that given the dire situation we are in we should be doing everything we can to stimulate demand. Sure, that includes massive asset purchases (we are now at about 3 trillion and counting!). What I don’t understand is why you want to throw away one very effective tool, namely manipulating expectation about future interest rates and inflation, which many of our models suggest is very effective. That seems to me deeply counterproductive.

In other words you seem to be acting as if there are zero costs to balance sheet actions and infinite costs to using forward guidance and policy commitment about interest rates. I don’t know in what model that sort of policy making would be optimal. I think under any kind of reasonable type of model uncertainty it would make sense to be acting on all margins. If asset market purchases are not working, hopefully forward guidance is. If forward guidance is not, hopefully asset market purchases will.  Etc.

Best – Gauti

PS. I like reading your blog, its great fun to read. Hope you  keep it up! 

Miles:  Thanks for reading my blog! 

I should clarify. Given the gaps in our knowledge, I don’t see any problem with forward guidance of the sort the Market Monetarists are recommending: here is our nominal GDP target (which can be adjusted upward if the growth rate of technology is higher than we expected or downward if not) and we will keep interest rates low until we are fully on track to hit it. This is more or less the same thing as price level targeting if adjusted for technology shocks as I said. I am worried about forward guidance that is promising to be more stimulative than that, which it was my understanding that some of the models recommend. Is that wrong?  

The focus on lengths of time (as opposed to states of the economy) bothers me, since I think we should be doing enough QE that we get there fast enough that the dates they have set are after the economy has already been fully recovered for a while.  

Actually, my understanding of the forward guidance as they are doing it now is that they are not making much of a precommitment. Is the Fed actually viewing it as a precommitment? If they want to go further in precommitting, I hope they would make commitments relative to the state of the economy and not for a length of time.  

Monetary policy only has a lag of 9 to 12 months. If we do it right (many many more trillions of asset purchases) the economy should be fully recovered by Fall 2013. So it doesn’t make any sense to commit beyond then if one focuses on time. Focusing on the state of the economy the commitments could be quite helpful as you say because they would be a backup in case the QE doesn’t do the trick.   

Am I missing something? 

Miles: By the way, an important part of my argument that it should only take 9 to 12 months is that we should be just as willing to overshoot as to undershoot. Instrument uncertainty in relation to QE should make us a little conservative, but not too much.  

Another part of my consideration in saying what I did is that I am pretty sure that I am a small enough fish at this point that nothing I say will reduce the confidence people have in the Fed’s forward guidance, which the Fed is  going to do anyway. By the next recession after this one, I think we can have departures from Wallace neutrality much better figured out and either get *more* serious about forward guidance if QE is weak and costly or emphasize it less if QE is powerful and not too costly at the right dosages. So I am trying to provide more options for the Fed in the future.  

Miles: One place I am coming from is that I think interest rate smoothing is a terrible idea. When we need to move the economy in some direction, the Fed funds rate should be moved very very fast in my view. I know you have a paper justifying interest rate smoothing to some degree, but it just seems to me that if I have a continuous-time model and turn up the power on the microscope the optimal fed funds rate has to look like a random walk at a high-enough magnification. I somehow doubt that that gets to be a bad approximation at an every-six-week frequency. 

Am I missing something?

Gauti:  Provided the target is high enough, the nominal GDP target maps relatively well into the optimal commitment, as least in the simple New Keynesian model, which is why people like Mike Woodford have been proposing it. What many have against it, is that actually it may be too stimulative relative to what that the current stance is as it they worry it may imply a commitment to lots of inflation, in case real growth does not pick up. The bottom-line of all these models, however, is that it is optimal to commit to some amount of future inflation and/or output boom beyond what a discretionary policy maker might like to do at that future date. Whether this is done via commitment to some price level, nominal GDP target, etc, is more a question of “communication”.

The calendar date has in my mind never been particularly elegant. The best thing I can say about it is that perhaps it created the perception that the Fed would be slow to raise rate, slower than people otherwise might have thought, and that putting that date down raised to cost of pre-emptive tightening. The problem is that those sort of announcements may just feed into pessimism, which I take to be your concern, as you give the impression you are keeping rates low for long, not to stimulate the economy, but because you think things will be crappy for a very long time.

As for firm commitment, I think this part of the last FOMC statement was at least helpful in that respect

“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. ”

Regardless of intentions of the Fed, I think the market is interpreting this as a commitment to allow for inflation to overshoot it long-run target some as the economy starts recovering, since the Fed will be trading off inflation and output then in accordance with its dual mandate, as it is trading off inflation and output today (intra and intertemporally). You can actually see this pretty clearly in tips markets. That’s a good thing in my mind. It should reduce the real interest rate and make some of those firms sitting on piles of cash wonder if investing it is not better than sitting on the money .

With respect to more asset purchases, there are two issues as I see it. One, their effect is uncertain, which is of course no reason not to do them (in fact that may instead be a reason to do even more to make sure they are doing anything). The other is that in practice it is actually not all that trivial to design which assets to buy and communicating it to the public, since things like MBS are not in unlimited quantities. So one has to start buying bunch of privately issued paper that has risks. Moreover, I think one way in which these purchases have effect – perhaps even the only way they have an effect – is by signalling something about future policy stance, thus working through inflation expectations. If one takes that perspective, it seems much more straight forward to communicate directly what one is trying to achieve, in particular commit to some inflation. Ideally one should do both at the same time, and I think the last statement was a bit in that direction.

My main problem with how you were writing about this, was not so much that you were for asset purchases based upon you the “Wallace neutrality” failing. That’s all fine. I don’t know how much they will do, but by all means lets try. What troubles me, and perhaps I’m misreading your views, is that you seem to think that they are so effective that there is no reason to use any other tools that may very well work much better, such as committing to somewhat higher inflation and lower future nominal rates. Given the uncertainty of the effectiveness of all tools, I think a reasonable policy should be acting on all margins. There is also the issue that we should not pretend that balance sheet actions are not costly, there are certainly big risks there as well for tax payers (the Icelandic Central Bank, for example, lost approximately 30 percent of GDP due to having taken bad collateral in the crisis in Iceland).

Gauti: I think the instrument uncertainty can actually cut both ways (I gather you may here have in mind Brainard’s 67 paper?). In this case, I actually think it might point towards the direction of doing more. 

Gauti: So the interest rate smoothing aspect of my work as it relates to this crisis is simply that even if you can’t cut the rate below zero, you can have an effect by making a commitment to keep rates low for some time in the future in a way that was different from your historical reaction function. I’m not quite sure what you mean with respect to the continuos time analog of the model, and that it would imply random walk. I’m not really seeing that. In the models I’m used to work with then usually the optimal thing to do is to make the nominal interest rate track the “natural rate of interest” as closely as possible, i.e. the real interest rate that would take place in absence of nominal frictions. To the extent that the natural rate is very volatile, then the nominal interest rate may also be quite volatile (I’ve a problem seeing it ever being a random walk, however, as it got to be bounded in some range given all the restrictions imposed by the model). 

Miles: You haven’t been misreading me. I have been saying that the asset purchases are so effective that we should not be committing to something later on that would not be optimal from the perspective of later. The concern is about having more than the optimal inflation then. I don’t have any problem with buying risky assets, in fact I think that is much safer for the Fed than buying long-term Treasuries because of predictable capital gains and losses on those if the purchases are having any effect at all. There is a good argument to made that in this particular crisis we might need some precommitment–especially given the fact that the Fed has been so limited by law in the assets it can buy it can’t really do the asset purchases the way they should be done, but since I think I will have very little effect on what happens during the current crisis, I am focused on the underlying principles of how things should be done in general. But the worst of all worlds is for the Fed ex post to think it made a stronger precommitment than the markets read it as having. Since the Fed is, in fact, making fairly weak promises, I don’t want the Fed to think it is making strong promises while the markets thought it was making only weak promises.  

What you are saying about instrument uncertainty pointing to doing more is important. Could you explain more? 

Any diffusion process looks like a random walk when you turn up the power on the microscope because the drift gets small much faster than the fluctuations. I am claiming that 6 weeks is a short enough time that whether the Fed increased the Fed funds rate last meeting *ought* to have very low predictive power for which way it jumps this meeting. What happens this meeting to the Fed funds rate should be *mostly* about information that arrived in the last 6 weeks, which is equally likely to favor raising the rate as lowering it. There would be a little drift, but not much. This is away from the ZLB.  

Miles: Two more things:

1. If asset purchases do affect expectations, then why not use them, since they won’t actually tie the Fed’s hands later on when we figure things out better? However, I want to avoid putting the Fed in a position of taking huge capital losses if and when it tightens if we can help it, so I don’t want to affect expectations through that channel. But if it affects expectations by showing everyone that the Fed isn’t excessively hawkish, that is great.  

2. Is there any paragraph or two in existence that gives a good intuitive explanation of the virtues of price-level targeting as opposed to inflation targeting that really gets to the heart of what is going on mathematically as well as being intuitive? If not, it would be great if you could try to write that paragraph or two. 

Gauti: What I find odd about your perspective, is the unwillingness to trade of some output by committing to some inflation, yet at the same time recommending very aggressive balance sheet action. It seems to me relatively clear that given the uncertainty about the effects here, we should do both, i.e. explicitly state we are willing to tolerate some inflation going forward and intervene in various asset market. My sense is that the latter is actually more costly than the former. (Was it very costly, for example, to bring down inflation from four percent to two in 1994-2004). I’m just not seeing the case against over-shooting inflation from the long term objective of the Fed, given what we know, and the dual objective that tells us to trade the two off.

What I was saying about  doing more if you have instrument uncertainty just comes out of Brainard 1967 AER paper. I think people often misread his paper as saying that under uncertainty you should do less that compared to certainty equivalenve. But as he shows, this would only be the case of the uncertainty about your policy is uncorrelated with the size of the shock you are reacting to. If the effectiveness of policy is correlated with the severity of the real shock you can easily get that you should act more the more uncertain you are about policy effectiveness (imagine for example that in the states of the world in which output is very far away from potential is also the state of the world in which policy has very small effect. Then you want to do more the more uncertain you are about effectiveness…..)

Gauti: On those two points:

1. Well you may argue that asset purchases affect expectations because they directly change the asset composition of the fed, eg buying long term debt makes it now more costly to raise short rates due to the resulting balance sheet losses. Anticipating this, people expect lower nominal the more the fed holds of long term debt….

2. Mike Woodford and I discuss the price level target in our BPEA in 2003. The basic idea is just that a correctly specified price level target increases inflation expectations and thus reduces real rates, increasing demand. A nice feature of a PLT is that if you miss it, i.e. there is deflation, then inflation expectations will increase even more, as now you have accumulated a bigger “price-level gap” which you need to fill. Thus there is an “automatic stabilizer” element to it.

Miles: Two more things:

1. If asset purchases do affect expectations, then why not use them, since they won’t actually tie the Fed’s hands later on when we figure things out better? However, I want to avoid putting the Fed in a position of taking huge capital losses if and when it tightens if we can help it, so I don’t want to affect expectations through that channel. But if it affects expectations by showing everyone that the Fed isn’t excessively hawkish, that is great.  

2. Is there any paragraph or two in existence that gives a good intuitive explanation of the virtues of price-level targeting as opposed to inflation targeting that really gets to the heart of what is going on mathematically as well as being intuitive? If not, it would be great if you could try to write that paragraph or two. 

Miles: What about this point that I made, though:

But the worst of all worlds is for the Fed ex post to think it made a stronger precommitment than the markets read it as having. Since the Fed is, in fact, making fairly weak promises, I don’t want the Fed to think it is making strong promises while the markets thought it was making only weak promises. 

In other words, I think there is a key issue of not interpreting a commitment as being any stronger than the markets think it is.

Miles: To answer your question about the overall perspective, since I think my voice is a small one, you should interpret the point I am making as a marginal adjustment point: I really do believe that *relatively speaking* people are overemphasizing forward guidance relative to making the asset purchases large enough. So I really do think there should be a shift toward larger asset purchases–large enough that the amount of forward guidance could be reduced somewhat. As you are saying, I don’t think I would take a strong stand in the current situation that forward guidance should be eliminated entirely given our uncertainty about how all the policies work. But it really does bother me how long into the future the forward guidance is extending. And I just don’t see why a full recover should take more than 12 months if we do enough asset purchases. If we made forward guidance conditional on how the economy is doing rather than timing, and did huge asset purchases that should make the forward guidance moot because the economy would recover anyway if I am right, of course there is no problem.   

Miles: And I definitely am willing to risk extra inflation by doing asset purchases that *might* be too large. But it bothers me to *plan* to do something that will definitely be too much in the future.  

Miles: As I think about it more. I think there is a big political cost of the precommitment to overstimulation. It would be remembered for a long time that the Fed overdid the cure and caused a lot of inflation that it did not bring down very fast because it had promised not to. So the whole idea of doing dramatic things to stimulate in a situation like now might be (inappropriately) discredited. People remember the end. (One of Danny Kahneman’s favorite results.)

By contrast, if we do big things in a way where we can reverse course very fast if needed, the end will look like it was being done well. That is true even if, say, there is a side effect of capital losses to the Fed, which is the side effect of large-scale asset purchases that I worry about. 

Miles: Also, I worry a lot that the doves lose out to the hawks if the doves don’t include *some* hawkish statements in what they say. Precommitting to have too much inflation makes it very hard to maintain one’s credibility as someone who will keep inflation down. 

Miles: I feel that the foreward guidance in 2001 or so, which led to low interest rates in 2003 had exactly this kind of discrediting political effect. If the Fed hadn’t felt bound by the foreward guidance it had given, wouldn’t it have raised interest rates faster in 2003? And then maybe there wouldn’t be the false canard about how the Fed caused the financial crisis by those low interest rates in 2003.

Miles: One more consideration I have is that I think we are still learning a lot about how to do monetary policy, fairly fast. Precommitment makes it harder to use the new things we learn in the meantime.  

Gauti: I think there is always the risk that what a central bank says is not credible, and then it may be more costly to fulfill the pledge if you don’t manage to convince people. It seems to me that this is an important consideration, but should not be overdone since you have ways to back up your words. IF the Fed made clear statement about being willing to tolarate some overshooting of its inflation target, my sense is that it would widely be viewed as credible and expectations would adjust. But I agree there should be a backup plan about what to do if its not credible, e.g. as measured by market expectations. I see buying stuff (balance sheet actions) as playing mainly a role there. So the Fed says its going to overshoot on inflation…. the market does not believe it ….. the Fed buys stuff until the market gets the message….. (and note here that wallace equivalence type violations work in tandem with the objective of shifting expectations).

Gauti: I agree that the emphasis on time commitment is a bit problematic. With respect to if people over emphasize forward guidance versus quantitative easing, my sense is that it is exactly the other way around. We have expanded the balance sheet by 3 trillions, and done qe1, qe2 and qe3. And it is only in qe3 that there is any meaningful forward guidance (the “commitment” about time duration had much more the sound of a pessimistic forecast than any meaningful commitment).

Gauti: Ah, but that basically says that you are uncomfortable with anything that is not time consistent. But most things we do are not timeconsistent (most punishments mandated by law, for example….) And by the way, so is a commitment to low inflation……..

Gauti: Cost – yes. But the alternative — very high unemployment and a balance sheet expansion that may not accompolish anything is also a very costly affair.

Gauti: I think this is real concern, and why a commitment to a fixed price level target, for example, is problematic. But it seems like a problem you can solve by making the commitment a bit broader taking those considerations into account….

Miles: I think just saying that it wants to get prices on a track that would be a 2% annual increase since 2008 (even though that means tolerating some catchup inflation) would be a big step and a good one.  

Luke Kawa: How Central Banks Gained More Control Over the World's Major Currencies

Link to the article on Bloomberg Business

It was a very pleasant surprise when I received an email from Luke Kawa just a day after I put out “Why a Weaker Effect of Exchange Rates on Net Exports Doesn’t Weaken the Power of Monetary Policy” on Medium (the day before I posted it here) asking for clarification since he wanted to quote it in a Bloomberg Business article. He understood the point perfectly in his excellent article “How Central Banks Gained More Control Over the World’s Major Currencies.” You should read the whole thing, but here is a key graph, a key passage, and Luke’s quotation from my post: 

The foreign exchange team determined that an expected change in interest rate differentials between two countries from the Group of 10 nations is now accompanied by a much bigger move in the exchange rate:

… The rising import content in exports, however, does not imply that the efficacy of monetary policy has deteriorated.  In fact, it’s compatible with the increased responsiveness of currencies to expected interest rate differentials described by HSBC.

“If net exports are relatively insensitive to the exchange rate, the exchange rate will simply move more,” wrote Miles Kimball, professor of economics at the University of Michigan. “Large fluctuations in the exchange rate are exactly what one should expect if net exports are relatively insensitive to movements in the exchange rate.”

Why a Weaker Effect of Exchange Rates on Net Exports Doesn’t Weaken the Power of Monetary Policy

Link to this post on Medium

On New Year’s Day, 2016, I tweeted what you see above.

Let me explain at greater length. Paul Hannon is right in his Wall Street Journal article “Why Weak Currencies Have a Smaller Effect on Exports” in writing:

When a country loosens its monetary policy, interest rates fall and investors tend to pull their money out in search of higher yields elsewhere, pushing down the currency’s value.

And the article goes on to make a very interesting point about how global supply chains might be blunting the effect of a given change in the exchange rate on net exports:

Measuring the impact of global supply chains on trade flows is the task of a project undertaken by the Organization for Economic Cooperation and Development and the World Trade Organization. …

Economists at the International Monetary Fund and the World Bank have used those measures to assess whether currency movements have the same impact they once did on exports and imports. They found that the effect has in fact reduced over time, by as much as 30% in some countries.

But Paul Hannon’s overall subtext that this weakens the power of monetary policy is wrong. Start with the basic accounting identity of international finance that Paul alludes to and that I discuss in detail in my post “International Finance: A Primer”: the provision of domestic currency to those outside one’s currency zone through net capital outflows NCO (and through other channels as remittances of foreigners sending money to their families back home) must lead to an increase in net exports NX of equal magnitude. (Also see my column “How Increasing Retirement Saving Could Give America More Balanced Trade.”) The only wiggle room in this statement is that for whatever period of time someone abroad are willing to temporarily hold a growing pile of our domestic currency provided byintentional purchases of foreign assets that counts as an unintentional capital flow in the reverse direction. As soon as they want to unload our currency, our currency will make its way back home one way or another. (If people abroad decided to hold a pile of our currency more permanently, that rightly counts as an intentional capital flow in the reverse direction, canceling out all or part of the initial capital flow.)

Of course, the way the price system guarantees the return home of domestic currency that is unwanted abroad is through exchange rate movements. But the logic here means that exchange rates move as much as it takes to bring about the return of domestic currency that is unwanted abroad. So an increase in intentional capital outflow of $1 creates a $1 increase in net exports over whatever horizon it takes for domestic currency that is unwanted abroad to make its way back home. The relevant horizon is not instantaneous, but foreigners are unlikely to be willing to hold piles of unwanted domestic currency for very long. (Of course, governments sometimes choose to override this part of the prices system by imposing fixed exchange rates. Fixed exchange rates work by having the government equal and opposite capital flows to neutralize the effect of changes in intentional private capital flows on exchange rates.)

When the central bank cuts interest rates, the initial step in affecting international finance is in generating net capital flows of a certain size as domestic investors search for higher returns abroad, and potential foreign investors think better of sending their funds to a low-interest-rate country. These capital flows then have a 1-for-1 effect on net exports after the recycling of currency described above, regardless of the elasticity of net exports with respect to the exchange rate.

If net exports are relatively insensitive to the exchange rate, the exchange rate will simply move more. Indeed, many casual observers are struck by the large fluctuations often seen in the exchange rate. Large fluctuations in the exchange rate are exactly what one should expect if net exports are relatively insensitive to movements in the exchange rate, as I wrote about in“The J Curve.”

What would affect the potency of monetary policy is if the effect of a given movement in interest rates on international capital flows went down. But I don’t know of anyone claiming that is the case. (What I do hear a lot of is the speculation that cutting interest rates into the negative region would be especially salient to investors and so might have a particularly large effect on international capital flows — which would then increase the potency of monetary policy.)

One particular area where the discussion above matters is in assessing Japanese monetary policy. How much stimulus the Bank of Japan has achieved through the international finance channel is much better measured by the size of the international capital flows generated than by the size of the exchange rate movements that result. Because overall Japanese investors have a particularly strong home-bias, the effect of monetary policy on international capital flows may be weaker than in most other countries. But it is factors such as home-bias that matter for the contribution of international finance to the potency of monetary policy, not the elasticity of net exports with respect to the exchange rate. (On Japanese monetary policy, also see “Is the Bank of Japan Succeeding in Its Goal of Raising Inflation?”, “Japan Should Be Trying Out a Next Generation Monetary Policy” and “QE May or May Not Work for Japan; Deep Negative Interest Rates Are the Surefire Way for Japan to Escape Secular Stagnation.”)

To repeat: Weak effects of a given size of exchange rate movement on net exports does not blunt the effects of monetary policy because exchange rates do whatever it takes to make net exports equal to net international capital flows.

QE May or May Not Work for Japan; Deep Negative Interest Rates Are the Surefire Way for Japan to Escape Secular Stagnation

Link to “Bank of Japan’s QE efforts seen stimulating inflation” on MarketWatch

In my view “secular stagnation” is simply a name for being stuck at the zero lower bound. Yimian Wu interviewed me in an article for MarketWatch about whether Japan was on the road to getting the higher inflation it wants in order to make the zero lower bound less binding. In the article she writes:

University of Michigan economics professor Miles Kimball, said Japan should keep stimulating its economy until it is overheated to a point that the inflation rate is higher than desired.

This deserves clarification. What I said is this: I think there is still a lot of slack in the Japanese economy, and I will only believe that the slack in the Japanese economy is exhausted when Japan gets more inflation than it wants. To find out exactly how much slack it has, it is worth it for Japan to risk higher-than-desired inflation.

When I walk around Tokyo, I see many workers doing low-productivity activities that no one would ever be paid to do in the US. So I think there is a lot of potential to increase output per work hour by having workers work more intensely or do higher productivity activities as demand picks up. 

Hanging on to workers even if there isn’t much of any great importance to do is sometimes called “labor-hoarding.” The amount of labor-hoarding in Japan is reflected by its historically high percentage of extra output from each percentage point reduction in unemployment in Japan’s version of Okun’s law. And historically, Japan has been able to have quite low unemployment rates without accelerating inflation.  

Yimian goes on to write about her phone interview with me:

However, he said Japan’s large-scale QE might have some side effects that can’t be predicted. “We knows a fair bit about what it (quantitative easing) does with a certain dosage, and then you triple that dosage and nobody knows.”

Instead of quantitative easing, Kimball advocated negative interest rates. In a phone interview, he explained that cutting interest rates, even below zero, would have a more direct effect in stimulating the economy than increasing long-term bond purchases.

In addition to the phone interview, Yimian emailed a set of questions, which I answered as follows:

Yimian: How would you comment on Japan’s Quantitative Easing from 2001-2006? It clearly did not help improve inflation but without the QE, would Japan’s economy then be worse? Did it increase economic activities?

Miles: The size of QE during that period was quite small. I wouldn’t have expected it to do much, and it didn’t do much. 

Yimian: How would you comment the QE starting in 2013? When do you expect Japan would exit QE this time? When do you project Japan can hit the 2 percent inflation target?

Miles: Here is what I have written on recent QE in Japan:

• Is the Bank of Japan Succeeding in Its Goal of Raising Inflation?
• Japan Should Be Trying Out a Next Generation Monetary Policy

With a negative interest rate policy, as I would recommend, it is not necessary to hit a 2% inflation target. What matters is getting to full employment, which is quite achievable. Once Japan is at full employment so people can easily find jobs, the Japanese government should take measures to make layoffs easier so that people can be steered away from less productive toward more productive work.  

Yimian: Do you think a large scale of QE is sustainable for Japan, considering its speed and scale of asset purchase? How would you compare the two QE programs, in terms of goal, scale and impact? Did the two QE spur company borrowing and consumer spending? Real wages and household savings seem to continue declining, how will QE work if consumers have less to spend and consumption tax is increased?  

Miles: QE is a very risky way to go because it might not work. Also, no one knows the side effects of very large doses of QE. There is no real experience from other countries in the use of QE starting from such a low level of inflation. The surefire way to get the economy to full employment is to use negative interest rates.

… I have links to other things I have written and a video of an interview you should look at here:

• How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide

Also, you should be aware that many of the shorter pieces I have written on negative interest rate policy have been translated into Japanese:

• http://supplysideliberaljp.tumblr.com/

The Wall Street Journal Gets It Right On Negative Interest Rate Policy, Thanks to Tommy Stubbington

Link to the article on wsj.com. Link to Google search for the article.

The Wall Street Journal has been slow to understand the potential of negative interest rate policy that I have laid out in various ways. But now, thanks to Tommy Stubbington–who interviewed me at length last Thursday–the Wall Street Journal has done an excellent front page treatment of negative interest rate policy. The whole article is great for giving the current context of negative interest rates in Europe, but below are the passages that most closely reflect Tommy’s interview of me. The first bit below has the same message as the title of my recently published paper “Negative Interest Rate Policy as Conventional Monetary Policy.” The rest should also be familiar to those who follow supplysideliberal.com:

Europe’s economic stagnation has proved so long and intractable that the region’s central banks are cutting interest rates to spur their economies. If it helps to move rates from 1% to 0.5% and 0.5% to 0%, why not try minus 0.5%? …

There is no hard limit on how low they can go. If commercial banks start widely imposing negative rates on retail customers, physical cash might look attractive. After all, it has a rate of 0%, although it isn’t without cost. One needs vaults and guards to store it, and it is no good for buying merchandise online.

Still, some economists said negative rates can be a powerful stimulative tool, if central banks can fully harness them.

Miles Kimball, an economist at the University of Michigan, has been preaching the gospel of deeply negative rates to central banks. When demand for money is low, as it is during a deep recession, Mr. Kimball argues, central banks should make borrowing as easy as necessary, even if that means paying banks to do it.

Mr. Kimball has a novel way around the physical-cash problem: make bank notes less valuable. He proposes that the Federal Reserve set an exchange rate between bills and electronic money. If it wanted, say, a minus 1% rate, it could decree that a $100 bill deposited in a year’s time would yield a $99 credit to a bank account. …

The interest in such schemes isn’t purely academic. With rates still at zero in much of the developed world years into the postcrisis recovery, central bankers may find themselves facing the next recession without much room to cut.

“It’s wrong to say central banks have run out of ammunition,” said Mr. Kimball. “Negative rates can be on tap before the next recession. There’s no limit to how deep we can go.”

Alex Rosenberg Interviews Miles Kimball on the Responsiveness of Monetary Policy to New Information

Link to Alex Rosenberg’s “Beyond the first hike: Fed’s pace is unknown”

CNBC’s Alex Rosenberg interviewed me on the phone last week about how the Fed should approach its moves beyond the first interest rate hike. In advance of our conversation, I pointed him to my tweet saying

Fed should not raise rates until it explicitly commits to reverse course quickly if needed.

and my post Larry Summers: The Fed Looks Set to Make a Dangerous Mistake by Raising Rates this Year where I wrote:

In addition to Larry Summers’ arguments for holding off on raising rates, I have a conceptually quite distinct argument: the Fed can afford to wait to raise rates, because it can always raise rates very fast if it needs to later on.

Contrary to what optimal control models suggest, monetary policy committees around the world tend to believe the fallacy that (although events can sometimes overrule this) it is a good thing to raise and lower rates slowly. This belief shows up as policy rate movements being predictably in one direction for a long time, with small steps along the way. Optimal control models suggest that instead a policy rate should look a lot more like a random walk modified by some drift and mean reversion. That means that optimal monetary policy should have lots of reversals and dramatic movements in the interest rate when there has been relatively big news since the last meeting.

Let me address one myth: that Mike Woodford has shown that interest-rate smoothing makes sense. I would be glad to be corrected, but I think this myth arises because Mike talked about the Fed carrying about affecting the bond markets (and more generally macroeconomic) expectations of future rates. Just as backward-looking state variables have forward-looking costate variables, bond market expectations are like a forward-looking state variable for the Fed; those bond market expectations have a corresponding backward-looking costate variable.

As an analogy, in working toward my dissertation, I did an unpublished efficiency-wage model (which you can see and freely download here) in which, to motivate workers with an expectation of future pay making a job valuable, there is a backward-looking costate variable that can be interpreted as “seniority.”

Such backward-looking costate variables giving guidance about doing the right thing in relation to bond-market expectations contribute additional drift terms to the optimal policy rate, but it still seems to me that over a six-week span of time between FOMC meetings, the variance of news is sufficient that the effect of news should typically be substantially larger than the sum of all drift terms on the policy rate. Hence the metaphor of a muddy random walk.

In our conversation, I emphasized that the responsiveness of the Fed’s interest rate target to news–“data dependence”–should go in both directions. I can easily imagine both events that would indicate the target rate should be raised fast, and events that would indicate that the target rate should be cut significantly–whatever direction the Fed had gone at the last meeting. (As an example of why the Fed might need to cut rates, I pointed to the possibility that a big cut in the European Central Bank’s target rate–which would be the right thing for the European Central Bank to do–might cause a significant appreciation in the US dollar, reducing the contribution of net exports to US aggregate demand.) 

I explicitly criticized the inhibition by many central banks against reversing direction, even if incoming data calls for doing so. I also suggested that, overall, being willing to make larger, faster moves in the target rate would make it possible to close output gaps quicker–whether the output gap is negative or positive.  

I recommend that you read the whole article for context, but here is how Alex boiled down our conversation (I corrected the spelling of the adjective “dependent”):

For University of Michigan economist Miles Kimball, the fact that hawks and doves have become divided on the question of data dependency — with the former swearing their allegiance to the data, and the latter emphasizing the psychology of market participants — is unfortunate.

“You do want to be data-dependent, but you want to be data-dependent in both directions,” Kimball said in a Friday interview with CNBC. “No one is mentioning the possibility that if the economy ends up doing worse, that the Fed can reverse course.”

In other words, the Fed has the flexibility to cut rates after it has raised them (or in a reverse situation, raise after it has cut them). That would be in stark contrast to the “path” model currently in force, under which the first rate hike begins a one-way path to further hikes, with the only real question being the pace of such hikes.

“The nature of news is that news is bad about as often as it is good. If you’re really and truly data-dependent, it shouldn’t be a shocking thing if you make your target rate go up by a quarter point and then at the next meeting, if bad news comes, cut it back down,” Kimball said. “We’d have better policy if we made interest rates more sensitive to data.”

It looks as if Alex talked to Robert Murphy after he talked to me. Robert said 

… there is a view that it’s not the movement in the rate today that really matters; it’s the long-term path for where we see rates going.

Here it is quite important to point out that models that have only nondurables give the misleading impression that only medium-to-long-term rates matters for aggregate demand. Once investment goods and consumer durables are brought in, the short-term interest rate has a separate effect. The reason is that an optimizing decision to buy a durable or investment good must pass two tests:

1. The net present value test, which depends on an interest rate over the life of the durable or investment good.
2. The Dale Jorgenson delay condition test–“Would it be better to wait to buy the durable or investment good later?”–which depends on the short-term interest rate. (I discuss the importance of this condition in “The Medium-Run Natural Interest Rate and the Short-Run Natural Interest Rate” and “On the Great Recession.”

Because of the delay condition, the current level of the short-term rate is more important than economists whose intuition has been formed by models of optimal monetary policy with only nondurable consumption might realize. 

US Law for the Tussle Between Different Modes of Payment

Customer choices between different modes of payment (paper currency, check, credit card, debit card, etc).–and what retailers do in relation to those choices– are important for understanding the effects of paper currency policies intended to enable deep negative interest rates when deep negative interest rates are called for. So it is worth knowing the law that applies to merchants trying to influence the mode of payment a customer uses among the modes of payment the merchant accepts. 

In part because my wife only recently retired as a massage therapist, our household received many copies of a notice from American Express, dated October 7, 2015 saying something quite interesting. I quote:

A federal court has ruled that American Express violated the law by prohibiting merchants from influencing the payment form that their customers use. As a result of that ruling, you may now favor any credit card brand that you wish, by, for example, communicating to customers which credit card brand you would prefer that they use, telling customers which credit card grands are the most or least expensive for you, or offering discounts or incentives to customers to use the credit card grand you prefer. Consistent with the federal court’s ruling, you may not, however, disparage or mischaracterize the American Express brand or impose a surcharge (as opposed to a discount) on customers who use an American Express credit card. 

To influence the credit card that a customer uses, you may employ any of the practices listed in Secton III.A of the court’s order, including:

• Offering a discount or rebate, including an immediate discount or rebate at the point of sale;
• Offering a free or discounted product;
• Offering a free or discounted service;
• Offering an incentive, encouragement, or benefit;
• Expressing a preference for a particular brand or type of card;
• Promoting a particular brand or type of card through posted information, through the size, prominence, or sequencing of payment choices, or through other communications to the customer; 
• Engaging in any other practices substantially equivalent to these.

To review all of the applicable terms and conditions, please refer to the court’s order, a copy of which may be found at [this link]. …

If you choose to attempt to influence a customer’s choice of credit or charge card, you must reasonably indicate that you accept American Express Cards by posting signage, either at the point of sale (including online or on mobile services) or at the store entry, or by communicating orally that you accept the American Express Card prior to the request for authorization of the transaction. For example, you may satisfy this requirement by displaying a sticker at the point of sale or at the store entrance indicating all brands you accept that includes the American Express log. …

To the extent that your Card acceptance contract, or other agreement that governs your acceptance of American Express Cards, contains provisions that are inconsistent with the federal court’s ruling, American Express will not enforce those provisions. 

American Express is presently appealing the federal court’s ruling. If the federal court’s ruling is reversed or modified as a result of the appeal, American Express reserves all rights to cancel or revise these modifications.

Mike Bird on Negative Interest Rate Policy | Business Insider

Link to the article on Business Insider

Despite an inflammatory picture and title, Mike Bird’s November 4, 2015 Business Insider article “This is how a central bank could kill off cash and bring in negative interest rates on your savings” is an excellent treatment of negative interest rate policy. Mike discusses at length my new paper “Negative Interest Rate Policy as Conventional Monetary Policy,” and provides helpful context.

Here are the two passages giving Mike’s assessment of the future for negative interest rate policy:

Since the financial crisis, the world’s understanding of economics has been undergoing a lot of rapid change.

Ideas that would have been considered crazy just a decade ago are now seen as much more likely.

One of those ideas is that central banks could bring in negative interest rates. 

However uncomfortable you are with the idea, you’d better get used to it. What HSBC chief economist Stephen King called the world economy’s “Titanic” problem is going to put governments around the world in a massive bind whenever the next recession hits.

Every lever of economic policy is pretty much tapped out, either for economic or political reasons: Finance departments and heads of government seem strongly against fiscal stimulus. Quantitative easing has been fairly unpopular, and its reputation among academics and economists is mixed at best.

In short, the world’s economy is an ocean liner, and there aren’t enough lifeboats. Despite objections, it may well be that negative interest rates are the path of least resistance.

Paul Taylor and Balazs Koranyi: ECB Rate Setters Converge on December Deposit Rate Cut →

Here is the most interesting quotation from this Reuters article:

Another Governing Council member also argued for a bigger deposit rate cut, saying it could go from -0.20 percent to -0.50 percent or even -0.70 percent after the Danish and Swiss examples.

The rate setter said that “zero lower bound”, a term meaning the bottom for interest rates, either “no longer exists, or if it does it is well below zero”.

Negative Interest Rate Policy as Conventional Monetary Policy

Here is a link to my first published journal article on negative interest rates: “Negative Interest Rate Policy as Conventional Monetary Policy,” in National Institute Economic Review (pdf). And here is the abstract page on the journal’s website.

Mario Draghi on Negative Interest Rates and Other Policy Tools—October 31, 2015 Interview by Alessandro Merli and Roberto Napoletano

Link to Wikipedia article on Mario Draghi

Mario Draghi gave a remarkable interview on October 31, 2015, labeled on an official webpage of the European Central Bank as “Interview with Il Sole 24 OreInterview with Mario Draghi, President of the ECB, conducted by Alessandro Merli and Roberto Napoletano.” I am grateful to Mike Bird and JP Koning for alerting me on Twitter to the importance of this interview.

To emphasize the points Mario Draghi is making about the role of various policy tools going forward, I have organized under my own headings what I consider the passages from the interview that I consider most important in their application to the future and to other central banks as well as the ECB. Mario Draghi has been head of the European Central Bank during a crucial period of time; I omit the parts of the interview focused primarily on reviewing that history, and focusing on the eurozone-specific issues.

To preview what is below, I include the Q&A about quantitative easing primarily as context. In the discussion of negative interest rates, Mario Draghi’s statement that 

• The lower bound of the interest rate on deposits is a technical constraint and, as such, may be changed in line with circumstances. 

is especially important. Compare this to the exact words of the statement I have urged central bank officials to make: 

From a technical point of view, we know how to eliminate the zero lower bound. 

On the truth of that statement, see my IMF Working Paper with Ruchir Agarwal, “Breaking Through the Zero Lower Bound,” which came out on October 23, 2015. (Also see my bibliographic post “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”)

Mario Draghi makes many other important points in the interview with which I am in strong agreement:

• international monetary policy coordination is not essential; it is OK if each central bank takes care of its own jurisdiction
• government investments are the safest type of fiscal policy, but good government investments can be hard to find
• supply-side reform is important; appropriate stimulative monetary policy is helpful to supply-side reform or in some cases neutral for supply-side reform

Here are the parts of the interview focusing on these issues:

Quantitative Easing

Q: You have always said that this outcome depends on the full implementation of your monetary policy and you have added on a number of occasions that there is flexibility in your asset purchase programme in terms of its size, composition and duration. You have also said that the next meeting on 3 December 2015 is when you will “re-examine” these aspects. The financial markets read this date as being decision time for the ECB. Is this interpretation correct? Have you started to consider the relative merits of these three types of action, which could have different effects? Do you envisage using them simultaneously?

Mario Draghi: If we are convinced that our medium-term inflation target is at risk, we will take the necessary actions. In the meantime we are assessing whether the change in the underlying scenario is temporary or less so. Moreover, after the meeting in Malta, we asked all the relevant committees and ECB staff to prepare analyses of the relative effectiveness of the different options for the December meeting. We will decide on this basis. We will see whether a further stimulus is necessary. This is an open question. The programmes that we have put together are all characterised by their capacity to be used with the necessary flexibility.

Negative Interest Rates

Q: However, for the first time you mentioned a cut in the ECB’s bank deposit rate and you said that “things have changed” since you had stated that -0.20% was the minimum lower bound. Can you explain what has changed?

Mario Draghi: The circumstances informing the decision to reduce the bank deposit rate to its current level actually consisted of a macroeconomic framework that has since changed. The price of oil and the exchange rate have changed. I would say that the global economic situation has changed. The interest rate on deposits could be one of the instruments that we use again. Now we have one more year of experience in this area: we have seen that the money markets adapted in a completely calm and smooth way to the new interest rate that we set a year ago; other countries have lowered their rate to much more negative levels than ours. The lower bound of the interest rate on deposits is a technical constraint and, as such, may be changed in line with circumstances. The main test of a central bank’s credibility is – as I have said before – the ability to achieve its objectives; it has nothing to do with the instruments.

Q: So, you see cutting the bank deposit rate as an instrument that can be used at the same time as the amendments to QE?

Mario Draghi: I would say that it is too early to make that judgement.

Q: In Malta, you also said you had discussed “some other monetary policy instruments”. What did you have in mind?

Mario Draghi: It would be too early at this stage to restrict the menu of instruments that will be assessed by the relevant committees and ECB staff. The existing menu is nevertheless extensive – you only have to look at what has been done in the past three years. However, it is too early to say in any case that “this is the menu” and that “there is nothing to add”.

International Monetary Policy Coordination

Q: You spoke earlier about the global macroeconomic environment which is changing. The Vice Chairman of the Federal Reserve System, Stanley Fisher, said that the Fed today takes much greater account of international factors than it did up until a few years ago. Is this true of the ECB as well? And does the Fed’s delay in starting to raise rates influence in some way your decisions, considering that the exchange rate is not a policy target?

Mario Draghi: As I said, external circumstances, the assumptions underlying our forecasts, are important because they influence inflation expectations, and therefore the profile of the return towards price stability and of the growth rate. They form part of the set of information that we, like the other policy-makers, use to take our decisions. As far as the Fed is concerned, there’s no direct link between what we are doing and what they are doing. Both central banks have their mandate defined by the jurisdiction in which they operate, for them it’s the United States, for us it’s the euro area.

Fiscal Policy

Q: In Lima you said that high-debt countries had to prepare for the day when they suffer from the impact of higher yields. At the same time, these countries suffer but also from the fact that inflation is very low, making debt reduction complicated. Isn’t this an even more serious risk? In Europe an increase in yields is not imminent, while too low inflation is making itself felt.

Mario Draghi: Low inflation has two effects. The first one is negative because it makes debt reduction more difficult. The second one is positive because it lowers interest rates on the debt itself. The path on which fiscal policy has to move is narrow, but it’s the only one available: on the one hand ensuring debt sustainability and on the other maintaining growth. If interest rate savings are used for current spending the risk increases that the debt becomes unsustainable when interest rates go up. Ideally, the savings are instead spent on public investments whose rates of return permit repayment of the interest when it rises. Growth is maintained today and future public finances are not destabilised when rates go up.

Obviously it’s not simple because, as we know, there aren’t many public investments with a high rate of return.

Supply-Side Reform

Q: Precisely on the subject of fiscal policy, there’s a lot of discussion in Europe at the political level. You are one of the first to use the expression “fiscal compact” in the European debate. Do you think now, looking back, that the degree of budget restrictions in the euro area was too strong after the crisis, in other words that there has been excessive austerity which has held back the recovery in the euro area?

Mario Draghi: First of all, there are countries which don’t have the scope for fiscal expansion according to the rules which we have given ourselves. Secondly, where this is possible, fiscal expansion must be able to take place without harming the sustainability of the debt. The high-debt countries have less scope to do this. But the fiscal space is not a fact of nature, it can be expanded, even a high-debt country can do it. How? By making the structural reforms which push up potential output, the participation rate, productivity, all factors which substantially boost the potential for future tax revenues. Increasing revenues on a permanent basis expands the possibilities for repaying debt tomorrow and at the same time creates the conditions for fiscal expansion today. The structural reforms are not popular because they involve paying a price today for benefits tomorrow, but if the government’s commitment is real and the reforms are credible, the benefits are gained more quickly and they include fiscal space.

Stimulative Monetary Policy and Supply-Side Reform are Complements or Separable, Not Substitutes

Q: The ECB’s Governing Council stands ready to increase monetary stimulus, should this be necessary. Your critics claim that this reduces the incentive to implement reforms.

Mario Draghi: I think that this is wrong for a number of reasons. First, if we look at the time frame of the main structural reforms implemented in the euro area over the past five years, it shows that this has no correlation with the level of interest rates on government debt in the countries concerned. Labour market reforms, for example, were implemented in both Spain and Italy when interest rates were already very low, and the same is also true in other cases. Second, the structural reforms cover a very wide range of areas. I do not believe, for example, that reform of the legal system has anything to do with interest rate developments. Third, recent experience shows that also when interest rates are high because a country’s fiscal credibility is threatened, this does not increase governments’ propensity to carry out reforms.

Q: How do structural reforms correspond to low interest rates?

Mario Draghi: Structural reforms and low interest rates complement each other: carrying out structural reforms means paying a price now in order to obtain a benefit tomorrow; low interest rates substantially reduce the price that has to be paid today. There is, if anything, a relationship of complementarity. There are also other more specific reasons: low interest rates ensure that investment, the benefits from investment and from employment, materialise more quickly. Structural reforms reduce uncertainty regarding macroeconomic and microeconomic prospects. Therefore, it is the opposite, rather than seeing an increase in moral hazard, I see a relationship of complementarity, of incentive. But it should never get to the point of having to consolidate the government budget when market conditions have become hopeless. Experience over recent years has shown that, in these circumstances, governments often make mistakes in designing economic policies, dramatically hike taxes and reduce public investment, without significantly reducing current spending, and postpone the structural reforms that require social consensus. In this way, they exacerbate the recessionary effects of the high interest rates and slow the fall of the debt-to-GDP ratio.

To conclude, in the euro area the markets do not typically influence the propensity of governments to carry out structural reforms; when this happens, because the governments have delayed the reforms for too long, and owing to the deterioration in the general conditions, the resulting economic policy action does not foster growth.