Mar 18, 2020

Even in a World of Zero-Percent Interest Rates, the Fed Likely Has Enough Monetary Policy Tools

But Congress should nevertheless give the central bank added authority in case of a crisis
Scott Sumner Ralph G. Hawtrey Chair of Monetary Policy

The United States experienced a seven-year period of near-zero-percent interest rates between late 2008 and late 2015. At the time, this seemed like an aberration, as it was the first instance in many decades that rates had fallen close to zero.

Now, with the Federal Reserve once again lowering rates to near zero, this time in response to the economic shocks caused by the Covid19 virus, there is a sense that low interest rates may be the new normal. This raises two important questions: How will the Federal Reserve (Fed) achieve its policy goals in a world of near-zero-percent interest rates? And does it need additional monetary policy tools?

In my view, the Fed’s current set of policy tools, if used correctly, are likely sufficient to stabilize the economy. At the same time, Congress should give the Fed additional tools, in case it ever faces a situation so dire that its current powers are insufficient. Even if these new powers are not used, just having an adequate tool chest could help to restore confidence during a crisis.

What’s the target and how do they achieve it?

Congress has given the Fed a dual mandate of stable prices and a high level of employment.  The Fed has decided that this mandate can be best achieved by setting a two percent inflation target and trying to keep unemployment close to its natural rate (believed to be roughly four percent.)  So, if the Fed lacks the tools to achieve its inflation target, then it also likely lacks the tools to fulfill its dual mandate.

A two percent inflation rate implies a two percent annual decline in the value (or purchasing power) of money.  At the most basic level, the Fed controls the price level by affecting the supply of and demand for money, and thus its value. For policy purposes, “money” refers to the monetary base or base money, the money directly created by the Fed and includes currency held in people’s wallets as well as bank reserves held in deposit at the Fed.

Any policy that increases the supply of money, reduces the demand for money, or both, is expansionary; any policy that reduces the supply of money, increases the demand for money, or both, is contractionary. No one doubts the ability of the Fed to conduct contractionary policy because, for example, there is no upper limit on how high it can raise interest rates.

However, some argue that there are limits to expansionary policy. Nominal interest rates cannot be reduced significantly below zero, as at some point people would prefer to hold cash rather than financial assets earning a strongly negative interest rate. This “effective lower bound” on nominal interest rates limits the ability of the Fed to conduct expansionary policy by cutting its interest rate target, which means that the Fed needs alternative tools to ensure that it can achieve its two percent inflation target.

How does the Fed affect the demand for base money?

When inflation is falling short of the two percent target, the Fed needs to adopt a more expansionary policy. This means it needs to reduce the demand for base money, increase the supply of base money, or both.

Any policy that reduces the demand for base money is expansionary. For example, if the Fed cuts the interest rate it pays on bank reserves (cash and cash equivalents), then there is less incentive to hold such reserves, and hence less demand for base money. That’s expansionary. To augment this policy, Congress could give the Fed the power to pay negative interest rates on bank reserves. This would further reduce the demand for reserves, thus boosting inflation.

It may be helpful for people to think of the process from the perspective of the banks. If banks must pay a penalty (negative interest rate) for reserves they hold, then they have a greater incentive to lend out the money into the economy. In my view, however, negative interest rates would be unpopular in the United States. In addition, while they might be modestly effective, they don’t provide a powerful enough tool to address a major crisis.

The Fed could also reduce reserve demand by changing bank regulations. Canada has a sound banking system without any bank reserve requirements, and the Fed eliminated these requirements last week.  But reserve requirements are not the only factors increasing bank demand for reserves.  After the 2008 crisis, regulators began pressuring banks to hold far more reserves than in the past. An alternative way of boosting bank safety would require higher levels of capital, which is the bank’s assets minus its liabilities. Capital requirements can be met by holding alternative assets that are almost as safe as cash reserves, such as Treasury securities.

Some economists have proposed price level targeting, which means setting, for example, a two percent growth path for the price level and promising to return to that path if inflation undershoots or overshoots the path. During recessions, inflation often undershoots a two percent path. A level-targeting regime would lead investors to expect higher inflation, as future expansionary policies push prices back up to the two percent trend line. That expectation of higher future inflation would reduce money demand today, which is expansionary.

In my view, this is something the Fed could do without any additional legislation, as it would not involve any change in the long-run inflation target (currently two percent). While inflation would vary somewhat on a year-to-year basis under level targeting, that can be justified under the Fed’s dual mandate, which includes high employment as an equally important objective. Level targeting would assure two percent inflation in the very long run while allowing year-to-year variation to help stabilize the labor market.

How does the Fed affect the supply of base money?

The Fed increases the supply of base money by purchasing securities with newly created money, a practice called “quantitative easing” (QE). In theory, there is no limit to how much new money the Fed can create and inject into the economy, though there are limits regarding the types of assets the Fed may purchase (riskier assets such as stocks and corporate bonds are currently off-limits). As such, the Fed has been purchasing Treasury bonds and mortgage-backed securities with newly created money. Treasury bonds are seen as being free of default risk. Mortgage-backed securities also are widely viewed as being at least implicitly backed by the Treasury. For instance, the bonds of Fannie Mae and Freddie Mac were protected by a Treasury bailout during the 2008 financial crisis.

In my view, the Fed should ask Congress for the ability to buy a wider range of assets during an emergency. These might include corporate stocks and bonds. That being said, the purpose of this proposal should not be to prop up the stock and bond market. The Fed should make very clear that the purchases will be temporary, and that the securities will be sold back to the private sector when there is no longer a need for the extra liquidity. In the long run, the Fed should not hold these assets, and thus their price would not be artificially inflated in the long run. Instead, the sole purpose of these open market purchases would be to inject money into the economy during periods of high demand for liquidity so that the Fed can achieve its two percent inflation target. The policy would only be necessary if the Fed had already purchased most of the available Treasury securities, an unlikely scenario.

In addition, if Congress were to give the Fed this extra policy tool, it would actually make it less likely that the Fed would need to purchase these assets. This seems counterintuitive and requires some explanation. Monetary policy works most powerfully through the “expectations channel.” That is, if the markets believe the Fed will achieve its target, then the demand for liquidity will be much lower than if the market fears a slide into recession or deflation.

Think of a military analogy: If the United States were to put together a military force that is powerful enough to repel any invasion, then it’s less likely that another nation state would directly attack the United States and, ironically, less likely that America would actually use its powerful weapons defending against military attack. If the markets believe the Fed has a “big bazooka,” capable of injecting almost unlimited funds into the economy if needed, then bearish expectations are less likely to set in. And that makes it unlikely that the Fed would actually have to purchase these riskier assets.

Even without this extra tool, the Fed has the ability to buy an enormous quantity of Treasury bonds and mortgage-backed securities. At no time has the Fed even come close to exhausting its “ammunition,” that is, buying up all of the assets it is currently allowed to purchase. Nonetheless, it is important to plan ahead, as future shocks may require policy responses that today seem unimaginable. If Congress were to provide the Fed with the option of buying a wider range of assets in an emergency on a temporary basis, it would help to calm markets and thus make it less likely that the Fed would ever need to take such extreme measures.

Photo by MANDEL NGAN/AFP via Getty Images

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