There is No Substitute for Monetary Policy

The emergency action by the Federal Reserve (Fed) to cut its benchmark interest rate in the face of the coronavirus prompted Harvard University economist Larry Summers to write in the Washington Post that monetary policy would be “much less useful” against supply disruptions and other economic effects from the epidemic than in a more traditional recession.

Summers, who was a top economic adviser in the Obama White House and who helped guide the administration’s response to the 2008 financial crisis, is a leading voice among the growing chorus of pundits and economists questioning the effectiveness of monetary policy, particularly in a low-interest-rate environment. In January, weeks before the scale of the coronavirus outbreak became clear, Summers said that the United States is “one recession away from joining Europe and Japan in the monetary black hole of zero rates and no prospect of escape.”

This gloom has stoked interest in using fiscal policy (i.e., government taxation and spending) rather than monetary policy to help stabilize the economy and prevent a recession. Even Mario Draghi, in his final weeks as European Central Bank (ECB) president, called for fiscal policy to “take charge.” Both Summers and Draghi’s views are mistaken. Monetary policy is still highly effective in a zero-interest-rate environment, and fiscal policy is unlikely to be helpful in stabilizing the economy.

Many people oversimplify monetary policy as being mostly about interest rates, equating low interest rates with “easy money,” and vice versa. This makes them pessimistic about the effectiveness of monetary policy when low rates coincide with low inflation and sluggish growth. Instead of understanding that low interest rates are the long-run effect of previous tight-money policies, they incorrectly see the low rates as a failed attempt at monetary stimulus.

Observers also question the effectiveness of monetary policy when interest rates fall to zero. If nominal interest rates are zero or slightly negative, investors tend to hold currency, a safe asset with a nominal rate of return of zero. This puts a floor on interest rates, prompting some pundits to infer that when interest rates are already quite low, they cannot be further reduced enough to significantly boost the economy.

Monetary Policy Has Many Powerful Tools

Once people move beyond equating “monetary policy” with “changes in interest rates” it becomes much easier to see why low interest rates do not prevent central banks from stimulating the economy. For instance, in Singapore the central bank uses exchange rates rather than interest rates as its policy tool. When the Singapore central bank wishes to stimulate the economy, it depreciates the Singapore dollar in foreign exchange markets. Unlike with interest rates, which cannot be pushed much below zero (a constraint known as the “zero lower bound”) there is no effective lower bound when depreciating the exchange rate.

Admittedly, it is unlikely that the Fed would use exchange rates as a policy instrument. But the central bank still has many other policy tools that can boost spending, even when interest rates are near zero. The most powerful of these tools would be to switch to “level targeting,” in which the central bank publicly commits to making up for past shortfalls or overshoots of its goals. Think of it this way: if a motorist intends to drive 50 mph but is slowed by heavy traffic to 30 mph for an hour, the driver would have to spend the next hour at 70 mph, or two hours at 60 mph, to make up for the slowdown.

Such a “makeup” policy constitutes a promise to make up for near-term shortfalls in order to return the policy goal variable to the long-run trend line. Thus, if the policy goal were 2 percent annual inflation in the long run, then a year of 0 percent inflation (such as in 2009), would lead the central bank to raise its inflation target above 2 percent over the next few years. It might aim for 2.5 percent inflation for the next four years to gradually bring prices back to the original trend line of 2 percent growth. In other words, the price level would be targeted starting from year-zero prices at 100 percent: 102 percent in year one, 104 percent in year two, 106 percent in year three, and so on. (Actually, the targets would be slightly higher, owing to the compounding effects of percentage changes.)

In my view, an even more effective policy than inflation level targeting would be to stabilize the growth of nominal gross domestic product (NGDP)—which is made up of economic growth plus inflation—perhaps along a 4 percent annual growth trend line. If a recession were to drive NGDP growth far below 4 percent, then the Fed would commit to faster-than-4-percent NGDP growth over the next few years. Expectations of higher inflation and faster real GDP growth would tend to boost the demand for credit, which would raise equilibrium interest rates above the lower bound of zero.

Central banks in Europe and Japan have also experimented with slightly negative interest rates as a way of discouraging banks from hoarding reserves. Under this system, banks must pay a fee to the central bank for holding reserves, essentially a negative interest rate on their deposits at the central bank. This reduces the demand for reserves, encouraging commercial banks to switch to other assets such as corporate bonds and bank loans, which then pushes the new money out into the economy, boosting spending.

There Is No Upper Limit on Money Creation

The Fed has indicated that it is unlikely to use negative interest rates during the next recession (and would not need to do so if it adopted a level-targeting regime), but it has another powerful tool, quantitative easing. In principle, there is no limit to the ability of a central bank to depreciate the value of its currency by printing money, and hence to create inflation, which implies higher nominal growth. 

Back in 1999, Ben Bernanke responded to skeptics of the effectiveness of monetary policy at zero interest rates with a thought experiment:

To rebut this [central bank ineffectiveness] view, one can apply a reductio ad absurdum argument, based on my earlier observation that money issuance must affect prices, else printing money will create infinite purchasing power. Suppose the Bank of Japan prints yen and uses them to acquire foreign assets. If the yen did not depreciate as a result, and if there were no reciprocal demand for Japanese goods or assets (which would drive up domestic prices), what in principle would prevent the BOJ from acquiring infinite quantities of foreign assets, leaving foreigners nothing to hold but idle yen balances? Obviously this will not happen in equilibrium. 

Bernanke’s thought experiment does not mean the Fed would have to buy up most of the world’s assets in order to create inflation. If the central bank has a credible policy to do whatever it takes to hit its policy goals, then this will create expectations of inflation, which will reduce the demand for non-interest-bearing base money (currency notes and bank reserves.) The commitment to a “whatever it takes” approach—inherent in level targeting, as opposed to in growth rate targeting—actually results in the central bank having to do much less.

Would such a Fed policy be credible? Unlike the Bank of Japan and the ECB, the Fed is not currently allowed to buy an unlimited range of assets. Nevertheless, there are more than $30 trillion in US Treasuries and mortgaged-backed securities in circulation, which gives the Fed plenty of “ammunition” (assets to purchase) to meet any foreseeable demand for base money.

In an extreme crisis where even more drastic steps were required, Congress would likely give the Fed additional tools, such as the ability to buy a wider range of assets. Thus, any monetary policy ineffectiveness is the result of political considerations; in a technical sense there is no upper limit on the ability of a central bank to create inflation, as Venezuela, Zimbabwe, and elsewhere have shown.

There Is No Alternative

While doubts about the effectiveness of monetary policy are not well founded, they have led to calls for the increased use of fiscal policy. This is a mistake for a number of reasons. First, fiscal policy is not very powerful. Between 1993 and 2013, Japan engaged in perhaps the largest fiscal stimulus in peacetime history, pushing its net public debt from 40 percent of GDP to nearly 190 percent of GDP. All of this stimulus had almost no impact, as Japan saw the weakest growth in aggregate demand (nominal GDP) over two decades ever experienced by a major developed economy.

Beginning in 2013, Japan switched to a tighter fiscal policy and adopted monetary stimulus, boosting its inflation target from 0 percent to 2 percent. Nominal GDP finally began increasing, and the national debt leveled off as a share of GDP.

A second problem with fiscal policy is that it asks far too much of the legislative and executive branches. To be effective, fiscal policy must be countercyclical, which means boosting the budget deficit during economic downturns and reducing it during booms. In recent years, however, the US government has done the exact opposite, sharply reducing the deficit in January 2013, when unemployment was 8.0 percent, and dramatically increasing the deficit during 2016–2019, when unemployment was falling to near-all-time lows. This sort of “procyclical” policy is destabilizing. Congress is not well equipped to engage in the sort of “fine tuning” required for an effective fiscal policy regime, especially when dominated by partisan gridlock.

And finally, fiscal stimulus through deficit spending puts a heavy tax burden on future generations, whereas monetary stimulus merely involves swapping one government asset for another of equal value.

Monetary policy is by far the most important factor in driving the business cycle. If targeting the expected future level of nominal GDP were to become the focus of central bank policy, the economy could avoid severe and prolonged recessions. The Fed probably already has the tools required to meet any foreseeable shock to spending, but in a crisis, Congress could and likely would provide additional tools.