I have written about this before several times over the years, but perhaps it is a good time to review the Fed's game plan.
The first item, communications to model and influence the perception of the markets, is obvious. Jawboning is a major element of any financial intervention. Acknowledging or denying the intervention is all about the message as well.
The most recent statement from the Fed, for example, about keeping rates at the zero bound for the next two years, depending on how the economy fares, is a good example of this. Other actions they may take through their own speeches, and the statements of informal intermediaries in the industry and the press, are good examples as well.
The expansion of the Fed's Balance Sheet is also known as quantitative easing, and that has been done at least twice now, and in epic proportions.
The third option, the targeted purchasing of certain assets, has been done to a large extent to support the banking and mortgage system, but not necessarily the real economy. This is the program by which the Fed has been taking non-traditional assets into its portfolio in the various vehicles it has constructed in order to shore up the shaky creditworthiness of the TBTF asset profiles.
What the Fed is not doing in a major program yet, although it certainly has done it in the past, is to conspiculously shift the duration of its Treasury bonds portfolio in order to achieve certain interest rate objectives, effectively setting caps on target rates up the curve.
In 1961 in a program called Operation Twist, the Fed moved the duration of its portfolio to help lower longer term rates. It should be noted that OT1, if you will, was conducted during the fixed exchange rate period known as Bretton Woods I, which included the redeemability of dollars for gold. Also, although the short end of the Treasury curve was not at the zero bound, it was not viewed as adjustable for policy constraints than the zero bound.
So there are some subtle differences perhaps in any OT2 which the Fed might announce this week, or soon thereafter.
John F. Kennedy was elected president in November 1960 and inaugurated on January 20, 1961. The U.S. economy had been in recession for several months, so the incoming Administration and the Federal Reserve wanted to lower interest rates to stimulate the weak economy. Under the Bretton Woods fixed exchange rate system then in effect, this interest rate differential led cross-currency arbitrageurs to convert U.S. dollars to gold and invest the proceeds in higher-yielding European assets. The result was an outflow of gold from the United States to Europe amounting to several billion dollars per year, a very large quantity that was a source of extreme concern to the Administration and the Federal Reserve.The buying of the longer end of the curve, moving out from the bills to the shorter notes, has been telegraphed repeatedly to the markets this year. So it does appear likely.
The effects would be to lower real rates more broadly across the curve, perhaps taking them all negative, or at least closer to zero on the longer end depending on how one wishes to calculate inflation. I think the Fed uses their chain deflator. I doubt its accuracy for practical purposes, but let's not quibble.
This is 'bad' for the dollar and good for gold and longer dated Treasuries which will enjoy a brief rally. However it will drive yield hungry investors to seek other alternatives, perhaps in the stock market and overseas. It may shake up the Treasury markets on the longer end moreso than we might expect if there is an erosion in confidence in the US' ability to put its house in order without devaluation of the dollar debt. That erosion may be well-founded.
Such a policy move is intended to stimulate consumption and investment in situations where the middle of the curve and out is used as a benchmark for setting non-governmental interest rates. There is thinking that by moving out from the short maturies, the pull lower on the even longer rates will be more pronounced.
I do not think this alone will work. Banks are reluctant to lend at any price, and lowering the rates would not improve the credit risk profile of potential borrowers.
The Fed could also reduce the interest it pays on reserves to zero, or even place a negative rate on it. This would stimulate banks to put the money to work in the markets for projects with positive yields. This is not so different from the Fed's actions in driving consumers out of short term bonds and zero interest savings accounts, which they have done from time to time.
There is some further indications that the Fed will be using a reverse repo mechanism in order to grow bank credit in a more targeted fashion. I will not get into that further here, because if it does develop I am sure there will be much more lucid explanations given in some detail based on Fed announcements.
But it does follow the theme of actively stimulating lending in ways other than lowering rates, even on the longer ends of the curve.
The Fed might couple this with government guarantees on loans for example, for certain situations where the government wishes to stimulate activity, such as housing for example. It is hard to imagine anything like this passes through the dysfunctional Congress.
There is another option that the Fed has, which is not cited in the summary of this paper shown below.
For this we have to turn to Chairman Bernanke's famous speech on Deflation in 2002 in which he stated that 'the Fed's owns a printing press' and highlighted various steps which they might take to insure that deflation does not happen in the US, the ability and the resolve of the Fed to prevent it, and some of the options the Fed might have if they reach the infamous zero bound:
However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero. In the remainder of my talk, I will first discuss measures for preventing deflation--the preferable option if feasible. I will then turn to policy measures that the Fed and other government authorities can take if prevention efforts fail and deflation appears to be gaining a foothold in the economy...In summation, I think Bernanke's next move will be to start capping the two and three year rates, with the five year to follow. The purpose will be to keep rates low for the purpose of enabling spending and devaluing the dollar. I do not think he will have to expand the Fed's Balance Sheet to accomplish this.
What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.
There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates.
A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.
Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association). Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities...
If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. (Obviously the Fed has already been doing this as well).
Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.17 The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.
Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money. (I think the Obama Administration used this as the rationale for extending the Bush tax cuts).
Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets. (I believe the Fed has already been doing this with the help of a few Primary Dealers.)
But it is important to note that while the Congress can enforce a debt ceiling on the US Treasury, there is no such hard ceiling on the Fed's Balance Sheet. And this is probably the genesis of Presidential candidate Perry's scarcely veiled threat to Mr. Bernanke and the use of the word 'treason.'
I am not saying that the Fed is right in what they are doing. I am using Bernanke's thinking, and his own words, to determine what the Fed is likely to do next. I have been using this model for the past five years, and it has served me well.
I have some sympathy for Bernanke, because he has few allies, especially among the libertine left and the luddites of the right, and the serpentine Obama. The major obstacle to the US recovery is a failure in governance.
I have very little sympathy for the manipulation of certain markets traditionally viewed as safe havens, based on the rationale outlined in Larry Summer's paper about Gibson's Paradox, and the linkage between interest rates and gold. That appears to be roughly analagous to machine-gunning the lifeboats.
Deflation or inflation are truly policy decisions in an unconstrained fiat currency regime such as that enjoyed by the US. On this Mr. Bernanke is correct, and anyone who thinks otherwise does not understand a fiat money system. It really is that simple. To their credit, the Modern Monetary Theorists understand it very well, except for the downside of excessive money creation in a co-dependent world, even if one does enjoy the exorbitant privilege of the world's reserve currency.
Various interests have been seeking to restrain the Fed, ranging from large creditors such as China, and the domestic monied interests who have already received their bonuses and bailouts, and who do not wish to see their dollar wealth erode. One is richer if all around them are made relatively poorer, or so some lines of thinking go. And of course there are the prudent savers, who have been fleeing the dollar to the relative safety of some foreign currencies and hard assets like gold and silver.
I would hope that by now that any reader here would know that, at least in my judgement, deflation through hard money and austerity, or inflation through stimulus and money printing, are both unable to achieve a sustainable economic recovery because the system is caught in a credibility trap in which the governance of the country is unable to act justly and reform the system without implicating themselves in the compliant corruption that caused the unbridled credit expansion, massive frauds, and financial collapse in the first place.
This was a major contributor to Japan's lost years. The lack of will was in the failure of their largely single party system to correct the inefficiencies and crony capitalism of the banks and their keiretsus that provided a drag on all stimulus and the real economy, siphoning off the additional money into unproductive projects and support for zombie corporations.
The Banks must be restrained, and the financial system reformed, with balance restored to the economy, before there can be any sustained recovery.
Federal Reserve
Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment
Ben S. Bernanke, Vincent R. Reinhart, Brian P. Sack
8 April 2004
Abstract
The success over the years in reducing inflation and, consequently, the average level of nominal interest rates has increased the likelihood that the nominal policy interest rate may become constrained by the zero lower bound.
When that happens, a central bank can no longer stimulate aggregate demand by further interest-rate reductions and must rely on “non-standard” policy alternatives. To assess the potential effectiveness of such policies, we analyze the behavior of selected asset prices over short periods surrounding central bank statements or other types of financial or economic news and estimate “no-arbitrage” models of the term structure for the United States and Japan.
There is some evidence that central bank communications can help to shape public expectations of future policy actions and that asset purchases in large volume by a central bank would be able to affect the price or yield of the targeted asset.
Non-Technical Summary
Central banks usually implement monetary policy by setting the short-term nominal interest rate, such as the federal funds rate in the United States. However, the success over the years in reducing inflation and, consequently, the average level of nominal interest rates has increased the likelihood that the nominal policy interest rate may become constrained by the zero lower bound on interest rates. When that happens, a central bank can no longer stimulate aggregate demand by further interest-rate reductions and must rely instead on “non-standard” policy alternatives.
An extensive literature has discussed monetary policy alternatives at the zero bound, but for the most part from a theoretical or historical perspective. Few studies have presented empirical evidence on the potential effectiveness of non-standard monetary policies in modern economies. Such evidence obviously would help central banks plan for the contingency of the policy rate at zero and also bear directly on the choice of the appropriate inflation objective in normal times: The greater the confidence of central bankers that tools exist to help the economy escape the zero bound, the less need there is to maintain an inflation “buffer,” bolstering the argument for a lower inflation objective.
In this paper, we apply the tools of modern empirical finance to the recent experiences of the United States and Japan to provide evidence on the potential effectiveness of various nonstandard policies. Following Bernanke and Reinhart (2004), we group these policy alternatives into three classes:
We describe how these policies might work and discuss relevant existing evidence...
- using communications policies to shape public expectations about the future course of interest rates;
- increasing the size of the central bank’s balance sheet, or “quantitative easing”; and
- changing the composition of the central bank’s balance sheet through, for example, the targeted purchases of long-term bonds as a means of reducing the long-term interest rate.
Additional Reading:
The Upcoming Expansion of US Bank Credit - Alasdair MacLeod
Gold and Interest Rates: More than Joined at the Hip - Rob Kirby
“The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it.”
John Kenneth Galbraith
