Shooting Bears: Ammunition and Central Banks

 

[ Statistics Canada  just announced the seasonally adjusted CPI fell by 0.5% from September to October. And it wasn’t just gas prices. Core was down too (not seasonally adjusted). That’s deflation (on a monthly basis).]

 Metaphors are like models, only with unclear responsibilities. Can the Bank of Canada (or the Fed, if you like) ever run out of ammunition? If so, should it sometimes hold its fire, to save some ammunition for later?

I will answer the second question first, because the answer is clear: if the enemy is deflation, and if there is any danger of running out of ammunition, the Bank of Canada should definitely not try to save ammunition for later. On the contrary, prudence requires it to fire more bullets than it thinks it needs to kill the bear, and to fire them as soon as possible. The answer to the second question is less clear, but the Bank of Canada can run out of ammunition. The only policy of last resort is money-financed fiscal policy.

Suppose, for the sake of argument, that each 25 basis point cut in the Bank of Canada’s overnight rate target is one bullet, so that if it fires nine of those bullets, to bring the target from the current 2.25% to zero, it runs out of ammunition. If it expects inflation to fall below its 2% target, the Bank of Canada will need to cut interest rates – to fire some bullets. If it gets the number of bullets right, and sets the actual interest rate equal to the “right” rate of interest, inflation stays at the 2% target. Suppose the Bank gets it wrong, and does not cut interest rates enough (does not fire enough bullets). With the actual rate of interest above the “right” rate of interest, the economy goes into recession, and inflation continues to fall. The recession causes households and firms to cut spending, which makes the recession worse. The fall in actual inflation causes a fall in expected inflation, which causes a rise in real interest rates (for a given nominal rate), which further cuts spending, and makes the recession worse still. The worsening recession means that the “right” rate of interest falls too, so a bigger cumulative cut in the actual rate of interest will be needed than if the Bank had got it right the first time. (Yep, this is just Wicksell’s cumulative process, plus a multiplier/accelerator and a feed-back loop from actual to expected inflation, and I have avoided the words “natural rate” to avoid needless definitional arguments).

The longer the Bank waits before firing the right number of bullets, the more bullets it needs to fire. The bear is getting bigger every minute it lives, and the number of bullets needed to kill the bear gets bigger as the bear gets bigger. If the hunter is uncertain about how many bullets is the right number, and has a limited number of bullets, he should fire more bullets than he thinks is the right number to kill the bear, and should do so as soon as possible. Ditching the metaphor, if A is the actual nominal rate of interest, and R is the “right” nominal rate of interest (defined as the one at which inflation would equal the target), then if the Bank has preferences defined over the deviation of inflation from target, and hence over the gap (R-A), has lagged and hence imperfect information on R, and if R changes over time proportionately to the gap (R-A) plus serially correlated noise, then any risk that the lower bound on A might become binding in future implies that the Bank should set A below E(R), even if the Bank’s preferences are symmetric. (I am sure that any mathematically-competent economist could prove this formally.)

So, if there is any danger that the Bank might run out of ammunition, it should cut interest rates by more than it thinks is enough, and should do so quickly. It should not save some ammunition for later; prudence dictates just the opposite.

That was the easy part. But can the Bank run out of ammunition?

James Hamilton http://www.econbrowser.com/archives/2008/10/deflation_risk.html says we can always use “quantitative easing” to increase the money supply even if the rate of interest falls to zero, so deflation can always be cured. Paul Krugman http://krugman.blogs.nytimes.com/2008/11/15/macro-policy-in-a-liquidity-trap-wonkish/

says that the money supply increase would need to be permanent to work, and it may be difficult to credibly commit to a permanent increase in the money supply, so deflation is a real danger. To put it another way, if the central bank runs out of interest rate bullets, or if these bullets turn out to be blanks, what else can it use?

First, the Bank of Canada could make a commitment to keep interest rates low in future. If credible, this would reduce long rates of interest, as well as short rates, and have a greater impact on demand for goods. This would help, but only a limited amount. Even a perfectly credible commitment to keep interest rates permanently at zero could at most reduce the nominal long interest rate on safe assets to zero, and this might not be enough. With expected deflation sufficiently high, the real rate of interest on long bonds could still be too high, in which case those expectations of deflation would be confirmed by subsequent experience.

Second, the Bank of Canada could engage in “quantitative easing” by buying safe nominal assets, like government bonds (or CMHC-insured mortgages, which are ultimately insured by the government). Again this would help, but again it might not be enough. It would circumvent the credibility problem of the first option above, but at best it could only bring the nominal long rate of interest down to zero.

Third, the Bank of Canada could engage in quantitative easing by buying risky nominal assets, like uninsured mortgages, commercial paper, or ‘troubled assets’. In principle, with a finite supply of risky nominal assets, the Bank of Canada could push the risk premium on risky assets down to zero, so that both safe and risky bonds would pay zero nominal interest. This would make the expected (or risk-adjusted) nominal rate of interest on risky bonds negative, which would certainly help stimulate risky investment financed by such bonds. But there are three problems: first the sheer magnitude of the open-market-operation would be mind-boggling; second the Bank of Canada would suffer losses; third the supply of risky nominal bonds would not remain finite. It would not take a financial genius to manufacture an infinite supply of lottery tickets, sell them to the Bank of Canada, hold the proceeds in cash, then keep the proceeds when the Bank of Canada loses.

 

 

 

 

Fourth, the Bank of Canada could engage in quantitative easing by buying real assets, like shares, houses, or farmland. The rent/price ratio on farmland is a real rate of interest, since nominal rents can be expected to rise and fall with inflation and deflation. By buying farmland (and renting it out), the Bank could push up the price of farmland, push down the rent/price ratio, and reduce the real rate of interest on farmland. This would give farmers an incentive to make new farmland, if the price of farmland exceeds the cost of clearing scrub (so Tobin’s Q exceeds one). The same is true if the Bank buys houses, or shares in Canadian firms. By buying real assets, the Bank pushes down the real rate of interest on those assets. This stimulates new investment spending. Yet even this form of monetary policy has limits. If the expected rate of deflation is (say) 5%, people can earn 5% real interest just by holding cash, and so the Bank of Canada would be unable to push the rent/price ratio below 5% without buying all the farmland in Canada. Farmers would offer it all to the Bank of Canada when prices approached 20x rents. The same is true of houses and shares. The Bank would eventually face a perfectly elastic supply of real assets, and might be unable to raise Tobin's Q sufficiently to create enough investment to prevent deflation. If the Bank could credibly  commit to buying all the farmland, and keep on bidding up the price thereafter (unless deflation stopped), that might do the trick. But how could such a commitment be made credible? (Maybe by appointing a Marxist-Leninist as Governor?)

Of course, even if buying real assets worked, exactly the same effect could be achieved by the Bank of Canada printing money and lending it to the government to finance new government investment, or any increase in government expenditure. Or a money-financed tax cut or transfer increase (which is just helicopter money). The difference between government and private farmers is that the government might not care if it would be more profitable to hold cash than to build more sewers.

The Bank of Canada could also buy foreign exchange in an attempt to force the exchange rate down and increase net exports. But in a global deflation, this beggar-my-neighbour policy would not be a good way to make friends. Plus it might not work, if the supply of foreign exchange from foreign central banks were perfectly elastic, as it would be if they resist.

Pure monetary policy does not stop when nominal interest rates hit zero, but the Bank of Canada can nevertheless run out of ammunition, if expected deflation is sufficiently high. But money-financed fiscal policy remains as the weapon of last resort.

And by the way, since the Bank of Canada can indeed run out of ammunition, it would be very unwise to reduce the target rate of inflation below the current 2%. Reducing the target to zero inflation would have meant eight fewer bullets in its magazine. It’s only got nine bullets left right now (plus a couple of weird ones), and will almost certainly need to use some of those nine.

Nick Rowe (until I can figure out how to do "author tags")

Comments

[Marc Lee]

A number of Post-Keynesians (Randall Wray being the most prominent) also argue that the federal government itself (rather than just the central bank) can be engaged in reflation by running deficits not financed by issuing bonds, ie they just cut cheques to people who spend them; there is no vault that runs out. In normal times printing money like this would run the risk of increase inflationary expectations but in a deflationary situation that might just be what the doctor ordered. Is that view consistent with your last resort, Stephen?

We also need to be cognizant of what we mean by inflation. In recent years the Bank has paid attention to consumer prices while asset prices have undergone a massive inflation. Now it is asset prices falling that is the core underlying problem as it generates negative wealth effects. In that sense, we are already experiencing deflation.

This dynamic is also somewhat at play in high-tech consumer durables like computers, software and iPods, and as you have pointed out, is at the core of the debate about whether investment to GDP has been falling (based on nominal calculations) or increasing (based on real) in recent years.

Back to housing, this is less about output gaps and more about self-fulfilling expectations about the future direction of prices. Greed has been replaced by fear, and the real effect of that is a slowdown in new investment after a huge increase in recent years (like 2 percentage points of GDP above normal historical levels).

[Nick Rowe]

Marc: (I think you meant me, not Stephen)

Yes, I think we are talking about the same policy. If the government increases transfer payments (same as cutting taxes) and the debt in public hands (i.e. excluding that held by the Bank of Canada) stays the same, then it is money-financed. And that is conceptually the same as Milton Friedman's thought-experiment of the central bank loading helicopters with newly-printed money and dropping it for people to pick up. Friedman thinks of it as monetary policy; post-Keynesians (perhaps) think of it as fiscal policy; I think of it as fiscal+monetary policy; but it's the same policy. I would perhaps prefer money-financed government investment rather than transfers, but that's not central.

In the current context, I'm not sure if it matters exactly how we define inflation/deflation. Sure, different definitions will give you different numbers, and different numbers for the real interest rate as well, but the only thing that matters here is whether the nominal interest rate would need to be negative to prevent a downward spiral in deflation (however defined). As to whether the Bank's inflation target should include asset prices, my views keep changing on that. (15 years ago, in one of my wilder moments, I argued the Bank should peg the growth rate of the TSX, i.e. only asset prices.)

Not sure about the wealth effects of falling asset prices either. Falling house prices for example don't have first-order wealth effects. Prospective sellers are worse off, but prospective buyers are better off.

[Marc Lee]

Thanks, Nick. Sorry to confuse you with Stephen - there is no author tag on the post. As the "new guy" this may come up again.

On the house prices, the dynamic I'm most concerned with is falling housing prices that put more families in negative equity positions, leaving them more vulnerable to the downturn and less likely to engage in other consumption. But you are right, people who have been priced out of the market to date are happier to see prices fall.

[Stephen Gordon]

Two things I've been wondering:

1) This may explain why Mark Carney was so aggressive in the early stages of this round of interest rate cuts.

2) What role does the exchange rate play in all this? It wouldn't be hard for the Bank to depreciate the exchange rate, and to the extent that this passes through to prices, then this would feed back on inflation. This isn't something that US and Japanese monetary authorities have to consider (much), but it is for us.

[Phillip Huggan]

If nationalization is a permanent policy fixture, you get an increasing pie share of public sectors at the expense of private. Eventually you might risk bubbles in public sectors like infrastructure construction. In Wpg recent highways and crown buildings budgets have gone far overbudget. Especially Cgy offers an example of construction inflation. On the other hand transit and health can absorb lots of FDR spending. A problem is the social rate of return of many public sectors isn't measured. Flaherty stated he might subsidize sustainable (Japanese knockoffs)models in an auto bailout. Policymakers have to be able to value sectors that are potential nationalization targets. I'd like high-speed transit lines at present materials prices but by the time a construction blueprint is ready to hedge in just a few months the prices may be much higher or lower. As Stephen Harper's mom's portfolio can acknowledge, maybe public actors aren't the best traders.

[Nick Rowe]

Marc: Ooops! I hadn't noticed the missing "author tag". Will gather up courage sometime to try to figure out TyePad better.

Stephen:
1. Yes, since the Bank of Canada of course understands this point. Whether it has been aggressive enough, only hindsight will tell. FWIW, I expect a very aggressive (>=50 basis point) cut at the next move, unless credit markets suddenly improve a lot.
2. In normal times it's easy for the Bank to depreciate the exchange rate, if needed, by lowering the overnight rate. But if it hits a lower bound, it's not obvious whether and how this would work. If Canadian deflation were (say) 5%, and expected to stay at 5%, then foreigners, as well as Canadians, might be willing to hold more or less unlimited quantities of Canadian dollars, so the Bank's buying forex and flooding the world market with Canadian dollars might not cause any depreciation. The world demand to hold Canadian dollars might be very elastic.

Phillip: I see money-financed fiscal policy as a temporary measure, that would stop as soon as expected inflation had returned to the 2% target. And since it would be done during a recession, the construction workers for infrastructure investment would be readily available. Of course, whether it would in fact be temporary, given public choice forces, might be another story.

[Nick Rowe]

Marc: I have changed my mind on how I would answer your first comment. I now think it does matter how we define deflation (see my latest post).

[Andrew]

You say that the BoC should move quickly to reduce interest rates. Are you calling for a more rapid decline than 50 bpt. per meeting? I realise that it would be fairly unusual and thus might make the market more nervous, but I can't imagine that a drastic rate cut could make things much worse.

I tend to agree that infrastructure spending will be called for--too bad the GST cut will likely be saved rather than spent.

[Nick Rowe]

Andrew: IF there's any danger of hitting the lower bound, then interest rates should be cut more, and more quickly, than we would cut them if we were certain of our forecasts. Haven't firmed my opinions on it as yet, but I would tend to lean towards a 100 bp cut sometime soon. Just waiting for Stephen Gordon's next post to help make my mind up.

An announced temporary GST cut (like in the UK) would probably encourage more spending than the cut in taxes (MPC>1 if you like).