Promising to keep nominal interest rates low for too long

I was lucky enough to be invited to a Bank of Canada conference on Thursday and Friday. The topic was "New Frontiers in Monetary Policy Design". One recurring theme in particular has stuck in my mind: that a credible promise to keep interest rates low for too long can help an economy escape a liquidity trap. (I apologise for not remembering which presenter or commenter expressed the point so clearly in this way that it stuck in my mind.)

It's not a new idea that expected future monetary policy, by raising the expected future price level, and so raising today's expected rate of inflation, can increase aggregate demand today. But expressing that idea in terms of keeping interest rates low for too long does give it a new perspective. We make commitments because by credibly committing to do something we would not otherwise want to do we can influence others' expectations today of our future behaviour. Rules vs. discretion. A central bank that can make credible commitments faces a trade-off between output today and inflation in the future. It will promise to create higher inflation in the future than it would want in future, in order to buy higher inflation, lower real interest rates, and higher output today. So if the central bank otherwise thought that 2% inflation is what it wants, it would promise to raise inflation temporarily above 2% as soon as it is able to do so. And of course it would want to renege on that prior commitment in the future, if it thought it could do so without harming its reputation thereafter.

Two unrelated thoughts come to my mind.

1. The Bank of Canada has said it would keep the overnight rate near zero for an extended period, conditional on the outlook for inflation. This is not the same as promising to keep the overnight rate too low so that inflation temporarily rises above the 2% target. It really amounts to promising to do what it would want to do anyway. That might be useful, in circumstances where others might be unsure what you want to do, or unsure what you currently think you will want to do in future, but it's not the same thing. But I can see the Bank's dilemma. It's credibility is so tied to trying to hit the 2% target, a promise not to hit that target in future is problematic. Promising to do something different from what you had initially promised to do does raise credibility issues.

2. The nightmare scenario. Making a promise to set nominal interest rates too low when we eventually escape the liquidity trap is all very well. But this assumes we eventually do escape the liquidity trap. What good is that promise if we never do escape? Of course, like all nightmares, this is daft. This too shall pass. But if we believed the logic of Neo-Wicksellian models, in which monetary policy is framed as setting the nominal interest rate, there can be no certainty that it will pass. Eventually the natural rate of interest will rise. But if by the time it does rise deflation and expected deflation are so strong, even a high natural rate might leave the equilibrium nominal rate negative. If people believe that a sufficiently high natural rate can break the deflationary spiral, then it can break the deflationary spiral. But if they don't, and deflation is already big enough to overcome any high natural rate, then it won't. And if we make the former, optimistic assumption, then why can't we get people to believe in high inflation right now, high enough to break the liquidity trap?

Dunno.

Comments

[Jon]

Nick,

Something I've been thinking about lately, is that in the US at least, people started to expect an inflation-rate much higher than 2%. By mid-2008, most people I knew estimated the inflation-rate around 5-8%. The one place where it wasn't yet was in wages, but people seriously started suggesting that COLA for wages should be higher right around the summer of 2008. i.e., we were right on the cusp of a wage-inflation spiral.

Then suddenly the oil-price bubble burst--stockpiling from China ended with the Olympics, a few mbb of temporarily lost capacity surged back, and a flurry of research reports came-out around then too pegging the oil supply as highly elastic at $70/barrel.

It seems more probable to me that the domestic problem stems from a 2% target being wildly low compared to the inflation assumptions built into contracts.

The UMich data bears this out:
http://research.stlouisfed.org/fred2/series/mich

[Stephen Gordon]

This seems to be linked to the idea of price level targeting. If the Bank were targeting the price level, the fact that inflation has been below 2% for a while means that its policy would be to generate a surge of inflation above 2% in order to get back to the path.

It looks hard to argue against the theory, but I'd be worried about the credibility of that sort of policy. Would the Bank really generate (say) 5% inflation in an expansion in order to make up for what happened during the previous recession?

[Adam P]

The thing about price level targeting is that it sounds good now but what about in normal times. Suppose the price level is targeted with a target that grows by 2% every year. Then along comes an oil shock (due to Chinese demand) that causes a 5% jump in the price level.

Do we really want the kind of recession that engineers a 3% drop in the price level? (The drop in the current recession has been something like 3% I'm guessing.)

[bill woolsey]

Target the growth path of nominal expenditure....

Don't target inflation.

When reading your last post about generateing promising to generate a boom, does that apply with nominal expenditure targeting or is it an artifact of inflation targeting and the specification of the phillips curve using expected and past inflation?

Why don't we just ruturn real output to a level consistent with the long run growth path of nominal expenditure?

[Adam P]

OK, suppose an oil shock comes along (due to Chinese demand) that requires a 5% jump in nominal expenditure to keep real expenditure unchanged. Do we really want to engineer the kind of recession that causes 5% drop in nominal demand?

[Stephen Gordon]

Just to update the price-path targeting comment. If the Bank had committed to a path with 2% core inflation in January 2007, we'd be 0.8% below the path as of September. To catch up over (say) the next two years, we'd have to average 2.5% inflation. Perhaps not that big a deal after all.

[bill woolsey]

Adam P--

Nominal expenditure for the U.S. is spending on final goods and services produced in the U.S. Stable growth in nominal expenditure is stable growth of nominal incomes earned from production in the U.S.

Spending on imported goods is not directly targeted. There is no need to reduce nominal expenditure on domestic products to offset an increase in nominal expenditures on imports.

It is only to the degree that the increased prices of imports results in great real demand for import competing goods or export goods that real expenditure of domestic product needs to be restrained. But that, of course, is offseting increases!

Real expenditure might be reduced, but only to match any decreased productive capacity in the U.S., perhaps resulting from the decreased availability of oil. But also because of other possible shifts in composition of demand and the allocation of resources.

Nominal expenditure, is maintained, of course. But higher prices means less real expenditure.

Real incomes would definitely be reduced most obviously because of the higher prices of oil and oil related products.

You need to break out of a framaing things in terms of targeting a growth rate of the cost of living.

That approach is bad. Using changes in nominal interest rates to manage it is worse.

And, yes, I do favor maintaining price level discipline by having real expenditures fall in proportion to excessive increases in the price level.

I do accept that a shift in the composition of demand and in the distribution of income across areas of the income will result in recessions in those areas of the economy with reduced demand.

It is the least bad option. Again, it is better than targeting the nominal interest rate and promising that prices will rise 2% from their current level wherever that might be. In other words, it is better than creating Great Recessions.

[Jon]

Nick,

Can you comment on my comment:
http://blogsandwikis.bentley.edu/themoneyillusion/?p=2914#comment-9812

And Scott's followup:
"Jon, Yes, I think in his model the effects on real output are driven by the real interest rate. I prefer to use a sticky wage model."

I always thought price-lags explained how a shift in real-rates could occur but that it was the rates themselves that altered the pattern of investment.

[Ramanan]

Nick,

I have a suggestion. Hope you don't mind. Is it possible for you to have the comments displayed differently like the name of the commentor on top in Bold ? Helps in reading one set of debate and not losing out when I or someone scrolls fast. I don't know how to handle this as my blog/HTML skills are zilch. (I could be in minority here and other people may find the present template more attractive.)

[Stephen Gordon]

I'll check.

[Nick Rowe]

Jon: It's noteworthy to me how we went into the crisis with inflation (and maybe expected inflation) a bit above target, and yet still hit the lower bound on nominal interest rates. But all the theory says that the higher the target, the less the chance of hitting the lower bound.

Stephen: this is very definitely linked to price level vs inflation targeting. Under discretion, a central bank that preferred a price level target would do better than one that preferred to keep to an inflation target, for just the reasons you cite. But price level targeting is generally not first best optimal under commitment. If the central bank preferred a particular price level, it would generally be optimal to promise a price level above that target in the period immediately following the recovery from the zero bound.

Adam P.: Your argument sounds good to me. Some might respond that under price level targeting, the rise in oil prices wouldn't have had such a big effect in the first place. Dunno.

Bill: the argument in this post should be the same whether the central bank preferred to keep inflation, price level, or nominal income on target. Relative to the preferred path, however defined, always promise to overshoot temporarily when you are off the zero bound.

Jon: OK. I'll respond on Scott's blog.

[JKH]

Nick,

This is becoming rather amusing:

http://www.moslereconomics.com/mandatory-readings/the-natural-rate-of-interest-is-zero/comment-page-1/#comment-13449

[Nick Rowe]

JKH: Oh dear. Like watching a car crash in slow motion? I wonder what will happen.

What's that line from the Ryme of the Ancient Mariner? "Unhand me, greybeard loon!"

[Scott Sumner]

Nick, I recommend looking at the Woodford paper in this post. If you want to save time you can just read my post, where I summarize the important parts:

http://blogsandwikis.bentley.edu/themoneyillusion/?p=2872

Woodford's views strongly support the views of Stephen Gordon; level targeting is the key in a liquidity trap.

In response to your point about inflation already being slightly above target going into the crisis, I have often argued that we need to drop inflation targeting, and go over to NGDP. Either we face a problem of inadequate AD or we don't. If we don't, what's all this discussion of the need for stimulus? If we do (and I think we do need more demand) then that means inflation can't be the right policy indicator if it's signaling no need for additional stimulus. In that case we need another indicator, and of course I keep arguing for NGDP, although other Taylor type hybrid functions would work as long as they involved level targeting, not rates.

[Nick Rowe]

Thanks Scott: yep, it's along the same lines. Both Woodford and Eggertsson were at the conference. I think it was probably Eggertsson who made the comment about keeping interest rates low for too long.

[Ramanan]

JKH,

I found this comment very amusing "You are a strange fellow, JKH, one of a kind in this financial world." here http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/10/economic-illiteracy-goes-viral.html?cid=6a00d83451688169e20120a6884f94970c#comment-6a00d83451688169e20120a6884f94970c

[Michael Buckley]

There is a large population that views this sort of talk as debasement. And they are responding almost as the CB wants -- abandoning the currency. But for gold, not consumption.

[Ramanan]

JKH,

Further .. to my comment .. imagine landing in other sites .. cant name them .. its a small world. "dead parrot" is a hint ..

[Jon]

It's noteworthy to me how we went into the crisis with inflation (and maybe expected inflation) a bit above target, and yet still hit the lower bound on nominal interest rates. But all the theory says that the higher the target, the less the chance of hitting the lower bound.

I think what's critical is that the UMICH data is about expected inflation. That is looking forward over the next year, what do you expect the average inflation-rate to be. Consequently, after summer, actual inflation didn't just drop below 'target' it dropped below an elevated expectation (5%)--significantly.

Rather than in opposition to theory--that is the theory. If the CB expands the money supply such that inflation expectations drift-up, the CB must commit to the new higher inflation rate or induce a recession.

[Adam P]

Well Nick, I wasn't really making an agument but asking the question. I'm not really sure what is the correct answer. You could ask the same question about inflation targeting but the big difference is that you don't need as deep a recession to reduce inflation as to reduce the price level. Just want to remind us that we won't always be in recession (one hopes).

[JKH]

Ramanan 10:25,

I'm on the right side of the moon on this one in particular.

Dead parrots beware.

[westslope]

I think I need to better understand why deflation is such a threat. For example, if modest deflation is driven by either productivity increases or excess productive capacity, what is the problem? Maybe I'm just a slow learner.

I also probably need to understand why so many monetary policy debate participants come across like material growth junkies, perhaps pre-programmed by some catchy phrase in the Old Testament or similar. The growth-at-any-costs approach created this current economic and financial crisis and continues to drive wealth- and hegemony-destroying colonialism in the Mid-East.

I read all this catchy rhetoric about Japanese liquidity traps, economic stagnation and the "lost decade". But I have yet to read anything about starving or malnourished Japanese, Japanese citizens emigrating in droves to healthier economies, increasing property crime rates, or soaring suicides. What am I missing?

After all the apparent policy failures experienced in 20th century, I'm really stumped by the on-going efforts of monetary policy economists to find innovative, clever ways to fool people. I understand that individual political leaders, activists and fund managers have been most successful deliberately misleading people but I don't see the benefits for academic pin-heads other than conforming to entrenched cultural values. Isn't the current backlash to the climate crisis/global warming issue a clear warning signal?

Within the context of the current Canadian monetary policy regime, I don't understand why the inflation target rate is not lowered to 0% with a range from -1% to +1%. Are clear, informative price signals important or not? Micro theory predicts that the value of the currency would grow over time. Is that bad thing?

Am sympathetic to the notion of price level targeting but probably need to understand the mechanics better.

[Andrew F]

Westslope: I think the issue is that while inflation can be either positive or negative (deflation), nominal interest rates can only be positive. Inflation is more desirable, as it allows greater flexibility with setting real interest rates, while deflation puts a lower bound on real interest rates that might be quite a bit higher than we'd like.

[Andrew F]

Oh, and Japan is in slow-motion meltdown. Their population is rapidly aging, their government is heavily indebted, and much of their economic activity relies on profligate government spending funded through government borrowing. These factors combine to indicate that eventually something will have to give, and government spending will fall, triggering a rather painful recession.

[Patrick]

To what extent do people set their inflation expectation by actually seeing the CB increase rates?

If they set expectation with a some combination of experience and watching the CB act, then at the zero lower bound you loose half the tools in your toolbox, and what you're left with is useless. They obviously can't raise rates because reality would trump expectation.

So they're left with these wishy-washy statements about leaving rates low for extended periods of time... meanwhile, everyone is watching for a rise in interest rates to signal inflation is coming - a rise that the CB has just promised isn't coming!

[Adam P]

Nick,

I highly recommend that you and Scott Sumner check out the Solow and Hahn book "A Critical Essay on Modern Macroeconomic Theory".

In chapter 2 they give an example that is remarkably relevant to today's situation. The work in an OLG framework and along comes a shock that pushes the economy off it's equilibrium (in the example the shock is an increase in the labour force that leaves us with a suboptimal capital/labour ratio but that's not the point).

The economy falls into a liquidity trap, one solution is a large and permanent monetary injection (as usual it must be permanent). However, this is suboptimal because the size of the required money injection is so large that it generates an excessively large inflation in subsequent periods, after the liquidity trap is history. Presumably this sort of worry is going on at the Fed right now.

Furthermore they show that a smaller monetary injection combined with an interest subsidy to investment is the optimal solution. If the Fed tried such a policy in real life might it look a lot (perhaps exactly) like the Fed's current credit easing program?

You'd like the model, the money injection operates both through quantity effects (relaxing credit constraints) and the real interest rate. Basically, with the capital/labour ratio too low it is not physically possible for the economy to provide the previously expected level of per capita consumption, thus the real wage to the current working generation falls. Now, this might just result in one slightly poorer generation but there is a further problem. Since the current generation is earning less, their savings are less and that means next periods AD will be less (per capita) and thus firms, seeing low demand tomorrow, won't invest enough to bring the capital stock up to its optimal level.

A monetary injection helps by giving the currently young cohort enough money to both consume and save, it has to be permanent so they don't have to save too much of it. If it is large enough and permanent then inflation happens today and this expropriates some of the real value of the older cohorts savings thus allowing eveyone enough consumption today. However, there is a catch, the injection must be big enough to allow the young cohort both enough savings and enough consumption at the new higher prices and next period this generates an excess supply of money and a further inflation (this follows from the algebra). In fact the inflation ends up lasting several periods and so there is a welfare loss for many periods before the steady state is obtained.

The interest subsidy gets around this by generating the required investment directly, this then combines with a monetary injection to cause the price rise today (so the current young get extract some real value from the current old cohort) and we go back to steady state in one period.

Perhaps there is a bit more to monetary policy then Scott Sumner lets on? He does make it all seem so easy, if only the Fed weren't so dumb everything would be fine.

[Nick Rowe]

Adam P. Why do i need to read stuff when I've got well-read commenters like you ;)

OLG models on the dynamically inefficient path, with negative natural rates, do keep running through my mind.

In the current case though, I don't see any reason to believe the "long-run" natural rate is negative. By "long run" natural rate I mean the rate of interest that gets y=y*, conditional on people expecting future y to equal future y*. But if people expect future y to be less than future y* (which I think they do now), the "short run" natural rate (the interest rate that would put current y=y* given expected future y) will be less than the long run natural rate, and may well be negative.

That's how I view the current recession, and I think Scott does too. I don't think there was any fundamental shock to technology, labour supply, tastes, demographics, etc. that caused the true (long run) natural rate to go negative in 2008. Or, to try to put it more accurately, the financial crisis temporarily widened spreads, causing the long run natural rate on safe liquid assets to go temporarily negative for a few months. But it's the fall in expected future y below y* that has caused the "short run" natural rate to stay negative, even though the long run natural rate is positive again.

Does that make sense? I don't know if I defined long run and short run natural rates clearly enough. Short run is where the actual IS curve cuts current y*. Long run is where the hypothetical IS curve, that would exist if people expect future y to equal future y*, cuts y*.

[Adam P]

Well, I agree that the long run natural rate is not negative but that the natural rate for trading between now and say 5-10 years from now is negative. And I do think that an inflation target that explicitly promises to allow some above trend inflation is the correct response.

Where I disagree strongly with you and Scott is that I don't think monetary policy could have prvented the recession, one problem here was in the credit channel (thinking Bernanke-Gertler here). That's why I think Scott's NGDP futures scheme, had it been in place, would have done more harm than good and NGDP growth still would have fallen. The other is that there is a real side to this, there are real frictions and we did have a lot of resources devoted to basically useless fixed residential and commercial property investment. Shifting that amount of labour to other sectors is a pretty painful process with all sorts of costs and frictions.

And the liquidity trap is real and it is harder than just making a non-binding promise to convince people that you'll allow inflation. Especially when lot's of other influential people are yelling that it's a horrible idea and once the trap ends everyone will want you to go back on your promise. That's why the difference between "monetary policy is now too tight", which is what Sumner keep saying, and "expected future monetary policy is too tight", which is correct, is so important. The first is someting the Bernanke can change, the second is not. At least not with Plosser and other around. Sumner makes it seem like it's all Bernanke's fault which is simply not true.

I think Bernanke, up until now, did an amazingly good job. However, I think that now is when a promise of inflation really would be a big help and so now I think Bernanke is being too conservative, so I'm agreeing with what Scott is currently saying.

The reason I appear to have this personal grudge against Sumner is that he's getting a lot of attention, a lot of people seem to like his ideas but they aren't all good and the good ones aren't his. And he gives a very misleading picture of how monetary policy works and what it can do, keeping expected NGDP growth at 5% is not as easy as he thinks. I'd be horrified if policy makers started listening to him in general and it's frustrating that you and everyone else keep supporting him. (Also, he is dismissive of comments that don't agree with him. He doesn't really debate his commenters like you do, he makes assertions not arguments, and that is really annoying when you're trying to make a point you think is important.)

[Jon]

The natural-rate should be the value society places (in aggregate) on deferred consumption. So the natural-rate in strictly real terms should be positive. It strikes me as deeply apocalyptic that someone would defer more of something today for the promise of something less later.

Adam: the liquidity trap is a nominal construction deriving from the future price-level. e.g., when I bought a mattress, I waited until the 4th of July--which is when I know Macy's gives the biggest discounts on mattresses. This is nothing more than contango, but in the money market, the government promises to preserve bank deposits and redeem currency such that is always preferable to take the government as a counter-party than to accept contangoed futures contract for money. Thus the trap of liquidity.

[reason]

Adam P.
"The other is that there is a real side to this, there are real frictions and we did have a lot of resources devoted to basically useless fixed residential and commercial property investment."

I'm not sure that we know that. I think the key here is debt and land prices. I think we went too much into debt to build residential and commercial property. I think the built environment is a big part of what an economy does. (And a large part of the value of the built environment is clearly in externalities - I think we don't think hard enough about it in fact. More public policy resources should be devoted to it.)

[reason]

Jon,
"It strikes me as deeply apocalyptic that someone would defer more of something today for the promise of something less later."
We had this discussion before, perhaps you missed it. Some people argued quite convincingly that this might in fact be the case. It certainly could be true for aging societies, and it could also be true for people concerned about resource depletion.

[reason]

Jon,
it strikes me as well that it could simply be a measurement problem (i.e. the future consumption is just not captured in the market). Think energy saving investments.

[Adam P]

reason, it could also be risk. Future consumption hasn't become lower in expectation but the (subjective) distribution has become riskier.

[Adam P]

It's also worth mentioning that savings is a flow variable. Someone who is paying down debt is saving that money, but if I'm paying down debt I'll keep doing it even at zero current interest rates.

In fact if the debt is fixed interest at a positive (perhaps high) rate and a large negative shock to the asset side of my balance sheet has left me unable to refinance at the now zero rates then paying down debt is a better thing to do with my savings then investing at zero return.

[JKH]

Nick,

I’ve taken a fairly close look at that Woodford paper, which I found incredibly good for several reasons. The first is that it demonstrates a rare understanding for how the monetary system actually works (very ironic given recent exchanges on your blog about MMT, accounting, etc.). Along these lines, it supports the view that interest rate targeting is the central mechanism for central banks, and that, startlingly, it comes up with the right conclusion about excess reserves – levels of excess reserves beyond the "satiation" point are impotent causally in the transmission mechanism, and that the "satiation" point is well defined by rates falling to the reserve interest rate lower bound. The paper clearly states that excess reserves in the current environment are an effect rather than a cause. Furthermore, the idea of level targeting and “the promise” has nothing to do with any monetary base “mechanism” and everything to do with interest rates. This is all the more startling in the context of Scott Sumner’s blog views, because while he embraces this paper for its promotion of “the promise”, the paper otherwise runs counter to just about everything he believes about the importance of excess reserves and the monetary base.

Quite amazing overall.

[JKH]

Adam P,

Would be interested in how you interpreted that paper if you had a chance to read it.

[JKH]

Here is the money shot from that paper:

"While our analysis implies that it is desirable to ensure that the supply of "reserves never falls below a certain lower bound ￣mt(Lt), it also implies that there is no benefit from supplying reserves beyond that level. There is, however, one important exception to this assertion: it can be desirable to supply reserves beyond the satiation level if this is necessary in order to make the optimal quantity of central bank lending to the private sector Lcb t consistent with (1.10). This qualification is important in thinking about the desireabiliy of the massive expansion in the supply of reserves by the Fed since September 2008, as shown in Figure 2. As can be seen from Figure 4, the increase in reserves occurred only once the Fed decided to expand the various newly-created liquidity and credit facilities beyond the scale that could be financed simply by reducing its holdings of Treasury securities (as had been its policy over the previous year)...

Some have argued, instead, that further expansion of the supply of reserves beyond the level needed to bring the policy rate down to the level of interest paid on reserves is an important additional tool of policy in its own right — one of particular value precisely when a central bank is no longer able to further reduce its operating target for the policy rate, owing to the zero lower bound (as at present in the US and many other countries). It is sometimes proposed that when the zero lower bound is reached, it is desirable for a central bank’s policy committee to shift from deliberations about an interest-rate target to a target for the supply of bank reserves, as under the Bank of Japan’s policy of “quantitative easing” during the period between Bernanke (2009) distinguishes between the Federal Reserve policy of “credit easing” and the type of “quantitative easing” practiced by the Bank of Japan earlier in the decade, essentially on this ground. Our model provides no support for the view that such a policy should be effective in stimulating aggregate demand. Indeed, it is possible to state an irrelevance proposition for quantitative easing in the context of our model."

[Adam P]

I haven't read it yet but will take a look in the next day or two.

[Scott Fullwiler]

JKH . . . haven't read the new Woodford paper, but, yes, he's one that has gotten cb operations mostly correct for several years now.

[Nick Rowe]

JKH: Yep. Michael Woodford epitomises/defines/created what is called the "Neo-Wicksellian" view of monetary policy. His book title "Interest and Prices" is presumably a direct reference to Don Patinkin's classic "Money, Interest and Prices". In other words, it's monetary theory, without money (well, that's a caricature, but there's some truth in it).

When I wrote this post, I adopted that Neo-Wicksellian perspective. "Monetary policy IS the central bank setting (current and future) interest rates". I set aside what I had previously said about this being a social construction, and treated it as a taken-for-granted concrete reality.

He's inside the Matrix ;)

But there are two separate questions: the importance of promises about future monetary policy; the language in which promises are framed. Scott Sumner (and I) can agree with Woodford on the first, but disagree on the second.

[JKH]

Adam/Scott/Nick,

Thanks for those responses. It was a pleasant surprise and very interesting to read - given its layering of some economic theory over a correct understanding of CB operations - and most impressively, what I think is the right understanding of the current Fed balance sheet situation.

[JKH]

And yes, Nick, the inherent separability of those two questions is also made very clear in the paper - another interesting aspect.

[Adam P]

Nick, I'm pretty sure the book title comes from Wicksell's book with exactly same title: "Interest and Prices".

[Jon]

JHK:

I addressed directly your claim about excess reserves being fully impotent in a prior post, reproduced below (slight reworked). We can debate sensitivities (slopes) but I believe an absolute conclusion of that form is unwarranted:

I’ve been trying to think of the right descriptive framing: even if the expected real-return on holding money is above the natural-rate, will there be infinite demand to hold money?

Initially I thought yes… if expected deflation is greater than the natural-rate, then people will ‘earn’ their time-preference simply by hoarding cash/reserves. This would lead one to believe that once nominal-rates cannot descend lower, people cannot be induced to spend now rather than later given a deflationary environment. But this is wrong. People’s indifference curves surely do not look that way: due to diminishing returns to future consumption. i.e., eventually I accumulate so much claim on future consumption that my natural-rate preference today must be different because of the diminishing value of future consumption.

The cash-rate (price which equalizes the supply and demand of cash balances) is different from the overnight-rate which is a credit-rate and equalizes the loan market. The cash-rate is and has always been zero (until it was raised by the reserve-policy) and therefore this effect derives from the future price-level.

But, as the demand curve for cash-balances is slopped, hoarding preference is not infinite even at the zero cash-rate bound. Higher holdings cause the natural-rate to fluctuate upward and eventually reach equilibrium against the deflationary trend.

[Ramanan]

JKH,

I did a brief Google on Michael Woodford and he seems to be so-close-yet-so-far to Chartalist kind of approach. There is also a comment by Scott at http://bilbo.economicoutlook.net/blog/?p=4977&cpage=1#comment-1486

He seems to be doing something on fiscal approach to achieving price stability.

[Ramanan]

JKH: http://www.columbia.edu/~mw2230/IFcashless2.doc is a good one too. Talks of the ability of the central bank :

"The special feature of central banks, then, is that they are entities the liabilities of which happen to be used to define the unit of account in a wide range of contracts that other people exchange with one another"

again somewhat similar to taxes drive money though not quite because he says

"There is perhaps no deep, universal reason why this need be so; nor, perhaps, is it essential that there be one such entity per national political unit."

[JKH]

Jon,

Just to be sure everybody’s referring to the same paper, it’s the November one that Scott Sumner linked to:

http://www.newyorkfed.org/research/staff_reports/sr404.pdf

Excess reserves are a bank asset. They are not accessible to non-banks. If one does not understand that, one cannot understand the structure and operation of the monetary system in general.

Therefore in describing excess reserves as impotent, one must be referring to their usefulness as a bank asset.

Woodford describes this in a way that seems consistent with a post Keynesian analysis of the usefulness of excess reserves. While I’d say that’s true, I’d stop there with the comparison, because I’m not at all familiar with Woodford’s work in general. Apparently there are significant differences beyond that.

The post Keynesian view is that banks are not reserve constrained. Equivalently, banks are capital constrained but not reserve constrained. What that means is that excess reserves alone will not cause banks to create new (risky) credit and stimulate the economy in doing so. And because of that, it will not cause them to create new money by creating new credit. Because excess reserves are a bank asset, and nobody else’s asset, that’s really the scope of the discussion if one is broaching the issue of “impotence”.

I must say that in general I am staggered by the type of non-specificity of monetary analysis that runs rampant through certain blogs. Woodford has been very specific about how excess reserves work. Post Keynesians and “modern monetary theorists” anchor their work in an analysis of actual banking system operations and accounts. The Woodford paper is attractive because it is also fairly specific along these lines.

What I find particularly mind-boggling is the analysis of those who tend to endow excess reserves with more power than they actually have, and then who systemically fail to identify and differentiate the complete balance sheet effect of “quantitative easing”. If the central bank acquires financial assets newly issued or sold by non-banks, the result is a dual balance sheet effect. Excess reserves increase. But so do bank deposit liabilities. I am staggered by the tunnel vision that focuses on the excess reserve effect without recognizing the bank deposit liability effect. The latter is the channel of money expansion that should be the proper focus, particularly given the actual impotence of the excess reserve effect itself. I’ve never seen ANYBODY do this type of monetary analysis.

For what its worth, your comment regarding diminishing returns to future consumption and its relationship to hoarding makes some sense to me when applied to the bank deposit liability side of things. But it has nothing to do with excess reserves as treated by Woodford or for that matter by post Keynesians.

[Nick Rowe]

Adam P. Yes, you're right. Two ways of "framing" the same facts (sorry): same title as Wicksell: A different title to Patinkin.

Neo-Wicksellians are the same as post-Keynesians in being "horizontalists". They differ on many other matters though, like microfoundations, natural rates, etc.

[Scott Fullwiler]

JKH . . . well said, as usual.

[Jon]

JKH:

I've been at the fore arguing that the Fed does not conduct OMOs with banks. It conducts those operations through the public. Whether those reserves are deposit liabilities is really a question about capital. In the short-run, bank capital is fixed. Any expansion by the Fed of the base necessarily by way of OMOs creates both deposit liabilities and excess reserves. Its 1:1 and interchangeable.

But I'm not even willing to cede you the point about capital. Bank capital is not an asset, its a liability to the owners.

The one place where I think you have a point is that direct lending from the Fed to the banks creates a liability to the Fed--which I agree is useless and ineffective given the present rate-regime.

AFAIK, this is part of the point of the QE program that the Fed undertook--to replace those ineffectual credit facilities with OMOs.

I wrote an op-ed last October arguing precisely this point: that the Fed was conducting OMOs to drain liabilities from the public and replacing them with direct lending to banks that was dollar-for-dollar equivalent from the perspective of the monetary base but in practice equivalent to pursuing a significant tightening once inflation turned sharply South.

[JKH]

Jon,

You’re completely misunderstanding what I said.

The Fed’s OMO’s or other types of asset acquisition, when done with non-banks, create excess reserves and bank deposits liabilities. That’s exactly what I said:

“If the central bank acquires financial assets newly issued or sold by non-banks, the result is a dual balance sheet effect. Excess reserves increase. But so do bank deposit liabilities.”

By "bank deposit liabilities", I meant commercial bank deposit liabilities, which I though was obvious. The non-bank seller of the asset deposits the central bank cheque in his commercial bank account, which increases money supply at that level.

Nowhere did I say anything to the effect that such intervention has some sort of effect on bank capital. And I’m quite aware bank capital is not an asset.

[Jon]

No, I understood what you said. I just took more comprehensive review...

I agree there are circumstances where excess reserves become a poor proxy (last October) but that arises because of special liquidity facilities wherein liabilities are owed to the Fed or sovereign rather than the public.

[westslope]

"Westslope: I think the issue is that while inflation can be either positive or negative (deflation), nominal interest rates can only be positive. Inflation is more desirable, as it allows greater flexibility with setting real interest rates, while deflation puts a lower bound on real interest rates that might be quite a bit higher than we'd like." -Andrew F

--------------------------------------------------

Andrew F: Are you suggesting that we put the inflation rate at the service of the central bankers in hopes of making their jobs easier? In those circumstances, a little bit of price fuzziness is OK? Don't central bankers already have sufficient tools to influence monetary events in addition to overnight rates?

With a central bank (CB) mandate limited to maintaining a stable price system, the impossibility of non-negative nominal rates would be unimportant. The "liquidity trap" would be relegated to the ranks of economic history. Maintaining central bank credibility would presumably be easier because the mandate would be rid of multiple, often contradictory objectives whose priorities are constantly being reassessed.

Is stable deflation really that scary? Let's assume a CB policy target of -1% to 1%. The economy arbitrarily enters into a 5-year period where actual inflation is constantly -1%.

A risk-averse person saving money in a shoe box makes a real return of 5% over 5 years. A risk neutral person invests savings into a low-risk stock yielding a nominal 5% yield that is re-invested in the same stock. The real return after 5 years is 34% or 6.6 times more than the shoe box strategy. Add risk of a non-negative inflation rate and the attractiveness of hoarding cash diminishes further.

Would consumers delay some purchases? Perhaps. Many consumers already delay purchases in technological product cycles and nobody views that as a serious social problem.

If the consumer holds cash and waits 5 years to buy a consumer durable good whose price stays constant in nominal terms, the real savings amount to 5% off the nominal price. Would you delay a purchase or upgrade of a washing machine by 5 years in order to save 5% off the real price? Especially, if you as a consumer benefited from a significant surplus produced by services from the durable good? (Compare a washing machine to hand washing.)

Re: Japan. The current per capita GDP is ~US$35K in PPP terms and ranks globally at 22 according to the CIA. New Zealand figures in at US$28K and #49 in world ranking. Japan has a ways to go before crossing Newfoundland and China on the way down.

[reason]

Adam P.
Re interest rates and debt repayments - good point indeed. Sort of a point about the difference between a dynamic view of the economy and an equilibrium view.