With interest rates around the world at close to zero or negative and another recession looming on the horizon central banks, having exhausted their firing powers with the so-called unconventional policies, appear rather anxious about the efficacy of their tools. This is why the Chair of the Federal Reserve, Janet Yellen, spent much of her speech at central bankers meeting in the mountain resort of Jackson Hole, Wyoming trying to explore the effectiveness of Fed's expanded monetary policy toolkit.
Overall, it appears that Fed still thinks or hopes that changes in nominal variables stemming from the conventional and unconventional policy tools such as changes in the Fed funds rate or Quantitative Easing will exert a lasting and long-term impact on the real variables such as the real GDP growth rate in these financially abnormal times. Ignoring the fact that the effectiveness of monetary policy tools has been seriously diminished in recent times at various advanced countries and abstracting from the distortionary effects of the unconventional tools on the economy, Ms. Yellen primary message at Jackson Hole was that:
I expect monetary policy will continue to play a vital part in promoting a stable and healthy economy. New policy tools, which helped the Federal Reserve respond to the financial crisis and Great Recession, are likely to remain useful in dealing with future downturns.
There were hardly any new information about the exiting tools or their effects on the transmission mechanism of monetary policy in the speech. However, the Chair mentioned that future monetary policymakers might choose to explore some additional tools that have been employed by other central banks, such as the possibility of purchasing a broader range of assets, raising the FOMC's 2 percent inflation objective or implementing policy through alternative monetary policy frameworks, such as price-level or nominal GDP targeting. She added "adopting these policies would require a very careful weighing of costs and benefits and, in some cases, could require legislation".
Among these various alternative policies only the idea of targeting for a higher inflation rate will be materially different, and extremely harmful, the rest like price-level or nominal GDP targeting are basically red herrings. The idea of opting for a higher inflation target was recently floated by the president of the San Francisco Fed, John Williams, who has argued
in the post-financial crisis world the significant decline in the natural rate of interest over the past quarter-century to historically low levels pose significant challenges for the conduct of monetary policy, defining the concept of the medium-term value of the natural as the real interest rate that balances monetary policy so that it is neither accommodating nor contractionary in terms of growth and inflation in an economy at full strength.
Despite its shortcomings in describing the Wicksellian concept of Natural Rate of Interest Williams' concept as an equilibrium interest rate can be thought of as the rate of interest corresponding to a configuration of interest rate, output growth rate, inflation rate, employment and exchange rate in a model in which goods and services, labour and money&credit markets all are in equilibrium and in the currency market the covered interest rate parity condition is satisfied. In other words, this is the interest rate that prevails in an economy operating at its production efficiency frontier. Williams believes this natural rate has declined and writes:
The new challenge for central banks is how to deliver stable inflation in a low r-star world. This conundrum shares some characteristics and common roots with the theory of secular stagnation; in both scenarios, interest rates, growth, and inflation are persistently low (Summers 2015).
This is also a belief shared by Ms. Yellen, who citing Lubik and Matthes (2015), Laubach and Williams (2016), and Johanssen and Mertens (2016) states "there is empirical evidence to support the conclusion that the neutral rate is currently not far from zero". This is indeed a remarkable inference, since it implies that in spite of the existence of a relatively large output gap, the interaction of the economy's aggregate demand and the long-term aggregate supply function on the space spanned by the real interest rate and real output variables has shifted down to a close-to-zero interest rate. It should be noted, however, that this inference appears to have been drawn from a conjecture, as she writes:
we know that the neutral rate must have been well below its historical norm in recent years, because with the actual real interest having been as low as it has been lately, the economy would have otherwise expanded much more than has been the case.
This conjecture would be flawed if the potential output growth rate has been slowing down due to a lack of capital formation stemming from the prevailing uncertainty. As we have argued before there is strong evidence that in such circumstances businesses in their capacity planning would be refraining from investing in irreversible capital expenditures, and this is the main cause of lower growth rate at the lower actual real interest in the recent times.
In fact, based on the following chart from Holston, Laubach, and Williams (2016) one can infer that the Wicksellian natural rates in the US, UK and euro area over the period 1980-2007 have been close to 3, 2.5 and 2 per cent respectively and the apparent decline since 2008 is basically an art effect stemming from a drastic structural change in financial markets in recent years. In other words, the fluctuation around the above mentioned estimated natural rates are caused by various cyclical factors. Moreover, given that natural rate is an equilibrium concept it does not stand to reason to argue that it demonstrates such an extreme volatility over short spans of time.
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| Estimated inflation-adjusted natural rates of interestSource: Holston, Laubach, and Williams (2016); data are four- quarter moving averages |
As we have argued in the past, the concept of neutral rate is a long-run phenomenon associated with potential output at equilibrium. When the economy has been in a prolonged state of disequilibrium and uncertainty as a result of which businesses have revised and delayed their capital expenditure plans then the concept of a lower neutral rate would be vacuous. In such circumstances the potential growth rate would be lower due to the fact that production efficiency frontier is shrinking, and businesses are not investing toward minimizing their long-run minimum average cost. The stimulative monetary policy becomes ineffective because it cannot stimulate investment and capital formation. The distortionary impacts of flawed policies create bizarre relationships, for instance lower interest rates will encourage more savings because of consumers anxiety about the viability of their pension plans. On the investment side corporation decide to buyback their own share instead of investing and many decide to operate under intensive margin.
The idea that the natural or the neutral rate has declined is of course the dual form of the argument concerning the progressive ineffectiveness of unconventional tools such as QEs or forward guidance. On her June 6th speech in Philadelphia Ms. Yellen, has referred to this ineffectiveness as less stimulative, reporting:
The current stance of monetary policy is stimulative, although perhaps not as stimulative as might appear at first glance,
which she has explained it in terms of a decline in the neutral rate. Similarly, Mr. Williams attributes this ineffectiveness to the "less room" conventional monetary policy has "to stimulate the economy during an economic downturn, owing to a lower bound on how low interest rates can go. He states:
Although targeting a low inflation rate generally has been successful at taming inflation in the past, it is not as well-suited for a low r-star era. There is simply not enough room for central banks to cut interest rates in response to an economic downturn when both natural rates and inflation are very low.
In other words, Mr. Williams argues that higher inflation rate would provide the monetary authority with a wider interest rate margin to be used as the policy instrument to fight the upcoming recession. Of course, if inflation rate target is arbitrarily raised to say 4 per cent the monetary policy would not automatically become effective in stimulating investment and exports. After all, we have experienced periods of stagflation and currency wars when monetary policy was ineffective. Furthermore, his argument ignores the fact that what matters is the information content of prices, and this content diminishes at higher inflation rates due to the increased inflation variability. As Okun (1971) has shown variability of inflation rises with the inflation rate, and therefore the information content that allows the two sides of the market to plan and to execute their consumption and production decisions will deteriorate. The result would be lower growth rates.
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Total debt securities, by residence and sector of issuer,
Amounts outstanding at end-September 2015, in trillions of US dollars
AU = Australia; CA = Canada, CN = China; DE = Germany; ES = Spain, FR= France; GB = United Kingdom; IE = Ireland, IT = Italy; JP = Japan; KR = Korea; KY = Cayman Islands; NL = Netherlands; US = United States.
Sources: National data; BIS debt securities statistics.
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Trimmed Mean One-year PCE Inflation Rate,
Source Federal Reserve Bank of Dallas
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Relying on a partial equilibrium analysis based on the conventional expectations-augmented, or a New Keynesian, Phillips curve in which actual inflation trends depend largely on inflation expectations, and considering the fact that for two decades inflation has been relatively stable, Ms. Yellen has argued that:
The most convincing explanation for this stability, in my view, is that longer-term inflation expectations have remained quite stable. So it bears noting that some survey measures of longer-term inflation expectations have moved a little lower over the past couple of years, while proxies for these expectations inferred from financial market instruments like inflation-protected securities have moved down more noticeably. It is unclear whether these indicators point to a true decline in those inflation expectations that are relevant for price setting; for example, the financial market measures may reflect changing attitudes toward inflation risk more than actual inflation expectations. But the indicators have moved enough to get my close attention. If inflation expectations really are moving lower, that could call into question whether inflation will move back to 2 percent as quickly as I expect.
However, considering the fact that the expected inflation rate usually constitutes the intercept of a Phillips curve with the inflation axis in the space spanned by inflation rate and the GDP growth rates it would be natural for this supply side relationship to generate lower expected inflation in response to a persisting output gap. The main reason why inflation expectations and actual inflation were closely connected prior to the mid-1990s was the relative consistency of such shifts that was enhanced by the relative stability of the potential output growth. Wheres according to a study by the Fed economist Jeremy Nalewaik
Movements in inflation expectations now appear inconsequential since they no longer have any predictive content for subsequent inflation realizations,
The reason for this break up is of course the greater variability of the gap measure due to the utilization of the contingent capacity that makes the Phillips curve shift rather erratically. At the same time the aforementioned erratic fluctuation of the capacity growth rate caused again by the utilization of the contingent capacity results in the erratic behaviour of the actual inflation rate.
Thus, the key to the effectiveness of monetary policy is economy's return to the efficient production frontier, through a healthy capital formation, which would result in higher growth of productivity. Unfortunately Ms. Yellen just in passing and almost as an after thought referred to the question of productivity growth in her Jackson Hole lecture :
Finally, and most ambitiously, as a society we should explore ways to raise productivity growth. Stronger productivity growth would tend to raise the average level of interest rates and therefore would provide the Federal Reserve with greater scope to ease monetary policy in the event of a recession. But more importantly, stronger productivity growth would enhance Americans' living standards.
We will be dealing with this issue in our next post.
