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Monday, March 17, 2003

The Conventions of Unconventional Policy

With the 'soft patch' getting softer and pressure once more rising on the Fed to lower rates, Stephen Cecchetti again asks the dreaded 'D' question: what should we do if and when we hit zero. His answer is not to panic, since, he tells us, policymakers have studied and prepared a set of unconventional options and are convinced that they will work. Now both these points should worry us a little: that the options are unconventional, and that they are 'guaranteed' to work. In the first place we need to exercise a little prudence. The dollar-peso peg was 'guaranteed' to work in Argentina, the euro was a 'guaranteed' good thing for the EU, and ........ These 'options' exist on paper, they are not in any sense tried and tested, and when we are offered 'foolproof' policies which are guaranteed to work to solve a problem which has been steadily growing for three years (this month is the third anniversary of the NASDAQ break), we have the right, nay the duty, to remain a little skeptical. I can see three major problems that deserve our attention.

Firstly while I am in no sense a 'rational expectations' fan, I think we need to remember Churchill's point about not being able to fool all of the people all of the time (because of course it is the citizens who are presumed to be the 'fools' here, or is it the politicians, I am never quite sure). Deflation is in part about expectations, not the sophistocated kind which are assumed to work in, for example, the Ricardian equivalence argument. No, a more basic and primitive set of expectations, possibly motivated by that most basic of emotions fear. Keynes 'animal spirits' comes to mind here. If the expectation sets in that deflation is here, and that it has come to stay for a time, then this will alter people's attitude to cash. Interest rates may reach zero, but if prices are declining at, say, 2% per annum, and are expected to continue to do so, then holding cash carries a positive interest rate. Much of what follows then depends on the stability of other prices.

If, as in Japan, this slow-burn deflation is accompanied by a more general decline in asset values, then cash can become extremely attractive, people can hold more of it, and the velocity of circulation can decline. If this happens to any significant extent then the central bank intervention is effectively sterilised. This, and not simply Ahearne style 'cut early and cut often', is the true lesson from Japan. If, with interest rates tending to zero, fixed operating costs and low margins, and an increase in non-performing loans, the banking sector becomes per se weaker, then this turns itself into yet another argument for holding cash. (Actually I have a feeling that if we wanted to be really 'smart' and look to really new ways to deal with a new situation, we would be thinking about e-money and its possible role and use, but this is for another day). I mean, at the end of the day, people aren't fools, and it is extremely hard to convince them you are going to be irresponsible long term, and that once the irresponsibility stops you won't fall back into the whole again, only this time deeper. The 'man on the clapham omnibus' is far more likely to use this type of rule of thumb guidance than the professional economist is. This is doubly true since 'responsible' central bankers have spent years convincing us that 'fine tuning' inflation is a difficult art, now they want to convince that they can fire it up to 3% and hold it there, no problem.

Secondly, the coming defation seems generalised and sustained. This seems to set it apart from being a mere business cycle phenomenon ( at least in the normal 'short cycle' sense, and with all due respect to Brad: I will have more to say on this on another occasion). In this case, what might work in an isolated case of localised and short-term deflationary pressure, seems from the start to be more problematic. The most effective and convincing part of the fire-fighting programme is the one relating to currency value. In fact I am pretty convinced that the recent 'permissive' fall in the value of the dollar forms part of the Bernanke strategy. But such currency devaluations, by their very nature, cannot be generalised. The dollar has fallen, at what price? Japan's export lead expansion has faltered, and Germany stands on the brink of deflation.

My third objection relates to the causes of the problem. I'm afraid I don't buy the view that all of this is simply a business cycle blip. There is, after all, a real economy out there somewhere. There is a globalisation process, the relative fortunes of countries can rise and fall. There is a something called Moore's law, it is still operative. We do live on an ageing planet, this must have consequences. I don't think I have all the answers, far from it. What worries me is that so many people are not even asking the pertinent questions. When Cecchetti tells us that 'these policies are bound to be effective, driving up prices and eliminating any deflation', we have the right to doubt. Remember, only last November he was informing us that "while there are some things that I think about late into the night, deflation and the ineffectiveness of monetary policy are not among them".

Overnight interest rates have fallen to their lowest levels in decades. With the US Federal Reserve's federal funds rate at 1.25 per cent, the European Central Bank's main refinancing rate at 2.5 per cent and the Bank of England's repo rate at 3.75 per cent, we are approaching a very clear limit. And since nominal interest rates cannot go below zero, what will policymakers do if they reach that limit? Importantly, what will they do if nominal interest rates are zero and the economy is experiencing deflation?

These questions have been on the minds of central bankers since before the Bank of Japan, in response to a mild but persistent deflation, moved its policy rate to zero in early 1999. Policymakers have studied a set of unconventional options thoroughly and are convinced that they will work. What are these unorthodox policies? How do they work and what do they mean for policy both now and in the future?

The mechanics of unconventional monetary policy is straightforward and based on the fact that the central bank controls the size of its balance sheet. It is through changes in its assets and liabilities that it influences the economy. During normal times, policymakers operate by controlling the supply of their liabilities to meet an interest rate target. The details vary with each central bank, but the thrust is always the same. All monetary policy, conventional or not, is the result of balance sheet manipulation...........

This line of reasoning leads to two important conclusions for policy today. First, the mere prospect of hitting zero means acting earlier and faster. What looks like caution in moving slowly, can turn out to be very risky. This was one element that led the Fed to lower interest rates 4.75 percentage points over a period of 11 months in 2001. While there is every reason to believe that tomorrow's meeting will not produce another cut, Open Market Committee members are surely ready to pull the trigger should conditions worsen perceptibly between now and their next meeting in early May. And, with the main refinancing rate at 2.5 per cent the ECB should be giving serious consideration to the same sort of pre-emptive action.

The second conclusion is that, in order to avoid having to use unconventional policies of uncertain effect, policymakers are willing to tolerate a bit more inflation. A year ago, the Federal Reserve would probably have been comfortable with consumer price inflation of 1-2 per cent. Today I am not so sure. My guess is that Fed officials are nervous enough that they are going to aim for inflation in the 2-3 per cent range in the hope that unconventional policies remain unnecessary. At least, I hope so.
Source: Financial Times

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