Unconventional monetary policy, liquidity trap, and asset prices

ABSTRACT

This article offers a fundamental critique of monetary policy implemented in the United States following the 2007–8 global financial crisis. It aims to show that the misunderstanding of the mainstream theoretical thinking underlying monetary policy actions led to the ineffectiveness of the policy response to the 2007–8 global financial crisis. The conventional view that monetary policy is the stabilization tool has serious flaws and is ineffective for bringing about economic recovery. The Federal Reserve’s experiment with the so-called unconventional monetary policy exposed the weakness of the conventional belief in understanding how banks operate, how the monetary authority can influence the yield curve, and how the monetary transmission mechanism works, resulting in prescribing an ineffective treatment to boost economic activity. In this regard, it is argued that the Federal Reserve’s decision to let long-term interest rates be market determined represents a significant self-imposed constraint, which limits policy options regarding monetary policy actions and the effective control of long-term interest rates. By limiting the setting of policy rates only to the overnight interest rate, the ability of the monetary authority to influence long-term interest rates is both weak and indirect.

KEYWORDS:

• Central bank targets
• federal reserve
• interest rate targets
• interest rates
• liquidity trap
• monetary policy

JEL CLASSIFICATIONS:

• E00
• E02
• E4
• E40
• E43
• E5
• E50
• E52
• E6
• G1

Notes

¹A careful reader of Keynes’s work will recognize that he can be considered to be the true father of unconventional monetary policies, which had already been proposed in the concluding chapters of volume 2 of his Treatise on Money (Kregel, 2012).

²Also, as in Meltzer’s (1999) version, as long as some assets are imperfect substitutes this would make “unconventional” monetary policy effective.

³See Kregel (2003) for an early critique of Krugman’s solution to the Japanese slump and more recently Kregel (2012).

⁴Not surprisingly in these models, the “banking sector generally was conspicuous by its absence, particularly in the New Keynesian synthesis models, which also dominated thinking within central banks” Bean et al., 2010, p. 1). In a New Keynesian model of the monetary transmission mechanism, developed by Cúrdia and Woodford (2010), portfolio balance effects induced through open-market operations are ineffective (Cúrdia and Woodford, 2010, p. 6). Buiter (2009) shows the inability of New Keynesian models to explain modern capitalist economies. However, this critique is not new. Post Keynesians have criticized these models for many years before the crisis (see Lavoie, 2010a; Tymoigne, 2009; Wray, 1998, 2004a, 2004b, 2007).

⁵See, for instance, Svensson (2001) and references therein. In 2002, Ben Bernanke stated two caveats in escaping a deflationary process in the Japanese situation. He argued: “Japan’s economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors … . Second, and more important, I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan’s overall economic problems” (Bernanke, 2002).

⁶See also Buiter (2009), Clarida (2012), and Galati and Moessner (2011) for a mainstream review of the main drawbacks of standard DSGE models.

⁷As in Friedman (1956) and Brunner and Meltzer (1972). Economists have extended the transmission mechanism to include a variety of channels. The primary neoclassical channels of monetary policy transmission are interest rate, wealth effects, intertemporal substitution, and exchange rate effects. See, for example, Kuttner and Mosser (2002) and, more recently, Boivin, Kiley, and Mishkin (2010) for a mainstream exposition.

⁸Brian P. Sack (2010), executive vice president of the Federal Reserve Bank of New York, also reinforced the portfolio balance channel as the primary channel of the Fed’s large-scale asset purchases.

⁹See, for instance, Chung et al. (2012), D’Amico and King (2010), Doh (2010), Gagnon et al. (2010), Hamilton and Wu (2010), and Swanson (2011).

¹⁰As Ben Bernanke (2002) observed in his remarks, his preferred method of reducing longer-term interest rates was for “the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt.” However, he decided not to do so.

¹¹See also Fullwiler and Wray (2010) for an earlier critique.

¹²See Anderson (1965), Eichengreen and Garber (1991), Hetzel and Leach (2001), Meltzer (2003), Sproul (1964), and Stein (1969). Moreover, “despite its protests, the Federal Reserve had not become an ‘engine of inflation.’ … The principal reason is not hard to find. The government budget was in surplus most of the time” (Meltzer, 2003, p. 714). Thus, the destruction of net financial wealth, via budget surpluses, of the nongovernment sector became an important stabilization tool.

¹³See, for instance, Davidson and Weintraub (1973), Kahn (1954), Robinson (1951, 1970), and Tobin (1970). To be sure, post Keynesians, more than three decades ago, documented the endogenous money process and the inability of monetary authority to control monetary aggregates (Moore, 1988; Wray, 1990). This does not mean that money is unimportant in the post Keynesian framework, insofar as in their analysis, business cycles and unemployment are explained by the existence of money. For more recent developments in post Keynesian economics see (Davidson, 2002; Kregel, 1998; Wray, 1998).

¹⁴See for instance Bernanke and Gertler (1999), who developed a model in which asset price booms generate wealth effects on consumption. However, firms’ rational behavior valuates asset prices based on assets’ fundamentals. See Clarida (2010, p. 8) for an analysis of this model in the context of the financial crisis.

¹⁵Note that the current legislation does not allow the Fed to pay interest on the reserve accounts of some institutions, including Fannie Mae and Freddie Mac.

¹⁶This policy ultimately requires coordination between the Fed and the Treasury. While the Fed purchased long-term securities, thus removing duration from the market, the Treasury increased the issuance of long-term securities, thus partially offsetting the effects of the Fed’s bond purchase initiative.

¹⁷Even though the banking literature offers mixed results about the impact of rate changes on bank earnings, recent research has suggested that net interest margins over the past decade have been affected by changes in the term spread for at least large banks in the United States. It also suggests that monetary policy affects different financial institutions that supply credit in different ways (Hanweck and Ryu, 2005).

¹⁸It should also be noted that one of the effects of the federal debt buyback program announced by the Treasury Department in August 1999 was the shrinking of federal debt for certain maturities. As Fleming observed, market participants adopted alternative benchmarks for pricing and hedging purposes in fixed-income markets. “These markets include the agency debt market, the corporate debt market, and the interest-rate swaps market” (Fleming, 2000a, p. 137). Also, according to Fleming (2000b, p. 242), “an active repo market in agency securities has developed allowing market participants to borrow securities for hedging and trading purposes. In addition, an active futures market is quickly developing since contracts started trading on the Chicago Board of Trade and the Chicago Mercantile Exchange in March 2000.” For instance, according to Dupont and Sack (1999, p. 805) “to fill the gap left by a dwindling supply of Treasury securities, two government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, in 1998 introduced new series of debt securities that in some ways mimic Treasury securities: Fannie Mae ‘benchmark’ and Freddie Mac ‘reference’ notes and bonds.”.

¹⁹For a discussion of financial institutions’ interest rate risk in the current low interest rate environment, see Clair, Touhey, Tuberville (2009).

²⁰There are various definitions of the term premium and there are alternative ways to measure the ex ante term premia. Rather than relying on yield curve steepness or term structure models to measure the bond risk premium, this study uses survey data to isolate the bond risk premium from the average expected future short rates.

Additional information

Notes on contributors

Felipe Rezende

Felipe Rezende is Assistant Professor of economics, Hobart and William Smith Colleges, and research fellow, Institute for Multidisciplinary Development and Strategy (MINDS). The author would like to thank two anonymous reviewers for their valuable comments. The usual caveats apply.