When strange things happen at the zero lower bound | FT Alphaville

When strange things happen at the zero lower bound

Hey, nobody said monetary policy was easy, but we can’t remember when it’s been more interesting. Here are two more items to wrap your mind around ahead of next week’s FOMC meeting.

First up is a recent study by Martin Bodenstein, Luca Guerrieri, and Christopher Gust, who argue that a rise in commodity prices brought about by further quantitative easing is not only to be expected, it’s also desirable. Our emphasis:

A key finding of our analysis is that oil price shocks propagate differently when policy rates in the oil importing country are at the zero lower bound. In particular, we show that the zero lower bound constraint tends to diminish rather than amplify the fall in GDP that occurs in response to higher oil prices in normal times when monetary policy is unconstrained by the zero lower bound.

Which means this:

When monetary policy is unconstrained, this shock tends to push up inflation and reduce output in the home country. When policy rates are at the zero lower bound, the higher inflation induced by the shock can lead to lower real rates, stimulating the interest-sensitive sectors of the economy, and offsetting the usual contractionary effects of the shock. In fact, if the increase in oil prices occurs gradually, it can induce a persistent rise in inflation that might even cause GDP to expand temporarily.

And also:

In normal times, monetary policy offsets the stimulative effects of the shock by raising interest rates. However, if the ZLB has been reached because the economy is mired in a deep recession, policy rates remain unvaried and the higher inflation induces a fall in real rates. These lower real rates in turn crowd in investment, amplifying the effects of the government spending shock. In contrast, the ZLB constraint on policy rates tends to cushion the effects of oil shocks on activity, since these shocks move output and inflation in opposite directions.

The issue of higher commodity prices and real rates was actually the source of a mini-smackdown on Wednesday, when an oil demand analyst at the IEA said that “QE2 could inflate prices in nominal terms and bring about inflation and could derail the recovery.”

To which Paul Krugman responded:

Higher commodity prices will hurt the recovery only if they rise in real terms. And they’ll only rise in real terms if QE succeeds in increasing real demand. And this will happen only if, yes, QE2 is successful in helping economic recovery.

We wish we knew what we were talking about could write with more conviction about this, but the truth is that we simply don’t know which of these analyses is right. What we can say is that whether or not it’s desirable, a spike in commodity prices would surely complicate life for the Fed in the near future.

That is, economists generally agree that more inflation than we have now would be helpful — but as we noted before, if higher commodity prices at some point lead to a situation where headline inflation starts to separate dramatically from the core figure, the Fed might have to decide between taming inflation (and risk stalling the recovery) and letting it rise above a level it is comfortable with.

And if you think FOMC meetings are interesting now…


Separate but not unrelated, Models and Agents had an intriguing post on Tuesday that cited a 2003 paper by NY Fed economist Gauti Eggertsson.

The paper argues, in a nutshell, that at the zero lower bound, inflation expectations mean everything. Quantitative easing will only work if it is part of a broader strategy to raise expectations of future prices levels — and it doesn’t matter what kinds of assets the Fed buys.

From the paper, emphasis ours:

Our key result is an irrelevance proposition for open-market operations in a variety of types of assets that the central bank might acquire, under the assumption that the open-market operations do not change the expected future conduct of monetary or fiscal policy (in senses that we specify below). … Although our proposition establishes that there is a sense in which a liquidity trap is possible, this does not mean that the central bank is powerless under the circumstances we describe. Rather, our intent is to show that the key to effective central bank action to combat a deflationary siump is the management of expectations. Open-market operations should be largely ineffective to the extent that they fail to change expectations regarding future policy; the conclusion we draw is not that such actions are futile, but rather that the central bank’s actions should be chosen with a view to signaling the nature of its policy commitments, and not for the purpose of creating some sort of “direct” effects.

So what else should be done to lift inflation expectations? Recall that Ben Bernanke recently signaled that he might formalise the understood 2 per cent inflation target. But according to Eggertsson, that’s not the best way to go about it:

Of course, the question of what future policy one should wish people to expect does not arise if current constraints leave no possibility of commit- ting oneself to a different sort of policy in the future than one would otherwise have pursued. This means that the private sector must be convinced that the central bank will not conduct policy in a way that is purely forward looking, that is, taking account at each point in time only of the possible paths that the economy could follow from that date onward. For example, we will show that it is undesirable for the central bank to pursue a given inflation target, once the zero bound is expected no longer to prevent that target from being achieved, even in the case that the pursuit of this target would be optimal if the zero bound did not exist (or would never bind under an optimal policy). The reason is that an expectation that the central bank will pursue the fixed inflation target after the zero bound ceases to bind gives people no reason to hold the kind of expectations, while the bound is binding, that would mitigate the distortions created by it. A history-dependent inflation target—if the central bank’s commitment to it can be made credible—can instead yield a superior outcome.

A “history-dependent inflation target” means price-level targeting — a commitment to getting prices back to where they would be if the current disinflationary period hadn’t set in.

In addition their effects on expectations, the way in which targeting a price level would differ from targeting an inflation rate is that for a couple of years it would require the rate to climb above 2 per cent. It’s an easy concept to grasp, nicely pictured here:

The chart is from a recent speech by Chicago Fed president Charles Evans, in which he cites the Eggertsson paper. Evans and NY Fed president William Dudley have been price-level targeting’s biggest advocates within the FOMC.

Of course, none of this matters if we don’t know what Bernanke thinks about price-level targeting. All the more maddening (to us) that in his own recent speech on “Monetary Policy Objectives and Tools in a Low-Inflation Environment”, he left it out.

Related links:
What do the Fed’s policies and poker have in common? – Models & Agents
What Bernanke left out – FT Alphaville
Inflation targeting and the FOMC – FT Alphaville