Monetary Policy—An Introduction
Ash: To start today, let’s discuss why you think monetary policy is so important to individuals? It’s a topic that’s often talked about, but in the context of banks and corporations—not individuals—and usually with a lot of academic jargon.
Nouriel: In the most fundamental sense, the ultimate goal of monetary policy is to keep the economy running smoothly.
Imagine that you are a person who, during the Great Recession, lost your job. Now, imagine that the value of your home fell 30 percent and the value of your 401(k) got cut in half. Economics doesn’t get any more personal than that—especially for someone who has already started to think about retirement.
When something like that happens, economics has the power to disrupt your life in the most personal and traumatic way you can imagine.
The way that monetary policy in the United States attempts to keep things stable is to balance the growth of the economy with the risks of inflation by changing the size of the money supply and the level of interest rates.
Ash: What do you mean by “balance”?
Nouriel: Well, when a country’s economic growth begins to weaken, because of either an external shock to the economy or just due to a slowdown of the business cycle, you need to loosen monetary policy in order to get out of a recession, ease the problems of unemployment, and jump-start demand when it is too low and there is a risk of deflation.
Now, economic growth is obviously a good thing. But if the economy is overheating, if there is too much growth, with scarce resources—meaning too much competition for labor and capital and goods—inflation can start to rise, sending prices through the roof. That’s the time when central banks need to tighten up the money supply.
In another sense, you can think of monetary policy’s main objective as being to smooth out the rough edges of the business cycle, the booms and the busts, so that the economy doesn’t go into recession or grow too quickly and cause inflation. That’s the job of central banks, and it’s extremely important that they get it right, or lots of people in an economy can suffer.
Ash: So to bring that back again to individual investors, how does knowing about monetary policy help people think about the future?
Nouriel: Well, monetary policy has a major impact on interest rates, so lots of personal decisions are influenced by the moves the Fed makes—that means everything from the rate you get on a mortgage to basic decisions about business and investments.
As an example, if the Fed’s economic measures show that inflation is too low, and the Fed decides to attempt to accelerate economic growth by cutting interest rates, the choices that an individual investor would make in that scenario would differ from the choices that the same investor might make if the economy were overheating and inflation were too high. Another example would be how Fed policy action might influence individuals’ decisions to invest in either stocks or bonds, or to stay in cash.
Ash: This is an especially important topic in the wake of the Great Recession.
Nouriel: Absolutely. In the case of the Great Recession, the actions of the Federal Reserve, together with Congress’s fiscal policy and backstopping the financial system, helped prevent the Great Recession from becoming a great depression. During the darkest days of the Great Recession, output fell five to six percent, and the unemployment rate jumped up to nine or ten percent. But, during the Great Depression, when the Fed failed to act aggressively enough, we had six years where economic output fell 30 percent and the rate of unemployment skyrocketed to 30 percent. Things got really ugly.
Ash: Nouriel, let’s talk a little bit about current monetary policy in the United States. The Fed has finally ended its third round of quantitative easing in October 2014. This policy had been going on for almost six years—do you think retail investors are starting to get nervous?
Nouriel: The individual investor says, “Oh my God, the Fed is printing money like crazy! That’s eventually going to be inflationary, right?” And isn’t it crazy that they have done quantitative easing three times—QE1, QE2, and QE3? The balance sheet of the Fed now stands at $4 trillion and rising, and other central banks are doing similar things.
Ash: Yes. I would say that about covers it. So how do you respond to that?
Nouriel: Well, what I usually say is that these have been exceptional times. This was a balance sheet recession—meaning not just an ordinary slowdown in the business cycle, but a recession where individuals and corporations accumulated too much debt. In a balance sheet recession, people and institutions need to pay down that debt, which obviously gets in the way of spending for consumption and investment.
Ash: So you’re suggesting the recovery was going to be slow, no matter what?
Nouriel: Yes, I think the recovery was going to be anemic, no matter what. Plus, the fiscal response to the recession was front-loaded—either for political reasons or economic ones.
Ash: Let’s talk about that for a moment. It sounds like you’re suggesting that monetary policy became the only game in town because fiscal policy, government’s ability to cut taxes and increase spending, was limited either because politics wouldn’t allow it or because the markets themselves limited government’s ability to channel revenue toward the recovery.
Nouriel: Right. Monetary policy had to do most of the heavy lifting. Let’s not forget, there was a risk of falling back into a double-dip recession. When I talk about a balance sheet recession, I mean there was too much debt in the system. And deleveraging, paying down those debts, takes time. And you have to be very careful when you are stuck in that position, because even after growth picks up, there’s a risk that it can collapse again and that you’ll slide back into recession. That ties back to the reason why fiscal policy is so constrained in this sort of recession—too much public and private debt.
Ash: So let’s turn back to monetary policy. The Fed cut interest rates to zero and started expanding its balance sheet back in late 2008. We’ve had over five years of that policy. Why isn’t that an inflation risk?
Nouriel: Well, the short answer is that even as the Fed keeps injecting money into the banking system, printing money to buy short-term bonds, the velocity of money collapsed. That’s why there’s no inflation.
Ash: Could you unpack that idea a little for me and the readers?
Nouriel: Well, basically that means that the demand for money from creditworthy borrowers has collapsed. First of all, you’re talking about a world in which the demand for credit is weak because people have too much debt and don’t want to borrow. And banks are cautious because there are problems with capital, there are problems with liquidity. It’s like trying to force a horse to drink. You can put the water in front of him, but if he doesn’t want to drink, he won’t.
Ash: So that describes monetary conditions, but how does this all tie back to the real economy?
Nouriel: As I said, the increase in the money supply has not been inflationary because the velocity of money has collapsed. Most of the extra money is being hoarded by the banks as excess reserves.
Specifically, on the macroeconomic side, workers still don’t have the power to bargain for higher wages. There’s still too much unemployment. Firms don’t have a lot of pricing power. Commodities have softened up too, because of a slowdown in China and in emerging markets. And there’s still excess capacity in housing. The housing market is still soft in the US because there was a boom and then a bust.
So all the central banks are struggling to achieve the two percent inflation rate that is their target, either implicitly or explicitly. This means the problem isn’t that there’s too much inflation; it’s that there’s not enough inflation.
Ash: I think a lot of people, including our readers, read the term “liquidity trap” pretty frequently in the newspaper, but it’s rarely explained very well. How would you describe it?
Nouriel: Well, when you are in the equivalent of a liquidity trap, you’re “pushing on a string.” Meaning, banks can take all the new money that’s been injected into the system and just hold it as reserves and not lend it out. That’s what has been happening for the last few years. It’s a situation in which both the demand and the supply of credit is weak. The demand side is weak because people have too much debt. And the supply of loans is weak because banks are being cautious, because they’re worried about liquidity shocks, or not having enough capital, or the creditworthiness of their borrowers.
So when the economy starts to slow down, once interest rates are at zero, you can’t make them any lower, in practice, so you print money as a way of inducing banks to lend money. But banks don’t want to lend, and people and firms in the private sector don’t want to borrow.
Ash: What are some of the causes of the liquidity trap?
Nouriel: Well, in part, the challenge of the collapsing velocity of money is related to the credit multiplier effect. The terminology sounds confusing, but it’s actually a simple concept to understand. A credit multiplier means that if a bank has, say, $100 in deposits, and they’re required to set aside $5 to comply with the mandates of their regulators, the remaining $95 can be lent.
Let’s say that money is lent to your business. You can use that $95 for payroll expenses or to pay your suppliers, right? If you’re an individual who receives a loan, you pay your bills or you buy something at a store—and then that $95 becomes a deposit somewhere else in the banking system. Then the process repeats itself. That $95 gets lent out again, minus the five percent. So the initial $100 doesn’t create only $95 of credit, it creates credit that gets lent out again and again.
Now, obviously, the number of times that money gets lent out depends upon how much people want to borrow and how much banks are willing to lend. That depends on how individuals and firms feel about borrowing, and on how banks feel about their customer’s creditworthiness.
But the concept is the same regardless of the level of demand. Essentially, a dollar of deposits creates a multiple in terms of the amount of credits and deposits in the system, since those deposits are lent out and re-deposited again and again. So, as you can see, there’s a kind of momentum effect in play.
Ash: Let’s talk a bit about the macroeconomic paradoxes that are at work. I think a number of our readers probably wonder how to think about monetary policy, because it’s hard for us to understand in terms of the mental framework we apply to, say, our businesses or household finances.
Nouriel: Well, that’s true. The phrase “printing money” is a little misleading. The usual way monetary policy works is that the central bank isn’t really printing money, just buying bonds and paying for them by creating virtual money and then injecting those credits into the banking system. Buying those bonds pushes down the short-term interest rate because as the demand for short-term bonds rises, the price goes up, and the yield on the bonds goes down, right?
Ash: That makes sense. Price and yield move in opposite directions, so as the Fed buys short-term bonds, short-term interest rates drop.
Nouriel: Yes. The way monetary policy usually works is by doing these kinds of open-market operations, like exchanging bonds for cash, to reduce short-term interest rates. That rate, the fed funds rate, is also referred to as the policy rate, since it’s the main policy tool the Fed uses to set short-term interest rates. Now, the problem, as I said earlier, is that we’re in a balance sheet recession, where there is too much debt in the system. Right now, core growth is anemic and inflation is too low.
Ash: How does this sort of recession differ from a typical recession?
Nouriel: During a normal recession, a “plain-vanilla recession,” let’s say you have interest rates at five percent. You cut them by, say, one percent or two percent—whatever is required to jump-start growth and get the economy to recover. During the last recession before this one, the fed funds rate was cut to one percent. And before that, after the economy recovered at the end of the 2004 recession, the Fed increased interest rates back to 5.25 percent. But this time around we’ve gone from 5.25 percent down to zero, and once we reached zero, that was not enough to get the economy going again. It was stuck in the doldrums.
Ash: These doldrums were a kind of a liquidity trap?
Nouriel: Yes. There was a kind of liquidity trap. So, effectively, since you can no longer nudge the policy rate any lower, you need to start looking for other kinds of policy action to take. What else can you do when the policy rate is already at zero? Well, you need to find a way to make monetary policy looser—so you take the steps that the Fed has taken, which are now called “unconventional monetary policy.”
Ash: We hear a great deal about “unconventional monetary policy” in the context of QE, for example. What does that “unconventional” mean, exactly?
Nouriel: Well, normally, monetary policy involves the Fed buying or selling short-term bonds. In traditional monetary policy, the central bank uses the short-term policy rate as its main policy instrument. So when the economy is in a slump, conventional monetary policy is to cut rates; when inflation starts creeping up, conventional monetary policy recommends raising borrowing rates to get inflation under control.
But this time the Fed has been buying long-term bonds instead of short-term bonds. It’s doing this in order to lower long-term interest rates, in order to assure the markets that interest rates are going to stay low for a longer period of time. It’s just another tool to stimulate borrowing. But since it’s not part of the traditional toolkit to lower the fed funds rate, it’s considered unconventional. The name that’s been given to the purchase of long-term bonds is quantitative easing, which is one of the elements of the unconventional monetary policy that we hear so much about.
Ash: So what are the other elements of unconventional policy?
Nouriel: Well, the first unconventional policy is pushing short-term rates down to zero. The second unconventional policy is quantitative easing, which we’ve just been discussing. The Fed buys long-term government bonds to push down long-term interest rates.
The third is credit easing. Basically, what credit easing means is that instead of buying public assets, meaning government bonds, you buy private assets, like residential mortgage-backed securities or corporate bonds. The idea behind credit easing is that you can directly reduce interest rates on lending in the private sector by using monetary policy.
And the final new jargon in the central bank toolkit has been “forward guidance.” Once you are at zero rates, people say, “We’re at zero rates, but how long are we going to stay there—and how long is the Fed going to continue to do quantitative easing?”
So forward guidance is a way of committing to keeping interest rates lower for longer. It allows the Fed to commit to staying at zero rates for a certain period of time. So that’s another way of essentially doing monetary policy by saying, “Not only are policy rates at zero today, but the policy rate will be at zero for the next 12 months or 24 months.”
Whether it’s ZIRP, zero interest rate policy, or QE, quantitative easing, or CE, credit easing, or FG, forward guidance, there’s an alphabet soup of new things in monetary policy, which once, not that long ago, did not exist.
Now, with all these other tools, with the policy rate a zero, and the economy still in need of a boost, you have to start doing stuff that sounds unorthodox—sounds even a little crazy—but is necessary to get the economy going again.
Ash Bennington, senior editor at Roubini’s Edge, is a financial commentator. He was a reporter and blogger at CNBC, where he specialized in writing about macroeconomics and the culture of Wall Street. Prior to working as a journalist, Ash was an assistant vice-president technical expert at Credit Suisse and a vice-president of e-commerce at BB&T.
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