The Wilder View

Central bank policy: too little or too much?

Global central banks have cut policy rates to near-zero levels (or in the case of the ECB, 1%), and in most cases, vowed to keep short-term rates low for some time (the Fed calls this an “extended period”). And as bond markets price inflation into the yield curve, the question that comes to my mind is: have central banks done “enough”? Perhaps for the financial markets, but not for the economy.


The chart illustrates the growth in asset holdings since the beginning of 2008 by the Federal Reserve (Fed), the Bank of England (BoE), and the European Central Bank (ECB) as of June 10, 2009 (if available). Each central bank has cut policy rate to the near-zero bound by increasing the liquidity in their respective banking systems; this is what drove the surge in assets across all three banks. However, the Fed and the BoE took the quantitative/credit easing path, which is why their asset bases are monstrous compared to that of the ECB.

But asset holdings have plateaued. The Fed, BoE, and ECB are in a mode of shifting portfolio composition rather than growing their balance sheets. To be sure, massive expansionary policy has helped to keep financial markets from collapsing, but a sense of urgency remains in the economic data…the worst has passed, but the economy still contracts.

There is a host of slack built into the system. In the US, the unemployment rate is 3.9% above its level just last year, and almost double its value at the beginning of this darned recession, 4.7%. Unemployment claims have likely peaked. But as James Kwak points out, they are not really falling; and unless there is a positive and extremely unexpected shock to the labor system that drops claims quickly, there will be slack building in the labor market for quite some time.

Perhaps central banks should shift focus again, making a real attempt to stimulate the economy (yes, in spite of the infamous liquidity trap).

I like what Scott Sumner at the MoneyIllusion blog has to say about furthering monetary stimulus:

There are three ways to make monetary policy more stimulative. Unfortunately the political viability of each approach is inversely related to its effectiveness. The most effective but least likely option would be for the Fed to commit to a NGDP target path, with level targeting (i.e. a growth path that they commit to catching up to if they fall short (and vice versa).) The second most effective option would be a modest interest penalty on excess reserves, perhaps 2%. The least effective option is quantitative easing. A bit of QE has been tried in the past few months, although less than many people realize. Again, there are far more effective monetary policy tools, but as the Fed seems unwilling to use them, it looks like QE is all we have for the moment.

Financial markets and the overall banking system are very different today than they were during Keynes’ days. As Scott Sumner suggests, why not take advantage of these “alternative tools”, like INTEREST ON RESERVES!

Originally published at News N Economics and reproduced here with the author’s permission.

2 Responses to “Central bank policy: too little or too much?”

Scott SumnerJune 17th, 2009 at 7:32 pm

Rebecca, Thanks for the link. I like what you are saying here and would just add a few comments.1. Yes financial markets are doing better, but in absolute terms are still very weak. So I agree with you there. The upswing in equities in the spring correlated with a widening of the 5-year T-Note/TIPS yield spread. Inflation expectations reached 1.85% a week ago, but have now fallen back to 1.46%. That’s still well below target, and indicative of sub-par growth ahead. Not surprisingly, equities have also fallen off in the past few days.2. I want to emphasize that the 2% figure I mentioned is an interest penalty, just the opposite of the current policy of paying positive interest on reserves. The current rate is only .25%, but that’s still above T-bill yields, and thus encourages banks to hold on to excess reserves. It’s actually a contractionay policy, as Robert Hall has also noted. If they went with an interest penalty on excess reserves, we could get more bang for the buck, that is a more expansionary impact from an equal, or even slightly smaller monetary base.

Rebecca Wilder Rebecca WilderJune 18th, 2009 at 1:06 pm

Hi Scott,You know, they could probably do it within the confines of the interest on reserves policy already in place. Simply modify the interest rate formula (again): if nominal income growth is negative, then the interest payment falls into negative territory (works like a fine). When nominal income growth is positive, then the interest on reserve equation reverts back to that which has already been prescribed by the Fed (at the level of the federal funds target).

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