“Given that inflation is trending down and the policy rate remains near zero, what can monetary policy do?” James Bullard, president of the Federal Reserve Bank of St. Louis, asked rhetorically in a presentation at the Goethe University Frankfurt on Tuesday. “This has been the key question in central banking since 2008.”
The EU-U.S. Macroeconomic Situation
Consensus among economists and market participants is that the U.S. economy is healing, but at a slower rate than desired. Unemployment remains high at a headline rate of 7.5 percent, and economists have suggested that much of the recent decline hasn’t been due to gains in employment but a reduction in labor force participation. Gross domestic product growth is positive but is slightly below the track that economists see as necessary to drive substantial organic employment growth.
Europe, on the other hand, has once again entered recession, if preliminary first-quarter negative GDP growth figures hold steady. Unemployment has trended higher over the past year, hitting 12.1 percent in the EA17 and 10.9 percent in the EU27. Recovery in the region has been tremendously uneven.
However, inflationary pressures in both regions remains weak — i.e. below target — suggesting that despite record central bank action, there is room for more.
“My conclusion will be that quantitative easing remains the best monetary policy option in this situation,” said Bullard, who is currently a voting member of the FOMC committee. In his presentation, he explored five policy options available to central bankers, articulated the weaknesses of each, and argued why he thinks QE was the best choice.
Monetary Policy Option 1: Do Nothing
“One might plausibly argue that the near-zero policy rate provides sufficient monetary accommodation to keep inflation near target and to assist the real economy to the extent possible,” Bullard said in this presentation.
Changes to the interest rate are one of the first lines of defense that central bankers and policymakers have in times of economic turmoil. The U.S. Federal Reserve refers to the near-zero rate environment as “highly accomodative.” As it stands, the target range for the federal funds rate is between 0.00 and 0.25 percent, and the Fed anticipates that this will remain the case as long as U-3 unemployment remains above 6.5 percent and inflation below 2.5 percent.
In Europe, the ongoing economic downturn forced the ECB’s hand, and it recently lowered the interest rate on both the marginal lending facility and main refinancing operations within the Eurosystem. Effective May 8, the rate on the marginal lending facility decreased by 50 basis points to 1.0 percent, and the rate on main refinancing operations decreased by 25 basis points to 0.50 percent. The interest rate on the deposit facility will remain unchanged at 0.0 percent.
However, Bullard points out that “the experience from Japan seems to indicate that merely keeping the policy rate near zero for an extended period of time does not by itself keep inflation positive. In particular, there seems to be a steady state equilibrium in which the nominal rate remains near zero and inflation remains mildly negative.”
Monetary Policy Option 2: Forward Guidance
“The New Keynesian, sticky price literature has been influential in U.S. monetary policymaking,” said Bullard. “This line of research argues that policy accommodation can be provided even when the policy rate is near zero. The extra accommodation comes from a promise to maintain the near zero policy rate into the future, beyond the point when ordinary policymaker behavior would call for an increase in the policy rate.”
In the U.S., this has manifested as the Federal Reserve’s 2.5 percent inflation threshold and 6.5 percent unemployment target as the minimum criteria for a policy rate move. “The adoption of threshold-based forward guidance was a clear improvement on the previous calendar-based forward guidance, which seemed to be plagued by the pessimistic signal problem,” wrote Bullard.
Before the adoption of forward guidance, markets were unsure about what the rate environment would look like in the near- and mid-term. As has been made increasingly apparently over the past few years, uncertainty is one of the most destructive forces that a market can be subject to.
Monetary Policy Option 3: Quantitative Easing
In a May 1 policy update, the FOMC announced that it had “decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.”
These purchases, the current iteration of QE in use by the Federal Reserve, have four primary effects on the economy: higher inflation expectations, currency depreciation, higher equity valuations, and lower real interest rates. QE is similar to normal monetary policy in that it puts downward pressure on nominal and real interest rates. (For more on quantitative easing, read this article about the upcoming FOMC meeting.)
Monetary Policy Option 4: Negative Interest on Reserves
Bullard doesn’t have much to say on this option. At a glance, negative interest rates on reserves means that the Fed and other central banks actually pay interest on reserves. Currently the rate is 25 basis points, and Bullard has been critical of this rate in the past. The heart of the argument is that, at the end of the day, negative interest rates on reserves just doesn’t do a whole lot of anything.
Monetary Policy Option 5: Twist
A twist operation is when the central bank sells short-term government debt and buys longer-term debt. The Federal Reserve engaged in Operation Twist between mid-2011 and the end of 2012 in an attempt to remove duration from the market.
Bullard sums up how he feels about twist by saying: “There is little historical evidence that the maturity structure of the U.S. debt is an important macroeconomic variable,” and that “”any effects from the twist operation were probably minor.”
For the U.S., Bullard concludes that the best course of action is to “continue with the present quantitative easing program, adjusting the rate of purchases appropriately in view of incoming data on both real economic performance and inflation.”
Here’s how the market traded Tuesday: