Why the zero lower bound matters

The zero lower bound is not an insurmountable obstacle: by shaping expectations of future interest rates, the Fed can have a tremendous influence on the macroeconomy, even when the current interest rate can’t go any lower. But it’s not irrelevant either: instilling the right expectations is trickier than simply moving around the federal funds rate, and a central bank unprepared to make a visible commitment can be remarkably ineffective.

Some economists argue that the zero lower bound is irrelevant, or at least overrated, for other reasons. In his response to an earlier post of mine, for instance, David Beckworth suggested that the Fed’s ability to buy other assets (e.g. long-term Treasuries, or corporate bonds) even when short-term interest rates are zero means that monetary policy retains its effectiveness. This has historically been one of the main arguments against a “liquidity trap”: sure, the Fed can’t do any more by buying 6-week T-bills, but why not 20-year corporate debt?

In fact, I agree to an extent: unconventional asset purchases can make a small difference in yields, and possibly a larger difference in times of financial disarray. But they are vastly, vastly less effective than the Fed’s traditional tools, and it takes an extraordinary expansion of the Fed’s balance sheet to have much effect at all.

Why is this? The Fed is a monopolist in the market for base money: no other institution is allowed to print paper currency that’s legal tender, or create electronic reserves that satisfy reserve requirements. Although base money is a relatively small market (about $1 trillion pre-QE), it has a dramatic effect on the rest of the economy because prices are quoted in money, in much the same way that Snickers bars would become pivotal if prices were quoted and transactions conducted in units of candy. By wielding its monopoly power in this market, the Fed can change a key rate (the federal funds rate) that determines the cost of credit across the economy.

At the zero lower bound, however, base money is no different from all other short-term, riskless assets. And that’s a much larger market, one that’s no longer dominated by the Fed. There’s $1.5 trillion in Treasury bills, $1 trillion in commercial paper, $2.7 trillion in money market funds, $900 billion in checkable deposits at commercial banks, more than $1 trillion in Treasury notes with less than a year until maturity, at least $1 trillion in the federal funds and repo markets, and a several trillion more in liquid savings deposits. To be sure, this involves a little double counting: for instance, money market funds invest some of their money in Treasuries. But the total is still very large: even if you take out the $1 trillion in currency, “Money Zero Maturity” is estimated at almost $10 trillion, and that excludes many assets. It’s a big market!

Just as importantly, short-term assets aren’t in fixed supply: financial intermediaries create them when they become sufficiently profitable. Maybe a bank holds a 5-year Treasury note using funds obtained through repo, effectively transforming a 5-year asset into a zero-maturity one. This makes the Fed’s job even harder. If it creates money and buys up Treasury notes in the hope of bringing down yields, financial institutions may start to unwind their own positions, offsetting much of the effect.

Here’s an extreme example: suppose that banks are only willing to borrow short and lend long (i.e. hold longer-maturity Treasuries) when the spread between short and long is at least X%. Then the Fed will have an extremely difficult time bringing the spread below X%; every bank will unwind its positions first, and the Fed will be forced to purchase even more to compensate.

This is why unconventional policy is so difficult, and why the best empirical estimates suggest that its effects are measurable but small. Away from the zero bound, a $400 billion purchase would immediately revolutionize monetary policy, forcing the fed funds rate down to zero (even if it started at a very high level). But at the zero bound, you’re lucky if a $400 billion purchase reduces long-term yields by 15 basis points.

There are two ways to spin this. First, we can’t pin all our hopes on quantitative easing: it’s fundamentally different in character from ordinary monetary policy, and much less likely to have a substantial effect.

On the other hand, we should recognize that normal intuition about magnitude doesn’t work for quantitative easing. I often hear statements like the following: “The Fed has engaged in absolutely unprecedented monetary policy, more than doubling the size of its balance sheet, and there wasn’t much of an impact. Clearly the Fed is out of ammunition.”

This sounds reasonable at first blush, but it doesn’t really make sense. When it’s purchasing assets at the zero lower bound, the Fed is participating in a market that’s fundamentally different from the market in which it usually intervenes—a market that’s far bigger, in which the Fed is no longer a monopoly player. There’s no reason to think that even a doubling or tripling of the Fed’s balance sheet is enough to achieve a meaningful stimulus. And there is still plenty of room for action: after all, there’s still more than $6 trillion of T-notes and T-bonds that the Fed doesn’t own, and even more in the market for agency securities and other debt. (But don’t expect $6 trillion in purchases anytime soon.)

Summing up: life at zero is hard. No longer can the Fed simply nudge rates up or down. It must either commit to lower rates in the future (testing its credibility in the process), make extraordinarily large asset purchases, or both. This requires courage and flexibility—qualities that Ben Bernanke is known to possess, but that the Fed has not consistently displayed.



Edit: I’ll be away starting in a couple days for my wedding and honeymoon. Despite my normal attachment to the internet, I do not plan on blogging or responding to comments during this period! I’ll be back in September.

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21 Comments

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21 responses to “Why the zero lower bound matters

  1. Bill Woolsey

    This is an important point, though your spin is wrongheaded.

    Quantitative easing isn’t hard or ineffective. It is just that tots of it is needed. Perhaps with a little care, the double counting can be reduced. And the problem that private sector intermediares might reduce their issue of zero yield debt isn’t much different than the impact of a higher reserve ratio when targeting M1 or M2. More base money is needed. And then, we can get better intuitions of how much should be tried.

    I am sure you are aware that quasi-monetarists typically favor going the rest of the way with ordinary easing (negative interest on reserves) and very much support a target path for GDP, both of which reduce the amount of longer term securities that would need to be purchased. I think most of us don’t favor a committment to keep base money at a high level, or to keep nominal interest rates at a low level. Make the committment to a growth path for GDP–base money, the Fed’s security holdings, and short and long rates should be allowed to adjust in the future however much is consistent with maintaining that path.

    • I guess I don’t understand why more base money is such an important target. At this point, base money is basically equivalent to T-bills and bank-created money. If adding more base money to the system is offset by a removal of bank-created money (as banks unwind their longer-term positions due to less favorable yields), then it seems like there should be a minor effect, even in a money-centric view like yours.

      I understand the usefulness of a target path for nominal GDP, but I feel that we should be able to discuss the effect of large-scale asset purchases independently of such a target, and I’m not sure why the intuition that more base money is useful is necessarily valid, at least independent of considerations like offsetting actions by banks. Is creating more base money a necessary part of maintaining the target for NGDP?

  2. Doc at the Radar Station

    Fascinating post. I would be greatly interested in your response to this related post:
    http://ftalphaville.ft.com/blog/2011/08/12/652166/the-feds-secret-qe-equivalent/
    “If banks do indeed perceive that capital deterioration risk from lending is much greater than a self-imposed haircut on the most liquid and safe security, they’re prepared to take that haircut — especially in a world with no alternative — because it guarantees some sort of remaining capital preservation. The haircut, of course, is the negative interest rate.”

    “If that is the case, the worse thing the Fed could do is more asset purchases. It would only take out more supply of quality collateral out of the market, heightening the pressure to take a self-imposed haircut just in order to get your hands on the security. A fact echoed by the number of above par bids at this week’s 30-year Treasury auction.”

    • Thanks. I’m glad you enjoyed the post.

      To be honest, if I didn’t know that the article was written by a blogger at the FT, I would have assumed that it came from zero hedge or one of the shadier corners of Seeking Alpha. At least to me, it’s rambling and unclear; she’s going in a million different directions, and I don’t understand what she’s really saying.

      For instance, the article talks about how lending opportunities are bad enough that banks will flock to safe securities (note: this should include money) that have low or even negative yield. Fair enough. But this is essentially saying that the “natural rate” is low—which seems like an argument for more stimulus and more Fed efforts to bring down rates, not the opposite.

      Then she briefly talks about how the Fed is taking all the “quality collateral” out of the market with its asset purchases. Maybe this is true, and long-term Treasuries are serving some incredibly important role as collateral that money (and short-term Treasuries, into which it is easily convertible) cannot, and that the Fed is disrupting this role through QE. But she doesn’t offer any support for this. Moreover, it’s not as if long-term Treasuries are being rationed: they’re still allocated via the market, and if they are so useful as collateral, the worst that has happened for anyone seeking to use them has been a slight decline in the yield they earn. If there is even slight pass-through from Treasury yields to other securities, I can’t imagine how the effect on a small set of financial institutions with idiosyncratic collateral demands outweighs the much broader effect on interest rates throughout the economy.

      Then she talks about money market funds. It’s true that money market funds will be disrupted if interest rates fall too close to zero. This is one of the reasons for the interest on reserves policy, which has indeed been disrupted somewhat by the FDIC fee. In my view, this probably isn’t such a bad thing: there is some risk of financial disruption from unwinding money market funds, but it’s not clear that a target as high as 0.25% on interest on reserves is necessary to prevent this from happening. Regardless, this seems conceptually disconnected from the earlier points in the article, except in the general sense that they all pertain to a low interest rate environment.

      I’m not particularly good at parsing Fedspeak, but if the New York Fed calls its upcoming operations “small scale”, my best guess is that they will not do much to change the situation for money market funds (whose combined holdings are well above the Fed’s entire balance sheet), and I don’t see why she feels otherwise.

      But mainly I’m just dazed and confused after reading that article. One of the worst features (and most suggestively amateurish) is that she is throwing around jargon where it doesn’t really apply: for instance, the term “haircut” has a specific purpose when discussing repo, but she’s using it to mean “lower yield”.

  3. Matt

    Away from the zero bound, a $400 billion purchase would immediately revolutionize monetary policy, forcing the fed funds rate down to zero (even if it started at a very high level). But at the zero bound, you’re lucky if a $400 billion purchase reduces long-term yields by 15 basis points.

    When I think about this, I find the appropriate apples-to-apples comparison elusive, but in any case, it is surely not a comparison in terms of basis points but in terms of aggregate demand (perhaps dollars of nominal GDP). In some sense that I’m having trouble making precise, a 15 basis point change in the federal funds rate is quite insignificant in terms of its effect on aggregate demand, but a 15 basis point change in the 10-year yield at least borders on being noteworthy.

    If you think of interest rates in terms of the expectations theory, a 15 basis point change in the federal funds rate is likely to be reversed over the course of the business cycle and therefore constitutes a much smaller change in the 10-year yield. But the problem I’m having is what to assume about that reversal. One possible ceteris paribus could be leaving everything else the same, say, a month later, in which case you’re comparing a 15 basis point change in the 10-year rate for a month to effectively no change at all. But it seems to me one could make a case for something even more extreme, since the Fed’s usual portfolio needs to be rolled over frequently whereas its long-term portfolio doesn’t. If the Fed buys long-term bonds (and if you believe in a “stock” view), then a one-time purchase has a lingering effect on the bond yield. If the Fed buys T-bills, then a one time purchase has only a brief effect on the federal funds rate, and that constitutes an almost imperceptible, and equally brief, effect on the bond yield.

    Perhaps you can think about this more clearly than I, but I would suggest anyhow that the the large change in the federal funds rate that $400 billion could produce, vs. the small change in long-term yields that it could produce, is not really a fair comparison, because it ignores the greater economic impact that changes in longer-term yields would have.

    • This is a very good point. I didn’t intend to suggest that the numerical effects on yield are comparable; for exactly the reasons you describe, a 15 basis point cut in the yield on a 10-year security is much more important than a 15 basis point cut in the federal funds rate, which is likely to be reversed in a span far shorter than 10 years. My post isn’t very clear in this regard.

      In fact, 13 basis points per $400 billion (the estimate given in Hamilton and Wu) is arguably a pretty sizable effect: at that rate, $2 trillion in QE gives you a 65 basis point change in 10-year yields. I don’t know if committing to lower rates (an alternative mechanism that I’ve emphasized) can actually do much more than that. For instance, the (admittedly rather weak) August 9 commitment coincided with a decline in 10-year yields of 20 basis points. In this light, QE looks pretty good.

      There is an additional consideration, however, that makes me more skeptical of QE. Some fairly convincing evidence from event studies, especially Krishnamurthy and Vissing-Jorgensen, suggests that the decline in Treasury yields associated with QE announcements is accompanied by much weaker movements in less safe assets, like Baa corporate debt. This indicates that the QE’s effect on Treasury yields is partly working through some kind of market segmentation, and that we can see big effects in the market for “safe” assets but much smaller effects in (macroeconomically more important) riskier fixed-income assets.

      We expect changes in the federal funds rate, on the other hand, to be transmitted roughly one-for-one to other assets. (And sometimes even more than one-for-one, as the expansionary impact from lower federal funds rates brings down default risk and narrows credit spreads.)

      So as I see it, there are two effects—working in opposite directions—that make naive comparisons of yield problematic. First, there’s the effect you mention: a drop in yield for a long-dated security implies a much larger change in prices (and incentives) than an identical change in the federal funds rate that lasts only a few years. Second, the effect on Treasury yields from QE partly reflects a decline in yields that is idiosyncratic to the “safe asset” category, while the effect from a lower expected trajectory of the federal funds rate is most likely transmitted across all asset classes.

      • …the decline in Treasury yields associated with QE announcements is accompanied by much weaker movements in less safe assets, like Baa corporate debt….We expect changes in the federal funds rate, on the other hand, to be transmitted roughly one-for-one to other assets.

        This doesn’t make sense to me. Why would a reduction in the return to duration risk result in a nearly offsetting increase in the return to credit risk? (Since there are highly liquid futures markets for Treasuries, duration risk and credit risk can be easily separated, and actual bond managers, one of whom is my employer, separate them in their minds in any case.) And why should it matter if the reduction in the cost of duration risk comes because of direct Fed purchases or because of a change in the expected future path of the federal funds rate? I can believe that the markets are screwy and that for some reason changes in Treasury yields don’t pass through to lower quality assets, but I can’t see why they would be more screwy in one case than in the other.

      • First I should say that I’m open to the possibility that these event studies simply give the market too much credit: maybe it takes a few days or weeks for the implications of asset purchase announcements to ripple through the fixed income markets, and the fact that the effect is mainly confined to Treasuries and similar assets in a shorter timeframe is just an illusion.

        But accepting the empirical results as valid, my interpretation is this. The spread between, say, BAA corporate yields and Treasuries can’t easily be rationalized in terms of expected default risk, which is actually quite low. This was particularly true during the financial crisis: yield spreads (even on longer-term bonds) shot up to something like 8%, which is absolutely insane and cannot possibly correspond to the scale of any expected default, unless investors were preparing for the apocalypse. (Though maybe ridiculously high yields for a few troubled financial institutions were contaminating these figures—I should check out the data at a more granular level.)

        My interpretation is that Treasuries have some special qualities that don’t easily fit into an asset-pricing model, even a fairly sophisticated one. The spread between Baa bonds and Treasuries isn’t cleanly expressible as “credit risk”, even though that is the ultimate origin—there is some kind of special premium on the ultimate safety and liquidity that Treasuries offer. I assume this is partly due to the preferences of institutions like central banks and pension funds. It seems reasonable that this special demand isn’t precisely the same for short-term and long-term Treasuries; the pool of investors with some special preference for short-term liquidity is different from the pool with a special preference for medium to long term complete nominal safety.

        When the Fed lowers the supply of long-term Treasuries on the market, I assume that the price of these Treasuries falls in large part because of these “special” preferences, which drive investors to scrounge for the remaining Treasuries. In this event, it’s possible that the price of longer-term Treasuries rises relative to everything else, including both T-bills and long-term corporate debt. This wouldn’t make sense if the spread between Treasuries and corporates was a direct “credit risk”,term, but it does make sense if the spread is a function of the “specialness” of long-term Treasuries.

        Obviously, this explanation also implies that the spread between the expected path of T-bills and long-term Treasuries is not some clean “duration risk” term either. Maybe banks will unwind some of their liquidity transformation, directly offsetting the effect of QE (and the reason why they do this is that duration risk makes such transformation costly), but after this is all over, the relative price of T-bills and long-term Treasuries is determined mainly by the extent to which their relative specialness is in demand.

        This explains why traditional open market operations have greater pass-through. By exchanging reserves for other short-term securities, they alter the relative supply of another kind of “special” security — reserves in the interbank market. An expansionary open market operation decreases the price of these reserves relative to all other securities (which do not have the same special properties), pushing down yields. But this affects yield of corporate debt just as much as it affects the yield on Treasuries.

        In other words, since open market operations work by changing the supply of reserves with special properties, rather than Treasuries with special properties, we expect to see the relative price of other securities and reserves affected. Since this is just the nominal price of other securities, it’s what we’re after. Interventions that change the supply of “special” long-term Treasuries, on the other hand, change the relative price of long-term Treasuries vs. everything else, which isn’t so important.

        (Sorry about the length. I’m afraid I’ve just revealed a deeply unscientific view of the bond market… which, unfortunately, seems to be more consistent with empirical evidence than many more traditional views.)

      • (Not sure this reply is going to appear in the right place.)

        I suppose it makes a some sense to say that there’s a liquidity premium on all Treasury securities and that liquidity is a much more important feature than safety. After all, it’s a lot easier to borrow against some random T-note than against some random corporate bond with otherwise similar characteristics. And I suppose its plausible that T-notes are almost as liquid as bank reserves, so exchanging one for the other has little effect. Maybe the relevant market segment has near-lexicographic preferences between Treasuries and corporates. I’ll have to think about that.

        Minor semantic point: be careful how you use the word “specialness.” When I hear that word, it’s usually a technical term that refers to the characteristic of collateral that gets the borrower an abnormally low interest rate because so many lenders want to get their hands on the collateral (usually to short-sell it). On-the-run Treasuries are often “special” because bond dealers want to short-sell them to hedge.

  4. Matt:

    At the zero lower bound, however, base money is no different from all other short-term, riskless assets. And that’s a much larger market, one that’s no longer dominated by the Fed…When it’s purchasing assets at the zero lower bound, the Fed is participating in a market that’s fundamentally different from the market in which it usually intervenes—a market that’s far bigger, in which the Fed is no longer a monopoly player.

    You focus on the safe asset, store of value role of base money. I look at it from a medium of exchange perspective. Here, the size of the market the Fed faces doesn’t fundamentally change at the 0% bound. Both above and below 0%, other entities beside the Fed create money assets (e.g. checking account, money market accounts, repos) that can serve as a medium of exchange. This doesn’t change. The Fed’s role in both cases is to use its control of the monetary base to properly shape expectations so that there is sufficient money assets created to meet money demand.

    What does change at the 0% bound is the demand for the medium of exchange. It is highly elevated and will not be satiated by the Fed simply buying up t-bills. Since the money demand is a function of an entire spectrum of interest rates and is not being satiated with the Fed purchasing short-term securities, the Fed has to move on to the other assets affecting money demand. QE2 was a step in that direction, but was not very effective because it never committed, either explicitly or implicitly through a level target, to buying up enough assets to satiate money demand. Ultimately, the Fed failed to sufficiently signal a determination and resolve to satiate money demand. It could do that through a price level or nominal GDP level target.

    • I guess I’m not sure whether you think the zero lower bound is a barrier in the absence of a strong level target of some sort.

      I think we both agree that you can get traction at the zero lower bound with a credible targeting policy. But my impression is that you think there is a fairly sizable effect from large-scale asset purchases, and it seems like that effect should still be present even when there is no nominal GDP level target (though monetary policy will be less effective in general in such a situation).

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  6. sunchaser

    I find this unconvincing. Are dollar-for-dollar effects of conventional monetary policy greater than those of QE? Probably, although I suspect that most of the difference you point out to is due to difference in times when they are implemented. QE is usually implemented in times of extreme risk aversion when, almost by definition, people seek money and government debt, so to lower interest rates on commercial paper, mortgages and other kinds of private debt might take more purchases of them than usually would. Moreover, as you pointed out in one of your previous points, even the conventional open market operations have only a marginal effect on the economy. If you get a flight to quality of extreme proportions like the last one, even a massive monetary expansion will not achieve as much as one would expect because the supply of credit-worthy borrowers actually shrinks and is not as “elastic” as FED’s ability to expand credit supply so banks end up sitting on much of that cash. Moreover, FED’s promise to keep interest rates lower for an extended period of time just simply isn’t credible. As soon as inflation shoots up they will increase them, regardless of whether it happens next year or in 2013 or 2020.

    • It’s hard to overstate the difference in dollar-for-dollar effects between conventional monetary policy and unconventional asset purchases at the zero lower bound. Look at a graph of the size of the monetary base over time: even large swings in the federal funds rate are barely perceptible, as only tiny changes in the size of the Fed’s balance sheet were necessary to implement them. Over time, the effects on the monetary base become larger (as currency demand slowly changes in response to interest rate changes), but the need to change actual quantities in conventional monetary policy is very small. It certainly pales in comparison to recent bouts of QE.

      I don’t think a quantitative difference of this magnitude—we’re talking about factors of 100 here—can be explained by a “time of extreme risk aversion”. (In fact, I think there is something logically questionable about this argument: in times of extreme risk aversion, spending is certainly lower conditional on any particular stance of monetary policy, but it’s not clear that the response to monetary policy is any less dramatic—maybe demand is 10% lower, but each incremental drop in yields will have the same effect as before. If your airplane is facing a 100mph headwind, that doesn’t mean that each incremental pound of thrust will do less; you cough up a constant, but the derivative is the same.)

      Regardless, in light of such enormous differences in magnitude, I think it is more plausible to suppose that there is a fundamental difference between these kinds of monetary policy—and the difference between “acting as a monopolist” (in the market for base money) and competing in a large market populated by banks (in the market for liquid securities in general) is a natural explanation.

  7. sunchaser

    I am not sure that the derivative will be the same. If you get a shift in risk aversion large enough interest rates on private debt could jump considerably, and even if FED goes in and buys tons of it the rates will likely stay up because the FED will not change the fact that there is large amount of uncertainty and risk. If we simplify the world and say that interest rates are a function of credit supply and credit demand, and say that in a crisis credit supply goes down due to a a shift in liquidity preferences, it is clear that an increase in base money will not restore credit supply absent some restoration of old risk preferences. I am even ignoring the fact that demand for credit will probably go down too in a delevaraging crisis like this one. It seems that there are too many moving parts in this story to make that derivative the same. To me it seems that that enormous increase in base money precisely speaks about the scope of the recent shift in liquidity preferences. If FED went in and bought 600 billion dollars of mortgage backed securities in 2004 it would’ve had a much greater effect on the housing market than it did in 2009 or whenever the FED bought all those securities. Same goes for hundreds of billions poured into commercial paper market and all kinds of collateralized private debt. I am not denying that FED has an inherent advantage in market for base money and that policy measures through conventional open market operations yield stronger results on a dollar-for-dollar basis, but you gotta look at the policy environment too.

  8. Congratulations on the wedding.

    As a new father I can strongly recommend you become one sooner rather than later, it’s just indescribably great.

  9. Zac

    Hi Matt,

    Congrats on the wedding!

    I was wondering if you had any thoughts on WCI’s series of posts on an upward sloping IS curve?

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/08/the-macroeconomics-of-double-pole-dancing.html?cid=6a00d83451688169e201543458c831970c

    Zac

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