"Summoning the ghost
I've been reading through the Annex of the Bank of Canada's most recent Monetary Policy Report (pdf), the "Framework for conducting monetary policy at low interest rates", and reading Deputy Governor John Murray's speech on unconventional monetary policy.
I can't quite put my finger on the right metaphor. "Atheists explaining the efficacy of prayer" comes close. So does "Materialists advocating exorcism". Except they are not trying to exorcise a ghost they don't believe in; they are trying to summon a ghost they don't believe in. I have ended up recycling David Laidler's metaphor (pdf), that monetary policy without money is like Hamlet without the ghost.
Despite what you might think, the Bank of Canada is not a monolith. It has many economists working there, and they don't all think the same way. They do try to cultivate a diversity of viewpoints within the Bank (they are aware of the dangers of group-think). And they do listen to and even encourage new ideas. I know this first hand. Some economists at the Bank will believe in ghosts. Most will allow that ghosts might exist.
But it is an institution in charge of monetary policy, and the Bank wants its monetary policy framework to be predictable, transparent and understood by the public. And the Bank believes that transparency should go beyond merely announcing the 2% inflation target. The Bank wants the public to understand how it plans to hit that 2% target. The Bank's view of the monetary transmission mechanism, the broad outlines of the Bank's models, how it interprets and responds to changes in the exchange rate, are all communicated to the public, either on the web, or in speeches by the Governor and Deputy Governors.
There is, in other words, an "official" Bank view of monetary policy, and how it works. And there needs to be an official view, if the Bank is to be able to communicate a stable predictable framework for monetary policy.
Any tension between the Bank's official view, and the views of individual economists at the Bank, is a manageable tension, an unavoidable tension, and ultimately a desirable tension. There's nothing new here.
What is new is the tension between the Bank's official view of how monetary policy works, and how "unconventional" monetary policy is supposed to work. Because, to put it crudely, if the official view is correct, the truth and the whole truth, there is nothing that unconventional monetary policy can do that cannot be done by conventional monetary policy. It won't work. The official view doesn't believe in ghosts.
The Bank's official view of the monetary policy transmission mechanism is that the Bank sets the very short term interest rate, and that rate influences all other interest rates, and those interest rates influence savings, investment, the exchange rate, net exports, aggregate demand, output, and inflation. Plus expectations of all those things matter, of course. But money itself is missing from the monetary policy transmission mechanism. The quantity of money gets determined by all those things, but does not determine anything. If you want to, you can tell the story without mentioning money, and the plot stays the same.
In the Bank's official view of the monetary policy transmission mechanism, money is an epiphenomenon, the ghost in the machine: like the mind in the cogwheels of a material brain. And now it wants to be able to summon the ghost, if it needs to, and argue that the ghost can move the cogwheels around.
John Murray describes three types of unconventional monetary policy.
The first type of unconventional monetary policy has already been put in place, at the April 21 announcement:
"With monetary policy now operating at the effective lower bound for the overnight policy rate, it is appropriate to provide more explicit guidance than is usual regarding its future path so as to influence rates at longer maturities. Conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target. The Bank will continue to provide such guidance in its scheduled interest rate announcements as long as the overnight rate is at the effective lower bound."
Now, it is clear that long term interest rates depend on expected future short term rates, and so a credible commitment to keep short term rates low can influence expectations and influence long rates. No problem. But this is a "conditional commitment" (my italics), and the condition is "the outlook for inflation". If we interpret that to mean "we will not raise the overnight rate from its current level as long as this does not result in our forecasting inflation above the 2% target", we might ask "what's new?". We always understood the Bank would not raise the overnight rate unless it thought it needed to do so to prevent its forecast of inflation rising above 2%.
But the Annex to the Report does explain how such a conditional commitment might influence market expectations:
"...a credible conditional commitment by a central bank to keep short-term rates at the [effective lower bound] for a longer period than previously expected by the market should lower bond yields throughout the term structure..."
Suppose the bond market expected inflationary pressures would require the Bank to raise the overnight rate this Summer. The Bank tells the bond market that in the Bank's opinion the bond market is wrong, and the Bank believes that inflationary pressures are weaker and will take longer to build, so the Bank will not need to raise the overnight rate until the second quarter of 2010. If the bond market thinks the Bank might be right about inflationary pressures, the bond market will revise its belief.
But this impact on market expectations is a double-edged sword. The Bank is saying two things: interest rates will be lower than you think they will be; and the economy will be weaker than you think it will be. If the bond market hears the first, the effect is expansionary. If the real economy hears the second, the effect is contractionary. The net effect is ambiguous. I think the Bank assumes, perhaps realistically, that the bond market is listening more closely than the real economy.
The second type of unconventional monetary policy is what the Bank calls "Quantitative Easing", which it describes as unsterilised purchases of bonds, whether government or private. How does the Bank see this affecting the economy? Let me quote John Murray fully:
"These purchases directly affect the yields of the securities that are bought, putting downward pressure on their interest rates and upward pressure on their prices. They also inject additional central bank reserves into the financial system, which deposit-taking institutions can use to generate additional loans.
All quantitative easing is, by definition, "unsterilized." Although this is correctly viewed as unconventional, it closely resembles the way monetary policy is described in most undergraduate textbooks, and is broadly similar to how it was conducted in the heyday of monetarism."
The first paragraph makes no explicit mention of increasing the stock of money, though an increase in the stock of money is implied if deposit taking institutions (banks) do generate additional loans. I keep thinking they want to summon the ghost, without mentioning him by name. And, according to the official view, bank lending is never constrained by the quantity of reserves, as long as they are willing to pay the target overnight rate. And that overnight rate target is already at the lowest the Bank is prepared to go, and is equal to the 0.25% rate of interest the Bank pays on reserves. If the official view were correct, why should bank lending increase, if the interest rate on reserves stays the same?
But it's the second paragraph that intrigues me most. The undergraduate textbook story of monetary policy is where an open market operation increases the money base, which causes a multiple expansion in the supply of money through the banking multiplier, and the increased supply of money causes changes in interest rates, asset prices, investment, consumption, aggregate demand, output, and ultimately inflation. It's the story of the monetary transmission mechanism that is most at odds with the Bank's official version. It's the story I teach in ECON1000, and have been told, many times, is wrong.
Now, you might argue that my ECON1000 story used to be wrong, but would become right if the Bank did decide to do Quantitative Easing. When the Bank changes what it does, the story that was wrong becomes right again. But the Bank has government securities on its balance sheet now. How did they get there? Did they fall from heaven? No, the Bank bought them. Open market operations are not new.
And in "...the heyday of monetarism" I remember how the Bank of Canada told the story of how monetary policy worked, and it was a very different story from the ECON1000 story. It went like this: the Bank would estimate a money demand function, then set a short term interest rate just high enough that the demand for money at that interest rate would be forecast by the Bank to be equal to the Bank's target for the money stock. The Bank still saw itself as setting the rate of interest, and the quantity of money being demand-determined. The only real difference from today is that it had a money growth rate target, rather than an inflation target.
Now let me quote footnote 4 in the Annex:
"Although quantitative easing is now referred to as an unconventional monetary policy tool, the purchase of government securities is, in fact, the conventional textbook approach to monetary policy. A central bank can alter policy by changing either the quantity or the price of liquidity supplied to the financial system. In practice, most central banks have chosen to conduct monetary policy by targeting the price of liquidity because the relationships between the amount of liquidity provided by the central bank and monetary aggregates on the one hand, and between the monetary aggregates and aggregate demand and inflation on the other, are not very stable"
Finally we get a mention of the "monetary aggregates". But it doesn't lead anywhere. Do monetary aggregates matter?
And the bit about changing either the quantity or the price of liquidity is strange. If a monopolist faces a downward-sloping demand curve, we can tell a story about the monopolist setting quantity (the textbook story) or price (the Bank's official story). But we get the same answer either way: the monopolist picks a point on the demand curve. Only if the demand curve fluctuates, and the monopolist does not immediately see those fluctuations, or cannot adjust quickly, does it matter if he sets quantity or price. But if the monopolist just wants to move down along the demand curve, it really doesn't matter if he cuts the price or increases the quantity.
Is there really a change in procedure, or just a change in the story we tell to describe that procedure?
And the monopolist can set either price, or quantity, but he cannot set both. The Bank of Canada wants it both ways. They want to keep the overnight rate at 0.25%, and they want to increase the quantity of "liquidity".
There is a massive tension when the Bank tries to explain how quantitative easing works using a theoretical framework which doesn't contain the concepts needed. It's like a materialist trying to summon a ghost.
The third type of unconventional monetary policy is what the Bank calls "credit easing". It is what is sometimes called "qualitative easing". It is sterilised purchases of particular assets where the market for those assets is not functioning properly.
No underlying tension here. Different financial assets are imperfect substitutes, especially at times of financial market stress. Rather than relying on the long chain of causation from short safe liquid assets to long risky illiquid assets, the Bank wants to intervene directly at the end of the chain.