Bernanke Redux
The text of Bernanke's recent speech 'Conducting Monetary Policy at Very Low Short-Term Interest Rates?' makes for an interesting read. He outlines three methods that the Fed can use to influence monetary policy when it is no longer feasible to lower interest rates. It seems fairly clear to me that they are executing this game plan already.
As long as they do not purchase debt directly from the Treasury, or exceed their charter and directly purchase equities and non-agency debt, it does not appear to be 'illegal.' However, the extent to which they are manipulating (in government parlance, 'stabilizing') the economy becomes almost mind-boggling, and one can only wonder if this is just not a never-ending pyramid scheme of circumventing the disciplines and balances of the markets.
Here are a few excerpts and the three main action points. No wonder the US dollar tanked after this speech.
I. Shaping Interest-Rate Expectations
"This literature suggests that, even with the overnight nominal interest rate at zero, a central bank can impart additional stimulus by offering some form of commitment to the public to keep the short rate low for a longer period than previously expected. This commitment, if credible, should lower yields throughout the term structure and support other asset prices."
Promise to keep rates low for a long time. If you have to, for credibility's sake, even set some negative financial conditions for the Fed if they do raise rates, although it won't matter, because losses don't matter to someone who has the ability to print money at will. Don't think he actually said that?
"An objection to this strategy is that it is not entirely clear why a central bank, which has the power to print money, should be overly concerned about its financial gains and losses."
To his credit, he does observe that building credibility is important, and to do this your deeds must match your words. However, "The requirement that deeds match words has the consequence that the shaping of market expectations is not an independent instrument of policy in the long run." In other words, if you can't fool all of the people all of the time, jawboning has a limited effectiveness.
II. Altering the Composition of the Central Bank's Balance Sheet
Buy longer dated Treasuries to shape the slope of the yield curve.
"Central banks typically hold a variety of assets, and the composition of assets on the central bank's balance sheet offers another potential lever for monetary policy."
"Over the past fifty years, the average maturity of the Federal Reserve System's holdings of Treasury debt has varied considerably within a range from one to four years. As an important participant in the Treasury market, the Federal Reserve might be able to influence term premiums, and thus overall yields, by shifting the composition of its holdings, say from shorter- to longer-dated securities."
Do you really think he stops there?
"In simple terms, if the liquidity or risk characteristics of securities differ, so that investors do not treat all securities as perfect substitutes, then changes in relative demands by a large purchaser have the potential to alter relative security prices. (The same logic might lead the central bank to consider purchasing assets other than Treasury securities, such as corporate bonds or stocks or foreign government bonds. The Federal Reserve is currently authorized to purchase some foreign government bonds but not most private-sector assets, such as corporate bonds or stocks.)"
"Yet another complication affecting this type of policy is that the central bank's actions would have to be coordinated with the central government's finance department (Treasury Department) to ensure that changes in debt-management policies do not offset the attempts of the central bank to affect the relative supplies of securities. According to James Tobin, the Federal Reserve's failure to coordinate adequately with the Treasury was the undoing of 'Operation Twist' in 1963."
"Probably the safest conclusion about policies based on changing the composition of the central bank's balance sheet is that they should be used only to supplement other policies, such as an attempt (for example, through a policy commitment) to influence expectations of future short rates. This combined approach allows the central bank to enjoy whatever benefits arise from changing the relative supplies of outstanding securities without risking the problems that may arise if the yields desired by the central bank are inconsistent with market expectations."
III. Expanding the Size of the Central Bank's Balance Sheet
"Besides changing the composition of its balance sheet, the central bank can also alter policy by changing the size of its balance sheet; that is, by buying or selling securities to affect the overall supply of reserves and the money stock. Of course, this strategy represents the conventional means of conducting monetary policy, as described in many textbooks."
"However, nothing prevents a central bank from switching its focus from the price of reserves to the quantity or growth of reserves. When stated in terms of quantities, it becomes apparent that even if the price of reserves (the federal funds rate) becomes pinned at zero, the central bank can still expand the quantity of reserves. That is, reserves can be increased beyond the level required to hold the overnight rate at zero--a policy sometimes referred to as "quantitative easing."
In other words, don't target the price of money, or the interest rates, but rather target the supply of money itself, and keep monetizing debt until the money supply increases, even if the interest rates are zero.
"Quantitative easing may affect the economy through several possible channels. One potential channel is based on the premise that money is an imperfect substitute for other financial assets. If this premise holds, then large increases in the money supply will lead investors to seek to rebalance their portfolios, raising prices and reducing yields on alternative, non-money assets."[Like gold - Sig]
"Lastly, quantitative easing that is sufficiently aggressive and that is perceived to be long-lived may have expansionary fiscal effects. So long as market participants expect a positive short-term interest rate at some date in the future, the existence of government debt implies a current or future tax liability for the public." [The use of monetary shock and awe will confuse and confound the free markets - Sig]
And to sum it all up....
"A quite different argument for engaging in alternative monetary policies before lowering the overnight rate all the way to zero is that the public might interpret a zero instrument rate as evidence that the central bank has 'run out of ammunition.' That is, low rates risk fostering the misimpression that monetary policy is ineffective. As we have stressed, that would indeed be a misimpression, as the central bank has means of providing monetary stimulus other than the conventional measure of lowering the overnight nominal interest rate. However, it is also true that the considerable uncertainty that surrounds the use of these alternative measures does make the calibration of policy actions more difficult. Moreover, given the important role for expectations in making many of these policies work, the communications challenges would be considerable. Given these risks, policymakers are well advised to act preemptively and aggressively to avoid facing the complications raised by the zero lower bound." [FWIW I believe that is where we are right now, and the equity and bond markets are being managed aggressively. - Sig]
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