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Here are the right questions:

1. If nominal rates are zero, and NGDP is expected to grow on target (let’s say 4.5%, for example), then what is the equilibrium base/GDP ratio. I.e., what’s the demand for base money at that expected NGDP growth rate?

2. What is the ratio of T-bills to GDP?

3. What is the ratio of Treasury securities to GDP?

4. What is the ratio of “eligible assets” to GDP?

When Keynesians like Woodford and Krugman talk about the (non) effectiveness of open market operations at the zero bound, they tend to envision a situation where expected NGDP growth is inadequate, and then ask whether OMOs “work” in the sense of boosting expected NGDP growth. But that’s looking at things backwards. Everyone (I think) agrees that if the Fed bought up all of planet Earth, then OMOs would be “effective,” i.e. they’d boost expected NGDP growth. When Keynesians worry about a lack of effectiveness of monetary policy, they typically restrict the term ‘monetary policy’ to something narrower than buying up all of planet Earth. Indeed they often call the purchase of non-government securities “fiscal policy.” I think that’s wrong, the purchase of high quality corporate debt at going market prices by central banks is just as much “monetary policy” as the purchase of Treasury debt, or the lending of reserves to commercial banks. But let’s put that issue aside for the moment, and agree that only the purchase of Treasury securities counts as monetary policy.

In that case here’s the right way to think about monetary policy ineffectiveness: Assume that the Fed always stands ready to buy enough assets to keep expected NGDP growing at say 4.5% per year, level targeting. They agree to start with the safest assets (say T-bills) then move on to slightly riskier assets, such as T-notes and bonds, and then move on to agency debt, municipal bonds, high quality corporate debt, etc. In that case monetary policy is “ineffective” if the public’s demand for base money when expected NGDP growth is on target is greater than the amount of Treasury debt held by the public. That’s it. It’s that simple. Monetary policy would be ineffective using the Keynesian definition (although it would still be effective using my broader definition.)

Treasury debt held by the public is around 70% of US GDP. It seems unlikely to me that the demand for base money would ever exceed 10% of GDP, if NGDP was expected to grow at 4.5%, the Fed was doing level targeting, and the IOR was zero. However I can’t say it’s impossible, after all, there’s been a surprisingly large secular decline in real interest rates since the early 1980s. Whose to say that doesn’t continue?

Some might point to the fact that base demand is currently around 18% of GDP. However that reflects two special factors; interest on reserves, and a very low rate of NGDP growth since mid-2008 (about 2% per year.) If there had been normal NGDP growth and zero interest on reserves, then base demand would have been much smaller.

If we use a Svenssonian “target the forecast” approach, then OMOs are very unlikely to be ineffective, even when at the zero bound. That’s because base demand in the US is unlikely to exceed 70% of GDP. On the other hand one could easily envision a situation where monetary policy became ineffective in a country with a small national debt, such as Australia. Of course in that case I presume the RBA would simple expand the definition of “monetary policy” to include the purchase of foreign government debt. Perhaps they already do this.

And I really don’t see any problem with relying exclusively on monetary policy for demand stabilization in the US, even if the demand for base money exceeded 70% of GDP. For God’s sake the US government already does insane things like bail out auto companies and banks. Why in the world would we be squeamish about having the Fed buy high quality private debt at fair market value? The EMH says they should not lose money on average, and they already make huge profits from seignorage.

As I pointed out a few years back, it all comes down to Yoda’s famous maxim:

Do or do not, there is no try.

When Keynesians worry about ineffective monetary policy, they are actually contemplating a situation where the central bank makes a half-hearted effort, with no intention to do whatever it takes to succeed. In that case yes, policy might fail. If the Fed sets the base at a level where the internal Fed forecasts calls for only 3.5% NGDP growth, then yes, the policy may fail to produce expectations of 4.5% NGDP growth. But is that any surprise?

Here’s the right approach: The Fed says; “We are going to do whatever it takes to succeed, so that our internal forecasts are on target.”

And here’s the right question: “How much stuff do we have to buy?”

No one should ever ask whether monetary policy is “effective.” As soon as you start thinking that way, you have begun to fail.

PS. Because of the secular decline in real interest rates, we are very likely to hit the zero bound in future recessions. Keynesians must give up this fixation on using interest rate targets, and shift to a policy of adjusting the the base to target NGDP expectations. Or at the very least, convince the Fed and ECB and BOJ to shoot for a more rapid trend rate of NGDP growth (as in Australia), so that nominal rates stay above zero.

Update: I just noticed an excellent Nick Rowe post, which does a great job of explaining why interest rates targeting must end.

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This entry was posted on September 06th, 2012 and is filed under Monetary Theory. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



