Alan S. BlinderPrinceton University

Burt Malkiel ConferenceApril 8, 2011

Rethinking Monetary Policy in a Very Low Inflation Environment

References

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“Quantitative Easing: Entrance and Exit Strategies,” Federal Reserve Bank of St. Louis Review, November/December 2010, pp. 465-479 (the 2010 Homer Jones lecture).

“Revisiting Monetary Policy in a Low Inflation and Low Utilization Environment,” Journal of Money, Credit and Banking, forthcoming in a special issue.

Things our intellectual fathers…

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a) taught usb) didn’t tell us

Things our intellectual fathers…

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a) taught usb) didn’t tell us

↑

one of mine

And while we’re on the subject…

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Bagehot and recent history

“Lend freely, at a penalty rate, against good collateral.”

Most CBs did Well, not much. Well, it varied.

•For the ECB, Bagehot+ was just about enough (until Greece).

•But the Fed, BoE, and BoJ felt compelled to do more.•Why? The zero lower bound (ZLB) on nominal interest

rates led to a perceived need for unconventional monetary policy.

ECB never hit the ZLB; neither did the BoE, but it came close.6

Friedman and recent history

“Don’t peg the nominal interest rate.”Why not? r = i - πFriedman was thinking mainly about upward

instability when π is rising and r is falling.But the argument is symmetric: When i is

stuck at zero, and π is falling, r is rising.Again, the ZLB leads to unconventional

monetary policy.And, BTW, can also lead to huge fiscal

multipliers.

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Keynes and recent history

The liquidity trap idea: In a very depressed economy, the central bank might push the short rate all the way down to zero--and still not stimulate the economy.

Then monetary policy becomes useless.But fiscal policy becomes powerful.But what if fiscal policy is paralyzed by

large deficits and/or public debt?

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Four quick conclusions1. (obvious) In an environment of very low inflation, we

need to worry much more about the ZLB.2. (less obvious, but should be) If that environment

also has low utilization, we may need large doses of expansionary policy.

If fiscal policy is paralyzed, that must be monetary policy.

3. (deduction) Given our starting point today, unconventional monetary policy will be more important than in the past.

So the “crazy aunt” may not be stuffed back in the closet so easily.

4. Maybe we should think more about unconventional monetary policy options.

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Types of unconventional monetary policy

1.Commitment via words (“extended period”)2.A higher π* (because r = i – π)3.Lower the interest rate on reserves (no ZLB

here)4.Quantitative easing (← will focus on this one)a) Treasury bonds (work on term premia)b) Private-sector assets (work on risk premia)

5.Pegging one or more bond prices Exactly what our forefathers told us not to do!

6.Supervisory forbearance (if CB is a supervisor)

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The underlying idea

Idea: Demand curves for financial assets are not horizontal, so changing relative supplies can change term and/or risk premiums.

Rj = r + ρj

• Requires imperfect substitutes or “frictions”

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A taxonomy of QE

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Alter the composition of the central bank’s balance sheet.

Increase the size of the central bank’s balance sheet.

a)Longer-dated government securitiesb)Private-sector securities

Simplified Fed balance sheetASSETS LIABILITIES AND

NET WORTH

Treasury bills CurrencyLess liquid assets Bank Reserves

Loans Treasury deposits

Capital

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Specific strategies To shrink term premiums Buy long-term government bonds...

-- and sell T-bills

-- by creating new bank reserves Relies on imperfect arbitrage across yield curve

(“preferred habitat” theory) Related option: commit to keeping the overnight

rate low for a long time Note: This strategy relies on the expectations

theory.

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Specific strategies To shrink term premiums Buy long-term government bonds...

-- and sell T-bills

-- by creating new bank reserves Relies on imperfect arbitrage across yield curve

(“preferred habitat” theory) Related option: commit to keeping the overnight

rate low for a long time Note: This strategy relies on the expectations

theory.

This man taught me those theories. →

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Specific strategies To shrink term premiums Buy long-term government bonds... -- and sell T-bills -- by creating new bank reserves Relies on imperfect arbitrage across yield curve

(“preferred habitat” theory) Related option: commit to keeping the overnight rate

low for a long time Note: This strategy relies on the expectations theory.

To shrink risk premiums Buy some risky asset… -- and sell the safe asset -- by creating new bank reserves Relies on imperfect substitutability (e.g., preferred

habitat)

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Swapping assets (QE 0)ASSETS LIABILITIES AND

NET WORTHTreasury bills Currency

Less liquid assets Bank Reserves

Loans ↑ Treasury deposits

Capital17

Early QE did not blow up the Fed’s balance sheet…

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…nor increase bank reserves much

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Lehman changed everything

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Lehman changed everything

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Blowing up the balance sheet (QE I)

ASSETS LIABILITIES AND NET WORTH

Treasury securities Currency

Less liquid assets↑ Bank Reserves ↑

Loans ↑ Treasury deposits

Capital22

CP and MBS purchases:Working on risk premiums

Ri = r + ρi

riskless rate

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Did QE I work?

CP vs. T-Bill risk spread Corporate bond vs. T-note risk spread

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Econometric evidence suggests: yes

Blowing up the balance sheet (QE II)

ASSETS LIABILITIES AND NET WORTH

Treasury securities• Bills• Bonds ↑

Currency

Less liquid assets Bank Reserves ↑

Loans Treasury deposits

Capital25

Did QE II work?

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It was supposed to work on term premiums.

They have widened. (see next slide)

Three yield curvesAugust 2010, November 2010, March 2011

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Did QE II work?

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It was supposed to work on term premiums.

They have widened. (see next slide)But perhaps for other reasons: brighter outlook for the economy higher expected inflation worsening outlook for national debt

• Too early for econometric evidence. (But you can guess!)

Questions for research/thinking

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• Which of the six unconventional monetary policies works best, under what circumstances?

• If it’s going to be QE, which kind?

There is a strong a priori casefor using private assets:

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• Treasury market is the broadest, deepest in the world → hardest to move.

• Any other market is thinner → easier to move.

• The substitutability between T-bills and T-bonds must be higher than the substitutability between, say, T-bills and MBS.

Thank you

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