The impotence of monetary policy

The Federal Reserve has released its latest statement on the state of the US economy.Its Chairman Ben Bernanke has now spoken to the press as well. The overall assessment was rather downbeat.

(video below)

Monetary Policy’s Impotence

If you compare the Fed statement to its previous one, you will understand the Fed has downgraded the economy’s outlook. And indeed its economic projections shade lower. The Economist’s Greg Ip asked Mr. Bernanke, why the Fed had lowered its medium-term outlook if the impediments to continued growth were temporary as the Fed had indicated in its statement. Here is what Mr. Bernanke said in response:

Part of the slowdown is temporary, and part of it may be longer-lasting. We do believe that growth is going to pick up going into 2012 but at a somewhat slower pace than we had anticipated in April. We don’t have a precise read on why this slower pace of growth is persisting. [S]ome of the headwinds that have been concerning us, like … weakness in the financial sector, problems in the housing sector, balance sheets and deleveraging issues…may be stronger or more persistent than we thought. And I think it’s an appropriate balance to attribute a slowdown partly to the identifiable temporary factors, but to acknowledge a possibility that some of the slowdown is due to factors which are longer-lived and which will be still operative by next year.

Now remember, since the Panic of 2008, the Fed has brought its policy rate down to zero. It has taken on all sorts of lower-quality assets as collateral for loans at effectively zero percent interest. And the Federal Reserve has more than tripled it balance sheet. Just looking at this objectively, it is an extraordinary amount of monetary liquidity. Yet the economy remains weak. What’s going on?

The Balance Sheet Recession

Nomura’s Chief Economist Richard Koo wrote a book last year called “The Holy Grail of Macroeconomics” which introduced the concept of a balance sheet recession, which explains economic behaviour in the United States during the Great Depression and Japan during its Lost Decade. He explains the factor connecting those two episodes was a consistent desire of economic agents (in this case, businesses) to reduce debt even in the face of massive monetary accommodation.

When debt levels are enormous, as they are right now in the United States, an economic downturn becomes existential for a great many forcing people to reduce debt. Recession lowers asset prices (think houses and shares) while the debt used to buy those assets remains. Because the debt levels are so high, suddenly everyone is over-indebted. Many are technically insolvent, their assets now worth less than their debts. And the three D’s come into play: a downturn leads to debt deflation, deleveraging, and ultimately depression. The D-Process is what truly separates depression from recession and why I have said we are living through a depression with a small ‘d’ right now.

Secular inflation will be non-existent

Therefore, the problem is a lack of demand for loans not a lack of supply. The Federal Reserve can print all the money it wants. But, if there is little demand for more indebtedness, it is not going to have the desired effect of permanently reflating the economy – although it can create bubbles.

The corollary of this is that inflation will be non-existent on a secular basis. For the increase in liquidity to feed into consumer price inflation, people have to actually buy more stuff. And that’s not what happens in a balance sheet recession because people are concentrated on reducing debt and increasing savings.

–Weak consumer spending will last for years, Aug 2009

For his part, the father of the Balance Sheet Recession theorem Richard Koo says QE2 drove speculation, but what about the real economy? His view is that monetary policy can aid speculative sentiment with residual feed through into the real economy but that it is largely impotent in a balance sheet recession. Only fiscal policy will have any measurable impact in driving the underlying demand side factors holding the economy back.

I believe Ben Bernanke senses this as well. I have noted this in the past at Credit Writedowns. Mr. Bernanke’s comment that “I’m a little bit more sympathetic to central bankers now than I was 10 years ago” underlines this.

Inflation Targets

It’s interesting to look back to that period, at the Japanese experiment with quantitative easing early in the prior decade after its policy rate fell to zero. At the time, a lot of foreign monetary policy experts were advising the Bank of Japan to do more.

For example, Ben Bernanke, now the Chairman of the Federal Reserve, remarked in a 2003 speech:

As you may know, I have advocated explicit inflation targets, or at least a quantitative definition of price stability, for other leading central banks, including the Federal Reserve. A quantitative inflation target or range has been shown in many countries to be a valuable tool for communication. By clarifying the objectives of the central bank, an explicit inflation target can help to focus and anchor inflation expectations, reduce uncertainty in financial markets, and add structure to the policy framework. For Japan, given the recent history of costly deflation, however, an inflation target may not go far enough. A better strategy for Japanese monetary policy might be a publicly announced, gradually rising price-level target.

What I have in mind is that the Bank of Japan would announce its intention to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred.

–Some Thoughts on Monetary Policy in Japan, Remarks by Governor Ben S. Bernanke Before the Japan Society of Monetary Economics, Tokyo, Japan, May 31, 2003

So what was Mr. Bernanke saying there? He was saying that an explicit inflation target would not necessarily be used only to limit consumer price inflation, but rather to target consumer inflation. In a deflationary environment, that would mean the Fed would use unconventional means like quantitative easing or interest-rate caps to create inflation. When the inflation target overshoots, the Fed would use conventional means like open market operations combined with increases the target Fed Funds rate to create disinflation.

Add inflation targets to interest rate caps and municipal bond purchases as policy tools the Fed will consider using in future.

My conclusion from reading Mr. Bernanke’s prior statements and his most recent ones is that he wishes fiscal agents would take the lead. But he has accepted this will not happen because of the political environment. Reluctantly then, he is going to have the Fed assume the stimulative role. Yet, here again, the same political forces which constrain fiscal policy are at work. And that means Bernanke will only resort to unconventional policy when the economy deteriorates significantly.

For my part, I am with Richard Koo. Monetary policy reflation will not work in a balance sheet recession when fiscal policy is contractionary. But at some point, the Fed will be compelled to act anyway.

Source: Serial disappointment, Greg Ip, The Economist