Lots of people have pointed me to an article on the zero bound by Eric Swanson:
According to traditional macroeconomic thinking, once monetary policy hits the zero lower bound, there is nothing more the Committee can do to stimulate the economy – monetary policy is essentially ‘stuck at zero’. A corollary of this observation is that fiscal policy becomes more powerful than in normal times because any stimulus from fiscal policy on output or inflation will not be partially offset by monetary policymakers raising interest rates to keep inflation in check. In other words, monetary policy will not act to ‘crowd out’ fiscal policy because interest rates will remain stuck at zero as long as the economy is weak (see, e.g., Mankiw 2013, Chap. 12).
The role of monetary expectations
More recent research, however, has emphasised how monetary policy expectations can alter this reasoning. Reifschneider and Williams (2000) and Eggertsson and Woodford (2003) show that, if the Federal Committee can credibly commit to future values of the federal funds rate, then it has the power to largely work around the zero lower bound constraint. As these authors point out, the economy depends not just on the current level of the federal funds rate (a one-day interest rate), but rather on the entire path of the expected future federal funds rate over the next several years. Put differently, businesses and households typically look at interest rates with maturities out to several years when making investment and financing decisions. Even if the current federal funds rate is stuck at zero, the Committee could continue to push longer-term interest rates lower by promising to keep the federal funds rate low for an extended period of time. In this way, the Committee could continue to stimulate the economy even when the current federal funds rate is constrained by the zero lower bound.
This line of reasoning suggests that monetary policy has probably not been as constrained by the zero lower bound as the traditional way of thinking would imply. Figure 1 plots the federal funds rate along with the one-, two-, five-, and ten-year Treasury yields. Although the funds rate (solid black line) is essentially zero from December 2008 onward, even the one-year Treasury yield averages close to 0.5% throughout 2009 and 2010, and fluctuates noticeably as the outlook for the economy and monetary policy rose and fell over this period. The two-year Treasury yield is even higher and more volatile. Thus, Figure 1 suggests that monetary policy might not have been very constrained by the zero lower bound until at least mid-2011.
I certainly agree with the primary claim of this article–monetary policy was not very constrained by the zero bound in 2009-10. But it’s disappointing to see someone call the wacky liquidity trap view “traditional macroeconomic thinking.” Perhaps it could be called traditional old Keynesian thinking, but it was certainly a discredited model by the 1980s, if not earlier.
I’m also a bit uncomfortable with focusing on mid-2011, when 1 and 2-year T-bond yields fell close to zero. There is nothing special about that date, because there is nothing special about 1 and 2 year T-bonds. Three-month yields were close to zero throughout 2009 and 2010, and 5-year yields have been well above zero since 2011. Nothing of importance changed in 2011. The Fed always has the ability to adopt monetary stimulus if it chooses to do so, as interest rates are not an important part of the monetary policy transmission mechanism. Of course the Fed ended QE1 and QE2 and QE3 because each time they (wrongly) thought the economy didn’t need any more stimulus.
The paper uses a rather indirect method of trying to ascertain whether monetary policy is constrained. Swanson looks at whether longer-term bond yields are impacted by economic news. But why not look at whether longer-term bond yields are impacted by monetary news? And why pick a highly ambiguous indicator like interest rates? Why not look at whether forex prices and stock prices and TIPS spreads are impacted by monetary news?
Nonetheless, I’m pleased that a distinguished economist like Eric Swanson has concluded that monetary policy was much less constrained than many pundits assumed. At the end of the article, Swanson notes that this implies that crowding out continued to apply after 2008, thus weakening the impact of the ARRA stimulus program. But crowding out assumes a constant money supply, which is obviously unrealistic. In fact, “crowding out” depends almost entirely on the degree of monetary offset. I’d like to see the profession stop talking about the crowding out of aggregate demand and move on to the real issue; how do central banks respond to fiscal initiatives?