Imagine the FOMC had listened to Al Broaddus in 2003

In my recent post on how the central banks of Australia, Poland and Sweden should have a look at Bennett McCallum’s MC rule I briefly mentioned how Richmond fed president Al Broaddus already back in 2003 warned that the Federal Reserve should have a plan for how to conduct monetary policy at the the “Zero Lower Bound”. It was of course Bob Hetzel’s brilliant book on the Great Recession that inspired me. In his book Bob quotes Broaddus’ comments at the June 24-25 2003 FOMC meeting.

Here is Broaddus (my bold):

With respect to our strategy and tactics going forward—trying to apply some of the lessons from history and even looking beyond them—I recognize that we may be able to address further disinflation by inducing significant additional reductions in long-term interest rates whether we explicitly target them or not. That’s what most people seem to be thinking about as the next step. But I’d like to add a new dimension to this discussion because bond rates, like short rates, are also subject to a zero bound at some point, which ultimately would put a limit on this policy channel if disinflation persisted or deflation began to threaten us. So I’d like to talk about what I’ll refer to as the “what next” issue for a couple of minutes. That issue is, How should we think about further monetary stimulus if we get to the point where both long- and short-term interest rate policies essentially have been immobilized?

Now, I agree with a lot of other people—although I’m not sure how many people around the table here—that the odds we will face this situation are small and may be exceedingly small. Because of that, it’s tempting to conclude that we have plenty of time and really don’t need to think about this or discuss it yet. In other words, we’ll cross that bridge when we get to it. But I would argue that it’s not only useful but actually urgent that we think about these kinds of options now. I’m building on the point you were making, Cathy, because confronting deflation just like confronting inflation involves a credibility problem. That’s the essence of it for me. Moreover, unlike inflation, the credibility problem in dealing with deflation is compounded by the zero bound on nominal interest rates. That raises at least the possibility that interest rate policy alone can’t deter deflation even if we’re willing to drive both short- and long-term interest rates to zero.

In the current situation—I’m not going to talk about current policy but use that as a framework in this situation—if the funds rate were to get closer to zero, the possibility of deflation has the potential to create deflation expectations and actual deflation simply because people may doubt that we can and will use monetary policy to combat deflation effectively at the zero bound. My concern is that waiting to say or think about how we would deliver further monetary stimulus if rates were to fall to zero could in some circumstances lead the public to conclude that we can’t do it.If people think we can’t deliver, that would risk creating a credibility deficit that could make it much more difficult to deal with this situation if in fact it arises and we try to use different types of policies to deal with it. So that’s why I think it’s essential that we begin to talk about this and consider it now. I’m not talking about developing a detailed strategy but at least putting something on the table.

Let me quickly recapitulate the key points I’ve tried to make here. The first is that, until we work through this “what next” scenario and communicate a credible strategy, addressing it to the public at some point, I think our contingency plans for confronting deflation will be incomplete. In my view, that would be a serious omission. We do a lot of contingency planning at the Fed, and I believe we should do some comprehensive contingency planning on this kind of scenario even if its probability is low. And I would say the sooner the better. We don’t have a stash of credibility as deflation fighters yet. If we delay thinking about and developing a strategy for dealing with further disinflation and it continues—and especially if it accelerates—we could wind up with a sizable credibility deficit.That could make it very difficult for us to employ successfully any strategy that we might be forced to come up with in this kind of situation. So I would just put that view on the table, too.

Today we can only imagine how the world would have looked if the FOMC had listened to Broaddus’ suggestions and put in place “contingency planning” to avoid crisis if the fed funds rate hit the zero lower bound. The FOMC unfortunately failed to do so – and so did the ECB, the Bank of England, the Bank of Japan and basically every single central bank in the world – maybe with the exception of the Monetary Authority in Singapore.

However, it is not to late for other central banks in the world to put in place contingency plans to “automatically prevent” disaster at the zero lower bound. Are you listening in Stockholm, Warsaw and Sydney? In Prague? (I have given up on Frankfurt…)

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Sweden, Poland and Australia should have a look at McCallum’s MC rule

Sweden, Poland and Australia all managed the shock from the outbreak of Great Recession quite well and all three countries recovered relatively fast from the initial shock. That meant that nominal GDP nearly was brought back to the pre-crisis trend in all three countries and as a result financial distress and debt problems were to a large extent avoided.

As I have earlier discussed on my post on Australian monetary policy there is basically three reasons for the success of monetary policy in the three countries (very broadly speaking!):

1)     Interest rates were initially high so the central banks of Sweden, Poland and Australia could cut rates without hitting the zero lower bound (Sweden, however, came very close).

2)     The demand for the countries’ currencies collapsed in response to the crisis, which effectively led to “automatic” monetary easing. In the case of Sweden the Riksbank even seemed to welcome the collapse of the krona.

3)     The central banks in the three countries chose to interpret their inflation targeting mandates in a “flexible” fashion and disregarded any short-term inflationary impact of weaker currencies.

However, recently the story for the three economies have become somewhat less rosy and there has been a visible slowdown in growth in Poland, Sweden and Australia. As a consequence all three central banks are back to cutting interest rates after increasing rates in 2009/10-11 – and paradoxically enough the slowdown in all three countries seems to have been exacerbated by the reluctance of the three central banks to re-start cutting interest rates.

This time around, however, the “rate cutting cycle” has been initiated from a lower “peak” than was the case in 2008 and as a consequence we are once heading for “new lows” on the key policy rates in all three countries. In fact in Australia we are now back to the lowest level of 2009 (3%) and in Sweden the key policy rate is down to 1.25%. So even though rates are higher than the lowest of 2009 (0.25%) in Sweden another major negative shock – for example another escalation of the euro crisis – would effectively push the Swedish key policy rate down to the “zero lower bound” – particularly if the demand for Swedish krona would increase in response to such a shock.

Market Monetarists – like traditional monetarists – of course long have argued that “interest rate targeting” is a terribly bad monetary instrument, but it nonetheless remains the preferred policy instrument of most central banks in the world. Scott Sumner has suggested that central banks instead should use NGDP futures in the conduct of monetary policy and I have in numerous blog posts suggested that central banks in small open economies instead of interest rates could use the currency rate as a policy instrument (not as a target!). See for example my recent post on Singapore’s monetary policy regime.

Bennett McCallum has greatly influenced my thinking on monetary policy and particularly my thinking on using the exchange rate as a policy instrument and I would certainly suggest that policy makers should take a look at especially McCallum’s research on the conduct of monetary policy when interest rates are close to the “zero lower bound”.

In McCallum’s 2005 paper “A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap? he discusses a new policy rule that could be highly relevant for the central banks in Sweden, Poland and Australia – and for matter a number of other central banks that risk hitting the zero lower bound in the event of a new negative demand shock (and of course for those who have ALREADY hit the zero lower bound as for example the Czech central bank).

What McCallum suggests is basically that central banks should continue to use interest rates as the key policy instruments, but also that the central bank should announce that if interest rates needs to be lowered below zero then it will automatically switch to a Singaporean style regime, where the central bank will communicate monetary easing and tightening by announcing appreciating/depreciating paths for the country’s exchange rate.

McCallum terms this rule the MC rule. The reason McCallum uses this term is obviously the resemblance of his rule to a Monetary Conditions Index, where monetary conditions are expressed as an index of interest rates and the exchange rate. The thinking behind McCallum’s MC rule, however, is very different from a traditional Monetary Conditions index.

McCallum basically express MC in the following way:

(1) MC=(1-Θ)R+Θ(-Δs)

Where R is the central bank’s key policy rate and Δs is the change in the nominal exchange rate over a certain period. A positive (negative) value for Δs means a depreciation (an appreciation) of the country’s currency. Θ is a weight between 0 and 1.

Hence, the monetary policy instrument is expressed as a weighted average of the key policy rate and the change in the nominal exchange.

It is easy to see that if interest rates hits zero (R=0) then monetary policy will only be expressed as changes in the exchange rate MC=Θ(-Δs).

While McCallum formulate the MC as a linear combination of interest rates and the exchange rate we could also formulate it as a digital rule where the central bank switches between using interest rates and exchange rates dependent on the level of interest rates so that when interest rates are at “normal” levels (well above zero) monetary policy will be communicated in terms if interest rates changes, but when we get near zero the central bank will announce that it will switch to communicating in changes in the nominal exchange rate.

It should be noted that the purpose of the rule is not to improve “competitiveness”, but rather to expand the money base via buying foreign currency to achieve a certain nominal target such as an inflation target or an NGDP level target. Therefore we could also formulate the rule for example in terms of commodity prices (that would basically be Irving Fisher’s Compensated dollar standard) or for that matter stock prices (See my earlier post on how to use stock prices as a monetary policy instrument here). That is not really important. The point is that monetary policy is far from impotent. There might be a Zero Lower Bound, but there is no liquidity trap. In the monetary policy debate the two are mistakenly often believed to be the same thing. As McCallum expresses it:

It would be better, I suggest, to use the term “zero lower bound situation,” rather than “liquidity trap,” since the latter seems to imply a priori that there is no available mechanism for generating monetary policy stimulus”

Implementing a MC rule would be easy, but very effective

So central banks are far from “out of ammunition” when they hit the zero lower bound and as McCallum demonstrates the central bank can just switch to managing the exchange rates when that happens. In the “real world” the central banks could of course announce they will be using a MC style instrument to communicate monetary policy. However, this would mean that central banks would have to change their present operational framework and the experience over the past four years have clearly demonstrated that most central banks around the world have a very hard time changing bad habits even when the consequence of this conservatism is stagnation, deflationary pressures, debt crisis and financial distress.

I would therefore suggest a less radical idea, but nonetheless an idea that essentially would be the same as the MC rule. My suggestion would be that for example the Swedish Riksbank or the Polish central bank (NBP) should continue to communicate monetary policy in terms of changes in the interest rates, but also announce that if interest rates where to drop below for example 1% then the central bank would switch to communicating monetary policy changes in terms of projected changes in the exchange rate in the exact same fashion as the Monetary Authorities are doing it in Singapore.

You might object that in for example in Poland the key policy rate is still way above zero so why worry now? Yes, that is true, but the experience over the last four years shows that when you hit the zero lower bound and there is no pre-prepared operational framework in place then it is much harder to come up with away around the problem. Furthermore, by announcing such a rule the risk that it will have to “kick in” is in fact greatly reduced – as the exchange rate automatically would start to weaken as interest rates get closer to zero.

Imagine for example that the US had had such a rule in place in 2008. As the initial shock hit the Federal Reserve was able to cut rates but as fed funds rates came closer to zero the investors realized that there was an operational (!) limit to the amount of monetary easing the fed could do and the dollar then started to strengthen dramatically. However, had the fed had in place a rule that would have led to an “automatic” switch to a Singapore style policy as interest rates dropped close to zero then the markets would have realized that in advance and there wouldn’t had been any market fears that the Fed would not ease monetary policy further. As a consequence the massive strengthening of the dollar we saw would very likely have been avoided and there would probably never had been a Great Recession.

The problem was not that the fed was not willing to ease monetary policy, but that it operationally was unable to do so initially. Tragically Al Broaddus president of the Richmond Federal Reserve already back in 2003 (See Bob Hetzel’s “Great Recession – Market Failure or Policy Failure?” page 301) had suggested the Federal Reserve should pre-announce what policy instrument(s) should be used in the event that interest rates hit zero. The suggestion tragically was ignored and we now know the consequence of this blunder.

The Swedish Riksbank, the Polish central bank and the Australian Reserve Bank could all avoid repeating the fed’s blunder by already today announcing a MC style. That would lead to an “automatic prevention of the liquidity trap”.

PS it should be noted that this post is not meant as a discussion about what the central bank ultimately should target, but rather about what instruments to use to hit the given target. McCallum in his 2005 paper expresses his MC as a Taylor style rule, but one could obviously also think of a MC rule that is used to implement for example a price level target or even better an NGDP level rule and McCallum obviously is one of the founding father of NGDP targeting (I have earlier called McCallum the grandfather of Market Monetarism).

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