Zero Lower Bound Denial

There is a great deal in Mike Woodford’s Jackson Hole paper. What was new to me was his comprehensive discussion of Quantitative Easing (QE). I hope I’m being objective in reading his account as being very sceptical of what QE can do, if it is not signalling intentions about future interest rate policy. The meat here is in the discussion of portfolio balance effects in section 3, but this paragraph from the conclusion is worth quoting in full.

“Central bankers confronting the problem of the interest-rate lower bound have tended to be especially attracted to proposals that offer the prospect of additional monetary stimulus while (i) not requiring the central bank to commit itself with regard to future policy decisions, and (ii) purporting to alter general financial conditions in a way that should affect all parts of the economy relatively uniformly, so that the central bank can avoid involving itself in decisions about the allocation of credit. Unfortunately, the belief that methods exist that can be effective while satisfying these two desiderata seems to depend to a great extent on wishful thinking.”

While I believe macroeconomists practicing demand denial represent a minority (albeit still a distressingly important minority), I think what I might call Zero Lower Bound (ZLB) denial is far more prevalent. What I mean by this is a belief that somehow monetary policy alone can overcome the problem of the ZLB. It is in many ways a perfectly understandable belief, reflecting what I have called the consensus assignment developed and implemented during the Great Moderation, which was (rightly) seen as an advance on the bad old days where fiscal policy was routinely used for demand stabilisation. Nevertheless the belief is incorrect, and damaging.

It is incorrect for two reasons. The first is summed up in the quote above. Monetary policy that involves temporarily creating money to buy financial assets is of an order less effective and reliable than conventional monetary policy, or fiscal policy. The second is not addressed in Mike’s paper, but is just as important. Even if you follow the Krugman/Woodford idea of using commitments about future interest rate setting to mitigate the recession today (which is equivalent to permanently creating more money), this does not mean that you can forget about fiscal policy. To put it another way, fiscal policy would still be a vital stabilisation tool at the ZLB even if the central bank targeted nominal GDP (NGDP). It is reluctance to accept this last point which is a particular characteristic of ZLB denial.

I have elaborated on this second point before, but let me sketch the reasoning in a different way. Suppose we only think about demand shocks, and suppose the central bank is all powerful and prescient, so absent the ZLB any demand shock can be completely offset through monetary policy. Inflation and output are related through a Phillips curve with no cost-push shocks, so keeping output at its natural rate keeps inflation on track, and NGDP on track. What the central bank actually targets does not matter here, because inflation, output, price level or NGDP targeting would all be perfectly successful in terms of desired levels of output and inflation.

Now suppose we have a large negative demand shock so that we hit the ZLB. We will hit the ZLB whether we have an inflation target or NGDP target. In both cases output falls below the natural rate and current inflation is too low (below its desired level). We will miss today’s NGDP target. What the NGDP target tomorrow does is reduce the impact of the shock on current output and inflation, because inflation that is too low today means the central bank will aim for inflation and output above their normally desired levels tomorrow (to hit the NGDP target tomorrow), which supports output today through expectations effects.[1]  

We can now make two key points. First, the ZLB still matters. NGDP targets help reduce (but not eliminate) the cost of the ZLB today, but only by incurring costs in the future. Second, fiscal policy could in principle eliminate all of these costs. A fiscal stimulus today could eliminate the ZLB constraint, allowing desired output and inflation to be achieved today and tomorrow. Equally, fiscal austerity today moves inflation and output further away from desired levels both today and tomorrow, even if we have NGDP targets.

This is why I keep irritating some by going on about fiscal policy when commenting on the current conjuncture. Apart from a few academic caveats, I’m a fully paid up member of the ‘monetary policy is all you need’ club outside of a potential ZLB or monetary union.  My views on monetary policy targets are very similar to, and have been heavily influenced by, those of Michael Woodford. But the ZLB does make a difference. It is a feature of the real world, not a consequence of any particular monetary policy strategy. ZLB denial, particularly in the hands of independent central banks, leads not just to wishful thinking, but encourages governments to make bad fiscal policy decisions.

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[1] Having a NGDP target tomorrow only becomes useful (and different from an inflation target) if we miss the NGDP target today. We could eliminate the ZLB constraint today by having a much more expansionary monetary policy tomorrow (which exceeded any NGDP target), but that has greater costs tomorrow (and is also less credible today).