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Staying unconventional

2014-03-27 06:59:55

New research suggests central bankers should be bolder and more innovative

Mar 22nd 2014 | From the print edition

AFTER half a decade of bucking convention, the Federal Reserve is settling into

more familiar routines. The central bank announced on March 19th that monthly

bond purchases under its quantitative easing (QE) programme will be cut by $10

billion to $55 billion, starting in April. For many in the staid world of

central banking it will be a relief: QE and other unconventional polices used

when interest rates hit rock bottom in December 2008 have always been

controversial. Yet a new set of papers released on March 20th at the Brookings

Institution, a think-tank (and now home to the Federal Reserve s previous

chairman, Ben Bernanke), give a different view. Taken together, they suggest a

return to monetary normality may be coming too soon.

Jitters about market bubbles are one reason the Federal Reserve is dialling

down its bond buying. A new study by Gabriel Chodorow-Reich of Harvard

University shows that since 2013 Federal Reserve committee members, including

Mr Bernanke, have cited concerns over increased financial-sector risk-taking as

a reason to mute QE. Their anxiety is understandable: central bankers are still

scarred by the lessons of the mid-2000s when banks searched for yield amid

low interest rates, financing riskier projects and pumping up leverage to

improve profits. After five years of shedding risk since the crisis that

followed, some fret they could flip back into risk-seeking mode.

But those worries wither under closer scrutiny, as Mr Chodorow-Reich shows. He

starts his hunt for a link between QE and risk with banks and life insurers,

examining market reactions to 14 Federal Reserve policy announcements between

2008 and 2013. Using minute-by-minute data, and isolating small windows either

side of each statement, Mr Chodorow-Reich measures market perceptions of risk.

He finds that QE extensions are associated with a drop in the costs of default

insurance that protects against a bank or insurer going bust. Markets, then,

are not worried about QE, even if the central bank is.

Money-market funds (MMFs) are another worry. These firms collect deposits,

investing the cash in short-term liquid assets such as Treasury bills. But the

returns on these assets tend to track central-bank rates they are so low that

the MMFs service charges might outweigh their customers gain. The concern is

that MMFs might switch into riskier assets to lift returns and justify their

fees. But an examination of over 500 MMFs shows they are taking a safer option,

cutting their fees rather than increasing risk in an effort to maintain them.

An analysis of balance-sheet data of over 4,000 pension funds concurs: despite

extended QE and low interest rates, there is no sign of a dangerous search for

yield.

And bold monetary policy has a big upside, suggests a new paper on Japan s

Abenomics by Joshua Hausman of the University of Michigan and Johannes Wieland

of the University of California, San Diego. Japan s monetary boost is huge,

including a new 2% inflation target, unlimited asset purchases and a doubling

of the money supply. Many worried, however, that it would not work. Japan s

slump is decades old and QE had already been tried. Between 2001 and 2006 the

Bank of Japan boosted the cash that lenders held from 5 trillion ($46 billion)

to almost 35 trillion using QE. Yet not much happened. Although inflation

nudged above zero, policymakers increased rates too soon. By the time Shinzo

Abe took office in December 2012 prices were falling by 0.1% a year and the

economy was drifting sideways.

But Abenomics has lifted Japan s GDP by up to 1.7%, according to Messrs Hausman

and Wieland: up to a percentage point of that may be due to monetary policy.

The market effects are clear: stock indices jumped and the exchange rate

depreciated sharply when the policy was announced (see left-hand chart). The

effects on broad money, which rises with bank lending, have been much stronger

than with previous QE attempts (see right-hand chart).

Inflation expectations explain the difference. Abenomics was announced not as a

temporary boost but a permanent change in policy. People quickly anticipated

that prices would begin rising by 2% a year, instead of remaining flat.

Long-run inflation predictions have risen too. This means borrowing looks more

manageable and gives shoppers confidence to spend more. Nonetheless, Japan s

economy remains weak. Reinforcing the commitment to monetary boldness would

give it a boost, the researchers say.

Moving the target

There are even more radical options. Kevin Sheedy of the London School of

Economics reckons that gains may be made from replacing an inflation target

with a nominal-GDP (NGDP) target. Typically central banks focus on inflation as

this helps stabilise the value of pay, which might otherwise be eroded by

rising prices. But wages are not the only rigid contracts workers face their

debts are fixed too. This means that a GDP shock which lowers incomes can cause

a big jump in their debt burden.

A central bank focused on NGDP would help, Mr Sheedy argues. Take a supply

shock, which tends to lower GDP without causing prices to fall. A central bank

focused on prices might not respond at all due to the absence of inflation. An

NGDP targeter would be bolder, stimulating the economy to generate inflation

and keep the value of debt and GDP aligned. Hard-wiring a shift like this into

the monetary system will take a lot of persuasion. But household debt-to-income

ratios were much lower when inflation targeting was set up in the early 1990s.

In today s high-debt world, an NGDP target looks more attractive.

How influential these studies will be remains to be seen. With central banks so

far from normal monetary policy, new academic insights have recently tended

to have a bigger impact than in more ordinary times. And this trio of papers by

quelling fears over QE s downsides, praising Japan s monetary expansion and

providing new arguments in favour of targeting nominal GDP make a clear case

for bold thinking and big action. Conservative central bankers, take note.