Hanging Out at the Lower Bound

(Also posted at The Voice)

After three weeks of math brush-up courses and a week of fall term, it is nice to know we can "start" the year here at BGSE. While cava and food were incentives to attend, there was another reason. Professor Otmar Issing, President of the Center for Financial Studies and former member of the Executive Board of the European Central Bank, was giving the opening lecture on monetary policy. While there are about as many opinions about monetary policy as people, Otmar Issing has the academic and policy credentials to deserve a serious listen. He isn´t some no name student on a blog.

Life at the Lower Bound

It is not easy being a central banker, especially at the zero lower bound (ZLB). The models used for the last 80 years (arguably) lose their relevance once the rates central banks directly control drop any more. Instead, central banks (specifically the Federal Reserve System of the United States) choose unorthodox policies, such as quantitative easing and forward guidance.

Professor Issing correctly warns of the inherent problems of unorthodox policies. Central banks are breaking new ground and, as with anything new and exciting, it is impossible to know the full risks. The known risks are scary enough.

Quantitative easing, through direct purchases of assets, is bound to have a distributive affect as Professor Issing notes. If the Federal Reserve is purchasing mortgage-backed securities, this will inevitably direct real assets and liquidity into this market. This could be good or bad, but clearly central banks directly impact specific markets and firms more than traditional interest rate manipulation.

Another unorthodox policy that Professor Issing addresses is so-called "forward guidance." The Federal Reserve attempts to lower long-term interest rates by assuring the public it will continue to force rates down in the future. Since short-term rates cannot fall any more at the ZLB, forward guidance intends to encourage more investment and close the "output gap." It hopes to make longer term investment "cheaper." Therefore, investments, specifically long-term investments, will be undertaken which would not be profitable without this intervention by the Federal Reserve. This is a concern with artificially low rates in general and especially for artificially low long-term rates.

Improved Models in this Difficult Time

Central banks find themselves in a very difficult spot. They are at the ZLB, but think that the economy still needs "stimulus." How does it know how much to simulate and when to stop, or at least slow down? It is the question that keeps central bankers up at night. Issing does not believe that GDP or inflation targeting is possible or will give correct guidance to central bankers. Central banks cannot target real variables, only nominal. Professor Issing suggests something easy to say, but hard to do.

By incorporating money and credit into economic models, Professor Issing argues that banks can have a better understanding of the nature of the data.

Monetary developments are a kind of summary indicator of asset price development. A thorough analysis of monetary aggregates considering also e.g. the old concept of inside versus outside money can deliver valuable information on risks emerging in the banking sector. Money and credit – more than real variables – contain information for signaling asset price booms which later might turn out to become very costly. Hence, a central bank which integrates the analysis of monetary developments into its strategy will have a compass for how to deliver its best contribution to preserving financial stability, too.1

Professor Issing seems hopeful that concern for money and credit in models can help central bankers respond to the problems addressed earlier. He makes one.

1. For more on Professor Otmar Issing´s speech, check out his paper on the same subject.

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