The Slippery Slope of a Higher Inflation Target

With inflation significantly above target in most advanced economies, there are renewed calls for central banks to raise their targets from 2% to 3% or 4%, in order to limit the prospective costs of disinflation. In this post, we review the benefits and costs of a higher inflation target.

Yet, regardless of the balance between the costs and benefits of raising the inflation target, our view is that central banks ought not be able to choose their inflation targets. The key problem with such discretion is the slippery slope. If households and firms come to expect that a central bank will opportunistically raise its inflation target to avoid the economic sacrifice associated with disinflation, inflation expectations will no longer be anchored at the target (whatever it is).

To limit the “inflation expectations ratchet”—avoiding perceptions of opportunistic central bank discretion— the Federal Reserve should follow an approach that it now employs regarding the possible introduction of a central bank digital currency: namely, the Fed should announce that it will not alter its inflation target without the explicit support of both the legislative and executive branches, ideally in the form of legislation….

Central Banks' New Frontier: Interventions in Securities Markets

In his 2016 book The End of Alchemy, our friend and former Bank of England Governor Mervyn King provided a template for financial reform aimed at reducing the frequency and severity of crises. At the time, we were very cautious for two reasons. First, we believed that adoption of King’s framework would vastly increase the influence of central banks on private financial markets, something that could ultimately lead to a misallocation of resources in the economy and to a diminution of the independence of monetary policy that is necessary for securing price stability. Second, we doubted that most central banks had the technical capacity to implement the proposal.

Well, the landscape has changed significantly. During the pandemic, central banks intervened massively in private securities markets and there now appears to be no turning back. In a number of jurisdictions, monetary policymakers broadened the scale and scope of their lending and intervened directly in financial markets, going significantly beyond even their extraordinary actions during the 2007-09 financial crisis. As a result, we likely will be paying the costs that we feared could accompany the implementation of King’s proposal, so we might as well reap the benefits.

In this post, we discuss central banks’ pandemic interventions and the type of infrastructure needed to support them. We then review King’s proposal, highlighting how adopting his approach would make the financial system safer, while radically simplifying the role of regulators and supervisors ….

Comments on Fed CBDC Paper

Last month, the Federal Reserve issued a long-awaited discussion paper on the possibility of introducing a central bank digital currency (CBDC) for retail use. The Fed paper calls for comments on the benefits and risk of introducing a U.S. CBDC, as well as on its optimal design. In this post, we respond to each of the 22 questions posed in the discussion paper. For the most part, these responses are based on our previous analyses of CBDC (here and here).

At the outset, we highlight our doubt that the benefits of a U.S. CBDC will exceed the risks. In our view, other, less risky, means are available to achieve all the key benefits that CBDC advocates anticipate. Moreover, we are not aware of sustainable design features that would reduce the risks of financial instability that many analysts agree will accompany the introduction of a digital U.S. dollar.

However, this overall judgment regarding a CBDC’s benefits and risks is sensitive to two considerations that appear in the Fed’s analysis either explicitly or implicitly. First, CBDC may be a less risky alternative to stablecoins, should regulation of the latter prove politically infeasible (see our earlier post). Second, if other highly trustworthy financial jurisdictions (with convertible currencies, credible property rights protections, and free cross-border flow of capital) offer their own CBDC, the case for a U.S. CBDC—as a device to sustain widespread use of the dollar—would become stronger.

Against this background, we applaud the Fed’s conservative approach. Most important, the U.S. authorities are not rushing to act. Instead, they are thinking carefully about the design elements, are actively engaged in public outreach, and have committed not to proceed without first securing broad public support….

Central Banks and Climate Policy

Avoiding a climate catastrophe requires an urgent global effort on the part of households, firms and governments to reduce our reliance on fossil fuels. Like many economists, we support a carbon tax. We also favor generous fiscal support for R&D to substitute for fossil fuels and remove carbon from the atmosphere.

What role should central banks play in this global effort? That is the prime focus of this post. We argue that central banks must preserve the independence needed for effective monetary policy. That implies only a modest role in addressing climate change.

Central banks are involved in both financial regulation and monetary policy. In each case, there are some things that central bankers can and should do to help counter the threat posed by climate change. As financial regulators, they should implement an improved disclosure regime and develop tools to ensure the financial system is resilient to climate risks.

In conducting monetary policy, central bankers should follow a simple, powerful principle: do not influence relative prices. To be sure, it is and should be standard practice to use interest rates to influence relative prices between consumption today and tomorrow. However, central banks ought not influence relative prices among contemporaneous activities. We will see that achieving this form of relative price neutrality may require central bankers to shift the composition of their assets and to alter the treatment of collateral in their lending operations….

The QE Ratchet

When it comes to quantitative easing (QE), where you stand definitely depends on where you sit. That is among the conclusions of the important new report of the Economic Affairs Committee of the UK House of Lords.

The report provides an excellent survey of how it is that central banks now use their balance sheets. Its key conclusions are the following. First, central bankers should clearly communicate the rationale for their balance sheet actions, stating what they are doing and why. Second, policymakers should provide more detail on their estimates (and uncertainties) of the effectiveness of their various actions, especially QE. Third, they should be aware that the relationship between central bank balance sheet policy and government debt management policy poses a risk to independence. Finally, and most importantly, central bankers need an exit plan for how they will return to a long-run sustainable level for their balance sheet.

We discussed several of these points in prior posts. On communication, we argued that central bankers should be clear about their reaction function for both interest rate and balance sheet policies (see here). On the justification for policymakers’ actions, we emphasized the need for clear, simple explanations tied to policymakers’ objectives, distinguishing carefully between the intended purposes (such as monetary policy, lender/market maker of last resort, or emergency government finance; see here). And, on the relationship between QE and fiscal finance, we noted how the ballooning of the U.S. Treasury’s balance at the Fed in the early stages of the pandemic looked like monetary finance, putting independence at risk (see here).

In this post, we turn to the challenge that Lord King highlights in the opening quote: the need to ensure that central banks do not see bond purchases as a cure-all for every ill that befalls the economy and the financial system, causing their balance sheets repeatedly to ratchet upward….

Limiting Central Banking

Since 2007, and especially over the past year, actions of public officials have blurred the lines between monetary and fiscal policy almost beyond recognition. Central banks have expanded both the scope and scale of their interventions in unprecedented fashion. This fiscalization risks central bank independence, thereby weakening policymakers’ ability to deliver on their mandates for price and financial stability. In our view, to find a way to back to the pre-2008 division of responsibilities, officials must establish clearer limits on what central banks can and cannot do.

In that division of official labor, it is fiscal authorities that ought to make the unavoidably political choices that directly influence resource allocation. And governments should not conceal such fiscal actions on the balance sheet of the central bank. In a democracy, doing so lacks legitimacy and would become unsustainable….

The Case of the Treasury Account at the Federal Reserve

Details of central bank balance sheets once were reserved for people who have a taste for policy minutiae. In fact, until 2008, monetary policy was entirely about interest rates, with quantities adjusting to meet the desired target. But, once interest rates neared their effective lower bound, things changed. When central banks introduced large-scale asset purchases, attention shifted to the overall size and composition of the balance sheet.

While it is surely important to consider the Federal Reserve’s securities holdings and lending, its liabilities are important as well. Here, analysts tend to focus on one of two things: some look at the path of commercial bank reserves, while others add currency in circulation to focus on the monetary base.

Rarely, however, does anyone (including us) look at the size of the U.S. Treasury account. In this post, we explain why we believe it is now quite important….

Helicopters to the Rescue?

Is helicopter money here? Do we need it now? Is it coming? The short answer to these questions is that it is not here and we currently do not need it, but should the economic disaster brought on by COVID-19 continue for much longer, that might change.

To be clear, the relief checks that governments are sending out to households and businesses are not helicopter money. Despite their enormous scale, the financing of these transfers is no different in character from that of traditional government benefits: governments are collecting taxes and issuing debt to the public.

Helicopter money is when the central bank finances government expenditure directly. In these circumstances, the fiscal authority, through its debt management policies, controls the size of the central bank’s balance sheet. This is monetary finance arising from fiscal dominance: to increase seignorage, the fiscal authority usurps the role of the independent central bank in determining the size of base money (currency plus reserves held by banks at the central bank).

Should monetary policymakers consider surrendering their independence in this way? In our view, a far better alternative is to peg the long-term interest rate at zero. Currently in use by the Bank of Japan, this policy of yield curve control allows central banks to retain a small, but significant degree of monetary control. It also captures the features of U.S. monetary policy from 1937 to 1951, when the Fed capped the long-term bond yield to support U.S. wartime finance (see here)….

Inflation is not (and should not be) a key worry today

A very simple version of 1960s monetarism has two elements. First, controlling money growth is necessary and sufficient to control inflation. Second, leaving aside a financial crisis, the monetary base―the sum of currency in circulation and commercial bank deposits at the central bank―determines the quantity of money. Putting those together means that, in order to control inflation, all central bankers need to do is ensure that their liabilities grow at the appropriate rate. Conversely, when the central bank’s balance sheet grows quickly, inflation inevitably follows.

This simple monetarist reasoning was still on display in 2010, when Ben Bernanke received this letter from a group of 24 economists warning against further large-scale asset purchases by the Fed. At that stage, the central bank’s assets exceeded 250% of their level in September 2008. Over just over two years, the Fed had purchased roughly $400 billion in Treasury securities and $1 trillion in federally guaranteed mortgage-backed securities. But, as Bernanke explained at the time, the purpose of these asset purchases was to aid the economy in recovering from the crisis-induced recession. Moreover, in contrast to prior norms, since October 2008 the Fed had been paying interest on reserves, raising the opportunity cost for banks to lend.

Subsequent experience proved the letter writers very wrong. The Fed’s balance sheet continued to grow, peaking at $4.5 trillion in early 2015. And, over the decade just ended, inflation (measured by the Fed’s preferred consumption expenditures price index) averaged 1.6%―below the central bank’s long-run goal of 2%. If anything, in recent years, and despite massive central bank balance sheet expansions, inflation both in the United States and in other advanced economies has been too low, not too high.

With central bank balance sheets now surging again, we recount this history in the hopes of blunting any inflation concerns, which we see as profoundly misguided. Over the six weeks ending April 22, the Fed’s assets have grown by the same amount as they did from September 2008 to March 2013. While this does raise some serious concerns, inflation is not high among them….

The Fed Goes to War: Part 2

In this note, we update our earlier comment on the first set of Fed actions that appeared on March 23 just as a slew of new ones arrived.

While most of the changes represent simple extensions of previous tools, the Fed also has introduced facilities that are going to involve it deeply in the allocation of credit to private nonfinancial firms. Choices of whom to fund are inherently political, and hence destined to be controversial. Engaging in such decisions will make it far more difficult for the Fed eventually to return to the standard of central bank independence that it has guarded for decades. We urge the Fed to limit its involvement in the allocation of credit to the private nonfinancial sector. And, should Congress deem it necessary, we encourage them to provide explicit authorization to the Treasury (along with the resources) to take on this crisis role.

Commentary

Money, Banking, and Financial Markets