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….

The Fed's New Strategy: More Discretion, Less Preemption

On August 27, marking the conclusion of the Fed’s first strategic review, the Federal Open Market Committee released an amended version of their fundamental policy guide—the Statement on Longer-Run Goals and Monetary Policy Strategy. The FOMC adopted a form of flexible average inflation targeting (FAIT). Partly because the new strategy largely confirms recent Fed behavior, the response in financial markets was minimal. Indeed, market-based long-run inflation expectations were virtually unchanged this week. Perhaps the only noticeable development was a modest steepening at the very long end of the yield curve.

In this post, we identify three key factors motivating the Fed review and highlight three principal shifts in the FOMC’s strategy. In addition, we identify several critical questions that the FOMC will need to answer as it seeks to implement the new policy framework. Specifically, the shift to FAIT implies a change in the Committee’s reaction function. How does this reformulated objective influence the FOMC’s systematic response to changes in economic growth, unemployment, inflation and financial conditions? Under FAIT, the effective inflation target over the coming years also now depends on past inflation experience. What is that relationship?

The Case for Strengthening Automatic Fiscal Stabilizers

For decades, monetary economists viewed central banks as the “last movers.” They were relatively nimble in their ability to adjust policy to stabilize the economy as signs of a slowdown arose. In contrast, discretionary fiscal policy is difficult to implement quickly. In addition, allowing for the possibility of a constantly changing fiscal stance adds to uncertainty and raises the risk that short-run politics, rather than effective use of public resources, will drive policy. So, the ideal fiscal approach was to set policy to support long-run priorities, minimizing short-run discretionary changes that can reduce economic efficiency.

Today, because conventional monetary policy has little room to ease, the case for using fiscal policy as a cyclical stabilizer is far stronger. Unless something changes, there is a good chance that when the next recession hits, monetary policymakers will once again find themselves stuck for an extended period at the lower bound for policy rates. In the absence of a monetary policy offset, fiscal policy is likely to be significantly more effective.

Against this background, a new book from The Hamilton Project and the Washington Center for Equitable Growth, Recession Ready: Fiscal Policies to Stabilize the American Economy, makes a compelling case for strengthening automatic fiscal stabilizers. These are the tax, transfer and spending components that change with economic conditions, as the law prescribes….

Negative Nominal Interest Rates and Banking

The financial crisis of 2007-2009 taught us many lessons about monetary policy. Most importantly, we learned that when financial systems are impaired, central banks can backstop both illiquid institutions and illiquid markets. Actively lending to solvent intermediaries against a broad range of collateral, purchasing assets other than those issued by sovereigns, and expanding their balance sheets can limit disruptions to the real economy while preserving price stability.

We also learned that nominal interest rates can be negative, at least somewhat. But in reducing interest rates below zero―as has happened in Denmark, Hungary, Japan, Sweden, Switzerland and the Euro Area―policymakers face concerns about whether their actions will have the desired expansionary effect (see here). At positive interest rates, when central bankers ease, they influence the real economy in part by expanding banks’ willingness and ability to lend. Does this bank lending channel work as well when interest rates are negative?

Why should there be any sort of asymmetry at zero? Banks run a spread business: they care about the difference between the interest rate they charge on their loans and the one they pay on their deposits, not the level of rates per se. In practice, however, zero matters because banks are loathe to lower their deposit rates below zero….

Inflation Policy

Inflation in the United States remains at levels that most people don’t really notice. Overall, the consumer price index rose 2.8 percent from May 2017 to May 2018. And, when you look at core measures, the trend is still below 2 percent.

With inflation and inflation expectations still so benign, it is no wonder that despite solid economic growth and the lowest unemployment rate in 50 years the Federal Open Market Committee continues to act quite gradually (see their June 2018 statement). Inflation could well turn up in the near term—perhaps by more than the policymakers expect. But, for reasons that we will explain, if we were on the FOMC, we would stay the planned course: remain vigilant, but certainly not panic.

We start with a look at the data. What we see is that trend inflation has stayed reasonably close to the Fed’s medium-term target of 2 percent for the past two decades. There have been occasional deviations, like the temporary rise in 2008 and again in 2011, but overall, the path is remarkably stable….

Banks and Money, Or Watch out What You Wish For

On 10 June 2008, a large majority of voters in Switzerland rejected a proposal that all commercial bank demand deposits be held at the central bank. This Vollgeld referendum was another incarnation of the justifiable public revulsion to financial crises and the bailouts that inevitably accompany them. Vollgeld proponents claimed that a system in which the central bank is the sole issuer of “money” will be more stable.

Serious people debated the wisdom of this proposal. One of Switzerland’s premier monetary economists, Philippe Bacchetta, wrote passionately in opposition. Martin Wolf, chief economics commentator at the Financial Times, argued in favor. And Swiss National Bank Chairman Thomas Jordan discussed the many dangers in detail.

It should come as no surprise that, had we had been among the Swiss voters, we would have voted “no.” In our view, the Vollgeld (sovereign money) initiative combined aspects of narrow banking with those of retail central bank digital currency. We see these as misguided, distorting the credit allocation mechanism and more likely to reduce than improve financial stability (see here and here). In the remainder of this post, we explain why….

A Monetary Policy Framework for the Next Recession

Hope for the best, but prepare for the worst. That could be the motto of any risk manager. In the case of a central banker, the job of ensuring low, stable inflation and high, stable growth requires constant contingency planning.

With the global economy humming along, monetary policymakers are on track to normalize policy. While that process is hardly free of risk, their bigger test will be how to address the next cyclical downturn whenever it arrives. Will policymakers have the tools needed to stabilize prices and ensure steady expansion? Because the equilibrium level of interest rates is substantially lower, the scope for conventional interest rate cuts is smaller. As a result, the challenge is bigger than it was in the past.

This post describes the problem and highlights a number of possible solutions.

The case for a higher inflation target gets stronger

For several years, economists and policymakers have been debating the wisdom of raising the inflation target. Today, roughly two-thirds of global GDP is produced in countries that are either de jure or de facto inflation targeters (see our earlier post). In most advanced economies, the target is (close to) 2 percent. Is 2 percent enough?

Advocates of raising the target believe that central banks need greater headroom to use conventional interest rate policy in battling business cycle downturns. More specifically, the case for a higher target is based on a desire to reduce the frequency and duration of zero-policy-rate episodes, avoiding the now well-known problems with unconventional policies (including balance sheet expansions that may prove difficult to reverse) and the limited scope for reducing policy rates below zero.

We have been reticent to endorse a higher inflation target. In our view, the most important counterargument is the enormous investment that central banks have made in making the 2-percent inflation target credible. Yet, several lines of empirical research recently have combined to boost the case for raising the target….

How Low Can They Go?

Not long ago, nearly everyone thought that nominal interest rates could not go below zero. Now, we have negative policy rates in the euro area and Japan, while in Sweden and Switzerland, the lowest controlled rate is below -1%. And government securities worth trillions of dollars bear negative rates, too.

When we first wrote about negative rates a year ago, we argued that the effective lower bound (ELB, rather than ZLB) for nominal rates was determined by the transactions costs of storing and transferring cash. We reasoned that the ELB might be in the range of -0.50% (minus one-half percent). Below that, we thought, there would be a move into cash, facilitated by banks and others who efficiently manage the notes for clients.

But, at the negative rates that we have seen so far, cash in circulation has not spiked. So, how much further can nominal interest rates fall? And what role should negative interest rates play in the future?

Commentary

Money, Banking, and Financial Markets